Banking Sector Reforms

Banking Sector Reforms

NUCFDC: Umbrella Body for Urban Co-op Banks established

Note4Students

From UPSC perspective, the following things are important :

Prelims level: NUCFDC, Urban Cooperative Banks and their regulations, NBFCs

Mains level: NA

In the news

  • The Union Home Minister and Minister of Cooperation officially inaugurated the National Urban Cooperative Finance and Development Corporation Limited (NUCFDC), marking a significant milestone in the development of urban cooperative banking.

About NUCFDC

  • Regulatory Approval: NUCFDC has obtained approval from the RBI, authorizing it to function as a Non-Banking Finance Company (NBFC) and serve as the apex body for the urban cooperative banking sector.
  • Self-Regulatory Status: Additionally, NUCFDC has been granted the status of a Self-Regulatory Organisation (SRO) for the sector, empowering it to oversee and regulate various aspects of urban cooperative banking operations.
  • Capital Enhancement: NUCFDC aims to augment its capital base, with ambitions to achieve a capitalization level of Rs. 300 crores, facilitating its mission to support and strengthen Urban Cooperative Banks (UCBs).

Functions of NUCFDC

  • Utilization of Funds: The organization intends to deploy its capital resources towards bolstering the financial capabilities of UCBs, including the development of a shared technology infrastructure to enhance service delivery and reduce operational costs.
  • Comprehensive Support: Apart from providing financial liquidity and capital assistance, NUCFDC will establish a collaborative technology platform accessible to all UCBs, enabling them to expand their service offerings efficiently and affordably.
  • Advisory Services: NUCFDC will also extend advisory and consultancy services to UCBs, assisting them in areas such as fund management, regulatory compliance, and strategic planning.

About Urban Cooperative Banks (UCBs)

  • Origins: UCBs trace their roots to cooperative credit societies, offering financial services to members within specific community groups.
  • Regulations: Regulated by the RBI under the Banking Regulation Act of 1949, UCBs adhere to stringent prudential norms and guidelines to ensure financial stability.
  • Operational Classification: UCBs are categorized into urban and rural cooperative banks based on their geographic scope. They operate under the governance of State Registrars of Cooperative Societies (RCS) or the Central Registrar of Cooperative Societies (CRCS) and the RBI.
  • Historical Evolution: The journey of UCBs dates back to the establishment of the first Cooperative Credit Society of Haryana in 1904, evolving over time with regulatory amendments and institutional reforms.

Reforming the UCBs

  • Narasimham Committee Report (1998): It suggest subsequent regulatory interventions aimed at enhancing the governance, capitalization, and operational efficiency of UCBs.
  • Structural Recommendations Committee (2021): The formation of a 4-tier structure for UCBs, proposed by a committee appointed by the RBI in 2021, seeks to streamline their operations and ensure effective regulatory oversight based on deposit size tiers:
  1. Tier 1 with all unit UCBs and salary earner’s UCBs (irrespective of deposit size) and all other UCBs having deposits up to Rs 100 crore.
  2. Tier 2 with UCBs of deposits between Rs 100 crore and Rs 1,000 crore,
  3. Tier 3 with UCBs of deposits between Rs 1,000 crore and Rs 10,000 crore, and
  4. Tier 4 with UCBs of deposits more than Rs 10,000 crore.

Challenges Faced by UCBs

  • Capital Constraints: UCBs encounter limitations in capital mobilization due to regulatory restrictions on dividend payouts and limited avenues for raising external funds.
  • Diversification Hurdles: The lack of operational diversification and dependence on member contributions for capital infusion pose challenges to UCBs’ financial resilience and expansion prospects.
  • Funding Alternatives: Access to alternative funding sources remains constrained for UCBs, necessitating innovative approaches to address liquidity requirements.
  • Profit Distribution Dynamics: Incentives for profit distribution are subdued in UCBs, impacting their attractiveness to investors and hindering their growth trajectory.
  • Solvency Pressures: Expansion initiatives and acquisitions can strain UCBs’ solvency and liquidity positions, necessitating prudent risk management practices and strategic planning.

Try this PYQ from CSP 2021:

With reference to ‘Urban Cooperative Banks’ in India, consider the following statements:

  1. They are supervised and regulated by local boards set up by the State Governments.
  2. They can issue equity shares and preference shares.
  3. They were brought under the purview of the Banking Regulation Act, 1949 through an Amendment in 1966.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

Post your responses here.
0
Please leave a feedback on thisx

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Banking Sector Reforms

RBI Directs NPCI to Assess Paytm’s TPAP Request

Note4Students

From UPSC perspective, the following things are important :

Prelims level: TPAP

Mains level: Payments banks operations in India

Introduction

Understanding TPAP

  • Role: TPAPs facilitate UPI-based transactions by providing compliant applications to end-users, ensuring adherence to security protocols and regulatory standards.
  • Infrastructure: They leverage NPCI’s UPI framework and collaborate with payment service providers (PSPs) and banks to enable seamless transactions.

Implications of TPAP Approval

  • Operational Continuity: TPAP approval is vital for Paytm to sustain UPI-based transactions, ensuring uninterrupted service for customers.
  • Migration Process: If approved, Paytm’s ‘@paytm’ handles will transition seamlessly to designated banks to prevent service disruptions, with OCL prohibited from adding new users until successful migration.
  • Risk Mitigation: RBI mandates certification of multiple banks as PSPs to manage high-volume UPI transactions, minimizing risk and enhancing system resilience.

Recent Developments

  • PPBL Closure: Following RBI’s directive to shut Paytm Payments Bank (PPBL) operations by March 15, 2024, Paytm’s existing TPAP registration for UPI transactions faces uncertainty.
  • RBI Intervention: In response to PPBL’s impending closure, RBI has tasked NPCI with evaluating OCL’s request to maintain TPAP status, crucial for Paytm’s UPI operations continuity.

Current Landscape

  • Presently, 22 NPCI-approved third-party UPI apps, including Google Pay, PhonePe, and Whatsapp, facilitate peer-to-peer transactions via UPI IDs.
  • RBI’s directive underscores the regulatory focus on maintaining stability and security in India’s digital payments ecosystem.

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Banking Sector Reforms

Exposing India’s financial markets to the vultures

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Fully accessible route (FAR) bonds

Mains level: India's efforts in integrating government bonds into global indices

Internationalisation of Rupee - Rau's IAS

 

Central Idea:

The article discusses India’s efforts to integrate its government bonds into global indices, focusing on J.P. Morgan and Bloomberg’s recent moves. It explores the potential benefits and risks associated with opening local bond markets to foreign investors, emphasizing the broader initiative to internationalize the Indian rupee. The author cautions against underestimating the risks involved in such a move and suggests a more cautious approach to currency internationalization.

 

Key Highlights:

  • Timeline of Initiatives: The process of incorporating Indian government bonds into global indices began in 2019, with J.P. Morgan and Bloomberg making significant announcements in 2023 and 2024, respectively.
  • Benefits of Internationalization: The article highlights potential benefits, including access to international resources, stability in funds tracking indices, and facilitating financing of current account and fiscal deficits.
  • Original Sin Problem: Opening local currency bond markets helps shift exchange rate risk onto international lenders, addressing the “original sin” problem faced by emerging economies borrowing in reserve currencies.
  • Loss of Autonomy and Risks: The internationalization of bond markets exposes emerging economies to a loss of autonomy, interest rate risks, and vulnerability to global liquidity conditions, as seen in past instances.
  • Currency Internationalization: Besides bonds, the article discusses the broader effort to internationalize the Indian rupee, involving offshore markets and trade settlement in INR.

 

Key Challenges:

  • Exchange Rate Volatility: Opening local currency bond markets makes inflows volatile due to exchange rate risk, leading to sudden stops and exits by foreign investors.
  • Interest Rate Risks: Increased exposure to global interest rate fluctuations can impact long-term rates and domestic bond markets during periods of global market distress.
  • Speculation and Instability: The creation of offshore markets for the Indian rupee poses risks of speculation and potential instability, as seen in the experiences of Malaysia and Türkiye.

 

Key Terms:

  • Original Sin: The inability of emerging economies to borrow internationally in their own currencies, exposing them to exchange rate risk.
  • Fully Accessible Route (FAR): A segment of Indian government bonds made officially accessible to foreign investors without constraints.
  • Government Bond Index-Emerging Markets (GBI-EM): An index suite that includes local currency government bonds from emerging market countries.

 

Key Phrases:

  • “Original sin problem”
  • “Fully accessible route (FAR) bonds”
  • “Currency internationalisation”
  • “Offshore INR market”

 

Key Quotes:

  • “Currency internationalisation cannot be decided in one day and pursued the next. It comes about after a long evolutionary process, when all the building blocks are in place.” – Y.V. Reddy

 

Key Statements:

  • The move to include Indian government bonds in global indices is part of a broader effort to internationalize the Indian rupee.
  • The risks associated with opening local bond markets are underestimated, and caution is advised in pursuing currency internationalization.

 

Key Examples and References:

  • Malaysia and Türkiye Experiences: Instances of offshore market speculation leading to financial distress, with Malaysia implementing capital controls in 1998 and Türkiye taking measures against offshore lira speculation in 2022.

 

Key Facts:

  • Timeline: The process of incorporating Indian government bonds into global indices started in 2019, with J.P. Morgan and Bloomberg making significant announcements in 2023 and 2024, respectively.

 

Key Data:

  • Number of Banks Authorized: The RBI has granted authorization to 17 banks for settling trade in the Indian rupee across 18 countries, establishing 65 offshore deposit accounts.

 

Critical Analysis:

  • The article critically examines the potential benefits and risks associated with the internationalization of bond markets and currencies, emphasizing the importance of a sustained development process and improved economic performance.

 

Way Forward:

  • Suggests a cautious approach to currency internationalization, highlighting the need for all building blocks to be in place and emphasizing the role of sustained financial system development and improved economic performance.

 

In conclusion, the article provides a comprehensive overview of India’s efforts in integrating government bonds into global indices, discussing the associated benefits, risks, and broader initiatives for currency internationalization. It underscores the importance of a cautious approach and sustained development in managing financial integration.

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Banking Sector Reforms

The banking sector is leading the journey towards an Atmanirbhar Bharat

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Banking sector updates

Mains level: India's banking sector growth, reforms, opportunities, challenges and way forward

What’s the news?

  • Despite facing numerous challenges in the past quarter-century, including economic crises, pandemics, and geopolitical tensions, India’s banking and financial sector has continued to evolve and adapt.

Central idea

  • India’s remarkable growth and stability over the past 25 years have placed the country at the forefront of global optimism. This shift is attributed to the nation’s governance structures and policy apparatus, which have fostered innovation and positioned India as a hub of novel public goods. Among the sectors driving this transformation, banking and finance stand out as key contributors.

The Banking Evolution

  • Maturation of Banking in India: Over a period of 75 years, India’s banking sector has matured and grown into a vibrant and robust industry.
  • Reforms and Critical Enablers: The past 30 years have seen critical reforms that have played a pivotal role in enabling the growth and transformation of the banking sector.
  • Diversity in Banking: India’s banking sector now boasts a diverse landscape that includes public sector banks, private banks, non-banking financial companies (NBFCs), and a burgeoning fintech ecosystem. This diversity has made the financial sector more inclusive and dynamic.
  • Addressing Legacy Issues: Reforms and changes in the sector have addressed legacy issues such as non-performing assets (NPAs), making the banking system more resilient.
  • Internal Accruals: The internal accruals have become a significant source of growth capital for banks, enhancing their financial stability.
  • Technological Advancements: Banks in India have moved away from traditional, brick-and-mortar models to embrace advanced technology. Products such as mobile banking apps, UPI, Aadhaar e-KYC, and digital payment systems have transformed the banking landscape.

The role of artificial intelligence (AI)

  • Knowledge-Based Regime: India’s banking system is undergoing a transition toward a knowledge-based regime, primarily driven by AI and cognitive computing technologies. This shift represents a move away from traditional banking practices toward more data-driven and intelligent operations.
  • Personalization of Customer Engagement: AI is enabling banks to personalize customer engagement. Through AI-powered capabilities, banks can gain a deeper understanding of individual customer preferences and needs. This personalization enhances the overall customer experience.
  • Deeper Understanding of Customers: AI facilitates a more profound insight into customers’ behaviors and financial needs. By analyzing data and utilizing machine learning algorithms, banks can develop a comprehensive understanding of their customers, allowing for more targeted services.
  • Adaptation to a Changing Business Environment: In a landscape characterized by constant change, AI serves as a valuable tool for ensuring banks remain agile and responsive to shifting demands.
  • Challenges and Opportunities: While AI presents significant opportunities for banks, it also poses challenges. Banks must address issues related to data privacy, ethical considerations, and the potential biases inherent in AI algorithms.
  • Key to Future Success: AI will be a pivotal factor in differentiating successful banks in the coming years. Banks that effectively harness AI technologies are likely to maintain their competitiveness and adapt to the changing demands of customers and the business landscape.

What are the Challenges?

  • Digitalization Challenges: The digitalization of banking services has introduced several challenges. These include the proliferation of unregulated digital lending apps, the emergence of cryptocurrencies, and the risk of cyberattacks.
  • Cybersecurity Risks: There is a need to address cybersecurity risks. As digitalization advances, banks are increasingly vulnerable to cyber threats and attacks.
  • Critical Support Infrastructure: With the increasing reliance on digital banking channels, ensuring the availability of critical support infrastructure becomes paramount. This encompasses maintaining secure payment settlement systems, safeguarding ATMs, and ensuring the continuity of internet and mobile banking services.
  • Data Challenges: As banks increasingly rely on data for decision-making and personalization, addressing methodological and data challenges is essential. Ensuring data accuracy, security, and compliance with privacy regulations is a responsibility that banks must prioritize.

Way forward

  • Customer Grievances: The digital banking era comes with added responsibilities related to addressing customer grievances efficiently. Banks must establish mechanisms to handle and resolve customer complaints promptly to ensure the uninterrupted delivery of banking services.
  • Regulator frameworks: These digitalization-related challenges require banks to adopt robust security measures and regulatory frameworks to protect both customers and the financial system.
  • Climate Change Imperative: Initiatives for decarbonization present opportunities in renewables, green hydrogen, and green goods trade. Banks are expected to be major financiers in combating climate change, necessitating robust risk management practices.
  • Investment in Human Resources: In an ever-changing environment, the quality of human resources becomes a critical differentiator. Banks and financial institutions must attract, train, and retain talent while fostering adaptability and upskilling.
  • Innovation and Governance: Financial services must invest in research and embrace out-of-the-box ideas for seamless service delivery and product personalization. Governance remains the backbone of institutions and is crucial for financial stability.

Conclusion

  • India’s banking sector has endured and evolved, emerging from a challenging decade more resilient and adaptable. With a focus on robust governance, innovation, and a growing domestic market, it is poised to play a crucial role in India’s journey towards an Atmanirbhar Bharat, promoting equitable and sustainable development.

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Banking Sector Reforms

Self-Regulatory Organizations (SROs) in the Fintech Sector

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Self-Regulatory Organizations (SROs)

Mains level: Not Much

sro

Central Idea

  • In the rapidly evolving landscape of the fintech sector, the Reserve Bank of India (RBI) Governor has called upon fintech entities to establish Self-Regulatory Organizations (SROs).

What is an SRO (Self-Regulatory Organization)?

  • An SRO is a non-governmental entity entrusted with the task of formulating and enforcing rules and standards governing the behaviour of participants within a specific industry.
  • The primary objective of an SRO is to safeguard consumer interests, uphold ethical practices, promote equality, and nurture professionalism within the industry.
  • Typically, SROs collaborate with all industry stakeholders to establish and administer regulations.

Key Characteristics of an SRO

  • Impartial Governance: SROs maintain impartial mechanisms to oversee self-regulatory processes, ensuring that industry members operate within a disciplined framework and accept penalties when necessary.
  • Beyond Industry Interests: SROs extend their concerns beyond the narrow interests of the industry itself. They aim to protect not only industry players but also workers, customers, and other participants in the ecosystem.
  • Supplement to Existing Regulations: While SROs formulate regulations, standards, and mechanisms for dispute resolution and enforcement, they do not replace applicable laws or government regulations. Instead, they complement existing legal frameworks.

Functions of an SRO

  • Communication Channel: SROs serve as intermediaries between their members and regulatory authorities like the RBI, facilitating two-way communication.
  • Establishment of Standards: SROs work to establish minimum benchmarks and industry standards, fostering professionalism and healthy market behavior among their members.
  • Training and Awareness: SROs provide training to their members’ staff and conduct awareness programs to promote industry best practices.
  • Grievance Redressal: They establish uniform grievance redressal and dispute management frameworks to resolve issues within the industry.

Why is an SRO Necessary?

  • As the fintech sector continues to evolve, SROs can play a pivotal role in ensuring the industry’s responsible growth and maintaining ethical standards.
  • They address critical issues such as market integrity, conduct, data privacy, cybersecurity, and risk management.
  • SROs contribute to building trust among consumers, investors, and regulators.

RBI’s Expectations from Fintech Players

  • The Reserve Bank of India expects fintech companies to:
  1. Evolve industry best practices and privacy/data protection norms in compliance with local laws.
  2. Set standards to prevent mis-selling and promote ethical business practices.
  3. Ensure transparency in pricing.
  • RBI Governor has encouraged fintechs to establish an SRO voluntarily.

Benefits of an SRO

  • Industry Expertise: SROs possess deep industry knowledge, making them valuable contributors to industry discussions and educational initiatives.
  • Standardized Conduct: SROs promote a standardized code of conduct that encourages ethical business practices, ultimately boosting confidence in the industry.
  • Watchdog Role: SROs act as watchdogs, preventing unprofessional and unethical practices within the industry.

Conclusion

  • In the dynamic fintech sector, Self-Regulatory Organizations (SROs) emerge as indispensable entities.
  • Their role in shaping industry behaviour, promoting ethical conduct, and safeguarding consumer interests cannot be overstated.

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Banking Sector Reforms

Urban Cooperative Banks (UCBs): Concerns and Considerations

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Urban Cooperative Banks (UCBs)

Mains level: Not Much

Central Idea

  • The Reserve Bank of India (RBI) Governor recently addressed the issues and vulnerabilities surrounding Urban Cooperative Banks (UCBs), highlighting the importance of addressing these concerns.

What are Urban Cooperative Banks (UCBs)?

  • UCBs are primary cooperative banks primarily situated in urban and semi-urban areas, catering to the financial needs of small borrowers and businesses.
  • They are governed by the Banking Regulations Act, 1949, the Banking Laws (Cooperative Societies) Act, 1955, and registered under the Cooperative Societies Act of the respective State.
  • Initially, UCBs were permitted to lend exclusively for non-agricultural purposes; however, they have diversified their size and operations since 1996.
  • Approximately 79% of UCBs are concentrated in five states: Andhra Pradesh, Gujarat, Karnataka, Maharashtra, and Tamil Nadu.

Types of UCBs

UCBs are categorized into different tiers by the RBI based on their deposit size:

  • Tier 1: Deposits up to Rs 100 crore.
  • Tier 2: Deposits ranging from Rs 100 to 1,000 crore.
  • Tier 3: Deposits between Rs 1,000 to Rs 10,000 crore.
  • Tier 4: Deposits exceeding Rs 10,000 crore.

Key concerns/addresses raised by RBI

(1) Operational Stability

  • UCBs must enhance their financial and operational resilience to contribute to the overall stability of the financial and banking sector.
  • The quality of governance within UCBs plays a pivotal role in ensuring the stability of these individual banks.

(2) Setting up right priorities

  • Boards and directors of UCBs must prioritize integrity and transparency in financial reporting, refraining from innovative accounting practices that obscure the actual financial position.
  • Proactive management of Asset Liability is essential to manage liquidity risk systematically.
  • Establishing robust IT and cybersecurity infrastructure, along with the availability of necessary skills at the bank level, is crucial.
  • Governance practices, especially those related to Compliance, Risk Management, and Internal Audit, need strengthening.

(3) Functioning of Boards

  • Ensuring directors possess adequate skills and expertise.
  • Constituting a professional board of management.
  • Considering the diversity and tenure of board members.
  • Promoting transparent and participatory board discussions.
  • Ensuring the effective functioning of board-level Committees.

(4) Credit Risk Management

  • Upholding risk management through robust underwriting standards.
  • Implementing effective post-sanction monitoring.
  • Timely recognition and mitigation of emerging stress.
  • Pursuing follow-ups with large Non-Performing Asset (NPA) borrowers to facilitate recovery and maintain adequate provisioning.

Conclusion

  • Addressing the concerns and vulnerabilities in Urban Cooperative Banks is vital for the overall stability and resilience of the banking sector.
  • The RBI’s recommendations highlight the importance of governance, risk management, and transparency in ensuring the health of UCBs.

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Banking Sector Reforms

How NBFCs can be used to address the problem of credit inadequacy in India

Note4Students

From UPSC perspective, the following things are important :

Prelims level: NBFCs and other related concepts

Mains level: credit inadequacy and the role of NBFCs

What’s the news?

  • India’s Non-Banking Financial Company (NBFC) sector is on a path of recovery after a turbulent period following the collapse of IL&FS and the challenges posed by the COVID-19 pandemic.

Central idea

  • India’s NBFC sector’s revival aids credit flow in tandem with banks, bolstered by upgraded outlooks from ICRA due to enhanced oversight, wider bank credit, robust market performance, reduced NPAs, and higher provisions. However, Ind-Ra and Fitch’s caution highlights concerns over certain NBFCs’ unsecured credit exposures.

Non-Banking Financial Company (NBFC)

  • A NBFC is a financial institution that offers various financial services similar to those offered by traditional banks, but it does not hold a banking license and cannot accept deposits from the public.
  • NBFCs provide services such as loans and credit, investment and wealth management, insurance services, money market operations, and other financial products.
  • They play a crucial role in extending credit to sectors of the economy that might not be served by traditional banks, contributing to financial inclusion and overall economic growth.

What is credit inadequacy?

  • Credit inadequacy refers to the insufficiency of available credit or loans to meet the financial needs and investment requirements of various sectors within an economy.
  • In the context of India, it signifies a situation where the amount of credit available from traditional banking sources is limited and falls short of what is required to support economic growth, business expansion, and other investment activities.

What are credit sources?

  • Credit sources refer to the origins or channels through which funds are made available for lending or borrowing purposes.

Credit sources within the Indian financial system

  • Credit Flow through Financial Intermediaries (Banks and NBFCs):
  • This channel involves banks and Non-Banking Financial Companies (NBFCs) acting as intermediaries between savers and borrowers.
  • Banks collect deposits from individuals and businesses and then lend these funds to borrowers in the form of loans.
  • NBFCs, while similar to banks, cannot accept deposits but can still provide credit by borrowing from other financial institutions or markets and lending those funds to borrowers.
  • Market credit through bond markets:
  • This channel involves borrowing and lending directly through the financial markets.
  • Various participants, like mutual funds, insurance companies, and banks, engage in the bond market.
  • Borrowers issue bonds, which are essentially debt instruments, and investors purchase these bonds, effectively lending money to the issuers in return for interest payments.

Evolution of credit and banking sector challenges

  • Historical Credit Growth:
  • Between 1991 and the early 2000s, annual bank credit expanded by 15% on average.
  • From 2003 to 2008, the growth rate surged to 28%, driven by optimistic disbursements for the commercial sector due to positive growth outlook.
  • Challenges and Non-Performing Assets (NPAs):
  • The rapid credit expansion of 2003-2008 led to an increase in non-performing assets (NPAs) during the early 2010s.
  • The Reserve Bank of India (RBI) introduced asset quality reviews in 2016 as NPAs rose from 3.4% to 10% between 2013 and 2017.
  • The rise in bad assets hampered banks appetite for commercial sector exposure, leading to a shift towards retail loans.
  • Credit Slowdown and NBFC Emergence:
  • Bank credit growth declined after 2016, reaching 10% annually pre-Covid, and further dropping to 7% during the pandemic.
  • This slowdown created an opportunity for Non-Banking Financial Companies (NBFCs) to step in and bridge the credit gap.
  • NBFCs compensated for reduced bank credit, particularly in MSMEs and real estate, where they contributed 60% of incremental credit flows between 2014 and 2018.
  • Disruption and Liquidity Crisis:
  • A major infrastructural lending-focused NBFC’s collapse in 2018 created a sector-wide contagion.
  • Both commercial banks and NBFCs experienced a sharp decline in incremental credit, resulting in liquidity challenges.
  • This crisis highlighted the vulnerability of NBFCs due to concentrated liability books and disrupted funding sources.

Significance of NBFCs in a capital-constrained nation like India?

  • Filling the Credit Gap: In a country where credit flow is limited, NBFCs step in to bridge the credit gap, particularly in sectors like MSMEs and real estate. They contribute 60% of incremental credit flows to these sectors, supporting their growth and development.
  • Niche Expertise: NBFCs possess specialized sectoral expertise and flexibility in underwriting. They can evaluate borrowers based on unconventional parameters, extending credit to segments that traditional banks might consider riskier.
  • Financial Inclusion: NBFCs extend credit to underserved and remote regions where traditional banks have limited reach. This contributes to financial inclusion by providing loans to individuals and businesses that might otherwise be excluded from the formal credit system.
  • Timely Investment: With quick and efficient loan processing, NBFCs enable timely investment and economic activity. This agility is crucial in addressing credit needs promptly, supporting growth in various sectors.
  • Alternative Funding: NBFCs raise funds through diverse channels such as bank borrowings, market issuances, and commercial papers. This alternative funding approach ensures that credit is available even when traditional banking sources face limitations.
  • Complementary Role: NBFCs complement traditional banks by extending credit and financial services. They serve as an alternative credit avenue, ensuring a broader spectrum of borrowers can access the funds needed for their ventures.
  • MSME and Real Estate Focus: NBFCs’ emphasis on MSME and real estate financing fills a critical gap. These sectors, vital for India’s growth, often face challenges in accessing credit from traditional banks due to perceived risks or constraints.
  • Sectoral Growth: NBFCs, with their specialized approach, contribute to sectoral growth. For instance, they supported 60% of incremental credit flows to MSMEs and real estate developers between 2014 and 2018, facilitating expansion in these key sectors.
  • Diversified Credit Landscape: NBFCs enhance the overall credit landscape by offering an alternative credit channel. Their presence helps distribute credit more evenly across sectors, promoting balanced economic growth.

How can NBFCs be used to address the problem of credit inadequacy in India?

  • Targeted Credit Access: NBFCs can cater to segments that traditional banks might find riskier or less viable, such as MSMEs and real estate developers. Their specialized approach, nimbleness, and sectoral expertise allow them to provide tailored credit solutions to these underserved sectors.
  • Financial Inclusion: NBFCs extend credit to areas where traditional banks have limited reach, fostering financial inclusion. They can provide loans to individuals and businesses in remote and underserved regions, contributing to economic growth across the nation.
  • Flexibility in Underwriting: NBFCs often adopt innovative and tech-enabled approaches for assessing creditworthiness. This enables them to evaluate borrowers based on unconventional parameters, extending credit to those who might not meet traditional banking criteria.
  • Quick and Efficient Processes: NBFCs, with streamlined operations, can offer faster loan approvals and disbursements. This agility in processing loans can bridge the credit gap more rapidly, supporting timely investment and economic activities.
  • Sectoral Focus: NBFCs can concentrate on specific sectors or niches, catering to unique credit requirements. For instance, they can offer specialized real estate financing or support to micro and small businesses, contributing to sectoral growth.
  • Liquidity Channels: NBFCs can raise funds through various channels, including bank borrowings, market issuances, and commercial papers. This diversity in funding sources enables them to overcome liquidity challenges more effectively.
  • Diversification of Funding Sources: For sustainable growth, NBFCs can diversify their funding sources to reduce reliance on specific channels, reducing vulnerability to liquidity shocks, as highlighted in the article.
  • Complementing the Banking System: NBFCs complement traditional banks in extending credit and financial services. Their presence provides an alternative credit avenue, ensuring that credit is available to a wider spectrum of borrowers.

Conclusion

  • In a country where financial inclusion and access to bank credit remain challenges, NBFCs play a vital role in reaching underserved segments. Learning from the crisis of 2018–2021, diversifying funding sources, and implementing short-term liquidity buffers can fortify NBFCs against future shocks.

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Banking Sector Reforms

De-dollarisation: Is it a gateway to rupeefication?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Key concepts: rupeefication, Dollarisation, De-dollarisation

Mains level: De-dollarisation, rupeefication advantages and challenges

dollarisation

What’s the news?

  • Countries worldwide are pursuing de-dollarisation to reduce reliance on the US dollar in international trade, exploring bilateral currency agreements and strategies like rupeefication.

Central idea

  • In the past century, a single currency has dominated the global economy, transitioning from the pound sterling to the US dollar, now comprising 59.02% of COFER. The US dollar’s prevalence is due to its pivotal role in international trade. India’s push for the Indian Rupee’s use in trade showcases this trend, aiming at bolstering economic autonomy.

What is meant by Dollarisation?

  • US dollar as a substitute for domestic currency: Dollarisation refers to the phenomenon where countries adopt the US dollar as a substitute for their domestic currency to varying degrees.
  • This practice can take several forms:
  • Financial dollarisation (substituting domestic assets/liabilities with foreign ones)
  • Real dollarisation (pegging domestic transactions to exchange rates)
  • Transactional dollarisation (using the US dollar for domestic transactions)
  • Poor performance of the domestic currency:
  • Dollarisation typically arises due to the poor performance of the domestic currency, caused by factors such as political instability or economic uncertainty.
  • It can also result from financial market liberalization and economic integration, leading to reduced exchange rate risk and increased capital inflow.
  • The US dollar’s dominance: The US dollar’s dominance as an anchor currency for international trade contributes to its widespread acceptance and high demand, thereby driving dollarisation trends.

What is meant by De-dollarisation?

  • De-Dollarisation refers to the global trend of countries reducing their reliance on the US dollar in international trade and financial transactions.
  • This movement involves shifting towards bilateral currency agreements, using domestic currencies for trade, and promoting alternatives to the dollar.
  • The aim is to achieve greater economic autonomy, reduce risks associated with dollar fluctuations, and challenge the dominance of the US dollar in the global financial system.

What is meant by Rupeefication?

  • Rupeefication refers to the process of internationalizing the Indian Rupee (INR) by promoting its use in international trade and financial transactions.
  • This strategy involves enabling trade partners to transact in INR, issuing financial instruments denominated in INR to foreign entities, and facilitating greater access to the INR in global markets.
  • The objective of rupeefication is to enhance the INR’s status as a global currency, reduce dependence on the US dollar, and strengthen India’s economic resilience and autonomy on the global stage.

De-dollarisation in motion

  • Brazil’s Bilateral Currency Trade: Brazil is expanding bilateral currency trade agreements, notably with Japan and China. These agreements involve using domestic currencies for trade, reducing reliance on the US dollar.
  • China’s Leadership in De-Dollarisation: Following sanctions against Russia, China has been at the forefront of reducing dollar reliance. China’s actions have prompted other BRICS nations to follow suit in decreasing dollar usage.
  • Indonesia’s Local Currency Trade System: Indonesia has adopted a Local Currency Trade (LCT) system to lower the role of the US dollar in its current account transactions. This shift aims to promote greater usage of domestic currency.
  • Africa’s Consideration for Intra-Africa Trade: African nations are contemplating replacing the US dollar with domestic currencies for intra-Africa trade. This approach aligns with the broader global trend of de-dollarisation.
  • BRICS Summit and Integrated Payment System: The upcoming BRICS Summit will address the challenges of de-dollarising trade and establishing an integrated payment system. This reflects the growing global emphasis on reducing dollar dependence.
  • India’s Multi-Faceted Approach: India, while pursuing de-dollarisation, also considers bilateral currency agreements. However, it might opt out of a common BRICS currency due to existing trade commitments with the US and Europe

How is India actively advancing its systems to bypass the US dollar and fortify the INR?

  • Bilateral Currency Agreements: India is engaging in bilateral currency agreements with multiple nations. These agreements encourage trade partners to transact in INR instead of the US dollar, reducing the reliance on the dollar in international trade transactions.
  • Special Rupee Vostro Accounts (SRVAs): India has established Special Rupee Vostro Accounts with various countries, including the UK, Russia, Sri Lanka, and Germany. These accounts enable foreign entities to transact in INR directly with Indian banks, promoting the use of the Indian currency.
  • Currency Internationalization: By promoting the use of INR in international transactions, India aims to increase the acceptance of its currency in global markets. This strategy involves initiatives to make INR more widely recognized and used beyond its borders.
  • Reducing Dollar Dependency: India’s efforts to develop systems that bypass the dollar aim to reduce the country’s dependence on the US dollar for international trade and financial transactions. This can enhance India’s economic autonomy and mitigate the risks associated with fluctuations in the value of the dollar.
  • Enhancing the INR’s Global Role: Strengthening the INR involves making it a viable alternative to the US dollar in global transactions. By creating systems that support the use of INR in trade and finance, India aims to increase the currency’s global significance.

Advantages of rupeefication

  • Risk Mitigation for Exporters: Rupeefication provides exporters with a means to limit their exposure to exchange rate risks. By invoicing trade in INR, exporters can avoid the uncertainties associated with fluctuating US dollar exchange rates, enhancing predictability in their earnings.
  • Deepened Markets and Wider Access: The adoption of rupeefication can lead to increased market access and deeper trade relationships. As the INR gains wider acceptance, exporters can tap into new markets and expand their customer base.
  • Lower Borrowing Costs for the Private Sector: Rupeefication enables the private sector to access international financial markets with reduced borrowing costs. This can result in enhanced profitability and investment opportunities for businesses.
  • Public Sector Financing Flexibility: The public sector benefits from the ability to issue international debt denominated in INR. This provides an alternative source of financing for government projects without depleting official US dollar reserves.
  • Strengthened Economic Autonomy: By promoting rupeefication, India can gradually reduce its reliance on the US dollar, leading to increased economic autonomy. This reduces vulnerability to external economic shocks and fluctuations in the value of the dollar.
  • Microeconomic Growth and Livelihoods: A focus on rupeefication encourages the growth of the private sector, leading to increased economic activities and job opportunities. This approach can contribute to the improvement of livelihoods across various sectors.
  • Enhanced Monetary Policy Autonomy: As rupeefication gains traction, India can exercise more control over its domestic monetary policy. This autonomy allows for tailored economic measures that align with the country’s specific needs.

Potential challenges associated with its implementation

  • Exchange Rate Volatility: Shifting towards rupeefication could expose businesses to exchange rate volatility if the INR’s value fluctuates significantly against other major currencies. This could impact the predictability of earnings and increase risks for exporters.
  • Limited Acceptance in International Markets: Achieving widespread acceptance of the INR in global markets might be challenging. Many international transactions are still predominantly conducted in the US dollar, which could hinder the seamless adoption of rupeefication.
  • Global Economic and Political Factors: External economic and political events can impact the feasibility of rupeefication. Global factors such as economic crises or geopolitical tensions could influence the willingness of other nations to engage in transactions using the INR.
  • Trade Balance and Reserves: A swift shift to rupeefication might impact India’s trade balance and foreign exchange reserves, potentially necessitating greater reserves of foreign currencies to manage trade deficits.
  • Gradual Implementation: Rapidly transitioning to rupeefication might lead to economic disruptions.

Way forward

  • Gradual Transition: To address the challenges and uncertainties associated with shifting towards rupeefication, a gradual and phased approach is recommended. This allows businesses, financial institutions, and the economy as a whole to adapt to the changes smoothly.
  • Macroeconomic Stability: Maintaining macroeconomic stability is crucial. Efforts should be directed toward ensuring the stability of the INR’s value to inspire confidence among trade partners and investors.
  • Promoting INR Use: Initiatives to promote the use of the INR in international transactions should be continued. This could involve diplomatic efforts to foster bilateral agreements, increasing awareness about the benefits of INR invoicing, and addressing concerns about exchange rate risk.
  • Collaborative Approach: Collaborating with other nations and international organizations is essential. The adoption of rupeefication requires cooperation and coordination among various stakeholders to establish the INR as a viable global currency.
  • Balancing Trade and Reserves: Balancing trade and managing foreign exchange reserves remain crucial. Gradual rupeefication should align with maintaining a stable trade balance and adequate reserves to manage potential deficits.

Conclusion

  • While the journey towards de-dollarisation and rupeefication is multifaceted and not devoid of challenges, India’s persistent efforts to limit dollar reliance while nurturing the international status of the INR underscore its commitment to greater economic autonomy. By gradually integrating the INR into the global financial landscape, India aims to bolster its economic resilience, promote growth, and enhance its position as a global economic player.

Also read:

The Future of the US Dollar As a World Reserve Currency

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Banking Sector Reforms

Full-Reserve Banking vs. Fractional-Reserve Banking

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Full-Reserve Banking

Mains level: Not Much

bank

Central Idea

  • Full-reserve banking, also known as 100% reserve banking, and fractional-reserve banking are two different systems of banking that determine how banks handle customer deposits and lending practices.
  • This article discusses the key differences between these two banking systems and the arguments put forth by proponents of each approach.

What is Full-Reserve Banking?

  • Custodian Role: In a full-reserve banking system, banks hold all money received as demand deposits from customers in their vaults, acting as safekeepers of depositors’ funds.
  • Limited Lending: Banks can only lend money from time deposits, which customers can withdraw after an agreed-upon period.
  • Preventing Bank Runs: The full reserve ensures banks can meet depositor demands even if all customers seek to withdraw their money simultaneously, reducing the risk of a bank run.
  • Restricted Money Supply: Banks cannot create money through loans, limiting their influence on the economy’s money supply and potentially preventing artificial booms and busts.

Contrary Idea: Fractional-Reserve Banking

  • Lending with Electronic Money: Banks in a fractional-reserve system predominantly lend in the form of electronic money, allowing them to lend more than the physical cash they have in vaults.
  • Risk of Bank Runs: Although electronic money minimizes cash withdrawals, excessive loans can lead to a bank run if depositors demand cash that exceeds the actual cash reserves.
  • Supporting Economic Growth: Proponents argue that fractional-reserve banking fuels investment and economic growth by allowing banks to create loans without relying solely on customer savings.

Arguments for both systems

  • Fractional-Reserve Banking: Supporters believe fractional-reserve banking frees the economy from the constraints of real savings, stimulating investment and growth.
  • Full-Reserve Banking: Supporters argue that full-reserve banking is more natural, prevents bank runs, and limits banks’ ability to create money, which could prevent economic instability.

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Banking Sector Reforms

Bad loans at record low, but write-offs still in the mix

Note4Students

From UPSC perspective, the following things are important :

Prelims level: NPA, Writ off, its direct and indirect impact on financial stability

Mains level: NPA's, implications for banks and economy as a whole

What is the news?

  • The latest financial stability report released by the Reserve Bank of India (RBI) shows a continuous decline in both Gross Non-performing assets (GNPAs) and Net NPAs, reaching their lowest levels since 2015.

Central Idea

  • In recent years, the Indian banking sector has witnessed a remarkable turnaround in its non-performing assets (NPA) ratio, marking a significant improvement in its overall health. Just four years ago, Indian banks grappled with the highest NPA ratio among emerging economies.

What are Bad loans/ Non-Performing Assets (NPA’s)?

  • Bad loans refer to loans that are classified as non-performing assets
  • NPA is a term used to classify loans or advances that are in default. It indicates the inability of borrowers to fulfill their repayment obligations to the lender.
  • In general, a loan is classified as an NPA when the borrower fails to make payments for a specified period, typically 90 days or more.

There are two key classifications related to NPAs:

  • Gross Non-Performing Assets (GNPA): This refers to the total amount of loans or advances that have been defaulted by borrowers.
  • Net Non-Performing Assets (NNPA): NNPA is derived by deducting the provision amount from the GNPA. Provision refers to the amount set aside by banks or financial institutions as a precautionary measure to cover potential losses arising from NPAs.

Background and Current Situation

  • During the second quarter of 2019, the NPA ratio in Indian banks stood at a worrisome 9.2%, signifying that nearly one in ten loans had become bad.
  • The severity of the problem was unveiled when the RBI conducted an expansive Asset Quality Review in 2016, exposing the true extent of bad loans.
  • From 2016 to 2019, the NPA ratio remained high, causing apprehension among stakeholders.
  • However, subsequent years witnessed a decline in the NPA ratio, a trend that persisted even during the challenging times of the COVID-19 pandemic.

Factors contributing to the decline in NPAs

  • Insolvency and Bankruptcy Code (IBC): The implementation of the Insolvency and Bankruptcy Code in 2016 played a crucial role in the recovery of sick loans. It provided a structured and time-bound framework for resolving distressed assets, leading to improved NPA management and recovery.
  • Shift towards personal loans: Banks shifted their lending focus from industries to personal loans. This strategic move reduced the exposure to sectors heavily impacted by the pandemic, potentially mitigating the risks of loan defaults and lowering the NPA ratio.
  • Impact of COVID-19-related moratoriums: There were concerns about the potential increase in NPAs resulting from the COVID-19-related moratoriums. However, the data indicated that the moratoriums did not lead to a significant bump in NPAs, as initially expected. This suggests that the measures implemented to support borrowers during the pandemic were effective in preventing a major NPA crisis.
  • Write-offs: The reduction in NPAs, particularly in FY20, can be attributed to the practice of writing off bad loans. Banks voluntarily wrote off NPAs to maintain healthy balance sheets, which had a positive impact on the overall NPA ratio. However, the continued reliance on write-offs raises concerns about the sustainability of this approach in the long run.

What are Write-Offs?

  • Write-offs refer to the practice of removing non-performing assets (NPAs) from a bank’s balance sheet. When a loan becomes irrecoverable and the borrower is unable to repay, the bank may decide to write off the loan as a loss.
  • This means that the bank no longer considers the loan as an asset and removes it from its books.
  • Write-offs are typically done to maintain accurate financial records and reflect the true value of the bank’s assets

Concerns highlighted regarding write-offs

  • Sustainability of NPA Reduction: Write-offs may artificially lower NPAs, but heavy reliance raises doubts about sustainable NPA reduction without effective recovery measures.
  • Adequacy of Provisioning: Insufficient provisions to cover losses due to write-offs can weaken a bank’s financial position and ability to absorb future shocks.
  • Transparency and Accountability: Ensuring transparent and accountable write-off processes is crucial to prevent misuse and maintain trust in the banking system.
  • Impact on Lending Capacity: Write-offs reduce available capital, limiting a bank’s ability to lend and support economic growth. Inadequate replenishment may further constrain lending.

Decline in NPAs: Implications for the banks

  • Improved Asset Quality: A decrease in NPAs indicates an improvement in the asset quality of banks. It suggests that a lower proportion of loans are in default or arrears, reflecting healthier lending practices and reduced credit risk. Banks with lower NPAs are better positioned to maintain stability and profitability in their loan portfolios.
  • Enhanced Financial Health: Declining NPAs contribute to the overall financial health of banks. As the burden of bad loans decreases, banks can allocate resources more efficiently and utilize capital for productive purposes. This improves the banks’ ability to generate profits and strengthens their financial position.
  • Increased Profitability: Lower NPAs positively impact banks’ profitability. When the proportion of bad loans decreases, banks experience fewer loan write-offs and provisioning requirements. This results in lower expenses associated with NPA resolution and provisioning, thereby enhancing profitability and improving the bottom line.
  • Strengthened Capital Position: A decline in NPAs can lead to a strengthened capital position for banks. As they recover or resolve NPAs, banks can allocate capital more effectively and build buffers against potential losses. A stronger capital position provides resilience and stability to the banks, ensuring they can absorb shocks and maintain sustainable lending practices.
  • Improved Investor Confidence: Decreasing NPAs can boost investor confidence in the banking sector. It demonstrates efficient risk management and sound lending practices, attracting investors and potentially leading to increased investments in banks. Enhanced investor confidence can contribute to the stability and growth of the banking sector.
  • Enhanced Lending Capacity: With lower NPAs, banks can allocate more funds towards fresh lending and credit expansion. As the burden of bad loans reduces, banks have more capital available to extend credit to productive sectors of the economy, supporting economic growth and development

Conclusion

  • Indian banks have made remarkable progress in reducing NPAs, as evident from the declining NPA ratios and improved profitability. However, the reliance on write-offs raises concerns about the sustainability of this trend. To ensure long-term stability, banks must prioritize prudent lending practices and effective risk management.

Also read:

Sansad TV Perspective: Health of India’s Banking System

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Banking Sector Reforms

NaBFID to Boost Infrastructure Financing

Note4Students

From UPSC perspective, the following things are important :

Prelims level: NaBFID

Mains level: Not Much

Central Idea

  • The National Bank for Financing Infrastructure & Development (NaBFID) is making significant strides in infrastructure financing, with ambitious goals for loan disbursement and expansion.
  • Operational for less than a year it has already made substantial progress in lending and aims to further strengthen its presence in the infrastructure sector.

What is NaBFID?

  • The NBFID was established in 2021 through the enactment of The National Bank for Financing Infrastructure and Development Act, 2021.
  • It serves as a specialized Development Finance Institution (DFI) in India.
  • Its primary objectives include addressing the gaps in long-term non-recourse finance for infrastructure development, strengthening the development of bonds and derivatives markets in India, and fostering sustainable economic growth.
  • The Reserve Bank of India (RBI) will regulate and supervise NBFID as an All-India Financial Institution (AIFI).
Development Finance Institutions (DFIs): They are government-owned or public institutions that provide funding for infrastructure and large-scale projects. They play a crucial role in financing projects that are often unviable for traditional banks to lend to. DFIs offer two types of funds: Medium-term funds with a maturity period of 1-5 years, and Large-scale funds with a maturity period exceeding 5 years.

 

Loan Disbursement and Expansion Targets

  • Disbursement Target: NaBFID aims to disburse approximately ₹60,000 crore by the end of this fiscal year, showcasing its commitment to fostering infrastructure development.
  • Sanctioning Loans: NaBFID is poised to sanction loans amounting to ₹1 lakh crore during this fiscal year. These loans will be directed towards both greenfield and brownfield assets in the vital infrastructure space.
  • Debt Raise: Recently, NaBFID successfully raised ₹10,000 crore through debt issuance, signalling the institution’s ability to attract substantial funding.
  • High Demand: The debt issuance received an overwhelming response, with bids worth ₹23,629.50 crore, nearly five times the base issue of ₹5,000 crore.
  • Largest Debt Issuance: The debt securities, with a 10-year tenor, mark the largest debt issuance by a national-level institution.

 

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Banking Sector Reforms

Deposit Insurance Cover for PPIs

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Prepaid Payment Instrument (PPI), DICGC

Mains level: Not Much

Central Idea

  • Recommendation for DICGC cover extension: A committee suggests extending Deposit Insurance and Credit Guarantee Corporation (DICGC) cover to Prepaid Payment Instrument (PPI) holders to protect against fraud and unauthorized transactions.
  • Relief for PPI holders: Acceptance of the recommendation would provide significant relief to PPI holders.

Understanding Prepaid Payment Instrument (PPI)

  • Definition: PPIs are instruments facilitating various financial transactions and the purchase of goods and services.
  • Types: PPIs can be categorized as small PPIs and full-KYC PPIs, issued as cards or wallets.
  • Loading/reloading options: PPIs can be loaded/reloaded with cash, debit/credit cards, or bank transfers.

Issuers of PPI Instruments

  • Authorized issuers: Banks and non-banks authorized by the RBI can issue PPIs.
  • Examples of authorized issuers: Airtel Payments Bank, Axis Bank, Union Bank, and others are permitted to issue and operate PPIs.
  • Non-bank PPI issuers: Amazon Pay (India), Bajaj Finance, Ola Financial Services, and others also offer PPI services.

RBI Committee’s Recommendations

  • Call for DICGC cover examination: The committee recommends examining the extension of DICGC cover to bank and non-bank PPIs.
  • Purpose of examination: Considering PPIs as deposits held with regulated PPI issuers requires further examination.

Understanding DICGC

  • Role of DICGC: DICGC, a subsidiary of the RBI, provides deposit insurance.
  • Protection for depositors: DICGC ensures the stability of the financial system by protecting small depositors in the event of a bank failure.
  • Coverage scope: DICGC covers commercial banks, payments banks, small finance banks, regional rural banks, and cooperative banks licensed by the RBI.

DICGC Coverage and Limits

  • Types of deposits covered: DICGC insures savings, fixed, current, recurring, and accrued interest deposits.
  • Maximum insurance limit: Each depositor is insured up to a maximum of Rs 5 lakh for both principal and interest amounts.
  • Increase in insurance cover: The insurance cover was raised to Rs 5 lakh in 2020 from the previous limit of Rs 1 lakh.

Total Number of PPIs

  • PPI quantity as of March 31, 2023: The system comprised 16,185.26 lakh PPIs, including 13,384.68 lakh wallets and 2,800.58 lakh cards.
  • Transaction volume in FY2023: The total volume transacted through PPIs in FY2023 reached 74,667.44 lakh.

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Banking Sector Reforms

Credit cards put under Liberalised Remittance Scheme (LRS)

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Liberalised Remittance Scheme (LRS)

Mains level: Not Much

Central Idea: The Centre has amended rules under Foreign Exchange Management Act (FEMA) Rules, bringing international credit card spends under the Liberalised Remittance Scheme (LRS).

Changes introduced

  • Credit card spends outside India now fall under the LRS, allowing for the application of a higher TCS rate.
  • The amendment removes the exclusion of credit card transactions from the LRS, which was previously covered under Rule 7 of the Foreign Exchange Management (Current Account Transaction) Rules, 2000.
  • The changes do not apply to payments for the purchase of foreign goods/services from India.

What is Liberalised Remittance Scheme (LRS)?

  • LRS is a facility provided by the Reserve Bank of India (RBI) to resident individuals to remit funds abroad for permitted current or capital account transactions or a combination of both.
  • The scheme was introduced in 2004 and has been periodically reviewed and revised by the RBI.
  • Under the scheme, resident individuals can remit up to a certain amount in a financial year for permissible transactions including education, travel, medical treatment, gifts, and investments in equity and debt securities, among others.
  • The limit for LRS is currently set at USD 250,000 per financial year.

Eligibility for LRS

  • LRS is open to everyone including non-residents, NRIs, persons of Indian origin (PIOs), foreign citizens with PIO status and foreign nationals of Indian origin.
  • The Scheme is NOT available to corporations, partnership firms, Hindu Undivided Family (HUF), Trusts etc.

Benefits provided by LRS

  • LRS is an easy process that anyone can use to transfer money between two countries.
  • It’s especially useful for businesses because they can use it to transfer funds to India, and investors can receive their investments back home.
  • LRS also has some added benefits, like fast transfer timing and no issues with exchange rates.

Concerns with credit card spends

  • The amendment aims to achieve parity between the usage of credit and debit cards, which were already covered under the LRS.
  • Instances of disproportionately high LRS payments compared to disclose incomes prompted the amendment.
  • Business visits of employees, where costs are borne by the employer, are not covered under the LRS.
  • The data collected from major money remitters under the LRS indicated that international credit cards were being issued with limits exceeding the prescribed norm.

Exclusions and impact of the Scheme

  • The government assured that the LRS scheme would not cover genuine business visits abroad by employees.
  • The imposition of a 20% tax collection on source (TCS) for foreign remittances would primarily affect tour travel packages, gifts to non-residents, and domestic high net-worth individuals investing in assets like real estate, bonds, and stocks outside India.
  • The Ministry emphasized that the 5% TCS levied on medical or education expenses abroad, allowed up to ₹7 lakh per year, and would remain unchanged.

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Banking Sector Reforms

Explained: Interest Rate Risks

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Interest Rates Risk

Mains level: Global banking crisis

interest

Central idea: Finance Minister urged banks to remain vigilant about “interest rate risks” and undertake regular stress tests during a review of public sector banks’ (PSBs) performance on March 25.

Why in news?

  • Inflation-led rising interest rates across the world have caused concerns of contagion effects from banking crises in the US and Europe.

What is Interest Rate Risk?

  • Interest rate risk refers to the possibility that a loss could happen as a result of a fluctuation in interest rates.
  • A bond’s or another fixed-income security’s value will decrease if the rate rises.
  • Interest rate movement typically has an inverse relationship with the market value of fixed-income assets.
  • In general, the values of currently issued fixed income instruments decrease when interest rates rise and rise when interest rates decrease.

How does it affect banks?

Interest rate risk affects banks in several ways-

  1. Interest yields: Banks earn interest income by lending out funds to borrowers at a higher rate than the cost of borrowing those funds. When interest rates rise, the cost of borrowing funds for banks increases, thereby decreasing their net interest margins (NIMs) and profitability.
  2. Bond yield: Banks also hold a large amount of fixed-income securities in their portfolios, such as government bonds, corporate bonds, and mortgage-backed securities. These securities generate a fixed interest income, which can be affected by changes in interest rates. When interest rates rise, the value of fixed-income securities held by banks decreases, leading to a potential loss in the value of their investment portfolio.
  3. Liabilities burden: Banks’ liabilities, such as deposits, often have short maturities, while their assets, such as loans, have longer maturities. When interest rates rise, the cost of funding short-term liabilities increases, while the interest earned on longer-term assets remains fixed. This can negatively impact banks’ profitability and cash flows.

Why do banks resort to interest rate increases?

Banks resort to interest rate increases for several reasons-

  • Combat inflation: When the economy experiences a rapid increase in prices, the central bank may raise interest rates to discourage borrowing and spending, thereby cooling down the economy and reducing inflationary pressures.
  • Attract deposits: Banks may raise interest rates to attract more deposits from savers, which in turn allows them to lend more money and earn more profits.
  • Protection against risks: banks may also raise interest rates in response to changes in the global financial market or to protect their own financial stability in the face of potential risks or shocks.

 

Try this MCQ:

Which of the following best describes interest rate risk in banking?

(a) The potential loss of income due to changes in interest rates

(b) The risk that borrowers will default on their loans due to high-interest rates

(c) The risk that banks will become insolvent due to low-interest rates

(d) The potential loss of value of a bank’s assets due to changes in interest rates

 

Post your answers here.
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Banking Sector Reforms

Explained: Silicon Valley Bank (SVB) Crisis

Note4Students

From UPSC perspective, the following things are important :

Prelims level: SVB Crisis

Mains level: Global financial crisis

silicon valley

Central idea: The shutdown and takeover of Silicon Valley Bank (SVB) by US regulators has raised questions on how it impacts India’s startup industry. It was an important partner for the global startup economy.

Silicon Valley Bank (SVB)

  • It is a financial institution that provides banking services to the technology industry and venture capital firms.
  • Founded in 1983, it has since become the go-to bank for startups and entrepreneurs in Silicon Valley and beyond.
  • It is unique in that it understands the specific needs and challenges of the tech industry, and provides a range of services that cater to startups, including loans, deposits, and investment management.
  • It has become a critical player in the startup ecosystem, providing funding and financial services to many of the world’s most successful startups, including Tesla, Uber, and LinkedIn.

What is SVB crisis?

  • SVB Financial Group runs one of the largest American commercial banks – Silicon Valley Bank.
  • Last week, it had announced a $1.75 billion share sale programme to further strengthen its balance sheet.
  • This programme triggered a massive sell-off in the group’s shares.
  • Thereafter, market went severely bearish and bear rampage wiped out over $80 billion of its market value.
  • Alongside, the bond prices of the group collapsed and created a panic in the market.

Reasons for SVB’s downfall

  • Downturn of tech stocks: The bank was hit hard by the downturn in technology stocks over the past year as well as the Federal Reserve’s aggressive plan to increase interest rates to combat inflation.
  • Lower bond yield due to lower interest rates: SVB bought billions of dollars’ worth of bonds over the past couple of years, using customers’ deposits as a typical bank would normally operate.
  • Mostly startups account holders: SVB’s customers were largely startups and other tech-centric companies that started becoming needier for cash over the past year.
  • Drying VC funding: Venture capital funding was drying up, companies were not able to get additional rounds of funding for unprofitable businesses.
  • Fear over deposit insurance: Since its customers were largely businesses and the wealthy, they likely were more fearful of a bank failure since their deposits were over $250,000, which is the government-imposed limit on deposit insurance.

Immediate effects of SVB’s failure

  • Startups scramble: Many startups and other companies that relied on the bank’s services were suddenly left without access to their funds, which caused financial strain and uncertainty for these businesses.
  • Ripple effect: They now fear that they might have to pause projects or lay off or furlough employees until they could access their funds.

Major implications for SVB

There are two large problems remaining with Silicon Valley Bank-

  • Huge uninsured deposits: The vast majority of these were uninsured due to it’s largely startup and wealthy customer base.
  • No scope for asset reconstruction: There is no potential buyer of Silicon Valley Bank.

Could this lead to a repeat of what happened in 2008?

  • No probability: At the moment, experts do not expect any issues to spread to the broader banking sector.
  • Diversified customer bases: Other banks are far more diversified across multiple industries, customer bases and geographies.

Impact on Indian startups

  • Uncertainty over deposits: The failure of SVB is likely to have a ripple effect on Indian startups, many of which have significant amounts of funds deposited with the bank.
  • Hamper the funding: SVB has been a major player in the Indian startup ecosystem, providing banking services and funding to many of the country’s most successful startups, including Flipkart, Ola, and Zomato.
  • Ripple effect: This could lead to a cash crunch for many companies, which may be forced to cut costs, delay projects, or lay off employees.
  • Reduce global footprints: SVB has also been instrumental in helping Indian startups expand into the US market, by providing them with the necessary infrastructure and support to set up operations in Silicon Valley.

How can Indian startups mitigate the impact of SVB’s failure?

  • Diversify banking relations: Indian startups that have funds deposited with SVB may want to consider diversifying their banking relationships to reduce their exposure to any one bank.
  • Alternative financing: This may involve opening accounts with multiple banks, or exploring alternative banking services such as digital banks or fintech startups.

Back2Basics: 2008 Financial Crisis

  • The bankruptcy of Lehman Brothers was a key event in the 2008 financial crisis.
  • Lehman Brothers was one of the largest investment banks in the world, with assets of around $600 billion.
  • However, the firm had invested heavily in the US housing market, and when the housing market began to decline in 2007, Lehman’s investments began to lose value.
  • In addition, the firm had taken on a large amount of debt to finance its investments and operations.
  • As the value of Lehman’s assets declined and its debt levels increased, the firm became insolvent and was unable to meet its obligations to creditors.
  • In September 2008, Lehman Brothers filed for bankruptcy, triggering a financial panic and market turmoil.

Its impact

  • The Lehman crisis had far-reaching consequences, including the collapse of other financial institutions, a global recession, and widespread economic and social hardship.
  • The crisis highlighted the risks of excessive leverage and the interconnectedness of financial institutions, and led to significant reforms in financial regulation and risk management practices.

 


 

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Banking Sector Reforms

What are Primary Agricultural Credit Societies (PACS)?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: PACS

Mains level: Rural banking mechanisms

pacs

The Union Budget has announced Rs 2,516 crore for computerization of 63,000 Primary Agricultural Credit Societies (PACS) over the next five years.

Primary Agricultural Credit Societies (PACS)

  • PACS are village level cooperative credit societies that serve as the last link in a three-tier cooperative credit structure headed by the State Cooperative Banks (SCB) at the state level.
  • Credit from the SCBs is transferred to the district central cooperative banks, or DCCBs, that operate at the district level.
  • The DCCBs work with PACS, which deal directly with farmers.
  • Since these are cooperative bodies, individual farmers are members of the PACS, and office-bearers are elected from within them.
  • A village can have multiple PACS.

What is its lending mechanism?

  • PACS are involved in short term lending — or what is known as crop loan.
  • At the start of the cropping cycle, farmers avail credit to finance their requirement of seeds, fertilisers etc.
  • Banks extend this credit at 7 per cent interest, of which 3 per cent is subsidised by the Centre, and 2 per cent by the state government.
  • Effectively, farmers avail the crop loans at 2 per cent interest only.

NPAs with PACS

  • NABARD’s annual report of 2021-22 shows that 59.6 per cent of the loans were extended to the small and marginal farmers.
  • A report published by the Reserve Bank of India on December 27, 2022 put the number of PACS at 1.02 lakh.
  • At the end of March 2021, only 47,297 of them were in profit.
  • The same report said PACS had reported lending worth Rs 1,43,044 crore and NPAs of Rs 72,550 crore. Maharashtra has 20,897 PACS of which 11,326 are in losses.

Why are PACS attractive?

  • The attraction of the PACS lies in the last mile connectivity they offer.
  • For farmers, timely access to capital is necessary at the start of their agricultural activities.
  • PACS have the capacity to extend credit with minimal paperwork within a short time.

 

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Banking Sector Reforms

UPI for NRIs: What it means for India and Indians abroad

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Unified Payment Interface (UPI)

Mains level: Digital banking in India

upi

The National Payments Corp. of India (NPCI) has allowed Indians abroad to use fast payments network UPI, if their domestic bank accounts are linked to their foreign mobile numbers.

What is UPI?

  • UPI is an instant real-time payment system developed by National Payments Corporation of India (NPCI) facilitating inter-bank transactions.
  • The interface is regulated by the Reserve Bank of India and works by instantly transferring funds between two bank accounts on a mobile platform.

What exactly has NPCI allowed on UPI?

  • NPCI issued a circular that paved the way for wider adoption of homegrown payments platform UPI.
  • So far, only Indian phone numbers were allowed on UPI, leaving out non-resident bank accounts linked to their phone numbers abroad.
  • In the first phase, phone numbers from 10 countries including Singapore, Australia, Canada, Hong Kong, Oman, Qatar, the US, Saudi Arabia, United Arab Emirates, and the UK have been allowed to be used on UPI.
  • NPCI said it could extend this to other nations as well.

How will it benefit Indians abroad?

  • Once the systems are in place, non-resident Indians will be able to transact using UPI, irrespective of whether they are in India or abroad.
  • To use UPI, non-residents need to have either a non-resident external (NRE) account or a non-resident ordinary (NRO) account in India.
  • It would, of course, be more useful when account holders visit India, given the scale of UPI merchant infrastructure in India.
  • While abroad, they can use UPI to transfer funds to families in India and use it on e-commerce portals that allow such payments.

What are the prerequisites for this facility?

  • NPCI has asked banks to onboard only those accounts that meet the Foreign Exchange Management Act guidelines and instructions issued by the departments of the Reserve Bank of India (RBI).
  • Apart, the remitter, as well as beneficiary banks, will have to ensure they comply with anti-money laundering (AML) and combating of financial terrorism (CFT) checks.

Does it help the plan to take UPI global?

  • NPCI has been attempting to make UPI a global phenomenon and the idea to tap NRIs is a step towards that.
  • 10 countries are just to begin with and the list will expand in future.
  • NPCI has been trying to push homegrown payment systems in other countries through NPCI International Payments Ltd, a subsidiary it set up in 2020.
  • It has already tied up with payment system operators in Nepal, UAE, France, UK and others to allow UPI usage there.
  • There is also a plan to link UPI with Singapore’s Paynow.

How will it help the UPI ecosystem?

  • UPI is almost synonymous with digital payments in India, clocking over ₹12.8 trillion worth of transactions in December.
  • After a slow start in 2016, UPI payments have grown at a rapid pace. Given there are over 13.5 million NRIs, the availability of UPI is expected to raise transaction volumes.
  • Industry experts said that just like resident Indians do not have to pay for UPI, it will also be available to NRIs at no extra cost.
  • That said, it might be off to a slow start as the acceptance infrastructure abroad is still being developed.

 

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Banking Sector Reforms

Analyzing Multilateralism in Light of BIMSTEC

Multilateral

Context

  • While the efficacy of multilateral cooperation is often questioned amidst the compelling the politics of force and global power politics, the world simply does not yet have any other alternative to structured cooperation. Much like the progress and relevance of multilateral cooperation, the fate of BIMSTEC too needs to contextualized in a world order that demands action and resolve.

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What is BIMSTEC?

  • The Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation: (BIMSTEC) is an international organisation of seven South Asian and Southeast Asian nations, housing 1.73 billion people and having a combined gross domestic product of US$4.4 trillion (2022).
  • Members: The BIMSTEC member states Bangladesh, Bhutan, India, Myanmar, Nepal, Sri Lanka, and Thailand are among the countries dependent on the Bay of Bengal.

Present status of BIMSTEC

  • Poor connectivity and resources: On the one hand, the geographical limits of BIMSTEC suffer from poor intra-regional connectivity which is fundamental to enhancing economic engagement; on the other, the grouping itself is beleaguered by the lack of an institutional structure, operational blueprint, and financial resources.
  • New found interest: The BIMSTEC has indeed shown intent in recent years with member nations taking the first steps since the organisation’s inception towards according the latter agency, mobility, and funds.
  • Most recent activities: These include the adoption of a charter that accords the grouping a legal status; a reduction in the number of priority areas from 14 to seven pillars thereby allowing for more focused engagement, the signing of memorandums on technology transfer, diplomatic training and a master plan on connectivity all of which are of import to the grouping’s future as aspirational countries in a region that has already become the gravitational centre of global geopolitics.
  • Outcome of economic and political stability: The ‘renewed interest’ after remaining dormant for over two decades is attributed to the economic and political stability and growth that member states (barring Myanmar) have witnessed together with the world’s interest being directed towards the opportunities and Indo-Pacific and an increasingly hostile China.
  • BIMSTEC has lot of ground to cover: As a regional organisation, the BIMSTEC is, on paper, well-positioned to gear shared efforts towards the harnessing of economic, natural, and labour potential of member nations.

Understanding the Multilateral cooperation/Multilateralism

  • Hybrid rather than binary affairs: An assessment of multilateralism has to move away from binary understandings of world architectures. They are in essence, hybrid affairs, combining universal aspirations such as human rights with a more prosaic system of managed competition. This format is here to stay.
  • Achieving common objectives through collective strengths: Multilateral organisations help as facilitators of regional objectives by pooling the strengths of members for advancement, as lobbying entities for regional aspirations and demands on the global stage functions which form the core purpose of these groupings. But multilateralism also suffers from its own set of drawbacks.
  • Political disagreements: Perhaps the biggest limitations of multilateral engagement are ineffectiveness and becoming unwieldy as they comprise several member countries in terms of certain types of decision-making, particularly, those which are political.
  • This is particularly true of large regional or global organisations, with ASEAN being the exception that proves the rule.
  • Mini-laterals: To mitigate this challenge, smaller and more focused undertakings began in recent years in the form of mini-lateral engagement to enable smaller, and more ‘like-minded’ nations to band together for function-based cooperation.
  • BBIN as an example: In the South Asian region, an example of mini-lateral engagement is the BBIN sub-regional framework which has, however, because of the operational complexities, continued to struggle.

What should be the way forward?

  • Addressing the illegal migration: Multilateral forums also allow for united articulations of challenges unique to particular regions. Among the BIMSTEC’s common challenges are irregular migration, environmental degradation, transnational crimes, terrorism and insurgencies and drug trafficking, the efforts towards the mitigation of many of which, particularly the issue of migration and climate action, need the involvement of the world’s major powers.
  • Support through G20 presidency: India’s G20 presidency in 2023 offers a unique opportunity to leverage New Delhi’s enhanced position in global politics to usher support for BIMSTEC’s necessities and objectives.
  • Intent is stronger than hurdles: The success of groupings be it large or small rests on intent shown by members regardless of operational, financial, political or institutional constraints.
  • Finance, institutions and structure: A grouping that comprised members from what is frequently referred to as the least integrated region in the world, without sufficient financing, and devoid of institutional structures to guide its operations, there has been much to be concerned about regarding BIMSTEC. And yet, because the grouping has demonstrated intent, so far, BIMSTEC’s promise holds more sway than its impediments.

Conclusion

  • BIMSTEC have suffered from lack of funding, dedicated institution and proper structuring of the grouping. Hopefully new mini-laterals (BBIN) will revive the BIMSTEC in much objective stronger and successful way. India should take the lead in revival of this multilateral forum.

Mains Question

Q. Analyze the present status of BIMSTEC. What are the weaknesses of BIMSTEC and suggest way forward?

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Banking Sector Reforms

Reserve Bank Integrated Ombudsman Scheme (RBIOS)

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Banking Ombudsman Scheme

Mains level: Not Much

Issues related to ATM/debit cards and mobile/electronic banking were the top grounds of complaints received at the Office of Banking Ombudsman (OBO).

Why in news?

  • Of these, 3,04,496 complaints were handled by the 22 Offices of RBI Ombudsman (ORBIOs), including the complaints received under the three erstwhile Ombudsman Schemes till November 11, 2021.
  • Complaints related to ATM/ debit cards were the highest at 14.6% of the total, followed by mobile/ electronic banking at 13.6%.
  • About 90% of the total complaints were received through digital modes, including on the online Complaint Management System (CMS) portal.
  • Majority 66.1% of the maintainable complaints were resolved through mutual settlement/ conciliation/ mediation.

Banking Ombudsman Scheme

  • The Banking Ombudsman Scheme is an expeditious and inexpensive forum for bank customers for resolution of complaints relating to certain services rendered by banks.
  • It is introduced under Section 35 A of the Banking Regulation Act, 1949 by RBI with effect from 1995.
  • Presently the Banking Ombudsman Scheme 2006 (As amended upto July 1, 2017) is in operation.
  • All Scheduled Commercial Banks, Regional Rural Banks and Scheduled Primary Co-operative Banks are covered under the Scheme.
  • As per the present regulations, the ombudsman redressal is allowed for complaints where the compensation amount for any loss suffered by the complainant is limited to Rs 20 lakh.
  • Under the RBI-OS, 2021, following the ‘One Nation, One Ombudsman’ principle, the territorial jurisdictions have been abrogated, and complaints are assigned to all the ombudsmen by the CMS.

What about other sectors?

  • The Reserve Bank Integrated Ombudsman Scheme (RBIOS) amalgamates three ombudsman scheme of RBI – banking ombudsman scheme of 2006, ombudsman scheme for NBFCs of 2018 and ombudsman scheme of digital transactions of 2019.
  • The unified ombudsman scheme will provide redress of customer complaints involving deficiency in services if the grievance is not resolved to the satisfaction of the customers or not replied within a period of 30 days.
  • The new scheme also includes non-scheduled primary co-operative banks with a deposit size of Rs 50 crore and above.
  • The integrated scheme makes it a “One Nation One Ombudsman’ approach and jurisdiction neutral.

 

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Banking Sector Reforms

What are Systemically Important Banks?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Systemically Important Banks (SIBs)

Mains level: Too Big To Fail Banks

State Bank of India, ICICI Bank, and HDFC Bank have again been named as Domestic Systemically Important Banks (D-SIBs) by the Reserve Bank of India (RBI).

What are Systemically Important Banks (SIBs)?

  • SIBs are perceived as certain big banks in the country/world. They enjoy a huge customer base and also engage in cross sector activities and are perceived as ‘Too Big to Fail (TBTF)’.
  • The system of D-SIBs was adopted in the aftermath of the 2008 financial crisis where the collapse of many systematically important banks across various regions further fuelled the financial downturn.
  • A failure of any of these banks can lead to systemic and significant disruption to essential economic services across the country and can cause an economic panic.
  • As a result of their importance, the government is expected to bail out these banks in times of economic distress to prevent widespread harm.
  • D-SIBs follow a different set of regulations in relation to systemic risks and moral hazard issues.

Types of SIBs

There are two types of SIBs:

  1. Global SIBs: They are identified by BCBS (BASEL Committee on Banking Supervision)
  2. Domestic SIBs: They are declared by Central Bank of the country

How are D-SIBs determined?

  • Since 2015, the RBI has been releasing the list of all D-SIBs.
  • They are classified into five buckets, according to their importance to the national economy.
  • In order to be listed as a D-SIB, a bank needs to have assets that exceed 2 percent of the national GDP.
  • The banks are then further classified on the level of their importance across the five buckets.
  • ICICI Bank and HDFC Bank are in bucket one while SBI falls in bucket three, with bucket five representing the most important D-SIBs.

What regulations do these banks need to follow?

  • Due to their economic and national importance, the banks need to maintain a higher share of risk-weighted assets as tier-I equity.
  • SBI, since it is placed in bucket three of D-SIBs, has to maintain Additional Common Equity Tier 1 (CET1) at 0.60 percent of its Risk-Weighted Assets (RWAs).
  • ICICI and HDFC on the other hand, have to maintain Additional CET1 at 0.20 percent of their RWA due to being in bucker one of D-SIBs.

 

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Banking Sector Reforms

India’s Soft Loans to neighbours up to $15 billion

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Soft Loans

Mains level: India's soft loan diplomacy as against China's debt trap diplomacy

The volume of India’s soft loans to neighboring countries has increased from about $3 billion to almost $15 billion in the last eight years.

What are Soft Loans?

  • A soft loan is a loan with no interest or a below-market rate of interest.
  • Also known as “soft financing” or “concessional funding,” soft loans have lenient terms such as-
  1. Namesake interest rate
  2. Extended grace periods in which only interest or service charges are due
  3. Interest holidays
  4. Long tenure up to 50 years
  • Soft loans are often made by multinational development banks such as the Asian Development Fund affiliates of the World Bank etc.

Why are soft loans popular?

  • Diplomatic tool: Soft loans are often offered not only as a way to support developing nations but also to form economic and political ties with them.
  • Economic benefit: Nations exchange credit in return of some important resources.
  • Geopolitics: Soft loans have been an important diplomatic tool to sustain political influence in the neighborhood and beyond as well as counter the growing Chinese presence, especially in Africa.

Pros and cons of Soft Loans

  • Pro: Breaks for Business– Soft loans offer favorable business opportunities.
  • Con: Shaky Returns– The length of time it may take to repay a soft loan could mean the lender is tied to the borrower for an extended number of years.

Did India take any soft loan?

  • For instance, in 2015, Japan offered a soft loan to India to cover 80% of the cost for a $15 billion fund a bullet train project at a less than 1% interest rate.
  • This was done with the caveat that India would purchase 30% of the equipment for the project from Japanese companies.
  • By the time the countries signed a formal agreement, Japan’s commitment increased to 85% of the cost, in the form of soft loans, for a then-estimated $19 billion project cost.

Using soft loans as a diplomatic tool

  • The amount of development assistance India has offered to other nations in 2019-20 was more than twice what it had extended in 2011-12.
  • However, such loans have usually gone to countries in Asia, Africa and Latin America that are lower down the economic strength ladder.
  • India has extended a total of $27.8 billion in lines of credit since 2002-03.

Conclusion

  • Extending development assistance is nothing new for India and about half of the foreign ministry’s budget is made up of grants and loans to foreign governments, especially India’s neighbours.
  • For a country that for long had to rely on international loans to meet key development goals, India understands the diplomatic value of providing a helping hand.

 

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Banking Sector Reforms

Price regulation of UPI

Note4Students

From UPSC perspective, the following things are important :

Prelims level: UPI,MDR, etc

Mains level: Digital payment ecosystem, pricing mechanism and associated issues

UPI

Context

  • The recent discussion paper by the RBI on charges in payment systems has triggered widespread public debate, especially on the zero-charge framework for UPI transactions.

Know the basics- What is UPI?

  • UPI is an instant real-time payment system developed by National Payments Corporation of India (NPCI) facilitating inter-bank transactions.
  • The interface is regulated by the Reserve Bank of India and works by instantly transferring funds between two bank accounts on a mobile platform.

Why RBI wants to intervene?

  • Two important reasons:
  1. Goals of financial inclusion: Viewing digital payments as a public good and
  2. Addressing market failures: Such as the presence of dominant firms or externalities that may arise due to the two-sided nature of this market.
  • For both objectives, regulators might want to cap or set to zero the MDR or merchant discount rate (paid by merchants to their payments service provider) or the interchange fee (paid by the acquiring bank to the issuing bank), or both.

UPI

What is the present scenario of Pricing UPI?

  • Subsidies on operational cost: In the case of UPI, the government subsidizes the operational costs of facilitating UPI transactions, which is reportedly inadequate. In January 2022, the Payments Council of India reported that the industry expected a loss of Rs 5,500 crore.
  • Subsidies are inadequate: Even with a public good motive, in the absence of evidence, one cannot assume this to be the best allocation of limited government resources. As per the Indian Digital Payments Report (second quarter of 2022), the average ticket size of P2M transactions (person to merchant) on UPI is Rs 820. RBI’s estimated cost of Rs 2 for processing a Rs 800 transaction, is 0.25 per cent of the transaction value, much lower than the MDR cap set at 0.9 per cent for debit cards and an MDR of 2 per cent being pro- posed for RuPay credit cards on UPI.
  • Presently MDR is Zero: A floor MDR of 0.25 per cent is, therefore, not unreasonable. Arguably, these are substitutable services competing for the same pool of merchants. Policymakers must also bear in mind behavioural challenges in moving from zero MDR to a positive MDR. Anchored at a zero MDR since January 2020, merchants, especially ones with thin margins, may hesitate to accept an increase in MDR, even if they benefit on net terms.

How RBI can regulate price?

  • Understanding what to regulate: In order to understand how and what to regulate, we borrow from the rationale followed for other two-sided markets that exhibit cross-platform externalities. consumers benefit more if the size of the merchant network accepting a payment instrument (for example, debit cards) is larger and, at the same time, merchants benefit more if many consumers use debit cards.
  • Recovering the cost from merchants: Card networks like Visa and Mastercard compete for banks, usually not too many, to issue their cards. Since the acquiring bank must pay the interchange fee, they recover these costs from merchants.
  • Regulating the interchange fee: In most jurisdictions, the interchange fee is regulated to prevent banks from charging exploitative rates and the MDR is left to be commercially determined. This is also done for administrative ease, since banks are fewer, while monitoring bank-merchant contracts can be onerous.
  • Charging the MDR: In the UPI parallel, involving payment service providers of payers and payees, the remitter and beneficiary banks as well as NPCI, RBI could either regulate the inter change fee between payment service providers or the merchant discount rate charged by them.
  • Deciding between MDR and interchange fee: The market for merchant acquisition is usually more competitive and can be left unregulated, and if necessary, the interchange fee between the two payment service providers can be regulated. If both markets are sufficiently competitive, regulation could mean establishing a floor/ cap charge. The decision what to regulate is, therefore, crucial.
  • Example of telecom industry: A related example is available in the telecom industry where facilities provision is regulated through the interconnection fee, while retail prices for the relatively competitive telecom services segment are left to the market. For externalities of the two-sided market to be internalized, the choice of instrument must be carefully evaluated.
  • Determining the actual price: The next step is to determine the price level, which is a lot trickier. Drawing from economic theory, the optimal level would depend on whether the regulator cares only about consumer welfare (as op- posed to total welfare), and whether the issuing and acquiring banks make positive margins on each transaction.

UPI

How digital payment is charged around the world and India’s requirement?

  • Example of PIX of Brazil: Pix, a two-year-old interoperable digital payments system in Brazil, provides a good comparison of how price setting might be considered in the UPI context. Pix does not regulate MDR, payment service providers have the freedom to set MDR, though in practice most banks currently don’t charge an MDR, largely to onboard more merchants on their platforms.
  • MDR appears less attractive: The indicated cost is R$ 0.01 for each 10 transfers, or 16 paise in Indian rupees for every s10 transactions. This is substantially lower than the costs estimated for India and is also perhaps the reason why payment service providers are not immediately inclined to recover costs through MDR.
  • Not hampering the innovation and investment: In general, benefits of regulatory intervention should outweigh the costs of intervening. The costs of intervening not only include the administrative costs, but also potential costs arising from setting the wrong interchange fee or cap, as well as any costs arising from the impact of the intervention on future investment and innovation in the market.

Do you know what is Merchant Discount Rate?

  • Merchant Discount Rate (alternatively referred to as the Transaction Discount Rate or TDR) is the sum total of all the charges and taxes that a digital payment entails.
  • Simply put, it is a charge to a merchant by a bank for accepting payment from their customers in credit and debit cards every time a card gets swiped in their stores.
  • Similarly, MDR also includes the processing charges that a payments aggregator has to pay to online or mobile wallets or indeed to banks for their service.

Do you know what is Merchant Discount Rate? Merchant Discount Rate (alternatively referred to as the Transaction Discount Rate or TDR) is the sum total of all the charges and taxes that a digital payment entails. Simply put, it is a charge to a merchant by a bank for accepting payment from their customers in credit and debit cards every time a card gets swiped in their stores. Similarly, MDR also includes the processing charges that a payments aggregator has to pay to online or mobile wallets or indeed to banks for their service.

Conclusion

  • Policymakers must collect more data on costs of transfer, user preferences, both merchants and consumers, as well as undertake a thorough analysis of substitutability and competition in the digital payments sector, to put our best foot forward in helping achieve the potential of UPI in India.

Mains Question

Q. Explain the reasons for success of UPI in India? Analyze the Role of UPI in financial inclusion in India?

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Banking Sector Reforms

When does RBI step in to monitor a Bank?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: CAR, Basel Norms

Mains level: Not Much

The Reserve Bank of India (RBI) has placed a private bank under tight monitoring and greater public scrutiny.

What is the news?

  • The XYZ Bank’s capital to risk weighted assets ratio (CRAR) dropped to around 13% at the end of March this year from 14.5% a year ago.
  • This has dropped below the Basel III in the past and it has even been placed under the prompt corrective action framework (PCA) by the RBI to deal with serious deteriorations in its financial position.
  • Under Basel-III norms banks are supposed to maintain their CRAR at 9% or above.

What is Capital Adequacy Ratio (CAR)?

  • Capital adequacy ratio is an indicator of the ability of a bank to survive as a going business entity in case it suffers significant losses on its loan book.
  • The CRAR is a ratio that compares the value of a bank’s capital (or net worth) against the value of its various assets weighted according to how risky each asset is.
  • It is used to gauge the risk of insolvency faced by a bank.

How do it affects bank functioning?

  • A bank cannot continue to operate if the total value of its assets drops below the total value of its liabilities as it would wipe out its capital (or net worth) and render the bank insolvent.
  • So, banking regulations such as the Basel-III norms try to closely monitor changes in the capital adequacy of banks in order to prevent major bank failures which could have a severe impact on the wider economy.
  • The capital position of a bank should not be confused with cash held by a bank in its vaults to make good on its commitment to depositors.

Alternatives for bank

  • The said Bank has been trying to issue additional shares in the open market through a rights issue in order to deal with its capital adequacy woes.
  • Through a rights issue, the bank will be able to raise more equity capital from existing shareholders.
  • This is in contrast to an initial public offering where shares are issued to new shareholders.

Back2Basics: Basel Norms

  • Basel is a city in Switzerland. It is the headquarters of the Bureau of International Settlement (BIS), which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations.
  • Basel guidelines refer to broad supervisory standards formulated by this group of central banks – called the Basel Committee on Banking Supervision (BCBS).
  • The set of the agreement by the BCBS, which mainly focuses on risks to banks and the financial system is called Basel accord.
  • The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
  • India has accepted Basel accords for the banking system.

Basel I

  • In 1988, BCBS introduced a capital measurement system called Basel capital accord, also called as Basel 1.
  • It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
  • The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
  • RWA means assets with different risk profiles.
  • For example, an asset-backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

Basel II

  • In June ’04, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which the committee calls it as pillars:
  • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
  • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
  • Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

Basel III

  • In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
  • A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
  • Also, the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
  • Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
  • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

 

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Banking Sector Reforms

What are Small Savings Instruments (SSIs)?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Small Savings Instruments (SSIs)

Mains level: Not Much

The Centre has announced increases of 0.1-0.3 percentage points in interest rates payable on five small savings instruments (SSIs) marking the first increase in small savings rates since January 2019.

What are Small Savings Instruments (SSIs)?

  • Small Savings Schemes or instruments are a set of savings instruments managed by the central government with an aim to encourage citizens to save regularly irrespective of their age.
  • They are popular as they provide returns higher than bank fixed deposits, sovereign guarantee and tax benefits.

How is it managed?

  • Since 2016, the Finance Ministry has been reviewing the interest rates on small savings schemes on a quarterly basis.
  • All deposits received under various schemes are pooled in the National Small Savings Fund.
  • The money in the fund is used by the Centre to finance its fiscal deficit.

What are the different saving schemes?

The schemes can be grouped under three heads –

  1. Post office deposits
  2. Savings certificates and
  3. Social security schemes

(1) Post Office Deposits

  • Under this we have the savings deposit, recurring deposit and time deposits with 1, 2, 3 and 5 year maturities and the monthly income account.
  • The savings account currently pays an interest of 4% per annum and can be opened individually or jointly with an initial investment of Rs 500.
  • The recurring deposit that pays 5.8% a year compounded quarterly matures after 60 months from the date of opening.
  • It allows investors to save on a monthly basis with a minimum deposit of Rs 100 per month.
  • Investments under the 5-year time deposit up to Rs 1.5 lakh further qualifies for benefit under section 80C of Income Tax Act.

(2) Savings Certificates

  • Under this, we have the National Savings Certificate and the Kisan Vikas Patra.
  • The National Savings Certificate pays interest at a rate of 6.8% per annum upon maturity after 5 years. The interest that is earned is reinvested into the scheme every year automatically.
  • The NSC also qualifies for tax saving under Section 80C of the income tax act.
  • The Kisan Vikas Patra, which is open to everyone, doubles your one-time investment at the end of 124 months signifying a return of 6.9% compounded annually.
  • The minimum investment amount is Rs 1000 while there is no upper limit.

(3) Social security schemes

  • In the third head of social security schemes, there is Public Provident Fund, Sukanya Samriddhi Account and Senior Citizens Savings Scheme.
  1. Public Provident Fund
  • The Public Provident Fund is a popular saving option for long term goals like retirement.
  • It pays 7.1% a year and qualifies for tax benefit under Section 80C of the Income Tax Act.
  • Upon maturity of the account after 15 years, it can be extended indefinitely in blocks of 5 years.
  • The accumulated amount and interest earned are exempt from tax at the time of withdrawal.
  1. Sukanya Samriddhi Account
  • The Sukanya Samriddhi Account was launched in 2015 under the Beti Bachao Beti Padhao campaign exclusively for a girl child.
  • The account can be opened in the name of a girl child below the age of 10 years.
  • The scheme guarantees a return of 7.6% per annum and is eligible for tax benefit under Section 80C of the Income Tax Act.
  • The tenure of the deposit is 21 years from the date of opening of the account and a maximum of Rs 1.5 lakh can be invested in a year.
  1. Senior Citizen Savings Account
  • And finally, the 5-year ​​Senior Citizen Savings Account can be opened by anyone who is over 60 years to age.
  • It carries an interest of 7.4% per annum payable quarterly and qualifies for Section 80C tax benefit.
  • These time-tested and safe modes of investments don’t offer quick returns, but are safer when compared to market-linked schemes.

How are G-Secs and SSIs related?

  • RBI had observed that the rise in yields on government securities (G-Secs) had turned ‘the spread between the existing interest rates’ and formula-based rates ‘negative for most small saving schemes’.
  • Returns on SSIs are linked to market yields on G-Secs with a lag and are fixed on a quarterly basis.
  • The decision to raise rates on just five SSIs, will mean that returns for some of the schemes, such as the PPF, will be negative in the coming quarter in relation to the formula.

 

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Banking Sector Reforms

What happens after a Cooperative Bank to shuts down?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Deposit Insurance Programme, Banking License

Mains level: Not Much

The Reserve Bank of India (RBI) announced it had cancelled the banking licence of a Pune-based Rupee Cooperative Bank, and directed the Registrar of Cooperative Societies to liquidate the bank.

What is a Banking Licence?

  • Financial institutions wishing to carry out banking operations such as accepting deposits or lending have to obtain a licence from India’s central bank.
  • The RBI issues the licence under the Banking Regulation Act of 1949 after carrying out a series of checks about the financial suitability of the applicant institution.
  • Parameters like capital adequacy ratio (CAR) — the ratio of a bank’s available capital to its risk weighted credit exposure — and loan to deposit ratio (LDR) — the ratio of a bank’s total loans to total deposits in the same period — are checked before the licence is granted.
  • The 1949 Act in particular stresses on adequate capital and protection of the public interest before the licence is granted.
  • No company other than one that has been issued a banking licence is allowed to use the word bank in its name while doing business.

Cancelling the licence of a Bank

  • RBI, which issues the licence, has the power to cancel it as well, in case the bank fails to satisfy laid-down conditions.
  • This could mean an increase in bad debts — and if the RBI feels a bank does not have enough capital to cover its exposure and pay its depositors, its licence can be suspended or cancelled.

Why did RBI cancel the licence of Rupee Cooperative Bank?

  • The RBI audits banks every year, and can take action if it notes an increase in bad debts or other suspicious activities in their books.
  • In its press release, the RBI gave the reasons for the cancellation of the bank’s licence:
  1. The bank does not have adequate capital and earning prospects.
  2. The bank has failed to comply with the requirements of certain sections of the Banking Regulation Act, 1949;
  3. The continuance of the bank is prejudicial to the interests of its positions;
  4. The bank with its present financial position would be unable to pay its present depositors in full; and
  5. Public interest would be adversely affected if the bank is allowed to carry on its banking business any further.

Section 22 of the Act deals with “licensing of banking companies”, section 11 is about “requirement as to minimum paid-up capital and reserves”, and section 56 is about the applicability of the Act to cooperative societies, subject to modifications.

Was cancellation of the licence the only option left for RBI?

  • RBI had issued notice to that Cooperative Bank in 2013, and issued directions under the Banking Regulation Act before cancelling its licence.
  • All banking activities like withdrawal were suspended, the then board of directors was superseded.
  • The banker took a number of steps to revive the bank, including filing of criminal cases against defaulting directors, employees, and seizing of their properties.
  • The RBI extended the licence of the bank every three months as these steps were being taken.
  • The administrator also tried to merge the bank with a financially stable bank. But the bad debts scared away most suitors.

What will happen to the depositors’ money in Rupee Cooperative Bank?

  • The limiting of withdrawals by RBI had made things difficult for depositors, especially because cooperative banks are preferred by those from the lower income group.
  • The big question before the over 5.5 lakh depositors now is about the fate of their money.
  • The RBI has said that depositors with Rs 5 lakh or less in the bank, would get back all of their money through the Deposit Insurance and Credit Guarantee Corporation (DICGC).
  • Those who have larger deposits in the bank will not get back their money beyond Rs 5 lakh.
  • In this group are about 4,600 depositors with a total Rs 340 crore in deposits in the bank.
  • These people stand to suffer major losses.

Back2Basics: Deposit Insurance Programme

  • The bank savings are insured under the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act providing full coverage to around 98 per cent of bank accounts.
  • Earlier, account holders had to wait for years till the liquidation or restructuring of a distressed lender to get their deposits that are insured against default.
  • Last year, the government raised the insurance amount to Rs 5 lakh from Rs 1 lakh.
  • Prior to that, the DICGC had revised the deposit insurance cover to Rs 1 lakh on May 1, 1993 — raising it from Rs 30,000, which had been the cover from 1980 onward.

What are new changes?

  • Earlier, out of the amount deposited in the bank, only Rs 50,000 was guaranteed, which was then raised to Rs 1 lakh.
  • Understanding the concern of the poor, understanding the concern of the middle class, we increased this amount to Rs 5 lakh.
  • If a bank is weak or is even about to go bankrupt, depositors will get their money of up to Rs five lakhs within 90 days.

 

 

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Banking Sector Reforms

NITI Aayog’s plan for rollout of Digital Banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Digital Banks

Mains level: Read the attached story

Last week, federal think tank NITI Aayog released a report on digital banks, offering a template for their licensing in India. It said India already has a technology stack to facilitate digital banks.

What are the planned Digital Banks?

  • Digital Banks or DBs are full-scale banks to be licensed under the Banking Regulation Act.
  • Unlike traditional banks, which require brick-and-mortar infrastructure or physical access points, digital banks simply leverage technology to provide banking services through mobile applications and internet-based platforms.
  • DBs behave like any other scheduled commercial bank, accepting deposits, giving loans etc.
  • They will follow prudential and liquidity norms at par with the commercial banks.
  • Globally, terms like “digital banks”, “neobanks”, “challenger banks”, and “virtual banks” are often used interchangeably.

What about digital banking units then?

  • The Union budget for FY23 proposed to establish digital banking units (DBUs) of scheduled commercial banks in 75 districts.
  • The objective is to ensure that the benefits of digital payments, banking and fintech innovations reach the grass-roots.
  • DBUs are treated as banking outlets, equivalent to a branch.
  • These units do not have a legal personality and are not licensed under the Banking Regulation Act.
  • Only existing commercial banks may establish DBUs. In contrast, digital banks will be licensed.
  • These banks are expected to ensure credit penetration to underserved MSMEs and retail customers.

What purpose will digital banks serve?

  • Digital banks are expected to further innovation and support the underserved segments.
  • However, some believe that it will only cater to customers with some level of comfort with digital transactions.
  • According to them, RBI too is not comfortable with this model as the central bank believes that cash handling and credit decisions require physical branches.

What does NITI Aayog suggest for DBs?

  • In the first phase, a restricted digital bank licence may be given, with limits in terms of volume/value of customers. In the second stage, the licensee will be put in a regulatory sandbox.
  • Finally, a ‘full-scale’ licence may be granted contingent on satisfactory performance.
  • A digital bank will be required to have initial capital of ₹20 crore while in the regulatory sandbox.
  • Upon progression from the sandbox, a full-stack digital business/consumer bank will be required to bring in ₹200 crore capital.

What has been the global experience?

  • The UK has led the pack in terms of digital banks, with new entrants in the form of Monzo and Starling Bank.
  • Several jurisdictions in the South East Asian region have witnessed the rise of digital banks.
  • Hong Kong has issued separate licences for virtual banks.
  • As of May 2020, the Hong Kong Monetary Authority has licensed 8 entities out of 33 applications.
  • In South Korea, Kakao Bank and K Bank operate as internet banks licensed under the Banking Act.
  • The Philippines has approved six licenses for digital banks.

 

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Banking Sector Reforms

53 years of Bank Nationalization

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Bank merger and nationalization

Mains level: Debate over banks privatization

Last week, on July 19 was the 53rd anniversary of then Prime Minister Indira Gandhi nationalizing 14 banks.

Bank Nationalization: A Backgrounder

  • In 1955 Imperial Bank of India was nationalized as RBI with State Bank of India to act as the principal agent  for extensive banking facilities on a large scale, especially in rural and semi-urban areas.
  • The other banks of the princely states were acquired by SBI much earlier.
  • However, the nationalization of banks in 1969 and later in 1980 was of a completely different scale.
  • In 1969, the move covered 14 (followed by six in 1980) of the largest private sector banks—putting 85% of the deposit base into the hands of the government.
  • This brought 80% of the banking segment in India under Government ownership.

Why Nationalization of Banks?

  • After independence, the Government of India (GOI) adopted planned economic development for the country.
  • Nationalization was in accordance with the national policy of adopting the socialistic pattern of society.
  • The actual course came at the end of a troubled decade when India had suffered many economic as well as political shocks.

Other reasons

  • Social welfare
  • Controlling private monopolies
  • Expansion of banking to rural areas
  • Reducing regional imbalance to curb the urban-rural divide
  • Priority Sector Lending
  • Mobilization of savings

Immediate causes

  • There were two wars with China in 1962 and Pakistan in 1965 that put immense pressure on public finances.
  • Banks were failing largely due to speculative financial activities when Indira Gandhi became the prime minister in 1967.
  • Two successive years of drought had not only led to food shortages but also compromised national security because of the dependence on American food shipments.
  • Subsequently, a three-year plan holiday affected aggregate demand as public investment was reduced.
  • Agriculture needed a capital infusion, with the initiation of the Green Revolution in India which aimed to make the country self-sufficient in food security.
  • The collapse of banks was causing distress among people, who were losing their hard-earned money in the absence of a strong government support and legislative protection to their money.

Post-nationalization challenges

  • Having ownership and operational control of the banks was a challenging task for the government.
  • The banks were constantly challenged on their profitability parameters—particularly RRBs which had both geographical and portfolio concentration risks.

Establishing regional balance

  • The objective of social control was about making banking sector accessible in areas where these services were not accessible.
  • The state established 196 Regional Rural Banks (RRBs) between two nationalizations.
  • While nationalization, branch licensing policy and priority sector lending targets helped the banks to go to rural areas and certain sectors, it did not achieve regional balance.
  • Of the 20 banks that were nationalized, seven were concentrated in south India, six in west India, four in north India and three in east India.
  • The expanded rural branch network followed the extant regional concentration, bringing more intensive banking in southern and western regions.

How was regional balance achieved then?

  • This skew was partially set right by two initiatives. The first was an institutional intervention of opening 196 RRBs which had focused area of operation.
  • The RRBs contributed significantly to reduce the regional imbalance with their expanding branch network in the 1980s.
  • RRBs also had a greater proportion of their loans flowing to priority sector in general and agriculture in particular.
  • The second was the policy on lead bank scheme where one bank was assigned as a lead for each district.
  • The lead bank was responsible for the growth and penetration of banking in districts and had to achieve it in coordination with other banks and the state machinery.
  • A “district credit” plan (euphemism for a banking plan), dovetailed with the government schemes, was to be prepared and monitored by the lead bank.
  1. Regional Rural Banks
  • RRBs are a shade better when it comes to rural lending.
  • While they have deployed 72% of the rural and semi-urban deposits as credit in those areas, the figure for urban understandably is very low, and most of these funds have gone into investments.
  1. Small Finance Banks
  • The new small finance banks (SFBs) give an entirely different picture—a large number of them are MFIs that converted into banks.
  • These institutions are trying to collect deposits from the middle and upper middle class and deploy those resources towards the poor.
  • From a paradigm point of view, possibly SFBs are the most interesting institutions that have turned the tables and are trying to achieve from the private sector the objectives set out in the bank nationalization.

Public versus Private Banks

  • A look at the broad performance ratios for 2017-18 shows that private sector banks score better on efficiency and profitability parameters.
  • They have better return on assets, return on equity, net interest margin and a higher proportion of low-cost deposits.
  • On the other hand, public sector banks (PSBs) have a better impact on priority sector lending achievement, and paid higher wages.
  • Of the new Pradhan Mantri Jan Dhan Yojana accounts 77% were opened by state-owned banks, 20% by RRBs, and a mere 3.4% accounts were opened by private banks.
  • From this perspective bank nationalization was indeed a good move at that time.

What benefits do we reap today?

  • Banking under government ownership gave the public implicit faith and immense confidence about the sustainability of the banks.
  • Banks were no longer confined to only metropolitan or cosmopolitan in India. In fact, the Indian banking system has reached even to the remote corners of the country.
  • The present government has reached out to people through banks.
  • Assistance for constructing toilets under Swachh Bharat programme, DBT, Crop insurance schemes etc was given through banks.
  • The dispensing of Mudra loans to about 20 crore individuals, benefits under PM Kisan scheme for providing cash assistance to close to 15 crore farmers annually are only possible through this banks.
  • Thus banks became the government’s dispenser of goodies due to the decision which was taken 50 years ago.

What about Financial Inclusion?

  • The All India Debt and Investment Survey reports indicate that the formal sector has been losing ground to the informal sector in the rural indebtedness pie since 2001 onwards.
  • This is worrying and indicates that the inclusion agenda is far from achieved.
  • Some examples in the public sector banking system—particularly SBI—have shown that it is possible to achieve the double bottom line of being in the commercial market while continuing to achieve significant targets in inclusion, sectoral, spatial and geographical.

Way Forward

  • From the larger perspective of efficiency and better utilization of capital, it may be a good idea to move state-owned banks towards more market-based framework.
  • However, that call should be taken to achieve the residual task of inclusion.
  • Making state-owned banks more autonomous and accountable to the market may be the first significant step that can be taken for now.

Also read:

[Burning Issue] Privatization of PSBs

 

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Banking Sector Reforms

What are Primary Agricultural Credit Society (PACS)?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: PACS

Mains level: Rural banking in India

The Cabinet Committee on Economic Affairs (CCEA) has approved a proposal to digitise around 63,000 primary agricultural credit societies (PACS).

What are the Primary Agricultural Credit Societies (PACS)?

  • PACS is a basic unit and smallest co-operative credit institutions in India.
  • In 1904 the first Primary Agricultural Credit Society (PACS) was established.
  • It works on the grassroots level (gram panchayat and village level).
  • PACS is the final link between the ultimate borrowers, i.e., rural people, on the one hand, and the higher agencies, i.e., Central cooperative bank, state cooperative bank, and Reserve Bank of India, on the other.

Who regulates PACS?

  • PACS are registered under the Co-operative Societies Act and also regulated by the RBI.
  • They are governed by the “Banking regulation Act-1949” and Banking Laws (Co-operative societies) Act 1965.

Various objectives of PACS

  1. To raise capital for the purpose of making loans and supporting members’ essential activities.
  2. To collect deposits from members with the goal of improving their savings habit.
  3. To supply agricultural inputs and services to members at reasonable prices,
  4. To arrange for the supply and development of improved breeds of livestock for members.
  5. To make all necessary arrangements for improving irrigation on land owned by members.
  6. To encourage various income-generating activities through supply of necessary inputs and services.

Functions of PACS

  • As registered cooperative societies, PACS have been providing credit and other services to their members.
  • PACS typically offer the following services to their members:
  1. Input facilities in the form of a monetary or in-kind component
  2. Agriculture implements for hire
  3. Storage space

Who can form PACS?

  • A primary agricultural credit society can be formed by a group of ten or more people from a village. The society’s management is overseen by an elected body.
  • The membership fee is low enough that even the poorest agriculturist can join.
  • Members of the society have unlimited liability, which means that each member assumes full responsibility for the society’s entire loss in the event of its failure.

What capitalizes PACS?

  • The primary credit societies’ working capital is derived from their own funds, deposits, borrowings, and other sources.
  • Share capital, membership fees, and reserve funds are all part of the company’s own funds.
  • Deposits are made by both members and non-members.
  • Borrowings are primarily made from central cooperative banks.

Why need digitization?

  • PACS account for 41 % (3.01 Cr. farmers) of the KCC loans given by all entities in the country and 95 % of these KCC loans (2.95 Cr. farmers) through PACS are to the small and marginal farmers.
  • The other two tiers viz. State Cooperative Banks (StCBs) and District Central Cooperative Banks (DCCBs) have already been automated by the NABARD and brought on Common Banking Software (CBS).
  • Majority of PACS have so far been not computerized and still functioning manually resulting in inefficiency and trust deficit.

Significance of digitization

  • Computerization of PACS will increase their transparency, reliability and efficiency, and will also facilitate the accounting of multipurpose PACS.
  • Along with this, it will also help PACS to become a nodal centre for providing services such as direct benefit transfer (DBT), Interest subvention scheme (ISS), crop insurance scheme (PMFBY), and inputs like fertilizers and seeds.

Try this PYQ from CSP 1999:

Q.The farmers are provided credit from a number of sources for their short and long term needs. The main sources of credit to the farmers include-

(a) the Primary Agricultural Cooperative Societies, commercial banks, RRBs and private money lenders

(b) the NABARD, RBI, commercial banks and private money lenders

(c) the District Central Cooperative Banks (DCCB), the lead banks, IRDP and JRY

(d) the Large Scale Multi-purpose Adivasis Programme, DCCB, IFFCO and commercial banks

 

Post your answers here.
12
Please leave a feedback on thisx

 

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Banking Sector Reforms

Major reforms in Banks Board Bureau (BBB)

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Banks Board Bureau (BBB)

Mains level: Not Much

The Union Finance Ministry is working to expand and relaunch the Banks Board Bureau (BBB) by bringing in more representatives from the insurance sector.

What is Banks Board Bureau (BBB)?

  • Banks Board Bureau (BBB) is an autonomous body to Promote excellence in Corporate Governance in Public Sector Financial Institutions.
  • The BBB works as step towards governance reforms in Public Sector Banks (PSBs) as recommended by J. Nayak Committee.
  • It was formed in 2016 to select executive directors, and managing directors and chief executives of state-run banks.
  • It is tasked to search and select personages for Board of Public Sector Banks, Public Sector Financial Institutions and Public Sector Insurance Companies and recommend measures to improve Corporate Governance in these Institutions.
  • It has been selecting directors and chairmen and managing directors of PSU general insurance companies since 2018.

Its establishment

  • The Central Government notified the amendment to the Nationalised Banks (Management and Miscellaneous Provisions) Scheme, 1980.
  • It provided the legal framework for composition and functions of the Banks Board Bureau on March 23, 2016.
  • The Bureau accordingly started functioning from April 01, 2016 as an autonomous recommendatory body.

Functions of BBB

The mandate of the Bureau is to advise the Central Government on –

  • Selection and appointment of Board of Directors in Nationalised Banks, Financial Institutions and Public Sector Insurance Companies (Whole Time Directors and Chairman)
  • Matters relating to appointments, confirmation or extension of tenure and termination of services of the Directors of mandated institutions
  • Desired management structure of mandated institutions, at the level of Board of Directors and senior management
  • Suitable performance appraisal system for mandated institutions
  • Formulation and enforcement of a code of conduct and ethics for managerial personnel in mandated institutions
  • To build a data bank containing data relating to the performance of mandated institutions and its officers
  • Evolving suitable training and development programs for managerial personnel in mandated institutions
  • To help the banks in terms of developing business strategies and capital raising plan and the like;
  • Any other work assigned by the Government in consultation with RBI

Why such move?

  • The revamp is, in part, pushed by a Delhi High Court order last year.
  • It observed that the bureau was not a competent body to recommend appointments at PSU general insurers.
  • It held that circulars enabling BBB to select general managers and directors of PSU insurers were not legally valid.

Reasons behind the revamp

  • FM aims to legally empower the body to recommend candidates for public sector insurers, and accelerate top-level hiring at all state-run financial institutions.
  • The ministry plans to identify new members, restructure the bureau, and refer the new names to the appointments committee of the cabinet (ACC) in a couple of months.
  • The revamped BBB may also get a new name to indicate its remit over a wider set of financial institutions.

Significance

  • A revamp of the BBB will enable it to recommend full-time appointments at financial institutions where the current executives are given additional charge through interim arrangements.

 

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Banking Sector Reforms

The HDFC Ltd.-HDFC Bank Merger

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Bank merger and nationalization

Mains level: Banking sector reforms

Mortgage lender HDFC Ltd. and India’s largest private sector bank HDFC Bank on Monday announced a mega-merger.

Impact of the move

  • Under the terms of the deal, which is one of the biggest in the Indian financial sector, HDFC Bank will be 100% owned by public shareholders.
  • Existing shareholders of HDFC Ltd. will own 41% stake in HDFC Bank.
  • Post-merger HDFC Ltd. will no longer be a separate mortgage lender, it will get folded into the bank.

What are the terms of the merger?

  • The merger has to go through a series of regulatory approvals.
  • It has to get approval from the shareholders of both companies.
  • At this moment what has been announced by the two entities is that its an all-share deal, so there’s no cash transaction involved.
  • The terms of the share swap are such that shareholders of HDFC Ltd. will receive 42 shares of HDFC Bank for every 25 shares they hold in HDFC Ltd.

What happens to existing customers and employees?

  • As far as customers are concerned, HDFC Ltd.’s customers will become the bank’s customers as well.
  • As for employees, HDFC Bank is planning to absorb and retain all the employees.
  • Neither of the entities are very heavy on employee numbers and have been fairly conservative in their employee sizes.

What is the rationale behind this merger?

  • HDFC have largely had a fairly conservative lending culture, both reasonably customer-friendly, customer-centric, culturally, there wouldn’t be a big challenge.
  • The evolution of the regulatory framework for the NBFC (non-banking financial company) industry has been gradually moving closer, to harmonise with the banking sector’s regulatory framework.
  • Earlier, NBFCs had a fairly different and a far more loose sort of framework for lending and deposits.
  • This led to issues in the industry with some NBFCs struggling and going under or being taken over by others.
  • As Basel III norms for capital adequacy are in place, the NPA (non-performing asset) book is very closely monitored.

What is in it for HDFC Ltd. and HDFC Bank?

  • Post-merger, the mortgage lender, HDFC Ltd., gets access to HDFC Bank’s CASA (current and savings accounts) deposits, which are lower cost funds.
  • For the mortgage lending business, the capital cost will come down. As the capital cost comes down, automatically it will have the ability to lend at a finer rate.
  • For HDFC Bank, every home loan customer can be tapped to become a bank customer.

Impacts of the deal

  • It’s possible that we might see more NBFCs seeking to merge with banks.
  • There is already talk of the number of banks coming down.
  • So in some ways, this merger may be a precursor to what is going to happen in the state-run banking space, where the government has said it is going to reduce the number of public sector banks.

Back2Basics: Basel Accords

  • They refer to the banking supervision Accords (recommendations on banking regulations)—Basel I, Basel II and Basel III—issued by the Basel Committee on Banking Supervision (BCBS).
  • They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there.
  • These are a set of recommendations for regulations in the banking industry.
  • India has accepted Basel accords for the banking system.

Let’s revise them:

[1] Basel I

  • In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1.
  • It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
  • The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
  • RWA means assets with different risk profiles.
  • For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

[2] Basel II

  • In June ’04, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which the committee calls it as pillars:
  • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
  • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
  • Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

[3] Basel III

  • In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
  • A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
  • Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
  • Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
  • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

 

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Banking Sector Reforms

Bank Frauds in India

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Banking frauds

  1. Poor banking governance: Most frauds show that banks did not observe due diligence, both before and after disbursing loans. Poor level of checks and balances in the banking system is one of the reason.
  2. Poor monitoring: Lack of technology and fraud monitoring agencies to detect frauds makes the problem more complex. There is an absence of an effective mechanism to monitor the credit flow. Flawed risk-mitigation design, which creates an excessive focus on credit or market risks, but focuses less on operational risks also leading to more breaches.
  3. Technological backwardness: Excessive dependence on manual supervision, at both external and internal levels makes it impossible to manually control and supervise the sheer volume of transactions.
  4. Immoral behaviour: The disintegrating moral fibre of Indian businessmen, bankers and other white-collar professionals, nepotism in internal committees of banks, unnecessary political interventions lead to increased frauds.
  5. Political interference: The political pulls and pressures on investigating agencies, and long-drawn processes of legal system act less as a deterrent.

 

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Banking Sector Reforms

What are Scheduled Banks?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Scheduled Banks, Payment Banks

Mains level: Banking system in India

The Reserve Bank of India (RBI) has informed that Airtel Payments Bank Ltd. has been categorized as a Scheduled Bank.

Why such a move?

  • With this, the bank can now pitch for government-issued Requests for Proposals (RFP) and primary auctions.
  • It can undertake both Central and State Government businesses participating in government-operated welfare schemes.

What are Scheduled Banks?

  • Scheduled Banks refer to those banks which have been included in the Second Schedule of Reserve Bank of India Act, 1934.
  • Reserve Bank of India (RBI) in turn includes only those banks in this Schedule which satisfy the criteria laid down vide section 42(6)(a) of the said Act.
  • Every Scheduled bank enjoys two types of principal facilities: it becomes eligible for debts/loans at the bank rate from the RBI; and, it automatically acquires the membership of clearing house.
  • Banks not under this Schedule are called Non-Scheduled Banks

Types of Scheduled Banks

There are two main categories of commercial banks in India namely:

  1. Scheduled Commercial banks
  2. Scheduled Co-operative banks

Scheduled commercial Banks are further divided into 5 types as below:

  1. Nationalised Banks
  2. Development Banks
  3. Regional Rural Banks
  4. Foreign Banks
  5. Private sector Banks

Payment bank (currently four banks Airtel Payments Bank, Fino Payments Bank, India Post Payments Bank, Paytm Payments Bank have been granted Scheduled bank status).

Scheduled Co-operative banks are further divided into 2 types namely:

  1. Scheduled State Co-operative banks
  2. Scheduled Urban Co-operative banks

 

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Banking Sector Reforms

RBI proposes new norms for Capital Requirement for Banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Basel III norms

Mains level: Read the attached story

The Reserve Bank of India (RBI) has proposed to replace existing approaches for measuring minimum operational risk capital requirements of banks with a new Basel-III standardized approach.

What are Capital Requirements of a Bank?

  • Capital requirements are standardized regulations in place for banks and other depository institutions that determine how much liquid capital must be held of a certain level of their assets.
  • They are set to ensure that banks and depository institutions’ holdings are not dominated by investments that increase the risk of default.
  • They also ensure that banks and depository institutions have enough capital to sustain operating losses (OL) while still honoring withdrawals.

Why need such a requirement?

  • An angry public and uneasy investment climate usually prove to be the catalysts for capital requirements provisions.
  • This is essential when irresponsible financial behavior by large institutions is seen as the culprit behind a financial crisis, market crash, or recession.

What are the risks for a Bank?

There are many types of risks that banks face.

  • Credit risk
  • Market risk
  • Operational risk
  • Liquidity risk
  • Business risk
  • Reputational risk
  • Systemic risk
  • Moral hazard

 What is Operational Risk?

  • ‘Operational risk’ refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
  • This has been defined by the Basel Committee on Banking Supervision I as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
  • This definition includes legal risk, but excludes strategic and reputational risk.

Pros of Capital Requirements

  • Ensure banks stay solvent, avoid default
  • Ensure depositors have access to funds
  • Set industry standards
  • Provide way to compare, evaluate institutions

Unwanted consequences of such move

  • Raise costs for banks and eventually consumers
  • Inhibit banks’ ability to invest
  • Reduce availability of credit, loans

Back2Basics: Basel Accords

  • They refer to the banking supervision Accords (recommendations on banking regulations)—Basel I, Basel II and Basel III—issued by the Basel Committee on Banking Supervision (BCBS).
  • They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there.
  • These are a set of recommendations for regulations in the banking industry.
  • India has accepted Basel accords for the banking system.

Let’s revise them:

[1] Basel I

  • In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1.
  • It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
  • The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
  • RWA means assets with different risk profiles.
  • For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

[2] Basel II

  • In June ’04, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which the committee calls it as pillars:
  • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
  • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
  • Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

[3] Basel III

  • In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
  • A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
  • Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
  • Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
  • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

 

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Banking Sector Reforms

Bank Deposit Insurance Programme

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Bank Deposit Insurance Programme

Mains level: Bank distress and failure

The PM has addressed depositors during a programme titled ‘Depositors First: Guaranteed Time-bound Deposit Insurance Payment up to ₹5 Lakh’.

Deposit Insurance Programme

  • The bank savings are insured under the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act providing full coverage to around 98 per cent of bank accounts.
  • Earlier, account holders had to wait for years till the liquidation or restructuring of a distressed lender to get their deposits that are insured against default.
  • Last year, the government raised the insurance amount to Rs 5 lakh from Rs 1 lakh.
  • Prior to that, the DICGC had revised the deposit insurance cover to Rs 1 lakh on May 1, 1993 — raising it from Rs 30,000, which had been the cover from 1980 onward.

What are new changes?

  • Earlier, out of the amount deposited in the bank, only Rs 50,000 was guaranteed, which was then raised to Rs 1 lakh.
  • Understanding the concern of the poor, understanding the concern of the middle class, we increased this amount to Rs 5 lakh.
  • If a bank is weak or is even about to go bankrupt, depositors will get their money of up to Rs five lakhs within 90 days.

Significance of the scheme

  • Earlier account holders could not access their own money for up to 8-10 years after financial stress at banks.
  • The new changes would give confidence to depositors and strengthen the banking and financial system.
  • Now, depositors can get insurance money within 90 days, without waiting for the eventual liquidation of the distressed banks.

 

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Banking Sector Reforms

Co-op Societies are not banks, RBI cautions

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Cooperative Banks

Mains level: Cooperatives banking and its regulation

The Reserve Bank of India (RBI) has cautioned members of the public not to deal with cooperative societies undertaking banking business by adding ‘bank’ to their names.

What is the news?

  • It has also come to the notice of RBI that some co-operative societies are accepting deposits from non-members/nominal members/ associate members.
  • This is tantamount to conducting banking business in violation of the provisions.

Who can use ‘Bank’ title?

  • The Banking Regulation Act, 1949 was amended by the Banking Regulation (Amendment) Act, 2020, which came into force on September 29, 2020.
  • Accordingly, co-operative societies cannot use the words “bank”, “banker” or “banking” as part of their names, except as permitted under the provisions of BR Act, 1949 or by the RBI.

What is Cooperative Banking?

  • Cooperatives are people-centred enterprises owned, controlled and run by and for their members to realise their common economic, social, and cultural needs and aspirations.
  • Cooperative bank is an institution established on the cooperative basis and dealing in ordinary banking business.
  • Like other banks, the cooperative banks are founded by collecting funds through shares, accept deposits and grant loans.
  • They are regulated by the Reserve Bank of India (RBI) and governed by the
  1. Banking Regulations Act 1949
  2. Banking Laws (Co-operative Societies) Act, 1955

Features of Cooperative Banks

  • Cooperative banks are generally concerned with the rural credit and provide financial assistance for agricultural and rural activities.
  • Such banking in India is federal in structure. Primary credit societies are at the lowest rung.
  • Then, there are central cooperative banks at the district level and state cooperative banks at the state level.
  • Cooperative credit societies are mostly located in villages spread over the entire country.

History of Cooperative Banking in India:

  • The cooperative movement in India was started primarily for dealing with the problem of rural credit.
  • The history of Indian cooperative banking started with the passing of Cooperative Societies Act in 1904.
  • The objective of this Act was to establish cooperative credit societies “to encourage thrift, self-help and cooperation among agriculturists, artisans and persons of limited means.”
  • Many cooperative credit societies were set up under this Act.
  • The Cooperative Societies Act, 1912 recognised the need for establishing new organisations for supervision, auditing and supply of cooperative credit.

Structure of Cooperative Banking

  • The whole structure of cooperative credit institutions is shown in the chart given.
  • There are different types of cooperative credit institutions working in India.
  • These institutions can be classified into two broad categories- agricultural and non-agricultural.
  • Agricultural credit institutions dominate the entire cooperative credit structure.

Various facets of cooperatives in India

  • Cooperatives in India have grown exponentially.
  • In the banking sector, according to the RBI, their contribution to rural credit increased from 3.1 percent in 1951 to an impressive 27.3 percent in 2002.

Importance of Cooperative Banks:

  • The cooperative banking system has to play a critical role in promoting rural finance and is especially suited to Indian conditions.
  • Various advantages of cooperative credit institutions are given below:

(1) Alternative Credit Source:  The main objective of the cooperative credit movement is to provide an effective alternative to the traditional defective credit system of the village moneylender.

(2) Cheap Rural Credit: Cooperative credit system has cheapened the rural credit by charging comparatively low-interest rates, and has broken the money lender’s monopoly.

(3) Productive Borrowing:  The cultivators used to borrow for consumption and other unproductive purposes. But, now, they mostly borrow for productive purposes.

(4) Encouragement to Saving and Investment: Instead of hoarding money the rural people tend to deposit their savings in cooperative or other banking institutions.

(5) Improvement in Farming Methods: Cooperative credit is available for purchasing improved seeds, chemical fertilizers, modern implements, etc.

(6) Financial Inclusion: They have played a significant role in the financial inclusion of unbanked rural masses. They provide cheap credit to the masses in rural areas.

 

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Banking Sector Reforms

Our banks are mispricing capital

Note4Students

From UPSC perspective, the following things are important :

Prelims level: SLR and CRR

Mains level: Paper 3- Mispricing of capital

Context

We have a situation in India today where the policy repo rate has been kept low. Banks are just about managing their non-performing assets (NPAs) and there is uncertainty in the air.

Mispricing of capital by banks

  • There are different components of the cost of funds for banks, which are captured by the MCLR or marginal cost of funds-based lending rate.
  • For every 100 deposits that enter the banking system, there are different accompanying costs for the system.
  • These are deposit costs, provisioning for NPAs, return on assets (ROA or minimum profit), and the regulatory cost of cash reserve and statutory liquidity ratio balances (CRR and SLR) that perforce have to be held.
  • Adding these components, the basic cost works out to be 8.9%, which should be the rate at which incremental lending should take place.
  • By offering loans at a much lower rate of 7.23%, the system is actually mispricing capital.
  • It may be noted that deposit rates have been compressed to a very large degree and so this cost of 4% is very low.
  • Banks do have the advantage of getting free demand deposits and the right to offer differential rates on saving accounts.
  • Clearly, deposit-holders are subsidizing borrowers quite significantly.

Issue of NPA provisioning in India

  • In the past couple of years, provisions as a proportion of NPAs have averaged 30-40%.
  • As NPAs increase, ideally, banks should load this cost onto their borrowers.
  • But that rarely happens in India. Instead, it is taken on banks’ books and gets reflected in their balance sheets.
  • If NPAs were kept in the region of, say, 4-5% of assets, it would have been possible to bring the cost down to 1.5% (from 3%), which would then have justified the present MCLR.

Low return on assets (ROA)

  • The ideal return norm is 1%, which should be derived from all assets.
  • This does not happen for banks’ investment portfolios, and the value imputed here is only for loans.
  • The ROA for banks is abysmally low, as this aspect does not go into the pricing of products on the asset side.
  • Deposit costs have been driven down as savers don’t have a choice.
  • But a commensurate return does not materialize in the loan books of banks.

Cost of regulations

  • The CRR component gets no compensation, while the SLR part earns around 6%, which is the average cost of fresh borrowing for the Union government.
  • While these numbers vary across banks, the minimum rate of 8.9% would hold for the system, which will vary by the level of NPAs.
  • The concept of linking benchmarks to certain loans further misprices fresh lending, as those loans are not ideal anchors to use, for they are being manually driven downwards by a deluge of liquidity in the system after the pandemic.
  • Excess liquidity of 4-7 trillion a day since April 2020 has meant banks have been placing funds costing them 8.9% with the central bank which gives them just 3.35%.
  • This is eventually borne by bank shareholders.

Implications

  • With rather rigid policies on corporate lending to avert possible NPAs, banks have preferred lending to the retail segment, which is less risky, and small businesses, backed by the Centre’s credit guarantee.
  • The central bank’s government-bond buying programme to provide liquidity has been successful.
  • But in the absence of fructification of lending and a continuous rollover of funds at the reverse-repo window, Indian banks are bearing a negative carry trade, with a 6% return traded for just 3.35%.

Conclusion

Banks must price capital appropriately and not get overly influenced by arguments in favor of cheap credit or the fact that loans are cheaper in the West. We need to get practical on this issue.

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Back2Basics: CRR and SLR

  • Cash Reserve Ratio, or popularly known as CRR is a compulsory reserve that must be maintained with the Reserve Bank of India.
  • Every bank is required to maintain a specific percentage of their net demand and time liabilities as cash balance with the RBI.
  •  The banks are not allowed to use that money, kept with RBI, for economic and commercial purposes.
  • It is a tool used by the apex bank to regulate the liquidity in the economy and control the flow of money in the country.
  • Statutory Liquidity Ratio, shortly called as SLR also an obligatory reserve to be kept by the banks, as prescribed securities, based on a certain percentage of net demand and time liabilities.
  •  It is used to maintain the stability of banks by limiting the credit facility offered to its customers.
  • CRR is maintained in the form of cash while the SLR is to be maintained in the form of gold, cash, and government-approved securities.

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Banking Sector Reforms

RBI supervision of Cooperative Banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Cooperative Banks

Mains level: Regulations of cooperative banks

Maharashtra government has approved a plan to set up a task force to prepare an action plan against a recent change in the law that has brought cooperative banks under the supervision of the Reserve Bank of India (RBI).

What are Cooperative Banks?

  • Co-operative banks are financial entities established on a cooperative basis and belonging to their members.
  • This means that the customers of a cooperative bank are also its owners.
  • These banks provide a wide range of regular banking and financial services. However, there are some points where they differ from other banks.
  • They came into being with the aim to promote saving and investment habits among people, especially in rural parts of the country.

Structure of co-operative banks in India

  • Broadly, cooperative banks in India are divided into two categories – urban and rural.
  • Rural cooperative credit institutions could either be short-term or long-term in nature.
  • Further, short-term cooperative credit institutions are further sub-divided into State Co-operative Banks, District Central Co-operative Banks, Primary Agricultural Credit Societies.
  • Meanwhile, the long-term institutions are either State Cooperative Agriculture and Rural Development Banks (SCARDBs) or Primary Cooperative Agriculture and Rural Development Banks (PCARDBs).
  • On the other hand, Urban Co-operative Banks (UBBs) are either scheduled or non-scheduled.

Who oversees these banks?

  • In India, cooperative banks are registered under the States Cooperative Societies Act.
  • They also come under the regulatory ambit of the Reserve Bank of India (RBI) under two laws, namely, the Banking Regulations Act, 1949, and the Banking Laws (Co-operative Societies) Act, 1955.
  • They were brought under the RBI’s watch in 1966, a move that brought the problem of dual regulation along with it.

Now answer this PYQ in the comment box:

Q.Consider the following statements:

  1. In terms of short-term credit delivery to the agriculture sector, District Central Cooperative Banks (DCCB) delivers more credit in comparison to Scheduled Commercial Banks and Regional Rural Banks.
  2. One of the most important functions of DCCBs is to provide funds to the Primary Agricultural Credit Societies.

Which of the statements given above is / are correct?

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

How has The Banking Regulation Act been amended?

  • Cooperative banks have long been under dual regulation by the state Registrar of Societies and the RBI.
  • As a result, these banks have escaped scrutiny despite failures and frauds.
  • The changes to The Banking Regulation Act approved by Parliament in September 2020, brought cooperative banks under the direct supervision of the RBI.

Changes brought

  • The amended law has given RBI the power to supersede the board of directors of cooperative banks after consultations with the concerned state government.
  • Earlier, it could issue such directions only to multi-state cooperative banks.
  • Also, urban cooperative banks will now be treated on a par with commercial banks.
  • And a cooperative bank can, with prior approval of the RBI, issue equity shares, preference shares, or special shares to its members or to any other person residing within its area of operation, by way of public issue or private placements.
  • It can also issue unsecured debentures or bonds with a maturity of not less than 10 years.
  • This essentially means non-members can become shareholders of the bank, and this will allow the RBI to merge failing banks quickly.

What triggered the need for the changes in the law?

  • India has some 1,540 urban cooperative banks, with a depositor base of 8.6 crore and deposits of at least Rs 5 lakh crore.
  • Finance Minister told Lok Sabha last year that the financial status of at least 277 urban cooperative banks was weak, and around 105 cooperative banks were unable to meet the minimum regulatory capital requirement.
  • According to RBI’s latest financial stability report, the gross non-performing asset ratio of urban cooperative banks deteriorated from 9.89 percent in March 2020 to 10.36 percent in September 2020.
  • Not only do these banks have high levels of bad loans, they also have a small capital base — something that the changes in the law have tried to address by allowing these banks to issue shares with RBI’s approval.
  • Political interference in staff appointments is also a problem with these banks, which has added to inefficiencies.

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Banking Sector Reforms

RBI issues guidelines for tenure of bank CEOs, MDs

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Paper 3- Bank governance

What the guidelines say

  • The Reserve Bank of India recently issued certain instructions on the governance for banks.
  • As per the instructions from the central bank, the post of Managing Director (MD) and Chief Economic Officer (CEO) MD or Whole Time Director (WTD) cannot be held by the same incumbent for more than 15 years.
  • The individual will be eligible for re-appointment as MD&CEO or WTD in the same bank after a minimum gap of three years, subject to meeting other conditions.
  • The upper age limit for MD & CEO and WTDs in private banks would continue to be 70 years.
  • MD&CEO or WTD who is also a promoter/ major shareholder, cannot hold these posts for more than 12 years except in extraordinary circumstances.
  • Banks are permitted to comply with these instructions latest by October 01, 2021.

Applicability

  • These guidelines are applicable for banks, including private banks, Small Finance Banks (SFBs), Wholly Owned Subsidiaries of Foreign Banks.
  • However, it added that this circular is not applicable to foreign banks operating as branches in India.

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Banking Sector Reforms

Lessons from past for the new financial institutions

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Paper 3- Lessons from the past for the success of NBFID

The article explains the factors that resulted in the failure of several financial institutions created by the government.

Establishment of Development Finance Institution

  • As promised in the Budget, the Lok Sabha recently passed The National Bank for Financing Infrastructure and Development (NBFID) Bill, 2021.
  • The Bill seeks to establish a development finance institution (DFI) to fund infrastructure.

Providing finance to NBFID

  • The government will initially own 100% of the proposed NBFID’s 20,000-crore share capital.
  • The government’s stake will be reduced later to 26%.
  • The government will also support NBFID in raising cheap, long-term finance.
  • Apart from the initial share capital, the government will also provide a 5,000-crore grant at the end of its first financial year, presumably to defray initial costs.
  • The government has also committed to guarantee NBFID’s borrowings and bond issuances in the domestic and overseas markets.
  • In addition, the government will underwrite NBFID’s foreign exchange hedging costs.

Concerns and lessons from the past

  • Studying the performance of IL&FS Ltd and IDFC Ltd, two infrastructure financing institutions, set up in the public sector, will be instructive.
  • IL&FS had borrowed short-term loans to finance long-term infrastructure assets.
  • Sustaining this became difficult when a slowing economy and political interference forced infrastructure borrowers to stop repaying loans.
  • Also, it had grown unwieldy, was mismanaged, and escaped scrutiny for too long by handing out plum postings to select bureaucrats.
  • Similarly, 1996 budget speech announced the setting up of IDFC to address the lack of long-term infrastructure financing.
  • In 2004, interference by the bureaucrats to tackle slow growth of loan led to the resignation of several senior executives in IDFC.
  • IDFC, created originally to finance infrastructure projects, has since then wound down its project finance book.
  • 2021-22 Budget speech also mentioned the creation of another institution that will acquire the banking sector’s stressed assets.
  • On the similar lines, Industrial Reconstruction Corporation of India was create in 1971.
  • Mandated with nursing sick and weak companies, it collapsed under this onerous burden.
  • The institution was eventually shut down in 2012.

Consider the question “Examine the role the National Bank for Financing Infrastructure and Development will play in the infrastructure development in the country. Also, examine the factors that led to the failure of development finance institutions in the past.”

Conclusion

The short lesson is this: Fix the distorted demand side before increasing supply. Any number of institutions can be launched, but cannot be expected to work miracles in a corroded system.

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Banking Sector Reforms

National Bank for Financing Infrastructure and Development Bill, 2021

Note4Students

From UPSC perspective, the following things are important :

Prelims level: DFI

Mains level: Key provisions of the bill

Finance Minister has introduced the National Bank for Financing Infrastructure and Development (NaBFID) Bill 2021 in the Lok Sabha to pave way for setting up a government-owned DFI to fund infra projects.

NaBFID Bill

  • The NaBFID Bill, 2021 was introduced in Lok Sabha on March 22, 2021.
  • The Bill seeks to establish the National Bank for Financing Infrastructure and Development (NBFID) as the principal development financial institution (DFIs) for infrastructure financing.

What are DFIs?

  • DFIs are set up for providing long-term finance for such segments of the economy where the risks involved are beyond the acceptable limits of commercial banks and other ordinary financial institutions.
  • Unlike banks, DFIs do not accept deposits from people.
  • They source funds from the market, government, as well as multi-lateral institutions, and are often supported through government guarantees.

Note every statement about DFIs such as – Terms of finance, Sources of funds, Savings option etc. 

Key provisions of the Bill

NBFID:

  • NBFID will be set up as a corporate body with an authorised share capital of one lakh crore rupees.
  • Shares of NBFID may be held by (i) central government, (ii) multilateral institutions, (iii) sovereign wealth funds, (iv) pension funds, (v) insurers, (vi) financial institutions, (vii) banks, and (viii) any other institution prescribed by the central government.
  • Initially, the central government will own 100% shares of the institution which may subsequently be reduced up to 26%.

Functions of NBFID:

  • NBFID will have both financial as well as developmental objectives.
  • Financial objectives will be to directly or indirectly lend, invest, or attract investments for infrastructure projects located entirely or partly in India.
  • The central government will prescribe the sectors to be covered under the infrastructure domain.
  • Developmental objectives include facilitating the development of the market for bonds, loans, and derivatives for infrastructure financing.

Functions of NBFID include:

  • extending loans and advances for infrastructure projects,
  • taking over or refinancing such existing loans,
  • attracting investment from private sector investors and institutional investors for infrastructure projects,
  • organising and facilitating foreign participation in infrastructure projects,
  • facilitating negotiations with various government authorities for dispute resolution in the field of infrastructure financing, and
  • providing consultancy services in infrastructure financing

Source of funds:

  • NBFID may raise money in the form of loans or otherwise both in Indian rupees and foreign currencies, or secure money by the issue and sale of various financial instruments including bonds and debentures.
  • NBFID may borrow money from: (i) central government, (ii) Reserve Bank of India (RBI), (iii) scheduled commercial banks, (iii) mutual funds, and (iv) multilateral institutions such as World Bank and Asian Development Bank.

Management of NBFID:

  • NBFID will be governed by a Board of Directors.
  • The members of the Board include: (i) the Chairperson appointed by the central government in consultation with RBI, (ii) a Managing Director, (iii) up to three Deputy Managing Directors among others.
  • A body constituted by the central government will recommend candidates for the post of the Managing Director and Deputy Managing Directors.
  • The Board will appoint independent directors based on the recommendation of an internal committee.

Support from the central government:

  • The central government will provide grants worth Rs 5,000 crore to NBFID by the end of the first financial year.
  • The government will also provide a guarantee at a concessional rate of up to 0.1% for borrowing from multilateral institutions, sovereign wealth funds, and other foreign funds.
  • Costs towards insulation from fluctuations in foreign exchange (in connection with borrowing in foreign currency) may be reimbursed by the government in part or full.
  • Upon request by NBFID, the government may guarantee the bonds, debentures, and loans issued by NBFID.

Prior sanction for investigation and prosecution:

  • No investigation can be initiated against employees of NBFID without the prior sanction of (i) the central government in case of the chairperson or other directors, and (ii) the managing director in case of other employees.
  • Courts will also require prior sanction for taking cognisance of offences in matters involving employees of NBFID.

Other DFIs:

  • The Bill also provides for any person to set up a DFI by applying to RBI.
  • RBI may grant a licence for DFI in consultation with the central government.
  • RBI will also prescribe regulations for these DFIs.

With inputs from:

PRS India

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Banking Sector Reforms

India should abandon its suspicion of digital currency

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Blockchain technology and its applications

Mains level: Paper 3- Central bank digital currency

The article discusses the advantages of central bank digital currency which could combine the advantages of both fiat money and cryptocurrency.

India’s suspicion of the cryptocurrencies

  • In 2018, the Reserve Bank of India prohibited regulated entities from providing services to anyone who deals with or settles trades in any virtual currency.
  • This was effectively banning Bitcoin trading in the country.
  • The Supreme Court lifted this restriction in 2020.
  • There were rumours earlier this year that a new law was in the works that would make it a crime to possess, issue, mine, trade or transfer crypto assets in India.

Thinking of digital currencies as asset not currency

  • There are concerns over the speculative nature of cryptocurrencies.
  • There are also law enforcement concerns around how digital currencies make it hard for the police to track down criminals.
  • One of the most important attributes of a currency is that it should be a stable store of value, and Bitcoin is anything but.
  • To deal with this difficulty, it will be helpful to think of digital currencies as just another asset—the digital equivalent of a scarce commodity that, like gold, certain collectors prize.

Difference between working of banks and cryptocurrencies

  • Our financial system relies on banks to record transactions.
  • It is a ‘permissioned’ ledger system in that only trusted intermediaries-registered banks under the supervision of the central bank-can make changes to the ledgers to certify that a given transaction has been completed.
  • Cryptocurrencies, on the other hand, are ‘permissionless’ systems that need no intermediary.
  • Instead of a centralized ledger, transactions are recorded on a distributed database.
  • A purely permissionless system has no need of banks.

Role of banks in maintaining financial health

  • Central banks are not just intermediaries managing the great big financial ledger of the country, they are responsible for its financial health.
  • To perform this function, they need to be able to take money out of the system when required or put money back into economic circulation.
  • None of this is possible in a purely permissionless system.

Advantages of digitally native currencies

  • Digitally native currencies are programmable and capable of being incorporated into smart contracts, offering various opportunities for innovative digital solutions.
  • Since they can be directly allotted to citizens who don’t have a bank account, they are ideal for financial inclusion.
  • Being digitally auditable, transactions can be audited, reducing the scope for illicit activity.
  • The challenge is one of integrating the best that digital currencies have to offer into the traditional financial paradigm.

Central bank digital currencies as an alternative

  • CBDCs are a completely re-engineered form of money that use a distributed ledger as their underlying technology layer, but are backed by suitable amounts of monetary reserves, just like normal fiat currency.
  • Many countries have been toying with the idea of a central bank digital currency (CBDC).
  • They are run by central banks along with select financial entities responsible for managing the distributed ledger.
  • The best CBDCs will converge the best of both worlds—the programability and security of cryptocurrencies and the reserve-backed stability of fiat currency.
  • Several countries are already testing this concept.

How central bank digital currency differs from cryptocurrency? What are its advantages?”

Conclusion

Banning technology has never made it go away. Instead, let’s make an effort to better understand it, and having done so, do all we can to create the digital currency our country needs.

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Banking Sector Reforms

Privatisation of Banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Paper 3-Privatisation of banks in India and debate around it

The article highlights the different aspects that need to be considered while contemplating the idea of privatisation of public banks.

Opposite trends in India and the US

  • While the United States epitomises the private banking model, a nationwide public banking movement is coming into vogue.
  • In contrast, India seems to be quickly warming to the idea of bank privatisation.

Public or the private?

  • The development view sees government presence in the banking sector as a means to overcome market failures in the early stages of economic development.
  • The government-owned banks can improve welfare by allocating scarce capital to socially productive uses.
  • The stellar success of Indian PSBs in implementing the PMJDY while missing the mark on creating high-quality credit highlights a critical divide between the asset and the liability side of a bank.
  • Banks provide two functions at a fundamental level: Payments and deposit-taking on the liability side and credit creation on the asset side.
  • The payment services function, a hallmark of financial inclusion, is similar to a utility business — banks can provide this service, a public good, at a low cost universally.
  • The lending side, in contrast, is all about the optimal allocation of resources through better credit evaluation and monitoring of borrowers.
  • Private banks are more likely to have the right set of incentives and expertise in doing so.
  • It comes as no surprise that the PSBs in India are better at providing the public good functions, whereas private banks seem better suited for credit allocation.
  • However, the political view argues that vested interests can influence the lending apparatus to achieve political goals.
  • This results in distortion of credit allocation and reduce allocative efficiency in government-owned banking systems.

Reasons for privatisation of banks

  • Evidences shows that government ownership in the banking sector leads to lower levels of financial development and growth
  • This led to waves of banking sector privatisations that swept emerging markets in the 1990s.
  • Cross-country evidence suggests that bank privatisations improved both bank efficiency and profitability.

How public banks performed in India

  • Public sector Banks (PSBs) dominate Indian banking, controlling over 60 per cent of banking assets.
  • The private-credit to GDP ratio, a key measure of credit flow, stands at 50 per cent, much lower than international benchmarks — in China it is150 and in South Korea it is 150 per cent.
  • India’s Gross NPA ratio was 8.2 per cent in March 2020, with striking differences across PSBs (10.3 per cent) and private banks (5.5 per cent).
  • The end result is much lower PSB profitability compared to private banks.
  • The rationale for privatisation stems from these considerations.

Way forward

  • The optimal mix of the banking system across public and private boils down to what you need out of your banking system.
  • When the wedge between social and private benefits is large, as with financial inclusion, there is a strong case for public banks.
  •  At this stage, inefficiency in capital allocation seems to be a bigger issue for the Indian banking sector, whereas, in the US, the debate is centred around the public goods aspects of banking.

Consider the question “What are the factors India needs to consider as it reverses the course of history by privatising the public banks?”

Conclusion

At this stage, inefficiency in capital allocation seems to be a bigger issue for the Indian banking sector, whereas, in the US, the debate is centred around the public goods aspects of banking.

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Banking Sector Reforms

PSBs should operate like proper banks if they can’t be privatized

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Paper 3- Privatisation of PSBs

The article deals with the stark differences in the performance of the public sector banks (PSBs) and private banks and suggests ways to deal with the issues.

Comparing PSBs with private banks

  • The performance of PSBs over the years hasn’t been worth the money that the government has invested in them.
  • As the Economic Survey of 2019-20 pointed out that over 4.3 trillion of taxpayer money is invested as government’s equity in PSBs.
  • In 2019, every rupee of taxpayer money invested in PSBs, on average, lost 23 paise.
  • In contrast, every rupee of investor money invested in New Private Banks—banks licensed after India’s 1991 liberalization—on average gained 9.6 paise.
  • The combined market value of HDFC Bank’s shares is 8.56 trillion (as of 18 February), whereas the market capitalization of all PSBs is around 6.41 trillion (excluding IDBI Bank, which is now categorized as a private bank).
  • Of course, if we add up the assets of PSBs, they are a lot bigger than HDFC Bank’s.

Dual regulation

  • The private banks are regulated by the Reserve Bank of India (RBI).
  • PSBs are regulated both by RBI and the department of financial services under the finance ministry.
  • The P.J. Nayak Committee report of May 2014 had pointed out this issue of dual regulation.
  • This is primarily because PSBs are used by the government to fulfil its social obligations and pump-prime the economy when it’s not doing well.
  • The stock market discounts these factors while valuing them.

Way forward

  • The policies for regulating and promoting industrial growth do not have any social content in them.
  • Hence, PSBs should be run as proper banks irrespective of whether they are privatized or not.
  • If they are not privatized, the government’s stake in these banks needs to come down to 33%, something which would help them raise more capital.
  • Once investors see PSBs being run as proper banks their market capitalization will start to go up.
  • Once PSBs are properly valued by the stock market, the government can sell some of its stake in them every year, and use that money to fund its social objectives.
  • It can also use some of that money to incentivize all banks, not just PSBs, to deliver some of its social objectives.

Conclusion

The government should take these steps to let the PSBs realise their potential. At the end of the day, nothing improves service delivery more than some good competition.

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Banking Sector Reforms

Tighter regulatory framework for NBFCs

Note4Students

From UPSC perspective, the following things are important :

Prelims level: NBFCs and their regulations

Mains level: Not Much

The Reserve Bank of India (RBI) has suggested a tougher regulatory framework for the non-banking finance companies’ (NBFC) sector to prevent the recurrence of any systemic risk to the country’s financial system.

Try this PYQ:

Which of the following can be said to be essentially the parts of Inclusive Governance?

  1. Permitting the Non-Banking Financial Companies to do banking
  2. Establishing effective District Planning Committees in all the districts
  3. Increasing government spending on public health
  4. Strengthening the Mid-day Meal Scheme

Select the correct answer using the codes given below:

(a) 1 and 2 only

(b) 3 and 4 only

(c) 2, 3 and 4 only

(d) 1, 2, 3 and 4

What are NBFCs?

  • Nonbank financial companies (NBFCs) are financial institutions that offer various banking services but do not have a banking license.
  • An NBFC in India is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by a government or local authority, or other marketable securities.
  • A non-banking institution that is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments is also an NBFC.

What is the difference between banks & NBFCs?

NBFCs lend and make investments and hence their activities are akin to that of banks; however, there are a few differences as given below:

  • NBFC cannot accept demand deposits
  • NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself
  • The deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in the case of banks

What are the new RBI regulations?

  • The regulatory and supervisory framework of NBFCs will be based on a four-layered structure — the base layer (NBFC-BL), middle layer (NBFC-ML), the upper layer (NBFC-UL), and the top layer.
  • If the framework is visualized as a pyramid, at the bottom of the pyramid will be those where least regulatory intervention is warranted.
  • It can consist of NBFCs currently classified as non-systemically important NBFCs.
  • Moving up, the next layer may comprise NBFCs currently classified as systemically important NBFCs (NBFC-ND-SI), deposit-taking NBFCs (NBFC-D), HFCs, IFCs, IDFs, SPDs, and CICs.
  • The regulatory regime for this layer shall be stricter compared to the base layer.
  • The next layer may consist of NBFCs identified as ‘systemically significant’.
  • This layer will be populated by NBFCs having a large potential of systemic spill-over of risks and the ability to impact financial stability.

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Banking Sector Reforms

It’s better to stop the creation of bad debt than set up a bad bank

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Bad Bank

Mains level: Paper 3- Creation of Bad Bank is right idea at wrong time

The article argues that instead of creating the Bad Bank, several steps taken by the government and the bank regulator could deal with the problem of NPAs and also improve the performance of the banks.

Challenge of NPA: Is Bad Bank and answer to it?

  • Recently, RBI governor said that the RBI was open to considering setting up of a “bad bank”.
  • India’s economic growth, unless pandemic risks resurface, should be good enough to largely take care of its non-performing assets (NPAs) in the coming years.
  • It was the high economic and credit growth of the 2003-08 period that whittled down the NPA ratio.
  • The provision coverage ratio at banks had gone up from 42% in 2016 to 72.4% in September 2020, and that net NPAs were down to 2.8% in March 2020.
  • The bad loan legacy is almost done with.
  • Consequently, the bad bank is a right idea at the wrong time.

Steps the government and RBI should take

1) Resume the operation of IBC

  • The government should reinstate the operation of the Insolvency and Bankruptcy Code (IBC).
  • The code had improved the recovery rate from NPAs in the banking system.
  •  There is a need to create disincentives for deliberate delaying tactics, so that the original timeline of 270 days is honoured more in its observance than in breach.

2) Recapitalisation of banks

  • The government should provide more than adequate capital to the strong banks it owns, and adequate capital to the not-so-strong ones, with well-defined performance criteria for them to receive more.
  • If they don’t deliver, then the government should consolidate them or begin diluting its stake below 51% in such banks.

3) Level playing field improvement in compliance culture

  • The government should level the regulatory playing field between private-sector and government-owned banks.
  • The risk management and compliance culture in public-sector banks must improve.
  • However,  public sector banks should not be subject to excessive oversight by government investigative and audit agencies.

4) Plug the sources of NPAs through policy changes

  • More than these, there are two other important things that constitute the fountainheads of NPAs.
  • The government should evolve a framework for passing on explicit development goals of the state for banks to achieve through the credit mechanism.
  • The government should provide for them in the budget and compensate banks rather than direct credit by diktat.
  • The cost of directed lending is not just the creation of NPAs, but morale and market-value erosion as well.
  • In any case, recapitalization needs mean that the fiscal costs are not avoided. It is self-defeating.
  • Then, governments (Union and states) should plug the other underlying sources of NPAs.
  • Among things, they should ensure economic pricing of utilities, honour power purchase contracts and raw material purchase agreements, pay arrears to private counterparties, and stop being reflexive litigants.

Consider the question ” What is the Bad Bank? Do you agree with the view that India needs Bad Bank?”

Conclusion

The above measures would greatly help the country achieve high growth and sustain it. Setting up a bad bank may be unnecessary.


Back2Basics: Provisioning Coverage Ratio (PCR)

  • Banks usually set aside a portion of their profits as a provision against bad loans.
  • Provisioning Coverage Ratio (PCR) is essentially the ratio of provisioning to gross non-performing assets (NPA) and indicates the extent of funds a bank has kept aside to cover loan losses.
  • A high PCR ratio (ideally above 70%) means most asset quality issues have been taken care of and the bank is not vulnerable.

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Banking Sector Reforms

Bank Investment Company (BIC)

Note4Students

From UPSC perspective, the following things are important :

Prelims level: BBB

Mains level: Paper 3- Bank Investment Company for governance reforms in the Public Sector Banks.

Banks, especially the Public Sector Banks have to play an important role in the pandemic afflicted economy. With that aim, the government has been envisaging the Bank Investment Company (BIC) for the improvement of PSB governance. The article discusses the issues with the BIC.

Background of the BIC

  • Recent reports suggest that the upcoming budget may include proposals for a Bank Investment Company (BIC), anchoring the government’s shareholding in its banks.
  • The BIC was proposed by the P J Nayak Committee constituted by the RBI in 2014 to examine governance at public and private sector banks.
  • The committee had offered two options — privatisation or a complete overhaul of bank governance.
  • The overhaul of bank governance is envisaged in the form of a gradual disassociation of the government from the operations, management and governance of PSBs.
  • The BIC is a welcome step in as much as it signals the government’s intent to pursue reforms to improve the governance and performance of PSBs.

Concerns with the BIC

  • The ownership and governance of the BIC itself will be crucial.
  • BIC will need to be allowed to garner the requisite talent and expertise and operate with freedom.
  • In the absence of this, it would merely add another layer while preserving the status quo.
  • The less than encouraging experience of the Banks Board Bureau (BBB) that was to precede the BIC is instructive.

Why BBB failed to achieve its objectives

  • The BBB was set up in 2016 to advise on the selection and appointment of senior board members and management.
  • However, in practice, the BBB’s advice has not always been heeded to, and appointments have not always been made on time.
  • The BBB, as originally conceived, was to consist of three senior bankers.
  • However, it was expanded to include representatives from the RBI and the government.
  • The BBB was also originally envisaged by the committee as a temporary arrangement.
  • However, no further steps have been forthcoming after its establishment.

Way forward for BIC

  • The government would need to ensure the necessary freedom for the BIC to operate while circumscribing its own role.
  • The ultimate success of these reforms will depend on how the government disassociates itself and empowers the BIC.
  • The objectives of the BIC would have to be clearly defined too.
  • If capital raising is one of the goals, the structure of a holding company — with a portfolio of comparatively better performing and non-performing banks — to attract investments must be assessed.
  • In this regard, the RBI has reportedly, in the past, expressed reservations on the BIC structure being a potential challenge for investors to assess the relative risks, returns and performance of the banks.
  • This raises the question of whether privatisation would not be a better alternative, particularly as the transition of the government from an owner to a pure financial investor in its banks is likely to take time.

Conclusion

Given these concerns, privatisation may be a better alternative. The budget could signal this intent by announcing the first step — the repeal of the Bank Nationalisation Acts and the State Bank of India Act.

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Banking Sector Reforms

Recapitalization of state-owned banks: Privatization should do it

Note4Students

From UPSC perspective, the following things are important :

Prelims level: CRAR

Mains level: Paper 3- Recapitalisation of PSBs

The article suggest the approach to deal with the problems banking in India faces.

Banking sector under stress

  • Along with the other sectors, pandemic dealt a severe blow to the banking sector.
  • Stress tests reported in the Financial Stability Report (FSR) indicate that the low ratio of capital to risk-adjusted-assets (CRAR) is likely to decline further.
  • To revive the economy and resume sustained high growth, bold structural reforms will have to be combined with strong fiscal and monetary measures.

Declining credit growth: monetary challenge

  • India’s credit-to-gross domestic product ratio is around 51%.
  • 51% not too low compared to other countries at comparable levels of per capita income.
  • However, the worry is that credit growth is declining rapidly.
  • It is mainly attributable to rising risk aversion among lenders, reflecting the high and rising level of NPAs.
  • Risk aversion spiked during the economic contraction.

Rising NPA of Public Sector Banks

  • The FSR stress tests now indicate that the gross NPA ratio is likely to go up to as much as 13.5% by September 2021 in the report’s baseline case and 14.8% in the ‘severe stress’ case.
  • Within the banking sector, conditions are much worse in public sector banks (PSBs) compared to private banks (PBs) or foreign banks (FBs).
  • The gross NPA figure is forecast to rise to 16.2% for PSBs as compared to 7.9% and 5.4% for PBs and FBs in the baseline case.
  • Clearly, high NPAs are primarily a problem for PSBs, which still account for 60% of India’s total bank credit.

Expanding banking sector: bypass PSBs and give a big push to private banking

  • The recent report on Ownership and Corporate Structure for Indian Private Sector Banks submitted by an RBI internal working group (IWG) espouses this approach.
  • The IWG’s main  recommendation is to enable large corporations and industrial houses to acquire banking licences.
  • The proposal has been strongly opposed by former governors and deputy governors of RBI, several former chief economic advisers, a former finance secretary, and, most significantly, all save one of the many experts the IWG consulted.

Four issues with the push to private banking

  • 1) With an industry CRAR of only 12%, the proposed raising of the promoter share cap to 26% could potentially leverage the promoter’s investment by 32 times.
  • The very high risk appetite generated by such leveraging would subject depositors to a high level of systemic risk, given the limited deposit insurance provided in India.
  • 2) Excessive risk appetite would lead to imprudent lending, especially connected lending to group companies. Conglomerates always find ways around regulatory restrictions against such connected lending.
  • 3) Three, a conglomerate’s bank would have access to insider information on borrower companies that compete with its group companies.
  • 4) Conglomerate banks would lead to massive concentration of economic power and political influence against not just competing companies, but even the regulator.

Way forward

  • A safer and cleaner option would be to help the country’s banking sector grow through simultaneous privatization and recapitalization of PSBs.
  • However, these options do not change the ownership and governance structure of PSBs, which is what primarily is to blame for their poor performance.
  • A better option is for PSBs to recapitalize themselves by raising fresh equity.
  • It would be more prudent financially and also more acceptable politically to test this approach with one or two small PSBs.

Conclusion

Government should try to adopt the approach which reduces the risks associated with giving push to private players in the banking sector while making the PSBs more efficient.


Back2Basics: CRAR-Capital to risk-adjusted-assets

  •  The CRAR is the capital needed for a bank measured in terms of the assets (mostly loans) disbursed by the banks.
  • Higher the assets, higher should be the capital by the bank.
  • A notable feature of CRAR is that it measures capital adequacy in terms of the riskiness of the assets or loans given.

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Banking Sector Reforms

Payments Infrastructure Development Fund (PIDF) Scheme

Note4Students

From UPSC perspective, the following things are important :

Prelims level: PIDF Scheme

Mains level: Digital banking facilitation measures

The RBI has announced operational guidelines to create digital payments acceptance infrastructure across Tier III to Tier VI regions in India.

Possible prelims question:

Q. Which of the following is the major aim of Payments Infrastructure Development Fund (PIDF) recently created by the Reserve Bank of India (RBI)?

a) Promotion of UPI payments

b) Deploying Points of Sale (PoS) infrastructure

c) Creation of digital wallets

d) All of the above

PIDF Scheme

  • The scheme was first announced in June last year to encourage fintech companies and banks to deploy point of sale (PoS) infrastructure across the country to improve the penetration of card-based and other digital payments.
  • The primary beneficiaries will be merchants providing essential services, such as transport and hospitality, government payments, fuel pumps, healthcare facilities, and groceries.
  • Amid the rapid rise in the volume of payments through the UPI network, the RBI is taking steps to further widen the use of digital payments in the country.
  • The fund will be operational for three years from January 1, 2021, and would help subsidise banks and non-banks for the deployment of payments, subject to them achieving specific targets.

Why need PIDF?

  • Over the years, the payments ecosystem in the country has evolved with a wide range of options such as bank accounts, mobile phones, cards, etc.
  • To provide further fillip to the digitization of payment systems, it is necessary to give impetus to acceptance infrastructure across the country, more so in under-served areas.

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Banking Sector Reforms

What are Zero Coupon Bonds?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Zero-Coupon Bonds

Mains level: Banks recapitalization measures

The government has used financial innovation to recapitalize a bank by issuing the lender Rs 5,500-crore worth of non-interest bearing bonds called Zero-Coupon Bonds.

Try this PYQ:

Q.Which of the following is issued by registered foreign portfolio investors to overseas investors who want to be part of the Indian stock market without registering themselves directly?

(a) Certificate of Deposit

(b) Commercial Paper

(c) Promissory Note

(d) Participatory Note

Zero-Coupon Bonds

  • These are non-interest bearing, non-transferable special GOI securities that have a maturity of 10-15 years and are issued specifically to Punjab & Sind Bank.
  • These bonds are not tradable; the lender has kept them in the held-to-maturity (HTM) investments bucket, not requiring it to book any mark-to-market gains or losses from these bonds.
  • This will earn no interest for the subscriber; market participants term it both a ‘financial illusion’ and ‘great innovation’ by the government.

How do they differ from bonds issued by private firms?

  • There is a difference between zero-coupon bonds issued by other corporates and these.
  • Zero-coupon bonds by private companies are normally issued at discount, but since these special bonds are not tradable these can be issued at par.

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Banking Sector Reforms

What is Positive Pay System?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Positive Pay System

Mains level: Positive Pay System

With the New Year, a new concept of Positive Pay System for Cheque Truncation System (CTS) will be introduced by the Banking regulator Reserve Bank of India (RBI) seeking to further augment customer safety in cheque payments.

Try this PYQ:

Q.Which of the following is the most likely consequence of implementing the ‘Unified Payments Interface (UPI)’?

(a) Mobile wallets will not be necessary for online payments.

(b) Digital currency will totally replace the physical currency in about two decades.

(c) FDI inflows will drastically increase.

(d) Direct transfer of subsidies to poor people will become very effective.

Positive Pay System

  • The concept of Positive Pay involves a process of reconfirming key details of large-value cheques.
  • Put simply, cheques will be processed for payment by the drawee bank based on information passed on by its customer at the time of issuance of the cheque.
  • When the beneficiary submits the cheque for encashment, the cheque details are compared with the details provided to the drawee bank through Positive Pay.
  • If the details match, the cheque is honoured. In case of mismatch in cheque details, the discrepancy is flagged by CTS to the drawee bank and the presenting bank, which would take redress measures.

For cheques above 50k

  • The banks are advised to enable it for all account-holders issuing cheques for amounts of ₹50,000 and above.
  • While availing of this facility is at the discretion of the account-holder, banks may consider making it mandatory in case of cheques for amounts of ₹5 lakh and above, the RBI had said.

Benefits of the system

  • Under the Positive Pay system, the drawee bank is already aware of the issuer the details of the high-value cheque (above ₹50,000) he has issued.
  • Without this intimation, if a cheque gets presented, then the drawee bank can reject payment and examine the case. Positive Pay is going to benefit both the issuer and the beneficiary.
  • For the issuer, the benefit from this concept is that there cannot be fraudulent cheques encashed out of issuer’s account.
  • For the beneficiary, the benefit is that the cheques handed out to him will mostly get honoured.

Is Positive Pay the same as ‘certified cheque’?

  • The concept of ‘certified cheque’ was there long back — about 30 years back, long before technology swept across the Indian banking landscape.
  • Whenever anybody issued a cheque, banks used to certify that money is there in their customer’s bank account and, therefore, the cheque will get honoured.
  • This provided comfort to a beneficiary that cheque payment will get honoured and therefore did not insist on a pay order or demand draft.
  • Drawee banks used to earmark the amount in the account of the issuer and then certify the cheque.
  • This was adopted in an era when the cheque instrument used to travel physically for clearing.

Why need such a system?

  • The RBI says the Positive Pay system is to augment customer safety in cheque payments and reduce instances of fraud occurring on account of tampering of cheque leaves.
  • Banks had recently witnessed a rise in frauds involving high-value cheques.

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Banking Sector Reforms

A four-point agenda for Indian banking in the post-covid world

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Return on Equity

Mains level: Paper 3- 4 point agenda for banks to deal with the fallout of the pandemic successfully

The article suggest 4 imperatives to the banks in India to emerge successful from pain inflicted by the pandemic.

Impact of pandemic on banking industry

  • Unlike other shocks, covid is not a banking crisis; it is, instead, a crisis of the real economy.
  • Globally, the average return on equity (RoE) for banks could go below 1.5% in 2021 before recovering to the 2019 pre-crisis levels of 9% by 2024
  • This is effectively a loss of five years for the banking industry.
  • This will likely play out in two stages:
  • 1) Loan loss provisions over a period of 12-18 months.
  • 2) Followed by a period where banking revenue growth lags gross domestic product growth, or GDP.

Important role played by banks in pandemic

  • India has entered this crisis well-capitalized.
  • Their provision coverage ratios improved to 65% in 2019-20, compared to 41% in 2016-17, and RoE (return on equity) has turned positive to 2.5% after two years of negative readings.
  • The banking system is playing a critical role in the economic recovery by supporting businesses and individuals.
  • New challenges, however, continue to emerge. These, if left unmitigated, will lead to severe losses in efficiencies gained.

4 Imperative to tackle the emerging challenges to banking

1) Need to increase productivity

  • Indian banks start at a materially higher cost-to-assets ratio of 2.2% versus 1.4% globally.
  • Regaining pre-covid RoE levels and negating higher risk costs and margin compression will, however, require that Indian banks improve productivity by over 30%.
  • The Indian banking sector lagged in efficiency improvements; other industrial peers have leveraged a combination of digital adoption and analytics, and strong governance.

Suggestions for productivity transformation

  • The productivity transformation will comprise multiple agendas.
  • To start with, there will be a branch format and network re-configuration for custormers who has shifted to online mode.
  • To drive a permanent digital shift, banks will need to accelerate digital engagement via contact centre transformations.
  • In conjunction, there will be the equally important need to create minimum viable support functions (zero-based operations, demand management across human resources, finance, marketing).
  • And, finally, there will be the need to re-skill the workforce for digital operations.

2) Pre-emptive risk management

  • The second imperative is pre-emptive risk management.
  • Banks must rapidly rewire their policies and analytical models such that they reflect fast- moving indicators of risk.
  • This means investing in self-serve channels, digital nudges and frictionless journeys across payments, settlements and recoveries.
  • The overall collections strategy will have to be underpinned by micro-segmentation, and also leverage analytical models to drive efficiency.

3) Technology imperative

  • The third is the technology imperative that must scale with demand and analytical complexity.
  • Banks are required to handle high digital traffic and process enormous data sets, and regulators getting increasingly sensitive on downtimes.
  • This will requires modernizing core banking platforms, creating the data architecture that supports the analytics life-cycle, instituting modern engineering practices and moving towards automated infrastructure.

4) Capital management

  • Banks with exposure to hard-hit sectors will face more of a challenge.
  • And existing risk models are unlikely to be tuned to the differentiated impact the pandemic has had on various sectors.
  • Risk teams will need to review critical models and add overlays to account for different credit risk in each sector.
  • Scenario planning, stress testing and balance sheet optimization will need to become core to planning and management decisions.

Conclusion

In its own way, the pandemic has given banks a glimpse into the art of the possible. Banks should take this opportunity to embed their newfound speed and agility, reinvent their business model, and collaborate with the communities they serve to recast their contract with society.

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Banking Sector Reforms

Mistake in allowing industrial houses to own banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Paper 3- Challenges in allowing industrial houses to own an operate banks

The article analyses the risks involved in allowing the corporate houses to own and operate the banks.

Context

  • An internal working group of the RBI has recently made a recommendation to permit industrial houses to own and control banks.

Encourage bank but not owned by banks

  • According to the report, the main benefit is that industry-owned banks would increase the supply of credit, which is low and growing slowly.
  • Credit constraints are indeed a real problem, and creating more banks is certainly one way of addressing the issue.
  • But this is an argument for encouraging more banks but it is not an argument for creating banks specifically owned by industry.
  • The other powerful way to promote more good quality credit is to undertake serious reforms of the public sector banks.

Problems in allowing industrial houses in banking

  • The problem with banks owned by corporate houses is that they tend to engage in connected lending.
  • This can lead to three main adverse outcomes:

1) Over-financing of risky activities

  • Lending to firms that are part of the corporate group allows them to undertake risky activities that are not easily financeable through regular channels.
  • Precisely because these activities are risky, they often do not work out.
  • And when that happens, it is typically taxpayers who end up footing the bill.
  • In principle, connected lending can be contained by the regulatory authority.
  • However, experiences in other nations show that regulating connected lending is impossible convincing most advanced countries that regulating connected lending is impossible.
  • Indonesia tried to regulate the practice: It banned the practice.
  • The only solution is to ban corporate-owned banks.
  • Regulation and supervision need to be strengthened considerably to deal with the current problems in the banking system before they are burdened with new regulatory tasks.

2) Lack of exit

  • The economic landscape is littered with failed firms, kept alive on life support, making it impossible for more efficient firms to grow and replace them.
  • While some progress was initially made under the Insolvency and Bankruptcy Code (IBC), this had stalled even before the pandemic, largely because existing promoters and owners mounted a stiff resistance.
  • If industrial houses get direct access to financial resources, their capacity to delay or prevent exit altogether will only increase.

3) Increasing dominance

  • The Indian economy already suffers from over-concentration.
  • We not only have concentration within industries, but in some cases the dominance of a few industrial houses spans multiple sectors.
  • If large industrial houses get banking licences, they will become even more powerful, not just relative to other firms in one industry, but firms in another industry.

Impact on regulator and government

  • The power acquired by getting banking licences will not just make them stronger than commercial rivals, but even relative to the regulators and government itself.
  • This will aggravate imbalances, leading to a vicious cycle of dominance breeding more dominance.

Impact on quality of credit

  • Indian financial sector reforms have aimed at improving not just the quantity, but also the quality of credit.
  • The goal has been to ensure that credit flows to the most economically efficient users, since this is the key to securing rapid growth.
  • If India now starts granting banking licences to powerful, politically connected industrial houses we will effectively be abandoning that long-held objective.

Impact on economy and democracy

  • Indian capitalism has suffered because of the murky two-way relationship between the state and industrial capital.
  • If the line between industrial and financial capital is erased, this stigma will only become worse.
  • Corporate houses that are already big will be enabled to become even bigger allowing them to dominate the economic and political landscape.
  • A rules-based, well-regulated market economy, as well as democracy itself — will be undermined, perhaps critically.

Consider the question “What are the challenges and opportunities in allowing the industrial houses to own and operate the banks.”

Conclusion

The conclusion is clear. Mixing industry and finance will set us on a road full of dangers — for growth, public finances, and the future of the country itself.

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Banking Sector Reforms

Allowing corporate houses in banking

Note4Students

From UPSC perspective, the following things are important :

Prelims level: NBFCs

Mains level: Paper 3- Banking regulation and allowing corporate houses to own banks

The article argues against the suggestion of allowing the corporate houses in the banking sector in India.

Context

  • An Internal Working Group of the Reserve Bank of India (RBI) has recommended that corporate houses be given bank licences.

Background of the idea

  • In February 2013, the RBI had issued guidelines that permitted corporate and industrial houses to apply for a banking licence.
  • No corporate was ultimately given a bank licence.
  • None of the applicants had met ‘fit and proper’ criteria.
  • In 2014, the RBI restored the long-standing prohibition on the entry of corporate houses into banking.
  • The RBI’s position on the subject has remained unchanged since 2014.

Advantages

  • Corporate houses will bring capital and expertise to banking.
  • Moreover, not many jurisdictions worldwide bar corporate houses from banking.

Risks involved

  • As the report notes, the main concerns are interconnected lending, concentration of economic power and exposure of the safety net provided to banks
  • Corporate houses can easily turn banks into a source of funds for their own businesses.
  • In addition, they can ensure that funds are directed to their cronies.
  • They can use banks to provide finance to customers and suppliers of their businesses.
  • Adding a bank to a corporate house thus means an increase in concentration of economic power.
  • Not least, banks owned by corporate houses will be exposed to the risks of the non-bank entities of the group.
  • If the non-bank entities get into trouble, sentiment about the bank owned by the corporate house is bound to be impacted.

Suggestion by IWG and issues with them

  • The Internal Working Group (IWG) believes that before corporate houses are allowed to enter banking, the RBI must be equipped with a legal framework to deal with interconnected lending and a mechanism to effectively supervise conglomerates that venture into banking.
  • But there are following 4 issues with such suggestion-
  • 1) Tracing interconnected lending will be a challenge.
  • 2)The RBI can only react to interconnected lending ex-post, that is, after substantial exposure to the entities of the corporate house has happened.
  • It is unlikely to be able to prevent such exposure.
  • 3) Any action that the RBI may take in response could cause a flight of deposits from the bank concerned and precipitate its failure.
  • 4) Pitting the regulator against powerful corporate houses could end up damaging the regulator.

Issues in allowing NBFC owning corporate house in banking

  • Under the present policy, NBFCs with a successful track record of 10 years are allowed to convert themselves into banks.
  • The Internal Working Group believes that NBFCs owned by corporate houses should be eligible for such conversion.
  • This promises to be an easier route for the entry of corporate houses into banking.
  • The Internal Working Group argues that corporate-owned NBFCs have been regulated for a while.
  • However, there is a world of difference between a corporate house owning an NBFC and one owning a bank.
  • Bank ownership provides access to a public safety net whereas NBFC ownership does not.
  • The reach and clout that bank ownership provides are vastly superior to that of an NBFC.
  • The objections that apply to a corporate house with no presence in bank-like activities are equally applicable to corporate houses that own NBFCs.

Consider the question “What are the concerns and challenges in allowing the corporate houses in the banking sector in India?” 

Conclusion

India’s banking sector needs reform but corporate houses owning banks hardly qualifies as one. If the record of over-leveraging in the corporate world in recent years is anything to go by, the entry of corporate houses into banking is the road to perdition.

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Banking Sector Reforms

`Financial institutions in India need more freedom

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Paper 3- Challenges faced by lending financial institutions and the issue of stagnant credit growth in India

The article deals with the issue of credit and financial institutions in India. It also suggests the five changes needed in the lending financial institutions in India.

Financial institutions and credit in India

  •  India has labour and land but not enough capital.
  • The case for foreign financial institutions is also simple — their technology, processes, and experience raise everybody’s game.
  • India is open — foreigners own 25 per cent of public equity, 90 per cent of private equity, and Google and Walmart are UPI’s biggest volume contributors.
  • India’s challenge over the last 10 years has been bank credit.
  • Credit-to-GDP ratio is stuck at 50 per cent, banking concentration measured by flow has increased by 70 per cent, and bad loans exceed Rs 10 lakh crore.

Significance of  lending financial institutions

  • Foreign institutions are unlikely to lend when needed most and lend to small enterprise borrowers.
  • Bank numbers have practically remained unchanged since 1947 despite world-leading net interest margins.
  • Nationalised banks that have an eight-times higher chance of bad loan, would save Rs 35,000 crore annually with industry benchmarked productivity.
  • regulators prioritise domestic stakeholders.
  • The home bias for global bank lending is accelerating.
  • UPI crossing 2 billion monthly transactions demonstrates how mandated interoperability, local innovation, and enlightened regulation help insurgents take on incumbents.

5 Changes required in lending financial institutions

  • 1) The biggest impact lies in creating a nationalised bank holding company that replaces the Finance Ministry’s Department of Financial Services, has no access to government finances, and is governed by an independent board.
  • 2) We must licence 25 new full banks over 10 years.
  • 3) We must expect and empower the RBI to deal with bank challenges earlier, faster, and invasively, by reimagining post-mortems, granting listed bank capital induction flexibility and making regulation ownership agnostic.
  • 4) We must explore new eyes for banking supervision that include differential deposit insurance pricing.
  • 5) Finally, financial stability and innovation are not contradictory; let’s blunt regulatory barriers between banks, non-banks, and fintech.

Conclusion

The opportunities for India arising from the coming Asian century, China’s contradictions and China’s new inward focus strategy come not once in a decade but once in a generation. Let’s empower our financial services entrepreneurs to exploit this opportunity.

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Banking Sector Reforms

SC asks govt to implement ‘interest waiver’ scheme at the earliest

Note4Students

From UPSC perspective, the following things are important :

Prelims level: NPA

Mains level: Paper 3- Implications of Supreme Court order in the loan waiver.

The article examines the implications of the Supreme Court order dealing with the loan waiver and ban on the recognition of the bad loan.

Significance of common man as a depositor

  • India’s Rs 144 lakh crore in bank deposits make our Rs 110 lakh crore in bank loans possible.
  • The “common man” is more likely a depositor than a borrower; banks have 21 crore deposit accounts but only 2.7 crore loan accounts.

Issues with the court order

  • The Supreme Court has weighed in on the waiver scheme and recognition of the bad loan.
  • Waiving interest dues or banning bad loan recognition is economically ignorant because more than 20 per cent of Indians are depositors while less than 2 per cent are borrowers.
  • It has nothing to with economic justice defined as the greatest good for the greatest number.
  • It sabotages economic justice because fiscally funding banking diverts money from education, health and skilling expenditure.
  •  It’s commercially ignorant because any “annualised effective rate” is adjusted for interest payment frequency.
  • Resources are finite with total central government expenditure at Rs 29 lakh crore, scarce as COVID creates a Rs 3 lakh crore GST shortfall and fragile our fiscal deficit may exceed 12 per cent.
  • Also, it is hardly what our Constitution imagined as the role of courts.
  • Our Constitution writers made a distinction between fundamental rights and directive principles was not a lack of ambition but a measured assessment of state capacity, resources and sequencing.
  • The Constitution also envisaged distinct roles for the judiciary, executive and legislature to balance samaj (society), bazaar (markets) and sarkar (government).
  • Courts have become less mindful of these two distinctions.

Cost of credit and availability issue in India

  • One of the reasons for small size of Indian enterprises in the availability and cost of credit in India.
  • India’s credit-to-GDP ratio stands at dismal  50 per cent  — Bihar is 12 per cent and Arunachal is 1 per cent.
  • The MSME lending is stuck at Rs 20 lakh crore — needs to rise to 100 per cent.
  • Despite lower inflation and fiscal discipline, most borrowers don’t get globally competitive interest rates due to high bad loans and financial statement uncertainty.
  • The availability of credit will not rise and cost will not fall till our banking system has strong competition, consistent regulation, effective supervision and non-fiscal sustainability.

Consider the question “How the crisis in the banking sector is different from the crisis in other sectors? Also, examine the issues with the Supreme Court order on the loan waiver and recongnition of bad loan ban?” 

Conclusion

Institutional immunity needs balancing of independence and accountability; rising citizen concern about mandates and appointments should trigger court introspection.

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Banking Sector Reforms

Dilution of efficiency based principles and its implications for finacial markets

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Bond markets, SLR

Mains level: Paper 3- Issues with the financial markets in India

The article discusses the themes of the recently published books by Viral Acharya and Urjit Patel. Both the books deal with the issues with the financial markets in India

Context

  • Two recently published books by Viral Acharya and Urjit Patel throws light on the issues with India’s finance market and role of RBI and the government.

Importance of financial markets

  • Banks along with bond and equity markets oversee the matching of savers with borrowers.
  • Without financial markets, businesses would be restricted to investing out of retained earnings alone.
  • The financial markets have to satisfy the return appetites of savers while minimising their risk exposure.

Undue preference to fiscal interest of the government

  • A major theme of Acharya’s book is the rampant subjugation of the financial and monetary infrastructure to the fiscal interests of the government.
  • Consider, for example, the conduct of monetary policy.
  • Since bank assets are marked to market, cuts in interest rates induce treasury gains for banks that effectively recapitalises them.
  • Consequently, rate cuts are preferred by governments needing to inject capital into public sector banks (PSBs).
  • For the same reasons, liquidity injections, which raise bond prices, are preferred to liquidity absorptions.
  • Fiscal compulsions of government can induce liquidity policies that have the opposite effect on the rate-setting by the MPC.
  • This contradiction is further complicated by the fact that the RBI is also the debt management agency for the government.
  • As a debt management agency, RBI’s key tasks is to sell government bonds at the highest possible price.
  • Pressures for regulatory forbearance in recognising NPAs often arise from the government wanting to avoid having to recapitalise PSBs.
  • The sameexplains the fact that stock exchanges in India having a 30-day disclosure norm for registered borrowers who default on their bank loans.
  • The standard in developed capital markets is immediate disclosure.
  • But that would induce an overnight rating downgrade of the concerned borrower thereby triggering additional capital provisioning needs for the lending bank.

Conflict in government owning the PSBs

  • Patel’s book deals with conflicts inherent in the state owning the banks that control about three-fourth of total banking assets in India.
  • The primary problem with PSBs is that governments have used them as tools for macroeconomic management.
  • PSBs are regularly used for resource mobilisation to finance fiscal deficits.
  • The government often announces credit policies rather than having the banks allocate credit based on risk-return management criteria.
  • PSBs are the favoured instrument for meeting employment targets, supporting farmers through loan write-offs, etc.

What are the implications of government owning PSBs

  • This kind of state interface naturally induces extreme levels of moral hazard in the behaviour of both debtors and creditors.
  • PSBs are not incentivised to exercise due diligence since they expect regulatory forbearance and recapitalisation in the event of rising NPAs.
  • The dilution of efficiency-based principles for banking has implications for all borrowers.
  • Creditworthy borrowers pay the risk premia to cover the riskiness due to unhealthy borrowers.
  • The worsening risk pool of borrowers is partly to blame for the fact that long term borrowing rates have remained stubbornly high despite repeated rate cuts by the MPC over the past 18 months.

3 Problems and 3 Reforms

Problems

  • There are three obvious problems with the existing architecture.
  • The first is the state ownership of banks.
  • The second is the chronically high fiscal deficit run by the consolidated public sector.
  • The third is the widespread perception that market regulators work under close government direction. 

Reforms

  • Dealing with this will require, at a minimum, three reforms.
  • First, there has to be a wholehearted attempt at privatisation of PSBs.
  • Second, the RBI needs to be relieved of its public debt management role.
  • Third, the RBI has to be empowered to act independently of the government.

Conclusion

The growth of firms, which is a key driver of productivity and growth, requires well-functioning financial markets. India has a lot of work to do.


Back2Basics: How cuts in interest rates induce treasury gains for banks?

  • Falling rates across the debt markets increase the demand for instruments that pay higher interest.
  • At this stage, prices of bonds which banks had bought when interest rates were high rise.
  • Hence, the value of government securities that banks have bought for the SLR requirement rises.
  • This increases profits as banks record the market value of these securities in their books.
  • Under this process, called marking to market, organisations record profits/losses in their books on a daily basis without actually booking any profit or loss.
  • So, more SLR bonds the bank holds, the higher its mark-to-market profit.
  • The other reasons bank profits rise when interest rates fall are pick-up in growth as companies borrow at lower rates as well as improvement in liquidity.

Source:-

https://www.businesstoday.in/moneytoday/banking/banks-to-make-huge-treasury-gains-on-bonds-on-rbi-rate-cut/story/193552.html

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Banking Sector Reforms

What are Basel III compliant Bonds?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Basel norms

Mains level: Basel norms

The country’s largest lender State Bank of India has raised Rs 7,000 crore by issuing Basel III compliant bonds.

Try this PYQ:

Q.‘Basel III Accord’ or simply ‘Basel III’, often seen in the news, seeks to:

(a) Develop national strategies for the conservation and sustainable use of biological diversity

(b) Improve the banking sector’s ability to deal with financial and economic stress and improve risk management

(c) Reduce greenhouse gas emissions but places a heavier burden on developed countries

(d) Transfer technology from developed countries to poor countries to enable them to replace the use of chlorofluorocarbons in refrigeration with harmless chemicals

What are Basel III compliant Bonds?

  • The bonds qualify as tier II capital of the bank, and has a face value of Rs 10 lakh each, bearing a coupon rate of 6.24 per cent per annum payable annually for a tenor of 10 years.
  • There is a call option after 5 years and on anniversary thereafter.
  • Call option means the issuer of the bonds can call back the bonds before the maturity date by paying back the principal amount to investors.

Back2Basics: What are Basel Norms?

  • Basel is a city in Switzerland. It is the headquarters of the Bureau of International Settlement (BIS), which fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations.
  • Basel guidelines refer to broad supervisory standards formulated by this group of central banks – called the Basel Committee on Banking Supervision (BCBS).
  • The set of the agreement by the BCBS, which mainly focuses on risks to banks and the financial system is called Basel accord.
  • The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
  • India has accepted Basel accords for the banking system.

Basel I

  • In 1988, BCBS introduced a capital measurement system called Basel capital accord, also called as Basel 1.
  • It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
  • The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
  • RWA means assets with different risk profiles.
  • For example, an asset-backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

Basel II

  • In June ’04, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.
  • The guidelines were based on three parameters, which the committee calls it as pillars:
  • Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
  • Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
  • Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

Basel III

  • In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
  • A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
  • Also, the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
  • Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
  • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

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Banking Sector Reforms

EASE Banking Reforms Index

Note4Students

From UPSC perspective, the following things are important :

Prelims level: EASE Banking Reforms Index

Mains level: Banking sector reforms

Union Minister of Finance & Corporate Affairs has felicitated best performing banks on EASE Banking Reforms Index.

Note the various themes under which the index works.

EASE Banking Reforms Index

  • EASE stands for ‘Enhanced Access and Service Excellence’. The index is prepared by the Indian Banking Association (IBA) and Boston Consulting Group.
  • It is commissioned by the Finance Ministry.
  • It is a framework that was adopted last year to strengthen public sector banks and rank them on metrics such as responsible banking, financial inclusion, credit offtake and digitization.

Various themes and performance by the states

 

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Banking Sector Reforms

RBI revises guidelines for opening Current Accounts

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Current Account

Mains level: Paper 3- Steps taken by the RBI to stop banking frauds

The article explains the salience of the RBI’s recent restriction on the opening of current accounts by the companies.

Context

  • RBI has put restrictions on who can open a current account with which bank.

What are the restrictions and why it matters

  • A company that has borrowed from a bank cannot open a current account with another bank.
  • It can open a current account with its lending banks under some circumstances.
  • Otherwise such company is encouraged to use the cash credit and overdraft facilities under which it has borrowed.

Let’s understand why it matters

  • Firms borrow from PSU banks, but open current accounts with private or foreign banks.
  • When transactions move to current account of banks other than the lending bank, it loses visibility on end use of the funds.
  • Basically the PSU bank has no idea where the money has gone.
  • For example, when a firm gets money from its customers, instead of parking it with the lending bank it puts it in the current account with another bank.
  • The lending bank has no way of knowing if the loan is going bad wilfully or otherwise.

Why private banks may oppose the move

  • Easy revenue source has got blocked.
  • They can, of course, start lending to firms to retain this business but that would mean taking risk.
  • It would be far safer to be with retail customers who have neither power nor lawyers to defend them against sharp banking practices.

Why it matters to bank customers

  • Vanishing money raises the cost of funds to the bank and results in higher lending rates and lower deposit rates for us.
  • For taxpayers, it means regular use of our funds to recapitalize the banking system that periodically goes bankrupt due to loans gone bad.
  • So, an overall tightening of the system is great news.

Conclusion

For too long have the citizens been punished with greater scrutiny, tighter rules, higher costs and fewer benefits as compared to the suits. We should let the banks hand-wring, but celebrate the closure of each loophole as it happens.


Back2Basics: What is the current account?

  • A current account is like a savings bank account, but with many facilities for swift and multiple transactions, overdraft facilities and it carries no interest.
  • Banks like to sell these accounts as they enjoy huge floats, or money that just sits with the bank waiting to be used by the depositing firms.

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Banking Sector Reforms

Balancing the interest of lenders and borrowers

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much

Mains level: Paper 3- Problems of banks in India

The article suggests the 5 point strategy to balance the interest of borrowers and lenders. Banks hold the special significance for the country and so require special and stricter regulation.

Context

  •  COVID creates deep pain but we must resist consistently choosing borrowers over lenders.
  • We should persist with our multi-year five-pillar strategy to sustainably raise our Credit to GDP ratio from 50 per cent to 100 per cent.

Issue of lending

  • A modern economy grows by lending.
  •  But fiscal constraints or natural disasters often create temptations to disguise spending as lending.
  • The last 20 years have given three lessons:
  • 1) Giving loans is easier than getting them back.
  • Corporate credit growing from Rs 18 lakh crore in 2008 to Rs 54 lakh crore in 2014 created a Rs 12 lakh crore bad loan problem.
  • 2) Accounting fudging and restructuring would not help.
  • 3) Government banks need more than capital.
  • Government banks’ risk-weighted assets are lower than two years ago despite a Rs 2 lakh crore capital infusion.

History recommends patiently balancing financial inclusion and stability by persisting with our five-pillar strategy.

1) Bank competition

  • Raising credit availability and lowering its price needs competition-driven innovation.
  • Capital should be chasing Indian banking given its high net interest margins, high market cap to book value ratios, and massive addressable market.
  • Yet, the RBI’s on-tap licencing has few applications pending.
  • We need many more banks.

2) Private bank governance

  • Private banks are only 30 per cent of deposits but 80 per cent of bank market capitalisation.
  • Private banks are a special species with 20 times leverage, but this makes privatised gains and socialised losses possible.
  • Recent failures suggest problems with public shareholder collective action and the attention, skill, and courage of board directors.
  • Private bank governance must move from a perpetual private fiefdom to trustees that hand over in better condition to the next generation.

3) Government bank governance

  • Over 10 years, government companies have sunk from 30 per cent of India’s market capitalisation to 6 per cent.
  • Government banks mirror this decline — their 70 per cent bank deposit share translates to only 20 per cent bank market capitalisation share.
  • Many have irrational employee costs to market capitalisation ratios ex- Bank of India with 58 per cent.
  • We need only four government banks with strong governance and no tax access for capital.

4) RBI’s regulation and supervision

  • Recent failures in financial institutions reinforce the importance of statutory auditors, ethical conduct, shareholder self-interest, and risk management.
  • They also suggest a first-principles review that raises the RBI’s regulation and supervision.
  • Zero failure is impossible, but the RBI should boldly re-imagine its current mandate, structure and technology.

5) Non-bank regulatory space

  • Regulatory differences traditionally existed between banks and non-banks.
  • But progress in payments, MSME lending, and consumer credit suggest that non-banks are as important for financial inclusion.
  • They need more regulatory space and supervision.

Conclusion

We won’t test the RBI’s COVID worst-case scenario of 14.7 per cent bad loans but handling the inevitable COVID bank pain needs resisting short-termism. In the long run, we are not all dead.

Original article: https://indianexpress.com/article/opinion/columns/rbi-bank-and-the-covid-pain-india-gdp-6543101/

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Banking Sector Reforms

Will capping the bank CEO tenure make difference

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Bank CEO tenure and appointement

Mains level: Paper 3- Governance of the banks

The article examines the utility of the proposed limit on the banks CEO tenure.

Context

  • Last month, the Reserve Bank of India released a discussion paper on governance in commercial banks in India.
  • It has a proposal to cap the tenure of bank CEOs.

Details of the proposed limit and rationale

  • The paper proposes to cap the maximum tenure of a promoter/major shareholder of a bank as a CEO or a Whole Time Director (WTD) at 10 years.
  • This move aims to separate ownership from management.
  • The rationale offered is that 10 years is an adequate period for a promoter/major shareholder of a bank as CEO/WTD to stabilise its operations and to transition the managerial leadership to professional management.
  • The corresponding limit for a CEO who is not a promoter/major shareholder is 15 consecutive years. T
  • Thereafter, that individual is eligible for re-appointment as CEO or WTD only after the expiration of three years.

Why banks are different from other companies: 3 Reasons

  • Ordinary corporate governance norms exhort managers to run a company in the interest of shareholders but it may not be suitable approach for all types of banks.
  • 1) Banks are highly leveraged, creating powerful incentives for shareholders to engage in risky strategies at great risk to creditors, including retail depositors.
  • 2) Bank failure could involve systemic risk, which could result in a government bail-out.
  • This moral hazard creates even more high-powered incentives for shareholders to engage in risky strategies.
  • 3) Financial assets held by a bank are hard to monitor and measure.
  • Consequently, external scrutiny of a bank by depositors and creditors is difficult.
  • These unique factors are likely to encourage bank managers to take excessive risks to maximise shareholder value.

Purpose of Bank governance

  • Bank governance seeks to curb such excessive risk-taking discussed above.
  • It encourages prudent risk-taking such that shareholders’ interests are secondary to depositors’ interests.
  • This is the main logic as suggested in the Basel Committee on Banking Supervision guidelines and the Financial Stability Board principles respectively.

Will capping the CEO tenure help

  • It is unclear whether imposing a maximum cap on CEO tenure would encourage prudent risk-taking by the management.
  • For Indian banks, the limited empirical evidence seems to suggest that bank performance improves with increasing CEO tenure.
  • A paper published in International Journal of Financial Studies finds that an increase in CEO tenure is associated with significant improvements in asset quality and performance of the bank.
  • The effect of CEO tenure increases rapidly with the year of CEO tenure.
  • Concerning public sector banks (PSBs), the P J Nayak Committee report had identified shorter tenure of chairmen and executive directors as a key reason for weaker empowerment of their boards.
  • These findings seem to be at odds with RBI’s suggestion to cap CEO tenure.

Consider the question “Examine the factors that justify the application of stricter governance principle for the banks. What would be the impacts of the RBI’s proposed limit on the CEO term of the banks on governance?

Conclusion

It may be prudent for the RBI to publish an empirical study on the impact of CEO tenure on bank performance before translating this proposal into an enforceable regulation.

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Banking Sector Reforms

How reverse repo rate became benchmark interest rate in the Indian economy?

Note4Students

From UPSC perspective, the following things are important :

Prelims level: LTRO, Repo and Reverse repo rate

Mains level: Read the attached story

Context

  • The Indian economy’s slowdown during 2018 and 2019 is becoming much worse in 2020 with the spread of COVID-19 and the stalling of almost all economic activity.
  • Like most other central banks in the world, the RBI, too, has tried to cut interest rates to boost the economy.
  • However, unlike in the past, when the RBI used its repo rate as the main instrument to tweak the interest rates, today, it is the reverse repo rate that is effectively setting the benchmark.

We can expect a straight forward question based on this newscard.  For example:  “Critically examine the efficacy of reverse repo rate as benchmark interest rate in the Indian economy. “

What are repo and reverse repo rates?

  • The repo rate is the rate at which the RBI lends money to the banking system (or banks) for short durations.
  • The reverse repo rate is the rate at which banks can park their money with the RBI.
  • With both kinds of the repo, which is short for repurchase agreement, transactions happen via bonds — one party sells bonds to the other with the promise to buy them back (or repurchase them) at a later specified date.
  • In a growing economy, commercial banks need funds to lend to businesses.
  • One source of funds for such lending is the money they receive from common people who maintain savings deposits with the banks. Repo is another option.

Repo as benchmark

  • Under normal circumstances, that is when the economy is growing; the repo rate is the benchmark interest rate in the economy.
  • This is because it is the lowest rate of interest at which funds can be borrowed and, as such, it forms the floor rate for all other interest rates in the economy.
  • For instance, the interest rate consumers would have to pay on a car loan or the interest rate they will earn from a fixed deposit etc.

What has changed now?

  • Over the last couple of years, India’s economic growth has decelerated sharply.
  • This has happened for a variety of reasons and has essentially manifested in lower consumer demand.
  • In response, businesses held back from making fresh investments and, as such, do not ask for as many new loans.
  • Add to this, the pre-existing incidence of high non-performing assets (NPAs) within the banking system.
  • Thus, the banks’ demand for fresh funds from the RBI has also diminished. This whole cycle has acutely intensified with the ongoing lockdown.

Consequences: Rise in Liquidity

  • As such, the banking system is now flush with liquidity for two broad reasons.
  • On the one hand, the RBI is cutting repo rates and other policy variables like the Cash Reserve Ratio to release additional and cheaper funds into the banking system so that banks could lend.
  • On the other, banks are not lending to businesses, partly because banks are too risk-averse to lend and partly because the overall demand from the businesses has also come down.

So, how has reverse repo become the benchmark rate?

  • The excess liquidity in the banking system has meant that banks have been using only the reverse repo (to park funds with the RBI) instead of the repo (to borrow funds).
  • As of April 15, RBI had close to Rs 7 lakh crore of banks’ money parked with it.
  • In other words, the reverse repo rate has become the most influential rate in the economy.

What has the RBI done?

  • Recognising this, the RBI has cut the reverse repo rate more than the repo (see graph) twice in the spate of the last three weeks.
  • The idea is to make it less attractive for banks to do nothing with their funds because their doing so hurts the economy and starves the businesses that genuinely need funds.

Will the move to cut reverse repo, work?

  • It all depends on the revival of consumer demand in India.
  • If the disruptions induced by the outbreak of novel coronavirus continue for a long time, consumer demand, which was already quite weak, is likely to stay muted.
  • Businesses, in turn, would feel no need to borrow heavily to make fresh investments.
  • If consumer demand revives quickly, the demand for credit will build up as well.

Concerns of lower reverse repo

  • From the banks’ perspective, it is also important for them to be confident about new loans not turning into NPAs, and adding to their already high levels of bad loans.
  • Until banks feel confident about the prospects of an economic turnaround, cuts in reverse repo rates may have little impact.

Back2Basics: Long Term Repo Operations (LTRO)

  • The LTRO is a tool under which the RBI provides 1-3 year money to banks at the prevailing repo rate, accepting government securities with matching or higher tenure as the collateral.
  • Funds through LTRO are provided at the repo rate.
  • But usually, loans with higher maturity period (here like 1 year and 3 years) will have a higher interest rate compared to short term (repo) loans.
  • According to the RBI, the LTRO scheme will be in addition to the existing Liquidity Adjustment Facility (LAF) and the Marginal Standing Facility (MSF) operations.
  • The LAF and MSF are the two sets of liquidity operations by the RBI with the LAF having a number of tools like repo, reverse repo, term repo etc.

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Banking Sector Reforms

[pib] Capital to Risk Weighted Assets Ratio (CRAR)

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Regional Rural Banks (RRBs), CRAR

Mains level: Recapitalization of RRBs

The Cabinet Committee on Economic Affairs has given its approval for continuation of the process of recapitalization of Regional Rural Banks (RRBs) by providing minimum regulatory capital to RRBs which are unable to maintain minimum Capital to Risk weighted Assets Ratio (CRAR) of 9%, as per the regulatory norms prescribed by the RBI.

What is CRAR?

  • CRAR also known as Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital to its risk.
  • CRAR is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.
  • The Basel III norms stipulated a capital to risk-weighted assets of 8%.
  • In India, scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a CAR of 12% as per RBI norms.
  • It is arrived at by dividing the capital of the bank with aggregated risk-weighted assets for credit risk, market risk, and operational risk.
  • RBI tracks CRAR of a bank to ensure that the bank can absorb a reasonable amount of loss and complies with statutory Capital requirements.
  • The higher the CRAR of a bank the better capitalized it is.

Why recapitalize RRBs?

  • RRBs are primarily catering to the credit and banking requirements of agriculture sector and rural areas with focus on small and marginal farmers, micro & small enterprises, rural artisans and weaker sections of the society.
  • A financially stronger and robust RRB with improved CRAR will enable them to meet the credit requirement in the rural areas.
  • As per RBI guidelines, the RRBs have to provide 75% of their total credit under PSL (Priority Sector Lending).
  • In addition, RRBs also provide lending to micro/small enterprises and small entrepreneurs in rural areas.
  • With the recapitalization support to augment CRAR, RRBs would be able to continue their lending to these categories of borrowers under their PSL target, and thus, continue to support rural livelihoods.

Back2Basics

Regional Rural Banks (RRBs)

  • RRBs are Scheduled Commercial Banks operating at regional level in different States of India. They are recognized under the Regional Rural Banks Act, 1976 Act.
  • They have been created with a view of serving primarily the rural areas of India with basic banking and financial services.
  • However, RRBs may have branches set up for urban operations and their area of operation may include urban areas too.
  • The area of operation of RRBs is limited to the area covering one or more districts in the State.

Their functions

RRBs also perform a variety of different functions. RRBs perform various functions in following heads:

  • Providing banking facilities to rural and semi-urban areas
  • Carrying out government operations like disbursement of wages of MGNREGA workers, distribution of pensions etc.
  • Providing Para-Banking facilities like locker facilities, debit and credit cards, mobile banking, internet banking, UPI etc.
  • Small financial banks etc.

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Banking Sector Reforms

Let clear principles prevail in the bailout of Yes Bank

Note4Students

From UPSC perspective, the following things are important :

Prelims level: AT-1 bonds.

Mains level: Paper 3- Issues involved in banking system and resolution process in case of failures.

Context

Resolving bank failure is tough but following a set of principles could achieve a fair and efficient outcome.

Key issues involved in the resolution

  • Challenge in courts: Resolving Yes Bank’s failure is no easy task. Some bondholders are already challenging the restructuring plan of the Reserve Bank of India in court, and seem ready for a long-drawn battle.
  • How much dilution is fair for existing shareholders to take?
  • AT-1 Bonds issue: Should the value of the Additional Tier 1 (AT-1) bonds be written off entirely?
    • As such issues become matters of policy discussion and address, we must not lose sight of some fundamental principles of resolving bank failures.
  • Three of them should be on the top of the list: honour contracts, address market failure and protect systemic stability.

How honouring contracts matter for economy?

  • For efficient outcomes: Honouring contracts is vital for achieving efficient outcomes between contracting parties such as lenders and borrowers, managers and shareholders, and insiders and outsiders.
  • Shying away from entering a contract: If there is uncertainty over this fundamental principle, contracting parties will shy away from entering contracts in the first place.
    • Lenders will be less willing to lend.
    • Prospective minority shareholders will be less keen to buy shares in a company.
  • Impact on allocative efficiency: This will ultimately compromise the economy’s allocative efficiency, or the market’s ability to deploy capital to its best use.

AT-1 bond issue

  • Honouring contract in Yes banks resolution: There are several issues in the application of this principle in Yes Bank’s resolution.
    • The most visible one concerns the decision of writing off its perpetual contingent, or AT-1, bonds.
  • Write off: According to the original agreement, these additional tier-1 (AT-1) bonds are indeed supposed to be written off at a time like this.
    • And this write-off need not happen before the common equity value goes down to zero.
    • The entire idea behind these perpetual contingent bonds is to improve a bank’s capitalization if its common equity value falls below a certain threshold, but does not hit zero.
  • Counter argument: These bondholders and some commentators are arguing that writing off those bonds will be a big blow to India’s bond market.
    • Moral hazard problem: This is just the opposite of the truth. Not writing them off in accordance with the original contract will create a severe moral hazard problem.
    • What incentive would any bondholder have to correctly price and monitor these banks in the future?
    • Market discipline would die a quick death, and the bond market will suffer in the long run.
  • What the resolution process should do? Therefore, the resolution process should honour the contract and write off the entire value of Yes Bank’s AT-1 bonds.

Dealing with critical market failures

  • Second core principle: The second core principle in this resolution should be to tackle some critical market failures that led here.
    • Several observers have pointed out the failure of board oversight, promoter negligence and reckless lending at the bank.
  • Vital market failure in the purchase of AT-1 bonds by retail investors: Indeed, these issues must be addressed. But there seems to be another vital market failure hidden in this crisis: the purchase of AT-1 bonds by retail investors.
  • Why AT-1 bonds are complex? AT-1 bonds are “information-sensitive” instruments, which means that the value of these instruments is extremely sensitive to information on the firm’s fundamentals.
    • Complex financial security: They are very complex financial securities. Understanding the risk and reward associated with these securities and valuing them properly is not an easy task even for the best of market professionals.
    • Retail investors are certainly not suited to buy this product. Still, several of them ended up holding Yes Bank AT-1 bonds in their asset portfolios.
  • Demand deposits and market failure: Banking theory relies on the idea that demand deposits are information-insensitive instruments.
    • Hence, a retail investor can place deposits in a bank without worrying about understanding the real risks borne by it. Government-backed deposit insurance makes deposits even more liquid and riskless.
    • Hence, retail investors should hold regular deposits in a bank, and not complex securities like AT-1 bonds.
    • Where is the market failure involved? If such bonds are sold to them without proper disclosure of the associated risks, then it amounts to a serious market failure.
  • Way forward: This market failure must be corrected.
    • Holding investment advisors to higher standards of fiduciary responsibility is one way of doing so.
    • Prohibiting retail investors from investing in such securities is another critical step to prevent such a market failure.

Way forward to carry out the resolution process

  • Restitution of value to retail investors: Meanwhile, the resolution process could consider partial or full restitution of value to retail investors in Yes Bank’s AT-1 bonds, if these products were indeed mis-sold to them.
  • Large professional investors should be treated differently: But such a rescue must not extend to large professional investors who willingly bought these bonds for higher returns.
    • One mechanism to do this could be to create a separate fund for retail investors with investments capped at a certain point.
    • Or, their AT-1 investments up to a specific limit could be converted into a simple deposit contract. The legal hurdles may be insurmountable.
    • However, in principle, those who mis-sold these products to retail investors should be required to compensate them.
  • Conflict in two principles: Sometimes, these principles can come into direct conflict with each other.
    • If the resolution allows retail investors in those AT-1 bonds to recover their investments, it would go against the “honour the contract” principle, but it would address the “market failure” issue.
  • Ensuring systemic stability: How should we reconcile this conflict? That’s where the third principle comes in: ensuring systemic stability.
    • After all, the regulator’s main objective is to restore the market’s faith in the country’s financial system.
    • While this is not an easy task, protecting the capital and confidence of small investors can go a long way in restoring their faith in the banking system.

Conclusion

Resolving bank distress is never an easy job. But honouring contracts, addressing market failure and ensuring systemic stability can together go a long way in achieving a fair and efficient outcome.

 

 

 

 

 

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Banking Sector Reforms

Private: Banking Regulation (Amendment) Bill, 2020

Context

Banking Regulation (Amendment) Bill, 2020 was introduced in Lok Sabha on 3rd March 2020 to improve cooperative banks’ management and regulation to protect the interests of the depositors.

What is Banking Regulation (Amendment) Bill, 2020?

  • The Banking Regulation (Amendment) Bill, 2020 aimed to amend the Banking Regulation Act, 1949.
  • This bill seeks to give the Reserve Bank of India (RBI) the powers to regulate the cooperative banks.
  • It also looks to enforce banking regulation guidelines of the RBI in cooperative banks, while the Registrar of Cooperative deals with administrative issues.
  • This bill comes in response to the PMC bank crisis.

What are cooperative banks?

  • Cooperative banks are financial entities set up on a co-operative basis and belonging to their members.
  • This means that the customers of a cooperative bank are also its owners. They are registered under the States Cooperative Societies Act and they come under the RBI regulation under two laws:
  • Banking Regulations Act, 1949
  • Banking Laws (Cooperative Societies) Act, 1955
  • They aim to promote savings and investment habits among people, especially in rural areas.
  • These banks are broadly classified under two categories – Rural and Urban.
  • The rural cooperative credit institutions can be further classified into:
  • Short-term cooperative credit institutions
  • Long-credit institutions

The short-term credit institutions can further be sub-divided into:

  • State cooperative banks
  • District Central Cooperative banks
  • Primary Agricultural Credit Societies

Long-term institutions can either be:

  • State Cooperative Agricultural and Rural Development Banks (SCARDBs), or
  • Primary Cooperative Agriculture and Rural Development Banks (PCARDBs)
  • Urban Cooperative Banks (UCBs) can be further classified into scheduled and non-scheduled.
  • The scheduled and unscheduled can either be operating in a single state or multi-state.

What is the PMC bank scam?

  • Punjab and Maharashtra Cooperative Bank (PMC Bank) is facing regulatory actions and investigations over suspected irregularities in certain loan accounts.
  • PMC bank scam involves collusion between the bank’s top officials and the Housing Development and Infrastructure Ltd(HDIL).
  • This scam was exposed to the RBI by a whistle-blower, leading to the central bank clamping down the bank’s activities.
  • In September last year, restrictions were imposed upon the bank under Section 35A of the Banking Regulation Act, 1949.
  • Following this clampdown, the RBI found that about 6500 crores worth of loans(73% of bank’s total assets) were given to 44 HDIL group entities.
  • After the Central bank’s scrutiny, the percentage of gross NPA had spiked to 77% overnight, most of which belonged to HDIL.
  • PMC bank had violated the RBI norms of exposure.
  • According to the RBI norms of exposure, bank’s exposure to a group of connected companies is capped at 25%of its core capital, while it is capped at 15%for an individual company.
  • In this case, the exposure was 73% i.e., 73% of the total loan advanced were given to the HDIL group.
  • To breach the RBI norms of exposure, the bank had created approximately 21,000 dummy accounts. Through these accounts, the bank advanced loans to 44 HDIL group entities.
  • Whenever RBI inspects or an auditor looks at a bank’s books, they conduct a sample check of about 50 to 100 accounts only.
  • The 50 to 100 accounts shown by the PMC bank officials did not contain the undisclosed HDIL accounts.
  • Furthermore, these accounts were reported as standard accounts, which did not have defaults.
  • Due to these fraudulent activities, the extent of the violation was very low and thus was not exposed earlier.

Why do we need Banking Regulation (Amendment) Bill, 2020?

  • Prevent PMC -like crisis: The bill aims to bring multi-state cooperative banks under the radar of the RBIand prevent the repetition of a PMC-like crisis.
  • It also aims to bring cooperative banks at par with the commercial banks.
  • The changes proposed by this Bill are necessary to protect the interests of depositor
  • Currently, there are 1,540 cooperative banks in India, with about 8.60 depositors having savings worth approximately Rs.5 lakh crore.
  • In the past five fiscal years, there were nearly 1,000 fraud cases among urban cooperative banks worth more than Rs.220 crore.
  • The PMC bank scam had prompted the need for improved laws that can ensure better management and governance of these banks.

What are the salient features of the Banking Regulation (Amendment) Bill, 2020?

  • The recent amendments apply only to multi-state cooperative banks and urban cooperative banks.
  • The Cooperative banks are currently under the dual control of both the RBIand the Registrar of Cooperative Societies.
  • If this amendment bill is enforced, the RBI will have additional powers apart from regulatory functions. However, the Registrar of Cooperative Societies will continue to deal with the administrative issues of these banks.
  • This bill aims to enforce RBI’s banking regulation guidelines for cooperative banks.
  • These banks will be audited according to the RBI rules.
  • The bill mandates RBI’s approval for CEO appointments, similar to that of commercial banks.
  • The apex bank can supersede management in case of liquidation or failure of a cooperative bank. Recruitment will be based on certain qualifications.
  • The central bank can also replace the Board of Directors with a Board of management consisting of professionals any cooperative banks are facing stress. This is done after consultation with the state government.
  • This is to increase professionalism and ensure improvement in cooperative governance.

Significance of the bill

  • According to this Bill, larger cooperative banks will now be regulated like commercial banks.
  • Audit under RBI norms: Cooperative banks will be brought under the regulation of the RBI. They will be audited according to RBI’s norms.
    • Cooperative banks will now be required to meet stricter capital norms.
    • The amendments will now give legislative powers to the central bank.
  • Improve financial stability: To strengthen the Cooperative Banks, amendments to the Banking Regulation Act will help increase professionalism, enable access to capital and improve governance and oversight for sound banking through the RBI.
    • Observing The new changes will help strengthen financial stability.

 

Limitations

  • While this will help improve the UCBs, the rural cooperative banks are not part of this regulatory overhaul.
  • It should be noted that the issue of misgovernance and fraud is more in smaller cooperative banks since they are largely run by local politicians.
  • More often than not, these banks do not follow protocol and engage in dubious transactions.
  • According to the RBI data, the combined deposits of the rural cooperative banks are higher than those of UCBs.
  • Furthermore, the rural population is more dependent on these financial institutions than the urban populations.
  • Thus, the government must provide sufficient power to the RBI to govern rural cooperative banks while also ensuring stricter inspection and governance.

Conclusion:

The government must protect depositors’ interests and prevent fraud and corruption within banks. This bill seeks to provide the same. The government must take steps in expanding Bill’s ambit to rural cooperative banks to improve the rural economy’s growth and development

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Banking Sector Reforms

[pib] Mega Consolidation in Public Sector Banks 

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Bank Mergers

Mains level: Read the attached story

The Union Cabinet, chaired by the Prime Minister has approved the mega consolidation of ten PSBs into four which include the –

  • Amalgamation of Oriental Bank of Commerce and United Bank of India into Punjab National Bank
  • Amalgamation of Syndicate Bank into Canara Bank
  • Amalgamation of Andhra Bank and Corporation Bank into Union Bank of India
  • Amalgamation of Allahabad Bank into Indian Bank

About the merger

  • The amalgamation would be effective from 1.4.2020 and would result in creation of seven large PSBs with scale and national reach with each amalgamated entity having a business of over Rupees Eight lakh crore.
  • The Mega consolidation would help create banks with scale comparable to global banks and capable of competing effectively in India and globally.
  • Greater scale and synergy through consolidation would lead to cost benefits which should enable the PSBs enhance their competitiveness and positively impact the Indian banking system.

Must read

Bank Mergers

[Burning Issue] Merger of Public Sector Bank

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Banking Sector Reforms

Enhanced Access and Service Excellence (EASE) 3.0

Note4Students

From UPSC perspective, the following things are important :

Prelims level: EASE 3.0

Mains level: Ease and data-driven PSBs

 

 

Union Finance minister has released Enhanced Access and Service Excellence (EASE) 3.0, the new reform agenda for tech-enabled banking.

EASE 3.0

  • EASE 3.0 aims at providing smart, tech-enabled public sector banking experience for aspiring India, by establishing paperless and digitally-enabled banking at places where people visit the most such as malls, stations etc.
  • With EASE 3.0, the government is trying to enhance the customer experience with the introduction of features like Dial-a-loan, credit at a click, alternate-data-based lending or other analytics-based credit offers.

Various features

  • Palm Banking for “End-to-end digital delivery of financial service
  • “Banking on Go” via EASE banking outlets at frequently visited spots like malls, stations, complexes, and campuses
  • Digitalizing the experience at public sector bank branches

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Banking Sector Reforms

Specialized Supervisory and Regulatory Cadre (SSRC)

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Specialized Supervisory and Regulatory Cadre (SSRC)

Mains level: Governance of RBI

The RBI has decided to recruit 35% of the specialised supervisory and regulatory cadre from the market while the remaining 65% will be recruited via internal promotions.

Specialized Supervisory and Regulatory Cadre (SSRC)

  • The SSRC will comprise officers in Grade B to Executive Director level.
  • In Nov. last year RBI decided to reorganize its regulation and supervision departments.
  • It merged the three regulatory departments (department of bankingnon-banking and cooperative bank) into one and did likewise for the three supervisory departments.
  • As a result, there is only one supervisory department which looks after supervision of banks, NBFCs and cooperative banks and only one regulatory department for these three.
  • The move is aimed at dealing more effectively with potential systemic risk that could come about due to possible supervisory arbitrage and information asymmetry.

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Banking Sector Reforms

[op-ed snap] When the FRDI Bill Returns

Note4Students

From UPSC perspective, the following things are important :

Prelims level: Not much.

Mains level: Paper 3- Reforms in banking sector and financial stability, Deposit Insurance and its significance.

Context

The amendments to the FRDI Bill, 2017—now renamed the Financial Sector Development and Regulation (Resolution) Bill, 2019—are being worked out.

Three crucial issues

  • Specifics are being worked out in the bill on three crucial issues.
    • First issue: The first issue is regarding the increase in the deposit insurance cover of customers.
    • Second issue: To iron out the contentious issues related to the bail-in clause
    • Third issue: To decide whether this resolution framework should apply to the public sector banks.
  • Advantages of the move: At a time when the public sector banks have come under the stress of bad loans, increasing the deposit insurance coverage limit would be a welcome approach.
    • Increasing the depositor’s confidence: The move will reinforce depositors’ confidence in the banking system in general, and the public sector banks in particular.

The issue of the government “ownership” of the banks and financial stability

  • Ownership of government: The role of the “ownership” of banks towards financial stability is a much-debated issue in the country.
    • RBI is positive about govt. ownership: The Reserve Bank of India (RBI) has attributed a positive role to the government ownership of banks in attaining financial stability.
    • The issue of competitive neutrality: Committee to Draft Code on the Resolution of Financial Firms has blamed govt. ownership for causing a “lack of competitive neutrality” in the financial sector.
    • Need of level playing field: Committee argued for the need of a “level playing field” for both the public and private sector financial firms for the sake of competitive neutrality.
    • The concept of an overarching resolution framework for all financial firms gained traction.

Would the all-encompassing Resolution Corporation be efficacious?

  • The FRDI Bill, 2017 sought to amend as many as 20 legislations for the diverse financial sector in this country, which is regulated by various institutions, like-
    • RBI for the banks and the non-banking financial corporations.
    • Insurance Regulatory and Development Authority (IRDA) for the insurance markets,
    • Securities and Exchange Board of India (SEBI) for securities markets and mutual funds.
    • The Pension Fund Regulatory and Development Authority for pension funds.
  • The pertinent question
    • The pertinent question is whether an all-encompassing resolution corporation can be really efficacious for the much-discussed financial stability of this country.

 

Fundamental issues

  • Neutrality of ownership
    • Different motives behind operations: While private financial institutions are predominantly governed by profit motives, for the public sector agencies, various social obligations, such as “financial inclusion,” assume primacy.
    • Reason for commoner’s confidence: It is the sense of the government’s involvement (or ownership) that has forged commoners’ confidence to park their financial savings with them.
    • The move may end up destabilising the financial sector: If the sovereign guarantee and resolving power are taken away from the government domain to some resolution corporation, it may destabilise the financial system.
  • The Bail-in clause
    • Deposit over 1 lakh included in bail-in mechanism: The FRDI Bill 2017 suggests that deposit amounts over and above the cover limit (which currently is at one lakh) will be included in the bail-in mechanism.
    • Further, despite the RBI’s caution against financial instability, short-term debts and uncategorised client assets are also currently under this mechanism.
    • The falling growth rate of deposits: These provisions and the bill per se came against the backdrop of the Financial Stability Report, 2017 that revealed a 3.3% drop in the year-on-year growth rate of deposits for all scheduled banks in the country.

Conclusion

In the context of decelerating financial stability, the government needs to undertake these resolution reforms with caution that the reforms do not end-up eroding depositors’ faith in the domestic financial institutions.

 

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Banking Sector Reforms

Video based Customer Identification Process (V-CIP)

Note4Students

From UPSC perspective, the following things are important :

Prelims level: V-CIP

Mains level: Importance of KYC

The RBI has amended the KYC norms allowing banks and other lending institutions regulated by it to use Video-based Customer Identification Process (V-CIP), a move which will help them, onboard customers, remotely.

V-CIP

  • The V-CIP will be consent-based, will make it easier for banks and other regulated entities to adhere to the RBI’s KYC norms by leveraging the digital technology.
  • The regulated entities will have to ensure that the video recording is stored in a safe and secure manner and bears the date and time stamp.
  • As per the circular, the reporting entity should capture a clear image of PAN card to be displayed by the customer during the process, except in cases where e-PAN is provided by the customer.
  • The PAN details should be verified from the database of the issuing authority.
  • Live location of the customer (Geotagging) shall be captured to ensure that customer is physically present in India.

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