Changes In The Indian Banking Sector Pre And Post Reform Period Financial Essay

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Pre-reform Banking System:

The banking system was entirely in control of government and it catered to the needs of planned economy. The programme focussed on financial inclusion and rural focus. The requirement of huge expenditure for development was met by government through automatic monetization of fiscal deficit. And the interest rates were administered which resulted in cross subsidization.


Interest rate deregulation and reduction of public sector role were the main focus of the reforms. Huge capital infusion by government and promotion of consolidation and good governance were the targeted goals. But the privatization of public sector banks was not large scale.

Post reform Banking System:

There was a marked improvement in the capital position and asset quality of the commercial banks. Decline in operating cost followed by improvement in profitability of the banks lead to fall in income ratio. Modernisation of the banks was achieved to a certain extent.

Current Banking Scenario in India:

In Indian bank dominated and highly diversified financial system there has been a proactive approach to prudential regulations. RBI minimum capital requirement (9%) is more than Basel standards (8%). Indian banking sector has about US $ 35 billion of banking assets and the growth rate is about 15% per annum. Although bank assets/ GDP ratio is low (47.55%) as compared to other countries but it has survived well during the economic crises due to tight regulation because of 80% government holding of the assets.

Needs for Basel norms:

Need for Basel I arouse for the purpose of preventing bank crises and failures ex: Mexico crises (1982, 1984, and 1985), Latin American crises (1980's) through better risk sensitivity and management.

But as the world banking industry underwent major transformation and the increased use of complex and risky instruments like derivates in secondary market happened, the requirement for more risk sensitivity increased.

Basel Norms

Basel Norms I

Accord was completed in 1988 and became effective in end of 1992. It set minimum capital standards considering only credit risk which was set at 8% and was adjusted by a loans credit risk weight which was divided into 5 categories: 0%, 10%, 20%, 50% and 100%.

Basel Norms II

Focussing on internal rating and internal risk models, three pillars were developed:

Pillar 1: Minimum Capital Requirement

It was calculated on the basis of risk weighted average of three different risks viz. Credit risk, Market Risk and Operational risk.

Pillar 2: Supervisory Review

It provides framework for overall capital adequacy, minimum capital ratios and internal adequacy assessment and their implementation.

Pillar 3: Market Discipline and disclosure

It was there to promote greater stability in the financial system through timely disclosures of qualitative and quantitative information.

The status of implementation of Basel Norms

RBI being very optimistic decided the first deadline to be 31st march 2007 for the total implementation of the BASEL II norms in all the commercial banks. But due to pressure and coaxing from the commercial banks, RBI had to extend the deadline by another year for all those banks (Indian and foreign banks) which operate in India as well as abroad. For the rest all other banks the deadline was March 2009, and RBI assured that by end of March 2009 all the commercial banks will adhere to the norms of BASEL II. RBI decided to follow a phased approach for the implementation as mentioned in the BASEL II norms.

The progression hierarchy for pillar I implementation

Preparedness of the Indian Banking Sector

Evaluating the readiness through the preparedness of the Indian banks in accordance to all the three pillars of Basel norms, we find that:-

Pillar-1 preparedness -

RBI's initiatives like use of standard approach & basic indicator approach for calculation of credit risk and operational risk respectively.

Indian banks can leverage from large short term portfolio which they have as they are risk-weighted very low.

Pillar-2 preparedness -

Skill development carried out both at RBI and other banks.

Administration & enforcement of minimum capital requirement.

Validating & Upgrading Indian banks.

Pillar-3 preparedness -

Indian banking sector is lagging behind in IT infrastructure. Hence for market disclosure to be successful venture complex IT structure is required which must be defined with architecture with focus on scalability , availability, security and generation of MIS

Effect of implementation of norms

RBI used moody's ratings to risk-weight the assets

Table 1 for long term loans and table 2 for short terms loans (which comprise a substantial portion of Indians banks' lending). the loans and advances portfolios of Indian banks largely covers un-rated entities hence even if the riskiness of the higher rated corporate bonds is less but that is insignificant in Indian context. But we compare it to Basel I, Indian banks were profitable. The retail sector which was growing in India was low risk weighted; hence it was a profitable venture for the banks to invest in retail sector. As the table -2 shows short term bonds (A1+/A1) have low risk weights which Indian banks have in plenty hence banks had to maintain a low capital for those lending and could loan out more.

Dealing with the bad debt

The proportions of NPAs have declined (NPA- non performing asset) after the implementation.

Three steps followed by government:

Banks set aside potential profits as provisions for bad assets

Infusion of capital by the government into PSBs.

To retrieve as much of these assets as possible from defaulting clients.

In India the first two ways are predominant i.e. putting good money to compensate for the bad money. Hence to reduce the NPA further more infusion of capital is required, which the government alone can't fulfill. The banks (PSBs, private) want RBI to let them increase their equity by floating more number of shares. But this would lead to serious implications as the control of the government of the banks would reduce and the foreign banks would have a greater control. Dilution of the control will not help either the government or RBI to meet their objectives which were always in benefit of the common man.

The implications of the norms for Indian banking industry- The Monetary Policy

One of the major concerns about Basel norms implication is effect on the monetary policy. Let's suppose if contractionary monetary policy is implemented and no. of unconstrained bank is high then these banks can flow money in the market and purpose of policy will be vanished. Similarly in purpose of expansionary monetary policy will not be achieved if no. of constrained bank is high [binding on regulatory capital can lead banks to reduce money flow in the market]

To mitigate these unwanted results RBI should make a balance between constrained and unconstrained banks. RBI can put Limitation or norms on banks for lending.

11 Implication of Basel norms for India's financial inclusion agenda:Particularly, financial sector reform in 90s didn't consider credit structure for rural areas. So, farm communities, rural artisans and micro enterprises remained non-benefited by financial sector reform.

Basel Norm will control regulatory capital by high risk coverage standards. Three pillars of Basel II will ensure a huge capital fund against the risks which banks are taking; also these institutions will become sensitive to market perception. But execution of these norms can be affected by bank management's reluctance for informal sectors and small borrowers. Serious opportunities costs lying in this norm, as Banks will need to divert funds from industrial sectors to previously excluded rural sector {MSE}

Basel norms are expected to improve conditions for credit flow for agriculture and for SMEs by system of Easy deposit accounts and voluntary general credit cards (GCC). Although lack of Branches & staff in rural areas can affect execution of Basel norms, but a focused approach with balancing norms and genuinely inclusive with well spread services can overcome these hurdles in implications.

Implications of Basel Norms: Loan growth, GDP growth, Loan Loss Provisioning

Loan Loss Provision: Bank keeps reserve to compensate risks which it bare by giving loans. These risks include substandard losses to default losses.

Change in loan loss provisions with change in economic situation reduces bank profit volatility and prevent capital by negative shock. Banks measures expected loss by default premium rate rh-rf, and tries to compensate it by keeping reserve capital. Research and study on Indian banking sector found that public sector banks had provisions as 30% of NPAs {only five have more than 50%}. So Basel Norms are being expected to bring a change in this pattern [it should be up to 50%].

SWOT analysis of Basel norms implications on Indian banking industry

Implication of Basel norms on Indian banking industry has benefits and concerns on sides. Although some of concerns can be mitigated by RBI's approach by regulations but still some factors remain questioned. We will discuss it through a SWOT analysis



Basel norms requirement on regulatory capital &RBI's proposed norms will bring an approach towards developmentof Indian economy especially for SMEs and rural areas.

Basel norms will improve banking standards &intellectual capitalof banks.

Currently Indian banking sector is affected by poor technology, infrastructure.

Risk management practicesare not up to standard in Banking

No. of small banksin India is very high, &Basel norms implications can impact their progress



Effective risk management procedures and use of advanced technologycan bring positive outcome of Basel norms

Indian banking industry is benefited by strong asset base

Basel norms implication will lead to bring it in to economic growth

High regulatory capital requirement can lead banks to fight with managing capital to growth of the industry ( due to high no. of small banks)

High Opportunity costs [lending money to SMEs]

RBI's stand on the Basal Accord

RBI wanted focus of the Capital Accord be primarily on internationally active banks to ensure competitive equality and reasonable degree of consistency in application.

Cross holding of capital - RBI approved of cross holdings of equity and regulatory investments to a upper cap of 10% of total capital to preserve integrity of financial system and to minimise adverse effect of system risk.

Claims on Sovereign - Only those External Credit Agencies should be eligible for assigning preferential risk, as then their rating process and risk scores are disclosed.

Claim on Banks - There was a demand from RBI to separate the risk weightings of the banks from the credit ratings of the sovereigns.

Claim on Corporate Standardised Approach - RBI's view is that claims on banks denominated and funds in domestic currency to be assigned lower risk weights.

Since there is operational risk due to increasing globalisation, use of technology and growing complexity of operations, an explicit capital charge for the same is to be applied. To comply with the third pillar, RBI proposes frequent disclosure on information which enables market participants to take informed decisions. But even this should be done only after proper demarcation between core and supplementary disclosures. The three year transitional agreement is not sufficient for all banks.

Status of banks from other nations in meeting Basal norms

Overall response has been 70%. European Union has already implemented the accord and many banks have reported ratios according to norms. About 112 countries so far have ratified Basel norms [connected to BAN]. 95 nations have indicated to adapt standardized approach. Around 90 countries are planning to implement pillar 2 & pillar 3 by 2015. Economic crisis has delayed timetable of Basel II implementation in some countries (from Asia, Africa, Europe, and America & Middle East).

Major Criticisms against Basal Norms

Basal norms generally favour large banks and that of developed countries since they have huge investments in IT which helps them comply with all the pillars of Basal norm. Even in Basel II norms all the three risks were addressed, still it couldn't save the banks all over from the economic recession. Also it did not account for the complex financial instruments like forward cover, derivatives etc.

Our Stand

Our nation should strive to maintain strong and vibrant financial system keeping in mind the developmental priorities. This can be done by bringing a right tradeoff between regulatory issues and developmental priorities. Developmental priorities have been more towards infrastructure development and credit flow to SME and agriculture as compared to the regulatory issues that comprise of market discipline, corporate governance success, and application of proper accounting standards. Our approach should be to gradually converge with the international standards with suitable country specific standards.

All these above factors will be fruitful when these regulations are changed according to the need of the nation. Therefore, there is a strong need that the policymakers of the developing countries try to renegotiate the interests of the developing countries in these international forums.