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BANKING SECTOR REFORMS IN INDIA Dr. Sanjay Kumar
Senior Lecturer in Economics, R.K. Shahi govt. Degree College, Patherdewa, Deoria (U.P) 1 INTRODUCTION
The financial reforms as also the globalization and liberalization measures have brought in a completely new operating environment to the banks, which had earlier, worked in a very protected environment. Emergence of new public, private and foreign banks on the scenario has made survival tough and challenging. The banking system has to necessarily join in the stream of reformation. Globalization of Indian economy has put more stress on the need for banking reforms.
2 SECOND PHASE OF NARASIMHAM COMMITTEE: 1998
The Government appointed a second high level on "Committee on banking sector reforms" headed by Shri. M. Narasimham, to review the implementation of the reforms recommended by the earlier committee and to look ahead and chat the reforms necessary in the year ahead to make Indian banking system and better equipped to compete effectively in a fast changing environment.
The Committee in its report submitted in April 1978 made wide- ranging recommendations covering various aspects of banking policy, institutional, supervisory and legislative dimension. The Committee came out with recommendations with referred to capital adequacy, asset quality, non-performing assets, directed credit prudential norms, disclosure requirements, asset liability management, earnings and profitability systems and methods in banks restructuring including mergers and amalgamations and Voluntary Disclosure Scheme (VRS), reduction of cost and RBI share holding 33% in the Public sector banks as devising effective regulatory norms and review of banking sector laws.
These recommendations are being progressively implemented.
3 MAJOR COMPONENTS OF REFORMS The basis for banking reforms was provided by the committee on financial Systems (Narasimham Committee) which made recommendations in November 1991 and these recommendations are
land mark in the evolution of banking policy in the country. The major components of banking reforms are :
1. Modifying the policy frame work.
2. Improving the financial soundness of bank.
3. Strengthening the institutional frame work.
4. Strengthening of supervisory mechanism.
4 BANKING SECTOR REFORMS
Consequent upon the liberalization move and basing on the Narasimham Committee report in recent years a number of reforms measures have been introduced in the commercial banking sector to make them efficient and productive. These measures include;
(a) The administered interest rate structure is now made flexible, rationale and simple. Deposit rates have been deregulated subject to a ceiling and number of lending rates has been reduced from six to three with a floor rate for all advances above Rs. 2 lakh.
(b) With a view to substantially increasing the lend-able resources at the disposal of the banks, the cash reserve ratio and statutory liquidity ratio are being reduced/proposed to be reduced in a phased manner from 15 to 10 percent and from 38.5 to 25 percent respectively.
(c) The international standard of capital adequacy norm (minimum 8 percent has been implemented). The budget for 1993-94 has already announced Rs. 57000 crores as capital provision for the nationalized banks to help them meet the requirements of the new norms for capital adequacy.
In order to minimize the burden on government recapitalizing the banks, the State Bank of India and other nationalized banks which are in a position to do so, are allowed to approach the capital market directly to moblise funds from the public. Of course the Government will retain
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51 percent equity to exercise control as before.
(d) The new accounting and prudential norms related to income recognition, asset classification and provisioning for impaired assets has been implemented to make the bank balance sheets more transparent. It is expected that the books of the banks will reflect their true financial position which is a prerequisite for effective monitoring and improving performance.
(e) With a view to improving the sale of non-performing advances, it has been decided to set up tribunals for expeditious adjudication and recovery of debts.
(f) Guidelines for entry of new private sector banks have been pronounced.
(g) Foreign banks are allowed to open their shops, as a result of liberalization, with a view to infusing competition in the sector.
(h) Merger of banks/branches is allowed and simultaneously branch licensing policy has been liberalized.
(i) For effective supervision of banks a new board, Board for Financial Bank Supervision, is established with in the Reserve Bank of India.
(j) Steps have been taken to increase the interest yield Government securities as per the market rate.
5 IMPACT AND IMPLICATIONS
By introduction of reform measures the Indian Banking System has witnessed a significant change. The introduction of new accounting and prudential norms related to income recognition and provisioning for impaired assets has upset the applecart of the banks, particularly of those in the public sector, as reflected in their balance sheets.
The balance sheets of the banks have reflected their financial strength, revealing the true extent of the deterioration in their profitability. Apart from the SBI group, only 7 other public sector banks have declared profit. While the net profit of the SBI group amounted to Rs. 280.03 crores the net loss of the public sector banks was to the tune of Rs.
3,648.91 crores. But during the year 1992-93 all the private sector banks and foreign banks in India except Benaras State Bank and Standard Chaetred Bank have declared profit and they could
withstand the new accounting and prudential norms. The bleeding of the balance sheets of public sector banks would continue and possibly all the banks may turn red in the balance sheet of 1993-94, as the balance 70 percent provision has to be compulsorily made in addition to the provision for 1994.
The RBI has asked the banks to reach the capital adequacy norms of minimum 8 per cent by 31st March 1996, in relation to risk weighted assets. The risk weights attached to investment in Government securities is zero while the risk weight given to other types of advances is significantly high. Since yield rate government securities is around 13 per cent, now banks prefer to invest in gilt-edged securities rather than investing in other advances having high risk, both in recovery of principal and interest. This shift of investment may hamper the pace of economic development.
According to new norms of income recognition, interest will be taken into account only when it is received in cash. Banks will not be able to show the accrued interest not collected as income as before, while they incur expenses on payment of interest on deposits. Interest paid on deposits as a sound banking principle. Unless the banks recover sunstantial interest, they are likely to sow operating loss which will portray a very bad signal of sickness. Therefore what becomes more urgent today for the banks is speedy recovery of advances, both principal and interest.
5.1 Reforms
Reforms formed a significant part of financial sector reforms in India. The banking sector reforms can be divided into following broad areas:
(i) Policy Framework
(ii) Improvement in Financial health (iii) Institutional Strengthening 5.2 Policy Framework
A. Structured of the Interest Rates
In reforming the interest rates structure, a gradual approach has been adopted. It has been ensured that banks and financial intermediaries do not have incentives which tempt them to lend at high rates of interest assuming high risk.
Prudential norms relating to provisioning and capital adequacy have been prescribed. For this purpose,
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recommendations of BASLE COMMITTEE in 1993 have been compiled with. Capital adequacy has been raised to 9% For the purpose of provisioning, the banks and the financial institutions have been asked to classify their assets by compressing the health code into following broad groups :
1. Standard, 2. Sub-standard, 3. Doubtful, and 4. Loss.
In accordance with international practices, loans in arrears for three months or more are classified as sub- standard or below and loans in arrears of one to three month as precautionary loans.
B. Pre-Emption of Deposits
In order to reduce fiscal and monetized deficits or to contain deficit, reductions in reserve requirements, i.e. CRR and SLR, is being effected. It will help to increase the lendable resources available with the banking industry. CRR continues to be used flexibly depending upon the monetary situations. Reduction in CRR and SLR has taken place in phased manner. CRR has been reduced to 10% in May, 1999. RBI is likely to reduce CRR requirements further in April 2000 to 8%.
It could be spread across a period of two months.
C. Directed Credit
There is a prescription that 40% of the net bank credit should go to certain sectors.
It has become necessary. So, two concessional rates of interest have been prescribed. Targets regarding directed lending were fixed at a time when the reserve requirements of CRR and SLR combined were as high as 60%. The picture is not same for present. The lending based has more than doubled in last few years. So the lending must make a sense as banks fall short of their targets.
6 IMPROVEMENT IN FINANCIAL HEALTH
The introduction of prudential norms and regulations is aimed at ensuring the safety and soundness of the financial system. It is also required to impart greater transparency and accountability in operations and restoring the credibility of and confidence in the financial system.
Purposes are solved in this way –
1. The true position of a bank's loan portfolio is brought out.
2. It helps in arresting its deterioration prudential norms in India relate to – (a) income recognition
(b) asset classification
(c) provisioning of bad and doubtful debts, and
(d) capital adequacy norms.
Major challenge for banks is he management of assets. Non-performing assets (NPAs) of banks are considered to be at higher levels than those are in other countries. It has attracted the attention of public and also of International Financial Institutions. It has gained further prominence in the wake of Transparency and disclosure measures initiated by the RBI. NPAs of public sector banks, instead of declining on account of the measures initiated by banks such as better follow up, recovery, write-offs, compromise proposals, have considerably increased in absolute terms. Prescription of a given percentage lending/credit to priority sector has also led to higher level of NPAs for Indian banks.
6.1 Debt Recovery
For debt recovery, the objectives of the existing debt recovery Tribunals and the settlement advisory boards can be combined. The Narasimham Committee has reiterated its suggestion on the creation of a separate debt recovery institution, i.e. an Asset Recovery Corporation, a government body. But it was not done as the idea could have sent wrong signals. During the tenure of Sh. P.
Chidambaram as the finance minister, banks were encouraged to set-up settlement advisory boards headed by a judge.
6.2 Institutional Strengthening
Appropriate institution building measures are required to strengthen the banks sector in general and public sector banks in particular. These are :
6.3 Recapitalization
The Narasimham Committee
recommended that the government should reduce it's equity holding to below 51% in all banks. Banks are facing competition from NBFCs as well as from within and from the need to improve their profitability. Banks with strong balance
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sheet are now going to the capital market and raising funds.
The Narasimham Committee recommended has asked public sector banks with consistent record of profitability to tap the capital market. It will make them accountable to a wider base of shareholders and thereby resulting in better performance.
6.4 Improving the Quality of Loan Portfolio
Public sector banks were able to perform better in retaining market share in advances, mainly because new generation banks were facing constraints in rapid expansion,
(a) their limited resources base, and (b) Stringent capital adequacy norms.
Further private sector banks were required to maintain CRR of prescribed percentage from the day one whereas phased manner was prescribed for public sector banks to achieve a particular level. Moreover, private sector banks must have a profitable track for at least three years for the Initial Public Offerings as per RBI guidelines. After such time period, primary market conditions may not be conducive for mobilizing capital at attractive price.
6.5 Strengthening of the Supervisory Process
For a sound banking system, a strong system is essential. Alert mechanism for monitoring compliance with prudential regulations and the directives of the RBI and other regulatory agencies is needed.
The system of external supervision has been revamped with the setting up of a separate board for financial supervision (BFS) within RBI concentrating exclusively on supervisory issues. The compliance with regulations and guidelines in the areas of -
(a) credit management (b) Asset classification (c) income recognition (d) capital adequacy (e) provisioning, and
(f) treasury operations will be ensured by the board.
7 REFORM MEASURES AND OUTLOOK 7.1 Pre-emptions
Major problem faced by the banking system was on account of constraints, mainly in terms of massive preemption of
banks' resources to finance Government's budgetary needs and administered interest rates. Removal of these constraints meant a planned reduction in statutory pre-emption and a gradual deregulation of interest rate prescriptions.
Since FSR, total effective pre-emption has been brought down from 54 per cent to less than 35 per cent. The effective CRR which was as high as 16.5 per cent has been brought down to 9.75 per vent. CRR in excess of 3 percent is currently remunerated at 4 per cent per annum.
Given that the CRR is a tax on the banking system, it is better to gradually reduce the CRR rather than maintain a much higher CRR with a relatively higher remuneration on these balances. The medium-term objective of reducing CRR has to take account of money supply considerations and also the objectives of exchange rate stabilizations.
Furthermore, reduction of the CRR would depend on maneuverability on money supply impact presently constrained by degree of monetization of fiscal deficit and uncertainties in forex markets.
Statutory Liquidity Ratio (SLR) has been gradually brought down from an average effective rate of 37.4 in 1992 to the statutory minimum of 25 per cent, though at present, many banks hold SLR well in excess of statutory prescription.
Further reduction in SLR, though desirable, would have to await reductions in fiscal deficit apart from needed improvements in prudential standards including internal risk management system. Of course, enabling legislative changes would also be needed.
7.2 Interest Rates
Structure of administered interest rates has been almost totally dismantled.
Prescriptions of rates on all term deposits, including conditions of premature withdrawal, and offering uniform rate irrespective of size of deposits have been dispensed with. Currently, there is a prescribed rate of 4.5 per cent for savings bank accounts, which are used by individuals virtually as current accounts and as the cost of servicing these accounts is high, the remuneration on these accounts has necessarily got to be low. There is yet to emerge a consensus on further deregulation of interest rate on savings deposits. There is understandably a differentiated interest rate ceiling
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prescribed for foreign currency denominated deposits from non resident Indians, and such ceiling will have to continue as part of managing external debt flows, especially short-term flows till fuller liberalization of capital account.
Lending rates for different categories, which were earlier prescribed, have been gradually abolished but transparency is insisted upon. Each Bank is required to announce Prime Lending Rates (PLR) and the maximum spread that it charges.
However, there are three exceptions.
Currently interest rate on smaller advances (i.e., up to Rs. 200,000 has for been adjusted since 1990; the real effective protection for small loans has ben gradually reduced by the inflation drift. Lending rates for exports are still prescribed. The prescription of interest rates for exports linked to the period of availment is to some extent used as an instrument to influence leads and lags in repatriation of export proceeds. Finally, ceilings are prescribed in respect of certain.
7.3 Prudential Norms
Prudential norms are being introduced gradually to meet the international standards. Consequent upon CBSR recommendations, action has already been initiated to increase the capital adequacy ratio; assign risk weights to Government approved securities ; to take care of the market risks; and also assign risk weights to open position in forex and gold. In most of these, a time tale has been indicated for the first phase only, so that banks are on notice for the first phase while the RBI has retained the freedom to decide on the timing of the second phase. Given the normal growth of 17 to 18 per cent in credit, and the required level of capital adequacy after implementing CBSR recommendations, a substantial infusion of capital into the banking system will be warranted. This is likely to have significant implications for public sector. Government has to weigh the desirability of further budgetary support vis-a-vis substantial reduction in share of Government ownership of banks.
Incidentally, as long as capital markets are sluggish, and their view on banks, bearish, a high proportion of divestment may be needed to raise the resources required, since share premia may be low.
Similarly, internationally accepted norms of income recognition have been introduced except that income on asset is not recognized if it is not received within two quarters after it is past due, i.e., due date plus thirty days.
The international norm is 90 days. Tighter standards, though desirable, have to introduced gradually so that both banks and there is no serious disruption in the normal banking activity or erosion in public confidence in the banking system due to balance sheet impact. Also, a sharp tightening of the norms would pose an unbearable burden on banks and would serve no substantive purpose unless corresponding changes are made in credit appraisal systems and debt recovery mechanisms.
Asset classification, which was introduced as per internationally acceptable practices early in the reform process is sought to be further strengthened gradually, as per CBSR. A significant decision taken relates to treatment of assets guaranteed by the State Government as non-performing under certain circumstances. This is a somewhat exceptional provision to take care of the temporary delays observed in respect of a few State Governments in honouring their guarantee obligations when invoked.
7.4 Competition and Transparency Competition is sought to be fostered by permitting new private sector banks, and more liberal entry of branches of foreign banks. The share of public sector banks in the banking business is going down, particularly in metropolitan areas.
Competition is sought to be fostered in rural and semi-urban areas also by encouraging Local Area Banks. Some diversification of ownership in select public sector banks has helped the process of autonomy and thus some response to competitive pressures. The RBI's efforts to enhance competition do, however, take into account the response of public sector banks and their principal, i.e., the Government. There are some banking institutions such as co- operatives, regional rural banks and local area banks, which are yet to be brought fully into the discipline of reform process.
The transparency and disclosure standards have been enhanced to meet international standards, though there are
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a few areas where we are lagging. These relate to maturity pattern of assets and liabilities, movements in provision account and NPAs and progress needs to be made in all these areas. To provide an authentic comparative information on the performance of banks, the RBI's annual publication, "Trend and Progress of Banking in India' presents, since the last two years, detailed information on individual banks enabling public assessment of the working of banks.
7.5 Supervision
An independent Board for Financial Supervision under aegis of the RBI has been established, and consistent with international practice, focus is also on offsite inspections and on control systems internal to the banks. Status of implementation of Core Principles of Banking Supervision (Annex II) shows that of 46 principles, 33 have been implemented, 11 are partially implemented, while only two are yet to be implemented. These two relate to the critical aspect of adequacy of reserves against country risk and transfer risk;
and consolidated reporting. While the former is not a major issue at this juncture in view of limited cross border exposure, the latter is of significance warranting early action. Even in respect of the Core Principles, which have been implemented, the RBI is making constant efforts to improve the quality of supervision and the skills of supervisors.
7.6 Credit Controls
Selective credit controls have been dispensed with. Micro-regulation of credit-delivery has been given up, and there is a greater freedom to both banks and borrowers in matters relating to credit. However, there are apprehensions on two counts, viz., the discipline of priority sector lending and flow of credit to the needy and deserving, on a timely basis. The advances eligible for priority sector lending have been enlarged, interest rates deregulated and alternate avenues of investment permitted, thus making the priority lending far more flexible than before. No doubt, banks are averse to sub-ceilings in priority sector, and have some problems with procedural requirements. The major area of serious concern relates to Government sponsored programmes involving subsidies, where
there are serious problems of both co- ordination and recovery. CBSR has made some recommendations and these are still under consideration.
There was a general consensus that the real issue in credit-delivery is more availability of credit than cost.
Consequent upon the deregulation of interest rates, there was an expectation that credit flow to the needy will be enhanced, but there is some disappointment about the credit-delivery- especially to small industry. Procedural simplifications have been advised by the RBI for rural credit credit to small industry and more recently the RBI is working on procedural streamlining for export credit.
7.7 Incentives and Legal Reforms The most critical issue in financial sector reform relates to consequences of the extent of public ownership and special laws governing publicly owned banks.
CBSR has devoted a significant part of its report to reform of public sector banks, on which Government, as the principal, needs to act. At present, public ownership has adverse effects on level playing field among banks, capacity and willingness to compete in the market place, incentives to perform, and binding work practices/methods that inhibit efficiency.
The issue of efficiency in public sector banks has several dimensions, and legal is one of them. Again, issues of optimal efficiency, autonomy and ownership are intertwined and need to be resolved.
Reduction of public ownership below the majority level prescribed would need an amendment to the three different laws that govern public sector banks. Sale of shares already held by Government also needs amendments to law.
7.8 Debt Recovery
Progress in establishing and operationalising debtrecovery systems has been painfully slow, partly due to judicial review. CBSR suggested several legislative measures that would facilitate debt- recovery, securiti-zation, electronic systems, etc. A serious consequence of tightening prudential norms and pressurizing banks to reduce NAP without strengthening the debt-recovery system is the choking of credit. While large corporates may be partly spared by recourse to alternate sources such as
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debentures or commercial paper, the rest, especially medium and smaller corporates could face credit choke and hence the pace of introduction of measures needs to be carefully modulated.
7.9 Accounting Standards
There is an apprehension in some quarters that the Indian Accounting Standards as followed by the Indian banks are not in line with International Accounting Standards. Annexure III gives a comparative position of some of the significant standards relevant to banking sector and comparative Indian standards/regulations. It will be seen that on accounting and valuation. Indian standards and de facto practices are comparable with international standards.
The major area of divergence in accounting is in respect of group accounting and consolidation. In India, currently consolidation is not required and investments in associated companies are not account, and gross non- performing assets and related party transactions in the financial statements.
However, as regards disclosure of related party transactions, banks are prohibited from granting advances to firms in which a Director is interested. The Reserve Banks has formally stated that instructions on further disclosures will be announced in due course. Meanwhile, many banks are also taking steps to build appropriate information systems, which some disclosures entail.
8 BANKS
It is clear that actions of RBI and initiatives of Government provide enabling environment, incentive framework and to
some extent punitive measures. The outcome will depend on the response of banks, i.e., boards of banks, management, officers and staff. There are, in particular, four broad areas of internal systems which may need through overhauling and which need to be facilitated by Government and the RBI.
First, the internal control systems in the banks, especially Public Sector Banks.
Second, the placement, work practices etc., which inhibit incentives for efficiency and improved customer service.
Third, flexibility in obtaining and enhancing highly skilled or talented people.
Fourth, introduction and effective use of technology in banks, especially public sector banks.
9 CONCLUSION
Effective regulation and supervision must be based on a transparent set of rules as close as possible to the international standards combined with free and timely availability of information and strong proactive action against their breaking the rules. Close attention to the way, the regulating agencies are structured and empowered, has to be paid. Jurisdiction and the responsibility have to be clearly defined and the organization must be held accountable. There is undoubtedly a trade off between having strict regulations oriented to protecting the interests of ordinary investors and allowing greater freedom to the market players.
REFERENCES 1. IBA Bulletin.
2. RBI Bulletin.
