Personal Website of R.Kannan
Learning Circle- Banking Theory and Practice
Role of RBI - Regulation of Banks Before
& After the Reform Period

As regards the policy environment, it must be recognised that almost the whole of financial intermediation was on account of public sector, with PSBs being the most important source of mobilisation of financial savings. Resources for DFIs were also made available either by banks or mostly created money and governmental support. The major thrust was on expansion of banks' branches, provision of banking services and mobilisation of deposits. The interest rate regime was administered with interest rates fixed both on deposits and lending. At the same time, there was large pre-emption of banks' resources under the cash reserve ratio or in the form of statutory liquidity ratio. The delivery of credit was also by and large directed through an allocative mechanism or as an adjunct to the licencing regime. In the process, the private sector banks tended to be confined to the local areas and were unable to expand in such an environment. Banks, mainly public sector banks became the most dominant vehicle of the financial intermediation in the country. To a large extent, entry was restricted and exit was impossible and there was little or no scope for functions of risk assessment and pricing of risks. The Government, thus combined in itself the role of owner, regulator and sovereign.

The legal as well as policy framework emphasised co-ordination in the interest of national development as per Plan priorities with the result, the issue of corporate governance became subsumed in the overall development framework. To the extent each bank, even after nationalization, maintained its distinct identity, governance structure as incorporated in the concerned legislations provided for a formal structure of relationship between the RBI, Government, Board of Directors and management. The role of the RBI as a regulator became essentially one of being an extended arm of the Government so far as highest priority was accorded to ensuring coordinated actions in regard to activities particularly of PSBs. The SBI, which was owned by the RBI, was in substance no different from the other banks owned by the Government in terms of Board composition, appointment procedures of the executives and non-executive members of the Board of Directors. Both Government and RBI were represented on the Board of Directors of the PSBs. There has been significant cross representation in terms of owner or lender and in other relationships between banks and all other major financial entities. In other words, cross holdings and inter-relationships were more a rule than an exception in the financial sector, since the basic objective was coordination for ensuring planned development, with the result, the concepts of conflicts of interests among players, checks and balances etc., were subordinated to the social goals of the joint family headed by the Government.

The major challenge of the reform has been to introduce elements of market incentive as a dominant factor gradually replacing the administratively coordinated planned actions for development. Such a paradigm shift has several dimensions, the corporate governance being one of the important elements. The evolution of corporate governance in banks, particularly, in PSBs, thus reflects changes in monetary policy, regulatory environment, and structural transformations and to some extent, on the character of the self-regulatory organizations functioning in the financial sector.

During the reform period, the policy environment enhanced competition and provided greater opportunity for exercise of what may be called genuine corporate element in each bank to replace the elements of coordinated actions of all entities as a "joint family" to fulfill predetermined Plan priorities. The measures taken so far can be summarized as follows :

First, greater competition has been infused in the banking system by permitting entry of private sector banks (9 licences since 1993), and liberal licensing of more branches by foreign banks and the entry of new foreign banks. With the development of a multi-institutional structure in the financial sector, emphasis is on efficiency through competition irrespective of ownership. Since non-bank intermediation has increased, banks have had to improve efficiency to ensure survival.

Second, the reforms accorded greater flexibility to the banking system to manage both the pricing and quantity of resources. There has been a reduction in statutory preemptions to less than a third of commercial banks resources. The mandatory component of market financing of Government borrowing has decreased. While directed credit continues it is now on near commercial terms. Valuation of banks' investments is also attuned to international best practices so as to appropriately capture market risks.

Third, the RBI has moved away from micro-regulation to macro-management. RBI has replaced detailed individual guidelines with general guidelines and now leaves it to individual banks' boards to set their guidelines on credit decisions. A Regulation Review Authority was established in RBI, whereby any bank could challenge the need for any regulation or guideline and the department had to justify the need and usefulness for such guideline relative to costs of regulation and compliance.

Fourth, to strengthen the banking system to cope up with the changing environment, prudential standards have been imposed in a progressive manner. Thus, while banks have greater freedom to take credit decisions, prudential norms setting out capital adequacy norms, asset classification, income recognition and provisioning rules, exposure norms, and asset liability management systems have helped to identify and contain risks, thereby contributing to greater financial stability.

Fifth, an appropriate legal, institutional, technological and regulatory framework has been put in place for the development of financial markets. There is now increased volumes and transparency in the primary and secondary market operations. Development of the Government Securities, money and forex markets has improved the transmission mechanism of monetary policy, facilitated the development of an yield curve and enabled greater integration of markets. The interest rate channel of monetary policy transmission is acquiring greater importance as compared with the credit channel.

Prudential regulation and supervision have formed a critical component of the financial sector reform programme since its inception, and India has endeavoured to international prudential norms and practices. These norms have been progressively tightened over the years, particularly against the backdrop of the Asian crisis. Bank exposures to sensitive sectors such as equity and real estate have been curtailed. The Banking Regulation Act 1949 prevents connected lending (i.e. lending by banks to directors or companies in which Directors are interested).

Periodical inspection of banks has been the main instrument of supervision, though recently there has been a move toward supplementary 'on-site inspections' with 'off-site surveillance'. The system of 'Annual Financial Inspection' was introduced in 1992, in place of the earlier system of Annual Financial Review/Financial Inspections. The inspection objectives and procedures, have been redefined to evaluate the bank's safety and soundness; to appraise the quality of the Board and management; to ensure compliance with banking laws & regulation; to provide an appraisal of soundness of the bank's assets; to analyse the financial factors which determine bank's solvency and to identify areas where corrective action is needed to strengthen the institution and improve its performance. Inspection based upon the new guidelines have started since 1997.

A high powered Board for Financial Supervision (BFS), comprising the Governor of RBI as Chairman, one of the Deputy Governors as Vice-Chairman and four Directors of the Central Board of RBI as members was constituted in 1994, with the mandate to exercise the powers of supervision and inspection in relation to the banking companies, financial institutions and non-banking companies.

A supervisory strategy comprising on-site inspection, off-site monitoring and control systems internal to the banks, based on the CAMELS (capital adequacy, asset quality, management, earnings, liquidity and systems and controls) methodology for banks have been instituted. The RBI has instituted a mechanism for critical analysis of the balance sheet by the banks themselves and the presentation of such analysis before their boards to provide an internal assessment of the health of the bank. The analysis, which is also made available to the RBI, forms a supplement to the system of off-site monitoring of banks.

Keeping in line with the merging regulatory and supervisory standards at international level, the RBI has initiated certain macro level monitoring techniques to assess the true health of the supervised institutions. The format of balance sheets of commercial banks have now been prescribed by the RBI with disclosure standards on vital performance and growth indicators, provisions, net NPAs, staff productivity, etc. appended as 'Notes of Accounts'. To bring about greater transparency in banks' published accounts, the RBI has also directed the banks to disclose data on movement of non-performing assets (NPAs) and provisions as well as lending to sensitive sectors. These proposed additional disclosure norms would bring the disclosure standards almost on par with the international best practice.

The nationalized banks are enabled to dilute their equity of Government of India to 51% following the amendment to the Banking Companies (Acquisition & Transfer of Undertakings) Acts in 1994, bringing down the minimum Government's shareholdings to 51 per cent in PSBs. RBI's shareholding in SBI is subject to a minimum of 55 per cent. Ten banks have already raised capital from the market. The Government proposed, in the Union Budget for the financial year 2000-01 to reduce its holding in nationalised banks to a minimum of 33 per cent, while maintaining the public sector character of these banks. The diversification of ownership of PSBs has made a qualitative difference to the functioning of PSBs since there is induction of private shareholding and attendant issues of shareholder's value, as reflected by the market cap, representation on board, and interests of minority shareholders. There is representation of private shareholder when the banks raise capital from the market.

The governance of banks rests with the board of directors. In the light of deregulation in interest rates and the greater autonomy given to banks in their operations, the role of the board of directors has become more significant. During the years, Boards have been required to lay down policies in critical areas such as investments, loans, asset-liability management, and management and recovery of NPAs. As a part of this process, several Board level committees including the Management Committee are required to be appointed by banks.

In 1995, the RBI directed banks to set up Audit Committees of their Boards, with the responsibility of ensuring efficacy of the internal control and audit functions in the bank besides compliance with the inspection report of the RBI, internal and concurrent auditors. To ensure both professionalism and independence, the Chartered Accountant Directors on the boards of banks are mandatory members, but the Chairman would not be part of the Audit Committee. Apart from the above, Board level committees that are required to be set up are Risk Management committee, Asset Liability Management committee (ALCO), etc. The Boards have also been given the freedom to constitute any other committees, to render advice to it.

Government introduced a Bill in Parliament to omit the mandatory provisions regarding appointment of RBI nominees on the Boards of public sector banks and instead to add a clause to enable RBI to appoint its nominee on the boards of public sector banks if the RBI is of the opinion that in the interest of the banking policy or in the public interest or in the interest of the bank or depositors, it is necessary so to do.

As regards, appointment of Additional Directors on the Boards of private sector banks, since December 1997, the RBI has been appointing such directors only in such of those 'banks making losses for more than one year, having CRAR below 8%, NPAs exceeding 20% or where there are disputes in the management.

Appointment of Chairman and Managing Directors and Executive Directors of all PSBs is done by Government. The Narasimham Committee II had recommended that the appointment of Chairman and Managing Director should be left to the Boards of banks and the Boards themselves should be elected by shareholders. Government has set up an Appointment Board chaired by Governor, Reserve Bank of India for these appointments. More recently, in case of appointment of Chief Executive Officer of the PSBs identified as weak, the Government has formed a Search Committee with two outside experts.

Appointment as well as removal of auditors in PSBs require prior approval of the RBI. There is an elaborate procedure by which banks select auditors from an approved panel circulated by the RBI. In respect of private sector banks, the statutory auditors are appointed in the Annual General Meeting with the prior approval by the RBI.

In brief, central bank has a developmental role even in the period of reform but it is a different type of role, namely not directly financing development but help develop systems, institutions and procedures to enable a paradigm shift in public policy and in the process enhance corporate governance also in PSBs, in particular. While legislative changes are necessary for an enduring improvement in corporate governance and such legislative changes are not easy to effect in a democratic multi-party Parliamentary system, it is reassuring to observe that significant improvements in corporate governance in the Indian financial sector are being effected even within the existing legislative framework.