Banking Sector Reforms

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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.

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

 

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.

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/

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.

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.

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.

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.

 

 

 

 

 

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

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

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

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.

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.

Banking Sector Reforms

[pib] eBkry (eBक्रय) Portal

Note4Students

From UPSC perspective, the following things are important :

Prelims level : eBkry Portal

Mains level : Not Much

Union Finance Ministry has recently launched the eBkry e-auction portal.

eBkry Portal

  • To enable online auction by banks of attached assets transparently and cleanly for the improved realization of value, eBक्रय is launched.
  • It is framework for promoting online auction of assets attached by the banks.
  • It is equipped with the property search features and contains navigational links to all PSBs e-auction sites.
  • The framework aims to provide single-window access to information on properties.
  • eBkry also contains photographs and videos of the properties uploaded on the platform.

Banking Sector Reforms

International Financial Services Centres (IFSC) Authority Bill, 2019

Note4Students

From UPSC perspective, the following things are important :

Prelims level : IFSC Bill

Mains level : Banking regulation in India

The International Financial Services Centres Authority Bill, 2019 is likely to be taken up by Parliament.

IFSC Authority Bill, 2019

  • The Bill provides for the establishment of an Authority to develop and regulate the financial services market in the International Financial Services Centres in India.
  • The Bill will be applicable to all International Financial Services Centres (IFSCs) set up under the Special Economic Zones Act, 2005.

What is IFSC?

  • IFSCs are intended to provide Indian corporates with easier access to global financial markets, and to complement and promote further development of financial markets in India.
  • An IFSC enables bringing back the financial services and transactions that are currently carried out in offshore financial centres by Indian corporate entities and overseas branches/subsidiaries of financial institutions (FIs) to India.
  • This is done by offering business and regulatory environment that is comparable to other leading international financial centres in the world like London and Singapore.
  • The first IFSC in India has been set up at the Gujarat International Finance Tec-City (GIFT City) in Gandhinagar.

What is the need for such an Authority?

  • The release issued by the government explained that currently, the banking, capital markets and insurance sectors in IFSC are regulated by multiple regulators, i.e. RBI, SEBI and IRDAI.
  • However, the dynamic nature of business in the IFSCs necessitates a high degree of inter-regulatory coordination.
  • It also requires regular clarifications and frequent amendments in the existing regulations governing financial activities in IFSCs.
  • The development of financial services and products in IFSCs would require focussed and dedicated regulatory interventions.
  • Hence, a need is felt for having a unified financial regulator for IFSCs in India to provide world class regulatory environment to financial market participants.
  • Further, this would also be essential from an ease of doing business perspective.
  • The unified authority would also provide the much needed impetus to further development of IFSC in India in sync with the global best practices.

What is the Authority that the Bill seeks to set up?

  • The International Financial Services Centres Authority will consist of nine members, appointed by the central government.
  • They will include, apart from the chairperson of the authority, a member each from the RBI, SEBI, the IRDAI, and the PFRDA; and two members from the Ministry of Finance.
  • In addition, two other members will be appointed on the recommendation of a Search Committee.
  • All members of the IFSC Authority will have a term of three years, subject to reappointment.

Functions of the Authority

  • According to the PRS note, the Authority will regulate financial products such as securities, deposits or contracts of insurance, financial services, and financial institutions which have been previously approved by any appropriate regulator such as RBI or SEBI, in an IFSC.
  • It will follow all processes which are applicable to such financial products, financial services, and financial institutions under their respective laws.
  • The appropriate regulators have been listed in a Schedule to the Bill, and include the RBI, SEBI, IRDAI, and PFRDA.
  • The central government may amend this schedule through a notification.
  • Other functions of the Authority are the regulation of any other financial products, financial services, or financial institutions in an IFSC, which may be notified by the central government; and to recommend to the central government any other financial products, financial services, or financial institutions, which may be permitted in an IFSC.

Banking Sector Reforms

[op-ed snap] When a shadow bank is too indebted to fail

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FRDI Bill

Mains level : DHFL crisis; Resolution

Context

India is struggling to plug a hole in its shadow banking industry that gorged on lending to the real estate sector.

Failure of Financial Corporations

    • Insolvency – RBI is expected to refer to Dewan Housing Finance Corp. Ltd (DHFL) for insolvency proceedings that are hastily tailored for financial companies. 
    • IBC inadequate – India’s bankruptcy mechanism is missing vital components. 
    • FRDI not passed – The government withdrew the Financial Resolution and Deposit Insurance Bill. 
    • Depositors’ money – It happened after an outcry over a clause that would have let depositors’ money gets converted into equity in the event of a bank or credit company turning insolvent. 
    • Deposit insurance – Adequate deposit insurance is the solution. Centre has got back to it after the collapse of Punjab and Maharashtra Co-operative Bank has caused so much distress.

DHFL resolution

    • We have a system that can preserve value for creditors who have lent the company ₹84,000 crores.
    • No legislation – There may not be a legislative apparatus in place. But India knows what needs to be done with collapsing financial institutions. 
    • G20 – The G20 financial stability recommendations were based on the premise that the market must address stress in the system. 
    • No overarching mechanism – We do not yet have an overarching body like the US Federal Deposit Insurance Corp., which can identify and resolve financial stress expeditiously.
    • This job is divided among India’s central bank and other financial sector regulators. 
    • NCLAT – Such cases can now be referred to the National Company Law Tribunal for resolution. 
    • Courts – The courts could also back the claims of underinsured depositors. Supreme court upheld the standard hierarchy of claims in bankruptcy proceedings.

DHFL resolution

    • Its loan book looks largely healthy, especially its mortgage lending section. 
    • Buyers have shown interest in these assets and the insolvency process is expected to draw more. 
    • Bondholders and banks have their credit secured by underlying assets.

Challenges

    • Fraud – KPMG has flagged fraudulent transactions that could add up to about half the exposure banks have to DHFL. 
    • Writing off – If these charges are substantiated, banks may have to write off their loans to the mortgage lender. It would complicate any resolution plan involving a swap of debt for equity.
    • Possible attachment – DHFL is being investigated by the Enforcement Directorate on charges that could result in the attachment of its assets. This would make it tougher for resolution. 
    • If its insolvency resolution fails, India may have to subject its shadow banking industry to the same mechanism. 
    • Moody’s – Recently, the credit rating agency Moody’s Investors Service has flagged stress among non-banking financial companies as a key risk to India’s growth outlook.

 

Banking Sector Reforms

[op-ed snap] What PMC means

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Regulatory supervision over banking

Context

In at least three of the major financial sector scams in the last couple of months in India, featuring Punjab National Bank, IL&FS, Punjab and Maharashtra Cooperative Bank, apart from poor governance and fraudulent practices, a common thread has been a supervisory failure

Supervision

  • The country’s leading financial sector regulator, RBI, has been responding only after the event
  • As in IL&FS, in the PMC case too, there appears to be culpability on the part of the management and the board of the bank. 
  • Bank’s loan exposure to a single firm, HDIL, alone constituted 73% of its assets and several dummy accounts were created to camouflage this. 
  • The issue of dual control by the RBI and state governments has been cited as a hurdle by the regulator for its inability to effectively supervise cooperative banks.
  • Limitations in superseding the board of directors or removing directors of these banks, unlike in commercial banks. 

Cooperative banks & Credit delivery

  • The role of co-operative banks in ensuring credit delivery to the unorganised sector and last-mile access, to small businesses, is huge, as the large banks continue to focus on bigger cities and towns. 
  • A recent RBI report shows that fund flows to the commercial sector have declined by 88% in the first six months of this current fiscal. That would have hurt small businessmen, traders, and the farm sector.
  • Since liberalisation, the resilience of India’s financial sector is seen many times. This may have to do with the dominance of government-owned institutions or lenders and a strong central bank. 

Regulation – RBI

  • The central bank has already started building an internal cadre for the supervision of banks and other entities aimed at enhancing its oversight capabilities. 
  • This should be complemented by legislative changes which could lead to greater regulatory control and powers for the RBI. 
  • An insolvency regime for financial firms is the need of the hour. 
  • India needs not just a few large banks and lenders with a national or regional presence but also other players such as cooperative banks, small finance, and payment banks. 
  • There is a need for greater accountability on the part of India’s financial regulators.
  • Carving out a separate authority for supervision may only lead to regulators working in silos.

Banking Sector Reforms

[oped of the day] The current crisis at PMC Bank serves the country a warning

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Cooperative banks; PMC issue

Op-ed of the day is the most important editorial of the day. This will cover a key issue that came in the news and for which students must pay attention. This will also take care of certain key issues students have to cover in respective GS papers.

Context

The crisis unfolding at PMC Bank is a tip of the iceberg of larger, unresolved problems in India’s banking sector. 

Roots of the cause

    • The roots of the crisis in the banking sector go back to the unresolved problem of non-performing assets (NPAs).
    • These are magnified in the case of cooperative banks due to lax governance and a dicey business model.

Problems with RBI’s approach

    • By imposing severe withdrawal restrictions on depositors, those who suffer are largely the poor who prefer the higher deposit rates that cooperative banks offer.

Other problems with the cooperative sector

    • Bad loans and poor governance.
    • The business model offers depositors high-interest rates and lends money to borrowers of dubious credentials at low interests.
    • It can easily run into difficulty due to the resultant wafer-thin profit margins.
    • Poor regulatory response – it has so far been symptomatic and shows little understanding of the underlying disease. 
    • The government does not have a coherent and well-thought-out overarching strategy for economic policy. The policy seems reactive rather than forward-looking.

Way ahead for cooperative banks

    • Fundamentally reformed governance so that a crisis such as this one does not occur in the future. 
    • The long-run health of the banking sector requires short-run transitional costs. This dichotomy—between long-run and short-run cost—is at the root of many deferred or unfinished reforms.
    • Rationalizing taxes is a good start. But it cannot serve as a fix to the sort of problems that we are seeing at PMC Bank and other troubled banks. 
    • They need a more stringent regulatory process and, more fundamentally, legislative reform that overhauls the governance of cooperative banks as well as of the larger public banking sector. 

Conclusion

The fundamental political economy problem is that public sector banks serve multiple masters and, as a consequence, loan decisions are not always based on economic and financial logic. 

Banking Sector Reforms

[op-ed snap] Who pays?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Banking Regulation Act

Mains level : Need for stringent banking regulation

Context

RBI imposed curbs on the activities of the Punjab and Maharashtra Cooperative Bank (PMC) for a period of six months. This came when certain irregularities in the bank were discovered, including the under-reporting of non-performing assets (NPAs).

Problem

    • The crux of the problem is the bank’s exposure to a real estate firm, which itself is currently undergoing insolvency proceedings. 
    • The bank’s financials for the year ended March 2019 does not provide any indication of financial stress. 

RBI’s response

    • Initially, RBI allowed depositors to withdraw only Rs 1,000 over a six-month period. 
    • After a public outcry, it revised this limit upwards to Rs 10,000. With this relaxation, more than 60% of depositors would be able to withdraw their entire account balance.
    • The restrictions imposed by RBI under section 35A of the Banking Regulation Act, are aimed at safeguarding depositors’ interest and preventing a run on the bank.
    • These measures are seen as penalising depositors. But they can end up having the opposite effect of denting trust in cooperative banks and increasing the risk of contagion.
    • RBI has appointed J B Bhoria as an administrator of the bank. 
    • A forensic audit could shed light on an asset-liability mismatch and reveal the true extent of the problem. 
    • RBI could also explore the option of merging PMC with another healthy cooperative bank to avoid any instability, as it has done so in the past.

Issues that arise

    • It raises questions not only on the governance structures at these cooperative banks but also on their supervision
    • Cooperative banks are under the joint supervision of the RBI and states. 
    • While the RBI has signed MoUs with state governments, unless state governments cooperate in effecting regulations, supervision is likely to be ineffective.
    • There were no early warning signs of trouble in this case.
    • It is likely to raise calls for reviewing this regulatory framework and giving more powers to the RBI to oversee these entities. 

Way ahead

The RBI should also examine the long-term feasibility of their business models in light of the rapid technological changes in the financial sector. The larger question over the absence of a framework for the timely resolution of financial firms remains.

 


Back2Basics

The Banking Regulation Act, 1949 is legislation in India that regulates all banking firms in India.

Banking Sector Reforms

[op-ed snap] Banking on politics

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Bank mergers; Money in Politics

CONTEXT

India’s economic crisis is partly due to the decline of investments, which is partly due to the fact that companies cannot get access to loans as easily as before. This is a direct consequence of the huge level of the banks’ Non-Performing Assets (NPAs).

State of NPAs

  • NPAs have jumped from Rs 1.2 trillion in 2012 to 9.5 trillion in 2018. 
  • Public banks represented 70% of these NPAs.

On Bank Mergers

  • Centre announced reforms in the banking system which are mostly the mergers of weak banks

Background to the NPAs

  • Why did the public sector banks lent so much money to companies which are today unable to pay it back? 
  • In the 2000s, everybody thought that double-digit growth rates were there to stay and practised aggressive lending. This practice did not stop even in 2014.
  • In 2015, a 57-page report of Crédit Suisse gave a detailed account of the debts accumulated by a dozen big Indian companies. 
  • Soon after that, the RBI declared 12 Indian companies responsible for 25% of the NPAs. 
  • The Crédit Suisse report showed that companies facing heavy debts continued to borrow from the banking system. The Adani group’s debt, for instance, increased by 16% in 2015.
  • The piling up of the NPAs has to do with the relationship between the country’s rulers and the heads of the public banks
  • Crony capitalism – the nexus between businessmen and politicians is based on an exchange of favours: The former help the latter to get access to credit in return for funds for election campaigns.

Politics and money

  • According to several estimates — by the Centre for Media Studies and the Association for Democratic Reforms — India’s 17th general elections were the costliest ever in the history of democracies. Parties have spent $7.2 billion. 
  • Cash, drugs, liquor and precious metals worth nearly Rs 3,500 crore were reportedly seized by enforcement agencies in the run-up to the Lok Sabha polls.
  • Political parties were able to amass money due to a scheme authorising businesses and individuals to make anonymous contributions to political parties — electoral bonds
  • The ruling party reaped 95% of the contributions through such bonds which former Chief Election Commissioner S Y Qureshi, described as “legalisation of crony capitalism”.
  • Alt News scrutinised the Ad Library Report of Facebook to find out that pro-BJP and pro-central government pages represented 70% of the total ad revenue made public by Facebook. Of the top 10 political advertisers, eight were related to the BJP and spent Rs 2.3 crore on Facebook ads. 
  • The BJP spent about Rs 6 crore on political ads on Google platforms, 10 times more than the Congress. 
  • Unofficial BJP Facebook pages, such ‘Bharat ke Mann ki Baat’, ‘Nation with NaMo’ and ‘My First Vote for Modi’ cumulatively spent Rs 4.50 crore in the same period.

Way ahead on banking reforms

  • Protection of the banks’ CEOs from political interferences. 
  • Privatisation – the private banks are not as badly affected by the NPAs as the public ones.
  • More rigorous management autonomy under the aegis of a robust regulator.

Banking Sector Reforms

[op-ed snap] The case for privatizing public sector banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Public Sector Bank privatization

CONTEXT

Former RBI governor D. Subbarao raised the question of whether India needs public sector banks at all in this day and age.

Reasons for privatization

  • The country’s financial sector is now wide enough and deep enough to take care of financial intermediation without state support. 
  • Even after the bank nationalization of 1969, the state dominance of the sector has kept competition levels low.
  • There was unnecessary micro-management by RBI, resulting in poor lending decisions and market distortions.

Problem with interest rate benchmarking

  • Right now, banks are largely expected to do as they are told. Last RBI’s directive to commercial banks to link their loan rates with its repo rate or other external benchmarks need not be issued in truly free markets. 
  • Competition for loan customers would not let a bank keep its lending rates higher. Rivalry for deposits and other funds would mean a bank pays as much as it could afford to.
  • To find the best way to gain an edge in a competitive market, banks would turn efficient.
  • In India, state lenders are under little pressure to do this. Tough the entry of private banks has upped service standards and induced some changes, the sector is saddled with non-performing loans, inefficiencies and heavy costs. 
  • High state-controlled rates of interest on small saving schemes attract a big chunk of people’s savings, leaving lenders short of money to lend and paying too much for deposits.

Cause for privatization

The sector’s health requires banks to assess and price risks properly. For this, bankers need to act diligently in the interest of profit-seeking shareholders. This would be better enabled by privatization. 

Challenges with privatization

  • State’s exit could result in foreign equity control of banks and even a loss of sovereignty.
  • Since large banks would be “too big to fail”, the government would still need to bail them out in case they approach bankruptcy. This would involve public funds and amount to the socialization of losses.
  • Close regulation would still be needed.

Way ahead

With all the challenges above, the state could argue it needs to retain ownership control as well. Immediately, at least the appointment of public sector bank chiefs must be freed of state control.

Banking Sector Reforms

[op-ed snap] Bank merger announcement is a needless distraction

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Bank mergers - effectiveness : analysis

CONTEXT

Finance minister announced the last week of the merger of public sector banks.

Challenges with the merger – short term

  • It is coming in the wake of growth sinking to a six-year low and thus a needless distraction.
  • In the short-term, the mergers will contribute nothing towards a turnaround of the economy. 
  • The administrative and logistic challenges of mergers will divert the mind space of bank management away from managing the NPAs and aggressive lending.

Long term view on mergers – positives

  • Large banks will entail cost advantages by way of economies of scale, such as centralised back-office processing, elimination of branch overlap, eliminating redundancies in administrative infrastructure, better manpower planning, optimum funds management, and savings in IT and other fixed costs. 
  • Large banks will also be able to finance large projects on their own while staying within the prudential lending norms.

Long term view on mergers – drawbacks

  • Organic mergers of banks motivated purely by business considerations lead to efficiency gains, arranged marriages of this kind are debatable.
  • They can become too big to fail. 
    • The financial sector is all interconnected and a risk in any part of the system is a risk to the entire system. 
    • If a large bank were to fail, it could bring down the whole financial sector with it, as experienced by Lehman Brothers in 2008, which triggered the global financial crisis. 
    • RBI identified systemically important financial institutions and subjected them to higher capital requirements and more stringent regulation. Eg., SBI
  • The knowledge that a nation will be forced to rescue it encourages irresponsible behavior by big banks.

PSBs – a background

  • Banks were nationalised 50 years ago in a different era, in a different context. 
  • In the event, PSBs rendered commendable service to the nation by deepening bank penetration into the hinterland and implementing a variety of anti-poverty programs. 
  • Of the many factors responsible for India moving from low income to low middle income, financial intermediation by PSBs has a place in that list.

Do we still need PSBs? 

  • The financial sector is wide and deep enough to take care of financial intermediation without the government at the steering wheel.
  • Today’s economic slowdown is due to both cyclical and structural factors. RBI has cut rates and the government has announced a few measures like frontloading expenditures and slashing some taxes. 
  • We will become a $5-trillion economy not by growing at our current potential growth rate but by raising it. That requires structural reforms. 

CONCLUSION

If the government gives up its majority stake in PSBs, it will go a long way in pushing us into a $5-trillion economy.

Banking Sector Reforms

[op-ed snap] A big bank theory that won’t suffice

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Bank merger

Mains level : Bank mergers in the background of growth slowdown

CONTEXT

India’s GDP growth slumped for the fifth straight quarter to 5%, a six-year low. 

Background

  1. India is faced with job losses, the absence of fresh employment opportunities, farm crisis, a severe investment drought, and the financial sector’s myriad malaises. 
  2. This has resulted in sluggish aggregate demand and slowing growth.
  3. The government announced four mergers among public sector banks (PSBs). It involves 10 banks and reduces the total number of state-owned banks to 12.

Problem with the move

  1. Will it reverse the slowdown? 
  2. At this time, lenders have become lending-averse and bankers are wary of witch-hunts over commercial judgment calls.
  3. Mergers of this scale are likely to focus on institutional and professional energies on executing these unifications successfully.
  4. It could detract attention from the critical task at hand of identifying unmet credit needs and keeping India’s loan pipelines humming. 
  5. In terms of the other governance reforms announced for PSBs, the government did not distance itself from the appointment of chairpersons and managing directors.
  6. Of the three PSBs based in Kolkata, two—Allahabad Bank and United Bank of India—will lose their identities and be subsumed into other larger banks, leaving the city as the home base of only one PSB (UCO Bank) and the private lender (Bandhan Bank). 
  7. The government has not provided a rationale, or eligibility criteria, for its selection of PSBs.
  8. At a strategic level, the merger will partially ease pressure on government finances from the over-sized bank recapitalization bill.
  9. It is unlikely to set a credit supply rolling. The government allocated a mere ₹70,000 crore in this year’s budget.

CONCLUSION

The mergers are unlikely to generate any immediate benefits for the economy in the absence of appropriate government spending.

 


Back2Basics

Merger of Banks: Need & Challenges

Banking Sector Reforms

Explained: Mergers of public sector banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Read the attached story

Mains level : Merger of PSBs and various prospects associated


  • The Centre announced a mega amalgamation plan, the third in a row, that merged ten public sector banks into four larger entities.
  • With these series of mergers, the number of state-owned banks is down to 12 from 27.

About the merger

  • There are four new sets of mergers — Punjab National Bank, Oriental Bank of Commerce and United Bank of India to merge to form the country’s second-largest lender.
  • Canara Bank and Syndicate Bank to amalgamate; Union Bank of India to acquire Andhra Bank and Corporation Bank; and Indian Bank to merge with Allahabad Bank.
  • The biggest merger out of the four was Oriental Bank of Commerce and United Bank merging into Punjab National Bank to create a second largest state-owned bank with Rs 17.95 lakh crore business and 11,437 branches.
  • These three banks are technologically compatible as they use Finacle Core Banking Solution (CBS) platform.
  • The merger of Syndicate Bank with Canara Bank will create the fourth largest public sector bank with Rs 15.20 lakh crore business and a branch network of 10,324 branches.
  • Andhra Bank and Corporation Bank’s merger with Union Bank of India will create India’s fifth largest public sector bank with Rs 14.59 lakh crore business and 9,609 branches.
  • The merger of Allahabad Bank with Indian Bank will create the seventh largest public sector bank with Rs 8.08 lakh crore business with strong branch networks in the south, north and east of the country.

Why merge PSBs?

  • According to the government, banks have been merged on the basis of likely operating efficiencies, better usage of equity and their technological platform.
  • But the move marks a departure from the plan to privatize some of the banks or bringing in a strategic investors to usher in reform in the sector.
  • The government, after consultations, decided that amalgamation is the “best route” to achieve banking sector scale and to support the target of achieving a $5 trillion economic size for India in five years.
  • The amalgamations will help banks to meaningfully scale up operations but will not lead to any immediate improvement in their credit metrics.

Logic behind the move

  • For years, expert committees starting from the M Narasimham Committee have recommended that India should have fewer but bigger and better-managed banks to ensure optimal use of capital, efficiency, wider reach and greater profitability.
  • The logic is that rather than having several of its own banks competing for the same pie (in terms of deposits or loans) in the same narrow geographies, leading to each one incurring costs, it would make sense to have large-sized banks.
  • This may be true especially in India’s bigger cities and towns.
  • It has also been argued that such an entity will then be able to respond better to emerging market trends or shifts and compete more with private banks.
  • The proposed big banks would be able to compete globally and improve their operational efficiency once they lower their cost of lending and improve lending.
  • But none of India’s banks including the largest, SBI, figures in the list of the top 50 global banks. So that may be a long way away.

How does it help the government?

  • For over decades starting from 1992, the government as the biggest shareholder of over 25 banks had to provide capital for them.
  • To grow and lend more, the banks often need a higher amount of capital to set aside also for loans that could go bad.
  • With the government not willing to lower its equity holdings and with a large slice of the capital being set aside to cover for bad loans, the burden of infusing capital rests on the majority shareholder.
  • This means marking a large amount of money almost every year during the last few years in the Budget for capital infusion at many banks at a time when there is a huge demand for social sector.
  • By reducing the number of banks to a manageable count, the government hopes that the demands for such capital infusion will be lower progressively with increased efficiencies and with more well capitalised banks.
  • It will also help that the government can focus now on fewer banks than in the past.

How have previous bank mergers fared?

  • Last year, the government had merged Dena Bank and Vijaya Bank with Bank of Baroda, creating the third-largest bank by loans in the country.
  • The government said this merger has been “a good learning experience” as profitability and business of the merged entity has improved.
  • Earlier, the State Bank of India had acquired its associate banks.
  • Indian Overseas Bank, Uco Bank, Bank of Maharashtra and Punjab and Sind Bank, which have strong regional focus, will continue as separate entities.
  • The government said profitability of public sector banks has improved and total gross non-performing assets have come down to Rs 7.9 lakh crore at end-March 2019 from Rs 8.65 lakh crore at end-December 2018.

More thrust on RBI

  • The RBI keeps monitoring large institutions whose potential failure can impact other institutions or banks and the financial sector, and which could have a contagion effect and erode confidence in other banks.
  • A case in point is the recent instance of IL&FS Group, which defaulted on repayments hitting many lenders and investors.
  • The creation of more large-sized banks will mean the RBI will have to improve its supervisory and monitoring processes to address increased risks.

Will this help improve the performance metrics now?

  • While the announced consolidation of PSU banks is a credit positive as it enables the consolidated entities to meaningfully improve scale of operations and help their competitive position.
  • At the same time, there will not be any immediate improvement in their credit metrics as all of them have relatively weak solvency profiles.
  • While asserting that bank consolidation is a good move towards improving efficiency of the PSBs, he said “it is possible that the current mergers may face more friction than the last one with BoB, Dena and Vijaya.
  • In that case, a large, well-capitalised strong bank absorbed two much smaller entities.
  • In the present case, the mergers are mostly among larger banks, with absorbing bank not necessarily in strong health.
  • However, given the merged banks are on similar technology platform, the integration should be smoother.
  • Also it is likely that management attention and bandwidth of the entities being merged could get split impacting the loan growth and reduce focus on strengthening asset quality in the short term.

Banking Sector Reforms

Fit-and-Proper criteria for directors on PSB boards

Note4Students

From UPSC perspective, the following things are important :

Prelims level : About the criteria

Mains level : Governance of PSBs in India

  • The Reserve Bank of India (RBI) has tightened the fit-and-proper criteria for directors on the boards of state-run banks.

Changes in the fit-and-proper criteria

  • The terms with regard to the NRC and the manner of the appointment of directors have been aligned with the practice in private banks, the recommendations made by the Banks Board Bureau, and with the provisions in the Companies Act.
  • While the revised norms are applicable only to public sector banks (PSBs), separate guidelines for private banks and non-banking financial companies (NBFCs) may be in the offing.

Nomination and remuneration committee (NRC)

  • The Centre’s nominee director shall not be part of the nomination and remuneration committee (NRC).
  • The revised criteria for the first time laid down an exhaustive list for the disqualification of directors.
  • The NRC will have a minimum of three non-executive directors from amongst the board of directors.
  • Of this, not less than one-half shall be independent directors and should include at least one member from the risk management committee of the board.

List of entities

  • What will also be under scrutiny is the ‘list of entities’ in which a prospective director has an interest – to ascertain if such a firm is in default or has been in default in the past decade.
  • This is with respect to the credit facilities obtained from the bank (in which a directorship is being evaluated), any other bank, NBFC or other lending institution.

A not for member candidates

  • The negative list says that the candidate should not be a member of the board of any bank, the RBI, financial institution (FI), insurance company or a non-operative financial holding company (NOFHC).
  • The candidate should not be connected with hire-purchase, financing, money lending, investment, leasing and other para-banking activities.
  • No person is to be elected or re-elected to a bank board if the candidate has served as a director in the past on the board of any bank, the RBI or insurance company under any category for six years, whether continuously or intermittently.
  • The candidate should not be engaging in the business of stock broking.
  • The candidate should not be a member of Parliament, state legislature, municipal corporation, municipality, or other local bodies — notified area council, city council, panchayat, gram sabha or zila parishad.

In short: ‘Fit & proper’ regime

  • Members of Parliament, state legislatures, and local governments not eligible to be members of PSB boards
  • ‘Declaration and undertaking by director’ made more exhaustive
  • Maximum tenure on board pegged at six years
  • Candidates cannot be board member of rival banks
  • Directors’ connection with defaulting firms, links with chartered accountancy firms to be no-go areas
  • No links with financial institutions, insurance firms, and non-operative financial holding companies

Banking Sector Reforms

Explained: 50 years of Bank Nationalization in India

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Read the attached story

Mains level : Nationalization of banks in India and its impact

  • This 19th of July marked 50 years of nationalization of banks in India.
  • The govt. under Indira Gandhi carried out bank nationalization through an Ordinance in 1969.
  • 14 big private banks were nationalized to help agriculture and social welfare programmes.

Background

  • 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 that 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 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.

I. 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.

II. 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.

Banking Sector Reforms

Merchant Discount Rate

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MDR/TDR

Mains level : Promoting digital transactions in India

  • The recent budget proposal seeks to incentivise digital transactions by reducing Merchant Discount Rate (MDR) for customers as well as merchants.

What was the Budget announcement?

  • The business establishments with annual turnover more than 50 crore shall offer such low cost digital modes of payment to their customers and no charges or MDR shall be imposed on customers as well as merchants.
  • In other words, the government has mandated that neither the customers nor the merchants will have to pay the so-called Merchant Discount Rate (or MDR) while transacting digital payments.
  • It is good news for both customers and merchants because their costs of digital payments come down.

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.

Who will bear the MDR costs?

  • If customers don’t pay and merchants don’t pay, some entity has to pay for the MDR costs.
  • In her speech, the FM has said that RBI and Banks will absorb these costs from the savings that will accrue to them on account of handling less cash as people move to these digital modes of payment.
  • Necessary amendments are being made in the Income Tax Act and the Payments and Settlement Systems Act, 2007 to give effect to these provisions.

Issues surrounding

  • Contrary to public perception, the MDR has not been made zero.
  • The FM’s decision has just shifted its incidence on to the RBI and banks.
  • However, if banks pay for the MDR it will adversely their likelihood to adopt the digital payments architecture.
  • Moreover, many payments providers apprehend that the banks will find a way of passing on the costs to them.
  • In turn, this will negatively impact the health of a sector that needs nurturing.

Banking Sector Reforms

Basel Norms

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Basel Norms: I, II and III

Mains level : Banking regulation in India


  • The Basel Committee on Banking Supervision has said that India is compliant regarding regulation on large exposures though, in some respects, regulations are stricter than the Basel large-exposures framework.

Banking regulations in India are more stricter: Basel Accord

  • In some other respects, the Indian regulations are stricter than the Basel large exposures framework.
  • For example, banks’ exposures to global systemically important banks are subject to stricter limits in line with the letter and spirit of the Basel Guidelines.
  • The scope of application of the Indian standards is wider than just the internationally active banks covered by the Basel framework.

What are Basel Norms?

  • Basel is a city in Switzerland. It is the headquarters of 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 agreement by the BCBS, which mainly focuses on risks to banks and the financial system are 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 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 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.

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.

Banking Sector Reforms

[op-ed snap] Slippery slope

Note4Students

From UPSC perspective, the following things are important :

Prelims level : NBFC

Mains level : Crisis of NBFC institutions

CONTEXT

NBFC crisis could accentuate contagion risk in the financial sector. Cabinet committee on investment and growth must address it.

Background

  • The woes of non-banking finance companies and housing finance companies continue to reverberate through the financial system.
  • A few days ago, Dewan Housing Finance Corporation defaulted on its interest obligations. Its short-term rating has been cut to default.

Crisis in NBFC sector

  • Financial conditions have worsened with spreads of NBFC bonds rising significantly in the recent past.
  • At one level, the argument can be made that lenders are re-evaluating their risk.
  • That the market is discriminating between the better-rated NBFCs and those whose balance sheets appear problematic.
  • And, that an intervention at this stage will create problems of moral hazard. But, there is genuine concern that the DHFL default can “accentuate contagion risk in the financial sector”, as noted by the investment house CLSA in a note.
  • This needs to be addressed.

A solution to this problem

  • A possible solution is for the RBI to open a special borrowing window to provide liquidity to NBFCs/HFCs.
  • As was done during the financial crisis of 2008, the central bank, under sections 17 and 18 of the RBI act, can provide short term liquidity to NBFCs, till financial conditions normalise.
  • But, the RBI doesn’t seem inclined towards this route, presumably because it will be difficult to differentiate between NBFCs.
  • It could also nudge banks to increase their lending to NBFCs.

Steps taken by RBI

  • To this effect, it has already eased norms for maintaining risk weights on bank lending to NBFCs.
  • Further easing of systemic liquidity could boost flows to NBFCs.

Challenges

  • The question is will risk-averse banks lend?
  • Part of the problem is that the difficulty in differentiating between illiquid NBFCs from those that are insolvent.
  • To address this, some have advocated for an asset quality review to reveal the true state of NBFCs’ books.
  • While this will address issues of information asymmetry, such a move may end up prolonging the crisis.
  • Perhaps, the RBI could identify systemically important NBFCs and backstop them through banks.

Conclusion

But the larger issue of resolution of financial firms remains. Situations such as the current one warrant swift resolution so that problems remain contained. Perhaps, the newly formed cabinet committee on investment and growth could contemplate bringing back the FRDI bill, with modifications to address contentious issues like the bail-in clause and deposit insurance.

Banking Sector Reforms

Reserve Bank set to create a specialised supervisory cadre

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Board for Financial Supervision (BFS) under RBI

Mains level : NPA Crisis

  • The RBI has decided to create a specialised supervisory and regulatory cadre within the RBI in order to strengthen the supervision and regulation of commercial banks, urban cooperative banks and NBFCs.

Need for a regulatory Cadre

  • This move is followed a series of events including the IL&FS defaults, ICICI Bank loan issue, PNB fraud and the liquidity issues in the NBFC sector in the last two years.
  • The present structure of supervision in RBI in the context of the growing diversity, complexities and interconnectedness within the Indian financial sector is too complex.
  • There were complaints that the RBI was lax in the supervisory functions, especially in timely detection of frauds and poor governance in the banking sector.

All banks audit is not possible

  • When Urjit Patel was the governor of the RBI, the central bank had said that its supervisory process does not constitute an audit of banks.
  • With the number of commercial bank branches being more than 1,16,000 in the country it would be impossible to cover each and every branch under the RBI’s supervisory process.

If not RBI, then who performs supervisionary functions? 

Board for Financial Supervision (BFS)

  • The Reserve Bank of India performs the supervisory function under the guidance of the Board for Financial Supervision (BFS).
  • The Board was constituted in November 1994 as a committee of the Central Board of Directors of the RBI under the RBI (Board for Financial Supervision) Regulations, 1994.
  • Sub-committees of BFS are also constituted under the chair of Dy. Governor.
  • The primary objective of BFS is to undertake consolidated supervision of the financial sector comprising Scheduled Commercial and Co-operative Banks, All India Financial Institutions, Local Area Banks, Small Finance Banks, Payments Banks, Credit Information Companies, NBFCs and Primary Dealers.

Composition of BFS

  • The BFS has four Directors from the Central Board as members and is chaired by the Governor.
  • While the Deputy Governors of the Reserve Bank are ex-officio members, one Deputy Governor, traditionally the Deputy Governor in charge of supervision is nominated as the Vice-Chairman of the Board.

Other moves by RBI

  • The RBI had last week asked non-banking finance companies (NBFCs) with asset size of more than Rs 5,000 crore to appoint a Chief Risk Officer (CRO).
  • It clearly specified role and responsibilities amid growing worries over an “imminent crisis” in the NBFC sector due to credit squeeze, overleveraging, excessive concentration, massive mismatch between assets and liabilities and misadventures by some large entities like the IL&FS group.

Banking Sector Reforms

[op-ed snap] IBC hits and misses

Note4Students

From UPSC perspective, the following things are important :

Prelims level : IBC

Mains level : Gains and losses of IBC

CONTEXT

Even as the time taken for resolution under the Insolvency and Bankruptcy Code (IBC) continues to exceed the outer limit prescribed under the law, the process is yielding better outcomes in a shorter time frame as compared to the erstwhile regime.

Background

  • In FY19, financial institutions recovered close to Rs 70,000 crore through resolution under the IBC, estimates rating agency Crisil.
  • This works out to a recovery rate of 43 per cent.
  • In comparison, recoveries under the preceding regime through various channels — debt recovery tribunals, securitisation and reconstruction of financial assets, and enforcement of the securities interest act (SARFAESI) and Lok Adalats — stood at Rs 35,000 crore in FY18.

Cause of concerns

  • The time taken for successful resolution continues to exceed that envisaged in the law.
  • Under the law, the insolvency resolution process is to be completed in 180 days, which can be extended by another 90 days to a maximum of 270 days. But, of the 1,143 cases that are currently outstanding under the IBC, 362 cases or 32 per cent are pending for more than 270 days.
  • In a few of the big ticket cases, the resolution process has exceeded 400 days.

Reasons For delay

  • Part of the delay in resolution can be attributed to the absence of buyers, differences between members of the committee of creditors, as well as legal challenges mounted by existing promoters not willing to let go of their companies.
  • Then, there are issues of institutional capacity which need to be addressed.

Conclusion

  • However, despite these delays, Crisil estimates that it takes around 324 days for cases to be resolved under the IBC — in comparison, as per the World Bank’s Doing Business Report 2019, it took 4.3 years under the earlier regime.
  • In the months after the IBC kicked in, operational creditors had taken the lead in initiating the corporate insolvency resolution process (CIRPs) against errant debtors.
  • But thereafter, financial institutions stepped up.
  • In fact, in the quarter ended March 2019, the number of CIRPs initiated by financial creditors exceeded those initiated by operational creditors. But it is difficult to say whether this trend will continue after the Supreme Court ruling on the RBI’s February 12 circular.
  • The quashing of the circular has opened the door for banks to tackle the issue of bad loans outside the IBC process, a route they might prefer.

Banking Sector Reforms

[op-ed snap]Serious setback

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing Much

Mains level : Impact of Supreme court order cancelling RBI circular on credit availibility and way forward

CONTEXT

The Supreme Court order quashing a circular issued by the RBI on the resolution of bad loans is a setback to the evolving process for debt resolution.

Impact of this order

  • The voiding of the February 12, 2018 circular could slow down and complicate the resolution process for loans aggregating to as much as ₹3.80 lakh crore across 70 large borrowers, according to data from the ratings agency ICRA.

Need for the circular

1.Recognising defaults by Banks

    • The circular had forced banks to recognise defaults by large borrowers with dues of over ₹2,000 crore within a day after an instalment fell due.
    • And if not resolved within six months after that, they had no choice but to refer these accounts for resolution under the Insolvency and Bankruptcy Code.

2. Increasing share of  Bad loans

  • Mounting bad loans, which crossed 10% of all advances at that point
  • The failure of existing schemes such as corporate debt restructuring, stressed asset resolution and the Scheme for Sustainable Structuring of Stressed Assets (S4A) to make a dent in resolving them formed the backdrop to this directive.

3. Breaking nexus

  • The circular was aimed at breaking the nexus between banks and defaulters, both of whom were content to evergreen loans under available schemes.

4. Introducing Credit Discipline

  • It introduced a certain credit discipline — banks had to recognise defaults immediately and attempt resolution within a six-month timeframe, while borrowers risked being dragged into the insolvency process and losing control of their enterprises if they did not regularise their accounts.
  • RBI data prove the circular had begun to impact resolution positively.

Impact on Current banking situation due to order

  • It is this credit discipline that risks being compromised now.
  • It is not surprising that international ratings agency Moody’s has termed the development as “credit negative” for banks.

Faults with circular

  • It is true that the circular failed to take into account the peculiarities of specific industries or borrowers and came up with a one-size-fits-all approach.
  • It is also true that not all borrowers were deliberate defaulters, and sectors such as power were laid low by externalities beyond the control of borrowers.
  • The RBI could have addressed these concerns when banks and borrowers from these sectors brought these issues to its notice.
  • By taking a hard line and refusing to heed representations, the RBI may only have harmed its own well-intentioned move.

Way forward

  • it is now important for the central bank to ensure that the discipline in the system does not slacken.
  • The bond market does not allow any leeway to borrowers in repayment, and there is no reason why bank loans should be any different.
  • The RBI should study the judgment closely, and quickly reframe its guidelines so that they are within the framework of the powers available to it under the law.
  • Else, the good work done in debt resolution in the last one year will be undone.

 

Banking Sector Reforms

[op-ed snap] Setting limits

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: RBI functioning, reserves of RBI, Basel norms, BIS

Mains level: The tussle between RBI & the government and the need for its early resolution for sending correct signals in the economy.


NEWS

CONTEXT

The former governor of the RBI, Raghuram Rajan, has reignited the debate on the autonomy or independence of the country’s central bank by suggesting that it was perhaps an opportune time to set statutory limits to protect the term of the governor.

Background

  • The former RBI chief’s remarks appear to have been framed in the context of the exit late last year of Urjit Patel, well before the end of his term, after a spat with the government, as well as his own uneasy relationship during his three-year tenure.
  • He said that imposing checks on the government’s powers was important to secure operational independence and to put an end to constant interference by the sovereign, to achieve the broader objective of price and financial stability.

Need for autonomy

  • Some of his predecessors, too, have in the past pitched for a secure five-year term for the RBI Governor,
  • Arguing that a full service central bank — like the one India has — with a mandate not just for monetary policy but also oversight of the financial sector, besides currency management and payments and settlements, needs to be autonomous.

The conflict between the government and central bank regarding policy measures

  • The bank and government have differed often over how to achieve its goals
    1. Especially on interest rate management
    2. The approach to resolving the issue of bad loans.
  • It is not unusual to see such differences globally — like in the US.
  • Where President, Donald Trump, unhappy with the US Federal Reserve’s stance on interest rates, has issued threats to the world’s most powerful central bank chairman, Jerome Powell.

Reasons and nature of conflicts

  • These conflicts are naturally given
    1. The shorter political horizon of elected governments
    2. The need for central banks to take a non-political medium-term approach to achieve price or financial stability.
  • The 2008 financial crisis further
    1. Underlined the importance of macro-economic stability.t
    2. And that the policies for achieving it are inter-linked.s
    3. Signalling the importance of having a strong central bank free of political compulsions.

Ways to ensure autonomy

1. Making it accountable to parliament

  • One institutional response to ensure that and to shield the central bank from growing political assaults is to make it directly accountable to the Parliament without being dependent on funding,
  • like the way the US Fed derives its powers from the Congress.

2.Ensuring accountability

  • But that statutory protection to the RBI and its chief must be accompanied by an accountability mechanism.
  • Simply put, there is merit in central bank independence — not unbridled — as there are macro economic gains which would accrue besides boosting policy credibility.

Conclusion

  • Ultimately, as the first Indian governor of the RBI, CD Deshmukh, said seven decades ago, it is not the constitution of the institution that matters, but the spirit in which the partnership between the ministry of finance and the bank is worked.
  • The success of the partnership will, in the final analysis, depend on the manner in which the government asks to be served and provides opportunities accordingly.
  • It is the display of such a spirit by any government that will be critical to the future of India’s public institutions, including the RBI.

Banking Sector Reforms

Banks may set repo rate as benchmark for lending

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: MCLR, Repo Rate

Mains level: Role of RBI & various functions performed by it.


News

  • Most commercial banks in India are likely to select RBI’s repo rate as the external benchmark to decide their lending rates, from April 1.
  • The repo rate is the key policy rate of the Reserve Bank of India (RBI).

Deciding lending rates

  • Banks had four options from which to choose the external benchmark: the repo rate, the 91-day Treasury bill, the 182-day T-bill or any other benchmark interest rate produced by the Financial Benchmarks India Private Ltd (FBIL).
  • A few other banks confirmed that the repo rate is the ideal candidate for the external benchmark. At present, the repo rate is 6.25%.
  • The marginal cost of fund based lending rate (MCLR) is currently the benchmark for all loan rates.
  • Banks typically add a spread to the MCLR while pricing loans for homes and automobiles.

Why repo?

  • The RBI has mandated that the spread over the benchmark rate to be decided by banks at the inception of the loan should remain unchanged through the life of the loan.
  • It should remain unchanged unless the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract.
  • If the lending rates are linked to the repo rate, any change in the repo rate will immediately impact the home and auto loan rates, since RBI has mandated the spread to remain fixed over the life of the loan.

Benefits of Repo Rate

  • It will make the system more transparent since every borrower will know the fixed interest rate and the spread value decided by the bank.
  • It will help borrowers compare loans in a better way from different banks.
  • Under the new system, a bank is required to adopt a uniform external benchmark within a loan category so that there is transparency, standardisation and ease of understanding for the borrowers.
  • This would mean that same bank cannot adopt multiple benchmarks within a loan category.

Back2Basics

Repo Rate

  • Technically, Repo stands for ‘Repurchasing Option’.
  • It refers to the rate at which commercial banks borrow money from the RBI in case of shortage of funds. It is one of the main tools of RBI to keep inflation under control.
  • When we borrow money from the bank, they charge an interest on the principal. Basically, it is cost of credit.
  • Similarly, banks too can borrow money from RBI during cash crunch on which they must pay pay interest to the Central Bank. This interest rate is repo rate.

MCLR

  • Marginal Cost of Funds based Lending Rate (MCLR) is the minimum interest rate, below which a bank is not permitted to lend. RBI can give authorization for the same in exceptional cases.
  • MCLR replaced the earlier base rate system to determine the lending rates for commercial banks.
  • RBI implemented it on 1 April 2016 to determine rates of interests for loans.
  • It is an internal reference rate for banks to decide what interest they can levy on loans.
  • For this, they take into account the additional or incremental cost of arranging additional rupee for a prospective buyer.

Banking Sector Reforms

[op-ed snap] Safety nets

Note4students

Mains Paper 2: Polity | Parliament & State Legislatures – structure, functioning, conduct of business, powers & privileges & issues arising out of these

From UPSC perspective, the following things are important:

Prelims level: Banning of Unregulated Deposit SchemesOrdinance

Mains level: Illicit deposit schemes spreading across the country and measures to curb them.


NEWS

CONTEXT

There have been recent events of chit fund frauds leading to savings of low-income Indian households have traditionally remained unprotected.

 Banning of Unregulated Deposit Schemes Ordinance

  • It bars all deposit schemes in the country that are not officially registered with the government from either seeking or accepting deposits from customers.
  • The ordinance will help in the creation of a central repository of all deposit schemes under operation, thus making it easier for the Centre to regulate their activities and prevent fraud from being committed against ordinary people.
  • The ordinance allows for compensation to be offered to victims through the liquidation of the assets of those offering illegal deposit schemes.

Need for banning unregulated deposits

  • Popular deposit schemes such as chit funds and gold schemes, which as part of the huge shadow banking system usually do not come under the purview of government regulators, have served as important instruments of saving for people in the unorganised sector.
  • These unregulated schemes have also been misused by some miscreants to swindle the money of depositors with the promise of unbelievably high returns in a short period of time.
  • The Saradha chit fund scam in West Bengal is just one example of such a heinous financial crime against depositors.
  • An ordinance reflects a timely recognition of the need for greater legal protection to be offered for those depositors with inadequate financial literacy.

Effective Implementation Of Ordinance

  • Policymakers will have to make sure that the bureaucrats responsible for the on-ground implementation of the ordinance are keen on protecting the savings of low-income households.
  • There must also be checks against persons in power misusing the new rules to derecognise genuine deposit schemes that offer useful financial services to customers in the unorganised sector.
  • In fact, in the past, there have been several cases of politicians acting in cahoots with the operators of fraudulent deposit schemes to fleece depositors of their hard-earned money.

Conclusion

Another potential risk involved when the government, as in this case, takes it upon itself to guarantee the legitimacy of various deposit schemes is that it dissuades depositors from conducting the necessary due diligence before choosing to deposit their money. The passing of tough laws may thus be the easiest of battles in the larger war against illicit deposit schemes.

Banking Sector Reforms

[op-ed snap] Why India needs to set up a public credit registry

Note4students

Mains Paper 3: Economic Development| Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: Basic knowledge of Public credit registry (PCR).

Mains level:  Issues and challenges in the establishment of a public credit registry (PCR) and benefits arising from the same.

NEWS

CONTEXT

In its most recent policy statement, the monetary policy committee of the Reserve Bank of India (RBI) reduced the repurchase rate from 6.5% to 6.25%, mainly on account of low headline inflation and threats to domestic growth from global trade and geopolitical tensions.

Observations regarding current economic situation

  • One, the present level of growth owes itself primarily to public spending in infrastructure. Both private consumption and investment remain bleak.
  • Second, even though bank credit and overall financial flows remain robust, they are not broad-based. In other words, credit flows are focused on a few large enterprises even as a significant proportion of individuals and businesses remains out of the credit market.
  • Gross bank credit to micro and small enterprises reduced by 0.9% year-on-year in December. The micro, small and medium enterprises (MSME) sector employs approximately 111 million people in 63 million units across the country, contributing 31.6% to gross value added and 49.86% to the country’s exports.

Challenges in Reviving Growth

  • In order to revive private investment and consumption, there is a need to ensure greater credit disbursement to MSMEs.
  • But credit institutions face unique challenges. One, the credit market is characterized by information asymmetry, a situation where one party possesses more information about the transaction than others.
  • Borrowers have disproportionately more information about their financial situation and ability to repay the loan than the lenders.
  • There is also the problem of adverse selection, where safe borrowers are priced out of the credit market owing to their lack of credit history.
  • These market failures have partly been responsible for the inefficient allocation of credit in the economy, resulting in a rise in bad loans and sluggish economic growth.

Problems With current credit information system

  • At present, the credit information market in India, though mature, is highly fragmented.
    • Within the central bank, for instance, the Central Repository of Information on Large Credits (CRILC) provides timely information on credit deterioration of large loan accounts—those greater than 5 crore.
    • CRILC played a crucial role in the asset-quality review process initiated by RBI in 2015, which helped identify significant divergences in bad loans recognized by several commercial banks in their annual reports.
    • There are also four private credit information companies, which offer value-added services such as analytics and scoring to lenders and borrowers.
    • But these lack full and timely coverage, despite RBI mandating all its regulated entities to submit credit information to them.

Benefits of Public Credit Registry in reviving  growth

  •  A public credit registry (PCR), which would act as a central repository of information on credit data of individuals and businesses.
  • A public credit registry wouldn’t be constrained by any minimum threshold in loan requirement and would also collate comprehensive information—not just on bank credit, but also loans from non-banking financial companies, debentures, bonds, external commercial borrowings, utility payments and so forth—to provide a holistic picture of the borrower’s credit history.
  • Inclusion of ancillary information such as overdue utility payments, or overdue tax payments’ data from tax authorities, would help reduce the due diligence costs of lenders and foster financial inclusion by bringing into the fold all those who were previously left out of the credit market.
  • An added benefit would be the disintegration of information monopoly of some lenders.
  • A PCR will enable sharing of credit information mandated by law, fostering transparency and encouraging competition.
  • It will also enable efficient price discovery as the public availability of comprehensive credit information of the borrower will help lenders distinguish good ones from the bad.
  • The information architecture of the PCR must be consent-based, in compliance with the data protection laws of the country to prevent data abuse.

Way Forward

  • The Insolvency and Bankruptcy Code, though far from perfect, has started the process of unlocking the dead capital of bankrupt firms.
  • These funds will then flow back into the economy through credit.
  • The next logical step now is the establishment of a PCR.
  • This will not only ensure higher disbursement of credit to the MSME sector, thereby boosting employment and growth, but also help contain non-performing assets as lenders get access to better quality of information for their credit decisions.

 

 

Banking Sector Reforms

[op-ed snap] Legislating payments out of RBI’s excess capital could compromise its independence

Note4students

Mains Paper 3: Economic Development | Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: Basic knowledge of RBI’s equity holding capacity.

Mains level: The news-card analyses the issue that how much equity the Reserve Bank of India (RBI) should hold, in a brief manner.


Context

  • A committee is examining the issue that how much equity the Reserve Bank of India (RBI) should hold.

Many dimensions to the issue

The issue under examination has many dimensions such as:

  • How should the RBI’s equity level be computed?
  • What should be the structure of the RBI’s assets?
  • Should the RBI pay the government any excess equity holdings as a special one-time payment?

About RBI’s equity

  • The RBI’s current equity holding is around 27 per cent of its total assets.
  • This overall equity level can be divided into four categories: Paid-up capital, contingency capital, revaluation capital and asset development fund.
  • The two largest components of these are contingency capital (6.6 per cent) and revaluation capital (around 20 per cent).
  • The revaluation capital is an accounting entry that offsets changes in the rupee value of the foreign assets and gold holdings of the RBI due to changes in the exchange rate of the rupee and changes in the dollar price of gold, respectively.

Issue

  • The total equity of 27 per cent has attracted a lot of attention lately.
  • Arguments have been made that this is too high, especially when compared with other countries.
  • There are views that the RBI should transfer a part of this “excess” capital to the government as a one-time payment.

Method to calculate this apparent excess: VaR analysis

  • One way of judging whether or not this level of equity holding is excessive is to use a metric that is typically applied to commercial banks.
  • Under this method, one computes the fraction of the value of the banks’ assets that are at risk due to fluctuations in the market value of the asset. This is known as VaR analysis.
  • This approach tries to look at the worst “x” per cent changes in the asset value of the bank during the sample period and estimates the associated size of the fall in asset value.
  • If the bank has capital greater than this value then one can say it has enough capital to withstand negative shocks in 1-x per cent of cases.
  • The higher x is, the greater is the safety level that the bank has.
  • Thus, if the chosen x is 1 per cent then the bank has enough capital to absorb 99 per cent of the shocks that typically hit the system.

Study shows RBI’s current core equity level needs to be more than doubled

  • In a recent study, it was shown that the RBI would require a 30 per cent overall equity to asset ratio to cover 95 per cent of all shocks it faces.
  • Thus, its overall equity level has to be raised from the current 27 per cent level.
  • If, instead, one only focuses on non-exchange rate-related shocks, then the core equity to asset ratio needed by the RBI to cover 95 per cent of all such shocks is around 17 per cent.
  • That implies that the RBI’s current core equity level of 6.6 per cent needs to be more than doubled.

Central Bank cannot be treated like a Commercial bank

  • When the equity of a commercial bank becomes negative, they are bankrupt and their shareholders typically demand liquidation.
  • However, the central bank of a country is not a commercial bank.
  • Its owner is usually the government, which certainly will not demand liquidation of the central bank in the event its equity turns negative.
  • Indeed, there do exist central banks with negative equity.
  • What is crucial for a central bank is the level of its assets and the riskiness of the portfolio it chooses in terms of its term structure and currency composition.
  • In the event of an emergency, the central bank would need assets to fight it.
  • So, a VaR analysis of the asset portfolio of the central bank is a worthwhile exercise but only for determining its riskiness relative to the country’s risk appetite.

Central bank should hold equity rather than paying it out to the government

There are two important reasons for it:

(a) Builds fiscal credibility of the country

  • Putting a part of the country’s assets in a protected entity like the central bank builds fiscal credibility of the country as long as the central bank is viewed by markets as being independent of the government.
  • This can improve the country’s international credit rating.
  • It also gives the central bank greater credibility in committing to perform its emergency functions without worrying about the fiscal contingencies of the government.

(b)  Mandating payments from the Central bank: a policy moral hazard

  • Mandating payments from the capital of the central bank creates a policy moral hazard.
  • For example, a cut in the policy rate raises the value of government securities that the central bank holds.
  • If the resultant rise in the central bank’s equity sparks a payment to the government then there would be greater spending and inflationary pressure in the economy.
  • Anticipating this, the central bank would be tempted to not lower rates as much.
  • A similar argument operates with exchange rate depreciation.
  • More generally, legislating payments out of the central bank’s excess capital will tend to compromise its operational independence in achieving its policy mandate.

Way Forward

  • In light of the above, an advisable route for the committee currently looking into the RBI’s capital structure is to recommend a formal agreement between the government and the RBI with the agreement stipulating:
  1. a target band for the equity level of the RBI based VaR computations;
  2. the time frame within which the RBI needs to bring its capital level back within the band every time the bounds of the band are breached, and
  3. explicitly prohibit any payments to the government that is based on the equity level of the RBI.
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