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Jalan's statement on the Monetary Policy

Earlier part..

CREDIT POLICY

The annual policy Statements as well as Mid-term Reviews have been focussing on the structural and regulatory measures to strengthen the financial system and improve the functioning of various segments of the financial market.

These measures, introduced after extensive consultations with experts and market participants, have been directed towards increasing operational effectiveness of monetary policy, redefining the regulatory role of the Reserve Bank, strengthening the prudential and supervisory norms, improving the credit delivery system, and developing technological and institutional infrastructure of the financial sector.

Recent policy measures have endeavoured to take into account the technological developments which have a major impact on the financial sector.

Information technology allows sophisticated product development, better market infrastructure, implementation of reliable techniques for control of risks and also help the financial intermediaries to reach distant and diversified markets.

In view of this, technology has changed the contours of three major functions performed by banks, i.e., access to liquidity, transformation of assets and monitoring of risks.

The interaction of technology with deregulation is also contributing to the emergence of a more open, competitive and globalised financial market which should improve efficiency in the economy, while at the same time calling for greater vigilance and prudence in asset-liability management.

In this regard, banks have positively responded to the Reserve Bank's directions to adopt the necessary technology in their operations.

Keeping in view the progress made in the implementation of measures taken so far, and their impact on the soundness of the Indian banking system, it is proposed to speed up the process further to enable the Indian financial sector to be better equipped to meet the global competition.

MONETARY MEASURES

(a) Rationalisation and reduction in Cash Reserve Ratio

The Reserve Bank has been pursuing its medium-term objective of reducing CRR to the statutory minimum level of 3.0 per cent.

In this direction, RBI gradually reduced the CRR from 11.0 per cent in August 1998 to 7.5 per cent by May 2001. In the Mid-term Review of October 2001, CRR of scheduled commercial banks [excluding Regional Rural Banks (RRBs)] was reduced by 200 basis points to the present level of 5.5 per cent of their net demand and time liabilities (NDTL).

Rationalisation of CRR was also initiated by withdrawing various exemptions given to banks on certain specific categories of liabilities for the CRR requirement.

Subsequently, all categories of banks, including co-operative banks, were also made subject to the CRR prescription as applicable to the scheduled commercial banks.

These measures were designed to facilitate development of short-term yield curve, develop money market, enhance availability of lendable resources with banks and improve the efficacy of indirect instruments in the conduct of

• Reduce CRR further from 5.5 per cent to 5.0 per cent effective fortnight beginning June 15, 2002.

The proposed reduction in CRR is being made effective from fortnight beginning June 15, 2002 in view of the prevailing excess liquidity with the banking system as can be seen by larger turnover in the call money market and the higher average recourse to RBI repos.

However, in case there is an unexpected change in the liquidity conditions in the market, RBI may advance the effective date of reduction before the above announced date.

(b) Bank Rate

At present, there is substantial excess liquidity in the system which is reflected in the repo amounts received by the Reserve Bank during the past six weeks.

On April 4, 2002, the total amount tendered by way of repo was as high as Rs 30,055 crore.

On an average, amounts tendered by banks in one or three-day repos have ranged from Rs 1,565 crore to Rs 16,024 crore in the past six weeks.

The repo rate is currently 6.0 per cent, which is below the Bank Rate of 6.5 per cent, and call money rates on several days have also been lower than the Bank Rate.

In response to the easy liquidity situation, some banks have also recently reduced their deposit rates as well as lending rates.

Further, yields on fixed income securities have also come down substantially. Under these circumstances, on balance, it is considered desirable to leave the Bank Rate unchanged.

The matter, however, will be kept under constant review. In case the overall liquidity and credit situation warrants, and inflation rate continues to remain

(c) Statutory Liquidity Ratio of regional rural banks

RRBs are required to maintain SLR at 25 per cent of their NDTL in cash or gold or in unencumbered government and other approved securities.

Unlike in the case of scheduled commercial banks, balances maintained in call or fixed deposits by RRBs with their sponsor banks are treated as "cash" and hence, reckoned towards their maintenance of SLR.

As a prudential measure, it is desirable on the part of all RRBs to maintain their entire SLR portfolio in government and other approved securities, which many of them are already doing. Accordingly:

• All RRBs may maintain their entire SLR holdings in government and other approved securities. In order to allow sufficient time to RRBs to convert existing deposits with sponsor banks into government securities, this provision may be complied with by March 31, 2003.

INTEREST RATE POLICY

(a) Interest rate flexibility

As pointed out in the earlier Section, the year 2001-02 witnessed one of the steepest declines in interest rates on long-term government securities. The yield on 10-year government securities declined by as much as 287 basis points.

The secondary market yield on 10-year paper is currently 7.27 per cent. The Bank Rate, the repo rate and the overnight call money rates have also been very low in recent months ranging between 6.0 and 7.0 per cent.

In relation to the average rate of inflation of 3.6 per cent during 2001-02, it is evident that the real interest rates on long-term paper, the Bank Rate and short-term rates are now fairly reasonable.

However, the sharp reduction in nominal and real interest rates is not yet fully reflected in the interest rates generally charged by banks on advances.

There is also some evidence that the spread between the interest rates charged by banks to different borrowers has also tended to widen.

The relatively lesser reduction in the rates of interest that most borrowers have to pay is despite the action taken by the Government in the last three years to lower administered interest rates on Relief Bonds and small savings, etc. as well as the sharp reduction by RBI in the CRR of banks (along with an increase in the interest rate paid by RBI on eligible cash balances maintained by banks with RBI).

The reasons for the relative downward inflexibility in the commercial interest rate structure seems to be primarily due to the following factors:

• The average cost of deposits for major banks continues to be relatively high (6.25 to 7.25 per cent). Further, a substantial portion of deposits is in the form of long-term deposits at fixed interest rates. Thus, flexibility available to banks to reduce interest rates in the short-run, without adversely affecting their return on assets, is limited. The relatively high overhang of non-performing assets further pushes up the average cost of funds for banks, particularly public sector banks.
• The non-interest operating expenses of banks work out to 2.5 to 3.0 per cent of total assets, putting pressure on the required spread over the cost of funds.
• In view of legal constraints and procedural bottlenecks in recovery of dues by banks, the risk-premium tends to be higher resulting in wider spread between deposit rates and lending rates.
• The large borrowing programme of the Government, over and above SLR requirements, provides significant prospects for deployment of funds by banks in sovereign paper.

From the medium-term perspective, it is necessary to initiate measures to make the interest rate structure in India more flexible and reflective of the underlying inflationary situation.

So far as reduction in spreads is concerned, it is no doubt necessary to improve man-power productivity (for example, through increase in volumes), and also reduce establishment costs.

Some progress in this area has been made in the last two years, but there is still a long way to go.

However, it has to be recognised that, given various constraints (including public ownership in the banking sector and legislative provisions), especially poor debt-recovery systems, actual progress in reducing average spreads is likely to be slow.

Without prejudice to further progress in reduction in spreads, and other measures to reduce delays in recovery, in order to impart flexibility to interest rate structure, following measures need to be considered as early as possible:

• Encourage introduction of flexible interest rate system for all new deposits with reset at six-monthly intervals. At the same time, the fixed rate option should also be made available to depositors. Illustratively, banks may offer longer term deposits with six-monthly reset conditions and at the same time offer a fixed rate for similar maturity, the interest rate on which may be higher or lower depending on the period of deposit and banks' perception regarding inflation as well as interest rate outlook over the longer period. All banks are advised to put such a flexible rate system (with a fixed rate option also for depositors) in practice as early as possible.
• Banks are also urged to devise schemes for encouraging depositors to convert their existing long-term fixed rate past deposits into variable rate deposits. Commercial banks may consider paying the depositors at the contracted rate for the period of deposit already run and waive the penalty for premature withdrawal if the same deposit is renewed at the variable rate.

(b) Prime Lending Rate and spreads In the Mid-term Review of October 1996, it was stated that "a number of banks are charging lending rates far higher than PLR on a significant portion of bank credit to borrowers with credit limits of over Rs 2 lakh.

"It has, therefore, been decided that banks, along with the announcement of their PLR, should also announce the maximum spread over the Prime Lending Rate for all advances other than consumer credit.

"Banks should obtain the approval of their respective Boards for fixation of maximum spread over the Prime Lending Rate".

As per the latest available information, spreads above PLR of some banks are substantial. In the present interest rate environment, it is not reasonable to keep very high spreads over PLR. Banks are, therefore, urged to review the present maximum spreads over PLR and reduce them wherever they are unreasonably high so that credit may be available to the borrowers at reasonable interest rates.

Further, banks should also announce the maximum spread over PLR to the public along with the announcement of their PLR. The Reserve Bank will review the matter again in October 2002 after further consultations with select banks with very high spread over PLR.

In the interest of customer protection as also meaningful competition, it is necessary to have a greater degree of transparency in regard to actual interest rates for depositors as well as borrowers. In this direction, the following measures are proposed:

• Banks should provide information on deposit rates for various maturities and effective annualised return to the depositors. This information should be made available to RBI also, so that RBI can put a consolidated picture for all banks on its website.
• Banks should provide information on maximum and minimum interest rates charged to their borrowers. RBI will put this information also in public domain.
• Banks are urged to switch over to "all cost" concept for borrowers by explicitly declaring the processing charges, service charges, etc. charged to borrowers. Such bank charges may also be publicly announced.

(c) Interest rate on saving account - No change

In the recent years, banks have been given freedom in fixing interest rates on various deposit liabilities, and flexibility in offering interest rates depending upon tenor and size of deposits with the approval of their Boards.

The only interest rate on deposits side which is regulated by RBI is on "savings account" with cheque facility. This rate is at present 4.0 per cent per annum.

However, although the nominal interest rate is 4.0 per cent per annum, the yield on such deposits works out to 3.4 per cent per annum only as interest is payable on the minimum balance between tenth and last day of each month.

Nearly four-fifths of such saving deposits are held by households.

In view of the present deregulated interest rate environment and the reduction in interest rates on Government's small savings schemes in the recent period, there is an apparent case for deregulation of interest rates on savings account also.

However, considering the fact that bulk of such savings deposits are held by households, including households in rural and semi-urban areas, on balance, it is not considered as opportune time to deregulate the interest rate on savings account for the present.

In any case, the present effective yield of 3.4 per cent is quite reasonable in relation to other prevailing interest rates on even short-term instruments.

(d) Interest rate on export credit

Exporters have the option to avail of pre-shipment and post-shipment credit in foreign currency from banks in India.

Such credit is currently available at LIBOR plus a maximum spread of 1.0 percentage point making this rate internationally competitive for Indian exporters. In order to make the interest rate even more competitive in the present low interest rate environment, it is desirable to further lower the ceiling rate on foreign currency loans for Indian exporters by banks. Accordingly:

• The ceiling rate on export credit in foreign currency is being reduced to LIBOR plus 0.75 percentage point from the present LIBOR plus 1.0 percentage point.

Considering this competitive interest rate on foreign currency loans and to mitigate any possible exchange risk, exporters are encouraged to make maximum use of foreign currency loans in one or more currencies of their choice depending on the currency of their export receipts (e.g., US dollar, euro, Pound Sterling, etc.).

Indian banks, located in areas with concentration of exporters, are being advised to give this important facility due publicity and make it easily accessible to all exporters, including small exporters.

In the annual policy Statement of April 2001, interest rates on export credit in rupee terms were rationalised and ceilings were prescribed for both pre-shipment and post-shipment credit linked to PLR.

This prescription of ceilings of 1.5 percentage points below PLR has facilitated exporters to avail of credit at substantially lower rates than the PLR of the banks. Considering the unusual international developments, effective September 26, 2001, the ceilings on export credit interest rates were further reduced to 2.5 percentage points below PLR for a period of six months (i.e., up to March 31, 2002).

From April 1, 2002, the ceiling rates were to revert to 1.5 percentage points below PLR.

However, keeping in view the continued international uncertainties, the period during which interest rate of 2.5 percentage points below PLR will be applicable has been extended up to September 30, 2002.

With this concession, the ceiling rate on pre-shipment rupee export credit up to 180 days works out to 7.5 to 8.5 per cent.

In view of the need to ensure transparency and also encourage banks to continue to provide finance at competitive rates, there is a need for putting in place a reporting system by which commercial banks provide information on interest rates charged on pre-shipment and post-shipment credit.

This will facilitate exporters in choosing the most competitive rate. Accordingly:

• With effect from fortnight beginning June 15, 2002, banks will report to RBI, the minimum and maximum lending rates to exporters. This information will be placed in public domain.

In view of the above proposals (i.e., a reduction in interest rates for foreign currency loans to exporters and compulsory reporting of minimum and maximum lending rates charged by banks to exporters), a further proposal which requires consideration is to deregulate the interest rate on export credit in domestic currency.

Linking of domestic interest rates on export credit to PLR has become redundant in the present circumstances, when the effective interest rates are in any case substantially lower than the PLR for exporters.

Deregulation of the present ceiling on interest rate for domestic currency, may in fact encourage greater competition among banks and may have the effect of further lowering interest rates for exporters with a good credit record.

This proposal will be considered by RBI after further consultations as necessary.

(e) Deemed exports

As per the extant guidelines, banks are permitted to extend rupee pre-shipment and post-supply rupee credit at concessional rate of interest to parties against orders for supplies in respect of deemed exports.

Such rupee export credits, both at pre-shipment and post-supply stages, are eligible for refinance from RBI.

However, it has been represented that some exporters still do not get the advantage of the concessional rate of interest in the case of deemed exports. Banks are, therefore, urged to widely publicise the concessionality in the interest rates for deemed exports and make these available to all eligible exporters.

(f) Abolition of minimum lending rate for co-operative banks

State and Central Co-operative Banks were given freedom to determine their lending rates subject to the prescription of minimum lending rate (MLR) of 12.0 per cent per annum by the Reserve Bank since October 18, 1994.

Similarly, the Urban Co-operative Banks (UCBs) were subject to the prescription of MLR at 13.0 per cent per annum effective June 21, 1995, which was reduced to 12.0 per cent effective March 2, 2002.

Since August 26, 1996, RRBs were given freedom to determine their lending rate. At present, commercial banks other than RRBs have the freedom in deciding their PLRs with the approval of their Boards.

In the annual policy Statement of April 2001, PLR was made a reference/benchmark rate, so that commercial banks are free to lend at sub-PLR rates to creditworthy borrowers. In order to provide greater flexibility to co-operative banks in a competitive environment, it is proposed:

• To withdraw the stipulation of MLR for all co-operative banks with immediate effect. Co-operative banks will now be free to determine their lending rates taking into account their cost of funds, transaction cost, etc. with the approval of their managing committee. This will help the co-operative banks in attracting good/prime borrowers.
• It should be ensured that the interest rates charged by co-operative banks are transparent and known to all their customers. Banks are, therefore, requested to publish the minimum and maximum interest rates charged by them, and display this information in every branch.

(g) Liberalisation of investment norms of funds mobilised under FCNR(B) deposits

In the Mid-term Review of October 2001, RBI had announced finalisation of a scheme to encourage retail participation, in particular by mid-segment investors like UCBs, non-banking financial companies (NBFCs), Trusts, etc., in the primary market of government dated securities.

Accordingly, the scheme of non-competitive bidding facility with a provision for allocation up to 5.0 per cent of the notified amount to retail investors at the weighted rate that evolves in the case of competitive bidding was announced on December 7, 2001.

The scheme was operationalised on January 14, 2002, when auction of 15-year Government stock was held. In this auction, 36 non-competitive bids from 273 applicants were received through PDs and banks amounting to Rs.148.3 crore against the allocation of Rs.250 crore.

In the twin auctions held on April 4, 2002 for 7-year and 10-year Government stocks, 46 non-competitive bids from 304 applicants amounting to Rs.238.5 crore were received as against the reserved amount of Rs.350 crore.

While 2.97 per cent of the notified amount was allotted in January 14, 2002 auction, on April 4, 2002, it was 3.41 per cent.

The scheme was continued in the auction of a new 15-year Government stock for Rs.6,000 crore held on April 15, 2002, wherein 19 bids from 137 applicants for an amount of Rs.95.49 crore (1.59 per cent of notified amount) have been received and fully allotted.

It is advisable for banks to promote schemes for sale/purchase of government securities over their counters to retail investors through demat accounts with depositories or with CSGL account holders.

A few banks and PDs have taken useful initiatives to promote retail investment in government securities by offering these securities for sale at retail outlets coupled with facility of holding investments and servicing thereof through existing demat account with depositories or in CSGL accounts.

The proposed Government Securities Act specifically recognises the rights of ownership of such investors. In formulating such schemes, PDs and banks may also provide both sale and purchase facility to ensure that the retail investors are assured of liquidity of such investments.

Banks could also promote retail sale of government securities along with schemes for availing of automatic finance against such investment at attractive rates, thereby providing ready liquidity.

(e) Treasury Bills

The auctions of 14-day and 182-day Treasury Bills were discontinued since May 14, 2001. The notified amount of 91-day Treasury Bills was increased to Rs.250 crore from May 16, 2001.

The notified amount of 364-day Treasury Bills was enhanced from Rs.750 crore to Rs.1,000 crore with effect from April 3, 2002.

(f) Consolidation of the government stocks

The consolidation of the Government stocks by improving fungibility imparts liquidity to the existing stocks, limits the number of floating stocks and helps in building benchmark securities.

However, flexibility in active consolidation is limited because of large market borrowing programme of the Government year after year.

Since April 1999, RBI has been attempting "passive consolidation" by reissuing the existing stocks through price-based auctions which resulted in limiting the number of outstanding stocks.

As at the end of March 2002, there were 111 government securities with outstanding amount of Rs.5,36,325 crore, of which 23 securities, each with minimum outstanding amount of Rs.10,000 crore, accounted for more than 50 per cent.

(g) Floating Rate Bonds

In order to cater to the diverse needs of investors in government securities, several innovative instruments, like Zero Coupon Bonds, Floating Rate Bonds (FRBs), Index Linked Bonds, etc. were issued in the past.

Currently, except for one Capital Indexed Bond, which will mature this year, all outstanding government market loans are in the form of plain vanilla fixed rate bonds.

In view of ALM and risk weight needs of the major investors such as banks, two FRBs of 5-year and 8-year maturity were issued for a total amount of Rs.5,000 crore in November/December 2001 which were fully subscribed.

FRBs serve as a diversifying instrument in debt management as it takes advantage of the term premium while minimising refinancing risk. However, FRBs are vulnerable to interest rate risks.

Considering both the advantages and the risks, issue of further FRBs in the current year would be examined.

(h) Calendar for dated securities

In order to enable both institutional and retail investors to plan their investments better, the Government announced issuance of calendar for dated securities for 2002-03. Such an advance calendar imparts transparency to the Government's borrowing programme and is expected to bring stability in the government securities market.

Out of the total expected borrowing for first six months, a calendar for an amount of Rs.68,000 crore was announced.

The remaining market borrowing programme for the first half of the year, as in the past, will be announced from time to time depending upon the emerging requirement of the government and market conditions.

(i) Separate trading for registered interest and principal of securities

A road map for developing STRIPS was prepared and put on RBI website for comments and suggestions from the market participants.

The Government was requested to issue necessary clarification on tax treatment of Zero Coupon Bonds. In order to operationalise the scheme of STRIPS, it has been decided:

• To constitute a Working Group comprising banks and market participants to suggest operational and prudential guidelines in respect of STRIPS.

(j) Satellite dealer system

In the Mid-term Review of October 2001, RBI announced its decision to undertake a review of the Satellite Dealer (SD) system in consultation with market participants.

After obtaining the views of the Primary Dealers Association of India (PDAI) and after further discussions in TAC and considering their role in the present conditions, it has been decided to discontinue the system. Accordingly:

• No new SDs will be licensed.
• Existing SDs will be required to make action plans, satisfactory to RBI for termination of their operations as SDs by May 31, 2002.

(k) Issue of long-term bonds for insurance companies and others

RBI has been consciously elongating the maturity profile of government debt having regard to its implications for the Government's annual borrowing requirements and debt redemption pattern, need for establishing benchmark for long-term financing for infrastructure and catering to the needs of long-term investors such as insurance companies, provident funds and pension funds.

During 2001-02, a 25-year bond was issued for Rs. 8,000 crore after a span of 17 years. RBI proposes to continue its policy of issuing long-term bonds to meet the requirements of such investors.

(l) Automatic debit mechanism

In some cases, State Governments have given instructions to RBI to debit their accounts on specified dates either as a matter of course to meet certain obligations or in case of specified events. Such automatic debits carry an overriding priority over other payments.

After examining the past experience with automatic debits, a Technical Committee of State Finance Secretaries on State Government Guarantees had observed that pre-emption through automatic debit mechanism runs the risk of resulting in insufficient funds for financing critical minimum obligatory payments such as, salaries, pensions, amortisation and interest payments.

In view of the recommendation of the Committee, and keeping in view the need to maintain integrity of the public debt segment of debt markets, it is proposed that:

• In future, as a general policy, with prospective effect, to dispense with such automatic debits where there are no legal or other compulsions.
• Where there is a legal compulsion for creation of such mechanism, to suggest amendments to such provisions.
• To review all the existing automatic debits in consultation with State Governments and others concerned, with a view to dispensing with such mechanisms wherever feasible.

URBAN CO-OPERATIVE BANKS

(a) New apex supervisory body

The annual policy Statement of April 2001 had announced a proposal to set up a new Apex Supervisory Body to take over the entire inspection/ supervisory functions relating to scheduled and non-scheduled UCBs in consultation with the Central Government.

In the Mid-term Review of October 2001, it was mentioned that RBI has submitted a draft Bill on setting up of a separate Supervisory Authority. The matter is under consideration of the Government.

The events of the last two years have made it abundantly clear that the present system of dual/triple regulatory and supervisory control (involving Centre, States and RBI) is not conducive to efficient functioning of the co-operative banks in the interest of their depositors.

Several committees in the past have also recommended elimination of multiple layers of supervision and regulation of this sector. In view of the local interest involved, it is also clear that there is no consensus at present in favour of removing supervisory and regulatory responsibilities at Central/State Government levels, and for entrusting it exclusively to RBI.

As a result, the managements and boards of several co-operative institutions continue to reflect political interests rather than genuine co-operative spirit, and are not always amenable to normal banking discipline in their operations. In view of this, it would be best, in the interest of the public depositors, if the situation is faced squarely and a separate supervisor

(b) Working group on asset-liability management

It was indicated in the Mid-term Review of October 2001 that RBI has circulated the report of the Working Group on ALM guidelines for UCBs to select UCBs for their comments. Only six banks responded; however, their responses were positive.

It was felt that the guidelines need simplification and towards smooth implementation, a few workshops may be held to explain these guidelines for obtaining feedback from the officials/CEOs of UCBs in their implementation.

The first workshop held on January 14-15, 2002 at College of Agricultural Banking, Pune was attended by 37 executives from 17 UCBs.

The second workshop was conducted at Bankers Training College, Mumbai. After taking into account the suggestions received from the participating banks in the two workshops, the guidelines have since been issued.

(c) Supervisory rating system for UCBs

111. The Reserve Bank, based on its on-site inspection, had put in place a supervisory rating "CAMELS" model for Indian commercial banks and "CACS" model for foreign banks so as to assess their performance.

In 1999, on-site inspection based on "CAMELS" model was extended to UCBs as an additional tool for supervision. Since UCBs are members of the payment system and also beneficiaries of deposit insurance scheme, in the light of recent experience, it is felt that there is a need to further strengthen the supervisory regime for UCBs.

Towards this end, RBI constituted a Working Group in October 2001 to evolve a suitable rating model for UCBs taking into account their operational characteristics. The Working Group in consultation with CEOs of large UCBs, submitted its report on March 23, 2002.

The recommendations of the Group are being examined and necessary guidelines would be issued in due course.

SUPERVISION AND MONITORING

Progress made in respect of certain announcements made in the annual policy Statement of April 2001 is reviewed below:

(a) Off-site monitoring and surveillance

The Reserve Bank had rationalised off-site returns to monitor liquidity and interest rate risks on quarterly basis in 1999. With the intention to finally move over to a fortnightly reporting system, in consultation with the banks, a revised system was put in place in June 2000.

The reporting schedule for the reports on (i) interest rate sensitivity, (ii) structural liquidity, both for rupee and forex transactions, (iii) assets, liabilities and exposures, (iv) exposure to sensitive sectors, and (v) Indian subsidiaries, was made monthly with effect from October 2001.

(b) Risk-based supervision

The Project Implementation Group formed for the smooth switch over to Risk Based Supervision (RBS) process by 2003, has initiated certain management processes which include preparation of discussion paper, risk profiling, manual writing, training and legal requirements.

The responses from banks on the discussion paper were analysed and in order to assess their progress and needs in this regard, a consultation process has started. The Group has prepared a draft risk assessment template for risk profiling of banks under the RBS approach. The template is being tested with a few banks for further customisation and refinement. An internal group was constituted for drafting of Manuals.

(c) Prompt corrective action

As indicated in the Mid-term Review of October 2001, the scheme of prompt corrective action (PCA) with various trigger points for prompt responses by the supervisors was developed and sent to the Government for their views before implementation.

The Government has since cleared the scheme which will be put in place shortly.

(d) Macro-prudential indicators

It was indicated in the annual policy Statement of April 2001 that pilot reviews using macro-prudential indicators (MPIs) for the half-year ended March 2000 and September 2000 were prepared for internal circulation.

Subsequently, the reviews for the half-year ended March 2001 and September 2001 were also prepared. While the earlier reviews were largely compilation of MPIs, scope and coverage of the subsequent reviews are enhanced by including data on capital market, forex market and other segments of the financial system.

(e) Consolidated accounting and supervision

As mentioned in the annual policy Statement of April 2001, the Board for Financial Supervision (BFS) has evolved an approach for consolidated supervision as appropriate in the Indian context.

A multi-disciplinary Working Group was set up to look into the introduction of consolidated accounting and quantitative techniques for consolidated supervision, in line with international best practices.

The Group's report was placed before BFS on January 29, 2002. The report was also put in public domain for comments/suggestions. Based on the comments, necessary guidelines would be issued by RBI.

PRESENT STATUS OF PRUDENTIAL MEASURES

Increasing globalisation and blurring of distinction among different segments of financial intermediaries have posed a special challenge for banking sector.

Being the mainstay of financial intermediation, developing a sound and healthy banking system through promotion of prudent financial practices has become essential to sustain financial stability. It has been recognised that Indian banking system should be in tune with well laid down international standards of capital adequacy and prudential norms.

RBI initiated the banking sector reforms as per the recommendations of Committee on the Financial System to improve the financial health and enhance the efficiency, productivity and profitability of the Indian banking system over time.

Keeping in view the changes in pace and pattern of developments in the financial sector and with the objective of achieving convergence between Indian standards and international best practices, a number of measures were announced in earlier policy Statements.

The progress made in the implementation of these measures along with further measures considered necessary are indicated below.

(a) Adoption of 90 days for recognition of loan impairment

As indicated in the annual policy Statement of April 2001, banks were advised to adopt 90 days norm to classify their assets from the year ending March 31, 2004.

They were asked to chalk out an appropriate transition path for smoothly moving over to the 90 days norm and submit their action plans with the approval of their Boards to RBI. As a facilitating measure, they were advised to move over to charging of interest at monthly rests by April 1, 2002.

In this connection, some banks sought clarifications on application of interest on agricultural advances, options available for applying interest for longer rests, etc. In consultation with IBA, detailed guidelines were issued clarifying that with effect from April 1, 2002, banks may move over to charging of interest on loans/advances at monthly rests except for agricultural advances.

(b) New Basel Capital Accord

In the Mid-term Review of October 2001, it was mentioned that RBI had forwarded its comments on the second consultative paper on the New Capital Accord issued by the Basel Committee on Banking Supervision (BCBS).

The Committee received over 200 responses from national supervisors, banks, international institutions and others which can be accessed at www.bis.org. Such wide variety of comments indicate the fact that achieving global consensus on the methodology of capital regulation is not an easy task.

Many respondents have expressed their concerns at the difficulties that would be experienced in implementing the proposals on account of their complexity and costs.

Several respondents have also pointed out that capital requirements could increase across the board in most jurisdictions on account of the new proposals.

In view of these, the consultation process has been extended and some modifications to the proposals are currently being discussed by BCBS which could mitigate the more than anticipated upward impact on capital requirements.

Another Quantitative Impact Study (QIS) will be conducted in the coming months with wider participation and the Reserve Bank will also be participating in this impact assessment. At the same time, an internal group in RBI is also engaged in developing a suitably modified approach within the philosophical framework of the Basel proposals which could be adapted to the Indian situation and simpler to implement and supervise.

For this purpose, the internal group will invite representatives from select banks to provide inputs into the development of the modified approach as well as the upcoming QIS.

Further, assigning risk weights for bank assets should largely be a matter for the banks or their supervisors. Banks are expected to constitute an expert internal team to study the methodology

(c) Counterparty and country risks

The Reserve Bank is committed to the implementation of the "Core Principles for Effective Banking Supervision" drawn up by BCBS. It is a matter of satisfaction that the banking system in India is largely compliant with most of the Core Principles.

In October 1999, RBI had issued risk management guidelines which, inter alia, advised banks to use the country ratings of international rating agencies and classify the countries into low risk, moderate risk and high risk categories and endeavour to develop an internal matrix that reckons the counterparty and country risks.

With a view to moving further in complying with the Core Principles, RBI would be shortly issuing draft guidelines on country risk management and provisioning therefore in consultation with banks, IBA and other market participants.

(d) Capital for market risk

It was announced in the Mid-term Review of October 1998, that government and other approved securities would have to be provided for a risk weight of 2.5 per cent towards market risk by March 31, 2000.

Guidelines on categorisation and valuation of banks' investments, in consonance with international practices, were also announced in the Mid-term Review of October 2000 and were effective from the half-year ended September 30, 2000.

Accordingly, banks were required to provide for 2.5 per cent risk weight on SLR and non-SLR securities, with effect from March 31, 2000 and 2001, respectively, as an interim arrangement, till such time as banks move over to the framework suggested by the Basel Committee.

The Basel norms provide for assigning capital for market risk on a standardised or on internally developed Value at Risk (VaR) methods.

As the valuation norms on banks' investment portfolio have already been put in place and aligned with the international best practices, it is appropriate to adopt the Basel norms on capital for market risk.

In view of this, banks are advised to study the Basel framework on capital for market risk as envisaged in Amendment to the Capital Accord to incorporate market risks published in January 1996 by BCBS and prepare themselves to follow the international practices in this regard at a suitable date to be announced by RBI.

(e) Prevention of money laundering

India has been sharing the increasing international concern on the use of the financial system for money laundering and financing of terrorism.

The challenges faced by the international community in combating financial crimes require sustained and co-ordinated action among the various agencies concerned with regulation and enforcement responsibilities, both in India and abroad.

RBI and the Government have initiated various steps from time to time to check any misuse of the financial system for laundering proceeds of criminal activities.

As part of these initiatives, RBI is in the process of issuing a Master Circular setting out the policy, procedures and controls required to be introduced by banks.

These include strict adherence to "Know Your Customer" (KYC) procedures for prevention of misuse of banking system for money laundering and financing of terrorist activity.

The recommendations of the Working Group on Anti-Money Laundering set up by IBA would also be taken into account while framing the guidelines.

(f) Reduction in transition period of a sub-standard asset to doubtful category

Narsimham Committee II had recommended that an asset should be classified as doubtful, if it is in the sub-standard category for 18 months in the first instance and for 12 months subsequently.

Accordingly, RBI had announced in the Mid-term Review of October 1998 that with effect from March 31, 2001, an asset should be classified as doubtful, if it has remained in the sub-standard category for 18 months.

Consistent with the recommendations of Narsimham Committee II and with a view to moving closer to international best practices, it is proposed that:

• With effect from March 31, 2005, an asset would be classified as doubtful if it remained in the sub-standard category for 12 months. Banks are permitted to phase the consequent additional provisioning over a four-year period, with a minimum of 20 per cent each year.

(g) Recovery of Non-Performing Assets

It was indicated in the Mid-term Review of October 2001, that the broad framework provided for compromise settlements of NPAs issued by RBI in 1995 will continue to be in place and banks are free to design and implement their own policies for recovery and write off incorporating compromise and negotiated settlements with the approval of their Boards.

The Finance Minister in his meeting with the CMDs of banks held on November 12, 2001 at New Delhi had indicated that a suitable scheme be evolved for small borrowers by banks for recovery of dues up to Rs 25,000.

Accordingly, banks have been advised to formulate a policy for recovery of dues, principal amount (excluding the interest element) in all sectors irrespective of the nature of business or purpose, which have become NPAs as on March 31, 1998.

As announced in the Budget 2002-03, a special one time settlement (OTS) scheme for small and marginal farmers to cover loans up to Rs.50,000 has been issued.

(h) Corporate debt restructuring

It may be recalled that in August 2001, RBI had issued guidelines on Corporate Debt Restructuring (CDR) for implementation by banks and FIs to put in place a framework outside the purview of BIFR, DRT and other legal procedures to ensure timely and transparent mechanism for restructuring debts of viable corporate entities facing financial problems.

As proposed in the Budget 2002-03, RBI constituted a High Level Group (Chairman: Shri Vepa Kamesam, Deputy Governor) to review the operations of the CDR scheme to identify the operational difficulties, if any, in smooth implementation of the scheme and to suggest measures to make the scheme even more effective.

As an interim measure, it has been decided that permission for debt restructuring will be made available by RBI on the basis of specific recommendations of CDR "Core-Group", if a minimum of 75 per cent (by value) of the lenders constituting banks and FIs consent for CDR, irrespective of differences in classification of the assets by banks/financial institutions.

(i) Non-SLR investments by banks and financial institutions

A mention was made in the Mid-term Review of October 2001 that further prudence should be observed by banks and FIs in order to contain the risk arising out of non-SLR investment portfolio of banks and FIs, in particular through the private placement route.

The draft prudential guidelines on management of non-SLR investment portfolio were issued to banks for their comments/views. On the basis of feedback, guidelines are being finalised and would be issued in due course.

(j) Investment Fluctuation Reserve

The Reserve Bank, 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, advised banks in January 2002, to build up an IFR of a minimum 5.0 per cent of the investment portfolio within a period of 5 years.

However, banks have been given the freedom to build up IFR to a maximum of 10.0 per cent of the portfolio depending on the size and composition of their portfolio, with the approval of their Board.

On the basis of feedback received from banks on the above proposals, it has been decided that IFR should be computed with reference to investments in two categories, viz., "Held for Trading" and "Available for Sale". Thus, it will not be necessary to include the investment under "Held to Maturity" category, which is not meant to be traded, for purposes of computation of IFR.

TECHNOLOGY UPGRADATION

The Reserve Bank has been playing a pivotal role in upgrading the payment and settlement system in the country.

The progress achieved so far in consolidating the existing payment systems, developing new technologically advanced modes of payment and moving towards the ultimate objective of linking various payment and settlement systems into an efficient and integrated system that will function in real-time environment has been substantial.

The Mid-term Review of October 2000 mentioned the preparation of a "Payments System Vision Document". After examining the comments/feedback, the final version of the Vision Document was published in December 2001. It provides a road map of important developments in the payment system projects.

This would facilitate banks in getting fully prepared to participate effectively in the new products aimed at better payment and settlement services.

(a) Networking of branches of banks for information dissemination

The process of reforms in payment and settlement systems has gained momentum with the implementation of projects such as NDS, Centralised Funds Management System (CFMS) for better funds management by banks and Structured Financial Messaging Solution (SFMS) for secure message transfer.

This would result in funds transfers and funds-related message transfer to be routed electronically across banks using the medium of the Indian Financial Network (INFINET).

To reap the full benefits of such electronic message transfers, it is necessary that banks bestow sufficient attention on the computerisation and networking of the branches situated at commercially important centres on a time-bound basis.

Intra-city and intra-bank networking would facilitate in addressing the "last mile" problem which would in turn result in quick and efficient funds transfers across the country.

(b) Extension of electronic funds transfer facilities

Recognising that the key to quick, safe and efficient funds transfers lies in the use of electronic modes of funds transfers, the Reserve Bank has improved the existing facilities under Electronic Funds Transfer (EFT).

EFT is now available for transfer of funds across banks and 13 different centres with one settlement a day and an enhanced per transaction limit of Rs. 2.0 crore which would make EFT attractive even for corporate funds movement. In the case of four metropolitan cities, the settlement is being effected at three time slots every day which will shortly be extended to all the other centers so as to enable transfers on a T+0 basis.

Adequate security features are also being incorporated in the EFT scheme, apart from providing for integration of the RBI's EFT scheme with various schemes already in vogue within some banks.

Once all banks start using the EFT on a large scale, the dependence on conventional funds transfer modes would diminish.

(c) Real time gross settlement -- Status

In earlier policy Statements, RBI had announced its intention of putting in place a RTGS system, which will enable real time movement of funds.

The preparatory work for RTGS system has been completed and a suitable vendor for designing and development of the system has been selected. The work on design specifications is in progress.

These specifications would take into account the international best practices as suitable to requirements of Indian banking. The system is scheduled to be ready for testing in about a year.

OWNERSHIP FUNCTIONS OF RESERVE BANK OF INDIA

It was indicated in the annual policy Statement of April 2001 that RBI should not own the institutions it regulates. Towards this end, in the case of Discount and Finance House of India (DFHI) and Securities Trading Corporation of India (STCI), the process of disinvestment has already been completed.

The Finance Minister in his Budget speech for 2002-03 announced that the Deposit Insurance and Credit Guarantee Corporation (DICGC) will be converted into the Bank Deposits Insurance Corporation (BDIC) to make it an effective instrument for dealing with depositors' risks and distressed banks.

Appropriate legislative changes will be proposed for this purpose. In the case of transfer of ownership of RBI in State Bank of India, National Bank for Agriculture and Rural Development and National Housing Bank, an internal Working Group was constituted to recommend the modalities, viz., valuation, payment adjustments, etc. and the legislative measures required consequent to transfer of shareholding.

The Working Group has submitted its report in November 2001 which was forwarded to the Government for their comments.

NON-BANKING FINANCIAL COMPANIES

The Reserve Bank has received applications for Certification of Registration (CoR) from 36,414 Non-Banking Financial Companies (NBFCs), of which, 14,079 applications were approved and 19,058 were rejected as at the end of March 2002.

Out of 14,079 companies, only 780 NBFCs have been allowed to accept/hold deposits from the public. Applications of 3,277 companies are still pending for various legal/procedural reasons. Out of these, 2,916 applications are held in abeyance pending enactment of the Financial Companies Regulation Bill, 2002.

Certain NBFCs were granting demand/call loans with an open period or without any stipulation regarding the rate of interest and servicing.

Difficulty was experienced in ensuring compliance with prudential norms on income recognition, asset classification and provisioning in respect of such loans.

In order to obviate these difficulties and to ensure that all such loans are appropriately classified and the position of NPAs is truly reflected in the financial statements of NBFCs, it was decided that all NBFCs granting/intending to grant demand/call loans should lay down a policy duly approved by their Board.

The policy should cover aspects such as stipulation of cut-off date within which the repayment of the loan will be demanded/called up, stipulation of the rate of interest and the periodic rests for payment of interest, stipulation of cut-off date not exceeding 6 months for review of the performance of loan, criteria for renewal.

With a view to further strengthening the regulatory/supervisory framework for NBFCs, the following measures are proposed.

(a) Formation of SRO for NBFC Sector
The Reserve Bank has taken a number of steps to speed up the reform process in the functioning of NBFC sector along prudent lines.

For further development of this sector, emphasis has been placed on formation of a Self Regulatory Organisation (SRO), particularly for the benefit of smaller NBFCs. Towards this end, as mentioned in the Mid-term Review of October 2001, RBI has been on an on-going basis discussing with the Informal Advisory Group of NBFCs and also with various NBFC Associations.

In the meeting of the Informal Advisory Group held on March 11, 2002, the matter was discussed and the representatives of NBFC Associations have informed that SRO would be constituted at the earliest.

(b) Submission of returns by NBFCs
NBFCs are required to submit periodic control returns to RBI. However, as laxity has been observed in this regard, in order to inculcate a sense of discipline in this sector, it has been decided to take action against NBFCs for non-submission of returns. Accordingly, in the first instance:

RBI would impose penalties as provided for in the Reserve Bank of India Act, 1934 as also launch court proceedings, besides considering rejection/cancellation of the CoR of NBFCs having public deposits of Rs 50 crore and above, in case of default in the submission of returns.

The above stipulation in respect of the size of NBFCs (i.e., Rs.50 crore and above) will be progressively reduced over time to ensure that as far as possible, all NBFCs submit periodic returns on a timely basis.

RATIONALISATION OF CURRENT ACCOUNT FACILITY WITH THE RESERVE BANK

As indicated in the Mid-term Review of October 2001, an internal Group was set up to rationalise the present policy of access to current account facility provided by RBI in view of phasing out of non-banks from call/notice money market, upgradation of payment system infrastructure such as operationalisation of CCIL and NDS and operations of OMO/LAF only through banks and PDs.

These would obviate the need of non-bank entities to have access to current account with RBI. In this context, a Group of Senior Executives of RBI was constituted to examine the recommendations of the report, suggest modifications and take such other follow-up actions as necessary.

In order to ensure that current account facility with the Reserve Bank serves its core objectives, it has been decided that current account facility may be extended only to scheduled commercial banks, scheduled co-operative banks, and PDs.

Current account facility for entities other than those indicated above would be phased out in due course.

INTERNATIONAL FINANCIAL STANDARDS AND CODES

The Mid-term Review of October 2001 mentioned the progress made by the Advisory Groups on International Financial Standards and Codes. All the ten Advisory Groups constituted by the Standing Committee have submitted their reports to the Chairman of the Standing Committee and these reports were placed on RBI website for wider dissemination.

It was also mentioned that the Standing Committee will prepare its own report indicating the course of follow-up/reforms required and the regulatory agencies involved in such follow-up actions.

The Standing Committee is synthesising the views and comments of all the Advisory Groups and the final report will be placed shortly in the public domain for wider dissemination and appropriate follow-up action.

SHORT-TERM LIQUIDITY ASSESMENT MODEL

Considering the importance of guiding monetary policy operations on a sound basis, the annual policy Statement of April 1999 mentioned the need for developing a short-term operational model which takes into account the behavioural relationships among different segments of the financial system.

Under the guidance of a Group of eminent academic experts, an operational model was developed and is being tested. The draft model will also be put on RBI's website for wider public debate.

Once the model is made operational, it may be feasible to constitute a technical committee in order to assist in monetary policy strategy. It is felt that in future, a technical monetary policy committee would act as a back office projecting various alternate policy strategies as is the practice in some other central banks.

MID TERM REVIEW

A review of credit and monetary developments in the first half of the current year will be undertaken in October 2002. The Mid-term Review will be confined to a review of monetary developments and to such changes as may be necessary in monetary policy and projections for the second half of the year.

EXPERT COMMITTEE ON BANK FRAUDS

The Expert Committee on Bank Frauds (Chairman: Dr. N. L. Mitra) submitted its Report to RBI in September 2001.

The report was examined as per the directions of the BFS and the report along with comments of RBI was forwarded to the High Level Group on frauds in banking sector constituted by Central Vigilance Commission (CVC) for its examination and comments.

Consultative Group for Strengthening the Internal Supervisory Role of Boards of Banks

A consultative Group of Directors of Banks and FIs was constituted under the Chairmanship of Dr. A.S. Ganguly, Director, Central Board, RBI to suggest, for consideration of the Government/RBI, measures that could be taken in respect of strengthening the internal supervisory role of Boards of banks/FIs in view of the on-going financial sector reforms which has entrusted greater autonomy and powers to the banks' Boards. The Group submitted its report recently which is under examination.

TRANSPARENCY ACCOUNTING STANDARDS

A Working Group was constituted under the Chairmanship of Shri N.D. Gupta, President, ICAI along with representatives from RBI and commercial banks to put in place appropriate arrangements to identify the compliance and also gaps in compliance with the accounting standards issued by ICAI and to recommend steps to eliminate/reduce such gaps.

The Working Group will, inter alia, analyse the difficulties faced by the banks in adoption of the accounting standards and evolve suitable guidelines in this regard. Report is awaited.

DEFAULTERS' LIST - WIDENING THE COVERAGE A Working Group was constituted under the Chairmanship of Shri S. R. Iyer, Chairman, Credit Information Bureau (India) Ltd. (CIBIL), with representatives from RBI, commercial banks and FIs, to examine the possibility of the CIBIL performing the role of collecting and disseminating information on the list of suit filed accounts and the list of defaulters, including wilful defaulters, which is presently handled by RBI. The Group submitted its report which is under examination.

CREDIT INFORMATION BUREAU

A Working Group under the Chairmanship of Shri S.R. Iyer, Chairman, CIBIL with representatives from banks, FIs and RBI was constituted to evolve a framework for collecting and sharing of information on private placement of debt. The Report submitted by the Group is being examined.

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