CHAPTER ONE

Managing Banking and Financial Services—Current Issues and Future Challenges

CHAPTER STRUCTURE

Section I The Setting

Section II Change is in the air-is the financial system being revolutionised?

Section III The Global Financial system-After the financial crisis

Section IV The Indian Financial System—An Overview

Section V The Indian Banking System—An Overview

Chapter Summary

Test Your Understanding

Topics for Further Discussion

Annexures I, II, III

KEY TAKEAWAYS FROM THE CHAPTER

• Understand the present state of the global financial system and the disruptive changes.
• Understand the basic causes behind the global financial crisis of 2007.
• Learn how macro economic factors can affect financial stability.
• Learn how financial stability can be achieved through better regulation.
• Understand how the Indian financial system is organized.
• Understand the various types and characteristics of financial markets.
• Learn about the evolution of the Indian financial system.
• Understand the impact of the financial sector reforms.
• Take a look at the future challenges in the global and Indian financial systems.

SECTION I

THE SETTING

It is no exaggeration to say that we are in the midst of a defining moment for innovation in financial services. Some expect that new technology will cause a complete disruption of traditional financial institutions, giving businesses and households access to more convenient and customized services. Entrepreneurs are also finding applications well beyond finance, and these new technologies could transform other fields, such as humanitarian aid

Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, at Payments Canada, Calgary, Alberta, 17 June 2016. (accessed at www.bis.org)

Digital currencies, and especially those which have an embedded decentralised payment mechanism based on the use of a distributed ledger, are an innovation that could have a range of impacts on various aspects of financial markets and the wider economy. These impacts could include potential disruption to business models and systems, as well as facilitating new economic interactions and linkages

Introductory paragraph to the report by Committee on Payments and Market infrastructures, titled “Digital currencies”, published by the Bank for International Settlements in November 2015, accessed at www.bis.org

Financial institutions are increasingly at risk of losing business to fintech innovators, with 67 per cent already feeling the heat, says a PwC study.

News article, The Economic times, dated 7^thapril 2017, accessed http://economictimes.indiatimes.com/industry/banking/finance/banking/financialinstitutionsfeelingfintechheatsayspwcstudy/printarticle/58325723.cms

Banks should be monitoring innovations from five types of players: business-model disruptors, process innovators, technology start-ups outside the financial sector, digital banks, and platform attackers from other industries, such as e-tailing. Some of these innovations might radically reinvent banking; many can improve how banks currently do business.

Gergely Bacso, Miklos Dietz, and Miklos Radnai, “Decoding financial-technology innovation,” Mckinsey Quarterly, June 2015

In order to make more informed financial decisions, investors, lenders, and insurance underwriters need to understand how climate-related risks and opportunities are likely to impact an organization’s future financial position as reflected in its income statement, cash flow statement, and balance sheet…….

The Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures, Final report “Recommendations of the Task Force Climate-related Financial Disclosures”, delivered at the G20 Hamburg Summit in July 2017, page 8

Welcome to the new future of Banking……

SECTION II

CHANGE IS IN THE AIR….IS THE FINANCIAL SySTEM BEING REVoLUTIoNISED?

Fintech¹

Fintech is the term used to refer to technological innovations in financial services. It has been creating a lot of excitement – going by searches on Google – that have been reported to have soared more than 30 times in the last half decade!

In many cases, financial innovations are seen to be interesting twists on existing technologies and business models. They promise to lower costs, improve services and broaden access. Peer-to-peer lending is one example (Please refer to Chapter 6 for details). As the world has already seen with the taxi and hotel industries, peer-topeer services challenge traditional intermediaries.

This new paradigm may change the fundamental relationship existing financial institutions enjoy with their customers. Present regulations may need to tackle issues relating to consumer protection, market integrity, money laundering and terrorism financing, and their implications for financial stability.

Completely new technologies such as the Distributed Ledger Technology (DLT) have the potential to replace entire transaction systems, including core payment systems. New products are being offered in the form of smart contracts – agreements in computer code that do not need human intervention to be executed.

In this new technological environment, regulators could face issues related to governance, legal environments and financial stability as well.

Digital currencies²

Money – the traditional understanding

Money denominated in a particular currency (money in a traditional sense) includes money in a physical format (notes and coins, usually with legal tender status) and different types of electronic representations of money, such as central bank money (deposits in the central bank that can be used for payments) or commercial bank money

E money

Electronic money (e-money) is value stored electronically in a device such as a chip card or a hard drive in a personal computer and is also commonly used around the world. Some countries have developed specific legislation regulating e-money

Digital currency

Hundreds of digital currency schemes based on distributed ledgers (see above) currently exist, are in development or have been introduced and have subsequently disappeared. These schemes share several key features, which distinguish them from traditional e-money schemes.

Assets – such as Bitcoins (see below – The Bitcoin phenomenon)

They have some monetary characteristics, such as being used as a payment mechanism

• They are not connected to a sovereign currency
• They are not backed by any authority such as a central bank, and hence are not a liability of any authority (see Chapter 2 for Central Bank operations)
• They derive value from the belief that they can be exchanged for other goods and services or a certain amount of sovereign currency at a later point in time. Hence they have zero intrinsic value
• The transfer of these currencies is through a built in distributed ledger. The mechanism allows remote peer-to-peer exchanges of electronic value in the absence of trust between the parties and without the need for intermediaries. Typically, a payer stores in a digital wallet his/her cryptographic keys that give him/her access to the value. The payer then uses these keys to initiate a transaction that transfers a specific amount of value to the payee. That transaction then goes through a confirmation process that validates the transaction and adds it to a unified ledger of which many copies are distributed across the peer-to-peer network.
• The institutions that are actively developing and operating these schemes are non banks

Figure 1.1 illustrates the separation between the two basic aspects of digital currency schemes (the asset side and the decentralised exchange mechanism based on a distributed ledger), and aims to provide a framework to help explain where e-money and digital currencies could be placed in relation to other types of money.

The Bitcoin phenomenon

The original concept paper behind Bitcoins, a decentralized electronic cash system using peer-to-peer networking to enable payments between individual parties was presented in 2008 by Satoshi Nakamoto in “Bitcoin: A peer to peer electronic cash system”.

Figure 1.2 shows how a typical Bitcoin transaction works

Climate change and financial system³

One of the most significant but most misunderstood, and underrated risks that the world and its organizations face today relates to climate change. To stem the disastrous effects of climate change, nearly 200 countries agreed in December 2015 to accelerate the transition to a low carbon economy. Since such a transition requires considerable and even disruptive changes across economic sectors, financial policy makers have been exploring the implications for the global financial system. The negative implications could include financial dislocations and sudden losses in asset values. Against this background, the G20 Finance Ministers and Central Bank Governors asked the Financial Stability Board to review how the financial sector can take account of climate related issues.

FIGURE 1.1 FORMS OF MONEY AND EXCHANGE MECHANISMS

Source: Report by Committee on Payments and Market infrastructures, titled “Digital currencies”, published by the Bank for International Settlements in November 2015, Figure 1, page 6, accessed at www.bis.org

FIGURE 1.2 A BITCOIN TRANSACTION – THE STEPS

The Task Force set up for this purpose made its final recommendations in July 2017. These recommendations apply to financial sector organizations, including banks (lending activity), insurance companies (underwriting activity), asset managers (asset management such as Mutual funds) and asset owners (such as public and private sector pension plans, endowments and investment foundations).

The Task force has stated that the disclosures by the financial sector could foster an early assessment of climate related risks and opportunities, improve pricing of climate related risks, and lead to more informed capital allocation decisions.

The implementation plan spans a five year horizon reform.

SECTION III

THE GLoBAL FINANCIAL SySTEM – AFTER THE FINANCIAL CRISIS

It has been about a decade since the Global Financial Crisis (GFC) of 2007-08.

The Bank for International Settlements (BIS), in its 87th Annual Report, 2016-17, (http://www.bis.org/publ/arpdf/ar2017e.pdf) has looked back at satisfaction at the past one year, where the global economy has strengthened further. The salient points from the extensive discussions in the Annual Report are summarised in the following paragraphs.

The BIS report points out that growth has approached long-term averages, unemployment rates have fallen towards pre-crisis levels and inflation rates have edged closer to central bank objectives. It also looks to the near term future with optimism. However, the report examines four risks that could threaten the sustainability of the expansion in the medium term: a rise in inflation; financial stress as financial cycles mature; weaker consumption and investment, mainly under the weight of debt; and a rise in protectionism.

However, global response is vital in key areas –ranging from broad principles to common standards. The five key areas identified by BIS are: prudential standards, crisis management mechanisms, trade, taxation and monetary policy.

A first priority is to finalise the financial (prudential) reforms under way. Among the reforms, completing the agreement on minimum capital and liquidity standards – Basel III – is especially important, given the role banks play in the financial system. The task is to achieve agreement without, in the process, diluting the standards. There is ample empirical evidence indicating that stronger institutions can lend more and are better able to support the economy in difficult times. A sound international agreement, supported by additional measures at the national level, combined with the deployment of effective macroprudential frameworks, would also reduce the incentive to roll back financial integration. The Basel agreements are explained in detail Chapter 11 of this book.

A second priority is to ensure that adequate crisis management mechanisms are in place. Regardless of the strength of preventive measures, international financial stress cannot be ruled out. A critical element is the ability to provide liquidity to contain the propagation of strains. The intermediation of global currencies, especially the dollar, also creates close linkages between globally active banks. The Global Financial Crisis demonstrated how such interconnectedness propagated funding stress between the world’s largest banks and forced them to deleverage internationally. Thus, the regulatory reforms in the aftermath of the GFC have focused on strengthening the resilience of international banks that are the backbone of global financial intermediation. Liquidity risk management and its relationship with other risks is explained in Chapter 12 of this book

Another overarching priority would be to further the room for greater monetary policy cooperation that would help limit the disruptive build-up and unwinding of financial imbalances. A detailed explanation on Monetary Policy is contained in Chapter 2 of this book

The Annual Report also recognizes the increasing role of technology and non bank players in the management of banks globally.

Another paper from BIS⁴ categorizes financial crises into banking, currency and sovereign debt crises. Recent research shows that during the period 1970 – 2011, currency crises occurred most frequently (218), followed by banking crises (147) and sovereign debt crises (66).

Since the first quarter of 2010, sovereign debt tensions and their impact on banks and economies have dominated. Sovereign debt crises have been more pronounced in the euro area. How is sovereign risk related to the banking and currency crises? Box 1.1 explains.

A Rewind to the Financial Crisis of 2007–08

No discourse on ‘banks’, and more so, ‘managing banks’, can begin without reference to the credit market turmoil of 2007. The global crisis spared no country—developed or developing. With many countries’ financial systems having grappled with the after-shocks of what began as a sub-prime lending crisis in the United States, it comes as no surprise that voluminous literature already exists on the causes of and lessons from the crisis, as well as remedial action taken by governments and regulators in various countries.

We will discuss the events that led to the crisis in detail elsewhere in this book. However, what is more important is the way forward. The financial system is the lifeline of any economy. It is therefore only natural that the ‘future’ of banking is hotly debated topic at not only banking forums but also at every congregation of professionals from various walks of life.

The term ‘paradigm shift’ is now being applied to banking as well. The question is—what does this ‘shift’ constitute? Will it mean jettisoning the old model of banking and adopting a completely new one? Or, would it signify fine tuning existing banking practices so that ‘crisis management’ is strengthened through effective anticipation and preventive action?

The Causes of the Crisis

Several arguments/theories/events have been cited as the causes of the 2007 crisis. But, there seems to be consensus on one possible over arching cause—lack of adequate attention from monetary authorities and regulators to certain factors that were shaping the global financial system when the crisis happened. Three groups of mutually reinforcing factors were then contributing to increased ‘systemic’ risk. They were as follows:

• Lower interest rates caused by worldwide macroeconomic imbalances over the last decade, inducing heightened risk taking and contributing to extremely high asset prices—the asset price ‘bubble’.
• Changing structure of the financial sector and rapid pace of financial innovation over the last two decades, and the failure of ‘risk management’ to match up to the new demands.
• Failure to adequately regulate highly leveraged financial institutions.

Prevalent models of banking

The aftermath of the global financial crisis ushered in the consequent need for a fresh assessment of the financial and banking sectors, including institutional and regulatory structures. In addition, changes in regulatory requirements and approach envisaged by Basel III, requiring increased analytic and risk assessment capacity in banks, necessitated a fresh look at the desired and optimal contours of a dynamic banking sector

The broad functions and objectives of the banking structure are more or less similar across countries. However, globally, there are different models of banking structures, different ownership patterns, and different emphasis on size of the banks. Country-level studies show that small, regional and local banks may perform very differently from large banks

The theoretical debate on how much banks and the financial system should be regulated is voluminous and continuing. However, the necessity of regulating the financial system and banks in particular is universally accepted on financial stability and consumer protection concerns. In fact from the lessons of the current crisis, the regulatory and accounting framework for banks has become more stringent, as we would learn in subsequent chapters.

Investment banks, Commercial banks and Universal banks – what is the difference?

There are basically two pure models of banking: commercial banking and investment banking. Universal banking represents a combination of the two banking models in varying proportions. Thus there are commercial banking oriented Universal banks (Bank of America, Citi Group, HSBC, etc.) and Investment banking oriented Universal banks (Barclays, BNP Paribas, UBS, Deutsche Bank.)

Figure 1.3 makes a comparison between Investment Banks, Commercial Banks and Universal Banks

FIGURE 1.3 INVESTMENT BANKS, COMMERCIAL BANKS AND UNIVERSAL BANKS- A COMPARISON

With the demise of investment banks in the wake of the crisis, the universal banking model remains the dominant model. However the model is not without its risks. The potential systemic risks of the model is being addressed by the Basel III framework through enhanced regulatory framework, pro-active and intensive supervision and efficient resolution framework, enhanced transparency and disclosure and strengthened market infrastructure. In addition, there are proposals for structural reforms – Dodd-Frank Act (under implementation in USA), proposals in Vickers Report (UK) and Liikanen Report (Euro zone) – under consideration for implementation. These regulatory frameworks are discussed in later chapters

Macroeconomic and Financial Stability—Understanding the Linkages

Studies of economic cycles show that ‘booms’ and ‘busts’ are typical of market-driven systems. ‘Depressions’, ‘recessions’ and ‘market crashes’ have all happened and passed into history, leaving behind painful memories, case studies and vital practical lessons to be learnt.

How are a country’s macroeconomic developments and financial stability related? Figure 1.4⁵ depicts the linkages between shocks in the real sectors of the economy and the financial sector.

Let us understand the figure using the example of the global crisis of 2007. The shock to the US economy began as an asset bubble in the real estate (housing) sector, caused by banks lending to sub-prime (less than creditworthy) borrowers.⁶ The delinquency of such borrowers led to credit and interest rate risk⁷ for banks involved in the lending. Since many of these banks, by this time, had ‘securitized’ the loans⁸ and transferred the risks to other banks/entities, and the underlying asset prices had fallen drastically, liquidity in the market dried up. Funding available in the market also dwindled, partly because there was no liquidity and, also due to banks being wary of lending to other borrowers/banks which needed funding.⁹ The high degree of interlinkages in the various markets led to a rapid transmission of the crisis from one segment to other segments. Ultimately, many banks ‘and other institutions’ balance sheets¹⁰ were affected. Taken together, the combined effect of various risks reflected in the aggregate loss distribution, which can be mapped back to the adverse impact on bank lending and the economy. In this case, since several banks and other institutions around the world were involved as ‘buyers’ or ‘insurers’ or ‘traders’ of credit risk, a number of other countries’ financial systems were adversely affected. Hence, the United States sub-prime mortgage market triggered a credit market crisis at the global level, the depth of whose adverse effects are being estimated even in 2009–2010.

FIGURE 1.4 INTERRELATIONSHIPS BETWEEN MACROECONOMIC DEVELOPMENTS AND FINANCIAL STABILITY

Source: Haldane, Andrew; Hall, Simon and Pezzini, Silvia (2007). A New Approach to Assessing Risks to Financial Stability; Financial Stability, Paper No. 2; www.bankofengland.co.uk

How do we define ‘financial stability’? There is no single definition for financial stability (and the term ‘systemic risk’ which is used in tandem). Hence, the term takes on contextual meaning, signifying smooth functioning of the financial system, both under normal and stressed conditions.¹¹

The recent credit crisis, like others before it, has thrown up several issues and challenges for banks and other financial institutions, as well as central banks and regulators. However, all stakeholders agree on one thing—recovery of the global financial system depends on restoration of ‘TRUST’.

The Role of ‘Trust’ in Financial Stability

The global crisis witnessed the crumbling of the very foundation of a sound financial system—TRUST.

There was a ‘massive breakdown of trust across the entire financial system—trust in banks and non banks, trust in central banks and other regulators, trust in credit rating agencies, trust in investment advisors, trust in brokers, dealers and traders, and trust in the financial markets, if not in the market system itself’.¹²

The loss of trust, coupled with failure of banking behemoths and lack of transparency, led to great fear and uncertainty. Which were the banks/institutions that could withstand losses? Can the potential losses be estimated with certainty? Were there lurking risks in the system that could explode in the future? Frightening questions—with no reassuring answers—resulted in unprecedented panic. Banks that had liquidity, hoarded it. Banks that did not have liquidity faced doomsday, since they got no help from the distrusting markets. The financial markets nearly went into a deep freeze. Long-standing financial institutions that had appeared rock solid quietly folded up. Lack of trust had almost brought the entire chain of financial intermediation to a standstill.

The Role of Regulation in Ensuring Financial Stability

The G20 Working Group on ‘enhancing sound regulation and strengthening transparency’ (Working Group I), in its report¹³ dated 25 March 2009, has reiterated the paramount importance of robust financial regulation in each country based on effective global standards for financial stability in future. The report has acknowledged the role of regulation as the first line of defence against financial instability. It sums up the cause of the financial crisis: ‘In hindsight, policy makers, regulators and supervisors in advanced countries did not act to stem excessive risk taking or to take into account the inter-connectedness of the activities of regulated and non-regulated institutions and markets’.

Experts have identified some of the areas that were given inadequate attention as the following:

1. The ‘perimeter’ of regulation. In deciding which institutions and practices should be regulated and to what extent, the regulators had overlooked that some institutions outside their purview were taking on excessive risks, and that some of these risks were not ‘visible’ or ‘detectable’.
2. Procyclical practices. Booms in the economy lead to higher confidence levels both among borrowers and lenders. As a consequence, lenders become lax about credit standards and borrowers turn overconfident about the potential of projects they invest in. When the economy is on the downturn, banks become wary and tighten lending standards and pull back liquidity.
3. Information gaps about risk and where they were distributed in the financial system. This happened in the case of financially engineered products, where credit risk transfer was done in a distributed manner. Though the principle of ‘structuring’ was to transfer risk to those parties who could best bear them, the rapid increase in demand for such high-yielding products led to lower transparency. As a result, most sellers and the buyers of these products lacked adequate understanding of what they were selling or buying, thus exposing themselves to greater risks.
4. Lack of cross-border information flow and co-operation among regulators in various countries. There was no harmonization of national regulatory policies and legal frameworks in various countries, even though risks were being transferred across countries.
5. Provision of liquidity by regulators in the event of crisis.

It is, therefore, clear that the regulatory framework needs considerable strengthening. The stark lessons from the crisis will ensure that adequate regulation will be receiving significant attention in future.

The Objectives of Financial Regulation

According to an IMF Working Paper,¹⁴ there are two vital objectives of financial regulation, as depicted in Figure 1.5.

We have already seen how the failure of financial institutions can have a wider impact on financial markets and macroeconomic stability. However, even a weak financial system can have adverse effects on economic growth and stability. Individual banks or financial institutions would not be able to assess the overall economic impact of bank level business decisions. Hence, regulation is used to mitigate such systemic risks.

As seen in Figure 1.5, systemic risks can be macro or micro in nature. Both types of risks, in essence, are interrelated.

When risks taken by various banks/institutions in the economy have a correlated negative impact across other institutions, the financial system as a whole gets weakened and economic growth is adversely affected. This is macro systemic risk, and the credit crisis of 2007 is an example of this risk.

In micro-systemic risk, the failure of one bank or institution has an adverse impact on the financial system as a whole. For example, failure of one bank can cause a loss of confidence and trigger a run on other banks, even those that are fundamentally sound.

How are the objectives of mitigating systemic risks and customer protection related and regulated? The following examples illustrate the facts:

• In financial markets, the sellers of financial products (say, deposit accounts or insurance services) have more information than the buyers (customers of banks, insurance, etc.). Hence, regulation is required to establish rules and procedures for disclosure of information or limit risk by placing a cap on the amount that can be invested in certain products.
• In retail markets, it is necessary for the regulator/regulation to ensure that the provider of financial services is in good financial health, since the payoff to the customers (e.g., repayment of deposits, insurance proceeds, and so on) is dependent on it.
• In wholesale markets, say in the case of securities, the sellers of securities have more information than the investors. Hence, more disclosures by way of information given in prospectuses or stiff penal clauses to restrain undesirable practices, such as insider trading are required. More transparency can be achieved through regulation.

FIGURE 1.5 OBJECTIVES OF FINANCIAL REGULATION

FIGURE 1.6 TOOLS OF FINANCIAL REGULATION

According to the IMF paper, quoted above, financial regulation can be done using four broad tools (see Figure 1.6). These are as follows:

• Prudential regulation typically sets out regulatory prescriptions for maintaining capital or liquidity or credit quality. The regulation seeks proactive remedial action.¹⁵
• Specialized tools in the hands of central banks and other regulators are the role of ‘lender of last resort’(LOLR) or deposit insurance.¹⁶
• Regulation of payment and settlement systems is vital for ensuring post-trade transactions in financial contracts are managed well.¹⁷
• Business regulation aims to regulate activities of financial market participants through regulation of trading activity and financial market products.¹⁸

Financial Stability—the Over-arching Agenda for the Future

One of the key lessons from the crisis is that financial stability does not automatically follow price stability or macroeconomic stability. In an increasingly globalizing world, a threat to financial stability in any country could trigger a series of responses that jeopardize the financial stability of other countries. Hence, ‘financial stability’ will, in future, have to be looked at as an explicit objective, rather than an implicit objective of economic policy and growth.

A lot of discussion has already taken place at the highest levels in international forums, and these discussions are forming the basis for new or altered regulation or supervisory guidance. Some of the significant actions already taken include strengthening the Basel 2 capital framework,¹⁹ developing global standards for liquidity risk management,²⁰ strengthening supervision of cross-border financial conglomerates, reviewing international accounting standards,²¹ strengthening the functioning of credit rating agencies,²² rationalizing compensation structures and extending the scope of regulation to cover non-banking financial institutions.²³ (See Box 1.2, for the role of non-banking financial institutions—also called ‘shadow banking system’ in the financial crisis.)

The encouraging signal emerging from global deliberations is the recognition that international co-operation is key to resolve crises of such proportion. The various working groups constituted by the G-20 have emphasized that future regulation and supervision must reinforce risk management capacity of financial institutions. Greater transparency and lower regulatory ‘arbitrage’ (defined later in this chapter) have also been insisted upon. A major outcome is the establishment of a new Financial Stability Board (FSB) to be operated by the International Monetary Fund (IMF), with strengthened mandate that includes all large countries of the world.

The Global shadow banking monitoring report, 2016 (http://www.fsb.org/wp-content/uploads/global-shadow-banking-monitoring-report-2016.pdf) by the FSB throws up interesting trends. The report, covering 28 jurisdictions accounting for over 80% of global GDP, states that while banks continued to grow during 2015, their share in the financial system declined for the fourth consecutive year, particularly in the Euro area.

The ‘other financial intermediaries’ (OFI), that are comprised of all financial institutions that are not classified as banks, insurance corporations, pension funds, public financial institutions, central banks or financial auxiliaries, saw a growth in their assets equal to 150 % of total GDP of these countries at the end of 2015. The previous peak of 139% in this measure was observed prior to the financial crisis of 2007-08.

The report also mentions a Narrow measure of shadow banking (or the ‘narrow measure’ or ‘shadow banking under the economic functions approach’) that includes non-bank financial entity types that are considered by authorities to be involved in credit intermediation where financial stability risks from shadow banking may occur. This narrow measure, that is expected to financial stability risks, grew 3.2 % to $34 trillion in these countries, excluding China. The uncontrolled growth in shadow banking has serious implications for the economies and the banking systems.

SECTION IV

THE INDIAN FINANCIAL SYSTEM—AN OVERVIEw

Financial Stability in India

The financial system of any country has two important segments—the financial markets and the financial intermediaries.²⁶

The turmoil in the global financial system has triggered introspection and discussion on the stability of the Indian financial system. Some have termed the fact that India has not faced any financial crisis so far as a consequence of deregulation as ‘remarkable’, while others attribute it to the ‘correctness of ‘judgement’ that reforms to global standards need to be adjusted to local conditions’.²⁷ The relative insulation of India could also appear ‘fortuitous’, since the credit derivatives market is in an embryonic stage and the originate-to-distribute model in India is not comparable to that in developed markets, or ‘conservative’, since regulatory guidelines on securitization do not permit immediate profit recognition or the reforms were not speeded up through bold and drastic steps as in other countries.

However, the fact remains that the Indian financial sector has matured since the financial reforms were instituted. What we see today is a reasonably sophisticated and robust system delivering a diverse range of financial services, efficiently and profitably. With deregulation, the operational and functional autonomy of financial institutions has increased and, so has their participation in various financial market segments in the face of heightened international competition. It is also moving towards the goal of financial inclusion by accelerating growth momentum while containing risk and emphasizing on ‘financial stability’.

In order to understand the challenges and issues confronting, the Indian banking system in the present context, it is necessary to understand the structure and evolution of the Indian financial system.

One way of understanding the financial market structure is to look at its components. Table 1.1 classifies financial markets into broad components and lists their typical characteristics. The table also indicates the broad aspects of regulation in each market, as well as the depth of the market in India.

TABLE 1.1 CHARACTERISTICS OF FINANCIAL MARKETS

Table 1.2 outlines the typical instruments, their salient features, and some of issues to be resolved in each market.

TABLE 1.2 TYPICAL FINANCIAL INSTRUMENTS IN INDIA—SALIENT FEATURES

To summarize, Figure 1.7 depicts the manner in which the financial system is regulated at present.

FIGURE 1.7 REGULATORY STRUCTURE OF THE INDIAN FINANCIAL SYSTEM

SECTION V

THE INDIAN BANKING SYSTEM—AN OVERVIEW

The key feature that distinguishes the Indian banking sector from the banking sectors in many other countries is the plethora of different types of institutions that cater to the divergent banking needs of various sectors of the economy.

For example, Credit cooperatives were created to cater to the credit, processing and marketing needs of small and marginal farmers organised on cooperative lines. These institutions later expanded in urban and semiurban areas in the form of urban cooperative banks to meet the banking and credit requirements of people with smaller means. Regional Rural Banks were created to bring together the positive features of credit cooperatives and commercial banks and specifically address credit needs of backward sections in rural areas. Local Area Banks were brought in to bridge the gap in credit availability and strengthen the institutional credit framework in the rural and semi-urban areas.

Though the capital market size has expanded substantially since financial liberalization, the Indian financial system is dominated by financial intermediaries.³⁷ The commercial banking sector holds the major share (about 60 per cent) of the total assets of the financial intermediaries, which comprise of commercial banks, urban co-operative banks, rural financial institutions, non-banking finance companies, housing finance companies, development financial institutions, mutual funds and the insurance sectors.

The financial institutional structure in India

The financial institutional structure in India can be broadly classified into: (a) commercial banks; (b) financial institutions; (c) non-banking finance companies; and (d) co-operative credit institutions. (See Figures 1.8 to 1.8G).

FIGURE 1.8 THE FINANCIAL INSTITUTIONS STRUCTURE IN INDIA

FIGURE 1.8A THE COMMERCIAL BANKING SYSTEM

Note: Figures in brackets signify the number of banks under each category. All data pertain to March, 2016. The number of banks stated above would undergo a change after the process of merger of SBI with its associates is completed.

Source: RBI database.

WHO OWNS THE COMMERCIAL BANKS IN INDIA?

Public Sector Banks

At the end of March 2016, there were 27 public sector banks in India, comprising of State Bank of India and its associate banks (6), and 21 nationalized banks.

The public sector banks in India are regulated by statutes of the Parliament and some important provisions under section 51 of the Banking Regulation Act, 1949.

Specifically, the regulations are as follows:

• State Bank of India (SBI) regulated by the State Bank of India Act, 1955.
• Subsidiary banks of State Bank of India regulated by State Bank of India (Subsidiary Banks) Act, 1959. After the merger of SBI with its subsidiaries described below, these Acts would be amended suitably.
• Nationalized banks regulated by Banking companies (Acquisition and Transfer of Undertakings) Act, 1970 and 1980.

The statutes also stipulate that the central government is mandated to hold a minimum shareholding of 51 per cent in nationalized banks and 55 per cent in State Bank of India (SBI). In turn, SBI will have to hold a minimum 51 per cent of the shareholding in its subsidiaries. Another stipulation is that foreign investment in any form cannot exceed 20 per cent of the total paid up capital of the public sector banks.

Very shortly, SBI would complete the process of merger of five associate banks and Bharatiya Mahila Bank (BMB) with itself. Post merger, about 1500 branches of the combined entity would be closed. Once the merger is completed, SBI is expected to become a lender of global proportions, with an asset base of Rs 37 billion (over $555billion), and 22500 branches. SBI would figure in the list of top 50 banks globally, being ranked 45th. The Bill approving the amalgamation has been passed in the Indian parliament.

From 1984–1985, there have been three distinct ‘phases’ of equity infusion by the government into public sector banks. In the period up to 1992–1993, all nationalized banks were capitalized without any predetermined norm. Over the next couple of years, (up to 1993–1995), when the first phase of financial reforms were under way, some ‘weak’ nationalized banks were put on a recovery path and in the following years, the government, as owner, had to improve banks’ capital position to levels stipulated by the Basel Accords. In 2006–2007, banks were allowed to raise capital from the public through equity issues. The relevant Acts were amended to permit banks raise capital to a level not exceeding 49 per cent of their equity base.

The government is considering merging the nationalised banks to ultimately have about four large state run banks.

The Board of public sector banks comprises of whole time directors—chairman, managing director(s), executive directors, government nominee directors, RBI’s nominee directors, workmen and non workmen directors and other elected directors.

The Indian government has recently constituted the Banks Board Bureau (BBB) for selection of Managing Directors and Directors of public sector banks and financial institutions.

Private Sector Banks

At the end of March 2016, there were 21 private sector banks in India.

The broad underlying principle in permitting the private sector to own and operate banks is to ensure that ownership and control is well-diversified and sound corporate governance principles are observed. New private sector banks can initially enter the market with a capital of Rs 5 billion, which is the minimum net worth that should be retained at all times. In February 2013, fresh guidelines for licensing of new banks were issued. The guidelines permit business/industrial houses to promote banks, conversion of NBFCs into banks and setting up of new banks in the private sector by entities in the public sector, through a Non-Operative Financial Holding Company (NOHFC) structure.

In August 2016, RBI permitted ‘on tap’ licencing of new private banks to float universal banks (See Section III ). The guidelines have been liberalized since 2013, when IDFC Ltd and Bandhan Financial Services were allowed to set up universal banks.

The Universal bank has to get its shares listed on stock exchanges withing six years from commencement of business

Small Finance Banks (SFB)

Universal banks may not be in a position to understand or cater to the needs of small value customers. Hence, in November 2014, RBI gave approvals / licences for Small Finance Banks.

RBI issues licences to entities to carry on the business of banking and other businesses in which banking companies may engage, as defined and described in Sections 5 (b) and 6 (1) (a) to (o) of the Banking Regulation Act, 1949, respectively

According to RBI guidelines dated November 27, 2014 (https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR1090GLS1114.pdf accessed at www.rbi.org.in), the objectives for setting up Small Finance Banks is to give a fillip to financial inclusion by (a) providing savings vehicles, and (b) supplying credit to small business units, small and marginal farmers, micro and small industries and other unorganized sector entities, through high technology, low cost operations.

Small finance banks can be established by (a) individuals/ professionals with 10 years’ experience in the banking and finance industry, (b) companies / societies owned and controlled by residents, (c) existing Non Banking Finance Companies (NBFC), Micro finance institutions (MFI) and Local Area Banks (LAB) owned and controlled by residents

The minimum paid up equity capital required is Rs 1 billion. Promoters’ minimum initial contribution should be 40%. Foreign shareholding will be determined by the Foreign Direct Investment (FDI) Policy for private sector banks.

The SFB would be required to follow all prudential norms and regulations applicable to commercial banks. Including maintaining cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR). The regulations are explained in subsequent chapter. SFB lending is to be made to sectors specified by RBI.

Ten Small finance banks have been granted licences upto March 2017. Of these, 8 are Microfinance institutions. They are listed below.

1. AU Small Finance Bank
2. Equitas Small Finance Bank
3. Ujjivan Small Finance Bank
4. Utkarsh Small finance Bank
5. Janalakshmi Small Finance Bank
6. Capital Lab Small Finance Bank (converted from a Local Area bank)
7. Disha Small finance Bank
8. ESAF Small finance Bank
9. RGVN Small finance Bank
10. Suryoday Small Finance Bank

Why are Microfinance Institutions evincing keen interest on converting themselves to Small Finance Banks?

Microfinance institutions (MFIs) are a category of Non Banking Finance companies (NBFC), which are permitted to lend to Self Help Groups (SHG) or Joint Liability Groups (JLG) by borrowing funds from banks. When the MFIs convert to SFBs, they can access public deposits, and participate in the bank payment systems, such as issuing cheque books and e payments. SFBs can make bigger loans to small borrowers.

The operating guidelines for SFB were issued in October 2016, and can be accessed at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT81A721DA1E8CE745659C469519A38B75FA.PDF

The detailed compendium of guidelines in July 2017 on Small Finance banks by RBI can be accessed at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NOTI138800F49EEDBC418A9CB662EB2DEE4759.PDF

Payments Banks

Payments Banks are essentially ‘narrow banks’. To safeguard deposits placed with it, a narrow bank does not undertake lending activities. Rather, it invests the majority of its deposits in ‘safe’ instruments such as government securities. ( The term ‘narrow banks’ was developed by Robert E Titan of the Brookings Institutions in 1987, and was developed thereafter by many economists).

In November 2014, this class of niche banks was authorised by RBI. This category of banks was termed “Payments Banks” and the overarching objective was to accelerate financial inclusion. Payments banks are intended to provide (a) small savings accounts and (b) payments/ remittance services to migrant labour workforce, low income households, small businesses, unorganized sector entities and other users. The guidelines for eligibility for establishing Payments Banks can be accessed at https://rbidocs.rbi.org.in/rdocs/Content/PDFs/PAYMENT271114.pdf. The Operating guidelines for Payments banks were released by RBI in October 2016 (https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT8012D3D3858D194184981CAF033321AA26.PDF)

Payments banks are permitted to undertake only the following activities:

• Accept demand deposits. Payments bank will initially be restricted to holding a maximum balance of Rs. 100,000 per individual customer.
• Issue ATM/debit cards. Payments banks, however, cannot issue credit cards.
• Undertake payments and remittance services through various channels. Payments Banks basic business model is geared towards using newer mobile technology and payment gateways to enable transfers and remittances through mobile devices, and issue debit / ATM cards usable on ATM networks of all banks. Hence the operations of these banks should be fully networked and technology driven from commencement of business operations.
• Function as a Business Correspondent of another commercial bank, as allowed by the RBI guidelines
• Distribute non-risk sharing simple financial products like mutual fund units and insurance products.

Payments banks cannot use the funds sourced from the above activities for lending. However, the funds would have to be deployed as follows:

• As Cash Reserve Ratio (CRR) with RBI
• Minimum of 75% of demand deposit balances should be invested as Statutory Liquidity Ratio (SLR), in eligible government securities or treasury bills with maturity up to one year
• Maximum of 25% of demand deposit balances should be held in current and time / fixed deposits with other commercial banks for operations and liquidity management

The following entities can create Payments banks:

• Existing non bank Pre paid Instrument (PPI) issuers
• Individuals / professionals
• Non Banking Finance companies (NBFC)
• Corporate Business Correspondents (BC)
• Mobile telephone companies
• Super market chains
• Companies
• Real sector cooperatives
• Public sector entities

The minimum paid up equity capital for setting up Payments banks is Rs 1 billion. The promoters of these banks should contribute at least 40% of the equity capital and hold their stake for the first five years after the banks commence business. Foreign shareholding in Payments Banks is permitted and subject to the foreign direct Investment (FDI) policy for private sector banks as amended from time to time. The current FDI policy states that the aggregate foreign investment in a private sector bank from all sources will be allowed upto a maximum of 74 per cent of the paid-up capital of the bank.

Since the Payments banks are intended as a tool for financial inclusion, they have to provide at least 25 per cent of physical access points including BCs in rural centres

The following Payments Banks have been permitted to function (as of June 2017):

1. Airtel Payments Bank
2. India Post Payments Bank
3. Fino Payments Bank
4. Jio Payments Bank
5. Idea Payments Bank
6. Paytm Payments Bank

Foreign Banks

The presence and expansion of Foreign banks in India is with a view to fostering the inherent potential for sustained growth in the domestic economy and growing integration into the global economy.

In 2004, RBI permitted foreign banks regulated by a central bank in their home countries, to establish Wholly Owned Subsidiaries (WOS) in India. In 2005, a roadmap for the presence of foreign banks in India was drawn up. The first phase of the roadmap spanned the period between March 2005 and March 2009. The second phase would be operationalised after a review of the experience in the first phase.

In the first phase, foreign banks already operating in India were allowed to convert their existing branches to WOS.

In the second phase from April 2009, only the WOS route is permitted for a foreign bank to operate in India. Once established, the regulation is non-discriminatory in India, as foreign banks enjoy near national treatment in the matter of conduct of business. However, to prevent domination by foreign banks, restrictions are placed on further entry of new WOSs when the capital and reserves of the WOSs and foreign bank branches in India exceed 20% of the capital and reserves of the Banking system in India.

Local incorporation of foreign banks as WOS is advantageous due to the following reasons:

1. Local incorporation enables creation of separate legal entities that have their own capital base and local Board of directors;
2. There is a clear distinction between the assets and liabilities of the foreign banks operating in India and those of their foreign parent banks;
3. Local regulation and law enforcement is possible for better control

The initial minimum paid up capital for setting up the WOS is Rs 5 billion. If a foreign bank dilutes its stake in India to 74% or less, the existing FDI policy stipulates that the bank should list itself in India. The RBI guidelines in respect of foreign banks can be accessed at https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR936SC1113.pdf

INDIAN BANKS OPERATING OVERSEAS

There are 15 Indian banks (with187 branches) operating in various countries. They follow the local regulations when they operate outside India.

Regional Rural Banks (RRBs)

The RRBs were created for rural credit delivery and to ensure financial inclusion. Their capital base is held by the central government, relevant state government and the commercial bank that ‘sponsors’ them, in the ratio of 50:15:35, respectively. Recent policy initiatives include recapitalization and amalgamation of RRBs with their sponsor banks. So far, there have been two broad phases in the amalgamation of RRBs. In the first phase (September 2005–March 2010), RRBs of the same sponsor banks within a state were amalgamated bringing down their number to 82 from 196. In the second and ongoing phase, starting from October 2012, geographically contiguous RRBs within a state under different sponsor banks would be amalgamated to have just one RRB in medium-sized states and two/three RRBs in large states. In the current phase, 31 RRBs have been amalgamated into 13 new RRBs within 9 states to bring down their effective number to 56. Of these, 45 are profitable.

However, an issue that is considered to hamper performance efficiency of RRBs is the multiplicity of control—RBI is the banking regulator, while NABARD39 is the supervisor with limited supervisory powers.

FIGURE 1.8B NON-BANKING FINANCIAL INSTITUTIONS (NBFI)–THE COMPONENTS

Non-banking Financial Institutions (NBFIs) are a heterogeneous group of institutions that cater to a wide range of financial requirements. They can broadly be grouped as All India financial institutions (AIFIs), non-banking financial companies (NBFCs) and primary dealers (PDs). The structure of these components is described in the following paragraphs.

FIGURE 1.8C FINANCIAL INSTITUTIONS’ STRUCTURE

Non Banking Financial Institutions (NBFI)

The ‘financial institutions’ (FIs) fall under the category of ‘Non-banking Financial Institutions (NBFI)40 that complement banks in providing a wide range of financial services to a variety of customers and stakeholders. While banks primarily provide payment and other liquidity related services, the NBFIs offer equity and risk-based products. However, this distinction is blurring now, as some financial institutions convert themselves into banks and ‘financial integration’ proceeds at a rapid pace.⁴¹

Based on their major line of activity, the four all-India financial institutions are classified into: (1) term-lending institutions (EXIM Bank), which invests in projects directly through investments and loans; and (2) refinancing institutions (NABARD - National Bank for Agriculture and Rural Development, SIDBI - Small Industries Development Bank of India and NHB - National Housing Bank). The refinancing institutions extend refinance to both banks as well as other NBFIs. Specifically, however, NABARD extends refinance and other facilities for agriculture and allied activities, SIDBI for the micro, small and medium enterprises (MSME) sector and NHB for the housing sector. Table 1.3 provides the ownership of these financial institutions

TABLE 1.3 ALL INDIA FINANCIAL INSTITUTIONS – OWNERSHIP

Investment institutions, such as LIC and GIC deploy their resources for long-term investment. After the Insurance Regulatory and Development Authority came into being in 1999, the sector—both life and non-life—have been thrown open for private and foreign participation.

State/regional level financial institutions comprise of State financial corporations (SFCs) and State Industrial and development corporations (SIDCs).

Some institutions, including a few from those listed above, have been notified as ‘public financial institutions’ by the Government of India under the Companies Act, 1956. Of these, a few have ceased operations (such as the Industrial Investment Bank of India), while some others have been converted into NBFCs (see the discussion on NBFCs, below). Examples of FIs converted into NBFC-ND-SI (see definition, below) are Industrial Finance Corporation of India (IFCI) and Tourism Finance Corporation of India (TFCI).

Non Banking Finance Companies (NBFC)

The RBI Act 1934 was amended in January 1997 to bring in a comprehensive legislative framework for regulating NBFCs. The amendment called for compulsory registration and maintenance of minimum ‘net owned funds’ (NOF⁴²—the concept of ‘capital’ for NBFCs), for all NBFCs and conferred powers on RBI to determine policies and issue directions to NBFCs.

The two major categories of NBFCs in India are the deposit taking (NBFC-D) (from the public) and nondeposit taking (NBFC-ND) NBFCs. Housing Finance Companies (HFC) are considered a special type of NBFC. The residuary non-banking finance companies—RNBC, also accepts deposits from the public. Earlier, RNBCs held almost 90 per cent of all NBFC deposits, but their business model was found unviable. Hence, RNBCs were required to migrate to other business models. The two RNBCs exited the present business model by repaying their liabilities by 2015. Non-deposit taking NBFCs have been further bifurcated into NBFC-ND and NBFC-ND-SI, as shown in Figure 1.8D. ‘SI’ stands for ‘systemically important’. Understandably, NBFCs with asset size of over Rs 5 billion are classified in this category.

FIGURE 1.8D NBFC STRUCTURE BASED ON LIABILITIES

Note: Figures in brackets indicate the number of institutions at the end of March 2017. Note that NBFC-ND-SI constitutes only about 2.9 per cent of NBFC-ND by number, but accounts for about 95 per cent of business.

Source: RBI database (figures as of March, 2017).

While deposit taking NBFCs (NBFC-D) were subject to some prudential regulation since 1963, the non-deposit taking institutions (NBFC-ND) were almost unregulated. As ‘systemic risk’ became a frequently used term and began threatening the stability of financial systems, RBI designated those NBFCs with asset size of over Rs 5 billion as ‘systemically important’ (NBFC-ND-SI), due to their linkages with money markets, equity markets, banks and financial institutions and brought them under a specific regulatory framework (capital adequacy and exposure norms⁴³) from April 1, 2007. NBFC-ND-SI is the fastest growing segment of NBFCs, growing at a compound rate of 28 per cent between 2006 and 2008. They raise resources⁴⁴ primarily from issue of debentures, borrowings from banks and other financial institutions and issue of commercial paper (a money market instrument, discussed in a later chapter). This category of NBFCs is closely monitored by RBI due to their systemic importance.

Figure 1.8E also shows another classification of NBFCs according to their asset profile. Across NBFC categories, asset finance companies (AFC) hold the largest share in total assets/liabilities (above 70 per cent). They are followed by loan companies (LC) with about 30 per cent.

FIGURE 1.8E NBFC STRUCTURE BASED ON ACTIVITY

It can be gauged from the above discussion that NBFCs, especially NBFC-NDs, do not have access to lowcost sources of funds like the banks do.⁴⁵ Therefore, to compensate for high cost of funds, a significant segment of NBFC-ND companies have adopted a capital market based business model, such as providing loans against shares or financing public issues. While this is a model where high yields are possible, the risks are also higher.

Account Aggregators (AA) is the latest category of NBFCs authorised by RBI in September 2016 (https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MD46859213614C3046C1BF9B7CF563FF1346.PDF). At present, financial asset holders such as holders of savings bank deposits, fixed deposits, mutual funds and insurance policies, get a scattered view of their financial asset holdings if the entities with whom these accounts are held fall under the purview of different financial sector regulators. This gap will be filled by account aggregators who will provide information on various accounts held by a customer in a consolidated, organised and retrievable manner. The option to avail the services of an account aggregator by a customer will be purely voluntary. The NBFC –AA will be regulated by RBI. The business model will be driven entirely by Information Technology (IT), and will be governed by a Citizens’ Charter for customer protection. The minimum Net Owned Funds (capital) requirement for an AA is Rs 2 crore. Once authorized, the AA will be bound by the terms and conditions of the licence that include customer protection, grievance redressal, data security, audit control, corporate governance and risk management. The AA will not involve itself in the financial transactions of customers. The pricing of its services will be in accordance with a policy approved by its Board of Directors.

Housing Finance Companies (HFC)

Housing finance companies (HFC) are special types of NBFCs. When the National Housing Bank (NHB), one of the all India financial institutions (described earlier) was set up in 1988, there were about 400 housing finance companies regulated by the RBI that financed only 20 per cent of the population’s home financing needs. The remaining 80 per cent was being financed through informal sources. Housing Development Finance Corporation (HDFC) was the largest housing finance company. The housing finance market has grown stupendously since then, with many banks and other institutions entering the sector. The NHB is the regulator and supervisor of HFCs.

Other types of NBFCs are Chit Funds that are regulated by the State Governments, and Mutual Benefit companies that are regulated by Ministry of Corporate Affairs, Government of India. The multiplicity of regulators poses challenges in the functioning of the non banking sector

There are further regulatory challenges in this fast growing segment.

For example, RBI’s Panel for financial regulation and supervision classifies NBFCs into a third set of broad categories⁴⁶:

1. Stand-alone NBFCs.
2. NBFCs that are subsidiaries/associates/joint ventures of banking companies.
3. NBFCs and banks under the same parent company, i.e., ‘sister companies’.
4. NBFCs that are subsidiaries/associates of non-financial companies.

FIGURE 1.8F PRIMARY DEALERS (PD)⁴⁷ OPERATING IN FINANCIAL MARKETS

Note: Figures in brackets indicate the number at the end of July 2016. Bank PDs are run by banks. Standalone PDs are also called non-bank PDs and are registered as NBFCs under Section 45 1A of the RBI Act, 1934.

Source: RBI database.

FIGURE 1.8G STRUCTURE OF THE CO-OPERATIVE BANKING SECTOR (END-MARCH, 2016)

StCBs: State Co-operative Banks; DCCBs: District Central Co-operative Banks: PACS: Primary Agricultural Credit Societies; SCARDBs: State Co-operative Agriculture and Rural Development Banks; PCARDBs; Primary Co-operative Agriculture and Rural Development Banks.

Notes: 1. Figures In parenthesis indicate the number of Institutions at end-March 2016 for UCBs and at end-March 2015 for rural cooperatives.

2. For rural co-operatives, the number of co-operatives refers to reporting co-operatives.

Note: Tier 1 UCBs includes: (i) banks with deposits below Rs 1 billion, whose branches are located in a single district; (ii) banks with deposits below Rs 1 billion having branches in more than one district, provided the branches are in contiguous districts and deposits and advances of branches in one district separately constitute at least 95 per cent of the total deposits and advances respectively of the bank; and (iii) banks with deposits below Rs 1 billion, whose branches were originally in a single district, but subsequently, became multi-district due to reorganization of the district. All other UCBs are classified as Tier 2.

Source: RBI, Report on Trend and Progress of Banking in India, 2015–16,Chart 3.1, Page 16.

Co-operative Credit Institutions

India has a large number and broad range of rural financial service providers—with formal financial institutions/ banks at one extreme, informal providers such as money lenders or traders at the other extreme and between these two, a large number of semi formal providers. The ‘formal’ providers include rural and semi urban branches of commercial banks, regional rural banks, rural co-operative banks and primary agricultural credit societies (PACS). The ‘semi-formal’ sector is characterized by self-help groups (SHGs) with bank linkages and the microfinance institutions (MFIs).

The co-operative sector was conceived as the first formal institutional channel for credit delivery to rural India. It has been regarded as a key instrument for achieving the ‘financial inclusion’ objective. The urban co-operative banks (UCBs) are an important channel for financial inclusion in the semi-urban and urban areas, especially for the middle- and low-income customers.

Though these institutions play a critical role in the financial sector, their commercial viability and financial soundness are seen as areas of concern. The size of the rural and co-operative sector is small when compared with the commercial banking sector. However, there are certain issues that have to be resolved if these institutions have to function efficiently.

A key issue that hampers efficiency is that these institutions’ operations are overseen by both the RBI/ NABARD and the relevant state governments, which leads to multiplicity of control. According to the committee on financial sector assessment (CFSA, 2009), the dual control is ‘the single most important regulatory and supervisory weakness’ in the co-operative banking sector.

Another issue causing concern is the management and governance of these institutions. Since, only borrowers are members, co-operatives could tend to frame and pursue borrower-oriented policies. Many co-operatives function as banks without proper licences. Further, directors are appointed mostly on political affiliation and rarely on merit. To introduce best practices and professional governance, the CFSA recommends (Chapter II, page 174) that co-operatives in India be modelled on the lines operated by the World Council for Credit Unions (WOCCU).⁴⁸

The rural cooperative credit structure is shown in Figure 1.8G.

The RBI adopted a multi-layered regulatory and supervisory strategy aimed at the consolidation of UCBs by way of merger/amalgamation of viable UCBs and the exit of unviable banks for the revival of this sector, which led to a gradual reduction in the number of UCBs. The closures of UCBs were due to various reasons such as high non-performing advances, negative net-worth, deterioration in financial health, non-compliance with RBI guidelines, frauds, affairs conducted in a manner detrimental to the interests of depositors, misappropriation of funds, sanctioning of loans in excess of permissible limit, sanctioning of loans to the entity in which directors have interest, etc. The total number of UCBs as at the end of March 2016 stood at 1574 as against 1606 as at the end of March 2013. The progress of consolidation of UCBs is shown in Table 1.4.

TABLE 1.4 PROGRESS IN CONSOLIDATION OF URBAN COOPERATIVE BANKS (UCB)

Source: RBI – Financial Stability Report, December 2013, p. 43 and Table 2.10.

Box 1.3 summarizes the major findings and recommendations of an Expert Committee on the short-term cooperative credit structure.

Banking Models in India

Figure 1.9 shows the ways in which financial conglomerates can be organized.

In the ‘universal bank’ model, all financial operations are conducted within a single corporate entity. In the ‘operating subsidiary’ model, operations are conducted as subsidiaries of a financial institution. In the ‘holding company’ model, financial operations are carried out by distinct entities (such as banks, mutual funds, insurance, NBFCs and HFCs), each with separate capital and management, but together owned by a single institution (financial or non-financial).

In India, the universal banking model is followed. In structuring universal banks, the conglomerate structure is bank-led, i.e., banks themselves are holding companies which operate certain businesses through Subsidiaries, Joint Ventures and Affiliates. The policy has evolved over a period of time. The current policy has been expounded in the FAQs on the New Banks Guidelines dated 3^rd June 2013 (www.rbi.org.in). The general principle in this regard is that para-banking activities, such as credit cards, primary dealer, leasing, hire purchase, factoring etc., can be conducted either inside the bank departmentally or outside the bank through subsidiary/ joint venture /associates. Activities such as insurance, stock broking, asset management, asset reconstruction, venture capital funding and infrastructure financing through Infrastructure Development Fund (IDF) sponsored by the bank can be undertaken only outside the bank. Lending activities must be conducted from inside the bank

FIGURE 1.9 ALTERNATE ORGANIZATIONS FOR FINANCIAL CONGLOMERATES

Evolution of Indian Banking

The evolution of the Indian banking system can be categorized into four distinct phases:

• The pre-Independence (pre-1947) phase
• 1947–67
• 1967 to 1991–92
• 1991–92 (financial sector reforms) and beyond

In the pre-Independence phase, there were no entry norms and several banks were established. The Swadeshi Movement was instrumental for establishment of some banks that are in existence even today. This phase, marked by two World Wars and the Great Depression, also saw several banks failing. Most of the banks that failed were either too small to withstand global pressures or were mismanaged by directors, managers and practices of interconnected lending or had combined trading and banking functions. Partly in response to the bank failures, the RBI was set up in 1935.⁴⁹ However, due to the presence of a dominating unorganized sector (money lenders, etc.) and the lack of a sound regulatory framework, RBI’s control over banks was limited.

In the post-Independence era, the Banking Companies Act (now called, ‘the Banking Regulation Act’) was enacted in 1949, primarily to address the issue of banking failures. It also empowered the RBI to regulate and control the banking sector. The RBI could improve the safety and soundness of the banking sector by enabling weak banks to amalgamate or liquidate. Deposit insurance was introduced to increase depositors’ confidence in the banking system. Efforts were made through branch expansion of the State Bank of India to include more rural areas in the banking ambit. However, the nexus between banks and big industrial houses resulted in very little credit percolating down to the common man or to small industries and agriculture. RBI’s micro controls to ensure adequate credit to productive sectors resulted in a complex structure of regulated interest rates.

1967 to 1991–92 saw the tightening of social controls over the banking sector. To ensure equitable credit flow to the agriculture and small sectors, directed lending to ‘priority sectors’ was introduced. This period also saw the nationalization of major banks. This period was marked by rapid expansion in bank branches and, also an increase in lending to the priority sectors. However, the expansion in branches and credit was made without regard to banks’ profitability or asset quality. Credit to medium and large industries was more difficult to get due to strict targets for priority sector lending, stringent norms for lending to the ‘non-priority’ sectors and high statutory pre-emption (cash reserve ratio and statutory liquidity ratio). At the end of this phase, banks had accumulated a staggering amount of assets that gave no income to the bank (known today as ‘non-performing’ assets) and were low on profitability, efficiency and productivity.

‘Until the beginning of the 1990s, the state of the financial sector in India could be described as a classic example of ‘financial repression’.⁵⁰ The characteristic features of this state were manifested in the following forms:

• Administered and regulated interest rates.
• Large amount of resources drained away from productive lending by high rates of CRR and SLR.
• Extensive micro-regulation of flow of funds between banks.
• Limited disclosure and opaque accounting practices.
• Dominant public ownership with decreasing efficiency and productivity.
• Low capital and high level of non-performing loans.
• High investment in government securities, enabling high government borrowings at administered or concessional interest rates.
• Stringent barriers to entry of new and more efficient players into the banking sector.
• Restrained access of the private sector to bank credit, especially in the absence of other avenues for external financing.

During this period, the capital and foreign exchange markets also lacked depth. While the capital market reeled under complex regulations with little transparency or depth in secondary market trading, stringent controls, opaqueness and malpractices characterized the foreign exchange market. The Monetary Policy’s subservience to the fiscal policy⁵¹ had effectively blocked the development of the financial system. A serious balance of payments problem was in the offing. Foreign exchange reserves were hardly sufficient to cover three weeks’ imports. Gold reserves were swapped and India went in for a loan from the International Monetary Fund (IMF).

The year of 1991–1992 saw the dawn of one of the most productive phases in India’s banking history.

The RBI (report on currency and finance) divides this phase into two sub phases: 1991–92 to 1997–98 and 1997–98 and beyond. In the first sub phase, against the backdrop of a balance of payments problem, the need was felt for a vibrant and competitive banking and financial sector. The government of India constituted a high-powered committee on the financial system (CFS) under the chairmanship of Shri M. Narasimham. Popularly known as the ‘Narasimham Committee’, it made wide ranging recommendations that formed the basis of financial sector reforms. Annexure I lists the salient features of the committee’s recommendations, widely acknowledged as the very foundation of the country’s financial sector reforms process.

The approach to reforms was guided by the ‘Pancha Sutra’ or five principles: (1) cautious and sequenced reform measures; (2) introduction of reinforcing norms; (3) introduction of complementary reforms across relevant sectors—monetary, fiscal, external and financial; (4) development of financial institutions; and (5) development and integration of financial markets.

A major highlight of the first sub-phase was the improved profitability, competitiveness, capital position and asset quality of most banks. However, banks also developed a risk aversion that translated into slower credit growth, especially to the agriculture sector.

The early part of the second sub-phase, 1997–98 onwards, saw a push towards prudential norms in line with international best practices. By this time, new private sector banks had also been allowed to operate, which implied that existing banks had to turn more competitive. The thrust veered towards improving credit delivery and customer service, strengthening corporate governance practices and the urban co-operative banking sector and promoting financial inclusion, while taking appropriate measures to enable banks to recover non-performing loans. Banks were able to achieve a sharp decrease in non-performing assets (loans and investments). The asset quality improvement manifested itself in better capital adequacy. This phase has also been witnessing increasing use of technology by banks and customers alike.

To speed up financial sector reforms, the government of India set up a high level committee in 2007 (report published in 2009), under the Chairmanship of Prof. Raghuram Rajan. The terms of reference of the committee were as follows52:

1. To identify the emerging challenges in meeting the financing needs of the Indian economy in the coming decade and to identify real sector reforms that would allow those needs to be more easily met by the financial sector.
2. To examine the performance of various segments of the financial sector and identify changes that will allow it to meet the needs of the real sector.
3. To identify changes in the regulatory and the supervisory infrastructure that can better allow the financial sector to play its role while ensuring that risks are contained.
4. To identify changes in other areas of the economy, including the conduct of monetary and fiscal policy and the operation of the legal system and the educational system that could help the financial sector function more effectively.

Annexure 2 presents the 35 proposals made by the committee in summarized form. The proposals are grouped under the following broad heads:

1. Macroeconomic framework and financial sector development (2)
2. Broadening access to finance (4)
3. Levelling the playing field (6)
4. Creating more efficient and liquid markets (7)
5. Creating a growth friendly regulatory framework (9)
6. Creating a robust infrastructure for credit (7)

The numbers in brackets indicate the number of proposals under each head. It can be seen that the committee emphasizes on improving the regulatory framework, an important ingredient of financial stability.

The committee also offers its views on three critical aspects of economic growth for India—financing infrastructure growth, financing old age pensions and information generation. The report, in its conclusion, ‘places inclusion, growth and stability as the three objectives of any reform process and fortunately, these objectives are not in contradiction. With the right reforms, the financial sector can be an enormous source of job creation both directly and indirectly through the enterprise and consumption it can support with financing. Without reforms, however, the financial sector could become an increasing source of risk, as the mismatches between the capacity and needs of the real economy and the capabilities of the financial sector widen. Not only would the lost opportunities be large, but the consequences for the economy could be devastating’.

Thus, it is evident that the issue of structural changes to the banking system has been examined by a number of Expert Committees in the recent past. These Committees suggested various approaches towards reforming existing banking structure. The Committee on Financial Sector Reforms (Chairman: Shri M. Narasimham), 1991; the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham), 1998; the Committee on Fuller Capital Account Convertibility (Chairman: Shri S.S. Tarapore), 2006; and the Report of the Committee on Financial Sector Reforms (Chairman: Shri Raghuram G. Rajan), 2009 have dealt extensively about the need for structural reforms in the Indian banking system.

The Indian Financial Code (2015)

The Indian Financial Code (version 1.1 ) was distilled from various reports including the abovementioned reports, and was made public in 2015.

The latest revised version of the Indian Financial Code has proposed the following changes:

1. Committee approach to Monetary Policy with government representation on the Monetary Policy Committee (Please also refer to Chapter 2)
2. An independent debt management agency to manage government borrowing. Currently, the RBI manages government debt.
3. The Financial Stability and Development Council to identify and monitor systemic risk. the FSDC was set up in 2010 under the chairmanship of the Finance Minister with all sector regulators as members. The Board also focuses on financial literacy and financial inclusion.
4. Non bank credit institutions to be regulated by a separate Financial Authority (proposed). Currently, both banks and non banks are regulated by RBI
5. Systemically important payment systems alone to be regulated by RBI. Currently RBI regulates all payment systems and payment banks
6. A separate consumer protection agency is proposed for public awareness and protection relating to all financial products and services.
7. Capital account regulations with RBI under FEMA to be modified
8. Separating regulations of Money markets from RBI
9. Disclosures from the government and RBI to be made more transparent
10. Establishing a separate Resolution corporation to address financial institutions in distress.

While a few of the above proposals have been implemented, a few others are being analysed in more depth.

Annexure III outlines the major policy and legal reforms (related to the banking/financial sector) that took place in India since 1991–1992.

The Way Forward…

The Indian financial sector may have come through the financial crisis of 2007 relatively unscathed. But, there is much more that needs to be done. There are several challenges to financial stability and the most critical of them have been articulated by the RBI governor.53 In doing so, he has drawn from global experience.

According to him, the first challenge is, ‘defining and measuring’ financial stability. A second challenge is, determining who takes the responsibility for financial stability—will it be the central bank, the banks, other regulators and the government as well? While it is recognized that ‘risk management’ at all levels in the financial sector has to take precedence, the challenge remains as to where risk management amounts to ‘conservativeness’. Yet another challenge is the massive and continuing reforms that should go in to create an effective and efficient ‘regulatory architecture’ that ensures financial stability. And finally, there is the constant tension between fiscal and monetary policies that could impair financial stability if left unchecked.

Technology - the game changer

The RBI Report “Trends and Progress of Banking in India 2015-16” has taken cognizance of the disruptive influence that technology could have on the banking model. In page 3 of the report, the following statements have been made.

“ Leveraging technology in the retail delivery of financial services is turning out to be a game changer for the financial landscape in India. It is a cost-effective means of reaching last mile finance and thus helps in financial inclusion. For providing a greater impetus to card-based retail payments, an Acceptance Development Fund (ADF) is being designed to step up the card acceptance infrastructure. Further, the Unified Payments Interface (UPI) was launched on August 25, 2016 to boost mobile banking. This is expected to revolutionise retail payments given the high degree of penetration of mobile phones in the country.”

“Recent years have also witnessed the entry of several alternative nonfinancial institutions providing financial services, typically known as Fin Tech. The entry of these alternative institutions is expected to improve competition in the financial sector. However, it can also pose challenges resulting in long-term systemic concerns. “ These concerns are being addressed by RBI.

The Vision 2018 for Payment and Settlement Systems in India has outlined the future of payment systems using the latest and evolving technologies, while ensuring safety and soundness. The recently introduced Unified Payments Interface(UPI), the National Unified USSD Platform(NUUP), the Aadhar Payment Bridge, Bharat QR are intended to take banking technology into the future.

CHAPTER SUMMARY

• Three important factors are disrupting the financial system - Fintech, Digital currencies, and climate change.
• Several arguments/theories/events have been cited as the causes of the 2007 crisis. But there seems to be consensus on one possible over-arching cause—lack of adequate attention from monetary authorities and regulators to certain factors that were shaping the global financial system when the crisis happened.
• There is no single definition for financial stability. Hence, the term takes on contextual meaning, signifying smooth functioning of the financial system, both under normal and stressed conditions.
• The 2007 credit crisis, like others before it, has thrown up several issues and challenges for banks and other financial institutions, as well as central banks and regulators. However, all stakeholders agree on one thing—recovery of the global financial system depends on restoration of ‘TRUST’.
• The G20 Working Group on ‘enhancing sound regulation and strengthening transparency’ (Working Group I), in its report dated March 25, 2009, has reiterated the paramount importance of robust financial regulation in each country based on effective global standards for financial stability in future. The report has acknowledged the role of regulation as the first line of defence against financial instability.
• Some of the significant actions already initiated include strengthening the Basel capital framework, developing global standards for liquidity risk management, strengthening supervision of cross-border financial conglomerates, reviewing international accounting standards, strengthening the functioning of credit rating agencies, rationalizing compensation structures and extending the scope of regulation to cover non-banking financial institutions.
• In order to understand the challenges and issues confronting the Indian banking system in the present context, it is necessary to understand the structure and evolution of the Indian financial system.
• Though the capital market size has expanded substantially since financial liberalization, the Indian financial system is dominated by financial intermediaries. The commercial banking sector holds the major share (about 60 per cent) of the total assets of the financial intermediaries, which comprise of commercial banks, urban co-operative banks, rural financial institutions, non-banking finance companies, housing finance companies, development financial institutions, mutual funds and the insurance sectors.
• The banking landscape in India is changing with the entry of niche banks such as payment banks and small finance banks. The accent is on leveraging Information Technology.
• The evolution of the Indian banking system can be categorized into four distinct phases: (1) The pre-Independence (pre-1947) phase, (2) 1947 to 1967, (3) 1967 to 1991–1992 and (4) 1991 to 1992 (financial sector reforms) and beyond.
• The RBI (Report on currency and finance) divides the last phase into two sub-phases: 1991–1992 to 1997–1998 and 1997–1998 and beyond. In the first sub-phase, against the backdrop of a balance of payments problem, the need was felt for a vibrant and competitive banking and financial sector. The Government of India constituted a high-powered committee on the financial system (CFS) under the chairmanship of Shri M. Narasimham. Popularly known as the ‘Narasimham Committee’, it made wide ranging recommendations that formed the basis of financial sector reforms.
• The Raghuram Rajan Committee offers its views on three critical aspects of economic growth for India—financing infrastructure growth, financing old age pensions and information generation.
• The way forward for the Indian financial system is financial stability coupled with adopting technology in banking operations.

TEST YOUR UNDERSTANDING

1. Rapid fire questions

   Answer ‘True’ or ‘False”

   1. Fintech refers to technological innovations in financial services
   2. Bitcoins are a form of crypto currency
   3. Sovereign debt crisis and banking crisis are independent of each other
   4. Consumer protection is not an objective of financial regulation
   5. Prudential regulation is an important tool of financial regulation
   6. LOLR is a specialized tool for central banks
   7. Shadow banking and financial stability go hand in hand

   Check your score in Rapid fire questions

   1. True
   2. True
   3. False
   4. False
   5. True
   6. True
   7. False
2. Fill in the blanks with appropriate words and expressions
   1. ————— is a combination of investment banking and commercial banking in varying proportions
   2. Value stored electronically in a device such as a chip card or a hard drive in a personal computer is called ————— money
   3. Blockchain is a form of ————— technology
   4. In India, ————— is the regulator for the capital market
   5. In India, ————— is the regulator for the foreign exchange market
3. Expand the following abbreviations in the context of the Indian financial system
   1. LOLR
   2. FSB
   3. RBI
   4. SEBI
   5. NABARD
   6. NHB
   7. SIDBI
   8. NBFC
   9. AIFI
   10. DLT
4. Test your concepts and application
   1. Why did the European Central Bank decide to bail out Greece and other countries?
   2. What is the difference between the bail out of Greece and that of Cyprus? Why did the central bank take a different stance in the case of Cyprus?
   3. What is quantitative easing (QE)? Has it helped the US Fed in financial stability?
   4. Why and how did signals of QE tapers affect the emerging markets?
   5. What were the major causes of the global financial crisis of 2007?
   6. Who is to be blamed for the financial crisis–banks or regulators?
   7. Why did US banks lend to sub-prime borrowers?
   8. How are macro economic developments linked to financial institutions?
   9. Relate the following financial instruments to the different markets: (1) money market, (2) capital market, (3) foreign exchange market, (4) government securities market and (5) credit market.
      1. Commercial paper
      2. Certificates of deposit
      3. Equity shares
      4. Cheque
      5. Demand draf
      6. Treasury bills
      7. Forward exchange contrac
      8. 10 year government bonds
      9. Corporate bonds
      10. Housing loans/mortgages
   10. Relate the following transactions to (a) the respective markets and (b) the respective regulators in India.
       1. The Indian government issues securities in the market to cover a budget deficit
       2. An Indian blue chip company issues new shares in the market to fund its future expansion
       3. An Indian bank invests in bonds issued by a corporate body in India
       4. An Indian bank borrows funds abroad
       5. A foreign bank in India buys Indian government securities
       6. An Indian company sells its equity holdings in an Indian blue chip company
       7. An Indian bank invests in the ‘initial public offering’ of an Indian pharmaceutical company
       8. An Indian bank sells insurance products to a deposit customer
   11. Why are non-banking financial companies valuable to the financial system? Can their failure cause systemic risks?
   12. Why does lack of liquidity cause financial institutions to fail? If the financial institution had adequate liquidity, but made a loss on its operations during a year, what are the chances that it would fail?
   13. Relate the following transactions to the spot or forward markets.
       1. An Indian bank sells USD 1 million to a customer
       2. A foreign bank buys `₹1 crore
       3. A foreign bank agrees to sell USD 1 million of Indian rupees three months later at a price agreed upon today
       4. An Indian bank agrees to buy USD 1 million after three months at a price agreed upon today
   14. Why are credit co-operatives valuable to the Indian financial system and economic growth?
   15. What is the difference between Money, E Money and crypto currency?

TOPICS FOR FURTHER DISCUSSION

• What are the interlinkages between banking crises, currency crises and sovereign crises? How close are the interlinkages?
• Would international financial cooperation alone ensure financial stability? What are the other factors that contribute to global financial stability?
• Visit the International Monetary Fund website (www.imf.org). What are the financial soundness indicators prescribed by the IMF? Do these indicators ensure financial stability?
• India has faced banking and financial crisis in the past. How were these crises managed and why did they not have the large adverse impact that such crises created in other countries?
• How are Fintech, Regtech and Blockchain technology disrupting banking and financial intermediation? How severe will the disruption be?

ANNEXURE I

BANKING SECTOR REFORMS

The Narasimham Committee I

The banking sector reforms in the 1990s in India were based on the report of the committee headed by Mr M. Narasimham in 1991. Major recommendations of the committee were as follows:

• There should be no bar to new banks being set up in the private sector, provided they have the start up capital and other requirements prescribed by the Reserve Bank of India.
• The government should indicate that there would be no further nationalization of banks and there should not be difference in treatment between public sector banks and private sector banks.
• The banking system should evolve towards a broad pattern consisting of three or four large banks, including the State Bank of India which could become international in character; eight to ten national banks with a network of branches throughout the country engaged in universal banking; local banks whose operations would be generally confined to a specified region and lastly, rural banks to cater to rural areas.
• There should be an assets reconstruction fund (ARF) which could take over from the banks and financial institutions a portion of their bad and doubtful debts at a discount, the level of discount being determined by independent auditors on the basis of clearly defined guidelines. The ARF, according to the committee, should be provided with special powers for recovery, somewhat broader than those contained in Sections 29–32 of the State Financial Corporation Act, 1951. The capital of the ARF should be subscribed to by the public sector banks and the financial institutions.
• The banks and the financial institutions should be authorized to recover bad debts through the special tribunals and based on the valuation given in respect of each asset by a panel of at least two independent auditors.
• The public sector banks with profitable operations should be allowed to tap the capital market for enhancement of their share capital. Subscribers to such issues could be mutual funds, profitable public sector undertakings (PSUs) and the employees of the institutions besides the general public.
• Branch licensing should be abolished and the option of opening branches or closing of branches other than rural branches should be left to the commercial judgment of the individual banks. Further, the internal organization of banks is best left to the judgment of the management of the individual banks.
• There should be phased reduction of the CRR and the SLR.
• Banks should adhere to prescribed capital adequacy ratio (CAR) and should attain a CAR of 8 per cent by 1998.
• A board for financial supervision should be set up to oversee the operations of the banks.
• Banks should conform to prudential income recognition norms of provisioning against bad and doubtful debts and ensure transparency in maintaining balance sheets.
• There should be speedy computerization of the banking industry.

According to the committee, foreign banks should be subjected to the same requirements as are applicable to Indian banks and RBI policies should be more liberal in respect of allowing the foreign banks to open branches or subsidiaries. Joint ventures between foreign banks and Indian banks should also be permitted particularly in regard to merchant banking, investment banking, leasing and other newer forms of financial services. Priority sector lending by banks should be reduced from 40 per cent to 10 per cent of their total credit.

The committee recommended phasing out concessional interest rates. The committee was of the view that the present structure of administered interest rates was highly complex and rigid and proposed that interest rates be further deregulated so as to reflect emerging market conditions. Premature moves to market-determined interest rates could, as experience abroad has shown, pose the danger of excessive bank lending at highly nominal rates to borrowers of dubious credit worthiness, the committee observed.

Most of the recommendations of the committee have since been implemented. Meanwhile, keeping in view the changing global scenario after the setting up of the WTO and the need for more efficient, competitive and broad-based banking sector, the government has set up another committee, once again headed by Mr Narasimhan.

The Narasimham Committee II

The Narasimham Committee, in its second report on banking sector reforms, submitted in April 1998, made a series of sweeping recommendations. The report covers an entire gamut of issues ranging from bank mergers and the creation of globalized banks to bank closures, recasting bank boards and revamping banking legislations.

The major recommendations of the committee were as follows:

• Concept of ‘narrow banking’ should be tried out to rehabilitate weak banks. If this was not successful, the issue of closure should be examined. Narrow banking, according to the committee, implies that weak banks should not be permitted to invest their funds anywhere except in government securities as these were absolutely safe and risk-free.
• Two or three large Indian banks should be given an international character.
• Small local banks should be confined to states or a cluster of districts in order to serve local trade, small industry and agriculture.
• The committee has also commented on the government’s role in public sector banks by observing that government ownership has become an instrument of management. Such micro-management of banks is not conducive to the enhancement of autonomy and flexibility.
• Functions of boards and management need to be reviewed so that the boards remain responsible for enhancing shareholder value through formulation of corporate strategy.
• There is a need to review minimum prescriptions for capital adequacy. In this regard, the committee recommended that minimum CAR be raised to 10 per cent by 2002. Most of the banks have a CAR of 11 per cent or higher.
• The committee also felt a need to lay down prudential and disclosure norms and sound procedures for the purpose of supervision and regulation.
• There should be an integration of NBFC’s lending activities into the financial system.
• There is a need for public sector banks to speed up computerization and focus on relationship banking.
• A review of recruitment procedures, training and remuneration policies in public sector banks should be carried out.
• Threat of action by vigilance and other investigative authorities, even in the case of commercial decisions creates low morale. The committee recommended that this issue be addressed in right earnest.
• Need for professionalizing and depoliticizing of bank boards.
• The Banking Service Recruitment Boards should be abolished.

ANNEXURE II

COMMITTEE ON FINANCIAL SECTOR REFORMS—2009: MAIN PROPOSALS OF THE RAGHURAM RAJAN COMMITTEE⁵²

The Macroeconomic Framework

Proposal 1: The RBI should formally have a single objective to stay close to a low inflation number or within a range, in the medium term and move steadily to a single instrument, the short-term interest rate (repo and reverse repo) to achieve it.

Proposal 2: Steadily open up investment in the rupee corporate and government bond markets to foreign investors after a clear monetary policy framework is in place.

Broadening Access to Finance

Proposal 3: Allow more entry to private well-governed deposit-taking small finance banks offsetting their higher risk from being geographically focused by requiring higher capital adequacy norms, a strict prohibition on related party transactions and lower allowable concentration norms (loans as a share of capital that can be made to one party). Make significant efforts to create the supervisory capacity to deliver the greater monitoring these banks will need initially, and put in place a tough prompt corrective action regime that ensures these banks do not become public charges.

Proposal 4: Liberalize the banking correspondent regulation so that a wide range of local agents can serve to extend financial services. Use technology both to reduce costs and to limit fraud and misrepresentation.

Proposal 5: Offer priority sector loan certificates (PSLC) to all entities that lend to eligible categories in the priority sector. Allow banks that undershoot their priority sector obligations to buy the PSLC and submit it towards fulfilment of their target.

Proposal 6: Liberalize the interest rate that institutions can charge, ensuring credit reaches the poor, but require (a) full transparency on the actual effective annualized interest cost of a loan to the borrower, (b) periodic public disclosure of maximum and average interest rates charged by the lender to the priority sector and (c) only loans that stay within a margin of local estimated costs of lending to the poor be eligible for PSLCs.

Levelling the Playing Field

Proposal 7: Sell small under performing public sector banks, possibly to another bank or to a strategic investor, to gain experience with the process and gauge outcomes.

Proposal 8: Create stronger boards for large public sector banks, with more power to outside shareholders (including possibly a private sector strategic investor), devolving the power to appoint and compensate top executives to the board.

Proposal 9: After starting the process of strengthening boards, delink the banks from additional government oversight, including the Central Vigilance Commission and Parliament, with the justification that with government-controlled boards governing the banks, a second layer of oversight is not needed. Further ways to justify reduced government oversight is to create bank holding companies where the government only has a direct stake in the holding company. Another is to bring the direct government stake below 50 per cent, perhaps through divestment to other public sector entities or provident funds, so that the government (broadly defined) has control, but the government (narrowly defined) cannot be considered the owner.

Proposal 10: Be more liberal in allowing takeovers and mergers, including domestically incorporated subsidiaries of foreign banks.

Proposal 11: Free banks to set up branches and ATMs anywhere.

Proposal 12: Allow holding company structures, with a parent holding company owning regulated subsidiaries. The holding company should be supervised by the Financial Sector Oversight Agency, with each regulated subsidiary supervised by the appropriate regulator. The holding company should be well diversified if it owns a bank. The holding company structure is shown in the following figure:

Creating More Efficient and Liquid Markets

Proposal 13: Bring all regulation of trading under the Securities and Exchange Board of India (SEBI).

Proposal 14: Encourage the introduction of markets that are currently missing, such as exchange traded interest rate and exchange rate derivatives.

Proposal 15: Stop creating investor uncertainty by banning markets. If market manipulation is the worry, take direct action against those suspected of manipulation.

Proposal 16: Create the concept of one consolidated membership of an exchange for qualified investors (instead of the current need to obtain memberships for each product traded). Consolidated membership should confer the right to trade all the exchange’s products on a unified trading screen with consolidated margining.

Proposal 17: Encourage the setting up of ‘professional’ markets and exchanges with a higher-order size, that are restricted to sophisticated investors (based on net worth and financial knowledge), where more sophisticated products can be traded.

Proposal 18: Create a more innovation friendly environment, speeding up the process by which products are approved by focusing primarily on concerns of systemic risk, fraud, contract enforcement, transparency and inappropriate sales practices. The threshold for allowing products on professional exchanges (see Proposal 16) or over the counter markets should be lower so that experimentation can take place.

Proposal 19: Allow greater participation of foreign investors in domestic markets as in Proposal 2. Increase participation of domestic investors by reducing the extent to which regulators restrict an institutional investor’s choice of investments. Move gradually instead to a ‘prudent man’ principle where the institutional investor is allowed to exercise judgement based on what a prudent man might deem to be appropriate investments. Emphasize in providing access to suitable equity linked products to the broader population as part of the inclusion agenda.

Creating a Growth Friendly Regulatory Environment

Proposal 20: Rewrite financial sector regulation with only clear objectives and regulatory principles outlined.

Proposal 21: Parliament, through the finance ministry and based on expert opinions as well as the principles enshrined in legislation, should set a specific remit for each regulator every five years. Every year, each regulator should report to a standing committee (possibly the standing committee on finance), explaining in its annual report the progress it has made on meeting the remit. The interactions should be made public. In addition, to ensure there are more direct checks on the regulator in a system that is less rule-bound, the committee recommends Proposal 22.

Proposal 22: Regulatory actions should be subject to appeal to the financial sector appellate tribunal, which will be set up along the lines of, and subsume, the securities appellate tribunal.

Proposal 23: Supervision of all deposit-taking institutions must come under the RBI. Situations where responsibility is shared, such as with the state registrar of cooperative societies should gradually cease. The RBI will have to increase supervisory capacity to take on this task. The committee recognizes that this involves constitutional issues but nevertheless recommends a thorough overhaul of the system of shared responsibility.

Proposal 24: The Ministry of Corporate Affairs (MCA) should review accounts of unlisted companies, while SEBI should review accounts of listed companies.

Proposal 25: A Financial Sector Oversight Agency (FSOA) should be set up by statute. The FSOA’s focus will be both macro-prudential as well as supervisory; the FSOA will develop periodic assessments of macroeconomic risks, risk concentrations, as well as risk exposures in the economy; it will monitor the functioning of large, systemically important and financial conglomerates; anticipating potential risks, it will initiate balanced supervisory action by the concerned regulators to address those risks and will address and defuse inter-regulatory conflicts.

Proposal 26: The committee recommends setting up a working group on financial sector reforms with the finance minister as the chairman. The main focus of this working group would be to shepherd financial sector reforms.

Proposal 27: Set up an office of the financial ombudsman (OFO), incorporating all such offices in existing regulators, to serve as an interface between the household and industry.

Proposal 28: The committee recommends strengthening the capacity of the Deposit Insurance and Credit Guarantee Corporation (DICGC) to both monitor risk and resolve a failing bank, instilling a more explicit system of prompt corrective action (see Proposal 3) and making deposit insurance premia more risk-based.

Creating a Robust Infrastructure for Credit

Proposal 29: Expedite the process of creating a unique national ID number with biometric identification.

Proposal 30: The committee recommends movement from a system where information is shared primarily amongst institutional credit providers on the basis of reciprocity to a system of subscription, where information is collected from more sources and a subscriber gets access to data subject to verification of ‘need to know and authorization to use’ of the subscriber by the credit bureau. This will also require rethinking the incentives of providers to share information and a judicious mix of payments as well as mandatory requirements for information sharing will have to be developed.

Proposal 31: Ongoing efforts to improve land registration and titling-including full cadastral mapping of land, reconciling various registries, forcing compulsory registration of all land transactions, computerizing land records and providing easy remote access to land records-should be expedited, with the centre playing a role in facilitating pilots and sharing experience of best practices. The committee also suggests the possibility of special law courts to clear the backlog of land disputes to be examined.

Proposal 32: Restrictions on tenancy should be re-examined so that tenancy can be formalized in contracts, which can then serve as the basis for borrowing.

Proposal 33: The powers of SRFAESI that are currently conferred only on banks, public financial institutions and housing finance companies should be extended to all institutional lenders.

Proposal 34: Encourage the entry of more well-capitalized ARCs, including ones with foreign backing.

Proposal 35: The committee outlines a number of desirable attributes of a bankruptcy code in the Indian context, many of which are aligned with the recommendations of the Irani Committee. It suggests an expedited move to legislate the needed amendments to company law.

ANNEXURE III

SELECT MAJOR POLICY AND LEGAL REFORMS SINCE 1991–92

ENDNOTES

1. Source: Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, at Payments Canada, Calgary, Alberta, 17 June 2016. (accessed at www.bis.org)
2. Source: Report by Committee on Payments and Market infrastructures, titled “Digital currencies”, published by the Bank for International Settlements in November 2015, accessed at www.bis.org )
3. Source: The Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures, Final report “Recommendations of the Task Force Climate-related Financial Disclosures”, delivered at the G20 Hamburg Summit in July 2017
4. BIS, Monetary and Economic department, ‘Financial crises and bank funding: recent experience in the euro area’, by Adrian van Rixtel and Gabriele Gasperini, Working paper no. 406, March 2013.
5. RBI, March 2009, ‘India’s financial sector—an assessment’, Volume III, Advisory panel on financial stability assessment and stress testing, committee on financial sector assessment (CFSA), Government of India and RBI, chart 1.1, page 32.
6. ‘Creditworthiness’ of borrowers is discussed in detail in the chapters on lending.
7. ‘Credit risk’ and ‘interest rate risk’ are discussed in detail in the Chapters ‘Managing Credit Risk’ and ‘Risk Management in Banks’, respectively.
8. ‘Securitization’ and ‘credit derivatives’ are discussed in detail in the Chapter ‘Managing Credit Risk’.
9. ‘Liquidity risk’ is discussed in detail in the Chapter ‘Risk Management in Banks’.
10. Analysis of banks’ financial statements is discussed in the relevant chapter.
11. The Reserve Bank of India (RBI), in its ‘Report of trend and progress of banking in India, 2007–2008’ clarifies, ‘While under normal conditions, the financial system can be considered to be stable if it is generally free from imbalances, in periods of stress, financial stability would depend on the ability of financial markets (in terms of infrastructure and organization) and participants in these markets (intermediaries, investors and financial providers) not only to absorb shocks, but also to work properly (i.e., without major/lasting disruptions) when confronted with an unexpected shock of any nature (such as burst, bubble or terrorist attacks)’. (Chapter VII, page 253)
12. RBI Monthly Bulletin, October 2009, Speech by the RBI governor Dr D Subbarao, ‘Financial Stability—Issues and Challenges’, page 1698.
13. Final report of the G 20 Working Group I, March 25, 2009. The G 20 comprises of the following countries—Argentina, Australia, Brazil, Canada, China, EU, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States. The Working Group was constituted to review and make recommendations that will strengthen international regulatory standards, enhance transparency in global financial markets and ensure all financial markets, products and participants are appropriately regulated or subject to oversight.
14. International Monetary Fund (IMF) Working Paper (WP/09/70), April 2009, ‘Financial Stability and the Role of Central Banks: Lessons from the crisis’, prepared by Erlend W Nier.
15. Chapters on ‘Credit risk’, ‘Investments’, ‘Capital’ and ‘Risk management’ explain this role in detail.
16. These tools are described in the Chapters on ‘Monetary policy’ and ‘Sources of bank funds’.
17. This aspect is discussed in the Chapter on ‘Retail banking’.
18. These aspects are dealt with throughout the book wherever relevant.
19. The Basel 2 framework is discussed in the Chapter ‘Capital—Risk, Regulation and Adequacy’.
20. Discussed in the Chapter ‘Risk Management in Banks’.
21. Discussed in chapters relating to ‘Banks’ Financial Statements’ and ‘Risk Management in Banks’.
22. The role of credit rating is discussed in the chapter related to ‘Bank lending’.
23. Discussed later in this chapter in relation to India.
24. Most of these terms are defined in related chapters in the book.
25. The Financial Stability Board (FSB) (www.financialstabilityboard.org) is hosted by the Bank for International Settlements (BIS) (www.bis.org). The FSB has been established to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies.
26. For a discussion on the primary differences between financial markets and intermediaries, see chapters ‘Monetary policy tools for bank management’ and ‘The lending function’.
27. Speech delivered by Dr K C Chakraborty, Deputy Governor, RBI, on August 31, 2009, titled ‘Banking and finance in India: Developments, issues and prospects’, accessed at www.rbi.org.in
28. ‘Market depth’ is a concept related to its ‘liquidity’. An asset that can be easily bought or sold in the market is termed ‘liquid’. Hence ‘cash’ is the most liquid asset. In terms of financial instruments, liquidity signifies the extent to which a financial asset can be bought and sold in the market without affecting its price. In terms of the market, ‘depth’ signifies the ability of the market to sustain large orders without impacting the price of securities being traded in the market.
29. The RBI regulates the foreign exchange markets. The Foreign Exchange Dealers’ Association of India (FEDAI) frames rules for conduct of foreign exchange business. Settlement of transactions are done through Central Clearing Corporation of India Ltd. (CCIL).
30. Though open to individual investors, the government securities market is largely wholesale in nature. The major investors are banks, insurance companies, primary dealers, pension funds and foreign institutional investors (FII). At the end of September 2009, there were 19 primary dealers, of which 11 were banks (Bank-PDs) and the remaining eight stand-alone primary dealers registered as NBFCs under section 45IA of the RBI Act, 1934.
31. Though RBI is the regulator, where instruments are listed/ traded on stock exchanges, they come under SEBI’s purview. The Fixed Income Money Market and Derivatives Association of India (FIMMDA) and the primary dealers (PD) also have important roles in the market.
32. OTC—Over the counter (market trading)—as contrasted with ‘traded on a recognized exchange’.
33. Described in Chapter ‘Monetary Policy Tools for Bank Management’.
34. Described in Chapter ‘Risk Management in Banks’.
35. IOSCO—International Organization of Securities Commissions—is part of the ‘joint forum’ of international financial regulators. IOSCO’s members are the regulators of the world’s securities and derivatives markets. Its stated objectives are to maintain just, efficient and sound markets through international co-operation, information exchange, establishment of standards and surveillance of international transactions and mutual assistance to promote integrity of markets. More information on IOSCO is provided in Chapter ‘Sources of Funds’. The IOSCO ‘principles’ can be accessed at www.iosco.org
36. The major portion of this book will be devoted to this market.
37. The function and parts of a financial system are described in the Chapter ‘Monetary Policy Tools for Bank Management’.
38. NABARD—National Bank for Agriculture and Rural Development—is an all India development financial institution (DFI)—see Figure 1.8B.
39. The major intermediaries included under this group in India are development finance institutions (DFI), insurance companies, non-banking finance companies (NBFC), primary dealers (PD) and capital market intermediaries such as mutual funds (MF). Internationally, NBFIs are also called ‘other financial intermediaries’ (OFIs) that took a good share of the blame for the 2007 financial crisis. (See Box 1.2).
40. For example, banks can today deal in other financial products, such as insurance or mutual funds.
41. Briefly, NOF for NBFCs is measured as the total of paid up capital and free reserves less intangible assets, such as accumulated losses and deferred revenue expenditure. This figure is further adjusted by netting off investments and loans and advances to subsidiaries, companies in the same group and investments in excess of 10 per cent (of owned fund) in other NBFCs.
42. ‘Exposure norms’ are discussed in the chapter on ‘Bank Lending’.
43. When the financial crisis of 2007 caused tight liquidity in the markets, NBFCs were severely impacted. To ease the stress on liquidity, RBI permitted some temporary measures, such as permitting NBFC-ND-SI to (a) raise foreign currency borrowings through approval route (discussed in the chapter ‘Sources of bank funds’), (b) relax SLR maintenance, (c) borrow from banks at reduced risk weights, (d) issue perpetual debt instruments, (e) deferred stricter capital adequacy maintenance norms and (f) access a special ‘lender of last resort’ facility from RBI.
44. See chapter on ‘Banks’ Sources of Funds’.
45. CFSA, March 2009, volume II, page 185.
46. Primary Dealers (PD) deal in the government securities market—both in its primary and secondary segments. The PDs typically have a standing arrangement with RBI based on the execution of an undertaking and the authorization letter issued by RBI. They are registered with Securities and Exchange Board of India (SEBI) and are members of self-regulatory organizations (SROs) like Primary Dealers Association of India (PDAI) and Fixed Income Money Market and Derivatives Association (FIMMDA).
47. The WOCCU is the global trade association and development agency for credit unions, and is headquartered in Madison, Wisconsin, USA, with offices in Washington and program offices worldwide. Its current membership is 186 million people from 54,000 credit unions spread across 97 countries. It promotes sustainable development of credit unions and other financial co-operatives with a stated vision to ‘improve people’s lives’ through credit unions, translating into ‘empowering people through access to high quality and affordable financial services’. WOCCU works with national governments to improve legislation and regulation and runs ‘technical assistance programs’ to introduce new tools and technologies to improve credit unions’ performance. The council is funded by government agency and foundation grants, member dues and annual gifts from supporters. More details can be accessed at www.woccu.org
48. Interestingly, central banks in most other countries in the world, including the United States, were set up to address the problem of bank failures.
49. Mohan, Rakesh, 2007, ‘India’s financial sector reforms: fostering growth while containing risk’, Address by Dr Mohan, Deputy Governor, RBI, at Yale university on 3 December 2007, accessed at www.rbi.org.in
50. During the 1980s, the fiscal deficit was met through issue of ad hoc treasury bills. This caused expansion in money supply. Interest rate regulation, high reserve requirements and stringent credit rationing were used as the means to restrict expansion in money supply. For more on money supply and monetary policy, please refer to the Chapter ‘Monetary Policy Tools for Bank Management’.
51. ‘A hundred small steps’, Report of the committee on financial sector reforms, Planning commission, Government of India, 2009, accessed at www.planningcommission.nic.in
52. ‘Financial stability: Issues and challenges’, Speech by D Subbarao, Governor, RBI, at the FICCI-IBA annual conference, September 2009, accessed at www.rbi.org.in