RESERVE BANK OF INDIA

Second Quarter Review ofMonetary Policy 2010-11

(Including Review of Developmental and Regulatory Policies)

Dr. D. SubbaraoGovernor

November 2, 2010Mumbai

CONTENTS

Page No.

Part A. Monetary Policy

I. The State of the Economy..................................................................... 2

II. Outlook and Projections........................................................................ 7

III. The Policy Stance ................................................................................ 11

IV. Monetary Measures .............................................................................12

Part B. Developmental and Regulatory Policies

I. Financial Stability................................................................................14

II. Interest Rate Policy .............................................................................15

III. Financial Markets ................................................................................15

IV. Credit Delivery and Financial Inclusion ...........................................17

V. Regulatory and Supervisory Measures for Commercial Banks ......22

VI. Institutional Developments .................................................................28

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ACRONYMS

AACS - As Applicable to Co-operative Societies

AMA - Advanced Measurement Approach

ASA - Alternate Standardised Approach

BC - Business Correspondent

BCBS - Basel Committee on Banking Supervision

BF - Business Facilitator

BIS - Bank for International Settlements

BPLR - Benchmark Prime Lending Rate

CBS - Core Banking Solution

CDs - Certificates of Deposit

CDSs - Credit Default Swaps

CI - Confidence Interval

CP - Commercial Paper

CPI - Consumer Price Index

CPSS - Committee on Payment and Settlement Systems

CRAR - Capital to Risk-Weighted Assets Ratio

CRR - Cash Reserve Ratio

CSCs - Common Service Centres

CTS - Cheque Truncation System

DCCBs - District Central Co-operative Banks

DR - Disaster Recovery

EMEs - Emerging Market Economies

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FCs - Financial Conglomerates

FEDAI - Foreign Exchange Dealers’ Association of India

FIIs - Foreign Institutional Investors

FIMMDA - Fixed Income Money Market and Derivatives Association of

India

FIP - Financial Inclusion Plan

FSB - Financial Stability Board

FSRs - Financial Stability Reports

FSS - Farmers Service Societies

G-20 - Group of Twenty

GDP - Gross Domestic Product

GHOS - Group of Central Bank Governors and Heads of Supervision

IBA - Indian Banks’ Association

ICT - Information and Communication Technology

IDRBT - Institute for Development and Research in Banking Technology

IFRSs - International Financial Reporting Standards

IIP - Index of Industrial Production

IMA - Internal Models Approach

IMF - International Monetary Fund

INFINET - Indian Financial Network

INR - Indian Rupee

IRDA - Insurance Regulatory and Development Authority

IRFs - Interest Rate Futures

IT - Information Technology

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LAF - Liquidity Adjustment Facility

LAMPS - Large Adivasi Multi-purpose Co-operative Societies

LTV - Loan to Value

M3

- Broad Money

MFIs - Micro-finance Institutions

MICR - Magnetic Ink Character Recognition

MIS - Management Information System

MoU - Memorandum of Understanding

MSEs - Micro and Small Enterprises

MSMEs - Micro, Small and Medium Enterprises

NABARD - National Bank for Agriculture and Rural Development

NBFCs - Non-Banking Financial Companies

NCDs - Non-Convertible Debentures

NDTL - Net Demand and Time Liabilities

NEFT - National Electronic Funds Transfer

NPCI - National Payments Corporation of India

O&G - Ownership and Governance

OTC - Over-the-Counter

PACS - Primary Agricultural Credit Society

PNB - Punjab National Bank

PSLCs - Priority Sector Lending Certificates

Q - Quarterly

QIS - Quantitative Impact Study

RBI - Reserve Bank of India

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REER - Real Effective Exchange Rate

RRBs - Regional Rural Banks

RTGS - Real Time Gross Settlement

SBI - State Bank of India

SCBs - Scheduled Commercial Banks

SEBI - Securities and Exchange Board of India

SGL - Subsidiary General Ledger

SIFIs - Systemically Important Financial Institutions

SLBCs - State Level Bankers’ Committees

SMEs - Small and Medium Enterprises

StCBs - State Co-operative Banks

TSA - The Standardised Approach

UCBs - Urban Co-operative Banks

US - United States of America

USD - US Dollar

WOS - Wholly-Owned Subsidiary

WPI - Wholesale Price Index

Reserve Bank of IndiaSecond Quarter Review of Monetary Policy 2010-11

ByDr. D. Subbarao

Governor

Introduction

This Second Quarter Review is setin the context of a mixed backdrop ofpersistent sluggishness in advancedeconomies and positive signals fromemerging market economies (EMEs).While recovery in advanced economieshas slowed in the second half of 2010,EMEs continue to show strong growth.The fragile and uneven nature of therecovery and large unemployment inadvanced economies raise concerns aboutthe sustainability of the global recovery,which has prompted the InternationalMonetary Fund (IMF) to project a lowerworld GDP growth of 4.2 per cent in 2011as compared with 4.8 per cent in 2010.

2. The rising concerns aboutthe slowing momentum of recoveryhave prompted the central banks of someadvanced economies to initiate(or consider initiating) a second round ofquantitative easing to further stimulateprivate demand. While the ultra loosemonetary policy of advanced economiesmay benefit the global economy in themedium-term, in the short-term it willtrigger further capital inflows into EMEsand put upward pressure on globalcommodity prices.

3. On the domestic front, economicactivity is firmly in place. The 8.8 per centGDP growth for Q1 of 2010-11 suggeststhat the economy is operating close to thetrend growth rate, driven mainly bydomestic factors. The South-Westmonsoon was normal which should boostagricultural output and rural demand. Mostindustrial and service sector indicatorsalso point towards sustained growth.

4. Notwithstanding some moderationin recent months, headline inflationremains significantly above itsmedium-term trend. What is of concernis that while non-food manufacturedproducts inflation has stabilised, foodinflation has not shown the expectedpost-monsoon moderation. Persistentlyrising food prices even in the wake of anormal monsoon raise concerns about thestructural nature of food inflation and itsconsequent impact on inflat ionaryexpectations. Further, when the economyis growing close to trend, the risks ofstructural food inflation spilling over intoprices of other commodities aresignificant and that could potentiallyoffset the recent moderation.

5. This statement is organised in twoparts. Part A covers Monetary Policy and

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is divided into four sections: Section Iprovides an overview of global anddomestic macroeconomic developments;Section II sets out the outlook andprojections for growth, inflation andmonetary aggregates; Section III explainsthe stance of monetary policy; and SectionIV specifies the monetary measures. Part Bcovers Developmental and RegulatoryPolicies and is organised in six sections:Financial Stability (Section I), Interest

Rate Policy (Section II), FinancialMarkets (Section III), Credit Delivery andFinancial Inclusion (Section IV),Regulatory and Supervisory Measures forCommercial Banks (Section V) andInstitutional Developments (Section VI).Part A of this statement should be read andunderstood together with the detailedreview in Macroeconomic and MonetaryDevelopments released yesterday by theReserve Bank.

Part A. Monetary Policy

I. The State of the Economy

Global Economy

6. In its World Economic Outlookreleased in October 2010, the IMF revisedupwards its forecast for global growth for2010 from 4.6 per cent to 4.8 per cent.However, the estimate for the second halfof the year is significantly lower than forthe first. Moreover, the growth processremains uneven being driven largely byemerging and developing countries. Inadvanced economies, the recoverycontinues to be fragile as private demandhas not picked up sufficiently to offset thewaning fiscal stimulus.

7. In the US, growth remainedsluggish in the third quarter of 2010.Household spending is constrained by highunemployment, modest income growth,lower housing wealth and tight credit. Theeconomic recovery in Japan has alsomoderated recently as reflected inslowdown in industrial production andgrowth in exports. On the other hand,economic activity in the Euro area isshowing signs of resilience in the aftermath

of the sovereign debt problems inMay-June 2010, though at an uneven paceacross the region. Growth in the EMEscontinues to be strong, led mainly bydomestic demand but supported by exports.

8. Inflation rates in advancedeconomies remain subdued due to highlevel of slack in resource utilisation andhigh unemployment. In the US and Japan,inflation rates are significantly belowdesired levels providing a rationale forcentral banks to provide further stimulusthrough quantitative easing. In sharpcontrast, EMEs are witnessing risingdomestic demand which is beginning togenerate inflationary pressures. Thesecould be aggravated by significantincreases in commodity prices driven byinvestment flows into these markets.Inflation is a growing concern in severalEMEs.

Domestic Economy

9. India’s growth of 8.8 per cent inQ1 of 2010-11 suggests that the recoveryset in the second half of 2009-10 is

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consolidating. The normal South-Westmonsoon and its delayed withdrawal haveboosted the prospects of both kharif andrabi agricultural production.

10. Industrial growth has been robust,although apparently with a significantincrease in volatility. The year-on-yearincrease in the index of industrialproduction (IIP) varied in a range of5.6 to 15.2 per cent during April–August2010, with an average of 10.6 per cent.Industrial growth was high in the capitalgoods, consumer durables andintermediate goods sectors. While thevolatility raises concerns about adeceleration, other indicators of economicactivity suggest continuing momentum.Exports have grown steadily during thefirst half of 2010-11, showing an increaseof 27.6 per cent over the correspondingperiod of last year. Based on an analysisof a sample of 2,546 non-financialcompanies, private corporate sector salesrose by 24 per cent year-on-year in Q1 of2010-11. Early results of corporateperformance indicate sustained salesgrowth and improved profitability inQ2 of 2010-11. Direct tax collections, asreflected in advance taxes paid inSeptember 2010, rose by 16.5 per centover last year. Similarly, indirect taxcollections during the April-Septemberperiod were 43.1 per cent higher than inthe corresponding period of 2009.

11. The buoyancy in various servicesectors witnessed in the second half of2009-10, has continued this year as well.The latest quarterly industrial outlooksurvey conducted by the Reserve Bankindicates improvement in the overallbusiness conditions. Other business

conditions surveys also indicate a similartrend. While the Reserve Bank’s surveyon capacity utilisation indicates that thereis a small decline in utilisation at theaggregate level, several sectors appear tobe facing capacity constraints, resulting inincreased imports.

12. On the inflation front, the newseries of wholesale price index (WPI)released on September 14, 2010 is a betterrepresentative of commodity price levelswith an updated base (2004-05=100)and wider coverage of commodities. Whileinflation at the aggregate leveldoes not show much variation over themedium-term between the old and newseries, there are significant differences ininflation at the disaggregated level. As perthe new WPI series, the year-on-yearinflation moderated to 8.5 per cent inAugust 2010 and 8.6 per cent in September2010 after remaining in double digitsduring March-July 2010. At adisaggregated level, inflation in primaryarticles, especially food articles, in thenew series has been significantly higherthan in the old series, whereas formanufactured products, it has beensomewhat lower.

13. During 2010-11, although the year-on-year primary food inflation moderatedfrom 21.4 per cent in May 2010 to 15.7per cent in September 2010, themoderation was not commensurate withpatterns following a normal monsoon onprevious occasions. This is partly areflection of the growing importance ofprotein-rich items in the consumptionbasket for which price increases have beenlarge. The year-on-year inflation rate inprotein-based food items such as pulses,

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milk, eggs, fish and meat (with a combinedweight of 6.4 per cent in WPI basket),peaked at 34 per cent in May 2010 andremained very high at 23.9 per cent inSeptember 2010. Inflation in the otherprimary food articles (weight: 8.0per cent) moderated from 14.0 per cent inJune 2010 to 9.4 per cent in September2010, more visibly reflecting the impactof normal monsoon on prices of majorcereals, fruits and vegetables. In sum,despite some moderation, overall foodprice inflation remains at an elevated level.The year-on-year inflation as of September2010 was also high for certain primarynon-food articles such as raw rubber(57.4 per cent), sugarcane (53.3 per cent)and cotton (27.5 per cent). The rise incotton prices reflected global trends.

14. Focusing on the manufacturingsector, the year-on-year WPI non-foodmanufactured products (weight: 55.0per cent) inflation increased from (-) 2.0per cent in September 2009 to a peak of5.9 per cent in April 2010, beforemoderating to 5.0 per cent in September2010. Non-food items inflation (WPIexcluding food products and foodarticles), which was (-) 2.9 per centin September 2009, rose sharply to9.2 per cent in April 2010 beforemoderating to 7.8 per cent by September2010. Non-food items (weight: 75.7per cent) contributed 65.5 per cent to WPIinflation in September 2010, up from 40.5per cent in January 2010.

15. Inflation based on CPI forindustrial workers has moderated to singledigit since August 2010 after remainingin double digits for 13 months. However,the various CPI baskets still reflect the

consumption pattern of the mid-1980sand 2001 which have a relatively higherweight for cereals, whereas more updated(2004-05) WPI basket suggests thatfood consumption has shifted towardsprotein-rich items where price increase hasbeen high. To that extent, CPI basketsunderstate the underlying food inflation.

16. Money supply (M3) growth

moderated from 16.8 per cent on ayear-on-year basis at end-March 2010 to14.5 per cent at end-May 2010 beforeincreasing to 15.2 per cent by October 8,2010. At this level, it was below theindicative projection of 17.0 per cent for2010-11. The lower M

3 growth essentially

reflected the moderation in growth in bankdeposits, particularly long-term deposits.Furthermore, currency growth has beenhigher than deposits growth whichreduced the money multiplier, therebylowering M

3 growth. A contributory factor

to this trend has been negative real interestrates on deposits, which have induceddepositors to both hold currency andinvest in non-financial assets, includinggold and real estate, whose prices haveshown significant increases over thecourse of the current year.

17. Non-food credit growthaccelerated from 17.1 per cent on ayear-on-year basis at end-March 2010 to22.3 per cent by July 2, 2010, reflectingin part the higher credit demand emanatingfrom telecom spectrum auctions. Althoughit moderated to 20.1 per cent as of October8, 2010, it was in line with the indicativetrajectory of 20 per cent for 2010-11 setout in the Monetary Policy Statement ofApril 2010. Even after adjusting forspectrum auction related advances, growth

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in bank credit during the current financialyear so far has been in line with the long-term trend. Disaggregated data suggestthat year-on-year credit growth to largeindustries, including infrastructure(especially power and telecom), andhousing sectors improved significantly.The increase in bank credit to thecommercial sector was also supplementedby the higher flow of funds from othersources. Rough estimates showed that thetotal flow of financial resources frombanks, non-banks and external sources tothe commercial sector during the first halfof 2010-11 was higher at `4,85,000 crore,up from `3,29,000 crore during the sameperiod of previous year.

18. On the lending side, the Base Ratesystem replaced the Benchmark PrimeLending Rate (BPLR) system witheffect from July 1, 2010. Base Rates ofscheduled commercial banks (SCBs) werefixed in the range of 5.50-9.00 per cent.Subsequently, several banks reviewedand increased their Base Rates in the rangeof 10–50 basis points by October 2010.Base Rates of major banks, accounting forover 94 per cent in total bank credit, arein the range of 7.50-8.50 per cent. Bankshave also raised their BPLRs in therange of 25-75 basis points for their oldloans.

19. Liquidity conditions, whichremained tight between end-May 2010 andJuly 2010 due to huge outflow of liquidityfrom the system, eased in August 2010.After alternating between surplus anddeficit for a brief period, the LiquidityAdjustment Facility (LAF) window of theReserve Bank has remained in an injectionmode since September 9, 2010 with an

average daily net injection of around`24,000 crore in September and `61,700crore in October 2010 and a peak injectionof `1,28,685 crore on October 30, 2010.While the injection mode in the LAFwindow has been consistent with the statedpolicy stance, the sharp changes havelargely been due to significant increases ingovernment cash balances, which stood at`77,736 crore as on October 30, 2010.

20. With a view to alleviatingfrictional liqudity pressure, the ReserveBank on October 29, 2010 decided toconduct second LAF (SLAF) and alsoallowed scheduled commercial banks toavail of additional liquidity support underthe LAF to the extent of up to 1.0 per centof their NDTL as on October 8, 2010. Inview of the likely persistence of thefrictional liqudity pressure and in orderto provide liquidity comfort, thesemeasures have been extended up toNovember 4, 2010.

21. Both the increases in lending ratesby the banking system and liquidityconditions are consistent with themonetary policy stance of reining ininflation. Tight liquidity conditions arehelping to strengthen the transmissionfrom policy rates to commercial lendingrates, and the process is becoming muchmore transparent through the operation ofthe Base Rate system. As desirable asthese conditions may be from theviewpoint of inflation management, thereare legitimate concerns that the deficit, asreflected by borrowings under the LAF inrecent weeks, is significantly in excess ofthe Reserve Bank’s comfort zone of(+/-) one per cent of net demand and timeliabilities (NDTL) of banks. The high

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level of government balances indicatesthat the tight liquidity situation is likelyto ease to some extent as the Governmentdraws down its balances in the comingweeks.

22. On the basis of large spectrumauction realisations, buoyant tax revenuesand in anticipation of significant inflowsfrom disinvestment during the currentyear, the Government announced that itwould pare its market borrowing by`10,000 crore in the second half of thefinancial year. Further, on October 21,2010, as a part of its cash managementoperations, the Government, inconsultation with the Reserve Bank,announced the repurchase of governmentsecurities amounting to `28,553 crorematuring during 2010-11. The repurchaseoperations would be funded through thesurplus cash balances of the Government.In the first tranche, repurchase ofsecurities for an aggregate amount of`12,000 crore was notified and `2,148crore was accepted in the auction held onOctober 26, 2010.

23. The increase in the overall revenuerealisation of the Government during thecurrent year is a welcome development. Itvirtually eliminates the possibility of thefiscal deficit overshooting the budgetestimate. Fiscal consolidation is importantfor a number of reasons, including the factthat monetary policy works mostefficiently, particularly when it is dealingwith an inflationary situation, when thefiscal situation is under control. Severalthings are important to make the fiscalconsolidation effort credible and effective.The focus must be as much on expenditurerestructuring as on revenue augmentation,

recurring expenditure commitmentsshould not be made against one offrevenues such as from disinvestment andthe quality of adjustment should not belost sight of.

24. The combination of liquidityconditions and revised governmentborrowing estimates have had contrastingimpacts on the yield curve. At the shortend, as the LAF window operated indeficit mode, the overnight interest rateswere generally close to the ceiling of theLAF rate corridor during September-October 2010, even exceeding it onoccasions in response to sudden surgesin demand. However, at the long end, theannounced reduction in net borrowing ofthe Central Government had a downwardimpact on government bond yields, as the10-year benchmark government securityyield fell to about 7.92 per cent inearly October 2010 from a high of 8.07per cent in August. Yields have risenagain recently, reaching a high of 8.14per cent on October 20, 2010, reflectingthe tightening of liquidity conditions.

25. Domestic equity prices firmed upsignificantly in recent weeks due to largeinflows from foreign institutionalinvestors (FIIs), driven by better domesticgrowth prospects and a surfeit of globalliquidity. The foreign exchange market,which witnessed a significant increase innet inflows beginning September 2010,has remained orderly with the rupeeshowing two-way movements in the rangeof `44.03 – `44.74 per US dollar duringOctober 2010.

26. During 2010-11 so far (October22, 2010), the rupee appreciated by

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0.4 per cent on the basis of trade based36-currency real effective exchange rate(REER). The extent of appreciation was,of course, higher on the basis of6-currency trade based REER (3.1 percent) reflecting both the nominalappreciation of the rupee against the USdollar during this period and the higherinflation differential with major advancedcountries. Since the 36-currency REERincludes the currencies of many countrieswhich are India’s direct competitors inthe global market, it is a better reflectionof the impact of global exchange ratemovements on competitiveness. Therelatively small appreciation in this indexreflects the fact that many competingcountries have also seen their currenciesappreciate during this period. From thisperspective, the impact of the recentnominal appreciation of the rupee maynot have a significant implication forcompetitiveness.

27. The continuing sluggishness of theglobal economy led to some moderation inexports growth and invisible receipts, whileimport growth accelerated due to the strongdomestic recovery. Consequently, both thetrade deficit and the current account deficit(CAD) widened in Q1 of 2010-11. If thecurrent trend persists, CAD as a percentageof GDP will be significantly higher than inthe previous year. It is generally perceivedthat a CAD above 3 per cent of GDP isdifficult to sustain over the medium-term.The challenge, therefore, is to rein in thedeficit over the medium-term and financeit in the short-term. The medium-term taskhas to receive policy focus from both theGovernment and the Reserve Bank. Theshort-term task is to see that the currentaccount is fully financed while ensuringthat capital flows are not far out of line withthe economy’s absorptive capacity and thatthe component of long-term and stableflows in the overall capital flows is high.

II. Outlook and Projections

Global Outlook

Growth

28. In its latest World EconomicOutlook, the IMF has projectedglobal growth to slow down from4.8 per cent in 2010 to 4.2 per cent in 2011.Various indicators of economic activity inadvanced economies point to decelerationof growth in the second half of 2010 whichcould persist through the first half of 2011.The room to provide additional fiscalstimulus to support the growth processremains constrained due to debtsustainability issues in some major

advanced economies. Reflecting globallinkages, the slowdown in the globalrecovery will have an adverse impact ongrowth in EMEs, including India,especially through the trade channel.

Inflation

29. Inflation in advanced economiesin the short-term is expected to remainsubdued due to the prevailing low levelsof capacity uti l isat ion and highunemployment rates. However, the recentupward movements in internationalcommodity prices, despite prospects ofslow global recovery, raise some

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concerns. Several EMEs are alreadyfacing inflationary pressures. Food,energy and metal prices, in particular,have seen significant increases. Theupward risk to inflation, therefore, hasincreased for EMEs, both from risingdomestic capacity utilisation and fromglobal commodity price increases.

Domestic Outlook

Growth

30. Taking into account the goodperformance of the agriculture sector,and a range of indicators of industrialproduction and service sectoractivity amidst the prevailing globalmacroeconomic scenario, the baselineprojection of real GDP growth for2010-11, for policy purposes, is retainedat 8.5 per cent, as set out in the July 2010review (Chart 1).

31. The Reserve Bank’s growthprojection for 2010-11 is consistent withthe median growth forecast from itsprofessional forecasters’ survey and otheragencies.

Inflation

32. Although the headline inflationhas moderated in recent months, thecurrent rate of inflation is still well abovethe comfort zone of the Reserve Bank.The Reserve Bank’s quarterly inflationexpectation survey conducted duringthe first fortnight of September 2010indicates that short-term householdinflationary expectations have increasedmarginally. Further, notwithstandingsome moderation, food price inflationhas remained persistently elevatedfor over a year now, reflecting inpart the structural demand-supplymismatches in several commodities -besides protein sources, oi lseedsand vegetables also show this pattern.Given the changing consumption patternsand as yet inadequate supply response,food price inflat ion is becomingincreasingly structural in nature.Further, even as non-food manufacturinginflat ion has indeed moderated, i tstill remains above its medium-termtrend.

Chart 1: Projection of GDP Growth for 2010-11

GD

PG

row

th(%

)

50 Per cent CI 90 Per cent CI70 Per cent CIBaseline Projection CI - confidence interval

10

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

6

7

8

9

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33. Going forward, the inflationoutlook will be shaped by the followingfactors. First, it will depend as to how foodprice inflation evolves. Second, risingglobal commodity prices have become acause for concern. Third, demandpressures arising from sustained growthamidst tightening capacity constraints willhave an impact. On balance, inflation isexpected to moderate from the presentelevated level, reflecting in parts, someeasing of supply constraints and concertedpolicy action.

34. In its July Review, the ReserveBank made a baseline projection of WPIinflation for March 2011 of 6.0 per cent.This projection was based on the old seriesof WPI. As has been indicated, there isnot much difference at the aggregate levelin the medium-term inflation trendbetween the old and new series, but thereare significant differences at the grouplevels. On the basis of currently availableinformation and the fact that expectedmoderation in food price inflation has alsonot fully materialised, the baselineprojection of WPI inflation for March2011 has been placed at 5.5 per cent,which is equivalent to 6.0 per cent under

the old series. Effectively, this means thatthe projection remains unchanged fromthat made in the July 2010 Review(Chart 2).

35. The Reserve Bank will endeavourto achieve price stability and anchorinflation expectations. In pursuit of theseobjectives, the Reserve Bank will continueto evaluate an array of aggregate anddisaggregated measures of inflation in thecontext of the evolving macroeconomicsituation.

36. Notwithstanding the currentinflation scenario, it is important torecognise that in the 2000s, the averageheadline inflation rate remained in therange of 5.0-5.5 per cent, down from itshistorical trend rate of about 7.5 per cent.A combination of factors played a role inthis transformation. One of these was thecommitment on the part of the monetarypolicy to keep inflation low and stable.This record is an important foundation forthe credibility of monetary policy and,more generally, the broader inflationmanagement framework. Against thisbackdrop, the conduct of monetary policywill continue to condition and containperception of inflation in the range of

Chart 2: Projected Path of Y-o-Y Inflation

CI - confidence interval

Infl

atio

nR

ate

(%)

50 Per cent CI 90 Per cent CI70 Per cent CIBaseline Projection

-2

0

2

4

6

8

10

12

Mar

-09

Jun-0

9

Sep

-09

Dec

-09

Mar

-10

Jun-1

0

Sep

-10

Dec

-10

Mar

-11

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4.0-4.5 per cent. This will be in line withthe medium-term objective of 3.0 per centinflation consistent with India’s broaderintegration into the global economy.

Monetary Aggregates

37. While the year-on-year moneysupply (M

3) growth at 15.2 per cent in

early October 2010 was below theindicative projection of 17.0 per cent, non-food credit growth at 20.1 per cent wasclose to the indicative projection of 20.0per cent. There are already some signs ofpick-up in deposit and credit growth. It isexpected that monetary aggregates willevolve along the projected trajectoryindicated in the April policy statement.Accordingly, the M

3 and non-food credit

growth projections for 2010-11 have beenretained at 17 per cent and 20 per cent,respectively. As always, these numbers areindicative projections and not targets.

Risk Factors

38. The above macroeconomic andmonetary projections are subject to anumber of upside and downside risks.First, the main downside risk to growthemanates from the prospects of aprolonged slow and halting recoveryprocess in advanced economies asevidenced by the recent indicators ofglobal economic activity. Concerns arebeing expressed that the ongoing fiscalconsolidation in the absence of revival ofprivate demand might weigh on therecovery process. Should the globalrecovery falter, the growth performance ofEMEs, including India which hasremained robust so far, is likely to beadversely affected. While India’s exportsas a percentage of GDP are relatively low

compared to other major EMEs, awidespread slowdown in global tradecannot but have an impact on themanufacturing and service sectors.

39. Second, although overall inflationand non-food manufactured productsinflation have moderated in the recentperiod, inflationary pressures remainwhich may accentuate for severalreasons. Despite the fragile globalrecovery, international commodity priceshave risen in recent months due to strongdemand from EMEs and somefinancialisation of commodities due tolarge surplus global liquidity. Shouldthere be further quantitative easing byadvanced economies, it will pose afurther risk to global commodity prices.Persistently high domestic food inflationpoints to the presence of some structuralcomponent, which will continue to weighon the overall inflat ion. With thedomestic capacity utilisation slowlyapproaching the pre-crisis peak in manyindustries, demand side pressuresmay accentuate. Going forward,therefore, the risks to inflation are largelyon the upside.

40. Third, given the weak recovery inadvanced economies, Japan has alreadyresorted to further monetary easingthrough unsterilised intervention in theforex market. Some other advancedeconomies are in the process of resortingto another round of quantitative easing.Given that growth prospects in EMEs,including India, are much better, thesurplus liquidity generated by centralbanks in advanced economies could flowinto the EMEs. In fact, the expectation offurther quantitative easing in advanced

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economies has already resulted in largecapital inflows to EMEs. As a result,exchange rates have been appreciating andasset prices have been rising in EMEs.Excess global liquidity combined with thesignificant growth differential, interestrate differential and higher financialmarket returns in India vis-à-vis theadvanced economies might lead tointensification of capital flows to India.Although India needs capital flows tofinance its widening current accountdeficit, large capital flows beyond theabsorptive capacity of the economy couldpose a major challenge for exchange rateand monetary management.

41. Fourth, India’s current accountdeficit has widened in the recent perioddue to slowing down of exports andinvisibles on the one hand and rising

imports on the back of strong rebound ofthe domestic economy on the other.Although the current account deficit hasbeen easily financed by the rising capitalflows so far, the widening of the currentaccount deficit raises concerns given theuncertainty associated with internationalcapital flows.

42. Fifth, asset prices in India, as inmany other EMEs, have risen sharply. Theequity market is close to its previousall-time peak level. Residential propertyprices in metropolitan cities have gonebeyond the pre-crisis peak level.Gold prices are ruling at an all-time highlevel. Although the income levels ofhouseholds and earnings of corporates inIndia have continued to rise, a sharp risein asset prices in such a short time causesconcern.

III. The Policy Stance

43. Since October 2009, the ReserveBank has cumulatively raised the cashreserve ratio (CRR) by 100 basis points,and the repo and reverse repo rates underthe LAF by 125 basis points and 175 basispoints, respectively. The monetary policyresponse has been calibrated on the basisof India’s specific growth-inflationdynamics in the broader context ofpersistent global uncertainty.

44. Thus, our policy stance for 2010-11 for the remaining period hasbeen condit ioned by three majorconsiderations:

45. First, the domestic economy is ona strong footing. The 8.8 per cent GDPgrowth for Q1 of 2010-11 suggests that

the economy is steadily regaining the pre-crisis growth trajectory. Althoughuncertainty persists with regard to globalrecovery, India’s domestic growth driversare robust which should help absorb to alarge extent the negative impact ofslowdown in global recovery.

46. Second, inflation remains high.Both demand side and supply side factorsare at play. Inflationary expectations alsoremain at an elevated level. Given thespread and persistence of inflation,demand side inflationary pressures needto be contained and inflationaryexpectations anchored.

47. Third, even though a liquiditydeficit is consistent with an anti-inflation

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stance, excessive deficiency can bedisruptive both to financial marketsand to credit growth in the bankingsystem. To ensure that economic activityis not disrupted by liquidity constraints,the liquidity deficit needs to be containedwithin a reasonable limit.

48. Against the above stated backdrop,the stance of monetary policy isintended to:

• Contain inflation and anchorinflationary expectations, while

being prepared to respond to anyfurther build-up of inflationarypressures.

• Maintain an interest rate regimeconsistent with price, output andfinancial stability.

• Actively manage liquidity toensure that it remains broadly inbalance, with neither asurplus diluting monetarytransmission nor a deficit choking offfund flows.

IV. Monetary Measures

49. On the basis of the currentassessment and in line with the policystance as outlined in Section III, thefollowing policy measures are announced.

Bank Rate

50. The Bank Rate has been retainedat 6.0 per cent.

Repo Rate

51. It has been decided to:

• increase the repo rate under theliquidity adjustment facility (LAF)by 25 basis points from 6.0 per centto 6.25 per cent with immediateeffect.

Reverse Repo Rate

52. It has been decided to:

• increase the reverse repo rate underthe LAF by 25 basis points from 5.0per cent to 5.25 per cent withimmediate effect.

Cash Reserve Ratio

53. The cash reserve ratio (CRR) ofscheduled banks has been retained at 6.0per cent of their net demand and timeliabilities (NDTL).

Expected Outcomes

54. These actions are expected to:

i. Sustain the anti-inflationary thrust ofrecent monetary actions and outcomesin the face of persistent inflation risks.

ii. Rein in rising inflationaryexpectations, which may beaggravated by the structural nature offood price increases.

iii. Be moderate enough not to disruptgrowth.

55. The Reserve Bank will continue toclosely monitor both global and domesticmacroeconomic conditions. We will takeaction as warranted with a view tomitigating any potentially disruptive

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effects of lumpy and volatile capital flowsand sharp movements in domestic liquidityconditions, consistent with the broadobjectives of price and output stability.

56. Based purely on current growth andinflation trends, the Reserve Bank believesthat the likelihood of further rate actions inthe immediate future is relatively low.However, in an uncertain world, we needto be prepared to respond appropriatelyto shocks that may emanate from eitherthe global or domestic environment.

Mid-Quarter Review of MonetaryPolicy 2010-11

57. The next mid-quarter review ofMonetary Policy for 2010-11 will beannounced through a press release onDecember 16, 2010.

Third Quarter Review of MonetaryPolicy 2010-11

58. The third quarter review ofMonetary Policy for 2010-11 is scheduledon January 25, 2011.

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Part B. Developmental and Regulatory Policies

59. The recent global financial crisishas underlined the need for fundamentalchanges in the way banks and financialinstitutions are regulated. Important stepsin this regard at the international levelhave been taken under the auspices ofG-20, Financial Stability Board (FSB) andBasel Committee on Banking Supervision(BCBS). The broad elements of emergingframework that have been agreed upon arering-fencing of banking institutions withmore and better quality capital underBasel III, an appropriate framework forsystemically important financialinstitutions (SIFIs), aligning thecompensation practices to prudent risk-taking and long term value creation, andimproving the accounting standards, thatpromote financial stability. India being amember of G-20, FSB and BCBS, the

Reserve Bank has been actively associatedwith the evolution of the reform package.

60. The thrust of the regulation by theReserve Bank in recent years has not onlybeen on strengthening the financialsystem, but also on developing financialmarkets, promoting financial inclusion,improving credit delivery, especially tothe small and medium enterprises (SMEs)sector, improving customer service andstrengthening the payment and settlementsystems. The Reserve Bank, therefore,will continue to pursue reforms in theseareas so as to enhance the efficiency andstability of the financial system.

61. A synopsis of the action taken on thepast policy announcements together witha list of fresh policy measures is set outbelow.

I. Financial Stability

Financial Stability Report

62. The Reserve Bank conductsmacro-prudential surveillance of thefinancial system on an ongoing basis.Assessment of f inancial stabil i tyand the findings thereof are shared withfinancial institutions, market players andgeneral public in the form of FinancialStabili ty Reports (FSRs). The firstFSR was published in March 2010.The second FSR will be published inDecember 2010. Going forward, FSRswill be published in June and Decemberevery year.

Assessment of Financial Stability

63. Steps are being taken to strengthenmacro-prudential surveillance. Towards thisend, more frequent internal assessments,including systemic risk monitor reportstwice a year, have started. As per the latestinternal assessment, the financial system atthe current juncture is largely stable. Thebanking sector is sound and the financialsector is considered resilient to shocksemanating from adverse domestic andinternational developments. However,evolving risks to financial stability, bothglobally and within the country, need to bemonitored carefully on an ongoing basis.

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Base Rate

64. As indicated in the MonetaryPolicy Statement of April 2010, the systemof Base Rate came into effect on July 1,2010. The transition from the benchmarkprime lending rate (BPLR) system to thebase rate system has been smooth.

Deregulation of Interest Rateon Savings Bank Deposits

65. As a part of financial sectorreforms, the Reserve Bank has deregulatedinterest rates on deposits, other thansavings bank deposits. The interest rate

on savings bank deposits has remainedunchanged at 3.5 per cent per annum sinceMarch 1, 2003. Keeping in viewprogressive deregulation of interest rates,it is proposed:

• to prepare a discussion paper, whichwill delineate the pros and cons ofderegulating the savings bank depositsinterest rate.

66. The discussion paper will beplaced on the Reserve Bank’s website byend-December 2010 for feedback from thegeneral public.

III. Financial Markets

Financial Market Products

Interest Rate Futures

67. The Monetary Policy Statement ofApril 2010 had indicated that exchangetraded interest rate futures (IRFs) on5-year and 2-year notional coupon bearingGovernment of India securities and 91-dayTreasury Bills would be introduced. It wasalso indicated that the RBI-SEBI StandingTechnical Committee would finalise theproduct design and operational modalities.The issue relating to product design wasdeliberated by the RBI-SEBI StandingTechnical Committee. The Reserve Bankwill introduce such IRFs after taking intoaccount the experiences of cash-settledIRF regimes in other countries.

Regulation of Non-Convertible Debenturesof Maturity Less than One Year

68. It was proposed in the MonetaryPolicy Statement of April 2010 to issue

the final guidelines on the issuance ofnon-convertible debentures (NCDs) ofmaturity less than one year by end-June2010. Accordingly, keeping in view thefeedback received, the guidelines onNCDs were issued in June 2010, whichcame into force with effect from August2, 2010. The guidelines, among others,covered eligibility criteria to issueNCDs, rating requirement, maturity,denomination, limits and amount of issueof NCDs and responsibilities ofcorporates, debenture trustees and creditrating agencies.

Introduction of Credit Default Swaps

69. It was indicated in the MonetaryPolicy Statement of April 2010 that thedraft report of the internal Working Groupon introduction of credit default swap(CDS) for corporate bonds would beplaced on the Reserve Bank’s website byend-July 2010. Accordingly, the draft

II. Interest Rate Policy

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report was placed on the Reserve Bank’swebsite on August 4, 2010 for publiccomments till October 4, 2010. Thecomments/suggestions received are beingexamined by holding wider consultationswith all the stakeholders, includingcorporates.

Repo in Corporate Bonds

70. For development of the corporatebond market, the Reserve Bank had issuedguidelines in January 2010, permittingrepo in corporate bonds, subject to certainterms and conditions. To further facilitaterepo transactions in corporate bonds, areview of the guidelines governing repoin corporate bonds has been undertakenby the Reserve Bank in consultation withthe market participants. Accordingly, it hasbeen decided:

• to permit settlement of repo incorporate bonds on a T+0 basis inaddition to the existing T+1 and T+2basis and revise the repo haircutrequirements suitably.

71. Detailed guidelines, which will beeffective December 1, 2010, are beingissued separately.

Guidelines on Over-the-CounterForex Derivatives

72. The draft guidelines on over-the-counter (OTC) foreign exchangederivatives were placed on the ReserveBank’s website in November 2009 forpublic comments. The feedback receivedfrom stakeholders was discussed in themeeting of the Technical AdvisoryCommittee on the Money, ForeignExchange and Government Securities

Markets. On the basis of the discussions,the revised draft guidelines on the subjectwere again placed on the Reserve Bank’swebsite in July 2010 for final commentsby August 13, 2010. Comments receivedfrom stakeholders were examined anddeliberated in the meeting of the TechnicalAdvisory Committee on the Money,Foreign Exchange and GovernmentSecurities Markets. Final guidelines in thelight of the feedback received will beissued by end-November 2010.

Introduction of Exchange TradedCurrency Option Contracts

73. It was indicated in the MonetaryPolicy Statement of April 2010 that theReserve Bank would permit therecognised stock exchanges to introduceplain vanilla currency options on spot USdollar/rupee exchange rate for residents.In July 2010, the Reserve Bank permittedtrading of currency options on spot USD-INR rate in the currency derivativessegment of the recognised stockexchanges. The currency options marketwill function subject to the guidelinesissued by the Reserve Bank and theSecurities and Exchange Board of India(SEBI) from time to time.

Money Market

Working Group to Review the OperatingProcedure of Monetary Policy

74. As announced in the First QuarterReview of Monetary Policy of July 2010,the Reserve Bank, on October 4, 2010,constituted a Working Group to review thecurrent operating procedure of monetarypolicy, including the liquidity adjustmentfacility (Chairman: Shri Deepak Mohanty),

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with representations from the concerneddepartments of the Reserve Bank, IndianBanks’ Association (IBA) and FixedIncome Money Market and DerivativesAssociation of India (FIMMDA). TheGroup also includes external experts. TheGroup will submit its report in threemonths from the date of its first meeting.

Financial Market Infrastructure

Reporting Platform for Certificates ofDeposit and Commercial Papers

75. The reporting platform forsecondary market transactions

in Certif icates of Deposit (CDs)and Commercial Papers (CPs)developed by the FIMMDA hasbeen operationalised with effectfrom July 1, 2010. As mandated,enti t ies regulated by the ReserveBank, the SEBI and the InsuranceRegulatory and Development Authority(IRDA) are now reporting theOTC trades in CDs and CPs onthe FIMMDA platform. FIMMDA isalso making available onlineinformation on trades in CDs and CPs,including prices, transaction amountand yields.

Credit Flow to the Micro, Small andMedium Enterprises Sector

High Level Task Force on MSMEs

76. A High Level Task Forceconstituted by the Government(Chairman: Shri T.K.A. Nair) to considervarious issues raised by micro, smalland medium enterprises (MSMEs)associations and draw up an agenda foraction submitted its report in January2010. In terms of the recommendations ofthe Task Force, the Reserve Bank issuedguidelines in June 2010, advisingscheduled commercial banks that theallocation of 60 per cent of the micro andsmall enterprises (MSEs) advances to themicro enterprises was to be achieved instages, viz ., 50 per cent in the year2010-11, 55 per cent in the year 2011-12and 60 per cent in the year 2012-13.Further, banks were mandated to achievea 10 per cent annual growth in the number

of micro enterprise accounts and a 20per cent year-on-year growth in credit tothe MSE sector. The Reserve Bank isclosely monitoring the achievement oftargets by banks in this regard.

Rural Credit Institutions

Licensing of Co-operatives

77. The Committee on FinancialSector Assessment (Chairman: Dr. RakeshMohan and Co-Chairman: Shri AshokChawla) had recommended that ruralco-operative banks, which failed to obtaina licence by 2012, should not be allowedto operate. Accordingly, it was proposedin the Annual Policy Statement ofApril 2009 to work out a roadmap forlicensing of unlicensed state and centralco-operative banks in a non-disruptivemanner. For this purpose, revisedguidelines, in consultation with NationalBank for Agriculture and Rural

IV. Credit Delivery and Financial Inclusion

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Development (NABARD), were issued onlicensing of these banks. Subsequent to theissuance of revised guidelines on licensingof state co-operative banks (StCBs)/district central co-operative banks(DCCBs), 10 StCBs and 133 DCCBs havebeen licensed, bringing down the numberof unlicensed StCBs from 17 to 7 andDCCBs from 296 to 163 as on September30, 2010.

Revival of the Rural Co-operativeCredit Structure

78. The Government of India, based onthe recommendations of the Task Force onRevival of Rural Co-operative CreditInstitutions (Chairman: Prof. A.Vaidyanathan) and in consultation with thestate governments, had approved apackage for revival of the short-term ruralco-operative credit structure. As envisagedin the package, 25 states have so farentered into Memorandum ofUnderstanding (MoU) with theGovernment of India and NABARD.Sixteen states have made necessaryamendments to their respectiveCo-operative Societies Acts. As onAugust 31, 2010, an aggregate amountof about `7,990 crore has been releasedby NABARD to primary agriculturalcredit societies (PACS) in 14 states as theGovernment of India’s share under thepackage.

Financial Inclusion throughGrass-root Co-operatives

79. It was proposed in the MonetaryPolicy Statement of April 2010 toconstitute a Committee comprisingrepresentatives from the Reserve Bank,

NABARD and a few state governments tostudy the functioning of well-run PACS,large adivasi multi-purpose co-operativesocieties (LAMPS), farmers servicesocieties (FSS) and thrift and creditco-operative societies set up under theparallel Self-Reliant Co-operativeSocieties Acts to gather information ontheir working and assess their potential tocontribute to financial inclusion.Accordingly, the Reserve Bank, inassociation with NABARD and theconcerned state governments, is studyingthe working of select (about 220)well-functioning rural co-operativesacross the country to assess their potentialto contribute to financial inclusion. Thestudy is expected to be completed byend-January 2011.

Liberalisation in Branch Licensingof Regional Rural Banks

80. As part of further liberalisation ofthe extant branch licensing policy inrespect of regional rural banks (RRBs), itis proposed:

• to allow RRBs to open branches inTier 3 to Tier 6 centres as identified inthe Census 2001 (with population upto 49,999) without prior authorisationof the Reserve Bank, subject to theirfulfilling certain conditions.

81. Detailed guidelines in this regardwill be issued separately.

Priority Sector Lending

82. As announced in the SecondQuarter Review of October 2009, aWorking Group was consti tuted(Chairman: Shri V. K. Sharma) to

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examine the pros and cons of prioritysector lending certificates (PSLCs) asrecommended by the Committee onFinancial Sector Reforms (Chairman:Dr. Raghuram G. Rajan). As indicated inthe Monetary Policy Statement of April2010, the terms of reference of theWorking Group were expanded to reviewthe pros and cons of inclusion of banklending to micro-finance institutions(MFIs) under priority sector lending. TheWorking Group submitted its report inAugust 2010. However, considering themore recent developments in the MFIspace, a Sub-Committee of the CentralBoard of the Reserve Bank (Chairman:Shri Y. H. Malegam) has been constitutedto examine the various issues relating tomicro-finance extended by non-bankingfinancial companies (NBFCs) while alsotaking into account the recommendationof the Sharma Working Group. The Sub-Committee will make recommendations,among others, relating to regulation ofmicro-finance activities of NBFCs,especially with regard to issuesimpinging on borrowers’ interests. TheSub-Committee is expected to submit itsreport by end-January 2011. A holisticview will be taken on issues relating toPSLCs and bank lending to MFIs underpriority sector lending after the MalegamSub-Committee submits its report.

Financial Inclusion Plan for Banks

83. Considering the objective ofincreasing banking outreach for financialinclusion, domestic scheduled commercialbanks, both in the public and privatesectors, were advised, among others, to putin place a board approved three-yearfinancial inclusion plan (FIP) and submit

the same to the Reserve Bank by March2010. Domestic scheduled commercialbanks have since prepared and submittedtheir FIPs to the Reserve Bank. Theseplans have been discussed with majorbanks and revised plans based on thediscussions have been submitted by banks.To closely monitor the progress made inimplementation of these plans, a quarterlyreporting format has been communicatedto banks and the implementation of theseplans is being closely monitored by theReserve Bank.

Roadmap for Provision of BankingServices in Villages with Populationof over 2000

84. In pursuance of the announcementmade in the Monetary Policy Statement ofApril 2010, the roadmap to providebanking services in every village with apopulation of over 2000 has been finalisedby state level bankers’ committees(SLBCs) and 73,113 unbanked identifiedvillages as per 2001 Census have beenallotted to various banks for provision ofbanking services by March 2012. The timeline for provision of banking services hasbeen extended to March 2012 from March2011 in line with the Finance Minister’sannouncement in the Union Budget2010-11. March 2011 is retained as anintermediate target. The progress in theimplementation of the roadmap is beingdiscussed and closely monitored byrespective SLBCs.

Opening of Sub-Offices of the ReserveBank in North-Eastern States

85. At present, the Reserve Bank hasonly one office at Guwahati to cater to the

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needs of all the North-Eastern states. Overa period of time, while the population ofthese states and banking needs haveincreased significantly, bank brancheshave not kept pace with the requirementsin these areas. Considering therelative economic and infrastructuralbackwardness of these states and the needfor financial inclusion and generaleconomic development in these states, ithas been decided:

• to open sub-offices of the ReserveBank in the remaining six states of thenorth-east, viz., Arunachal Pradesh,Nagaland, Manipur, Mizoram, Tripuraand Meghalaya, in a phased manner.

Business Correspondents - Relaxations

86. In pursuance of the announcementmade in the Monetary Policy Statementof April 2010, the Reserve Bank issuedguidelines in April 2010 permitting banksto engage any individual, including thoseoperating common service centres (CSCs)as banking correspondents (BCs), subjectto banks’ comfort level and their carryingout suitable due diligence as alsoinstituting additional safeguards as maybe considered appropriate to minimise theagency risks. A discussion paper on“Engagement of ‘for profit’ Companies asBusiness Correspondent” was placed onthe Reserve Bank’s website in August2010 inviting comments from thepublic by August 20, 2010. Taking intoconsideration the pros and cons and basedon the feedback received from variousquarters, banks were permitted to engagecompanies registered under theIndian Companies Act, 1956, excludingNBFCs, as BCs in addition to the

individuals/entities permitted earlier,subject to compliance with the guidelinesissued in September 2010.

Urban Co-operative Banks

Licenses for Setting up new UrbanCo-operative Banks

87. As indicated in the MonetaryPolicy Statement of April 2010, an ExpertCommittee (Chairman: Shri Y. H.Malegam) was constituted in October2010 with representations from allstakeholders for studying the advisabilityof granting licenses for setting up newurban co-operative banks (UCBs) underSection 22 of the Banking Regulation Act,1949 [as applicable to co-operativesocieities (AACS)]. The Committee isexpected to submit its report in six months.The Committee will also look into thefeasibility of an umbrella organisation forthe UCB sector.

Extension of Area of Operationof UCBs

88. In order to further facilitate thegrowth of well managed and financiallysound UCBs, it is proposed:

• to withdraw the existing restrictionson granting multi-state status andextension of area of operation beyondthe state of registration for such UCBshaving a minimum net worth of `50crore;

• to allow such UCBs which haveacquired weak banks in other state(s)to extend the area of operation to theentire state of registration of the targetbank provided they have minimum networth of `50 crore; and

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• to allow Tier II UCBs registered ordeemed to be registered under theMulti-State Co-operative SocietiesAct, 2002 to extend area of operationto the entire state of originalregistration.

89. Detailed guidelines in this regardwill be issued separately.

Liberalisation of Branch LicensingPolicy for UCBs

90. In order to further liberalisethe branch licensing policy forurban co-operative banks (UCBs), it isproposed:

• to allow well managed and financiallysound UCBs to open branchesand extension counters withintheir existing/approved area ofoperation, beyond the current ceilingof 10 per cent as long as they havesufficient headroom capital for eachbranch.

91. Detailed guidelines in this regardwill be issued separately.

Business Correspondents/BusinessFacilitator Model for UCBs

92. With a view to expanding theoutreach of the UCBs, thereby furtheringthe objective of financial inclusion, it isproposed:

• to allow well managed and financiallysound UCBs to engage businesscorrespondents (BCs)/businessfacilitators (BFs) using informationand communication technology (ICT)solutions.

Enhancement of Limits on UnsecuredLoans and Advances Granted by UCBs

93. Keeping in view the growth inbusiness of the UCBs over the years, it isproposed:

• to enhance the existing limits onindividual unsecured loans andadvances extended by the UCBs,which are complying with theregulatory capital to risk-weightedassets ratio (CRAR) of 9 per cent,subject to the overall ceiling of 10per cent of total assets.

94. Detailed guidelines in this regardwill be issued separately.

Exposure of UCBs to Housing Loans

95. At present, UCBs can providehousing, real estate and commercial realestate loans up to 15 per cent of theirdeposit resources as on March 31 of theprevious year. It has now been decided tolink housing, real estate and commercialreal estate loans of UCBs to their totalassets instead of deposits. Accordingly, itis proposed:

• to replace the existing limit of 15per cent of deposits for housing, realestate and commercial real estateloans by a limit of 10 per cent of totalassets; and

• an additional limit of 5 per cent oftotal assets will be available forhousing loans granted to individualsby the UCBs for purchase/construction of dwelling units up to`10 lakh.

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Exemption from Share Linking toBorrowing Norm

96. It is mandatory for borrowers ofUCBs to subscribe to the shares of thebank to the extent of 2.5-5.0 per cent oftheir borrowings. In order to provideflexibility to UCBs, which are alreadywell capitalised to extend loans withoutadding to capital, it is proposed:

• to exempt UCBs which maintain aminimum CRAR of 12 per cent on acontinuous basis from the mandatoryshare linking norms.

Access to INFINET Membership, Current/SGL Accounts with the Reserve Bank andRTGS Membership for UCBs

97. In order to enable UCBs to servetheir customers better, it is proposed:

• to allow all licensed UCBs (other thanthose under all inclusive directions)the facility of Indian financialnetwork (INFINET) membership,current and subsidiary general ledger(SGL) accounts with the ReserveBank; and

• to allow real time gross settlement(RTGS) membership to only wellmanaged and financially sound UCBs

having a minimum net worth of `25crore.

Customer Service

98. Pursuant to the announcementmade in the Monetary Policy Statementof April 2010, a Committee on CustomerService (Chairman: Shri M. Damodaran)was constituted to look into bankingservices rendered to retail and smallcustomers, including pensioners.The Committee will also look into thesystem of grievance redressal mechanismprevalent in banks – its structure andefficacy – and suggest measures forexpeditious resolution of complaints.The Committee will also examinethe international experiences in thisregard. A need for conducting on-siteinspection and rating banks on customerservice will be examined based on theoutcome of the report of the Committee.The Committee is expected to submit itsreport by end-January 2011.

99. As indicated in the MonetaryPolicy Statement of April 2010,banks were advised in May 2010to devote exclusive time in a Boardmeeting once in every six months toreview and deliberate on customer service.

V. Regulatory and Supervisory Measures for Commercial Banks

Strengthening the Resilience ofthe Banking Sector

100. The Basel Committee on BankingSupervision (BCBS), in response to thefinancial crisis, submitted a report to theG-20 in October 2010. The reportcontained the measures taken by the BCBS

and its governing body - the Groupof Central Bank Governors and Heads ofSupervision (GHOS) - to strengthen theresilience of banks and the global bankingsystem. The new global standards toaddress both bank-specific and broadersystemic risks have been referred to as

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Basel III. Measures suggested under BaselIII, among others, include revisions to thedefinition of regulatory capital, capitalconservation buffer, counter-cyclicalbuffer, the treatment of counterparty creditrisk, the leverage ratio, and the globalliquidity standards.

101. It may be recalled that the BCBShad issued in December 2009 twoconsultative documents for publiccomments. It also undertook acomprehensive quantitative impact study(QIS) and top-down calibration ofminimum capital requirement. At its Julyand September 2010 meetings, the GHOSbroadly agreed on the overall design of thecapital and liquidity reform package,based on the comments received,the QIS and top-down calibration.The fully calibrated Basel III ruleswill be published by the BCBS byend-December 2010.

102. The Reserve Bank has beenadopting the international best regulatorypractices as appropriate to banks in India.Banks are, therefore, advised:

• to study the new developments and bein preparedness to meet therequirements; and

• to continue with the parallel runbeyond March 31, 2010, as advisedto them in April 2010, to ensurethat their Basel II minimumcapital requirement continues to behigher than the prudential floor of80 per cent of the minimum capitalrequirement as per Basel I frameworkfor credit and market risks. The

parallel run should continue for aperiod of three years, i.e., till March31, 2013, subject to review.

Implementation of AdvancedApproaches under Basel IIFramework

103. The Reserve Bank had announcedtimeline for implementation of advancedapproaches for computation of regulatorycapital under the Basel II framework inIndia in July 2009. The guidelines for thestandardised approach (TSA)/alternatestandardised approach (ASA) foroperational risk were issued in March2010 and those for internal modelsapproach (IMA) for market risk wereissued in April 2010. Guidelines foradvanced measurement approach (AMA)for operational risk will be finalised byDecember 2010. Guidelines for internalrating based approach for credit risk areunder preparation.

Housing Loans by Commercial Banks

Loan to Value Ratio in Housing Loans

104. At present, there is no regulatoryceiling on the loan to value (LTV) ratio inrespect of banks’ housing loan exposures.In order to prevent excessive leveraging,it is proposed:

• that the LTV ratio in respect ofhousing loans hereafter should notexceed 80 per cent.

Risk Weights on ResidentialHousing Loans

105. At present, the risk weights onresidential housing loans with LTV ratioup to 75 per cent are 50 per cent for loans

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up to `30 lakh and 75 per cent for loansabove that amount. In case the LTV ratiois more than 75 per cent, the risk weightof all housing loans, irrespective of theamount of loan, is 100 per cent.Accordingly, it is proposed:

• to increase the risk weight forresidential housing loans of `75 lakhand above, irrespective of the LTVratio, to 125 per cent.

Teaser Rates for Housing Loans

106. It has been observed that somebanks are following the practice ofsanctioning housing loans at ‘teaser rates’,wherein the loans are offered at acomparatively lower rate of interest in thefirst few years, after which rates are resetat higher rates. This practice raisesconcern as some borrowers may find itdifficult to service the loans once thenormal interest rate, which is higher thanthe rate applicable in the initial years,becomes effective. It has been observedthat many banks at the time of initial loanappraisal do not take into account therepaying capacity of the borrower atnormal lending rates. In view of the higherrisk associated with such loans, it isproposed:

• to increase the standard assetprovisioning by commercial banks forall such loans to 2 per cent.

Banks’ Investments inNon-Financial Companies

107. Under the extant prudentialframework, banks are not required toobtain prior approval of the Reserve Bankfor investment in companies other than

financial services companies. Banks maybe able to exercise control on such entitiesthrough their direct or indirect holdingsor have significant influence over them.Thus, banks may indirectly undertakeactivities not permitted to them underSub-section (1) of Section 6 of theBanking Regulation Act, 1949 or activitieswhich are not conducive to the spread ofbanking in India or otherwise useful ornecessary in the public interest. Therefore,it is proposed:

• to stipulate prudential limits toregulate the investments of banks incompanies engaged in forms ofbusiness other than financial services.Banks will be required to review theirinvestments in such companies and becompliant with the guidelines as perthe roadmap to be laid down.

108. Detailed guidelines in this regardwill be issued separately.

Prudential Norms on FinancialConglomerates

109. The Reserve Bank had constitutedan Internal Group on the Supervision ofFinancial Conglomerates (FCs) in India.The Internal Group had made variousrecommendations for strengthening thesupervision of the FCs, including changesin certain regulatory norms. The AnnualPolicy Statement of April 2009 indicatedthat the Reserve Bank was examining therecommendations of the Group from theregulatory and supervisory perspectives.To start with, it has been decided:

• to implement the recommendations ofthe Group on (i) capital adequacy for

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FCs; and (ii) intra-group transactionsand exposures in FCs.

Capital Adequacy for FCs

110. As per Basel II framework,investments in the equity of subsidiariesor significant minority investments inbanking, securities and other financialentities, where control does not exist,together with other regulatory capitalinvestment in these entities are requiredto be excluded from the banking group’scapital if these entities are notconsolidated. The Group recommendedthat the threshold of significant influence/investment may be fixed at 20 per centinstead of the present 30 per cent.Accordingly, it is proposed:

• that the entire investments in the paidup equity of the entities (includinginsurance enti t ies) , where suchinvestment exceeds 20 per cent of thepaid up equity of such entities shallbe deducted at 50 per cent fromTier I and 50 per cent from Tier IIcapital when these are notconsolidated for capital purposeswith the bank. In addition, entireinvestments in other instrumentseligible for regulatory capital statusin these enti t ies shall also bededucted at 50 per cent from Tier Iand 50 per cent from Tier II capital;and

• the deductions indicated above willalso be applicable while computingcapital adequacy ratio of the bank ona solo basis.

111. The capital adequacy requirementwill be further calibrated after finalisationof the Basel III rules, as indicated earlier.

Intra-Group Transactions andExposures in FCs

112. In order to limit the inter-connectedness between the bank and othergroup entities, it is proposed:

• to put in place an appropriate limit forsuch transactions and exposures, bothfor a single entity and on an aggregatebasis for all other group entities.

113. Detailed guidelines in this regardwill be issued separately.

Principles for Enhancing CorporateGovernance in Banking Organisations

114. The BCBS in October 2010 issued‘Principles for Enhancing CorporateGovernance’ for banking organisations.The Principles address fundamentaldeficiencies in bank corporategovernance that became apparent duringthe financial crisis. Taking into accountdifferent categories of bankingorganisations in India, the Reserve Bankhas been taking appropriate steps toimprove corporate governance standardsin banks. Implementations of ‘fit andproper’ criteria for directors on the boardsof banks and splitting of post of theChairman and Managing Director inprivate sectors banks as per therecommendations of the GangulyCommittee (2002) are some of thenotable steps taken by the Reserve Bankin this direction in the recent past, whichhave improved standard of corporategovernance. However, a review of thecorporate governance standard in thebanks is necessitated in the light of theprinciples issued by the BCBS.Accordingly, it is proposed:

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• to take appropriate steps to fully alignthe corporate governance practices inbanks in India with the principlesenunciated by the BCBS.

115. Detailed guidelines in this regardwill be issued separately.

Working Group on ValuationAdjustment and Treatment ofIlliquid Positions

116. It was indicated in the MonetaryPolicy Statement of April 2010 toconstitute a Working Group to recommendan appropriate framework for valuationadjustment for various risks/costs andtreatment of illiquid positions .Accordingly, a Working Group(Co-ordinator: Shri P. R. Ravi Mohan) wasset up in June 2010 with membersdrawn from the Reserve Bank, IBA,FIMMDA, Foreign Exchange DealersAssociation of India (FEDAI) and selectbanks. The Working Group submitted itsreport in September 2010. The Group hasgiven recommendations on a wide rangeof issues, including identification ofilliquid positions, adjustment forilliquidity and valuation adjustment forunearned credit spread and closeout costsfor the derivative portfolio of banks. Therecommendations of the Group are underexamination.

Convergence of Indian AccountingStandards with InternationalFinancial Reporting Standards

117. As indicated in the MonetaryPolicy Statement of April 2010, a WorkingGroup (Chairman: Shri P. R. Ravi Mohan)was constituted to address theimplementation issues and facilitate

formulation of operational guidelines inthe context of convergence of IndianAccounting Standards with theInternational Financial ReportingStandards (IFRSs) and prepare bankingand NBFCs and UCBs to adhere to theroadmap of implementation. As per theroadmap, all scheduled commercial bankswill convert their opening balance sheetas on April 1, 2013 in compliance with theaccounting standards converged with theIFRS. As regards NBFCs and UCBs, agradualist approach has been adopted.

Introduction of Bank HoldingCompany/Financial HoldingCompany in India

118. In pursuance of the announcementmade in the Monetary Policy Statementof April 2010, a Working group(Chairperson: Smt. Shyamala Gopinath)has been constituted to examine theintroduction of a holding companystructure together with the requiredlegislative amendment/framework. Thework is in progress.

Compensation Practices

119. In line with the steps taken by theglobal community and the initiatives takenby G-20 nations, draft guidelines forprivate sector banks and foreign bankswith regard to sound compensation policywere framed and placed on the ReserveBank’s website in July 2010 for publiccomments. These guidelines are largelybased on the FSB’s principles onsound compensation practices. Theguidelines cover effective governance ofcompensation, alignment of compensationwith prudent risk-taking and disclosures

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for whole time directors/chief executiveofficers, risk takers of banks as wellas staff in the audit, compliance andrisk management functions. Commentsreceived from various banks/organisations/individuals are beingexamined. Accordingly, it is proposed:

• to issue final guidelineson compensation practices byend-December 2010.

Licensing of New banks

120. The Hon’ble Finance Minister inthe Union Budget 2010-11 had mentionedthat the Reserve Bank would considergiving some additional bank licences toprivate sector players. Consequently, theMonetary Policy Statement of April 2010indicated that a discussion paper would beprepared marshalling the internationalpractices, the Indian experience as also theextant ownership and governance (O&G)guidelines for placing it on the ReserveBank’s website by end-July 2010 for widercomments and feedback, after which theguidelines will be finalised. Accordingly,the discussion paper was put in publicdomain in August 2010. Based on thecomments and suggestions received fromvarious parties and discussions held withmajor stakeholders in October 2010, it isproposed:

• to put the draft guidelines in publicdomain by end-January 2011 forpublic comments.

Presence of Foreign Banks in India

121. It was indicated in the MonetaryPolicy Statement of April 2010 thatdrawing lessons from the crisis, a

discussion paper on the mode of presenceof foreign banks through branch or wholly-owned subsidiary (WOS) would beprepared by September 2010. Accordingly,a discussion paper in consultation with theGovernment on the form of presence offoreign banks in India is in final stages ofpreparation.

Capacity Building in Banks

122. Banks should gear themselves upto meet various challenges in the comingyears. In particular, the implementation ofBasel III by all banks, the need for largeand internationally active banks to moveto the advanced approaches under BaselII and convergence with IFRS as onApril 1, 2013 would require banks toupgrade their technology and riskmanagement capabilities. Banks shouldundertake a review of the skills requiredand take up capacity building in rightearnest and in a time bound manner. TheReserve Bank will also intensify its effortsin this regard by undertaking morecapacity building programmes for thebanking sector in the coming years.

Information Technology andRelated Issues: Enhancementto the Guidelines

123. It was proposed in the MonetaryPolicy Statement of April 2010 to set up aWorking Group on information security,electronic banking, technology riskmanagement, and tackling cyber frauds.Accordingly, a Working Group onElectronic Banking, Controls, Governanceand Technology Risk ManagementStandards (Chairman: Shri G.Gopalakrishna) was constituted. The

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recommendations of the sub-groups ontechnology, governance, operationalissues, legal and educational aspects setup by the Group were discussed by the

Working Group and are now beingformalised. The Working Group is likelyto finalise its report by end-November2010.

VI. Institutional Developments

Payment and Settlement Systems

Membership to the Committee onPayment and Settlement Systems

124. India became a member of theCommittee on Payment and SettlementSystems (CPSS) constituted under theaegis of the Bank for InternationalSettlements (BIS). The Reserve Bank isrepresented on four Working Groupsof CPSS, viz. , (i) General Reviewof Standards; (ii) Repo MarketInfrastructure; (iii) Post Trade Services;and (iv) Retail Payment Systems.

Standardisation of SecurityFeatures on Cheque Forms

125. As indicated in the MonetaryPolicy Statement of April 2010, a chequetruncation system (CTS)-2010 standardwith benchmark specifications for securityfeatures on cheques and field placementson cheque forms has been prescribed. TheCTS-2010 standard, inter alia, included aprescription prohibiting alterations/corrections on cheque forms. It has sincebeen clarified that the prescription isapplicable only to cheques cleared underthe image-based cheque truncation systemand will be effective December 1, 2010.The prescription will not be applicable tocheques cleared under magnetic inkcharacter recognition (MICR) clearing,non-MICR clearing, OTC collection(for cash payment) or direct collection of

cheques outside the clearing housearrangement.

126. The IBA and National PaymentsCorporation of India (NPCI) have beenjointly vested with the responsibility forimplementation of the new chequestandards.

Operationalisation of NationalPayments Corporation of India

127. As indicated in the MonetaryPolicy Statement of April 2010, the NPCIhas the envisioned role to look at futureinnovations in the retail payment space inthe country. The NPCI has implemented apilot project for settlement of inter-bankmobile payments. Further, the roll-out ofthe grid-based cheque truncation system(CTS) project at Chennai is likely to beoperationalised by the end of March 2011.

Performance of National ElectronicFunds Transfer System

128. As at end-July 2010, around70,000 branches of 98 banks hadparticipated in the national electronicfunds transfer (NEFT) system and thevolume of transactions processedincreased to 9.5 million in July 2010.

Automated Data Flow from Banks

129. As indicated in the MonetaryPolicy Statement of April 2010, a CoreGroup consisting of experts from banks,the Reserve Bank, the Institute

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for Development and Research in BankingTechnology (IDRBT) and the IBA hasbeen constituted for preparing an approachpaper on automated data flow (a straightthrough process) from the core bankingsolution (CBS) or other IT systems ofcommercial banks to the Reserve Bank.The Core Group has prepared an approachpaper, which deals with automated dataflow from banks to the Reserve Bank.The paper, inter alia , discusses themethodology to be adopted by banks toclassify themselves into a cluster based onits technology and process dimensions.Based on this, estimated timelines forachieving complete automation ofsubmission of returns have also beenfurnished. The approach paper is beingexamined and it is expected to becirculated to the banks for necessaryaction at their end.

130. The approach suggested for bankswill be implemented in two phases. In thefirst phase, banks would be required toensure seamless flow of data from theirtransaction server to their managementinformation system (MIS) server andgenerate all returns from the MIS serverautomatically, without any manualintervention. In the second phase, theReserve Bank would introduce a pullmechanism for the flow of data from theMIS server of banks in a straight throughprocess. The timeline of the entire projectwill be determined in consultation withbanks.

Real Time Gross Settlement System

131. The Indian RTGS has displayedtremendous growth in both transactions

volume and the values that it has beenprocessing since its inception in March2004. With the increased number ofelectronic payment transactions, it hasbecome expedient to position the IndianRTGS system primarily for processing andsettling large value payment orders.Further, the Reserve Bank has set up arobust retail electronic funds transfersystem in the form of NEFT, with nearreal-time settlement finality with 11settlement cycles in a day. Accordingly, ithas been decided, in consultation withsystem participants:

• to increase the threshold limit forRTGS transactions from the presentlimit of `1 lakh to `2 lakh.

132. As a further incentive tocustomers to move their transactions toNEFT, a new value band in the `1 lakh to`2 lakh will be created, with customershaving to pay lower charges vis-à-visRTGS transactions.

133. The detailed guidelines in thisregard will be issued separately.

134. As indicated in the MonetaryPolicy Statement of April 2010, aWorking Group comprising representativesfrom the Reserve Bank and selectcommercial banks, viz. , SBI, PNB,ICICI Bank and HDFC Bank wasconstituted for preparing an approach forimplementation of next generation RTGS.The Group submitted its report in August2010, which has since been accepted. Theimplementation of the next generationRTGS system is in progress, which maytake about two years for completion.

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Cheque Truncation System

135. The CTS was successfullyimplemented in the National CapitalRegion of New Delhi in February 2008.Following complete migration to CTS,the separate MICR clearing wasdiscontinued from July 2009. The CTS,on an average, processes over 0.5 millioninstruments per day. The next roll out ofCTS is planned for March 2011 atChennai, with the project beingimplemented by the NPCI. The processof roll out will be a grid-based approachto cover the clearing houses in the othercities of Tamil Nadu and the adjoiningstates of Kerala and Karnataka.Simultaneously, efforts are underway toestablish common disaster recovery (DR)arrangements for both New Delhi andChennai CTS operations.

Currency Management

136. Banks were mandated to use NoteSorting Machines in all their brancheshaving average daily cash receipts of`1 crore and above by March 2010. As of

now, 1,108 branches (other than currencychest branches) have been identifiedhaving average daily cash receipt of`1 crore and above. Banks have reportedthat Note Sorting Machines have beeninstalled and made operational in 669branches. For the remaining branches,banks have made arrangements with thenearest currency chest branch/currencyadministration branch. It was also indicatedin the Second Quarter Review of October2009 that banks should use such machinesin all their branches having average dailycash receipts between `50 lakh and`1 crore by March 2011. Banks areexpected to enhance their efforts to reachthis position by March 31, 2011.

137. As indicated in the Second QuarterReview of October 2009, banks wereadvised to have the responsibility ofcurrency management entrusted to a nodalofficial of the rank not less than that of aGeneral Manager and will be accountablefor the obligations cast upon currencychests by the Reserve Bank. Allcommercial banks have since appointednodal officers.

Mumbai

November 2, 2010