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INDIA

FINANCIAL SECTOR REFO~ STATUS REPORT

March 9, 1994

Country Operations, Industry & Finance Division India Country Department

Q South Asia Region

CONFIDENTIAL

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INDIA: FINANCIAL SECTOR REFORM STATUS REPORT

Table of Contents

PAGE

I. BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 A. Economic Reform Agenda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

II. FINANCIAL SYSTEM AND INSTITUTIONS . . . . . . . . . . . . . . . . . . . . . . 2 A. Institutional Set-Up ..................................... 2 B. Historical Perspective and Key Problems . . . . . . . . . . . . . . . . . . . . . . . 3

III. FINANCIAL SECTOR REFORM PROGRAM . . . . . . . . . . . . . . . . . . . . . . 4 A. Medium-Term Reform Agenda . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 B. Liberalization of Financial Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1. Deregulation of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2. Reductions in the SLR and CRR Requirements . . . . . . . . . . . . . . . . . 7 3. Development of a Broad-Based Government Debt Market . . . . . . . . . . . 8 4. Rationalizing Priority Sector Lending Schemes . . . . . . . . . . . . . . . . . . 9

C. Competition and Promoting Private Sector Participation ............... 10 1. Entry of New Private Banks ............................. 10 2. Broadening Ownership of Public Sector Banks .................. 11 3. Enhancing Autonomy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

D. Restoring Health to Banking Institutions . . . . . . . . . . . . . . . . . . . . . . . . 12 1. Financial Performance of Public Sector Banks .................. 13 2. Improving Recovery of Non-Performing Loans ................. 16 3. Rehabilitation of Weaker Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 4. Recapitalization ..................................... 18 5. Improving Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 6. Strengthening and Modernizing Bank Supervision ................ 20

E. Initiating Reform of Rural Credit System ........................ 21

IV. .CAPITAL MARKET ISSUES . . . . . . . . . . . . . . . . . . . . . . ........ 23

V. BENEFITS AND RISKS . · . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

Tables

Table 1: India: Financial Performance of Public Sector Commercial Banks .................. 15

Table 2: India: Projected Capital Adequacy Position of Public Sector Commercial Banks, March 1995 ........... 20

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INDIA

FINANCIAL SECTOR REFORM STATUS REPORT

I. BACKGROUND

A. Economic Reform Agenda

1. Since Independence in 1947 India has pursued a strategy of mixed economic development, relying on state control of many key sectors of the economy on the one hand, and accommodating a vigorous and expanding private sector on the other. The boundaries between public and private sector interaction have not been ruled by rigid ideology, but by changing political and economic conditions and above all by the imperatives of social and economic development. In a country with a large poor populace, divided along ethnic, linguistic and religious lines, national economic policy has required building consensus across a multitude of political and regional spectrums. In the 1960s and 1970s the configuration of such forces implied a dirigiste approach to economic development, which involved tight control of industrial investment, a highly protective trade regime with a multiplicity of discretionary import licenses, , high tariffs and numerous quantitative restrictions, and establishment of a large number of public enterprises by the central and state governments, often with monopolistic positions in many core sectors.

2. Faced with a balance of payments crisis of unprecedented proportion, the Government that came into power in June 1991 , initiated a program of bold stabilization and reform measures that marked a decisive departure from the past dirigiste and autarkic development strategy. The medium term strategy for reform aims at promoting rapid and sustainable growth in income and employment coupled with more effective and efficient public interventions to reduce poverty and raise the status of India's human capital. This strategy combines the discipline of competitive market forces with a re-examination and re-orientation of the role of government in fostering the country's human resources and physical infrastructure, as well as a scaling back of the size of the public enterprise sector, elimination of a wide range of regulatory controls, including most industrial licensing requirements; a reversal of the excessive government involvement in fmancial intermediation and credit allocation; and a decisive shift away from an inward-oriented, import­substituting trade regime toward policies that reap the full benefits of closer integration with the world economy. Considerable progress has been made on this agenda during the last three years; The most striking evidence of progress has been in the external sector.

3. Responding to changes in the unification of the exchange rate, the liberalization of trade policies and the strong fiscal deficit correction achieved in the previous two years, export growth soared to 21 percent in dollar terms compared with 3.8 percent the previous year. Despite wide ranging liberalization of import policy, imports declined by 1. 3 percent in dollar terms. Trade deficit is about US$ 1 billion compared to US$ 9.4 billion in 1990-91. The external current account deficit wa,s reduced to about 0.5 percent of GDP, the lowest since 1977178 and from nearly 3.4 percent of GDP in 1990/91. These favorable developments in the current account, together with the growing inflows of foreign direct and portfolio investment, of nearly $ 3

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billion, have increased the level of foreign cury-ency reserves to $ 14 billion compared to only US$1 billion in July 1991. Inflation is currently around 8 percent down from nearly 17 percent

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in September 1991. Real GDP growth is about 4 percent from barely 1 percent in 1991/92. The growth is attributed to improved agricultural performance. Publicly held foodstocks reach 23 million tons, the highest level in seven years. However, industrial production and investment have been slow to recover from the deflationary effects of the initial stabilization measures.

4. Against this backdrop, the budget presented to Parliament on February 28, 1994 aims at stimulating the economy, while further deepening the reform process through the provision of further reduction in tariffs; providing incentives to private sector development and measures for public sector restructuring. The Central Government's fiscal deficit is to be reduced to 6 percent of GDP in 1994/95, from the current year level of 7. 3 percent, through wide ranging tax reform and regaining on expenditure increases. Maximum customs duties have been reduced from 85 percent to 65 percent; reduction in general capital goods imports duty from 35 percent to 25 percent and the rate on spare parts from 85 percent to 25 percent. To provide impetus to the private sector, corporate taxes have been unified at 40 percent (from 45 percent to 50 percent), however there remains a surcharge of 15 percent on incomes above Rs.75,000/-. The capital gains tax realized by domestic companies have been reduced by 30 percent from 40 percent. The package is expected to generate an overall growth rate of about 5 percent and keep inflation under control ..

II. FINANCIAL SYSTEM AND INSTITUTIONS

A. Institutional Set-Up

5. India's fin~ncial system is one of the largest in the world with a broad variety of banking and capital market institutions and instruments. Despite the country's low per capita income, financial assets consisting of bank deposits and corporate securities now amount to 97 percent orcfriP, up from 19 percent in the early 1970s. Commercial banks (with total assets of US$101.6 billion as of March 1993) are the mainstay of India's financial system. Since nationalization in 1969 and 1980, the commercial banking sector has been dominated by 27 public sector banks which account for nearly 90 percent of deposits, and 92 percent of bank branches. Their widespread network of 45,000 branches enables them to raise deposits countrywide, and some have established subsidiaries for leasing, underwriting, mutual funds, merchant banking and other corporate services. Private commercial banks presently in operation consist of twenty-three Indian and twenty-three foreign banks, each category accounting for about five percent of total assets. Three important all-India term-lending institutions -- (ICICI, IDBI and IFCI) --with total assets of US$ 17.1 billion as of end March 1993, are increasingly being compelled to tap local and foreign marke~s, and are active in areas of asset management, securitization, and investment banking. !

6. The country's large mutual fund industry has played an instrumental role in resource mobilization and in development of the capital market. The industry was opened to private

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sector entry in 1992, with the first one commencing business in October 1993. With a market capitalization of US$ 87 billion, and with over 6000 companies listed India's capital market is among the largest in the developing world. The market is composed of fifteen regional exchanges, with Bombay being by far the most important exchange in terms of number and market value of listed companies and turnover, accounting for over 7 5% of market capitalization in India. With liberalization of foreign direct investment and removal of administrative restrictions on interest rates on debentures and public sector bonds, new capital issues have risen dramatically in recent years, from US$ 0.88 billion in 1991192 to US$ 6 billion in ten months, April to January 1993/94. The Indian money market is broadly based, consisting of call money, rediscounting of bills, treasury bills, commercial paper, certificates of deposit, and the intercorporate deposit market, and in recent years has revived considerably with the regular auctioning of treasury bills, and reactivation of repurchase agreements between RBI and commercial banks in Treasury Bill market.

7. The Indian rural credit system comprises two main streams: the banking system, which includes Commerical Banks - CBs - (through their 32,000 rural and semi-rural branches) and 196 Regional Rural Banks - RRBs - providing short, medium and long term credit, and the cooperative credit system, which is represented by 28 State Cooperative Banks- SCBs (through affiliated 351 District Central Cooperative Banks and 89,000 Primary Agricultural Credit Societies) for short term credit and 20 State Land Development Banks and 708 Primary Land Development Banks for long term credit. At the apex of the credit system is the National Bank for Agriculture and Rural Development (NABARD) which refinances the system. India's large urban non-bank financial market, consist of the finance and hire purchase companies, housing finance companies, and other institutions. The market is considered competitive, and relative to commercial banks is technologically advanced, and has expanded in recent years much faster than banking industry, and captures currently about ten percent of total deposits of the banking sector.

B. Historical Perspective and Key Problems

8. Until quite recently, financial service industries were among the most controlled and regulated of all economic activities in India. Commercial banks were subject to a complex set of interest rate restrictions, high cash reserve requirements, high mandatory holding of government securities, directed lending, and detailed and restrictive norms governing credit operations. Social and fiscal compulsions evolved to dominate interest rate determination and credit allocation. In the face of persistent fiscal' deficits, interest rates on government debt were deliberately kept at low levels to alleviate the debt service burden. Under these circumstances, marketing of government debt involved imposition of mandatory investment in government securities through the stipulation of Statutory Liquidity Ratio (SLR) on commercial banks and other captive financial institutions. With int¢rest rates serving primarily as a fiscal tool, monetary management depended on quantitative credit controls, sector specific rediscount

/~ facilities, and a high Cash Reserve Ratio (CRRYrequirements. The combination of the Statutory \. __ )

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Liquidity Ratio (SLR) and Cash Reserve Ratio: (CRR), which imposed a marginal pre-emption of 28 percent of banking sector deposits in the:early 1950s, increased to 63.5 percent by 1991. In addition banks were required to allocate a· large proportion of their credits to designated priority sectors, comprising agriculture, small scale industry, and weaker sectors of society, with a large part of such lending at concessional rates.

9. As these objectives conflicted with the tenet of a private sector banking system, the authorities nationalized the largest Indian commercial banks in two rounds, fourteen in 1969 and six in 1980. The nationalization achieved many of the Government's initial goals, including exte~ding the reach of banking services to all parts of the country, including rural areas, and in channelling resources to the public and socially designated sectors. It, however, proved costly to the banking industry. For one thing, it politicized banking business in India. The potential to impart subsidies through credit allocation to such politically strong sectors as agriculture and small scale industry without the need for parliamentary deliberation and explicit budgetary support, had a strong political appeal in India's democratic system, and became, over time, an important source of bureaucratic interferences, as well as micro management. Second, the emphasis on meeting social objectives tended to divert supervisory attention from asset quality, and provided a rationalization for bad lending by bank management. Third, the nationalization prompted a strong bank employee union structure, which resisted for a long time introduction of modem communication and computer technologies with the result that Indian banks have lagged behind in the adaptation of the revolutionary changes in technology which have swept financial service industries elsewhere. These shortcomings have had a severe adverse impact on banks' quality of customer services, productivity, and financial health. As is now being unveiled, India's public sector banks suffer from a large volume of non-performing loans, drastically low . profitability, and inadequate capital. In addition the securities market irregularities which surfaced in 1992, exposed the perils of a highly controlled, yet poorly supervised banking system.

Ill. FINANCIAL SECTOR REFORM PROGRAM

A. Medium-Term Reform Agenda

10. In past few years, several government commission reports recognized the banking sector's problems and have formulated recommendations for their solution. In particular, a High Level Committee (the Narasimham Committee) was appointed in August 1991, to consider all relevant aspects of the structure, organization, functions and procedures of the financial system. The Narasimham Committee was followed by several other specialized committee reports which dealt with the more specialized aspects of financial sector reform. These committee reports have

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provided the basis for the government's progr~ of financial sector reform. Over the past two years the program has been intensively debated in the popular press, deliberated in Parliament

Q and articulated in several official statements, including the Union Budgets of 1992/93, 1993/94,

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1994/95 the Eighth Five Year Plan, and most forcefully the Discussion Paper, "Public Sector Commercial banks and financial sector reform: Rebuilding for a better future", released by the Ministry of Finance on December 15, 1993. With a candid recognition of the problems besetting India's commercial banks, the Discussion Paper outlines a medium-term reform strategy. The emerging perspective aims qualitatively to change the ownership structure, operational environment, incentive system, transparency of banks balance sheets and the interface between the fiscal apparatus and the financial system.

11. These changes are expected to transform Indian banks from bureaucratic institutions to commercially oriented, and competitive businesses that would be equipped to meet the challenge of an increasing liberalized economy. In pursuit of such objectives, the authorities have set several medium-term benchmarks. Thus by 1996, one-half of public sector banks (weighted by asset size) would be listed on the stock market, with corresponding representations of shareholders on bank boards; a significant increase in the market share of private banks' commercial banking business; complete liberalization of deposits and lending rates, subject to one concessional rate, a significant reduction in the pre-emption of bank resources through the SLR and the CRR; a broad-based, liquid, and active market for public sector debt; a significant reduction in the non-performing loans in banks' balance sheets; the full computerization of at least 500 branches of public sector banks; and modernization of the supervisory system for banks and non-bank financial institutions consistent with entry of new private banks, and renewed emphasis on profitability, capital adequa~y, and disclosure.

B. Liberalization of Financial Policies

12. The authorities have initiated over the past two years a phased process of financial liberalization, which has been implemented in pace with the Government's program of fiscal adjustment and macroeconomic stabilization. The success achieved in stabilizing the economy, has included, most notably, lowering of inflation, downward adjustment in interest rates, significant improvement in the country's external payments position and modest reduction in the fiscal deficit of the Central Government. Within this context, and in view of the authorities have moved toward a market -based system of funding government debt, reduced reserve requirements on commercial banks, removed restrictions on banks' issuance of certificates of deposit, and increased competition in credit markets. Such measures, which have been aided by the recent adoption of risk-weighted capital adequacy norms -- as banks have had strong incentive to voluntarily hold risk-free government securities, have been successfully implemented in a coor~inated and phased manner.

1. Deregulation of Interest Rates

13. Under the reform program, the RBI has simplified the administrative controls on interest rate structure considerably. It has reduced the multiplicity of interest rates on the asset side, has removed most restrictions on banks' issuance of certificates of deposit (a minimum denomination

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remains), and has freed interest rates on debentUres and most public sector bonds (other than tax free bonds). These measures imply that interest rates in areas such as the certificates of deposit and debentures are now market-determined, and banks have the freedom to raise funds at market rates through CDs. At present, the key remaining administrative restriction on the deposit side is the ceiling set by the RBI on time deposits for maturities of 46 days and beyond. On the lending side, there are now only three bank lending slabs --rate of interest on loans up toRs. 25,000 (US$800), on loans of 25,000 to two hundred thousand rupees (US$6451), and rates on loans exceeding two hundred thousand rupees. The rates on loans exceeding two hundred thousand rupees are subject to a floor, i.e., minimum lending rate, which is set by the RBI. The authorities have used the minimum lending rate as a key monetary policy instrument, serving both as a signalling device of monetary policy stance as well as a means of influencing credit demand. But it is understood that the minimum lending rate serves also to impair competition in the lending market and protect the weaker banks.

14. The Government's objective is to phase out ceilings and floors on bank deposit and lending rates 1 respectively, over the next three years, except for a single concessional lending rate set slightly below the prime lending rate. In managing the transition, the authorities have indicated that the minimum lending rate would be lifted before the ceiling on deposit rates. This sequencing is appropriate as it is likely to generate a lower interest structure, but needs to be carefully coordinated with. the establishment of a viable benchmark rate and banks' ability to improve their internal controls, asset-liability management capabilities, and communication systems throughout the vast network of urban and rural branches. When the authorities remove the ~inimum lending rate, they intend to have an alternative system in place, most likely a variant of the "prime rate" system used by many other banking systems. The authorities also aim to develop variable-rate lending practices for term loans. One obstacle is the lack of an obvious reference rate. India lacks a liquid secondary market for government debt (as discussed below), and so the T-hill rate has not generally been used as a referent for variable rate debt. Nevertheless, responding to growing demand from their corporate borrowers (who generally expest interest rates to fall over coming months), two of India's term-lending institutions, the IDBiand the ICICI, have been making loans at variable rates since December 1993, using the 364-day T -bill rate as the referent. If this experience proves successful, variable-rate debt is likely to become more widespread in the banking system and in the financial system generally. The authorities are evolving a comprehensive plan to deregulate interest rates, in a phased manner which includes, removal of the minimum lending rate, and subsequently the ceiling on deposit rates. The latter is to be announced not later than March 1996. It is anticipated that, by that date or sooner, banks will be sufficiently focused on earnings and capital needs to limit over-aggressive pricing of deposits. Enforcement of capital standards by restraints placed on the activities of under-capitalized banks should provide bank supervisions with the needed tools to avert problems that might arise because deposit interest ceilings are lifted.

15. Along with the measures lt!ken to deregul~te interest rates, th~ authorities have moved to f Q liberalize credit norms governing major areas of bank operations. In providing loans, banks in

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India were subject to cumbersome sector-specific credit norms and obligatory consortium arrangements for loans exceeding a certain magnitude. In its credit policy statement of October 11, 1993 the RBI announced several important measures, including: raising the loan size above which consortium lending is mandatory from Rs. 50 million to Rs. 500 million; liberalizing selective credit controls applying to sensitive agricultural commodities; allowing banks more leeway to decide levels of collateral and other requirements for particular loans; and raising the limit on banks' purchases of bonds of public sector undertakings from 1.5 to 5 percent of the net increase in deposits over the previous accounting year. In January 1994 this last ceiling was removed entirely. These reforms have removed many impediments to competition in the Indian commercial banking industry.

2. Reductions in the SLR and CRR Requirements

16. The reduction in the central government fiscal deficit achieved since 1991 , in conjunction with the Government's increasing reliance on market borrowing, has permitted considerable reductions in the pre-emption of bank resources through the SLR and CRR. In its credit policy statement of October 1993, the RBI reduced the base SLR (applicable to deposits outstanding as of September 17, 1993), to 34.75 percent from 38.5 percent in 1991, and the SLR on incremental deposits was reduced further to 25 percent. At the same time, as yields on public securities have risen, the SLR has become far less of a burden to banks, since yields available on gqvernment bonds have come much closer to bank loan rates. Moreover, to meet increased capitalization standards, banks increasingly prefer to hold public securities, which carry zero-risk weights, compared with loans, which carry 100 percent risk weights. In line with the anticipated pace of fiscal adjustment, the authorities intend to reduce the (average) SLR to 25 percent by 1996, through adjusting downward both the base and the incremental SLR. However, due· to unforeseeable monetary policy exigencies, they find it difficult to commit themselves publicly to precise quantitative intermediate targets. It is expected, however, that the overall rate should average 28 percent by end 1995 and 25 percent by March 1996.

17. . The authorities intend to increase the flexibility and effectiveness of the CRR as a tool of monetary policy. To that end, the authorities have already reduced the CRR on incremental deposits from 25 percent in 1991 to 14 percent at present and intend to phase out its

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remuneration. The medium-term goal is to enhance the efficacy, independence, and operation of monetary policy by phasing out monetization of the fiscal deficit by RBI via the ad-hoc Treasury Bills over a period of three years; reducing the CRR significantly to the same

1 "technical" level and more in line with increasing reliance on open market operations as the

:t ; basic day-to-day instrument of monetary control. In implementing this policy, the Finance \ Minister has proposed to limit Government's recourse to Reserve Bank financing through "as­\ hoc" Treasury bills over 1994/95 to Rs. 60 billion, representing two-thirds of one percent of

~DP. To ensure strict adherence to this limit, the RBI has been empowered to sell the ad-hoc reasury bills issued by the Government, shou~. d these exceed Rs. 90 billion (one percent of DP) for more than ten consecutive working days any time during the year. This limitation )\

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would slow the growth of monetary base and would provide considerable scope for a phased reduction in the CRR.

3. Development of a Broad-Based Government Debt Market

18. The move toward a more liberal interest rate policy and the adoption of the risk-based capital adequacy framework have reinforced the need to develop a broad and active market for Government securities that would allow secondary trading as well as orderly absorption of new issues. India's outstanding internal government debt consists of debt issued by the central and state governments, as well as government guaranteed securities issued by financial institutions and other public sector agencies. About 60 percent of this debt is held by commercial banks and about 30 percent by insurance companies and provident funds to meet government stipulated reserve requirements. The RBI acts as the agent for the government, and holds and manages government securities on its own account for open market operations. Due to a number of policy and institutional distortions, India's government debt market remains underdeveloped, particularly in comparison with the country's robust equity market. The market is narrowly based; there is virtually no secondary trading and there is no organized dealer network.

19. The authorities are conscious of the need to develop sound primary and secondary markets in government securities. In view of India's large and well-developed financial system, including a functioning corporate bond market and an individual investor base of over ten million, the key concerns relate to the question of how to link the pace of freeing primary market rates with the process of fiscal adjustment so as to ensure continued financing of government debt without exerting undue pressure on interest rates. Given India's relatively large internal government debt (42. 7 percent of GDP as of end March 1993, imposing an interest cost burden of about 4.8 percent of GDP), the authorities are proceeding rather cautiously in this area,' beginning with a managed auction for primary issues of both treasury bills and long dated securities (i.e. , bonds with maturities exceeding one year). In April 1992 the Reserve Bank introduced fortnightly auctions of 364-day T -Bills. While the RBI does not directly participate as a purchaser in these auctions, the volume of the auction is not preannounced, giving RBI the option of adjusting the supply to arrive at its "managed" rate. The auction procedure has been extended to include five and ten year dated securities. Also in an important move to phase ouu auton;tatic monetarization of the fiscal deficit, in January 1993, the RBI began auctions of 91-day T-Bills, which had previously been eligible for refinancing at RBI at a flat 4. 6-percent rate. The mechanics of this auction are identical to that of the 364-day T -Bills except that the auction quantity is pre-announced and in the case of dated securities issued by GOI and its agencies, RBI participates in the primary market. Also, on January 17, 1994 the Government successfully auctioned Rs. 30 billion in five-year zero-coupon bonds for the first time. In addition, the RBI maintains a ceiling on coupons of long-term borids issued by the Central and state governments which are eligible for the SLR requirements. :

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20. The authorities have indicated their desire to improve auction procedures, and broaden the base of the market by creating a network of well-capitalized government securities dealers to reach the larger pool of potential investors. The current environment of low inflation, declining interest rates, and portfolio restructuring by commercial banks is conducive to rapid removal of existing distortions. Thus, the authorities are formulating a comprehensive plan: (i) to improve

' procedures in the 364-day T -Bill market, by either preannouncing a fixed quantity or a minimum quantity to be auctioned; (ii) refraining from participating in the primary auction of "dated" securities; (iii) beginning to appoint a network of dealers in government instruments, and beginning to create a dealer network; and (iv) strengthening the Reserve Bank's ability to supervise such a dealer network. It is expected that by end 1995, the authorities would have (a) freed the 364-treasury bill primary market; (b) re-established a full repo market in treasury bills; and (c) adopted auctioning of all bills and long-term GOI bonds.

4. Rationalizing Priority Sector Lending Schemes

21. Priority sector lending emerged in India in the latter part of the sixties as part of an effort to direct credit to rural areas where the presence of commercial banks was not significant. Initially, one third of outstanding bank credit was to be directed to the priority sector, but over the years, this target was raised to 40 percent; several sub-targets, mainly for agriculture, village artisans and small and cottage industries were added, and the scope of priority sector was expanded in 1980 with the advent of the Integrated Rural Development Program (IRDP), as a nationwide program of poverty alleviation and promotion of self-employment among the poor. As of end March 1993, almost all public sector commercial banks fell short of meeting the 40 percent target by three to six percentage points.

22. In addition to the priority-sector requirements per se, over the past twelve months banks have been required to provide at least ten percent of their total lending in the form of export credit, mainly pre- and post-shipment finance. This credit is provided at interest rates about 3 percentage points below the minimum lending rate (which still leaves India's exporters at a disadvantage against most foreign competitors). Because export credit is eligible for RBI refinancing at a concessional rate, it is still profitable for banks. The authorities have been making it easier for exporters to obtain export credit from foreign sources, but relatively few Indian firms are now in a position to do so.

23. With considerable progress already achieved in reducing concessionality through narrowing of interest rate differentials between priority sector borrowers and others, the Government's reform strategy in the interim is intended to enhance banks' discretion in selecting the more creditworthy borrowers within the priority sector, and enforcement with full force of the new prudential norms to priority sector lending. In that respect, the next key measures to be taken are: (i) the existing sub-targets under the overall priority target would have been lifted; (ii) an alternative formula would be established whereby loanable funds released as a result of reduction

Q in the SLR and CRR would not be subject to the 40 percent priority sector lending; and (iii)

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priority sector loans would be subject to strict prudential guidelines applying to other loans. This new emphasis on sound lending in the priority sector is succinctly articulated in the Government's Discussion Paper, "All bank lending, including loans to the priority sector, must conform to basic requirements of good banking. A major task ahead is to. ensure that our banking system has an adequate incentive to meet legitimate credit needs of agriculture and other priority sector borrowers even in the absence of any compulsion in this regard." It is thus recognized that, from a longer-term perspective reforming the priority sector lending schemes would require a two-fold strategy: (i) devising a more cost-effective mechanism of credit delivery including informal self-help groups to reach the weaker sectors of society, particularly in the rural areas, and (ii) reforming the agricultural credit system. With a view to developing a workable approach to meet the credit needs of rural India, in particular women, on a financially sustainable basis, a study commissioned by several bilateral aid 'donors to India is underway to review the existing informal financial institutions in India. The study is expected to be completed by June 1994.

C. Competition and Promoting Private Sector Participation

24. Reinvigorating competition among banks constitutes a key instrument of Government policy of raising efficiency and improving bank performance. Competition is to increase through entry of new private sector banks, broadening of ownership in public sector banks, and enhancing managerial autonomy and governance in both the private sector as well as in the existing public sector banks.

1. Entry of New Private Banks

25. In January 1993, the RBI announced guidelines for entry of new commercial banks. The guidelines were intended to ensure that new entrants are well-capitalized, technically competent, technologically strong, and that there would be no adverse consequences from such factors as concentrations of credit or cross-holding with industrial groups. The RBI has so far authorized four financial and four non-financing institutions to set up banks, with some intending to set up commercial banks in collaboration with foreign interests. These new banks are expe~ted to have widely-held private sector equity ownership, and to meet the capital adequacy norms of 8 percent from their inception.

2. Broadening the Ownership Base of Public Sector Banks

26. In a major tum-around in the Government's interventionist approach to the banking industry, the authorities have recognized the need to broaden the ownership of public sector banks, including nationalized commercial banks through sale of their equity capital to private investors, both domestic and foreign. To that end considerable progress has been achieved over the past two years. Thus, the Industrial Credit and Investment Corporation of India (ICICI) is. Q a listed company with the private ownership of 48% as of September 1993, and the remaining

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owned by public sector financial institutions. The Industrial Finance Corporation of India (IFCI) I

Act 1948 has been repealed and IFCI has be~n converted into a public limited company (July · 1993). Following its conversion IFCI has :successfully made an initial public offering in December 1993 which has introduced 38% private ownership in its equity. The Industrial Development Bank of India (IDBI) Act, 1964; is being amended to enable it to raise capital in the market (see para. 41). Also, regarding the most. politically sensitive nationalized banks, private ownership up to 49 percent is being introduced as part of the process of their recapitalization and restructuring efforts. Also, it is expected that by April 1994, one new bank (Unit Trust of India Ltd.) would commence business with a fully computerized and automated system. Approval has also been given to three new foreign banks to set up operation in India, and existing foreign banks have been allowed to expand their networks branch. In addition,) )j} foreign banks have been recently allowed to have equity participation up to 20%, in the equity of new private banks.

3. Enhancing Autonomy

27. Encouraging private sector participation in the Indian banking industry also requires important legislative changes to strengthen managerial and operational autonomy. Private banks in India are presently governed by the provisions of the Companies Act, 1955, under which they are incorporated, and the Banking Regulation Act, 1949 (BR Act). The Acts confer broad discretionary power on the central government and the RBI to regulate these banks beyond the normal requirements of regulatory oversight, and requires ex-ante approvals for a variety of transactions, management changes, board proceedings, appointment of directors and · remuneration of top management. It is recognized that, along with efforts being made to strengthen bank supervision, certain provisions of the BR Act need to be changed to grant private banks necessary flexibility and autonomy. To that end, the authorities have prepared legislative proposals to amend the Banking Regulation Act of 1949 in order to raise the ceiling of 1 percent voting rights of individual shareholders to 10 percent. This legislation has already been· submitted to Parliament, and is expected to be approved in this session of Parliament. The authorities have also indicated that they would undertake a comprehensive review of the BR Act with the intention of eliminating provisions which require ex-ante government approval under the Act and establishing clear prudential regulatory standards against which bank conduct can be judged on a ex-post basis.

28. The management of existing public-sector banks in India works under relatively tight constraints, with limited autonomy for recruitment, deployment of staff, promotion and reward. The basic legal framework governing the structure and operations of national banks is based on regulations issued ~y the Central Government pursuant to the legislation that nationalized them: the Nationalized Banks (Management and Miscellaneous Provisions) Scheme, 1970; and the Nationalized Banks (Management and Miscellaneous Provisions) Scheme, 1980 ("schemes"). These schemes regulate the management and operation of these banks including the structure of the board of directors. The State Bank of India is governed by the State Bank of India Act,

0

0

0

' - 12 -

1955, as well as by designated provisions of thb Banking Regulations Acts, 1949 (BRAct). All recruitment to the nationalized banks goes through the 16 Banking Commission Regional Boards, which serve the system as a whole with little selectivity and autonomy given to each bank. Bank staffs are highly unionized and often have significant political affiliations.

29. The authorities recognize that fundamental changes in management autonomy, accountability, internal control recruitment, and staff promotional procedures and appointment of board members are essential to ensure that banks function as profitable enterprises and compete successfully in the new liberalized environment. Important steps already taken include reconstitution of Boards of Directors to give them more professional orientation, establishment of guidelines for increased private shareholder representation on boards in proportion to their increased equity ownership in banks, and the decision to stop nominating RBI staff members to the boards. Furthermore, in an attempt to enhance managerial autonomy in areas of recruitment, training and automation, the authorities are undertaking a comprehensive review of all policies and procedures related to these issues.

D. Restoring Health to Banking Institutions

30. While the health of India's public sector commercial banks has deteriorated over time, such deterioration had until recently, been masked by lax regulatory and accounting norms. The previous asset classification norms under which loans were classified into eight health codes ranging from 1 (best) to 8 (worst) involved a considerable degree of subjectivity and suffered from two major shortcomings: (i) income was recognized on an accrual basis rather than on actu~l recovery of cash; and (ii) the provisioning norms did not require banks to make sufficient provision for non-performing loans. To address such shortcomings and to bring India's bank regulatory framework closer to international standards, RBI issued new guidelines in April1992 for income recognition, asset classification, and provisioning requirements, and ,adopted the Bash! Accord capital adequacy standards. Banks are now required to classify assets into four categ'ories, standard, substandard, doubtful and loss, to cease accruing interest income on non­performing ,loans and to make prudential provisions against probable future losses. As a transitional measure, banks have been allowed to distribute their required provisions for the 1992/93 over two financial years. At least 30 percent of provisions on substandard and doubtful assets as well as full provision for losses (per guidelines of March 1993) must actually be taken in that year's accounts; and the remainder deferred to March 1994 accounts.

31. In moving towards conformity with international regulatory standards, loan classification and income accrual norms will become tougher in the next two years. Under present guidelines, a loan may be overdue for as long as three quarters as of March 1994, and two quarters as of March 1995, until it is classified as substandard and then it could remain in this category for as much as two years, even if no payment were received. Banks must now provide 10 percent against sub-standard loans and between 20 and 50 percent against the unsecured portions of doubtful loans. These standards imply anticipated recovery of 90 percent of substandard and 50-

0

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-13 -

80 percent of unsecured doubtful balances, which is optimistic in the light of il)temational experience. Moreover, for practical and cost considerations, loans below Rs. 25,000 (US$800) are hot classified and are only subject to a flat provision of 2.5 percent. That is clearly an unrealistically low estimate. Also there is no general reserve provision applied across the board for satisfactory loans, those classified standard. In an effort to strengthen the existing norms, on February 4, 1994 the RBI issued guidelines requiring all commercial banks in India, as of accounting year 1994/95, to classify loans under Rs. 25,000, and to cease taking interest income on the non-performing part of such loans into income. In view of the vast number of such small loans in banks portfolio and the virtual complexity of classifying non-performing part of such loans into sub-standard, doubtful, and loss, and making the necessary provisions, as per new regulatory norms, banks have been allowed to make provisions of 5 percent of aggregate outstanding amount of small loans, irrespective of the fact that part of such loans are covered under various Government guarantees. Moreover the authorities have indicated that a general provision against standard loans would be applied in the accounting year 1994/95, and this measure is expected to be announced shortly.

1. Financial Performance of Public Sector Banks

32. As of the financial reporting year 1992/93, all banks in India have complied with the new regulatory norms and their audited financial statements have already been released. Key indicators of bank financial positions as of March 1993 are summarized in Table 1. The results indicate that, while several banks, both large and small (accounting for about 67 percent of total advances), continue to show reasonable financial strength, many are in a very weak position in terms of capital adequacy and profitability. The banks with better overall loan quality have been more aggressive in making provisions and/or maintaining stronger capital positions through past earnings retention, and have posted profits after provisions and taxes even in 1992/93. These banks could play an important role in providing stability for the system and may be able to take over smaller and weaker banks. For public sector banks as a whole, non-performing loans are estin;lated to have been about 23 .4 percent of the total loan portfolio or 11.7 percent of total bank(ing sector assets in March 1993. However these percentages are likely to increase as the loan: classification guidelines are strengthened. Also, provision requirements will increase as existing non-performing loans age and when provision requirements are extended to standard loans. It should further be noted that the predominant form of bank lending, the cash credit, frequently masks borrower difficulties and delays the recognition of loan delinquency.

33. The authorities recognize that a number of government-owned banks need to be restructured financially in order to conform to the new prudential norms. Also, institutions need to prepare for potential future losses, as the economy adjusts to the increasing external and internal competitive pressure brought about as the result of the Government's liberalization efforts. The existing poor loan quality of commercial banks in India stems from a combination of external policy requirements (such as priority sector lending), internal organizational and management shortcomings, and inadequate supervision. For a long time both bank managements

0

0

,t') (\. .

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and the regulatory authorities focused excessively on quantitative indicators, such as growth of total lending, and sectoral deployment of credit, rather than on credit quality and the capacity of borrowers to service loans. In the case of smaller borrowers the repayment discipline suffered because of politically motivated loan waivers. Accounting practices that permitted extended interest accruals on troubled loans tended to mask the extent of weakness in credit policies and to lessen management accountability. The recovery of large loans was further impeded by lack of a strong legal framework, and the cumbersome process of corporate restructuring and closure, as well as willful defaults.

34. The authorities recognize these underlying problems, and have formulated a comprehensive work-out action program to restore health and soundness to India's banking institutions in the next three years. The key ingredients of their strategy are: (i) improving the recovery of non-performing loans; (ii) capitalizing of public sector banks through public and private capital; (iii) restructuring weak banks; (iv) improving profitability of banks through greater emphasis on operating efficiency; and (v) strengthening and modernizing bank supervisiOn.

0 - 15 -

Table 1 India: Financial Performance of Public Sector Commercial Banks

(end March 1993) (figures in %)

STATE BANK GROUP

State Bank of India* State Bank of. Bikaner State Bank of Hyderabad State Bank of. Indore State Bank of Mysore State Bank of'Patiala State Bank of.saurashtra State Bank of Travancore

NATIONALIZED BANKS

GROUP A Bank of Baroda* canara Bank*

0 Corporation Bank Indian Bank* Oriental Bank,of Commerce Punjab National Bank Union Bank of. India

GROUP B ALLahabad Bank Bank of India* Dena Bank Vijaya Bank \5\

GROUP C Andhra Bank Bank of Maharashtra Central Bank New Bank of India Punjab and Sind Bank Uco Bank* United Bank of India Syndicate Bank* Indian Oversees Bank*

ALL PUBLIC BANKS

Gross Profit/ Total Assets

1.8

1.8 1.3 2.1 1.1 1.2 2.1 1.8 1.5

0.3

1.4 2.2 1.5 0.8 1.2 1.2 0.7

0.0 0.5 0.1

-2.5

-0.7 -1.1 -0.3 -2.4 -1.9 -0.9 -1.7 -1.1 -0.4

0.9

Net Profit/ Total Assets

\1\

0.2

0.2 0.3 0.3 0.2 0.1 0.4 0.2 0.2

-1.7

0.0 0.1 0.1 0.0 0.4 0.2 0.1

-1.2 -1.4 -1.8

-3.0 -4.2 -2.5 -2.7 -5.2 -3.5 -3.9 -6.9 -6.8

-1.0

Non Performing Advances/

Total Advances \2\ \3\

21.8

22.3 22.0 22.4 23.5 20.6 14.7 19.1 16.8

24.5

20.4 25.3 11.2 24.2 10.8 18.6 19.5

24.6 26.0 25.3 28.8

24.7 37.2 29.0 47.3 36.3 22.8 19.5 28.3 33.4

23.4

Actual Provision/ Non Performing

Assets

32.3

33.6 28.7 26.3 18.1 34.4 29.2 25.0 12.6

26.2

25.6 43.1 16.5 9.3

25.7 25.2 16.7

9.2 27.3 17.4

16.1 25.6 21.9 22.4 14.7 42.2 16.7 26.8 46.3

28.4

Capital/ Risk Weighted

Assets \4\

2.7

2.3 2.9 2.9 2.9 1.8 8.0 3.2 2.7

2.4

4.1 7.3 5.6 5.9 7.0 4.4 4.6

2.9 1.9 2.3

-0.2 0.1

-1.8 1.8

-0.6 -0.6 5.4

-9.6 -6.9

2.5

Capital/ Total Assets

\4\

1.7

1.4 1.7 1.9 1.9 1.2

' 4.4 2.2 1.9

1.4

2.3 4.8 2.9 3.1 3.4 2.4 2.3

1.8 1.3 1.2

-0.1 0.0

-1.0 0.8

-0.2 -0.4 2.8

-5.0 -3.1

1.5 ~------------------------------------------------------------------------------------------------------------------------

Notes: "i"\Net profit is gross profit Less provisions & contingencies. 2\ Non-performing advances consist of substandard, doubtful, Loss Loans and 20 percent of Loans under Rs 25,000. 3\ Total advances are gross of Loan Loss provisions. 4\ Capital here refers to share capital plus disclosed reserves and surpluses (i.e. Tier I capital). 5\ Staff estimates based on incomplete data. * Indicates banks with foreign branches.

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2. Improving Recovery of Non-Perform~ng Loans

35. A concerted and successful effort to c9llect on non-performing loans could diminish the cost of bank restructuring and improve' resource allocation by transferring assets to productive uses. The authorities have stepped up efforts to collect on non-performing loans by initiating concerted actions in several areas. Recognizing that the weakness in the legal framework has been a major cause of delay in recovery of bank loans, the Reserve Bank of India established a high-level task force to review legal issues relating to debt recovery and collateral security. Based on the work of this task force report of The Committee on Legal Aspects Relating to Operations of Banking and Financial System (1992), as well as previous recommendation reports such as the Tiwari Committee, Parliament passed legislation to establish special Tribunals and Appellate Tribunals (the Recovery Debts due to Banks and Financial Institution Act, 1993), to expedite recovery of dues owed to banks and financial institutions. Issuance of notifications by GOI to establish such Tribunals in the four metropolitan cities of Bombay, Calcutta, Madras and New Delhi is expected by end 1995. It is also expected that by the tribunals would be operational, and satisfactory progress would have been made in achieving specific benchmarks in the operation (appointment of members of all tribunals; appointment of required administrative staff; commencement of hearing of cases). In addition, based on recommendations of the RBI Legal Task Force specific proposals would have been finalized for streamlining the laws governing mortgages. Secondly, the authorities are aware of the fact that the debt recovery problem is concentrated in a modest number of large accounts. In fact, it is estimated that of 1. 2 million suits filed by banks and financial institutions, 3500 suits account for about 48 percent of outstanding amounts to continuously monitor progress in recovering of large loans. As a major step to improve loan recovery owed to banks, the Finance Minister stated in his Budget speech of February 28, 1994, that, the Reserve Bank will henceforth maintain a list of defaulting bank debtors, and will circulate names of defaulters in amounts "above a threshold limit" among banks and financial institutions. The Reserve Bank will also "publish" a list of defaulting borrowers in instances where suits have been filed by banks and financial institutions. Also, the Finance Minister reported that the Special Recovery Tribunals authorized by legislation approved in 1993 "will soon be operational. "

36. In reinforcing actions taken to strengthen the legal framework the authorities are urging banks to intensify their own recovery efforts. Thus, banks are indicating to their line managers that their recovery performance will henceforth take on a far heavier weight in their performance evaluation. To the extent possible, banks are asked to settle non­performing loans which are tied to sick enterprises through negotiated compromise solutions. In addition the authorities are considering establishing a limited Asset Reconstruction Fund, that could take over large non-performing consortium loans from we.aker banks. If about 50 percent of bad loans could be· recovered through such efforts, there would still be a loss of about 15 percent of bank loan portfolios (3 percent of GDP),

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which needs to be financed. A recovery rate of 30 percent (more in line with experience elsewhere) would imply a loss of about 20 'percent of loan portfolios, or about 4 percent ofGDP. '

3. Rehabilitation of Weaker Banks

37. Nine of the 20 Nationalized banks were classified by RBI as "weak" banks, the weakest group requiring the most immediate attention and the greatest need for restructuring. The smallest of these (New Bank of India) was taken over by Punjab National Bank in 1993, a bank with an established successful track record. The 8 remaining banks had total assets of Rs.693.3 billion (about$ 22.4 billion), 29.5 percent of the assets of nationalized banks as of March 31 , 1993. All of the 8 banks had operating losses (before loan loss provisions) in the 1992-93 fiscal year, averaging about 1.0 percent of assets. The 8 banks' net interest income averaged about 1.0 percent of assets, ranging between 0.5 percent and 1.9 percent of assets. In contrast, the net interest income averaged 2.8 percent of assets for the 7 "best" nationalized banks. The non-interest expense of the "weak" banks, exclusive of provisions, averaged about 3. 0 percent of assets compared with an average of 2.4 percent for the "best" banks. Non-performing loans for the weakest banks averaged 28.5 percent of advances compared with 20.7 percent for the best banks. Thus, the weakest banks had higher non-interest expenses, a higher percentage of loans that were non-performing and lower interest margins than better-performing banks.

38. Individually weak banks vary significantly in size, location, and the nature of underlying problems. Thus, the turnaround strategy would have to be tailor-made to each specific case. The authorities are considering several options including: (i) merger as a vehicle for replacing weak management and improving efficiency in the weaker banks; and (ii) dividing the weakest banks among several stronger banks or transferring a weak bank's operations in a particular area into a stronger bank1• Such options afford the opportunity to rationalize operations and reduce costs, through closure of branches, redeployment of staff and consolidation. Potential benefits would supplement efficiency expected from attrition and absorbing excess staffing through growth. In formulating such options, the authorities have, through the Indian Banking Association, established a constructive dialogue with the three powerful bank employee unions, to seek their consent and support.

1Elsewhere, troubled or failing banks frequently have a franchise value associated with part of their operation, usually their deposit base. As a result, a strong existing bank or a newly-chartered bank may be willing to pay a positive price, sometimes by absorbing existing losses, for that deposit franchise. However, the deposit base of the weakest banks in India may not have a positive value if the acquirer has to keep excess branches open and to provide employment for all existing staff. As efficiency in Indian banks improves, as excess bank employment become less of a problem and as computerization increases, mergers and branch sales are apt to become more feasible options for troubled banks and bank regulators dealing with them.

0

0

(J

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Increasing public pressure is brought on unions to adopt a more accommodating approach to the needed reform of the banking sector. RBI has already entered into specific agreements with weak banks that are aimed 'at curbing their expenses and improving their operating efficiency. These banks have been asked: to rationalize their organizational structure by reducing unnecessary layers of management; to cease acquiring buildings or incurring new capital expenditures; to cease recruiting new personnel except for specialists in computerization and other key areas; and, apart from certain existing commitments, to cease opening new offices. Furthermore, eights banks have been asked to close or merge 145 branches by March 31, 1994.

39. The authorities have stated that plans for the rehabilitation/merger of one more weak bank (UCO bank) is at an advance stage of preparation. UCO Bank's operating earnings deteriorated significantly during the first half of the 1993-94 fiscal year, and were at an annualized level about- 1.25 percent of assets. UCO is a medium size bank with assets of Rs. 124.9 billion as of March 1993, has 1,791 branches, including 7 foreign branches and a staff of approximately 35,500. Approximately 26 percent of UCO Bank's deposits are in foreign branches and approximately 37 percent of its advances are· to foreign borrowers.

4. Recapitalization

40. The Government of India is committed to bolster the capital position of public sector commercial banks to meet the Basle Accord capital adequacy standards by March 1996, and for banks with overseas branches by March 1995. The Government's capitalization plan combines a system wide infusion of GOI bonds, a case-by-case work-out plan of asset consolidation, enhancing profitability, and permitting the stronger banks to niise private equity from the market. The Government has allocated a total of Rs. 57 billion, as appropriated in the 1993/94 Union Budget, to increase its equity holdings in the nineteen m1tionalized banks for which GOI is presently the sole shareholder. As a condition for release of the funds, the Government reached agreement with the top managements of the nationalized banks on performance criteria for coming years. These have been in~orporated in signed memoranda of understanding (MOUs). The banks are required to use the proceeds to purchase transferable 12-year treasury bonds yielding 10 percent annual interest. The proposed budget for 1994/95 would provide an additional Rs.56 billion in assistance for nationalized banks, which, like the assistance provided in 1993/94, would come in the form of Government bonds. The timing of this assistance and how it would be' allocated has not yet been indicated. After this assistance the estimated capital shortfall for nationalized banks with overseas branches for March 1995 would be Rs.23. 7 billion (see Table 2), which is expected to be met through stronger banks' tapping of the capital market and revolution of assets (see para. 39). However, it should be noted that capital requirements for nationalized banks that do not have overseas branches will be raised appreciably in March 1996 when these banks will be subject to the fullS percent risk-based

\

0

0

(:)

- i19 -

capital requirement. It should be further noted that the projections in Table 2 were made without the benefit of 1993/94 bank operating results which are not yet available. The budgetary costs of servicing such a capitalization plan are estimated to be on the. order of 0.13 percent of GDP for 1993/94, which is notable given the very serious fiscal situation currently facing the authorities.

41. The full burden of bank capitalization will not be borne by the budget. Government capital assistance will be supplemented by efforts on the part of stronger banks to tap the capital markets. Prepared proposed amendments to the Banking Regulation Act, 1949, and l

the Banking Companies (Acquisition) Act, 1970 and 1980, would allow nationalized commercial banks to raise private equity up to 49 percent of their equity capital. This proposal has already been approved by the Cabinet (September 1993) and is expected to be approved by Parliament in the Budget session. In addition, amendments to the SBI Act and SBI General Regulations Act to facilitate public issue of shares by SBI, have been I enacted through a Presidential Ordinance (October 14, 1993) and SBI has already raised fresh capital through a rights-cum-public issue of equity and debt (January 1, 1994). After the public issue of Rs.22 billion (US$ 704 million) of common stocks, the share of the RBI in SBI's equity has been reduced from 98.2 percent to 68 percent, and is expected eventually to decline to 55 percent. In the process, SBI's investor base has been considerably broadened to about 2.3 million individual shareholders. Furthermore several nationalized banks, including Bank of Baroda, Oriental Bank of Commerce, and Punjab National Bank are expected to tap the capital market this year. Subject to favorable capital market conditions, at least two of these banks are expected to raise private equity capital up to 49% of their share capital with corresponding representation of private shareholders on their boards by that time. Also, some banks have indicated that they will be able to boost their real net worth by taking advantage of appreciation in urban real estate. This would not be done by merely revaluing premises, but by actually selling or sub-leasing premises and moving to less costly facilities. Such actions would lessen the need for GOI capital assistance.

Table 2 India: Projected Capital Adequacy Position of Public Sector Commercial Banks, March 1995

(Rs billion)

SBI Group All with Foreign

Branches \1\

Nationalized Banks All with Foreign

Branches

All Public Banks All with Foreign

Branches

Total Assets \2\ Risk-Weighted Assets

Capital Required to meet stipulated Capital Adequacy Standards \3\

Capital Available (a+ b + c +d) (a) Unimpaired Capital as of March 1993 (b) Net profit in 1993/94 and 1994/95 \4\ (c) Capital provided by Government in 1993/94 (d) Capital raised from the market in 1993/94

Shortfall in Capital \5\

1680.1 1117.5

81.0

51.9 20.6 -1.0 0.0

32.3

31.8

1358.1 906.8

72.5

43.9 14.9 -3.2 0.0

32.3

28.6

2907.8 1641.1

103.7

85.3 28.2

-55.9 113.0

0.0

25.2

1\ The State Bank of India is the only bank of the SBI group to have overseas branches, 2\ Net of provisions for advances, 3\ 8% of risk-weighted assets for banks with overseas branches and 4% for others, 4\ Operating profit less provision for non-performing assets and less taxes and dividends,

1598.7 951.7

76.1

55.3 14.9

-17.1 57.5 0.0

23.7

4587.9 2758.6

184.7

137.2 48.8

-56.9 113.0 32.3

57.0

2956.8 1858.5

148.7

99.2 29.8

-20.3 57.5 32.3

52.3

5\ Projected capital shortfalls, include government's capital infusion of January 1994 and the SBI's public offering-cum-rights issue of January 1994, and including the proposed 1994/95 budgetary appropriation. The capital shortfall exceeds the difference between required and available capital because some banks are projected to have capital in excess of their required capital.

. --..

/ '---"

5. Improving Profitability

42. International experience indicates that the process of cleaning up bank balance sheets and their restoration to health has proved more successful and enduring, when it combines budgetary support from the government to fill any net-worth deficiency, with banks' own efforts to improve profitability through increasing operational efficiency. It is indeed on the strength of profitability that a bank can build up its capital commensurate with its asset expansion, pay taxes, and pay dividends to its present and prospective investors. Analysis of bank profitability in India demonstrates clearly the significance of the burdens imposed by specific factors, including the quality of loan portfolios, operating efficiency and management quality, as well as the overall regulatory and policy environment including reserve requirements. To improve earnings sufficiently so banks can provide most of their future capital needs, loan quality will have to be dramatically improved. The percentage of future loans that become non-performing will have to decline to less than five percent, and that will require important behavioral changes by bank management and by supervisors. With respect to operating efficiency, future expense control, better use of personnel, and strengthening internal control through computerization and automation will be important. The recent accord between Indian Banking Association and bank employee uilions has removed a long standing barrier against computerization in the banking industry in India . Each bank is now required to draw up a time-bound program of computerization with the

,•,

C)

(~

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aim of timely computerization of 500 branches in the identified metropolitan urban centers over the next year or two.

6. Strengthening and Modernizing Bank Supervision

43. Strong supervision is essen~ial when entry is liberalized and when interest rates and credit norms are being deregulated and where past credit experience has been so bad. In the past few years, several government appointed committees have recognized the weakness in the prevailing bank supervision process in India, and have formulated proposals for change, including establishment of an autonomous board of supervision and modernization of inspection methods.

44. The authorities have indicated that they plan to establish a functionally autonomous Board for Financial Supervision (BFS) within the RBI that will concentrate exclusively on supervisory issues and will ensure compliance with regulations and guidelines in the areas of credit management, asset classification, income recognition, capital adequacy, provisioning and treasury operations. The Board will have supervisory authority over banks and non-bank financial intermediaries. Its task will be formidable in view of the shortcomings in past bank and supervisory behavior and the need to effect change quickly. It will be important to assess the condition and performance of banks in a timely manner arid this requires more frequent and timely reporting by banks and a system whereby the accuracy of reports can be determined. Because of the large number of banking offices and limited existing computerization, more effective use of sampling is necessary. In addition, there will be significant opportunities to improve the use of supervisory resources by working more closely with auditing firms in developing standards for loan reviews, assessing provisioning policies and other matters.

45. BFS will need to review bank written policies and actual performance with respect to lending activities, internal controls, asset-liability management and other key areas of bank operations. The emphasis will be more on well-developed strategies and performance rather than the detailed rules that have characterized the past RBI-bank relationships. This requires some cultural change on the part of bank supervision that would parallel the cultural change contemplated for bankers in a more market-oriented economy. However, where bank performance falls short and banks fail to meet capital and asset quality standards in the future, the BFS is expected to pursue timely corrective action. Such action could include the imposition of financial penalties, removal of managerial and other personnel, and recommendations for closing. or merging troubled banks.

46. In addition to current supervision, BFS will develop an ongoing program for analyzing bank performance and profitability, where interest margins, expense ratios, loan losses and other performance variables are: compared. Studies of such matters as the prOfitability of different bank functions arid of the costs and benefits of regulations

.. ,

0 - 22-

pertaining to banks would broaden the perspective of bank supervision and prove to be useful for banks as well as the BFS. The a6tivities of the Board will also benefit from an Advisory Committee consisting of eminent persons drawn from different areas of public life with experience and knowledge of the financial system. However, key to the effectiveness of the BFS will be its ability to upgrade the technical knowledge and competence of inspectors and other supervisory personnel. i The r.nodalities for operation and staffing of the Board are at an advanced stage of preparation.

E. Initiating Reform of Rural Credit System

47. India's rural financial system comprises 28 state-level cooperative banks (with loan outstandings totalling about Rs. 135 billion); several state land development banks; some 26,000 rural commercial bank branches (with loan outstandings totalling about Rs. 200 billion); and 196 "regional rural banks" (RRBs), which are jointly owned by the Central Government, State Governments and sponsoring commercial banks, comprising 15,000 branches (with loan outstandings totalling about Rs. 20 billion). In addition, the National Bank for Rural Development (NABARD) provides term loans for agricultural projects, funding itself in tum from a combination of foreign credit and bonds (which are eligible for SLR). Credit growth in these institutions taken together has stagnated in real terms since 1980, and the rural credit system as a whole faces a number of institutional and policy problems. The authorities recognize that many of the existing problems are attributable to goyernmental interventions and the inherent misalignment of incentives, both on the part of the borrower and the lender. Servicing loans to a large number of borrowers and mobilizing resources through small deposits are inherently expensive, and this has placed a heavy burden on profitability. In addition, deep-seated operational problems have developed since the early 1980s. The performance of the RRBs has been particularly poor. The service area approach which restricted the lending operation of the RRBs implied considerable loan concentration and low loan recovery. About 75 percent of RRBs have suffered losses and 117 out of a total of 196 have accumulated losses in excess of their share capital. Also, in the cooperative system failure to mobilize adequate deposits, mounting overdues and lack of trained staff have implied that cooperative banks have low borrowing membership, low business turnover and large accumulation of losses.

48. There exists a fair degree of consensus in India as well as in the Bank, that efforts to reform India's complex rural credit system has to be seen as an integral part of broader financial sector reforms, and needs to be approached from three inter-related areas: (i) moving toward a more market driven and incentive system of promoting credit delivery to the agriculture and rural areas; (ii) restructuring the whole Regional Rural Banks; and (iii) improving the capabilities of cooperative banks to function as sound financial intermediaries. Drawing on the recommendation of several Government-established committees (the latest being the Agricultural Credit Review Committee (Khusro Committee) in 1989), the authorities are developing a broad reform program.

,•,

0

(:J

-;23-

49. Several important measures have already been taken. The scope for discretionary lending by RRBs has been expanded through reduction in their directed lending targets from 100 percent in 1992 to 40 percent at present; greater freedom to rationalize their branch network and those with disbursals below Rs.20 million in 1992/93 have been freed from the restrictive service area approach which had previously limited the area of their operation. Regarding commercial banks, an important step to induce them to expand their rural credit supply, they are now allowed to deduct five percent of their rural advances against their taxable income. In his 1994/95 Budget presentation, the Finance Minister announced measures to strengthen institutions providing rural credit. NABARD is to receiveRs. 1 billion each from the Government and RBI, thus tripling its share capital and permitting it to enlarge the scope of its activities. In addition, measures were announced to rehabilitate the RRBs: 50 RRBs will be selected for "comprehensive restructuring, including cleaning up their balance sheets and infusion of fresh capital. " The precise means will be determined on a case-by-case basis, in consultation with their sponsor commercial banks and state governments. The experience acquired will be used in later years to rehabilitate the remaining RRBs. NABARD will enter into memoranda of understanding with State governments and State and District Cooperative Banks to implement action plans necessary to revamp the cooperative system; further details are to be worked out later.

IV. CAPITAL MARKET ISSUES .

50. In recent past, India's capital market attracted significant non debt financial resources from foreign investors, particularly institutional investors, such as mutual funds, pension funds, and insurance companies seeking international asset diversification. With the withdrawal or substantial modification of restrictions on foreign investment in the past few months, the inflow of funds show sharp escalation. Some foreign institutional investors, also demonstrated phenomenal success in raising funds from the Indian market on the basis of their international reputation. In the Budget Speech of February 28, 1994, The Finance Minister reiterated the commitment of the Government to create an efficient and competitive capital market.

51. In the past two years the authorities have taken several important measures to reform the capital market. Private sector and joint sector mutual funds have been permitted to enter the market. Companies with good past performance have been authorized to issue convertible debentures or equity abroad. The Capital Issues (Control) Act has been repealed and thereby the Government's control over the issuance and pricing of capital by corporations via the Controller of Capital Issues has been removed. Statutory power has been given to the Securities Exchange Board. of India (SEBI) to regulate the functioning of securities markets, securities industry intermediaries and to oversee corporate acquisitions and takeovers. The Government has directed the Stock Holding Corporation of India Limited to establish a National Clearing and Settlement System and a Central Depository

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Trust for Securities. Also, in an effort to enhance investor protection, SEBI has issued detailed guidelines governing the various ~tages of public issue of capital, and also underwriting obligations. SEBI has also made several important changes, including registration of secondary market intermediaries, establishment of a customer protection fund· and Investor's Grievances Cell in each Stock Exchange, broadbasing the governing bodies of the stock exchanges, increasing the number of members- of stock exchanges, and electronically linking all stock exchanges in the country.

52. In insurance, The Malhotra Committee, appointed by the Government of India submitted its report early this year. While the recommendations have been appreciated by industry and trade, employees organizations of the public sector feel threatened. Briefly, the reforms cover conditions for entry of private sector firms and the uniform treatment of all players by doing away with special dispensation for public sector firms; the structure of mandated investments and tariffs to ensure greater efficiency in operations; the establishment of suitable regulatory apparatus for insurance business to ensure the protection of consumer interests, and compliance with norms; and lastly the restructuring of the two public sector giants in life insurance and general insurance, namely, The Life Insurance Corporation (LIC) and the General Insurance Corporation (GIC); to reduce Government's equity holding through phased disinvestment and expand capital base through issue of bonus shares out of reserves.

V. BENEFITS AND RISKS

53. The reform measures described above are expected, over the next three years, to restore health to most public sector commercial banks in distress, increase considerably private sector participation in the banking industry, and revitalize competition as an effective instrument of enhancing efficiency and performance. Such improvements would go a long way towards increasing allocative efficiency, improving macro economic management, facilitating industrial modernization, and meeting the massive infrastructural investment requirements of India in the 1990s. Success in achieving such objectives is ensured however, only if, the authorities remove the remaining administrative restrictions on interest rates, improve significantly the governance of public sector banks through broadening of their ownership, and upholding the integrity of bank accounting and prudential norms related to income recognition, asset classification, provisioning and capital adequacy requirements, on a timely schedule as described above.

54. The main risks against timely implementation of these actions relate to: (i) the pace and rigor of fiscal adjustment; (ii) political pressure by bank employee unions and other interest groups, notably, the farming cqmmunity; and (iii) the inability of banks to restore profitability sufficiently to be able to go to the capital market. Inadequate progress Q in reducing the fiscal deficit poses considerable risk as it is likely to put upward pressure

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on interest rates and compel the authorities to pursue a contractionary monetary policy in order to control inflation. A tight stance of monetary policy would impede the industrial recovery underway, would cause further deterioration in banks' loan portfolios, and would put political pressure on the authorities to slow down the pace of financial reforms. Such pressures could be reinforced by resistance of bank employee unions to the process of computerization, restructuring of weak banks and closure of unprofitable branches, which are essential to restore profitability and increase efficiency. The authorities' success, so far, in gaining the co-operation and consent of unions has been due to their policy of avoiding labor retrenchment even in the case of bank mergers. But lack of sufficient progress to reduce work force, and operating expenses would erode banks' profit margins, thereby lowering chances of going to the capital market. Restoring profitability is, however, crucial for banks to demonstrate their ability to pay dividends and to build up their capital through retained earnings. In India's competitive and sophisticated capital market environment a bank has to demonstrate a capability of paying steady dividend at a reasonably high rate to be able to attract and sustain investors interest in its equity share. Even in a favorable macro environment, it would essential to evolve a pragmatic strategy to deal with all the most troubled banks. Major changes in lending practices and managerial efficiency would have to be implemented very quickly for such success to be possible.

RSTATUS/03-09-94