Financial Sector Reforms were initiated as part of the overall structural reforms aimed at improving the productivity and efficiency of the economy. The Financial Sector Reforms recognise the fact that the Indian Banking System had over the years grown and that the geographical and functional coverage of the banking system have been truly impressive. However, questions have been raised from time to time on the viability of the banking institutions. Concerns have also been expressed about the deterioration in the quality of services provided by banks. It is with a view to finding solutions to these problems that Financial Sector reforms were initiated. The broad objective of the reform has thus been to create a banking system that is both viable and efficient.

There are four building blocks which have formed part of the Banking Sector Reforms. These are :-

1. Modifying the policy framework;

2. Improving the financial soundness and credibility of banks;

3. Creating a competitive environment;

4. Strengthening of the institutional framework.

Let me briefly emphasise the components of these various building blocks and also deal with some questions that have been raised in this context.

The improvements in the policy framework are aimed at removing and reducing the external constraints bearing on the profitability and functioning of commercial banks. In effect, an attempt has been made to bring down very substantially, the pre-emptions in the form of reserve requirements and to give greater freedom to banks in the determination of interest rates. The reductions in the reserve requirements have indeed been very substantial. This has had the effect of both expanding the lendable resources of banks as well as to improve the profitability. Between November 1995 and January 1997 the Cash Reserve Ratio had been reduced by five percentage points. Such a reduction has not happened in the past. The de-regulation of the interest rate structure has given a high degree of freedom to banks in determining the deposit rate and the lending rates. Obviously this has put greater responsibility on the banks and banks have to manage this freedom judiciously.

In trying to improve the financial health and credibility of banks, a major step that has been undertaken has been to introduce internationally accepted prudential norms relating to income recognition, asset classification, provisioning and capital adequacy. While world over it is recognised that strict prudential norms are extremely important in ensuring the soundness and solvency of commercial banks, sometimes questions are raised in this country as to the relevance of the prudential norms and more particularly with those relating to capital adequacy. The origin of the prescription of capital adequacy norms goes back to the Basle Committee Report on International Convergence of Capital Measurement and Capital Standards published in July 1988. In the early eighties, increased competition internationally led to a concern over deteriorating capital levels in international banks and the erosion of reasonable risk/return relationship for banking business. Consequently, national authorities in many countries began to press their banks to improve their capital ratios. Furthermore by 1982, market developments, particularly, the growth of new off-balance sheet instruments and techniques were requiring banks and regulators to address a range of risks other than those traditionally arising from the banks' loan portfolio. All these factors came together to produce a growing realisation among central banks and regulatory authorities that some greater standardisation and enhancing of capital measures and standards were highly desirable in the interest of the system. The framework suggested a minimum of eight percent capital to risk-weighted assets ratio which includes both on and off balance-sheet items.

The aim of this system is to relate capital to the risk of the portfolio of assets held by a bank. Further, at least four per cent risk weighted assets was to be in the form of pure capital that is equity capital and free reserves. In looking at the pressures and influences on banking, it is difficult to overestimate the importance of the capital ratios now imposed on banks.

However the prescription of Basle capital ratio of eight per cent has also drawn certain adverse comments. The prescription of a eight per cent ratio seems to follow a `one size fits all' formula. In fact, the desired capital ratio should be an appropriate way of controlling and reflecting the riskiness of banks' portfolios. Also, the uniform application of a 100 per cent weighting to non-bank private sector corporates does not recognise the different quality of borrowers as reflected in their ratings. Further the treatment of collateral was overly restrictive, as no credit is given for collateral which are not in the form of cash or government securities. Another argument heard particularly in India is that there is no need for this solvency based measure for government owned banks. The basis for this argument is that when Government is the owner, it will meet all the obligations and there is no possibility of a public sector bank failing.

It is true that the eight per cent norm cannot be operated like a `one size fits all' formula. This reflects only the minimum and it is for each regulatory authority to prescribe capital ratios for individual banks. The merit of the eight per cent prescription is that it is superior to a regime when there were no such prescriptions and to countries introducing these norms in the initial phase the objective has to be to attain this minimum and then make the prescription bank specific. The concerns over the broad weighting categorisations and the lack of allowance for differences in quality between borrowers are being met by countries setting individual target ratios above 8% bank-wise where the regulatory perception is that the bank's portfolio carries a higher element of risk. Countries are at liberty to follow a detailed risk weighting model but this could distort comparisons among banks across countries. The risk weighting categorisation was only a broad brush formula so as not to make it too complicated. The argument that government banks do not have to follow prescribed capital adequacy ratios as public are indifferent to the level of capitalisation in a public sector bank does not recognise the fact that banks are commercial entities and not departments of government. Capital is a cushion against losses. Just because banks are owned by government does not mean that the intrinsic commercial element is to be ignored. Banks deal in money and not in goods and this could lead to their being highly leveraged. More important, these norms prevent banks' balance sheets ballooning rapidly during booms with inevitable adverse consequences.

Capital gives owners and managers powerful incentives to run the bank safely and soundly. The banks' capital ratios are now seen by the investment community and rating agencies as a sign of strength while at the same time providing flexibility for future business growth. If government banks are exempt from complying with capital adequacy ratios, they will be at a disadvantage as compared to other banks particularly in their foreign exchange and international operations as it is not possible for the foreign banks and rating agencies to assess their solvency. The approach of wholesale and institutional clients is also to assess the counterparty risk (in this case the risk on the bank) and capital adequacy ratio is an important financial indicator. If government banks which have disclosed large losses have not been affected in any manner and the public continue to have confidence in them, it is because these banks are under restructuring and steps are being taken for turning them around with capital adequacy norms having been already prescribed. Besides serving as a cushion against losses, bank capital promotes better corporate governance. There is also the question of level playing field when private banks are also operating in the country. If capital adequacy ratios were to be abandoned, it will be very hard to put anything else in its place which can prevent anarchy in competition and unstable monetary developments. The eight per cent ratio is seen as a floor and banking systems in some countries have ratios that are considerably higher.

One criticism of capital adequacy requirements is that banks prefer investments in risk free securities. In several countries where capital adequacy norms were introduced, initially there was some degree of down-sizing of assets. Nevertheless, in the Indian context, the introduction of the capital adequacy requirements has not been the prime reason for higher investments in government securities. For example, in 1994-95 and 1995-96, non-food credit expanded by 29.8 per cent and 22.6 per cent respectively, despite the fact that these were the years when the pressure was greatly on to maintain capital adequacy requirement. The reasons for a larger investments in government securities in subsequent years must be traced to other reasons. Nevertheless, this ratio does emphasise the need for banks to have a balanced portfolio between risk-free assets and risk-assets. Creating a Competitive Environment

The two major steps taken in this regard are -

Allowing the nationalised banks access to capital markets and thereby reduce share of the government in the total equity. It has, however, been decided that the government will hold at least 51 per cent of total equity; ]

Within the current provisions of the Banking Regulations Act, new banks in the private sector are being allowed to be set up.

Some question the impact of partial privatisation in bringing about any change in the functioning of commercial banks. Having public as a part of the ownership of the banks indeed makes banks more conscious of the need to run the institutions efficiently and earn more profits. Access to the capital markets and listing of shares on the stock exchange themselves entail obligations on such banks in terms of publishing half-yearly results etc. Presence of elected directors do make a difference to the functioning of the board. Banks under such circumstances become accountable to diverse categories of shareholders and become more responsive in that process.

A distinct feature of the Indian financial sector reform process has been the strengthening of the institutional framework relating to banking. This has taken the form of:

1. re-capitalisation;

2. strengthening the supervisory process; and

3. creating new institutions; such as Ombudsman and Debt Recovery Tribunals.

The RBI supervisory strategy comprises now both off-site surveillance and on-site inspections. A detailed off-site surveillance system based on prudential supervisory reporting framework on a quarterly basis covering capital adequacy, asset quality loan concentration, operational results and connected lending has been made operational. In regard to on-site inspection, the focus is now on the evaluation of the total operations and performance of the banks under the CAMELS system, i.e. capital adequacy, asset quality, management, earnings, liquidity and internal control systems. Apart from evaluating asset quality and compliance with prudential norms, focus is now on the effective functioning of the Board, management, earning capacity of banks as also efficacy of internal audit and control systems and risk management systems besides regulatory compliance. The new approach to annual financial inspections has been adopted from the cycle of inspections commencing July 1997. An efficient result-oriented on-site inspection system requires an efficient follow-up mechanism without which the very objective of inspections will be vitiated. The entire cycle of inspection and follow-up action is now completed within a maximum period of twelve months. Monitorable action plan for rectification of irregularities/deficiencies noticed during the inspection within a time frame is drawn up and the progress in implementation pursued with the bank. Thus the present supervisory system makes a substantial improvement over the earlier system in terms of frequency, coverage and focus as also the tools employed.

The role of the external auditors has been enhanced and enlarged. In the auditing of a bank, the auditors' primary duty is to express an opinion on the financial statement such as the balance sheet and the profit and loss account. Besides the audit report on the financial statements, auditors of banks are also required to submit what has come to be known as Long Form Audit Report. Auditors are now required to verify compliance with SLR computation and prudential norms and also report serious irregularities to RBI. Further, auditors of nationalised banks should certify whether the transactions of bank are within the powers of the bank, and whether the returns received are adequate for the purpose of audit. The RBI has taken a number of measures to improve the transparency and disclosure in the published accounts of banks. From 1996-97, banks are required to disclose under `Provisions and Contingencies' in the Profit and Loss Account, details of provision for bad and doubtful debts, provision for diminution in the value of investments, provisions for tax separately instead of showing it as a conglomerate item. Banks are also required to disclose the capital adequacy ratio, as well as percentage of net NA to net advances. The above information will also have to be audited.

One has begun to see the impact of the financial sector reforms, both on the financial results as well as in the services provided. Operating profits have gone up from Rs.7568 crore in 1995-96 to Rs.8898 crore in 1996-97 and net profit from a loss of Rs.371 crore to a net profit of Rs.3095 crore. All banks except two have met the minimum capital adequacy ratio. Sixteen public sector banks have capital adequacy ratios over 10 per cent and five between 9-10 per cent.

Reduction in NPAs has acquired more focussed attention. The level of NPAs is no doubt high but the percentages are showing a decreasing trend. The percentages vary sharply among banks. Percentage of gross NPAs has come down from 23 per cent in 1992-93 to 17.8 per cent in 1996-97. The percentage of net NPAs to Net advances was 9.18 per cent. For purposes of international comparisons, it is this figure that should be taken into account. The priority sector advances accounted for 47 per cent of the total NPAs and non-priority sector for the balance.