Banking Sector Reforms

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

Issues with 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.

 

.

 

 

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.

Banking Sector Reforms

[op-ed snap] Capital idea? on banks recapitalisation plan

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: PCA framework

Mains level: Government initiatives for improving the state of banks


Context

Capital infusion in banks by the government

  1. The Centre has sought Parliament’s approval to infuse an additional ₹41,000 crore into public sector banks that are starved of precious capital to remain afloat
  2. Along with another ₹42,000 crore that is already budgeted for infusion, this tranche will take the total planned funds infusion into banks this year to ₹83,000 crore
  3. Adding the outlays since 2015-16 — when the exercise to enable PSBs to clean up their balance sheets by fully providing for and absorbing losses on bad loans began — the estimated aggregate capital infusion would come to over Rs 3 lakh crore

Motive behind the exercise

  1. The government’s claim is that recapitalisation will allow PSBs — especially those with large non-performing assets and facing lending restrictions under the Reserve Bank of India’s (RBI) so-called prompt corrective action — to resume normal banking operations, boosting credit growth necessary for overall economic revival
  2. As many as 11 public sector banks have been stopped from lending freely by the RBI under the PCA framework due to their poor financial health

Actual reforms required

  1. The roots of the bad loan crisis lay in these banks not being allowed to function as autonomous and board-managed entities
  2. By not linking recapitalisation to reform — which can happen only with the government’s stake falling to below 50 per cent and transferring even this to a separate holding company that would secure the former’s financial interests — the danger is of the seeds of the next crisis is being sown through imprudent lending
  3. It is important that the additional capital is not wasted on banks that have not shown any improvement but rather used to support the weak ones that are on the recovery path

Way forward

  1. There are enough headaches for banks to handle in the form of the waiver of agriculture loans and the rising share of loans to small businesses, which are risky
  2. While the idea of infusing more money into banks is not bad per se, given that they are grappling with inadequate capital, a lot depends on how and to which banks this money is distributed
  3. This is where the government has to exercise prudence and caution

With inputs from the article: Seeds of a crisis

Banking Sector Reforms

[op-ed snap] India’s shadow-bank risks put even China in the shade

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: Shadow lending and its role in maintaining balance in the economy


Context

Shadow lending

  1. “Shadow lending” is a useful catch-all for firms and financial instruments that, just like banks, turn shorter-term liabilities into longer-term assets
  2. But unlike banks, they don’t have access to liquidity from the central bank. They borrow wholesale
  3. When they take deposits, customers don’t enjoy the protection of deposit insurance
  4. In those two key respects, India’s non-bank finance firms fit the International Monetary Fund’s description of shadow banking

How does shadow lending work?

  1. The universe of more than 11,000 Indian shadow lenders draws its sustenance from formal banks, as well as from companies and individuals looking to deploy short-term surpluses
  2. As yield-seeking capital comes into mutual funds, their managers buy commercial paper issued by operating finance companies (OpCo) as well as subscribe to bonds issued by the finance firms’ holding companies (HoldCo)
  3. The OpCo lends to home buyers, small businesses, and students as well as property developers, while the HoldCo brings in the funds borrowed from mutual funds as equity in OpCo
  4. The minimum capital requirement of 15% of risk-weighted assets is easily met even as shadow lenders’ balance sheets expand by 20% or more

Role of shadow lending in the Indian economy

  1. The shadow lenders, pumping out 30% of all new credit over the past three years, are the reason why the Indian economy isn’t withering for lack of finance, despite a serious banking crisis
  2. 11 out of 21 state-run banks are languishing in a regulatory prison and the central bank wants them to boost their depleted equity before they can meaningfully expand their loan books again
  3. Small businesses are using loans against a property to meet their working capital needs
  4. Traders are getting finance by pledging warehouse receipts

Comparison with China

  1. At 14 % of GDP, India’s shadow-banking universe is much smaller than the 70% ratio in China
  2. While Beijing has successfully shrunk the industry from 87% of GDP at the end of 2016 a drop of 17 percentage points—India can’t afford the non-bank lenders to stumble even accidentally
  3. If they retreat, capital-constrained local banks won’t be able to take up the slack
  4. Nor will an indebted Indian government be able to offset a resulting economic slowdown

Way forward

  1. China’s shadow banking may be a lot bigger than India’s, but India’s is already too big to fail
  2. India’s financing arrangements are far more rudimentary than the opaque Wall Street world of asset-backed commercial paper; structured investment vehicles; subprime residential mortgage-backed securities; and collateralized debt obligations

Banking Sector Reforms

[op-ed snap] Building a framework for RBI surplus transfers

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: Role of RBI & various functions performed by it

Mains level: Issue of transfer of surplus reserves and various factors associated with it


Context

Tussle for RBI reserves

  1. Reserve Bank of India (RBI) governor has reiterated before a parliamentary panel the central bank’s well-known position that its reserves are “for periods of stress and not for meeting normal needs”
  2. A committee is set to go into the issue of an “economic capital framework” (ECF), or the reserves that the RBI must hold
  3. The RBI leadership and the government (along with the RBI board members with voting rights) are having entirely opposite views on this issue

International Norms vis a vis RBI

  1. The Bank of Japan transfers its surplus at 5%, Greece at 8%, and Turkey at 12%
  2. In the US, federal reserve banks, which were established by the Congress as the operating arms of the nation’s central banking system, are required by law to transfer net earnings to the US Treasury after providing for all necessary expenses of the reserve banks, legally required dividend payments, and maintaining a limited balance in a surplus fund
  3. In the case of the RBI, in effect, the entire surplus is transferred to the government after making provisions for two funds—Contingency Fund (CF) and Asset Development Funds (ADF)
  4. Though the RBI has a target of 12% (ratio of CF and ADF to total assets), it has not been able to maintain this and currently the ratio is about 7%

What should be the committee’s approach?

  1. The committee is required to design a framework for economic capital rather than a fixed or rigid formula for surplus transfer
  2. This framework should recognise that the roots of the autonomy of the central bank lie in it having the freedom to manage its balance sheet, not only in good times when it transfers a surplus but equally in times when it may incur losses
  3. This makes a case for a contingency fund that helps hedge the risk that is ever present, particularly when the balance sheet is exposed to the market

Issues being faced by RBI wrt reserves

  • There are cases of huge surplus (maintained with RBI as a deposit) or recourse to higher Ways and Means Advances (WMA)
  1. WMA and Overdraft (OD) have been accumulated over a prolonged period and makes them virtually a new form of borrowing, violating the very idea of providing respite from temporary cash mismatches
  2. Poor cash management of the government has adverse implications for liquidity management and debt management by the RBI
  3. Apart from this, it impacts the asset and liability of the RBI balance sheet and subsequently the RBI income and expenditure and consequently the profit and loss account
  4. The surplus transfer framework needs to recognize the dynamic and sometimes wayward cash management of the government
  • Another issue is the interim transfer of dividend to the government amounting to ₹10,000 crore during 2017-18 without the accounts being audited and before the finalisation of the profit and loss account
  1. One is not sure whether it is from gross income or from accumulated funds in CF and ADF
  2. There is no doubt that the government is the owner of the RBI and has all claims on the surplus funds, but how could the funds be transferred even before the annual accounts are finalised?
  3. The public does not know whether the RBI files quarterly or half-yearly audited accounts
  4. Both the government and the RBI are public institutions handling public policy and such practices are against the principles of transparency and integrity

Measures required

  1. The cash and debt management committee of the government and the RBI, which meets periodically, should look into the WMA requirements during the quarter and manage the cash flow in a non-disruptive manner
  2. If this exercise is followed in its true spirit, there will be no need for interim dividends, which are an attack on the very idea of a balance sheet
  3. The committee on ECF should look into the macroeconomic implication and financial market implication of such withdrawals from the accumulated funds for CF and ADF and also Currency and Gold Revaluation Accounts
  4. Any reduction in the liability side of the RBI by a possible withdrawal needs equivalent adjustment on the assets side. This monetary operation has to be transparent
  5. Any off-market operation has the colour of non-transparency and will raise questions on the integrity of the central bank
  6. It may be mentioned that the reduction in the asset side by selling these assets in the market will have an impact on the liquidity (both rupee and dollar) and thus on monetary management

Way forward

  1. The issue of surplus transfer takes into its sweep not just accounts but the entire gamut of issues related to a transparent monetary and fiscal interface
  2. This should be handled effectively keeping all such factors in mind

Banking Sector Reforms

[op-ed snap] The RBI concedes a vital principle

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


Context

Recent RBI board meeting

  1. The government and some of the current nominee directors on the RBI board have contended that all policy decisions must be deliberated by the board
  2.  The outcomes of the meeting suggest that the RBI has conceded this vital principle
  3. This augurs well for the relationship between the government and the RBI management hereafter. Indeed, it may well constitute a paradigm shift in the functioning of the RBI

The significance of the meeting

  1. Every one of the four decisions taken, including three decisions related to regulation, was ascribed to the board
  2. The note also mentions that the constitution of a committee to examine the economic capital framework of the RBI, which was one of the decisions taken, will be jointly determined by the RBI and the Government of India
  3. These announcements constitute a significant departure from what has appeared to be the position of the RBI thus far: policy decisions, especially those relating to regulation, are the exclusive province of RBI management
  4. Any departure from this position amounts to an infringement of the RBI’s autonomy

Relationship between RBI board & the management not defined

  1. The precise relationship between the RBI board and the RBI management is something of a grey area
  2. Various experts have made the point that the RBI Act vests all powers in the board and, concurrently, it vests those very powers in the RBI Governor
  3. Whether the board can issue directions to the RBI Governor in the event of a difference of opinion between the two is not clear

Arguments for the involvement of RBI board

  1. The RBI board has played an advisory role in the past and should continue to do so
  2. Corporate boards too play an advisory role for the most part even though they enjoy full powers in the running of the corporation but they tend to leave most decisions to management
  3. However, corporate boards do step in and play a more active role where management is found wanting
  4. The RBI board must play a largely advisory role
  5. The RBI management may or may not accept the inputs of the board. But the board must have its say
  6. This is elementary corporate governance

Debate regarding RBI reserves

  1. How much capital the RBI needs has been hotly contested in recent years
  2. The government’s position is that the RBI’s reserves are in excess of reserves typically held by central banks elsewhere
  3. Some commentators have described the government’s position as an attempt to ‘raid the reserves’ of the RBI to fund its fiscal deficit
  4. This is a crude mischaracterization of the position
  5. Reducing reserves enables the government to spend — but not by stealing the RBI’s cash

How do reducing reserves favour the government?

  1. The RBI’s reserves fall into two categories: revaluation reserves (which have mostly to do with the change in the rupee value of the RBI’s holdings of gold and foreign currencies) and contingent reserves (which represent plough back of a portion of the surplus earned by the RBI every year, the remaining portion being transferred to government as dividend)
  2. Contingent reserves are intended for risks related to the RBI’s balance sheet
  3. Let us suppose that these should not be touched. Revaluation reserves are an accounting entry
  4. The RBI can reduce some of the revaluation reserves on the liability side and extinguish an equivalent value of government securities on the asset side
  5. The latter step would lower the stock of debt owed by the government
  6. This would provide headroom for the government to raise debt for meeting its future expenditure (including recapitalisation of public sector banks)

Ensuring credit flow

  1. The other outcomes at the RBI board meeting have to do with increasing the flow of bank credit and easing the problems of borrowers, especially small and medium enterprises (SMEs)
  2. Banks are subject to capital adequacy requirements — that is, they have to hold a minimum of capital against every rupee of loans they make
  3. The RBI’s requirement of capital adequacy is one percentage point higher than that of the internationally accepted Basel norms laid down by the Bank for International Settlements
  4. The government would like to align Indian banks’ requirements with the Basel norms as that would reduce the demands for capital made on it by public sector banks (PSBs)
  5. The RBI did not yield on this point at the recent meeting
  6. However, it has agreed to defer an increase in the capital requirement of banks of 0.625% under another head by one year

Easing PCA framework

  1. The RBI has also agreed to consider the government’s suggestion for easing the norms for Prompt Corrective Action (PCA) for banks
  2. The PCA imposes restrictions of various kinds on banks, including restrictions on lending for the weakest banks
  3. The idea is that banks that are very weak should not create problems for themselves by making more loans
  4. They should focus on getting their balance sheet right by reducing costs, selling some of their non-core assets and the like
  5. A PCA regime has significant negative externalities
  6. If many banks face lending restrictions for a prolonged period, it could create serious problems for the economy
  7. Large corporates could get into distress because of their linkages with distressed SMEs
  8. So can the healthier banks that are exposed to these corporates
  9. A relaxation in PCA norms, by translating into higher credit flows, could relieve stress in the broader economy

NBFC capital requirements

  1. The strident demand to enhance flows to non-banking financial companies (NBFCs), which was heard ahead of the meeting, finds no mention in the press note
  2. It appears that the difficulties in rolling over NBFC debt that followed the collapse of Infrastructure Leasing and Financial Services (IL&FS), a leading NBFC, have abated somewhat
  3. Evidently, the RBI was able to make a persuasive case on this point at the meeting

Way forward

  1. As a public institution whose actions have enormous welfare implications, the RBI management cannot rule by fiat
  2. Its actions must flow from a consultative process
  3. It must explain and justify its actions
  4. It must be seen to be accountable
  5. The RBI board could be an important mechanism for ensuring that these conditions are met

Banking Sector Reforms

[op-ed snap] Time for the government to reassess its position

Note4students

Mains Paper 3: Economy | Indian Economy Issues relating to planning

From the UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: Unjustified borrowing demand of government from RBI and its implications


Context

Government’s demand for capital from RBI

  1. The government and the Reserve Bank of India (RBI) have not been able to find a middle ground to resolve outstanding issues
  2. One of the contentious issues is that of the central bank’s reserves
  3. The government believes that the RBI is holding excess reserves and a part should be transferred to it
  4. However, the RBI is of the view that it needs reserves to attain its policy objectives

Urgency behind reforms questionable

  1. If the government believes that RBI is holding excess reserves, or is looking at its capital more conservatively, what explains the urgency to “fix” it?
  2. The issue can be amicably settled by constituting an expert committee
  3. Such a committee would be in a better position to look into the matter in detail and recommend the appropriate level of capital for the central bank and, if necessary, also suggest ways to transfer reserves to the government
  4. This will make the process more transparent and financial markets will be in a better position to understand the issue

Risk of fiscal slippage

  1. The fiscal deficit reached 95.3% of the full year target in the first six months of the financial year
  2. Therefore, it is possible that because of lower than expected indirect tax collection, the government might have to cut capital expenditure, which will affect growth
  3. It would want to avoid this in an election year
  4. This is also the main reason why it is aggressively pushing for a relaxation in the prompt corrective action framework and improving liquidity in the non-banking financial space
  5. A large transfer by RBI will, at best, optically improve the fiscal position and give some room to the government to increase spending in an election year
  6. But any reduction in the size of the RBI balance sheet will affect the flow of dividend in the future

RBI’s role as seat belt

  1. Former RBI governor Raghuram Rajan has explained what RBI does with the analogy of a seat belt
  2. The driver—in this case, the government—has the option of not putting on the seatbelt, but in case of an accident, the damage could be severe
  3. The government undoubtedly needs such a safety measure, as the road ahead for the Indian economy is likely to be bumpy
  4. Financial condition in global markets will continue to tighten and growth is likely to soften
  5. With volatility in global crude prices and the uncertainty of domestic elections, policy reliability in one quarter will provide some comfort to financial markets
  6. Continued confrontation, or pushing the central bank too far on regulatory issues, will affect investor confidence in financial markets and the ensuing uncertainty will impact growth

Way forward

  1. A one-time transfer from the RBI will not structurally improve fiscal dynamics and is unlikely to impress investors or rating agencies
  2. On the contrary, it will be seen as an erosion of RBI’s operational autonomy and affect capital flows in the medium to long run
  3. The government and the RBI board would do well to carefully examine the longer-term cost of their decisions

Banking Sector Reforms

[op-ed snap] A nuanced understanding of the NBFC sector

Note4students

Mains Paper 3: Economy | Mobilization of resources

From the UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: Issues related to NBFC sector & why its functioning is important for economy


Context

NBFC sector in crisis

  1. Events revolving around the multi-notch downgrade of Infrastructure Leasing and Financial Services (IL&FS) last month have caused a liquidity squeeze for the entire non-banking financial company (NBFC) sector
  2. Risk aversion in debt markets has heightened to an extent that the market has lost its ability to make a distinction across NBFCs, bracketing all of them in the same risk category, irrespective of the underlying nature of their assets and liabilities

Is the whole NBFC sector at risk?

  1. The reality is that the sector is very heterogeneous and constitutes different types of companies with different business models addressing very different underlying borrower segments
  2. The differences in business models and the diverse target segments of NBFCs are stark
  3. This nuance needs to be seen, understood and acknowledged for markets to resume normalcy

Types of NBFCs

  1. NBFCs can broadly be divided into three segments—asset financing, personal loans and business loans
  2. The predominant asset financing NBFCs are commercial vehicle financiers
  3. The remaining NBFCs provide a range of personal and business loans with widely varying business models
  4. Housing finance companies (HFCs), which provide housing loans, can be considered as specialized NBFCs that have a separate regulator
  5. Within these broad classifications, there are further differentiation based on the borrower segment the NBFCs target

Risk aversion for NBFCs

  • Asset-liability mismatch (ALM)
  1. Short-term funding is being used to finance long-term assets
  2. The asset side duration for these businesses is very short ranging from eight to eighteen months
  3. On the liabilities side, the duration either mirrors the asset side, or is longer, and generally ranges from one to two years
  4. Thus, the small- to mid-sized NBFCs run a positive ALM mismatch
  5. This is further aided by low leverage and high capital adequacy
  • Refinancing or rollover of short-term capital market borrowings
  1. This concern is linked to the ALM issue discussed above as smooth rollover of shorter duration liabilities when assets are of longer duration is key for business continuity
  2. Commercial paper funding (of up to 90 days) for NBFCs from mutual funds has increased from ₹50,000 crore in March 2016 to ₹1.2 trillion in September 2018
  3. Recently mutual funds have withdrawn from the market for NBFC paper
  4. This has led to heightened refinancing risk for those who are dependent on such funding
  5. It is estimated that NBFC and HFC debt of about ₹2.5 trillion is due for roll-over in the next six months
  • Asset quality
  1. This primarily pertains to NBFC exposure to the real estate sector—either as builder funding or loan against property (LAP)
  2. Builder funding is non-existent in the loan book of NBFCs
  3. In the case of LAP portfolio of affordable housing financiers or small business loan financiers, the asset quality continues to be above par as the sourcing of these loans has been outside the ultra-competitive urban LAP market
  4. The property underlying the LAP loans is typically self-occupied and not purchased for investment purposes

Measures required

  1. For NBFCs with sound fundamentals that are caught in the current situation, a short-term squeeze on funding can be managed by curtailing growth

Way forward

  1. Over the years, NBFCs have played an important role in providing growth capital to various sectors of the economy
  2. What is required is a concerted effort across stakeholders to prevent a market contagion that can cut off the critical supply of capital to the grassroots of the nation

Banking Sector Reforms

Is RBI really being strict with banks under PCA?

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: PCA, Minimum Capital Requirement

Mains level: NPA problem and solution


News

Criticisms over PCA

  1. Reserve Bank of India is accused of being too stringent in applying the prompt corrective action (PCA) framework for banks.
  2. This has hurt the flow of credit to the economy.

Restrictions on Lending

  1. PCA has been imposed on 11 state-run banks, which did not meet RBI’s specified thresholds on either capital adequacy, asset quality or profitability.
  2. The idea behind this is that banks preserve capital and regain their health, which means that lending takes a hit.

Reality Check

  1. Analysis shows that far from being too stringent, the central bank has shown forbearance with some of the banks that are not already under PCA.
  2. At least four more banks need to be censured for not meeting the central bank’s specified risk thresholds, if RBI follows a strict rule-based approach.
  3. These are Andhra Bank, Canara Bank, Punjab National Bank (PNB) and Union Bank of India.
  4. Each of these has breached the maximum permissible levels of 6% for net non-performing advances as a percentage of total advances.
  5. RBI rules state that PCA can be imposed if any one of the risk thresholds for capital, asset quality, profitability or leverage is breached.
  6. However these banks met the minimum capital requirements needed to avoid PCA.

Norms are Conservative

  1. While recognition of NPAs has improved in the Indian banking system, provisioning norms are still conservative.
  2. In jurisdictions where only capital ratios are considered in the PCA framework, NPA provisioning norms are more stringent.
  3. Perhaps RBI’s forbearance has to do with an expectation that the government will recapitalize these banks, so that provisioning for their NPAs do not drag their capital down to low levels.

Back2Basics

Capital adequacy ratio(CAR)

  1. Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR), is the ratio of a bank’s capital to its risk
  2. National regulators track a bank’s CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements.
  3. It is a measure of a bank’s capital
  4. It is expressed as a percentage of a bank’s risk weighted credit exposures.
  5. This ratio is used to protect depositors and promote stability and efficiency of financial systems around the world
  6. Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors

Banking Sector Reforms

[op-ed snap] Is it time to introduce wholesale banks in India?

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: NBFCs, Wholesale banking, Financial Stability Report

Mains level: The problem of funding faced by NBFCs and the need of introducing wholesale banking concept in India


Context

NBFCs facing problems

  1. In the last few weeks, Indian non-banking financial companies (NBFCs), especially housing finance companies, have witnessed a fall in valuations and rising bond yields
  2. Liquidity for NBFCs has also significantly contracted across the board
  3. Yields on AAA-rated commercial papers (CPs) of NBFCs have risen from less than 7.5% in the beginning of September to almost 8.3% now, an increase of 80 basis points

Root of problem

  1. The liability profile of large, non-deposit taking NBFCs significantly comprises wholesale funding, with debentures accounting for nearly half of it
  2. This is not a problem in itself, but for certain types of NBFCs, such as housing finance and infrastructure financing companies, asset-liability mismatches can be severe, especially given the near-absence of markets for long-tenure paper, and payments on short-term borrowings come up sooner than repayments from loans originated
  3. This, coupled with the illiquidity in corporate bond markets, makes NBFCs particularly vulnerable to market reactions, unlike banks, which has access to both retail deposits and the liquidity facility of the Reserve Bank of India (RBI)

Better performance on NBFCs as compared to banks

  1. The banking sector is struggling to grow their lending book under the weight of persistent non-performing assets (NPAs), and NBFCs are beginning to meet the consequent unmet demand for credit across a variety of sectors and ensuring continuing credit flows to the real economy
  2. NBFCs have been maintaining low net NPA ratios of 3.5% unlike their banking sector counterparts, where net NPAs continue to remain stubbornly high at 6.1% (RBI Financial Stability Report, June 2018)
  3. NBFCs have been found to be relatively more resilient to stress applied for credit risk and  even under severe stress conditions, continued to remain stable, buoyed by high economic capital levels hovering above 20% against a regulatory requirement of 15%

Funding problem of NBFCs

  1. NBFCs have been able to complement the credit intermediation by banks by serving regions, sectors and customer segments that banks have either been unable or unwilling to serve profitably
  2. But, these entities are particularly vulnerable to wholesale funding constraints in the form of high and volatile borrowing costs even when there is no concomitant deterioration in asset quality

Demand for providing LOLR facilities to NBFCs

  1. There have been some calls for providing the RBI’s lender of last resort (LOLR) facilities to NBFCs
  2. But merely providing LOLR facilities to NBFCs, such as the liquidity adjustment facility and the marginal standing facility, would lead to behaviour consistent with moral hazard
  3. This is because, without demand liabilities, a LOLR disincentivises efficient liquidity management
  4. This also creates inconsistency in regulatory treatment between banks and NBFCs, which unlike banks, do not have restrictions like statutory liquidity ratio

Solution: Wholesale Banks

  1. It is worth bringing back to the table and considering wholesale bank licensing for India
  2. This idea was first floated by the RBI Committee for Comprehensive Financial Services for Small Businesses and Low Income Households in 2014
  3. The committee envisaged these licensees to be like universal banks on their asset side with freedoms to originate a variety of assets, but with important differences for their liabilities side
  4. Without permissions to access retail deposits, liabilities would comprise wholesale demand deposits (of minimum ₹5 crore, which is large enough to keep retail depositors at bay, but small enough to ensure a diversified depositor base) and other wholesale funding instruments
  5. This obviates the need to apply micro-prudential tools, which are needed when public retail deposits are accessed

Types of wholesale banks

  1. The committee identified two categories within the wholesale banks, namely wholesale consumer banks and wholesale investment banks, which differed from each other in the nature of assets originated
  2. While the former would originate retail loans, the latter would originate infrastructure and/or corporate loans
  3. The limited construct of the wholesale investment bank was later taken up by the RBI and put forward in the form of the wholesale lending and term financing (WLTF) banks, in its discussion paper in April 2017

Way forward

  1. The regulator would do well to revive the wholesale bank idea and provide a pathway for some of the larger and better-run NBFCs to transform into wholesale banks with a cleaner design of wholesale demand liabilities supported with LOLR and business strategy driven choice of lending book
  2. Such a transition would ensure that these important institutions now have a more permanent and stable way of dealing with their funding problems

Banking Sector Reforms

[op-ed snap] PSSA 2018: A step towards separating banking, payments

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: Payment and Settlement Systems Act (PSSA), 2007

Mains level: Draft PSSA 2018 and how it will affect banking as well as the new wave of payments banks


Context

Amendments to PSSA 

  1. The inter-ministerial committee set up to finalize the amendments to the Payment and Settlement Systems Act (PSSA), 2007, has submitted its report
  2. When PSSA was passed by Parliament in December 2007, it initiated the first phase of recognizing payments from banking or classic banking

Difference between classic banking and payments

  1. Classic banking is “accepting, for the purpose of lending and investment, of deposit of money from individuals or legal entities”
  2. Bank’s earnings would directly depend on how they are able to reduce cost of deposit through current account savings account and are able to lend at higher rates with a decision on security/risk taken for such lending
  3. Apart from the interest income, banks would impose different kinds of fees for providing loan products, as an additional revenue stream
  4. Payments, on the other hand, are the transfer of monetary value from a person/legal entity to another person/legal entity for either consideration towards goods and services rendered or just transfer of money

Recommendation of PSSA 2018 draft amendment

  1. It is a step towards separating banking and payments
  2. It recommends setting up a separate seven-member Payments Regulatory Board (PRB)
  3. It will be chaired by a person appointed by the government in consultation with Reserve Bank of India (RBI)
  4. There will be one deputy chairman nominated by the central board of RBI, two members appointed by the central board of RBI, one officer nominated by the government and two whole-time members
  5. The proposed Bill recognizes RBI’s role in the context of monetary policy in making regulations for existing or new payments systems/enhancements/amendments
  6. It also provides for test systems or regulatory sandbox for a period of six months for a legal entity to apply and launch the test system/innovation

Banking Sector Reforms

[op-ed snap] Banking on mergers

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: The strategy behind bank consolidation and its pros and cons


Context

Bank consolidation

  1. The Union government has proposed the merger of three public sector banks — Bank of Baroda, Dena Bank and Vijaya Bank
  2. This merger will create an amalgamated entity that will become the country’s third-largest lender
  3. The merger is part of the government’s efforts to consolidate the banking industry with an eye on overcoming the bad loan crisis
  4. The current merger comes after the government let State Bank of India’s associate banks merge with their parent last year and the Life Insurance Corporation of India take over the troubled IDBI Bank this year

Impact of forced mergers

  1. Forced mergers such as the current one make little business sense for the stronger banks as the weaker banks tend to be a drag on their operations
  2. They are also unlikely to solve the bad loan crisis that has gripped the banking system as a whole
  3. From a corporate governance perspective, however, the merger sends out rather poor signals
  4. Here a dominant shareholder in the form of the government is dictating critical moves that impact the minority shareholders, who are left with no say in the matter
  5. The move to merge banks is understandable, but shareholders should have been consulted

Managing mergers

  1. There are too many public sector banks in India and thus consolidation is a good idea in principle
  2. It needs to be ensured that the merger fallout is managed prudently
  3. Identifying synergies and exploiting scale efficiencies will be crucial

Way Forward

  1. Asking healthy banks to take over weak banks appears to be the strategy to handle the bad loans crisis
  2. It is important to ensure that such mergers do not end up creating an entity that is weaker than the original pre-merger strong bank

Banking Sector Reforms

[pib] Government initiated consolidation – amalgamated entity to be India’s third largest bank

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: MSME Udyamimitra

Mains level: The newscard discusses potential advantages of merger of the banks.


News

Context

  1. The Alternative Mechanism comprising of its Chairperson, the Union Finance Minister decided that Bank of Baroda, Vijaya Bank and Dena Bank may consider their consolidation.
  2. It will be the First-ever three-way consolidation of banks in India, with a combined business of Rs. 14.82 lakh crore, making it India’s Third Largest Bank.

Impact of the Merger

  1. It will help create a strong globally competitive bank with economies of scale and enable realization of wide-ranging synergies.
  2. Leveraging of networks, low-cost deposits and subsidiaries of the three banks has the potential for substantial rise in customer base, market reach, operational efficiency, wider products and services, and improved access for customers.
  3. Some of the strengths of the envisaged amalgamated entity are—
  • Provision Coverage Ratio (PCR) at 67.5% is well above Public Sector Banks (PSBs) average (63.7%), and steadily increasing
  • Net NPA ratio at 5.71% significantly better than PSB average (12.13%), and declining further
  • Gross NPAs for the combined entity have started declining (decline of Rs. 1,048 crore in Q1)
  • Cost to income ratio of the combined entity at 48.94% better than the PSB average of 53.92%
  • Capital Adequacy Ratio (CRAR) at 12.25% is significantly above the regulatory norm of 10.875%, and stronger amalgamated bank will be better positioned to tap capital markets

Combined range of Services

  1. Dena Bank’s strength in MSME will further augment the strength of the other two to position the amalgamated bank for being an MSME Udyamimitra
  2. Larger distribution network will reduce operating and distribution costs with benefits for the amalgamated bank, its customers and their subsidiaries
  3. Global network strength of Bank of Baroda will be leveraged to enable customers of Dena Bank and Vijaya Bank to have global access.

Banking Sector Reforms

[op-ed snap] How Basel III plugged regulatory loopholes

Note4students

Mains Paper 3: Environment | Conservation, environmental pollution and degradation, environmental impact assessment

From UPSC perspective, the following things are important:

Prelims level: Basel II, Basel III

Mains level: Need for financial regulation via various mechanisms


Context

Regulatory mechanism for financial institutions

  1. There is a vast gulf between academic discourse on the financial regulation and actual practice
  2. The regulatory architecture for depository institutions proved ineffective in the global financial crisis
  3. The crisis originated in non-deposit taking financial institutions, it spread to the regulated deposit accepting entities with remarkable agility

Basel II proved ineffective

  1. Basel-II, the international accord for banking regulation that was formalized just before the onset of the crisis, was an important improvement over its earlier version in many ways
  2. But, it gave excessive discretion to financial institutions for computing crucial parameters like risk weights
  3. These parameters are important inputs in the computation of risk-weighted assets (RWAs), which in turn determined the level of required capital buffers
  4. In this, banks had a skewed incentive to underestimate their risk weights by using complex models
  5. Additionally, divergent methodologies used to compute risk weights meant that there was enormous variability in reported numbers, making any meaningful comparison across banks virtually impossible
  6. The risk weight for the mortgage, the very instrument that precipitated the crisis, was reduced

Improvements in Basel III

  • It has mandated a higher capital adequacy ratio to absorb potential losses originating in both trading and banking books, including additional capital conservation buffers
  1.  The idea is that once this buffer is depleted, regulators should be worried
  2. The financial institution must build its reserves before it is allowed to distribute its profits by way of dividends, share buybacks and employee bonuses
  • It has taken steps to reduce the variability of the risk-weighted assets by constraining the discretion of banks
  1. For many asset classes, use of more sophisticated and complex models (so-called “advanced approach”) is disallowed
  2. Moreover, many crucial parameters used to calculate risk weights
  • The realization that financial institutions can build leverage while apparently complying with capital adequacy norms has led to the adoption of new risk metrics such as leverage ratio which is insensitive to precise risk weights
  1. In many cases, banks built up excessive leverage while apparently maintaining strong risk-based capital ratios
  2. At the height of the crisis, financial markets forced the banking sector to reduce its leverage in a manner that amplified downward pressures on asset prices
  3. This deleveraging process exacerbated the feedback loop between losses, falling bank capital and shrinking credit availability
  • The need for an integrated and enterprise-level risk management approach is emphasized
  1. Besides the capital requirement and new liquidity/ leverage ratios, Basel-III envisages forward-looking supervisory control that includes periodic stress testing
  2. It is hoped that these measures, together with mandatory disclosure requirements and associated market discipline, will reduce the frequency and severity of financial crises

Way Forward

  1. It would be too early to claim that the final word on banking regulation has been written
  2. Still, Basel-III has plugged many loopholes and reduced the likelihood of such cataclysmic events taking place in future

Banking Sector Reforms

Reserve Bank tightens Ombudsman Scheme

Note4students

Mains Paper 2: Governance | Important aspects of governance, transparency and accountability, e-governance- applications, models, successes, limitations, and potential

From UPSC perspective, the following things are important:

Prelims level: Not Much

Mains level: Need for Banking Ombudsman 


News

Strengthening Grievance Redressal Mechanism

  1. The RBI has tightened the banking ombudsman scheme with the objective to strengthen the grievance redressal mechanism for customers.
  2. It has asked all commercial banks having 10 or more banking outlets to have an independent internal ombudsman (IO) to review customer complaints that are either partly or fully rejected by the banks.
  3. The IO shall examine customer complaints which are in the nature of deficiency in service on the part of the bank, that are partly or wholly rejected by the bank.
  4. The instructions are not applicable for Regional Rural Banks sponsored by commercial banks.
  5. As banks should internally escalate complaints that are not fully redressed to their respective IOs before conveying the final decision to the complainant, customers need not approach the IO directly.

Fixed term

  1. According to bankers, the Internal Ombudsman Scheme of 2018 mandates banks to grant a fixed term of three to five years, which cannot be renewed, to the IO.
  2. The IO can be removed only with prior approval from RBI.
  3. The remuneration would have to be decided by the customer sub-committee of the board and not by any individual.
  4. RBI has said that the Ombudsman Scheme of 2018 covers appointment/tenure, roles and responsibilities, procedural guidelines and oversight mechanism for the IO.
  5. The implementation of IO Scheme 2018 will be monitored by the bank’s internal audit mechanism apart from regulatory oversight by RBI.

Back2Basics

Banking Ombudsman Scheme

  1. Banking Ombudsman Scheme is a mechanism created by the RBI to address the complaints raised by bank customers.
  2. It is run by the RBI directly to ensure customer protection in the banking industry.
  3. The scheme was introduced under Section 35 A of the Banking Regulation Act, 1949 by RBI with effect from 1995. The present Ombudsman scheme was introduced in 2006.
  4. The Banking Ombudsman is a senior official appointed by the Reserve Bank of India.
  5. He has the responsibility to redress customer complaints against deficiency in certain banking services.
  6. All Scheduled Commercial Banks, Regional Rural Banks and Scheduled Primary Co-operative Banks are covered under the Scheme.
  7. The Banking Ombudsman can receive and consider any complaint relating to a number of deficiencies related to banking operations including internet banking.

Banking Sector Reforms

Why is a Public Credit Registry important?

Note4students

Mains Paper 3: Economy | Inclusive growth & issues arising from it

From UPSC perspective, the following things are important:

Prelims level: PCR, Deosthalee Committee Report

Mains level: Read the attached story


News

What is PCR?

  1. A public credit registry is an information repository that collects all loan information of individuals and corporate borrowers.
  2. It helps banks distinguish between a bad and a good borrower and accordingly offer attractive interest rates to good borrowers and higher interest rates to bad borrowers.

How will it impact?

  1. PCR will address issues such as information asymmetry, improve access to credit and strengthen the credit culture among consumers.
  2. It can also address the bad loan problem staring at banks, as corporate debtors will not be able to borrow across banks without disclosing existing debt.
  3. A PCR may also help raise India’s rank in the global ease of doing business index.
  4. Setting up the PCR will help improve India’s rankings in the World Bank’s ease of doing business index.

Panel’s proposals

  1. The move is based on the recommendations of a committee, headed by Y.M. Deosthalee.
  2. The committee has suggested the registry should capture all loan information and borrowers be able to access their own history.
  3. Data is to be made available to stakeholders such as banks, on a need-to-know basis. Data privacy will be protected.

Why PCR is necessary?

  1. Credit information is now available across multiple systems in bits and pieces and not in one window.
  2. Data on borrowings from banks, non-banking financial companies, corporate bonds or debentures from the market, external commercial borrowings (ECBs), foreign currency convertible bonds (FCCBs), masala bonds, and inter-corporate borrowings are not available in one data repository.
  3. PCR will help capture all relevant information about a borrower, across different borrowing products in one place.
  4. It can flag early warnings on asset quality by tracking performance on other credits.

PCR in other countries

  1. PCR in other countries now include other transactional data such as payments to utilities like power and telecom for retail consumers and trade credit data for businesses.
  2. Regularity in making payments to utilities and trade creditors provides an indication of the credit quality of such customers.

Innovation in lending

  1. Access to credit information, including debt details and repayment history would drive innovation in lending.
  2. For example, currently most banks focus on large companies for loans and consequently the micro, small and medium enterprises are left with limited options for borrowing.
  3. With satisfactory payment history and validated debt details made available, it will increase the credit availability to micro, small and medium enterprises along with deepening of the financial markets.
  4. This will support the policy of financial inclusion.

Banking Sector Reforms

[pib] Cabinet approves Revised Cost Estimate for setting up of India Post Payments Bank

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Particulars of the IPPB, payments banks, etc.

Mains level: Extending banking services through all possible mechanisms is the need of hour and IPPB serves best example for this.


News

Context

The Union Cabinet has given its approval for revision of the project outlay for setting up of India Post Payments Bank (IPPB) from Rs. 800 crore to Rs. 1,435 crore.

India Post Payment Bank Project

  1. The IPPB is aimed to provide modes of payments/financial services through its technology enabled solutions which will be distributed by the post employees/last mile agents transforming them from mail deliverer to harbinger of financial services.
  2. The IPPB shall pay incentive/commission to the last mile agents ( Postal Staff and Gramin Dak Sewaks) directly in their accounts for providing IPPB services so as to motivate them to promote IPP8 digital services to the customers.
  3. A part of commission to be paid by IPPB to Department of Posts will be used for increasing the wherewithal of Post office

Details of the Project

  1. IPPB services shall be available at 650 IPPB branches and 3250 Access Points from 1st September 2018 and in all 1.55 lakh post offices (Access Points) by December 2018.
  2. The project will generate new employment opportunity for about 3500 skilled banking professionals and other entities engaged in propagating financial literacy across the country.
  3. The objective of the project is to build the most accessible, affordable and trusted bank for the common man; spearhead the financial inclusion agenda by removing the barriers for the unbanked and reduce the opportunity cost for the under banked populace through assisted doorstep banking.
  4. The project will supplement Government’s vision of “less cash” economy and at the same time promote both economic growth and financial inclusion.
  5. The robust IT architecture of IPPB has been built taking into consideration bank grade performance, fraud and risk mitigation standards and in line with the best practices from payments & banking domain.

Banking Sector Reforms

Banks set to come out of PCA framework this year

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: PCA

Mains level: NPA problem and solution


News

New PCA framework under process

  1. RBI has placed eleven public sector banks – Dena Bank, Central Bank of India, Bank of Maharashtra, UCO Bank, IDBI Bank, Oriental Bank of Commerce, Indian Overseas Bank, Corporation Bank, Bank of India, Allahabad Bank and United Bank of India under the PCA framework.
  2. Of these, two banks – Dena Bank and Allahabad Bank – are facing restriction on expansion of business.
  3. Various measures taken by the government including implementation of the Insolvency and Bankruptcy Code (IBC) has yielded good results in terms of reining bad loans and increasing recovery.
  4. The framework is not intended to constrain the performance of normal operations of the banks for the general public.

Progress over NPAs

  1. Banks have made recovery of Rs 36,551 crore during the first quarter registering a 49 per cent growth over the last financial year.
  2. The NPAs are also decreasing and credit growth is simultaneously taking place.
  3. Hence the resolve of government is extremely clear that every stakeholder has to be responsible.
  4. Capital infusion has revitalized some PSBs whereas some don’t need it.

Back2Basics

Prompt Corrective Action (PCA)

  1. RBI has issued a policy action guideline (first in May 2014 and revised effective from April 1, 2017) in the form of PCA framework if a commercial bank’s financial condition worsens below a mark.
  2. The PCA framework specifies the trigger points or the level in which the RBI will intervene with corrective action. This trigger points are expressed in terms of parameters for the banks.
  3. The parameters that invite corrective action from the central bank are:
  • Capital to Risk weighted Asset Ratio (CRAR)
  • Net Non-Performing Assets (NPA) and
  • Return on Assets (RoA)
  • Leverage ratio
  1. When these parameters reach the set trigger points for a bank (like CRAR of 9%, 6%, 3% and Net NPAs between 10 to 15% ) the RBI will initiate certain structured and discretionary actions for the bank.
  2. As per the revised framework by the RBI capital, asset quality and profitability continue to be the key areas for monitoring. Along with this, leverage of banks also will be monitored.
  3. The some of the structured and discretionary actions that could be taken by the Reserve Bank are: recapitalization, restrictions on borrowing from inter-bank market to steps to merge/amalgamate/liquidate the bank or impose moratorium on the bank if its CRAR does not improve beyond etc.).
  4. The PCA framework is applicable only to commercial banks and not extended to co-operative banks, non-banking financial companies (NBFCs) and FMIs.

Banking Sector Reforms

Govt decides to withdraw contentious FRDI bill

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Bail-in, bail-out

Mains level: Focus on issues related to the ‘Bail in’ clause of the Bill


News

FRDI Bill

  1. The government has decided to withdraw the contentious Financial Resolution and Deposit Insurance Bill 2017, or FRDI Bill to avoid controversial legislation ahead of the 2019 general election.
  2. It was tabled in the Lok Sabha in August, following which it was referred to the joint parliamentary committee. The panel is due to submit its report on the last day of the ongoing monsoon session.
  3. The bill aims to limit the fallout of the failure of institutions such as banks, insurance companies, non-banking financial companies, pension funds and stock exchanges.
  4. However, some of its provisions have been termed anti-people and anti-poor by the opposition parties who have pointed out that people’s money will be used to bail out banks that make bad lending decisions through a corresponding reduction in the claims of depositors.

What is ‘Bail in’ clause?

  1. A bail-in is rescuing a financial institution on the brink of failure by making its creditors and depositors take a loss on their holdings.
  2. A bail-in is the opposite of a bail-out, which involves the rescue of a financial institution by external parties, typically governments using taxpayer’s money.

Ambiguity over ‘bail-in’

  1. The bill has been criticized for some of its controversial provisions, including a “bail-in” clause, which suggests that depositor money could be used by failing financial institutions to stay afloat.
  2. The lack of clarity over protecting existing levels of deposit insurance for smaller deposits also led to a lot of criticism.
  3. At present, deposit insurance is available for all deposits of up to ₹1 lakh but there was no clarity on whether it will be continued in the bill.
  4. The decision to withdraw the bill comes as a surprise because the government has been vociferously defending the provisions of the bill by pointing out that the bail-in clause will not adversely impact depositors.
  5. The government had maintained that the implicit sovereign guarantee for state-run banks remains unaffected.

Banking Sector Reforms

[op-ed snap] Does India need a financial policy committee?

 Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: London Inter-bank Offered Rate (Libor), Financial Policy Committee, Banking Regulation Act (1949), Financial stability and development council (FSDC),

Mains level: Risks associated with the banking sector in India and need for specialized committees to separate banking and finance roles


Context

Diversified banking problems

  1. Varied kinds of banking and finance problems seem to be spreading around the world
  2. There has been London Inter-bank Offered Rate (Libor) fraud, Bank of Italy officials are grappling with non-performing assets problems in their economy
  3. India’s central bank governor has highlighted that the Reserve Bank of India (RBI) needs more powers to regulate ailing public sector banks

The idea of Financial Policy Committee (FPC)

  1. What is the FPC? It’s mandate was to look at the financial sector in a holistic manner and assess macroprudential risks
  2. It was instituted in the UK in the wake of 2008 financial crisis
  3. FPC is a 12-member committee with diverse representation from the Bank of England, Financial Conduct Authority, private sector and academia
  4. The committee meets four times a year and releases its flagship financial stability report twice in those meetings
  5. Just like India’s monetary policy committee sets interest rates, the FPC sets the countercyclical capital buffer rate, which basically tweaks the capital requirements for banks
  6. If the FPC sees that risks could be high in the future, it asks banks to increase its capital ratio
  7. It also analyses debt of households and firms and takes suitable measures

Institutional measures in India

  1. India already has some institutional arrangements that require reporting on the financial sector
  2. The Banking Regulation Act (1949) mandates that the RBI release an annual report, “Trend And Progress Of Banking In India”
  3. The RBI also started the “Report On Currency And Finance”, which was not mandatory but nevertheless gave us an overview of developments in the financial sector
  4. In its monetary policy decisions, the RBI also releases a document on regulation developments, which contains proposed changes in banking regulations
  5. The government established a financial stability and development council (FSDC) to bring greater coordination among financial market regulators
  6. In 2010, the RBI also started releasing its biannual “Financial Stability Report” (FSR), which has become the flagship report

Will these measures suffice?

  1. Given how financial markets and activities have become increasingly interconnected, they might not
  2. It is only a matter of time before problems in Indian financial markets start to resemble those in the West
  3. India is poised to have its own sub-prime moment in the near future

What can be done?

  1. The alternative is to appoint a new FPC and reallocate the finance-related decisions, responsibilities and publications to it
  2. The MPC can focus on macroeconomics and interest rates
  3. FPC and MPC would have common members like the RBI governor and deputy governors but FPC would have more specialists in the domain of finance

Way Forward

  1. Finance has become heavily specialized and interconnected in recent years and warrants attention from specialists
  2. We may not be able to prevent a future financial crisis but can at least try mitigating its damaging effects
  3. FPC could be one of the ways to achieve this

Banking Sector Reforms

[op-ed snap] Time to do away with priority lending norms

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Priority sector landing(PSL)

Mains level: The newscard comprehensively discusses some of the main issues related to the priority sector lending(PSL) norms of the RBI.


News

Context

  1. The RBI has recently tightened priority sector lending (PSL) norms for foreign banks in India

New norms

  1. Foreign banks with more than 20 branches in India will now be required to extend a portion of their loans to small and marginal farmers as well as micro enterprises from fiscal year 2018-19
    (as per the respective sub-sectoral targets)
  2. Those with less than 20 branches will also need to fulfil the overall PSL norms of 40% of adjusted net bank credit (ANBC) in a phased manner by 2020

Reaction from foreign banks

  1. Foreign banks have cited their lack of knowledge, and fear of stressed assets, as reasons for their reluctance to lend to these sectors

The International Monetary Fund (IMF) on priority sector loan targets

  1. The impact of priority sector loan targets on banks’ credit risk management strategies in India has been commented upon by the IMF
  2. In a recent report, the IMF has advised the RBI to review its PSL policy to allow for greater flexibility in meeting targets
  3. It also suggests a gradual reduction in PSL as a means to move funds into “more productive activities”,
  4. and greater participation of the private sector in capitalizing public sector banks, together with full capitalization

“Trend And Progress Of Banking In India” reports: RBI

  1. According to the report, public sector banks have been continuously underperforming on the total priority sector target of 40% since 2012,
  2. while private sector banks have continuously lent more than the mandatory target of 40%, except for two years
  3. Foreign banks also outperformed their mandated target of 32% throughout the decade till 2015-16, as well as the higher targets required later
  4. However, all banks have defaulted on their sub-sectoral targets, especially that of 18% for agriculture, in most years

Is priority sector lending responsible for the NPA’s?

  1. Public sector banks had a large proportion of NPAs among their priority sector loans (50%) in 2012, a figure that had come down to 24.1% in 2017
  2. Non-priority sector loans contributed to 82% of NPAs in the case of private sector banks in 2017, against the 18% of NPAs in the case of priority sector loans
  3. Foreign banks had a comparable figure for NPAs within their non-priority loans
  4. Thus, priority sector lending may not be responsible for compromising banks’ credit risk minimization strategies, or risk accumulation
  5. Yet, most bankers seem reluctant to lend to the priority sectors

Main issue with the priority sector lendings

  1. The problem with priority sector loans is the lack of understanding of the sub-sectoral target groups, especially agriculture and the small and medium sector
  2. A foreign bank, desirous of opening a bank branch in some remote area to service agricultural borrowers, neither understands its borrower, nor is clearly aware of the legal provisions to recover stressed assets
    Risk in agricultural sector
  3. Further, given the vagaries of the monsoon that agriculture is susceptible to and the undiversified risk portfolios in such rural areas, the credit risks for such banks from such PSL would be extremely high
    Risk in MSME sector
  4. The same would be the case for PSL to the micro, small and medium enterprise (MSME) sector
  5. The sector, with its unorganized operations and lack of proper accounting records and financial statements, poses higher costs and greater risks in credit disbursement

What should be done?

  1. Banks should be allowed to choose the category they wish to lend to
  2. Foreign banks may then choose to lend in the form of export credit (which was a sub-sectoral target for foreign banks prior to 2012, and was later removed), rather than to agriculture
  3. Similarly, private sector banks may choose to lend housing credit in urban areas, rather than being forced to lend agricultural finance

Back2basics

Priority Sector Lending

  1. Priority Sector Lending is an important role given by the Reserve Bank of India (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low income groups and weaker sections
  2. This is essentially meant for an all round development of the economy as opposed to focusing only on the financial sector

Banking Sector Reforms

[op-ed snap] An alternative to privatization of public sector banks

Note4studens

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Read the attached story

Mains level: There is an important debate going on among banking experts and the government on ‘Privatization of Public Sector Banks’. And the government is seriously considering this option, due to the current issues created in the banking industry mainly due to the lending irregularities. The newscard suggests a solution to solve the lending issue of the PSBs.


News

Context

  1. The troubles of the banking sector, and public sector banks (PSBs) in particular, are well known
  2. Reform proposals have focused largely on ownership and have issued strident calls for privatization
  3. Even if there was political support for the idea of privatization of banks, there are a few important challenges

People have confidence in India’s Public Sector Banking Services

  1.  The total current account and savings account (CASA) base of PSBs in India was Rs30.2 trillion (including State Bank of India, or SBI) and Rs 18.9 trillion (excluding SBI) in 2017
  2. Given the low deposit rates offered by banks in India relative to the risk-free rate, these deposits represent tremendous value in terms of a profitability cushion
  3. By and large, this reflects the confidence of customers in the implicit government support to these entities
  4. The core strength of PSBs is the deposit franchise
  5. Their branch network in far-flung areas means that they are the preferred choice of the mass-market customer, rural customers, and, often, retired individuals

What is the main issue?

  1. The real issue happens on the lending side
  2. This occurs due to a few reasons
    (1) mandated lending through various schemes, in addition to priority sector lending targets
    (2) the poor risk management competencies of banks, particularly vis-à-vis managing the concentration risks of specific sectors and business groups
    (3) lack of specialized underwriting skills, given that customers tend to range from large firms and farmers to small businesses and mortgages
  3. The math here is straightforward—the risk-adjusted return from the lending activity of the bank erodes all the value created by the deposit-taking activity

What should be done on the lending side?: The suggested model

  1. On the lending side, rather than PSBs directly originating credits through branches and hoping for the best,
  2. they would assemble a portfolio of credits that are originated by specialist institutions (non-bank finance companies and small finance banks)
  3. Assembling this portfolio of loans can be done through a variety of ways,
    such as direct purchases of their loans, and by investing in securitized assets representing underlying loans originated by these specialist institutions
  4. This also implies a clearer role for these specialist institutions and their contributions to extending credit in an efficient manner
    This is not a new idea
  5. Glimpses of this model can be seen in the priority sector lending certificates market and the micro-loan securitization market where specialists trade assets with non-specialists in a markets framework
    The idea will increase the ratings of the book asset of the PSBs
  6. The implementation of this idea would ensure a more efficient approach to capital, while, importantly, preserving the deposit franchise of PSBs
  7. This is because under this model, the PSB asset book would be highly rated owing to the high levels of diversification and granularity in underlying loans

The right way to implement this model

  1. Portfolio-level guidelines would need to be specified,
  2. The model would be subjected to high-quality risk reporting requirements that would be made possible by the availability of accurate and complete data
    (along business lines, legal entity type, asset type, industry, region and other groupings)
    that permit identifying and reporting risk exposures, concentrations and emerging risks

Banking Sector Reforms

[pib] Fugitive Economic Offenders Ordinance, 2018

Note4Students

From UPSC perspective, the following things are important:

Prelims level: Fugitive Economic Offenders Ordinance, 2018

Mains level: Measures taken by the government to reduce instances of frauds


News:

  • The President of India has given his assent to the Union Cabinet’s decision to promulgate the Fugitive Economic Offenders Ordinance, 2018
  • Fugitive Economic Offenders Ordinance, 2018 (“the Ordinance”) lays down the measures to empower Indian authorities to attach and confiscate proceeds of crime associated with economic offenders and the properties of the economic offenders.
  • This will deter economic offenders from evading the process of Indian law by remaining outside the jurisdiction of Indian courts.    

The Fugitive Economic Offenders Ordinance, 2018, inter alia provides for–

  • Making an application before the Special Court for a declaration that an individual is a fugitive economic offender;
  • Attachment of the property of a fugitive economic offender and proceeds of crime;
  • Issue of a notice by the Special Court to the individual alleged to be a fugitive economic offender;
  • Confiscation of the property of an individual declared as a fugitive economic offender or even the proceeds of crime;
  • Disentitlement of the fugitive economic offender from defending any civil claim; and
  • Appointment of an Administrator to manage and dispose of the confiscated property under the Act.

Major impact:

  • It is expected that a special forum to be created for expeditious confiscation of the proceeds of crime, in India or abroad, would coerce the fugitive to return to India to submit to the jurisdiction of Courts in India to face the law in respect of scheduled offences.    
  • Since the proposed law would utilise the existing infrastructure of the Special Courts constituted under the Prevention of Money-laundering Act, 2002 and the threshold of scheduled offence is high at Rs. 100 crores or more, no additional expenditure is expected on the enactment of the Bill.   

Banking Sector Reforms

[op-ed snap] The risks from the unending banking mess

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Book value, M. Narasimham committee, second Narasimham committee and Raghuram Rajan committee, etc.

Mains level: Important points disucussed in the newscard, related to the present issues of the Indian Banking System.


News

Little trust of investors on Indian Banks

  1. Nineteen Indian banks are being traded at large discounts to their book value in the stock market
  2. This essentially means that investors have little trust in the published accounts of these lenders
  3. The Reserve Bank of India (RBI) does not seem to have much confidence in many of the weakest banks either
  4. Eleven of them have in effect been told to stop giving fresh loans

Depositors still have faith in Indian banks

  1. The only stakeholders who have maintained their confidence in the Indian banking system till now have been depositors
  2. They have thankfully held their nerve despite the daily flow of negative information about the banks they put their life savings in
  3. One reason is the public view that there is an implicit sovereign guarantee to back banks

Earlier attempts to tackle the issues related to Banking System

  1. here have been three previous attempts—the report of the first committee headed by M. Narasimham in 1991, the report of the second Narasimham committee in 1998 and the report of the committee headed by Raghuram Rajan in 2009
  2. It is now time for a fourth attempt

There are some important issues that need to be addressed

FIRST: Issue of ownership

  1. The ongoing problems at ICICI Bank and Axis Bank show that private sector banks are not immune from the problems of bad lending, but have generally done better than public sector banks when it comes to asset quality
  2. The case for a banking system with more private sector participation continues to be a strong one

SECOND: There needs to be more clarity on the structure of Indian banking

  1. It is time to look at a more diverse banking structure,
  2. that have access to  project analysis capabilities to assess large infrastructure projects of the type that are now creating havoc in bank balance sheets

THIRD: Role for bond markets

  1. Policymakers need to decide what role bond markets will play in the Indian financial system
  2. It is worth asking whether the bond markets would have been as ready to accommodate over-leveraged companies, compared to the enthusiasm shown by bankers to either evergreen or restructure loans

The way foreword

  1. The harsh fact is that no country with a broken banking system can hope to grow rapidly, in effect compromising the battle against poverty
  2. That is the real cost of inefficient banking
  3. This is the time to look ahead to a new policy framework

Back2basics

Book Value

  1. Book value of an asset is the value at which the asset is carried on a balance sheet and calculated by taking the cost of an asset minus the accumulated depreciation
  2. Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities
  3. For the initial outlay of an investment, book value may be net or gross of expenses such as trading costs, sales taxes, service charges and so on

Banking Sector Reforms

RBI lets banks spread out provisioning for bond market losses over 4 quarters

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: RBI, provisioning, government bond, investment fluctuation reserve, Mark-to-market (MTM) provisioning

Mains level: Issues related to Indian banking sector


More provisioning allowed

  1. The Reserve Bank of India (RBI) has allowed banks to spread out the provisioning to cover losses on their government bond portfolio across four quarters
  2. This will give a relief for lenders who would have otherwise faced an immediate hit to their bond portfolio due to rising yields
  3. The RBI has also directed banks to create an investment fluctuation reserve to build up an ammunition against rising yields

MTM provisioning

  1. Mark-to-market (MTM) provisioning is available for the quarters ending December 2017 and March 2018
  2. Banks using such an option will have to make the disclosure in their notes to accounts of the quarterly results
  3. The disclosure should contain details such as how much provisioning is done and the balance that is required to be done

Why such move?

  1. Banks have to revalue their bond portfolio at the end of every quarter
  2. In case the value of the securities is lower than the market rate, they are mandated to keep aside funds as MTM provisioning
  3. The bond portfolio is divided into three categories, namely—available for sale (AFS), held for trading (HFT), and held to maturity (HTM)
  4. HTM is the only category where quarterly MTM provisioning is not applicable

Back2Basics

Provisioning

  1. When a loan is not being repaid, the Bank has to reconstitute this money from its other sources like Profit
  2. Setting aside of money from Profits to compensate a probable loss caused on lending a loan is called Provisioning
  3. Provisioning is done to cover the risk
  4. There are various percentages of Provisioning to the value of loan based on the duration the account has been out of order
  5. If an account stays non-performing for a prolonged period of time, the account is eventually written off and the account is closed
  6. The amount set aside as the provisioned money is used to close the account

Banking Sector Reforms

[op-ed snap] Why bank privatization may not be the answer

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: The newscard discusses both advantages and problems related to privatisation of banks. After the recent PNB fraud case, the privatisation of PSBs is a hot topic of discussion among experts.


Call for privatization of the Public Sector Banks

  1. The nearly $2 billion fraud at the Punjab National Bank (PNB) last month has renewed calls for privatization of state-owned banks

Why are experts asking for Privatization?

  1. According to experts, it would make for more prudent decisionmaking, increase accountability to shareholders, reduce complacency in management, improve profitability and end political influence in business decisions
  2. These points are discussed below:

FIRST: Importance of Operational Control

  1. The alleged fraudulent transactions at PNB reflect very bad operational controls, poor risk management and regulatory failure
  2. Privatization, without strengthening regulatory controls and improving governance, won’t prevent fraud, or curtail undue exposure to risk

SECOND: The government will always come to the bank’s rescue

  1. It has been argued that state control encourages management complacency
  2. as managers are secure in the knowledge the government will always come to the bank’s rescue if it is in trouble
  3. But is ownership the sole criteria for government intervention?
  4. Governments have in the past bailed out banks that were considered “too big to fail”, regardless of ownership, to prevent a systemic collapse
  5. Arguably privatization in some instances led to privatizing profits and socializing losses

THIRD: Privatization makes management more accountable to markets

  1. But the point is that, these state-backed banks are already subject to stock-market discipline—including corporate disclosures and regular audited financial reports

FOURTH: It would foster increased competition

  1. Yet again, it is unclear how a change in ownership from government to private hands would increase competition if the number of participants in the industry remain the same
  2. Fewer but stronger banks could, however, provide more effective competition than a large number of weak banks

FIFTH: The strongest case in support of privatization

  1. The strongest case is that state-backed banks are hobbled by bureaucratic restrictions and undue political interference, making the sector susceptible to elite capture
  2. Indeed, it has been said that India’s mounting bad debt problem may be partly a reflection of crony capitalism
  3. Political considerations may have forced the hand of bankers to extend credit to several powerful business houses who have since defaulted

SIXTH: State-owned banks have a social objective

  1. It must be remembered that state-owned banks in developing countries have an important social objective—to meet the needs of the most vulnerable sections of the economy
  2. Though both state and private sector banks are required to lend 40% of their loanable funds, at a concessional rate, to the priority sector,
  3. the main burden of the government’s development policies(from rural lending to infrastructure development) falls on state-run banks given that they are dominant players in India’s banking system

The way forward

  1. Public or private ownership, both can be equally good or equally bad
  2. It is the institutional factors that determine managerial success
  3. The boards of state-backed banks should be independent of political influence
  4. The clean-up of bank balance sheets and the overhaul of India’s archaic insolvency law are steps in the right direction

Banking Sector Reforms

RBI bans letters of undertaking for seeking overseas loans

Image source

Note4students

Mains Paper 3: Economy | Investment model

From UPSC perspective, the following things are important:

Prelims level: LoUs, LoC, bank guarantees, London Interbank Offered Rate

Mains level: Banking frauds and measures to curb them


Issuing of LoU and LoC banned

  1. The Reserve Bank of India (RBI) has barred banks from issuing letters of undertaking (LoUs)
  2. RBI also barred lenders from issuing letters of comfort (LoC) as trade credit for importing goods into India with immediate effect

Effects of the move

  1. The move may deal a blow to trade financing in India and raise credit costs for importers
  2. It will also put companies that have received credit based on LoUs in a spot, as they have to now repay their borrowings since there will no rollover of existing LoUs

Importance of these instruments

  1. Importers prefer taking loans based on LoUs as they are denominated in foreign currency and are cheaper
  2. A letter of credit is used to establish the creditworthiness of the buyer in the purchase of goods
  3. The interest of buyers’ credit is linked to London Interbank Offered Rate

Alternate measures

  1. Lenders will have to look at alternative instruments like bank guarantees

Back2Basics

London Interbank Offered Rate

  1. LIBOR or ICE LIBOR is a benchmark rate, which some of the world’s leading banks charge each other for short-term loans
  2. It serves as the first step to calculating interest rates on various loans throughout the world
  3. LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF)
  4. There are a total of 35 different LIBOR rates each business day
  5. The most commonly quoted rate is the three-month U.S. dollar rate (usually referred to as the “current LIBOR rate”)

Banking Sector Reforms

[op-ed snap] Bank frauds and the HR factor in PSU banks

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: EASE

Mains level: The newscard discusses the importance of the HR in Banks. It also discusses a strategy to solve the vulnerable condition of Indian Banks.


News

Human resource (HR) failure: One of the main reasons behind Bank Frauds

  1. Human resource (HR) department in bans failed in implementing measures for “preventive vigilance”
  2. So much so that the central vigilance commissioner has had to step in and order the transfer of all officers who have exceeded three years and clerks, five years, in the same position and office

An opportune time to have another look at the Enhanced Access and Service Excellence (EASE)

  1. It was proposed last year by the department of financial services (DFS)
  2. This outlines the duties and responsibilities of public sector banks for their healthy growth
  3. It recognizes that banking is intrinsically human-centric despite the increasing invasion of machines

Helping the Banks bounce back will require focusing on a 4R policy:
(1) Recruitment:

  1. The current practice of common recruitment by an outside agency needs to be shunned
  2. Instead, every PSU bank needs to recruit depending on its specific requirements
  3. Banks, being “special”, need specialized talent, as observed globally
  4. Banking has become increasingly knowledge and information intensiv
  5. Now, PSU banks need a wide spectrum of specialists in the policy and operation cycle, encompassing all activities, rather than jacks of all trades

(2) Remuneration:

  1. As per RBI data, the compound annual growth rate of per employee wages and salaries, which was 13.7% from 2004-05 to 2010-11, decelerated to 6.4% from 2010-11 to 2016-17
  2. However, the more crucial point is the current “different banks same pay” practice based on five-yearly bipartite settlements with unions
  3. This has built-in perverse incentives
  4. It undermines enterprise not only among the workers of the underperforming banks but also the well-performing ones, thus doubly jeopardizing systemic efficiency and flouting economic principles and logic
  5. Therefore, instead of collective bargaining, the salaries of PSU bank employees need to be linked to the respective bank’s “ability to pay” with components of variable pay

(3) Reskilling:

  1. In any profession, skilling/reskilling is the most valuable link in the entire HR chain of recruitment to retirement
  2. For this, the 2014 RBI suggests the importance of both internal and specialized certification-based external training programmes, coupled with appropriate placement policies in banks, to bridge the talent deficit
  3. The report needs to be implemented without delay

(4) Research

  1. Banking must be recognized as a knowledge-based industry, like information technology, where decisions necessitate constant research and development
  2. In general, the research quotient in PSU banks’ decision-making process is minimal.
  3. Only a few large banks have research units—which are, by and large, devoted to macroeconomic studies
  4. PSU bank leadership must embrace the knowledge and learning ecosystem

The way forward

  1. HR capabilities have a strong correlation with business results
  2. In PSU banks, the time has come to move on from episodic HR initiatives to connecting HR to the mainstream corporate strategy and transformation agendas

Banking Sector Reforms

[op-ed snap] The fight to the finish against banking frauds

Image Source

Note4students

Mains Paper 2: Governance | Important aspects of governance, transparency and accountability, e-governance- applications, models, successes, limitations, and potential

From UPSC perspective, the following things are important:

Prelims level: Not Much

Mains level: The three important issues discussed in the newscard. It is one of the most important newscards on the recent Banking Frauds issue.


Data on Banking Frauds(Source: RTI)

  1. RBI data shows that public sector banks (PSBs) reported 8,670 cases of “loan fraud” involving Rs61,260 crore over the last five financial years up to March 2017
  2. The amount will go up significantly once the recent frauds are added
  3. But after the recent issuance of a new framework for the resolution of stressed assets by the RBI, the government is working on reducing the possibility of bank frauds

Positive steps done by the government against the recent crisis(related to Banking frauds)

  1. The government has done well by not letting this crisis go to waste. For instance, it has asked PSBs to inspect all bad loan accounts above Rs50 crore
  2. It has also given them 15 days to address technological and operational risks
  3. It has also directed PSBs to rationalize overseas operations and proposed a new law against fugitive economic offenders
  4. This will give the government the power to confiscate the assets of a fugitive offender, both in India and abroad
  5. It has also decided to set up a regulatory body for auditors
  6. The RBI too has formed an expert committee to look into rising instances of fraud

Three broad issues in this fight against bank frauds
FIRST: Government should avoid over-regulating or overburdening the banking system

  1. Inspecting all bad loan accounts in excess of Rs50 crore, for instance, could result in excessive fear among bankers
    (as at some point investigative agencies will also get involved)
  2. This could affect the flow of credit in the economy
  3. Action by investigative agencies in some of the cases related to non-performing accounts in recent years is said to have affected bank lending
  4. Therefore, it is important that bankers are protected adequately and are able to take commercial decisions

SECOND: Laws by themselves don’t act as a deterrent(Indian Experience)

  1. The government will need to build investigatory and judicial capabilities so that cases are decided in a reasonable time frame
  2. Only time-bound closure of cases will deter fraudsters
  3. India will also need to build institutional capabilities to be able to negotiate with foreign authorities in order to bring back fugitives and prosecute them under Indian laws

THIRD:  PSBs need urgent governance reforms

  1. The fraud is the consequence of a complete collapse of governance
  2. Governance in PSBs needs an overhaul and government interference in appointments should be minimized
  3. In this context, the P.J. Nayak committee (2014) rightly noted: “Government officers and regulators may not possess the skills to appoint the top management of commercial banks”
  4. Therefore, the government needs to revisit the way appointments are made in PSBs, starting with the board

The way forward

  1. The shock of frauds and subsequent regulatory action can affect the flow and cost of credit in the short run
  2. Indian banks will emerge stronger after the short-term pain of cleansing the system

Banking Sector Reforms

Banks Board Bureau may be revamped

Note4students

Mains Paper 2: Polity | Statutory, regulatory & various quasi-judicial bodies.

From UPSC perspective, the following things are important:

Prelims level: Banks Board Bureau, FSRASC

Mains level: Deteriorating condition of PSBs and reform measures


Revamping BBB

  1. The government is looking to revamp the Banks Board Bureau (BBB)
  2. It may select a successor for the incumbent chairman Vinod Rai if he is not available further
  3. If the government decides to replace Rai, it may search for a candidate through the Financial Sector Regulatory Appointments Search Committee (FSRASC)

Background

  1. The Banks Board Bureau, which started to function in April 2016, was set up for a period of two years
  2. It was initially given the mandate to recommend candidates for the top post in state-run banks and financial institutions
  3. Later, its role was expanded to help banks in developing strategies and capital raising plans

Expanding its ambit

  1. The BBB is looking to appoint a knowledge partner to help it design, implement and institutionalize a flagship leadership development strategy for PSBs
  2. It will also appoint an advisory firm to help it assess the leadership competencies and potential capabilities of personages appearing in the process for appointment as whole-time directors of PSBs

Back2Basics

Banks Board Bureau

  1. Banks Board Bureau is an autonomous body of Union Government of India
  2. It is tasked to improve the governance of Public Sector Banks, recommend selection of chiefs of government-owned banks and financial institutions and to help banks in developing strategies and capital raising plans
  3. It will have three ex-officio members and three expert members in addition to Chairman
  4. Financial services secretary, deputy governor of the Reserve Bank of India and secretary- public enterprises are BBB’s ex-officio members

Banking Sector Reforms

FinMin releases road map to rationalize PSU banks’ foreign operations

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: What are LoUs?

Mains level: Government is taking necessary steps to counters frauds in Banking Sectors. This step is one many steps undertaken by the government.


Road map for Banks’ foreign operations

  1. The finance ministry has released a road map for consolidation of the overseas operations of state-run banks
  2. All existing 216 operations of state-run banks in other countries will be examined to check for possible consolidation
  3. The rationalization of overseas branches is aimed towards “cost efficiencies and synergies in overseas markets”

How will it be done?

  1. The rationalization in foreign operations will be through a mixture of closure of overseas branches, subsidiaries, representative offices and remittance centres
  2. And through consolidation of joint ventures where more than one bank is a shareholder
  3. Banks have been asked to close non-viable operations for cost efficiencies
  4. Banks have also been asked to consolidate equity holdings in joint ventures where more than one state-run bank is a stakeholder

Why this step?

  1. The government is examining lapses in systems followed by overseas branches while giving loans to group firms of Nirav Modi and Mehul Choksi against letters of undertaking (LoUs) fraudulently issued by some PNB officials

Back2basics

What are Letter of Undertakings (LoUs)?

  1. An LoU is an assurance given by one bank to another to meet a liability on behalf of a customer. The LoU is akin to a letter of credit or a guarantee
  2. LoUs are used in international banking transactions. An LoU is issued for overseas import remittances and involves four parties — an issuing bank, a receiving bank, an importer and a beneficiary entity overseas
  3. According to norms, the term of an LoU is 180 days, and can be rolled over once for six months. Since LoUs are a form of lending, they are typically backed by security

Banking Sector Reforms

[op-ed snap] To fix the rot in public sector banks, start with the boards

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: The newscard discusses the conflicts between Government’s role as a owner(of PSBs) versus the entity responsible for financial stability(in the country). It also suggests some solutions to counter Banking frauds(as happened in the PNB recently).


Question of “privatization of public sector banks”

  1. The recent fraud in the PNB  has reopened the debate on privatization of public sector banks
  2. That debate will take years to resolve as multiple stakeholders are involved
  3. But this debate should not distract from the more immediate problem

What should be done immediately? 

  1. The discussion should be around the separation of ownership and professional management
  2. It should be about ways to strengthen the board and management of public sector banks and build capacity to address risks(related to frauds)

Loan Management: The first thing needs to be addressed

  1. Apart from supporting financial inclusion projects and government bond-buying mandate, PSU bankers often have to extend loans(against their wish) because of pressure from bureaucrats and ministers
  2. That is a credit risk, and the first thing that needs to addressed

Appointment issues: Public Sector Banks and Private Banks

  1. State-owned banks are regulated in a different way from private banks
  2. The roles of their boards also are different
  3. Key executive appointments in PSU banks are recommended by the Bank Board Bureau and then approved by the appointment committee of the cabinet
  4. The board of a public sector bank doesn’t have the power to fire the CEO for poor performance or failure in oversight
  5. If such a fraud had occurred in a private sector bank, the central bank would be well within its powers to remove the board
  6. But in a PSU bank, the power rests with the government itself
  7. While the board may ensure the government’s bidding is done, it is powerless to give directions to management and hold it accountable
    What should be done?
  8. Boards should be free to set their own vision and mission
  9. They should be free to hire and fire top executives, and roll out human resource management, governance and compensation strategies as they see fit

The way forwad

  1. The PNB fraud is a call to action for the government to do the right thing and ensure that the scope for such frauds is minimised forever
  2. This is also about the government having to resolve the conflicts between its role as a owner versus the entity responsible for financial stability

Banking Sector Reforms

[op-ed snap] Can banking recover?

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

The following things are important from the UPSC perspective:

Prelims Level: The LoU

Mains Level: Need of privatisation of banks, reasons behind the recent frauds in Indian Banks, possible solutions, etc.


Pressure on the Indian Banking System

  1. The Indian banking system is under the pressure of growing NPAs which will touch nearly Rs. 10 lakh crore by March this year
  2. This does not include the Rs. 6 lakh crore already written-off
  3. Recent cases of banking frauds are making the system more vulnerable

These failures has occurred at many levels

  1. It is now clear that the recently revealed scams are fundamentally and overwhelmingly a failure of regulation
  2. At the level of the bank, it is impossible to believe that only a handful of employees have been implicated. Senior management and auditors did not track these problematic transactions for years
  3. The RBI did not monitor banks properly and created opacity with new financial instruments
  4. The Finance Ministry failed in its oversight and regulation
  5. And successive Central governments, including the present one, did and have not done anything to address the obvious problems that were festering, and made them even worse

What are the letter of undertaking (LoU)?

  1. The PNB scam relied on the existence of an unusual financial instrument, the LoU
  2. This is a bank guarantee that enables a bank’s customer to raise short-term credit from another Indian bank’s foreign branch
  3. It has to be another Indian bank, because the LoU as a form of underwriting other borrowing does not exist in other countries and is not even recognised by foreign banks
  4. It was created by the RBI as an additional incentive to importers who could then avail of cheaper credit abroad, even though import credits already exist

Is Privatisation of banks a solution?

  1. Many analysts within and outside government have responded to these scams by pointing the finger at public sector banks, claiming that they are more vulnerable to influence peddling and crony capitalism
  2. The current mess has also become an excuse to demand the privatisation of state-held banks
  3. But the key issue is one of poor regulation, and not ownership
  4. Poorly regulated private banks are even more prone to scams and failure as the financial sector is rife with information asymmetries and market imperfections
  5. Private profit orientation generates incentives for managements to exploit loopholes in the rules and engage in risky behaviour
    Example of Foreign banks
  6. The U.S. and European bank behaviour leading to the great financial crisis of 2008-09 show
  7. The bailouts they then require tend to be even more expensive for the public exchequer because bank runs have to be prevented

 Why has banking regulation in India failed to this extent?

  1. More significantly, this government(like the previous one) has created incentives for all banks to privilege large high-profile corporate borrowers and be relatively lax on their repayment in the mistaken belief that this would encourage sustained income growth
  2. This context makes it easy for some players to game the system

Banking Sector Reforms

[op-ed snap] How banking frauds can be nipped in the bud

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: Corporate governance, RBI, Blockchain technology

Mains level: Banking frauds and measures to reduce their incidence


Context

Frauds in banking system

  1. The Nirav Modi case has once again cast the spotlight on the dark corners of the Indian banking universe
  2. The information available till now suggests that there was a failure at different levels—internal controls, corporate governance and weak regulatory capabilities

Ideas that could prevent such frauds in future

  1. Internal controls in a bank
  • This is the basic line of defense
  • Most banking regulation across the world works on this principle
  • A good technology system should make it impossible—or at least extremely difficult—for individual employees to bypass controls
  • Bank boards and especially the audit committees must have clear responsibilities

2.  Banks can also set up a special fraud monitoring agency

  • It may include officials specially trained to detect incipient frauds
  • Banks can also choose to appoint one member of the board to oversee fraud risk management

3. The role of third parties should be examined with a tough eye

  • Chartered accountants, auditors, and advocates who figure in bank frauds should be dealt with strictly
  • The regulator should revisit the role of auditors both in the case of borrowers and lenders

4. Banking regulators need to be a backstop

  • The Reserve Bank of India (RBI) has said it had earlier warned banks about frauds
  • The Indian central bank will have to build capabilities, both in terms of designing rules and making sure that they are effectively implemented

5. The government should actively pursue the idea of privatizing public sector banks (PSBs)

  • Public sector banks have always been marred by poor governance
  • It is reflected in their stock market valuations
  • High levels of non-performing assets and the recent fraud are consequences of inept governance
  • The required reforms will go the distance only when banks are free of political and bureaucratic control

6. Use of blockchain technology

  • Blockchain technology could be used to make banking transactions more transparent
  • This would mean that every link in the chain can be scrutinized publicly
  • This also won’t affect privacy as borrowers disclose a lot of information in public statements, while mutual funds provide detailed disclosures about their bond portfolios

Way forward

  1. India needs a safe and efficient banking system to service the needs of a growing economy
  2. The government and RBI would do well to use the current opportunity to strengthen the banking system

Banking Sector Reforms

Bank bureau stares at uncertain future

Image source

Note4students

Mains Paper 2: Polity | Statutory, regulatory & various quasi-judicial bodies

From UPSC perspective, the following things are important:

Prelims level: Banks Board Bureau, Indradanush programme, PJ Nayak committee

Mains level: Reform measures in banking sector and their successes


Term expiration near

  1. The Banks Board Bureau (BBB) is facing an uncertain future with the tenure of its members coming to an end on March 31, 2018
  2. The government is yet to communicate if the terms will be extended or a new board will be formed

Banks Board Bureau

  1. The BBB was set up under the government’s Indradanush programme to reform public sector banks
  2. It started operations in April 2016
  3. BBB has representatives from government and RBI apart from independent banking professionals
  4. The BBB was conceived by the PJ Nayak committee and was seen as a step taken towards reforming the boards of public sector banks
  5. The committee, in its report, had recommended that the government should distance itself from the appointment process of top management and board members of PSBs

Success of BBB

  1. The BBB was only involved in shortlisting and interviewing candidates
  2. The final appointment was always made by the government
  3. There were instances of delays in appointment by the government despite the BBB recommending it

Banking Sector Reforms

[op-ed snap] Banking on good faith

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Read the attached stories

Mains level:  Complement this newscard with some of our previous newscards on the same issue, [op-ed snap] Reforms needed to back bank recapitalisation and [op- ed snap] A bold step in bank reform


News

Recapitalization plan

  1. About Rs. 1 lakh crore is expected to be pumped into India’s 21 public sector banks by March, which the Centre hopes will enable them to extend fresh credit lines worth over Rs. 5 lakh crore to spur economic activity

PCA (prompt corrective action)

  1. The Reserve Bank of India has placed, a significant part of the recapitalization plan, under the prompt corrective action, or PCA, framework
  2. The RBI deploys the PCA to monitor the operation of weaker banks more closely to encourage them to conserve capital and avoid risks
  3. For these entities, this capital(provided under the plan) offers a fresh lease of life as it will help meet regulatory requirements under the Basel-III regime
  4. Also, it cushions them to an extent from possible haircuts on stressed loans that are going through the insolvency resolution process

Government’s view on the Financial Resolution and Deposit Insurance legislation

  1. While announcing this package, the government has described each of the banks as “an article of faith”
  2. Its assertion that no public sector bank will fail and that depositors’ money will remain safe
  3. It diminish allay customers’ worry about the safety of their savings under the proposed Financial Resolution and Deposit Insurance legislation

Is there any future plan?

  1. More structural reforms may well be on the anvil(open for discussion) in the second half of this recap plan, which the RBI had described
  2. Yet, the absence of any reference to consolidation through mergers is glaring
  3. Moreover, the government has repeatedly ruled out privatisation of these banks, the only one where it intended to offload its majority stake

Banking Sector Reforms

Cut loans to firms, focus on retail: Govt to smaller banks

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: NPA

Mains level: Banking reforms


Redirecting focus

  1. The government has directed small public sector banks (PSBs) to cut their corporate loan exposure to 25 percent of their risk-weighted assets over the medium term
  2. And to focus more on retail lending
  3. This strategy is being followed to shrink the size of relatively weaker banks over the next two years

Why curtailing corporate loans?

  1. Corporate loans have been mainly responsible for the build-up of stressed assets in the banking system
  2. Retail loans such as housing, vehicle and car loans typically exhibit low level of non-performing assets

Bank boards to approve reform plan 

  1. The government has asked the bank boards to approve each bank’s plans to implement the PSB reforms agenda and monitor it quarterly
  2. The government has announced a set of measures to keep close watch on the asset quality of the banks, including “specialized monitoring” by agencies for corporate loans of more than Rs 250 crore
  3. A total of around Rs 1 lakh crore will be infused in the PSBs by March-end

Banking Sector Reforms

Rs 1,00,000 crore boost: Centre infuses cash, unveils reforms map for public banks

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: Recapitalization bonds, Prompt Corrective Action, Annual EASE index survey

Mains level: Restructuring of PSBs


Reforms roadmap for public sector banks

  1. The government has announced details of how Rs 80,000 crore of funds raised through recapitalization bonds will be allocated to 20 PSBs by March-end
  2. A total of around Rs 1 lakh crore will be infused in the PSBs by March-end
  3. Twenty PSBs will be getting the amount from government
  4. These include 11 weak and 9 strong banks

PSBs under RBI’s Prompt Corrective Action 

  1. The eleven weak banks are currently under the RBI’s Prompt Corrective Action (PCA)
  2. PCA kicks in when banks breach regulatory norms on issues such as minimum capital, amount of non-performing assets and return on assets
  3. The central bank enforces these guidelines to ensure that banks do not go bust and follow prompt measures to put their house in order

Keeping a watch on banks asset quality

  1. The government announced a set of measures to keep a close watch on the asset quality of the banks
  2. These include “specialized monitoring” by agencies for corporate loans of more than Rs 250 crore
  3. Banks have been asked to ring-fence cash flows of corporate borrowers, to ensure that their earnings are not diverted for other purposes
  4. The government has also mandated each of the PSBs to have a stressed assets management vertical and monetize their non-core assets such as real estate to boost their capital adequacy

Annual EASE index survey

  1. An independent agency will conduct an Annual EASE (Enhanced Access & Service Excellence) Index Survey of banks
  2. This will be to ensure that banks comply with the reforms parameters
  3. As per the EASE plan, the government wants to ensure that there is a banking facility within 5 km of every village in the country

Banking Sector Reforms

[op-ed snap] Long live India Post Payments Bank

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Particulars of the IPPB, payments banks, etc.

Mains level: The newscard briefly discusses the issues related to the IPPB. Payment banks have very important role in providing banking services to the vulnerable, poor, etc.  sections of the society.


News

How has India Post Payments Bank (IPPB) been doing?

  1. IPPB has a customer base of a few thousands and its deposit kitty is less than Rs1 crore
  2. Important issue: IPPB started operations with a borrowed information technology (IT) platform from Punjab National Bank (PNB)
  3. How will a bank with very different objectives move ahead on the IT platform of a conventional universal bank?
  4. A large number of bankers coming on board from PNB on deputation hasn’t helped the cause either
    (Note: After using the PNB technology platform at the initial stage, IPPB is now looking for its own platform)

What is the primary objective of setting up payments banks ?

  1. RBI in its guidelines says “the objectives of setting up of payments banks will be to further financial inclusion by providing
    (i) small savings accounts and
    (ii) payments/remittance services
  2. to migrant labour workforce, low income households, small businesses, other unorganised sector entities and other users”

Some important conditions on the payment banks

  1. IPPB, like all other payment banks (and small finance banks), is required to maintain 15% minimum capital adequacy ratio and also the cash reserve ratio,
  2. Or the mandatory deposits with RBI on which it does not earn any interest (currently, it is 4% of deposits)
  3. A payments bank needs to invest 100% of its demand deposits (it cannot take fixed deposits and recurring deposits) in government securities and deposits of scheduled commercial banks in the ratio of 3:1

How will a payments bank make money?

  1. It cannot make money from deposits as the return typically is less than the cost of deposits
  2. It can make money from payments transactions only if it has a robust, secured and comprehensive technology platform that enables clients and service providers to come together and transact at an extremely competitive cost
  3. Not possible in current situation, for the IPPB

Is Department of Post affecting the working of the IPPB?

  1. IPPB’s dependence on DoP is understood to be continuing even after the bank will be fully operational
  2. For example, the connectivity of the bank for all its operations will be through the existing DoP network
  3. One can only hope that the technology shortcomings of DoP do not get replicated in the bank
  4. If the government aims to achieve deeper banking inclusion, it would be wise to let the board of IPPB and its top management decide on its strategy
  5. Piggy-backing DoP will create an inefficient animal always looking for the indulgent patronage of its parent—far removed from India’s digital banking dream

Back2basics

Financial Inclusion in India: Need and future; PMJDY; Payment Banks and Small Banks

Banking Sector Reforms

RBI, govt may give banks more time to switch to IndAS

Note4students

Mains Paper 3: Economy | Issues relating to planning

From UPSC perspective, the following things are important:

Prelims level: IndAS, GAAP standards, Banking Regulation Act, Companies Act, International Financial Reporting Standards, IRDA, National Advisory Committee on Accounting Standards

Mains level: Status of banks in India and way forward


New accounting standards for banks likely to be postponed

  1. The government and the Reserve Bank of India (RBI) may postpone the implementation of new accounting standards for banks
  2. This might be due to the legislative changes and additional capital requirements the process would entail

Indian Accounting Standards (IndAS)

  1. Banks and non-banking financial companies are due to switch to Indian Accounting Standards (IndAS) from 1 April 2018
  2. They currently follow Indian generally accepted accounting principles (GAAP) standards
  3. Other corporate entities started complying with IndAS with effect from 1 April 2016

Legislative hurdle

  1. The implementation of IndAS for public sector banks requires an amendment to the Banking Regulation Act
  2. The schedule in BR Act relating to financial statement disclosures needs to be changed to the IndAS format
  3. Due to a delay in amending the BR Act, RBI is yet to issue operational guidelines for the implementation of the new accounting standards

Banking regulation

  1. Section 29 of the BR Act deals with the accounts and balance sheets of public sector banks
  2. Private sector banks are covered by the Companies Act, which is based on the new accounting standards

NPAs might rise

  1. The transition to IndAS is expected to see a significant jump in bad-loan provisions
  2. Under the current rules, banks set aside money to cover loans that have turned bad
  3. Under IndAS, they must make provisions after assessing the expected loss from the time a loan is originated rather than waiting for a trigger event

International standards being followed

  1. These norms are in line with international norms, the International Financial Reporting Standards
  2. These were designed to avoid credit shocks like those seen in the aftermath of the global financial crisis in 2008

RBI may delay implementation like IRDA

  1. The Insurance Regulatory and Development Authority of India (IRDA), which had earlier decided to implement IndAS from 2018-19, has decided to defer it by two years
  2. It is likely that RBI will follow the Irda path and defer the implementation of IndAS starting FY20-21

National Advisory Committee on Accounting Standards (NACAS)

  1. RBI had agreed with the National Advisory Committee on Accounting Standards (NACAS) that banks would switch to IndAS by April 2018
  2. NACAS advises the government on the formulation and laying down of the accounting policy and standards for adoption by firms

Banking Sector Reforms

[op-ed snap] Money in the bank, or for it?

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Bail-in and Bail-out clause given in the FRDI bill(read attached stories)

Mains level: It is a hot topic of discussion these days, due to the infamous ‘bail-in’ clause. Read this newscard with the attached newscards, for a comprehensive view on the issue.


What are the issues regarding The Financial Resolution and Deposit Insurance Bill 2017 (FRDI Bill)?

  1. Most experts want major clauses changed or dropped
  2. Some even argued for a rethink on the Bill itself
  3. No one talked about the one provision in the FRDI Bill: the infamous ‘bail-in’ clause
  4. It has caused alarm and despondency amongst millions of bank depositors, mostly India’s much-neglected poor, and the middle class
  5. [op-ed snap] Time to go to FRDI Bill’s roots

Why is this ‘bail in’ clause infamous?

  1. This is the clause that empowers the Resolution Corporation to either cancel, alter or modify the liability owed by a service provider
  2. The Corporation will be created to handle cases of bank failure if the Bill becomes law
  3. It will simply put, one’s money in the bank (whether in a savings account or in a fixed deposit) is a liability owed by the ‘service provider’, i.e., the bank
  4. If the bank is going bankrupt, the Resolution Corporation is empowered to either use your deposit money to shore up the bank’s finances and make you suffer the losses, or convert your deposit into bonds or equity

Government’s view on the bill

  1. According to the government, the Bill provides “enhanced protection” for depositors
  2. This includes a clause which says that no depositor will receive less than what he/she would have got if the bank had been liquidated and its assets distributed among creditors
  3. Further, your deposit can be cancelled or converted only if you have agreed to do so in the contract governing such debt

Is the Deposit Insurance and Credit and Guarantee Corporation (DICGC) a solution?

  1. The Deposit Insurance and Credit and Guarantee Corporation (DICGC), an RBI arm, insures deposits only up to Rs. 1 lakh — a sum unchanged since 1993
  2. Less than a third of the deposits with banks (by value) are covered by insurance
  3. The government and the RBI point out that the global average is 20-30% of deposits in the system (which India meets)
  4. But what they don’t tell you is that the quantum of cover is among the lowest in the world
  5. In the U.S., deposits up to $250,000 are covered
  6. Even Brazil offers coverage of over $75,000, while in India, this is a measly $1,500
  7. Furthermore, 85% of deposits are higher than the cover limit of Rs. 1 lakh
  8. So, if banks do fail, an overwhelming majority of depositors will suffer massive losses
  9. Therefore, the amount of insurance cover should be increased substantially, to at least half the average value of deposits

The way forward

  1. Forcing higher insurance premiums on banks will only worsen their already precarious situation
  2. But the alternative — of doing nothing, or letting a loosely worded FRDI Bill with no clear-cut provisions will only make the situation much worse

Banking Sector Reforms

Bank recapitalization: The mockery of MoUs and statements of intent

Note4students

Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: Department of financial services, Statements of intent (SoI), Memorandum of understanding (MoU)

Mains level: Management of Public sector banks


Sets of tools used ensuring “efficiency” in management of PSBs

  1. For ensuring “efficiency” in management of PSBs, two sets of tools were used by the administrative department, the department of financial services (DFS)
  2. These were: the statements of intent (SoI) and memorandum of understanding (MoU)
  3. Both were supposed to play a critical role in monitoring capital infusion in PSBs

Statements of intent (SoI) system

  1. The mechanism of SoI on annual goals to monitor the performance of PSBs was introduced on the directions of the finance ministry in June 2005
  2. A set of performance parameters was defined and targets were set for PSBs against these parameters
  3. There were 44 SoI parameters which were to be monitored by DFS
  4. The SOIs were also used to incentivize top management of PSBs when the SoI targets were achieved
  5. The SoI parameters were used as an instrument for efficient management of PSBs and not for ensuring either capital conservation or capital efficiency
  6. The SoI became a routine annual management tool on paper with little or no relevance to the process of capital infusion

Memorandum of understanding (MoU) system

  1. In February-March 2012, DFS introduced the system of MoU with PSBs
  2. This was to ensure that PSBs lay down a firm plan for long-term business development and performance enhancement, and relate the same to their capital requirement
  3. The MoU, signed by the PSBs and DFS, consists of a set of agreed targets that the PSBs are expected to achieve, which would form the basis for future capital infusion by the government
  4. The aim of the MoU was to achieve optimum utilization of scarce capital funds, with PSBs focusing on improving their efficiency simultaneously with the infusion of capital

Lax implementation

  1. Both these tools were not used the way they were supposed to
  2. DFS as well as PSBs did a lax implementation and made them survive only on paper

Banking Sector Reforms

[op-ed snap] Three paradigms of banking regulation

Note4banks

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: The newscard discusses evolution of banking regulations. And also talks about there importance from India’s point of view.


News

History of control over Banks

  1. Banks are among the most regulated businesses
  2. Ever since the inception of banking as a business in the medieval period, the state has exercised some form of control
  3. While banks have been regulated since their inception, the approach to regulation has followed an evolutionary path where we can discern different paradigms
  4. The Money paradigm, the Intermediation paradigm, and the emerging Marketplace paradigm(as described by the writer)

The Money paradigm

  1. It views banks essentially as monetary institutions whose primary role is to “create” money
  2. When banks are seen primarily as issuers of money, issuing loans is incidental
  3. The approach to bank regulation focuses on the role they play in the creation and use of money, and on controlling the price of money i.e interest rates
    Transformation from money paradigm to intermediation paradigm
  4. Central banks had became more powerful in the 20th century, with a monopoly in issuance of money which transformed note issuance of banks into deposits
  5. Post World War II, under the Bretton Woods system, the gold standard was abandoned and central banks started issuing “fiat” money, making the money role much less important
  6. The intermediation role became more prominent and progressively became the focus of regulation

The Intermediation paradigm

  1. I this, the role of banks is to use loans with deposits as “raw material”
  2. The Banking Regulation Act of 1949, defines banking as an activity of “accepting for the purpose of lending or investing, deposit of money from public”, thus indicating the primacy of the Intermediation paradigm
  3. The most prominent example of the Intermediation paradigm is the Basel regime that has at its core capital regulation based on risk-weighted assets

Issues with the above two paradigms

  1. These two traditional paradigms of bank regulation sit somewhat uncomfortably with each other
  2. The Money paradigm results in some form of administered interest rates, which will invariably result in mispricing of risk a
  3. And, hence, misallocation of capital by banks due to artificially and somewhat arbitrarily determined cost of funds
  4. The Intermediation paradigm, on the other hand, will mostly result in capital regulation with unregulated deposit pricing, which will invariably dampen monetary transmission
  5. As a result, the banking channel is quite poor in transmitting monetary policy, as we witness in India

The Marketplace paradigm

  1. The banking system can be viewed as a marketplace for funds where banks act as market makers
  2. Regulating market making is primarily about regulating the liquidity provided by the market maker
  3. In the more developed financial systems, there is a clear evolution of the regulatory approach from the Money to the Marketplace paradigm, reflecting the underlying evolution in the role and functioning of banks

The Marketplace paradigm in India

  1. As the financial markets develop in India and bank balance sheets have more tradable securities and loans, this paradigm will become more relevant

The way forward

  1. A comprehensive approach should carefully balance these three paradigms. Banks are a collection of several businesses and activities
  2. For specific businesses or activities, one of the three paradigms may be more relevant
  3. Especially for a developing country like India, the regulating banks(through the above discussed paradigms) is an important component of the management of the overall economy

Banking Sector Reforms

Govt. injects funds into 6 public banks

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: PCA and CAR

Mains level: Importance of the CAR and steps taken by Government for saving the given banks.


News

Releasing of equity capital 

  1. The Centre has released the much-required equity capital to six stressed public sector banks (PSBs)
  2. Why: as some of these lenders were on the verge of breaching minimum capital norms on December 31, 2017

Particulars of the step taken by the government

  1. The PSBs are Bank of India (Rs. 2,257 crore), Central Bank of India (Rs. 323 crore), Dena Bank (Rs. 243 crore), IDBI Bank (Rs. 2,729 crore), Bank of Maharashtra (Rs. 650 crore) and UCO Bank (Rs. 1,375 crore)
  2. These lenders would be asked to improve on parameters such as bad loans and recovery to which effect a communication would be sent shortly
  3. All these banks are saddled with huge non-performing assets and are under the prompt corrective action (PCA) framework of the RBI, which means certain operations of these banks have been curtailed by the regulator

What is the minimum regulatory capital requirement?

  1. Banks are mandated to maintain minimum 9% capital adequacy ratio (CAR) plus a capital conservation buffer of 2.5%

Back2basics

Capital adequacy ratio(CAR)

  1. Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio (CRAR), is the ratio of a bank’s capital to its risk
  2. National regulators track a bank’s CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements.
  3. It is a measure of a bank’s capital
  4. It is expressed as a percentage of a bank’s risk weighted credit exposures.
  5. This ratio is used to protect depositors and promote stability and efficiency of financial systems around the world
  6. Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors

Banking Sector Reforms

[op-ed snap] Another tool of resolution

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Particulars of the Bill

Mains level: The article clears confusion on the ‘Bail in’ clause. Very important. Complement it with our other newscards on the same issue.


News

Why we need a special law to deal with the demise of a bank?

  1. The reason we need bank resolutions and also a special law to deal with the demise of a bank is simply because banks are special
  2. They have become a repository of public faith in the financial system
  3. So long as consumers have unrestricted access to deposits, their faith in the banking system is maintained

The Financial Resolution and Deposit Insurance Bill

  1. It is an attempt to make the system more credible, less chaotic, and systematic in times when credibility is at risk, by treating banks differently from regular corporations
    (as mentioned above)
    The issue of ‘Bail in’ clause
  2. The Bill brings in a system of risk-based monitoring of financial institutions
  3. At the stage of ‘critical’ risk to viability, when the proposed Resolution Corporation takes the decision to use a particular method of resolution which includes the tool of a ‘bail-in’
  4. It is the Corporation that takes all decisions, and not the bank
  5. A bare reading of the relevant provisions of the Bill shows that the Resolution Corporation can use this tool only in consultation with the regulator
  6. It is an exaggeration to suggest that the Reserve Bank of India (RBI), along with the Resolution Corporation, will ‘bail-in’ depositor’s money to recapitalise the bank
  7. Especially when the Bill is designed to take away power from the failed financial institution at the stage of failure

‘Bail in’ clause: Safeguards in the law

  1. The Bill makes it explicitly clear that only such liabilities may be cancelled where the liability/instrument contains a bail-in provision
  2. It makes it abundantly clear that the Resolution Corporation will specify the liabilities to be bailed in
  3. Creditors/depositors will need to consent in advance to have their liabilities bailed-in
  4. Even when liabilities are being bailed in, the Bill makes it incumbent upon the Resolution Corporation to follow the prescribed route
  5. Lastly, the Bill gives aggrieved persons a right to be compensated by the Resolution Corporation
    (if any of the safeguards have not been followed during a bail-in or in the conduct of any other resolution action)

The way forward

  1. When the rest of the world is finding ways to make its financial system more robust, we seem to be continuing with public discourse using incomplete information
  2. The Bill simply adds another tool of resolution without taking away from the government’s implicit guarantee to depositors

Banking Sector Reforms

[op-ed snap] The potential of smart contracts in banking

Image source

Note4students

Mains Paper 3: Science & Technology- developments & their applications & effects in everyday life

From UPSC perspective, the following things are important:

Prelims level: Bankchain, blockchain, bitcoin, Smart contracts

Mains level: Use of Digital technology for easing banking and other services


Context

Technology underpinning bitcoin—blockchain—is gaining mainstream acceptance

  1. Bankchain is a consortium of 27 banks (22 of them are Indian) of which the State Bank of India (SBI) was the first Indian member
  2. It is working to devise blockchain-based solutions for banking and, along with the SBI, planning to launch a beta program to use smart contracts next month

About Blockchain and bitcoin

  1. In late 2008, an unknown person (or group) named Satoshi Nakamoto created a crypto-currency, bitcoin
  2. Its novelty consists in the fact that its operations are authorized without any trusted third-party carrying out administrative or security tasks
  3. This minimizes the transaction fees eventually weighing on users and considerably reducing the time for processing the operations
  4. Centralized networks rely on one or more trusted bodies (for example, banks) to keep a detailed record of transactions and update users’ balance
  5. Bitcoin, on the other hand, decentralizes the administrative activity and lets “miners” process the transactions carried out in the system
  6. The transparency, accessibility and stability of the transactions’ record are ensured by the public broadcasting of the operations throughout the nodes of the network (the computers running the software)
  7. And their subsequent addition to a shared database containing the complete transaction history for any given bitcoin
  8. This shared ledger is called the “blockchain”, i.e the sequence of all the verified “blocks” of transactions, recorded chronologically—timestamped—one after the other

Use of Blockchain in Smart contracts

  1. Just as bitcoin uses the blockchain to maintain a ledger of a crypto-currency, the blockchain can be used to keep track of the ownership of any asset or data that can be digitized and represented by computer code
  2. Once the asset is on blockchain, users can compose smart contracts that contain the terms of the agreement, and automatically execute them once certain predetermined conditions are satisfied
  3. They roughly follow the scheme of an “if-then” function
  4. For example, if the smart contract relates to the acquisition of an intellectual property right licence, Party A creates a smart contract to which the licence X is permanently attached, programming that X is to be released upon certain conditions Y, and launches it into a blockchain
  5. Whenever Party B wishes to obtain the information/licence, they transfer consideration Y to the protocol
  6. Automatically, the smart contract algorithm releases X to party B and delivers Y to Party A, eliminating delays and room for non-compliance
  7. Once the obligation is fulfilled on the one side (Y), the computer protocol autonomously performs the other side of the agreement (X)

Disadvantages of traditional contracts and how smart contracts can help

  1. Traditional contracts are always subject to a degree of uncertainty with respect to their final outcome
  2. Smart contracts leave no room for voluntary breaches of the agreement
  3. By entrusting the network with the performance of the agreed terms, they reduce the likelihood of expensive and time-consuming disputes

Why are banks reluctant to Blockchain?

  1. Smart contracts on a decentralized, “permission-less” blockchain like bitcoin don’t allow any meddling by third parties
  2. This is because in a permission-less system, any computer can join as a node to run the code and amending the leger will require access to all the nodes
  3. Banks are uncomfortable with losing control of the system and they prefer “permissioned” blockchains like Bankchain
  4. Bankchain restricts the access to nodes to other banks, while individual customers can join as users after complying with know your customer (KYC) norms
  5. Pre-selected nodes allow banks to intervene between transactions, providing the ‘emergency entry’ into the system whenever interventions are deemed appropriate

Potential of Smart contracts

  1. Currently each bank carries out its own KYC process.
  2. This can be done by one bank and securely uploaded on the blockchain, thereafter shared with the other banks once the trigger is generated by the customer
  3. Smart contracts can automatically release insurance payments for verifiable claims like delayed flights, motor accidents or death
  4. This would involve bringing authorized third parties like hospitals and garages to join a single platform with insurers and the insured, and bring process efficiencies
  5. Most securities have settlement delays of two days or longer that can be brought down to minutes, which will also reduce working capital requirements for collateral
  6. Other applications include crowdfunding for small businesses, enabling the trading of tokenized equity shares and settlement of syndicated loans between banks

Threats involved

  1. While permissioned blockchains bring many benefits of a decentralized network, they compromise on the promise of immutability by limiting the nodes in the system
  2. The unlimited nodes in bitcoin make it tamperproof while pre-selected nodes in a permissioned blockchain allow authorities to intervene between transactions and expose the points of vulnerability
  3. It is quite unsure that banks can provide the same level of data integrity that is guaranteed by permission-less blockchains like bitcoin

Banking Sector Reforms

More capital will push PSBs to up MSME credit: Arun Jaitley

Image source

Note4Students

Mains Paper 3 | Indian Economy and issues relating to planning, mobilization of resources, growth

Prelims level: FDI, Bank Recapitalization, MSME

Mains level: The news card highlights the need for increasing private investments in the economy and the steps taken by the government for the same.


News

Pumping Third Engine to propel growth and create jobs

  1. Amid declining credit to micro and small enterprises, the finance minister said more capital for public sector banks will prompt them to increase credit flow to MSMEs
  2. This will ensure that “third engine” of private investment is fired up to propel growth and create jobs
  3. While there has been a significant increase in public investment and FDI inflows, but the private investment a key growth engine has continued to lag

Why increase Credit flow to MSMEs

  1. This is because the sector creating jobs and giving the boost to the economy has no access to international finance or bond market
  2. Last year’s Demonetisation decision has especially affected the MSMEs

Steps Taken by the Government

  1. Last month, the government had unveiled a mega capital infusion worth Rs 2.11-lakh crore two-year roadmap to strengthen PSBs, which includes recapitalization bonds, budgetary support, and equity dilution
  2. The government has decided to put in more capital through bonds and banks’ equity expansion and therefore, it is the country which is virtually going to pay to keep the banking system in good health
  3. The government also ensured noninterference in commercial transactions
  4. A robust public sector banking system is desired so that ability to support growth itself increases

The Statistics

  1. Latest data from the Reserve Bank of India shows that credit to micro and small industry contracted at 3.4 percent in the financial year so far while for medium sector industry the credit contraction was at the rate of 5.7 percent
  2. Non-performing assets of PSBs have increased to Rs 7.33 lakh croreas of June 2017, from Rs 2.78 lakh crore in March 2015
  3. In the last three-and-a-half years, the government pumped in more than Rs 51,000 crore capital in PSU banks.

Banking Sector Reforms

Rs 2.11-lakh crore recapitalisation plan: To help fund bank cash infusion, Government looks to tap RBI’s reserves

Note4students

Mains Paper 3: Indian Economy and issues relating to planning, mobilization of resources, growth.

Prelims: RBI, Bank Recapitalization, FOREX.

Mains level: The news card talks about the government’s move to consider partial financing of bank recapitalization through RBI. It also talks about the Economic Survey recommendations regarding the same.


Context

  1. The government is weighing the option of getting the Reserve Bank of India (RBI) to part-finance the capital infusion plan for public sector banks and has initiated discussions with the central bank to deploy a portion of its foreign exchange or other reserves for this purpose.
  2. The discussions are at a “nascent stage” and depending on the response of the RBI, the Finance Ministry will work on creating a mechanism for capital infusion that is in consonance with fiscal responsibility regulations.
  3. The government last month announced plans to inject Rs 2.11 lakh crore of equity in PSU banks — Rs 1.35 lakh crore through recapitalisation bonds, Rs 18,000 crore from budgetary resources and Rs 58,000 crore to be raised by banks from the market.
  4. The government will stick to the timeline of capital infusion announced earlier and a significant portion of the equity can be injected in a couple of months.

Foreign exchange Reserves and Bank Recapitalization

  1. With foreign exchange reserves crossing $400 billion, there is a view within the government that a portion can be used for capitalising banks without adversely affecting the country’s import cover and macro-economic stability.
  2. As of September 22, the RBI’s foreign exchange reserves were $402. 24 billion.
  3. The forex reserves comprised foreign currency assets of $377.751 billion, gold of $20.69 billion, special drawing rights of $1.51 billion and reserve tranche position of $2.29 billion with the International Monetary Fund.
  4. In 2007, the RBI had approved a proposal to invest up to $5 billion out of its forex reserves to fund a wholly-owned UK-based subsidiary of the India Infrastructure Finance Company Ltd (IIFCL).
  5. The IIFCL subsidiary used these funds to lend to Indian companies executing infrastructure projects in India, or to co-finance their external commercial borrowings for such projects for expenditure outside India for infrastructure projects.

Economic Survey Recommendations

  1. Earlier this year, the Economic Survey 2016-17 had suggested that the government use a part of the extra capital available with the RBI to capitalise banks.
  2. Even at current levels, the RBI is already exceptionally highly capitalised. In fact, it is one of the most highly capitalised central banks in the world. So, it would seem to be more productive to redeploy some of this capital in other ways.
  3. It could be used in several good ways:
  • For recapitalising the banks and/or recapitalising a Public Sector Asset Rehabilitation Agency (PARA);
  • And, for extinguishing debt to demonstrate that the government is serious about a strong public sector fiscal position.

Why there is a need for the creation of SPV ?

  1. The government may need to create a special purpose vehicle to use resources from the RBI.
  2. This is because the FRBM (Fiscal Responsibility and Budget Management) Act does not allow the government to borrow from the RBI.
  3. But routing resources through the SPV should be in conformity with the law.

The Government’s Approach

  1. The government plans to adopt a differential and selective approach for capital infusion in the public sector banks.
  2. While strong banks will get greater capital, weak banks may have to either shrink in size or not grow from the current position.
  3. Of the total 22 PSU banks, as many as eight PSU banks currently have gross non-performing assets (GNPAs) above 15 per cent and 14 banks have GNPA of more than 12 per cent.
  4. The government had earlier hoped to reap significant windfall gains from the decision to withdraw Rs 500 and Rs 1,000 n
  5. The amount of currency that was not be deposited with the banks could have been a gain to the Centre after extinguishing the RBI’s liability which could have been used to capitalise PSU banks.
  6. But with over 99 per cent of the demonetised currency coming into the banks, the government took the recapitalisation bonds route to fund the banks.

Banking Sector Reforms

[op-ed snap] Capital infusion: Prepping strong banks to acquire the weak

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

The following things are important from UPSC perspective:

Prelims Level: Not Much

Mains level: Complement this article with our previous newscards on the recapitalisation of the banks. It will give you a comprehensive view. Very important for the Mains paper.


News

Context

  1. The article talks about the plan of recapitalization and how it will get implemented

The government’s plan of recapitalization

  1. The mega recapitalisation of state-owned banks will begin with the Centre infusing greater capital in larger and stronger lenders
  2. And thus preparing them to take over smaller and weaker banks
  3. According to Finance Ministry officials, stronger PSBs helped by capital support, will be better equipped to consolidate weaker banks
  4. Contrary to expectations of consolidation taking a backseat post the announcement of capital infusion
  5. The government will strengthen the larger banks while at the same time priming them for taking over weaker ones

What will be the approach for recapitalisation of banks?

  1. Government officials have indicated the Centre’s plan to adopt a differential and selective approach for infusion
  2. While strong banks will get greater capital, weak banks may have to either shrink in size or not grow from the current position
  3. Banks that are well capitalised will be able to better absorb the weak banks through consolidation

Recent steps taken by the government for expediting consolidation of banks

  1. In order to expedite consolidation, the Cabinet had approved a framework for consolidation among PSBs, including a proposal to set up an Alternative Mechanism
  2. As per the consolidation framework, merger decisions should originate from the banks and these should be based on commercial decisions
  3. The proposals received from banks for in-principle approval to formulate schemes of amalgamation shall be placed before the Alternative Mechanism
  4. And after in-principle approval, the banks will take steps in accordance with the SEBI requirements

The way forward

  1. Resolution of bad loans, recapitalisation of banks and consolidation have to work alongside other reforms for creating a banking system
  2. Bad loan resolution helps the government in realistically estimating the capital requirements of the banks. It will help in cleaning up of the balance sheets
  3. Cleaning up of the balance sheets and injection of capital will mean that banks have the wherewithal to absorb any transitory shocks that may arise from merger of the weak banks

Banking Sector Reforms

[op-ed snap] India needs a new banking policy framework

Image source

Note4students

Mains Paper 3: Economy | Effects of liberalization on the economy, changes in industrial policy & their effects on industrial growth

From UPSC perspective, the following things are important:

Prelims level: 1991 reforms, Narasimham committee, Raghuram Rajan committee, international capital adequacy standards, fiscal deficit

Mains level: Present status of banking in India and need for banking reforms


Context

Bold move by government

  1. The government has decided to spend big money to clean up the banks it owns
  2. This is despite the obvious risks of moral hazard that bank bailouts across the world have inevitably faced

What happened in the recent past

Three important policy documents laid the groundwork for banking reforms since the 1991 reforms

  1. The report of the first Narasimham committee set up in 1991
  2. The report of the second Narasimham committee set up in 1998
  3. The report of the Raghuram Rajan committee that was released in 2009

Changes that have happened over the years

  1. Indian banks now have to meet international capital adequacy standards
  2. A smaller portion of their deposits has to be handed over to fund the fiscal deficit
  3. Interest rates are determined by the market
  4. Branch expansion policies are more liberal
  5. New private sector banks offer competition to the public sectors banks

Banking policy issues that the government needs to deal with

  1. The need for public sector bank autonomy
  • India needs to now shift the needle from autonomy towards privatization
  • Banking is the only important sector of the economy in which the private sector is dwarfed by the public sector
  • The share of public sector companies has fallen sharply in most sectors such as airlines

2. India should move towards a three-tier banking structure

  • The first Narasimham committee had said that India should move towards a three-tier banking structure
  • Four large lenders were to be developed as global banks, 10 banks were to become nationwide universal banks and local banks would concentrate on specific regions
  • The ongoing debates about bank consolidation and differentiated licensing require a framework rather than the current ad hoc statements

3. The weakest banks cannot be shut down at once

  • This move could cause a disruption
  • There is a strong case to convert at least some of them into narrow banks that use all their deposit money to buy government bonds
  • They could in effect become large payments banks rather than the more traditional financial intermediaries

4. India needs to move towards a new financial structure

  • In this system, large companies get mostly funded by the bond markets while smaller firms depend more heavily on banks for their finance
  • The problem is that the corporate bond market is still illiquid, with most bonds held to maturity by a narrow set of investors

Lessons of the global financing crisis

  1. No country has figured out how to maintain financial stability
  2. Credit booms have inevitably left bad loans in their wake
  3. Bank-led financial systems such as Japan have been in trouble
  4. So have financial systems such as the US where the bond markets are more important

What do unstable financial systems lead to?

  1. Unstable financial systems hurt economic growth and job creation in the long run
  2. The fiscal costs of bailouts can also be staggering

What should be the next step?

  1. The next step should be a clear roadmap for future financial policy before India stumbles into its next banking mess
  2. The Indian political leadership needs to get a sense of what financial structure it desires—and then get experts to advise it on how to achieve it that goal

Banking Sector Reforms

[op- ed snap] A bold step in bank reform

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: Recapitalisation of banks is hot topic of discussion these day. It is one of the most important steps taken by the government to counter credit problem in banks. Complement this newscard with our other newscards on the same topic.


News

Contex

  1. The article is about the recently announced plan of the government to recapitalise Public Sector Banks

Government’s plan to counter low growth rate

  1. With India’s economic growth falling in the last couple of years, the government has been casting about for ways to strengthen the economy
  2. The government have realised that a simpler, more effective remedy is at hand: recapitalising public sector banks (PSBs) and enhancing the flow of credit
  3. The proposal to recapitalise PSBs to the extent of Rs. 2.11 trillion (Rs. 2.11 lakh crore) is a much needed step
  4. It is, perhaps, the most effective way to provide a much-needed fiscal stimulus to the economy and revive growth

How Bank capital affects loan growth?

  1. When loans go bad and turn into non-performing assets (NPAs), banks have to make provisions for potential losses
  2. This tends to erode bank capital and put the brakes on loan growth
  3. That is precisely the situation PSBs have been facing since 2012-13

Level of stressed advances in the PSBs

  1. Stressed advances’ (which represent non-performing loans as well as restructured loans) have risen from a little over 10% in 2012-13 to 15% in 2016-17
  2. This has caused capital adequacy at PSBs to fall
  3. Average capital at PSBs has fallen from over 13% in 2011-12 to 12.2% in 2016-17
  4. The minimum capital required is 10.5%
  5. Inadequate capital at PSBs has taken its toll on the flow of credit
  6. Growth in credit has fallen below double digits over the last three years

Is poor demand behind this low credit growth?

  1. According to some experts, the deceleration in credit growth to poor demand
  2. They say that corporates have excessive debt and are in no position to finance any investment
  3. This may be true of large corporates
  4. However, it is not true of enterprises in general
  5. One study, which covered over 4,000 companies, showed that the debt to equity ratio fell below 0.8 (which is a low level of debt) in 2008-09 and remained low until 2012-13
  6. Moreover, demand for investment finance may have decelerated but demand for working capital remains strong
  7. If anything, the introduction of GST has increased small business demand for working capital
  8. Low growth in credit is confined to PSBs

Earlier stand of the government on the issue of stressed assets

  1. In 2014, market estimates had placed the requirement of government capital at a minimum of Rs. 2 lakh crore over a four-year period
  2. In 2015, under the Indradhanush Plan, the government chose to commit a mere Rs. 70,000 crore over the period.
  3. The dominant view in government at the time seemed to be that PSBs had messed up in a big way, so putting more capital into them was simply ‘money down the drain’
  4. Their role needed to be shrunk through consolidation or by selling strategic stakes to private investors
  5. This is a mistaken view
  6. The bad loan problem at PSBs is not entirely the result of mismanagement
  7. There have certainly been cases of malfeasance and poor appraisal of credit
  8. However, as the Economic Survey of 2016-17 made clear, these are not responsible for the bulk of the NPA problem
  9. The problem is overwhelmingly the result of factors extraneous to management

Fiscal impact of the recapitalisation package

  1. Analysts worry about the fiscal impact of the recapitalisation package
  2. International norms allow borrowings for bank recapitalisation not to be counted towards the fiscal deficit
  3. The proposed recapitalisation bonds are likely to add to the fiscal deficit’
  4. The government should not worry unduly about missing the fiscal deficit target of 3.2% of GDP
  5. The markets will understand that the fiscal stimulus is well spent

Other bank crisis around the world

  1. The International Monetary Fund has documented 140 episodes of banking crises in 115 economies in the world in the period 1970-2011
  2. The median cost of bank recapitalisation in these crises was 6.8% of GDP
  3. India’s cost of recapitalisation over a 20-year period is less than 1% of the average GDP during this period

Banking Sector Reforms

Bank funding will be liquidity-neutral

Note4students

Mains Paper 3: Indian Economy

The following things are important from UPSC perspective:

Prelims: Recapitalisation

Mains: This article gives points regarding why recapitalization is desirable and how it will bring market discipline in public recapitalization programme.


News

Context

  1. The Centre’s move to infuse Rs. 2.11 lakh crore capital into public sector banks through recapitalisation bonds and budgetary support is a welcome step, according to Governor, Reserve Bank of India.
  2. He also said that the recapitalisation bonds will be liquidity-neutral for the government except for interest payment.
  3. The banks will be recapitalised over a period of two years through recapitalisation bonds and budgetary provision.
  4. According to him a well-capitalised banking system was a pre-requisite for stable economic growth and this package to restore the health of the banking system was a monumental step forward in safeguarding the country’s economic future.

Why recapitalsisation is desirable?

  1. By deploying recapitalisation bonds, it will front-load capital injections while staggering the attendant fiscal implications over a period of time.
  2. The move will involve participation of private shareholders of public sector banks by requiring that parts of the capital needs be met by market funding.
  3. The healthier banks could get the capital first which will prompt others to also address the balance sheet issues.

Impact

  1. It will allow for a calibrated approach whereby banks that have better addressed their balance sheet issues and are in a position to use fresh capital injection for immediate credit creation can be given priority while others shape up to be in a similar position.
  2. This provides for a good way of bringing some market discipline into a public recapitalisation programme compared to the past recapitalisation programmes.
  3. It is for the first time in the last decade that there was a real chance that all the policy pieces of the jigsaw puzzle will be in place for a comprehensive and coherent, rather than piece-meal, strategy to address the banking sector challenges.
  4. It bodes us well that this step has been taken in a time of sound macroeconomic conditions for the economy on other fronts.

Banking Sector Reforms

[op-ed snap] Reforms needed to back bank recapitalisation

Image Source

Note4students

Mains Paper 3: Economy | Indian Economy Issues relating to planning

The following things are important from UPSC perspective:

Prelims Level: Not Much

Mains Level: This plan of government is very necessary for countering the rising NPA problems in the Indian Banking Sector. Complement this article with one of our previous newscard on the same topic, Click here


News

Context

  1. The article talks about the recent announcement of a plan of government that will infuse Rs 2.11 lakh crore into Banks

Bold step by the government

  1. The government has done well to commit itself to a bold programme to provide additional capital to public sector banks
  2. The Rs2.11 trillion recapitalisation plan—Rs0.76 trillion of equity from the government and financial markets and another Rs1.35 trillion through recapitalisation bonds, should be adequate for the next two years

Estimation by the CRISIL

  1. It has estimated that public sector banks will need about Rs1.4-1.7 trillion of additional capital by March 2019 to meet the international Basel III requirements

Three important issues that need to be dealt with
First

  1. The challenge will be to ensure that the improper lending to influential industrial groups that took place on both sides of the global financial crisis is not repeated
  2. Giving banks extra capital was only one of the seven grand themes of the Indradhanush programme announced in 2015
  3. The reform of the Indian banking sector—and especially the privatization of banks—should be the next step

Second

  1. Banks will not take adequate precautions when they are lending when they know that the government will step in to help if the loans turn sour
  2. The government should be selective about which banks get the additional capital on offer
  3. A statement by RBI governor suggests that the banks which have worked harder to deal with their problem loans will get priority in access to fresh capital
  4. Such market discipline is needed

Third

  1. The government needs to decide what proportion of the fresh capital will go for provisions against existing bad loans and how much is to be allocated for new loans
  2. That may not seem a crying matter right now, given the weak demand for loans
  3. But it is possible that companies will seek to borrow after a few quarters if the investment cycle does indeed turn in fiscal year 2019

Nature of the recapitalisation bonds

  1. The exact nature of recapitalisation bonds is not yet clear
  2. But it is possible that the government will keep them out of the budget to avoid expansion in the fiscal deficit
  3. Even if recapitalisation bonds are kept out of the budget, they will still add to the government’s debt stock and increase the interest liability
  4. According to estimates, interest payments could go up by about Rs9,000 crore
  5. It is also possible that international investors and rating agencies will look at deficit numbers after taking these bonds into account
  6. Although resorting to recapitalisation bonds is not a desired outcome, it is perhaps the best that the government could have done in the given circumstances
  7. It is important to note that India is predominantly a bank-financed economy and would find it difficult to grow at a higher rate without the necessary support from the banking system

The way forward

  1. The government should back bank recapitalisation with reforms in the financial sector—and in public sector banks in particular
  2. The fact that recapitalisation bonds can be used for capital infusion should not become an alternative for better governance

Banking Sector Reforms

Government unveils Rs 2.11 lakh crore plan to strengthen PSU banks

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

The following things are important from UPSC perspective:

Prelims Level: Not Much

Mains Level: NPA issue is very crucial for Indian Economy. It is one of the biggest step taken by the government to solve this problem.


News

Roadmap for strengthening Banking Sector

  1. The government has announced a Rs 2.11 lakh crore two-year road map for strengthening NPA-hit public sector banks
  2. It includes re-capitalisation bonds, budgetary support, and equity dilution
  3. The capital infusion will be accompanied by reforms to enable the state-owned banks to play major role in the financial system and give a strong push to the job-creating MSME sector

Particulars of the programme

  1. The programme entails mobilisation of capital to the tune of about Rs 2,11,000 crore over the next two years, with maximum allocation in the current year
  2. These allocations will be through budgetary provisions of Rs 18,139 crore, and recapitalisation bonds to the tune of Rs 1.35 lakh crore

How will the balance be raised?

  1. The balance will be raised by banks from the market by diluting government equity
  2. The government’s equity dilution will help banks to raise about Rs 58,000 crore
  3. The government equity, as per the current policy, can come down to 52 per cent in state-owned banks

Rising level of NPA

  1. NPAs of banks have increased from Rs 2.78 lakh crore in March 2015 to a staggering Rs 7.33 lakh crore as on June 2017

Plan for MSMEs

  1. MSMEs will be handheld by extending support through compulsory TReDS (Trade Receivables electronic Discount System) registration by major PSUs within next 90 days, for shortening the cash cycle
  2. TReDS is an institutional setup for flow of finance to micro, small and medium enterprises (MSMEs) through multiple financiers at a competitive rate

Banking Sector Reforms

Govt permits banks to sell more small savings schemes

Note4students

Mains Paper 3: Economy | Growth

From UPSC perspective, the following things are important:

Prelims level: National Savings Certificate (NSC), Public Provident Fund, Kisan Vikas Patra-2014, Sukanya Samriddhi Account, Senior Citizen Savings Scheme-2004

Mains level: Impact of increased money with banks due to investment in savings schemes on economy


Banks can now sell most of the small savings schemes

  1. In order to encourage savings, the government has allowed banks, including top three private sector lenders, to accept deposits under various small savings schemes like National Savings Certificate (NSC), recurring deposits and monthly income plan
  2. Until now, most of the small savings schemes were sold through post offices

Schemes now accessible through banks

  1. According to a recent government notification, banks can also sell National Savings Time Deposit Scheme 1981, National Savings (Monthly Income Account) Scheme 1987, National Savings Recurring Deposit Scheme 1981 and NSC VIII issue
  2. So far, these banks were allowed to receive subscription under Public Provident Fund, Kisan Vikas Patra-2014, Sukanya Samriddhi Account, Senior Citizen Savings Scheme-2004

Interest rates decided on quarterly basis

  1. On the basis of the decision of the government, interest rates for small savings schemes are to be notified on a quarterly basis since April 1, 2016
  2. These schemes have a higher interest rate than that offered by banks on normal savings account
  3. Increased outlets for selling small savings scheme would result in higher mobilization under the scheme

Banking Sector Reforms

Money-go-round is neat way to fix Indian banks

source

Note4students

Mains Paper 3: Government Budgeting, Indian Economy and issues relating to planning, mobilization of resources, growth and development, employment.

 

From UPSC perspective, the following things are important:

Prelims level: Basel norms, Recapitalisation bonds

Mains level: Recapitalisation of banks


News

Context-

  1. The article bats for recapitalisation of public sector with a financial instrument called as the recapitalisation bonds.

 

What are recapitalisation bonds?

Here the government borrows from the banks by issuing them bonds, and then uses the proceeds to bail the lenders out.
Need for recapitalisation bonds-

  1. According to Fitch Ratings, local banks need as much as $65 billion by 2019 to meet Basel III standards. With valuations below book value for most state banks, the government could raise barely $6 billion by reducing its stake in around 20 lenders.
  2. Also, government does not have much cash to deploy in direct injections, since it is already stretched to meet a 2% fiscal-deficit target.

 

Benefits of recapitalisation bonds-

  1. This looks attractive because banks are flush with deposits, giving them firepower to lend, but credit demand is weak.
  2. Over time, government can potentially settle the debt by selling the bank equity it acquires using the bond proceeds.
  3. According to Credit Suisse, under some accounting standards this fix would not add to the fiscal deficit — though it would do under India’s current norms. Perhaps those might be changed.

 


 Back2basics

  1. History and Working of recapitalisation bonds: In the early nineties, nationalised banks in India saw a severe erosion in their profitability and capital base. This prompted the government to issue recapitalisation bonds. It simply borrowed from the banks themselves to meet their capital requirements! To do this, it issued several tranches of special non-marketable securities to the nationalised banks. The banks subscribed to these bonds in the normal course of their business. The cash thus raised was used by the government to infuse fresh ‘equity’ into the beleaguered banks. Initially issued for a specified period, these bonds were later converted into marketable securities or into perpetual bonds, by mutual agreement between the banks and the Centre. While the government was merely postponing its obligations through these bonds, this move did not result in undue fiscal burden over the long term, as the Centre earned both dividends and market returns on bank shares.
  2. Basel norms: Baselguidelines 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

 

Banking Sector Reforms

First, Fix the Banks

Note4students

Mains Paper 3: Government Budgeting, Indian Economy and issues relating to planning, mobilization of resources, growth and development, employment.

 

From UPSC perspective, the following things are important:

Prelims level: Tier 1 Capital in banks, Fiscal stimulus

Mains level:Steps to revive economy, Recapitalisation of banks

 

 


News

Context-

  1. The article bats for selective recapitalisation of public sector banks in order to ease financing and revive the economy.

 

Background-

  1. The economy has seen growth spiralling downwards for the last six quarters consecutively.
  2. And as some experts suggest, due to poor design and implementation of GST the growth might further fall in the next two quarters.
  3. Some have suggested initiating a fiscal stimulus in order to revive demand and consequently the economy. However, fiscal stimulus will not address the root cause of the problem i.e. shrinking credit disbursement by the banks.

Main reason for deceleration of growth is
The massive tightening of credit disbursement by the banks.

 

Why have the banks reduced credit disbursement?

  1. The Indian Public Sector Banks comprising 21 “nationalised banks” and six of the State Bank of India group, account for almost 70 per cent of the assets and liabilities of the system.
  2. Post global financial crisis of 2008, government initiated fiscal stimulus and at that time banks were also keen to lend (sometimes with inadequate evaluation). This is the time when big projects were undertaken in the power, ports and housing sectors. However, the coal and spectrum scandals withthe policy paralysis experienced at the top leadership led to squeeze in debt disbursement by the banks. From a growth of around 15 per cent four years ago, Public Sector Banks (PSB) advances grew by just 3 per cent in 2015-16.
  3. As of December 2016, gross NPAs for the 27 PSBs were Rs 6,47,800 crore, or 88 per cent of the total NPAs recorded across all banks.
  4. Today for the PSBs as a whole, gross NPAs are greater than their tier-1 capital (the one that really counts).
  5. Another major reason for downfall in credit disbursement is the provisioning for bad loans done on account of the Asset Quality Review by the Reserve Bank of India.

 

Solution

  1. The RBI has done the right things: Tightened income recognition and provisioning and forced banks to book losses on their balance sheet.
  2. The banks have also done the right things of going after major defaulters and initiating better bankruptcy resolution.

What should the government do?

  1. It should initiate selective recapitalisation of better banks so that these banks can get back to lending.
  2. In order to avoid the ‘’moral hazard’’ government can recover this cost by raising capital directly from the market by divesting some shares from these banks. This will strengthen the stressed balance sheets of the banks and give them a breathing space to re-start credit disbursement.

 


Back2basics

  1. NPA: Read in detail here.
  2. Tier 1 Capital: This includes common shares, preferential shares and all the assets which are highly liquid and can be used to ward off any sudden crisis.
  3. Fiscal Stimulus: Increasing government spending on infrastructure etc in order to lift investor sentiment, increase money supply in the market and increase demand in the economy.
  4. Moral hazard: The government believes that if it recapitalises the banks then it might cause a moral hazard. Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.
  5. Asset Quality Review: The RBI periodically conducts review of the asset qualities of banks. However, in 2015-16 it clubbed the procedure for two quarters and reviewed them collectively. This review is conducted to make sure banks are provisioning sufficient amount for bad loans.

Banking Sector Reforms

Extra capital into PSBs: Recapitalisation bonds being considered

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Read the attached story.

Mains level: Important step to counter issues of loss making PSBs. It will definitely help solve the problems related to the NPAs.


News

Recapitalisation bonds

  1. The government is discussing infusion of an additional capital in public sector banks (PSBs)
  2. How and why: By issuing recapitalisation bonds, to provide capital(to PSBs) without disturbing the fiscal deficit figures
  3. Government’s plan: Discussions are underway to raise capital support by another Rs 20,000-25,000 crore for the PSBs
  4. This addition will be in addition of the Rs 10,000 crore provided in the current financial year’s Budget for PSBs’ capitalisation
  5. The extra capital is expected to be generated through sale of non-core assets of the banks and equity infusion by the government via the recapitalisation bonds
  6. With enough liquidity in the banking system post-demonetisation, lenders are expected to buy these bonds
  7. And the money so raised can be used to provide capital to government banks

Particulars of the proposed bonds

  1. The annual interest on these bonds and the principal on redemption will be paid by the Central government
  2. And the funds so raised are to be used to capitalise the PSBs

Banking Sector Reforms

Banks’ cuppa to brew with mergers

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Not Much

Mains level: The step shows keenness of Government. The government wants to expedite the merger process.


News

Issues with Bank Merger

  1. Various governments has highlighted the need for large-sized banks to fund the huge infrastructure requirements of the country as well as compete with global lenders
  2. But a serious question arises: ‘Which chief executive will propose to merge his bank with another and lose his job?’

Seriousness of the current government

  1. Present government has no intention to make it ‘voluntary’ for the board of a bank to decide on a merger
  2. It is evident from the fact that government has wrote letters to banks to kick start the process of mergers and get their respective boards’ approval
  3. This may be the first time in recent history that an official communication has been made by the government to the banks asking them to act on mergers

Alternative Mechanism

  1. The government has also set up an ‘Alternative Mechanism’
  2. It would comprise a ministerial group, to oversee proposals for mergers among banks
  3. A framework had been conceived in which a bank’s board would first clear the decision to merge
  4. And then send the proposal to the ‘Alternative Mechanism’ for its in-principle approval
  5. After the in-principle approval comes through, the bank will take steps in accordance with law and SEBI’s requirements
  6. The final scheme will be notified by the government in consultation with the Reserve Bank of India (RBI)

No need of CCI permission, now

  1. Some hurdles have been removed to expedite the process
  2. For example, approval requirement from the Competition Commission of India(CCI) has been done away with

Post Merger Issues

  1. The merger would create a lot of complexities in terms of branch rationalisation and reduction in human resources productivity for the merged entity
  2. At present, we’ve an example of the merger of SBI with associate banks
  3. Bhartiya Mahila Bank; post merger, the merged entity fundamentals have weakened significantly
  4. Also, after its merger, SBI has seen NPAs rising significantly, from Rs. 1.01 lakh crore (6.94%) to Rs. 1.88 lakh crore (9.97%)

Banking Sector Reforms

Centre tells PSBs to begin merger process ‘immediately’

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Not Much

Mains level: The step shows keenness of Government. The government wants to expedite the merger process.


News

Directions from the Central Government

  1. The Centre has send an official letter to public sector banks asking them to start the merger process immediately
  2. The government had also started preparing the ground to remove certain hurdles for consolidation, such as doing away with the approval from Competition Commission
  3. This is the first time in recent history that an official communication had come from the government to the banks asking them to start the merger process

Objective of the Government

  1. While giving the direction , the government cited the Narasimham committee report
  2. And highlighted the need for large-sized bank that could fund the huge infrastructure need of the country

Framework for the Merger Process

  1. The Centre has provided a broad framework to the banks to take the merger exercise forward
  2. According to the framework, once the board approves the merger plan, it has to be sent to the ‘alternative mechanism’(approved by the Union Cabinet, recently)

Banking Sector Reforms

[op-ed snap] No silver bullet

Image result for Bank merger

Image source

Note4students

Mains Paper 3: Economy | Mobilization of resources

Once you are done reading this op-ed, you will be able to attempt the below.

“Mergers of state-owned banks are not the whole solution. Balance-sheets must be strengthened, governance improved.” Critically examine

From UPSC perspective, the following things are important:

Prelims level:  Not much

Mains level: Bank consolidation -Challenges


News

Context

  • Government has announced that a ministerial panel headed by the finance minister will oversee mergers among state-owned banks

Aim?

  • To create strong banks and that the merger proposals will have to come from the boards of these banks and decisions will be taken purely on commercial grounds

Why such a move?

  1. Bad loans as a ratio of total loans are already close to 10 per cent and the ratio could worsen given the current economic conditions
  2. To address twin balance-sheet problem
  3. The so-called Alternative Mechanism to oversee mergers of PSU banks could be seen as an attempt to skirt the challenge of infusing capital for banks which the government controls or divesting some of these weak banks.
  4. The RBI’s latest Financial Stability Report shows that the gross bad loan ratio of PSU banks could be as high as 14.2 per cent by March 2018 if there is no economic rebound.

Bank consolidation-Challenges?

  1. The global experience shown that they are bound to fail if they don’t meet the test of efficiency, synergy and cultural fit.
  2. Results show a deterioration in earnings of State Bank of India, after the merger of its associate banks with the parent.
  3. It is still not sure whether this planned consolidation will lead to rationalisation, both at the branch level and in terms of staff, and a more efficient banking system.
  4. Pursuing the mergers of these banks without strengthening their balance-sheets and raising governance standards poses the risk of compounding the problems being faced by these lenders.

Banking Sector Reforms

New mechanism to spur PSB mergers

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Not much

Mains level: It is a step taken by government to counter rising NPA problems in banks. This step also have some other objectives.


News

Step for quicker consolidation among public sector banks

  1. The Cabinet has approved ‘in-principle’ the constitution of an alternative mechanism that will oversee the proposals for mergers among banks
  2. According to the government, the decision to create strong and competitive banks will be solely based on commercial considerations
  3. And such decisions must start from the boards of the banks

Why this step?

  1. Because most of the banks are facing with huge levels of NPAs, slow credit offtake and resultant pressures on capital adequacy
  2. Stronger public sector banks will help meet the credit needs of a growing economy, absorb shocks and give them the capacity to raise resources 

Banking Sector Reforms

Amended Banking Regulation Bill gets elders’ nod

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Particulars of the Bill

Mains level: Banks are facing huge NPA problem in India. This will help Banks to counter issues related to NPA.


News

Nod from Rajya Sabha

  1. The Rajya Sabha has passed the Banking Regulation (Amendment) Bill
  2. This Bill empowers the RBI to issue instructions to the banks to act against major defaulters
  3. It  will replace the Banking Regulation (Amendment) Ordinance, 2017

Why this Amendment?

  1. According to the Finance Minster, the capacity of banks to lend money to small creditors is being impacted, the growth is impacted

Banking Sector Reforms

ATM expansion slows due to note ban

Image Source

Note4students

Mains Paper 2: Governance | Government policies and interventions for development in various sectors and issues arising out of their design and implementation.

From UPSC perspective, the following things are important:

Prelims level: Different types of ATMs

Mains level: Article gives shows bad effects of demonetisation on banking industry, as ATMs are important for financial inclusion.


News

Expansion of ATMs

  1. Cash crunch following demonetisation, have led to commercial banks cutting down on the number of automated teller machines (ATMs) 
  2. According to Reserve Bank of India (RBI), there were 98,092 off-site ATMs in June 2017 against 99,989 in the same month last year
  3. However, on-site (located within a branch) ATMs rose to 110,385 from 101,346 in the same period
  4. According to bankers, demonetisation was one of the factors that impacted ATM expansion

Banking Sector Reforms

What is NHB Residex?

Image Source

Note4students

It is a prelims specific article.

From the UPSC perspective, the following things are important:

Prelims Level: Particulars of the NHB and NHB Residex.


News

NHB Residex from the National Housing Bank

  1. It is a set of benchmarks that aims to track housing price indicators across Indian cities
  2. It is designed by a technical advisory committee comprising Government representatives, lenders and property market player

Two sets of indices

  1. The NHB Residex currently offers two sets of quarterly Housing Price Indices (HPIs) across the cities it tracks

Back2basoics

National Housing Bank (NHB)

  1. It is a wholly owned subsidiary of Reserve Bank of India (RBI), was set up on 9 July 1988 under the National Housing Bank Act, 1987
  2. NHB is an apex financial institution for housing
  3. NHB has been established with an objective to operate as a principal agency to promote housing finance institutions both at local and regional levels and to provide financial and other support incidental to such institutions and for matters connected therewith.
  4. NHB registers, regulates and supervises Housing Finance Company (HFCs), keeps surveillance through On-site & Off-site Mechanisms and co-ordinates with other Regulators.

Banking Sector Reforms

Centre for more PSB mergers

  • Fresh from the successful merger of five associates with the State Bank of India, the government is looking to
    consolidate more public banks going forward, with an aim to create only a few lenders of global size and scale.
  • The Finance Ministry will soon undertake a broad study on further consolidation and look at various options for merger among the remaining 21 public sector banks.
  • There are factors like regional balance, geographical reach, financial burden and smooth human resource
    transition that have to be looked into while taking a merger decision.
  • The merger process will get a boost with the likely improvement in the NPA (non-performing asset)
    situation over the next two quarters.
  • The merger proposals in the banking sector would require clearance from the Competition Commission of
    India.

Banking Sector Reforms

Finmin revises criteria for recapitalisation of PSU banks

  1. Change: PSU banks looking forward to the next round of capital infusion will need to fulfil a new set of criteria, including credit recovery
  2. Conditions: The second tranche of capital allocation for the current fiscal would be based on cost of operations as well as recovery and quality of credit on the basis of risk weighted assets
  3. Background: Govt in July had announced the first round of capital infusion of Rs.22,915 crore for 13 banks
  4. The first tranche was announced with the objective to enhance their lending operations and enable them to raise more money from the market

Banking Sector Reforms

India not ready to privatise public sector banks: Arun Jaitley

  1. Finance Minister: India has not reached the point where it can consider selling majority stakes in the public sector banks that control seven tenths of assets in the financial system
  2. Also, public or political opinion has not converged to the point where we can think of privatisation in the banking sector
  3. Govt is consolidating some of the public sector banks to strengthen them, but does not plan to reduce the state’s share below a threshold of 52%

Banking Sector Reforms

Banks should identify key areas for certification of staff: RBI committee

  1. News: A Reserve Bank of India (RBI) committee has recommended that banks should identify specialised areas for certification of staff manning key responsibilities
  2. To begin with, banks should make acquiring of a certificate course mandatory for areas like treasury operations, risk management, accounting, audit function and credit management
  3. Background: RBI had constituted a Committee on Capacity Building in July 2014, under the chairmanship of former executive director, G Gopalakrishna
  4. Objective: Implementing non-legislative recommendations of the Financial Sector Legislative Reforms Commission (FSLRC), relating to capacity building at banks and non-banks, streamlining training intervention
  5. Also, suggesting changes thereto in view of ever increasing challenges in the banking and non-banking sector