Speeches
Banking Regulatory Powers Should Be Ownership Neutral
Dr. Patel highlighted some fundamental fissures that
exist in the regulation of banks in India, in
particular, public sector banks (PSBs). The RBI has
made substantial progress in strengthening banking
supervision as stated in the FSSA (Financial System
Stability Assessment) report. A key achievement was
the introduction of risk-based supervision through a
comprehensive and forward-looking Supervisory
Program for Assessment of Risk and Capital
(SPARC).The Basel III framework and other
international guidance have been implemented or
are being phased in, including stricter regulations on
large exposures. In April 2017, the RBI established a
new Enforcement Department and revised its
prompt corrective action framework to incorporate
more prudent risk-tolerance thresholds.
The Financial Sector Assessment Programme (FSAP)
for India laments at several points the fact that the
RBI's regulatory powers over banks are not neutral to
bank ownership. Its legal powers to supervise and
regulate PSBs are constrained as it cannot remove
PSB directors or management, who are appointed by
the Government of India (GoI), nor can it force a
merger or trigger the liquidation of a PSB.It has
limited legal authority to hold PSB Boards
accountable regarding strategic direction, risk
profiles, assessment of management, and
Monthly Newsletter May 2018
compensation. Legal reforms are thus highly
desirable to empower the RBI to fully exercise the
same responsibilities for PSBs as now apply to
private banks, and to ensure a level playing field in
supervisory enforcement. This legislative reality has
in effect led to a deep fissure in the landscape of
banking regulatory terrain and is bound to lead to
tremors such as the most recent fraud.
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Urjit R. Patel, Governor, Reserve Bank of India - March 14, 2018 - Inaugural Lecture: Centre for
Law & Economics, Centre for Banking & Financial Laws Gujarat National Law University, Gandhinagar
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The temptation to engage in fraud at the employee
or employees' level necessitates powerful
mechanisms to induce discipline against frauds.
Criminal investigation of frauds and attached
penalties which are adequately severe relative to the
gains from fraudulent activity can serve as an
effective deterrence. Management and board
members need to put in place governance
mechanisms to prevent or reduce the incidence of
fraud and/or hold larger buffers in the capital
structure to bear losses when fraud materializes.
Detection and punishment by the regulator needs to
be effective to discipline fraud.
In case of private sector banks, the real deterrence
arises from market and regulatory discipline, and
their confluence. They could be readily cautioned
through their Boards and even replaced by the RBI
in case of large or persistent irregularities. Further, a
private bank failing to meet bank solvency standards
and under RBI's prompt corrective action (PCA)
would find it hard to raise capital. In contrast, the
market discipline mechanism for PSBs is weaker
compared to that at private banks. There is implicitly
a stronger perceived sovereign guarantee for all
creditors of PSBs, and the principal shareholder, the
government has not fundamentally modified the
ownership structure so far. This weakened market
discipline implies that the government would prefer
stronger regulatory discipline of these banks, not
weaker.
The Banking Regulation (BR) Act exemptions for
PSBs mean that the one agency, the regulatory that
can respond relatively quickly against banking
frauds or irregularities cannot take effective action.
From the RBI's standpoint, legislative changes to the

BR Act that make banking regulatory powers fully
ownership neutral is a minimum requirement. In the
specific case at hand, the RBI had identified, based
on cyber risk considerations, the source of
operational hazard, and had issued precise
instructions through circulars to enable banks to
eliminate the hazard. However, it turned out ex post
the bank had simply not done so.
Another issue of greater magnitude than the most
recent banking fraud, is the bigger issue of stressed
assets on bank balance-sheets and its significance
stems from several practices in promoter-bank credit
relationship that need immediate attention. Rather
than resolving stressed credit problems swiftly, banks
either through loan-level fudges or refusal to
recognize the true asset quality of the credits have
allowed promoters in charge of enterprises to have a
soft landing. This soft landing has comprised of
even more bank lending so as to keep the accounts
artificially in full repayment on past dues, protracted
control for promoters over failed assets, and
effectively granting them the ability to divert cash
and assets, often outside RBI's jurisdictional reach.
The RBI has released a revised framework for prompt
recognition and resolution of stressed assets. The
steady-state approach is aimed at ensuring early
resolution of stressed assets in a transparent and
time-bound manner so that maximum value could
be realized by the lenders while also recognizing the
potential ongoing concern value of stressed assets.
The BR (Amendment) Act, 2017, and the subsequent
authorization given by the GoI therein, has
empowered the RBI to issue directions to the banks
for resolution of stressed assets, including referring
assets to the Insolvency and Bankruptcy Code 2016
(IBC). The revised framework substitutes for pre-IBC
schemes and does away with forbearance since it
delayed resolution. The framework relies instead on
Speeches
the biggest structural reform in the credit system in
the country in several decades, viz., the IBC, as an
important part of resolution. Also, the revised
framework would allow lenders absolute flexibility
to put in place any credible resolution plan, subject
to meeting certain implementation conditions.
In case of accounts with aggregate exposure greater
than `2,000 crores, the resolution plan would be
required to be implemented within 180 days from
the date of default, failing which these would be
referred under the IBC. The IBC along with RBI's
revised framework will help break the promoter-
bank nexus which has led to crony capitalism and
attendant NPA/credit misallocation problem,
thereby preventing the erosion of growth from the
emergence of zombie firms and sectors. The revised
framework specifically excludes the revival and
rehabilitation of Micro, Small and Medium
Enterprises (MSMEs) with exposures of up to `25
crore, which shall continue to be covered under the
earlier norms.
Lastly, the owner of public sector banks, the
government which has provided the IBC, the related
ordinances and the bank recapitalisation package,
might consider making further contributions by
making banking regulatory powers neutral to bank
ownership and leveling the playing field between
public sector and private sector banks, and
informing about what do with the public sector
banking system going forward as part of optimizing Monthly Newsletter May 2018
over the best use of scarce national fiscal resources.It
is an open issue whether centralized government
control alone can be effective enough at designing
and implementing governance of banking franchise
comprising over two-third of the sector's deposits
and assets. It would be better instead to restore
regulatory and market discipline.
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Source: www.rbi.org
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 Speeches
It is not Business as Usual for Lenders and Borrowers
In his speech, Mr. Vishwanathan spoke on the
resolution of stressed assets and the recent steps
taken by the Reserve Bank (RBI) for resolution of
stressed assets, including the new framework
articulated in the February 12, 2018 circular.
There has been a steady growth in stressed assets since
2011 and more particularly after 2015-16. In
February 2014, as a part of the framework for
resolution of stressed assets, Central Repository of
Information on Large Credits (CRILC) was set up
and it captured all exposures of banks above `50
million. The asset quality review (AQR), backed by
CRILC, enabled a holistic assessment of the true
state of health of those exposures, and led to
identification of NPAs that had not been recognized
as such by the banks and also of accounts that were
required to be downgraded over various timelines, if
necessary closures such as resolution or account
upgrade were not achieved. The resulting
recognition of true asset quality at banks largely
explains the spurt in NPAs in the recent years.
The Insolvency and Bankruptcy Code, 2016 (IBC), a
comprehensive bankruptcy code, was enacted and
notified. The code envisages timely resolution of
borrower defaults through collective decision
making by the creditors. The amendments to the
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Banking Regulation Act, 1949 empowering RBI to
direct banks to refer specific cases of default for
resolution under IBC was an indication that an
external nudge was required for banks to file
insolvency application against large borrowers. As a
result, RBI constituted an Internal Advisory
Committee (IAC) in 2017 to determine cases to be
referred under IBC. However, the IAC opined that
RBI should evolve a steady-state framework for filing
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insolvency applications in future, rather than
Mr. N. S. Vishwanathan, April 18, 2018, NIBM, Pune
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identify cases itself periodically.
The recommendations of the IAC were considered
for the following reasons. Firstly, the IBC is a
comprehensive and time-bound framework for
dealing with corporate stress. Secondly, a clear
articulation of policy in this regard would bring
certainty to all the stakeholders. Thirdly, a steady-
state framework for reference under IBC was the
logical outcome of the amendments to the BR Act.
Finally, the IAC recommendation was in
consonance with RBI's preference all along for an
efficient legal framework for insolvency and
bankruptcy over regulatorily mandated schemes. As
a result, the new framework for resolution of stressed
assets was outlined in the RBI's circular of February
12, 2018. The revised framework is outcome-
oriented and provides considerable flexibility to
banks to determine the process as well as the
contours of the restructuring plan. It tries to reduce
the arbitrage of the borrowers while raising funds
through borrowing from banks vis-à-vis raising
funds from the capital markets. It also aims to
restore the sanctity of the debt contract, especially in
case of large borrowings.
The framework requires banks to report even one
day default and also mandatorily report defaults on
a weekly basis, with the idea to nudge lenders and
borrowers to take timely corrective action to avoid
deterioration in the asset quality and improve credit
discipline. It requires lenders to put in place a
resolution plan within 180 days of default. Under
the revised framework, resolution plans can be
implemented individually or jointly by lenders.
However, if at the end of the 180 days of first default,
the borrower is in default to a bank, that bank is
mandated to refer the case under IBC. The

credibility of the resolution plan is sought to be
ensured through the requirement of independent
credit evaluation by credit rating agencies. The
revised framework requires grant of additional credit
facilities to a firm in financial difficulty to be treated
as a case of restructuring and list out the criteria for
determining whether or not the borrower is in
financial difficulty.
In order to avoid slippages, the repayment schedules
of loans should take into account idiosyncratic risks
and accordingly be customized to suit the cash flow
pattern of the borrowers. There must be adequate
buffers (debt service reserve accounts) to tide over
temporary cash flow volatility. The present problem
is that banks allow excessively high leverage thus
leaving out any possibility that the borrower can be
made to deal with emergencies. However, the
framework for restructuring has been consciously
made non-applicable to the Micro, Small and
Medium Enterprises (MSMEs) with borrowings of
`250 million and less.
There is also an equity perspective to the revised
framework. The proportion of stressed assets in the
larger advances is higher than the share of larger
advances in the total advances. If the stress in larger
advances is not handled in a manner such that both
probability of default and loss given default are
contained, the resultant low risk-adjusted return on
Speeches
bank assets may have to be compensated in the form
of higher borrowing rates for the smaller borrowers.
Alternatively, it may mean a low return on bank
equity, which may have externalities through the
fiscal channel given the principal shareholder of
many stressed banks is the government. Secondly,
smaller firms and new entrants get unfairly
competed out when large borrowers are routinely
able to obtain soft landing even upon defaults and
under-performance. The revised framework seeks to
inculcate such behaviour in both lenders and
borrowers so as to create a credit culture that is
conducive to a safe and sound banking system, and a
vibrant business environment.
In summary, the revised framework brings the
regulatory framework for stressed assets on par with
international norms shorn of all for bearances. This
has been made possible as the IBC provides a time-
bound legal framework for dealing with debt
resolution if the lenders cannot sew up a resolution
quickly. The framework undoes many intrusive
regulations by specifying outcomes rather than
processes. Finally, the framework seeks a
fundamental change, for the better, in behaviour of
lenders and borrowers, as it can't be business as
usual.
Source: www.rbi.org
Monthly Newsletter May 2018
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