The reform process in the financial sector has been taken forward with the primary objective of having a strong and resilient banking system. Considerable progress has been made in strengthening the regulatory and supervisory norms with a view to inducing greater accountability and market discipline amongst the participants. This has enabled the Indian banking system to acquire strength, efficiency, and vibrancy necessary to meet global competition. The most significant achievement in the banking sector has been the marked improvement in financial health of banks in terms of capital adequacy, profitability and asset quality with an increasing focus on risk management. The Reserve Bank has made persistent efforts towards adoption of international benchmarks as appropriate to Indian conditions, improvement in management practices and corporate governance, and upgradation of technological infrastructure. While certain changes in the legal infrastructure are yet to be effected, the developments so far have brought the Indian financial system closer to global standards. From the mid-1990s, public sector banks had to face competition from the more customer-focused private sector entrants. This, competitive pressure induced public sector banks to revitalize their operations. After almost a decade of financial reforms, the banking sector in India is distinctly better placed in terms of its strength, efficiency and modernisation.

The reform process has changed the relationship between the Reserve Bank and commercial banks from one of micro regulation to that of macro management. With the focus on deregulation and liberalisation coupled with enhanced responsibilities for banks, the banking sector is faced with several challenges. Consistent with the shift to functioning in a competitive economy and to the adoption of prudential best practices, the major challenges facing the banking sector are the deployment of funds in quality assets and the management of revenues and costs. Concurrently, the issues of corporate governance and appropriate disclosures for enhancing market discipline have received regulatory attention for ensuring increased transparency and greater accountability.

Credit growth during the first half of 2004-05, traditionally a slack season for credit off-take, has been one of the highest in recent years. Inspite of a rapid acceleration in non-food credit growth caused by lending to the retail segment, the pick up in non-food credit appears to be broad-based. Improvement in credit delivery mechanisms has been the focus of recent policy measures. In the Union Budget 2004-05, the Central Government announced a broad outline of programmes for doubling the flow of credit to agriculture in three years with a credit growth of 30 per cent for 2004-05. The flow of credit to agriculture may lead to greater credit penetration by replacing non-institutional sources of finance.

Over the past few years there has been a steady decline in interest rates largely reflecting sustained reduction in inflation rates and inflationary expectations. Such reductions in interest rates occurred in an environment where credit growth remained sluggish. Consequently, there was a favourable impact on banks’ balance sheets in terms of increased operating profits from treasury operations given the asset concentration in favour of Government securities in excess of the requirement of statutory liquidity ratio (SLR). For example, treasury income of the banking sector increased from Rs.9,541 crore in 2001-02 to Rs.19,532 crore in 2003-04 and constituted 32.0 per cent and 37.1 per cent of operating profit in the corresponding years. This in turn enabled banks to make larger loan loss provisions. Consequently, the net NPA ratio has declined from 5.5 per cent in 2001-02 to 2.9 per cent by 2003-04. While a declining interest rate scenario has positive spin offs for the banking sector, given that interest rates had touched historically low levels by 2003-04, there does not appear to be any further scope for similar trends to be observed during 2004-05. In future, therefore, an increasing proportion of banks’ income would emanate from the traditional business of lending. Banks now have a diversified credit portfolio with increasing shares of lending to housing, consumer credit and credit to other priority sectors such as small transport operators. The flow of credit to agriculture also continues to remain robust given the enabling policy environment which has emphasised credit delivery. In this direction, vehicles of rural credit delivery through Kisan Credit Cards (KCC) and increasing linkage of bank credit and self help groups (SHGs), have proved effective. As regards industrial credit, greater thrust is placed on lending to small and medium enterprises (SMEs), especially the small scale industries (SSIs).

In order to enable the banks to determine appropriate pricing of loans to small and medium enterprises, development of a system of proper credit records would be very helpful. For this purpose, the Credit Information Bureau of India Ltd. (CIBIL) would work out appropriate mechanisms in consultation with the Reserve Bank, SIDBI and IBA. The Reserve Bank has also exhorted banks to make persistent efforts in obtaining consent from all their borrowers, in order to establish an efficient credit information system. This would help in enhancing the quality of credit decisions and improving the asset quality of banks, apart from facilitating faster credit delivery. As the risk profile of bank lending is more diversified and banks are expanding their loan books, it is essential that banks pay adequate attention to quality of lending so that credit expansion could be on a sustained trajectory building upon higher profitability while ensuring financial stability. 8.6 Keeping in view these requirements, as well as the increasing focus on credit delivery mechanisms, the Reserve Bank initiated various measures in its mid-term Review of annual policy for 2004-05. These measures include raising of limits for direct finance to the housing sector, raising of the composite loan limit for small-scale industries, removal of the restrictive provisions of service area approach, enhancing limits on advances under the priority sector for dealers in agricultural machinery and distribution of inputs for allied activities and allowing banks to extend finance to Non-Banking Financial Companies (NBFCs) against second hand assets financed by them subject to the approval of the policies by the banks’ Boards.

Infrastructure Financing

The Reserve Bank has announced several policy measures in the recent years to facilitate infrastructure financing. These measures included enlarging the scope of the definition of infrastructure lending, permitting banks to raise long-term bonds with a minimum maturity of five years to the extent of their exposure of residual maturity of more than five years to the infrastructure sector, etc. It is intended that banks should first provide assistance to such infrastructure projects before raising resources through bonds. The Reserve Bank has already set up a Working Group to examine the instruments for credit enhancement which the State Governments can offer to improve creditworthiness and borrowing capability of State Public Sector Undertakings (PSUs)/Special Purpose Vehicles (SPVs) to attract institutional financing for infrastructure projects.

Risk Management

Growth in the economy has been leading to a natural expansion of the credit portfolio to fund the increasing demand for industrial growth and new plans of corporate expansion. The demand for higher levels of infrastructure financing has also followed this growth. In this context, to ensure a healthy growth in the credit portfolio, integrated risk management systems to address all relevant risks need to be evolved alongside selection of appropriate risk management models.

With a view to building up of adequate reserves to guard against any possible reversal of interest rate environment in future due to unexpected developments, the Reserve Bank advised banks in January 2002, to build up an Investment Fluctuation Reserve of a minimum of 5.0 per cent of the investment in held for trading and available for sale categories within a period of 5 years. Taking cognisance of hardening of inflation and an environment subject to unanticipated changes because of unforeseen domestic and external developments, the banking system, in particular, has to recognise interest rate cycles and strengthen risk management processes to cope with eventualities so that financial stability could be maintained and interest rate movements could be passed in a non-disruptive manner.

Basel II Developments

The process of benchmarking prudential norms applicable to Indian banks with international best practices has been carried forward. The Basel Committee on Banking Supervision, after a protracted consultative process, issued the framework of New Capital Accord (Basel II) in June 2004, which is expected to be implemented in many jurisdictions by end-2006. An important pre-requisite for implementation of advanced approaches under Basel II is a well-established risk management system in banks. Risk management comprises various risks that a financial institution has to manage viz., credit risk, operational risk, market risk, including interest rate risk and forex risk. Basel II aligns the capital measurement framework with sound contemporary practices in banking, promotes improvements in risk management, and is intended to enhance financial stability.

As Indian banks gear up for migration to Basel II, the progress made by banks in this direction is being monitored by the Reserve Bank with reviews at quarterly intervals. However, as a logical step before migration to capital adequacy norms under Basel II, banks have been mandated to maintain capital charge for market risk. Banks would need to chalk out development strategies to ensure full compliance with capital requirements arising out of implementation of Basel II. The Reserve Bank on its part is making efforts to formulate policies to deal with risks arising on account of operations of large and complex financial institutions and issues relating to the adoption of Basel II in the form of supervisory and regulatory challenges. Banks have also been advised to undertake a self-assessment of their existing risk management systems taking into account the three major risks covered under Basel II and to concurrently initiate appropriate measures to upgrade them to meet the minimum standards prescribed under Basel II. In view of complexities involved in migrating to Basel II, a Steering Committee comprising members from banks, Indian Banks’ Association and the Reserve Bank has been constituted to prepare guidelines for implementation of Basel II.