VI.1 Indian banks and financial institutionsexhibited resilience in the midst of a severe globalfinancial cr isis. Notwithstanding the growingfinancial integration and globalisation, the bankingsystem in India had no direct exposure to the sub-prime assets that tr iggered the crisis in theadvanced economies. The indirect exposure ofbanks in this regard was also insignificant. Muchbefore the cr isis star ted in the advancedeconomies, the Reserve Bank had taken a numberof measures which contributed to strengthening theresilience in the Indian banking system. Theseincluded prudential regulations for limiting theexposure of the banking system to sensitive sectorsand appropriately rebalancing the risk weights ofdifferent assets. Necessary provisioning normswere prescribed and there has been a sustainedemphasis on CAMELS parameters for supervisionof Indian banks and financial institutions. TheCommittee on Financial Sector Assessmentunder took single-factor stress tests for end-September 2008, which revealed that the Indianbanking system could withstand significant shocksarising from large potential changes in credit quality,interest rate and liquidity conditions. It wasassessed that even under the worst case scenario,the capital to risk-weighted assets ratio (CRAR) of

Indian banks would remain above the regulatoryminimum. Notwithstanding the resilience of Indianbanks and financial institutions to the internationalfinancial crisis, when the global economic crisisstarted to dampen the domestic growth prospects,the Reserve Bank had to take a number of policymeasures aimed at preserving and promotingfinancial stability, while supporting faster economicrecovery.

VI.2 The regulatory and supervisory initiativestaken by the Reserve Bank during 2008-09 withregard to banks and other financial institutions arepresented in this Chapter. A distinguishing featureof the various policy initiatives to strengthen thebanking system and thereby promote financialstability is that some of these initiatives were a partof the ongoing policy efforts and not a response tothe sequence of events that led to the globalfinancial crisis. In addition to prudential regulations,steps were taken to improve customer service,enhance supervision and strengthen the anti-money laundering measures in the banking sector.

VI.3 For UCBs, further regulatory measureswere taken in order to reap the gains accruing fromthe path laid down by the vision document for thesector through the MoUs and the Task Force for

FINANCIAL REGULATIONAND SUPERVISIONVI

241

The banking system in India remained largely unaffected by the financial crisis, while several banks andfinancial institutions in the advanced countries failed or had to be bailed out with large sovereign support.The financial soundness indicators for the banking system in India during 2008-09 showed stability andstrength; every bank in the system remained above the minimum regulatory capital requirement. Stresstest findings suggested the resilience of the financial system, in the face of the severe external contagionfrom the global financial crisis. As at end-March 2009, all Indian scheduled commercial banks hadmigrated to the simpler approaches available under the Basel II framework. Post-crisis changes that maybe necessary to strengthen the regulatory and supervisory architecture would be based on the evolvinginternational consensus as well as careful examination of their relevance to the India-specific context.The time schedule for implementation of advanced approaches under Basel II has been notified and aninter-disciplinary Financial Stability Unit has been set up to monitor and address systemic vulnerabilities.

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UCBs arrangement. During 2008-09, the ReserveBank continued its regulatory focus on systemicallyimportant non-deposit taking NBFCs. A spate ofmeasures was taken to address the liquidityconcerns arising for the sector in the wake of theinternational financial crisis.

Measures Taken Before the Global Crisis

VI.4 Regulation of non-banking entities is beingprogressively strengthened and the process hadstarted before the onset of the global financial crisis.NBFCs owned by foreign banks and regulated bythe Reserve Bank, were brought under the Groupconcept, to contain the regulatory arbitrage. Anelaborate prudential framework was put in placefor NBFCs-ND-SI. Consolidated supervision ofbanking groups was introduced in 2003 and hasbeen constantly strengthened thereafter.

VI.5 To limit the growth of bank-led financialconglomerates (FCs), banks’ equity investment inindividual financial subsidiaries has been limitedto 10 per cent of paid-up capital and reserves ofthe bank and aggregate investment has beenlimited to 20 per cent of paid-up capital andreserves. Banks’ non-banking activities are alsolimited by law and any significant strategic equityinvestments by banks require the Reserve Bank’sprior approval.

VI.6 Prudential regulations have beenconsistently strengthened. Major steps takeninclude limits on capital market exposures of banks,prescription of 50 per cent margin for advancesagainst shares, limits on lending and borrowing incall money market, limit on inter-bank liabilities andrestrictions on investment in unlisted and unratednon-SLR securities. The provisioning requirementsfor sub-standard and doubtful assets have beenprogressively aligned with best internationalpractices, diminution in fair value of restructuredaccounts is required to be provided for and netappreciation in trading and available for sale bookis not permitted to be recognised. The dividendpayout ratio in case of banks is not allowed toexceed 40 per cent and dividend can be paid only

out of current year’s profit. Securitisation profitscannot be booked upfront to contain perverseincentives.

VI.7 In order to ensure higher quali ty ofregulatory capital, existing capital adequacyguidelines require that Tier I capital of banks shouldbe at least 6 per cent of risk-weighted assets byMarch 31, 2010. Tier III capital for market risk hasnot been introduced, as it is short-term.

VI.8 Further, when there was very rapid creditgrowth from 2004-05 onwards, risk weights andprovisioning for banks’ exposure to rapidly growingor sensitive sectors (such as commercial realestate, consumer loans and capital market), evenwhen classif ied as standard assets, wereprogressively increased since 2005-06 as acounter-cycl ical measure. Banks were alsoencouraged to maintain floating provisions whichcould be drawn down in extraordinary circumstances.

VI.9 To ensure adequate liquidity buffers withindividual banks, banks were required to invest25 per cent of their NDTL in government securitiesto maintain SLR (reduced to 24 per cent of NDTLin November 2008). The framework for monitoringand reporting of liquidity position of individualbanks was improved by way of introduction of moregranular liquidity buckets within the 1-14 segment(i.e., next day, 2-7 days, 8-14 days). Table 6.1shows that Indian banking system continues toremain healthy.

Table 6.1: Health of Scheduled CommercialBanks in India

Item End- March

1998 2008 2009

1 2 3 4

CRAR (per cent) 11.51 13.01 13.19

Gross NPA (Rs. crore) 48,306 55,842 67,497

Gross NPA (per cent) 14.78 2.39 2.42

Net NPA (Rs. crore ) 23,013 24,891 30,924

Net NPA (per cent) 7.63 1.08 1.12

Return on Equity (per cent) 14.63 12.52 13.25

Interest Spread (per cent) 3.05 2.37 2.44

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Measures Taken During the Global Crisis

VI.10 The measures taken by the Reserve Bankduring 2008-09 broadly include counter-cyclicalmoderation of capital and provisioning norms whichhad been enhanced earlier and provision ofadequate rupee/foreign exchange liquidity to enablethe banks to continue to lend for viable economicactivities. The prudential measures are discussedin detail in subsequent paragraphs of this Chapter.The measures relating to liquidity and creditdelivery are discussed in relevant Chapters.

REGULATORY FRAMEWORK FOR THE INDIANFINANCIAL SYSTEM

VI.11 In the overall architecture for the regulationand supervision of the financial system in India,the Reserve Bank’s regulatory and supervisorypurview extends to a large segment of financialinstitutions, including commercial banks, co-operative banks, non-banking financial institutionsand various financial markets. At end-March 2009,there were 801 commercial banks (excludingRRBs); 4 local area banks; 86 RRBs; 1,721 UCBs;4 development finance institutions; 12,739 NBFCs(of which 336 NBFCs were permitted to accept/holdpublic deposits) and 182 primary dealers (PDs) [ofwhich 11 were banks undertaking PD business asa departmental activity, known as bank-PDs, and7 were non-bank entities, also referred to as stand-alone PDs]. The Board for Financial Supervision(BFS) has been mandated to ensure integratedoversight over the financial institutions that areunder the purview of the Reserve Bank.

Board for Financial Supervision (BFS)

VI.12 The BFS, constituted in November 1994,remains the principal guiding force behind theReserve Bank’s supervisory and regulatoryinitiatives. It reviews the inspection findings inrespect of commercial banks/UCBs and periodic

1 Including Bank International Indonesia, which ceased operations in India and is being wound up.2 This excludes Lehman Brothers Fixed Income Securities Ltd., which was prohibited from undertaking primary market operations with effect

from September 16, 2008.

reports on critical areas of functioning of banks suchas reconciliation of accounts, fraud monitoring,overseas operations and banks under monthlymonitoring. In addition, the BFS also reviews themicro and macro prudential indicators, bankingoutlook and interest rate sensitivity analysis. It alsoissues a number of directions with a view tostrengthening the overall functioning of individualbanks and the banking system. The BFS held eightmeetings during the period July 2008 to June 2009.In these meetings, it considered, inter alia, theperformance and the financial position of banks andfinancial institutions during 2008-09. It reviewed 70inspection reports (27 of public sector banks, 16 ofprivate sector banks, 20 of foreign banks, 4 of localarea banks and 3 of financial institutions). Some ofthe important issues deliberated upon by the BFSduring 2008-09 are highlighted in this section.

VI.13 In the wake of the global financial crisis,the BFS was apprised of the exposure of Indianbanks to tainted assets and also the safeguardsavailable within the Indian banking system onaccount of the regulatory measures initiated tostrengthen the risk management and liquiditymanagement systems of banks. The BFS wasinformed that an in-depth examination of investmentportfolio of banks was being done as part of theAnnual Financial Inspection (AFI). The BFS alsoenhanced its focus on monitoring the mark-to-market (MTM) losses in credit derivatives and otherinvestment portfolios of overseas operations ofbanks in India on a monthly basis (Box VI.1).

VI.14 In response to concerns in some quartersregarding risks associated with foreign exchangederivatives, detailed information was called for instructured formats by the Reserve Bank fromcertain select banks which were operating at thetop-end of the system-level exposures. Based on adialogue process with these banks regarding, interalia, the ‘suitability and appropriateness’ principles

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Falling asset prices in the international markets exertedsevere stress on the balance sheets of many internationalbanks, on account of their significant exposure to suchassets. Large off-balance sheet exposures magnified theirstress levels further. In this context, it was felt necessaryby the Reserve Bank to keep track of the quality ofexposures of overseas operations of Indian banks for timelyaction and supervisory intervention, if required.Consequently, the Reserve Bank held discussions withselect major banks with overseas operations to assess thequality of their overseas exposures. The assessmentrevealed that the banks did not have any direct exposureto the US sub-prime market. Some banks, however, hadindirect exposure through their overseas branches andsubsidiaries to the US sub-prime markets in the form ofstructured products, such as col lateral ised debtobligations (CDOs) and other investments. Some of thebanks, with exposures to credit derivatives, had to bookMTM losses on account of widening of credit default swap(CDS) spreads. The assessment, however, showed thatsuch exposures were not very significant, and banks hadmade adequate provisions to meet the MTM losses onsuch exposures. Besides, the banks also maintained highlevels of capital adequacy ratio. The Reserve Bank’sassessment suggested that, the risks to the bankingsector associated with MTM losses, appeared to be limitedand manageable.

As the financial crisis persisted and started spreading beyondthe US, a need was felt to continuously monitor the exposuresof the overseas operations of the Indian banks to detectadverse signals impacting the quality of the banks’ overseasexposures. Accordingly, a monthly reporting system wasintroduced in September 2007 capturing Indian banks’overseas exposure to credit derivatives and investments suchas Asset Backed Commercial Papers (ABCP) and MortgageBacked Securities (MBS). An analysis of the information socollected reveals that the exposures of Indian banks throughtheir overseas branches in credit derivatives and otherinvestments are gradually coming down from the June 2008level (Chart). Their MTM losses, however, gradually increasedup to March 2009, reflecting the impact of the sustained fallin the value of the assets in their portfolios.

After the direct impact of the global financial crisis throughMTM losses was assessed to be insignificant for Indian

Box VI.1Global Financial Crisis and the Indian Banking System: An Assessment of MTM Losses

banks, the focus shifted to the possible asset qualityconcerns arising from weakening growth prospects ascertain sectors in the economy clearly came under theinfluence of falling external demand due to the globalrecession and subsequent deceleration in domestic privatedemand. The asset quality of banks’ exposures to the sectorsperceived to be under stress became a matter of supervisoryconcern. A credit risk stress test of banks’ exposure to sevensuch sectors (chemicals/dyes/paints etc., leather and leatherproducts, gems and jewellery, construction, automobiles, ironand steel and textiles), accounting for 15.4 per cent of grossadvances and 12.2 per cent of gross NPAs, was carried outto assess the impact on banks’ capital adequacy due to anassumed rise in NPAs. The stress tests were run under twoscenarios, viz., 300 per cent and 400 per cent increases inNPAs in the seven sectors simultaneously. The additionalprovisioning requirements, assuming the rise in NPAs wereadjusted from existing regulatory capital and risk-weightedassets, were estimated to arrive at the adjusted capitaladequacy. The results of the stress tests revealed theinherent strength of the banks to withstand sizeabledeterioration in asset quality in the identified sectors. Thecapital adequacy ratio of only two banks accounting foraround 3 per cent of total assets of the banking system wasassessed to drop below the prescribed minimum level underboth the stress scenarios.

The assessment of MTM losses and stress test results, thus,further validated the resilience of the Indian banking systemto the shocks and concerns emanating from the globaleconomic crisis.

and risk management policies, a comprehensivereport was placed before the BFS. In this context,stress tests of the credit portfolio of commercialbanks in India were also carried out to assess theresilience of banks under various stress scenariossuch as increasing the NPA level and provisioning

requirements for standard, sub-standard anddoubtful assets as at end-March 2008. The analysiswas carried out at the aggregate and individualbank level and the results indicated that the CRARwould not decline below the stipulated minimumlevel under any of the adopted scenarios.

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VI.15 During the period under reference, the BFSissued several directions for enhancing the qualityof regulation and supervision of financial institutionsand some of the important directions were asfollows: (i) need for evaluation by the Reserve Bank,for robustness and efficacy, of the statistical scoringand loss forecasting models deployed by banks formanaging retail credit portfolios; (ii) fine-tuning andmaking more dynamic the process for selection ofbranches for the AFIs, by including additionalparameters for branch-selection; (iii) prohibitingsubsidiaries of banks from undertaking activitieswhich the bank itself was not permitted to undertakeas per the provisions of the Banking Regulation Act,1949; (iv) submission of confirmation report andcompliance certificate with regard to adherence tothe Reserve Bank's guidelines on outsourcingarrangements entered into by banks; (v) sensitisingthe banks that the principles for sale/purchase ofNPAs, issued in October 2007, were laid down asa broad criteria only to be adopted while enteringinto compromise settlements and not meant to berigid or restrictive (hence, banks could enter intothese settlements based on the circumstances/factsof each case and their commercial judgement andshould be able to justify the decision taken); and(vi) recording of intent of holding the investments,for a temporary period or otherwise, at the time ofinvestment in a subsidiary, associate and jointventure, for the purpose of consolidation.

VI.16 The BFS also accorded its approval tocertain important proposals aimed at enhancingthe regulatory provisions/intent and supervisoryfocus. Some of them were as fol lows:(i) prescribing the extent of admissible liabilitytowards Tier I and Tier II instruments in the schemeof merger/amalgamation of banks as and whensuch cases arose; ( i i) a one-t ime measuredesigned to help banks to clear their large numberof smal l value outstanding nostro entr iesoriginated up to March 31, 2002 while concurrentlydirecting the banks to concentrate on follow-upeffort on the high value entries that were stilloutstanding and to leverage technology to avoidbuilding up of unreconciled balances.

COMMITTEE ON FINANCIAL SECTORASSESSMENT

VI.17 The work on a comprehensive self-assessment of India’s financial sector, particularlyfocussing on stability assessment, stress testingand compliance with all financial standards andcodes star ted in September 2006 by theCommittee on Financial Sector Assessment(CFSA), chaired by Dr. Rakesh Mohan. Shri AshokChawla, Shri Ashok Jha and Dr. D. Subbarao asSecretary, Economic Affairs, Government of India,were the Co-Chairmen of the CFSA at differentpoints of time. In March 2009, the Government andthe Reserve Bank jointly released the Report ofthe CFSA (Box VI.2). The CFSA followed aforward-looking and holistic approach to self-assessment, based on three mutually reinforcingpillars – financial stability assessment and stresstest ing; legal, infrastructural and marketdevelopment issues; and an assessment of thestatus of implementation of international financialstandards and codes.

VI.18 Overall, the CFSA found that the Indianfinancial system was essentially sound andresilient, and that systemic stability was, by andlarge, robust. India was broadly compliant with mostof the standards and codes, though gaps werenoted in the timely implementation of bankruptcyproceedings. The CFSA also carried out single-factor stress tests for credit and market risks,liquidity ratio and scenario analyses. These testsshowed that there were no significant vulnerabilitiesin the banking system. Though NPAs could riseduring the current economic slowdown, given thestrength of the banks’ balance sheets, the rise wasnot likely to pose any systemic risk.

VI.19 Since risk assessment is a continuousprocess and stress tests need to be conductedtaking into account the macroeconomic linkagesas also the second round effects and contagionrisks, consequent to the announcement in theAnnual Policy Statement for 2009-10, an inter-disciplinary Financial Stability Unit was set up tomonitor and address systemic vulnerabilities.

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The CFSA presented its assessment of India’s financialsector along with a set of recommendations meant for themedium-term of about five years. The key assessmentsand recommendations under major heads are summarisedbelow.

Sustainability of Macroeconomic Growth

India’s growth in the recent period was primarily contributedby high domestic demand, productivity, credit growth andhigh levels of savings and investment. In the wake of thecrisis, India could face deceleration in its macroeconomicgrowth in the short-term; however, growth of 8.0 per centwas sustainable in the medium-term. India would need tofocus on revival of growth in agriculture, address quickrestoration of the fiscal reform path, continue financialsector consolidation/development and address theinfrastructure deficit . While ful ler capital accountconvertibility was desirable, it should be concomitant withmacroeconomic and market developments.

Financial Institutions

Commercial Banks

The stress testing of the financial institutions revealed thatbanks were generally in a position to absorb significantshocks due to credit, liquidity and market risks, thoughthere were some concerns relating to liquidity risk due toincreasing illiquidity in banks’ balance sheets. There was,therefore, a need to strengthen liquidity management.

The CFSA highlighted risk management as a priority areaand noted that the counter-cyclical prudential normsimposed by the Reserve Bank had paid dividends in recenttimes. It highlighted the growing requirement of appropriateaccounting and disclosure norms, particularly with regardto derivatives transactions.

Co-operative Sector

While the financial position of UCBs had improved, stresstests conducted for this sector revealed that these entitieswould remain vulnerable to credit risk. The financialindicators of the rural co-operatives threw up some causefor concern. Noting the dual control over co-operatives andrural banks, the CFSA stressed the need for bettergovernance in these institutions.

NBFCs

The CFSA noted that NBFCs were important players infinancial markets with broadly satisfactory financials.Development of the corporate bond market could ease thefunding constraints of this sector. Further strengtheningof prudential regulations of NBFCs was also suggested.

Housing Finance Companies (HFCs)The CFSA recommended that a National Housing PriceIndex and a Housing Starts Index were priorities for thegrowing and important segment of HFCs.

Box VI.2Major Recommendations of the Committee on Financial Sector Assessment (CFSA)

Insurance Sector

For further development of the insurance sector, the CFSAsuggested, inter alia, that the supervisory powers of IRDAbe improved and an effective policy for group-widesupervision be put in place.

Financial Markets

The CFSA recommended, inter alia, further improvementsin infrastructure, risk management and transparency/disclosure in equity, foreign exchange and governmentsecurities markets. On the issue of development of marketsfor credit derivatives and asset securitisation products, theCommittee noted that it should be pursued in a gradualmanner, by sequencing reforms and putting in placeappropriate safeguards before introduction of such products.

Financial Infrastructure

Regulatory Structure

The CFSA felt that the existence of multiple regulators wasconsistent with the current stage of financial developmentin India, but stressed the need for further improvement inregulatory coordination. The Reserve Bank could, in theinterest of financial stability, be armed with sufficientsupervisory powers and monitoring functions in respectof financial conglomerates.

Liquidity Infrastructure

Systems and procedures should be developed forsmoothing out volatility in liquidity and call money ratesarising out of quarterly tax payments. The introduction ofauction of Central Government surplus balances with theReserve Bank in a non-collateralised manner could beconsidered, though with appropriate caution.

Payments and Settlement InfrastructureThe current low utilisation of the electronic paymentsinfrastructure could be increased with the use oftechnology to make the facilities more accessible tocustomers, thereby optimising the use of this infrastructureand achieving greater financial inclusion.

Others

The Committee also discussed insolvency regime,corporate governance and safety nets, among others.

Development Issues in the Socio-economic Context

A stability assessment of the financial sector should alsoaddress broader development aspects in the socio-economiccontext, which affect social stability and have an indirectbearing on financial stability. Financial inclusion is one ofthe major determinants of economic growth. Highereconomic growth and infrastructure, in turn, play a crucialrole in promoting financial inclusion. In order to achieve theobjective of growth with equity, it was imperative thatinfrastructure was developed in tandem with financialinclusion, to facilitate and enhance credit absorptive capacity.

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Table 6.2: Offices of Indian Banks Opened Abroad – Between July 2008 and June 2009

Name of the Bank Type of Presence Country Place

1 2 3 4

1. Andhra Bank Representative Office USA New Jersey2. Bank of Baroda Branch China Guangzhou3. Bank of India Branch Cambodia Phnom Penh4. Bank of India Representative Office UAE Dubai5. Canara Bank Branch UAE Dubai6. Corporation Bank Representative Office UAE Dubai7. Corporation Bank Representative Office Hong Kong Hong Kong8. Oriental Bank of Commerce Representative Office UAE Dubai9. State Bank of India Branch Maldives Hithadoo10. State Bank of India Branch Singapore Little India11. State Bank of India Branch Singapore Jurong East12. State Bank of India Branch Singapore Ang Mo Kio13. State Bank of India Branch Singapore Marine Parade14. Punjab National Bank Branch Hong Kong Kowloon15. Punjab National Bank Representative Office Norway Oslo16. Union Bank of India Representative Office Australia Sydney17. HDFC Bank Ltd Branch Bahrain Manama18. HDFC Bank Ltd Representative Office Kenya Nairobi19. ICICI Bank Ltd Representative Office UAE Abu Dhabi20. Kotak Mahindra Bank Ltd Representative Office UAE Dubai

COMMERCIAL BANKS

Operational Developments

VI.20 Indian banks continued to expand theirpresence overseas during 2008-09. Between July2008 and June 2009, Indian banks opened 20branches/subsidiaries/representative officesoverseas (Table 6.2). At end-June 2009, 20 Indianbanks (14 public sector banks and 6 private sectorbanks) had presence abroad with a network of 221offices (141 branches, 52 representative offices, 7 jointventures and 21 subsidiaries) in 52 countries. Severalforeign banks opened branches and representativeoffices in India during 2008-09 (Table 6.3). At end-June 2009, 32 foreign banks were operating in Indiawith 293 branches. Besides, 43 foreign banks werealso operating in India through representative offices.There were 73 banks under liquidation all over Indiaas on June 30, 2009. The matter regarding earlycompletion of liquidation proceedings is beingfollowed up with official/Court liquidators.

Regulatory Initiatives

VI.21 Policy measures taken by the Reserve Bankduring 2008-09 were driven by the twin objectives

of continued strengthening of the prudentialstandards for the banking system in order to makeit more resi l ient and al ign these with theinternational best practices while ensur ingcustomer protection, and deliver a counter-cyclicalprudential prescription to complement the fiscalpolicy measures initiated by the Government to fightthe downturn in the economy.

Basel II Implementation

VI.22 Foreign banks operating in India and Indianbanks having operational presence outside Indiamigrated to the simpler approaches available underthe Basel II framework with effect from March 31,2008. Other commercial banks (excluding local areabanks and RRBs) also migrated to theseapproaches from March 31, 2009. Thus, thestandardised approach for credit r isk, basicindicator approach for operational r isk andstandardised duration approach for market risk (asslightly amended under the Basel II framework)have been implemented for banks in India. Takinginto consideration the need for upgradation of riskmanagement framework as also the capitalefficiency likely to accrue to the banks by adoptionof the advanced approaches envisaged under the

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Basel II framework and the emerging internationaltrend in this regard, it was considered desirable tolay down a timeframe for implementation of theadvanced approaches in India (Table 6.4). Thiswould enable the banks to plan and prepare for theirmigration to the advanced approaches for creditrisk and operational risk, as also for the internalmodels approach (IMA) for market risk.

VI.23 Banks were advised to under take aninternal assessment of their preparedness formigration to advanced approaches, in the light ofthe criteria envisaged in the Basel II document andtake a decision, with the approval of their Boards,whether they would like to migrate to any of theadvanced approaches. The banks deciding tomigrate to the advanced approaches were advisedto approach the Reserve Bank for necessaryapprovals, in due course, as per the stipulated timeschedule. I f the result of a bank’s internalassessment indicated that it was not in a position

to apply for implementation of advancedapproaches by the above-mentioned dates, it couldchoose a later date suitable to it based upon itspreparation. Banks, at their discretion, would havethe option of adopting the advanced approachesfor one or more of the risk categories, as per theirpreparedness, while continuing with the simplerapproaches for other risk categories, and it wouldnot be necessary to adopt the advancedapproaches for al l the r isk categor iessimultaneously. Banks would, however, need toacquire prior approval of the Reserve Bank foradopting any of the advanced approaches.

Risk Management

VI.24 In the wake of the current crisis, the riskmanagement models based on normal distributionwere found inadequate to cope with the rapidlychanging events. It is widely believed that morerobust risk management systems, grounded in

Table 6.4: Timeframe for Implementation of Advanced Approaches in India

Approach Earliest Date of Submitting Applications Likely Date of Approvalto the Reserve Bank by the Reserve Bank

a. Internal Models Approach (IMA) for Market Risk April 1, 2010 March 31, 2011

b. The Standardised Approach (TSA) for Operational Risk April 1, 2010 September 30, 2010

c. Advanced Measurement Approach (AMA) for Operational Risk April 1, 2012 March 31, 2014

d. Internal Ratings-Based (IRB) Approaches for Credit Risk April 1, 2012 March 31, 2014(foundation as well as advanced IRB)

Table 6.3: Offices of Foreign Banks Opened in India – Between July 2008 and June 2009

Name of the Bank Type of Presence Place

1 2 3

1. DBS Bank Ltd Branch Pune2. DBS Bank Ltd Branch Bangalore3. DBS Bank Ltd Branch Chennai4. DBS Bank Ltd Branch Kolkata5. DBS Bank Ltd Branch Nashik6. DBS Bank Ltd Branch Moradabad7. DBS Bank Ltd Branch Salem8. DBS Bank Ltd Branch Surat9. Deutsche Bank Branch Salem10. Deutsche Bank Branch Vellore11. Deutsche Bank Branch Pune12. FirstRand Bank Ltd Branch Mumbai13. DnB NOR Bank Representative Office Mumbai14. KfW IPEX Bank GmbH Representative Office Mumbai

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Stress testing is a multi-dimensional risk management toolwith numerous and varied potential applications. It involvesthe use of a range of techniques, both quantitative andqualitative, to evaluate a bank’s financial position underexceptional but plausible scenarios of varying severity.Stress test findings could assist in forward looking decisionmaking.

Globally, banks are increasingly relying on statistical modelssuch as Value at Risk (VaR) for their risk managementframeworks. These models are, however, based mainly onlimited historical data and simplistic assumptions andtherefore, cannot capture sudden, dramatic, high magnitudeand long duration events. To overcome the limitations of riskmanagement models, stress testing is being used as asupplementary tool to quantify “tail risks”, i.e., the risk oflosses under abnormal market conditions and re-assessmodeling assumptions, particularly those in relation tovolatility and correlation. It is especially important after longperiods of favourable economic and financial conditions,when fading memory of negative conditions could lead tocomplacency and neglect as well as under-pricing of risk. Itis also a key risk management tool during periods ofexpansion, when innovations may lead to new products thatcould grow rapidly and for which limited or no loss data maybe available.

Stress testing is useful in a bank’s risk managementframework and decision making process on account ofthe following:

• It provides a means for estimating a bank’s riskexposures under stressed conditions and enables it todevelop or choose appropriate strategies for mitigatingsuch risks.

• It helps a bank in identifying hidden risks and riskconcentrations across multiple business lines or units.

• It enables a bank to better shape its risk profile througha forward-looking assessment of the risks it may beexposed to and facilitates monitoring of changes in theprofile over time.

• It allows the Board of Directors and senior managementto determine whether a bank’s risk exposure or profilecorresponds to its risk appetite and risk tolerance.

Box VI.3Risk Management: Role of Stress Testing

• It enables the bank management to integrate businessstrategy, risk management and liquidity and capitalplanning decisions in an improved way.

Considering the importance of stress testing in any riskmanagement framework, the Basel Committee on BankingSupervision issued in May 2009 the paper titled “Principlesfor Sound Stress Testing Practices and Supervision”. Thepaper presents sound principles for the governance, designand implementation of stress testing programmes in banks.It says that stress testing should form an integral part of theoverall risk governance and risk management culture of abank. Stress testing should be actionable, with the resultsfrom stress testing analyses impacting decision making atthe appropriate management level, including strategicbusiness decisions of the Board and senior management.Board and senior management involvement in the stresstesting programme is essential for its effective operation. Abank should operate a stress testing programme thatpromotes risk identification and control, provides acomplementary risk perspective to other risk managementtools, improves capital and liquidity management andenhances internal and external communication.

Though stress testing and scenario analysis play animportant role in any risk management framework, they havecertain limitations such as subjective selection of scenarios,skill of the modeler, uncertain probabilities of the eventsconcerned and use of a small number of parameters. Stresstesting, therefore, by itself cannot address all r iskmanagement weaknesses, but as part of a comprehensiveapproach, it has a useful role in aiding timely policyintervention to strengthen the resilience of individual banksand the financial system.

References

1. Basel Committee on Banking Supervision (2009).“Principles for Sound Stress Testing Practices andSupervision”, Bank for International Settlements, May 20.

2. Haldane A.G. (2009). “Why Banks Failed the StressTest”, Bank of England (speech), February 13.

3. Duguay P. (2009). “Financial Stability through Sound RiskManagement”, Bank of Canada (remarks), January 8.

appropriately designed stress tests, could havehelped prevent the build-up of leverage that becameunsustainable. Thus, there is an imperative needto strengthen the risk management systems/modelsby incorporating imaginative stress testing practicesto avoid recurrence of such events and preservenational and global financial stability (Box VI.3).

NPA Management

VI.25 The three legal options available to banksfor resolution of NPAs, viz., the Securitisation andReconstruction of Financial Assets andEnforcement of Secur ity Interest Act, 2002(SARFAESI Act, 2002), Debt Recovery Tribunals

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(DRTs) and Lok Adalats, have led to a steadyincrease in the adjudication and recovery ofdisputed amounts (Table 6.5).

Restructuring of Advances

VI.26 The guidelines on restructuring of advanceswere revised in August 2008 in accordance withthe recommendations of the Working Group toreview and align the existing guidelines onrestructur ing of advances [other than undercorporate debt restructuring (CDR) mechanism] onthe lines of provisions under the revised CDRmechanism. The main features of the guidelines,which are uniformly applicable across all sectors,are: (i) Retention of asset classification status onrestructuring is an exception rather than a rule. Itis, however, available to all borrowers who meetspecified conditions, except to the borrowers ofthree categories, viz., consumer and personaladvances, advances classified as capital marketexposure and advances classified as commercialreal estate exposures (subject to modificationscarried out subsequently); (ii) The CDR mechanismwould be available to the borrowers engaged inactivities other than industrial advances as well,albeit subject to the same terms and conditions asapplicable to industrial advances. There is nochange in the insti tut ional framework forrestructuring under the CDR mechanism; (iii) Thelinkage of asset classif ication benefit withmoratorium has been dispensed with considering

certain natural checks built in the guidelines againstextension of longer moratorium; (iv) Banks shouldmake provision for diminution in the fair value ofthe loan (both principal and interest cash flows)rather than for economic loss arising from reductionin rate of interest alone, as done hitherto; a simplermechanism to compute the diminution in fair valueat a flat rate of 5 per cent would be available toborrowers with outstanding amounts below Rs.1crore; (v) The unrealised income represented bythe Funded Interest Term Loan (FITL)/debt or equityinstrument should not be taken to the profit andloss account but credited into an account styled as‘Sundry Liabilities Account (Interest Capitalisation)’[SLA(IC)]. Only on repayment in case of FITL orsale/redemption proceeds of the debt/equityinstruments, the amount received would berecognised in the profit and loss account, whilesimultaneously reducing the balance in the‘SLA(IC)’; (vi) The terms – ‘satisfactory performanceduring the specified period of one year afterrestructuring’, ‘repeated restructuring’ and ‘securedadvances’ were clarified; (vii) In the case ofinfrastructure projects, in order to become entitledfor the asset classification benefit, the period withinwhich the viability had to be established wasincreased from 7 years to 10 years, and the periodwithin which the loan had to be repaid wasincreased from 10 years to 15 years. In the case ofhousing loans, individual banks, with the approvalof their Boards, were permitted to decide on therepayment period required for restructured loans;

Table 6.5: Resolution of NPAs(Cumulative as at end-March 2009)

(Amount in Rupees crore)

Resolution Mechanism Number Amount Number Amount Number Amount

1 2 3 4 5 6 7

SARFAESI Notices Issued Recovery Compromise Proposals

3,41,756 68,127 2,10,641 19,396 79,277 11,249

DRTs Cases Filed Adjudicated Cases Recovery

81,173 1,30,508 49,033 65,585 N.A. 24,889

Lok Adalats Cases Filed Cases Decided Recovery

17,12,958 11,763 4,55,423 2,220 3,75,858 982

N.A.: Not Available.

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(viii) One of the conditions for availing special assetclassification benefit in terms of guidelines onrestructuring of advances is that the account shouldbe fully secured. This condition would not beapplicable in the case of infrastructure projects,provided the cash flows generated from theseprojects were adequate for repayment of theadvance, the financing bank(s) had in place anappropriate mechanism to escrow the cash flowsand also had a clear and legal first claim on thesecash flows.

Credit Information Companies

VI.27 The Reserve Bank had invited applicationsfrom companies interested in continuing/commencing business of credit information in April2007. A High Level Advisory Committee (HLAC)under the Chairmanship of Dr. R.H. Patil was setup for screening the applications andrecommending the names of the companies towhich certificates of registration (CoRs) could begranted. The Government announced the FDI policyfor credit information companies (CICs) in March2008. The Reserve Bank announced in November2008 that FDI up to 49 per cent in CICs would beconsidered in cases: (a) where the investor was acompany with an established track record ofrunning a credit information bureau in a wellregulated environment; (b) no shareholder in theinvestor company held more than 10 per cent votingrights in that company; and (c) preferably, thecompany was a listed company on a recognisedstock exchange. Keeping in view the provisions ofthe CICs (Regulation) Act, 2005 as well as thedirectives issued by the Reserve Bank, the HLAChad recommended the names of four applicantswhich the Reserve Bank could consider for grantingCoRs. Accordingly, the Reserve Bank, in April 2009,issued ‘in-principle approval’ to four companies toset up CICs.

Approval for Offering Complex Financial Products

VI.28 Indian banks were advised in December2008 that if their foreign branches/subsidiaries were

transacting in any financial products, which werenot available in the Indian market, but on which nospecific prohibition was placed by the ReserveBank, prior approval would not be required only ifthese were plain-vanilla financial products. Theforeign branches/subsidiaries dealing with suchproducts, however, must have adequate knowledge,understanding and risk management capability forhandling such products. Such products were to beappropriately captured and reported in the extantoff-site returns. Banks would have to obtain priorapproval in case their foreign branches/subsidiariesproposed to handle such products.

Unhedged Foreign Exchange Exposure of Clients

VI.29 Banks had been advised in December 2003to have a policy, which explicitly recognised andtook into account risks arising on account ofunhedged foreign exchange exposures of theirclients. It was also advised that foreign currencyloans above a specified limit could be extended onlyon the basis of a well laid out policy of banks’ Boardswith regard to the hedging of such loans. It wasfurther advised in December 2008 that the Board’spolicy should cover unhedged foreign exchangeexposure of all clients, including SMEs, whichshould take into account exposure from all sources,including ECBs. Banks were advised to monitor andreview on a monthly basis the unhedged portion ofthe foreign currency exposures of clients with largeforeign currency exposures and the unhedgedexposure of SMEs. In all other cases, banks wereadvised to put in place a system to monitor andreview such positions on a quarterly basis.

Counter-cyclical Prudential Norms

VI.30 Banks’ loans and advances portfolio oftenmove pro-cyclically, growing faster during anexpansionary phase and vice versa. During timesof expansion and accelerated credit growth, thereis a tendency to underestimate the level of inherentrisk and the converse holds during times ofrecession. This tendency is not effectivelyaddressed by capital adequacy and specific

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provisioning requirements since they capture riskex-post, not ex-ante. It is, therefore, necessary tobuild up capital and provisioning buffers during acyclical boom, which could be used to cushionbanks’ balance sheets in the event of a downturnin the economy or deterioration in credit quality onaccount of other reasons. In order to ensure thatasset quality was maintained in the light of highcredit growth, r isk weights and provisioningrequirements on standard advances for banks’exposures to the sectors showing above averagegrowth had been progressively raised during thelast 3-4 years, as a counter-cyclical measure.However, with the global financial crisis starting toaffect Indian economy from September 2008onwards, the Reserve Bank reduced the enhancedrisk weights and provisioning requirements to thenormal level.

VI.31 Risk weight for all unrated claims, long-termas well as short-term, regardless of the amount ofclaim, on the corporates was reduced from 150 percent to 100 per cent in November 2008. Risk weighton the claims secured by commercial real estateand exposure to NBFCs-ND-SI was reduced to 100per cent from 125 per cent.

VI.32 Prior to the unfolding of the global crisis, toensure that asset quality was maintained in the lightof high credit growth, the general provisioningrequirement for standard advances in specificsectors, i.e., personal loans, capital marketexposures and commercial real estate loans hadbeen increased from 0.4 per cent to 2.0 per cent,and to 1.0 per cent for residential housing loansbeyond Rs.20 lakh in January 2007. To mitigate theimpact of the current economic slowdown, as acounter-cycl ical measure, the provisioningrequirement for standard assets was reduced witheffect from November 15, 2008, to a uniform levelof 0.4 per cent, except in the case of directadvances to the agricultural and the SME sectors,which continue to attract provisioning of 0.25 percent. The revised norms were made effectiveprospectively and thus, the provisions already heldwere not to be reversed. Similar instructions wereissued to UCBs.

VI.33 In December 2008, in view of the growingconcern of possible increase in stress in the Indianbanking system, certain modifications were madeto the guidelines on restructuring of advances(issued in August 2008) as a one-time measure andfor a limited period of time, i.e., up to June 30, 2009.The special regulatory treatment for assetclassif ication ( i .e., retention of the assetclassification status of the account as obtaining atthe time of restructur ing), was extended tocommercial real estate exposures restructured forthe first time and in the case of exposures (otherthan commercial real estate, capital markets andpersonal/consumer loans), which were viable butwere facing temporary cash flow problems andneeded a second restructuring. Accounts whichwere standard as on September 1, 2008 but slippedinto the NPA category subsequently, were treatedas standard on restructuring provided banks tookthem up for restructuring on or before March 31,2009 and the restructuring package was put inplace within the prescribed quick implementationtime schedule. The condition of full security coverfor availing the special regulatory treatment waswaived in case of cash credit accounts which hadbeen rendered unsecured due to fall in inventoryprices, subject to banks making provisions asprescribed. It was emphasised that the relaxationseffected to the guidelines on restructuring ofadvances by the Reserve Bank were aimed atproviding an opportunity to banks and borrowers topreserve the economic value of units and should notbe considered as means to evergreen the advances.

Floating Provisions

VI.34 Floating provisions made by the bankscould not be reversed by credit to the profit andloss account but could only be utilised for makingspecif ic provisions under extraordinarycircumstances with the prior approval of theReserve Bank. Unti l such uti l isation, theseprovisions could be netted off from gross NPAs toarrive at net NPAs, or alternatively, they could betreated as part of the Tier II capital within the overallceiling of 1.25 per cent of total risk weighted

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assets. The former option was, however, removedwith effect from April 1, 2009. Further, it wasdecided to allow banks to utilise, at their discretion,the floating provisions held for ‘advances’ portfolio,to the extent of meeting such interest/chargeswaived under the Agricultural Debt Waiver andDebt Relief Scheme, 2008.

Unsecured Loans

VI.35 In order to enhance transparency andensure correct reflection of the unsecuredadvances in banks’ balance sheets, it was advisedthat for determining the amount of unsecuredadvances that could be presented in schedule 9 ofthe published balance sheet, the rights, licenses,authorisations charged to the banks as collateralin respect of projects (including infrastructureprojects) financed by them, should not be reckonedas tangible security. Hence, such advances wouldbe reckoned as unsecured.

Off-balance Sheet Exposures

VI.36 For the purpose of computing creditexposure and also for computing capital adequacy,banks were advised in August 2008 to compute theircredit exposures/credit equivalent, arising onaccount of the interest rate and foreign exchangederivative transactions and gold, using the ‘currentexposure method’. The credit exposures computedwould attract provisioning requirement as applicableto the loan assets in the ‘standard’ category of theconcerned counterparties. In October 2008, bankswere advised that the overdue receivablesrepresenting positive MTM value of a derivativecontract would be treated as NPAs, if these remainedunpaid for 90 days or more, and all other fundedfacilities of the client would be treated as NPAfollowing the principle of borrower-wise classification.The principle of borrower-wise asset classificationwould apply to all overdues arising from forwardcontracts, plain vanilla swaps and options and othercomplex derivatives with the exception of complexderivative contracts entered into during the periodbetween April 2007 and June 2008.

Anti Money Laundering Measures

VI.37 The Prevention of Money Laundering(Amendment) Act, 2009 [PMLA] received theassent of the President on March 6, 2009. Theamendment sought, inter alia, to include paymentsystem operators and ‘authorised persons’ asdefined in Foreign Exchange Management Act,1999 within the prevention of money launderingframework. The reporting guidelines for banks wereupdated during the year by the Reserve Bank, thesalient features of which include:

(i) Al l cash transactions, where forged orcounterfeit Indian currency notes were used asgenuine, should be reported by the PrincipalOfficer to the Financial Intelligence Unit – India(FIU-IND) immediately in the prescribed format– counterfeit currency report (CCR).

(ii) The background including all documents/officerecords/memorandums per taining to al lcomplex, unusually large transactions and allunusual patterns of transactions, which had noapparent economic or visible lawful purposeshould, as far as possible, be examined andthe findings at the branch as well as thePrincipal Officer level should be properlyrecorded. These records should be preservedfor ten years as required under the PMLA, 2002.

(iii) It is likely that in some cases transactions areabandoned/aborted by customers on beingasked to give some details or to providedocuments. It was clarified that banks shouldreport all such attempted transactions insuspicious transactions reports (STRs), evenif not completed by customers, irrespective ofthe amount of the transaction.

(iv) While making STRs, banks should be guidedby the definition of ‘suspicious transaction’ ascontained in rule 2(g) of rules notified underPMLA, 2002. STRs should be made if there wasreasonable ground to believe that the transactioninvolved proceeds of crime, irrespective of theamount of the transaction and/or the thresholdlimit envisaged for predicate offences in part Bof schedule of PMLA, 2002.

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(v) In the context of creating KYC/anti-moneylaundering awareness among the staff and forgenerating alerts for suspicious transactions,banks were advised to consider the indicativelist of suspicious activities contained in theIBA’s Guidance Note for Banks, 2005.

Customer Service

VI.38 During the year, many important initiativeswere taken for improving customer service in banks.In order to make available all current instructionson the subject at one place, several importantinstructions relating to customer service werecompiled in the form of a Master Circular, whichwas issued on November 3, 2008.

VI.39 Based on the experience gained in runningthe Banking Ombudsman Scheme, 2006, arevision to the Scheme was effected in February2009. The salient features of the amendmentsinclude widening of the scope of the Scheme toconsider deficiencies ar ising out of internetbanking services, enabling customers to lodgecomplaints against banks for their non-adherenceto the provisions of the Fair Practices Code forLenders or the Code of Bank’s Commitment toCustomers and non-observance of the ReserveBank’s guidelines on engagement of recoveryagents. The Reserve Bank also asked all banksto place a copy of the Banking OmbudsmanScheme, 2006, on their websites, for widerdissemination.

VI.40 Banks were reported to be levying highservice charges for collection of outstation chequesand for use of certain electronic remittance/transferof funds services. To reduce the complaints in thisregard, instructions were issued in October 2008for uniform service charges for electronic paymentproducts and also charges for collection ofoutstation cheques.

VI.41 The Committee on Customer Services(Chairman: Shri H. Prabhakar Rao) submitted itsreport in April 2008 and covered matters relatingto currency management, Government business,

inclusive of payment of pension and taxes andforeign exchange services (Box VI.4).

VI.42 Banks were advised in August 2008 toconduct an annual review of accounts in which therewere no operations for more than one year andprocedures for tracing the customers, ascertainingthe reasons for inactivity in the account andlabelling the account as inoperative/dormant wherethere were no transactions for over a period of twoyears, and payment of interest on savings bankaccount were prescr ibed. Since one of theobjectives of the segregation of the inoperativeaccounts was to reduce the risk of frauds, thetransaction should be monitored by banks at a higherlevel both from the point of view of preventing fraudand making an STR.

VI.43 As display of customer-friendly informationby banks in their branches is one of the modes ofimparting financial education, commercial bankswere advised to put the important aspects ormandatory instructions relating to ‘customerservice information’, ‘interest rates’, ‘servicecharges’, ‘grievance redressal’ and ‘others’ on acomprehensive notice board and make thedetai led information avai lable in booklets/brochures.

VI.44 During the year, instructions were issuedto banks to ensure that their branches invariablyaccepted cash over the counter from all customerswho desired to do so; to ensure that all informationrelating to charges/fees for processing wereinvariably disclosed in the loan application formsand to inform the ‘all-in-cost’ to the customers toenable them to compare the rates charged withother alternative sources of finance; to indicate thename of the nominee in the passbook/statementof account with the consent of the customer; andto provide ramps in ATMs /bank branches and alsoto make at least one-third of new ATMs installedas talking ATMs with Braille keypads.

VI.45 At present, interest on savings bankaccounts is calculated on the minimum balancesheld in the accounts during the period from the tenth

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day to the last day of each calendar month. In viewof the present satisfactory level of computerisationand extensive networking in commercial banks, andin line with the announcement in the Annual Policy

Statement for 2009-10, it is proposed that thepayment of interest on savings bank accounts bySCBs would be on a daily product basis with effectfrom April 1, 2010.

The Reserve Bank had set up the Committee on CustomerServices (Chairman: Shri H. Prabhakar Rao) to look intocustomer services provided by the Reserve Bank directlyor through banks/institutions with a view to maximisinggeneral public satisfaction. The major recommendationsmade by the Committee include:

Payment of Government Pension through PublicSector Banks:

• Branch manager should interact with a cross-section ofpensioners serviced at the branch on a quarterly basis.

• Banks should follow-up actively and ensure that,wherever possible, pensioners who had retired earlierconvert their pension accounts to joint accounts.Nominations should invariably be taken.

• Banks should organise regular training sessions for bankpersonnel dealing with pension matters in consultationwith the concerned Government Department.

• Banks should establish a Centralised Pension PaymentCell (CPPC) to take over back-office work relating todisbursement of Government pension.

Collection of Taxes by Agency Banks (Online TaxAccounting System - OLTAS):

• All banks were advised to ensure that all concernedstaff were appropriately trained to the requirements ofthe OLTAS and were also sensitised to the needs ofthe individual assessees.

• All bank branches authorised to accept payment ofincome tax should clearly and prominently display thefact by way of a notice/board.

• Banks were advised to put up notices in their branchesasking assessees to quote correct PAN number,assessment year and other details in the challan.Further, an easy to read/comprehend list of “Do’s andDon’ts” is required to be put up as a notice for theguidance of customers.

• Banks should strictly follow the process of verificationof the PAN number of existing assessees to eliminateany incorrect entry by the assessees.

• Banks should provide blank printed challans for theconvenience of the assessees who could not obtainpre-verified, pre-printed challans over the internet.

Box VI.4 Committee on Customer Services

• Tax collecting bank branches should invariably givepaper token in acknowledgement of the receipt of thecheque.

• All banks should set up e-payment facilities in a time-bound manner.

Issue and Operations of ‘Savings Bonds’:

• Instructions were issued to banks to ensure that everybranch conducting Government business of volumeabove a specified amount (say Rs.25 lakh) was coveredby concurrent audit. The scope of the concurrent auditshould be prescribed to include various aspects ofservicing of savings bonds with specific reference tothe customer service related aspects.

• Each bank was asked to automate the processingrelated to the servicing of savings bonds to ensure thetimely servicing of the bonds.

• Banks were advised to actively make efforts to obtainthe bank accounts details of the investors in order tomigrate to electronic servicing of interest and maturityproceeds of the savings bonds through the electronicclearing service and the national electronic fundstransfer.

• Banks were advised to obtain the opinion and views ofthe investors on the quality of the services renderedby the authorised agencies by means of a survey orquestionnaires.

Additionally, the Reserve Bank took the following initiatives:

• Frequently Asked Questions (FAQs) relating to pensiondisbursement by the public sector banks under theCentral Government pension schemes were hosted onthe Reserve Bank’s website in June 2008.

• A checklist relating to pension payments/Governmentbusiness for use of internal inspection of bank brancheswas forwarded to banks advising them to issueinstructions to their internal auditors/inspectors tobestow due attention to adherence to the items of worklisted therein and comment on the quality of customerservice in their report.

• Efforts were made to extend the electronic paymentnetwork to more locations in the country so that everyinvestor could opt for receiving interest and repaymentproceeds of Saving Bonds directly into his/her account.

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VI.46 Detailed instructions were issued to banksin July 2008 on their credit card operations coveringaspects such as issue of unsolicited cards,insurance cover to credit card holders, safeguardsagainst misuse of lost/stolen cards, educatingcustomers on the implications of paying only the‘minimum amount due’ on credit cards, excessiveinterest/other charges, escalation of unresolvedcomplaints, reporting to Credit Information Bureauof India Ltd./CICs, registration of telemarketers,wrongful billing and redressal of grievances.

VI.47 With a view to enhancing awareness aboutthe Codes evolved by the Banking Codes andStandards Board of India, the BCSBI launched aquarterly newsletter titled “Customer Matters”,which was distributed to each branch of eachmember bank. The BCSBI invited suggestions frommembers of the public, Banking Ombudsmen,various bodies representing interests of banks'customers, and has now completed the processof review of the Code of Bank’s Commitment toCustomers, in collaboration with the IBA. Publicgrievance is an effective tool through which theBCSBI carries out its ongoing monitoring of banks’compliance with the Code provisions. The BCSBI,by design and mandate, is not a redressal agencyto arbitrate on a dispute between an individual andhis/her bank but grievances ventilated by individualssometimes throw up issues on systemicdeficiencies. They enable the BCSBI to monitorCode compliances at system or bank-specific level.

Supervisory Initiatives

VI.48 An Internal Working Group constituted tolay down the road map for adoption of a suitableframework for cross-border supervision andsupervisory co-operation with overseas regulatorssubmitted its Repor t in January 2009. Therecommendations of the Group are being examinedfor initiating further action. An Inter-departmentalGroup is also examining additional areas/issueswhich need to be brought under the supervisoryfocus, including modalities for on-site supervisionof overseas branches and subsidiaries of Indian

banks. The Group is expected to submit its Reportshortly. Keeping in view the systemic importanceof financial conglomerates (FCs), efforts are beinginitiated to strengthen the FC monitoring systemfurther by introducing certain prudential measuressuch as group-wide capital adequacy requirements,safe conduct of Intra-Group Transactions andExposures (ITEs) and management of r iskconcentrations, governance systems in FCsincluding ‘fit and proper’ principles and r iskmanagement systems, supervisory co-operationand information-sharing amongst the sectoralregulators.

VI.49 Banks were advised to be extremelycautious while continuing relationships withrespondent banks located in countries with poorKYC standards and countr ies identif ied as‘uncooperative’ in the f ight against moneylaundering and terrorist financing. The anti-moneylaundering (AML)/combating financing of terrorism(CFT) guidelines issued by the Reserve Bank arein consonance with the Financial Action Task Force(FATF) recommendations. Increased disclosurerequirements have been emphasised on the partof tax payers and f inancial insti tut ions fortransactions involving uncooperative jurisdictions.The Reserve Bank would continue to incorporatethe latest international best practices in itsregulations.

Off-Site Returns

VI.50 Off-site supervision, introduced in 1995,has steadily become an integral component of theReserve Bank’s financial stability architecture,providing early warning on weaknesses at the banklevel as well as the system level. In order to maintainits effectiveness, changes have been continuallyincorporated into the off-site surveillance systemin alignment with the evolving internationalpractices as also the country-specific needs.

VI.51 As part of the policy decision to receive allregulatory returns through a secured online returnsfi l ing system (ORFS), the exist ing per iodicprudential off-site returns submitted by banks are

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being migrated to the ORFS in a phased manner.After migrating the fortnightly return on liquidity(statement of structural liquidity) from February2008, four more returns, viz., report on sensitivityto interest rate - both rupee and foreign exchange,report on maturity and position and report onsubsidiar ies/joint ventures/associates, weresuccessfully migrated to ORFS from January 2009.A new return on capital adequacy as per Basel IIwas developed using extensible BusinessReporting Language (XBRL) and integrated withthe existing ORFS. The benefits of ORFS includeease of compilation, speedy submission, monitoringof receipts, scope for incorporating changes in thereturns and maintenance of the system.

Monitoring of Frauds

VI.52 The fraud monitor ing function of theReserve Bank has assumed greater significancein recent years as there has been an increase inthe number of frauds involving larger amounts.Frauds have been noticed in traditional as also newareas, such as housing loans, credit cards, internetbanking and outsourcing business (Table 6.6).

VI.53 The complexity of cases is increasinglyexposing banks to greater operational risk. TheReserve Bank, as part of its supervisory process,has been sensitising banks from time to time aboutcommon fraud-prone areas, modus operandi offrauds and the measures to be taken to prevent/reduce the incidence of frauds.

VI.54 During the year 2008-09, 102 cautionadvices were issued to banks by the Reserve Bank

(through secured e-mail) in respect of unscrupulousborrowers who perpetrated frauds of amountsexceeding Rs.25 lakh, so that banks could exercisedue care while considering sanction of creditfacilities to them. With a view to putting in placesome deterrent action against entities such asbuilders, warehouse owners, char teredaccountants, lawyers and valuers of properties, whodo not have any contractual relationship with banks,it was decided that banks could inform the IBAabout the names of such entities so that the IBAcould prepare a caution list for circulation amongstbanks. A circular was issued to banks in March 2009in this regard.

VI.55 During the economic slowdown in 2008-09,the need for proactive credit expansion forstimulating the economy, especially in certainspecif ied segments such as housing andinfrastructure was recognised. There is, however,a potential scope for internal controls gettingrelaxed due to the exigency of credit expansion.Weaker standards of control and risk managementtend to facilitate frauds, especially when rapid creditexpansion has to be achieved in a slowing economy.Therefore, appropriate precaution needs to beintegrated into the bank oversight structure. In thiscontext, the Reserve Bank proposes to evolve aprudential approach to fraud oversight as againstthe existing legal approach. The approach wouldseek to align the supervisory oversight on fraudswith the Supervisory Review and EvaluationProcess (SREP) under Pillar 2 of Basel II byfactoring in the sharp rise in frauds, while profilingthe operational risks facing the banks.

URBAN CO-OPERATIVE BANKS

VI.56 The Primary (Urban) Co-operative Banks(UCBs) play an impor tant role as f inancialintermediaries in urban and semi-urban areascatering to the needs of the non-agricultural sector,particularly small borrowers. In the context of theirrole in the national economy, several initiatives arebeing taken by the Reserve Bank to help the sectorto grow on sound lines. The Reserve Bank has

Table 6.6: Frauds in the Banking Sector(Amount in Rupees crore)

Year Frauds Frauds involving Rs.1crore and above

Number Amount Number Amount

1 2 3 4 5

2004-05 10,450 779 96 4612005-06 13,914 1,381 194 1,0942006-07 23,618 1,194 150 8402007-08 21,247 1,059 177 6592008-09 23,914 1,883 212 1,404

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entered into MoUs with 26 State Governments andwith the Central Government (for multi-State UCBs)and Task Forces on Urban Co-operative Banks(TAFCUBs) were constituted in these States andat the Centre for identification of non-viable UCBsand deciding their future set up. The MoUarrangement now covers over 99 per cent of thebanks that account for over 99 per cent of depositsin the sector.

VI.57 With a view to providing an additionalavenue for non-disruptive exit of weak/unviableentities in the co-operative banking sector, theReserve Bank issued guidelines on merger/amalgamation of UCBs with Deposit Insurance andCredit Guarantee Corporation (DICGC) support inJanuary 2009. UCBs with negative net worth werepermitted to restructure their liabilities and converta part of deposits of the large depositors havingdeposits of Rs.1 lakh and above and those ofco-operative institutions into equity capital andInnovative Perpetual Debt Instruments (IPDIs) soas to restore viability to the restructured banks. Inorder to protect the interests of the depositors, theReserve Bank also permitted transfer of assets andliabilities of a mid-sized UCB to a public sectorcommercial bank. To overcome the difficulties inraising of capital funds and achieving the prescribedCRAR of 9 per cent, the Reserve Bank issuedguidelines for raising of capital by way of preferenceshares and long-term deposits. With the comfort ofcoordinated supervision, UCBs in States which hadsigned the MoUs, were permitted to open currencychests, sell units of mutual funds and insuranceproducts, provide foreign exchange services, opennew ATMs and convert extension counters intobranches. Further, banks were granted authorisationto open new branches.

VI.58 There has been a change in the profile ofthe sector due to measures taken in recent times.The number of banks in Grade I or II have increasedsignificantly from 1,147 (61 per cent of the total of1,872 banks) as on March 31, 2005 to 1,326 (77per cent of total of 1,721 banks) as on March 31,2009. The number of Grade III and Grade IV UCBstaken together, (implying weakness/sickness in

UCBs) have similarly declined from 725 (39 per centof the total) as on March 31, 2005 to 395 banks(23 per cent of total) as on March 31, 2009.

Branch Expansion

VI.59 Sound and well-functioning Tier II UCBs inStates that had signed MoUs were providedavenues for organic growth as they could submitapplications to the Reserve Bank for extension oftheir areas of operation to the entire State. Thebranch licensing norms for such Tier I and Tier IIUCBs were further liberalised in 2008-09 and it wasdecided that approvals for branch expansion,including off-site ATMs would be considered subjectto satisfaction of certain criteria. The eligibilitynorms for opening up of on-site ATMs wereliberalised following the announcement to the effectin the Annual Policy Statement for 2008-09.

Financial Restructuring

VI.60 UCBs were advised that, subject to certainconditions, their proposals for financial restructuringwould be considered as an additional option forresolution of problem banks.

Prudential Guidelines

VI.61 The proportion of SLR holdings in the formof Government and other approved securities aspercentage of NDTL was revised and non-scheduled UCBs were asked to maintain SLR of7.5 per cent by September 30, 2009, 15 per centby March 31, 2010 and 25 per cent by March 31,2011. Non-SLR investments of UCBs continue tobe limited to 10 per cent of a bank’s total depositsas on March 31 of the previous year.

VI.62 In view of the economic downturn in 2008-09, which created stress on liquidity and repaymentcapability of the otherwise viable units, revisedguidelines were issued to UCBs on restructuringof advances, applicable to all accounts restructuredafter March 6, 2009 (i.e., the date of issue of thecircular). Under the revised guidelines, specialregulatory treatment is available to the borrowers

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engaged in important business activities, subject tocompliance with certain conditions. The specialregulatory treatment has two components – incentivefor quick implementation of the restructuring packageand asset classification benefits.

VI.63 In respect of legacy cases pertaining toUCBs having negative net worth as on March 31,2007, it was decided that Reserve Bank wouldconsider a scheme of amalgamation that providesfor payment to depositors, financial contribution bythe transferee bank and sacr if ice by largedepositors. The detailed guidelines for merger ofUCBs in such legacy cases were laid down togetherwith guidelines for valuation of assets and liabilitiesof the transferor bank and the additional incentivesthat could be provided to the transferee bank.

Regulatory Initiatives

VI.64 More granular asset-liability managementguidelines (splitting the first time bucket in thestatement of structural liquidity into three buckets)became effective for scheduled UCBs from January1, 2009. Consequent to the announcement in theAnnual Policy Statement for 2008-09, Tier II UCBswere permitted to extend individual housing loansup to a maximum of Rs.50 lakh (Rs.25 lakh earlier)per beneficiary of a dwelling unit subject to extantprudential exposure limits.

Customer Service

VI.65 All UCBs were advised to conform to the timeframe prescribed by the National Consumer DisputeRedressal Commission in the matter of clearance ofcheques. For delays beyond the stipulated period,banks should pay interest at the fixed deposit rateor at the specified rate as per the respective bank’spolicy, to the payee of the cheques.

VI.66 Notifications oriented towards customerservice issued to UCBs by the Reserve Bank during2008-09 include instructions regarding display ofinformation by banks on comprehensive noticeboards, display of information relating to interestrates and service charges and need to make bank

branches and ATMs accessible to persons withdisabilities. Since visually challenged persons werelegally competent to enter into business contracts,UCBs were advised to ensure that all bankingfacilities such as cheque book facility (includingthird-party cheques), ATM facility, net bankingfacility, locker facility, retail loans, and credit cardswere invariably offered to the visually challengedwithout any discrimination. UCBs were advised toensure that a suitable mechanism existed forreceiving and addressing complaints from theircustomers with specific emphasis on resolving suchcomplaints fairly and expeditiously regardless of thesource of the complaints.

Business Facilitation

VI.67 UCBs, which are recognised as authoriseddealer category I and II, could par ticipate indesignated currency futures exchanges recognisedby the SEBI as clients, only for the purpose ofhedging their under lying foreign exchangeexposures.

Mergers and Amalgamations

VI.68 The process of consolidation of the sectorthrough the merger of weak entities with strongerones has been set in motion by providingtransparent and objective guidelines for grantingno-objection to merger proposals (Box VI.5). TheReserve Bank, while considering proposals formerger/amalgamation, confines its approval to thefinancial aspects of the merger, taking intoconsideration the interests of the depositors andfinancial stability. Invariably, it is a voluntary decisionof the banks that approach the Reserve Bank forobtaining no objection for their merger proposal.As of end-June 2009, 71 UCBs had been merged,with 50 being Grade IV banks of which 44 hadnegative net worth.

RURAL CO-OPERATIVES

VI.69 The Government of India had constituted aTask Force on Revival of Shor t-Term Rural

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Co-operative Credit Institutions to propose anaction plan for reviving the rural co-operativebanking institutions and suggest an appropriateregulatory framework for these institutions. In orderto give a further fillip to the co-operative bankingsector, the Task Force also undertook a study onrevival of long-term co-operative credit structure inthe country (Box VI.6).

VI.70 The Reserve Bank regulates state co-operative banks (St.CBs) and district central co-operative banks (DCCBs) under the BankingRegulation Act, 1949, (AACS) while NABARDsupervises them. Only 14 out of the 31 St.CBs and75 out of the 371 DCCBs have been grantedlicences by the Reserve Bank so far. 16 St.CBshave also been granted scheduled status underSection 42 of the Reserve Bank of India Act, 1934.

VI.71 The CFSA had observed that there was aneed to draw up a roadmap for ensuring that only

licensed banks operated in the co-operative spaceby the year 2012. This would expedite the processof consolidation and weeding out of non-viableentities from the co-operative space. Accordingly,it was announced in the Annual Policy Statementfor 2009-10 that a roadmap would be worked outfor achieving this objective in a non-disruptive mannerin consultation with NABARD. The discussions withNABARD have been initiated in the matter.

REGIONAL RURAL BANKS

VI.72 The process of consolidation throughamalgamation of RRBs is now almost complete,resulting in a decline in the total number of RRBsto 86 as on March 2009 (which includes a new RRBset up in the Union Territory of Puducherry) andfurther to 84 as on July 31, 2009. The process ofrecapitalisation of RRBs with negative net worth iscomplete, with 27 RRBs fully recapitalised with anamount of Rs.1,796 crore at end-July 2009.

With a view to facilitating consolidation and emergence ofstrong entities as well as for providing an avenue for non-disruptive exit of weak/unviable entities in the co-operativebanking sector, the Reserve Bank issued guidelines onmerger/amalgamation of UCBs in February 2005.

An elaborate process is fol lowed for merger andamalgamation. The merger proposal has to be submittedby the acquirer bank to the Registrar of Co-operativeSocieties (RCS)/Central Registrar of Co-operativeSocieties (CRCS) and a copy of the proposal is alsosimultaneously forwarded to the Reserve Bank along withcer tain specif ied information. The Reserve Bankexamines the proposals and places the same before anExpert Group for screening of applications of merger andamalgamation. On evaluation, if the proposal is found tobe suitable, the Reserve Bank issues no objectioncer tificate (NOC) to the RCS/CRCS and the banksconcerned. The RCS/CRCS then issue the order ofamalgamation of the target UCB in compliance with theprovisions of the Co-operative Societies Act under whichthe bank is registered.

In legacy cases pertaining to UCBs having negative networth as on March 31, 2007, it has been decided that theBank may also consider scheme of merger that providespayment to depositors under Section 16 (2) of the DICGC

Box VI.5Merger and Amalgamation of UCBs

Act, 1961, financial contribution by the transferee bankand sacrifice by large depositors. Additional incentiveswere provided to the transferor bank on merger. Theadditional incentives include permission for closure of lossmaking branches of the transferor bank, shifting/relocationof branches of the transferor bank within the area ofoperations, retention of facilities such as Authorised Dealerlicence where higher level of CRAR at 12 per cent wasprescribed on an ongoing basis provided the bankmaintained the benchmark CRAR of 9 per cent, minimumentry point norm of Rs.50 crore not being insisted for abank to become multi-State on account of taking overanother UCB registered outside the State.

Pursuant to the issue of the guidelines, the Reserve Bankreceived 119 proposals for merger in respect of 104 banks.The Reserve Bank has issued NOCs in 82 cases. Of these,71 mergers became effective upon the issue of statutoryorders by the concerned RCS/CRCS. 21 proposals formerger were rejected by the Reserve Bank, threeproposals were withdrawn by the banks and the remaining13 are under consideration. Out of the 71 banks for whichorders of merger were received from the RCS/CRCS, 44had negative net worth. The profit making banks were alsopermitted to merge with the aim of strengthening the sectorand in some cases, because they were not considered tobe viable on a stand-alone basis in the long run.

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Recognising the continued significance of the co-operative credit structure in the economy, despite thesignificant spread of banks and non-banks to all regionsof the country and taking into account the deep-rootedintegration of the co-operative structure in the Indiansocio-economic systems, the Government of India hadconstituted a Task Force on Revival of Short-Term RuralCo-operative Credit Institutions (Chairman: Prof. A.Vaidyanathan). The Task Force submitted its report to theCentral Government in February 2005. Based on therecommendations of the Task Force and in consultationwith the State Governments, the Government of India hadapproved a package for revival of the Short Term RuralCo-operative Credit Structure, which consists of PrimaryAgricultural Credit Societies (PACS) at the village/baselevel, Central Co-operat ive Banks (CCBs) at theintermediate level and the State Co-operative Banks(StCBs) at the apex level. The revival package aims atreviving the short-term rural co-operative credit structureto make it a well-managed and vibrant medium to servethe credit needs of rural India, especially the small andmarginal farmers. The package seeks to: (i) providefinancial assistance to bring the system to an acceptablelevel of health; (ii) introduce legal and institutional reformsnecessary for its democratic, self- reliant and efficientfunctioning; and (iii) take measures to improve the qualityof management.

The total financial assistance under the revival package isestimated at Rs.13,596 crore. The liability for funding thefinancial package would be shared by the CentralGovernment, the State Government and the co-operativecredit structure based on the origin of losses and existingcommitments. The financial assistance would be releasedonly on the implementation of the recommendation for legaland institutional reforms. The States willing to participatewere required to enter into a MoU with the CentralGovernment and NABARD. So far, twenty-five States haveexecuted MoUs with the Government of India and theNABARD, as envisaged under the package. This covers

Box VI.6Revival of Co-operative Credit Structure

more than 96 per cent of the short-term co-operative creditstructure units in the country.

Ten States, namely, Andhra Pradesh, Bihar, Gujarat,Haryana, Madhya Pradesh, Maharashtra, Meghalaya,Or issa, Tamil Nadu and Uttar Pradesh had madenecessary amendments in their Cooperative Societies Actsas at end-June 2009. The State Governments ofChhattisgarh and West Bengal have taken a Cabinetdecision approving the amendments in respect of thereform measures as they have submitted their new StateCooperative Societies Acts to Hon’ble President for assent.Draft amendments to Co-operative Societies Acts ofArunachal Pradesh, Assam, Karnataka, Punjab,Rajasthan, Tripura, Uttarakhand, Sikkim, Jharkhand,Jammu and Kashmir, Mizoram, Manipur and Meghalayaare under consideration.

As required in the revival package, the Reserve Bank hasprescribed ‘fit and proper’ criteria for the Directors and CEOsof the StCBs and CCBs for circulation amongst the concernedbanks through NABARD. An aggregate amount of Rs.6,170.3crore had been released by NABARD as the Government ofIndia’s share for recapitalisation of PACS in ten States namely,Andhra Pradesh, Chhattisgarh, Gujarat, Haryana, MadhyaPradesh, Maharashtra, Orissa, Tamil Nadu, Uttar Pradeshand West Bengal, as on June 30, 2009, while the StateGovernments had released their share of Rs.614.8 crore. TheNational Implementing and Monitoring Committee, set up bythe Government of India, is guiding and monitoring theimplementation of the revival package on an all-India basis.

Furthermore, the study of the long-term cooperative creditstructure was entrusted by the Government to the same TaskForce. The Report was submitted in August 2006. It wasannounced in the Union Budget for 2008-09 that the CentralGovernment and the State Governments had reached anagreement on the content of the package for revival of thelong-term cooperative credit structure. The cost of the packagewas estimated at Rs.3,074 crore, of which the CentralGovernment’s share would be Rs.2,642 crore.

VI.73 With effect from the fortnight beginningFebruary 28, 2009, penalty is imposed on thoseRRBs which default in maintenance of SLR. Theexemption granted to RRBs from the purview ofSection 31 of the Banking Regulation Act, 1949 inregard to publishing their balance sheet was alsowithdrawn, effective from the financial year endingMarch 31, 2009.

VI.74 Measures taken to further liberalise thebranch licensing policy for RRBs during 2008-09include relaxation of conditions for opening

branches in hither to uncovered districts andopening of service branches/central processingcentres/back offices. During 2008-09, the ReserveBank granted 780 licences to RRBs for openingbranches, of which 690 were opened.

VI.75 The CFSA had suggested a phasedintroduction of CRAR in RRBs, along with therecapitalisation, after consolidation of theseentities. It was, therefore, announced in the AnnualPolicy Statement for 2009-10 to introduce CRARfor RRBs in a phased manner, taking into account

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the status of recapitalisation and amalgamation.A time-table for this purpose would be announcedin consultation with NABARD. Accordingly, NABARDhas been advised to constitute a Working Group tosuggest bank-wise actionable measures for RRBswhich had CRAR less than 1 per cent as on March31, 2008 so that they could achieve the target of 7per cent by March 2010.

VI.76 In order to prepare the RRBs to adoptappropriate technology and migrate to core bankingsolutions (CBS) for better customer services, aWorking Group (Chairman: Shri G. Srinivasan) wasconstituted to prepare a roadmap for migration toCBS by the RRBs. The Working Group reviewedthe present status of computerisation in RRBs andviewed that RRBs could not remain isolated fromthe technological developments sweeping thebanking sector and that the “one strategy fits all”approach was not workable. The Group alsoexamined the use of solar power as an alternativesource of energy for powering branches located inremote places and suggested that although heavyinitial cost was involved in installation of solar powerunits, the long-term benefits would justify poweringbranches through solar power. The Report, amongother things, set September 2011 as the target forall RRBs to move towards CBS, with all branchesof RRBs opened after September 2009 to be CBScompliant from day one. The Report was forwardedto all sponsor banks to take necessary action.

VI.77 A Working Group (Chairman: Shri G.Padmanadbhan) was constituted to explore variousaffordable ICT-based solutions suitable for RRBsand to identify the cost elements and recommendthe manner and criteria for funding such ICTsolutions. The Group examined the existingconstraints, both financial and infrastructural, inadoption of financial inclusion initiatives by theRRBs. It also explored the various availabletechnology options and suggested modalities forthe Reserve Bank’s support to finance ICT solutionsfor the RRBs. It was announced in the Annual PolicyStatement for 2009-10 that a scheme would beworked out, in consultation with NABARD, to decidethe manner of providing assistance to RRBs

adopting ICT solutions for financial inclusion indistricts identified as having high level of exclusion.

ALL INDIA FINANCIAL INSTITUTIONS (AIFIs)

VI.78 As at end-March 2009, there were fourinstitutions, viz., EXIM Bank, NABARD, NHB andSIDBI, regulated by the Reserve Bank as all-IndiaFinancial Institutions (AIFIs). In the wake of theemerging global developments and their impact onfinancial institutions, the Reserve Bank receivedrequests from select AIFIs for liquidity support foron-lending to HFCs/NBFCs/MFIs and exporters,and accordingly, took a number of measures.

VI.79 In December 2008, the Reserve Banksanctioned refinance facilities of Rs.7,000 crore,Rs.5,000 crore and Rs.4,000 crore for SIDBI, EXIMBank and NHB, respectively, under the relevantprovisions of the Reserve Bank of India Act, 1934.The availment of refinance by the above AIFIs underthis facility is restricted to a period of 90 days and theamount could be flexibly drawn and repaid during theperiod. The facility could be rolled over and would beavailable up to March 31, 2010. Advances under thisfacility are charged at the repo rate under the LAF ofthe Reserve Bank. The funds provided under therefinance facility should be utilised as per the policyapproved by the Board of the respective financialinstitution, and in adherence with the extant exposurenorms for these entities. To facilitate monitoring, thefinancial institutions are required to submit a weeklyreport on the utilisation of the refinance facility. Theamount outstanding under the special refinance facilityremained small up to February 2009 for eachinstitution but picked up subsequently (Table 6.7).

VI.80 The ceiling on aggregate resources mobilisedby SIDBI, NHB and EXIM Bank was raised subject toconditions, with effect from December 8, 2008, for aperiod of one year. The guidelines regardingrestructuring of advances issued to banks have beenmutatis mutandis applied to the select AIFIs.Provisions relating to certain activities generally notundertaken by FIs, such as extending workingcapital, overdrafts and personal loans would,however, not be applicable to them.

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NON-BANKING FINANCIAL COMPANIES

VI.81 Tradit ionally, deposit taking NBFCs(NBFCs-D) were subjected to prudential regulationon various aspects of their functioning while thenon-deposit taking NBFCs (NBFCs-ND) weresubject to minimal regulation. In the light of thegrowing integration of the financial sector, it wasfelt that all systemically relevant entities offeringfinancial services ought to be brought under asuitable regulatory framework to contain systemicrisk. Therefore, as a first step, in December 2006all NBFCs-ND with an asset size of Rs.100 croreand above as per the last audited balance sheetwere designated as systemically important NBFCs-ND (NBFCs-ND-SI) and a specific regulatoryframework was put in place from April 1, 2007 forsuch entities.

VI.82 On a review of the experience with theregulatory framework, it was felt desirable toenhance the capital adequacy requirement and putin place guidelines for liquidity management andreporting, as also norms for disclosures. Thus,NBFCs-ND-SI were advised to attain minimumCRAR of 12 per cent by March 31, 2010 and 15per cent by March 31, 2011.

VI.83 In April 2008, existing instructions on KYCnorms and AML/CFT standards were reviewed withregard to identification of customers to ensure thatNBFCs kept in mind the spirit of instructions issuedby the Reserve Bank and avoided undue hardships

to individuals who were otherwise classified as lowrisk customers. It was advised that NBFCs shouldupdate the consolidated list of high risk individualsand entities as circulated by the Reserve Bank.Further, the updated list of such individuals/entitiescould be accessed from the United Nations’ website.While the names of their new customers should notappear in the list, NBFCs should also put in placean adequate screening mechanism as an integralpart of their recruitment/hiring process. Obligationsof NBFCs in terms of rules notified under PMLA2002 and certain clarifications regarding CTRsand STRs were revised in August 2008. Thesewere in l ine with the instructions issued tocommercial banks.

VI.84 To ensure a measured movement towardsstrengthening the financials of all deposit takingNBFCs, in June 2008, NBFCs-D with a minimumnet owned fund (NOF) of less than Rs.200 lakhwere asked to freeze their deposits, and bring itdown to the revised ceiling of deposits, which inturn was dependent on the extent by which theirNOF was less than the prescribed minimum ofRs.200 lakh.

VI.85 Statutory auditors play an important role inassisting the Reserve Bank in supervision of theNBFCs which are large in number. Earlier directionsto statutory auditors were issued way back in 1998.Given the changed operating environment sincethen, updated and consolidated instructionsencompassing supervision of both NBFCs-D as wellas NBFCs-ND were issued to the auditors of NBFCsin September 2008.

VI.86 To enhance the focus on the NBFCs-NDwith asset size of Rs.50 crore and above but lessthan Rs.100 crore (which were ear l ier notsupervised), it was decided to call for basicinformation from non-deposit taking NBFCs withasset size between Rs.50 crore and Rs.100 croreat quarterly intervals. To ensure better supervision,all NBFCs (both deposit taking and non-deposittaking) with asset size of Rs.100 crore and abovewere asked to furnish the information aboutdowngrading/upgrading of the assigned rating of

Table 6.7: Utilisation of Refinance Facilities(Amount in Rupees crore)

AIFIs Refinance Cumulative Cumulative Number ofsanctioned Amount drawn Amount beneficiaries

up to June 26, Disbursed up to2009 June 26, 2009

1 2 3 4 5

SIDBI 7,000 5,684 4,971 33 *988 1,043 22 **

7,747 1,841 5,179

EXIM Bank 5,000 3,000 3,478 35

NHB 4,000 3,979 3,979 14 #

* : State Finance Corporations and banks.** : NBFCs.# : Housing Finance Companies.

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any financial product issued by them, within fifteendays of such a change in the rating.

VI.87 On account of intensification of the globalfinancial crisis in September 2008, some immediateimpact was felt in the domestic capital markets,resulting in redemption pressure on mutual funds,which created liquidity constraints for NBFCs. Inresponse, the Reserve Bank introduced specialfixed rate Repo under LAF to banks exclusively forthe purpose of meeting the funding requirementsof mutual funds and NBFCs. The precautionarymeasures taken by the Reserve Bank sinceOctober 2008 to enhance the availability of liquidityto NBFCs are:

(i) Taking into consideration, the need forenhanced funds for increasing business andmeeting regulatory requirements, it wasdecided that NBFCs-ND-SI could augment theircapital funds by issue of Perpetual DebtInstruments (PDI) in accordance with thestipulated guidelines. Such PDI would beeligible for inclusion as Tier I capital to theextent of 15 per cent of total Tier I capital as onMarch 31 of the previous accounting year andthe excess amount would qualify as Tier IIcapital within the eligible limits. The minimuminvestment in each such issue/tranche by asingle investor would not be less than Rs.5 lakh.The amount of funds raised by NBFCs-ND-SIwould not be treated as ‘public deposit’ within themeaning of Reserve Bank directives in this regard.

(ii) NBFCs-ND-SI which were facing problems ofliquidity and ALM mismatch in the existenteconomic scenario were permitted, as atemporary measure, to raise short-term foreigncurrency borrowings under the approval route,subject to certain conditions.

(iii) To ease the flow of bank credit to the NBFCs,certain changes initiated were: (a) standardasset provisioning required to be made bybanks on advances to NBFCs was reducedfrom 2.0 per cent to 0.4 per cent; (b) the riskweight on banks’ exposure to NBFCs-ND-SIreduced to 100 per cent from 125 per cent

earlier, irrespective of credit rating whileexposure to AFCs which attracted risk weight of150 per cent was also reduced to 100 per cent;and (c) banks were permitted, on a temporarybasis, to avail liquidity support under the LAFwindow through relaxation in the maintenanceof SLR to the extent of up to 1.5 per cent of theirNDTL, exclusively for meeting the fundingrequirements of NBFCs and mutual funds.

(iv) A scheme for providing liquidity support toeligible NBFCs-ND-SI through an SPV formeeting the temporary liquidity mismatches intheir operations was introduced. IDBI StressedAsset Stabilisation Fund (SASF) Trust wasnotified as the SPV for under taking thisoperation. The SPV would purchase short-termpapers from eligible NBFCs-ND-SI to meet thetemporary liquidity mismatches. The instrumentswould be CPs and CDs, with a residual maturityof not more than three months and rated asinvestment grade. The facility would not beavailable for any paper issued after September30, 2009 and the SPV would cease to makefresh purchases after December 31, 2009 andwould recover all dues by March 31, 2010. Therate of interest charged by the IDBI SASF Trustwould be 12.0 per cent.

VI.88 These steps indirectly also helped indealing with the market pressure which had beenbuilding up on the liquid and fixed maturity planportfolios of mutual funds. In this context, a reviewof the impact of these measures/relaxations onrelease of credit by banks to mutual funds/NBFCswas carried out in mid-November 2008. The reviewrevealed that during the period from October 14 toNovember 20, 2008, many banks availed liquiditysupport under the 14-day special fixed rate repo ofthe Reserve Bank funding to mutual funds againstthe collateral of CDs. Some banks also availedliquidity support under 14-day special fixed raterepo of the Reserve Bank against their funding toNBFCs against the collateral of receivables of theirregular NBFC cl ients. Overall , the policyannouncement had a salutary effect on the mutualfunds that faced liquidity problems (Box VI.7).

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In view of the funding inter-linkages between NBFCs, mutualfunds and commercial banks, when the contagion from theglobal financial crisis created selling pressures in the stockmarkets in India, the liquidity needs of the system as a wholehad to be addressed by the Reserve Bank. The ripple effectof the US and European markets led to heavy redemptionpressure on mutual funds, starting in September 2008, asseveral investors, especially institutional investors, startedredeeming their investments in liquid funds/money marketfunds. Mutual funds are major subscribers to CPs anddebentures issued by the NBFCs, besides CDs issued bybanks. With the mutual funds facing redemption pressuresand difficulties in rolling over the maturing investments, oneof the prime sources of funds available to NBFCs dried upand, hence, there was no market for rollover of maturing short-term instruments floated by NBFCs for having regular accessto market funding. Apart from this, there were reports thatthe liquidity crunch also made banks reluctant to lend toNBFCs. This heightened the perception that NBFCs werefacing severe liquidity constraints. To ascertain the groundreality, a study involving discussions with a large number ofNBFCs-ND-SI was initiated.

The discussions centered on the immediate issue of liquidityconstraints faced by the NBFCs and their experience withthe measures taken by the Reserve Bank to ease the situation.The focus areas for discussions were: (i) the profile,composition and maturity pattern of assets and liabilities; (ii)liquidity issues/constraints faced by the companies; (iii)measures taken for mitigation of such constraints; (iv)feedback on the easing measures taken by the Reserve Bank;(v) business strategy/plans of the NBFCs in the immediatefuture, including substitution of short-term funds, possibilityof downsizing the balance sheet and growth plans; and (vi)real estate/capital market exposures.

It emerged from the discussions that based on their liquiditysensitivity to the changing market conditions, NBFCs couldbe categorised into four groups. The first group ofcompanies had financed assets with long-term liabilitiesand small amounts of CPs and had no asset-liabilitymismatches, as they mainly had short-term assets and also

Box VI.7Liquidity Crisis – Implications for NBFCs

back-up lines of credit. They constituted the largest groupand covered nearly three fourths of the total assets ofcompanies under discussion. Another minority group hadasset-liability mismatches but these companies had foreignparents from whom funds could be received. This grouprepresented only 2.0 per cent of the total assets of theNBFCs. The third group of companies had financed assetswith a mix of short-term CPs and bank funds and had amismatch within tolerance limits. They had around 6.0 percent of the total assets of the NBFCs. The last group ofcompanies had long-term assets and short-term liabilitiesand was facing liquidity problems. These companiesaccounted for 17.0 per cent of the total assets of the NBFCs.

There was a general view among the companies that fundshad become costlier and that raising funds outside bankborrowings had become extremely difficult in view of the thenmarket conditions. Further, banks were also reluctant to extendadditional credit or increase credit to NBFCs. Some of theNBFCs had put on hold incremental disbursements as theywere utilising inflows to repay their short-term obligations anduncertainty of funds flow did not encourage them to expandtheir balance sheets.

Loan companies were expecting a slight increase indelinquency rates, as they had ventured into riskier segments,viz., unsecured loans and retail finance. The investmentcompanies anticipated difficulty in subscriptions to their CPs/debentures for which mostly mutual funds and banks weretheir mainstay. A number of companies, particularly investmentcompanies, that had significant exposure in the capital marketalso had not indicated any liquidity problems except in thefirst few weeks of October 2008 largely on account of the factthat the companies lent only up to 50.0 per cent of the marketvalue and in some cases only up to 33.3 per cent, coupledwith regular margin calls.

Thus, even though at some point it was widely perceived thatthe NBFCs were facing significant problems, in reality, only asmall segment of the NBFCs had real liquidity constraints andthe Reserve Bank’s timely and adequate liquidity interventionscould address the problems over a short timeframe.

VI.89 In January 2009, the Boards of NBFCs wereasked to adopt a well documented interest ratemodel taking into account the relevant factors todetermine the interest rate to be charged on loansand advances. With reference to the queries raisedregarding repossession of vehicles, the ReserveBank clarified in April 2009 that NBFCs must havea built in re-possession clause in the contract/loanagreement with the borrower, which must be legally

enforceable. In order to ensure transparency, theterms and conditions of the contract/loan agreementshould also contain provisions regarding certainprocedures and a copy of such terms and conditionsmust be made available to the borrowers.

Securitisation Companies/Reconstruction Companies

VI.90 The Reserve Bank revised the formats ofquar ter ly statements to be submitted by

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Secur it isation Companies/ReconstructionCompanies (SCs/RCs) in September 2008. Therevised statements would capture, inter alia, dataon position of owned fund of the SCs/RCs (includingFDI component); position of acquisition/realisationof financial assets from banks/FIs by the SCs/RCsin terms of the SARFAESI Act, 2002; andinformation as regards security receipts (SRs)issued, redeemed and outstanding at the end ofparticular quarter.

VI.91 It was clarified that a SC/RC was neither a‘bank’ nor a ‘f inancial institution’ under theprovisions of the SARFAESI Act. Therefore, theacquisition of financial assets by a SC/RC fromanother SC/RC would not be in conformity with theprovisions of the said Act. There was, however, nobar on SCs/RCs deploying their funds forundertaking restructuring of acquired loan accountswith the sole purpose of realising their dues.

DEPOSIT INSURANCE AND CREDITGUARANTEE CORPORATION OF INDIA

VI.92 The deposit insurance scheme at presentcovers commercial banks including local area banksand RRBs in all States and Union Territories. Thenumber of registered insured banks as on March31, 2009 stood at 2,307 comprising of 80commercial banks, 86 RRBs, 4 local area banksand 2,137 co-operative banks. The extent ofprotection accorded to depositors in terms ofpercentage of the number of fully protectedaccounts to the total number of accounts and theamount of insured deposits to assessable depositsas on March 31, 2009 stood at 89.3 per cent and56.2 per cent, respectively (Chart VI.1). The currentlevel of insurance cover, at Rs.1 lakh, is 2.2 timesper capita GDP as on March 31, 2009, as againstthe global average of around three times per capitaGDP3 . During 2008-09, the Corporation settledaggregate claims worth Rs.228 crore in respect ofone commercial bank and 75 co-operative banks.

Evolving Regulatory and Supervisory Regimein the Context of the Crisis

VI.93 The lessons from the financial crisis haveprovided the necessary motivation and rationale forrevamping the financial stability architecture ofcountries, with a view to strengthening the systemsand preventing systemic crisis. Policy makers allover the globe have been assessing whether – andto what extent – certain features of the financialsystem encouraged market excesses and the build-up of large financial imbalances. They have alsobeen considering what changes need be made tothe financial system and to the regulatory andsupervisory frameworks so as to prevent similarfinancial crises in future (Box VI.8). Internationally,many countries are contemplating significantchanges to the existing regulatory regimes, in termsof jurisdiction powers, operational systems andprocedures. The financial regulation review in June2009 by the US introduces a ‘systemic-r iskregulation’ which includes a “Financial ServicesOversight Council”, which would coordinate policyand identify emerging risks, among other roles. Anew Banking Act has been introduced in the UK,

3 Based on data from 68 Countries - "Report of the Committee on Financial Sector Assessment (2009), constituted by Government of India,March, Vol. III, page 309".

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Several regulatory and supervisory issues have surfacedfrom the financial crisis in the advanced countries. Followingintense deliberations on these issues, national regulatorsare broadly highlighting the following for reforming theirfinancial stability architecture:

i. Strengthening the minimum capital adequacyrequirements, with a focus on both the quality andquantity of the capital, supplemented with an overallleverage ratio.

ii. Reducing the pro-cyclicality attached to the regulatoryframework (Basel II) through introduction of dynamicprovisioning or counter-cyclical capital requirements.

iii. Macro-prudential analysis to study the interactionsbetween the economy and the financial system and toprovide early warning signals about the risks to thefinancial system and to the economy.

iv. Monitoring and supervision of large and complex banks,especially those which have cross-border presence andinstitution of ‘college of supervisors’ for effective cross-border supervision and supervisory co-operation.

v. Strengthening the individual bank’s risk managementframework, especially for off-balance sheet items andneed for stress testing, regulation and supervision ofliquidity at micro (individual banks) and macro (systemic)level.

vi. Strengthening the corporate governance, includingadoption of ‘fit and proper’ norms by the Board and thesenior management of a bank.

vii. Extending regulation and supervision to all markets andinstitutions which are systemically important, even if theyare non-deposit taking institutions/not directly dealingwith the public.

viii. Creation of central counterparties in OTC derivativestrading.

ix. Considering alternative approaches for recognising andmeasuring loan losses that incorporate a broader rangeof available credit information; examining changes torelevant standards to dampen adverse dynamicsassociated with fair value accounting, includingimprovements to valuations when data or modeling maybe weak.

x. Reducing the complexity of accounting standards forfinancial instruments and improving presentationstandards to allow the users of financial statements tobetter assess the uncertainty surrounding the valuationof financial instruments.

Box VI.8:Evolving Regulatory Changes in Response to the Crisis: The Indian Position

The Indian regulatory structure for the entire financial systemwould respond appropriately to the emerging internationalinitiatives, modulating the changes to country-specific needs.The well thought out and calibrated approach adopted by Indiawhile globalising the financial system in a phased mannercommensurate with the system’s preparedness in terms ofrisk management and technology was instrumental in avoidingthe direct harmful effects of the contagion on the domesticfinancial system weathering the crisis to a large extent. Severalmeasures have been initiated in recent years, as detailedearlier in the Chapter, for strengthening the regulatory andsupervisory functions of the Reserve Bank. Management ofprivate pools of capital is not a major concern in India asventure capital funds and mutual funds are registered andregulated by the SEBI, while hedge funds do not operate inIndia at present. The High Level Co-ordination Committee onFinancial Markets (HLCCFM) provides a coordinationmechanism among financial sector regulators, viz., ReserveBank, SEBI, IRDA and PFRDA. It is supported by othertechnical committees/sub-committees, which examine issuesrelating to entities under various regulators that have cross-sector implications.

Since end-March 2009, all the SCBs in India have migratedto the Basel II framework and would be subjected to thesupervisory review and evaluation process (SREP) underPillar 2 of Basel II for assessing the capital requirement asalso the capital adequacy of each bank vis-à-vis its risk profileand the standard of its internal controls system and riskmanagement practices. The maintenance of financial stabilityhas been explicitly recognised as a key objective by theReserve Bank in various policy documents. The Reserve Bankhas also set up a Financial Stability Unit as announced in theAnnual Policy Statement for 2009-10, for carrying out periodicstress testing and for preparing financial stability reports.

References:

1. European Union (2009), Report of The High Level Groupon Financial Supervision in the EU, (Chairman: Jacquesde Larosiere), February 25.

2. G20 (2009), Report of the Group on Enhancing SoundRegulation and Strengthening Transparency, (Chairman:Dr. Rakesh Mohan), March.

3. Government of India and Reserve Bank of India (2009),Report of the Committee on Financial Sector Assessment,(Chairman: Dr. Rakesh Mohan), March.

4. Reserve Bank of India (2008), Report on Currency andFinance, 2006-08, September.

which assigns the Bank of England a statutory rolerelating to the financial stability objective and alsointroduces a new special resolution regime for

dealing with failing banks. A new Systemic RiskBoard in the EU identifies EU-wide systemic riskand makes appropriate policy recommendations to

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mitigate the same. A new central bank law inMalaysia seeks to provide clarity on the role of thecentral bank in ensuring financial stability. TheFinancial Stability Board has been set up at theBank for International Settlements and significantnew initiatives have also been taken by the G-20,the overall focus of these international responsesis to prevent another systemic crisis.

MACRO-PRUDENTIAL INDICATORS REVIEW

VI.94 The compilation and review of macroprudential indicators (MPIs) was done on a semi-annual basis since March 2000. The review, placedbefore the BFS, covers analysis of macroeconomicaggregates and financials of commercial banks,NBFCs, UCBs, AIFIs, PDs, RRBs, and co-operativebanks, on the CAMELS framework. Recently, asdirected by the BFS, the frequency of MPI compilationwas changed from semi-annual to quarterly and thecoverage of the review was expanded to includeassessment of banks’ vulnerability, financials ofsystemically important NBFCs and other keyparameters to make it more relevant to the changingneeds of effective surveillance of the financial system.The quarterly review of MPI is supplemented by thepreparation of a monthly banking system outlookincorporating balance sheet analysis of SCBs alongwith high-frequency market data and macroeconomic

data. The broad structure of the revised quarterly MPIreview covers assessment of macroeconomicindicators, outlook for banks and other financialintermediaries impacting their credit/market/liquidityrisk, resilience of banks and other financialintermediaries to plausible stress scenarios, analysisof their financials, and assessment of financial stabilityin the light of the macroeconomic indicators andinstitutions’ risk profile.

VI.95 An overview of MPIs for 2008-09 indicatesdeterioration in a few indicators but improvement inefficiency of the major constituents of the financialsector (Table 6.8). The crisis adversely impacted allthe segments of the financial markets where banksactively operate, viz., credit market, money market,foreign exchange market, equity market and bondmarket. The key performance analysis for the SCBsduring 2008-09 under four broad parameters, viz.,business growth, capital adequacy, asset quality andprofitability suggest that while growth in businessmoderated, the other critical financial soundnessmeasures continued to remain stable and comfortable.

Capital Adequacy

VI.96 The CRARs of the SCBs continue to be wellabove the prescribed minimum level of 9.0 per cent(Table 6.9). In fact, the core (Tier I) CRAR of SCBsitself was 9.0 per cent at end-March 2009 (almost

Table 6.8: Select Financial Indicators(Per cent)

Item End- Scheduled Scheduled Urban Development Finance Primary Non-BankingMarch Commercial Banks Co-operative Banks Institutions Dealers Financial Companies

1 2 3 4 5 6 7

CRAR 2008 13.0 11.8 26.3 37.5 22.42009 13.2 12.6 25.5 34.8 18.3

Gross NPAs to Gross Advances 2008 2.4 13.9 0.6 N.A. 1.52009 2.4 11.5 0.3 N.A. 1.7

Net NPAs to Net Advances 2008 1.1 2.9 0.12 N.A. -8.72009 1.1 2.3 0.07 N.A. -0.4

Return on Total Assets 2008 0.99 0.8 1.4 2.5 2.92009 1.02 1.2 1.2 6.6 N.A.

Return on Equity 2008 12.5 N.A. 10.7 10.7 16.92009 13.3 N.A. 9.3 21.5 N.A.

Efficiency (Cost/Income Ratio) 2008 48.9 56.4 19.4 25.4 68.52009 45.3 53.2 15.9 11.7 N.A.

N.A.: Not Available.Note: 1. Unaudited and provisional data.

2. Data for 2009 in respect of NBFCs pertain to the period ended September 2008.3. CRAR for scheduled UCBs excludes Madhavpura Mercantile Co-Op Bank Ltd.

Source: 1. SCBs: Off-site supervisory returns submitted by the banks pertaining to their domestic operations only; CRAR data is based on global balance sheet.2. UCBs: Off-site surveillance returns.

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Table 6.9: Scheduled Commercial Banks – Frequency Distribution of CRAR (Per cent)

Bank Group End-March Negative Below 0 and 9 Between 9 and 10 Between 10 and 15 15 per cent Totalper cent per cent per cent and above

1 2 3 4 5 6 7 8

Public Sector Banks 2008 0 0 0 28 0 28 2009 0 0 1 26 0 27Nationalised Banks 2008 0 0 0 20 0 20 2009 0 0 1 19 0 20SBI Group 2008 0 0 0 8 0 8 2009 0 0 0 7 0 7Private Sector Banks 2008 0 0 1 17 5 23 2009 0 0 0 16 6 22Old Private Sector Banks* 2008 0 0 1 10 4 15 2009 0 0 0 12 3 15New Private Sector Banks 2008 0 0 0 7 1 8 2009 0 0 0 4 3 7Foreign Banks 2008 0 0 1 7 20 28 2009 0 0 0 7 23 30All Banks 2008 0 0 2 52 25 79 2009 0 0 1 49 29 79

Note: Unaudited and provisional data.Source: Off-site supervisory returns submitted by banks pertaining to their domestic operations only.

Table 6.10: CRAR and Net NPAs of SelectFinancial Institutions

(End-March 2009)(Per cent)

Financial Institution CRAR Net NPAs Net NPAs to(Rupees Net Loans

crore)

1 2 3 4

Term-Lending Institutions (TLIs) EXIM Bank 16.77 79.08 0.23All TLIs 16.77 79.08 0.23

Refinancing Institutions (RFIs) NABARD 27.96 20.82 0.02NHB 18.17 0 0SIDBI 36.03 26.07 0.08All RFIs 28.60 46.89 0.03All FIs 25.49 125.97 0.07

Source: Off-site returns submitted by Fls.

the same as at end-March 2008), which indicatesa high proportion of better quality capital in theCRAR for the Indian banking system. There stillremains significant headroom, though, for banksto raise additional upper and lower Tier II capital.The CRAR of scheduled UCBs at end-March 2009was higher than that at end-March 2008 (referTable 6.8). Out of 53 scheduled UCBs, the CRARsof 43 UCBs were 9 per cent and above, while of 8UCBs were less than 3 per cent.

VI.97 The CRAR of FIs as a group decreasedduring 2008-09 (Table 6.10). This was mainly due to

the decrease in the CRAR of refinancing institutions.Though the CRAR of NBFCs as a group decreasedbetween end-March 2008 and end-September 2008,it continued to remain above the regulatory minimumof 12 per cent. While companies having CRAR lessthan 12 per cent declined both in absolute andpercentage terms during the period, there was alsoa marginal decline in percentage terms of companieswith CRAR exceeding 30 per cent (Chart VI.2). The

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Table 6.11: Scheduled Commercial Banks - Performance Indicators(Per cent)

Item/ Bank Group 2007-08 2008-09 2008-09

Q1 Q2 Q3 Q4

1 2 3 4 5 6 7

Operating Expenses/ Total Assets*Scheduled Commercial Banks 1.8 1.8 1.9 1.8 1.8 1.8Public Sector Banks 1.6 1.5 1.6 1.6 1.6 1.5Old Private Sector Banks 1.7 1.7 1.7 1.8 1.8 1.7New Private Sector Banks 2.5 2.5 2.6 2.5 2.5 2.5Foreign Banks 2.8 2.7 2.7 2.6 2.6 2.7Net Interest Income/Total Assets*Scheduled Commercial Banks 2.4 2.4 2.6 2.6 2.6 2.4Public Sector Banks 2.2 2.2 2.3 2.3 2.4 2.2Old Private Sector Banks 2.4 2.6 2.7 2.8 2.8 2.6New Private Sector Banks 2.4 2.9 2.8 2.9 2.9 2.9Foreign Banks 3.8 3.9 3.8 3.7 3.9 3.9Net Profit/Total Assets*Scheduled Commercial Banks 1.0 1.0 0.9 0.9 1.0 1.0Public Sector Banks 0.9 0.9 0.6 0.8 0.9 0.9Old Private Sector Banks 1.0 1.0 0.8 1.0 1.1 1.0New Private Sector Banks 1.0 1.1 0.9 1.0 1.1 1.1Foreign Banks 1.8 1.7 2.7 1.8 1.7 1.7Gross NPAs to Gross Advances**Scheduled Commercial Banks 2.4 2.4 2.4 2.3 2.3 2.4Public Sector Banks 2.3 2.1 2.2 2.1 2.1 2.1Old Private Sector Banks 2.3 2.4 2.4 2.3 2.4 2.4New Private Sector Banks 2.9 3.6 3.2 3.4 3.4 3.6Foreign Banks 1.9 4.2 1.9 2.1 2.8 4.2Net NPAs to Net Advances**Scheduled Commercial Banks 1.1 1.1 1.1 1.0 1.0 1.1Public Sector Banks 1.1 1.0 1.0 1.0 0.9 1.0Old Private Sector Banks 0.7 0.9 0.8 0.8 0.8 0.9New Private Sector Banks 1.4 1.6 1.5 1.6 1.7 1.6Foreign Banks 0.8 1.7 0.7 0.9 1.1 1.7CRAR**Scheduled Commercial Banks 13.0 13.2 12.7 12.5 13.1 13.2Public Sector Banks 12.5 12.3 12.3 12.0 12.4 12.3Old Private Sector Banks 14.1 14.3 13.9 14.1 14.3 14.3New Private Sector Banks 14.4 15.1 14.0 13.9 15.0 15.1Foreign Banks 13.1 15.1 12.2 12.2 13.7 15.1

* : Annualised to ensure comparability between quarters.** : Position as at the end of the quarter.Note : Provisional and unaudited data. Figures rounded off to single decimal point.Source : Off-site supervisory returns submitted by the banks pertaining to their domestic operations.

CRAR of primary dealers also declined during 2008-09 but remained higher than regulatory minimum.

Asset Quality

VI.98 Gross NPAs as percentage of grossadvances of SCBs and the net NPA ratio remainedvirtually unchanged during 2008-09 (Table 6.11).There has, however, been a significant rise in thisratio for foreign banks and new private sectorbanks, particularly after September 2008, reflecting

deterioration in the asset quality of these bankgroups following the global financial meltdown.Since, in absolute terms, both gross and net NPAsincreased during 2008-09 despite extension ofcertain relaxations permitted to banks to restructurecertain advances, banks need to exercise better riskmanagement and vigil to avoid future slippage inasset quality. Net NPAs of nine banks were inexcess of 2 per cent of net advances in 2008-09(Table 6.12). Asset quality of scheduled UCBscontinued to improve during the year. Out of the

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Table 6.12: Net NPA to Net Advances of Scheduled Commercial Banks(Frequency Distribution)

Year Public Sector Banks Private Sector Banks Foreign Banks

SBI Group Nationalised Old Private New PrivateBanks Sector Banks Sector Banks

1 2 3 4 5 6

2004-05Up to 2 per cent 7 10 4 6 22Above 2 per cent and up to 5 per cent 1 8 12 3 2Above 5 per cent and up to 10 per cent 0 2 4 1 2Above 10 per cent 0 0 0 0 4

2005-06Up to 2 per cent 7 15 11 6 26Above 2 per cent and up to 5 per cent 1 5 7 2 0Above 5 per cent and up to 10 per cent 0 0 2 0 0Above 10 per cent 0 0 0 0 3

2006-07Up to 2 per cent 8 18 14 7 27Above 2 per cent and up to 5 per cent 0 2 2 1 1Above 5 per cent and up to 10 per cent 0 0 1 0 0Above 10 per cent 0 0 0 0 1

2007-08Up to 2 per cent 7 19 15 7 25Above 2 per cent and up to 5 per cent 1 1 0 1 2Above 5 per cent and up to 10 per cent 0 0 0 0 0Above 10 per cent 0 0 0 0 1

2008-09 PUp to 2 per cent 7 20 14 4 24Above 2 percent and up to 5 per cent 0 0 1 3 5Above 5 percent and up to 10 per cent 0 0 0 0 1Above 10 per cent 0 0 0 0 0

P: Data unaudited and provisional.

Source: Off-site supervisory returns submitted by the banks pertaining to their domestic operations only.

53 scheduled UCBs, net NPA ratios of 44 were 5per cent or less (Table 6.13).

Earnings and Profitability Indicators

VI.99 While the cost of deposits and cost of fundsfor all bank groups increased in 2008-09, the returnon advances and return on funds also registeredan increase (Table 6.14).

VI.100 In terms of measures of profitability, theperformance of SCBs was not affected by theeconomic slowdown as the RoA of SCBs was higherduring 2008-09, than last fiscal year (Table 6.15). Thenon-interest income of SCBs increased by nearly25 per cent. The increase in income more than

Table 6.13: Net NPAs to Net Advances of SUCBs(Frequency Distribution)

2004-05R 2005-06R 2006-07R 2007-08R 2008-09

1 2 3 4 5 6

Up to 2 per cent 20 24 24 25 24

Above 2 and up to5 per cent 5 7 13 11 20

Above 5 and up to10 per cent 12 13 7 8 3

Above 10 per cent 18 11 10 9 6

Total 55 55 54 53 53

Net NPAs to NetAdvances (per cent) 8.4 5.5 4.3 2.9 2.3

R: Revised.Note: Provisional data.Source: Off-site surveillance returns.

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Table 6.14: Scheduled Commercial Banks – Cost of Funds and Return on Funds(Per cent)

Item End-March Public Sector Old Private New Private Foreign Banks All ScheduledBanks Sector Banks Sector Banks Commercial

Banks

1 2 3 4 5 6 7

Cost of Deposits 2008 5.41 5.72 5.93 3.81 5.412009 5.60 6.14 6.39 4.28 5.67

Cost of Borrowings 2008 3.47 4.58 3.13 4.44 3.572009 3.99 5.02 3.71 3.89 3.90

Cost of Funds 2008 5.29 5.70 5.53 3.96 5.262009 5.52 6.11 6.00 4.19 5.54

Return on Investment 2008 6.64 6.34 6.42 7.09 6.622009 6.23 5.66 6.89 6.74 6.35

Return on Advances 2008 8.57 9.59 10.00 9.75 8.932009 9.06 11.03 10.79 12.28 9.56

Return on Funds 2008 7.98 8.53 8.72 8.74 8.192009 8.18 9.09 9.45 9.81 8.52

Note: 1. Provisional data.2. Cost of Deposits = Interest Paid on Deposits/Deposits.3. Cost of Borrowings = Interest Paid on Borrowings/Borrowings.4. Cost of Funds = (Interest Paid on Deposits + Interest Paid on Borrowings)/(Deposits + Borrowings).5. Return on Advances = Interest Earned on Advances /Advances.6. Return on Investments = Interest Earned on Investments /Investments.7. Return on Funds = (Interest Earned on Advances + Interest Earned on Investments)/(Advances + Investments).8. The ratios for 2009 do not include data of three banks – Tamilnadu Mercantile Bank, ABN Amro Bank, and Bank International Indone-

sia as these banks’ annual accounts have not yet been received.

Source: Annual accounts of respective banks.

offset the increase in expenditure such that profitsbefore provisions and taxes (as per cent to totalassets) also registered an increase during the year.Out of a total of 79 banks, 55 registered an increasein earnings before provisions and taxes while 37recorded an increase in return on assets duringthe year (Table 6.16). The return on total assetsof scheduled UCBs increased during 2008-09(Table 6.17).

Sensitivity to Market Risk

Interest Rate Risk

VI.101 Interest rate risk faced by the banks as atend-March 2009, though subdued due to a higherproportion of held-to-maturity (HTM) portfolio intotal investments, still poses some risk due towidening spreads between short-term and long-termyields and because the HTM portfolios generallyhave higher duration bonds. Though sovereignyields have been declining, expectations of largefiscal deficit and inflationary pressures are

Table 6.15: Operational Results of ScheduledCommercial Banks – Key Ratios

(Amount in Rupees crore)

Indicators 2007-08 2008-09

1 2 3

1 Total Income (i+ii) 3,55,505 4,49,065 (i) Interest Income (net of interest tax) 2,96,289 3,74,995 (ii) Non-interest income 59,216 74,0692 Total Expenditure 2,74,924 3,41,604 (i) Interest Expenses 1,98,721 2,53,937 (ii) Operating Expenses 76,202 87,6673 Earnings before Provisions and Taxes (EBPT) 80,197 1,07,2994 Provisions and Contingencies 39,305 56,4945 Profit After Tax 40,892 50,805

As per cent to total assets

1 Total Income (i+ii) 8.62 9.05 (i) Interest Income(net of interest tax) 7.18 7.56 (ii) Non-interest income 1.44 1.492 Total Expenditure 6.67 6.89 (i) Interest Expenses 4.82 5.12 (ii) Operating Expenses 1.85 1.773 Earnings before Provisions and Taxes (EBPT) 1.94 2.164 Provisions and Contingencies 0.95 1.145 Profit After Tax 0.99 1.02

Note : Unaudited and provisional data.Source : Off-site supervisory returns submitted by banks pertaining to

their domestic operations only.

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Table 6.17: Operational Results ofSUCBs – Key Ratios

(As per cent to Total Assets)

Item 2007-08 2008-09

1 2 3

1. Total Income 7.0 7.9

(i) Interest Income 6.4 7.0

(ii) Non-interest Income 0.6 0.8

2. Total Expenses 5.7 6.4

(i) Interest Expense 4.1 4.7

(ii) Non-interest Expenses 1.6 1.7

3. Earning before Provisions and Taxes 1.3 1.5

4. Provisions for Taxes (if any) 0.5 0.3

5. Net Profit After Tax 0.8 1.2

Provisional data.Source: Off-site surveillance returns.

reversing the decline. The AIFIs are vulnerable tointerest rate risk as they have a large part of theirassets as investment in government securities andthe cushion available to them to absorb losses dueto rise in interest rate is limited.

Currency Risk

VI.102 Till the end of last quarter of financial year2008-09, slowdown in exports, deterioration in thecurrent account balance and weakening crude oilcontinued to weaken the rupee. Due to their nominal

foreign currency exposure, commercial banks arenot exposed to currency risk. Moreover, they alsohave lower overnight positions. The present outlookshows that the resilience of the Indian economyamidst the global crisis is attracting FDI inflowscoupled with equity market opportunities. This hasthe positive effect of arresting the depreciation inthe rupee. The unhedged foreign currencyexposures of banks on behalf of their clients maypose currency risk, which needs to be monitored.

Credit Risk

VI.103 As crunch persisted in other fronts offunding, commercial sectors continued to look fordomestic credit supply. Accelerated steps such ascuts in policy rates, relaxation in prudential norms,restructuring and moral persuasion by the ReserveBank enabled the commercial banks to lend more.However, this has also raised concerns of creditrisk and could affect bank’s asset quality. As atend-March 2009, banks’ off-balance sheetexposures had come down as percentage of totalbalance sheet assets and in terms of notionalprincipal amount accounted for marginally morethan two times of their total on balance sheetassets. This is a signi f icant decl ine whencompared with the figure of more than four timesin June 2008. Majority of the derivatives are over

Table 6.16: Operational Results of Scheduled Commercial Banks: 2008-09(Number of banks showing increase in ratios during the period)

Ratio to Total Assets Public Sector Banks Private Sector Banks Foreign All

SBI Group Nationalised Old Private New PrivateBanks Banks

Banks Sector Banks Sector Banks

1 2 3 4 5 6 7

1. Total Income 7 16 12 7 14 56(i) Interest Income 7 18 13 7 12 57(ii) Non-interest Income 3 13 11 3 16 46

2. Total Expenditure 7 17 13 7 10 54(i) Interest Expenses 7 17 13 6 10 53(ii) Operating Expenses 1 6 10 4 13 34

3. Earnings before Provisions and Taxes 6 14 10 6 19 55

4. Provisions and Contingencies 6 14 10 7 21 58

5. Profit After Tax 5 6 6 5 15 37

Note: Data are provisional and unaudited.Source: Off-site supervisory returns submitted by the banks pertaining to their domestic operations only.

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the counter deals and largely concentrated amonga few foreign banks.

Liquidity Risk

VI.104 When compared with the first three quartersof 2008-09, the last quarter saw some easing onthe liquidity front enabled by the Reserve Bank’sseries of monetary easing and liquidity enhancingmeasures. Despite the additional pressure ondemand for bank credit, commercial bankspreferred to tread cautiously and maintain liquidityon hand. The banking system has come back tosurplus mode since last quarter. Large demand forlong-term credit by the real and infrastructuresectors hardens liquidity management of banks.Continued recessionary conditions also createsmore funding and timing risk. Funding risk arisesdue to unexpected withdrawal of deposits,especially wholesale deposits. Liquidity timing riskcould arise when expected cash inflows falter. Thiscalls for di l igent l iquidity management bycommercial banks despite being in surplus modeat present.

VI.105 The effectiveness of the Reserve Bank’sregulatory and supervisory structure in dealing witha major contagion from a severe global crisis wastested in 2008-09. All financial soundness indicatorsfor the Indian banking system, however, exhibitedsigns of stability and strength at the end of March2009. Not only did every bank remain above theminimum regulatory capital requirement but eventhe quality of capital was high, which is evident fromthe fact that Tier I capital alone was at 9.0 per centfor the banking system. Gross NPAs as percentageof gross advances has not deteriorated, whileprofitability indicators (i.e., RoE and RoA) furtherimproved during 2008-09. Stress test results alsorevealed that Indian banks could withstandprobable extreme shocks. The comprehensive self-assessment was conducted by the CFSA at a timewhen a relook at the Indian regulatory architecturewas necessary in the context of the global financialcrisis. The findings of the Committee corroboratedthe resilience of the Indian banking system towithstand extreme shocks.

VI.106 The main factors responsible for thisendurance in the financial system were the robustregulatory regime in place and an effectivesupervisory mechanism. While assessing thesafety, soundness and solvency of banks, the riskprofile and systemic risk potential of banks, both atthe individual and sector level are also assessed.Any symptom of build-up of large imbalancesacross institutions/different economic segments/sectors as also perception of risks which couldescalate into a contagion are dealt withappropriately by enhancing the rigorousness ofavailable prudential and other regulatory andsupervisory measures. Several measures such asenhanced provisions, r isk weights, targetedappraisals, special supervisory review along withregulatory restrictions and penalties are resortedto, as and when considered necessary. A systemof Prompt Corrective Action (PCA), based on threeparameters viz., CRAR, net NPAs and RoA is in place.

VI.107 When the crisis reached a flashpoint inSeptember 2008, besides meeting the liquidityneeds of the banking system through provision ofboth domestic and foreign currency liquidity, theReserve Bank also prudently changed the counter-cyclical risk weights, provisioning requirements andasset classification norms for restructured assets,all of which created enabling conditions forpreventing sharp moderation in credit growth duringthe economic slowdown. NBFCs, mutual funds andfinance companies experienced some liquiditystress, which was carefully examined by theReserve Bank. Contrary to the initial perception, itturned out that liquidity problems were confined toonly a small section of NBFCs. The problem wasswiftly addressed by the Reserve Bank throughappropriate liquidity enhancing measures. With aview to preserving and further strengthening theregulatory and supervisory architecture, theReserve Bank would constantly review the lessonsfrom the global financial crisis, as also the emergingviews in the context of Basel II framework relatingto procyclicality, risk coverage, quality of bankcapital, credit ratings, stress tests, management ofliquidity and other emerging issues relating to

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cross-border supervision and supervisorycooperation, monitoring of large and complex banksand enhancing the scope of regulation andsupervision for systemic stability. As on March 31,2009 all Indian banks, including the foreign banks,had migrated to the Basel II simpler approaches,

and as such they will be subject to the SREP underPillar 2 of Basel II for assessing the capitalrequirement as also the capital adequacy of eachbank vis-a-vis its risk profile and the standard of itsinternal control system and risk managementpractices.