Banking Sector Reforms

BANKING SECTOR REFORMS
Need for Reforms

The Indian financial system of the pre-reform period essentially catered to the
needs of planned development in a mixed-economy framework where the
Government sector had a predominant role in economic activity. As part of
planned development, the macroeconomic policy in India moved from fiscal
neutrality to fiscal activism (Reddy 2000). Such activism meant large
developmental expenditures, much of it to finance long-gestation projects
requiring long-term finance. The sovereign was also expected to raise funds
at fine rates, and understandably at below the market rates for private sector.
In order to facilitate the large borrowing requirements of the Government,
interest rates on government securities were artificially pegged at low levels,
which were unrelated to market conditions. The government securities
market, as a result, lost its depth as the concessional rates of interest and
maturity period of securities essentially reflected the needs of the issuer
(Government) rather than the perception of the market. The provision of
fiscal accommodation through ad hoc treasury bills (issued on tap at 4.6 per
cent) led to high levels of monetization of fiscal deficit during the major part
of the eighties. In order to check the monetary effects of such large-scale
monetization, the cash reserve ratio (CRR) was increased frequently to
control liquidity.
The environment in the financial sector in these years was thus characterized
by segmented and underdeveloped financial markets coupled with paucity of
instruments. The existence of a complex structure of interest rates arising
from economic and social concerns of providing concessional credit to
certain sectors resulted in "cross subsidization" which implied that higher
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rates were charged from non-concessional borrowers. The regulation of

lending rates, led to regulation of deposit rates to keep cost of funds to banks
at reasonable levels, so that the spread between cost of funds and return on
funds is maintained. The system of administered interest rates was
characterised by detailed prescription on the lending and the deposit side
leading to multiplicity and complexity of interest rates.
By the end of the eighties, the financial system was considerably stretched.
The directed and concessional availability of bank credit with respect to
certain sectors resulted not only in distorting the interest rate mechanism, but
also adversely affected the viability and profitability of banks. The lack of
recognition of the importance of transparency, accountability and prudential
norms in the operations of the banking system led also to a rising burden of
non-performing assets.
In sum, there was a de facto joint family balance sheet of Government, the
Reserve Bank and commercial banks, with transactions between the three
segments being governed by plan priorities rather than sound principles of
financing inter-institutional transactions (Reddy, November 2000). There was
a widespread feeling that this joint family approach, which sought to enhance
efficiency through co-ordinated approach, actually led to loss of
transparency, of accountability and of incentive to measure or seek
efficiency.
The policies pursued did have many benefits, although the issue of the higher
costs incurred to realize the laudable objectives remains. Thus, the post-
nationalization phase witnessed significant branch expansion to mobilize
savings and there was a visible increase in the flow of bank credit to
important sectors like agriculture, small-scale industries, and exports.
However, these achievements have to be viewed against the macroeconomic
imbalances as well as gross inefficiencies at the micro level in the financial
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sector compounded by non-transparent accounting of intra-public sector

financial transactions.
Institutional Aspects of Reforms
At present, the institutional structure of the financial system is characterized

by (a) banks, either owned by the Government, the Reserve Bank or private
sector (domestic or foreign) and regulated by the Reserve Bank; (b)
development financial institutions and refinancing institutions, set up either
by a separate statute or under Companies Act, either owned by Government,
the Reserve Bank, private or other development financial institutions and
regulated by the Reserve Bank and (c) non-bank financial companies
(NBFCs), owned privately and regulated by the Reserve Bank.
Since the onset of reforms, there has been a change in the ownership pattern
of banks. The legislative framework governing public sector banks (PSBs)
was amended in 1994 to enable them to raise capital funds from the market
by way of public issue of shares. Many public sector banks have accessed the
markets since then to meet the increasing capital requirements, and until
2001-02, Government made capital injections out of the Budget to public
sector banks, totaling about 2 per cent of GDP. The Government has initiated
legislative process to reduce the minimum Government ownership in
nationalized banks from 51 to 33 per cent, without altering their public sector
character. The underlying rationale of the proposal appears to be that the
salutary features of public sector banking is not lost in the transformation
process.
Reforms have altered the organizational forms, ownership pattern and domain
of operations of financial institutions (FIs) on both the asset and liability
fronts. Drying up of low cost funds has led to an intensification of the
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competition for resources for both banks and FIs. At the same time, with
banks entering the domain of term lending and FIs making a foray into
disbursing short-term loans, the competition for supply of funds has also
increased. Besides, FIs have also entered into various fee-based services like
stock-broking, merchant banking, advisory services and the like. Currently,
while Industrial Credit and Investment Corporation of India Ltd. (ICICI) is in
the process of finalizing its merger with ICICI Bank, Industrial Development
Bank of India (IDBI) is also expected to be corporatised soon. At present, the
Reserve Bank holds shares in a number of institutions. The further reform
agenda is to divest the Reserve Bank of all its ownership functions.
In the light of legal amendments in 1997, the regulatory focus of the NBFCs
was redefined, both in terms of thrust as well as the focus. While NBFCs
accepting public deposits have been subject to the entire gamut of
regulations, those not accepting public deposits have been sought to be
regulated in a limited manner. In order to consolidate the law relating to the
NBFCs, regulation is being framed to cover detailed norms with regard to
entry point and the regulatory and supervisory issues.
Competition
Steps have also been initiated to infuse competition into the financial system.
The Reserve Bank issued guidelines in 1993 in respect of establishment of
new banks in the private sector. Likewise, foreign banks have been given
more liberal entry. Recently, the norms for entry of new private banks were
rationalized. Two new private sector banks have been given ‘in-principle’
approval under these revised guidelines. The Union Budget 2002-03 has also
provided a fillip to the foreign banking segment, permitted these banks,
depending on their size, strategies and objectives, to choose to operate either
as branches of their overseas parent, or, corporatise as domestic companies.
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This is expected to impart greater flexibility in their operations and provide

them with a level-playing field vis-à-vis their domestic counterparts.
As a group, however, the performance of PSBs in terms of profitability,

spreads, non-performing assets and standard assets position seems to have
been lower than that of the new private sector and foreign banks. There have
been significant divergences in performance among the public sector banks
-some have performed on par with private and foreign banks, whereas the
performance of others has been relatively unsatisfactory. Hence, although
PSBs have been subject to Government intervention, these do not appear to
provide a complete explanation of bank performance. Bank specific factors
such as rapid expansion, higher operating costs and differential industry focus
seem to have been important considerations as well. Public sector banks
operating in the same environment with the same constraints have shown
varied performance; ultimately this reflects the performance of management.
Regulation and Supervision
A second major element of financial sector reforms in India has been a set of
prudential measures aimed at imparting strength to the banking system as
well as ensuring safety and soundness through greater transparency,
accountability and public credibility.
Capital adequacy norms for banks are in line with the Basel Committee
standards and from the end of March 2000, the prescribed ratio has been
raised to 9 per cent. While the objective has been to meet the international
standards, in certain cases, fine-tuning has occurred keeping in view the
unique country-specific circumstances. For instance, risk weights have been
prescribed for investment in Central Government securities on considerations
of interest rate risk. Also, while there is a degree of gradualism, there is
intensification beyond the ‘best practices’ in several instances in recent
period, an example being exposure norms stipulated for the banking sector in
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respect of investment in equity. Investments are valued and classified into

appropriate categories, as per international best practices. To take into
account the vagaries of interest rate risks, a prescription for meeting a
targeted Investment Fluctuation Reserve out of the realised profits from sale
of investments within a stipulated time frame has also been prescribed
recently. The supervisory strategy of the Board for Financial Supervision
(BFS) constituted as part of reform consists of a four-pronged approach,
including restructuring system of inspection, setting up of off-site
surveillance, enhancing the role of external auditors, and strengthening
corporate governance, internal controls and audit procedures. The BFS, in
effect, integrates within the Reserve Bank the supervision of banks, NBFCs
and financial institutions.
Prudential regulations have had a significant impact on the banking system in

terms of ensuring system stability even in the face of both external and
internal uncertainties, almost throughout during the second half of the
nineties. As at end-March 2001, 95 out of 100 scheduled commercial banks
had capital adequacy ratio of 9 per cent or more. There was a distinct
improvement in the profitability of public sector banks measured in terms of
operating profits as well as in terms of net profits to total assets. Reflecting
the efficiency of the intermediation process, there has been a decline in the
spread between the borrowing and lending rates as reflected by the decline in
the ratio of net interest income to total assets. The most significant
improvement has been in terms of reduction in NPAs.
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Policy Environment
Changing Monetary Policy Framework
Since the onset of the reforms process, monetary management in terms of

framework and instruments has undergone significant changes, reflecting
broadly the transition of the economy from a regulated to liberalized and
deregulated regime. While the twin objectives of monetary policy of
maintaining price stability and ensuring availability of adequate credit to
productive sectors of the economy to support growth have remained
unchanged; the relative emphasis on either of these objectives has varied over
the year depending on the circumstances. Reflecting the development of
financial markets and the opening up of the economy, the use of broad money
as an intermediate target has been de-emphasized, but the growth in broad
money (M3) continues to be used as an important indicator of monetary
policy. The composition of reserve money has also changed with net foreign
exchange assets currently accounting for nearly one-half. A multiple indicator
approach was adopted in 1998-99, wherein interest rates or rates of return in
different markets (money, capital and government securities markets) along
with such data as on currency, credit extended by banks and financial
institutions, fiscal position, trade, capital flows, inflation rate, exchange rate,
refinancing and transactions in foreign exchange available on high frequency
basis were juxtaposed with output data for drawing policy perspectives. Such
a shift was gradual and a logical outcome of measures taken over the reform
period since early nineties.
The thrust of monetary policy in recent years has been to develop an array of
instruments to transmit liquidity and interest rate signals in the short-term in a
more flexible and bi-directional manner. A Liquidity Adjustment Facility
(LAF) has been introduced since June 2000 to precisely modulate short-term
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liquidity and signal short-term interest rates. The LAF, in essence, operates
through repo and reverse repo auctions thereby setting a corridor for the
short-term interest rate consistent with policy objectives. There is now greater
reliance on indirect instruments of monetary policy. The Reserve Bank is able
to modulate the large market borrowing programme by combining strategic
debt management with active open market operations. Bank Rate has
emerged as a reasonable signal rate while the LAF rate has emerged as both a
tool for liquidity management and signaling of interest rates in the overnight
market. The Reserve Bank has also been able to use open market operations
effectively to manage the impact of capital flows in view of the stock of
marketable government securities at its disposal and development of financial
markets brought about as part of reform.
The responsibility of the Reserve Bank in undertaking reform in the financial

markets has been driven mainly by the need to improve the effectiveness of
the transmission channel of monetary policy. The developments of financial
markets have therefore, encompassed regulatory and legal changes, building
up of institutional infrastructure, constant fine-tuning in market
microstructure and massive upgradation of technological infrastructure.
Since the onset of reforms, a major focus of architectural policy efforts has
been on the principal components of the organised financial market spectrum:
the money market, which is central to monetary policy, the credit market,
which is essential for flow of resources to the productive sectors of the
economy, the capital market, or the market for long-term capital funds, the
government securities market which is significant from the point of view of
developing a risk-free credible yield curve and the foreign exchange market,
which is integral to external sector management. Along with the steps taken
to improve the functioning of these markets, there has been a concomitant
strengthening of the regulatory framework.
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The medium-term objective at present is to make the call and term money
market purely inter-bank market for banks, while non-bank participants, who
are not subject to reserve requirements, can have free access to other money
market instruments and operate through repos in a variety of instruments. The
Clearing Corporation of India Ltd. is expected to facilitate the development
of a repo market in a risk free environment for settlement. A phased
programme for moving out of the call money market has already been
announced and the final phase-out will coincide with the implementation of
the Real Time Gross Settlement (RTGS) system. Further reform is being
contemplated in terms of reduction of CRR to the statutory minimum of 3 per
cent, removal of established lines of refinance, limits on call money lending
and borrowing by banks and PDs and a move over to a full-fledged LAF.
With the switchover to borrowings by Government at market related interest

rates through auction system in 1992, and more recently, abolition of system
of automatic monetisation, it was possible to progress towards greater market
orientation in government securities. Further reforms in the government
securities market have resulted in the rationalisation of T-Bills market,
increase in instruments and participants, elongated the maturity profile,
created greater fungibility in the secondary market, instituted a system of
delivery versus payment, strengthened the institutional framework through
Primary Dealers and more recently Clearing Corporation, and enhanced the
transparency in market operations. Clarity in the regulatory framework has
also been established with the amendment to the Securities Contracts
Regulation Act. A Negotiated Dealing System for trading in government
securities is in operation. Further developments in the government securities
market hinges on legislative changes consistent with modern technology and
market practices; introduction of a RTGS system, integrating the payments
and settlement systems for government securities and standardization of
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practices with regard to manner of quotes, conclusion of deals and code of

best practices for repo transactions.
The movement to a market-based exchange rate regime took place in 1993.

Reforms in the foreign exchange market have focused on market
development with prudential safeguards without destabilizing the market.
Thus, authorized dealers have been given the freedom to initiate trading
position in the overseas markets; borrow or invest funds in the overseas
markets (up to 15 per cent of tier I capital, unless otherwise approved);
determine the interest rates (subject to a ceiling) and maturity period of
Foreign Currency Non-Resident (FCNR) deposits (not exceeding three
years); and use derivative products for asset-liability management. These
activities are subject to net overnight position limit and gap limits, to be fixed
by them. Other measures such as permitting forward cover for some
participants and the development of the rupee-forex swap markets also have
provided additional instruments to hedge risks and help reduce exchange rate
volatility. Alongside the introduction of new instruments (cross-currency
options, interest rates and currency swaps, caps/collars and forward rate
agreements), efforts were made to develop the forward market and ensure
orderly conditions. Foreign institutional investors were allowed entry into
forward markets and exporters have been permitted to retain a progressively
increasing proportion of their earnings in foreign currency accounts. The
Reserve Bank conducts purchase and sale operations in the forex market to
even out excess volatility.
In respect of the financial markets, linkage between the money, government

securities and forex markets has been established and is growing. The price
discovery in the primary market is more credible than before and secondary
markets have acquired greater depth and liquidity. The number of instruments
and participants in the markets has increased in all markets, the most
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impressive being the government securities market. The institutional and

technological infrastructures that have been created by the Reserve Bank to
enable transparency in operations and secured settlement systems. The
presence of foreign institutional investors has strengthened the integration
between the domestic and international capital markets.
Credit Delivery
The reforms have accorded greater flexibility to banks to determine both the
volume and terms of lending. The Reserve Bank has moved away from micro
regulation of credit to macro management. External constraints to the
banking system in terms of the statutory preemptions have been lowered. All
this has meant greater lendable resources at the disposal of banks. The
movement towards competitive and deregulated interest rate regime on the
lending side has been completed with linking of all lending rates to PLR of
the concerned bank and the PLR itself has been transformed into a
benchmark rate.
As a result of reforms, borrowers are able to the get credit at lower interest
rates. The lending rate between 1991-92 and 2001-02 has declined from
about 19.0 per cent to current levels of 10.5-11.0 per cent. The actual lending
rates for top rated borrowers could even be lower since banks are permitted to
lend at below Prime Lending Rate (PLR). Further, since banks invest in
Commercial Paper (CP), which is more directly related to money market
rates, many top rated borrowers are able to tap bank funds at rates below the
prime lending rates. These developments have been possible to banks
because the overall flexibility now available in the interest rate structure has
enabled them to reduce their deposit rates and still improve their spreads.
In terms of priority sector credit also, the element of subsidization has been
removed although some sort of directed lending to Agriculture, Small Scale
Industry (SSI) and export sector have been retained. The definition of priority
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sector has been gradually increased to help banks make loans on

commercially viable terms. However, the actual experience has been that the
credit pick up is not up to the mark and has been generally less than projected
by the Reserve Bank in its monetary policies, in a number of years. Also,
while in general the rates of interest have come down, they are available more
to highly rated borrowers than to the small and medium enterprises. There is
considerable concern about the inadequate flow of resources to rural areas,
and in particular agriculture, while interest rates have not been reduced to the
extent they were, for the corporate sector.
Fiscal Policy and Financial Sector
There are several channels that link the fiscal and financial sectors and in the
Indian context four of them appear significant. These relate to
(a) Governments’ borrowing programme;
(b) Guarantees extended by governments;
(c) Mechanisms such as ‘direct debits’; and
(d) Governments’ investments in financial sector.
The market borrowing programme of the Central Government continued to

be relatively large, both in gross and net terms. Since a large part of the
borrowing programme has to be completed in the first half of the fiscal year,
in view of seasonality for demand for credit on private account, the monthly
average borrowing by centre is around three quarters of a per cent of GDP in
recent years. Further, there has been an upward revision in the borrowing
programme of Central Government during the course of every year, usually,
around three quarters of a per cent of GDP. It has been possible for the
Reserve Bank as debt manager to complete the borrowing programme while
pursuing its interest rate objectives without jeopardi sing external balance, by
recourse to several initiatives in terms of institution, instruments, incentives
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and tactics. At the same time, it has been able for the Reserve Bank to reduce
statutory preemptions in regard to banks to the prescribed minimum of 25 per
cent of their net liabilities. The banking system, in which PSBs account for
about three quarters of activity, holds majority of the outstanding stock of
government securities, and currently their holdings in excess of statutory
prescriptions are far in excess of the annual borrowing programme of the
Central and State Governments. In any case, a large part of outstanding
government securities are held by Government owned financial institutions,
especially in banking and insurance sectors. The Reserve Bank has so far
been able to successfully reconcile the interests of Government as its debt
manager and of banks as regulator and supervisor. In this regard, recognizing
the importance of containing interest rate risks and widening the participant
profile, the Reserve Bank has prescribed an Investment Fluctuation Reserve
for banks and is pursuing retailing of government securities. While
technological, institutional and procedural bottlenecks for retailing are being
overcome by the Reserve Bank, some of the constraints such as tax treatment
and relatively high administered interest rates do persist.
The conduct of borrowing programme of State Governments is, however,

posing several problems. While the market borrowing programme of states in
aggregate is well below a quarter of centre’s market borrowings, in a
liberalized environment, banks cannot be compelled to subscribe to the
programme. It was necessary to provide investors a premium for states’ paper
over the centre’s paper of a comparable maturity. Of late, the premium is
widening and differing as between states, while in the case of some states,
there have been some difficulties in ensuring subscriptions. In recent years,
the increases in states’ borrowing programme over the budgeted amounts
have been large with the attendant problems of garnering subscriptions. It
has, however, been possible for the Reserve Bank to conduct the programme
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without serious disruption in the markets, since some states have also begun
to take initiatives to improve their fiscal profile and discharge their liabilities,
especially to banks, in a timely fashion. It is necessary to recognize that size
of government borrowings is only one element in public debt management,
since there are other liabilities also, especially ballooning of pension
liabilities.
In this regard, extra budgetary transactions are also emerging, which impinge
on the balance sheets of banks and other financial institutions which take an
exposure on them. For example, "oil bonds" to settle Government’s dues to
public sector oil companies and "power bonds" to settle dues from State
Electricity Boards to national level power utilities fall in this category. Banks
exposure to food credit, which is in the nature of funding of buffer stock
operations is also relatively large at over 2.0 per cent of GDP. The Reserve
Bank had been advocating that a law be passed imposing a ceiling on
government borrowings as enabled by the Constitution, but more recently, a
Bill is under contemplation for fiscal responsibility at the centre and several
states.
Financial intermediaries, especially banks, take exposures with a great degree

of comfort when there is a sovereign guarantee. Such guarantees are often
formally extended and notified as such to the legislative bodies and financial
markets. The Reserve Bank has encouraged governments to pass a legislation
prescribing a ceiling on such guarantees and also charge a fee without
exception to ensure credibility to guarantees and comfort to subscribers.
Several State Governments have passed such legislations, though some are
less stringent than others. In view of the magnitudes of such guarantees by
many States, banks have been advised to exercise due diligence in
subscribing to them. Apart from explicit guarantees, recourse is occasionally
made by Governments to letters of comfort which have a similar effect, and
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the Reserve Bank has been dissuading such relatively non-transparent

practices.
There are, in addition, what may be termed as "implicit-guarantees" which

have maximum linkage between fiscal and financial sectors. A predominant
point of financial intermediation through banks, mutual funds, and insurance,
in spite of significant reform is undertaken by publicly owned or Government
backed financial institutions. Hence, public tend to repose confidence with a
corresponding implicit direct obligation on the part of government to protect
the interests of depositors or investors. Such a reasonable expectation is not
only justified on the considerations of reputational risk and the concept of
"holding out’ or backing, but also by the obligations discharged in the past by
the Government of India, in several cases; some of them at the instance of
regulator concerned.
In some cases, banks and financial institutions seek and obtain instructions
for direct debit of dues to them from government accounts to ensure the
timely recovery of dues to them and thus bring about comfort through credit
enhancement. Since large scale recourse to such mechanisms, especially
when State Governments are under fiscal strain has the potential of eroding
both the integrity of budget process and the de facto comfort to financial
intermediaries, the Reserve Bank has been vigorously advocating avoidance
of recourse to such direct debit mechanisms.
The Governments have, in its asset portfolio, equity holding and some debts
of financial intermediaries that they own, and financial returns on these do
impact the fiscal situation. More important, whenever pockets of
vulnerability arise in financial sector, the headroom available in the fiscal
situation to provide succour to financial entities needs to be assessed.
Fortunately, on present reckoning, the magnitudes of the few pockets of
vulnerability appear to be manageable without undue fiscal strain.
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In assessing fiscal financial linkage, the scope for money financing of

budgets vis-à-vis bond financing also needs to be considered. Since there are
elements of open capital account, the maneuverability for the Reserve Bank
in the short-term to monetize government’s deficit is severely circumscribed
by the direction and magnitudes of such flows. Keeping these considerations
in view, the Reserve Bank and Government have agreed upon freedom to the
Reserve Bank to determine the extent of monetization of government budget
consistent with macroeconomic stability.
Managing the Process of Reform

Financial Sector Reform and Changes in Law
Any reform has both public and private dimensions, and ideally all
participants should recognize the emerging new realities, assess costs and
benefits and make attempts to cope. Reform outcomes should thus, be related
not only to public action but also several other factors. In public action itself,
there can be legal, policy and procedural aspects including subordinate
legislations and institutional changes. There are possibilities of significant
policy and procedural changes within a given legal framework and these need
to be explored since changes in law are often difficult to get through in any
democratic process.
The Reserve Bank has been articulating the need for appropriate changes in
Law, assisting the Government in the process and has also been brining about
changes in the financial sector without necessarily waiting for changes in law.
Thus, several legislative measures affecting ownership of banks, IDBI, debt
recovery, regulation of non banking financial companies, foreign exchange
transactions and money market have been completed. Those on the anvil
include measures relating to fiscal and budget management, public debt,
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deposit insurance, securitization and foreclosure, and prevention of money

laundering. The agenda for further legal reform, as identified by several
Advisory Groups relate to the Reserve Bank, Banking Regulations,
Companies, Chartered Accountant, Income-tax, Bankruptcy, Negotiable
Instruments, Contracts, Unit Trust of India, etc.
The legislative process is complex in a democratic set up and it will be

inadvisable to rush into legislation through a "big bang" approach.
Furthermore, many elements of economic reform and underlying legislative
framework need to be harmonized. At the same time, it may not be necessary
to wait for legislative framework to change to bring about some of the
reforms or initiate processes to demonstrate usefulness of reform-orientation.
In fact, there are several examples of managing reform within constraints of
law which need to be recalled. For example, there are some enabling but not
mandated provisions which may or may not be used. Thus, the Reserve Bank
had shed its direct developmental role in the sense of money financing, by
ceasing to operate on relevant provision and by and large, and confining
money creation for Government of India only. Supplemental agreement to
terminate automatic monetization (WMA) of government’s deficit has been
used, by way of a signed agreement between the Reserve Bank and
Government of India, though a legislative compulsion in still under
consideration as part of Fiscal Responsibility and Management Bill.
In several cases, contracts with stipulated conditions have been framed in the
absence of specific law governing such transactions. Examples relate to
regulation of Clearing Houses; operating current payment systems and
functioning of electronic trading even before instructions under I.T. Act came
into force. Similarly, it has been possible to invoke prudential regulations
over the Reserve Bank regulated financial institutions to effectuate best
practices in financial markets, though the legal compulsion as a regulation on
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all market participants may not be possible; the example of successes

achieved are dematerialization of Commercial Paper and Dematerialization of
Debt instruments, brought about in the requirements on Banks and financial
institutions. There could also be use of incentives to conform though legal or
formal regulation may be difficult. Examples relate to valuation and
accounting norms being performed by a self regulatory organization and
adopted by banks and proposals relating to information sharing with Credit
Information Bureau pending legislative initiatives. A deliberate decision may
be taken not to use regulatory powers, thus enabling development of markets.
For example, current account convertibility in external sector was
implemented even before a new law was introduced by recourse to large scale
relaxations. Similarly, Credit Guarantee was virtually given up though a new
law is yet to be enacted giving up the credit-guarantee function of Deposit
Insurance Guarantee Corporation. In all these cases, however, a positive
approach to law to enable reform was possible because of clarity about what
was to be done and finding of legal ways of doing even if it were second best.
Managing Uncertainties during Reform
Reforms in the financial sector had to be implemented keeping in view not

only the desirable directions and appropriate measures carefully sequenced,
but also the emerging uncertainties, both in domestic and global arena. By all
accounts, India has managed the uncertainties reasonably well. Recognizing
that such uncertainties have a tendency to impact the exchange rate, it is
instructive to briefly review the processes of management and drawn some
tentative lessons. The Gulf crisis, which triggered the reform process, was
managed without any re schedulement of any contractual obligation, but with
recourse to stabilize measures and initiation of structural reforms. The current
account convertibility in 1994 led to liberalization of gold imports and large
capital inflows up to 1996. In 1997, the timely efforts to depreciate the
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currency warded off a possible crisis due to persistence of a relatively over

valued rupee in the forex markets. This also enabled the implementation of a
package of monetary and other prompt actions in resisting contagion effects
of Asian crisis in late 1997 and early 1998. The imposition of sanctions by
U.S. government and others consequent upon nuclear tests required
replacement of normal debt flows with a type of extra ordinary financing.
There was also an occasion, as in May-August 2000 where inexplicable

changes in expectations put pressure on the currency warranting yet another
package to counter the market sentiment. In contrast the events of September
11, 2001 needed measures to reassure the markets with timely liquidity and
stability in monetary measures. The reasonable success in managing these
uncertainties while adding to forex reserves with marginal addition to total
external debt but maintaining both reasonable overall macro-economic
stability and pace of reform in financial sector has some tentative lessons to
offer.
First, stable and appropriate policies governing overall management of the

external sector are important. As part of the reform process, a policy
framework was developed to gradually liberalize the external sector, move
towards total convertibility on current account, encourage non debt credit
inflows while containing all external debt especially short term debt in capital
account and make the exchange rate largely market determined. The policy
reform in the external sector, accompanied by other changes was guided by
the Report of High Level Committee on Balance of Payments, April 1993
(Chairman: Dr.C.Rangarajan).
Second, the impression that a closed economy is less vulnerable to crisis is

not borne out by facts. India was a closed economy on the eve of the Gulf
Crisis but the impact was severe. Though it is now a relatively more open
economy, it could without serious disruptions withstand several uncertainties.
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Third, as evident from experience, if the fundamentals are weak, the economy
is more vulnerable in the face of uncertainties.
Fourth, in all instances of serious uncertainties, the existence and

manifestation of harmonious relations between the Government and the
central bank become critical and appropriate coordination is extremely useful.
Fifth, while it is difficult to anticipate or assess the uncertainties, there may
be advantages in taking the risk of early action than late action. Sixth, while
in a rapidly changing world of uncertainties, commitment to ideology can
prove to be a drag on policy, especially in emerging countries, which are
attempting structural transformation, it has been demonstrated by events the
world over as well as by the Indian experience, that when the going is good,
Government is perceived to be a problem but when the going gets tough,
effective public policy may be the only solution. As such, the state has a
pivotal role in stabilizing the economy when there is a spell of stormy
weather.
Seventh, there may be need for several short-term actions to meet challenges
but this should not distort the medium term vision to proceed with economic
reform to improve standards of living. In other words, it is necessary for the
policy makers to be conscious and more importantly, essential for the policy
maker to convince market participants that some measures to meet the crisis
are short term, while some others may get embedded into the public policy in
the medium-term. Related to this approach and to reinforce this, there is
advantage in designing measures that are easily reversible, preferably with an
explicit indication that the measures are reversible even as they are being
announced, though a specific time frame may not be prescribed
Eighth, as regards the techniques and instruments of managing uncertainties,

they have to evolve keeping in view the reform process itself, especially
20
developments in financial markets, monetary policy, the nature, composition

and evolution of market participants and above all public opinion.
Ninth, it is necessary to have an appropriate mix of surprise elements and

anticipated elements in policy actions for meeting any uncertainties. As an
example, when the markets are in need of comfort or assurances, when the
convergence in the objectives of policy makers and the markets are matched,
and such convergence is observable in regard to instruments, there is merit in
taking the market into confidence and proceeding accordingly. Where there is
a perception that the market expectations and their possible actions in the
direction are not considered to be desirable by the policy makers, it is always
advantageous to bring an element of surprise preferably with firmness and
credibility so that all possible anticipatory actions as well as resistance are
avoided. There may be occasions when the wavelengths of markets or
segments thereof and policy maker differ significantly and in such
circumstances, the conduct of policy would presumably be more complex and
difficult.
Finally, the issue of transparency is extremely important. There are many

occasions where transparency is desirable but there are also occasions where
instant transparency is not entirely essential and could even be counter-
productive. An acceptable approach seem to be one that practices
transparency as a rule but the timing of transparency could vary depending on
the circumstances.
21
RBI and Government

During the early 1960s, Governor Iengar identified four areas of potential
conflict between the Bank and the Central Government. These were interest
rate policy, deficit financing, cooperative credit policies and management of
sub-standard banks. It may be of interest to note that these four areas are still
some of Reserve Bank’s concerns.
During the post-reform period, the relationship between the central bank and
the Government took a new turn through a welcome development in the
supplemental agreement between the Government and the Reserve Bank in
September 1994 on the abolition of the ad hoc treasury bills to be made
effective from April 1997. The measure eliminated the automatic
monetization of Government deficits and resulted in considerable moderation
of the monetized deficit in the latter half of the Nineties.
At the same time, with gradual opening up of the economy and development
of domestic financial markets, the operational framework of the Reserve
Bank also changed considerably with clearer articulation of policy goals and
more and more public dissemination of vast amount of data relating to its
operations.
In fact, during the recent period, the Reserve Bank enjoys considerable
instrument independence for attaining monetary policy objectives. Significant
achievements in financial reforms including strengthening of the banking
supervision capabilities of the Reserve Bank have enhanced its credibility and
instrument independence. It has been pointed out by some experts that the
Reserve Bank, though not formally independent, has enjoyed a high degree of
operational autonomy during the post-reform period.
In terms of redefining the functions of the Reserve Bank, enabling a

movement towards meaningful autonomy, Governor Jalan’s statement on
22
Monetary and Credit Policy on April 19, 2001 is a landmark event. First, it
was decided to divest the Reserve Bank of all the ownership functions in
commercial banking, development finance and securities trading entities.
Secondly, a beginning was made in recommending divestiture of the Reserve
Bank’s supervisory functions in regard to cooperative banks, which would
presumably be extended to non-banking financial companies and later to all
commercial banks. Thirdly, the Reserve Bank signaled initiation of steps for
separation of Government debt management function from monetary policy.
These measures would enable the Reserve Bank to primarily focus on its role
as monetary authority and enhance the possibility of a move towards greater
autonomy.
The emerging issues relating to autonomy of the Reserve Bank can be

addressed at different levels. First, at the level of legislative framework,
several suggestions have been made to ensure appropriate autonomy and
many of them are under consideration. In particular, proposed Fiscal
Responsibility and Budget Management Bill and other amendments to
Reserve Bank of India Act would cover significant ground. Several other
suggestions relating to legal framework, as recommended by the Advisory
Groups are yet to be taken up.
Second, at the policy level, there are three important constraints on the
operational autonomy even within the existing legal framework. One, the
continued fiscal dominance, including large temporary mismatches between
receipts and expenditures of Government warranting large involuntary
financing of credit needs of Government by the Reserve Bank. Two, the
predominance of publicly owned financial intermediaries and non-financial
public enterprises, which has created a blurring of the demarcation between
funding of and by Government vis-à-vis public sector as a whole. Three, the
relatively underdeveloped state of financial markets partly due to legal and
23
institutional constraints, which blunts the effectiveness of instruments of

monetary policy. These issues need to be resolved to enhance genuine
autonomy.
Third, at the operational and procedural level, there is a problem of "old

habits die hard". In a deregulated environment, there is considerable scope to
reduce micro-management issues in the relations between the Government
and the Reserve Bank. At the level of degree of transparency, there is a
temptation to continue, what has been termed as the "joint-family approach";
which ignores basic tenets of accounting principles in regard to transactions
between the Reserve Bank and Government.
Some Critical Elements for Progress in Reform

In spite of difficulties in prioritizing the elements relevant for reform, an
attempt is made to mention some elements which present themselves as
critical in the light of experience gained so far. First, as elaborated in
Governor Jalan’s recent statements on Monetary and Credit Policy, several
legislative measures are needed to enable further progress. These relate in
particular, to ownership, regulatory focus, development of financial markets,
and bankruptcy procedures.
Some of the serious shortcomings in the anticipated benefits of reform such

as in credit delivery do need changes in legal and incentive systems. In
particular, there is need to focus on reduction of transaction costs in
economic activity, and enhancing economic incentives. Severe penalties in
law, including criminal proceedings, may not be substitutes for increasing
enforceability (i.e., probability of being caught, prosecuted, and punished
adequately and in a timely fashion). In regard to institutions, there is need to
clearly differentiate functions of owner, regulator, financial intermediary and
24
market participant, to replace the joint-family approach that is a legacy of the

pre-reform framework.
Second, fiscal empowerment appears to be essential for obvious reasons.

While the existing level of fiscal deficit may be manageable, the headroom
available for meeting unforeseen circumstances appears rather limited. The
problem is somewhat acute in regard to finances of states, which have serious
structural problems and their resolution is possible only through accelerated
fiscal support from Central Government consistent with the fiscal soundness
of Central Government. Some of the legal reforms may also be necessary for
this purpose and the link for further progress in the financial sector is
obvious. In particular, the nature of fiscal dominance does constrain the
effectiveness of monetary policy to meet unforeseen contingencies as well as
maintain price stability and contain inflationary expectations.
Third, the reforms in the real sector are needed to bring about structural
changes in the economy. The liberalization of financial sector and of external
sector can provide impetus for further growth and in turn help more rapid
progress only when accompanied by reforms in the real sector, particularly in
domestic trade.
Fourth, there are what may be termed as ‘overhang’ problems in the financial
sector, such as non-performing assets of banks and financial institutions.
There are similar overhang problems in other areas as well, and it is
necessary to make a distinction between what may be termed as flow issues
and overhang issues. There is merit in insulating the overhang problem from
flow issues and demonstrably solve the flow problem upfront. For example,
in regard to food stocks there is addition to buffer stocks virtually on a
continuous basis and a policy needs to be evolved to tackle this flow. Any
attempt to sort out the overhang accumulated excess stocks on an ad hoc
basis would obviously have limited success. Any solution to the overhang
25
problem of large magnitude is bound to be operational over the medium-term

and may involve admission of the magnitude of possible losses to be
incurred. Yet another example relates to the power sector, where addition to
capacities to generate without ensuring cost recovery adds to the problem of
accumulated losses. Prima facie, the major areas with considerable overhang
problems apart from the financial sector are public enterprises, pension and
provident fund liabilities and the cooperative sector. The criticality of the
issue is in terms of their cumulative impact on financial sector as a whole.
Fifth, it will be useful to distinguish between what a financial sector can

contribute and what fiscal action can contribute to matters relating to poverty
alleviation. In the interest of efficiency and stability of financial sector,
intermediation may have to be progressively multi institutional rather than
wholly bank-centered. Social obligations may have to be distributed equitably
among banks and other intermediaries but that would be difficult to achieve
in the context of emerging capital markets and relatively open economy. In
such a situation, banks which are special and backbone of payment systems
may face problems if they are subject to disproportionate burdens. Hence,
mechanisms have to be found to reconcile these dilemmas.
Furthermore, monetary policy is increasingly focused on efficient discharge

of its objective including price stability, and this no doubt would help poverty
alleviation, albeit indirectly, while the more direct attack on poverty
alleviation would rightfully be the preserve of fiscal policy. Monetary and
financial sector policies in India should perhaps be focusing increasingly on
what Dreze and Sen Call "growth mediated security" while "support-led
security", mainly consisting of direct anti-poverty interventions are addressed
mainly by fiscal and other governmental activities.
26
I. Banking in the Pre-reform Period
It is useful to briefly recall the nature of the Indian banking sector at the time
of initiation of financial sector reform in India in the early 1990s. This would
facilitate a greater clarity of the rationale and basis of reforms. The Indian
financial system in the pre-reform period, i.e., up to the end of 1980s,
essentially catered to the needs of planned development in a mixed economy
framework where the government sector had a domineering role in economic
activity. The strategy of planned economic development required huge
development expenditures, which was met thorough the dominance of
government ownership of banks, automatic monetization of fiscal deficit
and subjecting the banking sector to large pre-emption – both in terms of the
statutory holding of Government securities (statutory liquidity ratio, or SLR)
and administrative direction of credit to preferred sectors. Furthermore, a
complex structure of administered interest rates prevailed, guided more
by social priorities, necessitating cross-subsidization to sustain commercial
viability of institutions. These not only distorted the interest rate mechanism
but also adversely affected financial market development. All the signs of
`financial repression’ was found in the system.
There is perhaps an element of commonality in terms of such a ‘repressed’

regime in the financial sector of many emerging market economies at that
time. The decline of the Bretton Woods system in the 1970s provided a
trigger for financial liberalization in both advanced and emerging markets.
Several countries adopted a ‘big bang’ approach to liberalization, while
others pursued a more cautious or ‘gradualist’ approach. The East Asian
27
crises in the late 1990s provided graphic testimony as to how faulty

sequencing and inadequate attention to institutional strengthening could
significantly derail the growth process, even for countries with otherwise
sound macroeconomic fundamentals.
India, in this context, has pursued a relatively more ‘gradualist’ approach to

liberalization. The bar was gradually raised. Each year the Central Bank
slowly, in a manner of speaking, tightened the screws. Nevertheless, the
transition to a regime of prudential norms and free interest rates had its own
traumatic effect. It must be said to the credit of our financial system that
these changes were absorbed and the system has emerged stronger for this
reason.
II. Contours of reforms
Financial sector reforms encompassed broadly institutions especially

banking, development of financial markets, monetary fiscal and external
sector management and legal and institutional infrastructure.
Reform measures in India were sequenced to create an enabling environment

for banks to overcome the external constraints and operate with greater
flexibility. Such measures related to dismantling of administered structure
of interest rates, removal of several pre-emption in the form of reserve
requirements and credit allocation to certain sectors. Interest rate
deregulation was in stages and allowed build up of sufficient resilience in the
system. This is an important component of the reform process which has
imparted greater efficiency in resource allocation. Parallel strengthening of
prudential regulation, improved market behaviour, gradual financial opening
28
and, above all, the underlying improvements in macroeconomic management

helped the liberalisation process to run smooth. The interest rates have now
been largely deregulated except for certain specific classes, these are: savings
deposit accounts, non-resident Indian (NRI) deposits, small loans up to Rs.2
lakh and export credit. Without the dismantling of the administered interest
rate structure, the rest of the financial sector reforms could not have meant
much.
As regards the policy environment on public ownership, the major share of

financial intermediation has been on account of public sector during the pre-
reform period. As a part of the reforms programme, initially there was
infusion of capital by Government in public sector banks, which was
subsequently followed by expanding the capital base with equity
participation by private investors up to a limit of 49 per cent. The share of the
public sector banks in total banking assets has come down from 90 per cent
in 1991 to around 75 per cent in 2006: a decline of about one percentage
point every year over a fifteen-year period. Diversification of ownership,
while retaining public sector character of these banks has led to greater
market accountability and improved efficiency without loss of public
confidence and safety. It is significant that the infusion of funds by
government since the initiation of reforms into the public sector banks
amounted to less than 1 per cent of India’s GDP, a figure much lower than
that for many other countries.
Another major objective of banking sector reforms has been to enhance

efficiency and productivity through increased competition. Establishment
of new banks was allowed in the private sector and foreign banks were also
permitted more liberal entry. Nine new private banks are in operation at
29
present, accounting for around 10-12 per cent of commercial banking assets.
Yet another step towards enhancing competition was allowing foreign direct
investment in private sector banks up to 74 per cent from all sources.
Beginning 2009, foreign banks would be allowed banking presence in India
either through establishment of subsidiaries incorporated in India or through
branches.
Impressive institutional reforms have also helped in reshaping the financial

marketplace. A high-powered Board for Financial Supervision (BFS),
constituted in 1994, exercise the powers of supervision and inspection in
relation to the banking companies, financial institutions and non-banking
companies, creating an arms-length relationship between regulation and
supervision. On similar lines, a Board for Regulation and Supervision of
Payment and Settlement Systems (BPSS) prescribes policies relating to the
regulation and supervision of all types of payment and settlement systems, set
standards for existing and future systems, authorise the payment and
settlement systems and determine criteria for membership to these systems.
The system has also progressed with the transparency and disclosure
standards as prescribed under international best practices in a phased manner.
Disclosure requirements on capital adequacy, NPLs, profitability ratios
and details of provisions and contingencies have been expanded to
include several areas such as foreign currency assets and liabilities,
movements in NPLs and lending to sensitive sectors. The range of
disclosures has gradually been increased. In view of the increased focus on
undertaking consolidated supervision of bank groups, preparation of
consolidated financial statements (CFS) has been mandated by the Reserve
Bank for all groups where the controlling entity is a bank.
30
The legal environment for conducting banking business has also been
strengthened. Debt recovery tribunals were part of the early reforms
process for adjudication of delinquent loans. More recently, the
Securitisation Act was enacted in 2003 to enhance protection of creditor
rights. To combat the abuse of financial system for crime-related activities,
the Prevention of Money Laundering Act was enacted in 2003 to provide the
enabling legal framework. The Negotiable Instruments (Amendments and
Miscellaneous Provisions) Act 2002 expands the erstwhile definition of
'cheque' by introducing the concept of 'electronic money' and 'cheque
truncation'. The Credit Information Companies (Regulation) Bill 2004 has
been enacted by the Parliament which is expected to enhance the quality of
credit decisions and facilitate faster credit delivery.
Improvements in the regulatory and supervisory framework encompassed a

greater degree of compliance with Basel Core Principles. Some recent
initiatives in this regard include consolidated accounting for banks along with
a system of Risk-Based Supervision (RBS) for intensified monitoring of
vulnerabilities.
The structural break in the wake of financial sector reforms and opening up
of the economy necessitated changes in the monetary policy framework. The
relationship between the central bank and the Government witnessed a
salutary development in September 1994 in terms of supplemental
agreements limiting initially the net issuance of ad hoc treasury Bills. This
initiative culminated in the abolition of the ad hoc Treasury Bills
31
effective April 1997 replaced by a limited ways and means advances. The
phasing out of automatic monetization of budget deficit has, thus,
strengthened monetary authority by imparting flexibility and operational
autonomy. With the passage of the Fiscal Responsibility and Budget
Management Act in 2003, from April 1, 2006 the Reserve Bank has
withdrawn from participating in the primary issues of Central
Government securities
Reforms in the Government securities market were aimed at imparting

liquidity and depth by broadening the investor base and ensuring market-
related interest rate mechanism. The important initiatives introduced included
a market-related government borrowing and consequently, a phased
elimination of automatic monetisation of Central Government budget deficits.
This, in turn, provided a fillip to switch from direct to indirect tools of
monetary regulation, activating open market operations and enabled the
development of an active secondary market. The gamut of changes in market
development included introduction of newer instruments, establishment of
new institutions and technological developments, along with concomitant
improvements in transparency and the legal framework.
III. Processes of Reform
What are the unique features of our reform process? First, financial sector
reform was undertaken early in the reform cycle in India. Second, the
banking sector reforms were not driven by any immediate crisis as has often
been the case in several emerging economies. Third, the design and detail of
the reform were evolved by domestic expertise, while taking on board the
32
international experience in this regard. Fourth, enough space was created for
the growth and healthy competition among public and private sectors as well
as foreign and domestic sectors.
How useful has been the financial liberalization process in India towards
improving the functioning of institutions and markets? Prudential regulation
and supervision has improved; the combination of regulation, supervision and
safety nets has limited the impact of unforeseen shocks on the financial
system. In addition, the role of market forces in enabling price discovery has
enhanced. The dismantling of the erstwhile administered interest rate
structure has permitted financial intermediaries to pursue lending and deposit
taking based on commercial considerations and their asset-liability profiles.
The financial liberalisation process has also enabled to reduce the overhang
of non-performing loans: this entailed both a ‘stock’ (restoration of net
worth) solution as well as a ‘flow’ (improving future profitability) solution.
Financial entities have become increasingly conscious about risk

management practices and have instituted risk management models based on
their product profiles, business philosophy and customer orientation.
Additionally, access to credit has improved, through newly established
domestic banks, foreign banks and bank-like intermediaries. Government
debt markets have developed, enabling greater operational independence in
monetary policy making. The growth of government debt markets has also
provided a benchmark for private debt markets to develop.
There have also been significant improvements in the information

infrastructure. The accounting and auditing of intermediaries has improved.
33
Information on small borrowers has improved and information sharing

through operationalisation of credit information bureaus has helped to reduce
information asymmetry. The technological infrastructure has developed in
tandem with modern-day requirements in information technology and
communications networking.
The improvements in the performance of the financial system over the

decade-and-a-half of reforms are also reflected in the improvement in a
number of indicators. Capital adequacy of the banking sector recorded a
marked improvement and stood at 12.3 per cent at end-March 2006. This is a
far cry from the situation that prevailed in early 1990s.
On the asset quality front, notwithstanding the gradual tightening of

prudential norms, non-performing loans (NPL) to total loans of commercial
banks which was at a high of 15.7 per cent at end-March 1997 declined to 3.3
per cent at end-March 2006. Net NPLs also witnessed a significant decline
and stood at 1.2 per cent of net advances at end-March 2006, driven by the
improvements in loan loss provisioning, which comprises over half of the
total provisions and contingencies. The proportion of net NPA to net worth,
sometimes called the solvency ratio of public sector banks has dropped from
57.9 per cent in 1998-99 to 11.7 per cent in 2006-07.
Operating expenses of banks in India are also much more aligned to those
prevailing internationally, hovering around 2.1 per cent during 2004-05 and
2005-06. These numbers are comparable to those obtaining for leading
developed countries which were range-bound between 1.4-3.3 per cent in
2005.
34
Bank profitability levels in India have also trended upwards and gross profits
stood at 2.0 per cent during 2005-06 (2.2 per cent during 2004-05) and net
profits trending at around 1 per cent of assets. Available information suggests
that for developed countries, at end-2005, gross profit ratios were of the order
of 2.1 per cent for the US and 0.6 per cent for France.
The extent of penetration of our banking system in our country as measured

by the proportion of bank assets to GDP has increased from 50 per cent in the
second half of nineties to over 80 per cent a decade later
IV. Way ahead
The first is the issue of consolidation. The emergence of titans has been one
of the noticeable trends in the banking industry at the global level. These
banking entities are expected to drive the growth and volume of business in
the global segment. In the Indian banking sector also, consolidation is likely
to gain prominence in the near future. Despite the liberalization process,
state-owned banks dominate the industry, accounting for three-quarter of
bank assets. The consolidation process in recent years has primarily been
confined to a few mergers in the private sector segment, although some
recent consolidation in the state-owned segment is evident as well. These
mergers have been based on the need to attain a meaningful balance sheet
size and market share in the face of increased competition, driven largely by
synergies and locational and business-specific complementarities. Efforts
have been initiated to iron out the legal impediments inherent in the
consolidation process. As the bottom lines of domestic banks come under
35
increasing pressure and the options for organic growth exhaust themselves,
banks in India will need to explore ways for inorganic expansion. This, in
turn, is likely to unleash the forces of consolidation in Indian banking.
However, there are two caveats. First, any process of consolidation must
come out of a felt need for merger rather than as an imposition from outside.
The synergic benefits must be felt by the entities themselves. The process of
consolidation that is driven by fiat is much less likely to be successful,
particularly if the decision by fiat is accompanied by restrictions on the
normal avenues for reducing costs in the merged entity. Thus, any
meaningful consolidation among the public sector banks must be driven by
commercial motivation by individual banks, with the government and the
regulator playing at best a facilitating role. Second, the process of
consolidation does not mean that small or medium sized banks will have no
future. Many of the Indian banks are of appropriate size in relation to the
Indian situation. Actual experience shows that small and medium sized banks
even in advanced countries have been able to survive and remain profitable.
These banks have survived along with very large financial conglomerates.
Small banks may be the more natural lenders to small businesses.
The second issue is related to capital adequacy. Basel I standards have been
successfully implemented in India and the authorities are presently moving
towards adoption of Basel II tailored to country’s specific considerations.
Adoption of Base II norms will enhance the required capital. Besides, banks’
assets will grow or will have to grow in tandem with the growth of the real
sectors of the economy. The public sector banks’ ability to meet the growing
needs will be inhibited, unless the government is willing to bring in more
capital. At present, the share of the government in the public sector banks
cannot go below 51 per cent. While there is some scope for expanding
36
capital through various modalities, tier-I capital, that is equity, is still critical.
While this constraint may not be binding immediately, sooner or later it will
be. If growth is modest, retained earnings may form an adequate source of
supply. However, when growth is rapid which is likely to be the case, there
is need for injection of equity, enlarging the shareholding. In this situation,
the government will have to make up its mind either to bring in additional
capital or move towards reducing its share from 51 per cent through
appropriate statutory changes. A third alternative could, however, be to
include in the definition of government such entities as the Life Insurance
Corporation that are quasi-government in nature and are likely to remain to
be fully owned or an integral part of the government system in the future.
However, even to do this an amendment is needed in the statute.
The third aspect concerns risk management. The most important facet of risk
in India or for that matter in most developing countries markets remains the
credit risk. Management of credit risks is an area which has received
considerable attention in recent years. The new Basle accord rests on the
assumption that an internal assessment of risks by a financial institution will
be a better measure than an externally imposed formula. The economic
structure is undergoing a change. The service sector has emerged as major
sector. Assessing credit risk in lending to service sectors needs a
methodology different from assessing risks while lending to manufacturing.
There are other areas of lending such as housing and consumer credit which
will need new approaches. Equally important will be the area of management
of exchange risk. Besides enabling customers to adopt appropriate exchange
cover, banks themselves will have to ensure that their exposure is within
acceptable limits and is properly hedged. The entire area of risk management
37
encompassing all aspects of risk including credit risk, market risk and
operational risk will have to receive prime attention.
Banks exist to provide service to customers. With the introduction of

technology, there has been a significant change in the way banks operate.
This is a far cry from the situation that existed even 15 years ago. The
induction of technology has enabled several transactions to be processed in a
shorter period of time. Transmission of funds to customers takes less time
now. ATMs provide easy access to cash. Nevertheless, it is not very clear
whether the customers as depositors and users of other banking services are
fully satisfied with the services provided when they come to a bank. This is
an area, which must receive continuous attention. The interface with the
customers needs to improve.
Provision of credit is a basic function of banks. The effective discharge of

this function is part of the intermediation process. The sectoral deployment
of credit must keep pace with the changes in the structure of the economy.
The banking industry in India must equip itself to be able to assess and meet
the credit needs of the emerging segments of the economy. In this context,
two aspects require special attention.
First, as the Indian economy gets increasingly integrated with the rest of the
world, the demands of the corporate sector for banking services will change
not only in size but also in composition and quality. The growing foreign
trade in goods and services will have to be financed. Apart from production
credit, financing capital requirements from the cheapest sources will become
necessary. Provision of credit in foreign currency will require in turn a
38
management of foreign exchange risk. Thus, the provision of a whole gamut

of services related to integration with the rest of the world will be a
challenge. Foreign banks operating in India will be the competitors to Indian
banks in this regard. The foreign banks have access to much larger resources
and have presence in many parts of the world. Therefore, Indian banks will
have to evolve appropriate strategies in enabling Indian firms to accessing
funds at competitive rates. Another aspect of global financial strategy relates
to the presence of Indian banks in foreign countries. Indian banks will have to
be selective in this regard. Here again the focus may be on how to help Indian
firms acquire funds at internationally competitive rates and how to promote
trade and investment between India and other countries. We must recognize
that in foreign lands, Indian banks will be relatively smaller players. The
motivation to build up an international presence must be guided by the route
Indian entities take in the global business.
Second, despite the faster rate of growth of manufacturing and service

sectors, bulk of the population still depends on agriculture and allied
activities for its livelihood. In this background, one cannot over-emphasize
the need for expanding credit to agricultural and allied activities. While
banks have achieved a higher growth in provision of credit to agriculture and
allied activities last year, this momentum has to be carried further. In this
context, it has to be noted that credit for agriculture is not a single market.
Provision of credit for high-tech agriculture is no different from providing
credit to industry. Provision of credit to farmers with a surplus is also of
similar nature. Commercial banks in particular must have no hesitation in
providing credit to these segments where the normal calculation of risk and
return applies. It is only with respect to provision of credit to small and
39
marginal farmers, special attention is required. They constitute a bulk of the

farmers and accounting for a significant proportion of the total output.
The National Sample Survey Organization has recently released a Report

entitled, “Indebtedness of Farmer Households”. This Report contains a
wealth of data relating to the extent and nature of indebtedness. As per
NSSO data 51.4 per cent of the total farm households did not have access to
credit. Another fact that emerges is that there is a substantial difference
between marginal and sub-marginal farmers on the one hand and the rest of
the farmer households on the other regarding the purpose for which loans are
obtained and the sources of credit. For all farmer households taken together,
at the all-India level, institutional sources were responsible for providing 57.5
per cent of the total credit. But as far as farmer households owning one
hectare and less, this proportion is only 39.6 per cent. For all farmer
households, the proportion of loan going for production purposes is 65.1 per
cent as against 40.2 per cent for marginal and sub-marginal farmer
households. Thus, for sub-marginal and marginal farmers, the proportion of
production loan is lower than for all farmers. Similarly, the proportion of
institutional credit is lower for sub-marginal and marginal farmers than for all
farmers. This, in fact, is true of every state of the country. Thus, a critical
issue is how to meet the credit requirements of marginal and sub-marginal
farmers. What changes do we need to introduce so that credit can flow to this
class of farmer households? Can the banking system through its present
mode of distribution of credit meet this challenge? Should we think in terms
of banks supporting other institutions that are in a better position to lend to
marginal and sub-marginal farmers? Banks need to think hard on how to
effectively use the `facilitator and correspondent’ models. These models
have great potential to reach out to small borrowers and depositors. In any
40
case, a re-look at the organizational structure of our rural branches is called

for. Banks need to think deeply on how to meet this challenge of meeting the
credit needs of marginal farmers. Financial inclusion is no longer an option;
it is a compulsion.
The task to be fulfilled by the Indian banks is truly formidable. At one end
we expect banks to be able to lend billions of rupees to large borrowers. At
the same time we want them to be able to deliver extremely small loans to
meet the requirements of the small borrowers. We must reflect on the kind of
organizational structure and human talent that we need in order to achieve
these twin goals which are at the two extreme ends of the spectrum of
lending.
The first phase of banking sector reform has come to a close and we are
moving on to the second phase. In the years to come, the Indian financial
system will grow not only in size but also in complexity as the forces of
competition gain further momentum and as financial markets get more and
more integrated. As globalization accelerates, the Indian financial system will
also get integrated with the rest of the world. As the task of the banking
system expands, there is need to focus on the organizational effectiveness of
banks. To achieve improvements in productivity and profitability, corporate
planning combined with organizational restructuring become necessary.
Issues relating to consolidation, competition and risk management will
remain critical. Equally, governance and financial inclusion will emerge as
key issues for India at this stage of socio-economic development.
41
Recent banking developments in India
The Indian banking sector has witnessed wide ranging changes under the
influence of the financial sector reforms initiated during the early 1990s. The
approach to such reforms in India has been one of gradual and non-disruptive
progress through a consultative process. The emphasis has been on
deregulation and opening up the banking sector to market forces. The
Reserve Bank has been consistently working towards the establishment of an
enabling regulatory framework with prompt and effective supervision as well
as the development of technological and institutional infrastructure.
Persistent efforts have been made towards adoption of international

benchmarks as appropriate to Indian conditions. While certain changes in the
legal infrastructure are yet to be effected, the developments so far have
brought the Indian financial system closer to global standards.
Statutory Pre-emption
In the pre-reforms phase, the Indian banking system operated with a high
level of statutory preemptions, in the form of both the Cash Reserve Ratio
(CRR) and the Statutory Liquidity Ratio (SLR), reflecting the high level of
the country’s fiscal deficit and its high degree of monetization. Efforts in the
recent period have been focused on lowering both the CRR and SLR. The
42
statutory minimum of 25 per cent for the SLR was reached as early as 1997,
and while the Reserve Bank continues to pursue its medium-term objective of
reducing the CRR to the statutory minimum level of 3.0 per cent, the CRR of
the Scheduled Commercial Banks (SCBs) is currently placed at 5.0 per cent
of NDTL (net demand and time liabilities). The legislative changes proposed
by the Government in the Union Budget, 2005-06 to remove the limits on the
SLR and CRR are expected to provide freedom to the Reserve Bank in the
conduct of monetary policy and also lend further flexibility to the banking
system in the deployment of resources.
Interest Rate Structure
Deregulation of interest rates has been one of the key features of financial
sector reforms. In recent years, it has improved the competitiveness of the
financial environment and strengthened the transmission mechanism of
monetary policy. Sequencing of interest rate deregulation has also enabled
better price discovery and imparted greater efficiency to the resource
allocation process. The process has been gradual and predicated upon the
institution of prudential regulation of the banking system, market behavior,
financial opening and, above all, the underlying macroeconomic conditions.
Interest rates have now been largely deregulated except in the case of: (i)
savings deposit accounts; (ii) non-resident Indian (NRI) deposits; (iii) small
loans up to Rs.2 lakh; and (iv) export credit. After the interest rate
deregulation, banks became free to determine their own lending interest rates.
As advised by the Indian Banks’ Association (a self-regulatory organization
for banks), commercial banks determine their respective BPLRs (benchmark
prime lending rates) taking into consideration:
43
(i) actual cost of funds; (ii) operating expenses; and (iii) a minimum margin
to cover regulatory requirements of provisioning and capital charge and profit
margin. These factors differ from bank to bank and feed into the
determination of BPLR and spreads of banks. The BPLRs of public sector
banks declined to 10.25-11.25 per cent in March 2005 from 10.25-11.50 per
cent in March 2004. With a view to granting operational autonomy to public
sector banks, public ownership in these banks was reduced by allowing them
to raise capital from the equity market of up to 49 per cent of paid-up capital.
Competition is being fostered by permitting new private sector banks, and
more liberal entry of branches of foreign banks, joint-venture banks and
insurance companies. Recently, a roadmap for the presence of foreign banks
in India was released which sets out the process of the gradual opening-up of
the banking sector in a transparent manner. Foreign investments in the
financial sector in the form of Foreign Direct Investment (FDI) as well as
portfolio investment have been permitted. Furthermore, banks have been
allowed to diversify product portfolio and business activities. The share of
public sector banks in the banking business is going down, particularly in
metropolitan areas. Some diversification of ownership in select public sector
banks has helped further the move towards autonomy and thus provided some
response to competitive pressures. Transparency and disclosure standards
have been enhanced to meet international standards in an ongoing manner.
Prudential Regulation
Prudential norms related to risk-weighted capital adequacy requirements,

accounting, income recognition, provisioning and exposure were introduced
in 1992 and gradually these norms have been brought up to international
standards. Other initiatives in the area of strengthening prudential norms
44
include measures to strengthen risk management through recognition of

different components of risk, assignment of risk-weights to various asset
classes, norms on connected lending and risk concentration, application of the
mark-to-market principle for investment portfolios and limits on deployment
of funds in sensitive activities.
Keeping in view the Reserve Bank’s goal to achieve consistency and

harmony with international standards and our approach to adopt these
standards at a pace appropriate to our context, it has been decided to migrate
to Basel II. Banks are required to maintain a minimum CRAR (capital to risk
weighted assets ratio) of 9 per cent on an ongoing basis. The capital
requirements are uniformly applied to all banks, including foreign banks
operating in India, by way of prudential guidelines on capital adequacy.
Commercial banks in India will start implementing Basel II with effect from
March 31,2007. They will initially adopt the Standardized Approach for
credit risk and the Basic Indicator Approach for operational risk. After
adequate skills have been developed, at both bank and supervisory level,
some banks may be allowed to migrate to the Internal Ratings-Based (IRB)
Approach. Banks have also been advised to formulate and operationalise the
Capital Adequacy Assessment Process (CAAP) as required under Pillar II of
the New Framework.
Some of the other regulatory initiatives relevant to Basel II that have been
implemented by the Reserve Bank are:
 Ensuring that banks have a suitable risk management framework
oriented towards their requirements and dictated by the size and

complexity of their business, risk philosophy, market perceptions and
expected level of capital.
45
 Introducing Risk-Based Supervision (RBS) in select banks on a pilot

basis.
 Encouraging banks to formalize their CAAP in alignment with their
business plan and performance budgeting system. This, together with

the adoption of RBS, should aid in
 Fulfilling the Pillar II requirements under Basel II.
 Expanding the area of disclosures (Pillar III) so as to achieve greater
transparency regarding the financial position and risk profile of

banks.
 Building capacity to ensure the regulator’s ability to identify eligible
banks and permit them to adopt IRB/Advanced Measurement

approaches.
With a view to ensuring migration to Basel II in a non-disruptive manner, a

consultative and participative approach has been adopted for both designing
and implementing the New Framework. A Steering Committee comprising
senior officials from 14 banks (public, private and foreign) with
representation from the Indian Banks’ Association and the Reserve Bank has
been constituted. On the basis of recommendations of the Steering
Committee, draft guidelines on implementation of the New Capital Adequacy
Framework have been issued to banks. In order to assess the impact of Basel
II adoption in various jurisdictions and re-calibrate the proposals, the BCBS
is currently undertaking the Fifth Quantitative Impact Study (QIS 5). India
will be participating in the study, and has selected 11 banks which form a
representative sample for this purpose. These banks account for 51.20 per
cent of market share in terms of assets. They have been advised to familiarize
themselves with the QIS 5 requirements to enable them to participate in the
46
Exercise effectively. The Reserve Bank is currently focusing on the issue of

recognition of the external rating agencies for use in the Standardized
Approach for credit risk.
As a well-established risk management system is a pre-requisite for

implementation of advanced approaches under the New Capital Adequacy
Framework, banks were required to examine the various options available
under the Framework and draw up a roadmap for migration to Basel II. The
feedback received from banks suggests that a few may be keen on
implementing the advanced approaches. However, not all are fully equipped
to do so straightaway and are, therefore, looking to migrate to the advanced
approaches at a later date. Basel II provides that banks should be allowed to
adopt/migrate to advanced approaches only with the specific approval of the
supervisor, after ensuring that they satisfy the minimum requirements
specified in the Framework, not only at the time of adoption/migration, but
on a continuing basis. Hence, banks desirous of adopting the advanced
approaches must perform a stringent assessment of their compliance with the
minimum requirements before they shift gears to migrate to these approaches.
In this context, current non-availability of acceptable and qualitative
historical data relevant to internal credit risk ratings and operational risk
losses, along with the related costs involved in building up and maintaining
the requisite database, is expected to influence the pace of migration to the
advanced approaches available under Basel II.
Exposure Norms
The Reserve Bank has prescribed regulatory limits on banks’ exposure to

individual and group borrowers to avoid concentration of credit, and has
47
advised banks to fix limits on their exposure to specific industries or sectors

(real estate) to ensure better risk management. In addition, banks are also
required to observe certain statutory and regulatory limits in respect of their
exposures to capital markets.
Asset-Liability Management
In view of the growing need for banks to be able to identify, measure,

monitor and control risks, appropriate risk management guidelines have been
issued from time to time by the Reserve Bank, including guidelines on Asset-
Liability Management (ALM). These guidelines are intended to serve as a
benchmark for banks to establish an integrated risk management system.
However, banks can also develop their own systems compatible with type
and size of operations as well as risk perception and put in place a proper
system for covering the existing deficiencies and the requisite upgrading.
Detailed guidelines on the management of credit risk, market risk, operational

risk, etc. have also been issued to banks by the Reserve Bank.
The progress made by the banks is monitored on a quarterly basis. With

regard to risk management techniques, banks are at different stages of
drawing up a comprehensive credit rating system,
Undertaking a credit risk assessment on a half yearly basis, pricing loans on

the basis of risk rating, adopting the Risk-Adjusted Return on Capital
(RAROC) framework of pricing, etc. Some banks stipulate a quantitative
ceiling on aggregate exposures in specified risk categories, analyze rating-
wise distribution of borrowers in various industries, etc.
48
In respect of market risk, almost all banks have an Asset-Liability

Management Committee. They have articulated market risk management
policies and procedures, and have undertaken studies of behavioural maturity
patterns of various components of on-/off-balance sheet items.
NPL Management
Banks have been provided with a menu of options for disposal/recovery of

NPLs (non-performing loans). Banks resolve/recover their NPLs through
compromise/one time settlement, filing of suits, Debt Recovery Tribunals, the
Lok Adalat (people’s court) forum, Corporate Debt Restructuring (CDR),
sale to securitization/reconstruction companies and other banks or to non-
banking finance companies (NBFCs). The promulgation of the Securitization
and Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFAESI) Act, 2002 and its subsequent amendment have strengthened the
position of creditors. Another significant measure has been the setting-up of
the Credit Information Bureau for information sharing on defaulters and other
borrowers. The role of Credit Information Bureau of India Ltd. (CIBIL) in
improving the quality of credit analysis by financial institutions and banks
need hardly be overemphasized. With the enactment of the Credit
Information Companies (Regulation) Act, 2005, the legal framework has
been put in place to facilitate the full-fledged operationalisation of CIBIL and
the introduction of other credit bureaus.
Board for Financial Supervision (BFS)
49
An independent Board for Financial Supervision (BFS) under the aegis of the
Reserve Bank has been established as the apex supervisory authority for
commercial banks, financial institutions, urban banks and NBFCs. Consistent
with international practice, the Board’s focus is on offsite and on-site
inspections and on banks’ internal control systems. Offsite surveillance has
been strengthened through control returns. The role of statutory auditors has
been emphasized with increased internal control through strengthening of the
internal audit function. Significant progress has been made in implementation
of the Core Principles for Effective Banking Supervision. The supervisory
rating system under CAMELS has been established, coupled with a move
towards risk-based supervision.
Consolidated supervision of financial conglomerates has since been

introduced with bi-annual discussions with the financial conglomerates.
There have also been initiatives aimed at strengthening corporate governance
through enhanced due diligence on important shareholders, and fit and proper
tests for directors.
A scheme of Prompt Corrective Action (PCA) is in place for attending to

banks showing steady deterioration in financial health. Three financial
indicators, viz. capital to risk-weighted assets ratio (CRAR), net non-
performing assets (net NPA) and Return on Assets (RoA) have been
identified with specific threshold limits. When the indicators fall below the
threshold level (CRAR, RoA) or go above it (net NPAs), the PCA scheme
envisages certain structured/discretionary actions to be taken by the regulator.
The structured actions in the case of CRAR falling below the trigger point
may include, among other things, submission and implementation of a capital
restoration plan, restriction on expansion of risk weighted assets, restriction
50
on entering into new lines of business, reducing/skipping dividend payments,

and requirement for recapitalization.
The structured actions in the case of RoA falling below the trigger level may
include, among other things, restriction on accessing/renewing costly deposits
and CDs, a requirement to take steps to increase fee-based income and to
contain administrative expenses, not to enter new lines of business,
imposition of restrictions on borrowings from the inter bank market, etc.
In the case of increasing net NPAs, structured actions will include, among
other things, undertaking a special drive to reduce the stock of NPAs and
containing the generation of fresh NPAs, reviewing the loan policy of the
bank, taking steps to upgrade credit appraisal skills and systems and to
strengthen follow-up of advances, including a loan review mechanism for
large loans, following up suit filed/ decreed debts effectively, putting in place
proper credit risk management policies/processes/procedures/prudential
limits, reducing loan concentration, etc.
Discretionary action may include restrictions on capital expenditure,

expansion in staff, and increase of stake in subsidiaries. The Reserve
Bank/Government may take steps to change promoters/ ownership and may
even take steps to merge/amalgamate/liquidate the bank or impose a
moratorium on it if its position does not improve within an agreed period.
Technological Infrastructure
In recent years, the Reserve Bank has endeavored to improve the efficiency
of the financial system by ensuring the presence of a safe, secure and
effective payment and settlement system. In the process, apart from
performing regulatory and oversight functions the Reserve Bank has also
51
played an important role in promoting the system’s functionality and

modernization on an ongoing basis. The consolidation of the existing
payment systems revolves around strengthening computerized cheque
clearing, and expanding the reach of Electronic Clearing Services (ECS) and
Electronic Funds Transfer (EFT). The critical elements of the developmental
strategy are the opening of new clearing houses, interconnection of clearing
houses through the Indian Financial Network (INFINET) and the
development of a Real-Time Gross Settlement (RTGS) System, a Centralized
Funds Management System (CFMS), a Negotiated Dealing System (NDS)
and the Structured Financial Messaging System (SFMS). Similarly,
integration of the various payment products with the systems of individual
banks has been another thrust area.
An Assessment
These reform measures have had a major impact on the overall efficiency and
stability of the banking system in India. The dependence of the Indian
banking system on volatile liabilities to finance its assets is quite limited,
with the funding volatility ratio at -0.17 per cent as compared with a global
range of -0.17 to 0.11 per cent. The overall capital adequacy ratio of banks at
end-March 2005 was 12.8 per cent as against the regulatory requirement of 9
per cent which itself is higher than the Basel norm of 8 per cent. The capital
adequacy ratio was broadly comparable with the global range. There has been
a marked improvement in asset quality with the percentage of gross NPAs to
gross advances for the banking system declining from 14.4 per cent in 1998
to 5.2 per cent in 2005.
52
Globally, the NPL ratio varies widely from a low of 0.3 per cent to 3.0 per
cent in developed economies, to over 10.0 per cent in several Latin American
economies. The reform measures have also resulted in an improvement in the
profitability of banks. RoA(return on asset) rose from 0.4 per cent in the year
1991-92 to 0.9 per cent in 2004-05. Considering that, globally, RoA was in
the range -1.2 to 6.2 per cent for 2004, Indian banks are well placed. The
banking sector reforms have also emphasized the need to review manpower
resources and rationalize requirements by drawing up a realistic plan so as to
reduce operating cost and improve profitability. The cost to income ratio of
0.5 per cent for Indian banks compares favorably with the global range of
0.46 per cent to 0.68 per cent and vis-à-vis 0.48 per cent to 1.16 per cent for
the world’s largest banks.
In recent years, the Indian economy has been undergoing a phase of high
growth coupled with internal and external stability characterized by price
stability, fiscal consolidation, overall balance of payments alignment,
improvement in the performance of financial institutions and stable financial
market conditions and the service sector taking an increasing share, enhanced
competitiveness, increased emphasis on infrastructure, improved market
microstructure, an enabling legislative environment and significant capital
inflows. This has provided the backdrop for a more sustained development of
financial markets and reform.
Narsimhan committee recommendations:
A strong and efficient financial system, functionally diverse and

geographically widespread, is critical to the attainment of our objectives of
creating a market driven, productive and competitive economy and to support
53
higher investment levels and accentuate growth. The creation of such a

system has been the objective that has inspired the process of financial sector
reform since 1992 as part of the broader programme of structural economic
reform.
Reforms in Banking Sector
As part of this process, reform of the banking sector is now under way. The
banking system is, by far, the most dominant segment of the financial sector,
accounting as it does for over 80 per cent of the funds flowing through the
financial sector and it is appropriate that reform measures taken in this area
have followed the recommendations of the Committee on the Financial
System (CFS), which reported in November 1991.
That Report had made a number of recommendations aimed at improving the

productivity, efficiency and profitability of the banking system on the one
hand and providing it greater operational flexibility and functional autonomy
in decision making on the other. It covered policy aspects, accounting
practices institutional and structural issues and matters relating
To organisational development. The report itself was conceived as a holistic

exercise and its recommendations were accordingly symbolically related to
each other.
Since the submission of the Report several measures have been instituted in
line with its recommendations. Accounting practices have been prescribed
more in consonance with internationally accepted standards in this regard
54
with the major objective of enhancing transparency and credibility and

ensuring accuracy of financial statements.
Asset classification criteria have been prescribed and principles governing

income recognition have been laid down with the aims of removing
subjectivity in this regard and providing for measurable objectivity.
Prudential norms have also been prescribed, most importantly, with respect to
provisioning for various categories of market related and substandard
assets Capital adequacy requirements have also been laid down, directed
towards enhancing the inherent strength of banking institutions. With regard
to policy measures, the significant changes that have been effected in line
with the recommendations of the CFS have been the progressive reduction
of the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio
(CRR) requirements as an aspect of correcting the impact of the high
proportion of directed investments on profitability and operational flexibility.
Another major step has been as suggested by the CFS, the progressive
deregulation of the bewilderingly complex and detailed administered interest
rate structure and to move interest rates more closely to a market determined
basis and to restore to the Bank rate its function of being an anchor or
reference rate.
These have been very major and significant changes but it would be observed
that while the ‘arithmetical’ of the CFS recommendations in relation to
various ratios, rates and accounting have been accepted and put through the
same measure of progress has not been made with regard to structural and
systemic aspects of the reform agenda outlined by the CFS. Even with regard
to ‘arithmetical’, an important recommendations relating to directed credit
has not been accepted. In some cases, as for instance in respect of the ways to
handle the problem of non performing assets (NPAs), while the problem has
been recognized the approach adopted has differed. Even as these measures
55
are making their impact there have been major changes in the macro
economic environment and policy and institutional developments.
These may call for an examination of the problem issues anew and possibly
for a review of some of the recommendations made earlier to see whether
they continue to have the same relevance in the changed context. The most
important change in the domestic macro environment has been the greater
focus or the containment of the fiscal deficit the subsidence of inflationary
pressures and the restoration to monetary policy of its defining function of
regulating money and credit in the pursuit of its central objectives of price
and exchange rate stability. For monetary policy itself to be effective we need
a well knit and integrated financial system and active money and capital
markets. The greater reliance on market instruments of monetary regulation
and especially on the interest rate has been implications for the banking
system in terms of expanding the scope and range of the risk management
function especially as marking assets to market prices comes, as it should
increasingly into vogue. Apart from the traditional concerns with credit risk,
banks will thus increasingly need to manage market and liquidity risks and to
develop the skills for this. The other development has been the much greater
flexibility now available to banks and financial institutions with respect to
forego exchange transactions. Indian banks are participating in growing
measure in the foreign exchange markets both in India abroad with all the
opportunities and risks that this entails. We could also expect derivative
trading to play an increasing role with appropriate forms of risk management.
Challenges Posed by Global Financial Integration
56
These changes in the domestic economic and institutional scene have

coincided with the movement towards global integration of financial services.
Financial autonomy is not a viable or even a possible option. Global financial
integration would call for a greater measure of competitive efficiency in our
financial system if it is to be able to face successfully the challenge of
increasing competition from abroad. This is more so in the context of our
objective of moving in a phased manner towards a more liberal capital
account regime. An open capital account would result in larger inflows and
outflows with attendant implications for the management of the exchange rate
and domestic liquidity. For the system to be able to handle such problems it
would need to be strong and resilient. The recent developments in East and
South East Asia have only underscored the importance of a strong domestic
financial system. The experience has shown that despite strong economic
fundamentals, such as high savings rate and prudent fiscal policies, weak
banking policies and practices and the consequent fragility of the financial
system can have a serious destabilizing influence.
Improving Quality Bank Assets vis-à-vis NPAs
Recent developments have thus served to reinforce the point that a strong and
efficient financial system is necessary both to strengthen the domestic
economy and make it more efficient and also to enable it to meet the
challenges posed by financial globalization. Building such a system
constitutes the unfinished agenda of banking and financial sector reform.
Action on strengthening the foundations of the system would necessarily
involve improving the quality of bank assets. Nothing is more indicative of
the quality of assets than the quantum and incidence of NPAs in relation to
the total portfolio. The causes for a high proportion of NPAs are various.
57
Poor credit decisions by bank managements, difficult recovery environment

and changes both cyclical and structural in the larger economic environment
represent some of the micro and macro aspects of this. This is not all. Often,
as international experience has shown, a high incidence of NPAs could be
traced to policies of directed credit, not to speak of cruder forms of behest
lending. In our own country, the ‘contamination coefficient’ of directed credit
has been shown to have a value above unity as the figures of NPAs
emanating from priority sector credit testify. There is nothing inherently
wrong in setting out social priorities for bank lending. Social banking need
not conflict with canons of sound banking but when banks are required by
directive to meet specific quantitative targets, there is as our own experience
has shown the danger of erosion of the quality of the loan portfolio.
In the last few years the overall proportion of net NPAs to the total portfolio
has come down. Gross NPAs amounted to a little under twice the proportion
of net NPAs. The reduction in the level of NPAs partly reflects banks efforts
at recovery and the write-offs of losses and provisioning for non performing
loans which banks were enabled to do as a result of infusion of Government
funds as part of a recapitalization programme. The figure of NPAs, however,
remains uncomfortably high as an average even as it conceals wide individual
variations with the position of some banks being quite disconcerting. The
NPA figures incidentally do not include advances covered by Government
guarantees which have turned sticky. It is also important to ensure that the
classificatory norms for NPAs are strictly adhered to in letter and spirit and to
see that the phenomenon of ever greening does not mask the true situation.
58
Recovery of NPAs - Creation of Asset
Recovery Fund (ARF) An important aspect of the continuing reform process

is thus to reduce further the high level of NPAs as a means of institutional
strengthening. While there is reason to expect that with a combination of
policy and institutional development, new NPAs could in future be lower
than hitherto, the problem remains of the huge backlog of existing NPAs
which impinges severely on banks performance and their profitability.
Several approaches are possible. The earlier Committee had suggested the
creation of an Assets Reconstruction Fund (ARF) to take these assets off
banks books at a discount. Recapitalization through infusion of capital is
another approach and has been used in the case of some banks. In the last six
years massive budgetary funds have been used for recapitalization of public
sector banks. This a costly and over time, not a sustainable option. The
problem, however, remains and consideration would need to be given to
revisiting the concept of an ARF.
Capital Adequacy Norms
Another measure intended to enhance the financial strength of the system is

the enhancement of capital funds of banks. At the time of the earlier
Committee reported the desirable and feasible target for capital adequacy
seemed to be the level set by the Basle Committee of BIS. Several
developments have taken place since. We now have a better idea of the nature
and volume of risk weighted assets. As observed earlier, with greater
volatility in exchange markets and the greater use of interest rate variations as
59
instruments of monetary policy the market of asset price risk of both foreign
assets and domestic investments is now quite considerable. Banks have also
been getting more exposed to off balance sheet risks. Banking is essentially
an exercise in risk management. All these considerations suggest the need to
review anew the minimum prescriptions for capital adequacy with a view to
their possible enhancement.
Improving Profitability
Another important measure of the strength of the system is its profitability

levels. The high level of NPAs has been a proximate cause for the low
profitability levels of our public sector banks. Other factors have been the
large number of unremunerative branches, low productivity, over manning
and arcane methods of operations apart from the impact of directed credit and
high pre-emption of funds. Spreads in the Indian banking system remain high
and yet profitability levels are low.
There has been some improvements in recent years is net profits for Public
Sector Banks (PSBs) as a group (partly as a result of some recapitalization in
some of them). With increasing competition from foreign and private banks,
margins will come under further pressure and issues of customer orientation
productivity and efficiency in relation to profitability will come to the fore.
Universal Banking
60
Action on strengthening the foundations of the system by improving asset

quality enhancing capital and improving profitability would need to go along
with structural changes in the system. One of the more important
developments that has been taking place in international banking is the
revival of the phenomenon of universal banking in terms of which the
distinction between commercial investment and development banking is
getting blurred. In this country also we are moving towards this concept.
Commercial banks have been making in larger measure than before, term
finance to industry and providing investment banking services apart from
setting up subsidiaries in such diverse areas as mutual funds securities trading
and factoring. At the other end of spectrum the development finance
institutions (DFIs) are increasingly getting into the areas of working capital
finance and have also set up banking and mutual fund subsidiaries. The
financing requirements of Indian corporate’s, whether from the DFIs or from
the banks, are now being seen as an integrated operation. Nonbanking
financial companies (NBFCs) have proliferated in India in areas like
consumer finance, hire purchase, equipment leasing and housing finance.
How their activities should be integrated into the financial system and
regulated is an issued which needs to be examined.
The financial structure is thus evolving towards a continuum of institutions

rather than discrete specialization and the facilities that are being provided
are to be seen as aspects of a spectrum of financial services in keeping with
relationship banking. Universal banking in fact provides for a cafeteria
approach or, if one was to vary the metaphor it would take on the role of a
one stop financial supermarket. These developments also have implications
for the frameworks are content of regulation.
61
CONCLUSION:
The impact of ten years of gradualist economic reforms in India on the policy
environment presents a mixed picture. The industrial and trade policy reforms
have gone far, though they need to be supplemented by labor market reforms
which are a critical missing link. The logic of liberalization also needs to be
extended to agriculture, where numerous restrictions remain in place.
Reforms aimed at encouraging private investment in infrastructure have
worked in some areas but not in others. The complexity of the problems in
this area was underestimated, especially in the power sector. This has now
been recognized and policies are being reshaped accordingly. Progress has
been made in several areas of financial sector reforms, though some of the
critical issues relating to government ownership of the banks remain to be
addressed. However, the outcome in the fiscal area shows a worse situation at
the end of ten years than at the start.
Critics often blame the delays in implementation and failure to act in certain
areas to the choice of gradualism as a strategy. However, gradualism implies
a clear definition of the goal and a deliberate choice of extending the time
taken to reach it, in order to ease the pain of transition. This is not what
happened in all areas. The goals were often indicated only as a broad
62
direction, with the precise end point and the pace of transition left unstated to
minimize opposition—and possibly also to allow room to retreat if necessary.
This reduced politically divisive controversy, and enabled a consensus of
sorts to evolve, but it also meant that the consensus at each point represented
a compromise, with many interested groups joining only because they
believed that reforms would not go “too far”. The result was a process of
change that was not so much gradualist as fitful and opportunistic. Progress
was made as and when politically feasible, but since the end point was not
always clearly indicated, many participants were unclear about how much
change would have to be accepted, and this may have led to less adjustment
than was otherwise feasible.
The alternative would have been to have a more thorough debate with the
objective of bringing about a clearer realization on the part of all concerned
of the full extent of change needed, thereby permitting more purposeful
implementation. However, it is difficult to say whether this approach would
indeed have yielded better results, or whether it would have created gridlock
in India’s highly pluralist democracy. Instead, India witnessed a halting
process of change in which political parties which opposed particular reforms
when in opposition actually pushed them forward when in office. The process
can be aptly described as creating a strong consensus for weak reforms!
Have the reforms laid the basis for India to grow at 8 percent per year? The
main reason for being optimistic is that the cumulative change brought about
is substantial. The slow pace of implementation has meant that many of the
reform initiatives have been put in place recently and their beneficial effects
are yet to be felt. The policy environment today is therefore potentially much
more supportive, especially if the critical missing links are put in place.
However, the failure on the fiscal front could undo much of what has been
achieved. Both the central and state governments are under severe fiscal
63
stress which seriously undermines their capacity to invest in certain types of

infrastructure and in social development where the public sector is the only
credible source of investment. If India grows at 6 percent per annum on a
sustained basis, it will take 14 years to reach the current level of per capita
income of People’s Republic of China, 36 years to reach Thailand’s, and 104
years to reach that of the United States. Thus, the need for accelerated growth
can hardly be overemphasized. At the same
Time, the task of implementing reforms in a democracy is complex.

Therefore, those wishing for rapid reforms will need to be patient. The good
news, however, is that the experience of the past decade shows that change
can occur. Moreover, the success of the reforms in delivering growth and
poverty reduction must make the road to future reforms less bumpy. The
support for reforms today, though far from universal, is fortunately much
stronger than it was 10 years ago
64
BIBLIOGRAPHY
I. Indian Banking sector and financial sector reforms
 By Raj Kapila and Usha Kapila (volume 6)
II. Indian Banking sector and financial sector reforms
 By Ravishankar kumar singh (volume 2)
III. The followed website of RBI (Reserve bank of India)
www.rbi.org.in
IV. Also from other links searched from GOOGLE search.
65

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BANKING SECTOR REFORMS

Need for Reforms

rates were charged from non-concessional borrowers. The regulation of

sector compounded by non-transparent accounting of intra-public sector

Institutional Aspects of Reforms

At present, the institutional structure of the financial system is characterized

This is expected to impart greater flexibility in their operations and provide

As a group, however, the performance of PSBs in terms of profitability,

Regulation and Supervision

respect of investment in equity. Investments are valued and classified into

Prudential regulations have had a significant impact on the banking system in

Changing Monetary Policy Framework

Since the onset of the reforms process, monetary management in terms of

The responsibility of the Reserve Bank in undertaking reform in the financial

With the switchover to borrowings by Government at market related interest

practices with regard to manner of quotes, conclusion of deals and code of

The movement to a market-based exchange rate regime took place in 1993.

In respect of the financial markets, linkage between the money, government

impressive being the government securities market. The institutional and

sector has been gradually increased to help banks make loans on

Fiscal Policy and Financial Sector

(a) Governments’ borrowing programme;

(b) Guarantees extended by governments;

(c) Mechanisms such as ‘direct debits’; and

(d) Governments’ investments in financial sector.

The market borrowing programme of the Central Government continued to

The conduct of borrowing programme of State Governments is, however,

Financial intermediaries, especially banks, take exposures with a great degree

the Reserve Bank has been dissuading such relatively non-transparent

There are, in addition, what may be termed as "implicit-guarantees" which

In assessing fiscal financial linkage, the scope for money financing of

Managing the Process of Reform

deposit insurance, securitization and foreclosure, and prevention of money

The legislative process is complex in a democratic set up and it will be

all market participants may not be possible; the example of successes

Managing Uncertainties during Reform

Reforms in the financial sector had to be implemented keeping in view not

currency warded off a possible crisis due to persistence of a relatively over

There was also an occasion, as in May-August 2000 where inexplicable

First, stable and appropriate policies governing overall management of the

Second, the impression that a closed economy is less vulnerable to crisis is

Fourth, in all instances of serious uncertainties, the existence and

Eighth, as regards the techniques and instruments of managing uncertainties,

developments in financial markets, monetary policy, the nature, composition

Ninth, it is necessary to have an appropriate mix of surprise elements and

Finally, the issue of transparency is extremely important. There are many

RBI and Government

In terms of redefining the functions of the Reserve Bank, enabling a

The emerging issues relating to autonomy of the Reserve Bank can be

institutional constraints, which blunts the effectiveness of instruments of

Third, at the operational and procedural level, there is a problem of "old

Some Critical Elements for Progress in Reform

Some of the serious shortcomings in the anticipated benefits of reform such

market participant, to replace the joint-family approach that is a legacy of the

Second, fiscal empowerment appears to be essential for obvious reasons.

problem of large magnitude is bound to be operational over the medium-term

Fifth, it will be useful to distinguish between what a financial sector can

Furthermore, monetary policy is increasingly focused on efficient discharge

I. Banking in the Pre-reform Period

There is perhaps an element of commonality in terms of such a ‘repressed’

crises in the late 1990s provided graphic testimony as to how faulty

India, in this context, has pursued a relatively more ‘gradualist’ approach to