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«I ndia and China are both large, poor countries that have benefited from greater integration into the world economy; both are still at an early but ...»

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Based on the committees’ recommendations, a series of measures were undertaken beginning in 1992. The suggested reforms included decontrol of interest rates, development of securities markets, building a credible risk-free yield curve, greater reliance on open market operations, auctions of government securities, phased decontrol of the capital account, and the insurance sector while the Securities and Exchange Board of India (SEBI) regulates securities and mutual funds (RBI, 2005b).

4The report of the CFS was submitted in 1991. Mr. M. Narasimham, a former RBI governor was the chairman of the committee. Subsequent to this report, the government appointed another committee, the CBSR, again with Mr. Narasimham as committee chairman, to review the progress made in reforming the banking sector and to chart the actions needed to strengthen the foundation of the banking system. The CBSR report was submitted in April 1998. For a summary see RBI (1998).

Suman Bery and Kanhaiya Singh 151 establishing prudential norms and mechanisms for supervision of the banking sector in line with international standards and practices, specifically those proposed by the Basel Committee for banks with significant international operations (the so-called Basel I norms). Significantly, neither committee forcefully championed denationalization.

In its external payments regime, India made the transition to a managed float of the rupee in 1993 (RBI, 2005b). Concurrently, most restrictions on current transactions were removed, and India accepted the disciplines of Article VIII status (current account convertibility) at the IMF as of March 1993. The exchange rate regime is officially described as marketdetermined, with no target rate, but the RBI reserves (and exercises) the right to intervene in the market to resist speculative attacks and to guide the exchange rate in the directions of “appropriate” competitiveness. One measure of this intervention has been the accumulation of foreign exchange reserves, which reached US$150 billion by March 2006.

By way of comparison, the equivalent figure at the end of March 2001 was US$54.1 billion. While part of this intervention has been designed to strengthen India’s defense against a speculative attack, part has been designed to insulate the nominal exchange rate from what are perceived as temporary capital inflows (Lal, Bery, and Pant 2003; Patnaik, 2004; Joshi and Sanyal, 2004).

Interest rate regime liberalization and the lowering of statutory requirements The framework of administered interest rates has been almost dismantled since 1997. In the case of deposit rates, only the rate on savings bank deposits remains under RBI control. At present, this is prescribed at 3.5 percent. The effective yield on deposits is lower, however, because interest is payable only on the minimum balance between the tenth day and the last day of each month. As for lending rates, the RBI now directly controls only the interest rate charged on export credit, which accounts for about 10 percent of commercial advances and indirectly controls the interest rate on small loans of up to Rs. 200,000, which accounts for about 20 percent of total advances5. Commercial banks are not allowed to exceed their Prime Lending Rate (PLR) in the case of loans up to Rs. 200,000.6 5For export credit, the RBI provides refinancing at concessional rates that mitigate the burden of this particular control on the banking system.

6Each commercial bank is statutorily required to declare its PLR in advance.

152 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION

The RBI specifies an interest rate ceiling for nonresident Indians’ foreign currency deposits and nonresident Indians’ rupee deposits. Since July 2003, these are linked to the London Interbank Offered Rate (LIBOR) for selected international currencies, less 25 basis points for nonresident Indians’ foreign currency deposits and plus 250 basis points for nonresident Indians’ rupee deposits.

With these reforms and given larger trends in financial markets, as influenced by the RBI’s monetary policy actions, the nominal deposit rate for 1–3 year maturities has dropped from 12.0 percent in 1991–92 to 4–5.25 percent in 2004–05, and the nominal lending rate has over the same period dropped from 16.0 to 10.25 percent.

The minimum cash reserve ratio has been lowered to 4.75 percent from

15.5 percent (prior to the reforms), and banks are paid interest on deposits in excess of the 3 percent statutory minimum at the rate of 6 percent, which is equal to the RBI policy-determined Bank Rate. The statutory liquidity ratio was gradually brought down from an average effective rate of 37.5 percent in 1992 to the statutory minimum of 25 percent in 1997, and it continues to be at that level, although actual holdings still remain in excess of the minimum.

Increasing role of private sector domestic and foreign banks Since the start of reforms in 1991, private sector banks, both domestic and foreign, have been allowed more liberal entry, albeit with different degrees of freedom. By end-March 2004, the domestic private sector banks held 18.6 percent of assets, 17 percent of deposits, and 19.8 percent of advances. The corresponding numbers for foreign banks were 6.9 percent,

5.1 percent, and 7.0 percent. While there is thus a substantial presence of private banking in India, the public sector banks (the State Bank of India group and the nationalized banks) continue even now to dominate the Indian banking sector. Indian banks, led by the public sector banks, have also continued to expand their presence overseas.





Expansion of foreign banks in India and their acquisition powers over domestic private banks have been the subject of considerable attention and debate, as well as being governed by India’s commitments under the General Agreement on Trade in Services. As India’s economy has improved, foreign banks have sought to expand their presence, both by branch expansion and by acquisition of private banks. (Unlike China, there has been no interest in providing a minority “strategic stake” in public sector banks even though this is not prohibited by law.) Following an announcement in the 2002–03 budget, foreign banks in India have been given more flexibility in their Indian operations wherein Suman Bery and Kanhaiya Singh 153 they are allowed to operate as branches of their overseas parent or as subsidiaries in India. Under a three-phase road map set out by the RBI on February 28, 2005, between March 2005 and March 2009 foreign banks satisfying the RBI’s eligibility criteria will be permitted to establish a wholly owned banking subsidiary (WOS) or to convert their existing branches into a WOS. The WOS is required to have minimum capital of Rs. 3.0 billion with sound corporate governance. The WOS will be treated on par with the existing branches of foreign banks for branch expansion with flexibility to go beyond the existing World Trade Organization (WTO) commitments of 12 branches in a year and preference for branch expansion in under-banked areas. The RBI would also prescribe market access and national treatment consistent with WTO commitments and also other appropriate limitations consistent with international practices and the country’s requirements. Permission for acquisition of shareholding in Indian private sector banks by eligible foreign banks will be limited to banks identified by the RBI for restructuring. Where such acquisition is by a foreign bank already present in India, a maximum period of six months will be given for conforming to the “one form of presence” concept. The second phase will commence in April 2009 after a review of the experience gained. Extension of national treatment to WOS, dilution of stake, and permitting mergers and acquisitions of any private sector banks in India by a foreign bank would be considered, subject to an overall investment limit of 74 percent (RBI, 2005a).

Strengthening prudential norms In order to strengthen the banking system, the RBI has already introduced capital adequacy norms to ensure uniform measurement of regulatory capital consistent with the recommendations of the Basel Committee and income recognition (Basel I). The initial target was to obtain a capital-to-risk weighted assets ratio (CRAR) of 8 percent as required by Basel I. The government contributed about Rs. 40 billion (0.6 percent of the 1990–91 GDP) to the paid-up capital of public sector banks between 1985–86 and 1992–93 and again about Rs. 177 billion (about 1.9 percent of the 1995–96 GDP) between 1992–93 and 2001–02 (Mohan and Prasad, 2005). Constrained by competing fiscal demands, the government permitted banks to raise fresh equity to meet a shortfall in capital requirements. Public sector banks were also encouraged to raise Tier-II (i.e., debt) capital without a government guarantee, subject to certain limits linked to their capital. Several public sector banks also accessed capital in India and abroad through global depository receipts (GDR), while other banks raised subordinated debt through private placement

154 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION

for inclusion under Tier-II capital. Unlike the big Chinese banks, however, there is no appetite in India for the sale of strategic stakes to foreign banks. Where the domestic private sector banks are concerned, foreign equity holdings are currently restricted to a total of 74 percent, with no individual shareholder able to exercise more than 10 percent of voting rights, other than with the RBI’s approval with sublimits for the three categories of foreign direct investment (FDI), foreign institutional investors (FIIs), and nonresident Indians (NRIs) (RBI, 2005a).7 With these efforts, the Indian banking sector has achieved more than required capital adequacy in almost all the groups except two banks in the old private sector (Table 7.1).

After substantially complying with the Basel I requirements, Indian banks are now moving towards the New Capital Adequacy Framework on International Convergence of Capital Measurement and Capital Standards (Basel II) regime (November 2005), which entails three pillars for establishing minimum capital requirements (incorporating credit risk, operational risk, and market risk), supervisory review, and market discipline. The RBI has, in principle, accepted to adopt Basel II. Accordingly, all commercial banks in India except RRBs are required to adopt the Standardized Approach for credit risk and the Basic Indicator Approach for operational risk by March 31, 2007. Banks are encouraged to formalize their capital adequacy assessment process in alignment with their business plan and performance budgeting system.

In order to ensure a smooth transition to Basel II, the RBI has appointed a steering committee comprising senior officials from 14 banks. On the basis of the recommendations of the steering group, draft guidelines on implementation of the New Capital Adequacy Framework were formuThe guidelines require that: (1) important shareholders (i.e., with shareholding of 5 percent and above) are “fit and proper” as per the RBI’s guidelines on acknowledgement for allotment and transfer of shares, (2) the directors and the Chief Executive Officer who manage the affairs of the bank are “fit and proper” and observe sound corporate governance principles, (3) banks have minimum capital/net worth for optimal operations and systematic stability, and (4) policies and processes are transparent and fair.

On the issue of aggregate foreign investment in private banks from all sources (FDI, FII, NRI), the guidelines stipulate that it cannot exceed 74 percent of the paid-up capital of a bank. If FDI (other than by foreign banks or foreign bank groups) in private banks exceeds 5 percent, the entity acquiring such stake would have to meet the “fit and proper” criteria indicated in the share transfer guidelines and get the RBI’s acknowledgement for transfer of the shares. The aggregate limit for all FII investments is restricted to 24 percent, which can be raised to 49 percent with the approval of the board/shareholders. The current limit for all NRI investments is 24 percent, with the individual NRI limit being 5 percent, subject to the approval of the board/shareholders.

Suman Bery and Kanhaiya Singh 155

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lated and issued to banks on February 15, 2005. An internal working group was also constituted for identifying eligible domestic credit rating agencies whose ratings may be used by the banks for computing capital for credit risk under Basel II (RBI, 2005a). It is the responsibility of bank management, however, to develop an internal capital adequacy assessment process and accounting standard.

In addition, the enactment of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 (with amendments in 2004), has offered great opportunities to step up loan recoveries and tighten credit administration procedures, which could further enhance the scope for greater profitability. The banks’ readiness is reflected in significant improvements in CRAR and nonperforming assets (NPA) across the banking sector (Table 7.2) while maintaining reasonable profitability.

Strengthening regulatory and supervisory institutions In order to strengthen the regulation and supervision of the banking system, a Board for Financial Supervision has been constituted as a Committee of the Central Board of the Reserve Bank since November 1994 and is headed by the Governor with a Deputy Governor as Vice Chairperson and other Deputy Governors and four Directors of the Central Board as members. The Board has focused on restructuring the inspection system, setting up off-site surveillance, enhancing the role of external auditors, and strengthening corporate governance, internal controls, and audit procedures, disclosures, and transparency.

156 INDIAN FINANCIAL LIBERALIZATION AND INTEGRATION

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Since March 1998, mandatory disclosures have also included profitability indicators such as the ratio of interest and noninterest income to working funds and the financial position of subsidiaries. And, since March 2000, banks have to disclose the maturity profile of loans and advances, investments, movements in nonperforming assets, and lending to sensitive sectors.



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