Thursday, 03 April 2014 09:59





Ever since the 2008 global economic crisis, the Indian banking sector has encountered several challenges due to the weakening domestic macro-economic condition, increasing spill-over risks and subdued global growth. The Reserve Bank of India, as also the financial planners took several policy initiatives to meet the challenges, both on the supervisory and regulatory fronts. In the short term, however, the stress asset quality of banks continues to remain a major challenge. Most banks experienced rise in asset impairment, on the one hand, and dip in profitability, on the other. The only silver lining has been the comfortable capital base.

A RBI discussion paper, "Banking Structure in India—The Way Forward”, suggests far reaching changes in the banking structure so that it better serves the growing needs of the real economy.

Globally, several initiatives have been taken for ring-fencing commercial banking activities and combat systemic risks. The proposed measures range from moving businesses identified as too risky and complex into standalone entities to prohibiting banks from engaging in these activities altogether. Major global initiatives of structural reforms include Volcker Rule under the Dodd-Frank Act in the US, Vickers Reform proposals in the United Kingdom and Liikanen reform proposals in the EU. The main aim of all the proposals is to construct a firewall between the deposit taking and the core banking activities, on the one hand, and investment banking/ proprietary trading activities, on the other.

The Volcker Rule restricts deposit-taking banks from engaging in proprietary trading and complex activities. It also forbids the co-existence of such trading activities and other banking activities in different subsidiaries within the same group.

The Vickers reform proposal has recommended ring-fencing of retail banking operations of large UK banks into separate legal subsidiaries.

The Liikanen Report seeks to carve out proprietary trading and market-making activities beyond a threshold on a stand-alone basis from the deposit taking bank, but allow these activities to co-exist with other banking business within the same group as long as these are carried out in separate subsidiaries.

These reforms will help to limit capacity of bank managements for excessive risk taking, as also shield systemically important financial services from excessive or abusive investment risk shocks.

The government of India has set-up the Financial Sector Legislative Reforms Commission (FSLRC), to make laws governing the financial sector compatible with a growing, globalised and modernising economy. The proposals of the Commission cover dedicated resolution authority, consumer protection and independence of regulators. The Commission also envisages a framework where governance standards will not depend on the form of organisation of the financial firm.

RBI is also working on providing new products, leveraging technology, as also relaxed regulatory guidelines to achieve sustainable and scalable financial inclusion.

There is also a need to reform the payment systems. In this context, the latest Vision Document on "Payment Systems in India-Vision 2012-15”, released on 1 October 2012, outlines the strategy to be followed for providing safe, efficient, accessible, inclusive, interoperable and authorised payment and settlement systems for the country.

The Basel III capital regulation has been implemented in India from 1 April  2013, in phases, and will be fully implemented by 31 March 2019. These norms lay more focus and importance on quality, consistency and transparency of the capital base.  An additional capital of Rs 4.15 trillion is estimated to be required to meet the Basel III regulation. Out of this amount, around Rs 1.5 trillion will be in the form of equity and balance will be non-equity capital.

The NPA ratio of all major sectors weakened during 2012-13, primarily due to the domestic economic slowdown. Other major factor has been lax credit appraisal/monitoring by banks. Recent years have seen a sharp increase in restructured debt, under the corporate debt restructuring mechanism. This has had huge implications on the already stressed asset quality of the banks.

RBI has also advised banks to upgrade their credit monitoring system for early detection of signs of distress and ensure an effective preventive asset quality management framework. It has also advised banks to strengthen the information sharing mechanism.

The Way Forward

One important indicator of financial health of banks is the asset quality. Today, more than any time before, there is an urgent need to not only strengthen the due diligence and credit appraisal mechanisms, but to also effectively recover bad loans. An effective post-sanction loan monitoring system needs to be in place with every bank to mitigate the problems of increasing NPAs. Towards this end, the working to Debt Recovery Tribunals and Asset Reconstruction Companies also needs to be accelerated.

Banks also need to play a much larger role in a faster, broad-based and inclusive growth, leading to a rapid fall in poverty. While number of accounts with banks has increased substantially in last few years, the actual number of transactions per account continues to be extremely low. This indicates to inadequacies on both the demand and supply sides. Business and delivery models for providing hassle-free financial services to poor, marginal farmer, small businessmen and traders needs to be evolved and implemented.

In a country like India, a hundred per cent reliance on technology-enabled, non-face to face channels alone will not work. Banks need to assess where the traditional brick and mortar outlets are needed to gain trust and acceptability, and put in such delivery points to serve financially excluded segment of the population.

To make it easy for the households to meet their day-to-day payment and fund transfer needs a pan-India bill payment system needs to be put in place that meets all the needs at a single point. More "White Label” point of sale (POS) devices and mini-ATMs by non-bank entities will go a long way to help improve access to modern financial services in rural and remote areas.

Participation of foreign banks also needs to be increased. India needs foreign banks to participate more in the growth process, but in exchange it is important to have more regulatory and supervisory control over their local operations, for which subsidiarisation of foreign banks needs be allowed.

To support economic growth, the banking business needs to expand significantly to an estimated Rs 288 trillion by 2020, from about Rs 115 trillion in 2012. To match the anticipated credit to GDP ratio due to the fast growing economy, the overall credit growth needs to be accelerated. The focus has to be on imparting dynamism and flexibility to the evolving banking structure, while keeping it safe from depositors’ perspective.

On the one hand, sufficiently stringent entry norms are needed to prevent entry of questionable and incompetent entities in the banking sector. However, on the other hand, it has to be ensured that regulation does not cause a moral hazard problem.  A fine balance is needed to be maintained by the Union government and RBI.

With a view to moving towards a dynamic banking structure, a RBI Discussion Paper has suggested following basic building blocks in the reorientation exercise:

  • To enhance competition the block licensing approach should be replaced by on tap licensing. This will enhance competition and bring in new ideas and variety into the system.
  • To deal with negative externalities of large banks a framework should be put in place.
  • Voluntary efforts need to be encouraged to create three or four global sized banks through consolidation among large public and private sector banks. This will will help in increasing the global reach of India’s banks.
  • Put in place a differentiated licensing regime to allow banks for niche segments to take care of specialised banking needs.
  • Steps should be taken to encourage investment banking activities.
  • Banks should be encouraged to reach out to the excluded and under-banked regions.
  • Intensity of regulatory and supervisory regimes should be enhanced for the systemically important banks.

  • Efficient deposit insurance and resolution mechanism should be evolved to support the envisaged tiered structure.

  • Steps should be taken to convert urban co-operative banks that meet the criteria into commercial banks or local area banks/small banks.

  • Presence of foreign banks should be enhanced to stimulate competition. From the perspective of financial stability, these banks should be allowed subsidiarisation.

To meet the increasing demands, both in credit and other services, the size and capacity of the banking structure needs to be expanded.

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