is heightened competition with the introduction of new generation private sector banks. in january 2001, revised guidelines were issued for entry of new banks in the private sector. despite the preponderant share of domestic banks in banking activity in india, foreign banks have been a source of competition, at least potentially, given their use of sophisticated technology, risk monitoring analysis and exposure management. in recent years, the policy thrust has been to level the playing field for domestic and foreign banks. for example, foreign banks that were earlier allowed to operate only branches but not subsidiaries, are now free to choose to set up either branches or subsidiaries under common banking regulations including lending norms. appropriate legislative changes are also under consideration of the government. foreign direct investment up to 49 per cent has been allowed in private sector banks and up to 20 per cent in nationalised banks. guidelines have been issued for the entry of banks into insurance business either as joint venture participants or to take up strategic investment for providing infrastructure and services support without any contingent liability. vi. issues in supervision and regulation recent international financial developments have underscored the critical role of the regulatory and supervisory function in ensuring the health and stability of the financial system. there is now a worldwide debate on how to strengthen financial regulation even further, including proactively, to contend with the dangers posed by creative accounting practices, even as the depressed state of economic activity exerts conflicting pulls on the extent of supervisory rigour. at the same time, the impact of technological advancement, financial liberalisation and the degree of integration between domestic and international financial markets has rendered the conduct of oversight of the financial system a highly complex task. regulatory and supervisory authorities need to be regarded as providing a range of services to the community. this includes the establishment of specific rules of behaviour for participants in the financial system, monitoring the observance of the rules, and general supervision of the behaviour of financial entities. unlike other services, however, these are not supplied through market processes but laid down by the regulator after necessary consultations. the primary need for regulation arises from the fact that consumers of financial services are not in a position to evaluate the soundness and safety of financial entities since even the most stringent laws regarding enforceability of contracts cannot protect for post - contract - signing behaviour. therefore, the rationale for financial regulation lies in the economic costs imposed on society by the external effects of financial market failure which can threaten systemic stability. there is also a potential for gridlocks in the financial system

rate with reference to a benchmark will make loan pricing fair, transparent and contestable. in the event, the bplr system failed to fulfil these objectives. 26. under the bplr system, banks were allowed to lend at rates below the bplr, but such lending was expected to be at the margin. however, in actual practice, banks started doing the bulk of their business below the bplr. in 2009, as much as 65 per cent of the advances were made at sub - bplr rates ; for private sector banks, the proportion was as high as 83 per cent. the lack of transparency in the system encouraged some perverse crosssubsidization. loans to priority sectors such as agriculture and sme sectors were overpriced so as to lend below the bplr to presumably preferred customers such as large corporates. the lack of transparency in the operation of the bplr also made it difficult to assess the effectiveness of monetary transmission from the policy rate of the reserve bank to lending rates by banks. 27. in order to correct the situation, the reserve bank appointed a committee under the chairmanship of deepak mohanty, executive director. as per the recommendations of the committee, the bplr system was replaced by a base rate system effective july 1, 2010. 28. under the new system, each bank is mandated to determine a base rate of interest to include those cost elements which can be clearly identified and are common across all borrowers – cost of deposits, cost of maintaining the statutory liquidity ratio and cash reserve ratio, cost of operations, and the profit margin. banks are allowed to determine the actual lending rate they charge on loans and advances by topping up the base rate with other customer specific charges such as product specific operating costs, credit risk premium and tenor premium. since the base rate is the minimum rate for all loans, banks are not permitted to do any lending below the base rate, save for specified exceptions such as dri advances, loans to banks ’ own employees, loans to banks ’ depositors against their own deposits and loans where borrowers enjoy subvention. as banks, in general, are not allowed to lend below the base rate, the stipulation of bplr as the ceiling rate for loans up to ₹200, 000 was rescinded in the expectation that with the freedom to determine the interest rate, banks will be encouraged to actively step into this large volume - low value business segment. 29. the base rate system is