Volckers RuleDEFINITION OF 'VOLCKER RULE'A federal regulation that prohibits banks from conducting certain investment activities with their own accounts, and limits their ownership of and relationship with hedge funds and private equity funds, also called covered funds. The Volcker Rules purpose is to prevent banks from making certain types of speculative investments that contributed to the 2008 financial crisis.Named after former Federal Reserve Chairman PaulVolcker, theVolckerRule disallows short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for banks own accounts under the premise that these activities do not benefit banks customers. In other words, banks cannot use their own funds to make these types of investments to increase their profits.Five federal agenciesthe Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission and the Securities and Exchange Commissionapproved the final regulations that make up the Volcker Rule in December 2013. The rules, formally known as section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, went into effect April 1, 2014, with banks' full compliance required by July 21, 2015.The rule allows banks to continue market making, underwriting, hedging, trading of government securities, insurance company activities, offering hedge funds and private equity funds, and acting as agents, brokers or custodians. Banks may continue to offer these services to their customers and generate profits from providing these services. However, banks cannot engage in these activities if doing so would create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within the bank or within the overall U.S. financial system.Depending on their size, banks must meet varying levels of reporting requirements to disclose details of their covered trading activities to the government. Larger institutions must implement a program to ensure compliance with the new rules, and their programs will be subject to independent testing and analysis. Smaller institutions are subject to lesser compliance and reporting requirements.UNION BUDGET 2015 - Banking Sector

McKinsey Report : Digital Banking Technology

Credit Market (Extension of Credit)

High credit Deposit RatioWHAT IS CREDIT-DEPOSIT RATIO?It is the ratio of how much a bank lends out of the deposits it has mobilised. It indicates how much of a bank's core funds are being used for lending, the main banking activity. A higher ratio indicates more reliance on deposits for lending and vice-versa .IS THERE AN IDEAL LEVEL FOR THIS RATIO?The regulator does not stipulate a minimum or maximum level for the ratio. But, a very low ratio indicates banksare not making full use of their resources. And if the ratio is above a certain level, it indicates a pressure on resources.WHY IS IT CONSIDERED A KEY PARAMETER?The ratio gives the first indication of the health of a bank. A very high ratio is considered alarming because, in addition to indicating pressure on resources, it may also hint at capital adequacy issues, forcing banks to raise more capital. Moreover, the balance sheet would also be unhealthy with asset-liability mismatches.The implication of the high credit-deposit ratio would mean banks would find it difficult to deposit rates. RBI would find it even more difficult to cut key lending rates. A cut in benchmark interest rates could further increase demand for money and reduce growth in deposits.But such a situation is considered extreme as there are not many known instances of banks overstreching themselves. But, the Reserve Bank has voiced concerns over the current ratio of banks as it could have financial stability implication at the systemic level.WHAT IS THE CURRENT SCENARIO?Public sector bankstogether accounted for 73.3 per cent share in aggregate deposits and 71.2 percent share in gross bank credit, followed by private sector banks at 19.2 percent in aggregate deposits and 21 per cent in gross bank credit at end-December 2014.Metropolitanbranches, constituting 53.1 per cent of aggregate deposits and 64.2 percent of gross bank credit, recorded the highest credit-deposit (CD) ratio at 92.3 per cent, it said.For other population groups, CD ratio was lower than the national level of 76.4 percent.The CD ratio was the highest for Tamil Nadu (121.1 per cent) followed by Chandigarh (114.9 per cent), Andhra (109.3 per cent) and Telangana (106.4 per cent).Credit Scoring ModelsThe theory behind credit risk scoring software is that the existence of certain risk factors, or combinations of risk factors, will result in a greater likelihood of serious payment delinquency or payment default. The stated advantages Faster decisions. More consistent decisions. Better decisions resulting in increased sales and profits. Increased productivity in the credit department. The ability to identify customers that can be offered higher credit limits at relatively low risk to the company. Flexibility built into the model so that the credit manager can alter certain parameters and increase or decrease the amount of credit risk the scoring model will consider acceptable, or unacceptable.Much has been said and written about the advantages and benefits of credit scoring applied to commercial credit risks, but little has been written about the limitations of credit scoring models. Here are a few comments about the problems, limitations and disadvantages of credit scoring models: A properly designed credit scoring system allows creditors to evaluate thousands of applications consistently, impartially and quickly. If this is true, then the opposite must also be true. A poorly designed credit scoring system can evaluate thousands of applicants and can make the wrong recommendation every time. Credit risk can never be measured precisely, and any model that says it can is wrong. Credit risk can change almost overnight. Example: The owner of a business dies and there is no one qualified to replace him. Credit managers should be able to override the credit score and its credit recommendation. However, doing so is difficult to justify if there is a serious payment problem, or worse a bad debt loss. For this reason, credit professionals are reticent to override the scoring model even when they believe the "recommendation" is wrong. Internally developed credit scoring models often lack sophistication and usually have not been subjected to critical analysis of the statistical significance of the factors used to develop a credit score and a credit recommendation...but Professionally designed, tested and validated credit scoring models can be expensive, and can be hard to customize. As a result, the credit scores these programs generate may not mimic the decision making style and the risk tolerance of the companies that purchase them - and therefore they do not produce the desired results. Some professionally designed models only provide the credit manager with a numerical score. With this limited information, it can be quite difficult for the credit manager to explain a negative credit decision [based only on a numerical score] to an irate credit applicant, or to an active customer.

Kyl

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er

J U LY 2 0 1 4

B u s i n e s s T e c h n o l o g y o f f i c e

Across Europe, retail banks have digitized only 20 to 40 percent of their processes; 90 percent of European banks invest less than 0.5 percent of their total spending on digital. As a result, most have relatively shallow digital offerings focused on enabling basic

customer transactions.

Neither customers nor digital upstarts are likely to wait for retail banks to catch up. Recent analysis shows that over the next five years, more than two-thirds of banking

customers in Europe are likely to be self-

directed and highly adapted to the online world. In fact, these same consumers already take great advantage of digital technologies in other industriesbooking flights and

holidays, buying books and music, and increasingly shopping for groceries and other goods via digital channels. Once a credible digital-banking proposition exists, customer

adoption will be breathtakingly fast and digital laggards will be left exposed.

We estimate that digital transformation will put upward of 30 percent of the revenues of a typical European bank in play, particularly in high-turnover products such as personal

loans and payments. We also estimate that banks can remove 20 to 25 percent of their cost base by leveraging this digital shift to transform how they process and service. Put together, the economics of a digital bank will give it a vast competitive edge over a tradi-tional incumbent. Its fair to say that getting digital banking right is a do-or-die challenge.

So why are European banks not aggressively moving in this direction? One of the reasons for the slower transformation in banking is that bank executives have tended to view digital transformation too narrowly, often as stand-alone front-end features such as mobile

apps or online product-comparison charts.

Commonly lost in the mix are the accompany-ing changes to frontline tools, internal processes, data assets, and staff capabilities

The rise of the digital bank

As European consumers move online, retail banks will have to follow.

The problem is that most banks arent ready.

Tunde Olanrewaju

2needed to stitch everything together into a coherent front-to-back proposition. Although

the journey may begin digitally on an online form or payment calculator, it does not remain so for long, as anyone who has taken on a mortgage can attest. Instead, the onerous documentation requirements and significant

manual intervention that characterize the typical banks mortgage process soon emerge. This can seem jarring to customers accus-tomed to more seamless interactions with nonbanking services.

Some banks point to security and risk con-cerns as justification for their slow approach,

but this is a contrast to other industries. The airline industry, arguably beset by even stronger risk concerns, has automated just about every aspect of its customer experience in the last ten years, boosting customer service without compromising safety. Banks can do the same. Whats more, the effort is

likely to pay for itselfand then some.

Where exactly is the value in digital banking?

Our modeling indicates that European retail banks that pursue a full digital transformation, pulling all improvement levers, can realize improvements in earnings before interest, taxes, depreciation, and amortization of more than 40 percent over the next five years.

Almost two-thirds of this potential value

comes from the impact of digital on the cost base and loss provisions rather than from revenue uplift, which is why a focus beyond front-end investments is critical.

While the cost-saving opportunity for banks

comes in many forms and touches every area

of the bank, there are two areas that are especially significant and represent the bulk of the value: automation of servicing and fulfillment processes and migration of front-end activity to digital channels. On automation, European banks can realize 40 to 90 percent cost reductions in a range of internal processes through careful deployment of work-flow tools and self-servicing capabilities for customers

and staff. On front-end transformation,

beyond diverting existing branch activity into digital channels, digital tools can also be used to augment frontline servicing (for example, with iPad forms rather than paper forms, or videoconference access to specialists to maximize their utilization)easily doubling staff productivity and en- hancing the customer experience.

The potential for revenue uplift is not quite so concentrated. Rather, European banks need to pursue a broader range of opportunities, including improved customer targeting via digital marketing and microsegmentation, more dynamic, tailored pricing and product bundling, third-party integration (for example,

with Facebook), product white-labeling,

appropriate distribution via aggregators, and, of course, establishment of distinctive mobile and online sales offerings. In the near term,

we expect shorter-tenure, high-turnover

products like credit cards, loans, and pay-ments to see the most digital transformation. In fact, these are the areas most under attack from new digital entrants. Looking further ahead, bank accounts and mortgages, which together drive more than 50 percent of many banks revenues and usually provide sticky annuity streams, will be brought into the fray. Given this development, European banks will need to carefully watch the evolution of their

Takeaways

European banks that dont

adjust to the needs and wants

of todays digital customer

put their very survival at risk,

but a narrow understanding

of digital transformation is

preventing them from taking

essential actions.

Most of the potential value

in digital banking comes from

the impact on the cost base,

particularly in the areas of

automation of servicing and

fulfillment processes and

migration of front-end

activity to digital channels.

Digital transformation is a

major process, but costs

can be contained by maxi-

mizing the use of existing

tech nology. However, no

amount of technology will

help European banks if they

dont address the people

issues driven by digital.

3digital share and the success rate of digital products in the front book. The future replacement rate of these annuity streams will be increasingly dependent on digital capabilities. In essence, its about securing the future and not being lulled into a false sense of security based on the back book.

How to go digital without going crazy

Going digital doesnt have to mean millions in new investment dollars or convulsive upheaval in IT. Sizable investment will no doubt be necessary in some areas, but in general, many of the elements banks need to exploit this opportunity may already be in place. Banks just need to leverage them better and invest in these targeted ways.

Maximize the use of existing technology. Many banks have widely deployed imaging and work-flow systems, online servicing,

capacity-management software, interactive-

voice-response systems, and other connectiv-

ity and work-management technologies. But

theyre not using them widely or well enough. One European bank, for instance, installed a new high-resolution-imaging platform but

never fully enforced its use. Customer-service

representatives continued to send documen-

tation by fax, and the poor image quality led to significant inefficiency in downstream

processing. Addressing this problem requires systematic evaluation of existing capabilities, their usage rates, and barriers to adoption.

Apply lightweight technology interven-tions. Banks can generate significant perfor-mance gains with surprisingly small targeted investments. Examples include wider deploy-

ment of tools like e-forms and work-flow

systems, which can be implemented rela- tively rapidly, sometimes without deep integration into complex legacy architectures. The relationship managers and underwriters at one bank, for instance, got together with IT to design a stripped-down and user-friendly

online loan application. The form auto - ma tically adapts to input data and guides underwriters on which risk processes to follow. Another European bank sped up mortgage decisions by tweaking its existing application to follow standard rules, such as minimum down-payment thresholds and rating data, which allowed applications to be scored and routed faster, with less manual intervention.

Place a few selective big bets. There will be places where you need to pursue more sweeping transformation investments. However, instead of trying to automate every aspect of a given process or product, home in on the few that drive the most capacity consumption and give the greatest return. Do not build a gleaming digital empire for the sake of it. One European bank that went through a systematic mapping of its processes for automation potential found fewer than ten processes that represented the bulk of full-time-employee capacity. In these targeted areas, the bank embarked on more radical investments, retiring old platforms, deploying new digital solutions, and reinventing the way the process works.

Address the people dynamics

No amount of technology will help if you dont address the people issues driven by digital. Success requires more than rethink-

4ing technology; it requires rethinking the organizational model, too, especially when it comes to skills, structure, incentives, and performance management. The following steps can help.

Set the right structure and incentives. Theres more than one way to organize around digital. Some European banks appoint a head of digital with profit-and-loss responsibility.

Others use a center-of-excellence (COE)

model to develop offerings that the rest of the

business can take and deploy. Either model can work, but you must make concerted efforts to realign incentives to ensure collabo-

ration. For instance, creating a COE but not giving the business digital targets often leads to a lot of technology being successfully built, but with limited drive and pull for adoption. In extreme cases, the wrong functionality is builtits exciting to demonstrate to senior leaders and wins awards externally but ultimately creates no bottom-line impact.

Increase the focus on business out-comes, not digital activity. Too often, banks manage the progress of their digital transformations by tracking activity metrics, such as the number of app downloads and log-in rates. Such metrics are inadequate

proxies for business value. Banks must set clear aspirations for value outcomes, looking at productivity, servicing-unit costs, and lead-conversion rates, and link these explicitly

to digital investments. Only then will the collective focus be on shaping the right actions to fully capture the value available.

Formulate and implement a people vision. Finally, you need a vision for the role of em ployees in the new digital reality. This takes two forms: expectations of how they spend their time and how they work alongside the new technologies, and clarity on what tech-

nology competencies they need to develop. Digital transformation will clearly diminish the importance of some roles, which is why many employees will view it as a threat and be resistant to the change that digital brings. However, it also shifts the focus of many workers time toward higher-value tasks,

creating exciting new opportunities for develop-ment. For example, relationship managers will spend less time capturing customer details and more time giving valuable advice. Additionally, deeper awareness of the technical capabilities available and how they can affect processes will be a prerequisite to effectively manage in this new world. Business leaders need to be conversant in how technology can be leveraged to address commercial challenges. You cannot rely on bringing in new talent from digitally savvy industries to transform your bank. New talent provides an important stimulus, but digital needs to become a new management competence across the organization.

. . .Digitization will change the traditional retail- banking business model, in some cases radi-cally. The good news is that there is plenty of upside awaiting those European banks willing to embrace it. The bad news is that change is coming whether or not banks are ready.

Tunde Olanrewaju is a principal in McKinseys London office. This article was originally published in the Financial

Times on October 25, 2013 (ft.com). Copyright 2014 McKinsey & Company. All rights reserved.

Our new survey shows Asias finance consumers are rapidly switching to online banking, presenting risks and opportunities for companies.

Since 2011, adoption of digital-banking services has soared across Asia. Consumers

are turning to computers, smartphones, and tablets more often to do business with their banks,

while visiting branches and calling service lines less frequently. In developed Asian markets,

Internet banking is now near universal, and smartphone banking has grown more than threefold

since 2011. In emerging Asian markets, the trend is similarly dynamic, with about a quarter of

consumers using computers and smartphones for their banking. And despite some structural

obstacles, we believe this surge will continueand incumbents and market entrants alike should

prepare for the consequences.

Last year, we surveyed about 16,000 financial consumers in 13 Asian markets,1 and the results

showed drastic shifts in behavior compared with a similar survey in 2011 (exhibit). Put simply:

Asian financial-services consumers are going digital, and fast. While this rise of digital banking

has been anticipated for many years, several factors have combined to accelerate it, most notably

the rapid increase in Internet and smartphone adoption and growth in e-commerce. Both have

helped demand for digital banking move from early adopters to a broad range of customers.

For incumbent banks, the stakes are particularly high. Among the consumers we surveyed in

developed Asian markets, more than 80 percent said they were willing to shift some of their

holdings to a bank that offers a compelling digital proposition. In emerging Asia, more than 50

percent of consumers indicated such willingness. Many types of accounts are in play, with

respondents saying generally that they could shift 35 to 45 percent of savings-account deposits, 40

to 50 percent of credit-card balances, and 40 to 45 percent of investment balances, such as those

held in mutual funds.

Capitalizing on Asias digital-banking boomSonia Barquin and Vinayak HV

M A R C H 2 0 1 5

1 McKinseys Asia Personal

Financial Services Survey was

conducted from July through

September, 2014. For our analysis,

developed Asia comprised

Australia (700 respondents),

Hong Kong (750 respondents),

Japan (750 respondents),

Singapore (750 respondents),

South Korea (750 respondents),

and Taiwan (800 respondents).

Emerging Asia comprised China

(3,500 respondents), India

(4,000 respondents), Indonesia

(1,100 respondents), Malaysia

(700 respondents), the

Philippines (700 respondents),

Thailand (750 respondents),

and Vietnam (700 respondents).

2Across Asia, we estimate more than 700 million consumers use digital banking regularly, with a

significant portion in fast-growing markets like China and India. In developed Asia, 92 percent of

respondents in 2014 said they had used Internet banking, compared with 58 percent in 2011. Also,

61 percent had accessed banking services using smartphones, more than three times the

penetration seen in 2011. Behaviors in emerging markets showed a faster shift, although from a

much smaller base. Internet-banking penetration in these markets rose from 10 percent in 2011 to

28 percent in 2014, and smartphone access rose from 5 percent in 2011 to 26 percent in 2014.

Further, customers across Asia are using digital banking more frequently. In developed Asia,

customers connect with their banks over the Internet or via smartphones more often each month

than over traditional channels. In emerging Asia, these traditional channels, especially ATMs, still

dominate, but customers are using Internet and smartphone banking almost five times more often

than in 2011. Across Asia, consumers made fewer branch visits and calls in 2014 than in 2011.

Risks and opportunities

The rapid shift toward digital banking might suggest the demise of the bank branch, but several

factors assure that branches will retain an important role in Asia for the foreseeable future. For

example, consumers are using multiple channels, rather than turning solely to online or branch

Exhibit

Web 2015ASEAN bankingExhibit 1 of 1

Penetration of banking channels,1 %

1Based on respondents use of channel.2Digital-banking penetration gures denote respondents who use Internet banking via PC or smartphone.3Australia, Hong Kong, Japan, Singapore, South Korea, and Taiwan.4China, India, Indonesia, Malaysia, Philippines, Thailand, and Vietnam.

Source: 2014 McKinsey Asia Personal Financial Services Survey of about 16,000 nancial consumers in 13 Asian countries

There has been a significant increase in the use of digital-banking channels.

2011 2014 2011 2014

Developed Asia3 n = 2,448 (2011)n = 4,500 (2014)

Emerging Asia4 n = 8,424 (2011)n = 11,450 (2014)

5992

92

61

58

19

1033

28

26

10

5

Internet banking

Smart- phone

1.6x

1.6x

3.2x

3.3x

2.8x

5.2x

Digital banking2

services. Regulatory requirements, demand for personal advice, and a sense of security support the

continued need for branches, the survey shows.

Drawing in digital consumers will require more than an online presence, even one that is best in

class.2 Our research shows that in developed Asia, consumers value the quality of basic services, the

strength of financial products, brand reputation, and the quality of customer service and experience.

Among these, they are typically least satisfied with the financial products offered and with customer

experience. Survey results from emerging Asia were less conclusive, indicating these markets are at

the early stages in digital banking.

Our findings also show that simplicity and security are crucial aspects for online offerings. Of

banking customers who have not made any online purchase of banking products, 47 percent in

developed Asia and 35 percent in emerging Asia said the primary obstacle is that the products are so

complicated that they needed a person to explain them. At the same time, security concerns stopped

about 56 percent of the respondents in emerging Asia and 44 percent of those in developed Asia

from purchasing products online.

For the full report on which this article is based, see Digital Banking in Asia: What do consumers really want?, on mckinsey.com.

Sonia Barquin is a consultant in McKinseys Kuala Lumpur office, and Vinayak HV is a principal in the Singapore office.

Copyright 2015 McKinsey & Company. All rights reserved.

3

2 For more on how companies

should respond, see Joe Chen,

Vinayak HV, and Kenny Lam,

How to prepare for Asias digital-

banking boom, August 2014,

mckinsey.com.

4.1 Credit markets have, historically, played acrucial role in sustaining growth in almost allcountries, including advanced countries, which nowhave fully developed capital markets. Credit marketsperform the critical function of intermediation of fundsbetween savers and investors and improve theallocative efficiency of resources. Banks, which aremajor players in the credit market, play an importantrole in providing various financial services andproducts, including hedging of risks. Credit marketsalso play a key role in the monetary transmissionmechanism.

4.2 Extension of credit, however, also poses somerisks, which range from pure credit risk to the risk ofover-lending. While pure credit risk is the risk of lossdue to non-payment by the borrower, even thoughadequate precautions are taken at the time of loanorigination, the risk of over-lending arises when banksextend loans without appropriate credit appraisal anddue diligence on account of excessive optimism aboutfuture prospects. While pure credit risk may not bewidespread and may normally not create systemicproblems, over-lending is unsustainable andpotentially destabilising for the system. Regulators inall countries, therefore, while seeking to maintainadequate growth, guard against its adverse impactby instituting appropriate regulatory and supervisorypolicies and strengthening of prudential norms.

4.3 The credit market in India has traditionallyplayed a predominant role in meeting the financingneeds of various segments of the economy. Creditinstitutions range from well developed and large sizedcommercial banks to development finance institutions(DFIs) to localised tiny co-operatives. They provide avariety of credit facilities such as short-term workingloans to corporates, medium and long-term loans forfinancing large infrastructure projects and retail loansfor various purposes. Unlike other segments of thefinancial market, the credit market is well spreadthroughout the country and it touches the lives of allsegments of the population.

4.4 Prior to initiation of financial sector reformsin the early 1990s, the credit market in India wastightly regulated. Bank credit was the principal focusof monetary policy under the credit planning approachadopted in 1967-68. In the absence of a formal

intermediate target, bank credit aggregate as wellas sectoral came to serve as a proximate target ofmonetary policy. Monetary policy up to the mid-1980swas predominantly conducted through directinstruments with credit budgets for banks beingframed in sync with monetary budgeting (Mohan,2006a). The credit market was characterised by creditcontrols and directed lending. Various credit controlsexisted in the form of sectoral limits on lending, limitson borrowings by individuals, stipulation of marginrequirements, need for prior approval from theReserve Bank, if borrowing exceeded a specified limit(under the Credit Author isation Scheme), andselective credit controls in the case of sensitivecommodities. Lending interest rates by all types ofcredit institutions were administered. Credit marketswere also strictly segmented. While commercial bankscatered largely to the short-term working capitalrequirements of industry, development financeinstitutions focused mainly on long-term finance.Competition in the credit market was also limited. Thisled to several inefficiencies in the credit market.

4.5 A wide range of regulatory reforms,therefore, were introduced as part of financial sectorreforms in the early 1990s to improve the efficiencyof the credit market. As a result, the credit market inIndia has undergone structural transformation. Thecredit market has become highly competitive eventhough the number of credit institutions has reduceddue to merger/conversion of two DFIs into banks,weeding out of unsound NBFCs and restructuringof urban co-operative banks and RRBs. Creditinstitutions now offer a wide range of products. Theyare also free to price them depending on their riskperception.

4.6 In the above backdrop, this chapter analysestrends in the credit market in India, with a specialfocus on various aspects of rapid credit growth inrecent years. The chapter is divided into six sections.Section I briefly explains the significance of the creditmarket in economic growth. The structure of thecredit market in India is delineated in Section II.Policy developments relating to the credit marketsince the early 1990s have been set out in SectionIII. Trends in credit growth in India in the post-reformperiod are analysed in Section IV. Recent trends inbank credit growth and their implications are also

CREDIT MARKETIV

120

REPORT ON CURRENCY AND FINANCE

analysed in this section. Section V suggests somemeasures with a view to further strengthening therole of the credit market in India. Concludingobservations are presented in Section VI.

I. SIGNIFICANCE OF THE CREDIT MARKET

4.7 There is a broad consensus, among bothacademics and policy makers, that a developedfinancial system spurs economic growth through anumber of channels: (i) acquisition of information onfirms; (ii) intensity with which creditors exert corporatecontrol; (iii) provision of risk-reducing arrangements;(iv) pooling of capital; and (v) ease of makingtransactions (Levine, 2004). There are twomechanisms for mobilising savings and channelingthem into investments, viz., bank-based and market-based, as alluded to in Chapter I. Empirical evidencereveals that while a more developed financial sectoris associated with higher income levels, there is noclear pattern with regard to financial structure.

4.8 In most countries, both the systems exist evenas one system may be more dominant than the other.However, of the two systems, credit institutions havethe distinct advantage in information gathering andprocessing to monitor the efficiency and productivityof projects. In fact, in recent years the existence ofbanks, which are the major players in the creditmarket, is attr ibuted more to their informationgathering capacity arising out of the existence ofasymmetric information and moral hazard problems,than to the classic explanation relating to their abilityto mobilise savings and channeling them intoinvestment. Savers usually have incompleteinformation on the affairs of companies, which makesit more difficult for companies to obtain direct financingfrom the market. Intermediation by banks mitigatessuch agency problems. When the cost of acquiringinformation on a company by the providers of financialresources is high, the process of financing companiescan be done more efficiently if the prospectiveinvestors are able to delegate the collection of suchinformation to a specialised organisation (Diamond,1984). Thus, financial intermediation is justified onthe grounds of information gathering and company-monitoring functions performed by banks. By reducingthe costs of acquiring and processing information,financial institutions encourage mobilisation of savingsand improve resource allocation. Banks can alsodiversify risk among a number of companies.

4.9 Firms in developing countries generally tendto rely more on debt finance, including bank credit.The emphasis on credit rather than equity arises due

to various reasons. The cost of equity in developingeconomies is often much higher than the cost of debtdue to the existence of higher perceived risk premiathan in developed countr ies. The existence ofartificially repressed interest rates contributes furtherto the problem. The other reasons for the heavyreliance on debt in developing countries include thefragility of their equity markets, lack of suitableaccounting practices and the absence of adequatecorporate governance practices. Given the highdependence on bank credit and lack of substitutesfor external finance, firms in developing economiesare generally highly sensitive to changes in the costand flow of credit.

4.10 Credit markets in developing countries, inparticular, play an important role, where apart fromindustry, agriculture is also an important segment ofthe economy. Besides, there are also a large numberof small and medium enterprises in the industrial andservice sectors, which are not able to access thecapital market and have to depend on the creditmarket for their funding requirements. Thus, theimportance of banks and other lending institutions indeveloping countries can hardly be overemphasised.

4.11 Commercial banks, given their preeminentposition in the regulated financial sector, dominate thecredit market. The quantity of loans created by thebanking system is generally a function of both thewillingness and ability of banks to lend. In an economywith ceilings on lending rates, banks face a highercredit demand than they can effectively supply, thus,necessitating reliance on a credit rationing mechanism.In a non-repressed financial system, on the otherhand, the borrowers are, in principle, differentiatedalong the lines of risk characteristics and riskierborrowers are charged higher interest rates to accountfor default probabilities. This, however, may create theproblem of adverse selection. Though riskier projectsbring higher returns, banks, out of sustainabilityconsideration, need to optimise the risk of their portfolio.

4.12 Another impor tant factor influencing thesupply of credit is the amount of reserves availablefrom the central bank to the banking system. A largepre-emption of central bank money by theGovernment may constrain reserve supply to thebanking system, thus, affecting their capacity for creditcreation. Moreover, credit expansion could also bean endogenous process, i.e., it is the demand forcredit that may drive the banking systems ability tocreate credit in the economy.

4.13 Development of the credit market plays animpor tant role in the monetary transmission

121

CREDIT MARKET

mechanism. The traditional interest rate channel,represented by the money view, mainly focuses onthe liability side as banks create money throughchequable deposits. The asset side is not emphasisedas firms financial structure is believed to be neutral toborrowings through loans from banks or throughissuance of securities. This is based on the assumptionthat different financial assets such as bonds and bankloans are perfect substitutes. However, in terms ofcredit view, bonds and bank loans are not seen asperfect substitudes primarily because of informationasymmetries. Firms facing informational problems findit more expensive to borrow through bonds than availingloans from banks.

4.14 According to the credit view, the direct effectof monetary policy is amplified by changes in theexternal finance premium (EFP) in the same direction.An EFP is the difference in cost of funds raisedexternally (by way of issuing equity or debt) and fundsgenerated internally (retained earnings). Thus,monetary tightening increases EFP, while easing ofmonetary policy reduces EFP. As a result, the impactof a given change in short-term policy interest rates ondemand and output is magnified, which reinforces theeffects of variation in interest rates (Bernanke andGertler, 1995). In this context, the most representativetheoretical model of the credit view is that of Bernankeand Blinder (1988). It is a modification of the IS/LMframework and contains all the elements that allow forthe theoretical definition of imperfect substitutionbetween credit on the one hand, and bonds andsecurities on the other (Box IV.1). As a policy guide,Bernanke and Blinder conclude that if money demandshocks are more important than credit demand shocks,then a policy of targeting credit is probably better thana policy of targeting money.

4.15 Given that a developed financial intermediationsystem facilitates growth, policy makers tend toliberalise the system to facilitate financial development.The literature, however, suggests that authoritiesshould take adequate caution in adopting a liberalisedpolicy frameworks intended to develop the financialsector (IMF, 2006). Lax supervision and rudimentaryregulation of newly liberalised financial institutions,often combined with a volatile macroeconomicenvironment, have led to systemic crises (Lindgren,et al, 1996 and Caprio and Klingebiel, 2003). Similarly,there is econometric evidence that shows that bankingcrises are more likely to occur in countries associatedwith liberalised credit markets operating in weakinstitutional environments. The East Asian crisisunderlined the risks to economic stability and growththat a weak or vulnerable financial sector could pose.

II. INSTITUTIONAL STRUCTURE OF THECREDIT MARKET IN INDIA

4.16 The credit market structure in India hasevolved over the years. A wide range of financialinstitutions exist in the country to provide credit tovarious sectors of the economy. These includecommercial banks, regional rural banks (RRBs), co-operatives [comprising urban cooperative banks(UCBs), State co-operative banks (STCBs), districtcentral co-operative banks (DCCBs), pr imaryagricultural credit societies (PACS), state co-operativeand agricultural rural development banks (SCARDBs)and primary co-operative and agricultural ruraldevelopment banks (PCARDBs)], financial institutions(FI) (term-lending institutions, both at the Centre andState level, and refinance institutions) and non-banking financial companies (NBFCs) (Exhibit IV.1).

4.17 Scheduled commercial banks constitute thepredominant segment of the credit market in India. Inall, 83 scheduled commercial banks were in operationat end-March 2006. The commercial banking sectoris undergoing a phase of consolidation. There havebeen 12 mergers/amalgamations since 1999. TheRRBs, which were set up in the 1970s to provideagricultural and rural credit, are being restructured atthe initiative of the Government of India. Till October31, 2006, 137 RRBs were amalgamated to form 43new RRBs, bringing down the total number of RRBsin the country to 102 from 196 at end-March 2005.

4.18 The co-operative banking system, with twobroad segments of urban and rural co-operatives, formsan integral part of the Indian financial system. Urbancooperative banks, also referred to as primary co-operative banks, play an important role in meeting thegrowing credit needs of urban and semi-urban areasof the country. The UCBs, which grew rapidly in theearly 1990s, showed certain weaknesses arising outof lack of sound corporate governance, unethicallending, comparatively high levels of non-performingloans and their inability to operate in a liberalisedenvironment. Accordingly, some of the weak UCBs havebeen either liquidated or merged with other banks. Asa result, the number of UCBs declined from 1,942 atend-March 2001 to 1,853 by end-March 2006.

4.19 Historically, rural co-operative credit institutionshave played an important role in providing institutionalcredit to the agricultural and rural sectors. These creditinstitutions, based on the nature of their lendingoperations, have typically been divided into two distinctsegments, commonly known as the short-term co-operative credit structure (STCCS) and the long-termco-operative credit structure (LTCCS). The STCCS,

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The impact of monetary policy on the real economy operatesthrough various channels. Under the conventional approach,referred to as the money view, monetary policy influencesthe economy via the interest rate. The alternate channel, thatemphasises credit conditions as the route of monetarytransmission, is of relatively recent origin and is referred toas the credit view. Genesis of the credit view could be tracedto the celebrated work of Bernanke and Blinder (1988), whichpresented the IS-LM framework augmented with bank-intermediated loans. It argued that since loans and bondsare not perfect substitutes, monetary policy operates not onlythrough the conventional money channel but also through thecredit channel. According to the credit view, a change inmonetary policy that raises or lowers open market interestrates tends to change the external finance premium in thesame direction. External finance premium is the differencebetween the cost of funds raised externally and the fundsraised internally. Because of this additional effect of policy onthe external finance premium, the impact of monetary policyon the cost of borrowing and consequently on real spendingand real activity is magnified (Bernanke and Gertler, 1995).There are three reasons for which the credit channel isimportant. First, evidence suggests that credit marketimperfections of the type crucial to the credit channel do indeedaffect firms employment and spending decisions. Second,evidence suggests that small firms, which are more likely tobe credit constrained, are hurt more by tight monetary policythan their larger counterparts. Third, asymmetric information- the core of credit channel analysis - proves to be highlyuseful in explaining some other important phenomena: e.g.,why do financial intermediaries exist; structure of the financialsector; and why do financial crises occur (Mishkin, 1996).

There are two channels through which credit conditions areexpected to affect monetary transmission. First, the banklending channel, that operates through modulation of bankreserves, is affected by monetary policy. Contractionary/expansionary policy limits or enhances the ability of banks tolend and thereby reduces/increases investment and output.The second, the balance sheet channel works through networth of the borrowers. Contractionary policy would raiseinterest rates and thereby reduce the value of the collateraland net worth of the borrowers. This, accordingly, limits theability of borrowers to borrow and invest. Further, the literaturealso points out a direct connection between the balance sheetchannel and housing demand by features such as down-payment requirements, up-front transaction costs andminimum income to interest payment ratios. However,empirical evidence suggests that effectiveness of the credit

Box IV.1The Credit Channel of Monetary Policy

channel depends upon conditions such as existence of bank-dependent borrowers, for instance, small and low net worthfirms (Gertler and Gilchrist, 1993 and 1994), substitutionbetween retail and bulk deposits and ability of the central bankto constrain banks potential to lend.

Empirical work to draw inferences on the existence of thecredit channel in India is rather limited. A recent studyexamining the impact of financial liberalisation shows thatbanks in general are constrained in their lending operationsby the availability of insured deposits and these constraintsare more severe for those banks that lend predominantlyagainst collateral. In India more than eighty five per cent ofbank lending is against collateral. This implies a potentiallyimportant influence of the bank lending channel. A veryrecent attempt in estimating the bank lending channel hasbrought out a number of facets of the transmissionmechanism - by employing structural VAR methodology onmonthly data for all the Indian scheduled commercial banksspanning from April 1993 to April 2002 (Pandit, et al, 2006).First, the study validates the existence of a bank lendingchannel in the Indian context. This implies that the centralbank, while formulating monetary policy, is likely toencounter independent shifts in the loan supply. Second,evidence seems to point to the fact that large banks with awider resource base can more successfully insulate theirloan supply from contractionary policy shocks vis--vissmall banks. Third, the quantitative instruments such asthe cash reserve ratio (CRR) continue to be important alongwith the price instruments such as the Bank Rate. Finally,prudential regulations have an important role to play ininfluencing lending decisions of banks. In particular, theintroduction of capital adequacy ratios has made banksmore concerned with the risk-return profile of loans, sinceadditional lending warrants augmenting of capital base inorder to adhere to the regulatory capital standards.

References:

Bernanke, Ben, and A. Blinder. 1988. Credit, Money andAggregate Demand. American Economic Review 135-139,May.

Bernanke, Ben, and M. Gertler. 1995. Inside the Black Box:The Credit Channel of Monetary Policy Transmission.Journal of Economic Perspectives, Vol.9: 27-48.

Pandit, B.L., Ajit Mittal, Mohua Roy and Saibal Ghosh. 2006.Transmission of Monetary Policy, and the Bank LendingChannel: Analysis and Evidence for India. DRG Study No.25, Reserve Bank of India.

comprising PACS at the village level, DCCBs at theintermediate level, and the STCBs at the apex level,provide crop and other working capital loans to farmersand rural artisans primarily for short-term purposes.The LTCCS, comprising SCARDBs at the State level

and PCARDBs at the district or block level, providetypically medium and long-term loans for makinginvestments in agriculture, rural industries and, in therecent period, housing. However, the structure of ruralco-operative banks is not uniform across all the States

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of the country. Some States have a unitary structurewith the State level banks operating through their ownbranches, while others have a mixed structureincorporating both unitary and federal systems.

4.20 Financial institutions owed their origin to theobjective of state driven planned economic development,when the capital markets were relativelyunderdeveloped and judged to be incapable ofmeeting adequately the long-term requirements of theeconomy. Over the years, a wide range of FIs, mostlyGovernment owned, came into existence to cater tothe medium to long-term financing requirements ofdifferent sectors of the economy. FIs played a key rolein extending development finance in India and for thispurpose they were given access to concessionalfinance in the form of Government guaranteed bondsand Long-Term Operations (LTO) Fund of the ReserveBank. However, the governments fiscal imperativesand market dynamics forced a reappraisal of thepolicies and strategy with regard to the role of FIs inthe economy and the concessional finance wasphased out by the mid-1990s. A major restructuringin the financial sector occurred when two major FIs,viz., ICICI and IDBI converted into banks. Thus, thisparticular segment of the credit market has shrunksignificantly in recent years.

4.21 NBFCs encompass a heterogeneous groupof intermediaries and provide a whole range of

financial services. Though heterogeneous, NBFCscan be broadly classified into three categories, viz.,asset finance companies (such as equipment leasingand hire purchase), loan companies and investmentcompanies. A separate category of NBFCs, called theresiduary non-banking companies (RNBCs), alsoexists as it has not been categorised into any one ofthe above referred three categories. Besides, thereare miscellaneous non-banking companies (ChitFund), mutual benefit financial companies (Nidhis andunnotified Nidhis) and housing finance companies.The number of NBFCs operating in the country was51,929 in 1996. Following the amendments to theprovisions contained in Chapter III-B and Chapter III-C of the Reserve Bank of India Act, NBFCs both,deposit taking and non-deposit taking, are requiredto compulsorily register with the Reserve Bank. Oneof the conditions for registration for NBFCs was aminimum net owned fund (NOF) of Rs.25 lakh at theentry point. This limit was subsequently enhanced toRs.2 crore for new NBFCs seeking grant of Certificateof Registration on or after April 21, 1999. The ReserveBank received 38,244 applications for grant ofcertificate of registration (CoR) as NBFCs till end-March 2006. Of these, the Reserve Bank approved13,141 applications, including 423 applications ofcompanies authorised to accept/hold public deposits.Due to consolidation in the sector, the number ofNBFCs declined to 13,014 by end-June 2006.

Exhibit IV.1: Credit Market Structure(End-March 2006)

Commercial Banks(216, including 133 RRBs) Financial Institutions

Non-Banking FinancialCompanies (13,014)

Co-operative Institutions

All-India Financial Institutions(Term-lending) (4)

Specialised FinancialInstitutions

State Level Institutions(SFCs, SIDCs.)

Urban Co-operativeBanks (1,853)

Rural Co-operativeInstitutions

Short-Term(109,177)

Long-Term(747)

STCBs(31)

DCCBs(367)

PACs(108,779)

SCARDBs(20)

PCARDBs(727)

Note : Figures in parentheses represent number of institutions in the respective category. Numbers relate to end-March 2005 in respect of ruralco-operatives and end-June 2006 in respect of NBFCs.

Source : Report on Trend and Progress of Banking in India, 2005-06, Reserve Bank of India.

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1 Priority sector comprises agriculture (both direct and indirect), small scale industries, small roads and water transport operators, smallbusiness, retail trade, professional and self-employed persons, state sponsored organisations for Scheduled Castes/Scheduled Tribes,education, housing (both direct and indirect), consumption loans, micro-credit, loans to software, and food and agro-processing sector.

2 Under Section 18 of the Banking Regulation Act, 1949, all scheduled banks are required to maintain SLR, i.e., a certain proportion of theirdemand and time liabilities (DTL) as on the last Friday of the second preceeding fortnight as liquid assets (cash, gold valued at a price notexceeding the current market price or unencumbered approved securities valued at a price as specified by the Reserve Bank from time totime). Following the amendment of the Act in January 2007, the floor rate of 25 per cent for SLR was removed.

4.22 Of al l insti tut ions, in terms of assets,commercial banks constitute the largest category,followed by rural co-operatives (Chart IV.1).

III. POLICY DEVELOPMENTS IN THE CREDITMARKET IN INDIA

4.23 The credit market, with commercial banks asits predominant segment, has been the major sourcefor meeting the finance requirements in the economy,both for the private sector and the Central and StateGovernment enterprises. In addition to sharing ofresources between the private and the public sectors,a significant proportion of credit by commercial banksis earmarked for the priority sector1 . For a fewdecades preceding the onset of banking and financialsector reforms in India, credit institutions operated inan environment that was heavily regulated andcharacterised by barriers to entry, which protectedthem against competition. The issue of allocation ofbank resources among various sectors was addressedthrough mechanisms such as SLR, credit authorisationscheme (CAS), fixation of maximum permissible bankfinance (MPBF) and selective credit controls. Thisregulated environment set in complacency in the

manner in which credit institutions operated andresponded to the customer needs. The interest rateplayed a very limited role as the equilibratingmechanism between demand and supply of resources.The resource allocation process was deficient, whichmanifested itself in poor asset quality. They also lackedoperational flexibility and functional autonomy.

4.24 As part of financial sector reforms in the early1990s, wide ranging reforms were introduced in thecredit market with a view to making the creditinstitutions more efficient and healthy. The reformprocess initially focused on commercial banks. Aftersignif icant progress was made to transformcommercial banks into sound institutions, the reformprocess was extended to encompass other segmentsof the credit market. As part of the reform process,the strategy shifted from micro-management to macrolevel management of the credit market. Thesemeasures created a conducive environment for banksand other credit institutions to provide adequate andtimely finance to different sectors of the economy byappropriately pricing their loan products on the basisof the risk profile of the borrowers.

4.25 Lending interest rates were deregulated witha view to achieving better price discovery and efficientresource allocation. This resulted in growing sensitivityof credit to interest rates and enabled the ReserveBank to employ market based instruments ofmonetary control. The Statutory Liquidity Ratio (SLR

2)

has been gradually reduced to 25 per cent. The CashReserve Ratio (CRR) was reduced from its peak levelof 15.0 per cent maintained during 1989 to 1992 to4.5 per cent of Net Demand and Time Liabilities(NDTL) in June 2003. The reduction in statutory pre-emptions has significantly augmented the lendableresources of banks. Although the Reserve Bankcontinues to pursue its medium-term objective ofreducing the CRR, in recent years, on a review ofmacroeconomic and monetary conditions, the CRRhas been revised upwards in phases to 6.5 per cent.

4.26 While the stipulation for lending to the prioritysector has been retained, its scope and definition havebeen fine-tuned by including new items. Further,restrictions on banks lending for project finance

Chart IV.1: Total Assets of Financial Intermediaries Relative Shares (end-March 2006)

Scheduled Commercial Banks

Regional Rural Banks and Local Area Banks

Urban Co-operative Banks

Rural Co-operatives

All India Financial Institutions

NBFCs (including RNBCs)

Source : Report on Trend and Progress of Banking in India, 2005-06,Reserve Bank of India.

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activity and for personal loans were gradually removedin order to enable banks to operate in a flexiblemanner in the credit market. As part of the financialsector reforms, the regulatory norms with respect tocapital adequacy, income recognit ion, assetclassif ication and provisioning have beenprogressively aligned with international best practices.These measures have enhanced transparency of thebalance sheets of banks and infused accountabilityin their functioning. Accounting standards anddisclosure norms were also strengthened with a viewto improving governance and bringing them inalignment with international norms. As part of thereform programme, due consideration has been givento diversification of ownership of banking institutionsfor greater market accountability and improvedefficiency. Accordingly, several public sector banksexpanded their capital base by accessing the capitalmarket, which diluted Government ownership. Toprovide banks with additional options for raisingcapital funds with a view to enabling smooth transitionto Basel II, the Reserve Bank, in January 2006,allowed banks to augment their capital funds by issueof additional instruments.

4.27 With a view to enhancing efficiency andproductivity through competition, guidelines were laiddown for establishment of new banks in the privatesector. Since 1993, 12 new private sector banks havebeen set up. Foreign banks have also been allowedmore liberal entry. Considering the special nature ofbanks, guidelines on ownership and governance inprivate sector banks were also issued in February 2005(Box IV.2). As a major step towards enhancingcompetition in the banking sector, foreign directinvestment in the private sector banks is now allowedup to 74 per cent (including investment by FIIs), subjectto conformity with the guidelines issued from time totime. A roadmap for foreign banks, articulating aliberalised policy consistent with the WTOcommitments was released in March 2005. For newand existing foreign banks, it was proposed to gobeyond the existing WTO commitment of 12 branchesin a year.

4.28 A large magnitude of resources of creditinstitutions had become locked up in unproductiveassets in the form of non-performing loans (NPLs).Apart from limiting the ability of credit institutions torecycle their funds, this also weakened them byadversely affecting their profitability. The ReserveBank and the Central Government, therefore, initiatedseveral institutional measures to recover the past duesto banks and FIs and reduce the NPAs. These were

Debt Recovery Tribunals (DRTs), Lok Adalats(peoples courts), Asset Reconstruction Companies(ARCs) and the Corporate Debt Restructuring (CDR)mechanism. Settlement Advisory Committees havealso been formed at regional and head office levelsof commercial banks. Furthermore, banks can also issuenotices under the Securitisation and Reconstruction ofFinancial Assets and Enforcement of Security Interest(SARFAESI) Act, 2002 for enforcement of securityinterest without intervention of courts. Further, banks,Fls and NBFCs (excluding securitisation companies/reconstruction companies) have been permitted toundertake sale/purchase of NPAs. Thus, banks andother credit institutions have been given a menu ofoptions to resolve their NPA problems.

4.29 Diversification of credit risk is essential forexpanding the flow of credit. Excessive concentrationof lending to certain sectors leads to a higher riskburden. There are various options available for sharingof risk. Asset securitisation allows banks to conserveregulatory capital, diversify asset risks and structureproducts to reflect investors preferences (IMF, 2006).There are various instruments for sharing andtransferring credit risk. One such instrument is assetsecuritisation (Box IV.3).

4.30 With a view to ensuring healthy developmentof the securitisation market, the Reserve Bank issuedguidelines on securitisation of standard assets onFebruary 1, 2006 to banks, financial institutions andnon-banking financial companies.

4.31 Comprehensive credit information, whichprovides details pertaining to credit facilities alreadyavailed of by a borrower as well as his repaymenttrack record, is critical for the smooth operations ofthe credit market. Lack of credit history is an importantfactor affecting the credit flow to relatively lesscreditworthy borrowers. In the absence of credithistory, pricing of credit can be arbitrary, the perceivedcredit risk can be higher and there can be adverseselection and moral hazard. Accordingly, a schemefor disclosure of information regarding defaultingborrowers of banks and financial institutions wasintroduced. In order to facilitate sharing of informationrelating to credit matters, a Credit Information Bureau(India) Limited (CIBIL) was set up in 2000 (Box IV.4).

4.32 Most of the reform measures initiated forcommercial banks such as deregulation of lendinginterest rates, prudential norms relating to capitaladequacy/asset classification provisioning, and NPAsmanagement were also extended to other creditinstitutions as well with some modifications asappropriate.

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Box IV.2Credit Market Reforms

Lending Interest Rates

Lending interest rates of commercial banks werederegulated in October 1994 and banks were requiredto announce their prime lending rates (PLRs).

The Reserve Bank mooted the concept of benchmarkprime lending rate (BPLR) on April 29, 2003 to addressthe need for transparency in banks lending rates as alsoto reduce the complexity involved in pricing of loans.

Banks now are free to prescribe respective BPLRs, asalso lend at sub-BPLR rates.

Banks are also permitted to offer floating rate loan productslinked to a market benchmark in a transparent manner.

Term-lending by Banks

Various restrictions on term loans by banks weregradually phased out by 1997. In terms of the guidelinesprevailing before the initiation of economic reforms in1991, banks were expected to extend term loans forsmall projects in participation with the State levelinstitutions, though it was not mandatory.

For large projects, however, they were allowed toparticipate compulsorily in participation with all-IndiaFIs, subject to the condition that the share of thebanking system would be restricted to 25 per cent ofterm loan assistance from banks and FIs and theaggregate term finance from the banking system couldnot exceed Rs.75 crore.

Asset Classification and Provisioning, and CapitalAdequacy

In terms of asset classification and provisioning normsprescribed in 1994, banks are required to classifyassets into four categories, viz., standard assets, sub-standard assets, doubtful assets and loss assets, withappropriate provisioning requirements for eachcategory of assets.

The concept of past due in the identification of non-performing assets (NPAs) was dispensed with effectivefrom March 2001, and the 90-day delinquency normwas adopted for the classification of NPAs with effectfrom March 2004.

As a major step towards tightening of prudential normsfrom the year ended March 2005, an asset is required tobe classified as doubtful if it remains in the sub-standardcategory for 12 months as against the earlier norm of 18months. Banks are now required to make provisioningagainst standard assets to the tune of 0.40 per cent exceptfor certain specified sectors. These include directadvances to agriculture and SME sectors (0.25 per cent),residential housing loan beyond Rs.20 lakh (1.0 per cent)and personal loans (2.0 per cent). (In case of specifiedsectors, the general provisioning requirement increasedfrom 0.4 per cent to 1.0 per cent in May 2006 and furtherto 2.0 per cent in January 2007).

Banks were advised to adopt graded higherprovisioning in respect of: (a) secured portion of NPAsincluded in 'doubtful' for more than three yearscategory; and (b) NPAs which have remained in'doubtful' category for more than three years as onMarch 31, 2004. Provisioning ranging from 60 per centto 100 pre cent over a period of three years in a phasedmanner, from the year ended March 31, 2005 has beenprescribed. However, in respect of all advancesclassified as 'doubtful for more than three years' on orafter April 1, 2004, the provisioning requirement hasbeen stipulated at 100 per cent. The provisioningrequirement for unsecured portion of NPAs under theabove category was retained at 100 per cent.

Banks were subject to capital adequacy norms in 1994,according to which, banks were required to maintaincapital to risk weighted asset ratio of 8 per cent.Subsequently, the ratio was raised to 9 per cent in 1999.

Exposure Limits

Regulatory limits on banks exposure to individual andgroup borrowers in India were prescribed to avoidconcentration of credit

The applicable limit is 15 per cent of capital funds in thecase of a single borrower and 40 per cent in the case ofa group of borrowers. Credit exposure to borrowersbelonging to a group may exceed the exposure norm of40 per cent of banks capital funds by an additional 10per cent (i.e., up to 50 per cent), provided the additionalcredit exposure is on account of extension of credit toinfrastructure projects. Credit exposure to a singleborrower may exceed the exposure norm of 15 per centof banks capital funds by an additional 5 per cent (i.e.,up to 20 per cent). In addition, banks may, in exceptionalcircumstances, with the approval of their boards, considerenhancement of the exposure to a borrower up to a further5 per cent of capital funds.

Competition Enhancing Measures

Public sector banks were allowed to raise capital from theequity market up to 49 per cent of the paid-up capital.

A comprehensive policy framework was laid down onFebruary 28, 2005 for ownership and governance inprivate sector banks. The broad principles underlyingthe framework ensure that : (i) ultimate ownership andcontrol is well diversified; (ii) important shareholdersare fit and proper; (iii) directors and CEO are fit andproper and observe sound corporate governanceprinciples; (iv) private sector banks maintain minimumcapital (initially Rs.200 crore, with a commitment toincrease to Rs.300 crore within three years)/net worth(Rs.300 crore at all times) for optimal operations andfor systemic stability; and (v) policy and processesare transparent and fair.

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4.33 The credit derivatives are gaining increasingpopularity in many countries. Since the early 1990s,

Box IV.4Credit Information Bureaus

Credit bureaus (or credit reference agencies) are useful asthey help lenders to assess credit worthiness of individualborrowers and their ability to pay back a loan. As credit bureauscollect and collate personal financial data on individuals fromfinancial institutions, a form of price discrimination can bemodelled taking into account credit rating and past behaviourof borrowers. The information is generally aggregated andmade available on request to contributing companies for thepurposes of credit assessment and credit scoring.Establishment of credit information bureaus can facilitate inobtaining the credit history of the borrowers and, thus, helpthe banks in correctly assessing the creditworthiness.

The CIBIL provides a vital service, which allows its membersto make informed, objective and faster credit decisions. CIBILsaim is to fulfill the need of credit granting institutions forcomprehensive credit information by collecting, collating anddisseminating credit information pertaining to both commercialand consumer borrowers, to a closed user group of members.Banks, financial institutions, non-banking financial companies,housing finance companies and credit card companies use

CIBILs services. Data sharing is based on the principle ofreciprocity, which means that only members who havesubmitted all their credit data, may access Credit InformationReports from CIBIL.

With a view to strengthening the legal mechanism andfacilitating credit information companies to collect, processand share credit information on borrowers of banks/FIs, adraft Credit Information Companies (Regulation) Bill waspassed in May 2005 and notified in June 2005. TheGovernment and the Reserve Bank have framed rules andregulations for implementation of the Act, with specificprovisions for protecting individual borrowers rights andobligations. The rules and regulations were notified onDecember 14, 2006. In terms of the provisions of the Act,after obtaining the certificate of registration from the ReserveBank to commence/carry on business of credit informationcompanies will be able to collect all types of credit information(positive as well as negative) from their member creditinstitutions and disseminate the same in the form of creditreports to the specified users/individuals.

Box IV.3Asset Securitisation

Securitisation is a process through which illiquid assets aretransformed into a more liquid form of assets and distributedto a broad range of investors through capital markets. Thelending institutions assets are removed from its balance sheetand are instead funded by investors through a negotiablefinancial instrument. The security is backed by the expectedcash flows from the assets. Securitisation as a techniquegained popularity in the advanced countries in the 1970s.Favourable tax treatment, legislative enactments, establishmentof Government-backed institutions that extend guarantees,and a pragmatic regulatory environment appear to havecontributed to the successful development of this market.

Securitisation involves pooling similar assets together in aseparate legal entity or special purpose vehicle (SPV) andredirecting the cash flows from the asset pool to the newsecurities issued by the SPV. The SPV is a device to ensurethat the underlying assets are insulated from the risks ofdefault by the originator of the assets. In general, there aretwo main advantages of securitisation. First, it can turnordinary illiquid assets into reasonably liquid instruments.Second, it can create instruments of high credit quality out ofdebt of low credit quality.

Securitisation is designed to offer a number of advantages tothe seller, investor and the debt market. For the seller ororiginator, securitisation mainly results in receivables beingreplaced by cash, thereby improving the liquidity position. Itremoves the assets from the balance sheet of the originator,thus, freeing capital for other uses, and enabling restructuringof the balance sheet by reducing large exposures or sectoral

concentration. It facilitates better asset liability management(ALM) by reducing market risks resulting from interest ratemismatches. The process also enables the issuer to recycleassets more frequently and thereby improves earnings. Forinvestors, securitisation essentially provides an avenue forrelatively lower risk investment. Credit enhancement providesan opportunity to investors to acquire good quality assetsand to diversify their portfolios. From the point of view of thefinancial system as a whole, securitisation increases thenumber of debt instruments in the market, and providesadditional liquidity in the market. It also facilitates unbundling,better allocation and management of project risks. It widensthe market by attracting new players due to availability ofsuperior quality assets.

Securitisation, however, if not carried out prudently canleave risks with the originating bank without allocatingcapital to back them. The main risk for a bank arises if atrue sale has not been achieved and the selling bank isforced to recognise some or all of the losses if the assetssubsequently cease to perform. Also, funding risks andconstraints on liquidity may arise if assets designed to besecur it ised have been or iginated, but because ofdisturbances in the market, the securities cannot be placed.There is also a view that there is at least a potential conflictof interest if bank originates, sells, services and underwritesthe same issue of securities.

Reference:

BIS. 2006a. Quarterly Review, June.

there has been proliferation of different types of creditderivatives in several countries (Box IV.5).

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4.34 The risk management architecture of banksin India has strengthened and they are on the way tobecoming Basel II compliant, providing adequatecomfort level for the introduction of credit derivatives.Accordingly, the Reserve Bank, as part of the gradual

process of financial sector liberalisation in India,permitted banks and primary dealers to begintransacting in single-entity credit default swaps (CDS)in its Annual Policy Statement for 2007-08 releasedon April 24, 2007.

Box IV.5Credit Derivatives

A credit derivative is a contract (derivative) to transfer therisk of the total return on a credit asset falling below anagreed level, without transfer of the underlying asset. Thisis usually achieved by transferring risk on a credit referenceasset. Early forms of credit derivatives were financialguarantees. Three common forms of credit derivatives arecredit default swap (CDS), total return swap (TRS) andcredit linked note (CLN). Credit derivatives are designedto allow independent trading/hedging of credit risk. It isalso possible to transfer and/or transform credit riskthrough securitisation. Credit derivative is a logicalextension of two of the most significant developments inthe financial markets, viz., securitisation and derivatives.

A CDS consists of swapping, usually on an ongoing basis,the risk premium inherent in an interest rate on a bond ora loan in return for a cash payment that is made in theevent of default by the debtor. The CDS has become themain driver of the credit derivatives market, offering liquidprice discovery and trading on which the rest of the marketis based. It is an agreement between a protection buyerand a protection seller, whereby the buyer pays a periodicfee in return for a contingent payment by the seller upon acredit event happening in the reference entity. Thecontingent payment usually replicates the loss incurredby creditor of the reference entity in the event of its default.It covers only the credit risk embedded in the asset, risksarising from other factors, such as interest rate movements,remain with the buyer.

A TRS also known as total rate of return swap is acontract between two counterparties, whereby they swapperiodic payments for the period of the contract. Typically,one party receives the total return (interest payments plusany capital gains or losses for the payment period) from aspecified reference asset, while the other receives aspecified fixed or floating cash flow that is not related tothe creditworthiness of the reference asset, as with a vanillainterest rate swap. The payments are based upon the samenotional amount. The reference asset may be any asset,index or basket of assets. The TRS is simply a mechanismthat allows one party to derive the economic benefit ofowning an asset without use of the balance sheet, andwhich allows the other to effectively "buy protection" againstloss in value due to ownership of a credit assets.

While the CDS provides protection against specific creditevents, the total return swap protects against the loss ofvalue irrespective of cause, whether default and wideningof credit spreads, among others.

A CLN is an instrument whose cash flow depends upon acredit event, which can be a default, credit spread, or ratingchange. The definition of the relevant credit events must benegotiated by the parties to the note. A CLN, in effect,combines a credit-default swap with a regular note (withcoupon, maturity, redemption). Given its regular-notefeatures, a CLN is an on-balance sheet asset, unlike a CDS.

Banks and the financial institutions derive at least threemain benefits from credit der ivatives. One, creditderivatives allow banks to transfer credit risk and hencefree up capital, which can be used for other productivepurposes. Two, banks can conduct business on existingclient relationships in excess of exposure norms andtransfer away the risks. For instance, a bank which has hitits exposure limits with a client group may have to turndown a lucrative guarantee deal. However, with creditderivatives, the bank can take up the guarantee andmaintain its exposure limits by transferring the credit riskon the guarantee or previous exposures. This allows bankto maintain client relationships. Three, banks can constructand manage a credit risk portfolio of their own choice andrisk appetite unconstrained by funds, distribution and saleseffort.

However, the use of credit derivatives also raises someconcerns. One, some of the credit derivatives, which arebeing used, are at their infancy and need to mature.Introduction of such products, therefore, may be potentiallydestabilising. Two, the measurement and management ofcredit risk is much more complicated than market risk.Third, documentation risk is an important aspect of creditderivatives. Fourth, certain incentive issues arise with theuse of credit derivatives. This is because such instrumentstypically change the under lying borrower-lenderrelationship and establish new relationships betweenlenders that become risk shedders and the new risk takers.This new relationship has the potential for market failuredue, for instance, to asymmetric information.

Reference:

The Reserve Bank of India. 2003. Report of Working Groupon Introduction of Credit Derivatives in India (Convenor:B. Mahapatra). Mumbai, March.

IMF. 2002. Monetary and Financial Statistics Manual.

Ueda Kazuo. 2003. On Credit Risk Transfer Instrumentsand Central Banks. 18th Annual General Meeting, Tokyo,April.

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IV. TRENDS IN CREDIT THE 1990s ANDONWARDS

Credit Trends All Institutions

4.35 Total loans outstanding by al l creditinsti tut ions (commercial banks, DFIs and co-operatives) combined together increased at acompound annual rate of 15.7 per cent during the1990s and by 17.7 per cent per annum during thecurrent decade so far (up to 2005-06). As percentageof GDP, loans outstanding increased from 34.2 percent at end-March 1991 to 54.1 per cent at end-March2006, suggesting increased credit penetration in thecountry (Table 4.1).

4.36 Dur ing the 1990s, the credit growth ofcommercial banks was lower than that of creditinstitutions in the co-operative sector. However, thetrend has reversed during the current decade (up to2005-06) with credit growth of commercial banksbeing significantly higher than the credit growth of theco-operative institutions. Credit growth of NBFCsduring the first five years of the current decade wassignificantly lower than the growth of total credit byall institutions. Loans and advances by DFIs declined

during the period from 2000-01 to 2005-06, essentiallydue to the conversions of two large DFIs into banks(Table 4.2).

4.37 Reflecting movements in growth rates, theshare of commercial banks credit in total outstandingcredit by all institutions increased significantly from59.7 per cent at end-March 1991 to 78.2 per cent atend-March 2006. During the same period, the shareof RRBs and SCARDBs also increased marginally.The share of all other credit institutions declined. Apartfrom aggressive retail lending strategies adopted bycommercial banks, which captured some of thebusinesses of NBFCs, increased and diversifiedlending into rural areas contributed to the rise in theshare of commercial banks. Conversion of two DFIsinto commercial banks also contributed to the increasein the share of commercial banks in the currentdecade and a sharp decline in the share of FIs (Table4.3). In the case of co-operative institutions, whichare financially weak and inadequately capitalised,reforms have been initiated very recently, which mayhelp in reversing the declining share of co-operativeinstitutions.

4.38 Since commercial banks account for morethan three-fourths of total credit outstanding anddetailed data on credit by other institutions are notreadily available, analysis in the remaining part of thechapter is based largely on credit extended byscheduled commercial banks.

Table 4.2: Institution-wise Growth ofOutstanding Credit

(Compound Annual Growth Rate)(Per cent)

Category 1991-92 to 2000-01 to1999-2000 2005-06

1 2 3

1. Commercial Banks 15.8 23.0

2. RRBs (and LABs) 15.4 21.1

3. Financial Institutions 14.2 -5.9

4. Urban Cooperative Banks 21.4 7.3

5. State Cooperative Banks 16.3 7.6

6. District Central Cooperative Banks 16.0 10.3

7. Primary Agricultural Credit Societies 17.9 9.3

8. SCARDBs 27.0 7.5

9. PCARDBs 15.9 9.1

All Institutions 15.7 17.7

Note : Data are provisional.Source : Report on Trend and Progress of Banking in India, various

issues, Reserve Bank of India.

Table 4.1: Total Outstanding Credit byall Credit Institutions

End-March Total Credit Annual Credit-GDPOutstanding Growth Ratio

(Rs. crore) (Per cent) (Per cent)

1 2 3 4

1991 1,94,654 34.21995 3,47,125 22.7 34.32000 7,25,074 17.1 37.12001 7,94,125 9.5 37.82002 8,93,384 12.5 39.22003 10,77,409 20.6 43.82004 11,99,607 11.3 43.42005 14,81,587 23.5 47.42006 19,28,336 30.2 54.1

Compound Annual Growth Rate (Per cent)

1991 to 2000 15.72000 to 2006 17.7

Note : 1. Data are provisional.

2. Data include commercial banks, RRBs, LABs, DFIs,UCBs, STCBs, DCCBs, PACSs, SCARDBs andPCARDBs.

3. In case of non-availability of data for select co-operatives,data for the previous year have been repeated.

Source : Report on Trend and Progress of Banking in India, variousissues, Reserve Bank of India.

130

REPORT ON CURRENCY AND FINANCE

Trends in Scheduled Commercial Bank Credit

4.39 Bank credit, after witnessing an erratic patternin the first half of the 1990s, showed a decelerationfrom 1996-97 to 2001-02, growing at an average annualrate of 15.1 per cent as compared with 19.5 per cent inthe preceding four years (Chart IV.2). Several factors,both on the demand and the supply sides, contributedto the contraction of credit. On the supply side,introduction of prudential norms relating to incomerecognition, asset classification and provisioning in

the mid-1990s made banks cautious. Application ofnorms revealed large gross NPAs with banks (15.7per cent of their gross advances at end-March 1997).Banks, therefore, became wary of enlarging their loanpor tfolio. The relatively high level of NPAs, inparticular, had a severe impact on weak banks. Bankscapacity to extend credit was also impaired due tolittle headroom available in the capital adequacy ratio(8.7 per cent at end-March 1996). Banks found risk-adjusted returns on government securities moreattractive. Hence, despite lowering of statutory pre-emption in the form of SLR, banks continued to investin government securities, far in excess of therequirements. Banks investment in SLR securities atend-March 1996 was 36.9 per cent of net demand andtime liabilities (NDTL) as against the statutoryrequirement of 31.5 per cent. Banks investments in SLRsecurities remained more or less at that level (36.7 percent) by end-March 2002, even as the SLR was broughtdown significantly to 25 per cent.

4.40 On the demand side also, several factorscontributed to the decline in demand for credit by thecorporate sector. The industrial sector witnessedmassive expansion in capacity in certain sectors,especially cement and steel, in the initial phase ofreforms. However, as the quantitative restrictions wereremoved and import tariffs reduced, the corporatesector faced intense competition during the latter partof the 1990s. The focus of the corporate sector, thus,shifted from expanding capacity to restructuring andthe industrial sector slowed down significantly. Theaverage annual growth rate of industrial productionwas 5.2 per cent during 1996-97 to 2001-02 ascompared with 9.4 per cent in the preceding threeyears. This affected the demand for credit by thecorporate sector. Increased competition also forcedcorporates to restructure their balance sheets,whereby they increased their reliance on retainedearnings and reduced their borrowings. This wasevident from the debt-equity ratio, which declined froman average of 85.5 per cent during 1990-91 to 1994-95 to 65.2 per cent during 1995-96 to 1999-2000 (seeTable 7.5 of Chapter VII).

4.41 Although the Reserve Bank pursuedaccommodative monetary policy during this period(1996-97 to 2001-02) by reducing the CRR and thepolicy rates, viz., the Bank Rate and the reverse reporate (the then repo rate), credit offtake did not pickup. Downward stickiness of nominal interest rates onthe one hand, and falling inflation rate on the other,led to a significant rise in real interest rates. Theaverage real lending rates of banks increased to 12.5per cent during 1996-97 to 2001-02 as against 6.5

Table 4.3: Distribution of Credit Category-wise Share

(Per cent)

Category End-March

1991 2006

1 2 3

1. Commercial Banks 59.7 78.2

2. RRBs (and LABs) 1.8 2.1

3. All-India Financial Institutions 24.9 5.8

4. Urban Co-operative Banks 4.1 3.6

5. State Co-operative Banks 3.4 2.1

6. District Central Co-operative Banks 6.0 4.2

7. Primary Agricultural Credit Societies 3.3 2.5

8. SCARDBs 0.7 0.9

9. PCARDBs 1.0 0.7

All Institutions 100.0 100.0

Note : Data are provisional.Source : Report on Trend and Progress of Banking in India, various

issues, Reserve Bank of India.

Gro

wth

Rat

e (p

er c

ent)

Chart IV.2: Bank Credit and Non-food Credit Growth

Total Bank Credit Non-food Credit

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CREDIT MARKET

per cent during 1990-91 to 1995-96 (Mohan, 2003).This also appeared to have contributed to slacknessin credit expansion.

4.42 Credit growth accelerated in 2002-03 only todecelerate sharply in 2003-04 even when theindustr ial sector was buoyant due mainly tocontraction in food credit and increased recourse bycorporates to internal sources of financing andincreased external commercial borrowings. During2004-05 to 2006-07, bank credit expanded at a robustpace of around 30 per cent. Major factors thatcontributed to the acceleration in credit growth werepick-up in economic growth, improvement in assetquality of the credit institutions, moderation in inflationand inflation expectations, decline in real interestrates, rising income of households and increasedcompetition with the entry of new private sector banks(as detailed in the subsequent sections). The removalof restrictions on retail credit and project finance bybanks also created new sources of credit demand.

Sectoral Deployment of Credit

4.43 Reforms and the evolving economic structurehad a profound impact on the flow of bank credit tovarious sectors of the economy during the 1990s andthe current decade. Credit growth to agriculture duringthe 1990s slowed down to almost one-half ascompared with the 1980s (Table 4.4). However, thetrend was reversed beginning from 2002-03 as a resultof concerted efforts made by the Reserve Bank andthe Government to increase the flow of credit toagriculture. Credit to the industrial sector slowed

down, albeit marginally, in the 1990s and the currentdecade as compared with the 1980s. A significantdevelopment during the current decade, however, hasbeen the rapid credit expansion to the householdsector (personal loans) in the form of housing andother retail loans.

4.44 The share of agriculture and industrial sectorsin total bank credit declined between end-March 1990and end-March 2005, while that of personal loans andprofessional services increased sharply.

Agriculture

4.45 As a result of the sharp deceleration in thegrowth of credit to agriculture, the share of agriculturein total bank credit declined sharply from 15.9 percent at end-March 1990 to 9.6 per cent by end-March2001 (Table 4.5). During this period, however, theshare of agriculture in GDP also