Financial Standards and Codes: Report of Advisory Group on Banking Supervision
Core Principles for Effective Banking Supervision (Contd)

Legal and other measures of support for the supervisor

RBI has powers to apply penalties and sanctions not only on banks but also on the management or Board of Directors. However, the public sector character of banks remains an important consideration in the supervisor deciding upon and initiating sanctions and/or penalties on banks. RBI should consider introduction of measures by which clear accountability can be fixed on individual directors and/or the board of directors for non-performance and/or negligence of their duties. Accountability, if fixed, should lead to penalties and, in extreme cases, if necessary, criminal prosecution.

The range of possible actions available to RBI should include imposition of conservatorship which can enable a bank in difficulty to gain some time until it completes remedial measures. Conservatorship is a workable solution where a bank in difficulty has the intrinsic strength to get over the difficulties but needs extensive corrective action under a more reliable management. It would be, therefore, desirable to provide RBI specifically with powers to impose conservatorship

As of now laws and regulations do not mitigate undue delays on the part of the supervisors in initiating appropriate corrective actions. However, a Prompt Corrective Action (PCA) framework is now being evolved with triggers identified for a range of mandatory and discretionary actions. It would also be desirable to extend the PCA concept further and define clear limits of forbearance that can be shown by the supervisor in any situation. RBI has circulated a draft PCA framework for comments. The Group’s views on the proposed PCA framework are given as an appendix to this chapter.

In formulating its views on the proposed PCA framework and making suggestions in these regards, the changes/developments in the banking sector that have taken place in the last few years have been taken into account. The Group is of the view that while the three parameters which have been identified as critical and in relation to which PCA is contemplated under the framework are sufficient at this stage, these would need to be reviewed in the coming years in the light of developments in information technology, payment systems, and in other important areas influencing the banking sector. Accordingly, the triggers as well as the corrective action suggested in this paper would need review from time to time to reflect the changes in the operating environment. It is important to recognise that no PCA framework could be treated as lasting in nature. The other important point, in the opinion of the Group, is that PCA needs to have some mandatory elements in order that all stakeholders as well as the supervisors are prepared for a certain course of corrective action in the event of the performance of a bank or banks falling below a given level. This will lend strength to the system and is likely to keep the banks on greater alert against any deterioration in their performance.

RBI may consider having more interactions with the external auditors of banks. This will provide a deeper understanding of operations of banks and help in discharging supervisory functions better. It will complement the on-site inspections of RBI well. While the auditors are required by law to report matters of material significance to the shareholders, they do not have any legal responsibility of reporting such matters to the supervisor. A suitable legal provision obliging the statutory auditors of banks to report on such matters simultaneously to the regulator will strengthen the supervisory regime.

RBI should practice consolidated supervision over internationally active banking organisations of which it is the home country supervisor. While the position in regard to supervision over foreign branches of Indian banks is fairly satisfactory, the position in regard to subsidiaries and joint ventures would need to be addressed. RBI has made a beginning in requiring banks to submit off-site returns in respect of their foreign subsidiaries and joint ventures on a solo basis.

RBI should look at the management’s local oversight of foreign operations and ensure that it is particularly close when the foreign activities differ fundamentally from those conducted in the home country, or are conducted at locations that are especially remote from the locations where the principal activities are conducted. Since the business of a foreign unit always has some special characteristics, as supervisor, RBI should ensure that the oversight exercised by the management matches the requirement of the situation.

The supervisor should visit the offshore locations periodically and exchange information with the host country authorities during such visits. RBI’s present approach, which is selective and, therefore, has some elements of ad-hocism, should be replaced by a system under which all foreign operations of Indian banks receive on-site supervisory oversight in a planned manner.

Quality of supervision in a country is one of the major factors of consideration before granting licence to an Indian bank to open a branch abroad. However, the assessment of the host country’s quality of supervision should be more rigorous. It would be desirable to introduce a structured assessment and not permit banks to open offices in areas where the quality of supervision does not measure up to international standards

It would be preferable to have formal arrangements between home and host country supervisors for sharing of information and supervisory concerns rather than having only informal arrangements as at present. RBI should endeavour to get into formal relationship with host country supervisors on the basis of MoUs. Proper understanding between home and host country supervisors helps improve the scope and quality of supervision.

The Reserve Bank of India, as supervisor, has clear responsibilities and objectives as regards supervision of banks. RBI is vested with sufficient powers to carry out its supervisory functions effectively and to address safety and soundness concerns. It is also so constituted and financed that its autonomy and independence are not undermined. A suitable legal framework is in place and these are reviewed and updated from time to time considering the changing needs of the banking industry and the economy.

The permissible activities of banks are clearly defined in law and the use of the word "bank" in names is restricted. RBI follows very strict licensing norms and these are reviewed periodically. It also has the powers to reject an application. While licensing banks, RBI makes a detailed assessment of the character of the proposed management and determines the suitability of the major shareholders, transparency of ownership structure and source of initial capital. Minimum capital is also prescribed. Fit and proper test is applied to evaluate the directors and the top management. The proposed strategic and operating plans of the banks and their viability are also reviewed. In the case of foreign banks, the prior consent of the home country supervisor is obtained. The compliance with the conditions imposed at the time of licensing is monitored through a quarterly system of on-site supervision.

Banks are required to fulfil minimum capital requirements which is broadly in conformity with the international norms. RBI has laid down detailed guidelines on income recognition, asset classification and provisioning covering both on- and off-balance sheet exposures in line with international standards. Wherever there are gaps in this regard, RBI is gradually but firmly moving the system towards international standards

RBI relies on both on-site and off-site supervisory mechanisms in pursuit of its supervisory objectives. It also has regular interaction with bank management and a thorough understanding of banks’ operations. The system of on-site inspection comprises of appraisal of asset quality and the impairment to asset values. The quality of assets is also monitored on quarterly basis through off-site monitoring returns. RBI seeks to ensure that the management information systems in banks enable identification of concentrations within their portfolios and also prescribes prudential limits to restrict single and group borrower exposures. In the course of on-site examination, among other things, the adequacy of credit and investment policies and adherence thereto are looked into. There are laws, and banks’ internal as well as supervisory guidelines to ensure that credit decisions are made free of conflicting interests and, where necessary, on arms length basis and free from inappropriate pressures from outside parties.

RBI has issued detailed guidelines for risk management and is monitoring their implementation regularly. It is also fast moving towards putting in place a formal system of risk-based supervision of banks. Inspections are conducted using in-house expertise, whose skills are being constantly upgraded, and occasionally also through chartered accountants for specific targeted appraisals.

RBI also determines that banks have in place internal controls that are adequate for the nature and scale of their business. It has means of collecting, reviewing and analysing prudential reports and statistical returns from banks. RBI also has systems in place and makes ongoing efforts to ensure that banks maintain adequate records based on consistent accounting policies and that the financial statements prepared and published based on such records represent a true and fair state of the banks. These are also independently validated by external auditors and by RBI during on-site inspections. Local operations of foreign banks are also required to be conducted to the same high standards as are required of domestic institutions.

For banks whose condition demands initiation of appropriate action, RBI has the powers and does take necessary steps. These are in the process of being structured in a framework of Prompt Corrective Actions. The public sector character of banks, however, remains a limitation in the supervisor deciding upon and initiating remedial action in respect of banks.

The other areas where urgent action could be initiated are, guiding banks to put in place appropriate advanced risk management systems, achieving greater coordination, on a formal basis, with other supervisors, including overseas supervisors, introducing consolidated supervision, and giving an anti-money laundering orientation to the existing "Know Your Customer" requirements

It may be concluded that the arrangements for supervision of banking in India is in almost complete and comprehensive agreement with most of the 25 core principles laid down by the BCBS with the exception of a few. Even in the case of those where the Group has observed significant gaps, these are not cause for any concern as of now and are capable of being bridged within a reasonable timeframe.