Banking Reforms: Policies and Impact

                                            As a resourse person 
           Paper presented in National Conference on

               "Emerging Trends in Banking Industry",
                             organised by
             Shri Bhausaheb Vartak Arts,Commerce
                                       and
                            Science College ,
                     Borivili, Mumbai-400 091
                                           on
                        3rd  and 4th February ,2012 

                    

Indian banking has undergone metamorphic changes over four decades and these changes continue unabated. With the nationalisation of 14 banks in 1969 and 6 banks in 1980, there has been tremendous growth in the number of branches of commercial banks which is unmatched by any other country. As at 31^st March 2011, commercial banks had 74,130 branches out of which 21,705 branches were in rural areas¹. This works out to around 29.28 percentages of the total branches of commercial banks. The impact of opening of branches in the rural areas has converted it into mass banking. The other impact was extension of credit to priority sector. More comprehensive reforms took place on the recommendations of Narasimham Committee.

The reforms suggested by Narasimham Committee in 1991 consisted of:

•  Reduction in the SLR and CRR
• Interest rate in CRR balances
• Redefining the priority sector
• Deregulation of Interest Rate
• Asset classification and defining Non Performing Assets
• Improving transparency in the banking system
• Establishment of the ARF Tribunal
• Structural Reorganizations of the Banking sector
• Allowing entry of new banks in private sector
• Removal of Dual control
• Banking Autonomy

The reforms suggested by Narasimham Committee in 1998 are:

• Strengthening Banks in India
• Narrow Banking :
• Capital Adequacy Ratio
• Bank ownership :
• Review of banking laws

Object of Reforms:

The objects of reforms were to relieve banks from:

1. Deregulation of Interest Rates:

In 1997, RBI deregulated the interest rates on fixed deposit schemes. In the year 2003, it increased interest rate on savings deposits to 3.5 per cent. On May 3, 2011 rate on savings deposits were increased to 4 percent per annum.²   On October 25, 2011 RBI deregulated Savings Bank Deposit Interest Rate.³ Banks are now free to determine their savings bank deposit interest rate, subject to the following two conditions:

     o      First, each bank will have to offer a uniform interest rate on savings bank deposits up to                   Rs.1 lakh, irrespective of the amount in the account within this limit.

     o       Second, for savings bank deposits over 1 lakh, a bank may provide differential rates of  

                  interest, if it so chooses, subject to the condition that banks will not discriminate in the

                  matter of interest paid on such deposits, between one deposit and another of similar

                 amount, accepted on the same date, at any of its offices.

The upward revision in the savings deposit rate and deregulation of interest rate on savings deposits is likely to improve mobilisation of savings deposit.

2. Allocation of credit to certain sector of the economy:

At a meeting of the National Credit Council held in July 1968, it was emphasised that commercial banks should increase their involvement in the financing of priority sectors, viz., agriculture and small scale industries. The description of the priority sectors was later formalised in 1972 on the basis of the report submitted by the Informal Study Group on Statistics relating to advances to the Priority Sectors constituted by the Reserve Bank in May 1971. Although initially there was no specific target fixed in respect of priority sector lending, in November 1974 the banks were advised to raise the share of these sectors in their aggregate advances to the level of 33 1/3 per cent by March 1979.

As per the recommendations of the “Working Group on the Modalities of Implementation of Priority Sector Lending and the Twenty Point Economic Programme by Banks” (Chairman: Dr. K. S. Krishnaswamy), all commercial banks were advised to lend to priority sector 40 per cent of aggregate bank advances by 1985. Sub-targets were also specified for lending to agriculture and the weaker sections within the priority sector^.4

As per the latest guidelines domestic commercial banks are required to lend 40 per cent of Adjusted Net Bank Credit (ANBC) or credit equivalent amount of Off-Balance Sheet Exposure, whichever is higher. Foreign banks are required to lend 32 per cent of ANBC or credit equivalent amount of Off-Balance Sheet Exposure, whichever is higher. In case of domestic commercial banks they are required to lend 18 per cent of ANBC or credit equivalent amount of Off-Balance Sheet Exposure, whichever is higher towards agricultural advances.

In the event of shortfall in priority sector lending, commercial banks are required to contribute to the Rural Infrastructure Development Fund (RIDF) established with NABARD or Funds with other financial institutions, as specified by the Reserve Bank. In case of shortfall in priority sector lending target / sub targets, foreign banks are required to contribute to the funds set up with Small Industries Development Bank of India (SIDBI) or with other Financial Institutions, for such other purpose, for a period of three years or as decided by Reserve Bank from time to time.

3. Guidelines for Income Recognition, Asset Classification and Provisioning:

On 7^th November, 1985, RBI introduced Health Code System indicating quality of health of individual advances. In1992, the health code system was replaced by income recognition, asset classification and provisioning norms. Banks also adopted capital adequacy standards for greater consistency and transparency in their published accounts.

Non-performing assets had been the single largest cause of irritation of the banking sector. For providing for delinquent loans and for capital adequacy, prudential norms were introduced for income recognition and asset classification. The 1998 report of the Narasimham Committee-II highlighted the need for 'zero' non-performing assets for all Indian banks with International presence. The committee blamed poor credit decisions, behest-lending, cyclical economic factors for mounting of non-performing assets of banks and recommended creation of Asset Reconstruction Funds or Asset Reconstruction Companies to take over the bad debts of banks, so that banks can  start on a clean-slate.Introduction of prudential norms relating to asset classification, income recognition and provisioning, along with legal and institutional reforms, has led to visible improvement in asset quality in banks.

 4. Capital to Risk Assets Ratio:

Capital adequacy is an indicator of the financial health of the banking system. It is measured by the Capital to Risk-weighted Asset Ratio (CRAR). It is the ratio of a bank’s capital to its total risk-weighted assets. Capital adequacy norm provide a buffer to absorb unforeseen losses due to risky investments. The Committee on Banking Regulations and Supervisory Practices (Basel Committee) released the guidelines on capital measures and capital standards in July 1988.  Reserve Bank of India decided in April 1992 to introduce a risk asset ratio system for banks (including foreign banks) in India as a capital adequacy measure. The fundamental objective behind the norms was to strengthen the soundness and stability of the banking system.

The Narasimhan Committee endorsed the internationally accepted norms for capital adequacy standards, developed by the Basel Committee on Banking Supervision (BCBS). BCBS initiated Basel I norms in 1988, considered to be the first move towards risk-weighted capital adequacy norms. In 1996 BCBS amended the Basel I norms and in 1999 it initiated a complete revision of the Basel I framework, to be known as Basel II. In pursuance of the Narasimhan Committee recommendations, India adopted Basel I norms for commercial banks in 1992, the market risk amendment of Basel I in 1996 and has committed to implement the revised norms, the Basel II, from March 2008. India adopted Basel I norms for scheduled commercial banks in April 1992, and its implementation was spread over the next three years. It was stipulated that foreign banks operating in India should achieve a CRAR of 8 per cent by March 1993 while Indian banks with branches abroad should achieve the 8 per cent norm by March 1995. All other banks were to achieve a capital adequacy norm of 4 per cent by March 1993 and the 8 per cent norm by March 1996.In the first stage of the application of capital adequacy norms and prudential accounting standards, the Government of India contributed Rs. 5,700 crore as equity to recapitalize nationalised banks during 1993-94 in order to enable all nationalised banks to meet the initial CRAR requirement of 4 per cent by the stipulated time.⁵  RBI prescribed, minimum capital to risk assets ratio (CRAR) at nine per cent which was one percentage above the international norm.

5. Opening of banks in the private sector:

In 1993, the Reserve Bank of India permitted entry of banks in the private sector. These new banks were not only well capitalized but were also technologically advanced. Due to spate of merger /amalgamation the number of new private sector banks has been reduced to 7 (as at March2011).RBI also prohibited cross-holding by industrial groups and imposed restrictions on new banks with respect to opening of branches.

6. Diversification of ownership in public sector banks:

The amendment of the Banking Act, in 1994 allowed public sector banks to raise private equity up to 49 per cent of paid-up capital. The public-sector banks, which were fully owned by the government (prior to the reform), were allowed to increase non government ownership. In order to give banks sufficient financial strength and to enable them to gain access to capital markets, public-sector banks were recapitalized. Government Infused capital in public sector banks. The Banking Companies (Acquisition and Transfer of Undertakings) Act 1994, enabled banks to raise capital from the market by way of public issue of shares for meeting their additional capital requirements. However, banks were directed to ensure that the share holding of the Central Government does not become less than fifty one per cent of the paid-up capital of each corresponding new bank (Nationalised bank). As at 31^st March 2011, governments holding in all public sector banks were more than 51%, Governments holding in Jammu and Kashmir Bank (a private sector bank) was 53.2%.⁶ Diversification of ownership has led to greater accountability and improved efficiency.

7. Establishment of a Board for Financial Supervision (BFS) in 1994:

BFS regulates and supervises commercial banks, banking financial institutions, development finance institutions, urban cooperative banks and primary dealers.

8. Opening of Local Area Banks:

In August 1996, RBI issued guidelines for setting up of ‘Local Area Banks’ in the private sector for providing institutional mechanisms for promoting rural savings as well as for providing credit for viable economic activities in the local areas.

9. Asset Liability Management:

As a part of the Risk Management and control Systems in banks, RBI introduced Asset Liability Management from April 1, 1999.⁷

10. Investment Fluctuation Reserve (IFR):

In January 2002, RBI advised banks to build up investment fluctuation reserve (IFR) to a minimum of 5 per cent of their investment portfolio under the “held for trading” and “available for sale” categories, by transferring the gains realised on sale of investments within a period of five years.⁸

11. Switching from benchmark Prime Lending Rate (BPLR) to Base Rate:

The BPLR system was introduced in 2003. Banks were asked to switch over from ‘Benchmark Prime Lending Rate’ (BPLR) system to ‘Base Rate’ system from July 01, 2010. Base rate are the lending rates that are common across all categories of borrowers. They are for a specific tenor and are disclosed transparently. The base rate system aims at enhancing transparency in banks lending rates. It enhances better assessment of transmission of monetary policy.

12. Reserve Requirements:

The statutory liquidity requirement requires banks to hold a certain amount of deposits in the form of government and other approved securities. In the 1960s and 1970s, the CRR which was 5 per cent, steadily increased to its upper limit of 15 per cent in early 1991.The SLR which was 25 per cent in 1970 increased to 38.5 per cent in 1991, which was very near to 40 per cent of the legal upper limit. The 1991 reforms lowered the CRR and SLR, and enabled banks to diversify their activities.

        Cash Reserve Ratio: In terms of Section 42 (1) of the Reserve Bank of India Act, 1934 the     

         Reserve Bank prescribes the CRR for scheduled commercial banks without any floor or ceiling

         rate. The CRR of scheduled commercial banks which was 6% has been reduced from the

        fortnight beginning January 28, 2012 by 50 basis points to 5.50 per cent of their net demand

        and time liabilities (NDTL). Reduction by 50 basis points would result in to release Rs.32,000

         crores to banks.

       Statutory Liquidity Ratio: Consequent upon amendment to the Section 24 of the Banking

        Regulation Act, 1949 through the Banking Regulation (Amendment) Act, 2007, (effective  

        January 23, 2007), the Reserve Bank has been permitted to prescribe the Statutory Liquidity

        Ratio (SLR) for scheduled commercial bank (SCB) in specified assets. The value of such assets

        of a SCB  would not be less than such percentage not exceeding 40 per cent of its total demand

        and time liabilities. Reserve Bank has decided that all SCBs would continue to maintain a

        uniform SLR of   24 per cent on their total net demand and time liabilities (NDTL) with effect

       from the fortnight beginning November 8, 2008.

13. Introduction to Risk Based Supervision:

The Risk based supervision was first mentioned by the Governor of RBI Dr.Bimal Jalan, during May 2000, while delivering the statement on 'Monetary and Credit Policy for the year 2000-2001. The recent years have witnessed a gradual shift towards deregulation, reinforced by introduction of prudential norms and adoption of international supervisory best practices. The risk based supervision entails the monitoring of banks by allocating supervisory resources and focusing supervisory attention according to the risk profile of each institution. A risk based supervision approach assesses the probability and severity of the risks. It assesses the effectiveness of the controls in reducing the probability of risk events occurring or the severity if they do occur. It further considers what the bank has in place to deal with an event occurring even though the controls are in place and are functioning properly. The risk of failure can be approximated as the combination of all the risks (being the product of the probability of an event happening and the severity if that event happened) less the value of the additional support.

14. Technological Developments:

Indian banks have entered in the era of mechanisation, computerization and automation. Technology has become an integral part of banking which has helped banks in acquiring and implementing world class systems and procedures in handling large volumes of business at a competitive cost. It has also helped banks in better risk management practices.

The Tandon Committee on ‘Customer Service’ in its report (1975) gave guidelines to banks for the follow-up of credit and recommended computerisation of some functions to avoid delays in customer service. The process of automation in banks started in the early 80s, with the introduction of Automated Ledger Posting Machine. In July 1983, the Reserve Bank of India appointed a ‘Committee on Mechanisation in Banking’ under the chairmanship of Dr. Rangarajan, Deputy Governor, Reserve Bank of India, for drawing up a plan for computerisation and mechanisation in the Banking Industry over a five-year time frame of 1985-89. With the encouraging experience of computerisation and mechanisation, RBI constituted a working group in the year 1982, for considering feasibility of introducing MICR (Magnetic Ink Character Recognition,) OCR (optical character recognition) technology for cheque processing. In the year 1986, the MICR clearing operations started in Mumbai.

In September 1988, the Reserve Bank of India constituted another committee, under the chairmanship of Dr. C.Rangarajan, Deputy Governor for preparing a perspective plan for computerization of banks for the period from 1990 to 1994. The Narasimham committee (April 1998) in its ‘Report on Banking Sector Reforms’ also dwelt upon the issues of technological up gradation in banks. In 1997, Reserve Bank introduced Electronic Funds Transfer system. A better version known as National Electronic Funds Transfer (NEFT) was launched by RBI from 21^st, November 2005. In the year 1996-97 RBI launched Electronic Clearing System for ECS (Debit) and ECS (Credit).

Vide letter No. 8(I) (h)/98(2) dated the 27^th November, 1998, the Central Vigilance Commission (CVC) on ‘Improving Vigilance Administration in Banks’ directed that “All the banks must ensure that 70% of their business is captured through computerisation before 1.1.2001. Vide letter No.99/VGL/10  dated the 22nd January, 2003, regarding ‘ Improving Vigilance Administration in Banks’ Central Vigilance Commission again directed banks to achieve 100% of computerisation by December 2004.

In March 2004, the Reserve Bank of India introduced RTGS, a fund transfer mechanism where money could be transferred from one bank to another bank on real time (continuous) and on gross basis (without netting). ‘On line tax accounting system’ for payment of direct taxes and Electronic accounting System in Excise and Service tax (EASIEST) became operative in 2004.

End March 2010, core banking solution was implemented in around 98 percent branches of public sector banks. Technology infrastructure for the payments and settlement system in the country has been strengthened with electronic funds transfer, Centralised Funds Management System, Structured Financial Messaging Solution, Negotiated Dealing System and Real Time Gross Settlement.

15. Negotiable Instruments Act.1881

A Working Group for Cheque Truncation and e-cheque was constituted by the Reserve Bank in January 2003 under the chairmanship of Dr. R. B. Barman Executive Director. The aim was to examine various models of cheque truncation and to suggest an appropriate one for India.

The amendments made in 2002 in the Negotiable Instruments Act, 1881, introduced a new payment instrument ‘Electronic cheque” and ‘Truncated cheques’. As per sec.6 (b) of the Negotiable Instruments (Amendment and Miscellaneous Provisions) Act, 2002, “A truncated cheque” is a cheque which is truncated during the course of a clearing cycle, either by the clearing house or by the bank whether paying or receiving payment, immedi­ately on generation of an electronic image for transmission, substituting the further physical movement of the cheque in writing.

Vide circular no RBI/2009-10/323 DPSS.CO.CHD.No. 1832 / 04.07.05 / 2009-10 February 22, 2010, RBI issued guidelines prescribing specifications for cheques known as “CTS-2010 standard".

RBI has advised banks that no changes / corrections should be carried out on the cheques (other than for date validation purposes, if required). For any change in the payee’s name, courtesy amount (amount in figures) or legal amount (amount in words), etc., fresh cheque forms should be used by customers. This would help banks to identify and control fraudulent alterations.

Earlier a cheque used to become stale if presented after a period of Six months from the date of issue. Reserve Bank has directed banks not make payment of cheques/drafts/pay orders/banker’s cheques bearing that date or any subsequent date, if they are presented beyond the period of three months from the date of such instrument. These guidelines have been made effective from April 1, 2012.⁹

Summary:

Since 1991, India has been engaged in banking sector reforms. The sustained and gradual pace of reforms has helped banks in avoiding crisis and has fuelled growth. These reforms have strengthened the fundamentals of the Indian economy and have transformed the operating environment for banks and financial institutions. Reforms have improved the financial health of commercial banks.

Liberalisation and deregulation has opened up new opportunities for banks and has opened flood gates of competition. Disclosures norms have brought transparency in bank balance sheets. Banks are now enjoying greater operational freedom. New areas like insurance, credit cards, infrastructure financing, leasing, gold banking, investment banking, asset management, factoring, etc. have been opened up for bank financing.

Passing of ‘The Securitisation & Reconstruction of Financial Assets and Enforcement of Security Interest Act, (SARFAESI) 2002’ has helped banks in reducing Non- performing Assets.

In January 2006, RBI permitted banks to use intermediaries as Business Facilitators (BFs) or Business Correspondents (BCs) for providing financial and banking services for ensuring greater financial inclusion and increasing outreach of the banking sector. Opening of branches of Regional Rural Banks, Local Area Banks, Banking Ombudsman scheme, Introduction of nomination etc., were the  other reforms in the banking sector.

These are some of the major import reforms regarding the banking sector in India.

References:

1. Trend and Progress of Banking in India 2010-2011, RBI publication
2. RBI circular number RBI/2010-11/507 DBOD.Dir.BC. 90 /13.03.00/2010-11 of May 3, 2011
3. RBI circular /2011-12/233 DBOD.Dir.BC. 42/13.03.00/2011-12 of October 25, 2011
4. RBI Master Circular number RBI/2011-12/107 RPCD. CO.  Plan. BC 10 /04.09.01/ 2011-12 July 1, 2011 on Lending to Priority Sector.
5. Capital Adequacy Regime in India: An Overview Indian Council for   Research on International Economic Relations, July 2007,
6. Trends and Progress of Banking in India 2010-11- Appendix Table IV.8 : Shareholding Pattern of Domestic Scheduled Commercial Banks
7. RBI Circular  DBOD No. BP. BC. 94/ 21. 04. 098/ 98 dated September 10, 1998 on Assets - Liability Management System in Banks.
8. Monetary and Credit Policy for the year 2003-04
9. RBI/2011-12/251 DBOD.AML BC.No.47/14.01.001/2011-12November 4, 2011