Broadly speaking, promoting financial stability is the task of limiting the effects of financial disturbances on the economy. This has gained considerable prominence in the recent past as a policy objective of central banks and supervisory agencies, primarily reflecting the concerns about the growing number, breadth and the severity of bouts of financial crises.

Amongst financial crises, banking crises are the most difficult to predict and have more lasting and damaging effects on the economy than those in other financial sector groupings. The recapitalisation costs associated with such crises in the recent past have been very high and it is estimated that on account of the Asian crises, some of the affected countries could have recapitalisation costs ranging from 15 per cent to 50 per cent of GDP. Since society at large has to pay a huge cost for banking crisis, there is an increased focus on banks and banking supervision in recent times.

India could avoid the crisis mostly due to a cautious approach towards short-term external borrowings and capital account convertibility, and insignificant exposure to sensitive sectors like real estate and equity capital market. We also took care to have phased implementation of reform process, particularly when it came to prescribing stricter prudential regulations in conformity with global standards.

A strong and efficient financial system is critical to the attainment of the objectives of creating a market-driven, productive and competitive economy. Promoting healthy financial institutions, especially banks, is, therefore, a crucial prerequisite for financial stability. It has been observed that largest number of crises still arise, in emerging market economies or industrial countries, due to over-extension in aggregate balance sheets in good times and receding widely afterwards.

Financial stability requires appropriate action at both the micro and macro level. The micro dimension consists of three pillars -institutions, markets and infrastructure. Preventive attention by the Regulators must then focus on each of the three pillars supporting both the domestic and international financial systems, namely,

• the good health of financial institutions through appropriate regulation and supervision,

• the proper functioning of the markets, and

• establishment of a sound infrastructure including legal and judicial system, payment and settlement systems, and establishing transparent accounting and adequate disclosure standards.

The Central Bank is expected to safeguard the three pillars by developing and implementing norms of behaviour as well as sanctions against non-compliance (regulations), by monitoring the norms (supervision) and by providing supportive role through emergency liquidity support, deposit protection schemes, etc. At the macro level, however, the safeguarding lever continues to be the monetary and credit policy.

The banking system in India, being the dominant segment of financial sector accounting for a major portion of the fund flows, is the main vehicle for monetary policy signals, credit channel and facilitator of payments systems. Hence, the health of banks remain the most crucial concern for the markets and the regulators. In this background, I will dwell upon some of the measures which have been taken to safeguard the health of the Indian banking system and the challenges which still lie ahead for both banks and their supervisors.

In the post liberlisation era, the Reserve Bank has initiated several measures to ensure safety and soundness of the banking system and at the same time encouraging banks to play an effective role in accelerating the growth process. It has been recognised that the Indian banking system should be in tune with well laid down international standards of capital adequacy and prudential norms. Banks have also been encouraged to adopt appropriate internal control systems and corporate governance procedures to foresee and manage all types of risks.

Banks in India have contributed significantly to the expansion of branch network, increase in savings rate and in extending credit in rural and small sectors. However, certain weaknesses such as decline in productivity and efficiency and erosion in profitability had developed in the system which were to be addressed to enable the financial system to play an effective role in a competitive environment. Keeping in view this objective, the Committee on Financial System (Narasimham Committee I) was set up. The Committee made a number of recommendations aimed at improving productivity, efficiency and profitability of the banking system on the one hand and providing it greater operational flexibility and functional autonomy in decision making on the other. The Report was conceived as a holistic exercise and its recommendations were accordingly interrelated.

Progressive reduction of reserve requirements to correct the impact of directed investments on the profitability of banks, deregulation of complex and administered interest rate structure to move to market determined rates and introduction of prudential norms for asset classification, income recognition and provisioning in order to remove subjectivity were some of the major steps taken in the direction of banking sector reforms. Accounting practices had been prescribed in consonance with internationally accepted standards with the objective of enhancing transparency and credibility and ensuring accuracy of financial statements.

In the mean time, major changes had taken place in macroeconomic environment and institutional structures. These called for a critical evaluation of policy initiatives already undertaken. The Government of India had, therefore, set up the Committee on Banking Sector Reforms in 1997, to review the record of implementation of financial sector reforms recommended by the earlier Committee and chart the reforms necessary in future to make India's banking system stronger and better equipped to meet the global competition.

A major part of the reform measures recommended by the Committee were primarily aimed at strengthening the banking sector which can be broadly grouped as under:

• Strengthening of capital adequacy including explicit capital for market risk

• Tightening of the prudential and disclosure standards in line with international best practices

• Consolidation of banking system

• Restructuring of weak public sector banks

• Dilution of government equity in public sector banks to 33 per cent and providing functional autonomy to government banks

• Technology improvements to modernize Indian banking

• Adoption of scientific tools for management of risks

• Legal reforms to expedite recovery of banks' dues

Strong capital base is very essential for absorbing unexpected losses. As a part of the follow-up of the recommendations of the Committee on Banking Sector Reforms, CRAR was raised to 9 per cent from the year ended March 31, 2000. Government of India had recapitalised a number of nationalised banks to the tune of Rs 20,446 crore to bolster their CRAR. Also, eleven public sector banks have raised capital from the market. As a result, all public sector banks except one had maintained the required level of CRAR as on March 31, 2000. The risk weightage pattern has also been realigned to fall in line with the basel accord.

The first Capital Accord of 1988 evolved by the Basel Committee provided a framework for a fair and reasonable degree of consistency in the application of capital standards. However, the methods used to determine the capital charge for credit risk in the Accord were not sufficiently sophisticated and not perceived to be risk sensitive. Keeping in view the financial innovation and growing complexity of financial transactions, a need was felt for a more broad based and flexible framework for capital adequacy. Towards this end, the Basel Committee released a consultative paper on "New Capital Adequacy Framework" in June 1999 for comments by market players. The new framework envisages a three pillar approach viz, minimum capital requirement, which seeks to develop and expand on the standardised rules set forth in the 1988 Accord, supervisory review of a bank's capital adequacy and internal assessment process and effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices.

Although it is too early to gauge the full impact of the new proposals, it is very likely that there would be an increase in capital requirements for our banks over the next few years on this account.

With a view to move towards the international standards, the prudential norms have been further tightened. Timeframe for doubtful assets would be reduced to 18 months from 24 months by March 31, 2001. General provision of minimum of 0.25 per cent has been introduced on standard assets from the year ended March 31,2000. Exposure ceiling in respect of individual borrower has been lowered from 25 per cent to 20 per cent of the capital funds. However, this is not the end of the tunnel.

As Governor Bimal Jalan observed recently, "It is no longer possible for developing countries to delay the introduction of strong prudential and supervisory norms, and introduce structural reforms in order to make the financial system more competitive, more transparent and more reliable."

We need to further tighten the prudential norms by increasing provisioning requirements on standard and sub-standard advances, revise the time-frame for migration to doubtful losses to 12 months and further reduce the exposure limits as we go along.