BANK & NON-BANK A financial institution which accepts different forms of deposits and lends them to the prospective borrowers as well as allows the depositors to withdraw their money from the accounts by cheque is a bank. If the financial institution has all the same functions but does nut allow depositors to issue cheque and withdraw their money from deposits then it is a non-bank

SERVE BANK OF INDIA The Reserve Bank of India (RBI) was set up in 1935 (by the RBI Act, 1934) as a private bank with two extra functions—regulation and control of the banks in India and being the banker of the Government. After nationalisation in 1949. it emerged as the central banking body of India and it did not remain a 'bank' in the technical sense. Since then, the governments have been handing over different functions- to the RBI which stand today as given below: li) It is the issuing agency of the currency and coins other than rupee one currency and coin (which am issued by the Ministry of Finance itself with the signature of the Revenue Sec-retary on the note). (ii) Distributing agent for the currency and coins issued by the Government. (iii) Banker of the Government. (iv) Bank of the banks/Bank of the last resort. (v) Announces the credit and monetary policy for the economy. (vi) Stabilising the rate of inflation. (vii) Stabilising the exchange rate of rupee. (viii) Keeper of the foreign currency reserves. (ix) Agent of the Government of India in the IMF (fo Performing a variety of developmental and promotional functions under which it did set up institutions like IDBI. SIDB1. NABARD. NHB, etc.

Credit and Monetary Policy The policy by which the desired level of money flow and its demand is regulated is known as the credit and monetary policy. All over the world it is announced by the central banking body of the country—as the RBI announces it in India. In In-dia there has been a tradition of announcing it twice in a financial year --before the starting of the busy and the slack seasons. But in the reform period, this tradition has been broken. Now the RBI keeps modifying this as per the requirement of the economy though the practice of the two policy announcements a year still continues. In India. a debate regarding autonomy to the RBI regarding announcement of the policy started when the Narasimham Committee-I recommended on these lines. As the Governor RBI it was Bimal Jalan who vocally supponed the idea. No such move came from the governments officially but it is believed that the RBI has been given almost working autonomy in this area. In most of the developed economics. the central bank functions with autonomous powers in this area (bifurcation of politics from the economics). Though we lack such kind of officially open autonomy for the RBI. we have learnt enough by now and are better today, there is no doubt in it. There are many tools by which the RBI regulates the desired/required kind of the credit and monetary policy—CRR, SLR, Bank Rate. Repo rate. Reverse Repo a PLR, Ulm interest rate. Small Saving Schemes' interest rates (SSSs), interest changes for the instruments of the Money Market. etc. CRR The cash reserve ratio (CRR) is the ratio (fixed by the RBI) of the total deposits of a bank in India which is kept with the RBI in cash form. This was fixed to be in the range of 3 to 15 per cent? A n.Namt Amendment (2007) has removed the 3 per cent floor and provided a free hand to the RBI in fixing the CRR.

At present it is 6.0 per cent and a I per cent change in it today affects the economy with r64,000 crore4—an increase sucks this amount from the economy while a decrease injects this amount into the economy. Following the recommendations of the Narasimham Committee on the Financial System (1991) the Government started two major changes concerning the CRR: (i) reducing the CRR was set as the medium-term objective and it was reduced gradually from its peak of 15 per cent in 1992 to 4.5 per cent by June 20035. After the RBI (Amendment) Act has been en-acted in June 2006, the RBI can now prescribe CRR for scheduled banks without any floor or ceiling rate thereby removing the statutory mini-mum CRR limit of 3 per centfr (ii) Payment of interest by the RBI on the CRR money to the scheduled banks started in financial year 1999-2000 (in the wake of banking slow down). Though the RBI discontinued interest payments from mid-2007.7

SLR The statutory liquidity ratio (SLR) is the ratio (fixed by the RBI) of the total deposits of a bank which is to be maintained by the bank with itself in non-cash form prescribed by the Government to be in the range of 25 to 40 per cent.8 At present it is 25 per cent (done in October. 1997 after CFS suggestions)°. It used to be as high as 38.5 per cent. The CFS has recommended the Government not to use this money by handing G-Sees to the banks. In its place a market-based interest on it should be paid by the Government it was being advised. However. there has been no follow up in this regard by the governments. The Government of India has removed the 25 per cent floor for the SLR by an Amendment (2007) providing the RBI a free hand in fixing it—soon it

was cut down to 24 per cent—but by late 2009 it was hiked back to 25 per cent to fight price rise. The ratio now stands at 24 per cent. Bank Rate The rate of interest which the RBI charges its cli-ents on their long-term borrowing is the Bank Rate in India. The clients arc the Central & State Govern-ments, Banks, Financial institutions, Cooperative banks. NBFC. etc. and the rate is at present 6 per cent". It has a direct impact on the interests banks charge on different kinds of loans they forward. Repo Rate The rate of interest the RBI charges from its cli-ents on their shon-term borrowing is the repo rate in India which is at present 6.5 per cent." Basi-cally. this is abbreviated form of the 'rate of repur-chase' and in western economies it is known as the 'rate of discount." In practice it is not called an interest rate but considered a discount on the dated Government Securities which are deposited by the institution to borrow for the short term. When they get their securities released from the RBI the value of the securities is lost by the amount of the current repo rate. This rate functions as the benchmark rate for the inter-bank short-term market (i.e. Call Money Market) in India. Banks usually use this route for one-day borrowing to fulfill their short-term liquidity crunch. Higher the repo rate costlier the loans banks forward and vice versa. It has direct impact on the nominal interest rates of the bank's lending. The repo rate was introduced in December 1992. Reverse Repo Rate It is the rate of interest the RBI pays to its clients who otTer short term loan to it (at present 5.5 per cent). It is reverse of the repo rate and this was started in November 1996 as part of Liquidity Adjustment Facility (LAF) by the RBI. In practice. Financial

instituions operating in India park their surplus funds with the RBI for short-term period and earn money. It has a direct bearing on the interest rates charged by the banks and the financial institutions on their different forms of loans. This tool was utilised by the RI31 in the wake of over moncy supply with the Indian banks and lower loan disbursal to serve twin purposes ofcutting down banks losses and the prevailing interest rate". It has emerged as a very important tool in direction of following cheap interest regime • the general policy of the RBI since reform process started. PLR The prime lending rate (PLR.) is the lowest rate of interest a bank will charge to its best customers on any loan in India. It means it is the 'benchmark rate' (by which name it is known in the Euro-American economies) below which a bank does not forward loans. Usual loans by banks are always above its PLR. Till 1994. the PLR for the public sector banks (PSBs) was announced by the RBI—a single rate. But it has been now 'decontrolled' and every indi-vidual bank announces its own PLR. At the same time. banks are allowed to lend its customers even below their PLRs (provided the loan amount is not less than Rs. 2 lakhs).ls In the financial year 2004-05 the RBI had shown its intention of again con-trolling the PLR for the PSBs again but no such policy announcements have been made since then. How banks calculate their PLR? Basically. they add up the main elements like--bank rate of the time. repo & reverse repo rates. interest forgone on different deposits. other overhead expenditures (salaries of staff, PF burden. pension burden. rent of branches, electricity, etc.) and fix their PLR. BPLR The benckmark prime lending rate (BPLR) is the lowest interest rate below the PLR which a bank charges from any borrower (i.e. the best customer) in the last financial year.'" In the fiscal 2004-05 the Government made it an obligation on banks operating in India to announce their BPLRs to pro-vide greater transparency in the lending activities of the economy. Since March 2010 the BPLR has been made the new PLR (prime lending rate). • The Base Rate has replaced the PLR and BPLR since July 2010.

NATIONALISATION AND DEVELOPMENT OF BANKING The development of banking industry in India has been intertwined with the story of its nationalisation. Once the Reserve Bank of India (RBI) was nationalised in 1949 and a central banking was in place the government considered the nationalising of selected private banks in the country due to the following major reasons: (i) As the banks were owned and managed by the private sector the services of the bank-ing were having a narrow reach—the masses had no access to the banking service; (ii) The Government needed to direct the re-sources in such a way that greater public benefit could take place; (iii) The planned development of the economy required a certain degree of government con-trol on the capital generated by the economy. Nationalisation of banks in India took place in the following two stages: 1. Emergence of the S131 The Government of India, with the enactment of the Sill Act. 1955 partially nationalised the three Imperial Banks (mainly operating in the three Presi-dencies of past with their 466 branches) and named them the State Bank of India—the first public sec-tor bank emerged in India. The RBI had purchased 92 percent of the shares in this partial nationalisation. Satisfied with the experiment, the Government in a related move partially nationalised eight more private banks (with good regional banks) via Sill (Associates) Act. 1959 and named them as the Associates of the SRI—the RBI had acquired 92

per cent stake in them as well. After merging the State Bank of Bikaner and the State Bank of Jaipur as well. the RBI came up with the State Bank of Bikaner and Jaipur. Now the SBI Group has a total number of eight banks—SBI being one and seven of its Associates.

2. Emergence of Nationalised Banks After successful experimentation in the partial -za!idnalisations now the Government decided to ar .-11 ,-.141e1 of go for complete nationansau the Banking Nationalisation Act. 1969. the Gov-ernment nationalised a total number of 20 private banks: (i) 14 banks with deposits more than ?5O crore nationalised in July 1969, and (ii) 6 banks with deposits more than 2200 crore nationalised in April 1980. After the merger of the loss-making New Bank of India with the Punjab National Bank (PNB) in September 1993. the total number of the nationalised banks came down to 19. Today there are 27 public sector banks in India out of which 19 are nationalised (though none of the so-called nationalised banks have 100 per cent ownership of the Government of India). After the nationalisation of banks the Government stopped opening of banks in the private sector though some foreign private banks were allowed to operate in the country to provide the external currency loans. After India ushered in the era of Vie economic reforms. the Government started a comprehensive banking system reform in the fiscal 1992-93." Three related developments allowed the further expansion of banking industry in the country: (i) In 1993 the SBI was allowed access to the capital market with permission given to sell its share to the tune of 33 per cent through SB! (Amend-ment) Act. 1993. At present the Government of India has 59.73 per cent shares in the SBI (It was on July 9. 2007 that the entire equity stake of RI31 was taken over by the Government of India. Thus. the RBI is no more the holding bank of the SBI and its Associates.). On October 10, 2007 the Government an-nounced its proposal of selling the shares of the SBI and cutting down its stake in it to 53 per cent level so that the bank can go for capitalisation. (ii) In 1994 the Government allowed the nationalised banks to have the access to the capi-tal sale of tal market isnined111:--of-33.Pcf shares through the Banking Companies (Amend-ment) Act. 1994. Since then many nationalised banks have tapped the capital market for their capital enhancement—Indian Overseas Bank being the first in the row. Though such banks could be better called the pub-lic sector banks (as the Got holds more than 50 per cent stake in them) they are still known as the nationalised banks. (iii) In 1994 itself the Government allowed the opening of private banks in the country. The first private bank of the reform era was the UTI Bank. Since then few dozens Indian and foreign private banks have been opened in the country. Thus, since 1993-94 onwards we see a rever-sal of the policies governing banks in the country. As a general principle the public sector and the nationalised banks are to be converted into private sector entities. What would be the minimum gov-ernment holding in them is still a matter of debate and yet to be decided)* Though the policy of bank consolidation is still being followed by the govern-ment so that these banks could broaden their capital base and emerge as significant players in front of the global banking competition." Every delay in it will hamper their interests, as per the experts.

FINANCIAL SECTOR REFORMS The process of economic reforms initiated in 1991 had redefined the role of government in the economy—in coming times the economy will be dependent on the greater private participation for its developments Such a changed view to devel-opment required an overhauling in the investment structure of the economy. Now the private sector was going to demand high investible capital out of the financial system. Thus, an emergent need was felt to restructure the whole financial system of India. The three decades after nationalisation had seen a phenomenal expansion in the ;;;;;;;;-1-,icaj cov-erage and financial spread of the banking system in the country. As certain rigidities and weaknesses were found to have developed in the system dur-ing the late eighties, it was felt that these had to be addressed to enable the financial system to play its role ushering in a more efficient and competitive economy. 2% Accordingly, a high level Committee on Financial System (CFS) was set up on August 14, 1991 to examine all aspects relating to struc-ture, organisation, function and procedures of the financial system—based on its recommedations. a comprehensive reform of the banking system was introduced in the fiscal 1992-93.n Thc CFS based its recommendations on certain assumptiont3 which are basic to the banking in-dustry. And the suggestions of the committee be-came logical in light of this assumption. there is no second opinion about it. The assumption says that "the resources of the banks come from the gen-eral public and are held by the banks in trust that they are to be deployed for maximum benefit of the depositors". This assumption automatically implied: (i) That even the Government had no business to endanger the solvency, health and effi-ciency of the nationalised banks under the pretext for using banks, resources for eco-nomic planning, social banking, poverty alleviation, etc. (ii) Besides. the Government had no right to get hold of the funds of the banks at low interest rates and use them for financing its consumption expenditure (i.c revenue and fiscal deficits)and thus defraud the depositors. Thc recommendations of the CFS (Narasim-ham Committee I) were aimed at: (i) Ensuring a degree of operational flexibility; (ii) internal autonomy for public sector banks (PSBs) in thcir dccision making rwww^' m10 oimme of professionalism in bank-ing operation.

Recommendation of CFS The CFS mcommondations could be summed up under five sub-titles:

I. On Directed Investment The RBI was advised not to use the CRR as a prin-cipal instrument of monetary and credit control, in place it should rely on open market operations (0M0s) increasingly. Two proposals advised re-garding the CRR: (i) CRR should be progressively reduced from the present high level of 15 per cent to 3 to S per cent: and (ii) RBI should pay interest on the CRR of banks above the basic minimum at a rate of interest equal to the level of banks one year deposit. Concerning the SLR it was advised to cut it to the minimum level (i.e. 25 per cent) from the present high level of 383 per cent in the next 5 years (it was cut down to 25 per cent in October 1997). The Government was also suggested to progres-sively move towards market-based borrowing programme so that banks get economic benefits on their SLR investments. These suggestions were directed to the goal of making more funds available to the banks, con verting idle cash for use. and cutting down the interest rates banks charge on their loans. 2. On Directed Credit Programme Under this sub-title the suggestions revolved around the

compulsion of priority sector lending (PSL) by the banks: (i) Directed credit programme should be phased out gradually. As per the committcc, agriculture and small scale industries (SSTs) had already grown to a mature stage and they did not require any special support two decades of interest subsidy were enough. Therefore, concessional rates of interest could be dispensed with. Directed credit should not be a regular programme—it should be a case of extraor-dinary support to certain weak sections—besides, it should M ttiiinontry, not a per-Ts-anent one. (ii) Concept of PSL should be redefined to in-clude only the weakest sections of the rural community such as marginal farmers, rural artisans, village and cottage industries, tiny sector. etc. (iv) The "redefined PSL" should have 10 per cent fixed of the aggregate bank credit. (v) The composition of the PSL should be re-viewed after every 3 years. 3. On the Structure of Interest Rates The major recommendations on the structure of interest rates are: (i) Interest rates to be broadly determined by market forces; (ii) All controls of interest rates on deposits and lending to be withdrawn; (ii) Concessionsl rates of interest for PSL of small sizes to be phased out and subsidies on the IRDP loans to be withdrawn; (iv) Bank rate to be the anchor rate and all other interest rates to be closely linked to it; and (v) The RBI to be the sole authority to simplify the structure of interest rates.

4. On Structural Reorganisation of the Bank

For the structural reorganisation of banks some major suggestions were given: (i) Substantial reduction in the number of the PSBs through mergers and acquisitions—to bring about greater efficiency in banking operations; (ii) Dual control of RBI and Banking Division (of the Ministry of Finance) should go immedi-ately and RBI to be made the primary agency for the regulation of the banking system; The PSBs to be made free and autonomous: (iv) The RBI to exami" •;',1 ism guidelines and affections issued to the banking system in the context of the independence and au-tonomy of the banks; (v) Every PSB to go for a radical change in work technology and culture. so as to become competitive internally and to be at par with the wide range of innovations taking place abroad; and (vi) Finally, the appointment of the Chief Executive of Bank (CMD) was suggested not to be on political considerations but on professionalism and integrity. An independent panel ofexperts was suggested which should recommend and finalise the suitable candidates for this post. S. Asset Reconstruction Companies/ s/ To tackle the menace of the higher non-perform-ing assets (NPAs) of the banks and the financial institutions, the committee suggested setting up of the asset reconstruction companies/funds (taking clue from the US experience). The committee directly blamed the Government of India (Gol) and the Ministry of Finance for the sad state of affairs of the PSBs. These banks were used and abused by the GoI, the officials. the bank employees and the trade unions, the report adds. The recommendations were revolutionary in many respects and were opposed by the bank unions and the leftist political panics. There were some other major suggestions of the committee which made it possible to get the followings things done by the Government: (i) opening of new private sector banks per-mined in 1993; (ii) prudential norms relating to income recog-nition, asset classification and provisioning by banks on the basis of objective criteria laid down by the RBI;

(ih) the introduction of the capital adequacy norms (i.e. CAR provisions) with interna-tional Siiinu"ri.a.-5.13fte.d_;____ (iv) simplification in the banking regtiiiiiiint7-- via board for financial supervision in 1994); etc.

*OWING SECTOR REFORM The government commenced a comprehensive reform process in the financial system in 1992-93 after the recommendations of the CFS in 1991. In December 1997 the Government did set up another committtee on the banking sector reform under the chairmanship of M. Narasimham.26 The objective of the committee is objectively clear by the terms of reference it was given while setting up—"To review tke progress of banking sector reforms to date and chart a programme of financial sector reforms necessary to strengthen India's financial system and make it internationally competitive" The Naraslmham Committee-11 (Popularly called by the Government of India) handed over its reports in April 1998 which included the fol-lowing major suggestions27: (i) Need for a stronger banking system for which mergers of the PSBs and the finan-cial Institutions (AIFIs) were suggested—

stronger banks and the DFIs (development financial institutions i.e. AlF1s) to be merged while weaker and unviable ones to be closed. (ii) A 3-tier banking structure was suggested af-ter mergers: • Tier-1 to have 2 to 3 banks of interna-tional orientation; • Tier-2 to have 8 to 10 banks of national orientation; and • Tier-3 to have a large number of local banks. The first and second tiers were to take care of the banking needs of the corporate sector in the economy. Higher norms of Capital-to-Risk—Weighted Adequacy Ratio (CRAR) suggested—in-creased to 10 per cent. Budgetary recapitalisation of the PSBs is not visa W".p shoulg be abandoned. Legal frameworkolioaii•Mivenf_ahould be strengthened (the government passed—tre SARFAES Act, 2002). Net NPAs for all banks suggested to be cut down to below 5 per cent by 2000 and 3 per cent by 2002. Rationalisation of branches and staffs of the PSBs suggested. Licensing to new private banks (domestic as well as foreign) was suggested to con-tinue with. Banks' boards should be depoliticised under RBI supervision. Board for financial Regulation and Supervi-sions (BFRS) should be set up for the whole banking, financial and the NBFCs in Indies.

DIU The differential rate of interest (DRI) is a lending programme launched by the government in April 1972 which makes it obligatory upon all the public sector banks in India to lend 1 per cent of the total lending of the preceding year to `the poorest among the poor' at an interest rate of 4 per cent

per annum. The total lending in 2005-06 was ns crores.

Priority Sector Lending All Indian banks have to follow the compulsory target of priority sector lending (PSL). The priority sector in India are at present the sectors—agriculture, small and medium enterprises (SMEs), road and water transport, retail trade, small business, small housing loans (not more than Its. 10 lakhs), software industries, Self Help Groups (SHGs), agro-processing, small and marginal farmers. artisans, distressed urban poor and indebted non-institutional debtors besides the SCs, STs and other weaker sections of society? The 5 minorities,

namely the Muslims, Christians, Sikhs, Buddhists and Persia have been included under the PSL." Thc PSL target must be met by the banks operating in India in the following way: (i) Indian Banks need to lend 40 per cent to the priority sector every year (public sector as well as private sector banks, both) of their total lending. There is a sub-target also—I8 per cent of the total lending must go to agri-culture and 10 per cent of the total lending or 25 per cent of the priority sector lending (whichever be higher) must be lent out to the weaker sections. Other areas of the pri-ority sector to be covered in the left amount i.e. 12 per cent of the total lending. (ii) Foreign Banks have to fulfill only 32 per cent PSL target which has sub-targets for the exports (12 per cent) and small and me-dium enterprises (10 per cent). It means they need to disburse other areas of the PSL from the remaining 10 per cent of their total lend-ing (lesser burden). The Committee on Financial System (CFS, 1991) had suggested to immediately cut it down to 10 per cent for all banks and completely phasing out of this policy for the betterment of the banking

industry in particular and the economy in general. Thc committee also suggested to shuffle the sectors covered under PSL every three years. No follow up has been done from the government except cutting down PSL target for the foreign banks from 40 per cent to 32 per cent meanwhile some new areas have been added to the PSL.

THE MENACE OF NPAs Non-Performing Assets (NPAs) are bad debts of banks/Financial Institutions defined as follows w.c.f. March 31, 2001:31 An advance of banks/Fls where—(i) interest and/or installment or principal re-mains overdue for a period more than 180 days in respect of a term loan: (ii) interest and/or installment or principal re-mains overdue for two harvest seasons but for a period not exceeding two-and-a-half years in the case of agricultural loans. The NPAs were classified into three types: (a) Sub-standard: remaining NPAs for less than or equal to 18 months; (b) Doubtful: remaining NPAs for more than 18 months; and (c) Loss assets : where the loss has been identified by the bank or internal/exter-nal auditors or the RBI inspection but the amount has not been written off. As per the All Indian Bank Employees Associa-tion (AIBEA), the premier union representing bank workers in India, the menace of NPAs has reached the following levels by March 31, 2001:32 • The NPAs of borrowers account owing more than ?l crore each to banks/Fls added to 280,574 crores • if interests are also calculated it becomes over t130,000 atoms. • Nearly 80 per cent of it is owed to the PSBs (public sector banks).

SARFAESI Act, 2002 Gol finally cracked down on thc wilful defaulters by passing the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI Act. 2002. The Act gives far reaching powers to the banks/ Fls concering NPAs: 1. Banks/Fls having 75 per cent of the dues owed by the borrower can collectively proceed on the following in the event of the account becom-ing NPA: (A) Issue notice of default to borrowers asking to clear dues within 60 days. (B) On the borrower's failure to repay: (i) Take possession of security and/or (ii) take over the management of thc bor-rowing concern and/or (iii) appoint a person to manage the concern. (C) If the case is already before the BIFR, the proceedings can be stalled if banks/Fls having 75 per cent share in the dues have taken any steps to recover the dues under the provisions of the ordinance. 2. The banks/Fls can also sell the security to a securitisation or Asset Reconstruction Company (ARC), estd. under the provisions of the Ordinance (The ARC is sought to be set up on the lines simi-lar to the USA, few years ago.]

Debt Recovery Tribunals (DRTs) Earlier, the Government had set up Debt Recovery Tribunals (DRTs) in 1993 which failed to bring about the desired change in the scenario due to"-(i) DRTs are also clogged up with many cases and the judgement takes time (many months, if not years): (ii) The sale of property can be made only through court appointed officials, adding delays; (iii) The tribunals cannot take up the medium-

or large-sized firms if they are under consideration of the BIER due to sickness. The praiseworthy step regarding recovery of the NPAs and allowing the setting up of the Asset Reconstruction Companies (ARCs) had an impact. Improved industrial climate and new options available to banks for dealing with bad loans helped in recovering a substantial amount of NPAs. The NPAs of scheduled commercial banks (SCBs) were at 1.9 per cent of total assets at end March 2005? The operations of the Assets Reconstruction Company of India Limited (ARCIL) has also been praiseworthy with recovery of dues to the tune of Z2I,126 Gray of 31 banks/financial institutions via a total number of 559 cases."

CAPITAL ADEQUACY RATIO At first sight bank is a business or industry a segment of the service sector in any economy. But the failure of a bank may have far greater damaging impact on an economy than any other kind of business or commercial activity. Basically, modem economics arc heavily dependent on banks today than in the past-banks arc today called the backbone of economics. Healthy functioning of banks is today essential for the proper functioning of an economy. As credit creation (i.e. loan disbursals) of banks are highly risky business the depositors' money depends on thc banks' quality of lending. More importantly, thc whole payment system, public as well as private. depends on banks. A bank's failure has the potential of creating chaos in an economy. This is why governments of the world pay special attention to the regulatory aspects of the banks. Every regulatory provision for banks tries to achieve a simple equation i.e. "how the banks should maximise their credit creation by minimising the risk and continue their functioning permanently". And in the banking business risks are always there and cannot be made 'zero'-as any loan forwarded to any individual or firm (irrespective of their credit-worthiness) has

the risk of turning out to be a bad debt (Le NPA in India)-thc probability of this being 50 per cent. But banks must function so that economies can function. Finally, the central banks of the world started devising tools to minimise the risks of banking at one hand and providing cushions (shock-absorbers) to the banks at the other hand so that banks do not go bust (i.e. shut down after becoming bankrupt). Providing cushion/shock-absorbers to banks has seen three major developments: (i) The provision of keeping a cash ratio of to-tal deposits mobilised by the banks (known as the CRR in India); (ii) Thc provision of maintaining some assets of the deposits mobilised by the banks with the banks themselves in non-cash form (known as the SLR in India); and (iii) The provision of the capital adequacy ratio (CAR) norm. The capital adequacy ratio (CAR) norm has been the last provision to emerge in the area of regulat-ing the banks in such a way that they can sustain the probable risks and uncertainties of lending. It was in 1988 that the central banking bodies of the developed economics agreed upon such a provi-sion, the CAR-also known as the Basel Accord36. The Accord was agreed upon at Basel. Switzer-land at a meeting of the Bank for International Settlements (BIS)." It was at this time that the Basel-I norms of the capital adequacy ratio were agreed upon-a requirement was imposed upon the banks to maintain a certain amount of free capital (Le. ratio) to their asset? (i.e loans and invest-ments by the banks) as a cushion against probable losses in investments and loans. In 1988 this ratio capital was decided to be 8 per cent. It means that if the total investments and loans forwarded by a bank amounts to ?I00, the bank needs to maintain a free capita139 of 118 at that particular time. The capital adequacy ratio is the percentage of total

capital to the total risk - weighted assets. (see ref-erence 39). Thc RBI introduced the capital-to-risk weighted asses ratio (CRAR) system for the banks operat-ing in India in 1992 in accordance with the stan-dards of the BIS-as part of the financial sector reforms.4° In the coming years the Basel norms were extended to term-lending institutions, primary dealers and non-banking financial companies (NBFCs), too. Meanwhile the BIS came up with another set of the CAR norms, popularly known as Basel-11. The RBI guidelines regarding the CAR norms in India have been as given below: I. Basel-1 norm of the CAR was to be achieved by the Indian banks by March 1997. 2. The CAR norm was raised to 9 per cent with effect from March 31, 2000 (Narasimham Committee-11 had recommended to raise it to 10 per cent in 1998). 3. Foreign banks as well as Indian banks with foreign presence to follow Basel-11 norms w.e. f. March 31, 2008 while other sched-uled commercial banks to follow it not later than March 31, 2009. The Basel-11 norm for the CAR is 12 per cent." Keeping in mind the future CAR norm, the banks in India have already started their preparation re-garding capitalisation. In October 2007, the Gol announced to offload its holding in the SBI to 53 per cent (from 59.73 per cent) so that the bank could raise a capital amounting to 1110,000 crore. The current position regarding achievements of the CAR norm by the various banks operating in India are well above the stipulated norm (i.e. 9 per cent)42: Nationalised banks - 12.3 per cent Ncw Private banks - 12.6 per cent Foreign banks - 13.0 per cent All Scheduled Commerical Banks-12.3 per cent.

WHY TO MAINTAIN CAR? The basic question which comes to mind is as to why do the banks need to hold capital in the form of CAR norms? TWO reasoniu have been gener-ally forwarded for the same: (i) Bank capital helps to prevent bank failure. which arises in case the bank cannot satisfy its obligations to pay the depositors and other creditors. The low capital bank has a nega-tive net worth after the loss in its business. In other words it turns into insolvent capi-tal, therefore, acts as a cushion to lessen the chance of the bank turning insolvent. (ii) The amount of capital affects returns for the owners (equity holders) of the bank. Basel Accords Thc Bud Accords (i.e. Basel I and II) are of para-mount importance to the banking world and are presently implemented by over 100 countries across the world. The BIS Accords were outcome of a long-drawn-out initiative to strive for greater international uniformity in prudendtial capital stan-dards for banks credit risk. Thc objectives of the accords could be summed up" as -(i) to strengthen the international banking system; (ii) to promote convergence of national capital standards; and (ii) to iron out competitive inequalities among banks across countries of the world. The Basel Capital Adequacy Risk-related Ratio Agreement of 1988 (I.e. Basel I) was not a legal document. It was designed to apply to internationally active banks of member countries of the Basel Committee on Banking Supervision (BCBS) of the BIS at Basel, Switzerland. But the details of its implementation were left to national discretion. This is why Basel I looks G-10-centric.43 From the very beginning Basel I was subject to criticism as the norms had to accommodate banking practices and regulatory regimes in countries with varied legal systems, business norms, and prevalent institutional structures. It was

in light of the criticisms to Basel I that a New Capital Adequacy Framework (referred as the Basel 11) in June 1999 was agreed upon by the BIS. Basel II incorporates the following three major elements or 'pillars'46: (i) minimum capital requirements, based on weights intended to be more closely aligned to economic risks than Basel I; (ii) supervisory review, which set basic stan-dards for bank supervision to minimise regu-latory arbitrage; and, (iii) market discipline, which envisages greater levels of disclosure and standards of trans-parency by the banking system. Basel II has generated intense debate among policy-makers and academia alike. since its publi-cation. Several questions have been raised in this connection. Does Basel II discriminate against developing countries? Will it reduce the flow of resources to emerging markets? India's reac-tions° to it could be summed up as given below: (i) It will involve a shift from direct supervi-sory focus to the implementation issues; (ii) Banks and supervisors would be required to invest large resources in upgrading their technology and human resources, (ii) A simplified standardised approach has been suggested for those banks that arc not ac-tive internationally; etc. Criticisms and objections set apart. all commer-cial banks. including foreign banks in India. mi-grated to the Basel II framework by March 31, 2009."

RRBs The Regional Rural Banks (RRBs) were first set up on October 2, 1975 (only S in numbers) with the aim to take banking services to the doorsteps of the rural masses specially in the remote areas with no access to banking services with twin du-ties to fulfill-

(i) to provide credit to the weaker sections of the society at concessional rate of interest who previously depended on private money lending and (ii) to mobilise rural savings and channelise them for supporting productive activities in the ru-ral areas. Following the suggestions of the Kelkar Com-mittee, the government stopped opening new RRBs in 1987-by that time their total number stood at 196. Due to excessive leanings towards social bank-ing and catering to the highly economically weaker sections, these banks started fetching huge losses by early 1980s. For restructuring and strengthen-ing of the banks, the governments set up two com-mittees-the Bhandari Committee (1994-95) and the Basu Committee (1995-96). Out of the total. 171 were running in losses in 1998-99 when the government took some serious decisions-(i) the obligation of concessional loans abolished and the RRBs started charging commercial interest rates on its lendings. (ii) the target clientele (rural masses, weaker sec-tions) was set free-now they can lend to any body. After the above-given policy changes, the RRBs started coming out of the red and at present only four such banks are in losses which arc supposed to turn green by the end of the fiscal 2006 -07. The CFS has recommended to get them merged with their managing nationalised or public sector banks and finally make them part of the would-be three-tier banking structure of India. At present there are 104 RRBs (after amalgamating 134 RRBs, 42 new RRBs were formed) functioning in India-amalgamation process is continued (India 2010).

Minimum Reserve The RBI is required to maintain a reserve equiva-lent of 2200 crows in gold and foreign currency with itself, of which 21115 crows should be in gold.

This is being followed since 1957 and is known as the Minimum Reserve System (MRS). Reserve Money The gross amount of the following six segments of money at any point of time is known as the Reserve Money (RM) for the economy or the government: I. RBI's net credit to the Government; 2. RBI's net credit to the Banks; 3. RBI's net credit to the commercial banks; 4. Net forex reserve with the RBI; 5. Government's currency liabilities to the Public; 6. Net non-monetary liabilities of the RBI. RM 1 + 2 + 3 + 4 + 5 + 6 The RM by the end of January 15. 2010 had a growth rate of 3.8 per cent." Money-Multiplier The ratio of M3 to the Reserve Money at any point of time is known as the money-multiplier in India. As on January 15. 2010. it was at 5.4 per cent". Stock of Money In every economy it is necessary for the central bank to know the stock (level, amount) of money available only then it can go for suitable kind of credit and monetary policy. Saying simply, credit and monetary policy of an economy is all about changing the level of money flowing in the economic system. But it can be done only when we know the real flow of money. That's why it is necessary to rust assess the level of money flowing in the economy. The RBI has been setting up Working Group on Money Supply in India from time to time. As per the Second Working Group on Money supply (1971-72), the RBI calculates the stock of money in India with the help of four components of money known as Money', Money2, Moncy3 and Money, which contain money of differing liquidities:

M1 = Currency & coins with people s Demand deposits of Banks (Current & Saving Ac-counts) + Other deposits of the RBI. M, = M, 4 Demand deposits of the post offices (i.e. saving schemes money). M, Time/Tenn deposits of the Banks (i.e. the money lying in the Recurring Deposits &

the Fixed Deposits). M4 = M3 total deposits of the post offices (de-mand as well time deposits). There am some important concepts dealing with the stock of money in India: Liquidity of Money As we move from M, to M4 the liquidity (inertia, stability. spendability) of the money goes on decreasing and in the opposite direction. the liquidity increases. Narrow Money In banking terminology, M, is called narrow money as it is highly liquid and banks cannot run their lending programmes with this money. Broad Money The money component My is called broad money in the banking terminology. With this money (which lies with banks for a known period) banks ran their lending programmes. Money Supply In general discussion we usually use money supply to mean money circulation, money flow in the economy. But in banking and typical monetary management terminology the level and supply of M, is known as money supply. It has a growth rate which is shown in percentage per annum (on January 15. 2010 it was at 19.1 per cent as per the Economic Survey 2009-10). Meanwhile, the RBI did set up a new Working Group on Money Supply which handed over its report in June 1998." It recommended new components of money i.c. Mo. MI, M2 and Mk At

the same time it suggested three components of liquidity measures also i.e. Li. L2 and L3. The working group advised for the quarterly publication of Financial Sector Survey to capture the dynamic linkages between banks and rest of the organised financial sector.

Credit Counselling Advising borrowers to overcome their debt bur-den and improve money management skills is credit counselling. The first well-known such agency was created in the USA when credit granters created National Foundation for Credit Counselling (NFCC) in 1951." Credit Rating To assess the credit worthiness (credit record, integrity, capability) of a prospective (would be) borrower to meet debt obligations is credit rating. Today it is done in the cases of individuals, companies and even countries. There are some world-renowned agencies such as the Moody's, S & P. Thc concept was first introduced by John Moody in the USA (1909). Usually equity share is not rated here. Primarily, ratings are an investor service. Credit rating was introduced in India is 1988 by the ICICI and UT!, jointly. The major credit rating agencies of India arc-(i) CRISIL (Credit Rating Information of India Ltd.) was jointly promoted by ICIC1 and UTI with share capital coming from SBI, LIC, United India Insurance Company Ltd. to rate debt instrument-debenture. In April 2005 its 51 per cent equity was :Ac-quired by the US credit rating agency Stan-dard & Poor (S & P)-a McGraw Hill Group of Companies. ICRA (Investment Information and Credit Rating Agency of India Ltd.) was set up in 1991 by IFCI. LIC, SBI and select banks as put on hold once the UPA Govt. came to power.

capital adequacy ratio is the percentage of total capital to the total risk-weighted assets (sec reference 39). Capital Adequacy Ratio (CAR). a measure of A bank's capital, is expressed as a percentage of a bank's risk weighted credit exposures: CAR= Total of the Tier 1 & Tier 2 capitals + Risk Weighted Assets Also known as 'Capital to Risk Weighted Assets Ratio (CRARy this ratio is used to protect depositors and promote the stability and efficiency of financial systents around the world. Two types of capital "Me measured as per the Basel II norms -Tier I capital. which an absorb losses without a bank being required to cease trading. and Tier 2 capital. which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors the new norms (Basel III) has devised a third category of capital. Tier) capital. The RIM introduced the capital-to-risk weighted assets ratio (CRAB) system for the banks operating in India in 1992 in accordance with the standards of the BIS as part of the financial sector reforms?' In the coming years the Basel norms were extended to term•knding institutions. primary dealers and non-banking financial companies (N Bits). too. Meanwhile the BIS came up with anotherset of the CAR norms, popularly known as Basel-11.11e RBI guidelines regarding the CAR norms in India have been as given below: 1. BoselsI 1101111 of the CAR was 03 be achtved by the Indian banks by Mardi 1997. 2. The CAR norm was raised to 9 per cent with effect from March 31. 2000

(Nanaisthant Committral bid erammtakel to ream it to 10 per ant in 1.92.5)." 3. Foreign banks as well as Indian banks with foreign presence to follow Dasel•li norms wax( March 31,2008 while other scheduled commercial banks to follow it not later than March 31,2009111c Basel-11 norm for thc CAR is 12 per cent."

I M' To MAIN= CM?

'live basic question which comes to mind is as to why do the banks need to hold capital in the form of CAR norms? Two reasons" have been generally forwarded for the same: 0 Bank capital helps to prevent bank adore. which arises incase the bank cannot satisfy its obligations to pay the depositors and other creditors. The low capital bank has a negative net worth after the loss in its business. In other words. it turns into insolvent capital. therefore. acts as acushion to lessen the chance of the bank turning insolvent (id The amount of capital affects returns for the owners (equity holders) of the bank.

Basel Accords The Basel Accords (ix. Basel I, II and now Basel 114 are a set of agreements set by the Basel Committee on Bank Supervision (BCBS), whicb provides recommendations on banking regulations in =girds to capital risk, market risk and operational risk. The purpose of the accords n to ensure that financul institutions have enough

Capital on account ro meet OMIEMIMISAII011310113 unexpected losses. They are of paramount importance to the banking amid and ate presently implemented by over 100 countries across the amid. The BIS Accords wen: the outcome of long-drawn-out initiative to strive for greater international uniformity in prudential capital standards for banks' credit risk. The

objectives of the accords could be summed up" as: 0 to strengthen the international banking system; (ii) to promote convergence of national capital standards; and (ii) to iron out competitive inequalities among banks across countries of the world. The Basel Capital Adequacy Risk-related Ratio Agreement of 1988 (i.e. Basel I) was not a legal document. It was designed to apply to internationally active banks of member countries of the Basel Committee on Banking Superb ision (BCBS) of the BIS at Basel. Switzerland. But the details of its implementation were left to national discretion. This is why Basel I looked 610- centric." The first Basel Accord. known as Bud I. WAS issued in 1988 and focuses on the capital adequacy of financial institutions The capital adequacy risk (the risk a fuuncial institution faces due to an unexpected loss), categorizes the assets of financial institution into five risk categories (0%, 10%, 20%. 50:'0.100'/0). Banks that operate internationally ate requited to have a risk weight of 8% or less. The second Basel Accord. known as Basel is to be fully implemented by 2015. It focuses on then. main areas, including minimum capital requirements. supervisory review and market discipline, which are known AS the riffirpliart The

10CUS 011111S accoru IS to SWC118111Cflinternanonm banking requirements as well as to supen•se and enforce these requirements. The third Basel Accord. known as Basel III is a comprehensive set of reform measures aimed to strengthen the regulation, supervision and risk management of the banking sector. These measures Aim" to: (i) improve the banking sector's ability to absorb shocks arising from financial and economic stress. whatever the source (id improve risk management and governance (iii) strengthen banks' transparency and disclosures. The capital of the banks has been classified into three den as given below: Tier I Capital: A term used to describe the capital adequacy of a bank - it can dumb losses without a bank being required to cease trading. This is the core measure of a hank's financial strength hum a regulator's point of view (this is the mod friable form of capital). It consists of the types of financial capital considered the most teluble and liquid. primarily stockholders equity and disclosed resents of the bank- equity capital can't be redeemed at the option of die holder and disclosed reserves are the liquid assets available with the bank itself. Tier 2 Capital: A term used to describe the capital adequacy of a bank - it can absorb losses is the event of a winding-up and so provides A lesser degree of protection to depositors. Tier II capital is secondary bank capital (the MU!, moll ridable forms of capital). This is related to Tier I Capital. This capital is a measure of a bank's financial strength from a regubtork point of view It consists of accumulated after-tax surplus of retained earnings, revaluation resents of fixed

Assets and long-term holdings of equity smithies, general loan-loss resents. hybrid (debt/equity) capital instruments, and subordinated skin and undisclosed resents. Tier 3 Capital: A term used to (Inscribe the capital adequacy of a bank - considered the tertiary capital of the banks which are used to meet/support market tisk. commodities risk and foreign currency risk. It includes a variety of debt other than Tier 1 and Tier 2 C9pitlIS. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to Tier 2 capital. To qualify as Tier 3 capital, assets must be limited to 250 per cent of a banks Tier I

capital, be unsecured. subordinated and have a minimum maturity of two years. Ditchued Referrer ate the total liquid cash and the Slit assets of the banks that may be used any rime. This way they are part of its an pia/ (let I). L'adadattd Rama arc the unpublished or hidden resents of a financed institution that may nor appear on publicly available documents such as a balance sheer, but are nonethekss real assets which are accepted as such by most banking institutions but cannot be used at will of the bank. That is why they are part of its tatuaday *fetal (Tier 2r'.

Basel ID Provisions*

The new provisions have defined the capital of the banks in different way - they consider common equity and retained earnings as the predominant component of capital (as the past) but they restrict inclusion of items such as defected tax assets. mortgage-son-icing rights and investments in financial institutions to no more than 15% of the common equity component.

These rules aim to improve the quantify and quallu. of the capital. While the key capital ratio has been raised to rA, of risky assets, according to the new norms, Tier-1 capital that includes common equity and perpetual preferred stock will be raised from 2 to 4.5% starting in phases from January 2013 to be completes' bylanuasy 2015. In addition, banks will have to set aside another 2.5% as a colainga9• for future Stress. Banks that Cid to meet the buffer would be unable to pay dividends, though they will not be forced to raise cash. The new norms are based on renewed focus of central bankers on 'macro-prudential stability'. The global financial crisis following the crisis in the US sub-prime market has prompted this change in approach. The previous set of guidelines, popularly known as Bard 11 focused on Macro-prudential regulation'. In other words global regulators are now focusing on financial stability of the system as a whole rather than micro regulation of any individual bank. Banks in the West, which are market leaders for the most part, face low growth, an erosion in capital due to sovereign debt exposures and stiffer regulation - they will have to reckon with a permanent decline in their returns on equity thanks to enhanced capital requirements under the new norms. In contrast. Indian banks - and those in other emerging markets such as China and Brazil - AFC well-placed to maintain their returns on capital consequent to Basel III. lite financial experts have opined that Basel III looks changing the economic landscape in which banking power shifts towards the emerging markets.

Preparing PSBs for Basel III Capital Compliance As capital is a key measure of blinks' capacity foe generating loan assets and is essential for balance sheet expansion, the Government of India (Gol) has regularly invested additional capital in the PSBs to support their growth and keep them financially sound so as to ensure that the growing credit needs of the economy are adequately met. A sum of Rs. 12,000 MOM was infused in seven PSBs during 2011-12 to enable them to maintain a minimum Tier-I CRAB of 8 per cent and also to increase shareholding of the Gol in them. In 2012-13 also, the Government has infused capital in PSBs to augment their Ticol capital so that they maintain their Tier-I CRAR at a comfortable level and remain compliant with the strictercapital adequacy norms c under Bawl III. This will also support internationally active PSBs in their national and international banking operations undertaken through their subsidiaries

and associates. An amount of Rs 12, 517 more was allocated by the Gol for the year 2012-13 on January 10, 2013. The High Level Committee to assess the capitalization of PSISs in the next 10 years, headed by the Arum; Secretary has =commended vatiao options for funding of PSBs. Given the budgetary constraints, it may not be feasible for the government to WOW huge sums into the PSIls. This is why the Committee has recommended the formation of a korsperadagfieasiaftstrfraproadury • (IlofdCo) under a special al of Adam:: with the folloowni: as g key objectives To act an investment company for the G

ii. To hold a major portion of the Ciol's holdings in all PSBs; in To raise king-term debt from domestic and international markets to infuse equity into PSBs; and iv: lit service the debt from within its sources. Due to weakening of the RRBs abo their sponsor banks have been incurring huge N PAs. RRBs have played a pivotal role in credit delivery in meal areas. particularly to the agecultute ROM — to enhance their outreach and provide banking services more effectively to rural masses, RRBs need to undertake a continuous process of technology and capital upgradation. With a view to bringing the CRAB of RRBs up to at least 9 per cent, Dr K C Chakrabarty Committee recommended =capitalisation support to the extent of Rs. 2.200 crow to 40 RRBs in 21 States. Pursuant to the recommendation of the Committee. recapitalization amount is to be shared by the stakeholders in proportion to their shareholding in RRBs, i.e. 50 per cent central government. 15 per cent concerned state government, and 35 per cent the concerned sponsor hanks The re-capitalisation will continue upto Match 3014. Stook of Money In every economy it is necessary for the central bank to know the stock (amount/level) of money available in the economy only then it can go for suitable kind of credit and monetary. policy. Saying simply, credit and monetary policy of an economy is all about changing the level of money flowing in the economic system. But it can be done only when we know the real now of money. That's why it o necessary to first assess the level of money flowing in the economy.

Following the recommendations of the Sand nrking Gm* on Along Slob' (SIVG) in 1977, RIM has been publishing four monetaty amtr,pata (component of money)- Me M,. NI, and M, ( are basically short terms for the Money-1, Money-2, Money-3 and Money-4) besides the Reserve NIoney. These components used to contain money of differing liquiditics: = Currency & coins with people + Demand deposits of Banks (Current & Saving Accounts) + Other deposits of the RBI. M.= hi ± Demand deposits of the post offices (it. saving schemes' money). M ,= M Tamerferm &posits of the Baths (i.e. the money lying in the Recurring Deposits & the Fixed Deposits). M.= M total deposits of the post offices (Froth, Demand and Term/Time Deposits). Now the RBI has sunned" publishing a set of new monetary aggregates following the recommendations of the Working Group Of Money Supply: Analogy And Methodology Of Compilation (Chairman: Dr. Y.V. Reddy) which submitted its report in June 1998. The Working Group recommended compilation of four monetary aggregates on the basis of the balance sheet of the banking sector inconformity with the norms of progressive liquidity (monesatary base), M, (narrow money), M„And M, (broad money). In addition to the monetary aggregates, the Working Group had recommended compilation of three liquidity aggregates namely, 1.1, L. and

I.,. which include select items of financial babihties of non-depository financial corporations such as development financial institutions and non-banking financial companies accepting deposits from the public. apart from post office savings banks The New Monetary Aggregates are as gram below:

Reserve Money (M,)= Currency in Circulation + Bankers' deposits with the RBI + 'Other deposits with the RBI. Noreen. Along (NJ = Currency with the Public + Demand Deposits with the Banking System + 'Other' Deposits with the RBI. 31=N1, + Savings Deposits of Post-office Savings Banks. BreadMintsy (Al) = M, + Time Deposits with the Banking System. M, = M, + All deposits with Post Office Savings Banks (excluding National Savings Certificates). While rho Working Group did not recommend any change in the definition of reserve money and M,. tit proposed a new intermediate moneaay ear to be referred to as NM, comprising currency and residents' short-term bank deposits with contractual maturity up to and including one sear, which would stand in between narrow money (which includes only the non-interest•baring monetary liabilities of the banking sector) and broad money (an all-encompassing measure that includes long-term time deposits). The new broad money aggregate (referred to as NM, for the purpose of clanty) in the atonality Survey wouldcomprise in addition to NM„ long-term deposits of residents as well as call/term borrowings from non-bank sources, which have emerged as an important source of =source mobilisation for banks. The critical differear between NI, and NM, is the treatment of non-resident repatriabk rued foreign currency liabilities of the banking system in the money supply compilation. There are two basic changes in the new monetary aggregates. Fifa. since the post office

bank is not a pan of the banking sector, postal deposits AM no longer treated as part of money supply, as was the ease in the extant M. and M,. Saved. the residency criterion was adopted to limited extent for compilation of monetary aggregates. The Working Group made a recommendation in favour of compilation of monetary aggregates on residency basis. Residency essentially relates to the country in which the holder has a centre of economic interest. Holdings of currency and deposits by the non-residents in the rest of the world sector. would be determined by (belt portfolio choice. I lowever. these transactions form pan of balance of payments (BoP). Such holdings of currency and deposits are not strictly related to the domestic demand for monetary assets. It is therefore argued that these transactions should be regarded as external kabdities to be netted from foreign currency assets of the banking system. However. in the context of developing countries such as India, which have a large number of expatriate workers who remit their savings in the form of deposits, it could be argued that these non-residents have a centre of economic interest in their count= of origin. Although in a macro-economic accounting framework all non-resident deposits need to be separated from domestic deposits and treated as capital flows, the underlying economic reality may point otherwise. In the Indian context. it may not be appropriate to exclude all categories of non-resident deposits from domestic monetary aggregates as non-resident rupee deposits are essentially integrated into the domestic financial system. The new monetary aggregates, therefore, exclude only non-resident

repatriable foreign currency fixed deposits from deposit liabilities and treat those IS external liabilities. Accordingly. from among

the various categories of non-resident deposits At present. only Foreign Currency Non-Resident Accounts (Banks) IECNR(B)1 deposits are classified as external liabilities and excluded from the domestic money stock. Since the bulk of the FCN R(14 deposits are held Abroad by commercial banks, the monetary impact of changes in such deposits is captured through changes in net foreign exchange assets of the commercial banks. Thus, now the new monetary aggregates NM, and NM, as well as liquidity aggregates L„ L, and L3 have been introduced. the components of which are elaborated as follows: NMI, =Currency with the Public + Demand Deposits with the Banking System + 'Other Deposits with the RIM. NM, = NM, + Short Term Time Deposits of Residents (including and up to thecontractual maturity of one year). NNI,= + Long-term Time Deposits of Residents + Call/Teem Funding from Financial Institutions. L, = NM, + All Deposits with the Post Office Savings Banks (excluding National Savings Certificates) L, = L, +Term deposits with Term Lending Institutions and Refinancing Institutions (As) + Term Borrowingby Fls + Certificates of Deposit issued by Fis 1., = 1.2 + Public Deposits of Non-banking Financial Companies. Data on Mare published by the RBI on weekly basis, while those for M, and M, are available on fortnightly basis. Among liquidity Aggregates, data on L, and L., are published mont ly. while those for L, arc disseminated rarteny. The working group advised for the quarterly publication of Financial Sector Survey to capture the dynamic linkages between banks and rest of the organised financial sector.

Basel Committee on Banking Supervision

The Basel Committee is the primary global standard•setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. Mr Stefan Ingves, Governor Of Soveriges Riks bank, is the chairman of the Bawl Committee. He was appointed as Bawl Committee chairman in July 2011 and has been reappointed until June 2017. The Committee reports to the Group of Governors and Heads of Supervision (GHOS). The Committee seeks the endorsement of GHOS for its major decisions and its Welk programme. The Committee's Secretariat is located at the Bank for International Settlements in Basel, Switzerland. Mr William Coen is the Secretary General of the Basel Committee.

Basel Norms / Accords (Basel I, II and III) easel Norm is a set Of agreements set by the BCBS (Basel Committee on Bank Supervision) which provides recommendations on banking regulations based on three risks (capital risk, market nsk and operational risk). The purpose of Basel Norms is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.

BaselI Accord: This is the first Basel Accord, so we call it as Basel 1. This was issued in 1988. This accord focused on the capital adequacy of financial institutions. The capital adequacy risk (the risk that a financial institution will be hurt by an unexpected loss), categonzes the assets of financial institution into five risk categories (%, 10%, 20%, 50% and 100%). Banks that operate internationally are required to have a risk weight of 8% or less. India adopted Bawl I Norms In the year 1999.

Basel II Accord: This is the second of the Basel Accords, published in the year 2004. This consists of the recommendations on Banking Laws and Regulations issued by BCBS. The purpose of Basel II Acord is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types Of financial and operational risks banks face. According to Basel II Norms Banks should maintain a minimum capital adequacy requirement of 8% of risk assets, banks were needed to develop and use better risk management techniques in monitonng and managing all the three types of risks that is credit and increased disclosure requirements. This focuses on three main areas, those are Minimum capital Requirements, Supervisory Review and Market Discipline. This is to be fully implemented by the year 2015.

Basel III Accord: Basel Ill guidelines were released In the year 2010. This fs to enhance the banking regulatory framework. It builds on the Basel I and Bawl 11 documents and seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency. These guidelines were introduced in

response to the financial cnsis of 2008. So the main focus of Basel III accord is to foster greater resilience at the individual bank level in•order to reduce the nsk of system

wide shocks. In simple words we can say that these norms mainly targeted to make most banking activities such as their trading book activities more Captal-intensive. All banks should become Basel III compliant. The organization has set deadlines for this. For international banks the deadline is 31st December 2018 and for Indian banks the dead line is 31st March 2019.

Is India Ready for Basel-II ?

Introduction One of the biggest tasks that the Reserve Bank of India has to face next year (March 2008) is that of synchronizing the local banks of India as per the Base141 norms for risk management. Banks in India over the years have operated on stringent capital base and low interest rates. With securities overpowering the global market for bank ctedib by the 19901, the notion of risk is no longer confined to credit alone. Risk today includes the possibilities of capital losses due to movements in prices or interest rates or even exchange rates in the market. in addition to opera-tional risks. The legislature over the years fried to awn a canna of kgis-lative reforms such as 'Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAFSI) Act, nor, the amendment of 'National Bank for Agneulture and Rural Development (NABARD) Act 198V. 'National /lousing Bank Act and Securities Contract (Regulation) Act'. Apart horn the above legislations there were standards and regulations laid down by the RBI and the Institute of Our-treed Accountants that struggled hard to maintain effective asset-liability management It was eventually obser-ved thai these amendments and legislations failed to create an effec-tive asset-liability mechanism and all the legislating were embedded with Impediments that couldn't be resol-ved. It was further observed that there had been strong mismatch bet-ween RBI Regulations and the recom-mendations given by Andhyarujina Committee in conjunction with the scope and object of SARFAESI Act. The ultimate mutt was that SARFABSI Act could neither deal with stressed assets nor could it deal with stemdard assets effectively. The SCRA amendment on the other hand, made no provision for recovery of defaulted loans by special purpose distinct entity (SPDE) and such SPDEs are required to file suits in civil courts. The SCRA coven any

kind of debt or receivables for swan-tisation but SARFAESI Is restricted to loam and advance; of banks and Fb.1 These impediments over time have been hidden by the rapid growth in the Indian Economy and the regula-tory mechanism that has been cam-mittedly implemented by RBI mak-ing Indian presence felt in foreign countries especially the middle-east countries. The result is that in Global Arena the Indian Banking Sector has been able to eam a reputation better than China and Russia but at the grass root level or at the nasal level Indian Banks may face great deal of pro-blems in terms of sensitisation of ants.' What is Basel-II ? The Basel-It Norms are the recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. These norms are basically related to minimumcapital adequacy for bards Their purpose is to create Inter-national Standards that banking regulators can use when creating

standards as to how much capital banks need to put aside to guard against financial and operational risks (especially seturitization of assets). India had adopted Basel-1 guidelines in 1999.4 Subsequently. based on the recommendations of a Steering Committee established In February 2005 for the purpose, the Reserve

Bank of India, India's Central Bank, had issued draft guidelines for imple-menting a New Capital Adequacy Framework, in line with Basel-II The BaseI•1 norms work on a triple layered structure-1. The tint layer provides banks with regulations to Anas and measure various kinds of asks that are present such as the credit, market and operational risk and the capital cover that has to be provided over it. 2. The second layer shifts the bur-den from capital adequacy mechanism to risk management mechanisms. The second layer Is concerned with the supervisory review process by national rep !atom for ensuring comprehen-sive assessment of the risks and capital adequacy of their banking institutions. 3. The third layer provides imple-mentation of disclosure mech• anism In conjunction with the capital structure. This layer helps in proper disclosure of Information related to capital adequacy, risk assessment and risk management processes to enhance the transparency in banking operations. Thew norms require the banks to maintain capital of at least 8 per cent of their risk-weighted loan exposures. Diffsisst risk weights were specified by the committee for different cate-gories of exposure. For Instance. government bonds carry risk-weight of 0 per cent, white the corporate loans have a risk-weight of 100 per ant. The above three layered WOO-ale clearly implies that banks in India have to restructure then work-ing and align themselves as per the International Standards of regulating capital. The above guidelines will effectively help Indian Banks to maintain a higher capital-to-risk-weighted-ands ratio (CRAR) of 9 per cent. RBI has specified that it Matti banks to adoot only the Basic

assessment of Operational Risk. The Standardized Approach fixes risk-weights linked to external credit assessments. and then weights them ltafl$ thew fixed welghW The Basic Indicator Approach prescribes • capital charge of 15 per cent of the average gross OKOTC for the preced• ing three years to cover operational risk? Change in Scenario Prima fade the implementation of Base1•11 may offer a lustrous picture for the Indian Banks as it helps Indian Banks to alter their working as per global standards pro-viding an adequate balance between assets and capital of a bank. But then Basel-Heise has to be seen in the light of changing circumstances In the Banking Sector in India. At the present moment all major banks in India have an adequate capital base. so even if these banks don't comply with Basel-11 norms their CRAB ratio will stand maintained without any major problems. Implementation of Basel U norms means that banks have to raise their additional capital. Credit rating agency ICRA said that Indian Banks have to raise Rs. 1200048000 acre to comply with Basel U norms.? Raising so much of capital is useless for the big banks that are sufficiently capitalized and on the other hand implementation of Basel-11 norms on capital adequacy may result in banks' reluctance on !endings to small Sala. Over the past decade Indian Banks have seen a steep increase in demand for credit In segments com-prising small business. retail trade, small transport operators, pro-fessional and self-employed persons, housing. education loam, micro credit and housing. Agriculture and small scale

industries (SSls)are also heavily dependent on brills for funds By the Introduction of Basel-II the above-entioned Frani shallstand at the losing end as these sectors shall be categorized under Itigh-risk' segment and the banks will be reluctant to give such sector loans. It is a general trend among banks to lend short to small and medium enterprises at a higher interest rate and that they are also heavily collaterised. Amording to the Third Census of Small Indus tries held recently, shortage of work-ing capital remains • major factor behind sickness in the 551 sector. Much of the so-called risk-aversion of banks with regard to loans to the small and medium Industries has its origin in the quick adoption of the Basel-approved credit risk adjusted ratios (CRAR) for capital.' Imple matting Basel-11 will funkier catalyze the ongoing tendency by moving credit away from the deserving industrial units in the small sector. International Scenario In the International scenario Basel-II 110C170 have created a strong divide between the USA and the European Union (MI)'; the USA has clearly specified that it shall not implement Basel-II and even If It does it shall confine itself to 26 inter-nationally active banks and even these basis will be allowed to follow the (ewrage ratio a a safety measure. In America, the :enrage ratio was introduced In 1991 in the wake or • housing-loans crisis; it ensures that • bank's core capital is at least 3%of its balance shod whatever the quality of its loans and its risk-management ratans. The different stance taken by the USA and the EU over Basel.11 norms may prove to be recipe for disaster for subsidiary banks, which means that a domestic bank that Is Sating up a subsidiary branch in the USA has to follow the letonwe ratio whereas the same bank has to pour in huge amount of investment in the EU to set up a subsidiary branch creating a great deal of confusion in tern regulating capital. Other Impediments In addition to the above set of problems, Basd-II also creates pro-bleats, related to maintenance of local capital which is a statutory require-ment for foreign banks in India; Basel-II regulations don't specify any means Of method to regulate the local capital. Further, India has three established rating agencies in which Leading international credit sating agencies are stakeholders and also extend technical support. Once Basel-II is introduced what will the RBI do with the existing agencies ? A lot of mishmash might also be created between banks which follow 11W (Internal Rating Based)approach and banks which follow Standardized Approach as banks adopting IRB Approach will be much more risk sensitive than the banks on Stan-dardized Approach, since even a small change in degree of risk might translate into a large Impact on additional capital requirement for the IRB banks. Hence. nth banks could avoid assuming high•isk exposures. Since banks adopting Standardized Approach are not equally nsk geni-tive and since the relative capital requirement would be less for the same exposure. the banks on Stan-dardized Approach could be incli-ned to assume exposures to high risk clients• which were not financed by IRB banks. As a result, high-risk assets could flow towards banks on Standardized Approach that need to maintain lower capita/ on thew ands than the banks on IRB Approach. Similarly. low risk awn would tend to get concentrated with IRB banks that need to maintain lower capital on thin afats than the Standardized Approach banks. Data Management is going to be another problem as Bast1-11 leaves great deal of amts gullies with reference to the way data have to be maintained. Banks will eventually face problems regarding merging of local data and global data"

To add an icing to the above problems shall be the problems of grow-nusreprtsentation of assets and capital in the balance sheets of the banks. Many banks may not be able to achieve the devised ratio between the assets and the capital and may

indulge in such misrepresentation to provide a perfect picture to the investors and to the capital market. Conclusion To conclude Basel•l1 might be an ideal scheme for a small country comprising • handful of banks but a country like India whose economy is run by more than 100 banks ranging from ultra-small banks working entirely at rural level tobanks such as SBI, Punjab National Bank and HDFC which have enough capital base to buy out economies of many coun-tries, Basel-11 will amplify confusion rather than making regulations simpler. Instead of adopting Base141 regulations it will be ideal for the RBI to strengthen the existing IRB approach so that the present ano-malies that are prevalent in the banking sector be cured fins. twitter, legislations like SARFAESI Act and SCRA Act should be cleared a the confusions that have been jointly treated by RBI and the Andhyarugna Committee. Until and unless the domestic legislations related to seen-Satin a assets are strengthened it cannot be super-imposed by global norms that have been implemented hall-heatedly by other nations.

Capital Adequacy and Risk Profile Risk management is increasingly becoming the single most important issue for the regulators and financial institutions. These institutions have over the years recognized the cost of ignoring Ask. However, growing research and improvements in information technology have improved the measurement and management of Ask. If is but natural, therefore. that the capital adequacy of a bank has become an important benchmark to assess is financial soundness and strength. The idea is that banks should be free to engage in their asset liabdity management as long as they are backed by a level of capital sufficient to cushion their potential losses. In other words, capital requirement should be determined by the risk profile of a bank.

The Indian banking sector today is operating in an environment characterized by globalization and integration of business. progressive deregulation. and IT usage. which has opened up a plethora of domestic and international opportunities for them. This has also increased the risks and financial fragility of the banking system and has exposed them to a wide array of risks. For Indian banks. it is the need of the hour to practice banking business at par with global standards and make the banking system in India more reliable. transparent and safe. In addition. they also need to take cognizance of the fact that banking worldwide has witnessed paradigm shifts from balance sheet to of balance sheet financing, from capital adequacy to capital efficiency and from pure banking to financial services. In the coming years. there will be an increase in cross-border economic and financial transactions and India will witness increased capital flows from foreign countries. The Basel Committee on Banking Supervision (BCBS) is a committee established by the Bank of International Settlements (BIS) consisting of representatives of 13 national banking regulators from leading industrialized nations. It is an international body that formulates policy on best practices in financial regulation. The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance the

understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques with a view to promote common understanding. The Committee's Secretariat is located at the Bank for International Settlements (BIS) in Basel. Switzerland. Basel I, adopted in different countries with certain country-specific adaptations. established itself at the core of the assessment of soundness and stability of the banking system. However. in view of the deficiencies in the Basel I framework, the revised framework (Basel II) was developed by aligning the capital requirements with underlying risks through enhanced risk measurement techniques. Basel II evoked mixed response in the light of the complexities inherent in the framework. Notwithstanding the need to refine and streamline Basel II in the light of recent experiences during the global financial turmoil. many experts have emphasized the need for a faster implementation of Basel II.

•BASEL 1 NORMS The Basel Committee was formed in response to the messy liquidation of bank in Frankfurt in 1974. On 26th June 1974. a number of banks had released Deutschmarks to the Bank Herstatt in Frankfurt in exchange for dollar payments deliverable in New York. On account of differences in the time zones. there was a lag in the dollar payment to the counter-party banks: and during this gap. before the dollar payments could be effected in Ncw York. the Bank Herstatt was liquidated by German regulators. This incident prompted the G-I0 nations to form towards the end of 1974 the Basel Committee on Banking Supervision under the auspices of the Bank of International Settlements (131$). The BIS is regarded as the bank for central banks and is based in Basel in Switzerland. The committee, which was constituted by Central Bank Governors of a group of I0 countries in 1974 under the aegis of the Bank of International Settlements (BIS). has. over the years. set out standards for capital measurement. For Indian banks, which are active globally. it is imperative to bolster their capital in accordance with the supervisory standards and guidelines formulated by the Bawl Committee. The major impetus for the 1988 Bawl Capital Accord was the concern of the Governors of the 010 central banks that the capital of the world's major banks had become dangerously low after persistent erosion through competition and the Lorin American debt crisis. The 1988 Basel Accord primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example. home country sovereign debt), ten, twenty. fifty, and up to one hundred per cent. The original accord was based on "actual" banking risk (i.e.. credit risk) for which banks were required to hold a minimum capital standard of 8% of the volume of outstanding loans (in the form of risk-weighted assets). The basic objectives of the 1988 Basel Capital Accord were to strengthen the international banking system and to promote convergence of national capital standards. The key features were: • A common measure of qualifying capital • A common framework for the valuation of bank assets in accordance with their associated credit risks (including those classified as off-balance sheet) • A minimum level of capital determined by a ratio of 8 per cent of qualifying capital to aggregate risk-weighted assets Figure 20.1 presents a brief overview of the 1988 Basel Accord.

The Basel Accord of 1988 was hugely successful with more than 100 countries accepting it as a benchmark. Apart from the accord being simple, it brought in uniformity and attempted to make regulatory capital requirement consistent with the economic capital. In line with the Basel Capital Accord. Reserve Rank of India introduced risk assets ratio system as a capital adequacy measure in 1992. In fact, RBI norms on capital adequacy at 9% are more stringent than Basel Committee stipulation of 8%. The financial crises of the 1990s drew attention to the ineffectiveness of the 1988 Basel Capital Accord as an instrument for the achievement of banking stability. For example. in some of the Asian countries affected by the crisis, capital standards based on the model of the 1988 Basel Accord provided little protection to banking systems owing to poor accounting standards and weak supervision. Also. the 1988 Capital Accord lacked explicit provisions for capital tocover banks' interest-rate risks, market risk and their operational risks. The extent of the weaknesses of the Accord varied among different countries and other panics affected. But three points were particularly prominent in the criticisms. In the first place was the Accord's failure to make adequate allowance for the degree of reduction in risk exposure achievable through diversification. Secondly, there was the possibility that the Accord would lead banks to restrict their lending particularly if the new capital requirements were introduced, and third was the uniformity in the standards for all banks -'the one size fits all approach. The New Basel Capital Accord is the reformed and refined form of Basel I Accord and was approved by the Basel Committee on Banking Supervision of Bank for International Settlements in June 2004. They are often referred to as the Basel II Accord or simply Basel II. They have been introduced to overcome the drawbacks of Basel I Accord. In India. Basel II was implemented on the basis of the draft guidelines issued by the Reserve Bank of India. Basel II was implemented in India from the year 2008. For foreign banks operating in India and Indian banks having overseas branches, the deadline for the implementation of Basel II regime was set at March 2008 and for all other Commercial Indian banks excluding the local area banks and regional rural banks the deadline was not later than March 2009. Basel 11 is a mom focussed document than Bawl I especially in the context of risk management and fast changing business environment in the banking sector. The Basel II Accord spurs improvement in the areas of risk taking. risk measurement and risk management in the banks. For Indian banks. it is the need of the hour to practice banking business at par with global standards and make the banking system in India more reliable. transparent and safe. The objectives of the Basel II Accord are: I. The Accord should continue to promote safety and soundness in the financial system and. as such. the new framework should at least maintain the current overall level of capital in the system. 2. It should continue to enhance competitive equality. 3. It should constitute a more comprehensive approach to addressing risks. 4. It should focus on internationally active banks. although its underlying principles should be suitable for application to banks of varying levels of complexity and sophistication. 5. Introduce a more risk sensitive capital framework with incentives for good risk management practices. The policy approach to Basel 11 in India is to conform to best international standards and the process emphasizes on harmonization with the best international practices. Basel II aims to encourage the use of modem risk management techniques. Previously, the main focus was on credit risk. Base II takes a look

at a much wider range of risks than this and that includes interest rate risk. foreign exchange risk, liquidity risk, operational risk, business risk, reputation risk, strategic risk and a more sophisticated approach to credit risk that allows banks to make use of internal ratings based Approach or • IRB Approach' to calculate their capital requirement for credit risk. The advantages of Basel II over Basel I are given in Table 20.1.

The new Basel Accord has its foundation on three mutually reinforcing pillars. viz. Capital Adequacy. Supervisory Review and Market Discipline. The Basel Committee calls these factors as the Three Pillars to manage and evaluate the various risks that banks face.

First Pillar: Capital Adequacy Requirements Under the Basel 11 norms. banks should maintain a minimum capital adequacy requirement of 8% of risk assets. For India, the Reserve Bank of India has mandated maintaining of 9% minimum capital adequacy requirement. This requirement is popularly called Capital Adequacy Ratio (CAR) or Capital to Risk Weighted Assets Ratio (CRAR). The first pillar deals with the maintenance of regulatory capital for the three kinds of risk that a bank faces-credit risk, market risk and operational risk. It spells out the capital requirement of a bank in relation to the credit risk in its portfolio which is a significant change from the 'one size fits all' approach of Basel I. The credit risk component can be calculated by using three different approaches. namely Standardized approach, Foundation 'Internal Rating-Based Approach' (1RB) and Advanced IRB. It also sets out the allocation of capital for operational risk and market risk in the trading books of banks. For operational risk, three different approaches are recommended - basic indicator approach or BIA, standardized approach or TSA. and the internal measurement approach (AMA). The preferred approach for the market risk is VaR (value at risk).

Second Pillar: Supervisory Review The second pillar provides a tool to the supervisors to keep checks on the adequacy of capitalisation levels of banks. It gives the regulators much improved tools over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face and distinguishes among banks on the basis of their risk management systems and profile of capital. It gives banks a power to review their risk management system and take appropriate remedial measures, if required. Thus, there are two objectives of this pillar-first to ensure that banks have adequate capital to support all risks and second to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

Third Pillar: Market Discipline The third pillar aims to complement the first two pillars and also provides a framework for the improvement of banks' disclosure standards for financial reporting. risk management. asset quality and regulatory sanctions. It aims to encourage market discipline by which market participants can assess the capital adequacy of a bank and keep a check on erring banks and maintain the integrity of the banking system. Further. Pillar 3 allows banks to maintain confidentiality over certain information disclosure of which could impact competitiveness or breach legal contracts. The third pillar provides a set of guidelines for public

disclosures. regulatory disclosures and, lastly. aims to increase risk awareness and boost market discipline through enhanced disclosures. These disclosures include quantitative and qualitative disclosures on capital adequacy and risk management systems.

A Menu of Approaches to Calculate Capital Requirements For measuring credit risk: I. Standardized approach. making some use of external ratings 2. Foundation internal ratings-based approach 3. Advanced internal ratings-based approach For measuring market risk: I. Standardized approach 2. Internal models approach For measuring operational risk: I. Basic indicator approach 2. Standardized approach 3. Advanced measurement approach

• CREDIT RLSK The possibility that a bank's counterparty will be unable to meet its obligations is known as credit risk. This is the most important of all banking risks. The three approaches to measure credit risk arc: 1. Standardised approach 2. Internal ratings based approach-foundation 3. Internal ratings based approach-advanced

• OPERATIONAL RISK Capital requirement for operational risk has been covered for the first time under Basel II. The Basel Committee on banking supervision has recommended that managing this risk has become an important feature of sound risk management practice in modern financial markets. Operational risk refers to any risk to which a bank is exposed simply because of being in business. In Basel II such risk is defined as that of loss due to failed or inadequate internal processes. people and systems. or from external events. According to the Basel Committee on banking supervision. the most important types of operational risk involve breakdowns in internal controls and corporate governance. Such breakdowns can result in financial losses through error, fraud, or failure to perform in a timely manner. Other aspects of operational risk include major failure of information technology systems or events such as major fires or other disasters. The types of operational risk included under Basel 11 arc: • Internal fraud (e.g., intentional misreporting of positions, employee theft) • External fraud (e.g.. robbery. forgery. damage from computer hacking) • Employment practices and workplace safety (c.g., workers compensation claims, violation of employee health and safety rules. organized labor activities. discrimination claims) • Clients. products and business practices (e.g.. fiduciary breaches. misuse of confidential customer information. improper trading activities on the bank's account. money laundering. sale of unauthorized products) • Damage to physical assets (e.g., terrorism. vandalism, earthquakes. fires and floods) • Business disruption and system failures (e.g., hardware and software failures. telecommunication problems) • Execution, delivery and process management (e.g., data entry errors, incomplete legal documen-tation, vendor disputes) Three approaches are used to determine operational risk under Basel framework (2004). They differ in their complexity and the banks arc encouraged to move along the spectrum of approaches as they obtain more sophistication in their risk management practices. These can be listed as: • The basic indicator approach (BIA) 1. The standardized approach (TSA) 2. The advanced measurement approach (AMA)

COMPLIANCE WITH BASEL III NORMS:THE INDIAN RCTURE

Perankree On Jeo• dCtmutaCalutilkenratz furddiksrn

INTRODUCTION: During the lam 43 years since 1969. remarkable changes have taken place in the Kinking industry: banks have shed their traditional functions and have been innovating. improving and coming out with new types of the services to cater to the emerging needs of their customers. Thus. banking has been rightly termed as 'innovative banking' in the present context. The current year has seen some wry positive influence on the banking industry. A host of initiatives haw been taken in the nxent past which has given a new dimension to the banking industry as a whole and a fresh stance toward customers. technology and banking as a sector has been espoused. Massive branch expansion of banks in the wham semi urban. coral and underdeveloped areas. mobilisation of savings and diversification of credit facilities have resulted in the widening and deepening of their financial infrastructure and transferred the fundamental character of class banking into mass Kinking. Again. some of the banks have made it global by expanding their branch network outside the eounuy as well. Moreover. there has been extensive innovation and diversification in the business of major commercial banks. Some of the emerging areas of modern banks arc consumer credit. credit cards. merchant banking. leasing, mutual funds. factoring. etc. Such expansion of banking activities. both in terms of volume and variety. has exposed the banking industry' ro certain risks. The modem day global banks have cooperate in different countries with diffeiena economic. firtincial and regulatory backdrops and condiulons. Time and again. financial crisis have shattered economies around the globe; whether it is the Asian Crisis or the Global (7risis• which sparked in the (ISA but rapidly penolated to the rest of the World. with a special mention of the EU. In fact. in most of the cases. it emerged that either these global banks vistaed such crisis or were the worst hit by such crisis. Mention may be made of several major European and American banks which haw been engulfed by the recent global financial crisis. Hence the need arises for a set of standards and practices for such global banks to ensure that they maintain adequate capital to withstand periods of economic strain, Basel is a comprehensive set of reform measures designed to improve the regu bum, disclosures and risk management within the banking sector so as to ant* the banks to endure crisis. The Bawl Committee on Banking Supervision (BCBS) wasconstitmed by the Cenual Bank Governors of the (i •I0 countries in 1974 to provide a forum for regular cooperation on banking stmervisory matters. It has been set with the objectiveto enluncean understanding of key supervisory issues and quality improvement of banking supention worldwide. It may he noted that the BOBS is a committee of the Bank for International Senkments (3IS) and is best known for its international standards on capital ;adequacy:Land primarily addresses the principles of banking supervision and the agreement on cross• border banking supervision. The committee published Basel I in 1988. Basel II in 2004 and Basel III in 2010 to address various issues relating to capital requirements and risk management of banks in dynamic and vulnerable financial climates. The following parnraphs give a brief account of the three accords.

BASEL I • A QUICK LOOK: In 1988. the BCBS in Bawl. Switzerland. published a set of minimum capital requirements for banks which is also known as the 1988 Bawl Accord. and was

enforced by the Group of Tell (G•10) commies in 1992. Said !primarily focused on credit risk. It defined capital requirement and structure of tisk weights for

banks. Assets of banks were classified and grouped in five categories according to credit risk. carrying risk weights of zero. ten. twenty. flit. and up to one hundred percent. Banks with international presence were required to hold capital equal to S ek of the risk-weighted assets. llowever. Basel I is nowadays widely viewed as pass!. Tremendous changes in the banking industry. financial innovation and risk management gave way to a more comprehensive set of guidelines. known as Bawl II.

BASEL II - A QUICK LOOK: The second episode of the Bawl Accords to be published in 2004. designed to (exult an intematiorn1 standartlon banks'caphal trquirements. Bawl II laiddown guidelines for capital adequacy, risk management and disclosure requirements and was introduced as a complex new standard for measuring tisk in financial services. Basel II was intended to CICale an international mandate] for banking regulators to control how much capital banks need to set aside to gum., against financial and operational risks. This would be done by setting up risk and capital management requirements, designed in such a way so as to ensure this a bank has sufficient capital to cover the risk arising out of its lending and investment operations. Basel II used a "thew pillars" concept for realizing inobjective:4-(D minimum capital requirements. (2) supervisory review and (3) market discipline. The earlier Bawl 1 Accord dealt with only pans of each of these pillar's. The first pillar dealt with maintenance of regulatory capital calculated for thew majorcomponentsof risk that a bank three credit risk, operational risk.and market risk.The second pillardeali with the regulatory response to the first pillar. giving regulators better tools over those available to them under Ba.sel I. It also provided a framework for dealing with all theodwrrisksauociated with banking operations such as systemic risk. pension risk. concentration tisk. strategic risk. mputational risk. liquidity risk and legal risk. which was eolkctively referred to as residual risk by the Accord. The third pillar aimed to compkment the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which allowed the market panicipams to measure the capital adequacy of a bank.

The Indian Picture: In India. Reserve Bank of India implemented the Basel II standardized norms on 31 March. 2009and moved to internal ratings in credit and AMA (Advanced bleasumment Approach) norms for operational risks in banks. The RBI norms for banks in Inlia (as on September 2010): • Common cqui ty (inclusive of buffer): 3.6%. (Buffer under Basel II requirements arc zero.): • Tier I iequirement: 6%. • Total Capital: 9% of risk weighted assets.

BASEL III • A QUICK LOOK: In response to the serious nature of the recent financial crisis. several measures at the micro and macro keel are being considered to increase the stability of the financial markets. One major focus is suengthen ins global capital and liquidity rules through Basel III. The BCBS came up with a comprehensive reform package entitled "Basel III - A global regulatory framework for more resilient banks and banking systems" in December. 2010

with the objective to improve the banking sector's ability to absorb shocks arising from financial and economic stress. thus reducing the risk of spillover from the financial sector to the real economy. The Committee claimed that the new standards would lead to improved banking sector resilience by strengthening global capital. increasing coverage of risk for capital market activities and better liquidity standmds. However. a revised version of Basel III was later issued in June 2011. The Said III guidelines intends to improve the ability of banks to withstand periods of economic and financial strain by implementing more rigorous capital and liquidity requirements. Some of the key aspects of the proposed Basel Ill Accord are: •

Better capital quality: Basel M establishes tougher capital standards through more restrictive capital definitions, higher risk-weighted assets (RWA), additional capital buffers and higher requirements for minimum capital ratios. In addition, the definition of Common Equity has been made stricter. Better capital quality implies higher loss absorbing capacity. Under the proposed Basel ill norms, banks will be required to hold more reserves by January 1, 2015. The Basel in norms would require banks to hold 4.5% of common equity, the highest form of loss absorbing capital (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel 111 of risk-weighted assets (RWA) by 2015.

•introduction of new mandatory capital conservation buffer: another key feature of Basel 3 is that now banks have to mandatorily maintain a Capital Conservation Buffer, which Is an additional reserve buffer of 2.5% to "withstand future periods of suns', bringing the total Tier 1 Capital reserves to 7%. Thus, this buffer which raises the minimum core capital may come to the bank's rescue in periods of financial and economic stress. Such enhanced capital requirements can be termed as a move in the right direction. This buffer is introduced to meet one of the four key objectives identified by the BCBS in the December 2009 Consultative Document 'Strengthening the resilience of the banking sector".

• Introduction of a discretionary countercyclical : This buffer allows national regulators to require up to another 2.5% of capital during periods of high credit growth. The buffer will slow banking activities when it overheats and encourage tending in bad times. In periods when credit is expanding faster than GDP, bank regulators can increase their capital requirements with the help of the Countercyclical Buffer. Varying between 0% • 25% it can thus, preserve national economies from excess credit growth.0

• Introduction of leverage ratio (ratio of tier 1capital to total assets): A review of the recent global crisis has indicated that the value of many assets fell quicker than assumed. To avoid such situations, the proposed Basel III rules Include a non risk based leverage ratio which would supplement the capital requirements vis-a-vis the risk-based measures illustrated above. A leverage ratio Is the relative amount of capital to total assets(not risk-weighted). A 3% leverage ratio of Tier I capital will be tested before a mandatory leverage ratio is imposed in January. 2018.

• Introduction of liquidity Ratios: Under the proposed Basel III, a framework for liquidity risk management has been created. in accordance, two new ratios are to be Introduced - Liquidity Coverage Ratio (LCRI and Net Stable Funding Ratio (NSFR). While the LCR Is designed to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted Into cash to meet Its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario; the NSFR requires the available amount of stable funding to exceed the required amount of stable funding over a antics period of extended stress. The NSFR would, thus, promote resilience of a financial Institution over a one year period and encourage banks to fund their activities with stable sources of funding. The standard requires that LCR and NSFR shall be e- 100% and banks need to implement them by 2015 and 2018 respectively.

Basel 3-the Indian picture:

The Reserve Bank of India. being a member of the BCBS. is fully committed to the objective of Basel Ill reform package. and hence. intends to introduce these proposals for banks operating in India. The final guidelines on Bawl III capital regulations were issued by the RBI vide circular DBOD. No. BP.BC. 981 21.06.201/2011•12 dated 2" May.2012 which would be effective from l• January, 2013, in a phased manner. Thus. on 31" December. 2012 banks will have to calculate capital adequacy according to existing Bawl norms and for the financial year ending on March 31. 2013. banks will have to disclose the capital ratios computed under the Basel II guidelines as well as those computed under the Basel III capital adequacy framework. Banks should get the capital adequacy computation as on I" January. 2013. verified by their external auditors and keep the verification reponon record. However. the Wrenn capital ratios will be fully implemented on March 31. 2018. Thus. the RBI has prescribed :a six years road map to make Indian banks less vulnerable to risks and crisis. but that shall come at a cost. According to RBI's estimates.. Indian banks will remain: to a capital of Rs S lakh crore over the next five years.of which Its 1.75 lakh crore will have to be equity capital. Within the Rs 1.75 !AA crore. mound Rs 70000400,000 CRUM will have to raised through the awake/. Guidelines on Implementation of Basel HI Capital Regulations in India As indicated in the SQR of October 2011. the Reserve Bank prepared the draft guidelines on Basel III - Implementation of Capital Regulations in India. The draft guidelines provide for a roadmap for smooth implementation of Baselllicapital regulations in tenets of the transitional arrangements (phase-in) of capital ratios and grandfathering (phase-out) of ineligible capital instruments. A summary of Basel III capital requirements is furnished below: I. Improving the Quality. Consistency and transparency of the Capital Base: Presently. a bank's capital comprises Tier 1 and Tier 2 capital with a restriction that Tier 2 capital cannot be more than 100% of Tier I capital. WithinTier I capital. innovative instruments arc limited to 15% of Tier I capital. Further. Perpetual Non-Cumulative Preference Shales along with Innovative Tier I attainments should not exceed 40% of total Tea I capital at any point of time. Within Tier 2 capital. subordinated debt is limited to a maximum of 50% of Tier I capital.) lowever. under Basel III. with a view to improving the quality of capita. the Tier I capital will predominantly consist of Common Equity. The qualifying criteria for instruments to be included in Additional

Tier 1 capiul outside the Common Equity elenwm as well aiTier 2 capital will be strengthened. The important modifications include the following: (it Deduction from capital in respect of shortfall in provisions to expected losws under Internal Ratings Based (IRB) approach for computing capital fat credit risk should be made from Common Equity component of Tier I capital: (ii) Cumulative unrealized gains or losses due to change in own credit risk on fair valued financial liabilities. if recognized. should be filtered out from Common Equity: (iii) Shortfall in defined benefit pension fund should be deducted from Common Equity: (iv) Certain regulatory adjustments whicharecurrently required to be deducted 50% from Tier land 50% fromTier 2 capital. instead will receive 1250% risk weight: and (v) limited recognition has been granted in regard to minority interest in banking subsidiaries and investments in capital of certain other financial entities. The transparency of capital Itaw has been immused. with all elements of capital required to be disclosed along with a detailed reconciliation to the published accounts. This requirement will improve the market discipline under Pillar 3 of the Rawl II framework.

2. Enhancing Risk Cover At present. the counterpany credit risk in the trading book covers only the risk of default of de counterpany. The reform package includes an additional capital charge for Credit Value Adjustment(CVA) risk which captures risk of mark-tomarket losses due to deterioration in thecredit worthiness of a counterpany.The risk of intereonneetedness among larger tinancial rims (defined as having total abaCts greater than or equal to S 103 billion) will be better captured through a prescription of 25% adjustment to the asset value correlation ( AVC) under IRB appmaches to credit risk. In addition. the guidelines on counterparty credit risk management with regard to collateral. margin period of risk and central counter's:sirs and counterparty credit risk management requirements have been strengthened. J.Padua:being theTotal Capital Requirement and Phase-In Period:The minimum Comnon Equity.Tier I and TotalCapitalrequirements will be phased-in between January 1. 201 3 and January I. 2015.as indicated below:

W Capita, s.umenation •UIRTI I or capital talltS014111011 OUIICI ILI-D) IS 1.101g1103 to ci,surc tat banks build up capital buffers donne normal times which can be drawndown:a losses are inc tried during a stressed period. Therefore. in addition to the minimum total of 8% as indicated above. banks will he required to hold a evital conservation buffer of 2.5% of RWAs in the form of Common Equity thereby bringing the total Common Equity requinment of 7% of RWAs and total capital to RWAs to 10.5%. The capital conservation buffer in the form of Common Equity will be phased•in over a periodof four years in a uniform manner of 0.625%per year.commencing (tonal:moan. I. 2016. b) Countercyclical Caphal Buffer: Further. a countacyclicalcapital buffer withina range of 0- 2.5% of RWAs in film of Common Equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of countercyclical capital buffer is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth.The countercyclical capital buffer. when ineffect. would be introduced as an extension of the capital conservation buffer range. c) SupplanentIng the Rbl•based Capital Requirement with a Latrine Ratio:One of

the underlying features of the crisis was the build-up of excessiw on- and off-balance sheet leverage in the banking system. In many cases. banks built up excessive leverage while still showing strong risk based capital ratios. tinder Basel 111. a simple. transparem. non-risk based regulatory leverage ratio has been introduced, 4. Additional aspects covered in Basel The guideline issued by the RBI also contains the following additional aspects covered in Basel 111 reform package: a) Capital Conservation Buffer and b) Leverage ratio. The capital requirements for the implementation of Bawl III guidelines may be lower during the initial periods and higher during the later years. All other instructions contained in remaining paragraphs of the Master Circular DBOD No. BP.BC.11/21.06.001/2011-12.dmed 1"July. MI I on "Prudential Ouidelineson Capital Adequacy and Market Discipline-NewCapitalAdequacy Framework (NCAFT will remain unchanged under Basel III framework.

CONCLUSION: Just like for international banks. Basel III norms will also affect the profitability and rewnuatios of Indian banks. Basel Ill requires higher and better quality capital. And it is a well-known fact that the cost of equity capital is high. The average Return on Equity (Rol) of the Indian banking system for the last three years has been approximately 15% and implementation of tlw Basel III norms could adversely affect it. The new capital adequacy norms of Bawl III do not impact Indian banks significantly in tarns of overalleapiul requitement and the quality of capital as they are already in a comfortabk position. Most of the Indian banks have improved on their capital adequacy ratio in line with the Basel II nonns. The financial health of Indian banking system has improved significantly in terms of capital adequacy ratio. In comparison to the mandated limit of 9 per cent CRAR posed by the Bale! II. the average capital adequacy ratio of commercial Kinks went up to 13 per cent in 2010 from 12 percent in the previous year. Thus. it may be said that the Indian banks are mach better off than their global count:spans who triggered the financial crisis. However. the need to shill to BaselllIcannot be overlooked. As India integrates with the rest of the worts. we do not have the ground to depart from the international regulatory framework. Also, it is important that Indian banks have the cushion afforded by improved risk management systems to endure shocks from external systems. especially as they deepen their links with the global financial system. But concerns are being raised as the stringent capital requirements come at a time when the global economy is in the midst of a deceleration. This will leave banks with less money to lend. in turn pushing up the cost of borrowing and thereby further infutiating the slowdown.

May 28, 2015, 09.55 PM IST | Source: PTI RBI issues draft Basel III norms on liquidity standards The Reserve Bank on Thursday released the draft guidelines on the net stable funding ratio (NSFR) under Basel III framework on liquidity standards for banks and sought comments from all stakeholders by June 26.RBI issues draft Basel III norms on liquidity standards The Reserve Bank on Thursday released the draft guidelines on the net stable funding ratio (NSFR) under Basel III framework on liquidity standards for banks and sought comments from all stakeholders by June 26.  6 0Google +0 3Comments (3) The Reserve Bank on Thursday released the draft guidelines on the net stable funding ratio (NSFR) under Basel III framework on liquidity standards for banks and sought comments from all stakeholders by June 26. The NSFR is defined as the amount of available stable funding relative to the amount of required stable funding. The objective of the NSFR is to ensure that banks maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. The Basel Committee on Banking Supervision issued the final rules on the NSFR in October 2014. "A sustainable funding structure is intended to reduce the probability of erosion of a bank's liquidity position due to disruptions in its regular sources of funding that would increase the risk of its failure and potentially lead to broader systemic stress," RBI said on Thursday. The NSFR limits over-reliance on short-term wholesale funding, encourages better assessment of funding risk across all on and off-balance sheet items, and promotes

funding stability. The Reserve Bank had proposed to issue the guidelines in the April 7, 2015 monetary policy. The NSFR will become applicable to banks in India from January 1, 2018 and would be applicable for domestic banks at the solo as well as consolidated level. For foreign banks operating as branches in the country, the framework would be applicable on a standalone basis, that is, for operations here only. The RBI has sought comments on NSFR guidelines by June 26, 2015.

RBI to prescribe net stable funding ratio for banksNSFR limits over reliance on short-term wholesale fundingBS Reporter  |  Mumbai  May 29, 2015 Last Updated at 00:40 IST

In a bid to ensure banks maintain adequate liquid resources, Reserve Bank of India (RBI) plans to

prescribe anet stable funding ratio (NSFR) under the Basel-III framework.

NSFR is the amount of available stable funding relative to the amount of required stable funding.

NSFR limits over reliance on short-term wholesale funding, encourages better assessment of

funding risk across all on- and off-balance sheet items, and promotes funding

stability. RBI proposes to make NSFR applicable to banks from January 1, 2018.

The available stable funding is a portion of capital and liabilities, expected to be reliable over the

time horizon considered by the NSFR, which extends to one year. The amount of stable funding

required is a function of the liquidity characteristics and residual maturities of the various assets

held by banks.

The NSFR requirements are over and above the Liquidity Coverage Ratio (LCR) norms announced

earlier. The NSFR would be applicable for Indian banks at the solo as well as consolidated level.

For foreign banks operating as branches in India, the framework would be applicable on a stand-

alone basis.

In the backdrop of the global financial crisis that started in 2007, the Basel Committee on

Banking Supervision (BCBS) proposed certain reforms to strengthen global capital and liquidity

regulations, with the objective of promoting a more resilient banking sector.

BCBS issued the final rules on NSFR in October 2014. RBI has started phasing in implementation

of the LCR from January 2015.

Banks would be required to meet the NSFR limit on an ongoing basis. By December 2017 quarter,

they should have the required systems in place for such calculation and monitoring.