Project on Indian Financial Market - Module: 4
Stability of Financial Sector
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Reinforcing Financial Stability (Contd)

Prudential Indicators

As part of regulation and supervision, the Reserve Bank has been monitoring several macro and micro-prudential indicators. As part of macroeconomic monitoring, the Reserve Bank has, in particular, paid special attention to bringing out analyses of the latest fiscal, monetary and financial and external sector positions in considerable detail in its Annual Reports. Besides, the Reserve Bank has been focussing on details of developments in the commercial and the co-operative banking sectors and in the areas concerning the development financial institutions (DFIs) and non-banking financial companies (NBFCs) in the Report on Trend and Progress of Banking in India. This publication provides commercial bank-wise details of prudential indicators as also aggregated prudential indicators for the commercial banking system as a whole (Box VI.3). The Reserve Bank has set up an Off-site Surveillance and Monitoring System (OSMOS) to monitor micro-prudential indicators, both at an aggregate and individual levels.

The cornerstone of the strategy to tackle the weaknesses in the Indian banking system was the institution of prudential norms relating to income recognition, asset classification and provisioning requirements and incentive-based regulation through the prescription of capital-to- risk-weighted assets ratio (CRAR). A strategy to introduce the attainment of risk weighted capital adequacy of 8 per cent in a phased manner was put in place. Initially (i.e., in 1992-93), banks were required to raise their CRAR from 4 per cent in the initial year to 8 per cent over a period of three years, i.e., by end-March 1996. Banks with an international presence were required to attain the prescribed CRAR of 8 per cent in 1993-94, while new private sector banks and foreign banks were required to attain the prescribed CRAR in the first year itself.

Based on the recommendations of the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham), the minimum CRAR was raised to 9 per cent, effective March 31, 2000. Other measures introduced based on the recommendations of the committee included:

1. an additional risk weight of 20 per cent for investment in Government guaranteed securities issued by PSUs;

2. 20 per cent risk weight on state government guaranteed advances which remain in default as on March 31, 2000 and 100 per cent weight in the case of continued default after March 31, 2001;

3. risk weight of 2.5 per cent to account for market risk for Government and approved securities; and

4. 100 per cent risk weight on the foreign exchange open position limit.

As regards asset classification, the earlier system of eight 'health codes' was replaced by the classification of assets into four categories, viz., standard, sub-standard, doubtful and loss assets in accordance with international norms. Provisioning requirements were prescribed for sub-standard, doubtful and loss asset categories. Provisioning requirements of a minimum of 0.25 per cent were also introduced for the standard assets from the year ended March 31, 2000. Banks have also been required to progressively 'mark-to-market' their holdings of Government securities, with the marked-to-market proportion rising from 30 per cent in 1993 to 75 per cent by 1999-2000. In the recent Mid-term Review of the Monetary and Credit Policy for 2000-01, banks have been advised to classify their investment portfolio (comprising SLR and non-SLR securities) under three categories, viz., Available for Sale, Held for Trading, and Held to Maturity categories and provided the flexibility to decide the extent of holdings under 'Available for Sale' and 'Held for Trading' categories.

In order to strengthen banking supervision, an independent Board for Financial Supervision (BFS) under the aegis of the Reserve Bank was constituted in November 1994. The Board is empowered to exercise integrated supervision over all credit institutions in the financial system including select DFIs and NBFCs relating to credit management, prudential norms and treasury operations. A comprehensive rating system based on Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems (CAMELS) methodology has been instituted for domestic banks. As regards foreign banks, the rating system is based on Capital Adequacy, Asset Quality, Compliance and Systems (CACS). This has been supplemented by a technology-enabled quarterly off-site surveillance system.

The status of banks with regard to their attainment of CRAR and the levels of their Non-Performing Assets (NPAs) over the last several years are presented in, respectively. Over the last four years from 1996-97 to 1999-2000, the capital base as a ratio of risk-weighted assets has improved for all major categories of banks. All the banks belonging to the SBI Group now have a CRAR exceeding 10.0 per cent. Amongst other public sector banks, all banks have met the enhanced CRAR norm of 9.0 per cent with the exception of Indian Bank. Four of the 34 Indian private sector banks had a CRAR below the prescribed norm of 8 per cent in 1996-97. In 1999-2000, three of 32 such banks had a CRAR below the enhanced norm of 9.0 per cent. All the 42 foreign banks operating in India in 1999-2000 had a CRAR exceeding the 9.0 per cent norm. As such, the capital position of banks operating in India is comfortable at present.

The position on the asset quality front has also improved over the last four years. Three of the eight SBI Group banks had NPA to net assets ratios exceeding 10.0 per cent in 1996-97. Their number increased to four in the following two years but declined to only one in 1999-2000. The number of nationalised banks having NPAs exceeding the 10.0 per cent also declined from six in 1996-97 to four in 1999-2000. In the case of old private sector banks, this number increased from three to five over the same period, indicating some deterioration in their asset quality. In the case of foreign banks operating in India, the number of banks with NPAs exceeding the 10.0 per cent benchmark increased from three in 1996-97 to 14 in 1998-99 but declined to 11 in 1999-2000. None of the new Indian private sector banks have NPAs exceeding the 10.0 per cent. Along with reduction in NPAs, the provisioning and contingencies made against NPAs of all major bank groups, except foreign banks, have declined.

In India, banks' exposure to capital markets, direct and indirect, remain and limited and, therefore, to a large extent, stock market volatility does not impinge on monetary and banking stability. Scheduled commercial banks were allowed to subscribe to shares and debentures of corporate entities (including PSUs) up to 5.0 per cent of their incremental deposits of the previous year with a sub-ceiling of 1.5 per cent for corporate shares in October 1993. Investments in PSU bonds were excluded from the 5.0 per cent ceiling in January 1994. Further, they were allowed to purchase shares and debentures in the secondary market within the existing 5.0 per cent ceiling in October 1996. Preference shares/debentures/ bonds of private sector bodies were excluded from the 5.0 per cent limit in the monetary and credit policy for the first half of 1997-98. As at end-March 2000, banks' investments in equity shares issued by public sector undertakings and private corporate sector amounted to Rs.2,841 crore and their advances to the capital market were limited to a mere Rs.4,890 crore. Banks have been required to publish their advances to the capital market in their balance sheets from 1999-2000.

The monetary and credit policy statement of October 2000 has revised guidelines on the bank financing of equities and investments in shares. First, bank boards are required to lay down a prudential ceiling on banks' aggregate exposure to the capital market keeping in view their overall risk profile. Second, bank's exposure to capital market by way of shares, convertible debentures and units of mutual funds (other than debt funds) should not exceed 5 per cent of the bank's total domestic credit as on March 31 of the previous year. Third, banks may grant advances for subscribing to initial public offerings only to individuals subject to a maximum of Rs.10 lakh and finance extended by banks for IPOs should be reckoned as an exposure to the capital market. Fourthly, a minimum margin of 25.0 per cent inclusive of cash margin should be obtained by banks for issue of guarantees on behalf of share brokers. Finally, banks should also mark to market their investment portfolio in equities like other investments on a quarterly basis and should disclose the total investments made in shares, convertible debentures and units of equity oriented mutual funds as also aggregate advances against shares, etc., in the 'Notes on Accounts' to their balance sheets from the year ending March 2001.

The statutory responsibility for prudential supervision of select financial institutions was assigned to the Reserve Bank from April 1995. The scope and coverage of inspection of select financial institutions has since been broadened to take into account their developmental, coordination and supervisory roles. The task of designing an enhanced off-site monitoring system for select financial institutions has been introduced effective March 1999.

With the exception of IFCI and IIBI, all the other financial institutions have CRAR exceeding 10.0 per cent. The IFCI, IIBI and IDBI had net NPAs exceeding 10.0 per cent of net loans in 1999-2000. A significant deterioration in loan quality was observed in the case of IFCI in 1998-99.

The Reserve Bank was vested with comprehensive legislative powers only from January 1997. Some of the significant measures initiated by the Reserve Bank in recent years for regulation and supervision of NBFCs are as follows:

1. compulsory registration;

2. higher entry norms of Net Owned Funds (NOF) of Rs.25 lakh (enhanced to Rs.2 crore for new NBFCs which seek registration with the Reserve Bank and commence business on or after April 21, 1999);

3. stricter prudential norms;

4. enhanced capital adequacy standards;

5. requirement of credit rating; and

6. commissioned audits through professional accountants at the behest of the Reserve Bank.

Under Non-Banking Financial Companies Prudential Norms (Reserve Bank) Directions, issued in January 1998, NBFCs are required to achieve a minimum 12 per cent CRAR on or before March 31, 1999. Most of the companies had CRAR above the stipulated minimum. As regards NPAs, the majority of the companies had NPAs within a reasonable limit.

During the first half of 1999-2000, there was a reduction in gross NPAs of NBFCs by Rs.259 crore, due mainly to reduction in sub-standard and loss assets. The ratio of gross NPAs to total credit, therefore, declined from 12.9 per cent to 12.2 per cent.

A detailed self-assessment of the Core Principles for Effective Banking Supervision has been issued by the Reserve Bank in October 1999. The assessment has shown that most of the Core Principles were already enshrined in the existing legislation or current regulations. Gaps had been identified between existing practices and principles mainly in the areas of risk management in banks, inter-agency co-operation with other domestic/international regulators and consolidated supervision. Internal working groups were set up to suggest measures to bridge these gaps and their recommendations are in the process of being implemented. Guidelines on Asset Liability Management (ALM) of banks were issued in February 1999. Banks were advised to put in place an ALM system, effective April 1, 1999. These guidelines were subsequently extended to cover select financial institutions in December 1999. Detailed guidelines on risk management systems have also been issued to banks in October 1999. A beginning has been made towards consolidated supervision by advising banks to not only voluntarily build in risk-weighted components of their subsidiaries into their own balance sheets on a notional basis and earmark additional capital in their books beginning with 2000-01, but also to annex the balance sheet of the subsidiaries (for public sector banks) to their balance sheets beginning from the year ending March 31, 2001. In addition, to guard against regulatory forbearance and to ensure that regulatory intervention is consistent across institutions, the Reserve Bank has prepared a Discussion Paper delineating a framework for Prompt Corrective Action (PCA) with various trigger points for prompt responses by the supervisors.