SBI DFHI Limited in India

8/2/2019 SBI DFHI Limited in India

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ASIAN DEVELOPMENT BANKOperations Evaluation Department

PROJECT PERFORMANCE EVALUATION REPORT

FOR

INDIA

In this electronic file, the report is followed by the Management response.


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Performance Evaluation Report

Operations Evaluation Department

Project Number: PPE: IND 29701Investment Number: 7122-INDDecember 2005

IND: SBI DFHI Limited


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CURRENCY EQUIVALENTS

Currency Unit Indian rupee/s (Re/Rs)

At Appraisal At Project Completion At Operations Evaluation(November 1995) (July 2001) (September 2005)

Re1.00 = $0.02970 $0.02136 $0.02273$1.00 = Rs33.660 Rs46.820 Rs43.990

ABBREVIATIONS

ADB Asian Development BankCCIL Clearing Corporation of India LimitedDFHI Discount Finance House of India LimitedFY fiscal yearGDP gross domestic productIPO initial public offeringFIRR financial internal rate of returnNDS negotiated dealing systemOEM Operations Evaluation MissionPCR project completion reportPPER project performance evaluation report

PSOD Private Sector Operations DepartmentRBI Reserve Bank of IndiaRRP report and recommendation of the PresidentSBI State Bank of IndiaSBIGL SBI Gilts LimitedSBICAP SBI Capital Markets LimitedSBI DFHI SBI DFHI LimitedT-bill treasury bill

NOTES

(i) The fiscal year (FY) of the Government ends on 31 March. FY before a calendar yeardenotes the year in which the fiscal year ends, for example, FY2000 ends on 31

March 2000.

(ii) In this report, $ refers to US dollars.

Director General : B. Murray, Operations Evaluation Department (OED)Director : D. Edwards, Operations Evaluation Division 2, OED

Team Leader : T. Ito, Evaluation Specialist, Operations Evaluation Division 2, OEDTeam Members : V. Ramos, Evaluation Officer, Operations Evaluation Division 2, OED

R. Perez, Senior Operations Evaluation Assistant,Operations Evaluation Division 2, OED

Operations Evaluation Department, PE-675


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CONTENTS

Page

BASIC DATA iiEXECUTIVE SUMMARY iiiI. INTRODUCTION 1II. PROJECT DESCRIPTION 1

A. Background 1B. Rationale 2C. Deal Processing 2D. Expected Outcomes 3E. Progress Highlights 3

III. EVALUATION 4A. Development Outcome 5B. Investment Outcome 13C. ADBs Effectiveness 14D. Overall Rating 16

IV. ISSUES, LESSONS AND FOLLOW-UP ACTIONS 16A. Issues 16B. Lessons Learned 17C. Follow-Up Actions 18

APPENDIXES1. Evaluation Standards 192. Statistical Data 22

3. Chronology of Government Securities Market Reforms 264. Key Infrastructure for the Government Securities Market 285. Summary of Financial Statements of SBI Gilts Limited and SBI DFHI Limited 306. Financial Internal Rate of Return on the Asian Development Banks Investment

in SBI DFHI Limited 32

Attachment: Management response

The guidelines formally adopted by the Operations Evaluation Department on avoiding conflictof interest in its independent evaluations were observed in the preparation of this report. Thefieldworkwas undertaken by Susan Thomas (international consultant, debt market specialist)and Renuka Sane (research assistant) under the guidance of the mission leader. To theknowledge of the management of the Operations Evaluation Department, there were noconflicts of interest of the persons preparing, reviewing, or approving this report.


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BASIC DATA

Investment No. 7122-IND: SBI DFHI Limited (formerly SBI Gilts Limited)

Key Investment Data ($ million equivalent)As per ADB

Document

Actual

Amount Approved 4.50Amount Disbursed 4.19

Terms of Equity Investment:- No. of Shares 15,000,000 15,000,000

a

- Par Value per Share Rs10.00 Rs10.00b

- Dividends Cash Cash- Divestment Mechanism Sale Sale

Key Dates Expected ActualFact-Finding 2431 Mar 1995Appraisal 24 Jul4 Aug 1995

Investment Negotiations 1920 Oct 1995Board Approval 19 Dec 1995Subscription Agreement 29 Oct 1996Letter Agreement 29 Oct 1996Disbursement 5 Mar 1997

Key Performance Indicators (%): Appraisal PCR PPERFinancial Internal Rate of Return 12.0 Not computed 18.3

c

Borrower SBI DFHI LimitedCountry IndiaType of Business Primary dealer in Government securitiesProject Title Investments in Debt Market Securities

Mission Data No. of Missions No. of Person-DaysFact-Finding 1 24Consultation 1 2Appraisal 1 15Negotiations 2 22Investment Review 4 14Operations Evaluation 1 28

ADB = Asian Development Bank, DFHI = Discount Finance House of India Limited, PCR = project completion report,PPER= project performance evaluation report, SBI = State Bank of India.a

Since the merger of SBI Gilts Limited with DFHI Limited in FY2004, ADB has held 1,363,266 shares of SBI DFHILimited.

bSince the merger of SBI Gilts Limited with DFHI Limited in FY2004, the par value per share has been set at Rs100.

cThe assumptions in this calculation include (i) ADBs divestment on 31 March 2006, (ii) no increase in net worthand no dividend paid to ADB in FY2006, and (iii) the 30 June 2005 exchange rate of Rs43.52 = $1.00.


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EXECUTIVE SUMMARY

On 19 December 1995, the Asian Development Bank (ADB) approved an equityinvestment of Rs150 million ($4.5 million equivalent) in SBI Gilts Limited (SBIGL) (the Project),together with equity investments of Rs715 million ($21.2 million equivalent) in SBI CapitalMarkets Limited (SBICAP) and Rs145 million ($4.3 million equivalent) in SBICAP Securities

Limited. SBIGL, the main focus of this project performance evaluation report, was incorporatedon 7 March 1996 and became operational on 1 July 1996. ADB subscribed Rs150 million ($4.19million equivalent at disbursement) on 5 March 1997. SBIGLs total paid-up capital was Rs1,000million, of which 85% was contributed by the State Bank of India (SBI) and its affiliatedinstitutions and 15% by ADB.

The purpose of the Project was to support the formation of an accredited primary dealersnetwork that would provide an impetus for active trading in Government securities. Theexpectation was that SBI would (i) reduce its shareholding in SBIGL to less than 50% within 4years of the date of incorporation of SBIGL; and (ii) arrange for the divestment of ADBsshareholding at the same price at which SBI sold it shares. SBIGL was also to make a publicoffering of its shares within 4 years of the date of incorporation. At the time of investment

approval, ADB assumed that the divestment of its shares would take place within 6 years of thedate of incorporation. The financial internal rate of return on the ADB investment in SBIGL wasestimated at 16.5% in rupee terms and 12.0% in dollar terms.

The main project developments are as follows. First, the Government securities marketgrew steadily during fiscal year (FY) 1997FY2004, but experienced a setback in FY2005.Second, SBIGL was profitable during FY1997FY2003. Third, SBIGL merged with the Discountand Finance House of India Limited (DFHI) in FY2004 and was renamed SBI DFHI Limited (SBIDFHI). Following the merger, ADB owned 4.69% of SBI DFHIs total shares. Fourth, SBI DFHIwas profitable in FY2004, but recorded a net loss in FY2005. Fifth, ADB received dividendsevery year throughout the investment period except FY2005. Sixth, divestment of SBIs andADBs shareholdings and SBI DFHIs initial public offering (IPO) have not yet materialized.

This report rates the development outcome of the Project as satisfactory for two mainreasons. First, the investee company contributed to establishing and maintaining the primarydealer system, which in turn served the development of the Government securities market asoriginally envisaged. Second, without the presence of SBIGL and SBI DFHI, the absorption ofprimary dealers in the primary market, especially at the initial stage and during the FY2005market downturn, would have been insufficient.

This report rates the investment outcome of the Project as satisfactory. The OperationsEvaluation Mission estimated the financial internal rate of return of this investment to be 18.3%in dollar terms, compared with the 12.0% estimated at appraisal, assuming that ADB woulddivest on 31 March 2006. As this estimate suggests, the investment return has been highly

satisfactory. However, effective measures to mitigate the market risk and the exit risk are not inplace, and thus the final investment outcome remains uncertain.

This report rates ADBs effectiveness as partly satisfactory because even though ADBsinvestment was timely and complemented its public sector operations, the quality of ADBs workin terms of processing and monitoring fell short of expectations. ADBs demonstration role alsoappears to be diminishing.

On the basis of the foregoing, the overall rating of this Project is satisfactory.


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This report identifies four key lessons as follows:

(i) ADB equity investments require a workable and viable exit mechanism. PlannedIPOs are often not a workable mechanism, because they depend on the natureof the investee, on a sponsor, and on industry and market conditions. ADBcannot rely solely on IPOs, and therefore needs to pursue a put option

incorporated in a letter agreement or shareholders agreements. To make suchan option enforceable, the method of revaluating an investee at ADBsdivestment should be carefully discussed during processing and stated in theagreements.

(ii) If an investee company proposes a merger or acquisition, both the Private SectorOperations Department and the Office of the General Counsel should carefullyexamine the implications of such a proposal and give prompt feedback to theinvestee. ADB may need to pursue a put option if it cannot agree to the proposal.To increase clarity and predictability, the subscription agreement should containa clause specifying the necessary procedures if the investee decides to pursue amerger or acquisition.

(iii) The quarterly private sector investment management note should elaborate and

update the status of projects that deviate significantly from their original scopeand plan. Extra attention should be paid to monitoring such projects. In the caseof this Project, the reluctance of the sponsor to divest its shareholding and of theinvestee company to undertake an IPO are major deviations.

(iv) ADB approved this Project in conjunction with the investment in SBICAP, but theinvestment in SBICAP was monitored and evaluated separately. ADBheadquarters administered this Project, whereas the India Resident Missionadministered the investment in SBICAP, and a project completion report wasprepared only for this Project. An assessment of the complementarity of the twoinvestments is beyond the scope of this project performance evaluation report.To the extent possible the monitoring and evaluation of closely related projectssharing the same sponsor should come under the purview of one investment

officer and a project completion report and project performance evaluation reportshould be prepared that cover all associated projects.

Considering the diminishing demonstration effect of this Project, the accumulated networth of SBI DFHI, the investment returns to date, and the limited prospects for privatizing SBIDFHI, ADB should develop an exit strategy from this investment taking market conditions intoaccount. SBI, as the sponsor of this Project, can be a possible counterpart for sales of SBI DFHIshares held by ADB.

Bruce MurrayDirector General

Operations Evaluation Department


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I. INTRODUCTION

1. This project performance evaluation report (PPER) assesses the Asian DevelopmentBanks (ADBs) equity investment in SBI DFHI Limited (SBI DFHI, the Project), formerly SBIGilts Limited (SBIGL).1 In line with the good practice standards identified by the EvaluationCoordination Group of Multilateral Development Banks on Private Sector Operations,2 this

PPER focuses on three project dimensions: development outcome, investment outcome, andADBs effectiveness.

2. An Operations Evaluation Mission (OEM) visited India from 8 to 20 September 2005.The OEM met with representatives of the Ministry of Finance, the Reserve Bank of India (RBI),the State Bank of India (SBI), SBI DFHI and other financial institutions participating in theGovernment securities3 market, the International Monetary Fund, and the International FinanceCorporation. This PPER incorporates the OEMs findings, the observations of relevant ADBstaff, and a review of reports and documents related to this Project. The draft PPER wascirculated to SBI DFHI and within ADB. Comments received were considered when finalizingthe PPER.

II. PROJECT DESCRIPTION

A. Background

3. In the early 1990s, the Government of India initiated a comprehensive economicreform program that ADB supported through its Financial Sector Program4 and Capital MarketDevelopment Program.5 One of the aims of these programs was to develop the Governmentsecurities market. The Financial Sector Program supported the introduction of a treasury bill(T-bill) auction, whereas the Capital Market Development Program supported the introductionof a primary dealer system for T-bills and dated securities. Primary dealers were expected toensure the orderly primary distribution of new issues of Government securities, to be marketmakers for Government securities that would increase liquidity in the secondary market, and

to serve as conduits for RBIs open market operations. In November 1995, RBI licensed sixprimary dealers,6 including SBI.

1ADB. 1995. Report and Recommendation of the President to the Board of Directors on Proposed Investments inDebt Market Institutions in the Republic of India. Manila. (Investment 7122: SBI Gilts Limited, approved on 19December 1995, for Rs150 million [$4.5 million equivalent at approval].)

2Evaluation Coordination Group of Multilateral Development Banks on Private Sector Operations, Working Group onPrivate Sector Evaluation. 2001. MDB-ECG Good-Practice Standards for Evaluation of Private Sector Operations.;Walter I. Cohen and Associates, LLC. 2005. Second Benchmarking Review of ECG Members Evaluation Practices

for the Private Sector Investment Operations Against Their Agreed Good Practice Standards. Preparation of ADBsevaluation guidelines on private sector operations is under way.

3Government securities in this report refer to securities issued only by the central Government.

4ADB. 1992. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Indiafor the Financial Sector Program. Manila. (Loan 1208-IND, approved on 15 December 1992, for $300 million.)

5ADB. 1993. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Indiafor theCapital Market Development Program. Manila. (Loan 1408-IND, approved on 23 November 1993, for $250million.)

6The initial six primary dealers were Securities and Trading Corporation of India Limited, Discount and FinanceHouse of India Limited, SBIGL, ICICI Securities Limited, PNB Gilts Limited, and Gilts Securities TradingCorporation Limited.


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4. ADBs policy dialogue on improving the efficiency of Government-owned banks focusedon SBI,7 its associate banks, and other affiliates, which are collectively referred to as the SBIgroupIndias largest financial conglomerate. In response to a changing policy environment,the SBI group formulated a restructuring plan. To reorient securities businesses under the plan,SBI Capital Markets Limited (SBICAP)8 was to spin off its brokerage activities to a newsubsidiary, SBICAP Securities Limited. SBI planned to set up SBIGL as a primary dealer of

Government securities.

B. Rationale

5. SBI recognized the need to sponsor a primary dealer for Government securities not onlyfor its investment banking interests, but also to support RBIs efforts to establish a Governmentsecurities market. A primary dealer was necessary to achieve integrated, full-service investmentbanking operations within the SBI group, complementing both SBICAP and SBICAP SecuritiesLimited. The SBI group requested ADB to support its restructuring process through equityinvestments in SBICAP, SBICAP Securities Limited, and SBIGL. ADB agreed because (i) theproposed investments in the three institutions were in line with ADBs strategy and policydialogue with the Indian authorities to develop Indias capital markets, (ii) the participation of

ADB would provide an impetus to the SBI groups privatization program, (iii) the backing SBIprovided to these institutions would be solid, (iv) the SBI group had good management teamsand a large pool of trained professionals in banking and financial services, (v) the proposedinvestments were expected to have a positive impact and a significant demonstration effect onother public sector financial institutions in India, and (vi) the management of SBI supportedcapital market reforms. Overall, this Project is a good example of ADBs private sectoroperations supporting broader policy dialogue undertaken by the public sector side of ADB. Inaddition to supporting the Governments reform program, the activities of the public sector sideof ADB helped develop a better enabling environment for the private sector in the Governmentsecurities market.

C. Deal Processing

6. Subsequent to the concept clearance in March 1995, ADB fielded processing missionsbetween April and August 1995. On 19 December 1995, ADB approved its equity investment ofRs150 million (about $4.5 million equivalent) in SBIGL, together with equity investments ofRs715 million (about $21.2 million equivalent) in SBICAP9 and Rs145 million (about $4.3 millionequivalent) in SBICAP Securities Limited.10

7Since the 1980s, the Government has gradually sold SBI shares to individuals and institutions. As of 30 September2005, RBI held 59.73% of SBIs shares. The other major shareholders included foreign institutional investors(11.86%); American Depository Receipts and Shares, and Global Depository Receipts (7.88%); Indian individuals(5.68%); Indian banks and other financial institutions (5.34%); and Indian corporate bodies, trusts, or partnerships

(1.73%).8SBICAP was incorporated in 1986 as a wholly-owned merchant banking subsidiary of SBI.

9ADBs equity investment in SBICAP was disbursed in January 1997, and this equity investment is still in ADBsportfolio. Thequarterly report on private sector operations for the quarter ended 30 September 2005 gave thisinvestment an RR-5 (substandard) risk rating and assessed its operational status as problems in full operationstage. A project completion report on SBICAP has yet to be prepared.

10Even though SBI incorporated SBICAP Securities Limited in 1998, no securities trading took place because of thedeclining Indian economy. SBICAP, which was already overcapitalized at that time, took over instead andincorporated the originally proposed securities trading business into its existing legal structure and businessoperations. Eventually, ADBs equity investment in SBICAP Securities Limited was canceled on 17 September1999.


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7. SBIGL, which is the main focus of this PPER, was incorporated on 7 March 1996 andbecame operational on 1 July 1996. ADB finalized the Subscription Agreement with SBIGL andthe Letter Agreement with SBI on 29 October 1996. Upon fulfillment of predisbursementconditions, for example, the adoption of an operating policy statement, the appointment of anindependent external auditor, and the submission of relevant legal documents, ADB subscribedRs150 million ($4.19 million at disbursement) on 5 March 1997. SBIGLs total paid-up capital

was Rs1,000 million, of which 85% was contributed by SBI and its associate banks andsubsidiaries and 15% was contributed by ADB.

D. Expected Outcomes

8. The purpose of ADBs investment in SBIGL, as stated in the report and recommendationof the President (RRP) (footnote 1), was to support the formation of an accredited primarydealers network to facilitate active trading in Government securities. ADB considered its supportto the Government securities market as beneficial to the debt market, because the yield curvefor Government securities would serve as a benchmark for pricing debt instruments in other riskcategories. The OEM concurs with this view.

9. The Letter Agreement stipulates that SBI will (i) reduce its shareholding in SBIGL to lessthan 50% within 4 years of the date of incorporation of SBIGL, and (ii) arrange for thedivestment of ADBs shareholding at the same price at which SBI divests it shares. Thesubscription agreement stipulates that SBIGL will make a public offering of its shares within 4years of the date of incorporation. At the time of investment approval, the divestment of ADBsshares from SBIGL was expected to take place 6 years from the date of incorporation. Thefinancial internal rate of return (FIRR) on ADBs investment in SBIGL was estimated at 16.5% inrupee terms and 12.0% in dollar terms, based on a price-earning ratio11 of 9 and the projectedearning per share of Rs2.77 in the sixth year.12 This calculation assumed that SBIGL would notpay any dividends to ADB during the entire investment period.13

E. Progress Highlights

10. A project completion report (PCR) on the equity investment in SBIGL was circulated inJuly 2001.14 The PCR assessed project implementation as successful for several reasons. First,SBIGL maintained its business scope as originally envisaged, and its performance wassatisfactory in terms of financial position, profitability, quality of management, and risk controlsystems. Second, SBIGL remained an active player in both the primary and secondary marketsfor Government securities. Third, ADB received dividends totaling $1.12 million from Fiscal Year(FY) 199715 throughFY2000. The PCR considered that calculating the FIRR of this investmentwould be premature and provided limited information on its development outcomes, especiallythe performance of the Government securities market.

11. The PCR highlighted two outstanding issues. First, the reduction of SBIs shareholding

to less than 50% and the listing of SBIGLs shares on the stock exchange within 4 years of thedate of incorporation of SBIGL had not materialized. The PCR stated that ADB would enter into

11The RRP did not indicate the basis of this price-earning ratio.

12The RRP did not discuss the reason for this 2-year discrepancy between the companys initial public offering andADBs divestment.

13The RRP did not indicate the basis of the zero dividend scenario throughout the investment period despite theprojected steady increase in profits.

14ADB. 2001. Project Completion Report on the Equity Investment in SBI Gilts Limited in India. Manila.

15SBI DFHIs financial year corresponds to that of the Government.


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discussions with SBIGLs management to develop a strategy for listing SBIGL in the next 2years. Second, ADB had not discussed the divestment of ADB shares in SBIGL with SBI andSBIGL. The PCR recommended that ADB monitor and actively seek divestments in the comingyears.

12. The OEM largely verified the PCRs findings. The Projects outcome can be summarized

as follows. First, the Government securities market steadily grew during FY1997FY2004 butexperienced a setback in FY2005. Second, SBIGL was profitable during FY1997FY2003.Third, SBIGL merged with the Discount and Finance House of India Limited (DFHI) in FY2004and was renamed SBI DFHI. Fourth, SBI DFHI was profitable in FY2004, but recorded a netloss in FY2005. Fifth, ADB received dividends every year throughout the investment periodexcept FY2005. Sixth, the two issues highlighted in the PCR remain unresolved, and the Projectremains in ADBs portfolio.

III. EVALUATION

13. The method of deriving performance ratings drew on the good practice standards(footnote 2). Table 1 shows the performance ratings for the three key dimensions and

underlying indicators for the Project.16 Appendix 1 defines the dimensions, indicators, and 4-point ratings scale referred to in Table 1. This chapter elaborates on the OEMs findings as thebases of the performance ratings for each dimension and indicator. The last section of thischapter provides the overall project rating.

Table 1: Evaluation of Investment 7122-IND: SBI DFHI Limited

Item UnsatisfactoryPartly

Satisfactory Satisfactory Excellent

Development Outcome Capital MarketDevelopment

Business Success Private SectorDevelopment

Investment Outcome(return on equity)

ADBs Effectiveness Screening, Appraisal,and Structuring Supervision andAdministration Role and Contribution

ADB = Asian Development Bank, SBI DFHI = SBI DFHI Limited.Source: Operations Evaluation Mission.

16The good practice standards suggest that the synthesis ratings for the three dimensions (development outcomes,investment outcomes, and ADBs effectiveness) reflect summary qualitative performance judgments based on theunderlying indicator ratings. The standards assume that the synthesis ratings for the three dimensions are not asimple average of the indicator ratings.


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A. Development Outcome

14. The good practice standards suggest that the rating of the development outcome offinancial market operations be based on a projects (i) contributions to the development of thecountrys private sector and/or the development of efficient capital markets, (ii) contributions tothe companys business success, (ii) economic viability, (iii) contributions to the countrys living

standards, and (iv) environmental sustainability. For this Project, the OEM identified theProjects contributions to capital market development17 and private sector development and theinvestees business success as the underlying indicators for the development outcome. Theassessments of the Projects economic viability18 and the contribution to the countrys livingstandards19 are integral to the assessments of capital market development in this evaluation.The OEM did not consider environmental sustainability to be relevant to this Project.

1. Capital Market Development

15. The OEM rated the Projects contribution to capital market development as satisfactorybased on the assessments in paras. 1621.

a. Performance of the Government Securities Market

16. Table 2 shows the key performance indicators of the Government securities market,extracted from Appendix 2. The assessment of these indicators can be summarized as follows:(i) the outstanding stock of Government securities20 steadily increased from 15% of grossdomestic product (GDP) as of the end of FY1996 to more than 30% as of the end of FY2005; (ii)the average maturity of dated securities issued during FY2002FY2005 was more than 14years, compared with less than 6 years in FY1996; (iii) the maximum maturity of the securitiesreached 30 years, compared with 10 years in FY1996; and (iv) the market turnover ofGovernment securities21 increased from 52% of the outstanding stock of securities from FY1996to 359% in FY2003, but dropped to 127% in FY2005. These performance indicators suggestlargely satisfactory progress in achieving the Projects purpose with some reservations about

the market setback in FY2005. This setback reflected the reversal in interest rates trends, whichhad constantly fallen during FY1996FY2004. The ensuing paragraphs further assess theseindicators and other relevant information.

17This PPER assesses the Projects contribution to capital market development separately from its contribution toprivate sector development for the following reasons. First, development of the Government securities market, theprimary purpose of this Project, might not immediately enhance private sector activities given the predominance ofstate-owned financial intermediaries and institutional investors in India. Second, the Government securities marketmight not immediately lead to a better corporate debt market. Third, privatization of SBI, a secondary purpose ofthis Project, could be considered as a separate issue from market development.

18The good practice standards suggest that the economic viability of financial sector operations should be rated on (i)whether the subprojects financed are economically viable; (ii) whether the project has led to the use of economicviability criteria, or economic internal rate of return, in the intermediarys investment decisions; and (iii) whether the

project has resulted in benefits to the economy. The first and second criteria are not relevant to this Project. Thethird criterion is covered in this evaluation under the assessment of capital market development.

19The good practice standards suggest that a projects contribution to the countrys living standards should be ratedbased on the projects economic benefits and costs to those who are neither its owners nor its financiers. Thissubject is covered in this report under the assessment of capital market development.

20Government securities in India comprise T-bills and dated securities. Dated securities are issued at maturitiesgreater than 1 year. Most dated securities bear coupons. T-bills are short-term instruments typically with a maturityof 92 days and 364 days. In the past, the Government also issued 14-day and 182-day T-bills. The OEM could notobtain consistent year-end data on the outstanding balance of 91-day T-bills, therefore Government securities hererefer only to dated securities and 364-day T-bills.

21Government securities here include all dated securities and T-bills with different maturities in circulation.


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Table 2: Key Government Securities Market Indicators, FY1996FY2005

Item UnitFY1996FY1999

FY2000FY2003 FY2004 FY2005

A. Performance Indicators

1. Outstanding Balance of DatedSecurities % of GDP

a14.117.9 19.727.4 29.9 29.9

2. Outstanding Balance of T-billsb

% of GDPa

0.71.2 0.81.5 1.2 1.1

3. Turnover Ratio of GovernmentSecurities

c% 52.0136.4 151.0358.7 312.9 126.9

4. Average Maturity of DatedSecurities Issued During the Year Years 5.57.7 10.614.3 14.9 14.1

5. Minimum and MaximumMaturities of Dated SecuritiesIssued Years 220 525 429 530

B. Memorandum Items1. Gross Fiscal Deficit of the Central

Government % of GDP

a

4.96.5 5.46.2 4.5 4.5

d

2. Weighted Average Cost of theDated Securities Issued Duringthe Year % 11.913.8 7.311.8 5.7 6.1

3. Net Market Borrowing by theCentral Government

e

% of thegross fiscal

deficit

39.555.5 62.171.8 72 33.1

4. Issuance of Dated Securities Rs billion 309778 8661,760 1,870 1,050

5. Issuance of 91-day T-Bills Rs billion 132252 71264 365 1,022

6. Issuance of 364-day T-Bills Rs billion 18162 130261 271 481GDP = gross domestic product, FY = fiscal year, T-bill = treasury bill.a

GDP is provisional for FY2003 and estimated for FY2004 and FY2005.b

This refers to 364-day T-bills only.c

See footnote 21.

d The fiscal deficit in FY2005 is an estimate.e

Market borrowing refers to dated securities and 364-day T-bills.Sources: Appendix 2; Center for Monitoring Indian Economy (memorandum items 46).

17. During FY1996FY2003, the central Government budget deficits were sustained withinthe range of 4.9% to 6.5% of GDP, while the proportion of net market borrowing increased from39.5% to 71.8% of the Governments budget deficit. This led to the increase in the outstandingstock of Government securities as a percentage of GDP. This trend changed when theGovernment embarked on a process of fiscal consolidation by enacting the Fiscal Responsibilityand Budget Management Act in 2003. Pursuant to this act, budget deficits were reduced toaround 4.5% of GDP in FY2004 and FY2005. In FY2005, international interest rates andinternational crude oil prices rose, contributing to an increase in inflation. This led to a tightening

of domestic monetary policy and a rise in the yield of Government securities (Figure 1). Inresponse, the Government increased nonmarket borrowing22 for deficit financing in FY2005.

22According to official statistics, nonmarket borrowing by the Government includes small savings, state providentfunds, special deposits, reserve funds, and 91-day T-bills. The OEM could not obtain the breakdown of nonmarketborrowing in FY2005 so that it could do a detailed analysis of the outcome of the increased reliance on nonmarketborrowing by the Government.


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18. The significant increase in liquidity of Government securities during FY1996FY200323helped price discovery as reflected in the finer bidding patterns emerging in auctions and the

narrow spreads in the secondary market. The increased primary issues and secondary markettransactions of Government securities, complemented by the diversification of debtinstruments24 (Appendix 3), led to the entry of additional private sector primary dealers (para.19). However, the rise in interest rates during FY2005 resulted in a drop in the turnover ratiofrom 313% in FY2004 to 127% in FY2005 (Figure 2). This suggests that the development of asecondary market in Government securities remains below its potential.25 The inadequate depthand breadth of the market relates to (i) the commercial banks and Life Insurance Corporation ofIndias ownership of the majority of dated securities in circulation; and (ii) the large portion of theholdings of dated securities by commercial banks and the Life Insurance Corporation of Indiabeing statutorily mandated investments.26 Recently, cooperative banks, regional rural banks,mutual funds, and nonbank finance companies have entered the Government securities market,but their trading activities remain limited.

23This partly reflected mutual funds active participation in the secondary market during this period in conjunction withthe launching of fixed income schemes.

24These included floating rate bonds introduced in 1995, capital indexed bonds introduced in 1997, and interest ratefutures introduced in 2003.

25In contrast, liquidity in the stock market remained largely consistent across episodes of much higher fluctuations inthe index price.

26For this reason, a large portion of the market trading volume typically ends once the securities are placed withcommercial banks and the Life Insurance Corporation of India. Consequently, of 140 to 170 dated securities incirculation, only 10 to 20 have significant liquidity. Little liquidity is available for dated securities that are more than3 years old.

Figure 1: The Zero Coupon Yield Curve as on 1 March (1998-2005)

Source: National Stock Exchange, Wholesale Debt Management Segment.

Yield(%)

Maturity (Years)


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b. Roles of Primary Dealers

19. India had largely achieved interest rate liberalization by the mid-1990s. This laid thefoundation for the development of the Government securities market, which in turn formed thebasis for the establishment of the yield curve of debt instruments. In 1996,27 RBI took the keystep of introducing primary auctions28 at the issuance of dated securities. To facilitate primaryauctions, RBI introduced the primary dealer system (described in the box) to assist pricediscovery and to develop the secondary market. Initially, licenses were given to six public sector

financial institutions, including SBIGL. Subsequently, RBI issued primary dealer licenses to 12additional financial institutions. Following the merger of SBIGL and DFHI in FY2004, 17 primarydealers were operating. Of these, eight are promoted by public sector banks and public financialinstitutions, six by foreign banks, two with the collaboration of foreign security houses, and oneby local nonbanking finance companies. The extent of operational diversification varies acrossprimary dealers.29

27The RBI started primary auctions of T-bills in 1992.

28Initially, RBI resorted to uniform price auctions, which since 1999 have progressively been replaced by multipleprice auctions.

29Tentative information obtained by the OEM suggested that five primary dealers, including SBI DFHI, had theirrevenues driven mostly by primary dealer business in Government securities.

Figure 2: Secondary Market Turnover and Dated Security Yield (10-year)

Source: National Stock Exchange, Wholesale Debt Management Segment.

10-yearzerocouponsecurityyie

ld(%)

Turnoverratio(%)

Year


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Box 1: Primary Dealer System

Primary dealers are responsible for ensuring the success of primary auctions of datedsecurities through a system of annual bidding commitments, annual success ratios, andunderwriting of the auctions. RBI sets the annual requirement for bidding commitments for

primary dealers based mainly on their capital size. The underwriting commitments, as theexclusive opportunity given to primary dealers, are decided separately prior to the actual auctionfor primary issuance. Primary dealers bid to underwrite various amounts at various commissionrates. RBI decides on the actual allotment of the underwriting commitment by primary dealersafter considering the commission sought, the amount that succeeded in the primary auction,and the permitted range for devolvement and RBIs underwriting. Primary dealers also bid in theprimary issue auction and must fulfill their annual commitment across all the primary auctionsconducted during the year. To ensure that bidding is not too defensive, RBI mandates a 40%success ratio. Unlike the underwriting auction, primary dealers compete with other auctionparticipants, mainly RBI-registered financial entities, in the primary bidding auction.a Primarydealers are given access to the RBI repo market, the call money market, and the RBI liquidityadjustment facility for their funding and liquidity management. There is no underwriting

procedure for T-bills, and for primary dealers, bidding commitments are fixed at a flatpercentage of the notified amount for each auction (determined at the beginning of the year).

aTo enable small investors to participate in the primary auction, RBI introduced a scheme for noncompetitive biddingin January 2002. The scheme provides for the allocation of 5% of a notified amount at the weighted average ofaccredited bids.

20. Most people interviewed by the OEM acknowledged the contribution of the primarydealer system, complemented by other relevant reforms and market infrastructuredevelopment30 (Appendixes 3 and 4), to the development of the Government securities marketduring the past decade. During FY2001FY2004, primary dealers continuously absorbed morethan half the Government securities issued in the primary market. Their turnover representedmore than 20% of secondary market transactions. However, the primary dealers absorption ofGovernment securities at primary auctions dropped to 28.5% in FY2005, reflecting theirreluctance to hold securities in an environment of rising interest rates. As a result, primarydealers turnover of Government securities in the secondary market dropped to 17.7% inFY2005. The contracted activities of primary dealers are closely related to the accounting norm,requiring mark-to-market reevaluation of all securities in hand on primary dealers financialstatements.31 The lack of interest rate hedging instruments also explained the primary dealersprudent stance during the adverse market conditions.32 According to OEM interviewees, mostprimary dealers, especially those specializing in Government securities trading, recordedfinancial losses in FY2005.

30The major achievement in this area included the negotiated dealing system and the Clearing Corporation of IndiaLimited, both operationalized for Government securities transactions in February 2002. The commencement ofGovernment securities trading on the three stock exchanges (the National Stock Exchange, the Bombay StockExchange, and the Over-the-Counter Exchange of India) as of January 2003 was another major achievement.

31A different accounting standard is applied to commercial banks in the revaluation of Government securitiescategorized as held to maturity.

32Reflecting the volatility in interest rates, over-the-counter markets have emerged for interest rate swaps andforward rate agreements. Given the short-term nature of these instruments, the risks associated with holdingGovernment securities can only be partially hedged.


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c. Investees Presence in the Market

21. Table 3 indicates that SBIGL (FY2001FY2003) and SBI DFHI (FY2004FY2005)constantly played a lead role in the primary market. Their secondary market transactions werelimited to 2.9% to 4.6% of primary dealers total turnover during FY2001FY2004, but increasedto 8.8% in FY2005.

Table 3: Primary Dealers Market Shares in Government Securities, FY2001FY2005(%)

Primary Market Secondary Market

Year

Absorption byPrimary Dealers/

Total AmountIssued

SBIGL and SBIDFHI

Absorptiona/

Absorption byPrimary Dealers

Primary DealersTurnover/

Total MarketTurnover

SBIGL and SBIDFHI Turnover

a/

Turnover byPrimary Dealers

FY2001 70.6 11.2 26.7 4.6FY2002 70.5 9.2 22.8 2.9FY2003 65.1 8.8 21.6 3.2FY2004 56.0 11.3 25.1 3.1FY2005 28.5 12.7 17.7 8.8FY = fiscal year, SBIGL= SBI Gilts Limited, SBI DFHI = SBI DFHI Limited.Note: Given the use of multiple sources, this table is highly tentative.a

FY2001FY2003 for SBIGL and FY2004FY2005 for SBI DFHI.Sources: Reserve Bank of India. 2005. Report of the Internal Technical Group on Central Government SecuritiesMarket. Bombay; State Bank of India. 2005. Annual Report 20042005. Bombay; SBI DFHI data.

2. Business Performance of SBI Gilts Limited and SBI DFHI Limited

22. The OEM rated the investees business performance as satisfactory33 based on the keyfinancial ratios of SBIGL (FY1997FY2003) and SBI DFHI (FY2004FY2005) (Table 4).

33The good practice standards suggest that a projects contribution to a companys performance should be rated onthe basis of its contribution to the financial intermediary.


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Table 4: Key Financial Ratios of SBIGL and SBI DFHI, FY1997FY2005(%)

ItemFY

1997FY

1998FY

1999FY

2000FY

2001FY

2002FY

2003FY

2004FY

2005

Return on Average Assets 4.4 12.8 6.1 3.3 3.1 9.1 9.8 12.6 (5.1)

Return on Average Capital 11.7 25.7 20.8 20.2 18.4 37.3 26.7 26.8 (9.4)Trading Income/Total Income 25.4 14.9 5.6 10.6 12.3 46.5 47.1 43.3

a

Interest Income/Total Income 74.6 83.4 85.0 88.2 87.3 53.3 52.8 56.7a

Underwriting Fees/Total Income 0.0 1.7 9.4 1.2 0.4 0.2 0.1 0.0a

Securities Held/Total Capital 251.7 140.2 419.1 525.6 486.8 338.6 224.7 198.9 112.2

Underwriting/Total Bidding Success 0.0 118.3 249.9 107.3 94.8 94.6 86.9 74.2 46.3

Noninterest Expense/Total Income 7.0 2.1 2.1 2.0 1.8 1.6 2.2 2.1a

Total Capital/Total Assets 37.6 68.3 19.7 14.3 19.9 29.7 45.4 47.5 63.9Current Assets/Short-TermBorrowing 8.3 13.0 21.7 28.8 3.6 (1.1) (4.0) 8.8 74.7

Market Shares in Primary Auctions 15.3 19.3 18.1 3.2 7.9 6.5 5.7 6.3 3.6

Market Shares in Secondary Trading 10.9 12.8 15.8 5.8 1.2 0.7 0.7 0.8 1.6FY = fiscal year, SBI DFHI = SBI DFHI Limited, SBIGL = SBI Gilts Limited.Note: Given the use of multiple sources, this table is highly tentative.a

The summary financial statements submitted by SBI DFHI Limiteds management to the Operations EvaluationDepartment indicated that its total income in FY2005 was negative because of large trading losses, making financialratios not applicable.

Sources: Appendix 5; SBI DFHI data.

a. SBI Gilts Limited (FY1997FY2003)

23. SBIGL remained profitable during FY1997FY2003, with a return on capital in the rangeof 18% to 27% from FY1998 (Table 4). During FY1999FY2001, SBIGL maintained a relativelylarge portfolio of Government securities that amounted to more than 400% of capital, whileincreasing short-term borrowing in FY1999FY2000 and decreasing current assets in FY2001.

The entry of 12 additional primary dealers into the market from FY2000 led to SBIGL having areduced market share in both primary and secondary markets. The new management that tookover in FY2001 emphasized profits rather than turnover, resulting in a significant contraction inthe secondary market share. As a result, during FY1999FY2001, more than 85% of SBIGLsincome came from interest income rather than from trading income. Subsequently, SBIGLprogressively reduced its total holdings of Government securities from 487% of capital as of theend of FY2001 to 225% as of the end of FY2003, taking advantage of the secular downwardtrend in market interest rates. During this period, SBIGL was highly profitable, resulting in anincrease in net worth from Rs1,817 million as of the end of FY2001 to Rs2,740 million as of theend of FY2003. Income from underwriting fees remained marginal throughout the period.

b. Merger of SBI Gilts Limited with Discount Finance House of India

Limited

24. In 1988 RBI, together with public sector banks and other financial institutions, formedDFHI, one of the oldest money market players in India outside the banking system. Afterobtaining its primary dealer license in 1996, DFHI shifted its operational focus to Governmentsecurities and became the second largest primary dealer in terms of net worth (as of the end ofFY2003). In FY2003, SBI bought DFHIs shares from the Industrial Development Bank of India,the Unit Trust of India, and the Life Insurance Corporation. As a result, the proportion of SBIs


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shareholding in DFHI increased from 29.05% as of the end of FY2002 to 55.13% as of the endof FY2003. The merger of SBIGL with DFHI was a strategic decision by SBI as the sponsor ofthe two primary dealers. The High Court of Judicature in Bombay sanctioned the proposedamalgamation of SBIGL with DFHI in July 2003. The effective date of the merger was 23 April2004. The shareholders of SBIGL were issued 1 share of Rs100 of DFHI for every 11 shares ofRs10 each that they held. This swap ratio was determined based on the independent valuation

of shares conducted by two external auditing firms. By the end of March 2005, SBI owned67.01% of the total of 29,090,906 shares, ADB owned 4.69%,34 and other banks and financialinstitutions owned the rest.

c. SBI DFHI Limited (FY2004 to date)

25. In FY2004, SBI DFHI recorded profits of 12.6% of average total assets, reflecting thedowntrend in yields of Government securities. SBIGLs and SBI DFHIs operational data indicatethat the merger resulted in an increased market share in the primary market, but not in thesecondary market, in FY2004. The operational efficiency of SBI DFHI in FY2004, measured bythe ratio of noninterest expense to total income, was comparable to that of SBIGL prior to themerger. As of the end of FY2004, SBI DFHIs total capital (as a percentage of total assets) was

also at the same level as that of SBIGL as of the end of FY2003. The rise in interest rates inFY2005 resulted in a substantial trading loss of Rs1,795 million and a net loss of Rs940 million(equivalent to 5.1% of average total assets). During FY2005, SBI DFHI, like many other primarydealers, reduced its market share in the primary market. The information submitted by SBI DFHIindicated that other public sector primary dealers35 recorded equivalent losses in FY2005. Themanagement of SBI DFHI explained that the loss in FY2005 was a natural consequence of thedrop in prices of Government securities, given that SBI DFHI had to fulfill a significant biddingcommitment and achieve the success ratio required by RBI. The management expectedimproved performance in the first half of FY2006 compared with the same period in FY2005.

3. Private Sector Development

26. The OEM rated the Projects contribution to private sector development as partlysatisfactory. While the Project and ADBs overall policy dialogue in the financial sectorcontributed to the entry of 12 private sector primary dealers, little progress has been made inprivatizing the SBI group companies, including SBIGL and SBI DFHI.

27. During appraisal, ADB considered that equity participation would provide an impetus tothe SBI groups privatization program, as stated in the RRP. The letter agreement and thesubscription agreement stipulated as follows:

Within 4 years from the date of incorporation of the Company, or at a later dateas the Bank may otherwise agree, the Sponsor shall reduce its shareholding inthe Company to less than 50%, and ensure that the combined share ownership

in the Company of the Sponsors majority-owned subsidiaries is reduced to lessthan 50% (which form of reduction in ownership may include divestment by theSponsor and issue of new Shares in the Company) subject to obtaining allapplicable governmental and other approval. (Paragraph 1 [e], Letter Agreement)

34The Subscription Agreement ensures ADBs representation on the board of SBIGL as long as ADB holds 5% ormore of the issued share capital of the company. With lower ADB shares after the merger, and no revisionsinitiated on the Subscription Agreement, ADBs representation on the SBI-DFHIs board is no longer ensured.

35These included Securities Trading Corporation of India Limited, PNB Gilts Limited, and Gilt Securities TradingCorporation Limited. These primary dealers are similar to SBI DFHI in terms of operational scope.


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The Company shall undertake, in consultation with the Bank, to make a PublicOffering of its Shares at a price of not less than Rs10 for each share within 4years from the date of the Companys incorporation or by a later date as theBank shall otherwise agree. (Section 3.07. [a], Subscription Agreement)

28. Notwithstanding the foregoing, SBIs management informed the OEM that it did notintend to reduce its shareholding in SBI DFHI to less than 50%, as a reduction in shareholdingof subsidiaries through an initial public offering (IPO) is not in accordance with SBIs currentcorporate policy. Given that SBI DFHI is unlikely to require any additional capital in view of itshigh net worth, SBI DFHIs management understandably does not consider an IPO to benecessary at this juncture.

29. SBI has undertaken a gradual process of organizational reforms since the mid-1990sfollowing the recommendations of an international consulting firm. As a result, the organizationbecame flatter, forming specialized business units for each market segment, namely, small andmedium enterprises, microcredit, rural credit, and so on. This has improved efficiency and

expedited decision making. However, little progress has been made in privatizing SBI and itsgroup companies. In view of market imperfections and the remaining weaknesses in the currentprimary dealer system that surfaced during the market setback in FY2005, the OEM justifiedcontinued public sector ownership in some primary dealers, including SBI DFHI, at least as atransitional measure. Assessing the justification for continued public sector ownership in SBIand other group companies is beyond the scope of this PPER (para. 45).

30. The entry of 12 primary dealers sponsored by private sector financial institutions as ofFY2000 promoted competition in the Government securities market and contributed to theincreased liquidity during FY2000FY2004. People interviewed by OEM suspected thatsophisticated risk management skills introduced by primary dealers sponsored by foreignfinancial institutions might have had some spillover effects on the local financial industry,

possibly contributing to a reduction of systemic risks in the market.

B. Investment Outcome

31. The OEM rated the investment outcome as satisfactory.36 If effective measures tomitigate market risk and exit risk had been in place, the investment outcome could have beenassessed as excellent.

32. The OEM used the net asset value method37 to estimate the FIRR of the investmentbased on the following: (i) ADB received dividends every year during FY1998FY2004 thattotaled Rs184,909,000 (equivalent to about $4.0 million) and no dividend in FY2005; and (ii) SBIDFHIs net asset value was Rs9,581 million as of the end of FY2005. If ADB had divested all of

its shares at the end of FY2005, the FIRR would be 24.4% in rupees and 20.0% in dollars(Appendix 6, tables A6.1 and A6.2). Using the same method and assuming that ADB woulddivest on 31 March 2006, the FIRR would be 18.3% in dollar terms (Appendix 6, Table A6.3).The assumptions in this calculation include no increase in net worth and no dividends paid to

36The good practice standards suggest that the investment outcome should be rated based on the investmentsgross contribution in relation to the corresponding at-approval standards for minimally satisfactory expectedperformance.

37The net asset value method is based on the book value of the companys net worth.


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ADB during FY2006 and that the 30 June 2005 exchange rate of Rs43.52 per $1 remainsconstant. As the figures suggest, the investment return has been highly satisfactory andexceeds the 12% FIRR in dollar terms estimated at appraisal.

33. The OEM initially planned to calculate FIRR projections also using the price-earning ratiowith reference to the industry average. However, the OEM subsequently discarded this

methodology for two reasons. First, the OEM could not obtain financial projections for SBI DFHI.Second, because the earnings of primary dealers have been volatile in recent years, the price-earning ratio is not a suitable indicator for making a valuation of primary dealers. Also only oneprimary dealer is listed on the stock exchange, which significantly limits the availability of thedata required to implement this methodology.

34. The significant drop in liquidity of Government securities and the deterioration of primarydealers performance in FY2005 suggest that this investment is exposed to considerable marketrisk. Given the unlikely prospect of an IPO by SBI DFHI in the foreseeable future, a potentialdifficulty in divestment is another risk associated with this investment. Representatives of SBIand SBI DFHI indicated to the OEM their expectation of continued shareholding by ADB in SBIDFHI. SBI DFHIs management noted that they might consider a buy-back of shares rather than

an IPO if ADB decided to exit; however, consent from SBI DFHIs more than 30 minorityshareholders would be required to pursue this option. SBIs management did not commentabout the possibility of taking over ADBs shares in SBI DFHI.

C. ADBs Effectiveness

1. At-Entry Screening, Appraisal, and Structuring Work

35. The OEM rated ADBs performance related to the Projects screening, appraisal, andstructuring as partly satisfactory.

36. ADBs performance before the subscription of shares was mixed. The Project was

relevant, because it complemented the Financial Sector Program (footnote 4)and the CapitalMarket Development Program (footnote 5). Considering the large influence of the SBI group onIndias financial system, ADBs at-entry screening of this investment can be justified. OEMsreview of the project file suggested that ADB adequately assessed the issues in theGovernment securities market and the SBI group. The RRP appropriately highlighted the marketrisk associated with this investment resulting from interest rate fluctuations and considered thatasset diversification would mitigate this risk. This consideration is questionable given thespecialized nature of SBIGLs operations (which would constrain asset diversification) and thelack of hedging instruments in the financial market.38

37. There is nothing to suggest that ADB had detailed discussions with SBI on the eventualreduction of SBIs shareholding in SBIGL, on an IPO by SBIGL, and on ADBs exit policy. The

RRP was silent on an alternative mechanism that would ensure the divestment of ADBsshareholding other than via an IPO and the potential difficulty of ADBs exit if an IPO turned outnot to be a realistic option. The letter agreement for the Project required SBI to arrange forADBs exit only if SBI decided to divest its shareholding in SBIGL. The lack of a workable,comprehensive exit mechanism for ADB was a major flaw in the project design.

38International Finance Corporation staff interviewed by the OEM noted that the International Finance Corporationdecided not to invest in a primary dealer in India because of the high market risk associated with such aninvestment given the lack of hedging instruments.


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2. Supervision and Administration

38. The OEM rated ADBs performance related to supervision and administration as partlysatisfactory.

39. After the subscription, the Private Sector Operations Department at headquartersadministered this investment. ADBs administrative performance was mixed. The OEM could notfully clarify why the India Resident Mission administered the associated investment in SBICAPbut not this investment.39 ADB was represented on SBIGLs board only during the earlier years(FY1997FY2000) of the investment.40 The OEM could not verify why this representation waswithdrawn.41 Throughout the investment period, SBIGL and SBI DFHI regularly submittedperformance review reports to ADB. Based on a review of these reports and attendance atannual general meetings, supplemented by occasional correspondence, ADB officers haveupdated the quarterly private sector investment management notes. Since 2003, ADB hasregularly proposed its exit from the investment as recommended in the PCR circulated inAugust 2001.42 However, ADBs response to the proposed merger of SBIGL with DFHI fell shortof expectations.43 ADB should have responded promptly to this proposal based on a thorough

assessment of the mergers implications in consultation with the Office of the General Counsel.Potentially, this merger could have offered an avenue for ADBs divestment had the option beenpursued more vigorously.

3. Role and Contribution

40. The OEM rated ADBs role and contribution as partly satisfactory.

41. SBI and SBI DFHI management explained the contributions of the ADB investment asfollows. First, this investment represented ADBs tangible support for the financial sectorreforms initiated by the Government since 1991. Second, ADBs broadly based strategicthinking and international perspective brought benefits to SBIGL and SBI DFHI. Third, this

investment was associated with a significant demonstration effect that enhanced confidence inthe emerging Government securities market. However, the OEM did not consider ADBs

39According to PSOD, the reason for the separation of the supervision function of the two accounts is that SBICAPwas downgraded shortly after project approval because of a number of reasons, requiring closer monitoringthrough the India Resident Mission. On the other hand, the PCR (para. 41) noted that it makes sense to closelyinvolve ADBs Resident Mission, which has staff with private sector experience (for SBIGL) The OEM agrees withthe latter view. India Resident Mission is of the view that PSODs current system of assigning projects on an ad hocbasis to resident missions should become more systematic and accountable so that the administration of privatesector projects would be more effective and efficient.

40There is no record suggesting that the nominee director from ADB actually attended SBIGLs board meetings,whereas the OEM confirmed ADBs representation at some of the annual general meetings of SBIGL and SBIDFHI.

41The PCR (para. 41) noted that the Resident Mission of ADB in India played an active role on SBIGLs Board as a

nominee director. The OEM recognized the active role played by the India Resident Mission throughout theinvestment period. However, the India Resident Mission officer was not designated as a nominee director on theboard of SBIGL at the time of the PCR according to the SBIGLs annual report for FY2002.

42The PCR (para. 38) noted that ADB will enter into discussion with SBIGLs management to develop a strategy forlisting SBIGL in the next 2years. This will depend, however, on overall investment conditions in the Indian stockmarket and the attractiveness of SBIGL to the investing public. The OEM did not consider stock market conditionsor the attractiveness of SBIGLs shares as major constraints to an IPO during FY2001FY2003. Rather, it was thereluctance of SBI and SBIGL as explained in para. 28.

43SBIGL initially notified ADB about the proposed merger by means of a letter dated 27 May 2003; but the OEMcould not find any document substantiating a thorough assessment by ADB officers of this proposal soon after thereceipt of this letter or following ADBs formal response to this letter.


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contributions to SBIGLs and SBI DFHIs operations to have been fully tangible. Moreover, noneof the three private sector primary dealers interviewed by the OEM was aware of ADBsinvestment in SBIGL. This is understandable given that the annual reports of SBIGL (FY2001FY2003) and SBI DFHI (FY2004FY2005) are not explicit about ADBs shareholding in thecompany. The OEM concluded that ADB played some demonstration role during the initial yearsof that investment, but that such effects are diminishing.

D. Overall Rating

42. On the basis of the foregoing, the overall rating for this Project is satisfactory. This OEMconclusion is based in particular on consideration of the following factors. First, the investeecompany contributed to establishing and maintaining the primary dealer system. This, in turn,supported the development of the Government securities market as originally envisaged.Without the presence of SBIGL and SBI DFHI, the absorption of primary dealers in the primarymarket, especially during the initial stage of its development and during the downturn of themarket in FY2005, would not have been sufficient. Second, to date the investment return hasbeen highly satisfactory and exceeds the 12% in dollar terms estimated at appraisal. However,effective measures to mitigate the market risk and the exit risk are not in place, and thus the

final investment outcome remains uncertain. Third, ADBs investment was timely andcomplemented public sector operations, though ADBs work quality fell short of expectations. IfADB had a tangible exit policy for the Project, its overall rating might have been excellent.

IV. ISSUES, LESSONS AND FOLLOW-UP ACTIONS

E. Issues

43. In line with the 2003 Fiscal Responsibility and Budget Management Act, as of April 2006,RBI will no longer play the role of underwriter of last resort in the primary auction of Governmentsecurities. The new arrangement aims to tighten fiscal management, enhance the transparencyof the interest rate determination process, and make RBIs open market operations more active

instruments for monetary control. The new arrangement is premised on a greater role forprimary market participants, especially primary dealers. However, most OEM intervieweesquestioned the viability of the current primary dealer system given the underperformance ofprimary dealers during the current period of rising interest rates. Because of this concern, RBIset up the internal Technical Group on Central Government Securities Market to examinereform options for the primary dealer system. Based on the groups recommendations,44 RBI iscurrently finalizing a reform plan. Implementation of this plan is expected to create a morerobust Government securities market.

44. In addition to reform of the primary dealer system, the development of a derivativesmarket and the removal of existing entry barriers for individual investors45 should help deepenand broaden the Government securities market. Progress in these areas may also serve to

44The recommendations included (i) introducing a system of 100% underwriting commitment by primary dealers toreplace the current system of the 100% bidding commitment, (ii) giving primary dealers exclusivity in primaryauctions on a selective basis based on relative secondary market performance, and (iii) permitting short-selling byprimary dealers. Most primary dealers interviewed by the OEM supported these recommendations.

45No explicit regulatory barrier hinders the entry of individual investors in the Government securities market, but thepresence of individual investors in the secondary market is negligible. One reason could be that the typical lot sizeof Government securities in the secondary market is Rs100 million, which is prohibitive for individual investors.While no rule prohibits individual investors from buying Government securities in smaller lots from banks or primarydealers, the latter are not proactive in distributing Government securities to individual investors. Reportedly, thedissemination of market information and settlement arrangements are also not investor friendly.


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develop the corporate debt market. Indias corporate debt market remains relativelyunderdeveloped, with the outstanding amount estimated at around Rs1 trillion. To date, the vastmajority of corporate debt paper has been issued on a private placement basis, leading to a lackof transparency and liquidity in the corporate debt market.

45. In the 1990s, the Government started diluting its equity in public sector banks in a

phased manner. A recent empirical study shows that in India, partially privatized public sectorbanks outperformed nonprivatized public sector banks.46 On the basis of this observation, theOEM generally supported the privatization of public sector banks; however, assessing the costsand benefits, particularly of the SBI groups privatization,47 is beyond the scope of this PPER.ADB would need to undertake such an assessment should it consider participating in a projectsponsored by SBI or its affiliates in the future.

46. As explained earlier, the Private Sector Operations Department (PSOD) has proposedits exit from the investment in the past but was not successful. Against this background, PSODwill need to discuss with the South Asia Department broader ADB leverage that might be helpfulin devising an effective exit strategy.

F. Lessons Learned

47. ADB equity investments require a workable and viable exit mechanism. Planned IPOsare often not a workable mechanism, as they depend on the nature of the investee, a sponsor,the industry, and the market conditions. ADB cannot rely solely on IPOs, and therefore needs topursue a put option incorporated in a letter agreement or shareholders agreements. To makesuch an option enforceable, the method of revaluation of an investee at ADBs divestmentshould be carefully discussed during processing and stated in the agreements.

48. If an investee company proposes a merger or acquisition, PSOD should carefullyexamine the implications of such a proposal in consultation with the Office of the GeneralCounsel and provide prompt feedback to the investee company. ADB may need to pursue a put

option if it cannot agree to the proposal. The subscription agreement should contain a clausespecifying the agreed procedures if an investee company decides to pursue a merger oracquisition. While such decisions cannot always be foreseen at the time of processing, a clearunderstanding needs to be in place on how to deal with such situations should they materialize.

49. The quarterly private sector investment management note should elaborate on andupdate the status of projects that have deviated significantly from the original scope and plan.ADB should pay extra attention to monitoring such projects. In the case of this Project, the

46Sathye, Milind. 2005. Privatization, Performance, and Efficiency: A Study of Indian Banks. Vikalpa30 (1): 7-16.Based on statistical evidence from financial data of 27 public sector banks (including SBI and its associated banks)in 19982002, this study derived the following conclusions: (i) the financial performance of partially privatized

banks and their efficiency were significantly higher than those of nonprivatized public sector banks, (ii) the portfolioquality did not differ significantly between partially privatized public banks and nonprivatized public sector banks,(iii) the financial performance and efficiency of partially privatized banks seem to be catching up rapidly with thoseof fully privatized banks, and (iv) the gradual privatization and well-developed financial markets seem to havecontributed to Indias success.

47As concerns the SBI group companies, Sathye (footnote 46) did not detect any statistical evidence about theeffects of privatization. Sathye (p. 14)commented on this finding as follows: The capital of the SBI is not directlyheld by the Government of India [but held by RBI and other state-owned financial institutions] and the groupcontinued to enjoy the privileges of government business being routed through them. This scenario is different thanthat of the nationalized banks [excluding the SBI group companies] where the Government of India held the entirecapital directly. As a result, the marketization shock seems to have worked well with the nationalized bank cohort.


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reluctance of the sponsor to divest its shareholding and of the investee company to undertakean IPO can be considered as major deviations that merited closer attention and more activefollow-up by ADB.

50. ADB approved this Project in conjunction with the investment in SBICAP. However,monitoring and evaluation of the investment in SBICAP was undertaken separately: ADB

headquarters administered this Project, whereas the India Resident Mission administered theinvestment in SBICAP. The PCR was prepared only for this Project. The assessment of the twocomplementary investments is beyond the scope of this PPER. This experience suggests that tothe extent possible (i) the monitoring and evaluation of closely related projects sharing the samesponsor should come under the purview of one investment officer, and (ii) the PCRs andPPERs48 for the associated projects should be prepared simultaneously.

G. Follow-Up Actions

51. Given the diminishing demonstration effect of this Project, the accumulated net worth ofSBI DFHI (even taking into account the net loss in FY2005), the investment returns to date, andthe limited prospects for the privatization of SBI DFHI, ADB should develop an exit strategy from

this investment taking market conditions into account. SBI, as the sponsor of this Project, canbe a possible counterpart for sales of SBI DFHIs shares held by ADB.

48This consideration may be reflected to ADBs evaluation guidelines on private sector projects, which is beingprepared.


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Appendix 1 19

EVALUATION STANDARDS

A. Development Outcome

1. These ratings measure Projects contributions to (i) capital market development, (ii)investees business performance, and (iii) private sector development:

(i) Excellent. A project with overwhelming positive development impacts and withvirtually no flaws. Indicates the type of project the Asian Development Bank(ADB) should use publicly to illustrate the contribution of private sectordevelopment.

(ii) Satisfactory. A project without material shortcomings or with some strongpositive aspects that more than compensates for shortfalls. The guidelineprinciple should be that if all ADBs projects were rated satisfactory, it should justbe able to justify its existence as a development institution.

(iii) Partly satisfactory. A project with either minor shortcomings across the board orsome egregious shortcoming in one area that outweighs other generally positiveaspects.

(iv) Unsatisfactory. A project with largely negative aspects that clearly outweigh itspositive aspects.

1. Market Development

2. These indicators address the extent to which the Project contributed to sustainablemarket development:

(i) Excellent. Considering its size, the project considerably contributed to marketdevelopment.

(ii) Satisfactory. The project had some, but no major, positive impact.(iii) Partly satisfactory. The project had some negative impacts, but these are not

expected to be of long duration or broad applicability (for example, a failedproject without substantial negative demonstration effects).

(iv) Unsatisfactory. The project had negative impacts that are broadly applicable orare expected to be of long duration or both.

2. Business Success

3. These indicators address the extent to which the Project contributed to the investeesoperational performance:

(i) Excellent. The project substantially raised the investees profitability.(ii) Satisfactory. The project had a neutral to positive effect on profitability.

(iii) Partly satisfactory. Project returns were sufficient to cover the cost ofassociated debt, but did not provide adequate returns to equity holders.

(iv) Unsatisfactory. Project returns were insufficient to cover the cost of associateddebt.

3. Private Sector Development

4. These indicators address the extent to which the Project contributed to the sustainableprivate sector development:


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20 Appendix 1

(i) Excellent. Considering its size, the project contributed considerably to privatesector development.

(ii) Satisfactory. The project had some, but no major, positive impact.(iii) Partly satisfactory. The project had some negative impacts, but these are not

expected to be of long duration or broad applicability (for example, a failed

project without substantial negative demonstration effects).(iv) Unsatisfactory. The project had negative impacts that are broadly applicable or

are expected to be of long duration or both.

B. Investment Outcome

5. These ratings measure financial returns of ADBs investment:

(i) Excellent. The financial internal rate of return (FIRR) of the ADB investment issignificantly higher than the expected returns cited in the original investmentproposal. Risks to a projects future cash flow can be a factor for downgrading ifthe investment remains in ADBs portfolio.

(ii) Satisfactory. The FIRR is on a par with or marginally higher than the expectedreturns cited in the original investment proposal. Risks to a projects future cashflow can be a factor for downgrading if the investment remains in ADBs portfolio.

(iii) Partly satisfactory. The FIRR is lower than the expected returns cited in theoriginal investment proposal. Risks to a projects future cash flow can be a factorfor downgrading if the investment remains in ADBs portfolio.

(iv) Unsatisfactory. The FIRR is negative.

C. The Asian Development Banks Effectiveness

6. These ratings measure ADBs overall performance related to the (i) Projects screening,appraisal, and structuring; (ii) Projects supervision and administration; and (iii) role and

contribution:

(i) Excellent. ADBs performance was exemplary.(ii) Satisfactory. ADBs performance was materially up to a high professional

standard.(iii) Partly satisfactory. A material shortfall occurred in at least one area of ADBs

performance.(iv) Unsatisfactory. Shortfalls in several areas or an egregious shortfall in one area

led (or could have led, under less favorable circumstances) to an unsatisfactoryinvestment outcome.

1. Screening, Appraisal and Structuring

7. These indicators address to what extent ADB has professionally executed its front-endwork to a sustainable corporate performance standard.

(i) Excellent. ADBs front-end work could serve as a best-practice example.(ii) Satisfactory. Materially, ADB met good practice standards.(iii) Partly satisfactory. A material shortfall occurred in at least one important area.(iv) Unsatisfactory. Material shortfalls occurred in several areas, and a glaring

mistake or omission bordered on negligence in at least one important area.


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Appendix 1 21

2. Supervision and Administration

8. These indicators show to what extent ADB has executed its supervision, taking intoaccount that the appropriate level of supervision will depend on a projects circumstances:

(i) Excellent. ADB has always kept itself promptly and fully informed about theprojects and the companys performance in all material areas and used thisknowledge proactively to improve the projects development outcome and/orADBs investment outcome.

(ii) Satisfactory. ADB has always kept itself sufficiently informed to react in a timelymanner to any material change in the projects and companys performance andtook timely action when needed.

(iii) Partly satisfactory. ADBs supervision was insufficient to monitor the projectsand companys performance and/or ADB did not take timely and appropriateaction.

(iv) Unsatisfactory. ADB missed material developments and/or did not useinformation to intervene in a timely and appropriate manner.

3. Role and Contribution

9. These indicators address the extent and relevance of ADBs role and contribution:

(i) Excellent. ADBs role was essential for the project to go ahead and ADBcontributed significantly to its success.

(ii) Satisfactory. ADBs role and contribution were in line with operating principles.(iii) Partly satisfactory. ADBs role or contribution fell short in a material area.(iv) Unsatisfactory. ADBs role was not plausibly additional and ADB did not deliver

its expected contribution.


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22 Appendix 2

STATISTICAL DATA

Table A2.1: Gross Domestic Product and CentralGovernment Deficit, FY1993FY2005

(Rs billion)

GDP at Gross CentralMarket Government

Fiscal Year Prices Deficit

1993 7,484 402

1994 8,592 603

1995 10,128 577

1996 11,880 602

1997 13,682 667

1998 15,225 889

1999 17,410 1,133

2000 19,368 1,047

2001 20,895 1,188

2002 22,720 1,410

2003a 24,633 1,4512004

b27,600 1,233

2005c

31,055 1,392GDP = gross domestic product.a

Provisional.b

Estimates.c

Revised estimates.Source: Reserve Bank of India. Database on IndiaEconomy. Handbook of Statistics on Indian Company.Available: http://www.rbi.org.in/scripts/Statistics.aspx.


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Appendix 2 23

Table A2.2: Outstanding Liabilities of the Central Government, FY1993FY2005(Rs billion)

Total Central 91-Day182 and364-day

Government Market Treasury Treasury

Fiscal Year Liabilities Loansa

Bills Bills

1993 4,019 817 206 88

1994 4,780 1,106 326 84

1995 5,386 1,375 323 82

1996 6,062 1,695 438 19

1997 6,757 1,929 565 82

1998 7,783 2,490 16b

162

1999 8,918 3,116 15 102

2000 10,210 3,819 15 143

2001 11,685 4,537 19 163

2002 13,664 5,363 50 196

2003 15,592 6,742 97 261

2004 17,367 8,246 72 2612005

c19,815 9,296 72 260

aMarket Loans comprise mainly dated securities.

bSharp decline in 91-day treasury bills is because of the conversion of ad hoc treasury bills intospecial securities.

cEstimate.

Source: Reserve Bank of India. Database on India Economy. Handbook of Statistics on IndianCompany. Available: http://www.rbi.org.in/scripts/Statistics.aspx.


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24 Appendix 2

Table A2.3: Maturity Pattern of Government Rupee Loans,a

FY1993FY2005

Rs billion

Fiscal Year

OutstandingStock of

Maturity Under5 Years

OutstandingStock ofMaturityBetween

5 and 10 Years

OutstandingStock ofMaturity

over 10 YearsTotal

Outstanding

WeightedAverage

YieldIssued

During theYear (%)

1993 66 116 635 817 12.46

1994 237 246 623 1,106 12.63

1995 348 377 650 1,375 11.90

1996 650 514 531 1,695 13.75

1997 873 559 498 1,929 13.69

1998 1,020 1,017 453 2,490 12.01

1999 1,291 1,323 503 3,116 11.86

2000 1,430 1,477 912 3,819 11.77

2001 1,588 1,781 1,168 4,537 10.95

2002 1,642 1,908 1,814 5,363 9.44

2003 1,779 2,337 2,626 6,742 7.34

2004 1,848 2,552 3,846 8,246 5.71

2005 2,212 2,838 4,245 9,296

6.11a

Government rupee loans comprise mainly dated securities.Source: Reserve Bank of India. Database on India Economy. Handbook of Statistics on Indian Company.Available: http://www.rbi.org.in/scripts/Statistics.aspx.

Table A2.4: Secondary Market Transactions in Government Securities,FY1996FY2005

(Rs billion)

FiscalYear Outright Repo Total

1996 638 480 1,1181997 1,603 202 1,805

1998 1,592 317 1,908

1999 3,705 705 4,410

2000 4,869 1,138 6,007

2001 11,096 2,728 13,824

2002 13,500 4,890 18,390

2003 17,069 8,397 25,466

2004 11,878 14,969 26,846

2005 5,321 6,894 12,215Source: Reserve Bank of India. Database on India Economy. Handbook of Statistics onIndian Company. Available: http://www.rbi.org.in/scripts/Statistics.aspx.


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26 Appendix 3

CHRONOLOGY OF THE GOVERNMENTS SECURITIES MARKET REFORMS

Year Reform Initiated Objective Remarks

June 1992 Introduction of auction method forissue of Central GovernmentSecurities

To make Governmentyields marketdetermined

Price discovery hasbecome very fine over aperiod of time.

December1992

Introduction of the Reserve Bankof India (RBI) repo auction

Fine-tuning liquidity Precursor to LiquidityAdjustment Facility

January1994

Issued Zero Coupon Bond for thefirst time. Securities TradingCorporation of India commencedoperations

To add new instrumentsand intermediaries

Securities TradingCorporation of India andother Primary Dealers(PDs) have becomeimportant intermediariesin the Governmentsecurities market.

August1994

Agreement between RBI andGovernment of India on limitingissue of ad hoc treasury bills

To do away withautomatic monetization

Improved cashmanagement forGovernment and atransparent issuanceprocess

March1995

PD system introduced To strengthen themarket Intermediationand support primaryissue

PD system has evolvedas an important segmentof Government securitymarket.

July 1995 Delivery-versus-Payment (DVP)in Government securities wasintroduced

To reduce settlementrisk

We have now moved toDVP-III.

September

1995

Floating Rate Bonds introduced To add more

instruments

Floaters are now

becoming popular. 1520% of fresh Governmentof India borrowing is nowthrough Floating RateBonds.

January1997

Technical Advisory Committeeconstituted

To advise RBI ondeveloping Governmentsecurity, money andforeign exchangemarkets

Plays a pivotal role inimplementing RBIsreform agenda based ona consultative approach

March

1997

Introduction of Way and Means

Advances system for Centre

Discontinuation of

automatic monetization

Improved transparency

and pricing as alsoautonomy in monetarypolicy making.

April 1997 The Fixed Income Money MarketDealers Association of India wasestablished

Introduction of selfregulation anddevelopment of marketpractices and ethics

Improved practices. Repomarket has beendeveloping.


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Appendix 3 27

Year Reform Initiated Objective Remarks

July 1997 Foreign Institutional Investorswere permitted to invest inGovernment securities

To broaden the market Foreign InstitutionalInvestors have becomeimportant players in themarket today, particularlyin Treasury Bill segment.

December1997

Capital Indexed Bonds wereissued

To help investors hedgeinflation risk

Efforts being made torevitalize this product

April 2000 Primary Dealer Association ofIndia was formed. Sale ofsecurities allotted in primaryissues on the same day

To improve secondarymarket

This has also helpedmanage the overnight risk

June 2000 Introduction of LiquidityAdjustment Fund

To manage short termliquidity mismatches

Emerged as an importantmonetary tool

May 2002 Compulsory holding ofGovernment securities in demat

form by RBI regulated entities

To improve settlementsystem

The progress ofdematerialization is being

monitoredJune 2002 PDs were brought under the

Banking and Finance Servicejurisdiction

For integratedsupervision of market

The position is beingreported periodically tothe Banking and FinanceService

October2002

Trade data of Negotiated DealingSystem is being made availableon RBI website

To improvetransparency

The measure is helpingthe small investors aswell.

January2003

Trading of Government securitieson stock exchanges

To facilitate easieraccess and widerparticipation

This has not taken offvery well. Efforts are on toimprove the position

February2003

Regulated constituents permittedparticipation in repo markets

To widen the market Activity in repo markethas improved

June 2003 Interest Rate Futures introduced To facilitate Hedging ofinterest rate risk

These futures have nottaken off

July 2003 Government Debt Buy-Backscheme implemented

To reduce interestburden of governmentand help banks offloadilliquid securities

Other measures for activeconsolidation beingconsidered

March2004

Introduction of DVP III To obtain nettingefficiency and to enablerollover of repos

Running successfully.

April 2004 Introduction of Real Time GrossSettlement

Real time, online, largevalue inter-bankpayment andsettlements

Running successfully

Source: Originally appeared in Reserve Bank of India. 2005. Report of the Internal Technical Group on CentralGovernment Securities Market.


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28 Appendix 4

KEY INFRASTRUCTURE FOR THE GOVERNMENT SECURITIES MARKET1

A. Securities Settlement System

1. Settlement of Government securities and funds is being done on a Delivery vs.Payments (DVP) basis in the books of the Reserve Bank of India (RBI) since 1995. A Special

Funds Facility from Reserve Bank for securities settlement has also been in operation sinceOctober 2000 for breaking a gridlock situation arising from the course of DVP settlement. Withthe introduction of Clearing Corporation of India Limited (CCIL) in February 2002, which acts asclearing house and a central counterparty, the problem of gridlock of settlements has beenreduced. To enable Constituent Subsidiary General Ledger account holders to avail of thebenefits of dematerialized holding through their bankers, detailed guidelines have been issuedto ensure that entities providing custodial services for their constituents employ appropriateaccounting practices and safekeeping procedures. With the implementation of Real-Time GrossSettlement (RTGS) System, Securities Settlement System will also be linked to RTGS Systemto provide intraday liquidity to the market participants.

B. Negotiated Dealing System

2. The Negotiated Dealing System (NDS), which was operationalize

Documents

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