Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: The Indian Approach
Policy Measures and Performance Scheduled Commercial Banks

Policy Initiatives

The commercial banking sector occupies a central position in systemic stability because of its dominance in the financial system as well as through its crucial payment focus. Strengthening of prudential supervision coupled with the gamut of measures undertaken by the Government/Reserve Bank has significantly improved the health of the sector. The Reserve Bank's approach to the institution of prudential norms has been one of gradual convergence with international best practices with suitable country specific adaptations. As a result of improvements in the regulatory and supervisory framework, the degree of compliance with Basel Core Principles has generally been high, and observed areas of weaknesses, primarily with respect to country risk guidelines have been addressed. Consolidated accounting for banks has been introduced along with a system of risk-based supervision (RBS) for intensified monitoring of vulnerabilities. RBS will facilitate allocation of supervisory resources by focusing them on relatively vulnerable banks and in areas in which a bank is relatively more vulnerable. The RBS Manual, customising the international best practices to Indian conditions, has been finalised and the RBS scheme has been extended on a pilot basis to 23 banks. A scheme of Prompt Corrective Action (PCA) was introduced effective December 2002 to undertake 'structured' and 'discretionary' actions against banks exhibiting vulnerabilities in certain prudential/financial parameters.

In view of banks being 'special', issues of ownership, size and governance have gained importance from the standpoint of financial stability. Banks are special in the sense that being financial intermediaries, they are critical for mobilising public savings and for deploying them to provide safety and return to the savers. For an emerging economy like India, there is also much less tolerance for downside risks among depositors many of whom place their entire savings in the banks. Hence, there is a more onerous responsibility on the regulator. Accordingly, in July 2004, the Reserve Bank issued draft guidelines on ownership for discussion and feedback, which are in consonance with the regulatory regimes in major countries. The objective of these guidelines is to have a regulatory road map for ownership and governance in private sector banks in the interest of depositors and financial stability. The draft guidelines envisage diversified ownership and restrictions on cross-holding of banks.

Safety and soundness in the banking system can be strengthened by market discipline through enhanced transparency in bank's disclosures to the public. Accordingly, the Reserve Bank has decided to disclose the penalties imposed by it on banks. Effective November 1, 2004, the Reserve Bank would issue a press release giving details of the circumstances under which the penalty is imposed on a bank and would also place the communication on the imposition of penalty to the bank in public domain.

With liberalisation, financial conglomerates are emerging. The Reserve Bank has, therefore, focused on consolidated supervision. Banks have been advised to prepare and disclose consolidated financial statements and prepare consolidated prudential reports. The inter-regulatory coordination has also been streamlined with the establishment of a monitoring system in respect of Systemically Important Financial Intermediaries (SIFIs), coupled with the establishment of three Standing Technical Committees constituted by the High Level Coordination Committee on Financial and Capital Markets (HLCCFCM) to provide a more focused inter-agency forum for sharing of information and intelligence. The reporting framework under SIFI would -

1. capture intra-group transactions and exposures among group entities within the identified financial conglomerate and large exposures of the group;

2. track any unusual movement in respect of intra-group transactions manifested in major markets and

3. track any direct/ indirect cross-linkages amongst group entities. Individual group transactions beyond threshold levels (Rs.1 crore for fund based transactions and Rs.10 crore for others) would be incorporated in the reporting format.

In the context of financial stability, both crisis prevention and crisis management and resolution assume importance. In this respect, availability of the lender-of-last-resort facility can play an important role. In India, liquidity adjustment facility (LAF) has evolved as an effective mechanism for absorbing and/or injecting liquidity on a day-to-day basis in a more flexible manner. Nevertheless, in some very rare and unusual circumstances, a situation may arise when a bank faces a sudden and unforeseen liquidity problem particularly outside the normal LAF auction timings and on days on which such auctions are not held. In such exceptional and unforeseen circumstances, the Reserve Bank has indicated that, at its discretion, it may extend liquidity support to such a bank if the said bank is otherwise financially sound, and after taking into account other relevant factors. The liquidity support in such exceptional circumstances will be made available only for a minimum number of days required to overcome the unexpected liquidity pressure. Such liquidity support will be available against eligible securities with adequate margin and other conditions as the Reserve Bank may consider appropriate.

A related issue is approach towards treatment of insolvent banks. Rather than closing them down, policymakers in India have shown a preference to merge such banks with healthy public sector banks. As regards concerns that such an approach may give rise to a moral hazard problem, two issues need consideration. First, commercial banks are the most dominant and systemically important segment of the financial system. Second, over 70 per cent of the bank depositors in India are small depositors. Therefore, systemic concerns coupled with the necessity to safeguard the interest of such depositors have been paramount in the minds of policy makers while dealing with insolvent banks.