The Reserve Bank of India: Volume 5: Volume 5, 1997–2008 9781316511329, 1316511324

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The Reserve Bank of India Volume 5: 1997–2008 The fifth volume on the history of the Reserve Bank of India covers eleven years from 1997–98 to 2007–08. During this period, the Reserve Bank introduced key institutional and financial market reforms in a rapidly changing economic environment and facilitated faster integration of the Indian economy. The Reserve Bank rationalised as well as introduced innovative instruments of monetary control; strengthened regulatory and supervisory processes for both the banking and non-banking sectors; adjusted its approach to achieve and sustain financial stability; focused on building financial market institutions and infrastructure; and spurred legal and other amendments in the larger public interest as also for achieving flexibility with stability in the economy. It also worked to improve the rural credit system, financial inclusion and customer protection. This volume is not just a narrative history of the Reserve Bank; it is also a rich resource for anyone interested in understanding how an emerging market central bank manages change and shapes the economy to face future challenges. Volume 5 has been prepared by a team of writers led by the economic historian Tirthankar Roy (author). Other members of the team were K. Kanagasabapathy, N. Gopalaswamy, F. R. Joseph and S. V. S. Dixit.

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The Reserve Bank of India Volume 5 1997–2008

Tirthankar Roy

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University Printing House, Cambridge CB2 8BS, United Kingdom One Liberty Plaza, 20th Floor, New York, NY 10006, USA 477 Williamstown Road, Port Melbourne, vic 3207, Australia 314–321, 3rd Floor, Plot 3, Splendor Forum, Jasola District Centre, New Delhi – 110025, India 103 Penang Road, #05–06/07, Visioncrest Commercial, Singapore 238467 Cambridge University Press is part of the University of Cambridge. It furthers the University’s mission by disseminating knowledge in the pursuit of education, learning and research at the highest international levels of excellence. www.cambridge.org Information on this title: www.cambridge.org/9781316511329 © The Reserve Bank of India 2022 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2022 Printed in India A catalogue record for this publication is available from the British Library ISBN 978-1-316-51132-9 HB Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. The facts and analysis presented in this volume have been brought together by the author and a team of consultants, under the guidance of an Advisory Committee, based on, inter alia, published sources, internal records of the Reserve Bank and oral evidence provided by experts and eminent personalities. As such, the exposition should not necessarily be attributed to the Reserve Bank of India.

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Contents

Foreword Preface Acknowledgements List of Abbreviations

1. Introduction: Managing Liberalisation

xiii xvii xxi xxiii 1

2. The Macroeconomic Context

14

4. Foreign Exchange Market and Management of the Capital Account

94

3. Monetary Management

44

5. Foreign Exchange Reserves Management

147

7. Public Debt Management

227

6. Financial Markets

8. The Payment and Settlement Systems 9. Currency Management

10. Regulation of the Financial System – Part I: Commercial Banks

187 286 336 373

10. Regulation of the Financial System – Part II: Other Financial Institutions428 11. Supervision of the Financial System

478

13. Financial Inclusion

559

12. Rural Credit

14. Communication Policy

15. Organisational Change Appendices Photographs Select Bibliography Index

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523 596 614 660 699 708 711

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Tables

2.1 GDP Growth Rates 2.2 Prime Ministers, Finance Ministers and Reserve Bank Governors: 1997–98 to 2007–08 2.3 Growth, Savings and Investment 2.4 Sectoral Shares in GDP (at 2004–05 Constant Prices) 2.5 Growth in Index of Industrial Production 2.6 Money Supply, Bank Credit and Inflation Rates 2.7 Major Fiscal Indicators 2.8 Balance of Payments Indicators 3.1 Revisions in Reverse Repo and Repo Rates 2004–08 3.2 Trends in Select Indicators: 2004–05 to 2007–08 3.3 Changes in Bank Rate: 1997–98 to 2007–08 3.4 External Members’ Views on the Stance of Policy and Actual Announcements by the Governor from July 2005 to January 2008 3.5 List of Transparency Practices 4.1 Select Indicators of External Sector 5.1 Net Sales/Purchases of US Dollars (in Billions) by the Reserve Bank 5.2 Indices of Real Effective Exchange Rate (REER) and Nominal Effective Exchange Rate (NEER) of the Indian Rupee (Trade Weighted) (Base: 1993–94 April–March) 5.3 Foreign Exchange Reserves 5.4 Deployment of Foreign Currency Assets 6.1 Main Components of the Money Market 6.2 Key Steps in the Transition to an Interbank Call Money Market 6.3 Comparative Prudential Benchmarks for Call Money Market Operations 6.4 Activity in the Money Market Segments 6.5 Role of Primary Dealers in the Government Securities Market

20 22 24 27 29 32 37 39 58 62 66 83 85 95 152 158 160 163 192 195 196 197 215 vii

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tables 7.1 Debt Management Functions of the Reserve Bank of India 7.2 Institutions Responsible for Internal Public Debt Management (as of March 2008) 7.3 Market Borrowings of the Central Government 7.4 WMA Limits for the Central Government 7.5 Ownership of Central and State Government Dated Securities 7.6 Conversion of Special Securities into Marketable Securities 7.7 Weighted Average Yield and Maturity of New Market Loans of the Central Government (Excluding Issues under MSS) 7.8 Maturity Profile of Central Government Dated Securities (Excluding Issues under MSS): Relative Shares 7.9 Monitoring Group on Cash and Debt Management of the Central Government: Illustrative List of Subjects Discussed at the Meetings 7.10 Market Borrowings of the State Governments 7.11 The Share of Auction in States’ MBP 7.12 Extent of Additional Borrowing by States 7.13 Revisions of WMA Limits for States 7.14 Major Deficit Indicators of State Governments 7.15 Issuance of Special Securities 8.1 Classification of Payment and Settlement Systems 8.2 Trends in Retail Payment Transactions 9.1 Value of Banknotes ( Billion) Supplied by the Presses 9.2 Currency Chests: 1997 and 2008 9.3 Supply and Cost of Banknotes: 2003–08 9.4 Detection of Fake Notes through Banking Channels: 1999–2000 to 2007–08 9.5 Components of ICCOMS 10.2.1 Share of Assets 12.1 Credit Outstanding to Agriculture and Allied Activities (Short Term and Long Term) as of End of March 13.1 Number of Complaints Handled by Banking Ombudsmen and the Expenditure Incurred 15.1 Staff Strength and Staff Recruitment 15.2 Issue Department – Balance Sheet 15.3 Balances in Contingency Reserve and Asset Development Reserve 15.4 Reserve Bank Accounts viii

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230 231 240 241 243 245 248 248 254 256 260 263 267 270 271 286 319 340 342 347 364 371 429 530 574 621 650 653 655

Figures

3.1 4.1 6.1 6.2 9.1 9.2 9.3A 9.3B

Liquidity Adjustment Facility and Weighted Average Call Rate Turnover in Indian Foreign Exchange Market Components of the Financial Market Regulatory Structure in the Indian Financial Market Share of Currency in Broad Money Currency Management Cycle Banknotes in Circulation: End of March 2001 Banknotes in Circulation: End of March 2008

59 96 188 189 337 340 341 341

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Boxes

1.1 Reflections on Managing Liberalisation 3 1.2 Reflections on the Autonomy of the Reserve Bank 4 3.1 Reflections on the Multiple Indicators Approach 50 3.2 Internal Group on the Liquidity Adjustment Facility (2003) 57 3.3 Internal Group on Bank Rate (1997) 64 3.4 Committee to Examine the Modalities of Phasing out of Ad hoc Treasury Bills 75 3.5 Relevant Parliamentary Acts and Amendments 78 4.1 Tarapore Committee I (1997) 98 4.2 Broad Comparison of FERA and FEMA 114 4.3 Extract from the Dissent Letter of the Reserve Bank (28 October 2005) 128 5.1 Reflections on Exchange Rate Management 154 6.1 Derivatives 209 6.2 Features of STRIPS 218 6.3 ‘When, As and If Issued’ Trading (WI Trading) 220 7.1 Main Features of the FRBM Act, 2003, and the FRBM Rules, 2004 235 7.2 Functional Separation of Debt Management from Monetary Management: Views Expressed by Various Committees 238 7.3 Conversion of Special Securities into Marketable Dated Securities 244 8.1 Indian Financial System Code 297 9.1 Growth of ATMs and Demand for Higher Denomination Banknotes 339 9.2 Security Features in Indian Banknotes 358 9.3 The Shift from the Ashoka Pillar Series to the Mahatma Gandhi Series Notes 362 10.1.1 Standing Technical Advisory Committee on Financial Regulation 378 10.1.2 Reflections on Regulation and Deregulation 417 12.1 New Directions in Legislative and Institutional Reforms 533 12.2 Revised Guidelines on the Priority Sector – 2007 537 14.1 Reflections on Communications Policy 597 xi

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Foreword

Unravelling the past in an objective and systematic manner brings with it many positive learnings that can shine a light on the path ahead. While grappling with contemporary complex policy dilemmas, a reference to institutional history often provides valuable guidance on time and context specific policy responses and their impact. I am happy to note that the documenting of its history by successive generations is entrenched as a living tradition in the Reserve Bank of India. This volume – The Reserve Bank of India (1997–2008), the fifth in the series – provides an absorbing and insightful account of central banking in India and the ethos in which it evolved over the period from 1997 to 2008. With this volume, the institutional history of the RBI has been recorded for 73 of the 87 years of its existence. This volume has been prepared on the basis of documentary records and oral evidence provided by eminent central bankers and policy makers. Drawing on this repository of information, the volume provides a perspective on the developments and challenges over the reference period, that is, 1997– 2008, which encompassed the Asian financial crisis and the initial phase of the global financial crisis in its ambit. During this period, India experienced high growth coupled with macroeconomic and financial stability, even as strong capital inflows posed significant challenges for exchange rate and monetary management. Against this backdrop, a number of institutional and structural reforms were put in place by the RBI in coordination with the government. Important among them were the institution of the Liquidity Adjustment Facility (LAF), introduction of the Market Stabilisation Scheme (MSS) and prohibition of the RBI’s participation in primary auctions of government securities as part of fiscal responsibility legislation. Sector-specific refinancing facilities were phased out to enable liquidity management at a system level under the LAF. Amendment to the RBI Act in June 2006 removed the floor and ceiling on the cash reserve ratio (CRR) and the RBI was prohibited from payment of interest on CRR balances. Amendment to the Banking Regulation Act came xiii

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foreword into force in January 2007 which removed the floor rate of 25 per cent of the statutory liquidity ratio (SLR). All these reforms enhanced the flexibility and effectiveness of monetary policy considerably. In the area of external sector management, the repealing of the Foreign Exchange Regulation Act (FERA) in 1999 and the establishment of a new legal framework under the Foreign Exchange Management Act (FEMA) on 1 June 2000 marked a regime shift from regulation and conservation of scarce foreign exchange to a liberalised environment in which foreign exchange came to be regarded as a strategic asset. On the banking and non-banking domains, the regulatory and supervisory processes were strengthened alongside greater convergence with global practices, combined with significant operational flexibility to these entities and their Boards. While infusing competition in the banking sector, the RBI consciously pursued improvements in customer service. In the payment system space, a state-of-the-art system, leveraging on cutting-edge technology, evolved during this period, owing to the establishment of modern wholesale and retail payment system infrastructure. These advances paved the way for a gradual shift from paper-based instruments to electronic systems. With the enactment of the Payment and Settlement Systems Act in 2007, the RBI also assumed regulatory and supervisory oversight over payment systems in the economy. In the area of currency management, the thrust on improving quality of notes in circulation received a substantial boost during this period under the ‘Clean Note Policy’. Mechanisation of note processing and destruction of non-issuable currency notes became an integral part of this endeavour. On the whole, it may not be an exaggeration to say that today’s modern financial system owes much of its origin to the surge of reforms undertaken by the RBI during this period. I am happy that all these landmarks have been assiduously recorded in this volume. This volume has been authored by eminent economic historian Professor Tirthankar Roy of the London School of Economics and prepared under the guidance of an Advisory Committee chaired by Dr Narendra Jadhav, economist and Member of Parliament, with Smt. K. J. Udeshi, former Deputy Governor; Dr Viral V. Acharya, then Deputy Governor; and Dr Niranjan Rajadhyaksha, Research Director and Senior Fellow, IDFC Institute, as members. Dr M. D. Patra, then Executive Director and now Deputy Governor, was actively associated in the deliberations of the Advisory Committee as a permanent invitee.

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foreword A team of consultants, namely Shri N. Gopalaswamy, Shri K. Kanagasabapathy, Shri F. R. Joseph and Shri S. V. S. Dixit, all former senior officers of the Reserve Bank, contributed to the project by putting together the material for framing the chapters of the volume. The History Cell of the RBI collated relevant official records from across various departments and other such evidence, and provided pivotal administrative support to the entire process. I gratefully acknowledge the steadfast dedication and meticulous efforts of the author, the Advisory Committee and the History Cell in this endeavor to record and carry forward the legacy of central banking in India. I do hope this volume will be an essential reference point for all those interested in knowing about the challenges confronted by the RBI as it maneuvered through storms and calm, adapting to evolving circumstances. October 2022 Shaktikanta Das MumbaiGovernor

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Preface

The Reserve Bank of India Volume 5 covers the eleven-year period of 1997–2008. This is an institutional history of the RBI and thus records developments in policies and operations in its major functional areas. The time period covered in this volume is unique as it was flanked by two major crises in the international economy. The RBI not only responded to the underlying developments and challenges but also took upon itself the remarkable role of the leader in initiating reform measures in several critical areas. These included rationalising and strengthening of monetary policy operating instruments, namely institution of the Liquidity Adjustment Facility (LAF) and the Market Stabilisation Scheme (MSS), establishment of financial market institutions (for example, Clearing Corporation of India Ltd.) and building up of payment system infrastructure (for example, Real Time Gross Settlement System, Delivery versus Payment, Negotiated Dealing System, Electronic Clearing Service, and so on), putting in place firm and sound legal structure for providing flexibility yet ensuring clear outcome and accountability (for example, Foreign Exchange Management Act, 1999, Government Securities Act, 2006, Payment and Settlement Systems Act, 2007, and so on), consolidating and strengthening the banking and non-banking sectors, improving the rural credit system and the financial inclusion. Thus, one may say that much of the plumbing was done during this period on which the present-day modern system stands. In the process, however, this volume documents the evolution of the RBI itself. Another distinguishing feature of this period was that it was characterised by a stable relationship between the government and the RBI though some differences surfaced during the latter part in such policy areas as monetary management, exchange rate and reserve management, and the quality of capital flows without having any bearing on the macro-economic stability. The journey of preparation of this Volume 5 had been a fascinating one. It was prepared by a team of consultants under the guidance of the author Professor Tirthankar Roy of London School of Economics. The focus had been on capturing the core areas of public policy interface of the RBI with the functions xvii

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preface of other non-core service departments kept to the minimum. The endeavour had been to prepare an authentic, objective and unbiased account of the RBI’s major functions backed fully by documentary evidence without making any value judgement. This effort was suitably supplemented by incorporating the inputs from the transcripts of structured oral evidence recorded with select dignitaries to impart the nuances as well as credibility to the RBI’s history. The size of the volume was a matter of concern to us. In our effort to weigh between easier-to-hold-the-volume and the need to record the history of the RBI as the most important public policy institution in the country, we considered that a size of about 700 pages would be a good compromise. This volume was completed within the stipulated time of three years which included collection of thousands of files spread across major departments in the Bank, completion of interviews of select dignitaries, copy editing, finalisation of fifteen chapters and, finally, printing of this volume. I owe special gratitude to the then Governor Dr Urjit R. Patel for not just entrusting me with this opportunity but also for affording complete freedom in terms of both access to official records and the ability to take our stand, besides supporting this project in every possible way. I am obliged to the then Deputy Governor Dr Viral V. Acharya and the then Executive Director and now Deputy Governor Dr M. D. Patra not only for their guidance but also for bearing with us for resolving occasional challenges that are bound to arise for a project of this complexity and scale. I am immensely indebted to Smt. K. J. Udeshi, former Deputy Governor and a member of the Advisory Committee, for lending her vast experience combined with her strong sense of prudence to bear upon this volume. She also led the process very commendably when I had become indisposed for a brief period. Without her guidance, this volume would not have attained the status that it has strived for. Dr Niranjan Rajadhyaksha, Research Director and Senior Fellow, IDFC Institute, was the other member to whom I veered to strengthen the balance between insiders and outsiders so that we would have the benefit of a pair of external eyes to balance the insiders’ disposition. I am very grateful to him. We are fortunate to have Professor Tirthankar Roy as the author of this volume. He not only placed his distinct stamp on all chapters by making them a dispassionate account of the RBI’s functions but also made the text more lucid and reader friendly. No amount of appreciation would be enough for the four consultants, namely Shri N. Gopalaswamy, Shri K. Kanagasabapathy, Shri F. R. Joseph and xviii

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preface Shri S. V. S. Dixit, for putting together extraordinarily diverse material taken from thousands of files into a more cogent shape. I would like to thank all the dignitaries, namely Dr C. Rangarajan, Dr Bimal Jalan, Dr Y. V. Reddy, Dr D. Subbarao, Dr Vijay Kelkar, Shri M. S. Ahluwalia, Dr Shankar Acharya, Dr Surjit Bhalla, Dr Indira Rajaraman, Smt. Shyamala Gopinath, Smt. Usha Thorat, Shri V. Leeladhar and Dr S. L. Shetty, for positively responding to our invitation for interviews. This volume would not have been possible without the support from all central office departments and the RBI Archives, Pune, in the form of sharing of the files and documents. Finally, the History Cell. With very limited staff, the Cell performed exceptionally well with not just co-ordinating with all Advisory Committee members, author and consultants almost on a daily basis but also for keeping constant dialogue with vast swathes of departments in the RBI in procuring files and meeting our innumerable queries, successfully completing the recording of oral interventions of dignitaries and finally arranging printing of this volume. We thank the entire team led by Shri Amitava Sardar, Adviser until his retirement in October 2017 and thereafter as consultant, and Shri A. Karunagaran, Director, for their strong sense of sincerity and commitment. We sincerely hope that this volume would supplement the past four volumes in meeting the quest for understanding the challenges of the central bank of an emerging market economy while opening up in terms of regulation, supervision and institution-building in an environment of financial stability. October 2022 New Delhi

Narendra Jadhav Chairman Advisory Committee of RBI History Volume 5

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Acknowledgements

A. Gogia; A. Gupta; A. Karkera; A. Karunagaran; A. Killawala; A. Mangalagiri; A. Mayekar; A. Nandan; A. Pasricha; A. Pendam; A. Reddy; A. Thomas; A. Udgata; A. A. Deshmukh; A. A. Garde; A. B. Padhye; A. J. Parakka; A. K. Sarangi; A. P. Biswas; A. R. Gade; A. T. Gandhi; A. V. Parab; Abhay Mohite; Abhishek Kumar; Aditya Gaiha; Alex Philip; Alice Sebastian; Amitava Sardar; Anand; Anil Jadhav; Aniruddha De; Anwesha Rana; Arghya Kusum Mitra; Arpita Agarwal; Ashish Kumar Verma; Ashok Kumar Sahu; Ashok Sahoo; Ashutosh Raravikar; Avdhesh Kumar Shukla; Aviral Jain. B. Jose; B. Laghate; B. Nair; B. K. Bhoi; B. L. Shinde; B. M. Misra; B. P. Kanungo; B. P. Vijayendra; B. S. Dekate; Bhupal Singh; Bichitrananda Seth; Binod Bihari Bhoi. C. Singh; C. D. Srinivasan; C. H. Richard; C. M. Jha; C. N. Menye; Chaman Guleria. D. Datta; D. Guram; D. Mathur; D. Sharma; D. B. Piprodia; D. M. Vyas; D. P. Jadhav; D. P. Rath; D. S. Bisht; D. S. Chand; Dimple Bhandia. E. E. Karthak; E. M. Sali; Erica Marie Anderson. G. Chatterjee; G. G. Shanbhag; G. Kamath; G. Rathod; Geetha Padmanabhan; Gunjeet Kaur. H. Dey; H. S. Grewal; Himanshu Joshi. Indranil Bhattacharyya. J. Goveas; J. Kurup; J. Roy; J. K. Dash; J. K. Mallik; J. L. Negi; J. S. Bandkar; J. S. Kalra; J. S. Sahni; Jai Nandan; Janak Raj; Jang Bahadur Singh. K. Prem Shankar; K. Shikha; K. Singh; K. Sonawane; K. Vishwanath; K. K. Saraf; K. M. Neelima; K. V. Chaudhari; Kapil Dev Manhas; Khyati; Krishna Mohan Kushawaha; Kunal Priyadarshi; Kunal Rahar. L. Shekhar; L. V. Save; L.Vadera. M. Anand; M. Balsaraf; M. Khaja; M. M. Vijaykumar; M. Phadke; M. Rajan; M. Saxena; M. Sinha; M. Thomas; M. K. Tripathi; M. M. Paranjape; xxi

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acknowledgements M. R. Pannikar; M. R. Rao; M. S. Deb; M. Y. Divekar; Manu Sharma; Meetu Aggarwal; Mridul Kumar Saggar; Muneesh Kapur. N. Agrawal; N. Dhopatkar; N. Kumar; N. Nambiar; N. Nigam; N. A. Amin; N. N. Rane; N. P. Sahasrabuddhe; N. S. Dave; N. S. Raman; Naveen Kumar. P. Appukkuttan; P. Brijesh; P. Jaya Lakshmi; P. Narayan; P. Singh; P. Vasudevan; P. Vijaya Kumar; P. J. Mathkar; P. K. Yadav; P. P. Ramachandran; P. R. Adgaonkar; P. V. Lakshmi; P. V. Radhakrishnan; P. V. Sundaram; P. V. Tawde; Prakash Baliarsingh. Qudsiya Ahmed. R. Balakrishnan; R. Bhandari; R. Garg; R. Iyer; R. Jain; R. Kausaliya; R. Maheshwari; R. Mishra; R. Patel; R. Rajesh; R. Sebastian; R. Subramanian; R. Warrior; R. G. Tarware; R. K. Pala; R. K. Singh; R. L. Das; R. N. Kar; R. N. Vatsa; R. S. Borse; R. S. Mirkar; R. S. Rathod; Rajas Saroy; Rajeev Dwivedi; Rajeev Jain; Rajib Lochan Sahoo; Rajiv Ranjan; Ranjana Sahajwala; Rohit Lohi Das. S. Agnihotri; S. Bhatnagar; S. Chatterjee; S. David; S. Desai; S. Ganesh Kumar; S. George; S. Gomathi; S. Inamdar; S. Jain; S. Marandi; S. Mohan; S. Patel; S. Radhakrishnan; S. Ramaswamy; S. Ramesh; S. Seet; S. Sen; S. Sharma; S. Sinha; S. Srilatha; S. Sthalekar; S. Thakur; S. Varma; S. Yadav; S. A. Badkar; S. A. K. Nair; S. B. Mahadik; S. C. Dhairyawan; S. D. Joshi; S. G. Jange; S. H. Hukerikar; S. K. Bal; S. K. Das; S. K. Gaonkar; S. K. Maheshwari; S. K. Pal; S. K. Singh; S. L. Sawant; S. M. Jambhrunkar; S. M. Velankar; S. P. Kalelkar; S. P. Naik; S. R. Chowdhury; S. S. Barik; Sangita Misra; Sanjay Kumar Hansda; Sanjeev; Sarvesh Singh; Saswat Kumar Mahapatra; Savitha Rajeevan; Scenta Joy; Shailaja Singh; Shromona Ganguly; Siddhant Kujur; Sonam Choudhry; Subodh; Subrata Das; Sujata Kundu; Sujata Shrikantiah. T. Rabi Sankar; T. K. Johnson; T. K. Rajan. U. A. Prabhu; U. B. Patil; U. B. Sonawane; U. V. Patil; Uma Shankar. V. Dhanya; V. Jain; V. Sitalakshmi; V. D. Gupta; V. D. Laghate; V. H. Prabhu; V. M. Swami Dasan; Vazkar. Y. Rambabu; Yogesh Dayal. Ministry of Finance, Government of India RBI Archives

RBI Monetary Museum

RBI Central Office Library

Various Departments and Regional Offices of the RBI xxii

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Abbreviations

ADRs American depository receipts ADs authorised dealers AFS available for sale AFT available for trading AIFI all India financial institution ALM asset liability management AMCs asset management companies AML anti-money laundering ARC asset reconstruction company ATMs automated teller machines BC business correspondent BCBS Basel Committee on Banking Supervision BCSBI Banking Codes and Standards Board of India BF business facilitator BFS Board for Financial Supervision (in RBI) BIS Bank for International Settlements BOS Banking Ombudsman Scheme BPLR benchmark prime lending rate BPSS Board for Regulation and Supervision of Payment and Settlement Systems BR Act Banking Regulation Act, 1949 BRBNMPL Bharatiya Reserve Bank Note Mudran Private Limited BRICS Brazil, Russia, India, China and South Africa BSR basic statistical returns BTC Bankers’ Training College CAB College of Agricultural Banking (in RBI) CABBF Central Advisory Board on Bank Frauds xxiii

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abbreviations CAMELS Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems & Controls CBLO collateralised borrowing and lending obligation CCB Committee of the Central Board, RBI CCIL Clearing Corporation of India CDBMS centralised database management system CDR corporate debt restructuring CDs certificates of deposit CDSL Central Depository Services Ltd CFMS Centralised Funds Management System CFSA Committee on Financial Sector Assessment CGRA Currency and Gold Revaluation Account CIBIL Credit Information Bureau (India) Ltd CIBs capital-indexed bonds CLF collateralised lending facility CLN credit linked notes COSMOS Computerised Off-site Surveillance and Monitoring System CP commercial paper CPPAPS Committee on Procedures and Performance Audit of Public Services CR contingency reserve CRAR capital to risk-weighted assets ratio CRR cash reserve ratio CSD Customer Service Department (in RBI) CSF consolidated sinking fund CSGL Constituent Subsidiary General Ledger CTS Cheque Truncation System CVC Central Vigilance Commission CVPS Currency Verification and Processing System DAD Deposits Accounts Department (in RBI) DAPM Department of Administration and Personnel Management (in RBI) DBOD Department of Banking Operations and Development (in RBI) DBS Department of Banking Supervision (in RBI) DCC District Consultative Committee xxiv

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abbreviations DCCB district central cooperative bank DEAP Department of Economic Analysis and Policy (in RBI) DEIO Department of External Investments and Operations (in RBI) DESACS Department of Statistical Analysis and Computer Services (in RBI) DFC Department of Financial Companies (in RBI) DFHI Discount and Finance House of India Ltd. DFI development finance institution DGBA Department of Government and Bank Accounts (in RBI) DICGC Deposit Insurance and Credit Guarantee Corporation DIT Department of Information Technology (in RBI) DLRC District Level Review Committee DNBS Department of Non-Banking Supervision (in RBI) DNS deferred net settlement DoT Department of Telecommunications DPSS Department of Payment and Settlement Systems (in RBI) DRI Differential Rate of Interest (Scheme) DRT Debt Recovery Tribunal DSS Debt Swap Scheme DvP delivery versus payment EAMs external asset managers EBT electronic benefit transfer ECB external commercial borrowing ECS Electronic Clearing Service EEFC Exchange Earners’ Foreign Currency Account EFT electronic funds transfer ERF Export Refinance Facility ETFs Exchange Traded Funds FATF Financial Action Task Force FC financial conglomerate FCA foreign currency assets FCCBs foreign currency convertible bonds FCNR(A) foreign currency non-resident account FCNR(B) foreign currency non-resident (banks) account FCRA Forward Contract (Regulation) Act, 1952 FDI foreign direct investment FEDAI Foreign Exchange Dealers’ Association of India

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abbreviations FEMA Foreign Exchange Management Act, 1999 FERA Foreign Exchange Regulation Act, 1973 FI financial institution FIFO first in first out FIIs foreign institutional investors FIMMDA Fixed Income Money Market and Derivatives Association of India FIPB Foreign Investment Promotion Board FLCC Financial Literacy and Credit Counselling Centre FMC Forward Markets Commission FMC-RBI Financial Markets Committee (in RBI) FMD Financial Markets Department (in RBI) FPI foreign portfolio investment FRA forward rate agreement FRBM Act, 2003 Fiscal Responsibility and Budget Management Act, 2003 FRBs floating rate bonds FSA Financial Services Authority (of UK) FSAP Financial Stability Assessment Programme FSF Financial Stability Forum GCC general credit card GDDS General Data Dissemination Standards GDRs global depository receipts GDS Gold Deposit Scheme GRC Grievance Redressal Cell GRF General Refinance Facility GRF Guarantee Redemption Fund GTB Global Trust Bank Ltd HFT held for trading HLCCFCM High Level Coordination Committee on Financial and Capital Markets HRDD Human Resources Development Department (in RBI) HTM held to maturity HVC high value clearing IAS Investment Advisory Services IAS Integrated Accounting System xxvi

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abbreviations IBA Indian Banks’ Association ICAAP internal capital adequacy assessment process ICADR International Centre for Alternative Disputes Resolution ICAI Institute of Chartered Accountants of India ICCOMS Integrated Computerised Currency Operations and Management System ICD inter-corporate deposit IDC Inter-Departmental Committee (in Government) IDFC Infrastructure Development Finance Company IDRBT Institute for Development and Research in Banking Technology IECD Industrial and Export Credit Department (in RBI) IFC International Finance Corporation IFR investment fluctuation reserve IFSC Indian Financial System Code IIBI Industrial Investment Bank of India Ltd IIFCL India Infrastructure Finance Company Ltd. IIP international investment position ILAF interim liquidity adjustment facility IMDs India Millennium Deposits INFINET Indian Financial Network IPO initial public offering IRDAI Insurance Regulatory and Development Authority of India IRS interest rate swap JPC Joint Parliamentary Committee KCC Kisan Credit Card KYC know your customer LAB local area bank LAF liquidity adjustment facility LERMS Liberalised Exchange Rate Management System LIBOR London Interbank Offered Rate LOLR lender of last resort MBP market borrowing programme MFI microfinance institution MICR Magnetic Ink Character Recognition MIFOR Mumbai Interbank Forward Offered Rate xxvii

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abbreviations MIS management information service MMBCS Magnetic Media-Based Clearing System MMCB Madhavpura Mercantile Cooperative Bank MMMF money market mutual fund MNSB multilateral net settlement batch MoU memorandum of understanding MPLS multi-protocol label switching MRTPC Monopolies and Restrictive Trade Practices Commission MSCB multi-state cooperative bank MSCS Multi-State Cooperative Societies (Act, 2002) MSS Market Stabilisation Scheme MTM mark-to-market NABARD National Bank for Agriculture and Rural Development NBFC-ND-SI non-deposit-taking systemically important non-banking financial company NBFCs non-banking financial companies NCAF New Capital Adequacy Framework NDA National Democratic Alliance NDS Negotiated Dealing System NDTL net demand and time liabilities NEER nominal effective exchange rate NEFT national electronic funds transfer NGO non-governmental organisation NHB National Housing Bank NIBM National Institute of Bank Management NIC(LTO) National Industrial Credit (Long Term Operations) NOF net owned funds NPA non-performing asset (advance) NPC National Payments Council NPCI National Payments Corporation of India Ltd NR(E)RA non-resident (external) rupee accounts NR(NR)D non-resident (non-repatriable) deposit account NR(S)R non-resident (special) rupee account NREGS National Rural Employment Guarantee Scheme NRIs non-resident indians NRO non-resident ordinary rupee account xxviii

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abbreviations NSDL National Securities Depository Limited NSE National Stock Exchange NSE-MIBOR National Stock Exchange–Mumbai Interbank Offered Rate OAT own account transfer OBS off-balance sheet OBU offshore banking units OCBs overseas corporate bodies OCI Overseas Citizen of India OGL Open General License Scheme OMOs open market operations OSMOS Off-site Monitoring and Surveillance OTC over-the-counter OTS one-time settlement PACS primary agricultural credit society PCA prompt corrective action PDAI Primary Dealers’ Association of India PDO Public Debt Office PDs primary dealers PE private equity (funds) PFI public financial institution PIO Persons of Indian Origin PKI public key infrastructure PLR prime lending rate PMLA Prevention of Money Laundering Act, 2002 PMS portfolio management services PNs participatory notes PoS point of sale PRD Press Relations Division (of RBI) PSAC Payment and Settlement Advisory Committee PSG Payment Systems Group PTLR prime term lending rate QID quarterly informal discussions RBS risk-based supervision RBSB Reserve Bank of India Services Board RBSC Reserve Bank Staff College RCS Registrar of Cooperative Societies xxix

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abbreviations RD Regional Director (of RBI) REER real effective exchange rate RFCD resident foreign currency (domestic) account RIDF Rural Infrastructure Development Fund RIG Regulated Institutions Group RNBC residuary non-banking company RPCD Rural Planning and Credit Department (in RBI) RRA Regulatory Review Authority (in RBI) RRB regional rural bank RIB Resurgent India Bond RTGS real time gross settlement RTP reserve tranche position SAC Standing Advisory Committee SAC Settlement Advisory Committee SARFAESI Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (Act, 2002) SASF Stressed Assets Stabilisation Fund SBI State Bank of India SBS Shredding and Briquetting System SCB scheduled commercial bank SCF Standing Committee on Finance (of Parliament) SCGPM Standing Committee on Gold and Precious Metals SCIFSC Standing Committee on International Financial Standards and Codes SDRs special drawing rights SEBI Securities and Exchange Board of India SEZ special economic zone SFC State Finance Corporation SFMS Structured Financial Messaging Solution SGL subsidiary general ledger SHGs self-help groups SIDBI Small Industries Development Bank of India SIDC State Industrial Development Corporation SIFI systemically important financial intermediaries SIPS systemically important payment systems SLBC State Level Bankers’ Committee xxx

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abbreviations SLR statutory liquidity ratio SME small and medium (sized) enterprises SPMCIL Security Printing and Minting Corporation of India Ltd SR security receipts SSS securities settlement systems STACFR Standing Technical Advisory Committee on Financial Regulation StCB State Cooperative Bank STCI Securities Trading Corporation of India STP straight through processing STRIPS Separate Trading of Registered Interest and Principal Securities SWF Sovereign Wealth Fund SWIFT Society for Worldwide Interbank Financial Telecommunication TAC Technical Advisory Committee (of RBI) TACMP Technical Advisory Committee on Monetary Policy TAFCUB Task Force for Cooperative Urban Banks T-bills treasury bills TFCI Tourism Finance Corporation of India UAT User Acceptance Test UBD Urban Banks Department (in RBI) UCB urban cooperative bank UN/EDIFACT United Nations/Electronic Data Interchange for Administration, Commerce and Transport UPA United Progressive Alliance URRCBH Uniform Regulations and Rules of Bankers’ Clearing Houses UTI Unit Trust of India VCF venture capital fund VPN virtual private network VSAT very small aperture terminal WAN wide area network WMA ways and means advances WSS Weekly Statistical Supplement ZTC Zonal Training Centre xxxi

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1 Introduction

Managing Liberalisation

This volume of the history of the Reserve Bank of India (RBI) covers events during the eleven financial years from 1997–98 to 2007–08 (the ‘reference period’). Over this period, the Reserve Bank faced several major external shocks and had to function in a rapidly changing economic environment within India. While the economic liberalisation process had begun in the early 1990s, key institutional and financial market reforms occurred, and integration of the Indian economy with the world economy accelerated, during the reference period. The Bank shaped the transition, and adapted to it, by adjusting its approach to containing inflation and maintaining financial stability, focusing on financial market institutions and infrastructure, taking legal and other steps to achieve operational autonomy, making improvements in organisational capability and communication practices. It also worked not only to improve customer service in banks and the rural credit system but also to enhance financial inclusion. In all these efforts, the Bank relied on its own expertise as well as that available outside the organisation. This is an institutional history. It thus records developments in policies and operations of the Bank in its functional areas and documents the evolution of the organisation itself. While the details of policies, operations and organisational changes appear in subsequent chapters, this introductory chapter presents a compact account of these developments during the reference period. The chapter begins with a brief review of the macroeconomic trends and political situation, followed by a review of the major areas of activity of the Bank during the reference period, and a brief chapter outline.

Backdrop The beginning of the reference period witnessed several stressful events. The Asian currency and financial crisis (1997) posed major challenges for the

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the reserve bank of india policy environment in India. In the aftermath of the nuclear tests in Pokhran in May 1998, several Western nations imposed sanctions on India, leading to the partial suspension of multilateral lending, downgrading by international rating agencies and reduction in investment by foreign institutional investors. Despite these shocks, the reference period saw robust growth of the Indian economy. Continuing from previous years, the corporate sector responded to increasing openness and global competition by improving productivity. All relevant financial parameters relating to solvency, liquidity and profitability improved. The services sector propelled overall economic growth, supported by booming software exports and advances in information technology related services. Inflation was relatively moderate, even though towards the end of the reference period, an increase in oil and food prices exerted pressure on the price level. The fiscal situation of both the central and the state governments improved after 2003, which narrowed the public sector saving–investment gap and released resources for the private sector. Increasing openness was a defining feature of the process of change during these years. India’s external sector expanded thanks to progressive liberalisation of current and capital account transactions. Growth in the invisibles, including remittances, and unprecedented capital inflows sustained the overall balance of payments position. The progressive opening of the foreign exchange market necessitated changes in the legal framework, especially the introduction of the Foreign Exchange Management Act, 1999, to replace the highly restrictive Foreign Exchange Regulation Act, 1973. Despite several changes in government, dominated by coalitions and regional parties, the political stance was generally in favour of continuing with economic and financial sector reforms initiated in the early 1990s. Between April 1997 and March 2008, the Finance Ministry was headed mainly by three ministers, P. Chidambaram, Yashwant Sinha and Jaswant Singh. Except for the first eight months when C. Rangarajan was the Governor, during the remaining part of the reference period, two Governors, Bimal Jalan and Y. V. Reddy, were at the helm of the Reserve Bank. This situation made for a stable relationship between the Bank and the government (see Box 1.1). Some differences nevertheless surfaced in the latter half of the period in such policy areas as monetary management, exchange rate, and reserve management and the quality of capital flows. It is well known that the government enjoys overriding statutory powers over the Bank. It is perhaps not so well known that the Reserve Bank of India 2

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introduction Box 1.1 Reflections on Managing Liberalisation … when one looks at this whole period 1997 to 2008, although it covers the tenures of two governors … I see it as having been quite remarkably continuous in the sense that policies and operational matters whose direction was decided in Jalan’s tenure continued in the same direction in Reddy’s tenure also. 

Indira Rajaraman, economist

Chidambaram, Yashwant Sinha and Jaswant Singh … we had an excellent relationship with all of them and were always in close consultation with them. 

Bimal Jalan, former Governor, RBI

Between 1991 and … [the] late 1990s … our macroeconomic management benefited a great deal from having more or less the same cast of characters. People like Dr. Rangarajan, Mr. Ahluwalia, Dr. Reddy and to some extent myself … we had been in the policy game since the 1980s; so we had internalized a lot of learning and we worked well together. 

Shankar Acharya, economist

Act, 1934, is the only statute among the regulatory legislations in India which requires the government to consult the Reserve Bank Governor before issuing any direction to the Bank in public interest. De facto, the Bank gained more independence from the 1990s in operating monetary policy, and in choosing the tools for doing so. There were three ways in which the Bank gained more operational autonomy in the conduct of monetary policy. First, in the early 1990s, following efforts by Governor C. Rangarajan, an agreement was signed (1994–95) that set limits on the net issue of ad hoc treasury bills, and, by 1997, ended automatic monetisation of deficits. Second, the Bank’s sustained dialogue with the government led to the passage of the Fiscal Responsibility and Budget Management Act, 2003, which, among other things, prohibited the Bank from purchasing government securities in primary issues. Third, amendments to the RBI Act, 1934, and the Banking Regulation Act, 1949, led, in 2006–07, to more flexibility in the use of conventional tools of monetary policy such as cash reserve ratio and statutory liquidity ratio. In the sphere of regulation and supervision of the financial system, and in exchange rate management, the Bank and the government needed to calibrate their stances and coordinate policies often (for reflections on the autonomy of the Bank in these years, see Box 1.2). 3

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the reserve bank of india Box 1.2 Reflections on the Autonomy of the Reserve Bank ... independence of our Central Bank is highly contextual.... [D]uring the period we were there, independence was very much in the news, but we were aware ... that we don’t have absolute independence. But we had to negotiate because we wanted to move to market economy. It should be more independent than it was before but not independent. 

Y.V. Reddy, former Governor, RBI

… in the Government, the importance of honouring the autonomy of Central Bank is not appreciated well enough.… Many people, including Finance Secretaries, some Finance Ministers … look upon the Reserve Bank of India as just another public sector institution. 

D. Subbarao, former Finance Secretary and former Governor, RBI

The reference period ends just before the global financial crisis (2007–08) began in the wake of the collapse of the Lehman Brothers in the United States of America (USA). The crisis did not have serious consequences for India, as the reforms undertaken in earlier years in the areas of the exchange rate and reserve management, financial regulation and supervision, and payment and settlement systems stood India in good stead in managing the crisis.

The Reserve Bank’s Activities during the Period A short account of the Bank’s activities during the period needs to distinguish eight main functional areas: monetary management; external sector policies; financial market policies; regulation and supervision; public debt management; currency management; financial inclusion, rural credit and customer service; and organisational reform. Subsequent chapters divide these eight larger themes into fourteen more specific topics.

Monetary Management Monetary policy in India was conventionally guided by two objectives – keeping inflation under control and ensuring adequate flow of credit to the economy. Until 1997, regulation of bank credit via direct and indirect means was the most important instrument to achieve this. During the reference period, there 4

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introduction was a shift away from administered rates towards market-driven interest rates, deregulation of credit supply, and a shift towards market-based auctions for government borrowing programmes. The Bank also intervened in the foreign exchange market and conducted both overt and covert operations through public sector banks to stabilise the market at minimum cost. The decisive change that made the deregulation possible took place in the sphere of liquidity management, in the shape of the liquidity adjustment facility (LAF). The LAF carrying a repurchase agreement clause (repo) allows the sale and purchase operations in government securities. It operates through daily repo and reverse repo auctions, which set a ‘corridor’ for the short-term interest rate. It allows the central bank to modulate short-term liquidity daily and enables it to de-emphasise the targeting of bank reserves, make interest rates free of administrative control, and focus on stabilising interest rates instead. The LAF was introduced in 2000. The reference period saw it being established, reviewed and fine-tuned. Open market operations and daily repo operations emerged as the principal instruments of liquidity management. In place of the Bank Rate, the repo rate evolved gradually into a signalling rate reflecting conditions of the money market. Many sector-specific systems of liquidity injection were abolished. There were, however, a few exceptions such as the export refinance facility, and collateralised support extended to the primary dealers (PDs) in the securities market. While monetary policy had operated reasonably well on the domestic front, a new challenge emerged in the form of having to deal with capital flows. This was complicated by the rapid escalation in asset prices, particularly equity and real estate, driven by capital flows. These pools of capital, which were private, often opaque, highly leveraged and largely unregulated, posed threats to overall financial stability. The Market Stabilisation Scheme (MSS) was an innovation introduced in 2004 to sterilise the liquidity impact of a surge in foreign exchange inflows during the latter part of the reference period. As part of the MSS, Government of India treasury bills and/or dated securities were issued to absorb excess liquidity. The unique feature of the MSS was that the proceeds from those issues were immobilised by holding them in a separate identifiable cash account maintained and operated by the Bank. As the financial system became more complex, the mode of monitoring economic activity and assessing the need for intervention changed. Traditionally, the Bank used M3 (broad money) as the intermediate target. After 1997, with the movement towards market operations and away from direct regulation, 5

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the reserve bank of india policy statements started to focus on movements in the financial market rates and liquidity conditions. In this way, the framework of ‘monetary targeting’ gave way to a ‘multiple indicators approach’ to managing liquidity. In the new regime, a range of monetary and financial market indicators such as credit, interest rates, exchange rates and prices began being monitored. On the pricing of bank credit, the Bank introduced in 1994 the requirement for banks to fix and announce their own prime lending rates (PLRs), the minimum rate that would be charged for prime or best borrowers. While the system of PLR was aimed at enhancing transparency in lending rates, in practice, the system became increasingly non-transparent. The Bank introduced modifications in and flexibility on PLR, and to impart more clarity to the process, in November 2003, handed over the responsibility to issue guidelines on the benchmark prime lending rate (BPLR) to the Indian Banks Association, the reason being that such decentralisation was more consistent with the reform process and international practice. The move brought BPLR under a self-regulatory mechanism. The Bank’s intent throughout was achieving transparency in the process of setting benchmark rates rather than being prescriptive.

External Sector Policies India in the early 1990s had a closely regulated external sector. India made its current account fully convertible in 1994 and in 1997 planned to open its capital account. A committee appointed to consider this reform suggested a phased movement to capital account convertibility subject to fulfillment of certain preconditions. The Asian crisis underlined the dangers of free capital movement and required India’s reform measures to be implemented with prudence. However, the drive to further liberalise was strong in the early 2000s. To rationalise many sector-specific rules and put in place risk mitigating tools, the Bank formed several committees, internal working groups and task forces. These included the Committee on Procedures and Performance Audit on Public Services (CPPAPS, 2004), Internal Technical Group on Forex Markets ( June 2005), Fuller Capital Account Convertibility or Tarapore II (2006), Working Group on Rationalising Remittances (2006), Task Force on Rationalising and Simplifications of Forex Regulations (2007) and Internal Working Group on Currency Futures (2007).1 In all cases, there was close collaboration among the regulator, market experts, settlement agencies 6

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introduction and other stakeholders. The overall outcome was that the anomalies in the regulatory framework were reduced, and the hedging of foreign exchange exposures, rupee–foreign currency swaps, currency futures and derivative products were made easier. The sharp rise in capital inflows into the economy, however, created four types of challenges. First, India had to confront the ‘impossible trinity’ (the idea that free capital movement, independent monetary policy and fixed exchange rate cannot be pursued together). The Bank sought to address the situation using unconventional macro-prudential policies. Second, the Bank continually expressed concern that the foreign institutional investors’ investment in the stock market through participatory notes without disclosure of their ownership should not be permitted. Third, the Bank restrained government proposals to use foreign exchange reserves for domestic investment on legal and economic grounds. Fourth, the Bank brought more clarity into the relative responsibilities of the government and the Bank in the management of the exchange rate. Despite initiating these changes, the Bank was criticised in several quarters that its policies were too conservative. However, ‘gradualism’ stood India in good stead when the global financial crisis of 2008 broke out.

Financial Market Developments There are three market segments under the purview of the Reserve Bank: the money market, government securities market and the foreign exchange market. Within the money market, the call money market occupies a strategic position by serving as the equilibrating mechanism between day-to-day surpluses and deficits in the financial markets, and by transmitting the monetary policy impulses to the financial system quickly. Since the economic liberalisation began, the three markets had become progressively integrated. A series of institutional and technological changes took the process further forward during the reference period. The Bank actively promoted the development of the government securities market in the early 1990s to ensure smooth government borrowings to finance the deficit, facilitate the emergence of a risk-free yield curve to serve as a benchmark for the pricing of other debt instruments, and improve the effectiveness of transmission of monetary policy impulses in a deregulated environment. The reforms in the government securities market were ultimately expected to further these objectives. In this market, therefore, major reforms 7

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the reserve bank of india were undertaken, and these were supported through the LAF combined with liquidity support to PDs. The foreign exchange market grew in importance with a large inflow of foreign funds and the liberalisation of the foreign exchange regime. The market operates in close affinity with the call money market because of the day-to-day liquidity management operations of the Bank. The money market was made purely an interbank market supplemented by a parallel process of market development. A significant initiative was the development of the repo market outside the official window for providing a stable collateralised alternative, particularly to banks and non-banks. This had the effect of money market activities migrating from the uncollateralised call market segment to the collateralised market segments of repo and collateralised borrowing and lending obligation (CBLO). The growth of repo (outside the LAF) and CBLO attracted a wide spectrum of investors such as banks, PDs, non-banks and mutual funds. Foreign institutional investors could participate in the government securities market. The links between the domestic money and foreign exchange markets and overseas markets were facilitated by allowing banks and authorised dealers to borrow and invest funds abroad and to lend in foreign currency to companies in India. Repo turned out to be the most useful and flexible tool of short-term liquidity adjustment. The new auction-based instruments introduced were: treasury bills of different maturities, zero-coupon bonds and floating rate bonds. An inflation-indexed bond was issued. The Bank also planned to issue new instruments to the extent feasible in the form of separate trading of registered interest and principal of securities, or STRIPS. Derivative products such as forward rate agreements and interest rate swaps were introduced in July 1999 to enable banks and other institutions to hedge interest rate risks. Institutional development facilitated market integration. The Clearing Corporation of India Ltd. was set up in 2001 to act as a central counterparty to all trades involving foreign exchange, government securities and other debt instruments routed through it and to guarantee their settlement. The Discount and Finance House of India, the Securities Trading Corporation of India and PDs could participate in more than one market, again facilitating market integration. At the same time, significant changes were made in the payments and settlement infrastructure. At the beginning of the reference period, the payment system in India was mostly paper based. During the reference period, major advances were made in the areas of electronic funds transfer system and 8

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introduction electronic clearing services. In 1996, the Bank set up an information technology institute dedicated to the application of technology to financial systems (Institute for Development and Research in Banking Technology, Hyderabad). A separate department, the Department of Payment and Settlement Systems, and a Board for Regulation and Supervision of Payment and Settlement Systems were in place from early 2005 to bring in a sharper focus on payment and settlement systems. The delivery-versus-payment system, the negotiated dealing system and its variants, and the real-time gross settlement system improved efficiency of the settlement process.

Regulation and Supervision While regulation provides the policy framework to ensure solvency and liquidity of financial institutions, supervision refers to the instruments used to ensure compliance with this framework. The Bank’s regulatory jurisdiction extends to commercial banks, including urban cooperative banks, non-banking financial companies (NBFCs) and all-India financial institutions. Whether the two functions can be performed by the same institution is a debated issue. Although the Bank handles both the functions, at the board level, a separate entity for financial supervision was created to avoid conflict of interest. Consistent with the financial sector reforms, the Bank shifted towards managing competition, new entry and corporate governance. There had been a gradual move away from an administered or fixed interest rate regime to a system of flexible interest rates. Banks were given the freedom to fix their own PLRs as early as 1994. While the Bank’s expectation was that the PLR would serve the objective of transmission of policy signals through changes in repo rate, the experience was not that satisfactory. As discussed earlier, by the end of the reference period, the Bank left the decision on PLR to the banks themselves. During the reference period, a series of steps were taken to provide more operational flexibility to banks and their boards. At the same time, an emphasis was laid on corporate governance, compliance with prudential norms, provisions for market risks, classification and valuation procedures for investments, and asset classification and provisioning norms. The Bank’s approach to banks’ exposure to the capital market and real estate, however, remained cautious. Steps were taken to ensure that consumers could choose from a broader range of products, and the system gained efficiency from complex and new business 9

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the reserve bank of india processes, and a reformed organisational structure. These changes blurred the difference between banking and non-banking businesses to some extent. In practice, regulatory reform involved negotiations with the government, which owned by far the largest segment of the banking system. The reforms undertaken during the reference period did produce significantly positive results. One indication of this was the limited impact that the 2007–08 subprime crisis had on India. More substantially, by all performance indicators, commercial banks improved their performance during the period. The Bank issued detailed guidelines on ownership and governance of private sector banks. The broad principles were to ensure that ownership and control remained well diversified and that the large shareholders, directors and executives commanded trust. During the reference period, several small and under-capitalised banks were merged with other entities. The availability of sovereign guarantee gave the government-owned banks a competitive advantage. Despite a skewed playing field, private sector banks raised their share of deposits, thanks to the accent on technological change, customer service, innovative products, a younger staff and less bureaucratic decision-making. The regulatory framework applicable to the all-India financial institutions underwent fundamental changes. The Bank played a pivotal role in effecting improvements in governance and transparency in NBFCs and urban cooperative banks. Despite occasional frictions and differences, the government shared that broad aim. In exercising supervision, the Bank adapted global best practices to the Indian context. During the reference period, off-site surveillance of banks was broadened and made more focused. The system handled and analysed more information than before. These actions contributed to some extent to the limited impact the global financial crisis had on Indian banks. The period, however, witnessed the failure of one private sector commercial bank and a major urban cooperative bank due to fraud.

Public Debt Management Two far-reaching changes took place in the framework of coordination between the Reserve Bank and the Government of India in the management of public debt. First, as mentioned earlier, the issuance of ad hoc treasury bills and automatic monetisation of the fiscal deficit came to an end on 10

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introduction 1 April 1997. Second, with the enactment of the Fiscal Responsibility and Budget Management Act, 2003 (FRBM Act), the Bank was prohibited from subscribing to the primary issues of government securities, and the government could not borrow from the Bank except by way of advances to meet temporary excess of cash disbursements over cash receipts. The Bank also played a significant role in strengthening public debt management of the states, by, inter alia, streamlining the floatation of state government securities, administering the ways and means advances and overdraft arrangements of the states, and assisting and guiding in enacting model fiscal responsibility legislation at the state level.

Currency Management The share of currency in broad money had fallen from 40 per cent at the end of March 1971 to 16 per cent at the end of March 2001 and fell further to 14 per cent at the end of March 2009. The long-term trend was a result of financial deepening, increased use of credit and debit cards, and more liquid financial markets. Consistent with this trend, the thrust of currency management by the Bank underwent a shift from managing volumes to improving the quality of notes in circulation, tackling counterfeit notes and making note exchange easier. The mechanisation of note processing and destruction of non-issuable currency notes became one of the major thrust areas. The last six years of the reference period saw continuous improvement in the technology of production and distribution.

Customer Service, Rural Credit and Financial Inclusion Banking reforms and the entry of new players did not serve customer interest significantly better than before. In rural areas, often only one bank served many people, and hence the benefits of competition remained limited. Further, the legal processes for establishing customer rights and entitlements were unaffordable in time and money. To refocus attention on the consumer, the Customer Service Department came into being in 2006. The Banking Codes and Standards Board of India was set up in collaboration with banks. The aims of the Board were to prepare and publish voluntary codes and standards for banks for providing fair treatment to customers, function as an independent watchdog to ensure that the codes were followed, undertake 11

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the reserve bank of india research of codes and standards, and enter into covenants with banks on the observance of codes and train their employees. These measures succeeded in making bank managements take the customer more seriously than before. The Bank started publishing bank-wise complaints received by the Banking Ombudsman, which put pressure on banks to strengthen their own internal grievance redressal machinery so as to avoid complaints getting escalated. Financial inclusion measures saw millions of new accounts being opened. By comparison, the initiatives on financial education and credit counselling, though timely, were less effective. The Bank is required to ‘study various aspects of rural credit and development’ as it may consider necessary to do so for promoting integrated rural development (Section 54 of the RBI Act). This aim was achieved by means of directed credit, mainly in the shape of ‘priority sector lending’. During the reference period, the Bank pursued its goal of transforming the banking system into a strong market player while securing the interests of the priority sector. This was a tightrope walk.

Organisation The Reserve Bank became a leaner, more dynamic and a more outward-looking organisation during the reference period, capable of handling a more diverse and challenging range of tasks with a smaller workforce. One of the ways this was achieved was by incentivising training and professionalism, restructuring the workforce, and making strategic changes in placement and recruitment policy. The Bank also began recruiting specialised staff on a contract basis, to meet the needs for new types of service. A particular problem of withdrawal of updating of pension by the Bank at the instance of the government, however, remained unresolved until the end of the reference period. Several old departments were either wound up or merged with other departments as their functions became redundant. The Bank also divested its ownership in subsidiaries and, at the same time, new departments were set up as the need arose. The Bank management, being conscious of the crucial role of communication in the conduct of its monetary, regulatory and supervisory initiatives, focused on enhancing the coverage, quality and format of information dissemination. Both internal and external communication of the Bank received impetus during this period. Internal communication processes facilitated two-way communication and, during the period of reference, were 12

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introduction made more transparent. The Bank officials were encouraged to engage more closely with market participants with an emphasis on providing prompt response to the media and the public.

Chapter Outline The rest of the book narrates these changes with more details than it has been possible to discuss here. The next chapter presents a longer overview of the macroeconomic conditions that form the background to the Reserve Bank’s operations during this period. The remaining chapters follow the eight large themes as set out in the previous section. Chapter 3 deals with monetary management. Chapters 4 and 5 discuss the external sector policies in two stages, which are (a) foreign exchange market and management of the capital account and (b) foreign exchange reserves management. Chapter 6 covers the financial market policies. Chapter 7 discusses public debt management. The payment and settlement systems is taken up in Chapter 8. Chapter 9 discusses currency management. Chapters 10 and 11 deal with the regulation and supervision of the financial system. Rural credit and financial inclusion are discussed in Chapters 12 and 13. The final two chapters of the book deal with, respectively, communication (Chapter 14) and organisational change (Chapter 15).

Note

1. The CPPAPS was a major initiative towards customer protection and service and covered foreign exchange transactions, government transactions, banking operations relating to deposit accounts and other facilities, and currency management.

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2 The Macroeconomic Context

Introduction Between 1997–98 and 2007–08, the Reserve Bank of India functioned in a fast-changing economic environment. The two defining features of the process of change were the continuation of the economic liberalisation process begun earlier and the increasing openness of the Indian economy. This chapter provides a review of these two developments and a descriptive account of the behaviour of key macroeconomic variables during the period under reference. The review will serve as a backdrop to the succeeding chapters dealing with the Reserve Bank’s policies and operations. Three themes dominate the narrative: growth, institutional change and openness. During the reference period, India maintained relatively high economic growth, with an intervening period of slowdown. A debate exists on when the economy moved to a higher growth path, to which a reference will be made later in the chapter. The higher growth rate, especially in the latter half of the reference period, was supported by growing domestic savings and investment rates, besides capital flows from abroad. Despite frequent changes of governments, political stance was generally in favour of continuing with economic and financial sector reforms initiated in the early 1990s. Interestingly, more than any other sector of the economy, the services sector propelled growth; services came to occupy a dominant share in the gross domestic product (GDP). Inflation was relatively moderate despite high monetary and credit expansion. However, increasing global oil prices and domestic food price inflation started exerting pressure on prices towards the end of the period. Crucial to Reserve Bank operations, the fiscal situation at both the centre and states gradually improved after 2003. This was achieved thanks to cooperative efforts taken by the government and the Bank to contain deficits at sustainable levels by introducing rule-based fiscal reforms. India’s external 14

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the macroeconomic context sector expanded owing to increasing openness and progressive liberalisation of current and capital account transactions. Growth in the invisibles, especially remittances, supported the current account, where deficit was near-persistent, and unprecedented capital inflows sustained the overall balance of payments position. The Reserve Bank coordinated closely with the government to sustain the growth process, contain inflation and maintain financial stability through banking and financial sector reforms. The aim of these reforms was to develop markets and institutions, promote competition and efficiency, strengthen prudential standards and, increasingly, financial inclusion. That India dealt with the East Asian financial crisis at the beginning of the period and the beginning of the global financial turmoil towards the end of the period without serious consequences in either case is evidence of successful management of the transition. Strategic capital account management also helped the country ward off the adverse impact of crises (see Chapter 4). The present chapter has three sections. The next two sections deal with the two key features of the process of macroeconomic transformation of India in the period under discussion: increasing openness and its manifold implications, and persistence with economic reforms despite frequent changes of government. Whereas the former theme belongs to the realm of economics and policy analysis, the latter has attracted attention from political scientists. Having discussed briefly the international and political environment that enabled changes, we describe later what these changes were, with an overview of trends in the key macroeconomic parameters. Besides analysing the trend during the reference period, an attempt is made to compare these years with the previous decade (more precisely, eleven years, 1986–87 to 1996–97). The analysis shows that the reference period witnessed rapid improvements in almost all spheres, though the pace of change was uneven across areas. Developments relating to the financial sector, in general, will be briefly touched upon in this chapter as these subjects are integral parts of the Bank’s policies and operations and are covered in detail in the subsequent chapters.

The International Environment A number of global events that occurred during this period impacted India, including the Asian currency and financial crisis (1997), the adoption of the 15

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the reserve bank of india euro as a single common currency in Europe (1999), the founding of the G20 (or Group of Twenty) (1999), of which India was a member, the dot.com bubble (2000), the increasing prominence of BRICS (Brazil, Russia, India, China and South Africa) as a group of large emerging economies, the United States’ (US) invasion of Iraq (2003), the expansion of European Union (EU) membership (2004), the finalisation of Basel II norms by the Bank for International Settlements, or BIS (2004), and the crisis in the subprime mortgage market in the US (2007) which led to a full-blown global financial meltdown (2008). Despite these landmark events, the global economic and financial system in the 1990s and the early 2000s seemed to display a ‘great moderation’, at least so it seemed until the 2007–08 crisis broke out.1 The phrase refers to a substantial fall in the level of macroeconomic volatility since the 1980s. This, in turn, was owing to a fortuitous combination of factors, including an international consensus among monetary authorities on the need to focus on low inflation, greater fiscal discipline, trade liberalisation, deregulation in many industries and privatisation of state-owned enterprises with the objective of improving efficiency.2 Information flows greatly improved with the internet revolution. Furthermore, there was rapid international integration of financial markets that had followed the general trend towards financial market liberalisation in industrial countries from the late 1970s, and the reduction in capital and exchange controls in emerging market countries, including India, from the early 1990s. As a result, the period covered in this volume saw private capital flows on an unprecedented scale. During these years, many emerging economies experienced substantially higher growth than developed economies. Whereas trade and financial linkages between emerging markets and advanced economies had become stronger, the former was also seen to become more resilient to shocks originating in advanced economies. There was, as a result, larger growth of trade among emerging economies, and substantial capital inflows into these countries. Specific episodes imparted shock effects as well as generated responses that contributed to recovery and renewed growth. The East Asian currency and financial crisis was one of the more important examples. The crisis brought about a sharp decline in domestic demand and economic activity in Thailand, Indonesia, Korea and Malaysia, some of the most successful 16

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the macroeconomic context and highly open emerging market countries at that time. In fact, their very success had led domestic and foreign investors to underestimate certain institutional weaknesses. Property and stock market values were inflated. Persistence with pegged exchange rate regimes, which came to be viewed as implicit guarantees of exchange value, encouraged external borrowing and led to excessive exposure to foreign exchange risk. Weak management and poor control of risks by banks led to an asset–liability mismatch and bad debt syndrome. Weak transparency norms hid these issues from view. The crises, first in East and Southeast Asia and then in Russia, had contagion effects on other emerging market countries.3 The contagion effect was moderate in India, but a number of lessons were learned. A key lesson was the need to address promptly any signs of weaknesses in policies and institutions that might provoke sharp revisions in investor perceptions of a country’s prospects.4 This awareness reaffirmed India’s commitment to a calibrated approach to reforms, especially in relation to further opening up. Several key emerging market currencies had been floated, often to resolve problems associated with unsustainable exchange rate pegs after the East Asian crisis.5 The rupee had already become flexible. But convertibility was another matter. Although two committees went into the issue of making the rupee fully convertible, the actual steps taken were cautious and carefully sequenced. The Asian crisis made multilateral institutions, such as the International Monetary Fund (IMF) and the World Bank, turn their attention to strengthen the architecture of the international monetary systems through development of international standards and principles of good practices. India moved early in subjecting itself to financial sector assessment by the IMF (1999–2000).6 Simultaneously, India also attempted self-assessment by a committee headed by Deputy Governor Y. V. Reddy and later by a committee on financial sector assessment jointly chaired by Deputy Governor Rakesh Mohan and the Secretary (Ashok Chawla [Economic Affairs], D. Subbarao [Finance], Ashok Jha [Finance]), Government of India.7 These efforts of self-assessment of the Indian financial sector were unique to any country. There was evidence of a strong rebound in the global economy after the Asian crisis. The economic expansion continued to gain strength in 2000. The September 11 attack and its aftermath contributed to a deterioration in confidence across the globe. Beginning in 2002, the global economy again 17

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the reserve bank of india witnessed recovery (Table 2.1). By 2004–05, with global trade rising rapidly, financial markets had turned buoyant, and the world economy was growing. World economic outlook improved despite risks of terrorist attacks and a rise in oil prices. The momentum was particularly strong in emerging Asia, where GDP growth was 8.5 per cent in 2004, the highest level since the 1997–98 crisis, underpinned by accommodative macroeconomic policies, competitive exchange rates and the recovery in the information technology (IT) sector. Buoyant growth in China provided support to economic growth within and outside the region. In 2005, the economic expansion remained broadly on track. Following a temporary slowdown in mid-2004, global GDP growth picked up through the first quarter of 2005, with robust services sector output more than offsetting slower growth in manufacturing and trade. In the second quarter, however, in part reflecting the impact of higher oil prices, signs of a renewed ‘soft patch’ emerged, with leading indicators turning downwards and business confidence weakening in most major countries. Notwithstanding higher oil prices and natural disasters (the tsunami in southern Asia in 2004), global growth continued to exceed expectations, and growth in emerging Asia rose to 9.2 per cent in 2005.8 The expansionary phase was sustained during 2006 and 2007 notwithstanding the nervousness of financial markets in mid-2007. Global growth worked out to 5.4 per cent and 5.5 per cent in 2006 and 2007, respectively. Rapid growth in emerging market and developing economies was led by China and India. China’s economy gained momentum, growing at 12.7 per cent and 14.1 per cent in 2006 and 2007, respectively. India continued to grow at more than 9 per cent. Three countries (India, China and Russia) accounted for one-half of global growth, but other emerging market and developing economies also maintained robust expansion. Economic growth in the US slowed notably in the fourth quarter of 2007, with indicators showing weakening manufacturing and housing sector activity, employment and consumption. Growth had also slowed in western Europe but the crisis was much deeper in the US, where the housing market correction continued to cause financial stress. On this occasion, the emerging market and developing economies were less affected by financial market turbulence. Sustained growth was again led by China and India. The momentum came from strong productivity gains 18

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the macroeconomic context in these countries, and their integration into the global economy. Further, terms-of-trade increases in commodity producers, as oil and other raw material prices soared, helped some oil-exporting countries. The extraordinary growth of China and India was partly a result of their accumulated strengths. Of further help to them were the facts that they were net exporters of capital, were less dependent on foreign finance, and had large foreign exchange reserves, growing trade among themselves, better macroeconomic policies, including flexible exchange rates, rising per capita income, domestic savings, and a growing middle class that supported demand in the home market.9 During the reference period, global imbalances, reflected in large mismatches in current account positions among countries, received attention in international circles. Between 2001–02 and 2003–04, India registered modest current account surpluses but this was more of a reflection of a phase of the business cycle, and with the turnaround in the business cycle, India started registering current account deficits. While, generally, current account surplus accounted for a considerable proportion of reserve accumulation in most of the Asian emerging economies and Japan, for India current account surplus had been a minor source of reserve accretion. Capital flows played an increasingly important role in the accumulation of reserves. Besides, the main driver of growth in India had been domestic demand. Table 2.1 presents trends in global growth during the reference period for a broad group of countries, China and India. Global growth on an average improved from 3.4 per cent from 1986 to 1996 to 4.2 per cent during the reference period, and in the last five years (2003–07), the rise was faster at 5.1 per cent. But the performance of advanced economies deteriorated from 3 per cent in the earlier period to 2.8 per cent in the latter periods. Therefore, the overall improvement in global growth was essentially brought about by contributions from emerging market and developing economies, especially China and India. Emerging Asia grew at an average rate of 9.4 per cent in the last five years of the reference period compared to an average of 7.8 per cent in the previous decade. For India, average growth picked up from 5.7 per cent during 1986–96 to 6.9 per cent during the reference period, and in the last five years, growth was 8.8 per cent. The power of the global economy to shape India’s growth depended on continuing with the institutional and market reform process that had begun earlier. It is to this issue we now turn. 19

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the reserve bank of india Table 2.1 GDP Growth Rates  Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Average for 1997 to 2007

(per cent)

World Advanced Emerging Market Emerging and China India Economies and Developing Developing Economies Asia 4.0

3.5

4.6

6.1

9.2

4.1

3.6

3.6

3.5

6.6

7.9

8.5

2.6 4.8 2.5 2.9 4.3 5.4 4.9 5.4 5.5 4.2

2.8 4.1 1.6 1.7 2.1 3.3 2.8 3.1 2.7 2.8

2.3 5.8 3.6 4.5 7.0 7.9 7.1

2.8 6.5 6.1 6.6

8.5 8.4 9.1

8.4

10.1

9.2

11.3

8.5

7.9

10.1

5.7

7.4

8.4

7.9

11.1

10.2 12.7 14.1 9.9

6.2 4.0 4.9 3.9 7.9 7.8 9.3 9.3 9.8 6.9

Average for 1997 to 2002

3.4

2.9

4.0

5.8

8.5

5.3

5.1

2.8

7.7

9.4

11.7

8.8

Average for 1986 to 1996

3.4

3.0

3.9

7.8

10.1

5.7

Average for 2003 to 2007

Source: IMF, World Economic Outlook Database, April 2021 edition (https://www.imf. org/en/Publications/WEO/weo-database/2021/April). Note: Growth rates are based on GDP expressed in domestic currencies.

Economic Reforms and the Political Environment The end of India’s inward-looking and state-dominated economic regime, and the start of the liberalisation process, now constitute too well known a story to deserve a long restatement here.10 It is necessary, however, to repeat some essential details, because the time span covered in the book was part of the long-term process of reform. As mentioned in the introduction to the chapter, 20

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the macroeconomic context this phase was marked by further openness and continuing institutional changes in the domestic economy, the pace of which was affected by political shifts. These last two issues will figure prominently in this section. Although several crucial steps to liberalise the economy were introduced in 1992, it is believed that a partial liberalisation process had started in the mid-1980s. In the earlier phase, when Rajiv Gandhi was Prime Minister, industrial policy was rationalised, and software and telecommunications industries were encouraged. In the latter phase, when P. V. Narasimha Rao was Prime Minister, Manmohan Singh as the Finance Minister initiated new reforms. During the five-year term of the government from 21 June 1991 to 16 May 1996, industrial licensing was abolished, capital markets were reformed, and the foreign investment and the trade regimes were liberalised. There was an accent on the need to reduce fiscal deficit, privatise loss-making public sector enterprises and increase infrastructure investment. Among the measures that mattered to the capital market, the office of the Controller of Capital Issues (CCI) was abolished in 1992. This office had regulated the number of capital issues a company could undertake and the issue prices. The passing of the Securities and Exchange Board of India (SEBI) Act, 1992, and the related amendment to the Securities Contract (Regulation) Act, 1956, introduced a new regulatory framework. The National Stock Exchange (NSE) was started as a computer-based trading system from 1994, and by 1996 it had become the largest exchange in the country. The rupee was made fully current account convertible in August 1994. Equity markets were opened in 1992 to foreign institutional investors. By the mid-1990s, India recovered from a balance of payments crisis that had occurred in 1990–91. GDP (as per 2004–05 base year) growth, which had fallen to 1.4 per cent in 1991–92, exceeded 5 per cent in the next two years and rose further to more than 7 per cent, on average, in the succeeding three years until 1997. In 1996, the Congress government lost the general elections and was succeeded by four short-lived governments from 1996 to 1999: the Bharatiya Janata Party under Atal Bihari Vajpayee for thirteen days in 1996, about a year each under the United Front Prime Ministers H. D. Deve Gowda and I. K. Gujral, and Vajpayee again for nineteen months in 1998–99. After Vajpayee was sworn in in 1999, he managed to lead the National Democratic Alliance (NDA) government to a full five-year term until May 2004, the first non-Congress government to do so. In May 1998, nuclear tests and border conflicts in Kargil (mid-1999) caused political uncertainties. These and frequent change of 21

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the reserve bank of india government had apparently slowed the pace of reforms between 1998 and 2002, the first five years of the time span covered by this history. However, the process did not stall altogether, and with the return of a stable government, it picked up again. The Congress-led United Progressive Alliance (UPA) formed the next government on 22 May 2004 and ruled until the end of the reference period. These years saw very strong growth of the Indian economy. Despite the frequent change of government between 1996 and 2007, the Finance Ministry was held mainly by three ministers, P. Chidambaram, Yashwant Sinha and Jaswant Singh (Table 2.2). At the same time, by and large, two Governors, Bimal Jalan and Y. V. Reddy, were at the helm of the Reserve Bank. This situation made for an environment of a stable relationship between the Bank and the government despite political shifts. The average annual growth rate of GDP slowed to 4.5 per cent during 2000–01 to 2002–03. Growth, however, picked up thereafter. For five years from 2003–04, GDP (as per 2004–05 base year) grew by an average rate of around 9 per cent per annum.11 By then, the private corporate sector had grown stronger and become a more global player than before. The software and information technology-enabled services (ITeS) sectors came of age in the first half of the 2000s. Two factors had changed the image and capability of the Table 2.2 Prime Ministers, Finance Ministers and Reserve Bank Governors: 1997–98 to 2007–08 Party/Alliance in Power United Front United Front

National Democratic Alliance United Progressive Alliance

Prime Minister

Finance Minister

H. D. Deve Gowda: 1 June 1996 to 21 April 1997

P. Chidambaram: 1 June 1996 to 21 April 1997

Manmohan Singh: 22 May 2004 to 18 May 2009

P. Chidambaram: 22 May 2004 to 30 November 2008

Reserve Bank Governor

C. Rangarajan: 22 December 1992 to 22 November 1997 Bimal Jalan: 22 I. K. Gujral: 21 April I. K. Gujral: 21 April November 1997 1997 to 19 March 1997 to 1 May 1997; P. to 6 September 1998 Chidambaram: 1 May 2003 1997 to 19 March 1998 Y. V. Reddy: 6 A. B. Vajpayee: 19 Yashwant Sinha: 19 March September 2003 to March 1998 to 22 1998 to 1 July 2002; 5 September 2008 May 2004 Jaswant Singh: 1 July 2002 to 22 May 2004

22

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the macroeconomic context Indian IT industry towards the end of the 1990s. First, the Y2K12 scare caused a sharp increase in demand for less expensive IT professionals worldwide. It gave Indian companies exposure and allowed them to scale up rapidly. Second, the success of expatriate Indians in Silicon Valley gave the Indian industry a lot of confidence as well as market access. The IT revolution soon began to have spin-offs in the form of ITeS such as call centres, medical transcription and servicing of credit card accounts. Armed with rising incomes, consumer loans and credit cards, the Indian consumer began to buy more goods and services. By 2006, there were several shopping malls in every major city. These factors contributed to economic growth, supported by institutional changes. Institutionally, a lot was achieved by this time. New technologies were introduced, the banking system was overhauled, and the labour force was rationalised in many corporate and industrial firms. In 2001, a huge roadbuilding project called the Golden Quadrilateral was launched. Companies had weathered the storm of a sharp increase in global competition when tariffs were drastically reduced in 1992. There was a feeling that the global success of the software sector could be replicated in other industries. Indian companies began to expand abroad and acquire foreign companies. Meanwhile, several IT and pharmaceutical firms expanded very rapidly by making better use of external markets. By 2008, the country’s economic landscape was looking vastly different. It had foreign exchange reserves of over US$300 billion, more than its external debt; the share of gross fixed capital formation in private sector in total gross fixed capital formation grew to about three-fourths from about half in the late 1980s; imports plus exports of goods and the invisibles (net) jumped to over 40 per cent of GDP from around 13 per cent during the same period. Debates continue over why the reforms happened, and how the reform process was sustained for so long despite the frequent change in government, criticisms, and, at times, resistance. The answer to the question is not relevant to the book. It is sufficient to note that two broad perspectives exist on the question; one of these lays emphasis on the rise of pro-market views among policymakers and economists, and the other lays emphasis on the rise of probusiness views in the sphere of politics.13 The latter perspective suggests that with deregulation, government control on business reduced, creating more opportunities for making deals. The rise of coalition politics and regional political parties encouraged the tendency, especially at the local level. Having outlined the political and global backdrop, let us turn to the key elements of the process of macroeconomic change in the Indian economy.

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the reserve bank of india

Macroeconomic Trends

Growth, Savings and Investment As mentioned earlier, GDP growth accelerated between the 1990s and the 2000s (Table 2.3). As population growth decelerated, per capita net national income growth rate increased from an average of 3.6 per cent during 1986–87 to 1996–97 to 5 per cent in the next eleven years. Table 2.3 confirms a point made earlier: economic activity in India held up relatively well throughout Table 2.3 Growth, Savings and Investment  Year

GDP Growth at 2004–05 Prices

1997–98

4.3

1999–2000

8.0

1998–99 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Average for 1997–98 to 2007–08

6.7 4.2 5.4 3.9 8.0 7.1 9.5 9.6 9.3 6.9

(per cent)

Per Capita Net National Income Growth at 2004–05 Prices

Gross Gross Capital Domestic Formation* Savings*

2.2

25.6

24.2

6.0

26.6

25.6

4.6 1.7 3.3 2.3 6.5 5.0 7.8 7.9 8.1 5.0

24.2 24.3 24.2 24.8 26.8 32.8 34.7 35.7 38.1 28.9

23.2 23.7 24.9 25.9 29.0 32.4 33.4 34.6 36.8 28.5

Average for 1997–98 to 2002–03

5.4

3.4

24.9

24.6

8.7

7.1

33.6

33.3

Average for 1986–87 to 1996–97

5.8

3.6

23.2

21.5

Average for 2003–04 to 2007–08

Source: Summary of macroeconomic aggregates (Base: 2004–05), Ministry of Statistics and Programme Implementation, Government of India (https://www.mospi.gov.in/web/ mospi/download-tables-data/-/reports/view/templateOne/16701?q=TBDCAT).

Note: * Per cent of GDP at current prices. 24

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the macroeconomic context the financial crisis in Asia, supported in part by earlier structural reforms. Being a relatively closed economy, capital controls also helped limit India’s vulnerability to abrupt movements in short-term capital. Long-term capital flows were affected by the regional turmoil and the sanctions that followed the nuclear tests in May 1998. Although not a deep crisis, there was still a slowdown in economic growth in 1997–98 compared to the previous three years. Growth recovered between 1998 and 2000 due to the good performance of agriculture, exports and manufacturing. The fall in 2000–01 and 2002–03 resulted from weak monsoon and a severe drought. Recovery in agriculture, buoyant manufacturing activity, a sharp rise in exports, and strong investment sustained an impressive acceleration in GDP growth from 2003–04 onwards. In the years after 2003–04, the high growth rate was underpinned by an improvement in savings and investment rates. The turnaround was caused by improvements in mainly the public and corporate sector savings. In the long run, growth in savings and investment, supplemented by substantial growth in bank credit, propelled India’s growth. There was a high correlation between domestic savings and investment; a substantial part of investment was supported by domestic savings rather than foreign investment. If savings was key to the acceleration, the improvement between 2003–04 and 2007–08 came from a number of structural changes. The rule-based fiscal consolidation programme (see Chapter 6) together with high growth delivered a steady increase in the tax–GDP ratio and improvement in savings of the government sector. The process enabled a narrowing of the public sector savings–investment gap and release of resources for the private sector. Financial restructuring of the corporate sector and reduction in the overall debt–equity ratio had a significant impact on the profitability of the corporate sector and its savings. Traditionally, household savings was high in India. Their contribution to overall savings remained steady during the 2000s. Another major driver of the growth process was improved level of productivity reflected in the stable and low incremental capital–output ratio. While studies show that both industry and services recorded productivity gains, such gains were more pronounced in respect of the services sector. Productivity gains in industry and services emanated from increased use of technology, reorientation of processes, increased capacity utilisation and continued restructuring of the corporate sector.14 25

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the reserve bank of india

Structural Change India’s growth experience was very different from the East Asian countries. The East Asian growth model consisted of an export-oriented strategy reliant on investment in manufacturing capacity, especially in labour-intensive industry and infrastructure. Over time, the labour force became more skilled, shifting exports to high-end electronics and automobiles. The services sector became an independent driver of growth at a much later stage. Japan was the first country to adopt this model, followed by the so-called Asian Tigers and China. Manufacturing played a much smaller role in Indian growth (Tables 2.4 and 2.5). The contribution of agriculture and allied activities came down from an average of 28.9 per cent during 1986–87 to 1996–97 to an average of 20.8 per cent during the reference period (1997–98 to 2007–08). Its share in 2007– 08 was as low as 16.8 per cent. The share of the industrial sector, and within that distribution among mining and quarrying, and manufacturing, changed little. The contribution of the services sector, on the other hand, improved from an average of 44 per cent during 1986–87 to 1996–97 to 51.6 per cent in the next eleven years. Indian growth since the mid-1980s did involve the expansion of labour-intensive industry, such as clothing, jewellery and leather, but the country was also biased towards skill-intensive production, which became more pronounced after liberalisation. India’s exports, for example, included automobile parts and pharmaceuticals. The most dramatic impact of the opening up occurred in skilled services such as software and back office outsourcing operations. The resultant innovations in financial services played a significant role in money and capital market operations, as we shall see. They also contributed to the development of new products and activities in media, leisure, recreation and entertainment industries as well as to the circulation of knowledge, information and knowhow. India’s share of the global IT market accounted for 4 per cent overall in 2007, but in the area of global outsourcing, two-thirds of the world market in ITeS and engineering services and 38–42 per cent in business process outsourcing involved India.15 The so-called non-tradable outputs of the services sector had, in fact, become internationally tradable commodities. One explanation for this feature of India’s development was that the country was relatively capital-scarce. The savings rate was relatively low and the real interest rates high. The banking sector clean-up of the late 1990s and tight monetary policy resulted in low credit flow to the industry. Further, the 26

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the macroeconomic context reforms did not completely get rid of the regulations on industry. Agriculture remained burdened by state procurement monopolies and restrictions on internal trade. The service sector was considered largely incidental and was not brought under the same tight regulation (also see Chapter 4). When the reforms began, the services sector was in the best position to take advantage of the situation. To this, of course, we have to add a comparative advantage that India had. Unlike other Asian countries, higher education, including technical education, found a relatively high priority in India from 1950 to 1980, even as the record of primary and secondary education was disappointing in India. Table 2.4 Sectoral Shares in GDP (at 2004–05 Constant Prices)  Year 1997–98 1998–99

1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Average for 1997–98 to 2007–08

(per cent)

Agriculture Agriculture Industry Mining Manufacturing Services and Allied (including Activities Construction) 24.5

20.6

27.9

3.2

15.9

47.6

23.2

19.7

26.8

3.0

15.0

50.0

24.4 22.3 22.4 20.1 20.3 19.0 18.3 17.4 16.8 20.8

20.7 18.7 18.9 16.7 17.2 16.0 15.5 14.7 14.3 17.5

27.3 27.3 26.5 27.4 27.2 27.9 28.0 28.7 28.7 27.6

3.1 3.0 2.9 3.0 2.8 2.9 2.6 2.6 2.5 2.9

15.4 15.5 15.0 15.4 15.2 15.3 15.3 16.0 16.1 15.5

48.3 50.5 51.1 52.5 52.4 53.0 53.7 54.0 54.5 51.6

Average for 1997–98 to 2002–03

22.8

19.2

27.2

3.0

15.4

50.0

18.4

15.5

28.1

2.7

15.6

53.5

Average for 1986–87 to 1996–97

28.9

24.3

27.2

3.3

15.1

44.0

Average for 2003–04 to 2007–08

Source: Summary of macroeconomic aggregates (Base: 2004–05), Ministry of Statistics and Programme Implementation, Government of India (https://www.mospi.gov.in/web/ mospi/download-tables-data/-/reports/view/templateOne/16701?q=TBDCAT). 27

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the reserve bank of india Because of these features, including persistent barriers to integration with the world and a relatively small share of manufacturing in GDP, India’s economy was somewhat insulated from the East Asian crisis. The corporate sector emerged from the slowdown stronger than before. Table 2.5 shows that in the last five years of the reference period, manufacturing grew faster than before. The report of the Committee on Financial Sector Assessment (CFSA, 2009)16 acknowledged that the acceleration was enabled by a surge in private sector investment and productivity growth. The policy environment helped entrepreneurial activity. The corporate tax rate was steadily reduced from 45 per cent in 1992–93 to 30 per cent by 2005–06 and was kept stable thereafter. The peak rate of customs duty on non-agricultural goods was reduced gradually from 150 per cent in 1991–92 to 10 per cent in 2007–08, which encouraged the import of machinery. Further, debt servicing cost fell as the debt–equity ratio for public limited companies showed a generally declining trend from 63 per cent in 2003–04 to about 50 per cent in 2006–07. In private companies, the ratio showed an increasing trend, but it was lower than that in the public sector. The profitability of the Indian companies, measured by return on equity, was healthy and increased during the period under review. The low debt–equity ratio pointed at higher internal accrual and buoyancy in the capital market. Until 1991, the corporate sector in India encountered several constraints on its financing choices. The CCI controlled access to the equity market. Longterm debt was largely under the purview of state-owned development banks, which, either through direct lending or through refinancing arrangements, virtually monopolised the supply of debt finance to corporates. The economic reforms, among other changes, freed capital markets and allowed entry of foreign investors, which brought new financing and ownership opportunities and raised the volume of new equity issues. Profits after tax (PAT) recorded annual average growth of around 47 per cent per annum over a four-year period that ended in 2006–07. Profit margins recorded large gains while the interest burden witnessed a decline. In fact, the ratio of interest expenditure to sales revenues fell from around 6 per cent in the 1990s to about 2 per cent in 2007, thereby contributing greatly to the enhanced profit growth. The PAT to net worth ratio, after declining from 14.4 per cent in 1995–96 to 5.1 per cent in 2001–02, increased to 16.6 per cent 2005–06. The share of retained profits in PAT increased from 30.9 per cent in 2001–02 to 73.6 per cent in 2005–06. The improved corporate financial performance 28

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the macroeconomic context resulted in doubling of the private corporate sector savings rate (from 3.9 per cent in 2002–03 to 7.8 per cent in 2006–07 and further to 9.4 per cent in 2007–08), which also contributed to the pick-up in the overall savings rate. The Reserve Bank had been publishing special articles on the finances of non-government and non-financial public limited companies (implicitly covering private corporate sector in industry, mining and services) annually, based on their audited accounts. The number covered during 1990–91 to 2007–08 increased from 1,802 to 3,114, most of the growth occurring after 1999–2000. But for two intervening years, 1991–92 and 1996–97, the coverage of companies showed an upward trend, signifying that the sector as a whole was growing in size. Table 2.5 Growth in Index of Industrial Production  Year

1997–98 1998–99

1999–2000 2000–01 2001–02 2002–03 2003–04

General 6.7 4.1 6.7 5.0 2.7 5.7 7.0

Manufacturing Mining 6.7

-0.8

5.3

2.8

7.1 2.9 6.0 7.4

2004–05

11.7

13.2

2006–07

12.9

15.0

Average for 1997–98 to 2007–08

7.9

2005–06 2007–08

Average for 1997–98 to 2002–03 Average for 2003–04 to 2007–08 Average for 1986–87 to 1996–97

8.6

15.5

6.9

4.4

10.3 18.4 8.8

1.0 1.2 5.8 5.2 4.4 2.3 5.2 4.6 3.5

(per cent) Electricity

Infrastructure*

6.5

2.8

6.6 7.3 4.0 3.1 3.2 5.1 5.2 5.2 7.3 6.3 5.4

5.7 9.1 5.1 3.2 5.0 6.1 5.8 3.9 8.4 5.2 5.5

5.1

5.4

2.8

5.1

5.2

11.2

12.8

4.3

5.8

5.9

7.2

7.4

4.6

8.0

6.7

Source: RBI, Database on Indian Economy (https://dbie.rbi.org.in/DBIE/dbie. rbi?site=publications).

Note: * Relates to the combined index of eight core industries (coal, crude oil, natural gas, refinery products, fertilisers, steel, cement and electricity).

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the reserve bank of india Specific details on the corporate turnaround can be found in a study done in 2009.17 This analysis of the performance of companies focused on three aspects: overall performance in terms of growth in assets, sales, income and expenditure; solvency and liquidity; and profitability and other efficiency parameters. The study found that both the total value of production and assets increased at a faster rate from about 2002–03. The total value of production increased at the rate of 18.6 per cent during 2002–03 to 2007–08 compared with 7.2 per cent in the previous five-year period, and the value of total assets increased faster than the value of production. This lends support to the hypothesis that the capital intensity of firms increased in the period of expansion. The growth rate in income, which had fallen somewhat earlier, dramatically improved in 2002–07. So did the value of production and income from interest and dividend. There was evidence that the companies diversified their activity into investments, possibly because of the cash surpluses that they enjoyed. Investments as a proportion of total assets increased from 6.6 per cent in 1997–2002 to 13.1 per cent in 2002–07. As for solvency and liquidity, borrowings as a percentage of total liabilities fell in 2002–07 and the current ratio improved. Finally, on efficiency and related aspects, the study found improvements in the trend in gross profits, profit before tax, dividends, retained earnings and inventory management. Further, both import and export intensities increased. Another study showed that from 2000–01 to 2008–09, at the firm level, firm size, dividend payout ratio, the effective cost of borrowing, cash flow ratio and growth in the value of production were significant in determining corporate investment decisions.18 At the macro level, capital market developments and real effective exchange rate influenced corporate investment decisions whereas inflation and non-food credit growth were not significant in predicting investment decisions. Using the broad classification of sources of funds into internal and external, and comparing their constituents’ share in total sources of funds, the study showed that internal sources of funds contributed on an average a little more than one-third of the total sources of funds during the 1980s and the 1990s. Although firms relied more on the internal source of finance during 2000–01 to 2004–05, their reliance on external finance was increasing since 2005–06. During 2008–09, external sources contributed more than two-thirds of the total sources of funds. The rise in the share of external funds in total funds was largely due to borrowings in the 1980s, and borrowings along with fresh issues of capital in the 1990s. During the early 2000s, the reliance on 30

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the macroeconomic context borrowings showed first a fall and then a rise. The lower interest rate, the study concludes, helped in higher fixed capital formation in the corporate sector. How was the RBI involved in this process of macroeconomic transformation? Let us start with the money supply.

Money Supply There was a large expansion in the money supply and bank credit during the reference period. While the average annual growth in money supply for the reference period as a whole was flat at 17.3 per cent, which was by no means low when compared to the previous eleven years (17.4 per cent), the last three years of the reference period saw money supply exceed 21 per cent. Bank credit drove this trend in the last six years (Table 2.6). Reserve money increased at an average annual rate of 14.1 per cent during 1996–97 to 2007–08. There was a substantial shift in sources of reserve money between these periods. The two major contributing factors to reserve money growth are net Reserve Bank credit to the government and net foreign exchange assets with the Reserve Bank. Compared to earlier periods, foreign exchange assets saw higher growth. This is reflected in the share of domestic and foreign assets in the Reserve Bank balance sheet. The Bank had to absorb excess foreign capital flows to maintain external competitiveness of the economy, avoiding real appreciation of the rupee and, at the same time, contain the monetary impact to rein in inflation, which was nearing double digits.

Prices The GDP growth rate was very high in the last five years of the reference period. On several occasions, the Reserve Bank raised the issue of ‘overheating’ of the economy. Though the average wholesale price index (WPI) inflation came down to 5.2 per cent from the previous elevenyear period (8.8 per cent), this picture conceals an increase in inflationary pressures in the last two years of the period, 2006–07 and 2007–08. The sign of overheating was emphasised by Governor Reddy in his policy statements during these years.

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the reserve bank of india Table 2.6 Money Supply, Bank Credit and Inflation Rates  Year

M3*

Bank Credit*

(per cent)

Inflation Rate Wholesale Consumer Of which: Consumer price index price index food group price index for (WPI) for industrial agricultural workers labourers (CPI-IW) (CPI-AL)

1997–98

18.0

16.4

4.3

8.3

7.5

3.8

1998–99

19.4

13.8

5.4

8.9

7.5

8.8

1999–2000

14.6

18.2

5.6

4.8

3.5

3.4

2000–01

16.8

17.3

6.4

2.5

0.0

-2.0

2001–02

14.1

15.3

1.8

5.2

3.6

3.0

2002–03

14.7

23.7

6.0

4.1

3.7

4.9

2003–04

16.7

15.3

4.8

3.5

3.1

2.5

2004–05

12.0

30.9

5.3

4.2

1.6

2.4

2005–06

21.1

30.8

3.9

4.9

4.9

5.3

2006–07

21.7

28.1

6.6

6.7

12.2

9.5

2007–08

21.4

22.3

7.5

7.9

9.3

7.9

Average for 1997–98 to 2007–08

17.3

21.1

5.2

5.5

5.2

4.5

Average for 1997–98 to 2002–03

16.3

17.5

4.9

5.6

4.3

3.7

Average for 2003–04 to 2007–08

18.6

25.5

5.6

5.4

6.2

5.5

Average for 1986–87 to 1996–97

17.4

15.9

8.8

9.5

10.0

9.9

Source: WPI: Office of the Economic Advisor, Department for Promotion of Industry and Internal Trade, Government of India; CPI-IW: Labour Bureau, Ministry of Labour and Employment, GOI; CPI-AL: RBI, Database on Indian Economy. Notes: * Per cent of GDP. Inflation rates represent point-to-point inflation for March of respective financial years.

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the macroeconomic context Was there a growth–inflation trade-off in India? Economists sometimes suggest a prospect of a growth–inflation trade-off. A period of high growth tends to raise the inflation rate as well, which raises the issue of the role of monetary policy in managing the trade-off in the short run. Theoretical and empirical research suggests the presence of a country-specific ‘threshold level’ of inflation. Monetary policy may accommodate inflation up to the threshold level, but it must resist any increase in inflation beyond the threshold level because of the risk that further inflation could affect growth. From the time of the Chakravarty Committee19 report (1985) until recently, several analyses were conducted and alternative measurements made on the trade-off between inflation and output.20 A related concept and policy tool is ‘potential output’, or the level of output that is consistent with full capacity utilisation along with low and stable inflation. An assessment of the potential output is used to assess what is known as the ‘output gap’ – the difference between actual output and potential output. When this gap is negative, the economy is considered to be growing below potential, leaving scope for monetary easing.21 The acceleration in the GDP growth rate made these measures timely. Was the level of potential output rising in India? The CFSA (2009) examined the issue of sustaining high growth and concluded that 9 per cent growth in India during 2007–08 and the previous year could not be viewed as an unusual phenomenon. Indian economic growth had been largely enabled by a sustained increase in the level of domestic savings. The efficiency of resource use had also been high with a long-term incremental capital–output ratio of around 4, which was comparable to the record of the best countries in the world. How is the Reserve Bank affected by economic growth? In principle, economic growth impacts the Reserve Bank balance sheet. A 1 percentage point change in nominal GDP impacts the balance sheet positively by roughly 0.53 percentage point over the period 1990–91 to 2007–08 (data compiled by EPW Research Foundation).22 The size of the balance sheet expanded slowly at 13.1 per cent during the ten years ending 2002–03, and much more rapidly at 23.5 per cent during the next five years. This was an effect of higher growth rates. There was an unusual increase in the size of the balance sheet by 46 per cent during 2007–08, contributed essentially by

33

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the reserve bank of india a large increase of 55 per cent in foreign currency assets on account of net purchase of US dollars from the market.23

Money and Financial Markets Financial markets in India had seen major developments since the financial sector reforms initiated in the early 1990s. As the CFSA observed, in keeping with the evolving global financial developments and the ongoing Indian reforms, financial markets had emerged as the major channel of resource mobilisation during the reference period. The two decades since 1990–91 had seen tremendous growth in Indian equity markets. There were big changes in the market and settlement infrastructure, and major strides had been taken in areas of risk management, especially after the SEBI was empowered as the market regulator. The turnover in both cash and derivatives markets, along with market capitalisation and returns from stock markets, increased considerably. The Indian foreign exchange market volumes showed the fastest growth between 1998 and 2007 among the countries surveyed by the BIS. The total annual turnover increased from US$1.3 trillion during 1997–98 to US$12.3 trillion during 2007–08. The daily average turnover increased from about US$5 billion during 1997–98 to US$49 billion during 2007–08. The low and stable bid–ask spread of the INR/USD market was an indicator of the deep liquidity and efficiency of the market.  Given the important strategic intervention role that the government was required to play, the government securities market was one of the most important segment of the financial market. The market also served as an important transmission channel for monetary policy. Consequent to the various steps taken to develop the government securities market, there had been tremendous growth in both volume and liquidity in this segment. The outstanding stock of marketable government securities as a percentage of GDP increased from 14.3 per cent to 28.3 per cent during 1995–96 to 2007– 08 (CFSA, 2009). Trade associations like the Fixed Income Money Market Derivatives Association of India (FIMMDA) also played a crucial role in the development of the government securities market. The major steps taken for the development of the government securities market included diversification of the investor base to non-banks and retail segments, availability of varied hedging instruments for effective mitigation of interest rate risk across a diverse set of market participants, gradual increase 34

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the macroeconomic context in the number of trading days for short-selling in government securities along with appropriate borrowing/lending mechanisms in government securities and capacity building to study the suitability of a derivative product and its appropriateness. The important components of the money market in India were the interbank call (overnight) money, market repo, collateralised borrowing and lending obligation (CBLO), commercial paper, certificate of deposit and term money market. Treasury bills constitute the main instrument of short-term borrowing by the government. Historically, the call money market was the core of the money market in India. However, the collateralised segments, that is, market repo and CBLO, came into prominence in later years of the reference period. The market continued to be liquid. A better trading and settlement infrastructure, together with the introduction of financial market reforms, led to a decline in money market volatility. In the derivatives segment, the swap market (especially overnight index swaps) was the active segment and used by banks, as well as other entities, to manage their interest rate risk more than any other instrument. Interest rate deregulation had made financial market operations more efficient, but it had also exposed participants to increased risks. Interest rate derivative products could be an effective risk depressor in this regard. Rupee derivatives in India were introduced in July 1999, when the Reserve Bank permitted banks, financial institutions and primary dealers to undertake interest rate swaps and forward rate agreements. At the close of the reference period, when several money markets in developed countries experienced serious difficulties, the Indian money market continued to function normally. However, the inability of market participants to take a medium- to a long-term perspective on interest rates and liquidity, coupled with the absence of a credible long-term benchmark interest rate, was a major hurdle for further market development. The expansion of the corporate bond market could have been a source of long-term finance for corporates. But the development of this market suffered from a lack of interest from buyers, the absence of pricing of spreads against the benchmark, and a flat yield curve. It required further regulatory and legislative reforms for its development.

Fiscal Developments A positive development during this period was the overall improvement in fiscal indicators. But fiscal consolidation was a slow process (and it was 35

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the reserve bank of india halted in the wake of the 2007–08 global financial crisis). The fiscal position of the central and state governments in the face of increasing social and economic responsibilities had been under considerable stress until the early 2000s. Though the Fiscal Responsibility and Budget Management (FRBM) Act was passed in 2003, it was not until 2007–08 that the fiscal deficit level was brought down to less than 3 per cent of GDP in the case of the central government. The deficit levels were much higher at over 5 per cent until 2002– 03 (Table 2.7). The IMF had been continuously cautioning on this issue, and the Reserve Bank in its policy statements commented regularly on how such deficits complicated monetary management. The combined deficit of the central and state Governments remained well above 6 per cent until 2005–06 but in the last two years of the reference period, it was brought down to 5.1 per cent and 4.0 per cent, respectively. The total liabilities to GDP ratio worsened from 59.6 per cent to an average of 61.3 per cent in the case of the central government and from 69.1 per cent to 75.4 per cent in the case of the combined level for the centre and the states (between 1986–96 and 1997–2007). The continued high fiscal deficit position and higher levels of market borrowings were the two major reasons for the Reserve Bank to not support the separation of debt management function from monetary management – which was recommended by several committees – during the period. The CFSA noted that fiscal consolidation was a prerequisite for sustained growth. High fiscal deficits would crowd out private investments. Depending on how they were financed, fiscal deficits could have an adverse impact on the economy through movements in inflation, interest rates and the exchange rate. Some degree of fiscal adjustment or correction was achieved by a reduction in public investment during the reference period. Despite awareness of the risks, progress was mixed. Public sector savings continued to deteriorate during the 1990s and turned negative over the fiveyear period 1998–2003 owing to deterioration in savings of the government. There was some reduction in the centre’s fiscal deficits up to 1996–97. The process was reversed over the next few years under the impact of industrial slowdown and the Fifth Pay Commission24 award. Fiscal consolidation, which was envisaged to be achieved through revenue enhancement and curtailment in current expenditure growth, was brought about instead through compression of capital expenditure. A major problem with reforming public finances was 36

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the macroeconomic context fall in the gross tax–GDP ratio of the centre from 10 per cent in 1991–92 to 9.1 per cent in 1996–97 and further to 7.9 per cent in 2001–02, a fall mainly attributable to a reduction in tax rates. Table 2.7 Major Fiscal Indicators  Year

1997–98

Central Government

Combined Central and State Governments

Total Gross Revenue Monetised liabilities fiscal deficit deficit* deficit

Gross Revenue Total fiscal deficit liabilities deficit

56.2

5.7

1998–99

56.1

6.3

2000–01

59.4

5.5

1999–2000

(per cent of GDP)

56.8

3.0

3.7

5.2

3.3 3.9

0.8

0.7

6.4

73.7

-1.1

9.3

6.4

82.9

-1.9

7.2

-0.1

5.1

4.3

2003–04

66.0

4.3

3.5

-2.7

63.9

4.0

2.5

0.8

2004–05

65.5

2006–07

Average for 1997–98 to 2007–08

4.3

6.0

9.2

0.3

6.0 5.7

9.1

-0.2

8.7

9.6

8.3

6.8

6.5

2.7

79.1

61.4

3.3

1.9

61.3

4.8

3.1

-0.6

-2.3

4.0

0.2

Average for 1997–98 to 2002–03

59.8

5.7

3.7

0.0

63.1

3.6

2.3

Average for 1986–87 to 1996–97

59.6

6.3

2.6

Average for 2003–04 to 2007–08

58.9

2.5

1.1

78.8

83.2

2.4

2007–08

70.5

5.6

3.9

2005–06

66.3

67.1

63.4 66.9

4.0 6.1

-0.3

2001–02 2002–03

7.0

3.5

82.1

1.3

74.7

4.5

75.4

8.8

6.0

73.2

-1.2

6.2

2.7

78.1

1.3

7.7

3.2

69.1

7.6

71.4

Source: RBI, Database on Indian Economy (https://dbie.rbi.org.in/DBIE/dbie. rbi?site=publications). Note: * Refers to net RBI credit to the central government, which includes both primary and secondary market investments by the RBI.

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the reserve bank of india In view of the deterioration in fiscal deficits over 1997–98 to 2002–03 and rising public debt, a renewed emphasis was laid on improving the health of the public finances. The FRBM Act, 2003, and similar fiscal responsibility legislation at the state level were a means to achieve this aim. The idea behind the legislation was to implement rule-based fiscal policies at the centre and the states. The move paid off. Furthermore, the growth of revenues helped improve the situation from 2003–04 onwards. The strategy to raise revenue involved keeping tax rates moderate and broadening the tax by introducing service tax, removing exemptions, and making the tax administration more efficient. Reflecting these measures, the centre’s tax–GDP ratio rose from 8.8 per cent in 2002–03 to 11.8 per cent in 2007–08. On the expenditure front, while the total expenditure of the centre declined from 16.3 per cent of GDP in 2002–03 to 14.3 per cent in 2007–08, the capital outlay rose from 1.2 per cent to 2.1 per cent of GDP. The movement in key deficit indicators reflected the progress made in fiscal consolidation. The fiscal deficit of the centre and the states taken together had declined from 9.3 per cent of GDP in 2002–03 to 4 per cent in 2007–08, led by a reduction in revenue deficit from 6.4 per cent of GDP to 0.2 per cent. States benefited greatly from the introduction of rule-based fiscal consolidation. The role of the Reserve Bank was especially significant in achieving this. The Bank did much more than perform its mandated roles as a banker and debt manager of the state governments; it also worked to improve market access for resources, introduce innovations and transparency, and facilitate the introduction of FRBM Acts by the states. The Bank enabled conditions for the states to switch over to a full-fledged auction system for market borrowings. It also helped states in swapping high-cost debt with low-cost debt (also see Chapter 7).

External Sector Increasing openness was a defining feature of the process of change during the years of interest in the present study. Trade to GDP ratio increased from 21 per cent in 1997–98 to 34 per cent in 2007–08 (Table 2.8). There was substantial growth in the contribution of the net invisibles to GDP, rising, on average, from 1 per cent (1986–87 to 1996–97) to 3.7 per cent in the reference period.

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the macroeconomic context The inflow provided enormous support to the current account, mitigating in large measure the adverse effect of the deficit in the trade account. This was possible because of the rise in service exports and large inflows by way of remittances from expatriates during this period. Table 2.8 Balance of Payments Indicators  Year

(per cent)

Exports to GDP

Imports to GDP

Invisibles (Net) to GDP

1997–98

8.4

12.1

2.3

1999–2000

8.0

11.9

2.8

1998–99 2000–01 2001–02

8.0 9.5 9.1

2002–03

10.3

2004–05

11.8

2003–04 2005–06 2006–07 2007–08

Average for 1997–98 to 2007–08 Average for 1997–98 to 2002–03 Average for 2003–04 to 2007–08 Average for 1986–87 to 1996–97

10.7 12.6 13.6 13.4 10.5

11.1 12.2 11.4 12.3 12.9 16.5 18.8 20.1 20.8 14.5

Current Account Balance to GDP

Import Cover of Foreign Exchange Reserves (no. of months)

(-) 0.9

8.2

2.1 2.1 3.0 3.2 4.5

(-) 1.3 (-) 1.0 (-) 0.5

2.3

16.9

5.5

(-) 1.0

3.7

8.8

11.5

1.2 (-) 0.4

6.1

8.2

0.7

4.3 5.0

6.9

(-) 1.2 (-) 1.3 (-) 0.3

14.2 14.3 11.6 12.5 14.4 11.6

8.9

11.8

2.6

(-)0.3

9.6

12.4

17.8

5.1

(-) 0.3

13.9

6.5

9.1

1.0

(-) 1.6

5.0

Source: RBI, Database on Indian Economy (https://dbie.rbi.org.in/DBIE/dbie. rbi?site=publications).

Foreign investment flows into India, comprising foreign direct investment (FDI) and foreign portfolio investment (FPI), rose during the 1990s. Growing capital flows made it possible for the Bank to follow a policy of building up foreign exchange reserves as insurance against adverse external shocks. The 39

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the reserve bank of india import cover of foreign exchange reserves in terms of the number of months of imports improved substantially. The growth of inflows accelerated in the second half of the period. Net FDI flows and capital issues under American depository receipts (ADRs) and global depository receipts (GDRs) continued to support capital inflows. While the capital inflows eased the balance of payments situation, they posed dilemmas for the conduct of monetary policy as also for financial stability. Containing fluctuations in the exchange rate and the task of maintaining orderly conditions in the foreign exchange market became difficult to achieve. More specifically, if capital inflows outstripped the demand for foreign exchange, the appreciation of the domestic currency often necessitated interventions by the central bank to drain off the excess supply of foreign currency. In doing so, the accretion to official reserves implied an immediate expansion in primary money supply with consequences for maintaining price stability. In this context, judgements had to be made whether capital flows were of an enduring nature or temporary, which were difficult to make ex ante. The judgement about excessive volatility would depend not merely on the quantity of the flow but, to some extent, on the quality in terms of components of the capital flow. India’s approach to the capital account had consistently made a distinction between debt and equity, with greater preference for liberalisation of equity markets vis-à-vis debt markets. Equity markets provided risk capital. In view of higher domestic nominal interest rates, open debt markets could attract large capital flows and further add to sterilisation costs. Thus, debt flows into India were subject to ceilings. The CFSA recognised the role of capital account liberalisation in promoting growth among developing countries but recognised that this should be done strategically to help the evolution of Indian financial markets in alignment with improvements in macroeconomic management. Among the more important areas of improvement were: fiscal consolidation, sustained reduction in inflation to international levels, strengthening the banking system, diversifying financial intermediation through both banks and nonbanks, and strengthening the regulation of financial markets.

Conclusion India witnessed markedly robust economic expansion during the reference period, thanks to economic reforms initiated in the mid-1980s, which were 40

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the macroeconomic context further strengthened since 1991, and the increasing integration of the Indian economy with the world economy. Most of the economic parameters showed positive and accelerated improvements during the reference period, particularly during the latter half, compared to the previous eleven years – 1986–87 to 1996–97. While there were political uncertainties and frequent changes of governments, the focus on reforms was not lost. There were many strengths of the Indian economy but towards the end of the reference period, there were also many challenges that needed to be addressed. The Reserve Bank had to function and adapt its policies and operations to these macro developments.

Notes

1. Governor Ben Bernanke’s speech at the Federal Reserve Board, 2004, available at https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/default. htm. 2. International Monetary Fund, World Economic Outlook (Washington DC: IMF, 1999). Also see Mary M. Shirley, ‘The What, Why and How of Privatization: A World Bank Perspective’, Fordham Law Review 60, no. 6 (1992): S23–S36. 3. On the Asian crisis, a large literature exists. A useful contemporary analysis can be found in Steven Radelet, Jeffrey D. Sachs, Richard N. Cooper and Barry P. Bosworth, ‘The East Asian Financial Crisis: Diagnosis, Remedies, Prospects’, Brookings Papers on Economic Activity, no. 1 (1998): 1–90. 4. International Monetary Fund, World Economic Outlook, April 1998 to April 2008 (Washington DC: IMF, 2009). 5. Ibid. 6. India was one among the twelve pilot countries to volunteer for financial sector assessment. 7.  Ashok Chawla was Secretary, Department of Economic Affairs, from 6 September 2008; D. Subbarao was Finance Secretary from 16 July 2007 to 5 September 2008; and Ashok Jha was Finance Secretary from 13 September 2006 to 15 July 2007. The composition of the committee may be seen here: https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/CFSA1.pdf. 8. IMF sources reported a 31 per cent increase of average petroleum spot price during 2004 and a further increase by 50 per cent in 2005. 9. M. Ayhan Kose and Eswar Prasad, Emerging Markets: Resilience and Growth amid Global Turmoil (Washington DC: Brookings Institution Press, 2010). Net exporters of capital refer to countries running ‘current account surplus’. China had been a regular capital exporter whereas India was a capital exporter during three consecutive years from 2001–02 to 2003–04. 41

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the reserve bank of india 10.  The scholarship on India’s growth turnaround since the 1980s, the contribution of the economic reforms to the process, and the ideological debates over liberalisation is now very large. A selective bibliography should include Ashok Kotwal, Bharat Ramaswami and Wilima Wadhwa, ‘Economic Liberalization and Indian Economic Growth: What’s the Evidence?’ Journal of Economic Literature 49, no. 4 (2011): 1152–99; Arvind Panagariya, India: The Emerging Giant (Oxford and New York: Oxford University Press, 2008); Kunal Sen, ‘Why Did the Elephant Start to Trot? India’s Growth Acceleration Re-examined’, Economic and Political Weekly 42, no. 43 (2007): 37–47; Dani Rodrik and Arvind Subramanian, ‘From “Hindu Growth” to Productivity Surge: The Mystery of the Indian Growth Transition’, IMF Staff Papers 52, no. 2 (2005): 193–22; and Montek S. Ahluwalia, ‘Economic Reforms in India since 1991: Has Gradualism Worked?’ The Journal of Economic Perspectives 16, no. 3 (2002): 67–88. 11. As per the revised national accounts series with base year 2011–12, the growth averaged lower at 7.9 per cent. 12. The Y2K issue refers to the problems of digitally storing and recording calendar data for years after 2000. 13. For an example of a work that stresses attitudes more, see Rodrik and Subramanian, ‘From “Hindu Growth” to Productivity Surge’; for an example of a work that stresses political alliances and pro-business tilt, see Atul Kohli, ‘Politics of Economic Growth in India, 1980–2005, Parts I and II’, Economic and Political Weekly 41, nos 13–14 (2006): 1251–59 and 1361–70. 14. RBI, Annual Report, 2007–08, 2008. 15. Shujiro Urata, ‘The Indian Economy: Growth, Challenges, and Regional Cooperation’, in Asia Research Report 2009 ( Japan Center for Economic Research, 2010). 16. Government of India and Reserve Bank of India, India’s Financial Sector: An Assessment – Committee on Financial Sector Assessment Reports, Vol. 4 (New Delhi: Cambridge University Press, 2009). 17. K. Kanagasabapathy, Post-Reform Performance of the Private Corporate Sector (Mumbai: EPW Research Foundation, 2009). 18.  Ramesh Jangili and Sharad Kumar, ‘Determinants of Private Corporate Sector Investment in India’, Reserve Bank of India Occasional Papers 31, no. 3 (2010): 67–89. 19. A committee headed by Professor Sukhamoy Chakravarty to review the working of the monetary system in India. 20. See, for example, Reserve Bank of India (2002), Report on Currency and Finance, Chapter 5, available at https://rbidocs.rbi.org.in/rdocs/Publications/ PDFs/25525.pdf; R. Kannan and Himanshu Joshi, ‘Growth–Inflation Trade-off: Empirical Estimation of Threshold Rate of Inflation for India’, Economic and Political Weekly 33, nos 42–43 (17–30 October 1998): 272442

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the macroeconomic context 28; K. Mohaddes and M. Raissi, ‘Does Inflation Slow Long-Run Growth in India?’ IMF Working Paper No. WP/14/22, Washington DC, December 2014, available at https://www.imf.org/external/pubs/ft/wp/2014/wp14222. pdf; Deepak Mohanty, A. B. Chakraborty, Abhiman Das and Joice John, ‘Inflation Threshold in India’, RBI Working Paper Series (DEPR), 18/2011, October 2011. 21. For alternative estimates of potential output, and more discussion on the topic, see Rajiv Ranjan, Rajeev Jain and Sarat C. Dhal, ‘India’s Potential Economic Growth Measurement Issues and Policy Implications’, Economic and Political Weekly 42, no. 17 (2007): 1563–72; Barendra Kumar Bhoi and Harendra Kumar Behera, ‘India’s Potential Output Revisited’, RBI Working Paper Series (DEPR), 05/2016, April 2016. 22. Until 2019–20, the Reserve Bank’s accounting year was from July to June. The span of the accounting year has been changed to April to March, in alignment with that of the government, with effect from 2021–22. In the process of transition, the accounting year ran from July to March for 2020–21. 23. RBI, Annual Report, 2007–08. 24.  The Pay Commissions review the pay structure of civil and military establishments of the Government of India. Since 1947 until the present, seven Pay Commissions were formed. The Fifth Pay Commission (1996– 2006) generated a controversy for the large pay rise it recommended.

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3 Monetary Management

Introduction The conduct of monetary policy underwent significant changes during the years 1997–98 to 2007–08. Changes occurred in objectives, instruments, monitoring of economic indicators and the process of policymaking, including legal procedures. The present chapter will describe these changes. The rest of the chapter is divided into seven sections. Six of these deal with, in that order, the shift from monetary targeting to multiple indicators approach to monetary management, the liquidity adjustment facility (LAF), the Market Stabilisation Scheme (MSS), implications of the new regime for the Bank Rate, pricing of bank credit, and changes in process and legal procedures. A brief account of the main areas of change may be useful, to begin with, to set the stage for a more detailed narrative the rest of the chapter will present.

An Overview

Objectives of Monetary Policy Monetary policy traditionally served two objectives: keeping inflation under control and ensuring adequate flow of credit to the economy. During the reference period, these two remained the main aims. The relative emphasis, as usual, could shift from one to the other, depending on market conditions. From the late 1990s, a third objective was added. The change came mainly in response to developments in the external sector. This was to achieve financial stability by maintaining orderly conditions in financial markets (money, government securities and foreign exchange markets) and sustaining the health of the banking system in the face of increasing exposure to foreign currency inflows and external shocks.1 44

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monetary management

Instruments The instruments of monetary management changed during the reference period. Until 1997, regulation of bank credit via direct and indirect means, mainly interest rate regulation, was the most important instrument. Monetary management was earlier carried out through open market operations (OMOs) in the form of outright purchase or sale of government securities, regulation of the reserve ratio (or cash reserve ratio, CRR) and the statutory liquidity ratio (SLR), or mandatory holding of government securities by banks. The CRR was the major instrument for absorbing liquidity in the period before India’s economic liberalisation began and was usually set at a relatively high level. In addition, various refinance facilities helped the Reserve Bank ration out liquidity among banks for short periods. These elements were not completely given up during the reference period, but there was a shift away from administered interest rates towards market-driven interest rates, deregulation of credit supply, and marketbased auctions for government borrowing programmes, and along with all this, greater transparency and consultation with market participants and economists. The shift followed the trajectory of reform set out in the report of the Committee on the Financial System (1991),2 famously known as the Narasimham Committee I. In April and October 1997, the CRR and SLR were drastically reduced, and banks’ boards were empowered to take decisions on interest rates and provided with greater operational flexibility.3 At the same time, the automatic monetisation of government deficits came to an end.4 The decisive change that made the deregulation possible took place in the sphere of liquidity management, in the shape of a LAF. The LAF allows sale and purchase operations in government securities carrying a repurchase agreement clause (or repo).5 It operates through daily repo and reverse repo auctions, which set a ‘corridor’ for short-term interest rates. It allows the central bank to modulate short-term liquidity daily and to de-emphasise the targeting of bank reserves, make interests rates free of administrative control, and focus on stabilising interest rates instead, while at the same time allowing banks more freedom of operation. The LAF was introduced in 2000. The time span of this volume saw it being established, reviewed and fine-tuned. OMOs, including and especially repo operations, emerged as the principal instrument of liquidity management. In place of the Bank Rate, the repo rate evolved gradually into a signal to 45

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the reserve bank of india reflect conditions of the money market. This change, as we shall see, gave rise to extensive discussion on what, if any, role the Bank Rate should perform. The desire to phase out all sector-specific systems of liquidity injection in favour of only market-based repo/reverse repo operations had been expressed before and was operationalised between 1997 and 2007. But there were a few exceptions. Since the export sector was considered a priority, export refinance facility (ERF) was continued. Furthermore, since primary dealers (PDs), given their new role and limited access to resources, wanted assured liquidity support, some collateralised support was extended to them. The MSS was yet another innovation introduced in 2004 to handle the sterilisation of the liquidity impact of a surge in foreign exchange inflows during the latter part of the reference period. On the pricing of bank credit, banks were given freedom to fix their own prime lending rates (PLRs) as early as 1994. The position was continually reviewed and refined during the reference period.

Monitoring Economic Activity There was a change in the mode of monitoring economic activity and assessing the need for intervention. Traditionally, central banks tried to influence output and prices by controlling a variable that had a stable and predictable relationship with output and prices. The Reserve Bank was using M3 (broad money) as the intermediate target until 1997.6 With the movement towards market operations and away from direct regulation, policy statements started focusing increasingly upon movements in financial market rates and liquidity conditions before drawing appropriate policy stances in relation to policy rate and liquidity management. In this way, the rule of ‘monetary targeting’ gave way to a ‘multiple indicators approach’ in managing liquidity in the economy. In the new regime, a range of monetary and financial market indicators, such as credit, interest rates, exchange rates and prices, began being monitored.

Process Finally, the process of policymaking went through deep changes. The Reserve Bank redefined its relations with the market by creating frequent occasions for consultation with market participants, many of them relatively new, increasing the frequency of policy announcements, and involved external experts and 46

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monetary management economists into the consultation process. The Bank also redefined its relations with the government and the legal remits of its own operations. In the long run, the reform in the conduct of monetary management stayed its course because it was aided by three legislative actions – the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, amendments to the Reserve Bank of India (RBI) Act, 2006, and the Banking Regulation Act, 2007. The Reserve Bank played a key role in spearheading these reforms and setting out the design of new laws and amendments.7 Formally, the decision-making power in all policy announcements rested with the Reserve Bank Governor. The Governors in question during this time span were C. Rangarajan, Bimal Jalan and Y. V. Reddy (see Table 2.2).8 The Reserve Bank Governors held pre-policy consultations with the Finance Minister and the Technical Advisory Committee on Monetary Policy, or TACMP (set up in 2005), consisting of eminent economists and experts from the financial sector. The process of internal consultation was aided by the Deputy Governors, especially the officer in charge of monetary policy and the Executive Director and officials of the Monetary Policy Department (MPD). As a follow-up, mid-term reviews of the annual policy statement were undertaken in October or November. Since 2005–06, two quarterly reviews of monetary policy have been introduced in the months of July and January, in addition to the already established practice of one annual and one half-yearly announcement.

Shift from Monetary Targeting to Multiple Indicators Approach The Multiple Indicators Approach

With the liberalisation of interest rates, the limitation of the monetary targeting approach was recognised in 1997. The Reserve Bank formally adopted a multiple indicators approach, in place of monetary targeting, in April 1998. In the latter case, a monetary aggregate is held as the target to achieve the objectives of inflation control and credit supply for growth. In the former, there is no one nominal anchor, such as money supply or an interest rate or the exchange rate; instead, ‘movements not only in money supply but also in a host of economic variables are tracked for policy responses’.9 As part of this approach, information content from a range of quantity variables, such as money, credit, output, trade, capital flows and fiscal position, as well as rate variables, such as rates of return in different markets, inflation 47

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the reserve bank of india rate and exchange rate, were analysed to guide monetary policy actions. It was a considered decision not to adopt the option of one-instrument-onetarget, which was deemed to be an oversimplification of reality. To respond to the changing environment, the Credit Planning Cell, responsible for the formulation of monetary policy and other policy initiatives, was renamed as the Monetary Policy Department on 1 January 1998. This was necessary in the context of the growing integration of money, foreign exchange and other financial markets. The emphasis, thereafter, shifted to market analysis, policy evaluation and implementation techniques.10 A previous paradigm shift, which led to the adoption of the monetary targeting approach, had been influenced by lengthy deliberations that followed the Committee to Review the Working of the Monetary System (1985), better known as the Sukhamoy Chakravarty Committee. By contrast, the 1998 shift occurred quickly and internally. A draft note on monetary policy for 1998–99, prepared by A. Vasudevan, Executive Director, dated 19 March 1998 and submitted to the Reserve Bank Governor, significantly influenced the policy shift from monetary targeting to a multiple indicators approach presented in the Monetary and Credit Policy for the first half of 1998–99 on 29 April 1998. There appears to be no formal reference made to the government in this regard. In several countries in the 1980s, monetary targeting lost favour and inflation targeting gained ground.11 The underlying reason was the apparent instability in the relationship between money, output and prices, or the demand for money function. This was, however, not the case in India. At least until 1997, the stability of demand for money in India was never questioned. The Reserve Bank’s Annual Report 1996–97 defended monetary targeting by restating its advantages: ‘Monetary aggregate as an intermediate target is useful since it helps to predict price movements with reasonable accuracy over a period of time. It is also easily understood by the public at large as indicative of the stance of monetary policy.’12 While monetary targeting did not completely lose credibility, it was coming into question for different reasons. In a practical sense, between 1985 and 1998, on only four occasions were the monetary targets achieved. Following a slowdown in credit growth during 1995–97, former Reserve Bank Governor S. Venkitaramanan remarked: ‘India has been crucified on the monetarist paradigm, which makes expansion of credit a by-product of decisions on the numbers that go to make up M(1), M(2) and M(3).’13 Furthermore, the reaction lag of policy actions under the monetary targeting

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monetary management approach was considered to be too long, particularly under volatile market conditions. Before the formal adoption of the multiple indicators approach under his governorship, Governor Jalan observed that an important lesson from the developments in the exchange markets was that all countries, developing countries in particular, had to be constantly watchful, indirectly calling for a flexible and discretionary approach. In fact, it was the pace of trade and financial market development, following the initiation of structural reforms in the early 1990s, that rendered the efficacy of broad money as a target of monetary policy questionable. In December 1997, the Reserve Bank set up a working group on ‘Money Supply: Analytics and Methodology of Compilation’ (Chairman: Y. V. Reddy, Deputy Governor) to examine the analytical aspects of the monetary survey. While the working group did not find evidence of parameter instability for the period 1970–71 to 1996–97, it recognised that the predictive stability of the money demand equation was equally important for its use for policy purposes. Before the group submitted its report ( June 1998), the Reserve Bank’s Monetary and Credit Policy for the first half of 1998–99 observed: ‘It is not easy to evolve, in the present circumstances, a monetary conditions index or a clear-cut interest rate channel of transmission of the effects of monetary policy…. It is necessary to adopt a multiple indicator approach.’ The experience of the 1990s had also shown that relying solely on a single instrument, growth in M3, was no longer possible. The movements in market rates of interest, exchange rates, foreign exchange reserves, credit to the government and commercial sectors, and the fiscal position of the government had been closely monitored and utilised for policy actions (Box 3.1). Since the mid-1990s, apart from dealing with the usual supply shocks, monetary policy had to increasingly contend with external shocks emanating from swings in capital flows, volatility in the exchange rate, and global business cycles. In short, there was increasing evidence of changes in the underlying transmission mechanism of monetary policy with interest rate and the exchange rate gaining importance vis-à-vis quantity variables. An alternative to monetary targeting would have been inflation targeting, a position recommended by multilateral institutions such as the International Monetary Fund (IMF). This, however, did not find favour with the Reserve Bank.14 The Monetary and Credit Policy for the year 2000–01 stated that ‘the high frequency data requirements including those on a fully dependable inflation rate for targeting purposes are yet to be met’.15 Since India was introducing structural changes during the reference period, forecasting of inflation was rendered difficult.

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the reserve bank of india Box 3.1 Reflections on the Multiple Indicators Approach [Under multiple indicators approach], the rate of interest became the target variable or the instrument variable which you want to manipulate rather than money supply…. [T]his was made possible only because of the reforms we had introduced between 1992 and 1997. Until we dismantled the administrative structure of interest rates, you could not use interest rate as a policy variable. 

C. Rangarajan, former Governor of RBI

... I found this whole multiple indicator approach to be a bit of a jumble…. [T]he big downside of the multiple indicators approach was that it gave too much play to the central bank – too many degrees of freedom. Any policy step could be interpreted in diverse ways with the result that markets were oftentimes confused about central bank intentions. 

D. Subbarao, former Governor of RBI

Liquidity Adjustment Facility Introduction of LAF

The Committee on Banking Sector Reforms (1998, better known as the Narasimham Committee II), as part of its recommendations on integration of the financial market, observed that the interest rate movement in the interbank call money market should be orderly and that could only happen if the Bank had a presence in the market through repos for as short a period as one day through primary markets. The Bank should introduce a LAF under which it would reset, daily if necessary, the repo and reverse repo rates. The committee also recommended phasing out non-banks from the call or notice money market to make it a pure interbank market. The Reserve Bank broadly agreed with the Narasimham Committee II’s suggestion and decided ‘to take all actions that will enable, in due course, to replace general refinance facility’, or the GRF, with security transactions.16 However, for procedural reasons, a partial or interim LAF was recommended at first, pending technological and procedural changes, to facilitate electronic transfer and settlement. The interim LAF, or ILAF, would operate through reverse repos for absorption of liquidity and lending against collateral of central government securities for injection of liquidity. 50

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monetary management A major challenge was to rationalise the existing sector-specific lending facilities at different rates from the Reserve Bank, often without any reference to market rates. In principle, the automatic additional liquidity available through refinance facilities to banks and PDs would constrain the effectiveness of the LAF. The ILAF took this into account and introduced the following measures. First, the GRF was replaced by a collateralised lending facility (CLF) of up to 0.25 per cent of the fortnightly average outstanding aggregate deposits in 1997–98, which would be available for two weeks at the Bank Rate. An additional CLF for an equivalent amount would also be available at the Bank Rate plus 2 per cent. Lending availed for periods beyond two weeks would be subject to a penal rate of 2 per cent for an additional two-week period. There would be a cooling period of two weeks thereafter. The existing restriction on participation in the money market (during the period that such facilities were made use of ) was withdrawn in order to facilitate adjustment in liquidity.17 Second, scheduled commercial banks became eligible for export credit refinance facility at the Bank Rate (15 April 1997). Third, liquidity support against the collateral of government securities would be available to PDs at the Bank Rate and the amounts would remain constant throughout the year. Each withdrawal would be subject to the usual restriction of repayment within ninety days. The limits for individual PDs were announced separately. Additional liquidity support would also be provided to PDs. The ILAF operated through a combination of reverse repo at a fixed rate, export credit refinance, collateralised lending facilities and open market operations. A substantial use had been made of export credit refinance and collateralised lending facilities. There was, however, an asymmetry in respect of absorption and injection of liquidity. Whereas funds could be absorbed without any limit (limited only by the availability of securities with participants) at a fixed rate, only a fixed quantum of funds could be injected at the Bank Rate or Bank Rate plus 2 per cent. The short-term market rates could not breach the floor given by the fixed reverse repo rate but exceed the ceiling rate under deficit conditions. Furthermore, under the ILAF, multiple lending facilities at multiple rates continued. The ILAF called for a review of the role of the Bank Rate. An informal internal group set up on 18 May 1999 examined this question (for more detailed discussion, see next section).18 The group observed that a review of developments in operating procedures showed that changes in the Bank Rate were complemented by other measures like changes in the CRR and in 51

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the reserve bank of india reverse repo rate, and such a combination of measures added credibility to the policy stance taken by the Bank. Effectively, the Bank Rate had become a signalling rate. The group pointed out an anomaly. Under the system prevalent then, which assured potential liquidity for definite amounts at pre-committed rates, the Reserve Bank had little manoeuverability for tightening liquidity temporarily unless it changed the Bank Rate. Further, the assured support at assured rates also created a certain complacency among the PDs to buy and hold securities rather than trade and distribute them. The group observed: ‘[A] ll facilities and accommodations at present provided at the Bank Rate should be dispensed with since it is the assured availability of large funds at this rate that has made the Bank Rate a ceiling rate for call money market.’19 In a meeting held between the internal group and representatives of industry bodies on 4 February 2000, the Primary Dealers’ Association of India (PDAI) voiced concerns that in the absence of the Bank’s liquidity support, they would become vulnerable to market forces since LAF rates would be decided in auctions. They argued that the PD system was still new. In fact, a few of them had not even completed a year. Their minimum capital requirement ( 50 crore) was low, which impaired their ability to borrow from the market. Their return on investment in government securities was relatively low. If their ability to hold a higher level of stocks for trading was curtailed, they might not be able to achieve sufficient levels of turnover. For all these reasons, the absence of the Reserve Bank’s liquidity support would make them vulnerable in the market. The Bank members in the meeting pointed out that liquidity support during the financial year was high enough, imparting stickiness in the call rates at the upper range, and that it was not desirable for a central bank to make available large sums for a continued period on an assured basis. There was, therefore, a need to move over to a more flexible system of liquidity support. In any case, the concerns of PDs were addressed by retaining liquidity support to them as part of the new scheme. In a subsequent meeting with PDs (8 March 2000), the Chief General Manager of the Internal Debt Management Department (IDMD), Usha Thorat, announced that a last resort or ‘back-stop facility’ could be considered. Before these discussions began, a phased introduction of LAF had been planned. In the first stage (from 5 June 2000), the additional CLF and Level-II support to PDs would be replaced by variable rate repo auctions with sameday settlement. In the second stage, CLF and Level-I liquidity support would also be replaced by variable rate repo auctions. With full computerisation 52

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monetary management of the Public Debt Office of the Reserve Bank and the introduction of real time gross settlement (RTGS) by the end of the financial year 2000–01, repo operations through electronic transfers would be introduced. In the final stage, it would be possible to operate LAF at different timings on the same day. There was no change in the export credit refinance scheme. Given some rigidities in the interest rate structure and the desirability of giving maximum support to exporters, there was a case for the scheme of export credit refinance to continue for some more time. In addition to the regular reverse repo auctions, additional reverse repos for periods varying from three to seven days were introduced from 3 August 2000 as a measure of currency support. A weekly calendar of additional repos was worked out for internal purposes, but auctions were announced a day before the auctions. A review (24 November 2000) showed that the market interest for these additional reverse repos was fading and proposed that these could only be resorted to under extraordinary circumstances when there was a need to absorb liquidity on a continuous basis for longer periods – hence the additional reverse repo. The practice of preparing a calendar for that purpose could be discontinued.

Review of Operation A review of the scheme undertaken by the IDMD about two weeks after its introduction made a few interesting observations.20 The LAF was launched in a situation when worries over the dollar–rupee exchange rate had necessitated tightening of liquidity in the domestic market. The market was witnessing upward movement in yields, which subdued the demand for government securities, pushing down the prices of securities on a day-to-day basis, and turned market sentiment negative. As the volume of lending in the call money market fell, banks turned to LAF. The LAF rates were relatively high, and the PDs demanded assured support even at the higher rate. Based on the review, the IDMD concluded that assured liquidity support, in this case, would dilute LAF, and such support could be considered by reducing some other forms of assured support, such as export refinance. The Adviser-in-Charge, MPD, K. Kanagasabapathy, noted that the operations of the LAF were unduly influenced by volatility in the foreign exchange market, and that the role of PDs and their place in the market had to be viewed specially, since high call rates for a number of days may adversely affect their function and viability. The note also advocated uniform price auctions (more on this later). 53

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the reserve bank of india In April 2001, an internal group recommended that the system of uniform price repo auctions could be replaced with discriminatory price with a view to making the market more sensitive to trades while bidding. Second, with a view to providing interest rate signals, the Bank should have the option to switch over to fixed-rate volume tender reverse repos on overnight basis when necessary. Third, a ‘backstop facility’ should be made available to banks and PDs. Fourth, although long-term repos were not favoured as a rule, at times of exigencies and when there was a need to either mop up or inject liquidity on a longer-term basis as a result of large unanticipated flows, multi-period repos could be used. Fifth, to activate interest in treasury bills (T-bills), there was the need to focus on a few maturities and to enhance the volume in primary issues of these bills. It would, therefore, be desirable to discontinue issuance of 14-day and 182-day T-bills and enhance the amount in respect of 91-day and 364-day T-bills.

The Second Stage In 2001–02, the Bank moved forward to implement the second stage of the LAF. The move consisted of several steps – introducing multiple auctions within a day, which would be feasible after the proposed introduction of electronic transfers of funds and securities, the phasing out of all liquidity support, and working towards a pure interbank call/notice money market. The Monetary and Credit Policy for the year 2001–02 announced a package of measures encompassing changes in operating procedures of the LAF, including auction methods and periods, a strategy for a smooth transition of the call money market to a pure interbank market, and a comprehensive and coherent programme for rationalisation of liquidity support available to the system. The main forms of liquidity support then were support to banks at the Bank Rate under a CLF and export credit refinance, and collateralised support to PDs. The main reform consisted of splitting liquidity support into ‘normal’ and ‘backstop’ components, the former to be provided at the Bank Rate, and the latter at a variable daily rate linked to rates emerging in regular LAF auctions or, in the absence of such rates, to the Mumbai Interbank Offered Rate (MIBOR). Of the total limit of liquidity support available to PDs and banks, the normal facility would initially constitute about two-thirds and the back-stop facility about one-third. Primary dealer-wise and bank-wise limits were announced separately. 54

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monetary management Banks were provided export credit refinance based on outstanding export credit eligible for refinancing on an incremental basis over a base date. It had been observed that some banks that had large exposure to the export sector on the base date were either unable to get any refinance from the Reserve Bank or had very small entitlements. The Bank had, therefore, decided to rationalise the export credit refinance facility so that it could focus more on the extent of the total credit support being provided by banks to exporters. The new limits would be fixed based on the total outstanding export credit eligible instead of the incremental export credit eligible over a base date. The Bank decided that from 5 May 2001, scheduled commercial banks would be provided export credit refinance to the extent of 15 per cent of the outstanding export credit eligible for refinancing as at the end of the second preceding fortnight. As a matter of further comfort to all banks, the existing refinance limit would constitute the minimum limit available for a bank until 31 March 2002. Further, several measures were taken to improve the LAF operating procedures, including a reduction in minimum bid size, extension of the timing of auctions, the supply of additional information to the market, and use of fixed-rate reverse repo and longer-term reverse repo. A discussion with market participants on the advantages, or otherwise, of uniform price auctions as opposed to variable price auctions was resolved into a decision to allow variable price auctions on an experimental basis in 2001. Overall, the opinion of the internal monitoring groups and market bodies on the operation of the LAF was positive. But a surge in capital flows from 2002–03 put liquidity management under strain and forced the Bank to play a delicate balancing act between monetary management and financial stability. The average annual capital inflow, which stood at US$3.3 billion between 1990–91 and 1999–2000, shot up to US$14.8 billion from 2000–01 to 2004–05. During that period, the Reserve Bank’s stock of central government securities was being used in reverse repo operations under LAF, OMO sale of securities, investment of surplus funds of governments into central government securities, investment in the Consolidated Sinking Fund and the Guarantee Redemption Fund besides backing up note issue. The balance consisted of non-marketable securities. Initially, the inflow was sterilised through the LAF and OMOs.21 Later, other measures were used for this purpose, including the 91-day T-Bills, encouraging state governments to prepay high-cost debt of the centre and foreign exchange swaps. Capital account transactions were further 55

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the reserve bank of india liberalised, for example, rules regarding overseas investments and remittances abroad were relaxed. In view of the need to create effective systems of sterilisation and free the LAF of this large burden, two internal groups were constituted to review the operation of monetary policy.

Two Reviews: 2003 The internal groups – one on the LAF and another on instruments of sterilisation – discussed some of the operational problems and suggested further refinements in the system. Their analyses and recommendations were compatible so that the Reserve Bank had to consider them together for drawing policy conclusions.22 These two reports paved the way for the introduction of the Market Stabilisation Scheme (see the next section of this chapter, and Box 3.2). Between January and March 2004, several proposals were made.23 First, the Reserve Bank may conduct reverse repo under the LAF based on fixedrate auction while retaining the option to conduct variable-rate reverse repo auctions. The minimum tenure of the repo would be changed from overnight to seven days to be conducted on daily basis. The Reserve Bank would have the discretion to hold both overnight repo and longer-term repo as and when required. Second, to relieve the economy of temporary shortages of funds, the Reserve Bank may continue with repo under the LAF on a fixed-rate auction basis. The tenure would be overnight. Third, the reverse repo rate, acting as policy rate, would continue to be announced taking into account various macroeconomic policy parameters. Fourth, the Bank Rate would be aligned with the repo rate, but changes in the former would be considered on merit from time to time. Fifth, the amount under standing liquidity facilities offered to banks would be made available at a single rate. Accordingly, a normal facility and a backstop facility may be merged into a single facility made available at repo rate. The Financial Markets Committee (FMC-RBI) accepted the proposals. The revised scheme came into effect from 29 March 2004. As per the revised scheme, 7-day fixed-rate reverse repo auctions were conducted on a daily basis. It was indicated that the reverse repo rate would be fixed by the Reserve Bank from time to time (see Table 3.1 for revisions in rates since 2004; also see Box 3.2). 56

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monetary management Box 3.2 Internal Group on the Liquidity Adjustment Facility (2003) The group reviewed the first three years of the operation of the LAF and raised the following points. First, there was a need to clarify the role of the Bank Rate vis-à-vis the reverse repo rate in signalling the approach of monetary policy. Second, despite some rationalisation of interest rates, which was one of the objectives of the LAF, multiple interest rates persisted. Third, the relative position of the reverse repo rate within the interest rate corridor was subject to a debate. International experience showed that central banks preferred keeping liquidity in shortage mode and, therefore, the policy signalling rate in the form of repo rate was placed in the middle of the corridor. However, under the LAF, the reverse repo rate was placed at the bottom of the corridor and acted as both the policy rate as well as the rate for passive sterilisation of excess liquidity from capital flows. Fourth, the surge in capital flows from 2002–03 onwards forced the Reserve Bank to maintain a balance between monetary management and financial stability. Initially, such inflows were sterilised through the LAF and OMOs, but the Reserve Bank’s portfolio was limited. To address the situation, the entire stock of non-marketable special securities issued by the government to the Reserve Bank was converted into the tradable lot in two tranches by September 2003. Fifth, the Reserve Bank’s reverse repo operations tended to substitute market activities in call/notice money, term money, and market reverse repo operations. Banks seemed to have less incentive to lend fully in call/notice market in the presence of a narrow spread between the call rate and the repo rate. In fact, after considering credit risk, banks preferred to lend even at a marginally lower rate through reverse repo. The reverse repo in its existing form appeared to hinder market developments as it provided a haven to market participants. Whereas the placement of funds under the LAF window should normally take place as a matter of last resort, with the persistence of excess liquidity, the window was being treated as an absorber of funds of the first resort. Sixth, the group recommended a standing deposit facility, which would provide more flexibility to the Reserve Bank’s reverse repo operations and impart a floor to the movement of call money rates. However, it appeared that the RBI Act, 1934, did not permit borrowing on a clean basis and payment of interest thereon.

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the reserve bank of india Table 3.1 Revisions in Reverse Repo and Repo Rates 2004–08 Effective Date 27 October 2004 29 April 2005

26 October 2005 24 January 2006 8 June 2006

25 July 2006

31 October 2006 31 January 2007 31 March 2007

30 October 2007

Source: RBI.

Reverse Repo Rate (in per cent)

Repo Rate (in per cent)

Spread (in basis points)

5.00

6.00

100

4.75 5.25 5.50 5.75 6.00 6.00 6.00 6.00

6.00*

6.00 6.25 6.50 6.75 7.00 7.25 7.50 7.75

7.75*

125 100 100 100 100 125 150 175

175*

Note: *These remained unchanged until the end of the reference period.

With full computerisation of the Public Debt Office of the Reserve Bank and the introduction of the RTGS system in 2005–06, repo operations could be performed through electronic transfers at different times of the same day. Around this time, the economy witnessed strong and sustained credit demand, lower accretion of foreign exchange reserves, the build-up of the centre’s cash balances with the Reserve Bank, and redemption of India Millennium Deposits (IMDs). To manage liquidity better, a second LAF (SLAF) was introduced in November 2005. The SLAF was used periodically, depending on liquidity conditions (see Figure 3.1 on volumes of transaction under all LAFs and movements in call money rate). The eight-year period from the introduction of the LAF to its 2004 reform was a success story for the Reserve Bank’s monetary operations and alignment with international practice in managing liquidity. One reason for the success was the transparent and consultative way in which the whole process was carried out. The MSS, as mentioned, provided a backdrop to the reforms.

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monetary management Figure 3.1 Liquidity Adjustment Facility and Weighted Average Call Rate Chart 3.1: Liquidity Adjustment Facility and Weighted Average Call Rate 1500

₹ Billion

500

24

0

18

Per Cent

30

1000

-500 12

-1000

6

-2000

5-Jun-00 5-Sep-00 5-Dec-00 5-Mar-01 5-Jun-01 5-Sep-01 5-Dec-01 5-Mar-02 5-Jun-02 5-Sep-02 5-Dec-02 5-Mar-03 5-Jun-03 5-Sep-03 5-Dec-03 5-Mar-04 5-Jun-04 5-Sep-04 5-Dec-04 5-Mar-05 5-Jun-05 5-Sep-05 5-Dec-05 5-Mar-06 5-Jun-06 5-Sep-06 5-Dec-06 5-Mar-07 5-Jun-07 5-Sep-07 5-Dec-07 5-Mar-08

-1500

Reverse Repo Amount Repo Rate (Right Scale)

Repo Amount Reverse Repo Rate (Right Scale)

0

Call Rate (Right Scale)

  Source: RBI.

Market Stabilisation Scheme The MSS was established following a memorandum of understanding (MoU) signed by the Government of India and the Reserve Bank on 25 March 2004 (also see Appendix A3.1). As part of the MSS, the government T-bills and/or dated securities were issued with a view to absorbing excess liquidity consequent on the surge in capital inflows. Those securities had all the attributes of existing T-bills and dated securities and were tradable in the secondary market. This was essentially a political decision accepting the Reserve Bank’s recommendation.24 Initially, when this idea was taken to the government, Finance Minister Jaswant Singh said that the Chief Economic Adviser Ashok Lahiri was not supportive since it could undermine the independence of the Reserve Bank. Governor Reddy pointed out that such independence was not needed and excessive use of sterilisation by the Reserve Bank would weaken its balance sheet. Finance Minister agreed to the proposal of MSS saying that he would not do anything that weakened the central bank. The cost of sterilisation, it was said, was distributed between the central bank through LAF, commercial banks through CRR, and the government through the issuance of MSS securities. 25 59

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the reserve bank of india The unique feature of MSS issues was that the proceeds from those issues were immobilised by holding them in a separate identifiable cash account maintained and operated by the Reserve Bank. The amounts credited into the account were appropriated only for redemption and/or buyback of the Treasury bills and/or dated securities issued under the MSS. The interest cost on these issues was borne by the government. Unlike repo and reverse repo operations under the LAF, operations under the MSS were not expected to impact reserve money. To start with, an annual aggregate ceiling for securities to be issued under the MSS for 2004–05 was fixed at 600 billion. Within this ceiling, a threshold limit of 400 billion was also agreed upon so that as soon as securities outstanding under the MSS touched this limit, the Reserve Bank would notify the government and seek revision of the ceiling, if needed. With sustained capital inflows resulting from surpluses in both current and capital accounts of the balance of payments, Deputy Governor Rakesh Mohan requested the government on 24 June 2004 to raise the ceiling to 1,000 billion, but on 19 August 2004 he requested a modified ceiling of 800 billion. The government agreed to this proposal. Subsequently, the ceiling and the threshold levels were revised generally upwards from time to time through mutual consultation between the government and the Reserve Bank except for 2006–07 when the ceiling was reduced to 700 billion from 800 billion in 2005–06. In the following year, the situation changed dramatically. There was an extraordinary surge in capital flows from September 2007, particularly following the reduction of 50 basis points (bps) in US federal funds target rate combined with the sustained growth momentum of the Indian economy and its relative attractiveness as an investment destination.26 The inflow was so large that the government and the Reserve Bank had to revise upwards the annual ceiling on as many as six occasions from the level of 800 billion set on 20 February 2007 to 2,500 billion (threshold limit at 2,350 billion) as on 5 November 2007. In the process of implementing the MSS and announcing quarterly calendars of MSS issuance, the Reserve Bank had been continually assessing the liquidity position in the market considering the movements in foreign exchange inflows, the government’s cash balances with the Reserve Bank, the amount lying under the LAF, the behaviour of non-food credit, the growth of currency in circulation and, most importantly, the progress of the government’s borrowing. However, the exercise was not straightforward. The unpredictability of the magnitude, composition (short-term or long-term) and even the direction of flows complicated decision-making.

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monetary management Liquidity management also required issues of a mix of short-term (T-bills) and long-term (dated) securities under the MSS.This helped modulate liquidity under both surplus and deficit situations. Mere dependence on T-bills runs the risk that MSS auctions merely roll over the impounded liquidity with little prospect of absorbing liquidity when needed. Similarly, excessive dependence on dated securities can make unwinding difficult. The importance of dated securities in the MSS bag is also on account of insufficient market response for large T-bill issuances or on yield considerations as happened during the latter part of 2006–07. Under these challenging circumstances, the FMC-RBI set up a committee to review the liquidity conditions and advise the FMC-RBI every week.27 Thus, though the MSS was intended to sterilise the impact of capital flows, in practice it had proved to be an instrument also for meeting the shortage of liquidity whenever the situation so warranted. For instance, the MSS had been quite useful in liquidity management in the face of an anticipated event like redemption of IMDs on 29 December 2005. In fact, the Reserve Bank, in consultation with the government, increased the notified amount for the auctions of 91-day T-bills under the MSS for the five auctions scheduled during 31 August–28 September 2005 so that these amounts would eventually flow into the system to make available additional liquidity in December 2005. The Reserve Bank also stopped issuing any dated security under the MSS during the same period to check any upward pressure on long-term yields. Further, close to redemption, weekly T-bill auctions were discontinued from 9 November 2005 to retain liquidity in the system. Progressively larger injections through the LAF were allowed during the last week of December 2005 to supplement the additional liquidity need, following the large build-up of government cash balances on account of quarterly advance tax payment. Subsequently, auctions under the MSS remained suspended during 30 December 2005–2 May 2006 due to tightness in underlying liquidity. All these measures ensured that the Reserve Bank could sell foreign exchange for redemption of IMDs totalling nearly US$7.1 billion (about 320 billion) during 17–20 December 2005 without any disruption in the market. Such an effort in ‘reverse’ sterilisation combined with market operations helped to limit the liquidity mismatch. In that sense, the LAF, the MSS and other market operations were used as complementary instruments for systemic liquidity management. The challenges faced by the Reserve Bank towards the latter part of the reference period cannot be explored fully without reviewing the developments in 2006–07 and 2007–08 when the MSS as an instrument came into its

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the reserve bank of india Table 3.2 Trends in Select Indicators: 2004–05 to 2007–08 Year

I.  Monetary Policy Instruments Average MSS outstanding ( billion) Average LAF outstanding ( billion)

2004–05

2005–06

2006–07 2007–08

464.45

587.92

376.98

1,286.84

355.92

109.86

219.73

46.77

 

Increases in CRR (in bps)

50

0

100

150

Increases in repo rate (in bps)

0

50

125

0

II.  Macro Indicators

 

Capital flows – net (US$ billion)

28.0

25.5

45.2

106.6

Growth in non-food credit (%)

27.5

31.8

28.5

23.0

Current account balance (as % of GDP)

-0.4

-1.2

-1.0

-1.3

WPI inflation* (%)

5.3

3.9

6.6

7.5

Source: RBI. Note: * Represents point-to-point inflation for March of respective financial years.

full bloom. The Indian economy had witnessed real GDP (as per 2004–05 base year) growth of 9 per cent and above over the three-year period ending 2007–08.28 Such robust growth amid a global financial crisis since September 2007 made India an attractive destination for capital flows. In consequence, capital flows zoomed to US$45.2 billion in 2006–07 before rising to an unprecedented level of US$106.6 billion in 2007–08 (Table 3.2). At the same time, the combination of strong growth in non-food credit, escalation in asset prices, widening of the current account deficit, and hardening of inflation and inflation expectations underscored the need to deal with the dangers of overheating. In response, the Reserve Bank introduced a package of measures over the two-year period that virtually made the cost of sterilisation a national cost sharable among the government (interest cost on MSS securities), the Reserve Bank (interest cost on both reverse repo balances under the LAF and CRR balance) and the banking sector (opportunity cost on CRR balance).29 While the conventional instrument, the CRR, had been raised by as much as 250 bps over these two years, the raising of the repo rate by 125 bps had to be moderated so as not to affect adversely the high growth process continuing at that time and, at the same time, not to encourage more capital flows. Similarly, the relative burden of sterilisation had been pushed 62

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monetary management more towards the MSS because of which its average outstanding reached an all-time high in 2007–08 while that under the LAF declined. In fact, the improvement in liquidity was so significant that the Reserve Bank had to put in place a modified LAF scheme from 5 March 2007, whereby daily reverse repo absorption was capped. Also, an enhanced MSS programme was put in place wherein a mix of T-bills and dated securities for MSS issuances were used in a flexible manner. Eventually, however, the daily ceiling on reverse repo facility was withdrawn on 6 August 2007. These apart, the Reserve Bank not only reduced the interest rate ceiling on non-resident Indian (NRI) deposits to below the London Interbank Offered Rate (LIBOR) in April 2007, it also liberalised various limits associated with outflows, such as prepayment of external commercial borrowing (ECB), overseas investment limit by an Indian entity and the annual limit under the Liberalised Remittance Scheme between December 2006 and September 2007 (see Chapter 4).30 Evidently, the MSS had turned out to be an extraordinarily powerful tool for dealing with surplus and shortage of liquidity from 2004–05 to 2007–08. It also complemented other monetary policy instruments of the Reserve Bank well, thereby increasing the Bank’s options in dealing with various situations.31

Bank Rate Before and After LAF The Reserve Bank attempted to activate, at first, the Bank Rate as a reference and policy signalling rate. With the establishment of the LAF as the principal operating procedure for liquidity management, the reverse repo rate evolved into a sole policy signalling rate by 2006. In the interim, the role of the Bank Rate was reviewed from time to time, but it ceased to be an active policy instrument for all practical purposes. In April 1997, Governor Rangarajan in his policy announcement favoured the use of the Bank Rate as a device to signal monetary policy stance and influence the direction of market interest rate movements. This was consistent with the shift in emphasis from reserve requirements to market-based monetary instruments. A number of interest rates, including the deposit rates of banks and the Bank’s refinance rates were then linked to the Bank Rate. An Internal Group on Bank Rate (March 1997) advocated steps to make the Bank Rate the reference rate for the financial system (Box 3.3).

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the reserve bank of india Box 3.3 Internal Group on Bank Rate (1997) The Internal Group on Bank Rate (1997) played a role in drawing a blueprint for interest rate policy reform. The report started from the premise that the objective of the reform would be to do away with sector-specific accommodation provided by the Bank at concessional rates, and that during the transition to a fully market-led interest rate regime, the interest rates on such accommodation would be linked to the Bank Rate. The sector-specific accommodations involved the following main categories: Export credit refinance: In the transitional phase, the refinance rate might be fixed below the Bank Rate. The interest rate on export credit refinance was linked to the Bank Rate from 15 April 1997. Ways and means advances (WMA) to the central government: This should initially be below the Bank Rate. There should be a progressive reduction in the spread between the rate and the Bank Rate in two years. WMA rate to the central government was provided at the Bank Rate from April 1998.

Liquidity support to primary dealers: Liquidity support to PDs engaged in repo trading operations was provided at the Bank Rate.

The group considered two further issues: What the Bank Rate should be, and at what rate banks should be provided liquidity. While there was no consensus on whether the Bank Rate should be related to the short-term money market rates, different views were expressed on what rate it should be set at.

In 1996–97, there was considerable debate over the justification for a high level of 12 per cent for the Bank Rate.32 After different arguments were considered, the Bank Rate was reduced to 11 per cent on 15 April 1997, 10 per cent on 25 June 1997 and 9 per cent on 21 October 1997. Accordingly, all interest rates linked to the Bank Rate were also reduced. In January the following year, the Bank Rate was raised in response to market volatility because of the East Asian crisis, but was reduced again in April. Provision of liquidity at the Bank Rate made it an upper bound to overnight interest rates, thereby creating an informal band. The reverse repo rate was considered the floor in the call money market rate, while the Bank Rate the ceiling. The spread between the reverse repo rate and the Bank Rate had narrowed considerably, which would imply that short-term interest rates could fluctuate within a narrow band, thereby minimising volatility. While the call money rate represented by the MIBOR and T-bill auction yields seemed to have gained some acceptance as a reference rate, since the Bank Rate was fixed by the Reserve Bank, the market was hesitant to link other instruments to it.

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monetary management The announcement or signalling effect of the Bank Rate was pronounced on PLR of banks. Following the 1 March 1999 reduction in the Bank Rate, several banks reduced their PLRs by 0.75 to 1.00 percentage points, while the prime term lending rate (PTLR) was reduced by 0.90 to 1.00 percentage points. The Bank Rate needed to be delinked from the liquidity operations of the Bank to serve as a policy instrument. When the LAF started working, the reverse repo began to emerge as a major instrument of liquidity management. The auction of reverse repo – a short-term sale of security by the central bank to a dealer on a repurchase agreement – was introduced in 1992 on a next-day settlement basis. In November 1997, it was observed that the next-day settlement was not effective as a tool of monetary regulation, particularly in containing foreign exchange market volatility. Along with same-day settlement, fixed-quantity-based auctions at 4.5 per cent were introduced. Between 16 January and 20 August 1998, the reverse repo rate was raised and reduced three times. There were signs that the rate started to signal market expectations about movements in short-term interest rates. This was reflected in the fact that the interbank call rates had generally tracked above the fixed-rate reverse repo. Since then, the Bank Rate was used less frequently, whereas the reverse repo rate began to assume the role of a regular monetary policy instrument. The use of the repo rate and interest rate corridor as signalling rates left the role of the Bank Rate ambiguous. With the withdrawal of the CLF in October 2002, the role of the Bank Rate in setting the ceiling for overnight call rate came to an end. At the same time, various refinancing schemes that the Reserve Bank made available were rationalised and delinked from the Bank Rate. In April 2003, the emergency lender of the last resort facility was available at repo rate plus 4 per cent.33 Several other facilities made available at the Bank Rate were linked to the repo rate over time. Ever since the Bank Rate was promoted as a reference rate in 1997, irrespective of surplus or deficit liquidity scenarios, it was generally revised downwards, except on two occasions – 17 January 1998 and 22 July 2000 – both in the wake of volatile foreign exchange market situations. The rate was revised on as many as fifteen occasions until 29 April 2003 when the last revision was made to reduce the rate from 6.25 per cent to 6 per cent. The Bank Rate was set to remain unchanged thereafter (Table 3.3).34 As in the case of the Bank Rate, so too with the policy on the lending rate of banks, ambiguity seemed to increase after the reforms. 65

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the reserve bank of india Table 3.3 Changes in Bank Rate: 1997–98 to 2007–08 Year

Effective since

Bank Rate

Change

1997–98

16 April 1997

11

(-1.00)

1992–97

26 June 1997

22 October 1997

1998–99

1999–2000 2000–01

9

(-1.00) (-1.00)

11.00

(+2.00)

3 April 1998

10

(-0.50)

19 March 1998 29 April 1998

2 March 1999 2 April 2000 22 July 2000

2 March 2001

2001–02

23 October 2001

2003–04

29 April 2003

2004–05 to 2007–08

10

17 January 1998

17 February 2001

2002–03

12

29 October 2002

Source: RBI.

10.50 9 8

(-0.50) (-1.00) (-1.00)

8

No Change

8

(+1.00)

7.0

(-0.50)

7 7.5 6.5

6.25 6 6

(-1.00) (-0.50) (-0.50) (-0.25) (-0.25)

No Change

Pricing of Credit Lending rates of banks were tightly regulated until the 1980s and rationalised initially by reducing the multiplicity of rates and linking them to the size of advances in September 1990. From 17 October 1994, banks could set their own lending rates. The only lending rates still regulated were the concessional rates for certain sectors like exports, small loans of up to 0.2 million and loans made under the differential rate of interest scheme. Banks were required to declare their PLRs, taking into account the cost of funds and transaction costs, among other factors. The PLR was the minimum or floor rate for credit for loans above 0.2 million.

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monetary management In 1997, a chamber of commerce (Deccan Manufacturers Association) wrote a letter to the Reserve Bank stating that the revision of interest rates was discriminatory since the revised rates on loans became applicable to all outstanding advances, whereas revised rates on deposits were applicable only to fresh deposits.35 The Association held that the depositors and the borrowers were both clients of the bank and, from a legal point of view, had to be treated uniformly. In its reply, the Bank clarified that the deposits were accepted by banks as part of a contract under the terms of which banks were liable to pay interest at the rate contracted, whereas interest rates applicable to loans and advances were subject to changes as per the provisions of the agreement, mainly to ensure the profitability of banks. The reply did not convince the Association. The MPD again clarified that the interest chargeable on loans and advances was subject to changes taking into account the monetary policy, wherein interest rate was viewed as an important component of the overall transmission mechanism of monetary policy. Credit, the clarification went, was a continuous process and was determined as per the requirements of the business, whereas deposit was a fixed contract for a fixed period and was renewed only after the expiry of the term. Therefore, it was necessary to ensure that there was no rigidity built into the response of the credit mechanism to changes in policy interest rates. This brief exchange made it clear that in the eyes of the Reserve Bank, the interest rate that would act as a channel of monetary transmission was the lending rate. In November 1996, the Corporation Bank made it known that it had introduced two PLRs, one on the loan component and the other for cash credit and other working capital facilities, the latter being half a per cent higher. The reason was that this would encourage borrowers to switch over to the loan delivery system. The MPD stated in a response in 1997 that banks had to declare only one PLR. After discussions, a circular was issued on 12 February 1997 to allow two rates. Banks could prescribe PLRs and spreads over PLRs separately for loan component and cash credit component. In July 1997, Bank of America sought a clarification whether the Bank Rate could be used as a reference to set maximum and minimum lending rates, instead of announcing a separate PLR and maximum spread. While the MPD agreed that the linking of a bank’s PLR to the Bank Rate with the approval of its board would be in order, to refrain from defining a PLR spread would go against the interest of transparency implied in the existing directives. 67

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the reserve bank of india These individual exchanges showed that the transition from administered interest rates to market rates could not occur without negotiations with banks. To begin with, in 1997, banks asked for and received permission to set PTLR on term loans of three years’ maturity or more. Whereas the PLR was the floor rate for loans above 0.2 million, for loans of smaller amounts, the PLR was expected to be the ceiling rate. For four categories of borrowings, the reference to PLR was waived from 29 October 1999 and these were: (a) loans covered by refinancing schemes of term lending institutions, (b) lending to intermediary agencies, (c) discounting of bills and (d) advances/overdrafts against domestic non-resident external rupee (NRE[R])/foreign currency non-resident (banks) (FCNR[B]) deposits. Banks also represented that the requirement of all changes in interest rates being approved by the board of directors of banks restricted their ability to respond promptly to changes in the market environment. The Reserve Bank decided that the boards could delegate necessary powers to the Asset Liability Management Committee for fixing interest rates on deposits and advances subject to reporting to the board immediately thereafter. There were five larger issues with the transition to PLR – fixed rate loans, deposit rates, differential rates, the meaning of PLR for operational purposes and the downward rigidity of interest rates. On a proposal from industry seeking project loans, the Reserve Bank permitted banks to offer fixed rate loans. In 2000, it decided that banks would be free to offer different types of project loans subject to a reference to the PLR. A major point of negotiation was the fact that the deposit rates on existing deposits continued to be subject to regulation. While the PLR had been coming down, interest rates had remained unaltered on existing deposits. In certain cases, this had resulted in the interest rate on advances against fixed deposits based on the PLR turning out to be lower than the interest rate on deposits. In order to remove this anomaly, when the deposit rate exceeded the PLR, advances to depositors against fixed deposits could be made by banks without reference to the ceiling of the PLR and banks could charge suitable interest rates. The Reserve Bank introduced further changes in 2000–01.36 Banks were given the freedom to operate different PLRs for different maturities, provided there were transparency and uniformity of treatment. It was observed that some banks were declaring a standalone PLR in addition to ‘tenor-linked’ PLRs. The Reserve Bank directed that the banks that had moved over to declaration of tenor-linked PLRs should always indicate the specific tenor for which the declared PLR was applicable. There were negotiations 68

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monetary management with banks on the meaning of PLR: should it be a floor or a benchmark? In their meetings with bankers, a request was made that the PLR should be converted into a reference or benchmark rate for banks rather than treating it as the minimum rate chargeable to the borrowers.37 A review of international practices showed that while the PLR was traditionally the lowest rate charged for prime borrowers, the practice of providing loans below the PLR by banks had become common. Accordingly, the requirement to treat PLR as the floor for loans up to 0.2 million was relaxed. From the early 1990s, the Reserve Bank initiated a number of measures to pursue a regime of soft interest rates. Interest rates, in general, had softened considerably except for occasional fluctuations. The reduction in interest rates was not fully reflected in lending rates charged by banks, and the spread above the PLR was substantial for some banks.38 Banks were urged to review the spread, reduce them, publicize them along with their PLRs, and switch over to an ‘all cost’ concept for borrowers by explicitly declaring processing and service charges to borrowers. Similar freedom was extended to the state and central cooperative banks and urban cooperative banks. They needed to maintain a minimum lending rate. This rule was removed, subject to the requirement that they should announce lending rates and set them on a cost basis. Clearly, the PLR regime did not work quite as expected. The mid-term policy review on 19 October 2002 observed that both the PLR and the spread varied widely across banks. Furthermore, there was an increasing tendency by banks to advance credit to prime borrowers at rates below the PLR.39 At the same time, credit was extended to other borrowers at increasingly higher spreads over the PLR. Governor Jalan queried in a note dated 12 November 2002: ‘Should we use some “moral suasion” on banks to voluntarily fix a maximum spread above PLR?’ To these issues of high spread was added the fact that the lending rate on consumer credit and other retail advances which gained prominence in the 2000s were delinked from the PLR. In 2003, a set of three reviews ( June, August and September) took place between the Reserve Bank and bankers on the functioning of the PLR. The first of these revealed that there was a difference in perception between banks, depending on the portfolio. The benchmarking of floating rate loans, for housing, for example, was not straightforward. From the Bank, Deputy Governor Rakesh Mohan and Advisors Deepak Mohanty and D. Anjaneyulu were in favour of allowing more flexibility in the use of other market-related benchmarks for pricing floating rate loans, while the benchmark PLR, or BPLR, scheme continued. Governor Jalan felt it would be useful to discuss 69

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the reserve bank of india this modification with the same set of bankers. The second review focused on transparent benchmarks for floating rate loans. While agreeing to the principle of a BPLR, the banks spoke against measures that would make it difficult to accommodate bank-specific requirements and wanted the BPLR to become effective from a future date.40 The third review meeting was held with chief executives of select banks. Much to the surprise of the Reserve Bank, the banks, except for SBI and Indian Overseas Bank, expressed discomfort with a single BPLR. So, while the Reserve Bank wanted a single BPLR set by transparent criteria, the banks seemed to be apprehensive about the intention behind the Reserve Bank’s insistence on transparency. They, it seemed, would be happier to have the freedom to set a range of PLRs for different products. The third review ended with a decision on further review to be done by the Indian Banks’ Association (IBA). The IBA constituted a group, headed by V. Leeladhar, Chairman, Union Bank of India, to provide suggestions for alternative approaches to lending rate determination. According to a letter from the IBA dated 6 October 2003, the consensus among bankers was that it was unacceptable to have a single BPLR around which banks could price all their products, given the great diversity in the customer profile, cost structure and risk premia. Accordingly, the IBA requested the Reserve Bank to retain the status quo on the then existing PLR norm while asking for additional flexibility in terms of allowing market benchmarks for floating rate loans. The IBA’s views were publicised in the press. Former Deputy Governor S. S. Tarapore, in an article in the Financial Express, said that ‘the whole PLR issue was a storm in a tea cup and an end should be put to this fiction’, even though his proposal to announce a cost-and-risk-adjusted base lending rate did not seem very different from what the Reserve Bank wanted to have.41 In its response, the Reserve Bank clarified that the system they asked for was aimed at enhancing transparency in lending rates and did not curtail banks’ freedom on pricing decisions or their loan products. Transparency would demand that a reference rate like the BPLR was set by considering term premia and/or risk premia. Following this response, there were again consultations between the Reserve Bank and the IBA. In 2003, the Reserve Bank reiterated that since lending rates for all loans could be determined with reference to the BPLR by taking into account term premia and/or risk premia, a need for multiple PLRs was not compelling. But banks had the freedom to price their loan products based on term premia and transaction costs.42 In a circular issued on 25 November 2003 by H. N. Sinor, Chief Executive of the IBA, the principle was ratified. A range of specific types of loan, however, remained exempt from

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monetary management the BPLR regime.43 Thus, the Reserve Bank shifted the responsibility to issue guidelines on BPLR to the IBA, the underlying reason being that it was consistent with the reform process and international practice. Passing on the responsibility to the IBA brought BPLR under a self-regulatory mechanism. By January 2004, of twenty-seven public sector banks, sixteen had adopted BPLR and eleven were waiting for board approvals; of thirty private sector banks, only six had adopted BPLR, four awaited board approvals and twenty had not considered implementation yet; and of twenty-seven foreign banks, four had adopted BPLR, one awaited board approval and twenty-two were yet to start the process.44 By 4 May the same year, almost all commercial banks had adopted the BPLR, and the BPLRs were lower in the range of 25–200 bps from their earlier PLRs. Big differences around the BPLR persisted. The Reserve Bank urged banks to rationalise the difference. Intense competition was forcing banks to extend sub-BPLR lending for segments such as corporates, housing and real estate.45 The aggregate sub-BPLR lending at end of June 2005 accounted for 64 per cent of the total lending, with a credit limit above 0.2 million. The percentages for the private sector and foreign banks exceeded 80 per cent. Deputy Governor Rakesh Mohan wrote on the note: ‘Clearly, BPLR has lost all meaning except as ceiling rate for small loans!’ The Reserve Bank and the IBA discussed the matter again in 2005. In a meeting in December, the IBA explained why banks seemed reluctant to adopt the guidelines. Interest rates in retail and corporate segments had lost linkage with the BPLR system. Given the surplus liquidity in the economy, corporate access to capital and foreign exchange market, and cutthroat competition in the banking industry, the lending rates for corporates did not always cover the cost or risk involved in such lending. But banks did not want to revise their BPLRs since any revision warranted corresponding changes in lending rates for the entire loan portfolio, including loans contracted earlier. The easier system for them was what had existed before – a sector-specific segmented lending rates system. What was at stake in this protracted debate on banking practice? The complaint of many Indian corporates was that banks did not easily lend, and when they did, they charged high interest rates and did not pass on the benefit of lower rates signalled in monetary policy statements. Economists were concerned over the lack of transparency in the interest rate regime, there being significant price discrimination but no apparent basis to show why. The rigidity and lags in the transmission of monetary policy were also at stake. The Reserve Bank’s Report on Currency and Finance (2005) devoted several

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the reserve bank of india pages to interest rate ‘pass-through’. For the interest rate channel of policy to work effectively and efficiently, changes in the short-term policy rate should feed into the market rates. It would depend on a number of factors, such as the structure of the financial system, the extent of regulation, the degree of competition between banks, the use of variable-rate products, the response of portfolio substitution to the policy rate and the transparency of monetary policy operations. Its survey of international practice found that there was no uniform pattern in the pass-through between deposits and loans. Why was the change so difficult to achieve? Reserve Bank data show that the average cost of deposits for major banks remained high and rigid because a substantial portion of deposits was in the form of long-term deposits at fixed interest rates. Banks had the freedom to offer variable interest rates on longer-term deposits. However, the preference of depositors was in favour of, and the traditional practice with banks was to offer, fixed interest rates on term deposits. Earlier data had revealed that in public sector banks, the average cost of funds was in the region of 8 per cent. The non-interest operating expenses worked out to 2.5 to 3 per cent of total assets. The relatively high overhang of non-performing assets (NPAs) together with interest tax pushed up the lending rates further. The relatively high interest rates offered on statesponsored savings schemes, and the legacy of NPAs, legal constraints and procedural bottlenecks in the recovery of dues, all reduced banks’ options on changing rates. The large borrowing programmes of the government provided banks with the option to invest in sovereign paper instead of lending to trade. One might argue that deregulation of interest rate was attempted without deep institutional reforms. In part at least, these obstacles were common to other emerging economies undergoing reform.46 Further complicating the story, an analysis by the EPW Research Foundation concluded that the flexibility of lending rate was asymmetric – it was sticky downwards. When money was tight, it paid banks to increase lending rates because their deposit rates were sticky. During an easing phase, it might prove to be difficult to adjust lending rates downwards when deposit rates did not change much. There was also the fear of flight of deposits and the prevalence of administered contractual savings rates like those on provident funds and small savings instruments, further adding to rigidity in deposit rates.47 During the reference period, there were deep changes in the way the Reserve Bank transacted with the government and the private sector, delivering greater autonomy to the Reserve Bank and greater transparency in its operations. It is to these issues that we now turn.

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monetary management

Changes in Process and Procedure Relationship with the Government

The central government enjoys overriding statutory powers over the Reserve Bank. It can remove the head of the institution without assigning any reason and can supersede the governing board. It may also give directions to the Bank, though only after consultation with the Governor of the Bank, in public interest (Section 7 of the RBI Act). This is a unique feature, not found in any other regulatory legislation in India. De facto, the Reserve Bank gained greater degrees of freedom from the 1990s in operating monetary policy, choosing the tools for doing so and communicating with the public. The mutual trust that existed among the people involved also helped in promoting coordination and operational independence of the Reserve Bank. Independence was thus negotiated between the Reserve Bank and the government and not decided unilaterally. There were three ways in which the Reserve Bank gained more operational autonomy in the conduct of monetary policy. First, in the early 1990s, the then Reserve Bank Governor, C. Rangarajan, campaigned forcefully in favour of greater autonomy for the central bank, which had a direct effect, resulting in an agreement (1994–95) that set limits on the net issue of ad hoc T-bills, and, by 1997, ended automatic monetisation of government deficits. Second, the Reserve Bank’s sustained dialogue with the government led to the passage of the FRBM Act, 2003, which, inter alia, prohibited the Reserve Bank from purchasing government securities in primary issues. Third, amendments to the RBI Act, 1934, and the Banking Regulation Act, 1949, led in 2006–07 to more flexibility in the use of conventional tools such as the CRR and the SLR, and more clarity on its money market and foreign exchange market operations.48 In his letter addressed to Finance Secretary Montek Singh Ahluwalia dated 28 January 1997, Governor Rangarajan reiterated the need to curtail monetised deficits in order to meet the larger aims (growth and price stability) with more certainty. This was perhaps the last letter from the Governor to the Finance Ministry setting out, along with market borrowing projections, strategies for monetary and debt management. While correspondence on the projection of the market borrowing programme continued, specific proposals for monetary and credit policy measures were not part of formal letters since 1998–99. 73

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the reserve bank of india These letters on the market borrowing programme were also not signed by the Governor after 1998–99. There were pre-policy consultation meetings, but such meetings and their outcomes remained informal and no formal records are available. Mutual consultations replaced the practice of formal proposals and communication since formal communication became irrelevant after elimination of ad hoc T-bills, deregulation of administered interest rates and phasing out of the financing of development financial institutions. He then elaborated on the proposals on the termination of ad hoc T-bills and the discontinuation of 91-day tap T-bills, and outlined a new provision of WMA for accommodating temporary mismatches in government receipts and payments from 1 April 1997. Already these issues were under discussion with the government, leading to the supplemental agreement signed between the Reserve Bank and the Government of India on 26 March 1997 (Box 3.4). Eventually, the ad hoc T-bills were discontinued from 1 April 1997, and a WMA scheme was introduced to accommodate temporary mismatches in the government’s receipts and payments. Besides WMA, the Reserve Bank’s support would be available for the government’s borrowings programme. Governor Rangarajan, in his policy announcement for the first half of 1997– 98, called the move ‘a bold and radical change which will strengthen fiscal discipline and provide greater autonomy to Reserve Bank in conducting monetary policy in the coming years’. A further decisive step towards responsible debt management was the FRBM Act, which followed the recommendations of a government-instituted committee, set up on 17 January 2000.49 Governor Jalan desired that Deputy Governor Reddy should head the committee on fiscal responsibility legislation and prepare the draft legislation. Deputy Governor Reddy, however, declined on the ground that it would not be appropriate for him as a central banker to work on a draft of legislation on fiscal matters. But he promised Governor Jalan to provide support to a government-appointed committee. Three years earlier, a Working Group on Separation of Debt Management from Monetary Management set up by the Reserve Bank had submitted its report. The report recommended, inter alia, separation of debt management from monetary management, and the establishment of an independent company under the Companies Act, 1956, to take over the debt management function. While the Reserve Bank took no decision on the details, a decision to separate the two functions was considered desirable in principle, subject to development of financial markets, control over fiscal deficit and necessary legislative changes. 74

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monetary management Box 3.4 Committee to Examine the Modalities of Phasing out of Ad hoc Treasury Bills To further fiscal consolidation and flexibility of the Reserve Bank in monetary management, the 1994–95 Union Budget announced an end to the practice of financing the central government’s budget deficit through the creation of ad hoc T-bills without any limit. There followed a three-year period when caps were fixed for the net issue of ad hoc T-bills and the central government’s access to ad hoc T-bills. A committee was formed by the government to examine the process. The committee submitted its report on 25 January 1997. The recommendations of the committee were:

1. The issue of ad hoc T-bills and 91-day T-bills would be discontinued from 1 April 1997. 2. The outstanding ad hoc T-bills on 31 March 1997 would be funded into special securities. 3. The outstanding tap T-bills on 31 March 1997 would be paid off on maturity, with an equivalent creation of special securities. 4. In the medium term, the special securities would be converted into marketable securities, as and when the need arose, to facilitate the Reserve Bank’s openmarket operations. 5. The committee fixed WMA limits for the year 1997–98 and recommended a review of these limits for subsequent years. The WMA would not be a supplementary source for the government to finance its deficit. The committee also fixed interest rates on the WMA, linking it with yields on 91-day auction T-bills. 6. For the period beyond 1997–98, when 75 per cent of the WMA was utilised, the Reserve Bank will trigger fresh floatation of government securities. 7. If the union government ran surplus cash balances exceeding an agreed level, the Reserve Bank would make investments as might be mutually agreed with a view to enabling the government to earn market-related interest rates on the surplus. 8. With the discontinuance of tap 91-day T-bills, the Reserve Bank would devise an arrangement for the disposition of surpluses of state governments. 9. Efforts should be made to effect improvements in cash management of the government and debt management by the Reserve Bank.

At the same time, the Reserve Bank set up an informal group which prepared an approach paper and a draft of a Fiscal Responsibility Bill for the committee.50 During the process of its work, the committee regularly consulted the Reserve Bank in finalising the draft Bill. In the draft Bill, Governor Jalan 75

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the reserve bank of india suggested that the words ‘economic growth with social justice on a sustainable basis’ be dropped, because these might be ‘open to misinterpretation and fiscal irresponsibility in the name of growth or social justice’. The point was accepted. The committee had set out to delink debt management from monetary management as far as possible, in the presence of the risk that managing public debt by monetising the debt compromised price stability, unless the tendency was legally restrained. The committee recommended that after a three-year transition period, the government should not directly borrow from the Reserve Bank except through the WMA repayable during the same year. The Reserve Bank may buy and sell government securities in the secondary market. These provisions were duly incorporated in the FRBM Act that was passed in August 2003.51 Among other areas of reform, institutional reforms in the financial market were already proceeding, with closer integration of financial market segments, and the introduction of new instruments, participants and institutional infrastructure. Notably, amendments to the Securities Contracts (Regulation) Act, 1956, demarcated the regulatory roles of the Reserve Bank and the Securities and Exchange Board of India (SEBI) over financial markets. With the setting up of the Clearing Corporation and the operation of the full-fledged LAF and the other technological infrastructure being put in place, the Reserve Bank would be able to operate its instruments of monetary policy with greater flexibility. The Finance Ministry and the Reserve Bank agreed on the need to accord greater operational flexibility to the Reserve Bank for the conduct of monetary policy and regulation of the financial system. Accordingly, the Reserve Bank had proposed amendments to various Acts, which was under active consideration. The Reserve Bank had already proposed an amendment to the RBI Act to take away the mandatory nature of management of public debt by the Reserve Bank and vesting the discretion with the central government to undertake the management of the public debt either by itself or by assigning it to some other independent body if it so desired. There was, however, no further progress relating to this until the end of reference period as the Reserve Bank reversed its stance later (see Chapter 7).

Legal Reform In 2003, an internal working group reviewed the laws for regulation and supervision.52 The group prepared recommendations for amendments in the 76

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monetary management RBI Act, 1934, and the Banking Regulation Act, 1949, in 2003. After further consultations, the government referred to the Reserve Bank two draft Bills, the RBI (Amendment) Bill and the Banking Regulation (Amendment) and Miscellaneous Provisions Bill, 2005, for comments. The Parliament passed the RBI (Amendment) Act, 2006, on 17 May 2006 and the Banking Regulation (Amendment) Act, 2007, on 23 January 2007 (see Box 3.5). Amendment to Section 42(1) of the RBI Act provided discretion to the Reserve Bank in deciding the percentage of the CRR to be maintained by scheduled banks. Earlier, the Reserve Bank could not prescribe CRR lower than 3 per cent and higher than 20 per cent. Now, the Reserve Bank acquired full manoeuverability. Amendment to Section 42(1A) enabled the Reserve Bank to change the prescribed CRR through a regular circular, without notification in the official gazette. The subsections (1AA) and 1(B) were omitted by the amendment, removing the provision for payment of interest by the Reserve Bank on CRR balances, effectively prohibiting the Reserve Bank from paying interest on such balances, since it was considered that such interest payments compromised the effectiveness of the CRR as a monetary tool. Insertion of a new Chapter IIID provided clarity to the regulatory powers of the Reserve Bank over money and foreign exchange market derivatives, money market instruments, including repo and reverse repo and in general over money, government securities and foreign exchange markets. While some of these powers were earlier exercised by the Reserve Bank by convention and practice, these amendments provided clarity. The definitions of repo and reverse repo as borrowing and lending instruments in the money and foreign exchange markets were for the first time incorporated in the RBI Act in accordance with best international practices. Earlier, such transactions were treated as separate sale and purchase transactions in securities.53 The Reserve Bank was empowered to regulate agencies dealing in related transactions. This amendment made the role of the Reserve Bank vis-à-vis SEBI clearer. Among the amendments to the Banking Regulation Act, the definition of approved securities for SLR was made flexible. Approved securities were redefined to mean the securities issued by the central government or any state government or such other securities as may be specified by the Bank from time to time. Earlier, all trustee securities were eligible approved securities. Much before this amendment, approved securities were those issued by the central and state governments under their market borrowing programmes announced in respective budgets. 77

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the reserve bank of india Box 3.5 Relevant Parliamentary Acts and Amendments Act

Date Enacted

Key Provisions

Reserve Bank of India (Amendment) Act, 2006

17 May 2006

Banking Regulation (Amendment) Act, 2007

23 January 2007

The Reserve Bank (a) gained necessary discretion in deciding the percentage of CRR to be maintained by banks; (b) was empowered to change the prescribed CRR through a regular circular, without notification in the official gazette; (c) was effectively prohibited from paying any interest on CRR balances, since it was considered that interest payments reduced the effectiveness of CRR as a monetary tool. Further, insertion of a new Chapter IIID provided clarity on regulatory powers of the Reserve Bank over money and foreign exchange market derivatives, money market instruments, including repo and reverse repo and in general over money, government securities and foreign exchange markets. The definitions of repo and reverse repo were for the first time incorporated in the RBI Act as per best international practices. The Reserve Bank was empowered to regulate agencies dealing in related transactions.

Fiscal Responsibility and Budget Management Act, 2003

26 August 2003

The central government shall not borrow from the Reserve Bank except by way of advances to meet temporary excess of cash disbursement over cash receipts in accordance with the agreement which may be entered into from time to time.

The definition of approved securities for the purpose of the SLR was made flexible. Approved securities were redefined to mean securities issued by the central government or any state government or any other as may be specified by the Reserve Bank.1

Note: 1. An earlier proposal by the Reserve Bank to the government in May 1998 to this effect was not incorporated in the regular Budget for 1998–99 presented in June 1998. Pending this amendment, the Reserve Bank advised banks that only securities issued under the market borrowing programme approved by the central government would be eligible to be included under SLR prescription. 78

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monetary management Interestingly, the discussion that led to this had shown that there was a difference between the legal position and the policy view on approved securities. One question was ‘whether shares issued by their subsidiary banks were deemed to be included among the approved securities as defined under Section 5 of the Banking Regulation Act, 1949’. The Legal Department held that ‘by virtue of the statutory provision, the shares of subsidiary banks have to be regarded as approved securities for the purpose of maintenance of SLR’. The MPD had all along been taking a different view on the matter and followed a practice of reckoning those securities for the purpose of Section 24 of the Banking Regulation Act that were issued under the market borrowing programme of the government.54 In effect, the SLR was basically operated by the Reserve Bank to protect the market borrowing programme of the government. This proved to be quite a complicated issue. When the IDMD received a number of references from regional offices of the Reserve Bank and from other departments seeking clarification on the SLR status of specific securities, one proposal considered was to prepare a list of approved securities under the market borrowing programme and place it on the Reserve Bank’s website. The IDMD, however, considered that this could be a potentially disputatious move because it would invite many new applications and possibly legal challenges. There was also a protracted correspondence with the government on notifying IDBI and Industrial Finance Corporation of India (IFCI) bonds as approved securities for SLR requirement of banks. The key policy issue was set out in a letter by Executive Director Usha Thorat addressed to Atul Kumar Rai, Director, Banking Division, Department of Economic Affairs (1 July 2003): SLR status helps in maintaining a differentiation between the bonds issued under the approved market borrowing programme of the government and the bond which are not issued under the approved market borrowing programme. Elimination of this differentiation would lead to a situation in which both categories of bonds would compete with each other for limited investible resources in the economy.

Another amendment to Section 24(2A) of the Banking Regulation Act, 1949, allowed the Reserve Bank to prescribe the SLR without any statutory minimum (floor), retaining, however, the maximum (ceiling). Earlier the SLR was subject to a minimum of 25 per cent and a maximum of 40 per cent. The Reserve Bank was empowered to change the prescribed SLR through 79

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the reserve bank of india a circular, without notification in the official gazette of the government. The differential requirement of SLR for regional rural banks from that of other commercial banks was also removed.

Interface with Markets: Towards More Transparency As the Bank started operating increasingly through market-based instruments, transparency improved. Traditionally, the making of monetary policy had been largely internal, with only the final measures being announced in the form of a circular signed by the Governor. This practice continued until October 1997. Since the late 1990s, the process became more consultative and participative, and communication became more open. The stance and rationale of monetary policy were communicated in a variety of ways, including through publications and speeches delivered by top management. The policy statements had become more comprehensive, giving detailed background information and data and analytical inputs that went into policymaking and in support of the stance taken from time to time. The frequency of these statements increased from 2005–06, as we have seen. The consultative process changed somewhat in the 1990s, mainly by means of more frequent announcements and accommodating feedback on policy measures and instruments (also see Table 3.4). By the mid-2000s, there was a much better understanding than before on what the Reserve Bank was doing, and consequently there were more debates and consultations with the IBA, market participants, trade bodies and associations, and economists. This process had been of critical importance for India in view of economic reforms, which meant that there was a great deal of learning, un-learning and re-learning to do. The formation of the FMC-RBI in 1997, which reviews the liquidity and interest rate situation in financial markets and advises the top management on strategic actions, strengthened policymaking and improved interdepartmental coordination. The earlier practice of quarterly credit budget discussions with select bankers was converted into monthly resource management discussions between the MPD and senior officials of select banks from 1999. Besides reviewing a return-based data, in particular, on sectoral deployment of credit and other financial parameters of the individual banks, the department made use of the opportunity to get feedback about policies introduced from time 80

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monetary management to time, perception regarding current trends in macroeconomic indicators such as GDP, exports and imports, inflation, financial market trends, liquidity conditions, and suggestions for forthcoming policies.

Technical Advisory Committee on Monetary Policy While pre-policy consultations with select bankers continued, the involvement of external experts and market participants was further enhanced with the formation of the TACMP in July 2005. The origin of this goes back to the Narasimham Advisory Group on Transparency in Monetary and Financial Policies (2000). This group, which was set up to advise the Reserve Bank on sound standards of central banking with reference to international practice, had suggested that even without legislative changes, the Reserve Bank should appoint a Monetary Policy Committee. A subcommittee of the Reserve Bank Board had been considered, but it was clarified that the Governor of the Reserve Bank or, in his absence, the Deputy Governor nominated by him had been given parallel powers of general superintendence and direction of the affairs and the business of the Bank under Section 7(3) of RBI Act; therefore, the Governor became individually accountable in decisionmaking. Hence, a suggestion based on a staff review was that, to begin with, an Advisory Committee on Monetary Policy on the lines of the Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets, or the Standing Technical Advisory Committee on Financial Regulation, could be constituted within the current provisions of law. A survey of eighteen countries by the BIS examined the approaches and structures of the Monetary Policy Committees’ practices on the composition of internal and external members, and the size of the committees varied. Most countries covered by the survey did not publish minutes of the meetings. The committee was appointed by the Governor and was set up to strengthen the decision-making process. It also strengthened the hands of the Governor in negotiating with the Finance Minister during discussions on monetary policy. Whereas the Governor remained accountable and responsible for the conduct of monetary policy by the central bank, the actual deliberations had an element of collegiality and informality. An informal advisory group was formed on 28 April 2005. The group consisted of D. M. Nachane (Director, Indira Gandhi Institute of Development Research), R. H. Patil (Chairman, Clearing Corporation of India Ltd.), 81

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the reserve bank of india Shankar Acharya (Honorary Professor, Indian Centre for Research in International Economic Relations) and S. S. Tarapore (former Reserve Bank Deputy Governor). The Hindu Business Line on 13 July 2005 commented that ‘the introduction of the wise men was a first and sure step to increasing the independence of India’s central bank’. The informal advisory group was converted into the TACMP through a memorandum dated 8 July 2005. The TACMP had the Governor as the Chairman and four external members as mentioned earlier; the Deputy Governors were special invitees. The TACMP had the following terms of reference: (a) to review macroeconomic and monetary developments and (b) to advise on the stance of monetary policy. The views of the advisory committee would be discussed in the following meeting of the Central Board of the Reserve Bank. The tenure of the TACMP was up to 31 January 2007. The TACMP was reconstituted in March 2007 for a further period up to January 2009 with five external members and two members of the Central Board of the Reserve Bank. The additional members were Suman Bery (economist and external member) and Y. H. Malegam and A. Ganguly (Central Board members). The Deputy Governor in charge of monetary policy was made the Vice-Chairman and other Deputy Governors were inducted as regular members. External members were drawn from the areas of monetary economics, central banking, financial markets and public finance. The initial TACMP met during the reference period on seven occasions starting from 19 July 2005 and the reconstituted TACMP on four occasions starting from 17 April 2007. The issues for discussion had some common themes, such as demand pressures, the reasonableness of medium-term outlook, credit growth and the prospect of overheating, the balance of payments position, asset prices and their implications for monetary policy, and the monetary policy stance. Depending upon macroeconomic conditions, specific issues such as pass-through effects of international oil prices, the impact of capital flows and the consequent liquidity management challenges, and movements in exchange rates drew the attention of members from time to time, including the impact of developments in global financial markets since the second half of 2007. On monetary policy, the views of members differed on the nature of instruments to be used and the extent of changes in rates that could be effected. The specific suggestions related to changes in repo and reverse repo rates and the percentage changes in the CRR. While no formal vote was taken and the views of the TACMP were purely advisory, it is interesting to observe the impact of these on policy announcements. Table 3.4 presents these details. 82

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monetary management It is observed that of the eleven meetings held during the reference period, policy announcements reflected the majority view of the external members on five occasions, the announcements were against the majority view of the external members on three occasions, and the views expressed by majority members were partially accepted on the remaining three occasions. Thus, in eight out of eleven meetings, the majority view of the TACMP was accepted fully or partially. The TACMP indeed influenced the direction of policy stance during mid-2005 to early 2008 (also see Table 3.3). Table 3.4 External Members’ Views on the Stance of Policy and Actual Announcements by the Governor from July 2005 to January 2008 Meeting Date 1

19 July 2005

2

18 October 2005

3

17 January 2006

4

12 April 2006

5

18 July 2006

General Stance of External Members

Policy Review Date

Actual Policy Decision

Two members were for no change in policy rates. One member favoured hike in repo rate by 25 bps.

26 July 2005

Status quo. (Majority view)

All members supported hike in policy rates up to 50 bps, among whom one also supported a hike in the CRR.

25 October 2005

Two members favoured an increase in policy rates up to 50 bps. One favoured the status quo. No view from one member.

24 January 2006

Increase in reverse repo rate by 25 bps. No change in repo rate or CRR. (Partially accepted)

One member favoured the status quo. Three members supported policy tightening by increasing repo rate up to 50 bps, among whom one wanted an increase in CRR by 50 bps.

18 April 2006

No change in policy rates or CRR. (Against majority view)

Three members favoured an increase in repo rate by 25 bps. One member favoured a reduction in reverse repo rate and hike in CRR by 50 bps.

25 July 2006

Increase in repo and reverse repo rates by 25 bps. (Majority view)

Increase in reverse repo rate by 25 bps. (Partially accepted)

(Contd.) 83

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the reserve bank of india (Contd.) Meeting Date 6

20 October 2006

7

23 January 2007

8

17 April 2007

9

23 July 2007

10 25 October 2007

11 22 January 2008

General Stance of External Members

Policy Review Date

Two members spoke for 31 October an increase in policy rates, 2006 among whom one also favoured an increase in CRR. Two members supported status quo.

Actual Policy Decision Increase in repo rate by 25 bps. (Partial view)

All members wanted an 31 January increase in policy repo rate in 2007 the range of 25 to 50 bps.

Increase in repo rate by 25 bps. (Majority view)

Two members favoured increase in CRR. Four favoured status quo. One absent.

31 July 2007

CRR increased by 50 bps. (Against majority view)

All members suggested a reduction in repo rate from marginal to 50 to 75 bps. One member favoured the imposition of 10 per cent incremental CRR.

29 January 2008

One member suggested repo 24 April 2007 No change in policy rate increase by 25 bps. One rates. (Majority view) member favoured increase in both repo and CRR by 50 bps. Other four members favoured status quo. One absent.

Two members favoured 30 October lowering of policy rates. Three 2007 members favoured increasing CRR. One member favoured increasing both policy rates and CRR. No view from one member.

Increase in CRR by 50 bps. (Majority view)

No change in repo rate or CRR. (Against majority view)

The Reserve Bank had, over the years, developed a communication policy which was based upon announcements of a hierarchy of objectives, autonomy in policy operations, anchoring inflation expectations by promoting credibility and understanding of monetary policy, and supply of information (Table 3.5). 84

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monetary management The speeches, press releases and interviews of officials generally followed these principles. The message communicated to the media could be taken to represent the views of the institution rather than the personal views of individuals. Table 3.5 List of Transparency Practices Communication and Disclosure

Operating Procedures

Consultative Process

Publication of more information on the central bank’s operations and also money and financial markets.

Financial Markets Committee to monitor and review day-to-day market developments.

Technical Advisory Committee on Financial Markets.

Business confidence and expectations surveys.

More detailed pronouncement of policy with a clear statement of stance, after careful assessment of macroeconomic and monetary developments.

Resource management discussion with select banks.

Technical Advisory Committee on Monetary Policy.

Inflation expectations survey.

Consultation with economists/media

Inter-institutional coordination with other regulators.

Survey of forecasters.

A detailed supplement to policy statement assessing macroeconomic and monetary developments.

Consultation with industry/trade/ other associations representing various stakeholders.

Coordination Surveys on lead committees with the indicators. government, such as on debt and cash management.

More frequent interventions in the market.

Speeches of top management and press statements. Assessment of downside as well as upside biases to projections.

Internal working groups on major policy issues and sharing of reports with the public.

Strengthening of Information/ Database

Regulatory changes through consultative process accommodating comments from market players and the public. Extensive interactions with multilateral institutions and other central banks.

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the reserve bank of india The coordination between the government and the Reserve Bank was again an issue. Governor Reddy observed that the government happened to be a significant player in many emerging market economies, especially in the financial sector. It was quite possible that there were communications or signals, if not directions, from the Ministry of Finance often on issues relating to monetary policy or banking, a sector predominantly government-owned. If these were consistent with those of the central bank, they reinforced the central bank policies. But if these were divergent, it posed a dilemma for central bank communication and, to that extent, a central bank may be constrained in freely articulating its policies. Governor Reddy was keen to connect Indian practice with the global practice in central banking and suggested that elements from a lecture delivered by Ben Bernanke (then a member of the Board of Governors of the Federal Reserve System, USA) on frameworks of monetary policy be incorporated in Indian policy statements.55 Bernanke compared forecast-based policy process with the feedback-based or consultative process – the former involved adjustments when actual values deviated from the trend or desired values in a model, while the latter involved adjustments based on, in addition to macroeconomic variables, communications with the market to gauge private sector expectations. It is significant that the latter, or the consultative approach, seemed to fit well the way the Reserve Bank went about instituting reforms. Governor Reddy also desired to conduct a survey of the frequency and contents of monetary policy statements of select central banks.56 Based on the findings, the frequency and pattern of policy announcement changed during his tenure. There were discussions on improvements in data, measurement and representation of macroeconomic activity. A meeting of the TACMP held on 23 July 2007 saw a wide-ranging discussion on this subject. The meeting considered a variety of issues connected with measurement, how to capture economic outlook of India and the world, expectations regarding corporate performance, their savings/investment, especially in light of interest rate changes, the outlook on inflation and inflation expectations in light of changes in international crude oil and other commodity prices, the evolution of liquidity conditions, expectations regarding balance of payments developments and capital flows, risk-adjusted asset prices, developments in subprime market, hedge funds and private equity funds, and monetary policy stance and measures. The meeting was held against the backdrop of the subprime crisis in the US and its global repercussions, and the prospect of a crisis following ‘overheating’ in emerging market economies. A sharp rise in stock market indices in

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monetary management 2006–07 added to the worry. The issue of stability and measurement, therefore, dominated the discussion. Governor Reddy, for example, raised the issue of choice of price index, the limitations of core inflation measures, and especially the danger of oversimplification by treating specific commodity prices as conveying shocks. Uncertainty about the direction of the exchange rate, the scale of capital inflows and the contagion effects of the global crisis occupied the discussion.

Conclusion

The period between 1997–98 and 2007–08 began with the Asian financial crisis. In these eleven years, the Indian economy remained remarkably crisisfree and stable. During these years a paradigm shift occurred in monetary management, which – by making new instruments available in addition to old ones, by allowing for greater coordination with the government and the financial market and by means of technological and legislative changes – enabled the Reserve Bank to effectively deal with the unintended consequences of the ongoing globalisation process.

Notes

1. From 2003–04, rapid expansion of credit in retail and real estate segments raised the fear that the economy could be ‘overheating’. External sector liberalisation resulted in unprecedented capital inflows with consequent impact on domestic liquidity. Towards the end of the reference period, the sub-prime crisis in the United States (US) raised the fear of contagion. These developments reinforced the need for caution and led to the use of both old and new instruments to achieve stability. 2. Government of India (Committee on the Financial System), Narasimham Committee Report on the Financial System, 1991 (New Delhi: Standard Book Company, 1992). 3. The minimum and maximum statutory CRR rates were originally 3 and 15 per cent of net demand and time liabilities of banks. The maximum was raised to 20 per cent in 1990–91. From the early 1990s, the Reserve Bank had followed a strategy of reducing the CRR to the minimum level of 3 per cent. Given the economic environment engendered by the currency crises in the South-East Asian region, the proposal to reduce CRR by 2 percentage points, envisaged in October 1997, could not materialise in full during 1997–98. Instead, CRR was raised with effect from 6 December 1997 and 17 January 1998 to siphon off liquidity and control the arbitrage opportunities between the call money market and the foreign exchange market. Subsequently, it was brought down 87

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the reserve bank of india to 4.5 per cent by early 2003. The SLR was earlier used mainly to support the borrowing programme of governments. It was statutorily set at a minimum of 25 per cent and the maximum was 40 per cent. It was about 38 per cent by 1990–91. Following recommendations of the Narasimham Committee I, governments were required to raise resources at market rates, and reliance on SLR was to be brought down. The SLR was reduced to 25 per cent by 1997. 4. However, as we shall see, the process of implementation of these changes needed to be cautious. An example of caution would be 2003–04 onwards, when growth in foreign exchange inflow led the Reserve Bank to devise a sterilisation strategy that spread the burden among MSS, LAF and the CRR. As a result, the CRR again acquired a prominent position. 5. With effect from 29 October 2004, the nomenclature of repo and reverse repo was interchanged by the Reserve Bank as per international usage. Prior to that date, repo indicated absorption of liquidity while reverse repo meant injection of liquidity. The nomenclature in this volume is generally based on the new use of terms even for the period prior to 29 October 2004, that is, reverse repo indicates absorption of liquidity while repo indicates injection of liquidity. Furthermore, following a change in accounting practice with effect from 11 July 2014, liquidity operations (repo, term repo, and Marginal Standing Facility, net of reverse repo and term reverse repo) are now treated as loans and advances to banks and the commercial sector instead of the earlier treatment of purchase/sale of securities and therefore excluded from net Reserve Bank credit to government. 6. While this approach is ‘monetary targeting’, in technical parlance, it was ‘monetary targeting with feedback’ as recommended by the Sukhamoy Chakravarty Committee (1985), which allowed intra-year review of the target. The feedback is to emanate from the real sector and the specific mechanism suggested for this purpose is the mid-year review of the monetary target. 7. Certain amendments relating to the Securities Contracts (Regulation) Act, 1956, that influenced policy and operations in financial markets are covered in Chapter 6. 8. The reference period starts in April 1997 when Rangarajan was in position and covers his period up to November until Bimal Jalan took over; at the end of the reference period, in March 2008, Reddy was the Governor and his tenure extended up to September until Duvvuri Subbarao took over. 9. RBI, Annual Report 1997–98. 10. RBI, Report on Currency and Finance (2006). 11. Deepak Mohanty and A. K. Mitra, ‘Experience with Monetary Targeting in India’, Economic and Political Weekly 34, nos 3–4 (1999): 123–32. 12. RBI, Annual Report 1996–97. 13. S. Venkitaramanan, Discussant’s remarks on ‘Managing External Economic Challenges in the Nineties: Lessons for the Future’, paper by Shankar 88

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monetary management Acharya, Indian Council for Research on International Economic Relations, New Delhi, September 1999. 14. D uring the L. K. Jha Memorial Lecture by Donald T. Brash, Governor, Reserve Bank of New Zealand, on 17 June 1999 in Mumbai, the speaker argued in favour of inflation targeting for countries like India, and Governor Jalan questioned the position. He reiterated the point on 7 December 2000 at the time of the C. D. Deshmukh Memorial Lecture by Charles Goodhart of the London School of Economics in Mumbai. 15. See https://www.rbi.org.in/scripts/BS_ViewMonetaryCreditPolicy.aspx?Id=2261. 16. In its ‘Mid-Term Review of Monetary and Credit Policy for 1998–99’ (30 October 1998), available at https://www.rbi.org.in/Upload/Notification/ Pdfs/3546.pdf. 17.  The restriction was that if an entity borrowed from the Reserve Bank, it was not expected to lend in the money market. This was followed as a supervisory norm. However, subsequently the Reserve Bank issued a specific instruction on 21 March 2007 that banks can utilise the funds borrowed (from the Reserve Bank’s LAF window) for interbank lending. Such interbank lending is part of normal money market functioning that enables daily liquidity management by market participants having temporary mismatches. However, such borrowings should not be persistent in order to fund balance sheets for credit needs of customer. 18. The members of the group were D. Anjaneyulu, Shyamala Gopinath, Usha Thorat, K. Kanagasabapathy and G. S. Bhati, with Jaya Mohanty acting as Coordinator and Secretary. 19. The same group was reconstituted into another Group on Operationalising LAF. The report of the latter group, submitted on 29 October 1999, was discussed with various bodies and market participants, including the Advisory Committee on Money and Government Securities Markets, chairmen and presidents of the Indian Banks’ Association (IBA), the Fixed Income Money Market and Derivatives Association of India (FIMMDA) and the Primary Dealers’ Association of India (PDAI). 20. A note prepared by S. C. Misra, 22 June 2000. 21. The net reverse repo increased from an average of 111.96 billion in 2002–03 to 387.50 billion on 30 September 2003. Net OMOs increased from 354.19 billion in 2002–03 to 537.80 billion in 2003–04. 22. See https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?FromDate =12/02/03&SECID=21&SUBSECID=0. The Financial Markets Committee (FMC-RBI) discussed the issue of releasing the reports on the LAF and on sterilization. The consensus was that if the LAF report alone was released, the impact on bond markets would be positive as the market would expect the liquidity absorption rate to be below the repo rate, in view of the suggestion for having a more flexible corridor. The impact on bond markets would,

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the reserve bank of india however, be moderated if the sterilisation report was released simultaneously because it emphasised the need for sterilisation and the preparedness of the Reserve Bank to use several instruments for this purpose. The overall impact could well be neutral because the market would recognise that the suggestions for sterilisation required either government consent or legislative changes. In other words, the market would expect the Reserve Bank to continue to use the LAF as the main instrument of sterilisation. In the end, both reports were released simultaneously (on 2 December 2003). 23. By Amitava Sardar, Director, MPD. 24. In the meeting of the Central Board held in Thiruvananthapuram on 6 May 2004, Deputy Governor Rakesh Mohan mentioned that in view of earlier seminar discussions and the feedback, and following the recommendations of the Working Group on Instruments of Sterilisation, an MSS was introduced in April 2004 to strengthen the Bank’s ability to conduct exchange rate and monetary management operations. 25. The government informally expressed an opinion that the Reserve Bank should consult them in the event of a higher cut-off in the auctions of both normal and MSS securities as it could prefer taking lesser amount in both auctions. The Reserve Bank did not agree with such an arrangement with respect to MSS securities on grounds that those were part of monetary policy operations and, therefore, discretion should lie with the Reserve Bank. 26. Letter by Deputy Governor Rakesh Mohan to Finance Secretary D. Subbarao on 31 October 2007 (see Appendix A3.2). 27. An internal group formed of officers from various departments such as the Department of External Investments and Operations (DEIO), IDMD and MPD. 28. As per the revised national accounts series with base year 2011–12, the growth averaged lower at 7.9 per cent. 29. Following the amendment of the RBI Act, no interest was payable by the Reserve Bank on CRR balances of banks with effect from the fortnight beginning 31 March 2007. Also see the section ‘Legal Reform’ in this chapter. 30. See https://www.rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=14666 (para 12). 31. The situation later turned full circle when the MoU on the MSS was amended on 26 February 2009 to enable the Bank to de-sequester MSS cash balance for financing the government’s expenditure in lieu of the approved market borrowings. 32. The Bank Rate remained at 10 per cent since July 1981 before being raised to 11 per cent in July 1991 and further to 12 per cent in October 1991, against the backdrop of high inflation and difficult balance of payments situation. 33. Policy note on Lender of Last Resort Facility presented to the Central Board of Directors in its meeting held on 15 July 2002. A special liquidity facility 90

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monetary management in the nature of last resort was granted at the Bank Rate plus 4 per cent to Global Trust Bank on 28 July 2004. 34. At the instance of Deputy Governor Rakesh Mohan, an interdepartmental group was constituted on 2 November 2006 to review the legal position of the Bank Rate in Section 49 of the RBI Act, 1934, ascertain its role as a signalling device, and consider how efficient a policy tool it still was. The group submitted its report (with a dissenting note) on 17 January 2007. The majority report concluded that the Bank Rate had largely become redundant as a policy instrument, the repo rate could be treated as a reference rate for all purposes, and the Bank Rate be treated as a penal rate for shortfall in reserve requirements. The Bank Rate, it was suggested, could be fixed at the level of the repo rate, in line with the recommendation of the Internal Group on LAF (2003), and be used as a reference rate for medium-term policy stance. This could be achieved by placing the Bank Rate in the middle of the reverse repo rate and repo rate corridor. The Reserve Bank did not accept the recommendations of the report. 35. A symmetrical clause in the case of deposits, stipulating that ‘the rate of interest payable on the deposit was subject of the directives of the Reserve Bank that may be issued from time to time’, was reportedly withdrawn on 24 June 1991. 36. RBI, ‘Monetary and Credit Policy for the Year 2000–01’, available at https:// www.rbi.org.in/scripts/BS_ViewMonetaryCreditPolicy.aspx?Id=2261. 37. Until then the Reserve Bank maintained that charging loans below the PLR would contravene Reserve Bank directives. In the context of participating in a consortium lending led by State Bank of India (SBI), State Bank of Indore asked (September 1997) if they could charge a rate of 13.5 per cent, consistent with SBI and 1 percentage point below their own PLR, to be able to participate in the consortium lending. State Bank of Patiala also came up with a similar request. The MPD, on examination of the case, held that charging loans below the PLR would contravene Reserve Bank directives. However, it said that the consortium could address the problem and arrive at a settlement. Even in public discussion, this remained a controversial issue. In the column on ‘Counter View’ in the Hindu Business Line dated 16 August 1997, bankers discussed under the heading ‘Subverting the PLR?’ the pros and cons of charging lending rates for borrowers below bank’s own PLR. One banker’s view was that once a bank decided on the PLR and justified it based on various parameters, lending below the PLR would send wrong signals to the customers. Another view was that this was normal internationally – subLIBOR lending existed. PLR and LIBOR were only reference or benchmark rates. A third view from a corporate borrower was that the very concept of PLR was not going to last long because of its inherent inflexibility. 38. RBI, ‘Annual Policy Statement of 29 April 2002’. 91

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the reserve bank of india 39. An internal note of the MPD stated that, as on December 2002, nearly a third of all credit was extended at sub-PLR rates. 40. The point was noted earlier by Deputy Governor Rakesh Mohan in an internal meeting. In view of the Reserve Bank’s policy of moving away from micro-regulation of banks, he stressed that Reserve Bank guidelines should be advisory. 41. S.S. Tarapore, ‘PLR: Fact or Fiction’, Financial Express, 8 October 2003. 42. Mid-term policy of 3 November 2003. 43.  Loans to individuals for acquiring residential properties or purchase of consumer durables, loans to individuals against shares and debentures/ bonds, non-priority sector personal loans, advances/overdrafts against domestic/NRE/FCNR(B) deposits with the bank, subject to restrictions, finance granted to intermediary agencies (excluding those of housing) for on-lending to ultimate beneficiaries and agencies providing input support, loans covered by refinance schemes of term lending institutions, finance granted to housing finance intermediary agencies for on-lending to ultimate beneficiaries, discounting of bills, loans to cooperative banks or any other banking institution, and loans to own employees. 44. Note prepared by the MPD, dated 8 January. 45. Note recorded in the MPD, 21 October 2005. Internationally the PLR meant rate generally charged for prime borrowers and sub-PLR rates offered for a section of prime borrowers. 46. Several studies reported that, especially in the Euro area, shifts in policy rates were not completely passed through to retail lending rates. See Teruyoshi Kobayashi, ‘Incomplete Interest Rate Pass-Through and Optimal Monetary Policy’, International Journal of Central Banking 4, no. 3 (2008): 77–118. 47. EPW Research Foundation, ‘Downward Sticky Lending Rates’, in Money Market Review, Economic and Political Weekly 44, no. 25 (2008): 25–31. 48. Partly as a follow-up to the recommendations of the ‘Action Taken Report on the Report of the Joint Parliamentary Committee on Stock Market Scam and matters Relating Thereto’, Government of India, Ministry of Finance, 9 May 2003. 49. Headed by E. A. S. Sarma, Secretary, Economic Affairs, Government of India (GOI). The other members of the committee were: from the Reserve Bank, Y. V. Reddy, Deputy Governor; and from GOI, A. M. Sehgal, Controller General of Accounts; J. S. Mathur, Additional Secretary (Budget); K. N. Khandelwal, Additional Deputy Comptroller and Auditor General; Ashok Lahiri, Director, National Institute of Public Finance and Policy; N. L. Mitra, Director, National School of Law; Ajoy Sinha, Joint Secretary, Department of Legal Affairs; V. K. Bhasin, Joint Secretary, Legislative Department; and S. C. Pandey, Director (Budget), as Convenor. 92

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monetary management 50. The approach paper was prepared by K. Kanagasabapathy and R. K. Pattnaik, and the illustrative draft Bill by N. V. Deshpande and L. N. Mitra as the external member. 51. The passage of this Act took about three years and was not smooth. Though the FRBM Bill was introduced in December 2000 by Yashwant Sinha, Finance Minister, it was referred to the Parliamentary Standing Committee on Finance. The Standing Committee recommended that the numerical targets proposed in the Bill be incorporated in the rules to be framed under the Act rather than the Act itself. When the Act was passed, Saumitra Chaudhary commented that ‘all teeth of the Fiscal Responsibility Bill have been pulled out and in the current form it will not be able to deliver the anticipated results’ (ENS Economic Bureau, ‘Tenth Plan for Adoption of Fiscal Responsibility Bills by States’, Indian Express, 4 November 2002). See Chapter 7 for more details of the larger provisions of this Act and the process of its implementation. 52. The internal working group consisted of heads of several departments and was chaired by N. V. Deshpande, Principal Legal Advisor. 53. The reverse repo auctions in government securities were proposed as early as October 1992. There was no specific mention about repo transactions in the RBI Act then. Subsequently, in response to two queries about the legal status of these transactions, the Legal Advisor of the Reserve Bank gave different opinions. On 6 October 1992, the Legal Department held that repo transactions in government securities would not amount to ‘borrowing’ within the meaning of section 17(4) of the RBI Act. On 6 April 1998, in response to another query, the Legal Department held that Section 17(12A) of the RBI Act could be taken to cover transactions of sale and purchase of securities of every type and it was possible to take a view that the repo and reverse repo transactions were also covered by this section as the condition to repurchase could simply be considered as part of the terms and conditions of the transactions. The amendment to the RBI Act at that time was, therefore, not pursued. 54. A reference was also made by the Urban Banks Department, RBI, on shares and bonds of the Industrial Investment Bank of India (IIBI) issued under private placement. On this, the MPD has taken a view that the shares, bonds and debentures issued by the IIBI under Section 11 of the RBI Act, although approved securities under the Banking Regulation Act and also the Indian Trust Act, 1882, are not issued under the market borrowing programme. 55.  ‘Central Bank Talk and Monetary Policy’, Remarks by Governor Ben S. Bernanke At the Japan Society Corporate Luncheon, New York, 7 October 2004, available at https://www.federalreserve.gov/boarddocs/ speeches/2004/200410072/default.htm. MPD note prepared by Sanjay Hansda, Assistant Adviser, 17 December 2004. 56. Note prepared by Mohua Roy, Director. 93

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4 Foreign Exchange Market and Management of the Capital Account Introduction Between 1997 and 2008, the Indian foreign exchange (or forex) market underwent a major transformation in terms of the scale of turnover, players, institutional arrangements, and instruments. Although the Indian rupee had become convertible on current account in 1994, some of the current account transactions were still subjected to limits. These were either removed or relaxed subsequently and brought under a new legal framework, the Foreign Exchange Management Act (FEMA), 1999, which replaced the earlier, and far more restrictive, Foreign Exchange Regulation Act (FERA) 1973. Authorised dealers (ADs) were provided with more flexibility to undertake forex operations and greater freedom to manage risks. The liberalisation of the capital account, by contrast, was a more gradual process and marked by cautious optimism. The period witnessed ‘effective’ full capital account convertibility for non-resident Indians (NRIs) and the introduction of limited liberalisation measures for capital transactions of residents. The underlying aim was to open up the forex market in line with the ongoing reforms. That expectation was so well fulfilled that the resultant transition posed problems for capital account management. Between 2001 and 2008, capital inflows occurred on a scale beyond the absorbing capacity of the economy, forcing the Reserve Bank to explore ways in which the ‘problem of plenty’ could be handled (Table 4.1). In terms of the powers conferred by FEMA, the Reserve Bank is responsible for development and regulation of the forex market as well as management of the capital account. The measures that were taken to further open up the market during 1997–2008 necessitated changes in the legal framework and introduction of a large number of specific regulatory measures on the part of the Bank. The focus of the present chapter is on these measures. 94

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foreign exchange market and management of the capital account Table 4.1 Select Indicators of External Sector  Year  

Exports Imports    

(per cent of GDP)

Private Transfersa

Software Exports

1997–98

8.4

12.1

2.8

0.4b

1999–2000

8.0

11.9

2.6

0.9

1998–99 2000–01 2001–02

8.0 9.5 9.1

2002–03

10.3

2004–05

11.8

2003–04 2005–06 2006–07 2007–08

10.7 12.6 13.6 13.4

11.1 12.2 11.4 12.3 12.9 16.5 18.8 20.1 20.8

2.4 2.7 3.2 3.3 3.6 2.9 3.0 3.2 3.5

Source: RBI, Database on Indian Economy.

Current Account Balance

0.6b b

1.3 1.5 1.8 2.1

-1.3 -0.9 -1.0 -0.5 0.7 1.2 2.3

2.4

-0.4

3.3

-1.0

2.8 3.2

-1.2 -1.3

Foreign Net Investment Capital (Net) Flows 1.3

2.3

1.1

2.2

0.5 1.2 1.4 0.8 2.2 1.8 1.9 1.6 3.5

2.0 1.9 1.7 2.1 2.7 3.9 3.0 4.7 8.6

Notes: a. Migrants transfer. b. Based on National Association of Software and Service Companies (NASSCOM) data.

The rest of the chapter has two main sections, dealing with the forex market and management of the capital account.

Foreign Exchange Market Until the late 1990s, the Indian forex market was relatively shallow and had an uneven flow of demand and supply. Most transactions were spot and trade based. Transactions emanating from market expectations were rare because arbitrage opportunities between onshore and offshore financial asset markets were not freely allowed to be exploited. Interbank transactions were not significant as there were many restrictions on forex transactions of the banks. ‘Forward’ contracts were allowed only with underlying transactions and did not exist for a tenure beyond six months. As such, turnover in the Indian forex market was low (Figure 4.1). 95

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the reserve bank of india Figure 4.1 Turnover in Indian Foreign Exchange Market           

 

 

   

(per  cent of GDP)

1.20 1.00 0.80 0.60 0.40 0.20 0.00

8

-8

87

19

0

-9

89

19

2

-9

91

19

4

-9

93

19

6

-9

95

19

Interbank

8

-9

97

19

0

-0

99

19

Merchant

2

-0

01

20

4

-0

03

20

6

-0

05

20

8

-0

07

20

Total

Source: RBI.

There were a few major players in the market. In 1997, 40 per cent of the total value of customer transactions was accounted for by State Bank of India (SBI), and the remaining shared by other public sector banks. In the interbank segment of the market, only SBI and a few other banks were ready to quote two-way price both in the spot and forward markets and they were regarded as market makers. The Reserve Bank intervened in the forex market either to buy or sell forex, as the case may be, to meet the deficit, or to absorb the surplus, thereby playing the role of market stabiliser. In terms of types of transaction, debt service payments and imports were major components of forex outgo. Demand for forex came mainly from oil companies and other public sector enterprises. In terms of supply, export of goods and services was the major contributor. From the late 1970s, workers’ remittance had also gained prominence as an inflow. As capital transactions were restricted, only traditional components, such as official capital flows and NRI deposits, formed the major part of capital flows. Foreign direct investment (FDI), though allowed, was limited to a few sectors, subjected to sectoral caps, and not encouraged without technology transfer. In terms of ratio to gross domestic product (GDP), total current and capital transactions were only around 44 per cent in 1996–97 compared to nearly 114 per cent in 2007–08. Transactions were closely regulated. The genesis of forex regulation in India goes back to the 1930s when the Defence of India Act, 1939, was passed because of the scarcity of forex in the aftermath of the Great Depression. An independent legislation, FERA,

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foreign exchange market and management of the capital account 1947, empowered both the government and the Reserve Bank to control and regulate receipts and payments of forex. While all current transactions were regulated by the Bank, capital transactions were controlled by the government. The government dealt with contraventions of FERA. FERA, 1947, was replaced by FERA, 1973. The new law contained more stringent controls on forex transactions. FERA was repealed in 1999 and FEMA, 1999, was passed, which was liberal and more conducive to external trade and investments. India had a fixed exchange rate arrangement until the mid-1970s. From 1975 to 1992, the Reserve Bank set the exchange rate of the rupee in terms of a weighted basket of currencies of India’s major trading partners. There were significant restrictions on current account transactions and only a few transactions were allowed under the capital account. The Bank was ready to buy and sell forex to tide over the mismatch between demand and supply. After an interim arrangement of dual exchange rate arrangement under a Liberalised Exchange Rate Management System (between 1 March 1992 and 28 February 1993), the exchange rate was unified from 1 March 1993, which heralded a new era of a market-determined exchange rate. This, together with the relaxations of restrictions on the current transactions, culminated in the announcement of current account convertibility in 1994.1 There is a large scholarship on the liberalisation process from the early 1990s so that another descriptive account of the process can be avoided here. Instead, this chapter focuses on the role of the Reserve Bank in leading the transition.

Reviews and Recommendations The discussion can begin with the step taken by Governor Rangarajan in November 1994 to set up an Expert Group on Foreign Exchange under the chairmanship of O. P. Sodhani, Executive Director. The committee, which submitted its report in June 1995, made several recommendations that became a blueprint for forex market reforms introduced in 1996. Some of the recommendations of the committee, such as allowing the ADs to use derivative products, changed the structure of the market. In his 1997–98 Budget speech, Finance Minister P. Chidambaram announced that he would be asking the Reserve Bank to appoint a group of experts to lay out the road map towards capital account convertibility. The Bank appointed the Committee on Capital Account Convertibility, popularly known as Tarapore I, under the chairmanship of S. S. Tarapore, former Deputy Governor.

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the reserve bank of india The committee’s report, which was submitted on 30 May 1997, recommended a phased implementation of capital account convertibility in a three-year time frame beginning 1997–98 (Box 4.1). The committee recommended a gradual liberalisation of controls on capital outflows and inflows, which had a bearing on the forex market.2 Box 4.1 Tarapore Committee I (1997) The setting up of the Committee on Capital Account Convertibility (Tarapore I) was a milestone in the external sector liberalisation process. The committee recommended a phased implementation of capital account convertibility over a three-year period: Phase I (1997–98), Phase II (1998–99) and Phase III (1999–2000). The committee suggested that the implementation of measures contemplated for each phase should be based on meeting certain preconditions. The recommended preconditions aimed generally at creating a stronger and healthier financial system with fewer controls. These included:

• Fiscal consolidation in the form of a gradual reduction in the centre’s gross fiscal deficit to GDP ratio to 3.5 per cent in 1999–2000, accompanied by a reduction in the states’ deficit as also a reduction in the quasi-fiscal deficit. • Limiting the inflation rate for the three-year period at an average of 3–5 per cent; the Reserve Bank should have full independence to achieve the inflation rate mandated by Parliament. • Consolidation of the financial system with full deregulation of interest rates in 1997–98, a gradual reduction in the average effective cash reserve ratio (CRR) to 3 per cent in 1999–2000, and reduction in gross non-performing assets (NPAs) of banks to 5 per cent in 1999–2000 and strengthening of the financial system. • To design external sector policies to ensure a rising trend in the current receipts to GDP ratio from the present level of 15 per cent as well as to reduce the debt service ratio to 20 per cent (from around 23 per cent in 1996–97), and to prepare the financial system for capital account convertibility. While commenting on the implementation of these recommendations, Tarapore II in 2006, discussed later in the chapter, stated that by and large RBI has taken action on a number of recommendations but the extent of implementation has been somewhat muted on some of the proposed measures (e.g., outflows by resident individuals and overseas borrowing by banks), while for some other measures, RBI has proceeded far beyond the Committee’s recommendations (e.g. outflows by resident corporates). RBI has, however, taken a number of additional measures outside the 1997 Committee’s recommendations.

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foreign exchange market and management of the capital account At the instance of Prime Minister Manmohan Singh, a second committee on capital account convertibility was instituted, again under the chairmanship of Tarapore, in March 2006. The committee is commonly known as the one on ‘Fuller Capital Account Convertibility’ (Tarapore II). It submitted its report on 31 July 2006. The committee again recommended a phased implementation of capital account convertibility, as discussed later in the chapter. While the Sodhani Committee set the agenda, Tarapore I and II drew the road map. In addition, the Reserve Bank appointed several committees, internal working groups and task forces to work out the process of reform of specific rules and regulations. These included the Committee on Procedures and Performance Audit on Public Services (CPPAPS) (2004), the Internal Technical Group on Forex Markets (2005) and the Internal Working Group on Currency Futures (2007). The first of these was set up, again, under the chairmanship of Tarapore. One of these committees recommended procedural liberalisation in forex services for residents to provide ‘seamless flow of services’ and to ‘move away from micromanagement of controlling forex transactions, particularly for individuals’. The committee recommended several steps leading to the speedier release of forex at the branch level.3 Residents could maintain foreign currency account outside India within the aggregate limit. NRIs were allowed easier remittance. The committee recommended changing the name of the Exchange Control Department to Foreign Exchange Department and urged a change in the attitude of bank officers from controllers to facilitators. The Internal Technical Group on Forex Markets examined options for further liberalisation. The group suggested several ways to expand the forex market.4 Since remittances from NRIs were a significant component of the country’s forex inflows, a working group (April 2006) examined the cost of remittances.5 Expatriates wishing to send small amounts back home to their families bore excessive costs. The group recommended, among other steps, that NRIs should route their remittances through Indian bank branches, and that the banks in India should view the remittances as volume-generating business and reduce the fees. Accordingly, the existing restrictions on the number of tie-ups with exchange houses and the number of drawee branches for rupeedrawing arrangements were to end. Banks were also advised to review the charges and adopt the latest technology for remittances. The Task Force (Chairperson: Shyamala Gopinath, Deputy Governor) on rationalisation and simplification of forex regulations, constituted internally by Reserve Bank in the latter half of 2006, also made a contribution. The aim was to 99

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the reserve bank of india identify anomalies in the present regulatory framework. Its recommendations covered resident and non-resident corporates and individuals as well as financial institutions. Almost all the policies relating to the forex market and capital account liberalisation introduced during 2007-08 had their roots in the recommendations of the Task Force. Earlier, the R.V. Gupta Committee on Hedging through International Commodity Exchanges (1997) and a working group (1999) to look into the system of reconciliation of Nostro accounts (account held in a foreign country by a domestic bank) in public sector banks had made significant contributions to liberalisation of the forex market. In April 2008, an internal working group chaired by the Chief General Manager, Foreign Exchange Department, recommended the introduction of currency futures as an additional hedging tool, and proposed that, for introduction of USD–INR futures, contract size, tenor, design and settlement of contracts, among other issues, should be considered. The report also dealt with central clearing, ‘margining’ (facility given to traders to transfer margins from one account to another), and efficient surveillance and monitoring. Besides committee reports, feedback received in the annual conferences led to procedural changes. These conferences were conducted by the Foreign Exchange Department, together with its regional offices and ADs. On the part of the Reserve Bank, bringing the officers of its regional offices and representatives of concerned ADs face to face was a useful learning experience. So was the system of periodic internal inspection, especially on procedural matters. Following the Sodhani Committee report, in April 1996, a Foreign Exchange Market Technical Advisory Committee was set up. The committee recommended that the ADs should be free to fix their own aggregate gap limits. In January 1997, ADs were allowed to use derivative products, such as interest rate swaps, currency swaps and forward rate agreements, to hedge their asset–liability portfolio, which was expected to impart liquidity to the swap market and to ensure better management of foreign currency assets and liabilities by banks. While these steps were being taken, the Southeast Asian crisis broke out. The August 1997 crisis raised doubts about the continuity of the liberalisation process. The Reserve Bank, however, accepted the recommendations of Tarapore I and decided in October 1997 to implement a number of measures relating to the liberalisation of capital transactions. 100

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foreign exchange market and management of the capital account Again, in November 1997, when the forex market came under pressure, the Bank took several administrative measures to discourage arbitrage between domestic and foreign money markets. The reversal interrupted the process of market reform, but only temporarily. By mid-January 1998, as markets calmed down, the liberalisation exercise resumed. These measures related to corporates, individuals and financial institutions. Individuals can be further disaggregated into residents and non-residents. Irrespective of the group, liberalising inflow was prioritised over outflows, though outflows related to inflows were somewhat relaxed, and equity flows were preferred to debt-creating ones.

Companies In October 1997, to provide flexibility to meet their cash flow, exporters were permitted to retain up to 50 per cent of receipts in their foreign currency accounts with banks in India. In August 1998, streamlining the procedure, external commercial borrowing (ECB) guidelines were relaxed.6 To encourage inward investment, from 12 October 1999, permission was granted to Indian companies to issue rights or bonus shares to non-residents and to send such shares out of India. Subsequently, they were also allowed to issue nonconvertible bonds. Two-way fungibility in American depository receipts (ADRs) and global depository receipts (GDRs) issued by Indian companies was introduced in March 2001.7 In January 2001, general permission was granted to Securities and Exchange Board of India (SEBI)–registered foreign venture capital investors to invest in Indian venture capital undertaking or in a venture capital fund. The first major episode of misuse of liberalisation in capital accounts came to light in 2001. In mid-2001, SEBI reported that certain overseas corporate bodies (OCBs), though poorly capitalised, had remitted large amounts out of India. An OCB is usually a firm owned to the extent of at least 60 per cent by NRIs. Reserve Bank investigations also revealed that the accounts of OCBs were not operated within the parameters laid down under the Portfolio Investment Scheme. The issue of OCBs was again discussed by the High-Level Coordination Committee on Financial and Capital Markets (HLCCFCM) in August 2001, and by a Joint Parliamentary Committee on the stock market scam involving Ketan Parekh in December 2002.8 Already in November 2001, it had been decided that OCBs would not be permitted to 101

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the reserve bank of india invest under the Portfolio Investment Scheme in India. A particular problem was that of tracing their addresses. Some of the letters issued during the survey conducted by the Bank were returned as the respective companies were not found at the addresses they had furnished. To allow corporates to have a wider choice of external borrowing, they were allowed, in March 2002, to issue foreign currency convertible bonds up to US$50 million per year. As capital flows turned buoyant, the period of realisation of exports was allowed to be beyond six months where the invoice value did not exceed US$100,000 ( January 2002). All forex earners were allowed to credit 100 per cent of their earnings to their exchange earners’ foreign currency (EEFC) accounts. Companies were allowed to retain commercial borrowings in bank accounts abroad ( January 2003). In February 2003, resident shareholders of Indian companies, who offered their shares for conversion of ADRs, were allowed to receive the sale proceeds in foreign currency, subject to the approval of the Foreign Investment Promotion Board (FIPB). Further, the sale proceeds so received were also permitted to be credited to their EEFC/resident foreign currency (domestic), or RFC(D), accounts. In January 2004, ECB guidelines were revised to make the procedure more transparent. ECBs were permitted to be raised for investment in the real sector, the industrial sector and especially the infrastructure sector.9 In October 2004, conversion of such borrowings into equity was allowed. Permission was also granted for the transfer of shares, increase in foreign equity participation by fresh issue of shares, and conversion of preference shares into equity capital. Outflows were further liberalised during the latter part of the period. After the onset of the Southeast Asian crisis, some monetary and administrative measures were taken to discourage outflows (also see Chapter 3). As the crisis subsided, the Reserve Bank took steps to remove the restrictions on outflow transactions.10 In December 1998, many forex provisions for outflow were eased. The yearly ceiling for clearance of proposals for investment abroad by an Indian company was raised from US$4 million to US$15 million. The Bank decided to grant blanket approval to Indian companies for investment abroad in the field of software.11 In April 1999, Indian entities were permitted to open, hold and maintain a foreign currency account with a bank outside India in the name of its office or branch set up outside India. A significant amount of ECB was contracted at a fixed interest rate. When international interest rates began to fall in the late 1990s, the Reserve Bank permitted (September 1999) prepayment of loans up to US$100 million, 102

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foreign exchange market and management of the capital account enabling companies to take advantage of low international interest rates. The limit was gradually raised to reach US$400 million by April 2007. In March 2001, the Reserve Bank allowed Indian companies wishing to acquire foreign companies or make direct investment abroad in joint ventures or wholly owned subsidiaries to invest up to US$50 million annually through the automatic route, and invest up to 100 per cent of the proceeds of depository receipts issued for acquisition of foreign companies and direct investments. The ban on overseas investments by registered partnership firms was removed. Indian direct investment abroad was allowed under two conduits – fasttrack (automatic route) and normal route. The former had limits that were raised from time to time. A committee assessed the twofold division and recommended increasing the limit under automatic route from US$15 million to US$50 million.12 The Reserve Bank would process all proposals above US$50 million under the normal route. On 3 September 2002, the amounts were revised further upwards. The decision process in the committee was often slow, however (see Appendix A4.1).13 Although the committee remained with the Bank, the meetings became few and far between as most aspects of Indian investment abroad were liberalised. As capital inflows picked up from 2001–02, liberalisation of outflows was construed as one of the ways in which the problem of excess capital flows could be handled. In November 2002, the limit for advance remittance without bank guarantee by ADs was raised for import of goods into India.14 In July 2003, all companies entering into foreign technology collaboration agreements under the automatic route, irrespective of the extent of foreign equity in the shareholding, were permitted to make royalty payment at 8 per cent on export and 5 per cent on domestic sales without any restriction on duration of royalty payments. In March 2005, the ceiling of investment by Indian entities in overseas joint ventures and/or wholly owned subsidiaries was raised from 100 per cent to 200 per cent of their net worth under the automatic route.15 Although foreign institutional investors, or FIIs, were allowed to invest in the equity market with some restrictions, they did not have access to the debt market. There was a long-standing demand that they be allowed to participate in the debt market. On 8 March 1997, FIIs were permitted to invest in dated government securities. From June 1998, ADs could provide forward cover facilities for FIIs with respect to their fresh investments in equity. In August 1998, limits for investments by OCBs, FIIs and NRIs in Indian companies 103

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the reserve bank of india were enhanced, and ceiling applicable to individual NRIs and OCBs with respect to their portfolio investment in shares/debentures of an Indian company was raised from 1 per cent to 5 per cent of the paid-up equity capital of the company concerned. In April 1999, the limit of the aggregate ceiling of FII investment was raised from 30 per cent to 40 per cent of issued and paidup capital of an Indian company. The government securities market and the corporate bond market were opened to FIIs in a more measured way. They were allowed to invest in longterm securities in March 1997, and in treasury bills (T-bills) in June 1998.16 In February 2004, multilateral development banks, such as the International Finance Corporation (IFC) and the Asian Development Bank (ADB), which were specifically permitted by the central government to float rupee bonds in India, could purchase dated government securities.

Non-residents The Reserve Bank introduced a new type of account, the non-resident special rupee (NRSR) account, in April 1999 for NRIs who would voluntarily undertake not to seek repatriation of funds held in such accounts.17 In November 1999, general permission was granted to Indian mutual funds to issue units or similar instruments under schemes approved by SEBI to FIIs with repatriation benefits, subject to certain conditions. To enhance FII participation, they were allowed to invest up to 49 per cent in an Indian company under the portfolio investment route with the approval of the company’s general body of shareholders from March 2001. Deregulation of interest rates on non-resident accounts has been discussed in Chapter 3 and does not require further discussion here. Liberalising outflows further, in July 2002, ADs could repatriate funds out of balances held by NRIs and persons of Indian origin (PIOs) in their non-resident ordinary rupee (NRO) accounts for certain purposes.18 To avoid asset–liability mismatches and meet risk management guidelines, banks were permitted to invest their foreign currency non-resident (banks) (FCNR[B]) deposits in longer-term fixed-income instruments, provided these instruments had an appropriate rating. In September 2002, Indian branches of ADs were permitted to grant foreign currency loans in India, against the security of funds held in their FCNR(B) deposit accounts, to the account holders only. The following year, ADs were allowed remittance up to US$1 million in a 104

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foreign exchange market and management of the capital account calendar year out of the balances held in NRO accounts or from sale proceeds of assets. In February 2004, ADs were permitted to grant rupee loans to NRIs, other than for specified prohibited purposes.19 The CPPAPS had recommended that the power-of-attorney holder in non-resident accounts should be allowed to remit money outside India as he or she was permitted to execute domestic transactions. The recommendation was accepted in November 2004, and extended to NRO accounts in 2007. The concern raised by the Legal Department that this might lead to money laundering was rejected because the onus to prove the genuineness of the transaction remained with the NRI concerned. Further, the Reserve Bank clarified to banks that NRO accounts could be held by non-residents jointly with residents. In 2007, ADs were allowed to remit the maturity proceeds of FCNR(B) deposits to third parties outside India.

Residents Residents were subjected to more restrictions. These were liberalised step by step. In May 1997, residents could take interest-free loans from NRIs for personal purposes or for carrying on business activities on repatriation basis under the automatic approval route, subject to certain conditions. In March 1998, general permission was granted to resident individuals and proprietorship concerns for raising non-repatriable rupee loans from NRIs. From September 1998, residents could use facilities against the collateral of fixed deposits in NR(E)R accounts.20 In November 2001, a ceiling of US$500, allowed to those travelling to countries other than Iraq, Libya, Iran, Russia and the Commonwealth of Independent States, was raised to US$2,000 or its equivalent, without prior permission from the Reserve Bank. In September 2002, to make the release of forex to resident individuals easier, ADs were permitted to release an amount up to US$500 for all permissible transactions on the basis of a simple letter from the applicant. There was still a limit of US$5,000 to be released by ADs to resident individuals in one calendar year for travel; this was enhanced to US$10,000 in 2002. Residents were also allowed to hold US$2,000 in cash or in an RFC(D) account.21 These steps, taken in quick succession, did not always follow a predetermined script. The emergence of a virtuous circle between inflow and outflow influenced the reform process. There was always more regulation upon 105

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the reserve bank of india outflow. But there was also the force of an argument that reducing restrictions on outflows was a precondition for more inflow to occur. When inflows did pick up in the early 2000s, further liberalisation of outflows became possible, as the country had enough reserves to meet the unforeseen scale of repatriation. Indeed, higher outflows could then be a way to handle excess capital inflows, or as a stabilisation measure. In January 2003, the limit for advance remittance for import of services by ADs without the prior approval of the Reserve Bank was raised by a large margin. Resident individuals were permitted to invest abroad in companies.22 In July 2003, the limits on remittances for specific purposes like education, employment, or maintenance of close relatives were substantially and uniformly enhanced.23 In December 2003, the limit for forex remittance by resident individuals for miscellaneous current transactions other than imports was raised and did not need documentation.24 More controversially, Indian students studying abroad were treated as NRIs and eligible for all the facilities available to NRIs. By international norm, students studying abroad were treated as residents. The Reserve Bank made a deviation. A press release dated 8 December 2003 stated that the purport of their [Indian students abroad] argument is that though they are students, they are, in reality, not dependent for a dominant part of their expenses on remittances from their households in India. Often they are permitted to work and have to undertake certain related financial transactions. They urge, therefore, that the definition needs to be revised.

This argument was accepted, even though in the balance of payments accounting, students studying abroad continued to be treated as residents. There is an interesting backdrop to the change of residential status of students. A Board member of the Reserve Bank had written to Governor Jalan (1 April 2003) that his son, then studying in the United States (US), ought to be considered as a non-resident. His tax attorney, he said, supported the claim. The response from the Reserve Bank Legal Department was initially negative. However, after much deliberations, the Legal Department responded by saying that without prejudice to the interpretation of NRI under FEMA, some of the facilities extended to NRIs, like opening foreign currency deposits with banks in India, could be extended to students by making necessary amendments to the deposit regulation of the FEMA. Concurrently, the Reserve Bank had taken up the matter with the Government of India. The government convened 106

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foreign exchange market and management of the capital account a meeting, following which the deposit regulation of FEMA was amended, allowing students studying abroad to open NRI deposits. Eventually, the residential status of Indian students was changed and a circular was issued on 8 December 2003.

Who Is a Non-resident Indian? There were two definitions of an NRI, one set out by FEMA and the other by the Income Tax Act, 1961. FEMA contains a clause (Section 2[V]c) that says that a person going abroad with an intention of staying there for an uncertain period would become a non-resident. This clause was absent in the Income Tax Act. The implication of the FEMA clause was that persons going abroad with an intention of staying for a definite period, like students, business visitors and tourists, would be treated as residents. This anomaly made the case of students, like the one just mentioned, open to legal disputation. Not only with students but in several other contexts too, the Reserve Bank needed to engage with the interpretation of residents and non-residents. One of these was the acquisition and transfer of immovable properties. FERA provisions had laid down that only Indian nationals could acquire immovable property in India. Under FEMA, the eligibility criteria were based on residential status rather than nationality. An NRI or a foreign national living in India on employment, business, or any other purpose for an uncertain period, and who was thus a resident, could acquire immovable property in India. The only exception was made for those from Pakistan, Bangladesh, Sri Lanka, China, Iran, Afghanistan, Nepal and Bhutan.25 A few foreign nationals on long visa acquired immovable property, particularly in Goa. When such cases were reported, the Reserve Bank advised the buyers to transfer the assets in favour of residents. These cases revealed a further anomaly in the law. While the Registration Act was a state law, FEMA was the centre’s responsibility. If the Government of India did not want these acquisitions to happen, it should have instructed the states to follow the provisions of FEMA. In any case, because such cases were frequent in Goa, the Reserve Bank regional office in Panaji held a meeting with the sub-registrars in the state on 19 February 2005. The registrars held that they were required to apply only those laws at the time of registration that were made supplemental to the Registration Act, 1908, and FEMA was not one of them. Further, it was found that some registrars’ offices in Goa refused 107

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the reserve bank of india to register sale deeds without the Bank’s clearance regarding the residential status of foreigners. Against this backdrop, the Bank wrote to U. K. Sinha, Joint Secretary, Ministry of Finance (14 January 2005), stating, As residential status of a person in India in terms of Section 2(V) of FEMA is dependent both on specific parameters like length of stay and intention of the concerned person, it was impractical for RBI to try to determine residential status of a person.… [I]n view of the foregoing, we request you to take up the matter for such action deemed necessary, with the State Government of Goa, as well as other Administrative Ministries.

In the meantime, a few of these cases were referred to the Enforcement Directorate. A few media reports appeared and questions were asked in Parliament about flouting of the FEMA by foreign nationals.26 In another incident, a resident of Delhi filed a petition on 22 August 2003 with the Committee on Petitions, Rajya Sabha, stating that foreign nationals from neighbouring countries, though staying in India for long and holding ration cards, were not allowed to purchase residential flats from government agencies like the Delhi Development Authority. The case was referred to the Reserve Bank for their view by the Ministry of Finance. The Bank wrote (21 September 2003) that the policy of the government did not permit such investment. Complaints received by the Bank showed that there were, in fact, many such cases of illegal acquisition of immovable properties by nationals of the ‘de-listed’ countries. There were also curbs on NRIs transferring agricultural and plantation property and farmhouses. It was a subject of discussion between the Bank’s central office and its Kochi regional office in August 2004. The matter was ‘resolved’, if that is the right expression, with the statement that ‘the applicant may be advised to take up the matter with the Ministry of Finance’ as it was the policy of Government of India. There was yet another inconsistency. All Indian residents were outside the purview of FEMA for the purchase of immovable property in India. They were also allowed transfer of any immovable property in India from NRIs (who were citizens of India, Regulation 3[b] of FEMA 21/2000). However, this made it technically possible for a foreign national, treated as a resident, to acquire agricultural and plantation property from an NRI, which was not intended. Similar confusion arose when the Intelligence Bureau (IB), Ministry of Home Affairs, wrote a letter to the Ministry of Finance on 10 August 2006 108

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foreign exchange market and management of the capital account which, in turn, was referred to the Reserve Bank. The letter drew attention to the discrepancy in the definition of NRI in FEMA, which equated NRIs with persons of Indian origin, or PIOs, and overseas citizens of India (OCIs). According to the letter, three distinct clauses within FEMA were not mutually consistent in the treatment of PIOs. In two of these, an NRI was defined as a ‘person resident outside India who was a citizen of India or a person of Indian origin’, whereas the third stated that an ‘NRI was a person resident outside India who was a citizen of India’. ‘Our concern,’ the letter went, ‘is that PIO cannot be equated with NRI, as NRI is an Indian citizen who stays abroad for employment, business, vocation or any other purpose, whereas PIO is a foreign national, though of Indian origin.’ The Reserve Bank, after consultation with its Legal Department, replied on 2 March 2007 that the regulation, which dealt with remittance of assets, did not include PIOs as the intention was to dissuade citizens of certain countries acquiring immovable property in India. For most other transactions, the two sets could be treated equally. It was not necessary, therefore, ‘to address the issue of difference in the definitions of NRI and PIO in the notifications issued under FEMA as suggested by IB’.27 In the process that led to FEMA, this definitional issue had been discussed and left somewhat unclear. The Reserve Bank originally suggested in its draft FEMA Bill sent to the Government of India in 1997 that ‘persons resident in India’ meant an individual residing in India, including citizen of India undergoing any training or study abroad, but did not include a tourist or visitor from outside India visiting for a period not exceeding 180 days, nor include a foreign national residing in India for a specified period not exceeding five years and for a specific purpose. But the FEMA Bill tabled in Parliament (August 1998) carried the definition of ‘persons resident in India’ as a person residing in India for more than 182 days during a 365-day period. The Parliamentary Standing Committee on Finance, to which the 1998 Bill was referred, did not agree to change the definition of residents in FEMA. As this recommendation of the standing committee was not acceptable in its entirety, several rounds of meetings and discussions took place between the government and the Bank, the outcome of which was the present definition of residents, which gave rise to interpretational issues. As far as one can see, there was no subsequent attempt to simplify the definition of residents during the reference period of this volume. 109

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the reserve bank of india

Financial institutions In April 1997, ADs were permitted to borrow from their overseas offices and correspondents as well as invest up to US$10 million in overseas money market instruments, which was essentially intended to augment banks’ resources and strengthen integration between overseas and domestic money markets. The limit was increased in October 1997 up to a maximum extent of 15 per cent of their unimpaired Tier I capital.28 In April 2002, the limit was again raised to 25 per cent of unimpaired Tier I capital.29 A further increase in the limit was announced in November 2002, and in December the same year the limit was removed completely. In March 2004, to rationalise the existing facilities for overseas borrowings and introduce a monitoring and reporting system for all ADs, existing facilities available to them were replaced by a single facility.30 In April 1997, ADs had been allowed to arrange forex–rupee swaps between corporates and run a swap book within their open positions or gap limits without the approval of the Reserve Bank. The Bank allowed branches of foreign companies operating in India to remit profits to their head offices through ADs without the Bank’s approval. To make the pricing of rupee interest rate derivatives more flexible, interest rates implied in the forex forward market were allowed to be used as a benchmark in addition to the existing domestic money and debt market rates.31 In November 2004, ADs were granted general permission to issue guarantees, letters of comfort, and letters of undertaking in favour of overseas suppliers’ banks for their importer clients.32 In July 2005, ADs were allowed not to follow up submission of evidence of import involving an amount of US$100,000 or less if they were satisfied with the genuineness of the transaction and the bona fide purpose of the remitter. Banks’ Board of Directors would frame a suitable internal guideline. Banks could approve proposals for commodity hedging in international exchanges from their corporate customers. In February 2006, banks and authorised money changers were advised to take necessary steps to ensure compliance with the rules under Prevention of Money Laundering Act, 2002. The guidelines required asset management companies to put in place a policy framework on ‘know your customer’ and ‘anti-money laundering’ measures for the prevention of money laundering while undertaking money changing transactions. As the external sector liberalisation progressed, the number of customers undertaking forex transactions rose exponentially. More and diverse entities 110

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foreign exchange market and management of the capital account could handle non-trade current account transactions. Select ‘full-fledged money changers’, urban cooperative banks and the regional rural banks were permitted to release and remit forex for specified types of current account transactions. The regulations relating to insurance companies were liberalised.33 Liberalisation of investment by mutual funds in overseas markets experienced a bumpy road. As part of the implementation of the recommendations of Tarapore I, Governor Rangarajan, on 21 October 1997, announced in his monetary policy statement that Indian funds registered with SEBI, including mutual funds, would be allowed to invest in the overseas markets.34 The committee set up by SEBI to work out the details of the process submitted its report in July 1998. In the meantime, the High-Level Committee on Capital Market discussed the issue in August 1998 and recommended that mutual funds’ investment abroad be restricted for the time being to investments in the ADRs or GDRs of Indian companies only. Within the Reserve Bank, there was some hesitation about this move.35 Finance Secretary Vijay Kelkar wrote on 21 May 1999 to Governor Jalan that the Finance Minister approved the mutual funds’ overseas investment in depository receipts. Necessary guidelines on limits to such investments and procedural aspects were issued on 30 September 1999 after a group of officers from the Reserve Bank and SEBI worked out the details of the regulation. In November 1999, SEBI requested the Reserve Bank to consider an extension of the facility to securities other than depository receipts. Governor Jalan agreed.36 The Bank issued a circular on 13 January 2003 allowing mutual funds (and corporates and individuals) to invest in the equity of listed foreign companies having at least 10 per cent stake in Indian companies. In May 2003, the Bank decided to henceforth give only general permission.37 In June 2004, an internal study analysed the progress of the scheme and observed that as of end of March 2004, out of the seventeen mutual funds that had taken approval from SEBI, only four had made investments of a total of US$23.12 million. The reason for the poor performance of the scheme was that the condition that mutual funds could invest in the equities of only those foreign companies that had 10 per cent stake in Indian companies was too restrictive. The Reserve Bank in its Budget proposal for 2006–07 sent to the government recommended its removal. Finance Minister P. Chidambaram rescinded this clause and increased the overall limit.38 111

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the reserve bank of india

Legal and Institutional Framework The repeal and replacement of FERA with FEMA have been mentioned on a number of occasions before. During the latter part of 1997, there was an attempt to introduce the FEMA Bill in Parliament but opposition to the Bill, especially from Left parties, disrupted the process. Eventually, FEMA Bill, 1998, along with the Prevention of Money-Laundering Bill, 1998, was introduced in the 12th Lok Sabha on 4 August 1998.39 While the FEMA was passed, the Prevention of Money Laundering Bill was referred to the Select Committee of the Rajya Sabha on 8 December 1999. FEMA became effective 1 June 2000, and the Prevention of Money Laundering Act was enacted in January 2003.40 FEMA was not merely an amendment of FERA. It reflected a different approach, a shift from ‘control’ to ‘management’. FEMA was built around the main theme of dismantling controls and affording an enabling condition for all stakeholders in forex transactions. The main tenets of FEMA were transparency, transaction monitoring and data dissemination. Unlike FERA, which treated any violation or contravention of the provision of the Act as a criminal offence, FEMA treated these as civil offences. FEMA drew a clear line of demarcation between the current and capital accounts. All current account payments, except those notified by the government, were eligible for appropriate foreign currency release from ADs. The Reserve Bank was empowered with the necessary regulatory jurisdiction over capital account transactions. FEMA thus formalised current account convertibility with the common law principle of ‘all that is not forbidden is permitted’, but left the capital account still subjected to the rule of ‘all that is not permitted is forbidden’. It provided for an elaborate redressal process with separate administrative procedure and mechanism in the form of compounding rules, adjudicating authority, Special Director (Appeals) and Appellate Tribunal, with a stipulated time frame for each leg of the judicial process. The concept of ‘compounding’ was another distinguishing feature of FEMA, especially from the perspective of customers. Under FERA, all violations were subject to separate investigation and adjudication of the Enforcement Directorate. It was next to impossible to track all the offences, especially those that were of small order. Only when contraventions were detected were offenders brought to book. Under FEMA, the redressal mechanism was changed to give the supposed offender a chance to make an application suo moto, seeking the contravention to be compounded. 112

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foreign exchange market and management of the capital account Contravention could be compounded only if the amount involved was quantifiable. The intent was to reduce transaction costs and at the same time deal with fraudulent transactions severely. No request for compounding of contraventions would be entertained for earlier violations after a contravener was found guilty of violating FEMA provisions. The compounding authority was required under the Act to dispose of the application within 180 days in the normal course. Once a contravention was compounded, no proceeding or further proceeding could be initiated or continued, as the case may be. Although the compounding rules delegated the authority of compounding to the Reserve Bank, the actual transfer of work relating to compounding from the Enforcement Directorare to the Bank took place only on 1 February 2005. The initial notifications in this regard had given incomplete power to the Bank. A revised notification on 13 September 2004 delegated to the Bank the entire power of compounding, except cases dealing with informal hawala transactions,41 which were retained with the Enforcement Directorate. Soon after the move, the Bank issued the necessary directions to operationalise the scheme.42 To begin with, the compounding task was handled at the central office of the Foreign Exchange Department, Mumbai, and subsequently delegated to select regional offices after holding several rounds of interactive sessions, workshops and seminars with all stakeholders. The delegation of powers by the Reserve Bank to ADs to release forex constituted a major improvement to the institutional framework. Along with specific measures, there was also an effort to change the administrative work culture. To ensure such seamless change, the Foreign Exchange Department’s central office conducted several workshops, seminars and discussions in all regional offices of the Bank to educate staff, corporates and important customers. These discussions highlighted the distinctive approach embodied by FEMA (also see Box 4.2). A high-level coordinating committee was in place to address the common issues that different regulators of the capital market faced. The secretariat was in the Reserve Bank. The committee was initially called the High-Level Committee on Capital Market and had members from the Bank, SEBI and the Ministry of Finance. Subsequently, in the early 2000s, the committee was called the High-Level Coordination Committee on Financial and Capital Markets and added the Insurance Regulatory and Development Authority of India (IRDAI) as a member. All issues, including major liberalisation measures, were first deliberated in the committee. 113

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the reserve bank of india Box 4.2 Broad Comparison of FERA and FEMA Foreign Exchange Regulation Act (FERA)

Foreign Exchange Management Act (FEMA)

FERA came into force with effect from 1 January 1974.

FEMA replaced FERA with effect from 1 June 2000.

Violation of the provisions was a criminal offence.

FEMA is a civil law and contravention of its provision is only liable for monetary penalty and dealt with through civil procedures.

The main objective was ‘foreign exchange control’ by conserving the forex resources of the country and utilising them properly.

Offences were not compoundable and all violations were subject to separate investigation and adjudication of the Enforcement Directorate. The burden of proof was on the implicated.

Carried the principle of ‘all that is not permitted is forbidden’.

Citizenship/nationality was the criteria to determine the residential status of a person.

The major objective is to ‘facilitate external trade and payments, and to promote orderly development and maintenance of forex market’.

A contravener has an opportunity to make an application suo moto to the compounding authority requesting for compounding the contraventions. The burden of proof is on the enforcement agency. FEMA provides for an elaborate process with separate administrative procedure and mechanism in the form of compounding rules, adjudicating authority, Special Director (Appeals) and Appellate Tribunal, with a stipulated time frame for each leg of the judicial process. FEMA formalises current account convertibility with the common law principle of ‘all that is not forbidden is permitted’ but leaves the capital account unchanged – ‘all that is not permitted is forbidden’ – as India does not have full capital account convertibility.

‘Person resident in India’ means a person residing in India for more than 182 days during the course of the preceding financial year, excluding such person as who stays outside India on employment, business, or vocation or who indicates his intention to stay outside India for an uncertain period. By the same token,

(Contd.) 114

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foreign exchange market and management of the capital account (Contd.) Foreign Exchange Regulation Act (FERA)

Foreign Exchange Management Act (FEMA)

FERA was applicable to all citizens of India outside India.

Unlike FERA, FEMA does not apply to Indian citizens resident outside India.

non-residents who have come to stay in India on employment, business, or vocation or who indicate their intention to stay in India for an uncertain period are treated as residents.

A Mumbai Interbank Forward Offered Rate (MIFOR) swap curve evolved in 2000 gave impetus to market development. The CCIL launched a Forex Trading Platform to facilitate US Dollar/Rupee deals by banks in India. The Clearing Corporation of India Ltd (CCIL) brought the entire range of forex transactions under its scope. In 2004, the ambit of the Technical Advisory Committee on Money and Government Securities Markets set up by the Reserve Bank was expanded to include the forex market and was renamed as the Technical Advisory Committee on Money, Securities, and Foreign Exchange Markets. On-site and off-site monitoring mechanisms were strengthened to build a robust management information system.43 Closing time for the interbank forex market was extended up to 5 p.m. in May 2005. In October 2006, the Reserve Bank of India (RBI) Act was amended to define the regulatory purview of the Bank over derivatives.

Hedging and Its Instruments The evolution of the forward market and hedging instruments in India can be documented by tracing the developments under different segments of market players – residents, non-residents and financial institutions, particularly banks. For all practical purposes, the history of the forward market in India began in 1992 when residents were allowed to enter into a forward contract with ADs to hedge their exchange risk of buying or selling forex for approved transactions. In September 1996, residents in India were permitted with certain conditions to enter into a foreign currency option contract with ADs in India to hedge forex exposure arising out of their trade, and cross-currency 115

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the reserve bank of india options were only allowed to be written on a fully covered back-to-back basis. In April 1997, the scope of the forward cover mechanism was expanded to include residents, with forex or rupee liability, who could enter into a contract for a foreign currency–rupee swap with ADs in India to hedge long-term exposure under certain terms and conditions. In October 1997, more instruments of hedging were added. Residents with foreign currency borrowing were permitted to enter into an interest rate swap, currency swap, coupon swap, foreign currency option, interest rate cap or collar (purchases), or forward rate agreement (FRA) contract with an AD in India or with a branch outside India of an AD for hedging loan exposure and unwinding such hedges. It was stipulated that the contract should not involve the rupee, and also that the maturity of the hedge should not exceed the unexpired maturity of the underlying loan, besides other conditions. Export growth during 1996–97 in US dollar terms had contracted. There was no hedging mechanism available for exporters or importers. Against this backdrop, the Reserve Bank appointed ( July 1997) a committee on Hedging through International Commodity Exchanges.44 The committee recommended that all Indian entities with genuine underlying commodity price risk exposures should be permitted recourse to hedge instruments available in offshore markets, subject to safeguards. In September 1998, the Bank permitted hedging in international commodity markets. A further series of measures was introduced in 2003. In April, ADs were permitted to enter into forward contracts with residents with respect to transactions denominated in foreign currency but settled in rupees, with the condition that these contracts should be held until maturity and cash settlement would be made on the maturity date by the cancellation of the contracts. In July 2003, foreign currency–rupee options were introduced. ADs were permitted to offer the product on a back-to-back basis or run an option book as per the specified terms and conditions. In December 2003, residents with overseas direct investments (ODIs) were permitted to hedge the exposure under certain terms and conditions. In November 2004, the limit for outstanding forward contracts booked by importers/exporters was increased from 50 per cent to 100 per cent of their eligible limit. In June 2005, cancellation and rebooking of all eligible forward contracts booked by residents, irrespective of the tenor, were allowed, subject to certain conditions. In April 2007, domestic entities were allowed to hedge their price risk on aluminium, copper, lead, nickel and zinc, as well as users of aviation turbine fuel 116

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foreign exchange market and management of the capital account in international commodity exchanges, based on their underlying economic exposures. The Reserve Bank also decided to consider requests for those not covered above. The stipulation that forward contracts booked by exporters and importers in excess of 50 per cent of the eligible limits should be on deliverable basis and could not be cancelled was relaxed by extending the limit to 75 per cent. Residents with ODI and small and medium-sized enterprises (SMEs) were provided more flexibility to cancel and rebook forward contracts. In October 2007, to enable resident individuals to hedge their forex exposures arising out of actual or anticipated remittances, the Bank decided to permit them to book forward contracts without production of underlying documents, subject to a limit.45 The Reserve Bank had recognised the danger of expansion of off-balancesheet forex exposure of banks, which had contributed to some of the banking crises before. Therefore, a cautious policy approach was followed in this regard. In April 1997, a beginning for rupee-based derivatives was made in India and banks were permitted to offer dollar–rupee swaps to corporates to actively manage their forex exposures. A major step was taken in June 1997, when ADs were permitted to use interest rate swaps, currency swaps and forward rate agreements to hedge their asset–liability portfolio.46 In October 2002, ADs were permitted to offer forward contracts to their constituents (exporters of gold products, jewellery manufacturers, trading houses, and so on). Another major decision taken in November 2002 was that foreign banks could hedge their entire Tier I capital in India held by them in Indian books as long as the capital funds were available in India to meet local regulatory and capital to risk-weighted asset ratio (CRAR) requirements.47 In October 2003, ADs were delegated the power of offering forward cover for such investments. In October 2007, in order to enable ADs to manage their risks efficiently, they were permitted to run cross-currency options books, subject to the Reserve Bank’s approval. As against the existing practice of allowing ADs to offer only ‘plain vanilla’ European options, they were permitted henceforth to offer American options as well, in keeping with the market demand and gradual evolution of the forex market. Non-residents were generally not allowed to play in the forward market in India. However, a few facilities were extended to non-residents that were essential from the standpoint of facilitating the inflow of certain varieties of foreign capital.48 117

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the reserve bank of india

Reforms in Data Collection and Dissemination In January 1999, a working group set up to look into the system of reconciliation of Nostro accounts in public sector banks suggested that banks should initiate measures for mechanisation of branches, immediate follow-up of large-value items, and training and re-training of the employees.49 FEMA made a few procedures redundant. For example, persons resident in India were not required to submit annual returns with respect to all types of foreign assets held by them, either in terms of general permission or specific permission of the Reserve Bank. The reform process could outpace data collection. At the time of exports, exporters were required to submit GR forms in duplicate.50 The original was submitted to the customs and the duplicate to AD for negotiation. ADs were required to submit, on the realisation of export proceeds, the duplicate of different types of GR forms to the nearest office of the Reserve Bank. The Bank, in turn, would match the original GR form that was transmitted by the customs to the concerned regional office of the Bank. In September 2002, ADs were advised that, henceforth, such duplicate copies of the export declaration forms should not be submitted to the Bank. Instead, these should be retained by the ADs, who should carry out random checks to confirm that non-realisation or short-realisation cases, if any, were allowed by them or approved by the Bank. Thus, the GR-matching exercise for each transaction was in effect done away with. When an export scam involving iron ore broke out in 2010–11, the Bank was not in a position to assess the magnitude of unrealised exports under iron ore exports. The internal committee set up to study the episode in September 2012 observed that one of the reasons for non-matching of export data of the customs with that of the banking systems had been the non-submission of export documents to AD banks. India was one of the first few countries to become a member (1996–97) of the International Monetary Fund’s (IMF’s) special data dissemination standards and general data dissemination standards, which required dissemination of a wide range of information. India started posting its metadata on the IMF’s dissemination standards bulletin board on 30 October 1997. The Reserve Bank had achieved full disclosure of information pertaining to international reserves, foreign currency liquidity position, balance of payments and external debt as well as international investment position under the standards. Also, the Bank improved statistical coverage in its periodic publications such as the Weekly Statistical Supplement, the Monthly Bulletin and the Annual Report. 118

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foreign exchange market and management of the capital account One such example was data on forex turnover. The Bank was periodically issuing instructions to its regulated entities regarding rules and regulations for conducting their business. In order to enable the regulated entities to have all the instructions at one place, a master circular consolidating and incorporating all currently operative instructions and guidelines on the subject was issued. These were a one-point reference of instructions issued by the Bank on a particular subject between July and June (the Bank’s financial year), with a sunset clause.

Capital Account Management Internationally, private capital flows had been increasing rapidly since the 1980s, surpassing official flows. To take advantage of the increased private flows, many emerging economies relaxed the restrictions on capital transactions to capture more of the flow. Until the Southeast Asian crisis in mid-1997, the received wisdom tilted towards more openness in this respect. The Organisation for Economic Co-operation and Development (OECD), for example, was trying to spread its ‘Code of Capital Account Liberalisation, 1961’ to jurisdictions beyond the OECD. The IMF advised its members to liberalise capital account. Since the IMF’s Articles of Agreement had permitted the members to allow capital controls, it sought to amend its Articles to incorporate capital account convertibility as one of the obligations of the membership. The Asian crisis brought the dangers of free capital movement to the fore. The international debate on the merits of capital account liberalisation turned out to be inconclusive.51 The Reserve Bank had, in fact, raised concerns about the adverse consequences of unbridled cross-border capital flows well before the crisis. In his statement in the IMF’s Interim Committee meeting in April 1997, Governor Rangarajan stated, [S]everal staff studies have shown that there are important preconditions for introducing capital account convertibility. Given the differences among countries with regard to progress made towards structural reform and stabilization, it may be unwise to put all the members in a straitjacket where they lose their independence to take corrective action in times of crisis.52

Despite the uncertain international economic environment, the liberalisation process was carried forward, but with caution. 119

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the reserve bank of india The initial years of the reference period – up to the new millennium – saw several initiatives to ward off the negative effects of international developments. Some of these included elements of tightening control but those were announced as ‘temporary’ to gain market confidence, which were relaxed subsequently. The year 1997–98 opened with enormous optimism emanating from an impressive performance of the Indian economy in 1996–97. The external sector, in particular, had fared well in 1996–97, adding almost US$6 billion to forex reserves buoyed up by a surge in capital flows. This trend continued until the first half of 1997–98. The Reserve Bank made a net purchase of foreign currency assets from the market to the tune of US$5.4 billion between April and August 1997. In the wake of the Asian crisis, the forex market came under pressure because of capital flows drying up. Deputy Governor Reddy’s statement on 15 August 1997 and the subsequent statement by Prime Minister I. K. Gujral (reported in the Economic Times on 20 August 1997) on the exchange rate of the rupee added to the stress in the Indian forex market. The market became highly volatile – especially from November 1997 to January 1998 (see Chapter 5).53 It also led to an increase in activity and expansion of the forex market. For example, interbank forex turnover as a percentage of GDP, which was 0.19 per cent in 1995–96 and 1996–97, went up to 0.26 per cent in 1997–98. Liquidity management remained a primary engagement for Reserve Bank authorities. New monetary measures were introduced to control the arbitrage opportunities because of the difference between domestic interest rates and forward rates. The negative market sentiment due to the crisis and adverse domestic political developments made the rupee highly volatile. In November 1997, besides intervening in the forex market, the Bank announced a few monetary measures.54 By the end of January 1998, capital flows resumed. The Reserve Bank could recoup forex reserves in the January–March quarter in 1998 more than what it had lost during October–December 1997. As capital inflows picked up from March 1998, some of the monetary policy measures initiated in the previous months were rolled back.55 During 1998–99, the reversal of the monetary policy measures announced in January 1998 continued. However, in May 1998, when the Pokhran nuclear test was conducted, economic sanctions were imposed on India, and fresh multilateral lending was suspended. Moody’s, which had maintained India at the lowest slot of investment grade at Baa3, pushed Indian sovereign 120

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foreign exchange market and management of the capital account rating down on June 1998 by two notches to Ba2, which was second in the list of non-investment grade rating. As a result, FII inflows fell. Delayed recovery in Asia, together with crises in Russia and Latin America induced the Reserve Bank to announce a fresh package of measures on 20 August 1998, including the floating of Resurgent India Bonds (RIBs).56 The RIBs were meant for NRIs and overseas corporate bodies and aimed at mobilising resources to deal with possible disruptions in capital flows, particularly debt flows, which were anticipated as India’s sovereign ratings were downgraded to non-investment grade. The scheme opened on 5 August 1998 and closed on 24 August 1998, mobilising US$4.23 billion. The RIBs had a five-year tenor and were denominated in three currencies – the US dollar, the pound sterling and the Deutschmark. The US-dollar-denominated bonds carried an interest rate of 7.75 per cent and mobilised US$4 billion, while the pound sterling bonds were at 8 per cent interest rate and brought in the equivalent of US$180 million. The Deutschmark bonds fetched US$63 million at 6.25 per cent interest rate. Emboldened by improvement in March 1999, policy rates were eased in April 1999. The border conflict at Kargil (from 3 May 1999 to 26 July 1999) caused several episodes of mismatch between forex demand and supply in May and August 1999, which were addressed with a mix of operations in forex and money markets, essentially by aligning interest rates so as to reduce arbitrage opportunities. By November 1999, capital flows returned to the Indian market enabling the Reserve Bank to ease monetary conditions. The Bank also withdrew the stipulation of a minimum interest rate of 20 per cent per annum on overdue export bills and the interest rate surcharge of 30 per cent on import finance imposed in January 1998. In between, Indian companies were permitted to issue rights/bonus shares and nonconvertible debentures to non-residents, while mutual funds were permitted to issue units to FIIs. Foreign corporates and high-net-worth individuals were permitted to invest in Indian markets through FIIs. Besides, ECB policies were substantially liberalised. More importantly, FDI in all sectors, except for a small negative list, was placed under the automatic route. Indian overseas investment was also liberalised. As a result, the Bank added a little over US$6.1 billion to its corpus of forex reserves during 1999–2000. As external conditions were benign, the Reserve Bank remained in policy easing mode at the beginning of 2000–01. A package of measures was introduced with the lowering of policy rates in April 2000. However, in May 121

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the reserve bank of india 2000, oil import payments rose on the back of a rise in the international price of crude oil. In just two months (May and June), the Bank lost close to US$2 billion by way of market intervention. The Bank announced on 25 May 2000 an interest rate surcharge of 50 per cent of the lending rate on import finance on all non-essential imports. The Bank also committed to undertake sovereign debt service payments, if necessary. Forex requirements for import of crude oil by Indian Oil Corporation were met directly and through the market. An interest rate of 25 per cent was charged on delayed export receipts. ADs acting on behalf of FIIs could approach the Bank to procure forex at the prevailing market rate. Between May and August 2000, demand for forex had outstripped supply, which was addressed by monetary and regulatory measures. As the market stabilised from November 2000 onwards, monetary measures were phased out during the last quarter of 2000–01 to return to the April 2000 position. The main policy initiative during 2000–01 to encourage and facilitate industry’s access to external capital flows was to relax FDI policy so as to improve the climate for new investment. Similarly, policies for international offerings through depository receipts by Indian companies were liberalised. Indian corporates’ access to ECBs as a window for resource mobilisation was considerably improved and procedures streamlined. These measures yielded results as reflected in the net capital flows of close to US$6 billion in excess of the current deficit that was added to the reserves in 2000–01. Another major development in the year 2000 was the issuance of India Millennium Deposits (IMDs). Rising crude oil prices in the early 2000s eroded foreign currency assets of the Reserve Bank by around US$3 billion during April–October 2000. Sanctions were still in force (until August 2000). To bolster forex reserves and impart stability to India’s balance of payments, the scheme was launched on 21 October 2000 with a tenor of five years. Denominated in three currencies – the US dollar, the pound sterling and the euro – the scheme carried an interest rate of 8.5 per cent, 7.85 per cent and 6.85 per cent, respectively, and mobilised US$5.5 billion. These bonds were not tradeable in the secondary market and not eligible for encashment prematurely. Both the RIBs and IMDs carried an exchange guarantee provided by the government to the borrowing bank, which was SBI. The cost of borrowing for both schemes, however, was deemed to be high. In response to a Parliamentary question seeking information on cost and use of the schemes (RS No. 3422, answered on 7 April 2001) Minister 122

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foreign exchange market and management of the capital account of State (Ministry of Finance) Balasaheb Vikhe Patil stated that the interest rates were compatible with international rates in view of India’s credit rating. The response also clarified that the funds were utilised for investment in government securities placed with participating banks, and in infrastructure bonds, among other uses. There was another issue of exchange guarantee given to the issuing bank (SBI) for both the schemes. While there was no exchange loss under IMDs as the rupee appreciated, there was an exchange loss of 8.57 per cent under the RIBs, which was insignificant in the light of the positives of the bond. Authorities maintained that, all things considered, both these schemes eased the process of recovery from the aftermath of the Asian crisis and political uncertainties. India faced a different kind of problem during the latter part of the period under reference. The liberalised capital account environment at home and benign international financial conditions led to substantial capital inflows, which complicated monetary and exchange rate management (also see Chapter 5). Current account deficit either remained low or recorded surplus for some intervening years. During 2001–02 to 2007–08, total net capital flows were close to US$243 billion while total net current account deficit was a little over US$15 billion. Capital inflows in excess of the current account deficit of around US$230 billion (on balance of payments basis) were added to forex reserves to avoid appreciation of the rupee. Private flows formed the major part of the inflows and they were of the non-debt type. This enabled India to prepay some of its external loans, which brought down the external debt to GDP ratio from 24.6 per cent as of end of March 1997 to 18 per cent at the end of March 2008. In fact, the international investment position improved significantly during this period. Net international liabilities, which were about US$81 billion as of end of March 1997, came down to US$51 billion at the end of March 2008. Notwithstanding higher outflows, capital inflows (net) were on the rise since 2001–02. They rose from around US$8.6 billion in 2001–02 to US$11 billion in 2002–03. On the monetary side, there was large reserve money expansion. The Reserve Bank had absorbed a good amount of capital flows into its reserves to avoid appreciation of the nominal exchange rate. Capital flows complicated exchange rate and monetary management even more in the latter part of 2002. During January–September 2002, forex assets of the Bank rose by US$19 billion. To stem accretion, policy focus shifted to further liberalisation of outflows. 123

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the reserve bank of india The Annual Monetary Policy Statement of April 2004 discussed the key issue faced by the authorities, which was to decide whether capital flows were of a permanent and sustainable nature or temporary and subject to reversals. This being difficult to settle, the issue of whether to use market-based (withdrawing liquidity by the central bank) or non-market-based techniques (quantitative barriers) to deal with excess capital flows cropped up. The policy statement discussed several possible responses such as trade liberalisation, investment promotion, liberalisation of capital outflows and liquidating international liabilities. The Reserve Bank took several measures to mitigate the impact of capital flows, which have been mentioned earlier. As capital flows remained buoyant, sterilising excess capital flows became a major concern for the policymaker. The monetary management part of the story has been told in Chapter 3. The chapter discusses the setting up of a Market Stabilisation Scheme (MSS). Under the MSS, T-bills and dated securities of the central government were issued for conducting sterilisation operations and the Reserve Bank followed the same method as for other government securities, that is, notified the amount, tenure and timing of issuances under the MSS. Money raised under the MSS was held by the government in a separate identifiable cash account maintained and operated by the Bank. The amount held in this account was appropriated only for the purpose of redemption of the MSS securities. The increase in the Bank’s net foreign assets was largely matched by accretion in government balances under the MSS, shrinking the net Bank credit to the government, thereby neutralising the monetary impact. The impact on the Union Budget was only to the extent of interest paid on such securities.57 The IMF invited India in September 2002 to participate in its Financial Transaction Plan as India’s forex reserves had reached a respectable level and its balance of payments position was also comfortable. As a result, India became a creditor to the IMF. Not long before, India had paid the last instalment of an IMF loan (in April 2000) taken in the wake of a balance of payments crisis in 1991. The Financial Transactions Plan means the following: when members borrow from the IMF, the latter finances its lending from a general resources account where quota resources are held. Loans requested in foreign currency are financed by converting the quota resources paid in domestic currency. Members to finance IMF transactions are selected from across its membership based on the assessment of a member’s balance of payments and reserve position, including developments in exchange and financial markets 124

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foreign exchange market and management of the capital account and the adequacy of the member’s international reserve assets. When a member participates, its international reserves undergo a compositional shift with a fall in the forex holdings being entirely offset by an increase in its reserve tranche position in the IMF. From 2004–05 to 2007–08, a number of relaxations were made with regard to capital account transactions. Prime Minister Manmohan Singh, while releasing The History of RBI, Volume 3 on 18 March 2006, requested the Finance Minister and the Reserve Bank to revisit the subject of capital account convertibility and suggest a road map. Tarapore II was the outcome. The Committee on ‘Fuller Capital Account Convertibility’ under the chairmanship of Tarapore was set up on 20 March 2006. The report detailed a broad five-year time frame for movement towards fuller convertibility of the rupee in three phases: Phase I (2006–07), Phase II (2007–08 to 2008–09) and Phase III (2009–10 to 2010–11). Besides, it reviewed the international experience and produced the report card of the implementation of Tarapore I. It made far-reaching recommendations in seven areas: money market,58 government securities market,59 foreign exchange market,60 fiscal consolidation,61 the banking system,62 monetary policy,63 and the external sector.64

Portfolio Investment Of the main forms of inflow and outflow, FDI was stable in nature and relatively moderate in scale in the period under discussion. However, portfolio investment was different – it directly entered the financial sector, was large in scale, and volatile in nature. FII inflow, therefore, concerns stabilisation issues directly. FII inflow (net) was large, increasing from around US$3.3 billion in 1996–97 to US$11.4 billion in 2003–04 and to as much as US$27.4 billion in 2007–08, but they were volatile as they recorded outflows in some quarters or years in between. Until 1992, only NRIs and OCBs could undertake portfolio investment in India, which remained very small. Within a few years, the doors were opened to FIIs to invest in the Indian market. To begin with, they were allowed only in the equity market with sectoral caps. Ceilings on FII investments were progressively relaxed and aggregate investment by FIIs in a company was allowed within the sectoral cap prescribed for FDI. Indian debt market was opened to FIIs gradually. The government decided to permit FIIs in the category of 100 per cent debt funds to invest in dated government (central

125

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the reserve bank of india and state) securities in both primary and secondary markets in March 1997. In mid-1998, they could buy short-term T-bills. Indian corporates were also allowed to access equity capital from foreign sources in the form of depository receipts and euro issues. From 1998, FIIs could invest in dated government securities. In June, fresh equity investments by FIIs were allowed for forward cover, which was raised subsequently in August to 15 per cent of the market value. In August, limits for investments in Indian companies were enhanced; ceilings applicable to portfolio investments in shares and debentures of an Indian company were raised from 1 per cent to 5 per cent of their paid-up equity capital of the company concerned. The Reserve Bank introduced a new scheme for investment by NRIs and OCBs of up to 51 per cent in the new issues floated by Indian companies, which were not listed on the stock exchanges and granted general permission for issue and export of shares by Indian companies, withdrawing the earlier 40 per cent scheme. In April 2000, Indian companies (other than banking companies) were permitted to enhance the aggregate ceiling on FII investment from 30 per cent to 40 per cent of issued and paid-up capital of the Indian company. Further enhancement of investment limits and permission to FIIs to hedge the market value of their entire investment in equity were announced in 2002 and 2003. In October 2004, the requirement of prior approval of the Reserve Bank for transfer of shares and convertible debentures (excluding financial services sector) was dispensed with and general permission accorded, subject to compliance with the terms and conditions and reporting requirements, for transfer by a person resident in India to a person resident outside India and vice versa. Increase in foreign equity participation by fresh issue of shares, as well as the conversion of preference shares into equity capital, was allowed, provided such increase fell within the sectoral cap in relevant sectors and were within the automatic route. The Reserve Bank monitored the aggregate ceiling of investments by FIIs/NRIs in Indian companies on a company-wise basis under the Portfolio Investment Scheme. The Bank was issuing an early warning signal to the companies – placing them in the caution list – as well as to their bankers after certain threshold limits of FII exposure were crossed. A meeting held on 28 June 1997 decided that the early warning would be given at 2 per cent below the applicable limit of FII investment in a particular company. On 27 December 2002, M/S Bharati Tele-Venture Ltd wrote to the Bank requesting 126

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foreign exchange market and management of the capital account a raise in the cut-off point as their company had a large capital base. The Bank considered the request favourably and proposed a relaxation of the trigger limit to 0.5 per cent below the applicable ceiling with respect to companies that had a capital base of 10 billion or more. After obtaining SEBI’s views, Executive Director K. J. Udeshi wrote to Finance Secretary S. Narayan on 31 January 2003 for the approval of the Ministry of Finance. In reply, on 27 February 2003, G. S. Dutt, Joint Secretary, Ministry of Finance, drew the Bank’s attention to the observations of the Joint Parliamentary Committee in its report on the stock market (Ketan Parekh) scam presented to the Parliament on 19 December 2002. Para 8.78 of the report stated, The Committee does not agree that RBI should leave it entirely to the custodian Banks to monitor compliance of its guidelines regarding OCBs. There is no system of periodical inspection of OCB accounts of Banks by RBI. RBI claimed that its role was limited to monitoring OCB’s company-wise investment ceiling of 10 percent. The Committee notes that RBI’s monitoring failed to detect violations of even this limited aspect. It is only after SEBI’s investigation that violations regarding ceiling norm came to light.

He, therefore, said the proposal could be agreed to by the government, provided a mechanism for monitoring investment by non-residents was ensured. The Bank in its response not only explained the system put in place for monitoring but also gave the reason why it did not agree to SEBI’s proposal of extending the trigger limit of 0.5 per cent to all companies. The Bank began issuing alerts based on the new norm after the press release of 19 April 2003. The inflows of FII investment were constantly monitored by the Reserve Bank as well as by SEBI. As inflows swelled, the short-term nature of flows under certain categories of FII investment attracted the attention of the policymakers. The Bank was always concerned about the quality of FII investment. One of the matters for discussion under FII investment was the investment through participatory notes (PNs), which were instruments issued by registered FIIs to overseas investors who wanted to invest in the Indian stock markets without registering themselves with SEBI. PNs could also be issued by the sub-accounts held with registered FIIs. Thus, there were multiple layers of investors, such as registered FIIs, sub-accounts and PNs. When FII inflows were rising, there was a view that ‘hot money’ was flowing into India.65 The PN route investment was substantial.66 The matter was discussed in the HLCCFCM meeting on 23 October 2003.67 SEBI issued a notification amending the SEBI (FII) 127

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the reserve bank of india regulations, 1995, that PNs should be issued only in favour of those entities that were regulated in the countries of their incorporation, and existing PNs should be liquidated when such contracts expired.68 The Bank, and Governor Reddy in particular, who had raised the issue at high levels were concerned that the nature of the beneficial ownership or the identity of the investor might not be known in this case, unlike in the case of FIIs registered with a financial regulator. This and other cautionary arguments did not find favour in the expert group69 that considered the matter. The Bank, however, submitted a dissent note (Box 4.3). Box 4.3 Extract from the Dissent Letter of the Reserve Bank (28 October 2005) While the thrust of the report is towards encouraging FII flows, sufficient attention also needs to be given to addressing the macroeconomic implications of the volatility of capital flows. In the light of the concerns highlighted by us during the discussions of the [Expert] Group from time to time and based on our written responses, we suggest that the following points should be considered while finalizing the recommendations of the Group:

A) Measures to contain volatility: In view of macroeconomic implications, impact on financial stability, especially on the exchange rate, and fiscal vulnerability, apart from monetary management, a special group may be constituted to study measures to contain large volatility in FII flows as a priority. B) Measures to encourage FII flows: As already indicated in the earlier report of the Committee on Liberalisation of FIIs, caps may be set which will be of three types, viz. (i) a separate cap on FDI, (ii) a separate cap on FII and (iii) a composite cap on FDI and FII combined together. C) Winding down of Participatory Notes (PNs): The Reserve Bank’s stance has been that the issue of PNs should not be permitted. Major concerns of PNs are that the nature of the beneficial ownership or the identity of the investor will not be known, unlike in the case of FIIs registered with a financial regulator. Trading of these PNs will lead to multi-layering which will make it difficult to identify the ultimate holder of PNs. Both conceptually and in practice, restriction on suspicious flows enhances the reputation of markets and leads to healthy flows. We, therefore, reiterate that issuance of PNs should not be permitted. D) Hedge funds: In case there are any hedge funds registered with SEBI, they need to be looked at closely for deregistration. E) Ceiling on holding of shares by FII and sub-accounts: The period prescribed for the unwinding of the investments (in excess of permissible limits) should be three years in line with the dispensation proposed in the case of PNs.

(Contd.) 128

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foreign exchange market and management of the capital account (Contd.)

F)  Operational flexibility to impart stability to the markets: Operational flexibility is required to facilitate the liquidity management of FIIs arising from a mismatch in their cash flows arising out of their operations in equity markets. But, it would not be appropriate to permit FII to treat debt securities (both government and corporate debt) as an investment avenue to address the issue of their cash flow mismatch. Since the requirement for operational flexibility is a narrow one, the ceiling should be on the total stock of FII investment in debt and not on an incremental basis as suggested. Therefore, the related recommendation may be deleted. Since most of the recommendations of the Group have significant macroeconomic implications and also because policy actions based on them will be irreversible, considerable thought is needed to be applied before their implementation. We, therefore, suggest that the Expert Group Report, as well as the Report of the Special Group, indicated in paragraph 4(A) above, along with the Reserve Bank’s comments, are placed in the public domain, for wider debate and consultation, before processing the proposals further.

External Commercial Borrowings Corporates and public sector undertakings were permitted to access the international capital market for the purposes of expansion of existing capacity as well as for fresh investments. ECBs included commercial bank loans, bonds, buyers’ credits, suppliers’ credits, securitised instruments such as floating rate notes and fixed rate bonds, and commercial borrowings from the private sector window of multilateral financial institutions such as the IFC and ADB. Gross disbursements under commercial borrowings were significant during this period, rising from US$7.6 billion in 1996–97 to US$28.7 billion in 2007–08, with a two-way movement in the intervening years. Prudent external debt management policy, which was integral to capital management, guided the Reserve Bank’s approach towards ECBs. While there were limits on longterm borrowings, short-term borrowing was controlled. However, long-term borrowings beyond ten-year maturity were kept outside the purview of ECBs. Policy focused on infrastructure and export sectors and end-use stipulations were relaxed over the years step by step except for loans relating to real estate and capital market. The maturity structure of ECBs was being closely monitored. As a result, unlike the Southeast Asian countries in 1997–98, India did not face the problem of mismatch in banks’ external asset and liability – in terms 129

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the reserve bank of india of either currency or maturity – which insulated India from the contagion. The policy for ECB also encouraged the use of derivatives for hedging interest and exchange rate risks on underlying foreign currency exposures. Loans, raised by the private sector from international capital markets, with more than three years’ maturity were classified as ECBs. While those with a maturity of one year or less fell under the category of short-term credits, loans with a maturity of less than three years were categorised as trade credits. ECB proposals were approved within an overall annual ceiling, keeping in view the sectoral requirements and the outcome of the balance of payments in the medium term. The principal elements of policy for ECBs included keeping the maturities long and costs low, and encouraging investments in infrastructure and export sectors. Utilisation of ECB proceeds was not permitted for on-lending or investment in the capital market and in real estate by corporates. End use of ECBs for working capital and prepayment of existing rupee loans were also not allowed since January 2004. Furthermore, the minimum average maturity for loans above US$20 million was stipulated at five years. Trade credits with a maturity period beyond one year and up to three years were permitted only for import of capital goods up to US$20 million per transaction. As foreign investment in equity was liberalised, the only instrument available with the authorities for managing capital account was modulating debt flows. Accordingly, there was an indicative limit fixed every year for ECBs.70 On 29 November 2004, the ceiling on corporate debt was removed, and there was an inflow of US$1 billion into corporate debt. As there were excess capital flows, the Reserve Bank suggested that SEBI may fix a ceiling on such inflows. On 2 December 2004, SEBI, after obtaining the approval of the government, fixed the limit of US$500 million of investment in corporate debt. ECBs were also subjected to all-in-cost ceiling in 2004, which was modulated depending upon the cycle of capital flows. ECBs were also subjected to a ‘dual route’: automatic and approval (case-by-case approval). Gradually, the automatic route was expanded and the approval route was compressed.71 In October 1998, the ECB limit of US$3 million or its equivalent at a minimum simple maturity of three years was raised to US$5 million or its equivalent. In March 1999, the Reserve Bank was empowered by the central government to consider proposals for raising ECBs up to US$10 million or its equivalent with a minimum average maturity of three years for utilising the proceeds for business-related expenses, including expenditure to be incurred in rupees under various windows. 130

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foreign exchange market and management of the capital account This was in addition to the scheme under which the Bank considered applications from corporate, and others, for raising ECBs up to US$5 million. This limit was increased to US$100 million in June 2000. In September 2000, the Bank operationalised the automatic route for ECBs up to US$50 million. The refinancing of existing ECBs was also brought under the automatic route.72 The policy on ECBs was revised and streamlined in January 2004 in view of the need to replace the prevailing temporary restrictions on access to ECBs with more stable, transparent and simplified procedures and policies. Also, the aim was to enhance investment activity in the real sector, particularly in infrastructure, and to enable corporates to access resources from international markets at competitive rates. The review took into account subdued investment activity, challenges faced in external sector management, the past experience and borrowers’ concerns in the administration of the ECB policy. The comfortable level of key indicators of India’s external debt provided the necessary headroom for some increase in incremental debt in the form of ECBs to finance the real investment for higher growth. The main element of the revised policy was an increase in eligibility limits for the automatic route from US$50 million to US$500 million with certain maturity conditions. All corporates, non-banking finance companies (NBFCs) and financial institutions, except banks, were made eligible borrowers. Interest rate spreads or all-in-cost ceilings were specified. ECBs with an average maturity of three to five years were subject to a maximum spread of 200 bps over the sixmonth London Interbank Offered Rate (LIBOR) of the respective currency in which the loan was raised or the applicable benchmark(s). ECBs with more than five years of average maturity were subject to a maximum spread of 350 bps. No bank guarantee was allowed. All ECBs satisfying the above criteria would be eligible under the automatic route up to US$20 million for ECBs between three to five years of average maturity and up to US$500 million for ECBs having an average maturity of more than five years. The eligibility criteria were applicable to foreign currency convertible bonds (FCCBs) also. All cases falling outside the purview of the automatic route in the new liberalised ECB policy were decided by an empowered committee of the Reserve Bank.73

NRI Deposits The experience with the FCNR(A) scheme, which existed until the 1990s and as part of which an exchange guarantee was offered to banks, was not 131

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the reserve bank of india encouraging. The effective cost worked out to be high and the scheme accentuated the crisis in 1991 by recording substantial outflows. Therefore, the policy with respect to NRI deposits underwent changes subsequently. While the broad features and attractiveness of the scheme were retained, the emphasis was laid on reducing the effective cost of borrowing and outgo of forex. Interest rates on these deposits were steadily deregulated and interest rate ceilings were modulated in step with capital flow phases before they were completely freed. The reserve requirement was operated flexibly as a tool for managing capital flows in relation to the needs of the underlying conditions. There were five types of NRI deposits prevalent during the period under reference: FCNR(B), NR(E)RA, non-resident (non-repatriable) rupee deposit, or NR(NR)RD, NRSR deposit account scheme and NRO accounts. Under FCNR(B) deposits, which were only term deposits and denominated in designated foreign currencies with fully repatriable benefits, exchange risk was borne by banks. NR(E)RA deposits, allowed under savings, current and term deposit, were fully repatriable and denominated in rupees, and thus exchange risk was borne by the depositors. The interest on these two deposits was revised depending upon the ebb and flow of capital inflows. In addition, after a review of the investment activities of OCBs, in consultation with the government, they were derecognised as a distinct eligible class of investors in India with effect from 16 September 2003. With a view to reducing the country’s external short-term liabilities, deposits with the maturity period of less than one year were disallowed under FCNR(B) in October 1999 and under NR(E)RA in April 2003. NR(NR)RD was initially non-repatriable but later interest income was permitted to be repatriated and thereafter principal also was made repatriable. Banks were allowed to fix the interest rates from the inception of the scheme ( June 1992), even before such freedom was granted to domestic deposits. These deposits were exempted from the statutory liquidity ratio and the CRR for most of the period. NRSR deposits were introduced, with effect from 15 April 1999, for such persons who voluntarily undertook not to seek repatriation of funds held in such accounts and the interest/income accrued thereon. These accounts had the same facilities as well as restrictions that were applicable to domestic resident accounts of individuals with respect to repatriation of funds, with the exception that the investment of funds held in these accounts in shares/securities and immovable property would be governed by the existing exchange control regulations. Both the schemes 132

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foreign exchange market and management of the capital account were withdrawn in April 2002, with a view to providing full convertibility of deposit schemes for NRIs. The maturity structure of NRI deposits was also readjusted.74

Short-Term Credits Short-term credits (debt) are those loans that have the maturity of one year or less. One of the key components of capital account management was keeping the short-term debt liabilities within manageable levels. It was believed that a large short-term debt exposure would lead to external sector vulnerability as borrowers faced financing/rollover risk, more so during a crisis when access to the international financial market becomes restricted. This could mean heavy net repayments on account of short-term maturing obligations, which could further aggravate the payment difficulties. Therefore, capital account management required careful planning of short-term exposure. In fact, shortterm debt overhang had added to the 1991 balance of payments crisis. After the crisis, trade-related short-term credits were allowed only for import purposes. Overall limits were fixed for contracted short-term credits of original maturity, within which the category of oil companies and the ‘group of other importers’ had separate shares. These limits were being monitored carefully and revised from time to time. The short-term debt based on residual maturity, meaning total claims or debt service payments falling due during a year, was also being monitored as this type was perceived to be more relevant from the point of view of capital account management. The Indian approach of close monitoring of short-term exposure was vindicated by the Southeast Asian crisis and helped India remain insulated. However, the limits were relaxed later when the forex reserve became somewhat comfortable. The other segment of short-term debt was the shortterm portion of non-resident deposits that was gradually eliminated. As explained elsewhere, deposits with maturity of one year or less were withdrawn under FCNR(B) in October 1999 and those under NR(E)RA in April 2003. Another type of short-term exposure which received attention under capital account management was unhedged forex exposures of corporates, which could have resulted in larger payments in terms of rupees when the rupee depreciated. The Reserve Bank in its different monetary policy statements from 2001 to 2003 expressed concern over such exposures and cajoled banks to hedge them. As banks did not heed the advice, the Bank mandated that, 133

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the reserve bank of india henceforth, all foreign currency loans by banks above US$10 million could be extended only on the basis of a well laid-out policy by the banks’ Boards to ensure hedging.

Rupee Debt The Indo-Russian agreement of 1992 and 1993 specified that rouble debt owed to the erstwhile Union of Soviet Socialist Republics (USSR) be converted into rupees and made payable through exports.75 On several occasions, prepayment of the entire rupee debt was proposed because its repayment arrangement was complex. A working group in 1997 suggested the dollarization and prepayment of total rupee debt with suitable discount.76 The proposal was discussed in several Indo-Russian joint technical committees but no consensus emerged due to the absence of agreement on the rate of discount. Russia was required to utilise the repayments of rupee debt only for purchases of identified goods and services from India. As Russia was not able to import specified items, rupee balances in Russian account with the Reserve Bank gradually accumulated to 46.23 billion as of 15 April 2007. In November 2007 a ‘Letter of Exchange’ signed between the Government of India and the Russian Federation stipulated, inter alia, that the accumulated rupee balances should be earmarked for productive investment in India. However, no investment materialised during the reference period. Finally, when there was a surge in capital inflows in the early 2000s, many current payments were further relaxed. Although India had complied with current account convertibility conditions of Article VIII of the IMF in 1994, some limits continued to be in force for current transactions. Excess capital inflows provided an opportunity to further relax current payments.77

Indian Investment Abroad Indian investment abroad rose from US$198 million in 1996–97 to US$2.1 billion in 2003–04 and to US$21.3 billion in 2007–08. On this issue, the approach was to facilitate direct overseas investment through joint ventures and wholly owned subsidiaries and the provision of financial support to promote project exports. There were two ways to do this: the automatic route and the ‘normal’ route (or case-by-case approvals). In December 1998, the ceiling for clearance of proposals for Indian investment under the 134

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foreign exchange market and management of the capital account automatic route was raised substantially. In 2002, the limit was again raised, and investment made free of certain conditions. Policies on ADRs and GDRs by Indian companies were also made liberal at the same time. Overseas business acquisition through this route was permitted under the simplified system in certain activities, including information technology and biotechnology. Such businesses could issue employees’ stock options to their permanent employees. The policy became more liberal during excessive capital flows. In 2003, listed Indian companies could invest in companies listed abroad.78 For banks, the freedom to initiate trading positions, borrow and invest in overseas markets added enormous flexibility to the forex business. In April 1997, ADs were permitted to borrow from their overseas offices/correspondents as well as to invest funds in overseas money market instruments, which was essentially intended to augment banks’ resources and strengthen the integration between overseas and domestic money markets. This was subject to limits and conditions, eased later. In March 2004, to rationalise these rules, the existing facilities were replaced by a single facility in terms of which all categories of overseas foreign currency borrowings, including existing ECBs and overdrafts in Nostro accounts not adjusted within five days, were not to exceed 25 per cent of their unimpaired Tier I capital.

Conclusion India in the early 1990s had a closely regulated external sector. Deregulation came in the next fifteen years. Liberalisation led to impressive capital inflows. India’s forex reserves rose from US$22 billion at the end of March 1996 to US$310 billion at the end of March 2008, and the ratio of net foreign assets to reserve money rose from around 38 per cent to nearly 130 per cent in the same period. The chapter shows how this transition occurred and the challenges that it gave rise to. It also illustrates a point often made about Indian reforms, that the reform process was ‘gradualist’. Those critical of the Reserve Bank’s external policies during this period suggested that a more open economy would have delivered higher growth, that the Bank’s policies were too conservative, and that a constricted financial sector depressed growth. The gradualism, however, served India well when the 2008 global financial crisis broke out. Subsequently, the Bank’s stance was vindicated, and Reserve Bank governors received international acclaim.79 135

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the reserve bank of india Gradualism takes a concrete meaning in the context of external sector reforms. The Indian approach to international capital flows adopted an implicit hierarchy of various types of flows. The general aim was to encourage non-debt-creating flows as compared to debt-creating flows. Within debtcreating flows, long-term debt was preferred to short-term debt. In this hierarchical order, FDI was at the top, followed by FII investment into equities, since, though volatile, both market and exchange rate risks were borne by the investor. While this hierarchical order governed the pace of deregulation, the environment was another governing factor. The advisory committees were, by and large, pro-reform but the pace of reform depended on market conditions. From this point of view, the first half of the 2000s saw a few exceptionally good years in terms of economic growth and capital market flows. This enabled the Reserve Bank to implement deregulation and institutional change with relative ease. After a decade of its endeavour to open up the forex market and manage capital account, the Bank noted in its Annual Report 2007–08 that while in the medium term, development of financial market could alone meet the challenge of capital flows, which is a gradual process, in the short-run, capital flows would have to be managed with a set of well-crafted tools. The report further noted, ‘[T]he issue is not either financial market development or management of the capital account, but how much of each approach should be adopted in a given situation and over time while recognizing and taking into account the scope and prospects for reforms in the fiscal and real sectors.’

Notes

1.  When Article VIII of the Articles of Agreement of the International Monetary Fund was accepted. Conforming to the provisions of Article VIII confers on its members the status of current account convertibility. India complied with the requirement and acquired current account convertibility in August 1994. 2. More specifically, it recommended Indian companies to invest up to US$50 million abroad, forex earners to retain 100 per cent of their earnings in exchange earners’ foreign currency (EEFC) accounts, liberal limits for banks’ foreign borrowing, phased raising of limits of individual outward remittances. It also permitted participants in the spot market to take part in the forward markets and currency futures. Tarapore I influenced the repeal of FERA. 136

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foreign exchange market and management of the capital account 3.  And an end to the remittance limit of US$5,000 per transaction for miscellaneous purposes, as well as individual purpose-wise limits, subsuming these under a new aggregate limit of US$25,000. 4. Its suggestions ranged from hedging of forex exposures to further liberalization of rupee–foreign currency swaps, allowing banks to use their discretion to introduce structured products, adopting proper accounting standards for derivatives, extending closing time for interbank transactions, maintaining capital on the banks’ actual overnight open exchange position rather than on the limit available, and monitoring interest rate risk using value at risk method (a statistical technique used to measure the level of financial risk of a firm or portfolio). 5. Working group under the chairmanship of P. K. Pain, Chief Executive, Foreign Exchange Dealers’ Association of India, 2006. 6. The minimum average maturity of ECBs was reduced to five years for loans above US$20 million, and three years for lower amounts. 7. Under which Indian stockbrokers would be able to purchase shares and deposit them with the Indian custodian for the issuance of ADRs/GDRs by the overseas depository. These issues should be to the extent of the ADRs/ GDRs converted into underlying shares. 8. Comprising members from the Reserve Bank, SEBI, Ministry of Finance and the Insurance Regulatory and Development Authority of India. All the issues, including major liberalization measures with respect to financial markets, were first deliberated in the high-level committee. 9. Up to US$500 million or equivalent with a minimum average maturity of five years. 10. For example, the system of monitoring the cancellations of forward contracts beyond US$500,000 was reintroduced in November 1997. As the crisis spread, the facility of rebooking the cancelled contracts for imports was withdrawn on 20 August 1998, partly rescinding the permission granted in April 1997 to corporates to book forward cover for their export and import transactions through ADs. Subsequently, a limit of US$100 million for cancellation and rebooking was set for exports and imports separately. In December 2002, ADs were allowed to freely offer the facility of rebooking of cancelled contracts to all forex exposures falling due within one year. In June 2005, cancellation and rebooking of all eligible forward contracts booked by residents, irrespective of tenor, was reintroduced. 11. Up to 50 per cent of their forex earnings subject to certain conditions. 12. Headed by the Commerce Secretary and comprising members from the Ministry of Finance, Ministry of External Affairs and the Reserve Bank. 13. Vepa Kamesam, Deputy Governor, wrote a confidential letter to Finance Secretary S. Narayan, on 16 December 2002, drawing his attention to 137

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the reserve bank of india Governor Jalan’s discussion emphasizing the need for the Reserve Bank and the government to evolve a suitable mechanism to avoid delays in the disposal of applications. Inordinate delay had occurred in a few cases of approval, essentially because of the stance taken by the representative of the Ministry of Finance (see Appendix A4.1 for the full text of the letter). 14. From US$25,000 to US$100,000, or its equivalent. 15. Among further measures of liberalisation, corporates were allowed, in April 2007, to donate abroad subject to a limit of 1 per cent of their forex earnings during the previous three financial years or US$5 million, whichever was lower, and they were also allowed to remit up to US$10 million against the then prevailing limit of US$1 million for consultancy services for executing infrastructure projects. In June 2007, the limit for portfolio investment by listed Indian companies in the equity of listed foreign companies was raised from 25 per cent to 35 per cent of the net worth of the investing company, which was further raised in September 2007 to 50 per cent. Further, the requirement of reciprocal 10 per cent shareholding in Indian companies was dispensed with. 16. The limit of FII exposure to government papers was set at US$1 billion in 1998, which was subsequently raised to US$1.75 billion in November 2004, US$2 billion in April 2006, US$2.6 billion in January 2007, US$3.2 billion in January 2008 and US$5.0 billion in June 2008. Similarly, FII investment limit fixed for the corporate bond market was US$0.5 billion in December 2004, US$1.5 billion in April 2006 and US$3.0 billion in June 2008. 17.  W hich was closed along with non-resident (non-repatriable) deposit (NR[NR]D) accounts effective 1 April 2002 as part of rationalization of NRI deposits. 18. Such as to meet expenses in connection with the education of their children (up to US$30,000 per year), meeting medical expenses abroad of the person or family (up to US$100,000) and repatriation of sale proceeds of immovable property (up to US$100,000 per year, subject to tax payment and other conditions). In January 2003, the existing restrictions on repatriation of funds out of NRO accounts for education, medical and other approved purposes were removed. 19. In April 2004, to provide consistency in the interest rates offered to NRIs, interest rates on deposits under non-resident (external) rupee accounts (NR[E]RAs) for one- to three-year maturity were set at par with the London Interbank Offered Rate (LIBOR)/swap rates for the US dollar of the corresponding maturity. Further steps to achieve a consistent interest rate policy has been discussed in the chapter on monetary management (Chapter 3). Interest rates on FCNR(B) deposits were allowed to be fixed on a monthly basis against the then current weekly basis, as in the case of NR(E)RA deposits. As capital flows were large, the debt component of such 138

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foreign exchange market and management of the capital account flows was decided to be moderated. Therefore, in January 2007, interest rate ceilings on FCNR(B) and NR(E)RA deposits were reduced to LIBOR/swap rates minus 25 basis points (bps) and LIBOR/swap plus 50 bps, respectively. In April 2007, the ceiling on FCNR(B) deposits was reset at LIBOR/swap minus 75 bps and NR(E)RA at equal to LIBOR/swap rates. 20. In April 1999, these rules were further relaxed. 21. In the internal note put up by the Exchange Control Department on 3 October 2002, examining a proposal received from the Indian Merchants Chamber, Mumbai, that the policy of allowing individuals to retain up to US$2,000 in cash could be extended to hold the amount in a bank account, K. J. Udeshi, Executive Director, agreed and specified the eligible credits. 22. Listed on a recognised stock exchange and with a shareholding of at least 10 per cent in an Indian company listed on a recognised stock exchange in India, without any limit. 23. To US$100,000. Release of up to US$100,000 or its equivalent (against the existing limit of US$50,000 or its equivalent) to resident Indians by ADs was allowed for medical treatment abroad without insisting on any estimate from a hospital or doctor. 24. Among other measures, in February 2004, resident individuals were allowed to freely remit up to US$25,000 per calendar year for any current or capital account transactions, or a combination of both. The limits were raised further in May 2007 to US$100,000 and again in September 2007 to US$200,000. Under this facility, resident individuals would be able to acquire immovable property and hold bank accounts, immovable property, or shares, or any other asset outside India, barring specific countries. 25. Notification No. FEMA 21/2000, section 7. 26.  Rajya Sabha, Dy. No. 3280 for 19 December 2006 by B. K. Hariprasad, MP. 27. The Reserve Bank further stated that the perception of the IB that the PIO status should be cancelled was not appropriate as FEMA did not provide for registration of persons as PIO or the cancellation of such status. 28.  The International Monetary Fund (IMF) called this ‘perhaps the most significant move’. IMF, ‘India: Selected Issues’, IMF Staff Country Reports, no. 112, Washington DC, 1998. 29. Within the bank’s open position limit and maturity mismatch limits (gap limits). 30. In terms of which all categories of overseas foreign currency borrowings was not to exceed 25 per cent of their unimpaired Tier I capital as at the close of the previous quarter or US$10 million or its equivalent, whichever was higher. 31. In April 1998, the High-Level Committee on Banking Sector Reforms (Narasimham Committee II; also see Chapters 3 and 10) recommended that forex open credit limit risks of banks should be integrated into the calculation 139

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the reserve bank of india of risk-weighted assets and should carry a 100 per cent risk weight. This was taken into account when Basel II norms were implemented. In April 1999, permission was granted to banks to crystallize their forex liability in rupees in select cases. ADs were permitted to allow remittances for the purpose of normal business operations of the office (trading or non-trading) or branch or representative outside India of Indian entities, subject to terms and conditions. In April 2004, entities other than ADs or authorized banks were prohibited from accepting deposits from NRIs, either through fresh remittances or by debit to their NR(E)RA/FCNR(B) accounts. Banks were also permitted to fix interest rates on non-resident deposits, thereby enabling them to raise funds at a commercially viable cost. 32. Up to US$20 million per transaction for a period of up to one year for import of all non-capital goods permissible under the foreign trade policy (except gold), and up to three years for import of capital goods, subject to prudential guidelines. 33. Settlement of claims in foreign currency with respect to general insurance policies in foreign currency, issued with the approval of the Reserve Bank, was permitted in October 2001, subject to specified conditions. In April 2002, insurance companies, registered with the Insurance Regulatory and Development Authority of India (IRDAI), were permitted to issue general insurance policies denominated in foreign currency and receive premium in foreign currency without the prior approval of the Bank. 34. With an individual cap of US$50 million and overall cap of US$500 million. 35. In an internal note of the Exchange Control Department (8 August 1998), Deputy Governor Jagdish Capoor suggested that general permission be granted to domestic mutual funds within the overall limit to invest abroad, and expressed no objection to the proposal of mutual funds’ investment in depository receipts which would, according to him, increase efficiency because of two-way fungibility. On 14 January 1999 Governor Jalan remarked in a note, ‘A great deal has happened since the announcement of the proposed scheme in October 1997, and there are considerable uncertainties about capital flows and BOP prospects.... [I]t may be better not to embark on this scheme.’ 36. He noted on 28 February 2000 that ‘the reserves position being much better than the previous year, this extension may be agreed to’, and that ‘SEBI may be informed that a reference is being made to the government for their concurrence’. Accordingly, a communication dated 16 March 2000 was sent to the government. 37. Which Deputy Governor Capoor had proposed five years ago. Mutual funds were allowed to invest in overseas index funds based on a decision taken on 5 April 2003. 140

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foreign exchange market and management of the capital account 38. SEBI wrote to the Reserve Bank to increase the individual limit of US$50 million to US$100 million. A circular was issued on 26 July 2006 giving effect to all the three budget proposals. Subsequently, the limits were relaxed in a number of steps. 39. D uring the extensive discussion on both the Bills that followed, Finance Minister Yashwant Sinha said FERA was long thought to be out of tune with economic liberalization. Both the Bills were passed by the Lok Sabha on 2 December 1999 and sent to the Rajya Sabha. The Bills were laid on the table of the Rajya Sabha on 3 December 1999. 40. The Act along with the rules framed thereunder came into force on 1 July 2005. 41.  Hawala refers to remittance systems. 42. To deal with contravention cases and decide the penalty, the government notification had fixed the quantitative limits in terms of amount involved per transaction for different levels of officers in the Reserve Bank – from Grade ‘C’ (Assistant General Manager) to ‘F’ (Chief General Manager). However, for effective implementation of the compounding process, the Bank had framed a set of rule-based instructions. 43. The reporting system was revamped as certain prescribed returns became no longer relevant with the introduction of FEMA, which is discussed elsewhere. 44. R.V. Gupta, Deputy Governor, was the Chairman. 45. Further, based on the recommendations of an internal group for preparing consolidated guidelines on derivatives, importers and exporters were allowed to write covered call and put options both in foreign currency and the rupee. 46. Expanded in October 1999 to include purchase call or put options to hedge their cross-currency proprietary trading positions within the overall value and maturity of the underlying instrument. 47. The forward contract had to be for a tenor of one year or more and could be rolled over on maturity. Foreign banks were permitted to hedge their Tier II capital in the form of head office borrowing as subordinated debt by keeping it swapped into the rupee at all times. Earlier, entities with FDI in India had to approach the Reserve Bank for case-by-case approval to hedge their investment. 48. To describe the unfolding of hedging policy for non-residents, in October 1997, NRIs were allowed to enter into forward/option contracts with ADs to hedge (a) the amount of dividend due on shares held in an Indian company, (b) the amount of investment made under portfolio scheme in accordance with the relevant provisions for the purpose and (c) the balances held in the FCNRB and NR(E)RA. Until November 2002, designated branches of ADs maintaining accounts of FIIs could provide forward cover with certain limits. From November 2002, ADs could provide forward/option contracts to FIIs 141

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the reserve bank of india with rupee as one of the currencies, based on the declared market value of their entire investment in equity and/or debt in India. The cost of the hedge was to be met out of funds that could be repatriated and/or inward remittance through a normal banking channel. If the hedge became naked, the hedge could be allowed to continue until the original maturity. In order to facilitate dynamic hedging of forex exposures and keeping in view the size of the market in India and the large positions held by FIIs, it was decided to implement the flexibility for rebooking cancelled contracts in a gradual and phased manner. Accordingly, in February 2007, AD category-I banks were permitted to allow FIIs to cancel and rebook forward contracts up to a limit of 2 per cent of the market value of their entire investment in equity and/or debt in India. 49. Under the chairmanship of S. Gurumurthy, Executive Director. 50.  A declaration that an exporter gives against each shipment that the full export proceeds will be realised. 51.  The debate on this subject is reviewed in Dani Rodrik and Arvind Subramanian, ‘Why Did Financial Globalization Disappoint?’ IMF Staff Papers 56, no. 1 (2009): 112–138. 52. Statement at the 48th Meeting of the Interim Committee of the IMF, Washington DC, 28 April 1997, para. 9. 53. Reserve Bank press release, 20 August 1997; Y. V. Reddy, ‘Exchange Rate Management: Dilemmas’, Inaugural Address, XIth National Assembly, Forex Association of India, Goa, 15 August 1997. 54. To encourage early realization of exports, interest rate on post-shipment rupee export credit on usance bills for three to six months was increased by 2 percentage points to 15 per cent per annum for the period exceeding ninety days, which was subsequently restored to 13 per cent effective January 1998. Overdue export bills attracted 20 per cent of interest per annum, and an interest rate surcharge of 15 per cent of the lending rate was imposed on bank credit for imports effective 17 December 1997. Policy rates were raised on 16 January 1998 along with other measures. 55. To encourage exports, interest rate on pre-shipment credit was brought down from 12 per cent to 11 per cent effective 30 April 1998 and as a temporary measure, scheduled commercial banks were provided with export credit refinance at 2 percentage points below the Bank Rate between 6 August 1998 and 31 March 1999. 56. Apart from monetary measures, other measures included the enhancement of forward cover for FII investment, withdrawal of facility of rebooking cancelled contracts for imports, and restriction of the extension of time limit for repatriation of export proceeds to exceptional circumstances. 57. Interest amount paid by the government was of the order of 30 billion in the first year (2004–05), which progressively went up to over 84 billion in 2007–08. 142

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foreign exchange market and management of the capital account 58. Prudential regulations should be strengthened to encourage capital inflows; more players should be allowed to access the repo market; the repo markets should be allowed to cover corporate debt instruments; skills should be upgraded to develop the interbank term money market; prudential limits for commercial papers and certificates of deposit may be fixed; the market in interest rate futures should be activated and interest rate options should be allowed; and the Fixed Income Money Market and Derivatives Association of India (FIMMDA) should be suitably empowered to act as a self-regulatory organization to develop market ethics and trading standards, and also undertake regulation of participants, besides disseminating information. 59. The limit for FII investment in government securities could be gradually raised to 10 per cent of gross issuance by the centre and states by 2009–10. The allocation by SEBI of the limits between 100 per cent debt funds and other FIIs should be discontinued; short-selling across settlement cycles with adequate safeguards should be permitted; gilt funds should receive some tax exemption; non-resident investors be permitted to expand industry base; and repo facility in government securities should be widened by allowing all market players without any restrictions. 60. The spot and forward markets should be liberalized and extended to all participants, removing the constraint on past performance/underlying exposures; to nurture interest rate parity in forward markets, more flexibility may be provided to banks to borrow and lend overseas both on short term and long term, depending upon the strength of their balance sheet; currency futures may be introduced subject to risks being contained through proper trading mechanism, structure of contracts and regulatory environment; and the banking sector should be allowed to hedge currency swaps by buying and selling without any monetary limits. 61. The central and state governments should graduate from the present system of computing the fiscal deficit to a measure of the public sector borrowing requirement; and the Office of Public Debt should be set up to function independently outside the Reserve Bank. 62. All commercial banks should be subject to a single banking legislation; the minimum share of the central government/Reserve Bank in the capital of public sector banks should be reduced from 51 per cent (55 per cent for SBI) to 33 per cent; setting up of new private sector banks and conversion of nonbanking finance companies (NBFCs) into banks should be encouraged; issues of corporate governance in banks need to be given early attention; and linking the limits for borrowing overseas to paid-up capital and free reserves, and not to unimpaired Tier I capital, as at present, raising it substantially to 50 per cent in Phase I, 75 per cent in Phase II and 100 per cent in Phase III. 63. The Reserve Bank should activate variable rate repo/reverse repo auctions/ operations on a real-time basis and also consider somewhat longer-term LAF 143

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the reserve bank of india facilities; the Bank and the central government should jointly set out the objectives of monetary policy for a specific period and this should be put in the public domain. A formal Monetary Policy Committee should be set up for strengthening the institutional framework. 64. A monitoring exchange rate band of plus/minus 5 per cent around the neutral real effective exchange rate (REER) may be considered and the REER should incorporate services to the extent possible. As an operative rule, if the current account deficit persists beyond 3 per cent of GDP, the exchange rate policy should be reviewed. Other recommendations include raising the overall ECB ceiling as also the ceiling for automatic approval gradually; keeping ECBs of over ten-year maturity in Phase I and over seven-year maturity in Phase II outside the ceiling and removing end-use restriction in Phase I; monitoring import-linked short-term loans in a comprehensive manner and reviewing the per transaction limit of US$20 million; raising the limits for outflows on account of corporate investment abroad in phases from 200 per cent of net worth to 400 per cent of net worth; providing EEFC account holders access to foreign currency current/savings accounts with cheque facility and interest bearing term deposits; prohibiting FIIs from investing fresh money raised through participatory notes (PN), after providing existing PN holders an exit route so as to phase them out completely within one year; allowing institutions/ corporates, other than multilateral ones, to raise rupee bonds (with an option to convert into forex), subject to an overall ceiling that should be gradually raised; raising the annual limit of remittance abroad by individuals from the existing US$25,000 per calendar year to US$50,000 in Phase I, US$100,000 in Phase II and US$200,000 in Phase III; and allowing non-residents (other than NRIs) access to FCNR(B) and NR(E)RA schemes. 65. Refers to flow of funds (or capital) from one country to another to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts. 66. According to the report of the meeting of the Technical Committee of SEBIregulated entities held on 29 October 2003, the PN route investment was as high as 28 per cent of the total net FII investments at the end of September 2003. 67. The minutes of the meeting noted, ‘Governor [Y. V. Reddy], RBI observed that going into the original purpose for allowing FII investment, it is clear that only known and regulated entities should be allowed to make use of FII route and non-verifiable sources should not be allowed.’ 68. Or within a period of five years from 3 February 2004, whichever was early. 69. The group was formed in November 2005 by the Ministry of Finance under the chairmanship of Ashok Lahiri, Chief Economic Adviser, Ministry of Finance. 144

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foreign exchange market and management of the capital account 70.  For example, in 2003–04, the limit was US$9 billion, which was kept unchanged for the next year as well, and was progressively enhanced to US$16 billion in 2005–06, US$22 billion in 2006–07 and US$28 billion in 2007–08. Within the overall ceiling, a sub-ceiling was prescribed for investment in government securities and T-bills as well as corporate papers. 71. To track the policy developments, guidelines for ECBs were relaxed in June 1997, effecting: (a) ECBs of average maturity of ten years and above were kept outside the ECB ceiling and (b) ECB limits for telecom projects were made more flexible and an increase from 35 per cent to 50 per cent of the total project cost (including the licence fees) was allowed. 72. Among other measures, in March 2002, corporates were allowed to issue foreign currency convertible bonds (FCCBs) up to US$50 million in any single financial year under the automatic route, that is, without the approval of the government or the Reserve Bank. In September, in order to permit corporates to take advantage of low global interest rates, the Bank permitted prepayment of outstanding ECBs up to an amount of US$100 million without its prior approval. This liberalized automatic route was available to all categories of borrowers up to 31 March 2003. Proposals involving prepayment exceeding US$100 million would also be considered by the Bank expeditiously. Individuals, trusts and non-profit-making organizations were not eligible under the automatic route. 73. In October 2005, special purpose vehicles (SPVs) or any other entity notified by the Reserve Bank that were set up to finance infrastructure companies/ projects were treated as financial institutions. Also, prepayment of ECB up to US$300 million against the earlier limit of US$200 million was allowed by ADs without prior approval of the Bank, which was further raised to US$400 million in April 2007. 74. As FCNR(B) deposits were allowed a maximum three-year maturity, it was announced in the Monetary and Credit Policy for 2003–04 that with a view to providing uniformity in the maturity structure for all types of repatriable deposits, the normal maturity period of fresh NR(E)RA deposits was also made one to three years; if a bank wished to accept deposits with a maturity of more than three years, it may do so provided the interest rate on such long-term deposits was not higher than that applicable to three-year deposits. Net inflows under NRI deposits were generally in the range of US$2.5 billion to US$4.3 billion per year during this period barring a few years in between. 75. See Reserve Bank of India, The Reserve Bank of India, Vol. 4: 1981–1997 (New Delhi: Academic Foundation, 2013), Part A, p. 485. 76. Chairman: Y. V. Reddy, set up by the government on ‘settlement of rupee debt owed to Russia’, submitted its report on 12 March 1997. 145

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the reserve bank of india 77. For example, in 2003, the limit for advance remittance without bank guarantee by ADs was raised from US$25,000 to US$100,000 or its equivalent for import of goods into India, subject to specified conditions. As a matter of further liberalization, the limit of US$5,000 or its equivalent to be released by authorized persons to resident individuals in one calendar year, for any or more private visits to any country (except Nepal and Bhutan), was enhanced to US$10,000 or its equivalent. In July, the existing limits on remittances in respect of items, such as medical, employment, maintenance of close relatives and education abroad, were enhanced uniformly to US$100,000. In February 2004, resident individuals were allowed (under liberalized remittance scheme) to freely remit up to US$25,000 per calendar year for any current or capital account transactions or a combination of both. Under this facility, resident individuals were free to acquire and hold immovable property or shares or any other asset outside India without the approval of the Reserve Bank. Individuals could also open, maintain and hold foreign currency accounts with a bank outside India for making remittances under the scheme without prior approval of the Bank. The limit was raised to US$50,000 in December 2006 and applicable to remittances towards gift and donation by a resident individual as well. Subsequently, in May 2007, the limit was enhanced to US$100,000 and further increased in September 2007 to US$200,000 per financial year. 78. The latter would have the shareholding of at least 10 per cent in an Indian company listed on a recognized stock exchange in India (as of 1 January of the year of investment). Such investments were not to exceed 25 per cent of the Indian company’s net worth, which was raised to 35 per cent in 2007, as of the date of latest audited balance sheet. Residents could invest without limit. Mutual funds were permitted to invest, with conditions. 79. The economist and Nobel laureate Joseph E. Stiglitz said, ‘If America had a central bank chief like Y.V. Reddy, the U.S. economy would not have been such a mess’ (New York Times, ‘In India, Central Banker Played It Safe’, 25 June 2009). Stephany Griffith-Jones, economist, said, ‘I think not all countries are as lucky as India to have such common sense and balanced governors’ (CAFRAL, ‘Autonomy of the Central Bank’, Newsletter, May 2014).

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5 Foreign Exchange Reserves Management

Introduction Chapter 4 discussed key developments in the external sector and changes in the regulatory regime. This chapter will concentrate on the management of the exchange rate and foreign exchange reserves. During the years of interest, in the wake of cross-border capital flows of unprecedented scale, the Reserve Bank needed to intervene deeply in the foreign exchange, or forex, market to stabilise the rupee and to devise measures to prevent currency speculation. While the Bank’s stance on exchange rate was sometimes criticised, it succeeded in this aim, as this chapter will show. The chapter has four sections: The first two will deal with the exchange rate, presenting a chronological account of market intervention, and a discussion of some of the major debates and policy issues. The third section will deal with the management of reserves, and the fourth with policy on gold and its import, and related matters.

Exchange Rate Management: A Chronological Account The Reserve Bank derives its authority to manage the exchange rate of the rupee from the Reserve Bank of India (RBI) Act, 1934. The word ‘stability’ in the phrase ‘with a view to securing monetary stability … and generally to operate the currency and credit system of the country to its advantage’, appearing in the preamble, can mean internal as well as external stability. External stability, in turn, should mean maintaining a stable exchange rate. Section 40 of the Act, however, states that ‘the Central Government may, by order, determine foreign exchange at such rates of exchange and on such conditions as the Central Government may from time to time ... determine’. These extracts suggest that exchange rate management is in the domain of the government, which delegated this power to the Reserve Bank. As we shall see, these clauses made the process of reforming exchange rate management a particularly interactive one. 147

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the reserve bank of india Cross-border capital flows became more volatile from 1997 to 2008 because of both external and domestic developments, as we have seen (Chapters 3 and 4). Exchange rate management during this period became more challenging as a result. These eleven years can be divided into two parts. Between April 1997 and March 2003, the rupee (nominal) depreciated by nearly 25 per cent. In contrast, from April 2003 to March 2008, the nominal value of the rupee appreciated by around 19 per cent. During both the periods, the aim of exchange rate management was to manage the volatility of the rupee without a fixed target and allow it to find its level consistent with the ‘fundamentals’. Let us begin with a brief account of the institutional framework for market intervention. Following on the Sodhani Committee report, a Financial Markets Committee (FMC-RBI) was set up in early 1997.1 The FMC-RBI met every day, generally in the morning. During the period of high volatility in the foreign exchange market, the FMC-RBI met more than once a day. After discussing the major developments in domestic and international markets, decisions were taken on daily intervention in different segments of the financial market. Generally, while the FMC-RBI decided about the Reserve Bank’s intervention in money and government securities markets, the decision to intervene in the foreign exchange market was taken after members in the committee held discussions with the Governor. How often and to what extent was market intervention used? In the rest of this section, the major episodes of intervention in the foreign exchange market and the context for such intervention are described year by year.

1997–98 to 2002–03 Subsequent to the unification of exchange rate in March 1993, the nominal exchange rate of the rupee vis-à-vis the United States (US) dollar remained steady at around 31.37 from March 1993 to August 1995.2 From August 1995 to February 1996, after large swings, the rupee stabilised at around 35 per US dollar. April–August 1997 witnessed surplus conditions in the Indian foreign exchange market and continuation of a trend that had begun in 1996–97. As a result, the Reserve Bank mopped up US$5.4 billion by way of net cumulative purchases from the market during this period. On 15 August 1997, Deputy Governor Y. V. Reddy said that ‘compared to March 1993, the appreciation of Indian rupee in real effective terms is around 14 percent’.3 This was perhaps the first time that the Reserve Bank 148

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foreign exchange reserves management commented on contemporary exchange rate movements and acknowledged that the rupee was overvalued. As the rupee had appreciated in real terms, some correction was warranted. It seemed better that such correction took place at the initiative of the authorities rather than being forced by the market. Before making the speech, Deputy Governor Reddy had discussed with Governor Rangarajan about the statement that he would make on the status of the rupee. This was a calculated move.4 The Economic Times (20 August 1997) attributed to Prime Minister I. K. Gujral the view that the government would shortly fix a band to signal the exchange rate of the rupee in relation to the US dollar. The Reserve Bank issued a press release on the same day stating that the report was misleading.5 In any case, the rupee depreciated to 35.84 per US dollar on August 20 and to 36.08 on 21 August 1997.6 During October–December 1997, the nominal exchange rate of the rupee depreciated by 7.6 per cent. Corporates with large exposure to the foreign exchange market rushed to cover their position, which led to an increase in the forward premium.7 The liabilities of the Reserve Bank in terms of net forward market commitments rose from US$944 million at the end of September 1997 to around US$2 billion at the end of December 1997. That is, the Bank sold dollar to the tune of around US$1 billion on a net basis in the forward market alone during that period. The intervention in the spot and forward segments of the market was supplemented by several monetary measures that eventually stabilised the exchange rate. But the improvement proved to be temporary. The Bank again undertook stringent monetary measures at the beginning of January 1998. By the end of January 1998, the nominal exchange rate had stabilised around 38.92 per US dollar and traded at around 39.5 per US dollar by March 1998. There was a loss of reserves to the extent of over US$2 billion between September and December 1997. During the first half of 1998–99, the situation turned adverse as the Asian crisis reached Russia and Brazil. Following a nuclear test, India faced economic sanctions by the US. The rupee moved sharply from 39.73 per US dollar at the beginning of May 1998 to 42.38 per US dollar on 11 June 1998. Outflows under the head of foreign institutional investment (FII), though only US$137 million during May, contributed to the pressure on the rupee. In the first ten days of June 1998, the Reserve Bank sold US$1.4 billion. The Bank issued a statement announcing a package of policy measures on 11 June 1998 to contain the volatility.8 The market responded positively to these measures and remained stable until August 1998. But fear of devaluation 149

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the reserve bank of india of the Chinese renminbi and the deepening of a crisis in Russia made Indian markets turbulent again. The Bank announced a fresh package of measures on 20 August (also see Chapter 4). At the same time, the Resurgent India Bonds (RIBs) were launched following an announcement in the Union Budget 1998–99. As Deputy Governor Reddy would say later, the scheme was designed to manage an ‘extraordinary event’ caused by the sanctions on India and the downgrading of India’s sovereign rating.9 In contrast to cumulative sales by the Bank during May–July 1998, between August and March 1999, there was a cumulative purchase of dollars. The exchange rate, by and large, remained stable during September–March 1999, moving between 42.27 and 42.63 per US dollar. The exchange rate traded within a range of 42.44–43.64 per US dollar during 1999–2000. The months of April and May 1999 saw an excess supply of dollars. The Bank purchased US$1 billion (net) during these two months. From June to October 1999, excess demand conditions prevailed, partly caused by tensions on the India–Pakistan border in June 1999. During June– September 1999, the Bank made net sales. From November 1999 to March 2000, recovery in exports and sustained portfolio inflows enabled the Bank to make net purchases. The forward premia eased. The exchange rate averaged 43.33 per US dollar during 1999–2000, indicating a depreciation of about 2.9 per cent over the year. During 2000–01, the rupee depreciated about 5.1 per cent against the US dollar and was highly volatile during May–October 2000. Thanks to the India Millennium Deposits (IMDs), which brought in US$5.5 billion during October–December 2000, the rupee appreciated by 3.4 per cent and 8 per cent during 2000–01 against the pound sterling and the euro, respectively. In the next year (2001–02), the rupee was relatively stable and depreciated mildly by 1.9 per cent. Reflecting the nervous sentiment ruling financial markets in the wake of the September 11 events, the rupee depreciated against the dollar, the euro, the pound sterling and the Japanese yen by 1.1 per cent, 2.4 per cent, 2.9 per cent and 3.5 per cent, respectively, between August and September 2001. Between September and March 2002, there was a recovery. The Reserve Bank could make a net purchase of around US$7.1 billion during 2001–02. The rupee remained stable during the first four months of 2002–03, except for a brief period of uncertainty in May 2002. At the beginning of the year, rising crude oil prices, riots in Gujarat and short covering by importers imparted a downward pressure on the spot exchange rate of the rupee. 150

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foreign exchange reserves management Escalated border tensions led to short covering, which reduced the spot rate even further in May. Reduced inflows through the FII channel weakened the rupee in June. Thereafter, improved supply conditions and weakening of the dollar against major currencies strengthened the rupee.

2003–04 to 2007–08 The year 2003–04 marked the beginning of a trend of appreciation. In 2003–04, the current account surplus in the balance of payments and surge in capital inflows contributed to the appreciation. Notwithstanding market interventions by the Reserve Bank by way of net purchase of US$30.5 billion, the rupee appreciated by 9.3 per cent against the dollar during 2003–04. During the year, in the context of large capital inflows, the Bank introduced the Market Stabilisation Scheme (MSS) as a sterilisation tool to support its operations in the forex market. Interest on MSS securities was paid by the government, which was perceived by Finance Minister P. Chidambaram as a ‘subsidy to the export sector’.10 The rupee traded in a narrow range of 43.36 to 46.46 per US dollar during 2004–05, and appreciated by 2.2 per cent during the year, despite the Reserve Bank’s purchase of US$20.8 billion. In the second quarter of 2005–06, the revaluation of the renminbi (21 July 2005) introduced some volatility in the market. The rise in oil prices and widening of current account deficit pushed the rupee down to 46.33 per US dollar on 8 December 2005. Subsequently, the rupee appreciated significantly, more than offsetting the impact of IMD redemptions. Purchases of US$10.8 billion more than offset the sales of US$6.5 billion under IMDs during February–March 2006. The traded range of the rupee was 43.14–46.97 per US dollar during 2006–07. In the earlier part of the year, the rupee depreciated but strengthened thereafter as oil prices stopped rising and capital inflows resumed.11 Table 5.1 makes a concise statement of market intervention on a monthto-month basis. A few episodes stand out. For example, there was a record net purchase of US$78 billion in 2007–08 despite outflows being encouraged to stem net capital inflows. The nominal exchange rate of the rupee appreciated from 44.61 per USD at the end of March 2006 to 39.98 at the end of March 2008. The surge in capital inflows raised three main issues. These were the burgeoning foreign exchange reserves, increasing cost of sterilisation and rise 151

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the reserve bank of india Table 5.1 Net Sales/Purchases of US Dollars (in Billions) by the Reserve Bank  

April May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. Mar. Total

1997– 1998– 1999– 2000– 2001– 2002– 2003– 2004– 2005– 2006– 2007– 98 99 2000 01 02 03 04 05 06 07 08

+ 0.64 + 1.39 + 1.34 + 1.19 + 0.87 - 0.98 + 0.19 - 1.59 - 0.41 + 0.42 - 0.68 + 1.45

+ 0.20 - 0.75 - 1.63 - 0.12 + 0.54 + 0.76 + 0.10 + 0.08 - 0.08 + 0.48 + 0.86 + 1.42

+ 0.04 + 0.97 - 0.16 - 0.36 - 0.24 - 0.53 - 0.01 + 0.62 + 0.35 + 0.17 + 0.74 + 1.65

+ 0.37 -0.90 -1.05 -0.41 -0.47 -0.29 -0.49 +3.69 -0.16 +0.83 +0.62 +0.61

-0.02 +0.47 +0.04 -0.27 +0.68 -0.89 +0.24 +1.54 +1.04 +1.39 +0.57 +2.28

+0.48 +0.09 +0.24 +1.83 +1.18 +0.97 +1.17 +2.11 +1.68 +1.78 +2.33 +1.85

+1.43 +2.34 +0.90 +3.15 +2.35 +2.34 +1.59 +3.45 +2.89 +3.29 +3.36 +3.38

+7.43 -0.22 -0.41 -1.18 -0.88 +0.02 -0.10 +3.79 +1.39 0.00 +4.97 +6.03

0.00 0.00 -0.10 +2.47 +1.55 0.00 0.00 0.00 -6.54 0.00 +2.61 +8.15

+4.31 +2.06 +0.50 +4.43 0.00 +3.19 0.00 +11.43 0.00 +1.82 0.00 +11.87 0.00 +12.54 +3.20 +7.83 +1.82 +2.73 +2.83 +13.63 +11.86 +3.88 +2.31 +2.81

+3.83 +1.86 +3.24 +2.36 +7.06 +15.71 +30.47 +20.85 +8.14 +26.82 +78.20

Source: RBI, Database on Indian Economy.

Notes: Purchase minus sales; + means net purchase, including purchase leg under swaps and outright forwards; - means net sales including sale leg under swaps and outright forwards. Includes transactions under RIBs and IMDs. Data are based on value dates.

in inflation. The size of India’s foreign exchange reserves was considered too large and any further increase would add to the opportunity cost of holding more than the required amount of reserves, as discussed in detail later in the chapter.

Exchange Rate Management: Debates and Practices India was not alone in facing a challenge managing its exchange rates. Emerging economies often need to pursue multiple objectives, such as the promotion of exports, maintaining price and financial stability, and ensuring adequate inflow of foreign capital, which makes management of exchange rate a major task and a complicated one for central bankers.12 The principle of exchange rate regulation, therefore, was a subject that received close attention of the Bank’s management in these years. In this section of the chapter, the key issues of policy and interpretation are discussed.

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What Kind of Exchange Rate Management System Did India Follow? During the period 1975–92, the Reserve Bank set the exchange rate of the rupee in terms of a weighted basket of currencies of India’s major trading partners. After a series of reforms, from 1 March 1993, the rupee became more or less fully market determined. Under the new arrangement, the dayto-day movements in exchange rates depended upon demand and supply conditions in the foreign exchange market. The goals were, first, to manage volatility without a fixed target and, second, to allow the rupee to find its level in line with the ‘fundamentals’. The Bank monitored the developments in the financial markets at home and abroad closely, and took measures to reduce excessive volatility, and maintain an adequate level of foreign exchange reserves. A third and long-term goal was to help develop a deep and liquid foreign exchange market.13 What kind of exchange rate management system did India follow in these years? The question has been answered in different ways. The official position, as we have seen in this chapter, was that the exchange rate was market determined with no pre-set target rate or band but moderated by market intervention to avoid volatility. Did the Reserve Bank have a target rate? Was the Bank targeting a rate or trying to influence the rate to move in a direction? Deputy Governor Reddy explained that the Bank did not have a ‘target exchange rate’.14 Determination of exchange rate was left to the forces of market demand and supply, subject to the condition that inexplicable volatility and suspected speculation required intervention. On another occasion, Governor Jalan clarified that ‘flexibility in exchange rates is essential, but so is the ability to intervene, if and when necessary’.15 On this point of a target rate, the government and the Reserve Bank did not always hold identical views. In 1998 the government held the view that the exchange rate should not exceed a certain level. The Reserve Bank did not agree with the view.16

Should the Rupee Appreciate? The question of how the exchange rate of the rupee should move came into sharp focus when the US dollar began depreciating against major currencies and the rupee started appreciating in the wake of incessant capital flows after 2002–03. Some analysts suggested that the rupee should be allowed to appreciate since foreign exchange reserves were already above optimum and 153

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the reserve bank of india further purchase of US dollars by the Reserve Bank would lead to ‘liquidity overhang’. Corporate houses that were net users of foreign exchange had benefited from the appreciation of the rupee, but exporters were in favour of intervention. The government had, however, left the decision to intervene to the Reserve Bank. The Bank intervened to preserve external competitiveness of the rupee and ensure financial stability, besides allowing the rupee to find its level consistent with the fundamentals. Sometimes, particularly after the Asian Crisis, the Reserve Bank resorted to covert intervention through public sector banks to maintain secrecy and guide the market. The Bank, in fact, believed that exchange rates should be flexible and not fixed or pegged and that the Bank should intervene only to contain instability (also see Box 5.1). The Bank defended its position with the argument that the exchange rate should reflect fundamentals and inflation differentials over time, and, theoretically, it should appreciate when capital flows were strong and vice versa, though, in reality, the market behaviour between depreciation and appreciation would be asymmetrical. For example, during depreciation, there is a tendency to hold long positions in foreign currencies and hold back sales. Public pronouncements by the senior management of the Bank reiterated and justified the Bank’s stance.17 Box 5.1 Reflections on Exchange Rate Management I was leaving in November 1997, it was at that time I let the Rupee go down…. I did not hold it, spend the reserves to maintain it and that enabled my successor to carry on further. 

C. Rangarajan, former Governor of the Reserve Bank

I would say that we fought an appreciation much more vigorously than a depreciation which is also sensible. 

Montek Singh Ahluwalia, economist

… the pattern I discerned from within the Government as Finance Secretary, and from within the RBI as Governor, was that in the normal course, the Government was quite happy to leave the business of exchange rate management, including the long-term strategy, to the RBI. The Government took an activist role only in crisis times…. D. Subbarao, former Finance Secretary and former  Governor of the Reserve Bank 154

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foreign exchange reserves management

Dealing with the Impossible Trinity As capital account liberalisation progressed in India, the Reserve Bank needed to deal with the problem of the impossible trinity, which maintains that free capital movement, independent monetary policy and fixed exchange rate cannot be pursued simultaneously. Balancing these goals simultaneously being difficult, control over one pole of the trinity must be given up.18 India sought a solution to the conflict through a judicious mix of policies. The challenge was a difficult one. Raising the policy rates could attract more capital inflow; reducing it could overheat the economy and cause inflation. Allowing the exchange rate to appreciate might reduce inflation but lead to further rise in the trade deficit. With regard to the management of the capital account, the Bank’s apprehensions materialised in that as it progressively liberalised the capital account, capital inflows increased. In meeting these challenges, the Bank time and again underscored the point that full capital account convertibility could not be an option in a country like India with high gross fiscal deficit, current account deficit and high inflation. But capital account convertibility could be pursued as a process rather than an event. It was a cautious balancing act that the Bank had to undertake to manage stability in the country.

Did RBI Enjoy Autonomy in Exchange Rate Management? As stated at the beginning of the chapter, exchange rate management is a subject of the union government but delegated to the Reserve Bank through periodic notifications. The government decides the exchange rate regime while the operational aspects are left to the Reserve Bank. What exactly was the relationship between the two during this period of transition? There are no official records available to suggest that the government tried to influence or interfere in the day-to-day management of the exchange rate. Nor is there any correspondence to suggest that the Reserve Bank formally consulted the government in the conduct of exchange rate management. The matter relating to exchange rate appeared to have figured in the discussions during the periodic meetings of committees related to foreign exchange reserve management, short-term balance of payments monitoring group and external commercial borrowings, which were represented by both the Reserve Bank and the Government of India. 155

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the reserve bank of india The government did sometimes express a preference for a strong rupee and against depreciation. For example, in August 1997, Finance Minister Chidambaram felt the need to defend the rupee as he did not want to send the message that India was affected by the contagion of the Asian crisis. Another instance relates to Governor Jalan’s meeting with Prime Minister Atal Bihari Vajpayee and his senior ministers during the aftermath of the East Asian crisis in 1998, in which the Governor stated that the government should not ask him to defend the rupee (which had slipped below 40 to the dollar). When a senior minister asked him in that meeting how low it might go, Governor Jalan said anything was possible – even 100! There were no more questions, and thereafter the Governor had a free hand.19 In the meeting, Governor Jalan made it clear that while the Reserve Bank would do its best to stabilise the rupee, no target was sustainable. Prime Minister Vajpayee agreed. In Governor Jalan’s own words, exchange rate management by the Bank is related to the question of autonomy, as it is of utmost importance to have a consensus, what you might call a view which is shared by both the government and RBI. Government is ultimately responsible to the Parliament, and because whatever be the fiscal or economic policy dimensions, politics does trump economics.20

What Should Be the Monitoring Tool – REER or NEER? Another issue which engaged the attention of the Reserve Bank during the period was what the monitoring tool should be to assess the misalignment in the exchange rate. Should it be the real effective exchange rate (REER) or the nominal effective exchange rate (NEER)? The former trade-related indicator was important until India opened up to foreign capital. Tarapore I had recommended that the Bank should follow REER in its approach to exchange rate management. Tarapore II, stressing again the need for REER to be a valuable input into the formulation of exchange rate policy, noted: The 1997 Committee (Tarapore I) had recommended that there should be a more transparent exchange rate policy with a Monitoring Band of + or - 5.0 percent around the neutral real effective exchange rate (REER) and that RBI should ordinarily not intervene within the band. The RBI has not accepted this recommendation.21

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foreign exchange reserves management The REER reflected changes in the external value of a currency in relation to its trading partners in real terms, which was important for India’s exports. But the nominal rate appeared to be more appropriate in the presence of a large capital inflow. Similar questions arose in respect of which NEER or REER was to be used since there were two sets of indices, namely a thirty-six-currency index and a six-currency index. During the Asian crisis, it became necessary to have datasets of effective exchange rates with high frequency. In India, indices of NEER and REER based on thirty-six currencies of the countries that were major Indian trade partners were published by the Reserve Bank on a monthly basis. But the indices were available with a lag of three to four months, essentially for want of price data for all the countries. It was necessary to have a series available with short intervals, preferably on daily basis. An effort was made to construct REER and NEER series, shortening the number of countries covered but preserving the representativeness of the indices. Since the five major currencies – dollar, pound sterling, Deutschmark, yen and franc – represented 40 per cent of India’s trade, the Bank in 1997 commenced compiling new REER and NEER series based on these five currencies.22 The indices were computed every day and put up to the top management for information, especially during crisis time in the second half of the 1990s.23 Subsequently, the number of currencies was expanded to include the renminbi and the Hong Kong dollar, making it a six-currency index. At the same time, the thirty-six-currency indices were also revised and replaced with a new basket in 2005.24 In 1998 for the first time, the Reserve Bank came out with an official statement on REER, saying that the Bank did not consider REER to be an effective tool for management of short-term movements in the exchange rates, which were subject to various influences, including capital flows. Besides, REER was beset with several methodological issues, such as the choice of a basket of currencies, of the base period, of trade weights and the price index.25 Governor Jalan indicated that in the medium term and from the angle of preserving competitiveness, REER should be monitored as it reflected changes in the external value of a currency in relation to its trading partners in real terms, but that in day-to-day management the nominal rates were more important, these rates being sensitive to capital flows.26 S. S. Tarapore, former Deputy Governor, wrote in 1999 that ‘[t]ill 1998, RBI used the real effective exchange rate (REER) as the lodestar. However, in recent times RBI has stopped using REER, but no 157

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the reserve bank of india Table 5.2 Indices of Real Effective Exchange Rate (REER) and Nominal Effective Exchange Rate (NEER) of the Indian Rupee (Trade Weighted) (Base: 1993–94 April–March)  

6-Currency Indices

Year

NEER

1998–99

77.49

1997–98 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

NEER

96.14

89.05

87.94

104.41

77.16

97.69

77.43

102.82

71.27

97.68

76.04 69.97

102.71 99.17

69.58

101.78

69.49

105.57

72.28 74.76

Source: RBI monthly bulletin, various issues.

36-Currency Indices

REER

107.30 114.23

REER

92.04

100.77

91.02

95.99

93.04

92.12

100.09

89.12

98.18

91.58 87.14

100.86 99.56

87.31

100.09

85.89

98.48

89.95 93.91

102.35 104.81

other indicator has been installed in its place. In practice, RBI is still following REER, though it is not admitting it in public’.27 The Reserve Bank continued to de facto rely upon REER to manage the exchange rate.28 Did the choice between REER and NEER matter? Table 5.2 shows movements in REER and NEER, which shows that despite intervention, the rupee remained overvalued in terms of REER by the end of March 2008. Another dimension of exchange rate management, which became important during this period, was the growing non-deliverable forward (NDF) market.29

Non-deliverable Forward (NDF) Market Before the mid-1990s, the NDF market was of limited significance. Subsequently, the growth of trade and financial openness, a larger number of players in the foreign exchange market, persistent restrictions, and absence of instruments in the forward market encouraged NDF. Expansion in the NDF 158

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foreign exchange reserves management market complicated exchange rate management, particularly during the period of depreciation of the rupee. The movements in exchange rate onshore were reported to be affected by the NDF rates, as NDF became more active when onshore markets were volatile and market agents expected some correction in the exchange rate. For example, trading in the rupee segment of the NDF market rose during the Asian crisis of 1997. Whether movements in the NDF rates really provided the cue for dayto-day volatility in the exchange rate of the rupee in the domestic market was a moot question. Available studies were inconclusive on the point. An internal study referred to in the Reserve Bank’s Annual Report 2006–07 concluded that while these volumes were not large enough to affect the domestic onshore market under regular market conditions, these might impact the domestic spot market in volatile market conditions. In reality, there was no evidence of such an impact. In any case, the inconclusive answer on the relationship between the NDF and domestic markets continued to send mixed signals, complicating exchange rate management.

Management of Foreign Exchange Reserves The reserves were managed based on the framework mutually agreed by the Reserve Bank and the Government of India.30 The Bank consulted the government on all important matters relating to the foreign exchange reserve management.31 Within the given parameters, the Strategy Committee, headed by the Deputy Governor in charge of foreign exchange reserve management, met frequently to decide on various aspects of reserve management after holding discussions with the Governor. The FMC-RBI also provided inputs, besides coordinating the operationalisation of policies.

Composition and Level of Reserves The foreign exchange reserves initially were defined to include three components – foreign currency assets (FCA), gold and Special Drawing Rights (SDRs). FCA and gold were held in the balance sheet of the Reserve Bank, and the SDRs were held in the government books of accounts. Since April 2002, reserve tranche position (RTP) in the International Monetary Fund (IMF) was also included as part of reserves in line with international practices. 159

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the reserve bank of india FCA and gold were managed by the Bank. Of course, FCA was the major portion of reserves (Table 5.3). Gold did not play an active role in reserve management except during the crisis in 1991 when the Bank temporarily pledged a part of its gold holdings to raise loans abroad. Gold holdings remained practically unchanged in terms of quantity during the period of the present study, except for small and occasional sales by the government to the Bank. SDRs and RTP, which broadly related to the IMF’s SDR allocation and quota payment by its members, remained unimportant too. During the balance of payments crisis of 1991, the level of reserves had plummeted to one of its lowest. FCAs, at less than US$1 billion, were barely enough to finance three weeks of imports in June 1991. Since then, the level of foreign exchange reserves steadily increased (Table 5.3). Reserves grew not only in absolute terms but also in relation to imports and external liabilities. The adequacy of reserves is best measured by trade- and Table 5.3 Foreign Exchange Reserves  End of    

Gold  

SDRs  

25,975

3,391

1

1999–2000

35,058

2,974

4

2001–02

51,049

1997–98 1998–99 2000–01 2002–03

Foreign Currency Assets 29,522

39,554 71,890

2003–04

107,448

2005–06

145,108

2004–05 2006–07 2007–08

135,571 191,924 299,230

2,960 2,725

4,198

2 3

5,755 6,784

10,039

4 5 2

18

Source: RBI monthly bulletin, various issues.

Total   29,367 32,490 38,036

2

10

4,500

Reserve Tranche Position in IMF

8

3,047 3,534

(US$ million)

42,281

Import Cover of Reserves (in Months) 6.9 8.2 8.2 8.8

54,106

11.5

1,311

112,959

16.9

756

151,622

672

1,438 469 436

76,100

141,514 199,179 309,723

14.2 14.3 11.6 12.5 14.4

Note: Reserve tranche position in IMF was considered as part of foreign exchange reserves beginning April 2002.

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foreign exchange reserves management debt-based indicators. The import cover of reserves rose steadily to as much as 16.9 months in 2003–04 and remained robust thereafter. The proportion of short-term debt, based on original maturity, to foreign exchange reserves substantially declined from 25.5 per cent to 4 per cent between 1997 and 2004 (end of March), before rising to 15.2 per cent in 2008. Similarly, the ratio of foreign exchange reserves to total external debt of India rose from 28.3 per cent to 137.9 per cent between 1997 and 2008. The ratio of net foreign exchange assets of the Bank to currency with the public rose markedly from around 72 per cent to 218 per cent, and the proportion of net foreign exchange assets of the entire banking sector to broad money (M3) more than doubled from 15 per cent to 32 per cent.

Evolution of Reserve Management Policy Objectives

Until 1991, the reserve management policy consisted of buying and selling foreign currencies from and to authorised dealers to bridge the gap between supply and demand in the foreign exchange market, to finance government imports and other government payment obligations, particularly debt service payments, and to defend the exchange rate. Import cover of reserves appeared to have been the single indicator of the adequacy of reserves. Thus, India’s approach to reserve management was traditional in the sense that the main aim was to maintain a level of reserves that was equivalent to a certain number of months of imports. After the exchange rate of the rupee became market determined, there was a shift in India’s approach. The scope of reserve management was expanded to address unforeseen contingencies, volatile capital flows and other developments. A single indicator approach was replaced by a multiple indicators approach and the number of indicators gradually expanded. While operationally the change in reserves was essentially seen as a result of sale and purchase of foreign currency by the Bank, the level of foreign exchange reserves and its management assumed special importance and became an integral part of exchange rate policy and capital account management. Thus, the main objectives of maintaining reserves were to sustain confidence in monetary and exchange rate policies and stabilise markets, especially by absorbing shocks during times of crisis. 161

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the reserve bank of india

Adequacy of Reserves What is the optimum or adequate level of reserves? This question was debated quite often. The Indian approach to decide the adequate level of reserves was one of continuous revision and updating of the parameters of adequacy. The report of Rangarajan’s Committee on Balance of Payments had noted that ‘[i]t has traditionally been the practice to view the level of desirable reserves as a percentage of the annual imports’ and recommended that the other payment obligations should also be taken into account. The RBI Annual Report 1997–98 indicated that there was a need to take into consideration a number of factors, including the shift in the pattern of leads and lags in payments and receipts during exchange market uncertainties, besides the size and quality of reserves. After the Asian crisis, in addition to a trade-based indicator, potential risks and the residual maturity of external debt became important considerations. At the same time, advantages of accumulating reserves were scaled against the carrying cost of reserves. When capital flows became large and it was difficult to segregate temporary from permanent elements of flows, reserves were an insurance against the effects of a sudden reversal of capital flows. Sufficiently high level of reserves was necessary to ensure that even if there was prolonged uncertainty, reserves could cover the ‘liquidity at risk’.32

Deployment and Rate of Return The reserves were invested in deposits abroad and approved foreign securities with considerations of safety, liquidity and yield of the funds so invested. The return on foreign exchange reserves was not a major concern. The scope of investment of reserves provided for in the sections and subsections of 17 and 33 of the RBI Act was conservative and limited. The Act permitted deposits with other central banks, foreign commercial banks and the Bank for International Settlements (BIS). In terms of instruments, only debt instruments issued by a sovereign, or carrying the sovereign guarantee, with the residual maturity not exceeding ten years, were allowed. There was also a provision for investment in other instruments and institutions, with the approval of the Central Board of Directors. Deployment of reserves, asset allocation and currency composition were periodically reviewed by the Committee on Foreign Exchange Reserve Management, chaired by the Governor. The Ministry of Finance was represented by the Finance Secretary. 162

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foreign exchange reserves management Table 5.4 Deployment of Foreign Currency Assets   

As at end

1

Foreign Currency Assets

b.

Deposits with other central banks and BIS

a.

c.

2

(per cent)

Securities

Deposits with foreign  commercial banks

Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 100.0

100.0

100.0

100.0

100.0

100.0

46.5

42.7

48.0

45.1

48.0

63.4

37.5

16.0

32.6

24.7

27.2

24.8

24.2

30.7

27.6

24.4

34.6

2.0

Return on Forex reserves ( July–June)

Return on FCA and gold 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 3.1

2.1

3.1

3.9

4.6

4.8

Source: RBI, Report on Management of Foreign Exchange Reserves and Annual Report, various issues.

The share of different components in total investment varied over the years. However, the component of ‘deposits’ remained larger and deposits with ‘other central banks and BIS’ accounted for a major share in total investment. Austere restrictions imposed by the Act on the credit quality, counterparties of countries and institutions, and types of instruments implied that the safety of foreign exchange reserves was a major consideration. Consequently, the rate of return was relatively low (Table 5.4). As the level of reserves increased after 2002–03, there was an expectation that returns would also increase in tandem. The rise in the share of FCAs in total reserves shifted the focus on risk profile and the overall return of such assets. The issue was often discussed in many quarters, including the Parliament. The Reserve Bank clarified the limitation imposed by the Act and underscored the fact that high returns were associated with high risks. Therefore, the objective of keeping the risks at a possible minimum level overrode the profit motive.33 There was also another reason why returns on reserves were low. The Bank followed conservative accounting norms. While the portfolio of bonds and securities was marked to market, either the book value or market value, whichever was lower, was considered under the profit and loss account, implying that only depreciation was considered. Since reserves were on the rise during 2002–03, the accounting practice of booking only depreciation mattered. Incidentally, valuation gains or losses with respect to FCAs and gold were not booked in the 163

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the reserve bank of india income account but were provided for under a separate reserve head of account called Exchange Fluctuation Reserve, which was called the Currency and Gold Revaluation Account from the year 2001–02.

Repo and Reverse Repo Until 2000, the agencies that the Reserve Bank dealt with for the purpose of foreign exchange reserve management were commercial banks, financial institutions and securities brokers. In the strategy meeting on the deployment of foreign exchange reserves that Governor Jalan had with the Economic Affairs Secretary in June 2000, the government indicated its approval for ‘repurchase’ (repo) transactions with counterparties in international repo markets as one of the modes of reserve management. These were standard international instruments, in which central banks showed substantial interest for investment and funds management. The minutes of the meeting noted: ‘Repos and Reverse repos mitigate credit risks in lending/ investment. It was decided to start with these operations which could be carried out within limits, after drawing up detailed operational guidelines.’ Accordingly, master agreements were drawn in consultation with the Legal Department, counterparties were selected, instruments were finalised, and the operational aspects and accounting procedures were set out. The initial limit for repos was set at around US$625 million, which translated into just 2 per cent of FCAs.

Deposits with Foreign Commercial Banks As stated earlier, a portion of foreign exchange assets was invested in shortterm deposits with foreign commercial banks. For example, in 1996–97, such deposits formed around 25 per cent of the average total FCAs held during the year. Only major foreign banks were selected. The broad parameters for selection of banks were the rank, size, capital assets ratio in Tiers I and II, and high credit rating both for the country and the individual bank. The list of banks, revised every year, was quite diverse and large. For example, in 1998, there were seventy-four banks in the shortlist. Besides the annual review of the banks, an ongoing watch was kept throughout the year for adverse developments on the approved banks. A risk analysis was carried out for each bank. Cross-currency volatility of exchange rate was assessed. For the purpose of online monitoring 164

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foreign exchange reserves management of both pre-settlement and settlement risk exposures on account of outstanding transactions, appropriate software applications were put in place.

Practices of Risk Management and Management Information System Credit risk was addressed so far as the RBI Act provided for investment only in financial instruments issued by sovereigns, banks and international institutions. Selected counterparties were kept under watch. Limits for each counterparty and transaction were in place. The currency composition of FCA was kept confidential but revised regularly depending upon the perceptions of international currency movements. Regular management information system reports kept the executives of the Bank informed about the change in the currency composition. The US dollar was chosen as the numeraire currency. The estimation of ‘liquidity at risk’ and the analysis of interest rate sensitivity of the reserves portfolio were conducted periodically. The focus was on keeping the duration short to minimise the risk and maintain a liquid portfolio. Operational risks were addressed by internal control systems with the clear demarcation of responsibilities of ‘front and back’ offices, which ensured several checks at each level of deal capture, deal processing and deal settlement.34

External Asset Managers In line with international practice, the Bank found it prudent to give a small portion of its foreign exchange assets to a few reputed external asset managers (EAMs), under the category of discretionary reserve management. The amount was small, but it was raised from time to time as the level of foreign exchange assets rose.35 While selecting EAMs, the size of funds under management with the firm having the same risk profile as the Bank’s, consistency of returns, track record, fees, technology and a variety of other indicators of capability were considered.36 While it was important to have an optimal number of EAMs and a good volume of the fund for placement, the number of EAMs was small. The number gradually increased, though still remaining in single digit (six in 2002) for the most part. The selected EAMs were provided with investment guidelines specifying currency composition, maturity profile, permissible instruments and other required guidelines that were revised from time to time. A global custodian was appointed to oversee the assets managed by the EAMs. 165

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the reserve bank of india The advantages of EAMs were several. Constant dialogue and interaction with the EAMs and the resultant feedback on the market enhanced in-house expertise. Further, EAMs afforded an opportunity to the Bank to provide a benchmark to compare and contrast the return on the assets managed by them and those managed by EAMs, which helped in fine-tuning strategy. On some occasions, earnings on the assets managed internally were found to be higher. The scheme also helped to create a mix of investment styles.

Bilateral Currency Swap Arrangement with Bank of Japan In 2007, the Reserve Bank was engaged in negotiation with the Bank of Japan for an arrangement of a bilateral currency swap.37 The first meeting on 13 February 2007 initiated discussions on the modalities of the swap arrangement. After several rounds of discussion, an agreement was finalised on 29 June 2008. The term of the agreement was three years from the date of signing, renewable by the consent of both the parties. In the history of the Reserve Bank, this was the first swap arrangement of its kind. Was the Bank authorised to undertake swap transaction under the RBI Act? The Legal Department confirmed that the transaction could be viewed as a derivative contract within the meaning of the Act.38 Apart from conditions that commonly applied to such agreements, there were two important conditions governing the Indo-Japan currency swap agreement. It was specified that as long as the agreement was in effect, the borrower should have biannual consultations with the lender on economic and financial conditions, based on the information and data supplied to the latter in the specified format on various economic parameters. As long as any monetary obligation under this agreement remained outstanding, the borrower would also not impose any controls on capital outflows. No withdrawals were made under the agreement by either India or Japan. However, on its expiry in 2011, the swap arrangement was renewed.

Cost of Rising Reserves The surge in reserves had given rise to two concerns. One of these, as we have seen, concerned the cost of reserves. The other one concerned ‘arbitrage’ involved in higher inflows, particularly non-resident Indian (NRI) deposits. The cost of maintaining high reserves (as it was made up of borrowed resources 166

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foreign exchange reserves management because India had current account deficit) and the opportunity cost of not utilising the reserves for productive purposes attracted the attention of both academics and policymakers. Some saw the building up of reserves as giving away national savings to the rest of the world, and not utilising them for domestic investment. Some had suspected that arbitrage opportunities gave rise to the flow of ‘hot money’. The Bank’s position was more measured, as Governor Jalan clarified: [T]he bulk of additions to reserves in the recent period is on account of non-debt creating inflows.... On NRI rupee deposits, interest rates in the last couple of years have been in line with interest rates on deposits by residents, and are currently even lower than domestic interest rates. So far as other non-debt creating inflows (i.e., foreign direct investment, portfolio investment or remittances) are concerned, such inflows by their very nature are commercial in nature and enjoy the same returns and risks, including exchange rate risk, as any other form of domestic investment or remittance by residents.… On the whole, under present conditions, it seems that the ‘cost’ of additional reserves is really a nonissue from a broader macro-economic point of view.39

Redemptions of Resurgent India Bonds (RIBs) and India Millennium Deposits (IMDs): How Were They Handled? There were two episodes of bunching of foreign exchange outflows during the period, one on account of redemption of RIBs at the end of September 2003 and another due to maturity of IMDs at the end of December 2005.40 The outflows were required to be handled in a way that different segments of the financial market were not disrupted. The challenges were twofold: to ensure non-disruption of domestic interest rates and to meet the demand for hard currency without impairing the exchange rate. RIBs, launched in August 1998, had brought in US$4.23 billion, the redemption value of which was US$5.5 billion at the end of a five-year tenor. The apprehension of turmoil in the markets due to a large outflow of the dollar did not materialise, however. The Bank began building up the foreign exchange liquidity well in advance by contracting forward purchases.41 The IMD scheme, launched in 2000, had mobilised US$5.5 billion and came up for redemption in December 2005. There was an outgo of US$7.1 billion IMDs in just two days (28 and 29 December). Excess domestic liquidity was building up for two years and the outstanding MSS was unwound through

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the reserve bank of india the normal process of the bonds maturing without being renewed, making it possible to handle liquidity requirement of around 28 billion without disrupting the system. But since there was a market perception of liquidity shortage, the call rate went up from 6.96 per cent to 7.15 per cent. On the foreign exchange side, the Bank had deployed IMD proceeds under foreign commercial and central bank deposits (FCBs) and Euro commercial papers, which had good liquidity and higher returns, so as to mature in December 2005. But only a part was used as it was decided in the internal Investment Committee meeting held on 15 December 2005 that only the FCBs matured till date, amounting to US$3.6 billion, would be used (the rest by liquidating other types of investment) to meet the redemptions of IMD.42 The funds mobilised from liquidating investments were parked temporarily with the BIS for a few intervening days with a request to transfer it to the Reserve Bank’s Nostro account, with the Federal Reserve Bank, New York, on 27 December 2005, which was finally transferred to State Bank of India’s (SBI’s) Nostro account on 28 and 29 December 2005. Consequently, foreign exchange assets of the Reserve Bank declined by US$7.1 billion to US$131 billion and the rupee slid marginally by 15 paise per US dollar.

Use of Reserves for Increasing the Level of Domestic Investment and Special Purpose Vehicle (SPV) for Use of Reserves In the early 2000s, a public debate emerged over whether or not India should use its foreign exchange reserves to increase the level of investment. The issue was discussed in Parliament. Lalitbhai Mehta, Member of Parliament, asked whether the Golden Corridor infrastructure scheme could be funded from the foreign exchange reserves.43 In reply to another question, whether a part of the FCA would be utilised for infrastructure investment, S. S. Palanimanickam, Minister of State in the Ministry of Finance, stated that ‘an informed debate on the feasibility of such an utilisation is currently on’.44 The Planning Commission noted that while the reserves did present such an opportunity, ‘the extent to which we can draw down foreign exchange reserves for this purpose will depend upon our perception of the need for reserves to cover balance of payments risks’.45 The Bank had reservations about the proposal. For example, Governor Jalan in 2003 stated that ‘the equivalent rupee resources have already been 168

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foreign exchange reserves management released by RBI to recipients of foreign exchange.... The decision on whether to invest, consume or deposit these additional rupee resources lies with recipients, and not with RBI. By all means, let us urge them to invest....’46 The difference of opinion between the Bank and the government became a matter of another public debate.47 In the meantime, at the Committee of Central Board meeting held on 30 July 2003, a Director enquired whether a part of the foreign exchange reserves should be placed as deposits with foreign branches of Indian banks; such a placement might improve the return on reserves and also provide low-cost funding to Indian banks abroad. The issue was discussed by the committee in its meeting held on 25 February 2004. The committee held none of the Indian banks was rated as investment grade and, more importantly, in case the reserves were maintained with domestically owned companies, those could not be construed as part of foreign exchange reserves as those might not be available for use by the monetary authorities, and international codes, too, never permitted such investments to be considered as part of foreign exchange reserves. The Finance Minister announced in his Budget speech of 2007–08 that ‘a small part of the foreign exchange reserves’ would be used ‘without the risk of monetary expansion’ for the purpose of financing infrastructure development projects and an offshore wholly owned subsidiary of India Infrastructure Finance Company Ltd. (IIFCL), which was established in January 2006, would be set up. The government wanted the Reserve Bank to lend in foreign currency directly to IIFCL. The Bank in its Board meeting held on 9 March 2007 observed that only ‘refinancing’ was possible as Section 17 of the RBI Act did not allow ‘direct’ lending. In June 2007, the government indicated that in view of operational inconvenience and additional costs involved in the refinancing route suggested by the Board, the Reserve Bank should directly invest in IIFCL.48 The government nominee (Finance Secretary D. Subbarao) said that in the government’s view, direct lending was legally possible if the Bank’s Board approved it. The Board, however, took a substantive view, reexamined different subsections of the RBI Act to conclude that subsection 13 allowed investment in securities. The foreign subsidiary of an SPV could, therefore, issue securities in the form of bonds to which the Bank can subscribe.49 Subsequently, a scheme was crystallised which envisaged the Bank investing, in tranches of US$250 million, up to US$5 billion (subsequently increased to US$10 billion) in fully government-guaranteed foreign-currency-denominated bonds issued by an overseas SPV of IIFCL.50

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the reserve bank of india Such a scheme for channelling foreign exchange funds to Indian private investment in infrastructure had no precedence.

Creation of Sovereign Wealth Fund It was sometimes argued that a part of the reserves, which could be considered to be in excess of the usual requirements, be managed with the primary objective of earning higher returns, setting them aside for assigning to the sovereign wealth fund to earn higher returns on the lines of posterity funds of oil exporting countries, or the Singapore government’s Investment Corporation. The issue was examined internally and the Reserve Bank did not find it viable to create a sovereign wealth fund. Besides governance, transparency and disclosure standards, there were a few other concerns. It was not clear how it would be possible to decide the adequacy of reserves in order to segregate ‘excess’ reserves. Second, citing Governor Reddy, the Indian economy has twin deficits – a current account deficit as also a fiscal deficit. India’s export basket is diversified and does not have any dominant ‘exportable’ natural resource output, which might promise significant revenue gains at the current juncture.… India is also having a negative international investment position with liabilities far exceeding the assets.51

Management of Gold Gold Policy

When liberalisation measures were introduced after 1991, the policy on gold was also overhauled. The process of liberalisation of gold encompassed many issues, ranging from imports to hedging, assaying and hallmarking. The Bank had set up a Standing Committee on Gold and Precious Metals (SCGPM) in 1992 and revived it in 1997.52 Initially, the main task of the SCGPM was to look into the gold policy and make suggestions on the gold import policy to the Government of India from time to time, besides addressing issues relating to the development of the gold market and gold instruments. However, over time, almost all issues concerning gold were handled by the committee.53 The SCGPM in its meeting held on 5 January 1998 discussed the possibility of authorised dealers (ADs) introducing a gold-denominated 170

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foreign exchange reserves management deposit scheme. The main features of the scheme were finalised and sent to the government as a Budget proposal. The Union Budget for 1999–2000 announced the Gold Deposit Scheme (GDS), which was to be introduced by select banks. Against the backdrop of enormous quantities of gold imports (600–700 tonnes per year) during the latter part of the 1990s, the scheme was expected to become successful. The GDS was expected to serve two aims: provide depositors the safety and security of gold holding and the opportunity to earn interest on their idle gold holdings on the one hand, and encourage them to move away from the physical holding of gold to gold-based financial assets on the other. The Reserve Bank issued guidelines in October 1999 to banks specifying what the scheme had envisaged and permitting them to accept deposits in any form, such as ornaments, jewellery or bars, which would be assayed and converted to scrap. The Bank fixed the tenure of the deposit, ranging from three to five years, prescribed a lock-in period if need be, set the interest to be paid to the depositors, allowed extending loans in the form of gold to domestic jewellers, and allowed banks to hedge their exposures in India as well as overseas. The cash reserve ratio on such deposits was decided to be applied at a minimum of 3 per cent. Not all nominated banks that were allowed to import gold introduced the GDS. Initially, the Reserve Bank granted approval for accepting gold deposits to six banks, of which only five – SBI, Indian Overseas Bank, Allahabad Bank, Canara Bank and Corporation Bank – started the scheme. A target of 100 tonnes was set. By 31 January 2004, total mobilisation was only 7.6 tonnes. Most of the depositors were individuals. Major gold holders, such as institutions and Hindu temples, had not shown much interest. The scheme had such poor response because of inadequate publicity, sentimental attachment to gold, high cost (because of difference in the places of mobilisation, assaying and deployment), absence of an amnesty scheme for large holders and absence of a forward market, among other reasons. The poor response was discussed in the SCGPM meeting more than once. The committee held the view that the scheme was not viable in the present form and further restructuring was neither feasible nor desirable. Therefore, the Reserve Bank suggested to the government in August 2004 that individual banks could be allowed to opt out of the scheme if they so desired. Subsequently, the banks stopped accepting gold deposits under the GDS, making the scheme unsuccessful. 171

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the reserve bank of india

Standardisation and Upgrading of Gold Reserves Held by the Reserve Bank As part of monetary gold, the Reserve Bank held around 398 tonnes under international reserves as at the end of March 1997, which came down to 358 tonnes at the end of March 1999 due to redemptions under the Gold Bond scheme and remained at that level during the rest of the years referenced in the book. Of total gold holdings, 65 tonnes were held in the Banking Department and the rest formed part of assets of the Issue Department. Gold held under the Banking Department was kept abroad, which conformed to international standards in terms of quantity and quality. But some varieties of gold held in the Issue Department in the form of gold tola and ounce bars, coins and sovereigns, though small in their share (29 per cent) and the fineness of 0.995 to 0.999, were different in size as compared to international standards of the London Good Delivery Bars (LGDB). Since 1995, several options were explored to upgrade the gold stock. One option was to ship out the gold stock to an international refinery and bring them back to India in the required size. But the cost involved was prohibitive. The second option was to exchange the portion of non-standard gold held in the Reserve Bank with commercial banks that were authorised to import gold, but banks raised the issue of customs duty and sales tax.54 The Bank also toyed with the idea of setting up its own refinery to upgrade and standardise its gold holdings in the late 1990s. While the legal aspects were yet to be examined, the proposal was not found to be practical because the listing requirement for the London Good Delivery List maintained by the London Bullion Market Association was a minimum of five years of existence. Although the issue of upgrade and standardisation was not resolved, the Bank continued its dialogue with banks and other stakeholders to find an answer.

Gold Hedging Beginning from 1991, the entire gold holding was valued at the prevailing prices in the international market, with resultant valuation changes (gain or loss) booked under a reserve head, the Exchange Fluctuation Reserve Account. Thus, gold reserves were exposed to price risk. During the period of price decline, the loss on account of valuation changes could not be avoided. This, in 172

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foreign exchange reserves management turn, affected the balance sheet of the Bank. In fact, as international prices of gold fell in the 1990s, the Bank booked losses on this count. For example, during 1994–95 (April–March), a revaluation loss of 770 million was recorded. Therefore, a need was felt to hedge the price risk through derivative products. But hedging was not a permitted activity under the RBI Act. The Legal Department held that even if the Act was amended, empowering the Bank to enter into gold derivative transactions, such transactions could not be undertaken because of the Forward Contract (Regulation) Act (FCRA), 1952, which prohibited options and futures in commodities (including gold), and recourse to gold futures and options for hedging could be made, provided an exemption from the application of the Act was allowed by the government under the provisions of the Act. On 13 January 1994, Governor Rangarajan wrote to Montek Singh Ahluwalia, Finance Secretary, Ministry of Finance, suggesting necessary amendments to the RBI Act as well as an exemption under the Act, enabling the Bank to hedge its gold holdings. On 27 November 1995, the Department of Economic Affairs conveyed the decision to ‘defer the matter’ without giving any reason. The Bank revived the matter when the gold import policy was liberalised in 1997. The whole issue of forward trading was also discussed in a high-level coordination committee meeting held on 5 November 1997, drawing attention to the notification of 1969 under the FCRA, which put a blanket ban on all types of forward trading and exceptions made subsequently by amendments. Deputy Governor Reddy proposed that the notification could be modified such that the regulators (Securities and Exchange Board of India and the Reserve Bank) might be empowered to draw up appropriate guidelines in the area. Deputy Governor Reddy, subsequently, in March 1998 wrote to Finance Secretary Montek Singh Ahluwalia stating that the SCGPM was exploring the possibility of some kind of gold-denominated deposit scheme to be introduced by banks, to operationalise which, the Reserve Bank would have to allow banks to hedge gold price, and that in this context, it was necessary to delegate to the Bank the government’s powers of granting exemption. Meanwhile, the views of the Additional Solicitor General of India, C. S. Vaidyanathan, on the issue of forward trading were conveyed to the Bank (22 June 1998). He was of the view that the FCRA would not apply to forward contract to be entered into by the Indian corporates in a foreign country. The R.V. Gupta Committee on Hedging through International Commodity Exchanges (1997) also suggested that Indian corporates should be allowed 173

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the reserve bank of india to hedge in the commodity exchanges abroad. Corporates were allowed to cover their commodity price risk in international commodity exchanges in September 1998. In March 1999, Deputy Governor Reddy wrote to Finance Secretary Vijay Kelkar renewing the request for exemption from the FCRA, and delegation of powers to the Bank under the FCRA, and argued for allowing forward trading in gold domestically, if the GDS were to become successful. When the guidelines were issued for the GDS in October 1999, the need for modification in the provisions of the FCRA became urgent. Finally, on 1 March 2000, the government issued the necessary notification under the FCRA, fulfilling the request.

Assaying and Hallmarking In November 1997, the National Foundation for Consumer Awareness and Studies filed a writ petition in the High Court of Kerala which, among others, drew attention to the absence of a hallmarking facility in India, and urged that hallmarking be made mandatory. The matter was referred to the Reserve Bank by the Ministry of Finance for its views. In its meeting held on 2 May 1998, the SCGPM stressed the need for assaying and hallmarking in India. In August 1998, the Bank set up a technical sub-group to examine the issue, comprising members drawn from the Bank, the World Gold Council, the India Government Mint and SBI. The group explored the possibility of some banks sponsoring the hallmarking activity. The Legal Department said that assaying and hallmarking could be performed in-house by a bank as incidental to the activity of buying and selling gold, which was a permitted activity under the Banking Regulations Act, but that it could not be performed as a specialised activity for a fee for other clients. Therefore, a separate subsidiary needed to be formed. Meanwhile, the Bureau of Indian Standards proposed to introduce a hallmarking scheme in India. At the same time, four banks– SBI, Allahabad Bank, Corporation Bank and Canara Bank – decided to form a subsidiary of SBI with a foreign partner to provide a modern assaying facility in the country. Credit Suisse First Boston (CSFB), London, was chosen as the foreign partner. The new company was to be called SBI Gold and Precious Metals Pvt. Ltd. The Reserve Bank gave the necessary approval and was anxious to see the company in place, as it did not want hallmarking to become a monopoly of the Bureau. But the joint venture did not happen. 174

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foreign exchange reserves management As SBI stated, there was little scope for hallmarking as the response to the GDS was poor and gold accumulation was insignificant. However, the Bureau announced on 11 April 2000 the launch of hallmarking of gold jewellery in India and gold jewellery certification.

Gold Imports India had followed a very restrictive policy on the import of gold. The demand for gold, which was one of the highest in the world, was largely met by smuggled gold. The Gold Control Act, 1968, was repealed in 1990 and the Export–Import (Exim) policy for 1997–2002 permitted jewellery exporters to obtain gold, silver and platinum from existing nominated agencies like the Minerals and Metals Trading Corporation (MMTC), and any other agency to be authorised by the Bank. In view of the shift, in July 1997, the Bank announced the eligibility criteria for scheduled commercial banks to be authorised to import gold. By March 1999, fourteen banks were authorised to import gold. Banks were selected on the basis of parameters such as capital base, profitability and strength of risk management. Freer import reduced the difference between the international and domestic prices of gold. The difference during 1986–1991 was more than 30 per cent; in 2001, it was just 8.5 per cent. Smuggling of gold reduced at the same time. The Exim policy announced on 28 January 2004 placed gold under the Open General Licence (OGL) Scheme, that is, removed it from the quantitative restrictions and allowed the import of gold by all entities, subject to the Reserve Bank’s guidelines. Executive Director Shyamala Gopinath convened a meeting on 4 February 2004. Besides Bank officials, representatives of the Ministry of Commerce attended. This was followed by a meeting (10 February 2004) of the SCGPM. The meetings discussed the implications of the new policy and changes in Bank guidelines. Following these meetings, draft circulars were prepared and sent to Governor Reddy for information, who suggested the need for a detailed study. An exhaustive joint study by the Foreign Exchange Department and the Department of External Investment and Operations (DEIO) was carried out and submitted to Governor Reddy. At the instance of Governor Reddy, Deputy Governor K. J. Udeshi wrote to D. C. Gupta, Finance Secretary, on 4 March 2004. The letter stated that the liberalisation of import of gold and silver required to be undertaken in conjunction with the rationalisation of 175

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the reserve bank of india existing policies with respect to the export of gold and silver. For example, existing ‘value addition norms’ for eligibility with respect to jewellery export, except those making use of the facility of duty-free import of gold and silver under the advance licence scheme, should be removed. Baggage rules with respect to primary gold should be reviewed and made applicable for returning residents and NRIs on an equal footing. The letter also noted that countries with no control on capital account transactions generally allowed free import of gold and silver, and since India was not convertible on capital account, gold and silver had the characteristics of surrogate foreign exchange. The metals were used for both consumption and investment purposes and were easily tradeable so that there was a need to monitor the import and export of these metals, and an in-built mechanism needed to be in place for policy changes in future. This was followed up by a letter from Governor Reddy to Jaswant Singh, Finance Minister, dated 11 March 2004, explaining the stance of the Bank. Around this time, the Bullion Association and importers of gold complained about the delay in the Bank issuing guidelines for import. On 31 March 2004, Joint Secretary (Ministry of Finance) P. K. Deb replied to Deputy Governor Udeshi’s letter, saying that import of gold and silver by NRIs or persons returning from abroad cannot be reconsidered, as it was fraught with risks. The risk was that a person could go abroad for a few days, and return with a huge quantity of gold as a form of money laundering. The Bank agreed to this point of view. However, the government was silent on the gold export proposal. Subsequently, Director General of Foreign Trade (Ministry of Commerce) L. Mansingh wrote to Deputy Governor Udeshi on 22 April 2004, a copy of which was sent to the Ministry of Finance. The letter stated that ‘there is no restriction on any tariff line pertaining to gold for its exports’. The letter also ‘commended’ the Bank’s initiative to coordinate with the ministries and finalising its own position on gold. A second letter from Mansingh (31 May 2004) further clarified that to facilitate export of gold jewellery, certain specific provisions were included in the export–import policy and the handbook of procedures concerned. The Ministry of Finance also gave the clearance for issuance of guidelines by the Bank. When the Bank was about to issue the necessary circular, there were reports that gold imports had shot up phenomenally. The Bank took up the matter with the Ministry of Finance. Executive Director Shyamala Gopinath wrote to Deb, with a copy to the Joint Secretary, Ministry of Commerce, on 14 June 2004, mentioning that ‘several banks have allowed large imports 176

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foreign exchange reserves management of gold by gold traders without waiting for RBI guidelines.... [W]e need to revisit the entire policy’. Against these new developments, the SCGPM had a meeting on 15 September 2004. The members felt that liberalisation of gold import should be undertaken in a phased manner and that only the designated star export houses in the jewellery business should be initially allowed to import gold directly. This was communicated to the Ministry of Finance for consideration. The data collected from banks on gold imports were also supplied to the government. In the meeting of the SCGPM held on 21 December 2004, government officials informed that both the Finance Minister and the Commerce Minister were of the view that the original policy of allowing free import of gold by all entities should be implemented. As this was not acceptable to the Reserve Bank, Gopinath, now Deputy Governor, wrote to Secretary (Department of Economic Affairs, Ministry of Finance) Rakesh Mohan, on 18 January 2005, reiterating the Bank’s stance. When it was put up to him, Finance Minister P. Chidambaram recorded on the letter: ‘I am inclined to agree with RBI’s views. There are some policy-induced distortions as a result of the new foreign trade policy.... Please consult Revenue Secretary.’ The opinions of the Revenue Secretary and others were against the Bank’s position. On 23 March 2005, this was conveyed to the Bank. The meeting of the SCGPM on 1 April 2005 ended inconclusively. Director (Ministry of Finance) Shyamala Shukla wrote on 6 July 2005 to the Bank that ‘the concerned number of authorised importers should be expanded beyond the current designated agents’. At the same time, there was no respite in the increase in gold imports. In October 2005, the Bank again requested the government to put on hold the proposal of free import of gold. On 28 February 2006, Joint Secretary (Ministry of Finance) Kumar Sanjay Krishna wrote to Deputy Governor Shyamala Gopinath that the ‘Ministry of Finance recommends that the present policy for import of gold may be liberalised by adequately increasing the number of commercial banks authorised, thereby restoring status quo, that is, allowing only nominated and authorised entities to import gold’. A new problem had arisen. The usance period allowed for the import of gold under the letters of credit was 180 to 360 days. Some exporters took advantage of the arbitrage opportunity. They imported gold in large quantities, which they sold in the domestic market immediately, and fulfilled export obligation closer to the expiry of the usance period by exporting substandard 177

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the reserve bank of india jewellery. Because domestic interest rates were higher than the international rates, handsome profits were made out of the transactions. The matter was discussed in the meeting of the SCGPM held on 10 February 2004. Executive Director (Gem and Jewellery Export Promotion Council) S. Ramaswamy suggested that the usance period be reduced to ninety days. The Bank issued a circular on 9 July 2004 to that effect. In 2004, a proposal was made by the government to reduce the tariff on gold to zero. Joint Secretary (Department of Commerce) R. Gopalan, wrote to the Bank (March 2004), seeking its views on the proposal, which fell under Non-Agricultural Market Access of the World Trade Organization. In response, Deputy Governor Rakesh Mohan wrote on 2 April 2004: ‘[G]old is not like any other commodity and has implications for the financial stability of the country being surrogate foreign exchange…. Therefore, we are not in favour of binding duty on gold to zero.’

Gold Loan for Domestic Jewellery Manufactures In 1978, banks had been advised not to extend any loan against gold bullion. But they could lend against gold ornaments after ensuring that the loans were not for speculative purposes. Even after liberalisation of the gold import policy in 1997–98, these restrictions continued. In December 1998, nominated banks that were authorised to import gold could also disburse gold loans to jewellery exporters. However, only three banks – SBI, Bank of Nova Scotia (BNS) and Corporation Bank – were active. In March 2003, BNS was allowed to lend to domestic users. But BNS began lending to the customers of other banks as well against letters of credit. Quoting the example of BNS, a few other banks approached the Reserve Bank for permission to lend. Internally, there was a view that the permission granted to BNS be withdrawn. Deputy Governor Shyamala Gopinath suggested in December 2004 that before withdrawing the scheme, an interdepartmental team should study the product offered by BNS. The Deputy Governors’ Committee (committee of Deputy Governors set up to sort out interdepartmental issues) could then take a final view on the matter. A group of senior officers of the Department of Banking Operations and Development, the Foreign Exchange Department and the DEIO studied the scheme and concluded that, instead of withdrawing the scheme, allowing more banks to lend imported gold would not only make it a level playing field but might also result in lower lending rates. In the 178

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foreign exchange reserves management meantime, the SCGPM also recommended that the request of other banks might be accepted. In September 2005, all nominated banks (for the import of gold) were permitted to extend gold (metal) loans to domestic jewellery manufacturers as well as customers of other banks. The tenor of the gold loan to the domestic users was also extended from 90 days to a maximum of 180 days in February 2007.

Conclusion Exchange rate policy pursued by the Reserve Bank was integrated into the overall management of the external sector. The policy had two aims: to intervene in the foreign exchange market in order to reduce excessive volatility in the exchange rate of the rupee and to initiate measures to prevent speculative attacks on the currency. Although the Bank’s stance on exchange rate was sometimes criticised, the day-to-day operation of the system did achieve its main goal – stability in the market. The aim of the management of reserves was to ensure safety, liquidity and optimisation of returns. Tarapore, former Deputy Governor, reflected in 1999 that though the articulation of a clear policy by the Bank had been weak, its management of a build-up of reserves deserved praise.55 In both cases, exchange rate and reserve management, the view of the Bank and that of the government often differed. But even on the most difficult issues, the consultative process between the ministries and the Bank worked well enough to eventually find compromise solutions.

Notes

1. With the senior officers of the Monetary Policy Department (MPD), the Department of External Investments and Operations (DEIO), and the Internal Debt Management Department (IDMD) as members (see Chapter 6). Officers of other departments were co-opted when necessary. Quite often Deputy Governors and Executive Directors, in charge of the departments concerned, also attended the meetings. 2. In 1992–93, under the Liberalised Exchange Rate Management System, the rupee became partially convertible on the current account through a dual exchange rate. The official exchange rate was reduced in December 1992 and the two rates unified in March 1993. 3. Y. V. Reddy, ‘Exchange Rate Management: Dilemmas’, Inaugural address, XIth National Assembly Forex Association of India, Goa, 15 August 1997. 179

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the reserve bank of india 4. The rupee did not, however, show much volatility immediately after the speech. The rupee, which traded at 35.73 per US dollar on 14 August 1997, remained at the same level on 18 August (16–17 August being Saturday and Sunday) and, in fact, strengthened to 35.71 per US dollar on 19 August. 5. The press release stated: It is clarified that while the Committee on Capital Account Convertibility had recommended a band in relation to a neutral real effective exchange rate, no decision in this regard has been taken by the government and RBI. While the exchange rate will continue to be determined by market forces, it is recognised that the exchange rate management will have to balance the needs of the exporters to have a favourable exchange rate and the need to prevent monetary expansion from going beyond what is considered appropriate for maintaining price stability.

6. On the positive side, these developments, together with subsequent measures, are said to have contributed to the growth of the Indian foreign exchange market. Second, there was also a view that because of the depreciation of the rupee, partly due to the statements made by the authorities, it did not become as volatile as other Asian currencies during the Asian crisis in 1997–98. 7. The average one-month forward premium rose from 4.23 per cent in October 1997 to 9.42 per cent in December 1997. 8. See https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/2313.pdf. Also see Chapters 3 and 4. 9. Y. V. Reddy, ‘Managing Capital Flows’, Address at a seminar at the AsiaPacific Research Centre, Stanford University, USA, 23, November 1998, https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/4399.pdf. 10. Union Budget (2008–09), Budget speech, para 90. 11. Barring a few short episodes, including the effect of the subprime mortgage crisis in the US, the rupee appreciated by 9 per cent against the dollar, 7.6 per cent against the pound sterling, but depreciated by 7.8 per cent against the euro, 7.6 per cent against the yen and 1.1 per cent against the yuan. 12. Speaking on the subject, Governor Jalan said that the issue ‘is particularly crucial for developing countries where foreign exchange markets are generally thin, which do not have automatic access to reserves of other central banks, and where large volatility in exchange markets can have significant real effect’. Bimal Jalan, ‘Welcome Remarks at the 11th C. D. Deshmukh Memorial Lecture’, Mumbai, 7 December 2000. 13. Y. V. Reddy, ‘Overcoming Challenges in a Globalising Economy: Managing India’s External Sector’, Lecture at the India Programme of the Foreign Policy Centre, London, 23 June 2005. 14. On a similar question raised by Moody’s Investors Service, in a meeting held on 17 August 1998. Also see Reddy, ‘Managing Capital Flows’; and Bimal 180

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foreign exchange reserves management Jalan, ‘Remarks’, Seminar on International Financial Architecture, Bank of England, London, 5 July 2002. 15. Jalan, ‘Remarks’. 16. ‘In the midst of the Asian crisis … there was a view that the exchange rate should be stable within a range. In our country also, at that time government’s informal view was that it should not be allowed to exceed a certain level. However, based on its own experience, RBI’s view at that time, during discussion with government, was that any target set for the exchange rate is bound to be flawed and cannot be sustained’ (Bimal Jalan, ‘Autonomy of the Central Bank’, Transcript of the Comments by Former Governors of Reserve Bank of India, Bimal Jalan, Y. V. Reddy and D. Subbarao, Newsletter, March 2014, https://www.cafral.org.in/sfControl/content/DocumentFile/ Autonomy_of_the_central_bank.pdf ) 17. Deliberating on the issue, Governor Jalan noted that whereas the case for depreciation and that for appreciation both had merit, large-scale intervention risked the ‘emergence of macroeconomic problems which are worse than what they are trying to solve’. Bimal Jalan, Address at 14th National Assembly of Forex Association of India, 14 August 2003. 18. Recognising the problem, Governor Jalan said: [I]n theory, the recommended approach is either free float or a currency board. In reality, however[,] … most countries have adopted intermediate regimes of various types, including fixed pegs, crawling pegs, fixed rates within bands, managed floats with no pre-announced path, and independent floats with foreign exchange intervention moderating the rate of change and preventing undue fluctuations. (Bimal Jalan, ‘Development and Management of Forex Markets: A Central Banking Perspective’, Inaugural Remarks at the 21st Asia Pacific Congress, New Delhi, 1 December 2000)

The International Monetary Fund (IMF) in its 2007 Article IV consultation report (Country Report No. 08/51, February 2008) recognised the trinity issue, and said that ‘the stated policy of a managed but market determined exchange rate with no target path, and intervention only to curb short-term volatility remains appropriate’ for India. The IMF recommended a more flexible rupee in order to avoid the cost of sterilisation consequent on rising net foreign assets in the balance sheet of the Bank. IMF, ‘India: Selected Issues’, Country Report No. 08/52, Washington DC, 2008. 19. T. N. Ninan, Business Standard (editorial), 16 July 2016. 20. Jalan, ‘Autonomy of the Central Bank’. 21. RBI, ‘Report of the Committee on Fuller Capital Account Convertibility’, 2006, pp. 17–18. 22. Rajiv Ranjan, Assistant Adviser, Department of External Investment and Operations, who had earlier constructed the thirty-six-currency REER, 181

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the reserve bank of india attempted the first set of five-currency REER and expanded subsequently to include six currencies. 23.  The Reserve Bank began publishing these indices, giving the monthly movements in its monthly bulletin, beginning July 1998, along with the thirty-six-currency indices. With the introduction of the euro, the franc and the mark were replaced (1 January 2002). 24. In 2007, there was a move to include services data in the REER index, but the required monthly data on export and import of services were not available for all countries. 25. RBI, ‘Statement on Recent Developments in the Foreign Exchange Markets’, 11 June 1998. 26. Bimal Jalan, ‘Development and Management of Forex Markets: A Central Banking Perspective’, Inaugural Remarks at the 21st Asia Pacific Congress, New Delhi, 1 December 2000. 27.  S. S. Tarapore, ‘Exchange Rate: Slave or Master’, Business Standard, 17 December 1999. 28. In fact, former Governor Reddy wrote: [W]e were guided by REER in practice…. The rule of thumb was: movements within 5 per cent of the rate as per REER would be welcome. Movements between 5 and 10 per cent warranted close observation and intervention if the volatility was higher than normal. Deviation of more than 10 per cent warranted intervention.... Prolonged stability at a rate also warranted our attention.... We felt that the markets were also comfortable with this arrangement. (Y. V. Reddy, Advice and Dissent: My Life in Public Service [Delhi: Harper Collins, 2017], p. 276.)

29. See Chapter 6 on financial markets for a detailed account of NDF. 30. The legal framework for management of foreign exchange reserves was provided by the RBI Act, 1934. While its preamble empowered the Reserve Bank to hold the foreign exchange reserves, different sections and subsections of the Act stipulated the minimum amount and also recommended the desired composition and instruments of reserves. The word ‘reserves’ refers to both foreign exchange reserves and domestic reserves (bank reserves). Forex reserves relate to foreign currency assets held in cash, securities, bonds and deposits with international banks and institutions, and gold in the Banking and Issue Departments. Sections 17 and 33 of the Act spelt out the broad ways in which foreign exchange reserves were to be deployed and managed. 31. Y. V. Reddy, ‘Forex Reserves, Stabilization Funds and Sovereign Wealth Funds: Indian Perspective’, Golden Jubilee Celebrations of the Foreign Exchange Dealers’ Association of India, Mumbai, 8 October 2007. 32. The adequacy of reserves issue was debated in Parliament. On the question of whether the government proposed to utilise the foreign exchange reserves 182

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foreign exchange reserves management beyond prudent norms ( Jagmeet Singh Brar, Member of Parliament [MP], Starred Question No. 170, answered on 12 December 2003), the government replied that the policy for reserve management is judiciously built upon a host of identifiable factors and other contingencies which inter alia include size of the current account deficit; the size of short-term liabilities, the possible variability in portfolio investment and other types of capital flows, pressures on the balance of payments arising out of external shocks and movements in the repatriable foreign currency deposits of NRIs.

This approach conformed closely to the statements made by the Bank. 33. The Reserve Bank stressed that while safety and liquidity of investment were the main tenets of reserve management, the primary objective was to preserve the long-term value of the reserves, that is, avoid risks even if the returns were relatively low. Y. V. Reddy, ‘The Role of Government-owned Investment Vehicles and Capital Flows: Indian Perspective’, Address at a session on ‘The Role of Government-owned Investment Vehicles in Global Capital Flows’ at the International Capital Markets and Emerging Markets Roundtable, Washington DC, 14 April 2008, BIS Quarterly Review 44 (2008), https:// www.bis.org/review/r080416d.pdf. 34. Further, the system of concurrent audit for monitoring the compliance of internal control guidelines was in place. Nostro accounts of important currencies were monitored and reconciled on a daily basis. Central banks were the custodians for the major part of these securities. Although external auditors conducted statutory audit, a special external auditor was appointed to audit dealing room operations. The Inspection Department of the Bank carried out regular inspections of the Department of External Investments and Operations. 35. For example, it was US$500 million in 1996, which was raised gradually to reach US$2.8 billion in 2007. An upper limit was set in 2006 at US$5 billion or 5 per cent of foreign exchange assets, whichever was lower, which was revised to 5 per cent or US$10 billion in 2007. Similarly, the amount assigned to individual EAMs, too, was not significant at US$75 million in 1996, which was increased to a maximum of US$1 billion in 2007. 36. A scoring model awarded marks on a scale of 0 to 5 for each parameter. A committee of senior officers appointed by the Deputy Governor reviewed and finalised the rating and selection. An EAM who obtained a score of over 60 per cent was considered. 37. Deputy Governor Shyamala Gopinath and Sanjay Krishna, Joint Secretary at the Ministry of Finance, were the main negotiators from the Indian side, while the Japanese team was led by Naoyuki Shinohara, Director-General, International Bureau, from the Ministry of Finance. 183

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the reserve bank of india 38. The arrangement was for a maximum amount of US$3 billion, essentially to tide over temporary balance of payments problems. The tenure of the swap was three months, which could be renewed seven times for three months each, meaning the total life of a drawal would be two years. The applicable interest rate was a three-month London Interbank Offered Rate (LIBOR) plus 150 basis points (bps) for the first drawal, the tenure of which was ninety days. Thereafter, starting with the second renewal, the premium added to the LIBOR would increase by 50 bps for every two renewals, provided that such premium shall never exceed 300 bps. There was also a clause of ‘late interest’ on delayed repayment. The interest and late interest would be computed from the original maturity date of the relevant swap transaction and every one month thereafter. 39. Bimal Jalan, Address at 14th National Assembly of Forex Association of India, 14 August 2003. 40. See Chapter 4 for other details of the two schemes. 41. An amount of US$2.97 billion was met out of forward purchases and the rest was paid from the reserves. The payments were made to State Bank of India (SBI) in two tranches on 29 September and 1 October 2003 as SBI was the issuing bank. Call rate (weighted average) just edged up from 4.44 per cent to 4.55 per cent and foreign exchange currency assets of the Reserve Bank did not fall but instead rose by US$771 million on a week-to-week basis. Exchange rate of the rupee per USD showed a small appreciation of 19 paise. 42. This was due to two reasons: (a) deposits under FCBs carried higher yield rate by a few basis points compared to BIS term deposit or Bank of England deposit bids and (b) using the entire maturity of FCBs would have led to the depletion of cushion to be maintained for the backing of note issue in terms of Section 33(6) of the RBI Act. 43. Rajya Sabha, Unstarred Q. No. 3295 answered on 25 April 2000. 44. Rajya Sabha, PQ, RS No.1179, 12 December 2004. 45. Planning Commission, Government of India, Mid-Term Appraisal of the Tenth Five Year Plan (2002–2007) (New Delhi: Government of India, 2007), p. 472. 46. Bimal Jalan, Address at 14th National Assembly of Forex Association of India, 14 August 2003. 47. Rajeev Shukla, MP, Rajya Sabha (Rajya Sabha, Unstarred Q. No. 1179 answered on 14 December 2004), asked, ‘[H]ow does Government propose to raise funds, particularly since RBI is not in favour of utilising the foreign exchange reserves for the purpose’, to which the government did not give any direct answer. To a related question asked by Uday Pratap Singh, MP, Rajya Sabha, on the utilisation of reserves (Rajya Sabha, Unstarred Q. No. 1190 answered on 14 December 2004), the government replied that ‘any decision to utilise a part of foreign exchange reserves for funding domestic projects 184

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foreign exchange reserves management requires careful assessment inter alia, of the impact of such a measure on the fiscal situation, money supply, exchange rate, domestic interest rates, reserve adequacy and inflation’. 48. During the discussion at the board meeting held in Kolkata on 13 December 2007, other options, such as the government buying foreign exchange from the Bank against issue of government securities, and the Bank extending ways and means advances and bridge finance, did not find favour because they were not in line with the Fiscal Responsibility and Budget Management targets, as emphasised by the Bank. The Act provided that the central government shall not borrow from the Bank except under exceptional circumstances. 49. The Board also deliberated upon the terms and conditions of the Bank’s investment, including tenor, rate of interest, government guarantee, drawal mechanism, end use and repayment. Tenor was fixed at a maximum of ten years as the RBI Act did not permit beyond it. Interest rate was linked to LIBOR. 50. On 7 February 2008 IIFCL (United Kingdom [UK]) was incorporated with the Registrar of Companies of England and Wales at London under the UK Companies Act, 1985, for on-lending to Indian companies implementing infrastructure projects in India, and/or to co-finance the external commercial borrowings of such projects for capital expenditure incurred outside India. The Bank made its first tranche of investment of US$250 million on 20 March 2009. 51. Reddy, ‘The Role of Government-owned Investment Vehicles and Capital Flows’. 52.  Consequent to the announcement of the Export–Import (Exim) policy (1997–2002) by the government in 1997, the Bank revived and activated the committee in March 1997 with V. Subrahmanyam, Executive Director, in charge of DEIO as Chairman. Members were drawn from relevant departments of the Bank. 53  Membership of the SCGPM was also gradually expanded to include representatives of the Ministry of Finance, the Ministry of Commerce and SBI. 54. The Bank also tried to put through ‘location swap’, whereby swap arrangement would be entered with international bullion banks such as the Union Bank of Switzerland. The mechanism was the following: Swap deals would be entered into with international banks who were suppliers of gold to Indian importers such as the Minerals and Metals Trading Corporation. These international banks would source the gold from the Reserve Bank by way of swap arrangement and supply it to the importing agencies in India. The concerned international bank would credit the equivalent volume of gold into the Reserve Bank’s account with the Bank of England, London, and the Reserve Bank would hold this as gold deposit with the Bank of England. 185

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the reserve bank of india This proposal was approved by the Government of India in 1995 and, legally, it was possible to hold gold deposits abroad except for a minimum quantity worth 1.15 billion to be held in the assets of the Issue Department as specified in the provisions of Section 33 of the RBI Act. But the scheme did not take off mainly due to lack of interest shown by gold importers. 55. Tarapore, ‘Exchange Rate’.

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6 Financial Markets

Introduction As a result of the ongoing financial market reforms of the previous decades, there was growing integration among the three main segments of the financial market – the money market, the government securities market and the foreign exchange market – with the money market acting as the fulcrum. But through a series of institutional and technological changes, the process was taken much further during the period of study. And as it continued, the role of financial markets in the economy was significantly enhanced. The chapter describes this process (Figures 6.1 and 6.2). One of the broader objectives of the reform was to facilitate market integration. Market integration has obvious advantages. It allows economies of scale, more competition, and reduces prices and costs. It allows market participants more choice of investment instruments and allows them to spread risks. Integration also increases the effectiveness of regulation and policy. On the other hand, there is a risk. An integrated market may spread impulses arising in one market to the others, which can be beneficial if the impulse is a growth-inducing one, and hurtful if it is in the nature of a crisis. These expected gains and risks are of special interest to this chapter. Within the money market, the call money market occupies a strategic position by serving as the equilibrating mechanism between day-to-day surpluses and deficits in the financial markets, and by transmitting the monetary policy impulses to the financial system quickly and efficiently. Consequently, it is the focal point for the Reserve Bank’s operations in influencing liquidity conditions. In the government securities market, major reforms were undertaken to deepen and widen the market, and thereby encourage transactions, and support these with financial accommodation under the liquidity adjustment facility, or LAF (see Chapter 3). The foreign exchange market grew in importance in the context of the large inflow of 187

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Figure 6.1 Components of the Financial Market Credit Market

Banks

All India Term Lending & Refinance Institutions

Commercial Banks Public Sector Banks

Money Market

Non Banking Financial Companies

Unorganised

Cooperative Banks

Call Notice Money Market

Money Market Derivatives

Term Money Market

FRA, IRS

T-Bills

Private Sector Banks

Urban Cooperative Banks

Rural Cooperative Banks

Foreign Banks

Long Term

RRBs

SLDBs

State Cooperative Banks

Local Area Banks

PLDBs

Central Cooperative Banks

Short Term

Foreign Exchange Market including Derivatives OTC

Spot

Forwards

Exchange Traded

Options

Futures

Capital Market

Equity Market including Derivatives

Options

Debt Market

Government Securities

PSU Bonds

Corporate Bonds

CDs CPs CBLO Repo MMMFs

Primary Agricultural Credit Societies

Note: This is a simplified version of the financial market as identified during the reference period (1997–2008) highlighting the salient features.

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Figure 6.2 Regulatory Structure in the Indian Financial Market Government of India, Ministry of Finance High Level Co-ordination Committee on Financial Markets

Reserve Bank of India

Securities and Exchange Board of India

Money Market & Derivatives

Equity Market, Mutual Funds

Foreign Exchange Market and Derivatives

Corporate Debt PSU Bonds Market

Government Securities Market

All Trades in Stock Exchanges

Insurance Regulatory and Development Authority of India

Life Insurance

Pension Fund Regulatory and Development Authority

Non-Life Insurance

Credit Markets- including Derivatives, Banks and Non-Banks

Note: This is a simplified version of the regulatory structure as identified during the reference period (1997–2008).

Pension Funds

the reserve bank of india foreign funds and liberalisation of the foreign exchange regime. The foreign exchange market also operated in close affinity with the call money market on account of the day-to-day liquidity management operations of the Bank. The rest of the chapter is divided into four main topics: an overview of major developments in the financial markets, the money market, the government securities market and the foreign exchange market. There are minor overlaps between Chapter 3, ‘Monetary Management’, and the present chapter with respect to government securities trade, although the focus of Chapter 3 is on institutional changes, while the focus of this chapter is on market process, instruments and participation. Similarly, there are minor overlaps with Chapter 4 on exchange rate management. Before embarking on the main narrative of this chapter, it would be useful to emphasise certain features of the development of the financial market during 1997–2008.

Major Developments, 1997–2008

Deregulation of interest rates by the Bank began with the removal of restrictions on the interbank money market in 1989. This was followed by putting the government’s market borrowing programme through the auction process in 1992–93. Phased deregulation of lending rates in the credit market followed this step. To activate the market, a number of instruments, such as commercial papers (CP), short-term treasury bills (T-bills) and certificates of deposit (CDs) were introduced, supplemented by a parallel process of market development, beginning with the establishment of the Discount and Finance House of India (DFHI) in 1988. Another significant initiative was the development of the repo market outside the official window for providing a stable collateralised alternative, particularly to banks and non-banks. This had the effect of money market activity migrating from the uncollateralised call money market segment to the collateralised market repo and collateralised borrowing and lending obligation (CBLO) markets. Reforms were undertaken in developing appropriate market infrastructure, such as increasing the width and depth of the market, improving risk management practices and increasing transparency in the markets. The growth of the repo (outside LAF) market and the CBLO market resulted in the entry of a wide spectrum of investors, such as banks, primary dealers (PDs), non-banks and mutual funds. Foreign institutional investors (FIIs) were allowed to participate in the government securities market. The enhanced presence of foreign banks in line with India’s commitment to the

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financial markets World Trade Organization (WTO) strengthened links between domestic and international markets and increased competition. The links between domestic money and foreign exchange markets and overseas markets were facilitated by allowing banks and authorised dealers (ADs) to borrow and invest funds abroad and to lend in foreign currency to companies in India. The Clearing Corporation of India Ltd. (CCIL) was set up in 2001 to act as a central counterparty to all trades involving foreign exchange, government securities and other debt instruments routed through it and to guarantee their settlement. Institutions such as the DFHI, Securities Trading Corporation of India and PDs were allowed to participate in more than one market. There were significant changes in the technological, payments and settlement infrastructure (Chapter 8). The delivery-versus-payments (DvP) system, the negotiated dealing system (NDS) and its variants, and the real-time gross settlement system (RTGS) improved speed and efficiency in the settlement process. Since 1997, the Bank held frequent consultations with regulatory authorities and market experts when making policies. Interactions took place with industry associations as well, such as the Indian Banks’ Association (IBA), Foreign Exchange Dealers’ Association of India (FEDAI), Primary Dealers’ Association of India (PDAI) and Fixed Income Money Market and Derivatives Association of India (FIMMDA). In policymaking, the Technical Advisory Committee (TAC) on Money, Foreign Exchange and Securities Markets played an important role.1 The objective was to benefit from the opinion of experts in banking as well as academics, government officers, stock exchanges, credit rating agencies and market participants. The TAC helped shape a wide variety of policy matters, such as guidelines on CP and documentation procedures, setting up of the CCIL, instituting the NDS, framing auction format for the sale of government securities and drawing a road map for phasing out non-bank entities from call and notice money markets.

Money Market

The main components of the money market are listed in Table 6.1. It is useful to begin with the call money market. The call money market deals in overnight funds, also known as money at call. Funds for the tenor of two–fourteen days are termed as notice money. Although technically the chapter deals with both types – call and notice – for convenience, we will refer to them together as the call money market.

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the reserve bank of india Table 6.1 Main Components of the Money Market Market Segment

Main Participants

Collateralised borrowing and lending obligation (CBLO)

Commercial banks; RRBs; cooperative banks; PDs; financial institutions; insurance companies; mutual funds

Call and notice money

Treasury bills (issued by the central government) Repo (outside LAF) Certificates of deposit (CDs) Commercial papers (CPs) Bills rediscounting Term money

Interbank participation certificates

Notes:

Commercial banks (excluding regional rural banks, or RRBs); cooperative banks; primary dealers (PDs)

Commercial banks; RRBs; cooperative banks; PDs; financial institutions; insurance companies; mutual funds; state governments; provident funds Commercial banks; RRBs; cooperative banks; PDs; financial institutions; insurance companies; mutual funds; state governments Commercial banks; select financial institutions; corporates; mutual funds Corporates; select financial institutions; PDs

Commercial banks; select financial institutions; insurance companies; mutual funds Commercial banks; financial institutions; PDs Commercial banks

1. Until 5 August 2005 select all-India financial institutions, insurance companies and mutual funds were permitted to participate in the call money market as lenders. 2. Financial institutions were the former Industrial Development Bank of India, insurance companies and mutual funds.

Call Money Market The call money market is an avenue to deploy very-short-term surpluses and it is the most important source of funds to meet individual bank’s cash reserve ratio (CRR) and other short-term liquidity needs. This is an over-the-counter market and does not involve the intermediation of brokers. The call money market was an interbank market until 1971 when the Life Insurance Corporation of India (LIC) and Unit Trust of India (UTI) were allowed to lend in the market. In 1990, with a view to widening the call 192

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financial markets and notice money market segments, the Bank allowed General Insurance Corporation of India (GIC), Industrial Development Bank of India (IDBI) and National Bank for Agriculture and Rural Development (NABARD) to participate as lenders. In April 1991, access as lenders expanded to include entities that were able to provide evidence of bulk lendable resources. These entities were required to observe a minimum size of operation, and such transactions were permitted only through the DFHI. Since 1995, private sector mutual funds were also given permission to operate in the call money market as lenders. In April 1997, the facility of routing transactions afforded to the DFHI was extended to other PDs, and, gradually, the minimum size of operations was reduced in 1997 and 1998. These relaxations saw the number of entities routing their call transactions through PDs rising sharply. The wisdom of opening the doors of the market had been discussed and debated for at least a decade before these moves took place.2 Several committees suggested that the call market should be purely an interbank market.3 Because the call money rates were market-determined while deposit rates of banks were administered, freeing entry could lead to diversion of funds from bank deposits to the call market, which would raise the cost of funds to banks. The Report of the Committee on Banking Sector Reforms4 in 1998 agreed with this reasoning, subject to an exception being made for PDs, who had been present in the call money market since 1996, and who could be formally treated as banks for the purpose. Non-bank participants would be given full access to bill rediscounting, CPs, CDs, T-bills and money market mutual funds for deploying their short-term surpluses and be removed from the call market. The Reserve Bank accepted this position and held consultations with a crosssection of financial institutions on the move.5 Generally, the participants were not against the idea. The Bank decided to implement the move towards a pure interbank market in a manner such that existing lenders would have the operational flexibility to adjust their asset–liability structure. Meanwhile, the Bank introduced a number of measures, such as widening the repo market and improving non-bank participation in a variety of other instruments, during the transitional period. The argument for keeping PDs in the call market was that they did not have any branch network, and relied substantially on this market and the repo market and that, apart from their net owned funds and liquidity support from the Bank, they had no other source of funds that was cost effective. Since repos resulted in immobilising securities, PDs needed to have an inventory 193

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the reserve bank of india for trading, which meant that some access to call borrowings would always be required. Moreover, any call money borrowing by a PD was backed by the stock of government securities, and there was no credit risk. In April 1999, the Bank introduced four measures. First, non-bank participation in repo was opened up, and their participation in a variety of other instruments was sought to be improved. Second, with the amendment to the Securities Contracts (Regulation) Act (SCRA), 1956, the repo market was widened to cover non-bank entities holding both current and subsidiary general ledger (SGL) accounts with the Bank. Third, to make the transition smooth, financial institutions were permitted to operate in the call money market for some time, along with permission to participate in the repo market, while they adjusted their asset–liability structure and redeployed short-term surpluses in other money market instruments. The exact time frame for phasing out nonbank participants from the call money market was to be synchronised with the development of the repo market. Fourth, permission given to non-bank entities to transact in the call market through PDs was to be withdrawn after 1999. Several other measures were taken at the same time to impart liquidity to government securities, including the introduction of the LAF (Chapter 3). A technical group was set up in December 2000 to suggest a smooth withdrawal of access of non-banking institutions from the call market, which agreed that complete withdrawal of non-banks from the call money market should take place together with full operationalisation of the CCIL, which was to start operations in 2001–02, and would be the agency to facilitate settlement of money, foreign exchange and government securities market transactions. The group recommended that access of non-bank institutions to call money may be reduced in stages by placing progressively lower caps upon their average daily lending.6 The corporates who were routing their funds through PDs might be disallowed, as these entities could always place their short-term funds with PDs through inter-corporate deposits. Nonbank participants under the new system were likely to build a portfolio of securities, thus creating additional demand in the debt market. It was also anticipated that since call money rates would be higher than the repo rate, banks with surplus statutory liquidity ratio (SLR) securities may act as conduits for funds from the repo market to the call market, thereby integrating them more. Towards the end of the reference period, banks and PDs were the main participants in the market. Financial institutions, which included insurance 194

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financial markets companies, mutual funds and development finance institutions, could participate until 5 August 2005, and corporates were allowed to lend through PDs until 30 June 2001. The market became a fully interbank market on 6 August 2005 (see Table 6.2). A related topic for discussion was a prudential ceiling on call market transactions. The Narasimham Committee II had recommended limits on grounds that access to this market should be restricted to meeting unforeseen mismatches and not as a regular means of financing the banks’ lending operations. This was also recognised in the guidelines on asset–liability management system issued by the Bank in February 1999.7 Further, to reduce excessive reliance on short-term funding, banks were advised to set a cap on interbank borrowings, especially call borrowings. In March 2001, the Bank suspected that unethical behaviour of a few cooperative banks had posed risks to depositors and other banks. In order to reduce their excessive reliance on the call money market, the Monetary and Credit Policy for 2001–02 (April 2001) set a limit on the borrowings of urban cooperative banks (UCBs) in the call money market, at 2 per cent of their aggregate deposit as at end of March of the previous year, on a daily basis. On 29 April 2002, the limit was extended to state and district central cooperative banks. Table 6.2 Key Steps in the Transition to an Interbank Call Money Market Effective Date

Prescribed Limit

14 June 2003

From the fortnight beginning 14 June 2003, non-bank lending was scaled down to 75 per cent. (Announcement was made in April 2002.)

5 May 2001

27 December 2003 26 June 2004

8 January 2005 11 June 2005

6 August 2005

Non-bank institutions (including financial institutions, mutual funds and insurance companies) were permitted to lend in a reporting fortnight, up to 85 per cent of their average daily lending in the call money market during 2000–01.

Lending limit scaled down to 60 per cent with effect from the fortnight beginning 27 December 2003. The lending limit was further reduced to 45 per cent. The lending limit was reduced to 30 per cent. Lending limit further reduced to 10 per cent.

Finally, call money market transformed into a pure interbank market as non-banks (excluding primary dealers) were phased out completely effective fortnight beginning 6 August 2005. 195

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the reserve bank of india An internal review in 2001 revealed that commercial banks continued to depend heavily on the call money market. In particular, a few foreign banks and new private sector banks were overexposed to the call market. The TAC on Money and Government Securities Markets also suggested linking of transactions in the call market to the balance sheet. These considerations led the Monetary and Credit Policy Statement for 2002–03 to specify prudential limits for scheduled commercial banks (Table 6.3).8 While the principle of prudential limit was acceptable, the multiplicity of rules was confusing. A point for discussion was whether caps should apply to owned funds or to capital. The Technical Group on Money Market (2005) examined the issue and found that migration from owned funds to capital funds would not materially impact the operations of banks. For certain cooperative banks, which were not yet subject to capital adequacy norms as applicable to commercial banks, data on capital funds were not available. Therefore, for cooperative banks, the current rules continued. For PDs, since the difference between capital funds and net owned funds was only marginal, the group proposed that the existing norm should continue. For non-bank entities, which were to be phased out of the market, no change in norm was suggested.9 An internal review carried out by the Monetary Policy Department (MPD) observed that the transition in the call and notice money markets took place without serious strains. Market participants had anticipated the application of prudential limits and had no problem in adjusting to them.10 The PDs emerged as the largest borrower group. The fortnightly averaging for compliance with limits, together with almost unrestrained access to the Bank’s LAF window, contributed to the stability in the call money market operations. Table 6.3 Comparative Prudential Benchmarks for Call Money Market Operations Entity

Lending

Borrowing

Cooperative banks

(No prescription)

Aggregate deposits

Non-banks

Average daily lending during 2000–01 in the call/notice money market

Scheduled commercial banks

Primary dealers

Pre-April 2005: Owned funds Post-April 2005: Capital funds

Net owned funds

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Owned funds or aggregate deposits, whichever is higher Net owned funds Not applicable

financial markets Table 6.4 Activity in the Money Market Segments

( billion)

1997–98 1998–99 1999–2000 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Call money 227 265 232 322 351 294 172 142 180 217 214

Average Daily Turnover Market repo 69 105 302 470 104 171 212 337 547

CBLO 5 67 200 324 556

Term money 2 3 5 5 8 10 7

Outstanding (End-March) CP

CD

15 48 57 58 72 57 91 142 127 178 326

143 37 12 8 16 9 45 121 436 933 1478

Sources: RBI, Annual Report (for various years), and RBI, Handbook of Statistics on Indian Economy, 2009–10.

Note: Turnover is two times the single-leg volumes in the case of call money and CBLO to capture borrowing and lending both, and four times in the case of market repo (outside LAF) to capture the borrowing and lending in the two legs for a repo.

After the limits came into place, lenders placed their surplus funds in the Bank’s repo window and other schemes. Some public sector banks, especially State Bank of India (SBI), bid aggressively in the primary auctions of government securities to deploy their excess funds.11 Some banks had invested large amounts in mutual funds. The term money market also saw more activity (Table 6.4). The spread between call money rates and term money rates reduced. The Reserve Bank, however, was concerned that the majority of lenders found an easy way out by placing funds in the Bank reverse repo window, hindering the growth of the term money market and the repo market.

Term Money Market Funds with a maturity from fifteen days to one year are borrowed and lent without collateral in the term money market. Like the other segments of the money market, term money was also strictly regulated until the late 1980s, with ceiling rates prescribed for various maturities. The market was sluggish.12 197

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the reserve bank of india And yet, a well-functioning term money market was needed to bridge the funding gap of financial institutions, to provide a reference rate for a variety of products, and to facilitate transmission of monetary policy signals.13 Interest rates in the term money market were deregulated in 1989. The participant base was widened by allowing select financial institutions, first as only lenders and subsequently as borrowers.14 But more action was needed. In April 1997, the Reserve Bank exempted banks from the maintenance of the CRR and the SLR on interbank liabilities to facilitate the development of the term money market. Term money of original maturity between fifteen days and one year was exempted from the prescription of minimum CRR from 11 August 2001. Dissemination of benchmark rates by the National Stock Exchange (1998), issuance of asset–liability management guidelines for banks (1999), introduction of the LAF in June 2000 that imparted stability to the overnight rates, and placement of caps on call lending (in addition to prudential caps on borrowing) but not on term money contributed to the process. Limits on the lending side were expected to drive surplus liquidity of banks to alternatives like term money. Enabling term money transactions on the NDS-CALL platform, which was launched in September 2006, also helped. Despite these moves, the term money market failed to become a vibrant one.15 Growth in the volume of transactions was small compared to those in call money or repo. The distribution of liquidity amongst banks was highly skewed, in that a few banks accounted for all borrowing from or lending to the Reserve Bank. Further, banks tended to deal with uncertainty by keeping excess cash. Part of the problem was that interbank claims accounted for a small proportion of banks’ assets in India. Prescription of limits on transactions in the uncollateralised segment of the market had not led to the development of the longer-term market but only resulted in the migration of funds from the overnight uncollateralised call segment to the overnight collateralised (CBLO and market repo) one. Thus, prudential norms reduced the dependence on instruments like term money.16 Compared to term money, alternatives such as CDs and mutual funds were seen to be more flexible because, among other reasons, CD was a tradable instrument. Towards the end of the reference period, there was a mood of acceptance that the Bank could do little to activate the market. A few initiatives were taken, however. The impact of the initiatives takes us beyond the reference period. 198

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financial markets

Treasury Bills T-bills are risk-free investments that carry a relatively low rate of interest. A long-standing system of automatic monetisation of the budget deficit by issuing ad hoc T-bills was replaced by ways and means advances for the central government in 1997 (see Chapter 3). When the ad hoc T-bills and the ‘on tap’ 91-day bills were discontinued (1 April 1997), the government needed an alternative arrangement for the transition period to take care of its cash management. A 14-day T-bill was introduced from 6 June 1997. The interest of market participants in 14-day T-bills was good in the beginning but started waning soon. By 2000, except for PDs and a few state governments, investors did not take much interest in them. With the small amount mobilised at each auction, these bills did not help the government in its cash management either. From 14 May 2001, the 14-day T-bills (and 182-day T-bills) were withdrawn, and a decision was taken to focus on few maturities and, at the same time, enhance the volume in primary issues of these bills. The 182-day T-bills had a chequered history. It was introduced in November 1986. Since then, it had seen several episodes of introduction, withdrawal and reintroduction. They were reintroduced on 26 May 1999 and continued in existence for two years. During this phase, the bills were issued through competitive auctions, for a fixed notified amount. On many occasions, the Reserve Bank had to participate as a non-competitive bidder. The 14-day, 91-day and 364-day T-bills were also in existence by that time. The objectives of having a number of T-bills with diverse maturities were to facilitate the availability of short-term funds to the government and give more choice to market participants. The T-bill market programme followed a certain schedule of issuance.17 The schedule offered short-term funds to the government at any point in time. But the programme lacked synchronisation in respect of issue/maturity date of T-bills, which did not allow ‘fungibility’ – easy interchangeability with other similar assets – of T-bills. Furthermore, the notified amounts for the issue of all the T-bills except for the 364-day T-bills were too low, which affected secondary market liquidity of T-bills. With a strong preference of market participants in favour of the call money market, the secondary market liquidity in the T-bill market was very low. The existence of a large number of T-bills of different tenor further fragmented total quantity into even smaller lots. There were few participants other than PDs in primary auctions. Even the participation of PDs in T-bill auctions was more out of their obligation to 199

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the reserve bank of india meet their annual bidding commitment targets rather than by choice. As PDs were generally dependent on the call money market to fund their holdings of T-bills, their auction bids largely reflected the call money rate. Several measures were taken to address these problems. First, the issue or maturity day of all T-bills was synchronised from April 2001. The auction and payment days for all T-bills were fixed on Wednesdays and Fridays. Second, issuance of 14-day and 182-day T-bills was discontinued from 11 May 2001. Third, the notified amount for the auction of 91-day T-bills was enhanced to increase the outstanding amount of the bills in the market. Subsequently, financial market developments, as well as regulations in other areas, helped the process. The main areas of change were the decision to phase out nonbank institutions from the call money market, foreign exchange inflows and revision in the notified amounts for auctions of 91-day and 364-day T-bills in response, and introduction of the Market Stabilisation Scheme (MSS) from 25 March 2004 (see Chapter 3), under which the notified amount for auctions was increased substantially. In the primary market, these measures contributed to widening the subscription base and strengthened the demand for T-bills. The menu of options for primary investors was reduced, but the existing T-bills did not quite fill in the maturity spectrum. A Working Group on Reintroduction of 182-day T-bills (2004) recommended reintroduction of the 182-day T-bills. The auctions were to be conducted on a fortnightly basis. To create fungibility among all the T-bills, the auctions for 182-day T-bills were to be on Wednesdays with payment on Fridays, as in the case of other T-bills. It was also suggested that, to begin with, the notified amount for the auction of 182-day T-bills could be fixed at 5 billion and in order to smoothen the weekly outflows of funds, the notified amount for the auction of 364-day T-bills under the normal market borrowing was to be reduced from 10 billion to 5 billion. The first auction of 182-day T-bills was conducted on 6 April 2005. To broaden market participation, and to eliminate the problem of ‘winner’s curse’ – the winning bid in an auction exceeding the intrinsic value of the item subsequent to the auction – the Bank (in October 1997) introduced a system of uniform price auction with 91-day T-bill auctions. Under the prevailing auction system of 14-day, 91-day and 364-day T-bills and dated securities of the central government, the respective cut-off yields determined the coupon rate/price and, as a result, all bidders at or below the cut-off yield were allocated 200

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financial markets up to the notified amount. It had been the practice to notify the amounts of the issue in respect of auctions of 91-day T-bills and dated securities, while the amounts were not notified in the case of 14-day and 364-day T-bill auctions. The practice of notifying the amount of issue was extended to all auctions, including those of 14-day and 364-day T-bills. In the 1990s, a few institutions, such as state governments, provident funds and Nepal Rastra Bank, were permitted to participate in the 14-day and 91-day T-bill auctions as ‘non-competitive’ bidders.

Collateralised Borrowing and Lending Obligation The move to promote CBLO needs to be seen in relation to the efforts to develop a repo market outside the LAF to provide participants with a stable funding alternative. The use of such collateralised products was expected to minimise the credit risk of lenders and help in evolving a short-term rupee yield curve. The CBLO was operationalised as a money market instrument through the CCIL on 20 January 2003. It is a discounted instrument available in an electronic book-entry form for the maturity period ranging from one day to ninety days (subsequently extended to one year). Membership was extended to banks, financial institutions, insurance companies, mutual funds, PDs, nonbanking financial companies (NBFCs), non-government provident funds, corporates and others. The CCIL assumes the role of the central counterparty through the process of novation and settlement of transactions.18 Borrowing limits for members are fixed by the CCIL at the beginning of the day taking into account the securities deposited by borrowers in their SGL account with the CCIL. The securities are subjected to a ‘haircut’ after marking them to the market.19 Automated value-free transfer of securities between market participants and the CCIL was introduced in 2004–05. The regulatory provisions and accounting treatment for the CBLO were the same as those applicable to other money market instruments. However, to develop the CBLO, the operations were exempt from the CRR until 24 November 2009, subject to a bank maintaining the minimum CRR of 3 per cent. Eligible securities were central government securities and T-bills. The securities lodged in the gilt account of the bank maintained with the CCIL under the SGL facility, and remaining unencumbered at the end of any day, were reckoned for SLR purposes by the concerned bank. 201

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the reserve bank of india For a variety of reasons, the CBLO was a success. The migration of money market activity from the uncollateralised call money market segments to the collateralised segments (market repo and CBLO) was driven by the standardisation of accounting practices, broad-basing of eligibility criteria in collateralised markets, gradual phasing out of non-banks from the call money market, exemption of CBLO from CRR requirements and anonymity provided by the order matching systems. Availability of alternative avenues for mobilising short-term funds, such as the market repo and the CBLO, also led to market rates aligning with the informal interest rate corridor of repo and reverse repo rates under the LAF. In the initial period, one insurance company and a few cooperative banks supplied funds in the CBLO market but, subsequently, mutual funds emerged as one of the largest suppliers of funds. On the demand side, apart from banks, PDs participated regularly on account of the lower borrowing costs in the CBLO vis-à-vis the call market. The collateralised market accounted for 80 per cent of the total turnover in 2007–08. The composition of borrowers underwent a change, with corporates becoming significant borrowers besides commercial banks and PDs.

Repo outside the LAF of the Bank Repo or repurchase agreement is a money market instrument that enables collateralised short-term borrowing and lending through sale or purchase of debt instruments. To activate the repo market, in April 1997, repo and reverse repo transactions among institutions were extended, and non-bank holders of SGL accounts with the Reserve Bank were allowed entry into repo market transactions (but not into reverse repos). On 29 November 1997, the Bank commenced a scheme of 3–4-day fixed-rate reverse repos in government securities in order to impart greater maneuverability in short-term liquidity management. Following on the Narasimham Committee II recommendations, further steps were taken to develop the market. In April 1999, DvP, uniform accounting, valuation and disclosure norms, and restriction of reverse repos to instruments held in dematerialised form with a depository were adopted. Along with these prudential safeguards, the market was opened to UTI, LIC, IDBI and other non-bank participants in the money market. Following the recommendations made by an internal sub-group of the TAC, the Bank decided (April 1999) that non-bank entities could borrow money through repos like banks and PDs. 202

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financial markets The repo market widened (April 2000) to cover all non-bank entities.20 These entities could borrow as well as lend in the market. To broaden and expand the participant base, from March 2003, certain specified categories of non-bank entities like mutual funds, insurance companies, housing finance companies and NBFCs, which were earlier not eligible to participate in the repo market, were made eligible. These entities were allowed in the repo market through their ‘gilt accounts’ maintained with the custodians, subject to safeguards and transparency guidelines. The rollover of repo transactions in government securities was facilitated with the enabling of the DvP mode of settlement in government securities (2 April 2004). This provided significant flexibility in managing collateral. During the years 2005–06, 2006–07 and 2007–08, the repo market (outside LAF) continued to grow in the same manner as the CBLO. Both the CBLO and repo markets became important segments of the collateralised market. Mutual funds were the major lenders while commercial banks and PDs were the major borrowers.

Certificates of Deposit CDs were introduced in 1989 to widen the range of instruments and give investors greater flexibility in deploying their short-term surplus funds. The CD is a negotiable instrument and issued in the dematerialised form or as a usance promissory note for funds deposited at a bank or other eligible financial institutions for a specified time period. CDs can be issued by commercial banks (with some exclusions) and some all-India financial institutions to individuals, corporations, companies, trusts, funds, associations and non-resident Indians on a non-repatriable basis. CDs are generally accepted by banks during periods of tight liquidity at relatively high rates of interest (in comparison with term deposits). But the transaction cost of CDs is often lower compared to retail deposits. When credit picks up, banks try to meet their liquidity gap by issuing CDs at a premium. The required amounts are mobilised through CDs, often for short periods, in order to avoid interest liability in the subsequent months when credit demand slackens. The subscribers find it profitable to hold CDs until maturity as banks offer higher interest rates on them. Given these dynamics, the secondary market for CDs had been rather slow to develop. The Reserve Bank initially limited the issuance of CDs to a certain percentage of a bank’s fortnightly average of the outstanding aggregate 203

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the reserve bank of india deposits in 1989–90. Over time, bank-wise limits were raised and subsequently abolished (from 16 October 1993). These moves enabled CDs to emerge as a market-determined instrument. However, the reduction in the minimum maturity of time deposits with banks and permission to allow them to pay different interest rates based on deposit size reduced the attractiveness of CDs. To broaden the market for CDs, in October 1997, the minimum size of issuance to a single investor was scaled down to 0.5 million from 1 million and the minimum maturity period reduced from three months to fifteen days (April 2000) and further to seven days (April 2005). The restriction of a minimum period of transferability of CDs was withdrawn from 10 October 2000. In the interest of transparency, in June 2002, banks and financial institutions were asked to issue CDs only in dematerialised form. The minimum size of the issues was reduced again. At the instance of the Bank, the FIMMDA prepared and issued guidelines for issuing CDs, which contained standard procedures and documentation to be followed. Overall, higher credit growth, competitive resource mobilisation, differential perception on credit risk and bank-specific factors propelled the CD market’s growth during the period under review. Issuances of CDs came to depend not only on overall market liquidity conditions but also on bank-specific factors. Some foreign banks and banks in the private sector raised resources through CDs because they had a smaller retail network. Mutual funds increasingly invested in CDs to boost their returns from the money market.

Commercial Papers CPs are an unsecured money market instrument. These were introduced in India in 1990 to encourage corporate borrowers to diversify their sources of shortterm borrowings and to provide an additional instrument to investors. CPs are issued in the form of a promissory note. They are privately placed with investors through the agency of banks. Banks act as both principals (counterparties in purchase and sale) and as agents in dealership and placement. However, banks are not allowed to either underwrite or to co-accept issuance of CPs. The market for CPs in India is driven by demand from commercial banks. They prefer CPs due to the higher transaction costs of bank loans and the attractiveness of CPs as a short-term instrument during times of high liquidity. The secondary market for CPs was subdued on account of 204

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financial markets investors’ preference to hold on to the instrument due to higher risk-adjusted return relative to other instruments. The Bank encouraged the CP market by relaxing the guidelines for issuing CPs.21 The issuer base was widened by allowing PDs, satellite dealers and all-India financial institutions (apart from corporates) to access short-term funds through CPs. New guidelines in October 2000 further broadened eligibility, made credit rating of issuers mandatory, and specified the roles and responsibilities of the participants. In particular, the guidelines were to enable the companies in the service sector to more easily meet their short-term working capital needs. At the same time, banks and financial institutions were provided the flexibility to fix working capital limits, taking into account the resource position of companies’ finances, including CPs. In April 2003, banks and financial institutions were given the flexibility to provide credit enhancement for a CP issue by way of standby assistance and credit back-stop facility, subject to prudential norms. To grant further flexibility in the CP market, non-bank entities, including corporates, were allowed to provide an unconditional and irrevocable guarantee for credit enhancement of issue, subject to certain conditions. In October 2004, the minimum maturity period of CPs was reduced from fifteen days to seven days. The demand for CPs was generally inversely related to money market rates. Activity in the CP market picked up when good liquidity conditions enabled the entities to raise funds through CPs at an effective rate of discount lower than the lending rate of banks. Besides easy or tight liquidity conditions, a few other factors influenced transactions. For example, from mid-November 2003, the issuances of CPs picked up on account of increased interest shown by mutual funds and banks when the Reserve Bank issued new guidelines. Further, a reduction in stamp duty on CPs buoyed the market. As for issuers, manufacturing companies were prominent, but recorded a decline in the amount of CPs issued mainly due to larger internal accruals. Introduction of sub-PLR lending enabled corporates to raise funds at comparable rates from banks. Easier access to external commercial borrowings helped some large companies. On the other hand, large issuances of CPs by finance and leasing companies happened because of the phasing out of their access to public deposits. Investment interest by mutual funds followed the Bank’s guidelines on non-SLR securities by banks and a reduction in stamp duty.22 The spurt in 2007–08 may have been due to 205

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the reserve bank of india the amendment of the norms of an asset–liability management system for commercial banks. At the meeting of the Committee of the Central Board of Directors of the Bank on 18 September 2002, a Director observed that many banks borrowed money in the form of CDs at a higher rate than the rate at which they were lending through CPs of comparable maturity, which might affect their profitability. The remark led to a review of the use of these instruments by banks. It appeared that both decisions were driven by short-term liquidity conditions, which forced the banks to raise liquidity at high rates, and park surplus at a low rate in the absence of better alternatives. The Reserve Bank reviewed the CP market again in a status paper in July 2004. S. S. Tarapore, a former Deputy Governor of the Bank and himself a prominent policymaker in money market development, expressed reservations about certain aspects.23 Tarapore did not like reduction in the minimum rating for CPs, reduction in the maturity period to one day and the introduction of asset-backed CPs. He called these ‘avoidable’ measures, and warned: ‘The RBI must know that it will take just one CP failure to collapse the CP market, which it has so assiduously developed over the last 14 years.’ The criticisms had an immediate effect, and the Bank did not pursue many of these proposals. A study carried out by the MPD ( January 2008) revealed that both the CD and CP markets had remained concentrated. Smaller banks with limited branch networks generally mobilised funds through CDs, while public sector banks with surplus liquidity were the major investors in CPs. Divergence in the yields of these two instruments might have reflected differences in the strength of the balance sheets of these two sets of banks. Further, it was found that banks which issued CDs at a higher rate than the rate prevailing in the market had minimum exposure to CPs issued by companies. Thus, the two sets of operations might be viewed as a standard asset–liability management operation by banks without having much impact on profitability.

Commercial Bills, Interbank Participation Certificates and Money Market Mutual Funds The Reserve Bank controlled entry into the discount market. Several committees had in the past advocated measures to encourage bill rediscounting.24 206

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financial markets Notwithstanding these efforts, activity in the commercial bill market did not pick up substantially. As an additional instrument to even out short-term liquidity within the banking system, two types of interbank participation certificates – one on a risk-sharing basis and the other without risk sharing – had been introduced in October 1988. These instruments were also used by banks to meet priority sector norms. However, these had not been widely in use. The Bank guidelines governed the money market mutual funds (MMMFs), which invest in money market instruments. In 1999, the Bank withdrew its guidelines and the funds came to be governed by the Securities and Exchange Board of India (SEBI). However, banks and financial institutions that desired to set up mutual funds were required to seek necessary clearance from the Reserve Bank for undertaking this additional activity before approaching SEBI for registration. The resources mobilised were invested in the call money market, CDs, CPs, commercial bills, T-bills and dated government securities having an unexpired maturity up to one year. In October 1997, these mutual funds were allowed to invest in rated corporate bonds and debentures with a residual maturity up to one year. However, some prudential requirements continued.

Default Risk and Policy Norms Normally, the functioning of the money market was default free. However, instances of defaults in some segments of the money market were noticed. Between 2001 and 2004, a few cases, including that of a cooperative bank, were observed. Defaults were also reported in the CP market in 2003. The situation led to a discussion in the MPD. There was clearly a link between default risk and the moral hazard that might occur if risks were generally protected. International experience showed that in many countries, capital adequacy norms, contract law and bankruptcy law usually addressed default risks. The jurisdiction of the central bank was limited to the primary market for government securities and T-bills. Of course, if the default had the potential to destabilise the system, the central bank was likely to intervene. The MPD held the view that the default risk in the money market should be kept to the minimum as, otherwise, it could have a contagion effect in the economy, and that a self-regulatory organisation might be empowered to do 207

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the reserve bank of india the task. The FIMMDA, which had done substantive work on standardising market practices, was such a body. This course was preferable because moving the courts or the Company Law Board was time consuming. These issues were placed before the TAC at its meeting on 31 May 2004. A member expressed the view that international regulatory authorities did this job, and that the task could be assigned to the IBA rather than the FIMMDA. Another member pointed out that the RBI Act did not recognise any selfregulatory organisation.

Derivatives Deregulation of interest rates (Chapter 3) created risks stemming from unforeseen changes in interest rates. The Reserve Bank decided in October 1998 to encourage interest rate swaps, and allowed commercial banks, PDs and all-India financial institutions (excluding RRBs and mutual funds) to undertake forward rate agreements (FRAs) and interest rate swaps (Box 6.1), subject to the condition that risk management systems were put in place. Participants were also required to set up a sound internal control system, whereby a functional separation of trading, settlement, monitoring, control and accounting activities was provided. Corporates were also allowed to use these methods to hedge their exposures. In June 2003, banks, PDs and financial institutions were permitted to use interest rate futures. No specific permission from the Bank was needed to undertake these transactions, except to keep it informed. The FRA is a financial contract between two parties to exchange interest payments for a ‘notional principal’ amount – the nominal, or pre-determined, value used to calculate payments made on the derivative – on the settlement date, for a specified period from start date to maturity date. On the settlement date, cash payments based on contract and the settlement rate are made by the parties to one another. The settlement rate is the agreed benchmark or reference rate prevailing on the settlement date. An interest rate swap (IRS) is a financial contract between two parties exchanging or swapping a stream of interest payments for a notional principal amount on multiple occasions during a specified period.25

208

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financial markets Box 6.1 Derivatives A derivative is a contract that derives its value from the performance of the underlying entity. This entity could be an asset, index or interest rates. Derivatives are used for a number of purposes, such as insuring against price movements (hedging) and for speculation. Over-the-counter derivatives are contracts that are traded (and privately negotiated) between two parties without going through an exchange or other intermediaries. Products such as forward rate agreements and swaps are traded in this manner. Contracts are available for maturities up to one year. Derivatives serve to achieve a more complete financial system because previously fixed combinations of the risk properties of loans and financial assets can be bundled and unbundled into new synthetic assets. In other words, derivatives allow individual risk elements of an asset to be priced and traded individually, thus ensuring an efficient price system in the asset markets. Repackaging risk properties in this way provides a more perfect match between an investor’s risk preferences and the effective risk to the portfolio or cash flow. Deregulation of interest rates, which helped in making financial market operations efficient and cost-effective, brought to the fore a wide array of risks faced by market participants. In India, derivative instruments were available in the money market, foreign exchange market and equity market. Though some of the derivatives had recorded growth, the derivative markets as such faced rigidities on account of lack of (a) credible term money benchmark, (b) significant participation by large players such as public sector banks, mutual funds and insurance companies, (c) cash market for floating rate bonds and (d) transparency in price and volume information.

FRAs or IRS can be undertaken both for hedging underlying genuine exposure to risk and as a market-making activity, which would involve at times dealing in the market without underlying exposure. However, to ensure that market makers did not overextend themselves, they were required to place prudential limits on swap positions that may arise on account of marketmaking activity. Yet another instrument for managing risk was the exchange traded interest rate futures. Among other conditions, these entities had to become members of the futures and options segment of the stock exchanges for the limited purpose of undertaking proprietary transactions for hedging interest rate risk. The National Stock Exchange (NSE) introduced interest rate futures on cash-settled contracts on 24 June 2003.26 209

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the reserve bank of india In 2003, a working group on rupee derivatives recommended that the market regulator should lay down only broad eligibility criteria and the exchanges should be free to decide on the underlying stocks and indices on which futures were permitted.27 The broad eligibility criteria should focus on risk containment and manipulability. In the case of bond futures, contract settlement should be done on a delivery basis in order to ensure better integration between the spot market and futures market. It recommended a phased introduction of rupee option products, such as vanilla caps, floors and collars.28 Later that year (December 2003), the Committee on Rupee Interest Rate Derivatives29 noted that the exchanges had introduced yield-to-maturitybased contracts (yield to maturity, or YTM, is the estimated rate of return if the bond is held until maturity). The committee favoured a two-way position taking by banks in order to revive interest rate futures market and suggested that banks having adequate internal risk management and control systems, and robust operational framework could be allowed to run trading positions across various interest rate derivatives, including interest rate futures. The committee also recommended ‘marking-to-market’ to conduct a realistic appraisal of the financial situation for all interest rate products undertaken for trading purposes, including bonds, and the recording of unrealised gains and losses on derivative contracts on the balance sheet as an asset or liability. Further, to ensure that the futures reflected true expectations about the evolution of the cash market, the committee recommended the introduction of physical settlement (over cash settlement). The SEBI Advisory Committee on Derivatives and Market Risk Management in late 2003 also reviewed the product design. The exchanges, however, were not inclined to reintroduce interest rate futures based on the revised product design. The market response was weak.30 Initiatives like these failed to generate market interest in the products.31 The view of the exchanges was that banks, which formed the largest participant category in fixed income markets, did not play a major part. Since the Reserve Bank limited the participation of banks in futures to only hedge their government security portfolios, their interest was one-sided (net sellers of futures). With this limited one-way participation by banks, the futures market did not take off.

Government Securities Market The government securities market is the backbone of fixed income securities markets as it provides the benchmark yield and imparts liquidity to the 210

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financial markets financial system. From the perspective of the government, a deep and liquid government securities market facilitates its borrowings. For a central bank, a developed government securities market allows greater use of market-based instruments of monetary policy, such as open market operations and the repo. The debt markets in India are conventionally classified into three segments – the government securities market, the market for bonds of public sector units and the corporate debt market. Among the three, the government securities market is overwhelmingly large both in scale and importance as a policy instrument. Until the 1990s, the development of a liquid and active government securities market was impeded due to administered interest rates, automatic monetisation of fiscal deficits and a high SLR. With a captive investor base and low coupon rates on government securities, the secondary market for government bonds remained dormant. Artificial yields on government securities distorted the yield structure of financial assets in the system and led to a high-interest-rate environment in the rest of the market. As we have seen (Chapter 3), changes occurred in all these fronts from the 1990s and were taken forward in the period under review. In the early 1990s, the interest rates on government papers were made market related and the maturity periods reduced substantially. Since 1992, the borrowing programme of the central government had been conducted on an auction basis. Other reforms included the introduction of PDs, the DvP system for settlement of dealings and new instruments such as zero coupon bonds, partly paid stock and capital-indexed bonds (CIBs). Repos in government dated securities and T-bills of all maturities have been discussed in Chapter 3. These measures brought about a new treasury culture amongst banks and other financial institutions, one more sensitive to efficient management of liquidity. There were three phases in the reform process.

Phases of Reform in the Government Securities Market The first phase (1997–2000) saw a continuation of the earlier efforts towards building the infrastructure. The second phase (2000–05) focused on enhancing liquidity and safety, creating efficient and robust clearing and settlement systems, and building up of payment infrastructure. An especially relevant piece of legislation during this period was the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, which enabled the Bank to reorient the government debt management operations (discussed in Chapter 7), besides 211

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the reserve bank of india strengthening monetary operations. The third phase (2005–08) saw amendment of the laws relating to the issue and management of government securities – the Government Securities Act, 2006, and the Reserve Bank of India (Amendment) Act, 2006. These Acts have been discussed in Chapters 3 and 7. In the first phase, the system of PDs was strengthened to support the issuance programme and the secondary market. The market was expanded through the introduction of repos, by allowing FIIs to invest in government securities within limits and the introduction of CIBs. The mechanism of conducting auctions in government securities was refined by combining both price-based and yield-based auctions. The maturity for debt was made longer, and the emergence of a benchmark rate facilitated. Amendments to the Securities Contracts (Regulation) Act, 1956, gave the Bank more power to regulate dealings in securities and forward contracts from 1 March 2000. The scope of participation in the repo market was widened to all entities having SGL and current accounts with the Bank. In the second phase (2000–05), efficient clearing and settlement systems took shape. Consolidation of securities received attention, new participants were permitted in the market and processes like ‘short-sales’ and ‘when-issued’ were experimented with. The CCIL started in April 2001 and the NDS in February 2002. The NDS facilitated electronic bidding in auctions, secondary market transactions in government securities and dissemination of information on trades on a real-time basis. The CCIL introduced the CBLO (see earlier), which facilitated the move towards an interbank call market. Trading in government securities was introduced in stock exchanges. Non-banks were allowed to participate in the repo market. The government securities market became more diversified with the entry of high-net-worth individuals, cooperative banks, large corporates, mutual funds and insurance companies. The Reserve Bank had introduced the NDS to create an automated electronic reporting and settlement process and provide a platform for trading in government securities. The NDS helped in achieving paperless and straightthrough settlement of secondary market transactions and improved efficiency and transparency. However, the trading facilities in the NDS were hardly used, largely because they were not very user-friendly. To provide NDS members with a more advanced and efficient platform, the NDS-Order Matching (NDS-OM) module was introduced from 1 August 2005. The system was purely order-driven with all orders being matched based on price and time 212

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financial markets priority. The executed trades followed straight to the CCIL, in a ready-forsettlement stage. Further measures during these years dealt with maturity profile of securities, fungibility, liquidity, accounting norms and the introduction of derivatives. The uniform valuation basis, announced by the FIMMDA, provided transparency to the market and facilitated active management of portfolios. The regulatory and supervisory framework for PDs were strengthened. The Bank played a pivotal role in improving technology in financial market transactions. The Indian Financial Network (INFINET) facilitated an integrated payment and settlement systems and, in turn, encouraged retail electronic payment. In addition, the funds transfer module of the centralised fund management system was implemented and the RTGS system became operational. In the third phase (2005–08), the legislative framework was reformed. The Government Securities Act, 2006, repealed and replaced both the Public Debt Act, 1944, and the Indian Securities Act, 1920. With this enactment, the Bank had an instrument of transfer suitable to the present technological environment. It gave the flexibility to allow government securities to be held in depositories, while at the same time excluding government securities from the purview of the Depositories Act, 1996. The RBI (Amendment) Act and the FRBM Act have been discussed in Chapter 3. Both pieces of legislation deepened and widened the government securities market, and led to the withdrawal of the Bank from participating in the primary issues of government securities. A particular effect of the legislation was the facilitation of ready forward contracts. A Government of India notification dated 27 June 1969 under Section 16 of the Securities Contracts (Regulation) Act, 1956, had in effect prohibited forward contracts in securities. Nevertheless, banks did enter into buyback arrangements in government and other approved securities and public sector undertaking bonds. In 1987 and 1988, these practices were prohibited and, upon discovery of certain irregularities, a further ban on forward contracts was announced in 1992. The ban was partially relaxed in August 1994. In keeping with international practice and to make debt markets efficient, ready forward contracts were permitted in T-bills and government securities, subject to notifications issued by the Government of India on the recommendation of the Reserve Bank. It was necessary to avoid having to approach the government frequently and to devolve certain powers to the Bank. The High-Level Committee 213

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the reserve bank of india on Capital Markets, at its meeting on 31 January 2000, recommended demarcation of regulatory responsibilities between the Bank and SEBI. The Bank was to regulate any contract in government securities, money market securities, gold-related securities and securities derived from any of these, and in relation to ready forward contracts in bonds, debentures, debenture stock, securitised debt and other securities. However, in respect of these contracts, wherever entered into on the stock exchanges, the rules, regulations and bylaws under the Securities Contracts (Regulation) Act or directions issued by SEBI should apply. These changes were implemented in March 2000.

Retailing of Government Securities In order to promote the retail market in government securities, the Bank set up the system of PDs, satellite dealers and gilt funds, and permitted banks to buy and sell government securities. Retailing, however, did not take off. There were two main reasons for this. One was the favourable tax concessions available to investments in competing instruments, and the second was the higher returns and better services available in other avenues of investment.32 Moreover, small saving schemes were regarded not only as 100 per cent safe but also gave better returns and service to investors. The network of agents for mobilising small savings was well established. Several retail participants, notably the provident funds and small cooperative banks, felt comfortable buying government securities, provided they were sourced from the Bank rather than from a market intermediary. Further, provident funds lacked the expertise to operate in the secondary market or had misgivings about trades in the secondary market. As a result, there was limited participation by retail investors. To encourage small and medium investors to participate in primary auctions of government securities, non-competitive bidding was introduced in January 2002. This was open to any entity approved by the Bank. Some PDs introduced schemes for retail participation in government securities using the network of bank branches and post offices. The Bank had been encouraging PDs to offer two-way quotes to retail investors and to become members of stock exchanges. These measures did result in a more diversified holding of government securities. But retail investors remained marginal players. An anonymous order-driven screen-based trading for retail entities on stock exchanges was enabled in January 2003, again without much effect. 214

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financial markets Table 6.5 Role of Primary Dealers in the Government Securities Market Year 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Share in Primary Subscription (per cent) 58.5 51.5 52.9 40.4 43.7 57.1

Share in Market Turnover (outright, per cent) 27.8 25.2 25.3 31.1 29.1 18.1

Share of Government Securities in Total Assets (per cent) – End of March 83.9 82.2 61.0 62.0 55.0 70.0

Sources: Based on data from Rakesh Mohan, Growth with Financial Stability: Central Banking in an Emerging Market (New Delhi: Oxford University Press, 2011), p. 119, and Clearing Corporation of India Ltd., ‘Fact Book’. Data exclude devolvement but include the MSS and non-competitive bids.

There was a lack of ‘market makers’. Banks and PDs were not able to effectively market government securities, citing lack of investor interest and settlement issues.33 The Bank tried to enhance the secondary market in government securities. This discussion should begin with the PDs (also see Table 6.5).

Primary Dealers PDs are registered entities with the Bank, who are licensed to purchase and sell government securities. An applicant for PD authorisation should have registered as an NBFC at least a year prior to the submission of application. PDs are required to comply with the minimum turnover ratio, bidding ratio, underwriting ratio and rules regarding secondary market participation. PDs can be subsidiaries of commercial banks, subsidiaries of all-India financial institutions, companies under the Companies Act, 1956, engaged mainly in the government securities market, or subsidiaries of foreign banks and securities firms. PDs have five main obligations. First, they are required to participate in auctions for floatation of government dated securities and T-bills. Second, in their role as market makers, PDs should offer two-way quotes through the NDS-OM, over-the-counter market and recognised stock exchanges in India, and take principal positions in the secondary market for government securities. Third, a PD must have an effective internal control system for 215

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the reserve bank of india the fair conduct of business, settlement of trade and account maintenance. Fourth, PDs should achieve the prescribed annual minimum turnover ratio for government securities and T-bills, respectively, as laid down by the Bank. Fifth, they must comply with the prudential and regulatory norms. PDs bid at market auctions of government securities either on their own or on behalf of their clients and create a secondary securities market. Their performance is regularly reviewed by the Bank on the basis of their bidding commitments and the ‘success ratio’ achieved at primary auctions. They normally hold the most liquid securities in their portfolio. Their main sources of funds, besides their own capital and reserves, are market borrowings, liquidity support from the Bank, repo market borrowings and other instruments like CPs and inter-corporate deposits. The issue of liquidity support has been discussed in Chapter 3. The Bank supported the PDs with repos or refinance against central government securities. However, with the new system of underwriting commitment from April 2006, the Bank revised the method. Of the total liquidity support, half would be divided equally among standalone PDs and the remaining half extended on the basis of their performance in the primary auctions and turnover in the secondary market. Besides this, the Bank extended current account facility, SGL account facility (for government securities) with the Bank and the LAF, and favoured access to open market operations. The last facility was, however, subject to review, depending upon market conditions and requirement of funds. PDs could also become members of electronic trading, trading and settlement systems.34 The monitoring mechanism is a combination of on-site and off-site supervision. On-site inspections are conducted to assess the systems followed by PDs at intervals of one or two years. Off-site monitoring is mainly through three returns – a daily statement showing their sources and uses of funds, a monthly statement of their performance in respect of commitment obligations and a quarterly statement of capital adequacy. PDs were brought under the supervisory jurisdiction of the Board for Financial Supervision in 2002–03. They are also required to publish their annual audited results along with certain minimum disclosure norms in leading financial dailies and also on their websites. The system has worked well in their participatory functions in the government securities market, especially after April 2006. The Mid-Term Review of Monetary and Credit Policy for 2002–03 observed that the PDs had become systemically important and their participation in the money market 216

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financial markets was on par with banks and was quite significant. The Bank’s Annual Report for 2007–08 commended the key role played by PDs in the primary market activity such that reliance on the Bank in primary issuances had been greatly reduced, and government borrowings were completed successfully even after the Bank left primary market operations in April 2006.35

Instrument Development Prior to the 1990s, most government bond issuances were in the form of ‘plain vanilla’ fixed coupon securities. However, for a market to meet the diverse funding and hedging needs of the participants, a wider array of debt instruments was needed. Therefore, in the 1990s, various types of instruments had been introduced like the floating rate bonds (FRBs), CIBs and bonds with call and put options. But the plain vanilla bonds remained the mainstay.

Floating Rate Bonds and Capital-Indexed Bonds FRBs are medium- to long-term debt instruments offering variable coupons linked to some pre-fixed benchmark rate, say, yields on T-bills or money market rates. CIBs minimise inflation risk to the investors and issuers by adjusting both the principal and coupon payments to changes in inflation. CIBs are a preferred vehicle for investors sensitive to inflation risk. From the perspective of the issuers, CIBs help in reducing the cost of borrowing as they eliminate inflation-risk premium. The two most important issues relating to the design of CIBs are a selection of inflation risk and the indexation process to deal with inflation lag. In India, FRBs were issued by the government for the first time on 29 September 1995. As the first issuance failed to generate an enthusiastic response, no further issuance took place in the next six years. On 21 November 2001, FRBs were reintroduced with some modifications on the request of market participants. The overwhelming market response showed the way for subsequent issuances. Until 9 October 2004, ten issuances of FRBs were undertaken, the last two of which generated poor response. The main reasons for this were the strong credit pick-up, the low secondary market liquidity for FRBs and the complex pricing methodology followed by market participants. 217

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the reserve bank of india A 6 per cent CIB, 2002, was introduced in December 1997. The issue failed because, while these bonds offered inflation-hedging for the principal, the coupons of the bonds were left unprotected against inflation. The Bank worked out a modified structure in 2006. Around 2007, the Bank also simplified the method of pricing of FRBs in the secondary market.36 Among other bonds, in July 2002 the Bank issued a bond with an embedded put and call option (6.72 per cent Government Security 2012) exercisable on or after five years from the date of issue.37

Separate Trading of Registered Interest and Principal Securities (STRIPS) A road map for STRIPS (see Box 6.2) was prepared and placed on the Reserve Bank’s website in 2003. In response to the suggestions received, including those from a working group, the Bank planned to issue new securities to the extent feasible in the form of STRIPS. The Bank was to be the registry for stripped bonds. STRIPS were allowed to be undertaken in government securities from 1 April 2010. The Bank envisaged that in government securities STRIPS would ensure availability of sovereign zero coupon bonds, which would lead to the development of a market-determined zero coupon yield curve, provide institutional investors with an additional instrument and attract retail and non-institutional investors as they have zero reinvestment risk. Box 6.2 Features of STRIPS STRIPS is an acronym for Separate Trading of Registered Interest and Principal Securities. Stripping is the process of separating a standard coupon-bearing bond into its individual coupon and principal components. The mechanics of stripping neither impacts the direct cost of borrowing nor changes the timing or quantum of the underlying cash flows. Stripping only facilitates transferring the right to ownership of individual cash flows. STRIPS has the advantage of more accurate matching of liabilities without reinvestment risk and precise management of cash flows. Therefore, these instruments are preferred by pension funds, insurance companies, banks and hedge funds.

(Contd.) 218

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financial markets (Contd.) The objective of a scheme for gilt stripping facility was to develop an active government securities market for zero coupon bonds with a view to access long-term savings of different investor segments. Development of a STRIPS market was also part of strengthening the much-needed market infrastructure for the government securities market. Under the scheme, the central government dated securities were eligible for stripping. All investors who were eligible to invest in government stock were eligible for holding STRIPS, provided the investments were in dematerialised form. PDs and other entities permitted to undertake stripping of government dated securities could bifurcate the eligible stocks into two segments – stripped and non-stripped. The former had both principal and coupon STRIPS. Since coupon STRIPS with identifiable payment dates were fungible, they were traded freely without any distinction. No limits were fixed on the amounts or proportion of any gilt issue which could be stripped. Likewise, the limit on reconstitution facility would be the amount of the underlying asset. Stripping and reconstitution were undertaken by the Bank and PDs.

Short-Selling In the absence of instruments that allowed players to take a two-way view on interest rates, markets tended to be active and liquid when the rates fell but turned slow and illiquid when the rates rose. Low volumes rendered markets shallow and prone to price manipulations. An Internal Group on Central Government Securities Market considered this issue, and recommended short sales in government securities. This, it was expected, would enable market participants to express their views on interest rate expectations. In February 2006, banks and PDs were allowed to undertake outright sale of government dated securities that they did not own, subject to their being covered by outright purchase from the secondary market within the same trading day. The intra-day short-selling was permitted, subject to certain stipulations.38

‘When-Issued’ Trading The development of a ‘when-issued’ market (see Box 6.3) should be viewed as a useful step towards a more efficient price discovery process at primary auctions. This issue had been receiving the attention of the Bank since the early 2000s. 219

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the reserve bank of india Box 6.3 ‘When, As and If Issued’ Trading (WI Trading) ‘When, as and if issued’ (also known as ‘when-issued’) markets have been in place in many countries. The term refers to conditional security: one authorised for issuance but not yet actually issued. All ‘when-issued’ transactions are on an ‘if ’ basis, to be settled if and when the actual security is issued. In other words, it indicates a conditional transaction in a security authorised for issuance, but not as yet actually issued. ‘When-issued’ market facilitates the distribution period for government securities by stretching the actual distribution period for each issue and allowing the market more time to absorb large issues without disruption. As ‘when-issued’ transactions required a specific exemption under the Securities Contracts (Regulation) Act, 1956, or the SCRA, the functioning of the market became possible only after the relevant clause under the SCRA was amended in March 2000 (as mentioned earlier). The main advantages were the following: ‘When-issued’ minimised price and quantity uncertainties, resulted in increased confidence in such markets and encouraged participation from small investors; and because ‘when-issued’ trading facilitated price discovery and distribution, the risk of underwriting became smaller and potential subscription from new issue increased. Finally, ‘whenissued’ issue promoted liquidity, efficiency and integrity through higher turnover and narrower bid–ask spreads.

Until 2003, no sale transaction in government security was permitted without the seller actually holding the security in its portfolio. The Bank received frequent representations that these restrictions be relaxed. As settlement risk came down and most government securities transactions were settled through the CCIL, the Bank decided that the sale of government security, already contracted for purchase, would be permitted, provided such purchase contract was either guaranteed by an approved counterparty like CCIL or the Bank. To operationalise the proposal, settlement of government securities transactions was switched over to the DvP mode (November 2003). The internal Technical Group on Central Government Securities Market recommended the introduction of ‘when-issued’ trading in government securities. The guidelines on ‘when-issued’ trading in reissued central government securities were prescribed in May 2006, and trading started in August. After a review, the Bank decided to permit ‘when-issued’ trading in newly issued securities, and guidelines were issued in November 2006. 220

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financial markets

Mumbai Interbank Offered Rate (MIBOR) Mumbai Interbank Offered Rate, or MIBOR, is the interest rate at which banks can borrow funds in marketable size from other banks in the Indian interbank market. MIBOR is calculated every day by the NSE as a weighted average of lending rates of a group of banks on funds lent to first-class borrowers. The Committee for the Development of the Debt Market (RBI) first launched MIBOR in June 1998 as an overnight rate. The intention was to develop a benchmark rate for the call money market. The NSE introduced the fourteenday MIBOR in November 1998 and the one-month and three-month ones in December 1998. Since its launch, MIBOR rates have been used as benchmark rates for the majority of money market deals made in India.

Foreign Exchange Market The trends in the foreign exchange market have been discussed in earlier chapters, and do not bear repetition here (Chapter 4). Nevertheless, since the foreign exchange market is an integral component of the financial markets in India and the interlinkages among the three markets have been growing, a brief review of the growth of the foreign exchange market is in order. On 3 September 1999, Deputy Governor Y. V. Reddy, in his Keynote Address at the Third South Asian Assembly at Kathmandu, identified a number of major issues relating to foreign exchange market development that required rethinking. These included freedom to banks in the matter of limits on their borrowing and investment overseas and ceilings on interest rates and maturities of non-resident foreign currency deposits; extension of forward cover facility to FIIs; trading in derivatives; setting up a foreign exchange clearing house; and speeding up legislative changes critical to the development of a foreign exchange market. Deputy Governor Reddy said that an efficient and vibrant foreign exchange market was a priority among steps to develop financial markets. The developments in the foreign exchange market may be broadly classified under three heads: strengthening the institutional framework, instrument development and liberalisation. In the area of the institutional framework, the enactment of the new Foreign Exchange Management Act, 1999, resulted in the delegation of considerable powers to banks and ADs to release foreign exchange for a variety of purposes. The scope of outward remittances for corporates and individuals was expanded. The method of 221

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the reserve bank of india foreign exchange clearing settlement was streamlined from 2001. The CCIL offered efficient and speedy clearance and settlement of interbank dollar– rupee transactions. The foreign exchange market in India, besides the spot segment, trades in derivatives, such as forwards, swaps and options. Foreign exchange swaps, since 2001, accounted for the largest share of total derivatives turnover in India, followed by forwards and options. However, the options remained insignificant. Currency futures were introduced in September 2008 for trading in dollar–rupee contracts. The Bank set up a technical group (2005) to review these initiatives. Some measures that followed the recommendations of the group were to allow cancellation and rebooking of all eligible forward contracts booked by residents, permit banks to approve proposals for commodity hedging in international exchanges from their corporate customers, extend the closing time by one hour for interbank foreign exchange market in India and disseminate the Bank’s part of information on trading volumes for derivatives. Private companies and investors looked for avenues to hedge their exposures to the rupee. As a result, non-deliverable forwards, or NDFs, became a popular derivative instrument for meeting the offshore investors’ demand for hedging. NDFs are derivatives used for trading in non-convertible or restricted currencies without delivery of the underlying currency. The NDF market for Asian currencies is largely concentrated in Singapore, where the rupee is one of the major traded currencies. The NDF market for the rupee had been in existence from the late 1990s to counter exchange control regulations in India. The INR NDF market also derived its liquidity from non-residents wishing to speculate on the rupee without any exposure to the currency, and arbitragers who exploited the differentials in the prices in the two markets. The spread, as well as the volatility, of the INR NDF was higher than that of onshore spot and forward markets. Though an accurate assessment of the volumes is difficult, the estimated daily turnover was reported to be around $100 million in 2003–04.

Conclusion A reassessment of the development of the financial market outlined in the chapter should acknowledge the sustained and effective attempt at structural reform, which touched institutions, instruments, procedures and participants with a particular emphasis on money market microstructure. All of these measures added depth and liquidity to the money market and government 222

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financial markets securities transactions and contributed to a reduction in transaction cost. It is worth keeping in mind that the period under review witnessed relatively stable macroeconomic conditions, and robust economic growth in the second half, which made the transition to a new market regime relatively easy.

Notes

1. The TAC was constituted on 12 July 1999 by merging two committees – the Standing Committee on Money Market and the Technical Committee on Government Securities Market – for a tenure of two years. Thereafter, the committee was reconstituted thrice during the reference period. 2. See Reserve Bank of India, The Reserve Bank of India, Vol. 4: 1981–1997 (New Delhi: Academic Foundation, 2013). 3. Especially the Report of the Working Group on the Money Market (Chairman: N. Vaghul) in 1987. 4. Chairman: M. Narasimham, also known as the Narasimham Committee II. 5. Mid-Term Review of Monetary and Credit Policy for 1998–99 (October 1998). 6. The implementation path was more liberal as can be seen from Table 6.2. 7. Which required that mismatches during the first two ‘time buckets’ – one– fourteen days and fifteen–twenty-eight days – should not exceed 20 per cent of the cash outflows in each time bucket. 8. A twofold strategy was adopted in order to ensure that these banks did not face any disruption in their asset–liability management. Borrowers and lenders were allowed to unwind their positions by 4 October 2002. The application of caps on banks was undertaken in two stages, one stage from the fortnight beginning 5 October 2002 and another from the fortnight beginning 14 December 2002. However, banks facing mismatches were allowed to approach the Reserve Bank for temporary access to the call money market in excess of the limit. Any increased access over stipulated norms was also permitted for a longer period for banks with fully functional and satisfactory asset–liability management systems. Under these rules, from 14 December 2002, banks were allowed to lend up to 25 per cent of their owned funds on a fortnightly average basis, and up to 50 per cent of such funds on any day during a fortnight (also see Table 6.3). Similarly, they were allowed to borrow up to 100 per cent of their owned funds or 2 per cent of aggregate deposits, whichever was higher, fortnightly and up to 125 per cent of their owned funds on any day during a fortnight. PDs were allowed to lend up to 25 per cent of their net owned funds on average basis during a reporting fortnight from 5 October 2002. A two-stage call money market borrowing restriction on PDs of up to 200 per cent and up to 100 per cent, respectively, of their net owned funds as at the end 223

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the reserve bank of india of March of the preceding financial year was to become effective, contingent upon greater deepening of the repo market. 9. The TAC at its meeting on 18 January 2005 favoured migration to capital funds as the benchmark for fixing prudential limits for the call money market only in the case of commercial banks. The Annual Policy Statement for 2005– 06 announced that the benchmark for fixing prudential limits on exposures to call or notice money market for commercial banks would be linked to their capital funds. 10. Net lending through repo and collateralised transactions by non-banking financial institutions and mutual funds also increased. Banks on their own scaled down their lending and borrowings in anticipation of introduction of limits while foreign banks’ borrowing went down. 11. The amount accepted under the Bank window showed an increasing trend, with SBI and other public sector banks being the major suppliers of funds in this window. 12. Which could be attributed to the regulated interest rate structure, statutory preemptions on interbank liabilities, cash credit system of financing and high volatility in call rates, among other factors. 13. Products such as floating rate loans, debt instruments, interest rate swaps and foreign exchange products like forwards. 14.  For example, IDBI, NABARD, and Industrial Credit and Investment Corporation of India (ICICI). The DFHI was permitted in the term money market for three to six months’ maturity. 15.  Annual Report for 2003–04 and, later, the Report of the Working Group on Term Money Market (2009). 16. The credit–deposit ratio was well below 1, thereby minimising the need for borrowed funds for funding the balance sheet. The lending rates were almost entirely linked to internal benchmarks like the prime lending rate (PLR) or mandated for certain sectors such as agriculture, housing and exports. As a result, the need for a floating rate benchmark for pricing loans was not felt as much. The smaller role of foreign banks together with prudential limits on foreign currency borrowings by all banks restricted the use of foreign currency swaps to fund domestic assets. Unsecured interbank funding was on the decline globally as it attracted regulatory capital charges. 17. The 14-day and 91-day T-bills were issued on a weekly basis for 1 billion each, and 182-day and 364-day T-bills on a fortnightly basis, by rotation, for 1 billion and 7.50 billion, respectively. 18.  Novation: replacing borrower and lender in a contract with itself or of replacing one debt or obligation with another. 19. Haircut: a reduction applied to the value of an asset. 20. Following the amendments to the Securities Contracts (Regulation) Act, 1956. 224

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financial markets 21. The minimum maturity period was brought down from three months to thirty days (April 1997). The minimum size of issue was reduced from 1 million to 0.5 million, and CPs above 0.5 million could be in multiples of 0.1 million (October 1997). 22. The CP market was dominated by first-class prime rated issuers (that is, P1+ above of CRISIL or equivalent). Issuances of CPs slowed down during the second half of 2005–06, but the generally rising trend was maintained in 2006–07 and 2007–08. 23. ‘RBI Revisits Commercial Paper Guidelines’, Financial Express, 28 July 2004. 24. The Working Group on Bills Rediscounting by Banks (Chairman: K. R. Ramamoorthy, 2000) examined, among other matters, the possibility of strengthening the existing bill discounting mechanism and extending its scope to the service sector. 25. Such contracts generally involve exchange of a ‘fixed-to-floating’ or ‘floatingto-floating’ rates of interest. On each payment date that occurs during the swap period, cash payments are made by the parties to one another. 26. Three types of contracts for maturities up to one year were made available: futures on 10-year Government of India security, futures on 10-year zerocoupon Government of India security and futures on 91-day T-bills. However, these instruments did not attract good response and trading died. 27. Chairman: Jaspal Bindra, January 2003. 28. A cap is an interest rate limit on a variable rate credit product. It is the highest possible rate a borrower may have to pay and also the highest rate a creditor can expect to earn. The cap is advantageous to borrowers since it limits the level of interest they have to pay in a rising environment and sets a maximum level of return for the lender or investor. A floor sets a base level of interest that a borrower must pay and also sets a base level of interest that a lender or investor can expect to earn. An interest rate collar ensures that the borrower will not pay any more than a predetermined level of interest on his borrowings. Variable rate borrowers are typical users of interest rate collars. They use collars to obtain certainty for their borrowings by setting the minimum and maximum interest rates they will have to pay on their borrowings. 29. Chairman: G. Padmanabhan. 30. A subcommittee of the TAC was set up as a working group on reintroduction of interest rate futures (Chairman: V. K. Sharma, June 2007), which included representatives from the FIMMDA, the Association of Mutual Funds in India, SEBI, the NSE and other bodies. The report was finalised by the Bank in August 2008.There were a number of recommendations to activate interest rate futures. 31. For one thing, the market did not seem to be comfortable with the product design. The bond futures were priced off a zero coupon yield curve derived by 225

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the reserve bank of india the exchange. As bond markets traded on YTM basis, and as large sectors of the YTM curve were illiquid, the derived zero curve did not effectively mimic the price movements in the underlying bond market. 32. Tax exemptions for investment in mutual funds were subject to 10 per cent dividend tax, giving equity funds an edge over 100 per cent gilt funds. The National Savings Scheme (of the Government of India) had attractive tax concessions and offered higher returns compared to government securities. 33. Incidentally, certain provisions in the new Government Securities Act, 2006, aimed to facilitate wider participation in the government securities market. These provisions included protection to the beneficial owners of government securities through the constituent general ledger accounts, enabling lien marking and pledge of securities for raising of loans against government securities, and liberalisation of norms relating to nomination and legal representation, thus facilitating easier transfer of securities. 34. They had to meet three main regulatory requirements relating to minimum capital to be deployed in government securities, leverage and capital adequacy. 35.  Also see Rakesh Mohan (2011), ‘Development Banking and Financial Markets in India’, in Rakesh Mohan, Growth with Financial Stability (New Delhi: Oxford University Press, 2011), p. 118. There was a brief experiment with the idea of satellite dealers in order to provide PDs with supporting infrastructure. The entry requirements were similar to those in the case of PDs, except that the limits to their turnover size was lower. However, the discussions that took place at the meeting of the TAC in March 2000 showed that their expected role was not clearly defined. Members expressed divergent views on this point, and some even argued that satellite dealers, instead of playing a complementary role with PDs, were in fact competing with them. The Bank discontinued the system from April 2002. 36. The Bank proposed to use the average cut-off yield on 182-day T-bills instead of the yield on 364-day T-bills as a benchmark rate for the FRBs to be issued in future. 37. A put option is a type of derivative contract that gives the buyer the right to sell the underlying asset at a specified price during a set period of time. A call option is a type of derivative contract that gives the buyer the right to buy the underlying asset at a specified price during a set period of time. 38. In January 2007, participants were permitted to keep their short positions open up to five trading days, including the day of trading. With a view to enable participants to short positions across settlement cycles, banks and PDs were allowed to use the securities acquired under a reverse repo (other than the LAF) to meet the delivery obligation of the short sale transaction. The total reported short sale volume was about 79 billion (0.4 per cent of total volume of government securities) during 2006–07. 226

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7 Public Debt Management

Introduction The Reserve Bank manages the debt of the central and state governments and acts as a banker to them under the provisions of the Reserve Bank of India (RBI) Act, 1934. While these functions are obligatory in the case of the central government, the Bank undertakes similar functions for state governments by agreement with the governments of the respective states. All states have such agreements.1 During the years covered in the book, major institutional reforms were undertaken that redefined the relationship between the Government of India and the Reserve Bank, facilitated market borrowing, introduced new instruments and participants in the government securities market, and contributed to a significant improvement in the state governments’ fiscal and debt management. Many of these changes followed the Fiscal Responsibility and Budget Management Act, 2003 (FRBM Act), and similar legislation passed at the level of the states. The chapter describes this transition. It covers four main topics, which are the system of public debt management, operation of the system in respect of the central government and state governments during the reference period and miscellaneous issues not covered elsewhere.

The System of Public Debt Management Objectives

As the manager of public debt, the Bank’s overall objective was to ensure smooth completion of the annual market borrowing programmes (MBPs) of the central and state governments. The Bank tried to pursue debt management in such a manner that the design of the programme was consistent with monetary policy and financial development goals. While performing this role, 227

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the reserve bank of india the Bank tried to achieve three broad aims: minimise cost, mitigate risk and develop the government securities market. During the reference period, cost minimisation was sought to be achieved by proper demand estimation and planned issuance and offering of appropriate debt instruments. The sovereign debt portfolio is exposed to rollover risk (risk associated with old debt maturing and rolling over into new debt), currency and exchange risks and sudden-stop risks (abrupt cessation of capital flow). Even though raising debt in foreign currency might at times be cost-effective, and provide a wide and varied investor base, such dependence could mean exposure to sharp volatility in the exchange rate. Given these considerations, no sovereign foreign currency bonds were issued by India. Investment limits for foreign institutional investors in government securities were enhanced in a phased manner. The limits were apportioned to different categories of investors, with a preference for long-term investors and investments in longer maturities.

Strategy The debt management strategy during the period of study concentrated mainly on diversification of investor base, managing maturity profile of marketable debt, the timing of issuance, consolidation of debt stock and managing the composition of different instruments. Steps to diversify the investor base could potentially mitigate risks by reducing ‘herd mentality’. In the government securities market, banks were initially the main investors in the short- to medium-term securities, and insurance companies and provident funds the main investors in long-term securities. Over time, cooperative banks, regional rural banks (RRBs), pension funds, mutual funds and non-banking financial companies (NBFCs) also entered the market. During the period of the study, the Reserve Bank took several steps to promote retail participation. Longer maturity of the portfolio can potentially limit rollover risk. Securities with short maturities also put pressure on government finances due to bunched repayments and refinance risk (the possibility of reissues not being fully subscribed). These risks can be mitigated by limiting issuances in short-term bonds and increasing issuance of medium-term and longterm bonds, subject to investor preferences, and the shape of the yield curve. This broad aim was achieved by reducing issuance of one–five-year maturity bonds, moderating issuance in five–nine years and increasing the share of 228

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public debt management the ten–fourteen-year tenor. Bonds in tenors of more than fifteen years were increasingly issued to meet the needs of insurance companies and provident funds. Banks responded to this move robustly. The weighted average maturity (of new loans) increased from 6.6 years in 1997–98 to 14.3 years by 2001–02 and stabilised around that level thereafter. Considering the trade-off between the carrying cost and uncertainties in market timing, the Reserve Bank’s strategy involved making the timing of issues coincide with favourable liquidity and yield environment. To meet any unanticipated needs of the government or when the market sentiment was rather uncertain or when liquidity conditions were unfavourable, the Bank resorted to primary acquisition of government bonds through private placement or devolvement. This practice continued until the FRBM Act became operational from April 2006. Consolidation of debt stock could help in the emergence of benchmark securities in the market, and thus aid the price discovery process. During the reference period, active consolidation was not resorted to in view of administrative cost and legal considerations, but because of continued issuance of bonds in benchmark securities, a passive consolidation did take place.2 The Bank attempted to issue a variety of instruments of varying maturities to cater to the preferences of different investors, besides fixed dated securities. For example, some investors (banks and financial institutions) might like to invest in floating rate bonds for their duration management. Similarly, institutional investors, such as insurance companies, provident funds and pension funds, would prefer to buy long-term bonds, zero coupon bonds and inflationindexed bonds for liability management. During the reference period, inflation-indexed bonds and bonds with call and put options were issued. Several other steps to develop the government securities market, including changes in the mode of settlement, strengthening of primary dealer mechanism and creation of new instruments, have been discussed in the chapter on financial markets.

The Institutional and Legal Framework

To keep pace with the developments taking place in the financial markets and provide an investor-friendly legal framework, the Reserve Bank drafted a new law, the Government Securities Act, 2006, which was enacted in August 2006. This Act replaced the Public Debt Act, 1944, and the now repealed Indian Securities Act, 1920. The Government Securities Regulations, 2007,

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the reserve bank of india Table 7.1 Debt Management Functions of the Reserve Bank of India Policy

Set debt management objectives, design annual debt management programme, a mix of debt instruments and devise the structure of stock of debt. All these are done in consultation with the Ministry of Finance.

Primary

Planning

Estimate borrowing requirement in consultation with the Ministry of Finance Operational

Debt service

Coordination

Financial market

Payment of interest and redemption

Primary issues

Secondary market

Marketing

Issue dated securities and treasury bills

Manage outstanding debt

Organise sale of securities

Advisory and research

Coordinating public debt and monetary management

Develop financial markets

Advise government on cash and debt management, research practices and developments in the field, and disseminate information on new practices to achieve transparency and efficiency.

were framed by the Bank in accordance with the Act, which came into force from 1 December 2007. The new Act and the regulations allowed for automatic redemption facility, the facility of pledge or hypothecation or lien on government security, simplified procedures and documentation, and nomination facility of securities. The Act empowered the Bank to call for information, cause inspection, issue directions in relation to government securities and impose a penalty in case of contravention of the Act. Public debt management involved several institutions, which are described in Tables 7.1 and 7.2. The Bank’s responsibilities may be classified under three categories. First, as an adviser, the Bank keeps the Ministry of Finance informed of the conditions in the financial system, especially the liquidity conditions in the banking sector and timing of issuance of government securities, so that the fiscal deficit is financed and monetary policy objectives are served. Second, as the issuing agency and redemption agent, the Bank devises procedures for issue and delivery of securities, collection of payments and redemption of securities. Third, as the fiscal agent, the central bank makes payment to and receives payment from investors. Further, as the 230

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public debt management Table 7.2 Institutions Responsible for Internal Public Debt Management (as of March 2008) Central Government Debt

Ministry of Finance

Reserve Bank of India

Sets borrowing programme in consultation with the Reserve Bank. Decisions on instruments, method and calendar of issuance of securities.

As the regulator of markets, manages primary market functions, such as auction procedures, and the functioning of financial markets, including the government securities market. Also attends to depository and servicing functions, clearing and settlement systems, technological innovations, and regulatory and supervisory matters. State Government Debt

State government

Reserve Bank of India

Debt of state governments is a state subject.

The Reserve Bank manages the debt of state governments in accordance with the agreements entered into with the respective states.

State legislatures have exclusive power to make laws relating to the debt of the state concerned.

The quantum of annual borrowing was (during the period of study) decided upon in advance in consultation with the Planning Commission and the Ministry of Finance, Government of India.

Controller General of Accounts

Maintains accounts of public debt.

Controller General of Accounts

The debt accounts are maintained by the Controller General of Accounts of the state concerned.

banker to the government, the Bank holds government deposits. In the light of its monetary policy role, the Bank has been made responsible for secondary market functions.

Coordination between the Government and the Reserve Bank One of the most important parts of the process of debt management is the coordination between the Bank and the Ministry of Finance. There were 231

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the reserve bank of india changes in the framework of coordination since the late 1990s. Following the Supplemental Agreement with the Government of India, the issuance of ad hoc Treasury Bills (T-bills), which led to automatic monetisation of the fiscal deficit, was discontinued from 1 April 1997.3 At the same time, a system of ways and means advances (WMA) was instituted. The term refers to the temporary accommodation granted by the Bank to the central government to meet mismatches in its receipts and payments. As ad hoc T-bills were phased out, and reliance on high-cost sources of funds like small savings reduced, market borrowings increased. With the increase in market borrowing, the major risk associated with the management of public debt was the size of the debt itself. It exerted pressure on the capacity of the market and on yields (Appendix 7A.1). Since the early 2000s, the Bank adopted various measures to deal with this situation, including market-related primary issuance of government securities, the introduction of instruments and alignment of maturity periods of new issues of debt, while keeping in view the redemption pattern of the existing stock. In view of these challenges, the Bank and the government recognised the need for greater coordination. The coordination was to be achieved mainly by four means. First, the Monitoring Group on Cash and Debt Management, consisting of the officials of the Ministry of Finance and the Bank, met periodically (usually twice a year) to assess the fiscal situation and the implications for borrowing requirements. Second, the Financial Markets Committee (FMC-RBI) operating within the Bank met daily, or, if necessary, more frequently, to share information on the government’s liquidity needs and market conditions. Third, debt management officials participated in the monthly monetary policy strategy meetings. Fourth, the Bank was involved in the annual pre-Budget exercise of the government which sought to achieve consistency between monetary and fiscal programmes. The FRBM Act was a landmark step in creating an operational rule for fiscal policy and defining the roles and responsibilities of the central government and the Bank in public debt management.

The Making of the FRBM Act Responsible fiscal policy had become an urgent matter in the 1990s. The Bank through its annual reports, speeches of Governors in various forums and in correspondence with the government repeatedly stressed this point and mooted 232

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public debt management the idea of a fiscal responsibility legislation.4 The Bank had also been trying to advocate prudence in extending sovereign guarantees, which resulted in some states passing legal enactments and the Government of India creating a guarantee fund. State Finance Secretaries were working as a committee assisted by the Bank on issues relating to the Budget process and transparency.5 The first intimation of a proposal for a Fiscal Responsibility Bill (as it was named then) came from the Ministry of Finance on 1 December 1999. Initially, the Finance Minister decided to ask then Deputy Governor Y. V. Reddy to head a committee to be set up to draft this legislation.6 However, Reddy’s reluctance to head a fiscal legislation led to a compromise. A committee was set up under the Economic Affairs Secretary, E. A. S. Sarma.7 Within the Bank, an internal working group under then Deputy Governor Reddy’s chairmanship was created to provide technical assistance to the committee.8 The Bank’s assignment was completed in about six months. The team produced an approach paper and a preliminary draft of the Bill. In the draft Bill proposed by the Bank, the objective of the legislation was ‘to promote a rulebased fiscal behaviour within the government with a view to restoring fiscal discipline’. In the draft that was finally adopted, the wording changed. The Bill was expected ‘to provide for the responsibility of the Central Government to ensure inter-generational equity in fiscal management and macro-economic stability by progressive elimination of revenue deficit, removal of fiscal impediments in the effective conduct of monetary policy and prudential debt management....’ Both versions retained an accent on transparency. Subsequently, certain other suggestions of the Reserve Bank’s working group were not incorporated by the government in the draft Bill, for instance, (a) provision for an independent section stating that the Act would be binding on the central government, (b) a clause stating, among other things, that ‘every fiscal policy statement shall be accompanied by the statement of responsibility, signed by the Finance Minister of the Government’ and (c) a clause proposed by Governor Jalan relating to the deficit of public sector undertakings (PSUs).

Passage of the FRBM Bill The FRBM Bill, 2000, was introduced in the Lok Sabha in December 2000. The Parliamentary Standing Committee on Finance was of the view that, 233

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the reserve bank of india while planned deficit financing was a good idea, the numerical ceilings and the time frame set for attaining the levels induced excessive rigidity into decisionmaking. Therefore, the committee recommended that the numerical targets should be incorporated in the rules to be framed under the Act, rather than in the Act itself. The Bill became law in May 2003. In accordance with the new Act, the government framed the FRBM Rules, 2004, which became effective from 5 July 2004. The rules set targets for phased reduction in key deficit indicators over the period ending 31 March 2008. The rules also imposed annual ceilings on government guarantees and additional liabilities.9 Although both the Bank and the government, in their assessments of the operation of the FRBM Act, congratulated themselves on the steps taken, economists and media experts expressed misgivings, especially on the ‘dilution’ of the original draft. In an interview to Business Standard (28 February 2008), Economic Affairs Secretary Sarma commented that the Act, though a big step forward, was a weaker version than the draft recommended by the committee. The point was reiterated in a stronger language in the Indian Express (22 December 2003) and by Saumitra Chaudhuri of the Investment Information and Credit Rating Agency of India Limited,10 as reported in the Financial Express (3 November 2002). C. P. Chandrasekhar and Jayati Ghosh in Business Line (7 July 2004) considered that by ruling out loans from the Reserve Bank, the Act also ruled out a cheap source of borrowing, and forced the government to borrow at higher rates ‘for no evident reason’. They were uneasy about the stipulation that when there was a shortfall in revenue, the government might cut expenditures even if the expenditure was necessary. One specific point of criticism related to the enforcement provisions. If a target was missed, the law required the government to report to Parliament, outlining the reasons for the overrun. The fiscal rule in the FRBM Act was narrow, in that it kept public sector enterprises, state governments and their enterprises outside its ambit.11 However, others felt that the FRBM Act did adopt rather more exacting transparency requirements.12 It required the executive to submit to Parliament additional documentation in support of the Budget. The main features of the Act and the Rules are shown in Box 7.1.

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public debt management Box 7.1 Main Features of the FRBM Act, 2003, and the FRBM Rules, 2004 The Act

The central government to take steps to reduce the fiscal deficit to eliminate revenue deficit by 31 March 2008 and thereafter build up adequate revenue surplus. Rules made under the Act would specify annual targets for the reduction of fiscal deficit and revenue deficit, contingent liabilities and total liabilities. The deficit may exceed targets on exceptional grounds such as national security or national calamity. The central government shall not borrow from the Reserve Bank except by way of advances to meet temporary excess of cash disbursements over cash receipts. The Bank would not subscribe to the primary issues of central government securities from 2006–07. The central government to take steps to increase transparency of fiscal operations. The central government to submit in each financial year before Parliament a Medium-Term Fiscal Policy Statement, a Fiscal Policy Strategy Statement and a Macroeconomic Framework Statement, along with the Annual Financial Statement and Demand. The Finance Minister to make a quarterly review of the trends in receipts in relation to the Budget and place the review before Parliament.

The Rules

Gross fiscal deficit to be reduced by 0.3 per cent or more of GDP every year, beginning 2004–05, so that it did not exceed 3 per cent of GDP by end of March 2008 (later extended to end of March 2009). Revenue deficit to be reduced by 0.5 per cent or more of GDP at the end of each year, beginning 2004–05, to achieve elimination by 31 March 2008, as prescribed in the FRBM Act (later extended to end of March 2009). Contingent liabilities: The central government shall not give guarantees aggregating to an amount exceeding 0.5 per cent of GDP in any financial year, beginning 2004–05. Additional liabilities (including external debt at current exchange rate) shall not exceed 9 per cent of GDP for the year 2004–05. In each subsequent year, the limit of 9 per cent of GDP shall be progressively reduced by at least 1 percentage point of GDP.

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the reserve bank of india

Changes Implemented by the Reserve Bank following the FRBM Act The three key provisions of the Act were: (a) from 1 April 2006, the Reserve Bank would be prohibited from subscribing to the primary issues of central government securities, (b) the government could not borrow from the bank except by way of advances to meet temporary excess of cash disbursements over cash receipts during any financial year following agreements between the government and the Bank and (c) the Bank could buy and sell government securities in the secondary market. These provisions could be relaxed in exceptional circumstances. In the context of the FRBM Act, the Annual Policy Statement for 2005– 06 indicated reorientation of government debt management operations, while strengthening monetary operations within the Bank, with a view to moving towards functional separation between debt management and monetary operations. Accordingly, on 6 July 2005, the Bank formed a Financial Markets Department (FMD). Its functions included monetary operations, such as open market operations (OMOs), the liquidity adjustment facility (LAF), standing liquidity facilities and the Market Stabilisation Scheme (MSS); regulation and development of money market instruments such as call/notice/ term money, market repo, collateralised borrowing and lending obligation (CBLO), commercial papers (CPs) and certificates of deposit; and monitoring of money, government securities and forex markets. The Bank’s role in the primary market was supplemented by the more active participation of primary dealers (PDs) (see Chapter 3). PDs undertook to participate regularly in the auctions of newly issued government securities. They bid at the government securities auction either on their own behalf or on behalf of clients and created a secondary market for these securities. They underwrote, made two-way quotes and had access to the call and repo markets for funds. The main sources of funds for the PDs, besides their capital and reserves, were market borrowing, the Bank’s liquidity support, borrowings in the repo market and other instruments like CPs and intercorporate deposits. On 27 February 2006, the Bank issued guidelines on the expansion of PD business to banks that fulfilled certain minimum eligibility criteria. Operational guidelines, which permitted standalone PDs to diversify their activities in addition to their core business of government securities, were issued on 4 July 2006. Following the report of the Internal Technical Group on 236

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public debt management Central Government Securities Market (2005), a revised scheme for obtaining underwriting commitment and providing liquidity support to PDs was introduced in April 2006. This was necessary as the system of annual bidding commitments neither guaranteed that the notified amount would be sold in each auction nor ensured that the cost of issuance was minimised. Accordingly, instead of bidding commitments, PDs were required to underwrite the entire notified amount of an auction. The Bank, from April 2006, was prohibited from participating in the primary auctions of government securities barring exceptional circumstances. This situation necessitated making changes in the procedures for floatations of government debt. The Bank’s role in the primary market (vis-à-vis new floatations) was substituted by more active and direct participation by PDs. Key institutional changes in the payments and settlement system facilitated this transition (see Chapter 8).13

Separation of Debt and Monetary Management An important aspect of debt management is the coordination between monetary and fiscal authorities.14 The Committee on Capital Account Convertibility15 advocated separation of debt management from monetary management and recommended the setting up of a separate Office of Public Debt by the government. A working group studied this recommendation of the committee and identified four types of conflict that could arise from the central bank undertaking policy decisions on debt management and monetary management simultaneously.16 These were: explicit or implicit pressure from the government to monetise fiscal deficit, imposition of large mandatory reserve requirements on banks and financial institutions to reduce the cost of government borrowing, monetary policy being manipulated to complete borrowing programme, and enlarging the volume of short-term debt under expectations of rollovers at lower yields in later years, in effect bringing about distortions in the debt maturity profile. The working group recommended the establishment of an independent company under the Companies Act, 1956, as a wholly owned subsidiary of the Bank, to take over the debt management function.17 In the 2000s, more support gathered in favour of separation. The views expressed by various committees are briefly enumerated in Box 7.2. 237

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the reserve bank of india Box 7.2 Functional Separation of Debt Management from Monetary Management: Views Expressed by Various Committees Internal Expert Group of the Ministry of Finance (Chairman: A. Virmani, 2001): Recommended a two-stage process to separate the two functions, namely setting up a centralised middle office in the Ministry of Finance to develop a comprehensive risk management framework and then establishing an autonomous Public Debt Office. Kelkar report submitted to the Ministry of Finance (2004): Emphasised the need for fiscal consolidation and recommended setting up a National Treasury Management Agency, an independent body, distancing the treasury function from the central bank.

High Powered Committee on Making Mumbai an International Financial Centre (Chairman: Percy Mistry, 2007), submitted to the Ministry of Finance: Recommended, among other steps, the creation of a Debt Management Office separate from the Reserve Bank.

Internal Working Group set up by the Ministry of Finance (Chairman: Jahangir Aziz, October 2008): Highlighting internationally accepted best practices, citing, inter alia, the guidelines on public debt management issued by the IMF and the World Bank (in 2003), recommended that debt management should be disaggregated from monetary policy and taken out of the realm of the central bank, and the establishment of a statutory body (that is, the National Treasury Management Agency) to perform debt and cash management. Also of note were the Committee on Financial Sector Reforms constituted by the Planning Commission (Chairman: Raghuram Rajan, 2009) and the Committee on Financial Sector Assessment, or CFSA (Chairman: Rakesh Mohan, 2009). The chairman of the latter committee did not favour separation of debt management from the Bank.

The Bank, on its part, took the view (about the year 2000) that the separation could be seen as a medium-term goal, subject to meeting three preconditions. These were: development of the securities market, durable fiscal correction and an enabling legislative framework. Governor Jalan, in the Monetary and Credit Policy Statement for 2001–02, observed that since progress had been made on these three fronts, the government and the Bank should consider the feasibility of separating government debt management function from the Bank.

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public debt management In September 2003, the Ministry of Finance forwarded to the Bank a draft cabinet note on amendments to the RBI Act. The note proposed amendments to Sections 20 and 21, which would take away the management of public debt from the Bank and vest it with the government or an independent body. However, by then, the Bank had modified its stance on the separation issue. Governor Reddy, on 8 September 2004, suggested that the proposal need not be pursued until the macroeconomic environment was conducive to taking such a step. In the Union Budget speech for 2007–08, the Finance Minister announced the decision to establish an autonomous Debt Management Office (DMO). The 36th meeting of the Monitoring Group on Cash and Debt Management was convened on 22 June 2007 to discuss the setting up of a DMO. D. Subbarao, Secretary (Economic Affairs) at the Ministry of Finance (who later became the Governor of the Reserve Bank), chaired the meeting. From the Bank’s side, Deputy Governor Shyamala Gopinath and other officials attended the meeting. The Secretary referred to a ‘shared understanding’ about the need to move forward with the implementation process. Deputy Governor Gopinath said that the FRBM Act, which restricted the Bank from subscribing to the primary issues, had partly mitigated the conflict between debt and monetary management, and that, given the current ownership structure of public sector banks, a DMO under the Ministry of Finance might give rise to a greater conflict of interest.18 Acknowledging these points, Secretary Subbarao replied that the issue of separation of the debt management function was a ‘settled matter’ in the light of the Budget announcement. He added that one of the tasks of the Middle Office was to study international experience and take the advice of all the stakeholders, including the Bank, on an appropriate model for India.19 The Ministry set up a Middle Office in September 2008 to help ‘pilot the evolution of the legal and governance framework appropriate to an independent debt office’.

Management of Central Government Debt Gross market borrowings of the central government ranged between 3.3 per cent and 6 per cent of GDP between 1997–98 and 2007–08 as shown in Table 7.3.

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the reserve bank of india Table 7.3 Market Borrowings of the Central Government Year

Gross

Net

( billion)

1997–98

596.37 (3.8)

404.94 (2.6)

1999–2000

996.30 (4.9)

730.77 (3.6)

1998–99

939.53 (5.2)

629.03 (3.5)

2000–01

1,151.83 (5.3)

2002–03

1,511.26 (6.0)

1,041.18 (4.1)

1,065.01(3.3)

460.50 (1.4)

2001–02 2003–04 2004–05

1,338.01 (5.7) 1,476.36 (5.2)

2005–06

1,600.18 (4.3)

2007–08

1,882.05 (3.8)

2006–07

1,793.73 (4.2)

737.87 (3.4) 923.02 (3.9) 888.16 (3.1) 982.37 (2.7)

1,112.75 (2.6) 1,095.04 (2.2)

Source: RBI, Handbook of Statistics on the Indian Economy, various years.

Note: Figures in brackets denote percentages to GDP at current market prices.

During the major part of the period, the generally comfortable liquidity conditions and domestic monetary policy measures helped the transition and facilitated successful completion of the major portion of the borrowing programme during the first half of the financial year. After 2002–03, liquidity conditions continued to be easy due to increased capital inflows.This, together with reductions in the cash reserve ratio and private placements, facilitated the smooth completion of the MBP. In 2003–04, for the first time since the introduction of auctions in primary issuances, the borrowing programme was completed successfully without any devolvement on the Bank. However, in 2004–05, the weighted average cost of market borrowings of the centre as well as states increased marginally after eight years of consecutive decline, reflecting a rise in market interest rates. The government’s net market borrowings in 2004–05 was significantly lower than in the previous year. The state governments prepaid 169.43 billion of central government debt through market borrowings, over and above their small saving collections. In addition to the normal market borrowings, the government raised 654.81 billion under the MSS for sterilisation purposes. Overall, the net resources raised through government securities compared favourably with the previous year. In the subsequent years, notwithstanding the large-scale borrowing programme of the government, the interest rates remained relatively stable. 240

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public debt management

Ways and Means Advances to the Central Government The Reserve Bank granted temporary accommodation to the central government as its banker. This temporary facility is called ways and means advances (WMA). WMA must be cleared within a period of ninety days. When the WMA limit was crossed, the government took recourse to overdrafts, which were not allowed beyond ten consecutive working days. The limits for WMA were mutually decided by the Bank and the Government of India, taking into account the prevailing circumstances (Table 7.4) (also see Chapter 3). The WMA scheme for the government came into effect from 1 April 1997, after the system of ad hoc T-bills to finance the government deficit came to an end, as part of the Supplemental Agreement entered between the Bank and the government. From 1 April 1999, interest rates on WMA were revised to the Bank Rate and on overdrafts beyond the WMA to the Bank Rate plus 2 percentage points. The transition period of two years to provide for the implementation of the overdraft regulation came to an end on 31 March 1999. The minimum balance required to be maintained by the Government of India with the Bank was to be not less than 1 billion on Fridays, on 31 March (the date of closure of the government’s financial year) and on 30 June (the date of closure of the annual accounts of the Bank), and not less than 0.1 billion on other days. Table 7.4 WMA Limits for the Central Government Year

1997–98

April– September

October– March

110

70

120

1998–99

1999–2000

60

100

2003–04

60

100

2004–05

2007–08

70

100

2002–03

2006–07

70

110

2001–02

2005–06

80

110

2000–01

60

100 Q1

200

100

200

( billion)

60 Q2

100

Source: RBI, Annual Report, various years.

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Q3 60

60

60

Q4 60

241

the reserve bank of india During the major part of 1997–98, the centre did not need to resort to WMA. In 1998–99, the centre’s finances remained under pressure throughout, necessitating WMA on a continuous basis for the major part of the year. The government took recourse to overdraft on eleven occasions. The net Reserve Bank credit to the government declined (by 5.59 billion) during 1999–2000, for the first time since 1977–78. From the middle of December 2002 to 31 March 2003, the government consistently maintained a surplus balance with the Bank mainly due to increased T-bill issuance, repayments by states under the debt swap scheme (DSS) (mentioned later) and higher inflows due to Relief Bonds. The surpluses were invested in the dated securities transferred from the Bank’s investment account. Again, from 8 August 2003 to 29 April 2004, the government continuously maintained a surplus cash balance in its current account with the Bank, mainly due to substantial inflows on account of the DSS and increased issuance of T-bills.20 The government took recourse to WMA on several occasions until 9 September 2004 but maintained a surplus cash balance in the remaining part of 2004–05. In view of the Bank’s need to preserve its existing stock of securities for the conduct of monetary policy operations, investment of the government’s surplus cash balances was temporarily discontinued from 8 April 2004. From 12 June 2004, the arrangement of investment of surplus balances was partially restored for investment up to 100 billion due to a reduction in the outstanding under the LAF, partly facilitated by absorption under the MSS. This limit was increased to 200 billion from 14 October 2004. The government did not resort to overdraft during fiscal 2005–06 due to the cash build-up, reflecting the investment of state governments in the 14-day intermediate T-bills (ITBs) and auction T-bills (ATBs). With the Bank withdrawing from participation in the primary issues of government securities from 1 April 2006, WMA limits were revised from 2006–07 in consultation with the government. The limits for 2006–07 were fixed on a quarterly basis, instead of a half-yearly basis. Interest rates on WMA and overdrafts were linked to the repo rate against the Bank Rate, as the repo rate emerged as the short-term reference rate. The interest rate on WMA was at the repo rate and that on overdraft at repo rate plus 2 percentage points. The liquidity position of the government remained comfortable during 2006– 07, even though the surplus cash balances of the centre dwindled during April 2006 and the centre used WMA during May–August 2006. But the centre did not resort to overdraft during the year. The surplus balance with the Bank reached a historic peak of 777.26 billion on 22 March 2007, reflecting the state governments’ investments in T-bills and buoyancy in advance tax collections. Again in 2007–08, the liquidity position of the government was comfortable in general though there were some pressures during the first quarter of the year and in July 2007.

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public debt management

Diversification of Investor Base

Traditionally banks and insurance companies invested in government securities. These entities held securities in compliance with statutory requirements, whereas the Bank held these securities in its role as the monetary authority and banker to the government. Ownership data for twelve years show an increase in the holdings of other market participants, even though commercial banks continued to account for the largest share of holdings, followed by the Life Insurance Corporation of India (LIC). The statutory liquidity ratio (SLR) requirement for commercial banks was reduced from 38.5 per cent in 1991 to 25 per cent by 1997. Their holding of government securities broadly varied between 50 per cent and 60 per cent (Table 7.5). The lower share of commercial banks in 2004–05 and 2005–06 reflected the increased participation of other insurance companies besides pension funds and provident funds. The outstanding stock of dated securities with the Bank showed a sharp decline from 10.7 per cent at the end of March 1998 to 4.1 per cent at the end of March 2004 but recovered to 7.2 per cent at the end of March 2008. The Bank, however, held a significant volume of government papers in non-marketable form, that is, in the form of ad hoc T-bills up to March 1997. Subsequently, these were converted into marketable dated securities (see Box 7.3). Table 7.5 Ownership of Central and State Government Dated Securities End March

RBI (Own Account)

Commercial Banks

(per cent)

LIC, Others Total GIC and Subsidiaries 1997 2.8 67.3 18.7 11.3 100 1998 10.7 58.9 18.0 12.5 100 1999 9.1 59.5 17.9 13.5 100 2000 7.0 60.9 18.1 14.1 100 2001 7.7 61.0 18.3 13.1 100 2002 6.4 60.6 19.6 13.4 100 2003 6.6 58.6 19.4 15.5 100 2004 4.1 56.1 19.4 20.4 100 2005 5.2 52.4 20.5 21.9 100 2006 5.0 46.5 22.2 26.4 100 2007 7.5 46.9 22.5 23.1 100 2008 7.2 50.8 21.1 20.9 100 Source: RBI, Handbook of Statistics on the Indian Economy, various issues. Notes: Central and state government securities represent face value of interest-bearing outstanding rupee securities, excluding T-bills, saving prize bonds, expired loans and interest-free non-negotiable securities of the Government of India; ‘Others’ category includes provident funds, PDs (from 2001) and all-India and some state-level financial institutions/corporations/institutions. 243

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the reserve bank of india Box 7.3 Conversion of Special Securities into Marketable Dated Securities The Committee to Examine the Modalities for Phasing out of ad hoc T-bills from April 1997 (Chairman: Y. V. Reddy) in its report submitted in January 1997 recommended, inter alia, that in the medium term, special securities could be converted into marketable securities in convenient lots as and when the need arose, to facilitate the Bank’s OMOs. However, such a conversion mechanism should be so structured that it is substantively expenditure/revenue neutral to the government. Keeping in view the recommendations of the committee, these special (undated) securities were fully converted into marketable dated securities during 1997–98, 2002–03 and 2003–04 (Table 7.6). The proposal to implement such conversion, however, dated back to 1995. On the second such occasion, the Bank found that the entire remaining stock of special securities of 1,018.18 billion was kept with the Issue Department as a back-up for note issue. The Internal Debt Management Cell (IDMC) took up the issue with the Department of External Investments and Operations and the Department of Government and Bank Accounts to explore whether the corresponding amount of foreign currency assets could be transferred to the Issue Department. Once these departments agreed, the conversion went ahead. The steps used for the purpose were the following: (a) issue of new dated securities to the Bank against redemption value of an equivalent amount of special securities on the day of conversion, (b) the coupon of the new marketable dated securities thus created was fixed on the basis of the market yield prevailing on the date of conversion and (c) the interest differential, that is, the difference between the coupon rate of a new marketable dated security and 4.6 per cent (coupon on special security) was borne by the Bank and passed on to the government as part of the annual surplus transfer. Following the recommendations of the committee, the process of conversion had been designed in such a manner that the expenditure impact of the conversion for the government got substantively neutralised by the matching inflows from the Bank in the form of interest differential. Conversion increased repayment liabilities of the government as the perpetual special securities got converted into dated securities at higher coupons with a certain maturity date.

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public debt management Table 7.6 Conversion of Special Securities into Marketable Securities Date

( billion)

Amount

Rate (per cent)

Tenor (years)

3 June 1997

50

13.05

10

12 August 1997

50

11.19

8

1997–98

18 June 1997

1 September 1997 2002–03

50 50

200

12.59 11.5

7 5

16 April 2002

50

7.37

12

3 September 2002

30

6.18

3

50

7.49

15

 

40

7.27

11

 

30

7.38

13

2 January 2003

40

5.73

5

 

50

5.87

7

 

60

6.25

15

 

50

6.25

17

12 June 2003

50

5.48

6

 

70

6.05

16

 

80

6.17

20

28 August 2003

35

4.83

3

 

45

4.88

5

 

110

5.87

19

400

2003–04

25 September 2003   Grand Total

Source: RBI.

61.3

5.69

15

166.88

5.97

22

1,218.18

 

 

618.18

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the reserve bank of india

Changes in Maturity Structure Around 1997–98, the high overhang of public debt and market expectations of a high interest rate premium on longer-maturity debt encouraged borrowings at the short end of the market to minimise the cost of borrowing. Consequently, the share of shorter-maturity market loans (loans maturing within a period of five years) in the total outstanding market loans stood at 41 per cent at the end of March 1997 against 8.6 per cent at the end of March 1991. On 23 June 1999, the Economic Times observed that the government would have to stretch the maturity profile of its borrowing programme to ensure that it retained control over the redemption obligations in the next few years. Deputy Governor Reddy asked for comments from the IDMC of the Bank. A review was done in the IDMC twice, in June 1999 and July 1999. The first review (in June 1999) observed that until 1996–97, mainly the 91-day ad hoc T-bills used to serve as the residual source of borrowing. With the discontinuation of ad hoc and tap T-bills, the role of the residual source of borrowing shifted to the MBP. The growing borrowing requirements together with the resort to short-term borrowings created problems of refinancing the loans at the time of maturity. The review noted that in the late 1990s, the Bank realised that there were opportunities to stretch the maturity profile. But the feeling that the market would not welcome a loan with a tenor of more than ten years inhibited the Bank from taking any step. During 1997–98, a decision was taken to test the market with long-dated security, and surprisingly the market welcomed the decision. A spate of long-term issues was not feasible, however.21 The IDMC suggested that long-dated securities might be linked to short-term rates, that is, issuance of floating rate paper. However, in the absence of a reliable and acceptable shortterm refinance rate, issuance of floating rate paper was not feasible. Deputy Governor Reddy proposed ‘a reset’ after five and ten years at secondary market yields of the remaining maturity at that time, which the IDMC examined. The idea behind the proposal was that the interest cost could be minimised while issuing long-dated securities by linking the coupon rate to the shortterm reference rate. This was possible when the interest rates were expected to fall. However, the experience in the past of the issue of floating rate bonds (FRBs) had not been encouraging.22 Since the FRBs were issued during a high interest rate regime, the floor rate (minimum return) had to be set high. Thus, the government ended up paying coupons for this five-year paper in the range of 14.26 per cent (much above the peak ten-year government bond rate) 246

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public debt management and 13 per cent (the floor rate). A reliable short-term benchmark rate, therefore, was necessary. Another alternative considered was resetting interest rates by means of a call option in the offer document. The government’s finances should enable the call-back of any security if such a move was desired in the event of falling interest rates. A call option involved an extra cost, especially in the absence of a put option, and a put option might not be suitable for the government. Further, issues with call option had the tendency to distort the maturity profile of government debt and impinge upon its cash management efforts. The Chief General Manager of the IDMC reported (office note dated 17 July 1999) that the proposal to issue a longer-term paper, with interest reset every three or five years on the basis of the prevailing three- or five-year yields, was discussed ‘discreetly’ with a few market participants and the response was encouraging, especially from banks that had a large chunk of three-year fixed rate deposit liabilities.23 The proposal is, therefore, to issue a 15-year bond with coupon at the prevailing 3-year yield (around 11.00 percent) plus some compensation for locking liquidity for 15 years [say, 10 to 15 basis points, or bps] issued at par on tap basis. We may not notify the amount and test the market on tap basis with pre-determined coupon for the three-year period minimizing uncertainty surrounding an auction....

Deputy Governor Reddy responded that the proposal was worth trying after discussing the matter with the Ministry of Finance, ‘urgently with no firm commitment now’. The matter was discussed with the Ministry officials. A further issue of ten-year paper by auction was to be considered with no floors or call/put options. To get over the rollover risk (which arose from bunching and redemption in the medium term), the Bank introduced long-term securities of eleven– twenty-year maturity during 1998–99. To ensure that long-term rates remained within a reasonable band, long-maturity stocks were initially privately placed with the Bank and then offloaded to the market through the sale window of the Bank.24 The weighted average maturity of bonds issued during a year increased from 6.6 years in 1997–98 to 16.9 years by the end of 2005–06 but then declined to 14.9 years (Table 7.7). The weighted average maturity of the outstanding stock increased too. With the fall in interest rates, a comfortable liquidity position and an accommodative monetary policy, the Bank could increase the maturity profile of new debt, while reducing the cost of borrowing at the same time (Table 7.8).

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the reserve bank of india Table 7.7 Weighted Average Yield and Maturity of New Market Loans of the Central Government (Excluding Issues under MSS) Year

Weighted Average Yield (per cent)

Range of Maturity (years)

1997–98

12.01

3–10

1999–2000

11.77

5–19

12.6

5–25

14.3

1998–99

11.86

2000–01

2–20

9.44

2002–03

7.34

2003–04 2005–06 2007–08

8.2 8.9 9.8 9.6

16.9

4–30

8.12

7.5

14.1

5–30

7.89

7.1

14.9

5–30

7.34

2006–07

6.3

13.8

4–30

6.11

7.7

6.5

10.6

7–30

5.71

2004–05

Weighted Average Maturity of Outstanding Stock (years)

6.6

2–20

10.95

2001–02

Weighted Average Maturity (years)

9.9

14.7

6–29

10.0

14.9

Source: RBI, Annual Report, various years.

10.6

Table 7.8 Maturity Profile of Central Government Dated Securities (Excluding Issues under MSS): Relative Shares Year

1997–98 1998–99

1999–2000 2000–01 2001–02 2002–03 2003–04

Issued during the Year

Under 5 Years

5–10 Years

18

5–10 Years

68

14

41

42

41

53

0

35

2 0 5

11

2006–07

7

2007–08

Under 5 Years

82

2004–05 2005–06

Over 10 Years

18

6

0 0

Outstanding Stock

24 36 15 11 26 47 57

Source: RBI, Annual Report, 2007–08.

0

65 74 64 80 78 74 46 43

41

41

37

39

27 31 26 24 27 26 26 20

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47 36 35 32 30 31 41 44

(per cent) Over 10 Years 18 16 24 26 33 39 44 43 43 33 36

public debt management As debt manager, the Bank had the obligation of minimising the cost of borrowing to the government. Normally, with an upward sloping yield curve, the longer the maturity, the higher the cost, and this would mean a trade-off between the tenor of borrowing and its cost.

Floating Rate Bonds and Bonds with Call and Put Options FRBs were first issued by the Government of India on 29 September 1995 and these matured in December 2002. FRBs are medium- to long-term debt instruments offering variable coupons linked to some prefixed benchmark. Inflation protection was available only for the principal and not the interest payment. As the first issue failed to generate a good response, no further issue of FRBs was undertaken for nearly six years. On 21 November 2001, FRBs were reintroduced with some modifications in the structure. The market response was initially good but a few years later, there was a drop in interest, attributed to strong credit pick-up, low secondary market liquidity in FRBs and complex pricing followed by market participants. The issuance of FRBs was discontinued in 2005–06. As a further step towards diversification, the government introduced capital-indexed bonds of five-year maturity bearing 6 per cent interest for the first time on 29 December 1997. This instrument had the provision for a complete hedge against inflation for the principal amount. There was no further issuance of these bonds mainly due to lack of response of market participants for this type of instrument. The first government bond with call and put options, the 6.72 per cent government securities 2012, was issued on 16 July 2002 for a maturity of ten years, maturing on 18 July 2012. The option on the bond could be exercised after completion of five years from the date of issuance on any coupon date falling thereafter. The government had the right to buy the bond (call option) at par value (equal to the face value), while the investor had the right to sell the bond (put option) to the government at par value on any day of the half-yearly coupon dates starting from 18 July 2007.

Liquidity of Securities One of the key issues in the development of the government securities market was the liquidity of securities. In the long list of securities, only a few were 249

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the reserve bank of india actively traded in the secondary market. A policy of passive consolidation through reissue/reopening was started in 1999 to improve the fungibility among securities and to facilitate the consolidation of debt. The strategy took the form of raising the progressively higher share of market borrowings by reissue, and elongation of the yield curve up to thirty years. However, active consolidation could not be resorted to due to administrative costs and legal considerations. In the years when interest rates were lower than in the past, buying back old securities involved payment of premia, which had to be provided for in the Budget. Banks and other institutional investors often held the high-yield securities in their ‘held-to-maturity’ portfolios, which were, therefore, not often advisable to be bought back.25 The fall in yields and the resultant steep premia in many cases deterred ‘buy-and-hold’ investors from subscribing to existing securities.

Debt Swap 2003–04 In January 2003, the Bank made a proposal to swap low-cost debt at current yields with banks holding high-yield government securities.26 The expectation was that if high-coupon debt was swapped with low-coupon debt at prevailing yields, that is, at market prices, the gains to the government from lower interest would be exactly offset by the premia the government would have to pay to the high-coupon bondholders, and the net present value of the cash flows under both streams would be exactly equal. Cash outflows in the initial years would be higher and in subsequent years lower. For the banks, highyield bonds enabled them to preserve their net earnings and the unrealised appreciation on these bonds acted as a cushion for future interest rate shocks. However, the high-coupon securities they held were not sufficiently liquid. In case the government could purchase its high-coupon bonds at a discount and reissue fresh bonds at lower yields without any impact on market yield, the transaction would be clearly advantageous to the government. But if the quantum of such swaps that banks were willing to do was not large, the gains would not be large either. The first buyback auction was conducted on 19 July 2003 for nineteen high coupons but relatively illiquid Government of India dated securities through a live interactive platform where participants could revise their bids. In all, 131 offers were received. The entire amount was accepted as the offers were at or above the minimum discount of 7.5 per cent (to the market value) 250

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public debt management expected by the government. The market value of the securities bought back was 193.94 billion. The difference between the market value and the face value ( 49.60 billion) was shared between the government and the market participants. While the premium paid to the market participants amounted to 34.72 billion, the government saved 14.88 billion or 7.67 per cent of the market value. In exchange for the securities bought back, the government reissued four existing liquid securities of equal face value ( 144.34 billion). The prices at which the securities were reissued were the weighted average prices during the period 14–18 July 2003. Banks were allowed an additional deduction for tax purposes to the extent such income was used for provisioning of non-performing assets (bad debt). The government proposed to repay foreign currency loans by purchasing foreign exchange from the Reserve Bank with the rupee funds generated through additional borrowing, initially through a private placement with the Bank. The two foreign currency loans under consideration were the Asian Development Bank loan of US$1,254 million with residual maturity of 11.24 years and rate of interest of 6.34 per cent, and the International Bank for Reconstruction and Development loan of US$1,549 million with residual maturity of 8.44 years and a rate of interest of 5.02 per cent. The Bank’s perception was that from the country’s perspective, prepaying external debt through the use of foreign exchange reserves seemed to ‘make sense’ as the return on the reserves was less than the interest rate on the debt.27 The Union Budget for 2003–04 announced a DSS to enable state governments to substitute their high-cost loans from the centre with fresh market borrowings and a portion of small saving transfers. Of the total debt swapped ( 604 billion), 61 per cent was financed through additional market borrowings at interest rates below 6.5 per cent, and the remaining through the issue of special securities to the National Small Savings Fund (NSSF) with the interest rate fixed at 9.5 per cent. The receipts under the scheme were used by the government to partially redeem the special securities issued to the NSSF at the time of its inception in 1999. The NSSF, in turn, reinvested the funds in fresh central government special securities in 2003–04 at market-related interest rates.

Debt Consolidation From the late 1990s, the Bank followed a policy of passive consolidation of government dated securities through the reissue of existing securities. Of the 251

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the reserve bank of india 188 outstanding securities issued by the central government by July 2005, 15 had a size of 150 million or more, and these together accounted for 29 per cent of the total stock of central government securities. Thus, while reissue had achieved some degree of consolidation, there were many small-sized securities, very few of which were actively traded in the market. A faster way to consolidate stock would be through the process of active consolidation. This process would involve, in one form or other, buying back a large number of small-sized illiquid central government securities from the existing holders and issuing a smaller number of liquid securities in exchange. These large-sized securities would be held across a wider base of market participants, which would improve the availability of floating stock and stimulate trading.28 The debt buyback scheme, introduced for a short period in July 2003 (see earlier) under the debt restructuring programme of the government, had an element of active consolidation. In the 28th meeting of the Monitoring Group on Cash and Debt Management of the Government of India (13 May 2005), the proposal was taken up for discussion. Deputy Governor Gopinath indicated that the Bank had the experience of buying back of securities in July 2003. However, V. S. Chauhan, Deputy Secretary (Budget), cautioned that the buyback operation had implications for the fiscal deficit and would require provisions in the Budget Demand for Grants/Appropriations in the event of a buyback. The group decided to explore international experience. A concept note prepared by the Internal Debt Management Department (IDMD) in June 2005 identified several problems with debt consolidation.29 In a letter dated 5 August 2005 to the Finance Secretary, Deputy Governor Gopinath explained the case for buyback. The case was that since the Bank was to withdraw from the primary market, for effective debt management it was necessary to ensure that securities traded ‘in a deep and liquid market’, which would require active consolidation of government securities. The government agreed ‘in principle’ to implement a scheme for active consolidation (letter dated 7 February 2006), subject to certain considerations. The proposal was that the Bank would participate in the primary government securities market, focus on the liquidation of nineteen securities maturing between 2009 and 2015, and link the consolidation proposal with other debt restructuring proposals under consideration.30 Subsequently, the government advised the Bank that, given the expenditure pressure during the current year, it was not a good time to initiate 252

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public debt management active consolidation and suggested that the Bank explore the possibility of working out an initial consolidation package that would have no net negative fiscal impact.31 The government also made several suggestions for revision of the scheme.32 The government’s view was that a reference to buyback ‘depending on funding requirements and market conditions’ might create confusion in the minds of investors. Such a step could imply that it was open to the Bank to delay payment for bought back securities, citing market conditions. Further, a suggestion was made for insertion of a clause enabling the Bank to cancel an announcement to meet sudden market situations. The government also proposed some changes in the accounting arrangement for consolidation. On 4 January 2007, the Bank forwarded the revised draft scheme, incorporating the suggestions except one. This was the insertion of a clause enabling the Bank to cancel an announcement regarding buyback or not accepting an offer for buyback after the same was received without assigning any reason. The government accepted the draft on 31 January. In October 2007, the IDMD sent the government a list of securities identified for buyback. Two days later (31 October 2007), the government replied that it agreed to put the final scheme in the public domain. There was then a lull for about two months. On 19 February 2008, the Chief General Manager, IDMD, spoke to the Additional Secretary (Budget Division) indicating that the time was not appropriate for the buyback because the yields were hardening and liquidity in the market was tight. The Additional Secretary agreed to defer the consolidation. Eventually, the scheme did not get off the ground during the reference period.

Monitoring Group on Cash and Debt Management With the discontinuance of the ad hoc T-bills and introduction of the new scheme of WMA (April 1997), a new monitoring mechanism was needed. The mechanism would transmit signals when 75 per cent of the WMA limit was utilised by the Government of India so that the Bank could float fresh government securities. The Ministry of Finance formed a Group on Monitoring of Cash and Debt Management on 28 April 1997 to discuss this.33 The terms of reference of the group were quite wide, and included estimating the monthly fiscal deficit of the government and the associated borrowing requirement at the start of the year, recommending the proper 253

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the reserve bank of india timing, amount and instrument of borrowing, reviewing the cash position of the government, creating a database for advance estimation of monthly revenues, and streamlining the flow of information to the Bank from banks and other agencies. From its start until March 2008, thirty-eight meetings of the monitoring group had taken place (see Table 7.9). Table 7.9 Monitoring Group on Cash and Debt Management of the Central Government: Illustrative List of Subjects Discussed at the Meetings Routine Matters

Policy Matters

Special Subjects

WMA position of the central government.

Raising market loans of longer maturities.

Review of trends in government finances and the current fiscal situation.

Establishment of a consolidated sinking fund (CSF) for the central government.

The possibility of borrowing through instruments like capitalTransition to a new regime indexed bonds, deep governed by the FRBM discount bonds and floating Act, 2003. rate bonds. Setting up of a DMO and, MBP of state governments. in the first phase, a Middle Office (MO) to facilitate Issues relating to the the transition to a fullSpecial Deposit Scheme, fledged DMO. 1975.

Fixation of WMA limits (annual, half year/quarter). Borrowing programme for the first half year/second half year. Preparation of advance (indicative) half-yearly calendar for floatation of market loans (Appendix 7A.3). Schedule of auctions for 364-day T-bills.

Investments of surplus cash balances of state governments and its implications for the centre’s cash management.

Finalisation of an auction of T-bills under normal MBP.

(Contd.)

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public debt management (Contd.) Routine Matters

Policy Matters

Special Subjects

Daily mismatches between receipts and payments in respect of railways, defence, telecommunication and posts. Non-receipt of drawing schedules from various accountants of the ministries of the central government.

Management of State Government Debt Market Borrowing Programme

The Reserve Bank entered into agreements with state governments under Section 21A of the RBI Act to manage their public debt. The Bank’s role as debt manager for state governments is voluntary. State governments are not allowed to borrow from abroad. Managing the market borrowing programme at the state government level was a two-stage process. The Government of India and the Planning Commission set annual allocations to the individual state governments under the annual MBP. The next stage involved floatation of loans in the government securities market by the respective state governments, and decisions on timing, amount of each issue and coupon rate. The Bank was involved in this stage and decided these matters in consultation with the state governments. Until 1998, the Bank conducted the combined borrowing programme of states in two or more tranches in a year through the issue of bonds with predetermined coupon and pre-notified amounts for each state. The relatively high SLR and the small size of state borrowings ensured that these primary issues would be completed successfully. However, the progressive reduction in the SLR, which left several banks with excess SLR securities in their investment portfolio, and perceptions of investors about the loans being raised by individual states, created problems.

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the reserve bank of india Following a review in 1997, the Bank decided to enable the bettermanaged states to access funds at market rates. State governments could now enter the market individually to raise resources using the auction method or tap method to raise between 5 per cent and 35 per cent of the allocated market borrowings. Some states were able to mobilise loans at competitive rates, while others had to pay higher rates, depending on their fiscal health and track record (Table 7.10). In 1997–98 and 1998–99, MBPs of the states were conducted smoothly. In the second tranche conducted on 8 September 1999, while loans of thirteen states were oversubscribed, those for ten states initially remained undersubscribed. Under such circumstances, the Bank used to persuade major players to reallocate their excess subscriptions with some states to the deficit states. However, on this occasion, the Executive Director (Investment) of LIC wrote back to the Bank (4 November 1999): ‘[W]e request you to make allotments in future to individual States within our subscription applied for and Table 7.10 Market Borrowings of the State Governments Year 1997–98

Gross (Per Cent of GDP at Market Prices) 77.49 (0.49)

( billion)

Net (Per Cent of GDP at Market Prices) 71.93 (0.46)

1998–99

121.14 (0.67)

107.00 (0.59)

2000–01

133.00 (0.61)

128.80 (0.59)

1999–2000 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

137.06 (0.68) 187.07 (0.79) 308.53 (1.22) 505.21 (1.78) 391.01 (1.21) 217.29 (0.59) 208.25 (0.48) 677.79 (1.36)

124.05 (0.61) 172.61 (0.73) 290.64 (1.15) 463.76 (1.63) 339.78 (1.05) 154.55 (0.42) 142.74 (0.33) 562.24 (1.13)

Source: RBI, Handbook of Statistics on Indian Economy, various years.

Note: Gross market borrowings of the states included additional market borrowings of 100 billion for 2002–03, 266.23 billion for 2003–04 and 169.43 billion for 2004–05 under the states’ DSS. 256

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public debt management in no State the allotment should exceed the subscription applied for.’ Deputy Governor Reddy informed the Finance Ministry of this request, adding that, in effect, it meant that the Bank would not be able to use ‘persuasion’ to divert surplus subscriptions. A different approach was needed. A letter written on 4 January 2000 reflects this transition especially well.34 The letter explained the three options available to the states to enter the market. The first option was to raise the balance amount of the loan from the market at a fixed coupon. The subscription received would depend on the extent to which banks and financial institutions were prepared to invest at the yield offered. There was a risk of undersubscription. The second method was an auction with flexibility in terms of maturity, timing and interest rate. The rate at which the state could raise full subscription depended on the rates of interest at which the institutions were prepared to invest. There was a risk of higher interest rates. The third route was a tap issue at a fixed coupon without specifying the notified amount. The tap was to be closed as soon as the required amount was received within a reasonable period. The amount received would depend on the coupon offered, market conditions and the interest shown by institutions. There was again a risk of undersubscription. The uncertainties about the subscription amount and the rate of interest could be moderated by recourse to underwriting. The state governments were cautioned that in all of the three options, there was a possible reputational risk that should not be ignored. ‘Let me assure you,’ the letter concluded, ‘that RBI would, as always, strive to make the issues of State Governments a success, but it is necessary to recognize the changing sentiments of market participants especially institutional investors like banks regarding the relative creditworthiness of individual States.’ The year 2000–01 saw huge shortfalls in subscriptions to individual state development loans (SDLs). It was with great difficulty that the undersubscribed loans of some states could be made up with the cooperation of banks and financial institutions, at the initiative of the Reserve Bank. The IDMC identified several reasons for this.35 There were persistent defaults in payment of interest and principal on state-guaranteed bonds by some states. There were defaults in payment of interest on state loans when the payments on behalf of Assam and Manipur were suspended by the Bank under the overdraft regulation scheme. Further, during the previous three years, additional allocations were made to states for one reason or another even after the MBPs for the year had been completed. Even though the Bank offered 257

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the reserve bank of india 25 bps above the Government of India securities rate for the state loans, in absolute terms, the coupon rate offered on state loans had been coming down. In the past, state loans were floated twice or thrice a year, but now the Bank entered the market throughout the year. In 2000–01, state loans were raised on seven occasions. Finally, state government securities had low liquidity and the investors had to hold these investments in their portfolio for a long time. During 2001–02, while the first tranche in May 2001 went through without any problem, in October 2001, a second tranche loan floated by Assam was undersubscribed. The officials of the Reserve Bank requested banks to make efforts for meeting the shortfall. Some banks agreed with considerable reluctance to reallocate. In a few cases, the Chairmen of the concerned banks contacted the Principal Secretary of Assam and agreed to commit the amounts on the assurance that the state arranged to meet the arrears due to them. Appraising the above developments, the Executive Director of the Bank in a letter (13 October 2001) to the Principal Secretary, Finance Department, Assam, did some plain-speaking and, among other suggestions, ‘counseled to meet without delay the state’s obligations under guarantees issued by it’. Similar letters went out to two other state governments whose borrowing programmes were under pressure. A meeting with state Finance Secretaries (26 May 2001) held that the borrowings by states could be raised by tap issuance without announcing the notified amount, to avoid the embarrassment of undersubscription. The tap was to be kept open for one day and closed the moment the intended amount was subscribed or, in the event of undersubscription on the first day, to be extended for a day or even two under exceptional circumstances. If the problem was not resolved, a repeat tap could be considered for the states concerned. Some states expressed the opinion in a meeting of state Finance Secretaries held on 28 November 2001 that it might not be possible for them to mobilise their borrowings with the spread limited to 25 bps. A few major investors believed that the spread should be higher. These views were discussed at the FMC-RBI of the Bank on 22 January 2002. The consensus was that, based on the approved yield curve rate of 7.86 per cent on 10-year maturity and 43-bp spread, the yield came to 8.29 per cent. Based on this, a yield of 8.30 per cent could be offered for state government tap issuance currently.36 The tap issue replaced the traditional tranche method in January 2002. This did not turn out to be of much help. On the first day of the tap issue on 28 January 2002, tap sales for sixteen state governments were closed on receipt 258

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public debt management of the respective target amounts. Partial allotments were done in respect of five states that were oversubscribed. On the second day, the tap sale for three states was closed on receipt of the respective target amounts. The tap sales for the remaining seven states were closed on the third day, 30 January 2002. But Jammu and Kashmir, Jharkhand, Madhya Pradesh and Meghalaya received a weak response, and the response for Assam, Bihar and Uttar Pradesh was very poor. Efforts were made by contacting investors to fill the gap. Eventually, a substantial portion of the shortfall was bridged. In 2002–03, a record amount was raised by state governments, in part due to the DSS (mentioned later). The tap sale of 6.75 per cent state loans opened on 12 March 2003 for twenty-six states, and while the tap closed for twentythree of these two days later, a large shortfall remained in the case of Assam, Rajasthan and West Bengal. Tremendous efforts were made by the IDMC to persuade the institutions to invest in these states. A tap sale of SDLs on 28–29 July 2004 ended with a shortfall for twelve out of nineteen states. In fact, four out of five issues conducted since January 2004 were undersubscribed. The only successful issue in April 2004 rested on subscriptions from the Employees’ Provident Fund Organisation (EPFO), which had benefitted from a sudden inflow by way of interest on the Special Deposit Scheme. The magnitude of the shortfall and the number of states involved were disquieting. Deputy Governor Mohan, in his letter of 11 August 2004 to the Finance Secretary, discussed the situation (Appendix 7A.4). The Bank was of the view that the fiscal management of the states needed to improve. Otherwise, states with better track record risked being crowded out and could face higher borrowing cost. The matter was discussed at a meeting arranged by the Finance Secretary on 16 September 2004, attended by officials from the Bank. There was a dramatic reversal after 2004–05. The fiscal position of states showed remarkable improvement, thanks to greater fiscal discipline and devolution of funds from the centre. Towards the end of our period, states on their own opted for the auction method for borrowing and, on occasions, were not keen to tap the market because of surplus cash position, better cash management, fiscal prudence and funds accrued to them under grants and devolvement. The first tap tranche of market borrowings for state governments opened on 17 May 2005. The coupon rate for the tap issue had been earlier determined (on 10 May 2005) to be 7.77 per cent per annum, after allowing a spread of 50 bps over the secondary market yield of the ten-year Government of India 259

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the reserve bank of india security. However, during the period of floatation, the spread increased to 60 bps due to a fall in the yield of the ten-year government security. The response for state loans was overwhelming, except for Uttar Pradesh. Initiatives were taken in individual states to improve their capacity to borrow.37 The third tranche of the MBP for 2005–06 was an overwhelming success. Following the recommendations of the Twelfth Finance Commission, central loans for state plan schemes were discontinued from 2005–06, and states were encouraged to take the auction route. The share of borrowings by way of auctions increased from 2.3 per cent (three states) in 2004–05 to 48.5 per cent (twenty-four states) in 2005–06 (Table 7.11). Punjab raised the entire amount through an auction. The success of auctions reflected the better market perception of states’ fiscal situation and was reflected in the lower spread of cut-off yields vis-à-vis tap issues. Ten states opted not to enter the market in view of their holdings of surplus cash balances.38 Sixteen state governments approached the market on 11 May 2005 for a notified amount. The loan amounts were raised through a yield-based auction using a multiple price auction method. Three states exercised the option of underwriting by PDs. The market yield of the ten-year government security stood at 7.53 per cent on the day of the auction. States accepted bids at cut-off rates, with spreads ranging between 34 bps and 52 bps. All state loans received a good response, except that of Meghalaya. The response in subsequent auctions was also considered favourable. Table 7.11 The Share of Auction in States’ MBP Year

1998–99

Share (per cent)

1999–2000

0.5 6.3

2000–01

12.6

2002–03

9.6

2001–02 2003–04 2004–05 2005–06 2006–07 2007–08 Source: RBI. 260

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14.0 5.7 2.3

48.5

100.0 100.0

public debt management During 2006–07, borrowings by states were lower than those allocated, mainly because of the build-up of cash balances. For the first time, states raised the entire amount through the auction route, except those that did not participate in the MBP. In general, the spreads of the cut-off yields in the auctions over the secondary market yields of comparable central government securities were lower than those in the previous year. To improve the liquidity of state government securities, in March 2007, these were made eligible as collateral for LAF operations conducted by the Bank. Faced with an accumulation of surplus cash balances, some state governments approached the Bank to arrange for buyback of their outstanding SDLs, which the Bank agreed to. The MBP during 2007–08 was again conducted entirely through the auction route.

Debt Swap of High-Cost Debt of State Governments The issue of debt swap was discussed earlier. A committee of the government set up to assess the fiscal situation of states (2002) deliberated on a DSS. The Bank’s involvement was vital because a decision had to be taken about the quantum of additional market borrowing by state governments to enable them to prepay the loan. A draft scheme was prepared in August 2002. The swaps would involve prepayment of loans from the centre carrying an interest rate of 13 per cent or above. Roughly, 75 per cent of such high-cost loans were loans against small saving collections. State governments could resort to higher market borrowings, subject to the condition that they used 30 per cent of their net small saving receipts to retire high-cost debt. The scheme was examined by the IDMC in August 2002. Their note was categorical that the prospect of states resorting to higher market borrowings was not only difficult but also dangerous for interest rates and unfair on smaller or better-managed states. In an alternative method proposed, the centre was to unilaterally cut the interest on high-cost loans. This approach had the advantage of reducing the interest burden on states without affecting the market. It was also simpler to administer. Governor Jalan was in favour of solving this politically sensitive problem through discussions with government officials, instead of through correspondence. Following the above developments, the Bank reiterated that there were difficulties with market borrowings for states in the recent past and 261

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the reserve bank of india that further efforts could raise the cost of borrowing and the risk of undersubscription. The Bank believed that the overall draft on the financial system through market borrowings should be restricted to the amount finalised under the approved MBP for the government, meaning that the increase in the borrowing of the states should match the decline in the amount raised by the centre. The government was of the view that this might be difficult to achieve.39 During 2002–03, twenty-five state governments (excluding Maharashtra, Sikkim and West Bengal) swapped high-cost loans amounting to 137.66 billion, partly out of small saving collections and partly through fresh market borrowings of 100 billion. During 2003–04, states swapped 462.11 billion with additional market borrowings of 266.23 billion and 30 per cent of small saving transfers. Similarly, during 2004–05, states raised 169.43 billion under the scheme.

The Issue of Additional Borrowing The borrowings of states comprised market loans under the ‘approved’ borrowing programme, central loans under plan and non-plan and small savings, provident funds, special deposits and other items in the public account, and the securities issued against small savings. Banks were not allowed to finance the expenditure by state governments except through the ‘approved’ MBP. The net allocation under the MBP for state governments had gone up even during the period when states enjoyed surplus cash balances. On top of this, there had been additional borrowing by states on account of a variety of reasons, such as drought, flood, DSS, prepayment of the high cost loans, and so on. Further, with the cessation of central loans to state governments from 2005–06, as recommended by the Twelfth Finance Commission, the reliance of states on alternative forms of borrowings also increased. The Ministry of Finance at times sanctioned additional borrowing to states over and above the approved MBP and the Bank was asked to arrange for open market borrowings accordingly. This caused concern to the Bank.40 On 20 February 2001, the Bank had issued a letter communicating the approval of the government for additional market borrowing of 15 billion for states. Deputy Governor Reddy, in a letter (23 February 2001) to Finance Secretary Ajit Kumar, reiterated the implications of enhancing the borrowing programme, namely a possible rise in interest rates and a shortage of funds with 262

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public debt management Table 7.12 Extent of Additional Borrowing by States Year

Net Amount Raised ( billion)

Additional Allocation The Share of ( billion) Additional Allocation in Net Amount Raised (per cent)

1998–99

107.00

13.73

12.8

1999–2000

124.05

19.20

15.5

2000–01

128.80

16.50

12.8

2001–02

172.61

63.82

37.0

2002–03

290.64

163.22

56.2

2003–04

463.76

266.23

57.4

2004–05

339.78

230.02

67.7

2005–06

154.55

35.22

22.8

2006–07

142.74

28.03

19.6

2007–08

562.24

402.34

71.5

Source: RBI, Annual Report, various years.

banks. The Bank proposed a reduction of an equivalent amount in the centre’s borrowing programme for the current financial year and to pre-announcing it to the market. The government agreed to the proposal. The share of additional allocation in the net amount raised increased from 12.8 per cent in 1998–99 to 71.8 per cent in 2007–08 (Table 7.12). A large part of such additional borrowing had, however, been on account of the DSS in which states prepaid high-cost debt to the centre and on account of shortfall in collections under the NSSF.

Bank Finance through Special Purpose Vehicles Special purpose vehicles (SPVs) issued state-guaranteed bonds that were defined as ‘negotiated loans’ by the Planning Commission. State governments were sometimes allowed to use the method. The Bank, however, was not comfortable. The bonds were usually not rated by rating agencies and were privately placed. In effect, such lending entailed little credit appraisal and appraisal of the project for which the loan was raised. The SPVs were neither 263

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the reserve bank of india serviced by the issuing entity nor honoured by the state government concerned when the guarantee was invoked. If it was to be repaid out of budgetary funds, then a proper appraisal would be needed to assess the finances of the states as well. The Bank’s guidelines regarding financing of projects carried out by public sector units allowed only term loans made by corporate entities. The intention was to enable bank financing of commercially viable projects undertaken by PSUs as a supplement to government financing of such projects. The Bank’s view was that for guaranteed loans, there should be credit assessment, possibly by rating agencies.41 One example was the West Bengal government, which borrowed on behalf of the West Bengal Industrial Development Corporation and sought direct debit permission from the Bank. A letter from the Bank (25 June 2001) to the Finance Ministry considered ‘this not only dilutes the monetary policy management by RBI but also undermines the macroeconomic stability and introduces a non-transparent fiscal burden on State Governments’ (See Appendix 7A.5). Towards the end of 2001, the issue was raised again with borrowing by the West Bengal Infrastructure Development Finance Corporation (WBIDFC). The West Bengal government received approval from the Ministry of Finance for borrowing huge amounts outside the approved MBP. As before, the funds were being mobilised from banks on the strength of an automatic debit mechanism with the Bank and an irrevocable mandate by the state government. The total amount approved was 48.05 billion over two years, 1999–2000 and 2000–01, which was three times the amount of loans under the MBP. The approvals contained a clearance from the Government of India for conducting the transactions on the terms and conditions agreed upon by the state government and the WBIDFC. The contractual arrangement, including the automatic debit mechanism, created a procedure that could continue in the future. All of this had serious implications for credit, fiscal risk, crowding out, and the Bank’s ability to conduct debt management. The Bank, therefore, instructed its Regional Director, Calcutta (Kolkata), not to allow any automatic debits for loans taken by the state government in future outside the MBP. The West Bengal government was also requested to make direct arrangement for servicing any such loans taken in the future, without routing such arrangements through the Bank. The state government was advised to ask the WBIDFC to disclose to the investors that such 264

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public debt management automatic debit arrangements with the Bank would not be available in the future. The response from the Government of India to these concerns was positive and helpful.42 To streamline the borrowing programme of states, the government decided to adopt a two-stage procedure. First, the Fiscal Reforms Unit of the Department of Expenditure would work out the limits of prudential debt and send it to the Planning Commission. Thereafter, within the allocation approved by the Planning Commission, the Budget Division in the Department of Economic Affairs would give permission, on application by states. Any reallocation by states, within the overall ceiling fixed by the Planning Commission, would require the agreement of the Ministry of Finance and the Planning Commission. For SPVs whose borrowings clearly had to be serviced by the state, prior permission was necessary. In short, SPVs should only fund commercially viable projects, and not become a substitute for the budgetary resource. In the case of ‘negotiated loans’, which were arranged from the apex financial institutions for SPVs for financing specific projects, there were two possibilities. If they did not enter the Consolidated Fund, there was only a sort of contingent liability. If they did enter the Consolidated Fund and were from non-banking sources, directly or indirectly, the issue was one of transparency. Where such loans entered the Consolidated Fund and constituted the direct liabilities of the state government, it was necessary to ensure that such negotiated loans were not raised from banks. In a meeting chaired by the Finance Minister on 9 September 2003, a decision was taken to allow state governments to borrow from outside the normal MBP – in this case, to assist sugar mills in paying cane arrears. On becoming aware of this development, Deputy Governor Mohan wrote (17 September 2003) to the Finance Secretary reiterating the adverse implications of the move and wanted the Bank to be involved in the scheme.

Special Category States43 In the meeting of the Finance Secretaries held on 28 November 2001, there was a proposal from Andhra Pradesh, Gujarat, Maharashtra, Karnataka and Tamil Nadu to extend auction beyond 35 per cent of the tranche. At the same time, there were requests from the special category states for retaining the status quo. The difference reflected the fact that in a deregulated environment, 265

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the reserve bank of india the capacity of states to raise resources differed according to the quality of fiscal management and the depth of the financial services sectors in states. The Bank felt that even under the tap method, it was unlikely that the special category states would receive an adequate response without the comfort of reallocation by banks. In the meeting, a view emerged that there should be a special arrangement for the northeastern states and others. The MBP of special category states amounted to about 10 per cent of the total borrowing programme of states. Considerable problems were faced by these state governments in interacting with the financial sector because financial services were less developed in these states. The Bank saw merit in a separate policy.44 However, the government did not agree on grounds of prudent fiscal management.

WMA and Overdrafts The Bank provided two types of WMA to state governments. The normal WMA were unsecured advances while the special WMA were given against the pledge of central government securities held by state governments. Any amount drawn more than WMA was treated as an overdraft. The use of WMA and overdrafts by states became more frequent from 1997–98. The WMA limits were doubled from 1 August 1996. The interest rates on WMA and overdrafts were placed at the Bank Rate and 2 percentage points above the Bank Rate, respectively.45 During 1997–98, sixteen states resorted to overdrafts, and three could not clear their overdrafts with the Bank within the stipulated time limit of ten consecutive working days. Thus, the Bank had to stop payment on behalf of three state governments. One state, in fact, breached the ten-day limit on as many as eight occasions. In 1998, a committee was asked to consider rationalisation of the WMA scheme.46 The committee recommended delinking WMA limits from the minimum cash balances, swtiching over to a formula (three-year average of the total revenue receipts and capital expenditures) in the case of normal WMA, adopting a liberal approach for special WMA and not allowing relaxation in the disciplinary mechanism underlying the overdraft regulation scheme. These recommendations were subsequently implemented in 1999 with minor modifications (Table 7.13). The WMA limits were revised a number of times. 266

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public debt management Table 7.13 Revisions of WMA Limits for States Effective Date

1 March 1999

1 February 2001 3 March 2003 1 April 2004 1 April 2005 1 April 2006 1 April 2007

Source: RBI.

Total for All States ( billion) 36.85 52.83 71.70 81.40 89.37 98.75 98.75

Committee/Annual Revision Vithal Committee

Revised WMA Scheme

Ramachandran Committee Annual Revision Annual Revision

Bezbaruah Committee Annual Revision

Based on the recommendations of the Ramachandran Committee (2002), the basis for determining WMA limits was simplified, and the scheme for overdraft regulation made more stringent. The special WMA continued to be linked to investments made by state governments in the Government of India securities.47 An Advisory Committee on Ways and Means Advances and Overdrafts of State Governments,48 in its report submitted on 29 October 2005, observed that there was an improvement in the finances of state governments in recent years, in view of which the normal WMA limits were more than adequate. Based on the recommendations of this committee, a revised WMA scheme was put in place.49 From 2003–04, a dramatic reversal set in. The utilisation of WMA and overdrafts by states during 2003–04 was generally lower than that in the previous year. The proceeds from small savings and higher market borrowings contributed to the improvement. The situation further improved during 2004– 05 and 2005–06 because of persistent cash surplus with state governments. The average utilisation of special WMA, normal WMA and overdrafts by states governments were lower than in the previous years and there was a reduction in the number of states that utilised normal WMA. The improvement in the overall cash position of states was also reflected in the spurt of investments in fourteen-day ITBs. There was a downward trend in the daily average utilisation of normal WMA, special WMA and overdrafts by state governments during 2006–07. Only two states resorted to overdraft against eight states in the previous year. Despite the slowdown in the automatic inflow of funds under the high-cost NSSF, most state governments continued to accumulate sizeable cash surpluses, 267

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the reserve bank of india emanating mainly from substantially higher central transfers. During 2007– 08, the average utilisation of normal WMA by state governments was high during the first half of the year, but moderated in the second half, particularly in the last quarter. The rise in the surplus cash balances of state governments from the middle of 2004–05 posed a new problem.

Management of States’ Surplus Balances The cash balances of state governments posed a new type of challenge. The existing investment avenues for surplus funds did not offer sufficient returns. The cash balances of state governments were automatically invested in fourteen-day ITBs issued by the central government. The rate of discount on these ITBs was 5 per cent (during August 2007), which was lower than the interest paid out on open market borrowings (8 per cent) and small savings (9.5 per cent). State governments were also permitted to invest as noncompetitive bidders in ATBs, earning an interest of 6.5 per cent. At that time, state governments were not permitted to invest in dated government securities, which yielded a higher return (7.8 per cent) than T-bills. Consequently, many state governments expressed the need for alternative investment options for their cash balances. The states’ investment in ITBs and ATBs showed up in the cash balances of the government maintained with the Bank, and had implications for monetary management. The existing arrangement needed a review. The matter was discussed at the 18th Conference of State Finance Secretaries (7 August 2006). Governor Reddy set up a group of state Finance Secretaries and Reserve Bank officials to suggest a framework for alternative investment options.50 The group made several recommendations that were discussed during the 20th Conference of State Finance Secretaries held on 24 August 2007. These discussions, however, extended beyond the reference period. While most states preferred to curtail the size of their market borrowing, Odisha, Tamil Nadu and Rajasthan prepaid their high-cost outstanding loans, including those from the NSSF during 2006–07 and 2007–08. Karnataka and Tamil Nadu also opted to buy back their entire outstanding under power bonds issued to central public sector power bond liabilities. Further, four states, namely Chhattisgarh, Haryana, Odisha and Tripura, with surplus cash balances did not raise market borrowings during 2007–08, reflecting their 268

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public debt management prudent cash and debt management. Yet there were as many as sixteen states that resorted to market borrowings during 2007–08 even when they enjoyed a build-up of surplus balances.51

Model Fiscal Responsibility Legislation at the State Level In view of the persistent concern over fiscal management of states in the first half of the 2000s, five state governments enacted legislation on fiscal responsibility and budget management. These Acts were the Karnataka Fiscal Responsibility Act, 2002; the Kerala Fiscal Responsibility Act, 2003; the Punjab Fiscal Responsibility and Budget Management Act, 2003; the Tamil Nadu Fiscal Responsibility Act, 2003; and the Uttar Pradesh Fiscal Responsibility Act, 2004. Interestingly, the enactment of fiscal responsibility legislation at the state level preceded that of the central government. These laws made the respective state governments responsible for ensuring fiscal stability, intergenerational equity and financial stability by achieving revenue surplus, containing fiscal deficit and maintaining a sustainable debt level (Table 7.14). The 12th Conference of State Finance Secretaries, at its meeting held on 1 August 2003, decided to draft a report on a model fiscal responsibility bill for state governments.52 The Bank provided technical assistance in the preparation of the report. A group was formed in October 2003 with the state Finance Secretaries of Kerala, Karnataka, Maharashtra, Punjab, Tamil Nadu and a representative from the Ministry of Finance, Government of India, as members. The Secretariat was provided by the IDMD of the Bank. A model law was drafted after the central FRBM Act and built upon the state fiscal responsibility legislation enacted already.53

Other Issues Concerning Public Debt Management Special Securities

The central government issued special securities to several entities, such as the oil marketing companies, fertiliser companies, the Food Corporation of India (FCI), the erstwhile IDBI, Unit Trust of India and State Bank of India (SBI). Such securities were issued to settle the outstanding dues of the government and not reckoned for the fiscal deficit. These, however, increased 269

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the reserve bank of india Table 7.14 Major Deficit Indicators of State Governments  (per cent of GDP at market prices) Year

Gross Fiscal Deficit

Primary Deficit

Revenue Deficit

1990–91

3.2

1.7

0.9

1991–92

2.8

1.2

0.8

1992–93

2.7

1.0

0.7

1993–94

2.3

0.5

0.4

1994–95

2.6

0.8

0.6

1995–96

2.5

0.7

0.7

1996–97

2.6

0.8

1.2

1997–98

2.8

0.9

1.1

1998–99

4.1

2.1

2.5

1999–2000

4.5

2.2

2.7

2000–01

4.0

1.7

2.5

2001–02

4.0

1.4

2.6

2002–03

3.9

1.2

2.3

2003–04

4.2

1.4

2.2

2004–05

3.3

0.7

1.2

2005–06

2.4

0.2

0.2

2006–07

1.8

-0.4

-0.6

2007–08

1.5

-0.5

-0.9

Source: RBI, Handbook of Statistics on Indian Economy.

Notes: Gross Fiscal Deficit (GFD) = Excess of total expenditure (including loans net of recovery) over revenue receipts (including grants) and non-debt capital receipt. Since 1999–2000, GFD excludes states’ share in small savings. Primary Deficit = GFD minus interest payments. Revenue Deficit = Difference between revenue receipts and revenue expenditure. Negative sign denotes surplus.

the outstanding interest-bearing liabilities of the government and, therefore, prevented the government from adhering to the FRBM targets. These special bonds did not have SLR status as the bonds were not part of the approved MBP; their coupon rates were based on the prevailing secondary market yield of SLR-eligible and comparable government securities, and 270

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public debt management these were transferable (except oil bonds before 2002) and eligible for market repo but not eligible for repo and reverse repo with the Bank during the reference period. From March 2002, oil bonds carried full transferability and tradability. However, in 2006–07, the issuance of additional supply of FCI bonds carrying full transferability meant that it would not only increase the cost of the MBP and crowd out private investment but would also result in a likely increase in yield rates. The Bank, therefore, proposed (7 September 2006) that these bonds should carry a limited transferability feature similar to the power bonds (see later). These special securities were issued in large volume from 2001–02 onwards but gathered momentum from 2006–07 when the FRBM Act, 2003, became operational (Table 7.15). The total volume of special securities amounted to as much as 36 per cent of the net market borrowing of the government in 2006– 07. The outstanding amount of special securities at the end of June 2006 was 10 per cent of the outstanding dated marketable securities. The Bank pointed Table 7.15 Issuance of Special Securities Year

Special Securities

Others*

Total

Net Market Borrowing

4

5

6

7

-

90

4

90

-

3

3

6

Fertiliser companies

FCI

1

2

3

2001–02

-

2000–01 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08

Source: RBI.

-

-

-

-

-

-

-

162

75

Oil marketing companies

1

0.1

44

1041

4

461

29

1113

36

58

74

131

-

403

-

206

241

-

100

8

738

44

115

Column 6 as % of Column 7

1

-

-

( billion)

115 380

923 888 982

1095

10 1

12 35

Note: * Special securities issued to Industrial Finance Corporation of India, Industrial Investment Bank of India, SBI, and so on. 271

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the reserve bank of india out to the government that if these bonds were included in the budget, the fiscal deficit would increase by at least 1 per cent of the GDP in 2006–07. Another interesting feature of these securities was that the maturity of these bonds increased from three–nine years in 2005–06 to nineteen–twenty years in 2006–07 and 2007–08. Although the government explored the feasibility of issuing bonds of lower maturity, as the Bank noted, there was small headroom available when market conditions were not conducive.

Power Bonds Power bonds were issued to certain central PSUs by the state governments in 2004–05. The scheme was an outcome of the report of the Expert Group on Settlement of State Electricity Board Dues,54 which recommended the issue of power bonds. The Bank had reservations about the proposal.55 The inclusion of such bonds in SLR borrowing, the Bank held, did not serve any purpose since most banks had excess SLR. An automatic debit mechanism by way of a tripartite agreement as planned was not desirable and ‘virtually inoperable’. The bonds could also crowd out private sector credit. The scheme was modified in 2002, but the Bank felt that more clarifications were needed. In a letter (3 May 2002) to the Secretary (Expenditure), C. S. Rao, Deputy Governor Reddy pointed out that the proposed power bonds having a coupon that was not aligned with the market, was tax free and had other special features, and could not be serviced in the same manner as other state government bonds issued through the Bank under the approved market borrowing programme. It was, therefore, suggested that these power bonds might be issued and serviced by the states themselves. To the extent the power bonds were released in the market, these were to be set off against the aggregate market borrowings in each year. The Bank was not in favour of the automatic debit mechanism as it eroded the credibility of the state governments. A meeting took place in Mumbai on 19 July 2002 between the Governor and Suresh Prabhu, Union Minister for Power. The Minister appreciated the concerns of the Bank, particularly with regard to the servicing of SLR bonds, and said that power sector reforms, which would have long-term implications on the fiscal position of the states, needed to be kept in view. He also appreciated the difficulties of the Bank in regard to its role in operationalising the tripartite agreement with the Government of India and state governments. In a letter dated 31 July 2002, written to R. V. Shahi, Secretary, Ministry 272

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public debt management of Power, Deputy Governor Reddy reiterated concerns over the tripartite agreement: ‘[T]he Cabinet should have the opportunity to assess whether faithful implementation of the Agreement could under some circumstances require RBI to give preference to debiting the State Government accounts with expenditures not necessarily approved by the legislature.’ In a meeting held on 26 August 2002, the Secretary, Ministry of Power, discussed the matter with Bank officials. The Secretary said that the Cabinet Committee decision was ‘final’ and there could be no going back on the treatment of power bonds on the same footing as market borrowing as regards the modality of servicing. Bank officials stuck to the stand that while the bonds would be issued under the Public Debt Act, the servicing of the bonds would be subject to availability of funds in state government accounts. As the issues were rather sensitive, the Finance Secretary was informed of the developments and the Bank’s views through a letter by Deputy Governor Vepa Kamesam (28 August 2002). The letter mentioned that as an exception if the Ministry of Finance was agreeable with regard to the treatment of power bonds as SLR securities, the Reserve Bank was prepared to go along with the Ministry on this point. However, the Bank considered the implications of such bonds being managed like any other market borrowings of states as serious and could have far-reaching repercussions in future in case the states were not in a position to meet their obligations. The Bank suggested two options. First, the government could consider giving a standing authorisation to the Reserve Bank to draw from the government an automatic temporary advance to pay for interest and principal on power bonds. Second, the Ministry of Finance could go back to the Cabinet to seek an amendment to the agreement that the servicing of those bonds would be subject to availability of funds in the state government’s account. In its reply, the Finance Ministry advised that the Ministry of Power had agreed that the bonds could be serviced subject to availability of funds in the state accounts, that the bonds would be released in the market subject to specific approvals by the Bank, and that debits to state accounts in respect of current dues could be done on the basis of specific debit instructions issued by the government. On 12 March 2003, the Ministry of Power, Government of India, informed the Bank that it wanted to have a signing ceremony, to which Deputy Governor Rakesh Mohan wrote (19 March 2003) that the Bank’s participation in the signing ceremony was on the understanding that the pending operational 273

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the reserve bank of india and procedural issues would be settled to mutual satisfaction. The agreement was signed on 20 March 2003 in New Delhi and after several deliberations involving the Ministry of Power, Ministry of Finance and the Bank, by August 2003 most of the pending issues relating to the issuance of bonds by the state governments were settled.

Guarantees An issue that generated considerable discussion was government guarantees to promote investment, mainly in the infrastructure sector. Articles 292 and 293 of the Constitution empower the central and state governments to offer guarantees within limits set by the legislature. Guarantees assumed significance in the early 1990s in the context of participation by the private sector in infrastructure projects. The central government gave guarantees for loans raised by public enterprises, railways, union territories, state governments, local bodies, joint stock companies and cooperative institutions, among others. State governments also provided guarantees in a similar fashion. While the guarantees did not form part of debt as conventionally defined, in the case of default, they could disturb the fiscal system. Further, guarantees were often given without proper assessment of the projects concerned. The Bank did not manage these contingent liabilities but played an indirect role in sensitising the government to the risk inherent in the guarantees. The Bank also issued guidelines to commercial banks advising them to examine the projects before providing loans to state governments against guarantees. The issue became quite alarming to the monetary and fiscal authorities, insofar as the state governments were concerned, during the reference period. The demand for extending guarantees for developmental projects was increasing because of a fall in the capital expenditure of states, and their limited borrowing capacity on the one hand juxtaposed with rising demand for basic infrastructure facilities to achieve a higher growth trajectory on the other. In its Annual Report, 1998–99, the Bank prophesied: ‘Most of the guarantees extended by States are concentrated in favour of financial institutions, which could be discouraging proper risk assessment of credit by such institutions, involving a moral hazard problem.’ In 1999, a Technical Committee on State Government Guarantees recommended fixing a limit on guarantees and exercise discretion. The Bank took some steps as a follow-up to the recommendations.

274

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public debt management To ensure that the risk profile of guarantees showed, the Bank, in October 1998, advised banks that from 2000–01, investments in state government guaranteed securities outside the MBP would attract a credit risk weight of 20 per cent. Further, in case of default, banks should assign 100 per cent risk weight for investments in such securities. From April 2000, these norms were amended so that the risk weight would apply only to the guaranteed bonds of defaulting entities. Some states initiated legislation towards placing a statutory limit on guarantees during 1999–2000. Gujarat was the first state to announce such a ceiling on the level of guarantees. Karnataka and Rajasthan also prescribed a cap on total outstanding government guarantees, while states like Tamil Nadu, Bihar and Nagaland were considering the issue of a ceiling on guarantees. The Bank persevered with its efforts to sensitise state governments about the problems posed by the increasing volumes of guarantees (Table 7.16). With the experience gained thus far, the Bank constituted a Group of State Finance Secretaries to Assess the Fiscal Risk of State Government Guarantees (2002) to suggest a method for the evaluation of the fiscal risk of state government guarantees. The group recommended that guarantees should be met out of budgetary resources and treated as equivalent to the debt; they needed to Table 7.16 Outstanding Guarantees of State Governments Year (end-March) 1997 1998 1999

Amount ( billion)

Per Cent of GDP

727.82

4.6

641.92 793.14

2000

1,320.29

2002

1,648.13

2001 2003 2004 2005 2006 2007 2008

1,687.19 1,842.94 2,196.58 2,042.55 1,950.49 1,920.87 1,843.55

Source: RBI, State Finances: A Study of Budgets, various issues.

4.5 4.4 6.5 7.7 7.0 7.3 7.7 6.3 5.3 4.5 3.7

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the reserve bank of india be assigned appropriate risk weights, and at least 1 per cent of outstanding guarantees should be transferred to the guarantee redemption fund (GRF) each year, specifically to meet the additional fiscal risk. As on 30 June 2008, seventeen state governments fixed statutory/ administrative ceilings on guarantees, of which eight states set up GRFs. The aggregate outstanding investments in these funds increased from 4.30 billion as at the end of March 2004 to 28.05 billion as on 31 March 2008.

Other Related Measures Following the recommendations of the Tenth Finance Commission (1995) and subsequent discussions with state governments, the Bank circulated the scheme of a consolidated sinking fund (CSF) to state governments in June 1999. The objective of setting up a CSF by state governments was to provide a cushion to the repayment of open market loans. As per the scheme, state governments would contribute to the fund every year 1–3 per cent of the outstanding open market loans as at the end of the previous year. A withdrawal was not allowed before five years from the date of notification of the scheme by a state government. The investments in CSF were undertaken by the Bank out of its own stock of government securities.56 The Reserve Bank managed the investments in both CSFs and GRFs out of its own portfolio of government securities. The transactions on account of CSFs and GRFs took place at the reference market price released by the FIMMDA. Apart from a small commission, the Bank did not impose any charge on state governments. As of 30 June 2008, twenty states had set up CSFs. The aggregate outstanding investments in CSFs increased from 25.84 billion as at the end of March 2004 to 202.84 billion as on 31 March 2008. The Technical Group on Borrowings by States57 constituted by the Government of India noted that liquidity in state government securities remained negligible in comparison to central government securities. One of the major reasons for this was that the securities were primarily subscribed to by nationalised banks, insurance companies, financial institutions and PDs. Due to the small size of individual stocks, the majority of these investors held these securities until maturity or partly offloaded to RRBs, cooperative banks, provident funds and pension funds. Therefore, reissue of existing security would make the secondary market more active.58 The matter was discussed in the 19th Conference of State Finance Secretaries on 24 January 2007. State 276

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public debt management governments agreed to consider issuing two new securities in a financial year. These securities could be reissued for subsequent tranches during the first and second halves of the year.

Conclusion The chapter outlined the Reserve Bank’s role in effecting a transition from a regulated to a market-oriented system of public debt management. The transition had a number of components, including an institutional change in the securities market, the redefinition of the relationship between the government and the Bank, and changes in the processes and procedures within the Bank. Some of these issues are also discussed in other chapters, though their relevance in the context of debt management required a fuller treatment here. The Reserve Bank played a pivotal role in framing the FRBM Bill (which was subsequently passed as the FRBM Act) and in introducing procedures for a smooth changeover to the new scenario vis-à-vis dealings in the government securities market. The executives of the Bank participated in the regular meetings of the Monitoring Group on Cash and Debt Management convened by the Ministry of Finance to oversee the developments taking place in the domain of government cash flows and in the debt securities markets. The Bank discharged its statutory responsibility of public debt management, in coordination with the government, through policy formulation and evolving operational procedures in response to the emerging situation in the securities market. The Bank took the initiative in exploring the possibility of ‘active’ consolidation of a portfolio of government dated securities through debt market operations. Equally significant, the need for separation of debt management from monetary management responsibilities was strongly mooted by the Bank. This concept found favour with the government. However, for reasons already cited earlier in this chapter as well as in Chapter 3, progress in this direction was modest. A particularly far-reaching transformation occurred in the sphere of public debt management of states. There is no better way to sum up the nature of the change than to refer to a speech that Governor Reddy delivered at the Madras School of Economics on 23 September 2007. In the Indian polity, Governor reminded the audience, the states had taken a prominent place in the reform process because areas of national priority, such as agriculture, 277

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the reserve bank of india education and public health, fell within the purview of states. There was, however, little literature available on the theory or practice of the role of central banks in dealing with sub-national governments, which made the Bank’s experience particularly valuable. The collaborative process started with the Annual Conference of State Finance Secretaries in November 1997, which founded the collaboration on dialogue, consultation and ‘mutual trust’. In the process, the Bank continuously adapted its WMA strategy and proposals on investment of cash balances. The Bank provided comprehensive technical inputs to the Government of India for formulating and enacting the FRBM Act by Parliament, which paved the way for a model fiscal responsibility legislation for states.

Notes 1. Jammu and Kashmir had such agreements in the period of the study. 2.  In the government securities market, a policy of passive consolidation through reissuance of securities was started in 1999 to improve fungibility among the securities and to facilitate consolidation of debt. The larger size of securities was intended to improve market liquidity and help in emergence of benchmark securities in the market. 3. See Reserve Bank of India, The Reserve Bank of India, Vol. 4: 1981–1997 (New Delhi: Academic Foundation, 2013) on the process leading to this step. Also see Chapter 3. 4. For example, the RBI Annual Report, 1998–99, expressed the fear that the revenue deficit of the centre and states placed enormous burden on the capital account of the budgets, and were not sustainable even if India’s real gross domestic product (GDP) grew at an average of 6–6.5 per cent per annum. Similar concerns were raised again in the next year’s annual report. The report added that in the interest of sustainability, a strong institutional mechanism in the form of fiscal responsibility legislation (FRL), as announced in the preceding Budget, would be necessary. The FRL would aid sustainability, but for it to be credible, the law should include stringent requirements for fiscal transparency, backed by strong enforcement mechanisms. Following a technical paper published in the RBI Bulletin (December 1997), a discussion followed on the theoretical and practical rationale for fixing a statutory limit on public debt. A statutory limit, apart from keeping the size of debt manageable, would enhance the credibility of anti-inflationary policy and make the domestic economy more efficient in terms of resources use. International experiences showed that many countries placed limits on the government’s access to central bank credit. The European Union countries 278

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public debt management had two separate limits for government borrowings, one based on flow of debt in a year and another based on the debt stock at the end of every financial year. 5. In early 2000, the Bank conducted a seminar, in which senior officials of the centre and states participated, on matters relating to fiscal rules and international practices. 6. An extract from the speech of Governor Y. V. Reddy, made at the National Institute of Public Finance and Policy (NIPFP) on 26 May 2008. 7. Other members included then Deputy Governor Reddy; Controller General of Accounts A. M. Sehgal; J. S. Mathur, Additional Secretary (Budget and Coordination), Department of Economic Affairs; Ashok Lahiri, Director, NIPFP; N. L. Mitra, Director, National School of Law; and a nominee of the Comptroller and Auditor General of India. 8. Prem Chand of the International Monetary Fund (IMF), at the invitation of the Reserve Bank, spent some time advising the working group on international best practice. 9. The government set up a Task Force on Implementation of the FRBM Act, 2003 (Chairman: Vijay Kelkar). The report of the Task Force was submitted on 16 July 2003. It addressed the issue of fiscal planning in two stages, provided baseline projections on central government finances and devised policy proposals which closed the gaps, if any, between the baseline projections and the requirements of the Act. 10.  Saumitra Chaudhuri later became a member of the Prime Minister’s Economic Advisory Council. 11.  Willem H. Buiter and Urjit R. Patel, ‘Fiscal Rules in India: Are They Effective?’ NBER Working Paper Series, Cambridge MA, 2010. 12. Ricardo Hausmann and Catriona Purfield, ‘Challenge of Fiscal Adjustment in a Democracy: The Case of India’, NIPFP/IMF Conference on Fiscal Policy in India, 16–17 January 2004, New Delhi. 13. Along with other measures to facilitate market participation in borrowing programmes, the settlement system for transactions in government securities was standardised to T + 1 cycle from 24 May 2005. The aim was to provide the participants with more processing time at their disposal, thereby enabling better management of both the funds and the risks. To provide the members of the Negotiated Dealing System (NDS) with a more efficient trading platform in government securities, the NDS-Order Matching (NDS-OM) trading module was introduced from 1 August 2005. Intra-day short-sale was permitted in government dated securities, subject to certain stipulations from 28 February 2006. Guidelines for introduction of ‘when-issued’ market in central government securities were issued on 3 May 2006. ‘Whenissued’ is a conditional transaction in a security authorised for issuance but not yet actually issued. This type of market facilitated stretching the actual distribution period for each issue and allowed the market more time to absorb 279

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the reserve bank of india large issues without disruption and thus helped in price discovery. ‘Whenissued’ trading commenced from 1 August 2006 with respect to two securities auctioned on 8 August 2006. 14. In countries with well-developed financial markets, debt management is based on the fiscal operations of the government while monetary policy is carried out independently. However, achieving a separation between debt management and monetary policy might be more difficult in countries with less-developed financial markets, since debt management operations in that case can have significant effects on interest rates and local capital markets. 15. Chairman: S. S. Tarapore, 1997. 16. The Bank set up a working group (Convenor: V. Subrahmanyam, 1997) against the backdrop of transfer of debt management from the Bank of England to the Treasury in the United Kingdom from July 1997. 17. The Advisory Group on Transparency in Monetary and Financial Policies (Chairman: M. Narasimham, 2000) also recommended separating debt management and monetary policy functions. 18. The group noted that different models of DMOs were available and in many countries, such as Denmark, debt management function continued to be performed by the central bank. 19. The meeting also discussed division of responsibilities and concluded that the Bank would continue to handle borrowings under the MSS and actual implementation of the borrowing programme. 20. There was a steep rise in the requirement of government securities due to sterilisation of foreign exchange inflows in 2003–04. In a letter to the Secretary (Expenditure and Budget) dated 26 March 2004, Deputy Governor Rakesh Mohan pointed out that the surplus balance in the Government of India’s cash account being very high in the previous two weeks, the Bank risked running out of securities for delivery under the LAF (see Appendix 7A.2). To avoid having to reject repo bids, the Bank suggested placing a ceiling on the amount of surplus balance of the government that could be invested. In other words, any balance eligible for investment more than the ceiling would not earn any interest. The letter added that the ceiling might be revised downwards depending on the availability of securities, consequent on the increasing size of the monetary operations in the future. 21. It could send feelers to the market that, henceforth, the government might not issue many short-dated securities in view of the implications of growing borrowing requirements. There was a trade-off between paying marginally more for current borrowing requirements by borrowing longer term and paying substantially more in future. 22. The FRBs were issued in 1995 when the interest rates were very high, and on the assumption that the rates would fall. The coupon on the FRB was linked to average cut-off yields in 364-day Auction T-bills. These were at that 280

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public debt management time auctioned without a notified amount and the rates that emerged at the auctions were not taken by the market as truly market determined, with the Bank deciding the cut-off. 23.  With the Discount and Finance House of India, Securities Trading Corporation, SBI and Punjab National Bank. 24. With a view to moderating the impact of large borrowing programmes, the Bank on occasions accepted private placement of government stocks and released them to market when interest rate expectations turned favourable and liquidity conditions improved. The Bank offloaded its initial subscriptions when it needed to through net open market sales. This practice came to an end in April 2006. 25. A ‘held-to-maturity’ security is purchased with the intention of holding the investment to maturity, a decision that is based on the view that in the long run, financial markets give a good rate of return even while taking into account a degree of volatility. The opposite of buy-and-hold is active trading, in which an individual tries to be short on the peaks and buy on the lows, with more money coming forth with more volatility. 26. Letter from Deputy Governor Mohan to Finance Secretary S. Narayan. 27.  The letter to the government by Deputy Governor Mohan considered the proposal. 28. Active consolidation involved a net premium payable by the government since most of the illiquid securities were high coupon, whereas the securities reissued would be largely current coupon. It would also involve a tradeoff between increased interest rate risks of banks and other investors and higher rollover risk for the government. Operationally, buyback would mean additional borrowing by the government, though the net increase in debt would be limited to the extent of net premium payable. 29. To quote, most of the illiquid securities are likely to be held by banks in their HTM category.... To the extent this is done, the objective of consolidation exercise will be defeated since HTM securities are virtually out of the pale of trading; and a large number of illiquid securities are held by LIC.... LIC might have a natural reason to hold high coupon securities if it follows a policy of matching liabilities with assets. If this is so, LIC may not like to sell these high coupon securities. Thus, tradability might actually not improve.

IDMC (Internal Debt Management Cell) was renamed as IDMD (Internal Debt Management Department) in May 2003. 30. A liaison group constituted by the Ministry of Finance, which included representatives from the Bank, met on 9 September 2005 and 24 May 2006, and worked out a firm proposal for implementing the scheme. The proposals 281

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the reserve bank of india included an auction to buy back the selected securities and, depending upon the response in the auction, to decide whether to go for further rounds of auctions or follow up the auction with bilateral deals with investors and PDs. These recommendations were conveyed to the Ministry of Finance (letter dated 18 July 2006 from Chief General Manager, IDMD). In November 2006, a new draft scheme was prepared by the IDMD under the guidance of Deputy Governor Mohan. The scheme envisaged that the entire consolidation exercise (buyback as well as replacement issues) was to be done in the books of the government and exclusively funded by the government without affecting the Bank. 31. Letter dated 18 December 2006 from L. M. Vas, Joint Secretary. 32. Some of the important suggestions were that the objectives should include smoothening of the maturity profile of debt, and the option of payment for the bought back securities, different methods of issuance such as auctions, switches or bilateral operations were to be highlighted, and a change be made such that buyback operations would normally precede the replacement issues, except in the case of switches. 33. The group was chaired by the Additional Secretary (Budget), Government of India, and the members included the Controller General of Accounts, the Economic Adviser and the Executive Director (RBI) dealing with IDMC, among others. 34. Written by the Executive Director, Khizer Ahmed, to the Finance Secretaries of Assam, Bihar, Uttar Pradesh and Arunachal Pradesh – states which had not completed their annual MBPs by December 1999. 35. Office note dated 28 March 2001. 36. The ten-year yield (liquid paper) was around 7.78 per cent. It was noted that the market participants had been asking for a higher spread for state government paper. In his note seeking the approval of the Governor, Deputy Governor Reddy observed that the effective spread for state governments over the centre’s paper came to 44 bps. In view of the low yields for the centre’s paper and market perceptions of states’ papers, a large premium seemed inevitable. 37. For example, on 27 May 2005, the Finance Secretary of Kerala informed the Deputy Governor that because of the improved fiscal position of the state, it had swapped some loans due to the Government of India and the outstanding loans with the General Insurance Corporation (GIC), with own resources. LIC had agreed to the prepayment with respect to their outstanding loans. But the premium being substantial, the state requested the Bank to support its proposal for an open market borrowing to fund this expenditure. On 9 June 2005, the Commissioner and Secretary to Assam advised the Bank that the Assam government had constituted a Consolidated Sinking Fund (CSF) for redeeming its open market loan. He requested that the bidders in the 282

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public debt management forthcoming auction issue may be informed of this so that they felt more comfortable with the bonds. 38. The 16th Conference of State Finance Secretaries (8 April 2005) stressed the need for a coordinated and smooth transition to a market-based system. Subsequently, in July 2005, the government constituted a technical group (chaired by Deputy Governor Shyamala Gopinath) to work out the mechanism of a transition. Based on the recommendations of the group, the Bank’s Annual Policy Statement for 2006–07 proposed to form a standing technical committee under the aegis of the Conference of State Finance Secretaries with representation from the central and state governments and the Reserve Bank to advise on wide-ranging issues relating to the borrowing programme of the central and state governments through a consensual and cooperative approach. 39. For states, the DSS was debt-neutral as it involved swapping one form of debt with another. In states’ budgets, repayment of loans to the centre reduced the debt of states. However, as this repayment was made out of additional market borrowings and small saving transfers, it increased the debt from these sources by an equal magnitude. Over a period of time, however, savings in the form of lower interest payments reduced the pressure on the revenue account of states and thereby reduced their borrowing requirement. 40. One such occasion arose in March 2000, when the Ministry of Finance advised the Bank to arrange additional market borrowings of 14.20 billion for six state governments. The Bank suggested that the government adjust the allocation against the current budget (1999–2000) and then get it readjusted in 2000–01. But the government wanted the money to be raised urgently. Deputy Governor Reddy desired that the issues arising out of the proposal be examined by the IDMC. The IDMC held (office note of 9 March 2000) that if state governments entered the market at that point in time, there would be problems of fixation of coupon as the yield for a ten-year coupon in the primary market then was quite volatile. The secondary market rate of a similar maturity had also varied widely. Moreover, since both the central and state governments would enter the market in April 2000, it would not be appropriate to enter the market in March. The note suggested that the quantum of additional borrowing could be taken as private placement with the Bank. The amount would be raised by the government as part of its MBP with a maturity period of ten years, and subsequently passed on to state governments as loans. This type of transaction, the office note felt, carried no adverse implication on the fiscal deficit as the amount raised would be shown in both the capital receipts and capital expenditure. Governor Jalan, after discussions with Reddy, instructed (on 13 March 2000) the office to go ahead with state loans. The matter, however, was raised in subsequent correspondence between the Bank and the Ministry. 283

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the reserve bank of india 41. The adverse effect was obvious for state governments. The Bank would not be affected as a debt manager, but it could face some challenges in trying to boost the confidence of the market. 42. The Secretary, Department of Expenditure, Ministry of Finance (C. S. Rao), ‘fully endorsed’ the Bank’s concerns, and agreed, with specific reference to West Bengal, that the debt profile was becoming ‘increasingly unsustainable’ (16 November 2001). 43. ‘Special Category’ refers to states considered by the Planning Commission and the National Development Council as either historically disadvantaged (difficult terrain, low population density, large tribal population) or strategically important (located on an international border) for allocation of central plan assistance. 44.  This perception was conveyed to the government in Deputy Governor Reddy’s letter dated 7 January 2002 to Secretary C. M. Vasudev. 45. The progressive reductions in the Bank Rate had brought the interest rates on WMA and overdrafts to 9 per cent and 11 per cent, respectively. However, when the Bank Rate was raised from 9 per cent to 11 per cent on 16 January 1998, the interest rates with respect to WMA and overdrafts of state were maintained at 9 per cent 11 per cent, respectively. 46. The Informal Advisory Committee on Ways and Means Advances to State Governments (Chairman: B. P. R. Vithal). 47. A lower and uniform margin of 5 per cent (compared to 10 to 15 per cent margin earlier) would be applied on the market value of the securities for determining the operating limit of special WMA. States would have to make use of special WMA limits at a rate of 1 per cent below the Bank Rate, before seeking accommodation under the normal WMA limits. The number of days a state could be in overdraft was extended to fourteen consecutive working days. 48. Chairman: M. P. Bezbaruah. 49. The aggregate normal WMA limit was increased for 2006–07. The interest rate on WMA was linked to the LAF repo rate (against the Bank Rate earlier) as it was more reflective of short-term monetary conditions. The rate of interest on overdraft would be 2 percentage points above the repo rate (the existing level was 3 percentage points above the Bank Rate) for overdraft of 100 per cent of normal WMA limit, and 5 percentage points above the repo rate (against the existing 6 percentage points above the Bank Rate) for overdraft exceeding 100 per cent of the normal WMA limit. The revenue deficit, wherever applicable, was to be excluded from the base. With the objective of providing an incentive to state governments to build up the consolidated sinking fund (CSF) and the guarantee redemption fund (GRF), net incremental annual investments in these funds were made 284

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public debt management eligible for making use of special WMA up to a ceiling equivalent to the normal WMA limit. 50. The working group report (December 2006) recommended reduction of noncompulsive borrowings (such as open market borrowings, negotiated loans and loans relating to externally aided projects), enhancement of contributions to CSF/GRF and discharge of overdue guaranteed obligations, buyback of securities (open market loans, power bonds with embedded call option, and so on), investment in securities other than T-bills, placing the funds in public accounts in a trust set up by state governments outside their Budgets or make financial investments in enterprises owned by them, linking the discount rate on ITBs to the reverse repo rate, and formation of specialised debt and investment management units (DIMUs) in state governments. 51.  Major states were Uttar Pradesh, Tamil Nadu, Assam, Bihar and Madhya Pradesh. 52. These meetings became an effective platform for all stakeholders – states, the centre and the Bank – to discuss transitional issues and form partnership. 53. The draft report of the group was discussed at the 14th Conference of State Finance Secretaries in August 2004 and the final report was submitted to the Bank in January 2005. It was intended to provide guidance to states for enacting their fiscal responsibility legislation regarding certain benchmarks. 54. Chairman: M. S. Ahluwalia, 2001. 55. Conveyed by Deputy Governor Reddy to the Finance Secretary, Ajit Kumar, on 29 March 2001. 56. The scheme was revised in line with the recommendations of the Twelfth Finance Commission (TFC, November 2004), the Advisory Committee on Ways and Means Advances to State Governments (Chairman: M. P. Bezbaruah, October 2005) and the Technical Group on Borrowings by the States (Chairperson: Shyamala Gopinath, December 2005). The revisions included extending the ambit of the CSF to cover amortisation of all liabilities (and not just open market borrowings); making states eligible to make use of special WMA equivalent to their net incremental annual investment in CSF; making states contribute at least 0.5 per cent of the outstanding liabilities to the fund; and allowing provision for acquiring of securities by the Bank from the secondary market. In May 2006, the revised scheme was circulated to state governments. 57. Chairperson: Deputy Governor Shyamala Gopinath. 58. If a security is reissued, the terms and conditions in respect of coupon payment and maturity remain unchanged. The increase in lot size through reissuance of the security would improve liquidity but would result in bunching of repayments. As a result, it was pointed out that states would have to make bullet payment of a larger size at the time of maturity of the security, which, in turn, would increase the refinance risk. 285

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8 The Payment and Settlement Systems

Introduction A payment system is defined as ‘a system that enables payment to be effected between a payer and a beneficiary, involving clearing, payment or settlement service or all of them, but does not include a stock exchange’, and includes ‘the systems enabling credit card operations, debit card operations, smart card operations, money transfer operations or similar operations’. Settlement means ‘settlement of payment instructions and includes the settlement of securities, foreign exchange or derivatives or other transactions which involve payment obligations’ (Payment and Settlement Systems Act, 2007). Clearing operations are subsumed in payment and settlement systems. A standard classification of the payment and settlement systems relevant for the reference period is shown in Table 8.1. The economic liberalisation process had led to growth and innovation in financial markets, as well as increased risks. Responding to these challenges Table 8.1 Classification of Payment and Settlement Systems Large Value Payment Systems*

Interbank Cheque Clearing† High-Value Clearing† Negotiated Dealing System Foreign exchange Clearing Real Time Gross Settlement System

Retail Payment Systems

Cheque Clearing (MICR/non-MICR) † Electronic Clearing Services (ECS [Debit] and ECS [Credit]) Electronic Funds Transfer Systems (EFT/ NEFT) Card Payments Electronic Benefit Transfer System Mobile Payments

Source: Adapted from RBI, Annual Report, 2002–03, and as updated at the end of 2007–08. Notes: * Considered as Systemically Important Payment Systems (SIPS). †

Paper-based systems in contrast with other retail payments which are electronic.

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the payment and settlement systems and opportunities, the Reserve Bank redesigned and developed the payment and settlement infrastructure. Several major initiatives had begun before 1997, including the introduction of magnetic ink character recognition (MICR) technology, electronic clearing service (ECS), electronic funds transfer (EFT) and delivery versus payment (DvP) in government securities transactions.1 In the capital market, the National Securities Depository Ltd. (established in 1996) pioneered dematerialisation of securities. In 1996, the Bank set up the Institute for Development and Research in Banking Technology (IDRBT) in Hyderabad. From 1 January 1995, the Bank carved out a separate department, the Department of Information Technology (DIT) out of the Management Services Department. Until 2005, the DIT oversaw initiatives based on information technology (IT) within the Bank and the industry, and improved the infrastructure of the payment-and-settlementrelated services. The organisational evolution culminated in March 2005 with the establishment of the Department of Payment and Settlement Systems (DPSS) and a Board for Regulation and Supervision of Payment and Settlement Systems (BPSS). A Payment and Settlement Systems Act, 2007, accorded regulatory and supervisory powers to the Bank over all payment systems in the country. This chapter outlines the major initiatives undertaken and implemented by these bodies during the reference period to improve speed, convenience, efficiency and safety in financial transactions.

The System in 1997–98 The banking network as at the end of March 1998 consisted of 66,306 bank offices belonging to 299 commercial banks (27 in the public sector, 34 in the private sector, 42 foreign banks and 196 regional rural banks). In addition, there were 413 cooperative banks at the state and district levels, 1936 primary urban cooperative banks and 745 primary land development banks. Restricted banking facilities were provided by post offices numbering over 100,000. Cash continued to be the dominant means of settling payments.2 However, over the previous two decades, there had been a substantial growth of paperbased instruments such as cheques, demand drafts, travellers’ cheques, payment orders and interest and dividend warrants. Banks also offered other means for funds transfer such as mail and telegraphic transfer. A small beginning 287

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the reserve bank of india had been made in electronic payment instructions through ECS (credit and debit) and EFT. Banks had started using plastic cards such as credit cards. Automated teller machines (ATMs) for various banking transactions had also been set up through a shared payment network of banks. Cheques were the most important form of payment apart from cash. In the previous two decades, the volumes of cheques had registered a growth of around 10 per cent a year. While it was recognised that the introduction of electronic substitutes might reduce the growth of cheques and other payment instruments, paper-based payment instruments would continue to play an important role in payment transactions in local and intercity payments. Under the Negotiable Instruments Act, 1881, all instruments had to be physically presented for payment and settlement. Therefore, in both local and intercity clearing, payment instruments had to be transported physically from the collecting bank or branch to the paying bank or branch. The communication flow (originating and responding advice) was sent through the post, telephone and telegram. In 1990, the Bank set up the BANKNET telecommunication network which connected four metros and three other centres through intercity leased Department of Telecommunications lines. Dial-up connectivity to the network was provided through RBINET communication software. Settlement of payment instruments took place in 860 clearing houses as at the end of March 1998. In fourteen major centres, the clearing houses were managed by the Bank, 840 were managed by State Bank of India (SBI) and its associates, and 6 by nationalised banks. Computerised cheque clearing settlement was available at four metros, with the cheque processing being done at the National Clearing Centres. Interbank settlements were done at the fifteen Deposit Account Departments of the Bank individually. Banks maintained a current account at each Deposit Account Department and these accounts were used to settle clearing and other payments. Interbank clearing settlement was done in the books of the Reserve Bank through an end-of-theday netting system. The Bank did not guarantee the settlement as it was done on the basis of availability of funds. In other centres, the bank that managed the clearing house maintained the accounts of the participant banks and a netting settlement was done with respect to the clearing transactions. The Remittance Facility Scheme of the Bank enabled banks to transfer funds between their accounts in different Deposit Account Departments. In other centres, SBI and its associates provided the remittance facility as well as treasury functions as agents of the Reserve Bank. 288

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the payment and settlement systems All members of the clearing house maintained an account with the clearing bank managing the clearing house. In case of an adverse position in the clearing, a banker’s cheque was issued to the clearing house. The branch managing the clearing house might either withdraw or deposit funds into the currency chest, without either decreasing or increasing the liquidity at that centre. Liquidity management was done at the controlling offices, where the Issue Departments of the Bank were located. The introduction of MICR-based clearing in 1986 started the era of computerisation in payment systems in India. Initially confined to the four metropolitan centres, the MICR technology was expanded in phases to cover 26 centres by 1998. In the centres where MICR was yet to be introduced, computerised settlement operations had been introduced gradually to cover all clearing houses managed by the Bank. ECS was used for repetitive payments such as dividend, interest or salary or utility bill payments by a large number of customers. This service had been initiated in a limited way in the previous four years and was mainly confined to the four metropolitan centres. It was being extended to other cities. EFT was started on an experimental basis between Mumbai and Chennai in 1996. The service, initially confined to twenty-seven public sector banks, was extended to all the four metropolitan centres and, subsequently, covered seven other major cities. All banks were allowed to participate in the EFT scheme at all the Bank centres where it was in operation. This was done through RBINET and extended to a very small aperture terminal (VSAT) based network as and when it was set up.3 The sale and purchase of government securities under the subsidiary general ledger accounts were done on a DvP basis in the Public Debt Office of the Bank. This was operational in Mumbai, Chennai, Bengaluru and Kolkata. The bulk of the transactions was concentrated in Mumbai. The paper-based systems offered considerable flexibility to customers and were well understood by users. The main strength of the system was an extensive network of banks working on a strong legal basis.4 However, there were several weaknesses too. There was considerable delay in the settlement of a transaction because of the time lag between the issuance of a payment instruction and the completion of payment. Typically, the settlement of a local cheque could take a minimum of three days and that of an intercity cheque seven days. There was a problem of reconciliation of transactions, and entries were often not reconciled for months and even years. This gap would be open 289

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the reserve bank of india to exploitation and frauds. The risk was high due to delay. Irregularities in securities transactions in 1992 were essentially a result of weaknesses in the settlement of government securities transactions. The system had low levels of security. Fund management by banks was not efficient because of the disaggregated nature of settlements and the absence of real-time information and funds transfer facilities.

Early Institutional Arrangements While several initiatives had been taken since the early 1980s with regard to the modernisation and development of payment and settlement systems in the country, the emphasis was laid on technology-based solutions, and what was missing was a holistic approach to issues pertaining to payment and settlement systems. The need for a comprehensive approach to strengthening the system was raised in December 1997 by Executive Director A. Vasudevan, in his report on the Conference of Managing Change in Payment Systems.5 The idea was endorsed by Deputy Governor S. P. Talwar and Governor Jalan, and an Internal Group on Payment Systems was formed on 30 December 1997.6 The group was asked to make an operational plan for the establishment of a Payment Systems Group within the DIT. On 1 January 1998, Vasudevan submitted a note on the ‘Information Technology Strategy’ for the Bank. The note observed that while the DIT had played a role in technological modernisation since 1995, there had been no definitive strategy, nor a wellestablished policy of IT for the Bank. The note attempted to present the main elements of an IT strategy of the Bank for the next three years. The DIT’s present work relating to the payment system of the economy needed to be taken care of by a special group within the DIT. Such a Payment Systems Group had to be multi-disciplinary, with experience in banking, law, economics and technology.7 An internal group was formed. Its report (1 February 1998) paved the way for a Payment Systems Group in the DIT.8 The Payment Systems Group met every week. It prepared position papers after internal discussions and with the department concerned and then put up the papers before the Payment System Advisory Committee. The committee was an advisory body and met every month. Improvements in payment and settlement systems necessarily required constant technology upgrading. The report of the Committee on Banking Sector Reforms (Narasimham Committee II) laid emphasis on this 290

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the payment and settlement systems requirement. To examine the issues pertaining to technology in the banking sector, the Bank appointed, in September 1998, a Committee on Technology Upgradation in the Banking Sector.9 The committee was asked to suggest, among other steps, necessary legislative changes for implementation of electronic funds transfer; computerisation of government accounts; development and utilisation of a satellite-based wide-area-network by financial institutions; standards relating to security, messages and smart cards; data warehousing and data mining; management information system; and guidelines for outsourcing of programme development and implementation. The committee in its report of 7 May 1999 made a number of specific recommendations on these matters.10 An action plan was drawn up and three subgroups were formed to review security policies, legal issues and computerisation in banks. Each bank was asked to prepare a five-year computerisation plan and follow it up. The internal group had recommended setting up of a National Payments Council (NPC). The NPC was formed in June 1999 with Deputy Governor S. P. Talwar as the Chairman and members drawn from major commercial banks, Ministry of Finance, stock exchanges, Securities and Exchange Board of India (SEBI) and non-banking financial companies (NBFCs).11 The objectives of the NPC included coordination of the reform process; giving policy directions; laying down parameters for design and development of an integrated payment and settlement system, and undertaking periodical reviews. To meet these aims, the NPC appointed five regular task forces: (a) Monetary Policy and Related Issues (Chairman: A. Vasudevan), (b) Payment and Settlement Systems Oversight (Chairman: Janakiraman, Deputy Managing Director, SBI), (c) Legal Issues (Chairman: A.T. Pannir Selvam, Chairman, Indian Banks’ Association [IBA]), (d) Technology Related Issues (Chairman: R.H. Patil, National Stock Exchange) and (e) Systems and Procedures (Chairman: Rashid Jilani, Chairman and Managing Director, Punjab National Bank). With these institutional arrangements in place, the DIT transformed from being a department looking after computerisation within the Bank into an agent of change. It played a catalytic role in the design and development of payment and settlement systems, and in promoting new and upgraded technologies in the banking sector in tune with the rest of the world by following the recommendations of the Committee on Technology Upgradation in the Banking Sector. The NPC continued to perform its advisory role until 2005. 291

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the reserve bank of india The Bank in consultation with market participants had started publishing ‘vision documents’ for payment systems. The first such document was released in December 2001 and covered a three-year period. It emphasised consolidation, development and integration of the payment and settlement systems. An evaluation revealed that most of the goals outlined had been met while a few were at various stages of implementation.12 Major achievements related to payment system offerings such as real time gross settlement (RTGS), centralised funds management system (CFMS), negotiated dealing system (NDS), conditions for the setting up of the Clearing Corporation of India Ltd (CCIL), securities settlement systems (SSS), ECS, EFT, new MICR centres, and compliance with the core principles of the Bank for International Settlements (BIS). This document was followed up by another vision document for 2005– 08 (May 2005). The mission was to achieve safe and efficient payment and settlement systems for the country. A summary of an internal assessment of these two vision documents is provided in Appendix 8A.1.

Developing the Communication Backbone: VSAT Technology and the INFINET In the early 1990s, one of the major bottlenecks in the banking system was the lack of fast, safe and secure intrabank and interbank communication. Most complaints against banks then related to the time taken for the transfer of funds across banks and between cities and to the delays in the collection of outstation cheques. The functioning of the terrestrial line networks was not very efficient. The wide geographical spread of branches of banks and the terrain of the country made a reliable communication backbone an imperative. The solution was a satellite-based network using VSAT technology. Without VSAT technology, it would be difficult to initiate the Indian Financial Network (INFINET), which was the telecommunications backbone for the banking and financial sectors.13 While the Bank and the IDRBT were in the process of setting up the VSAT-based INFINET as the main communication backbone, the project met with resistance from the Society for Worldwide Interbank Financial Telecommunication (SWIFT).14 Although SWIFT was present in India since 1992, banks used SWIFT only for transmitting international messages for settlement of international transactions. SWIFT prepared a country plan 292

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the payment and settlement systems for India in 1998, sent it to the IBA, and sought a meeting with it. The IBA sent this plan to the Bank. The country plan reviewed the status of the Indian financial system and SWIFT’s position and plans in the country. DIT in its note (by G. Srinivas, 7 November 1998) took exception to some of the observations in the country report. SWIFT had used unusually harsh language in describing the Bank and public sector banks. The Bank was described as an ‘authoritarian and strong central bank’ and public sector banks as being ‘overstaffed, bureaucratic, inward focussed and with a low international profile’. The use of the obsolete telex by banks in India, the report observed, was due to the Bank and the telecom authorities not permitting banks in India to use SWIFT for domestic messages. Deputy Governor Talwar recorded on the note, ‘I recollect on State Bank of India approaching us for more SWIFT centres, we have said “no” since we are contemplating VSAT to commence operations soon. [I] would like an approach paper in response to SWIFT letter so that we should brief IBA properly to enable them to know our perspective.’ The approach paper on ‘Domestic Use of SWIFT’ explained that the Bank had taken a consistent view from 1994 when the issue was first mooted, that SWIFT could not be used for the exchange of domestic messages. The process of a typical message transfer over SWIFT was the following: a domestic message from bank ‘X’ over SWIFT would travel to SWIFT’s overseas server (Holland or USA) through the Indian gateway and would be re-routed once again to the Indian gateway as the destination is a branch of bank ‘Y’ in India. The responsibility of SWIFT was limited to delivering the message to the gateway and it was the responsibility of the user to log into the gateway and download the message, that is, there was no point-to-point delivery of messages. In view of this limitation, it was felt that INFINET would provide a better solution as messages between branches would not have to travel overseas and then reside at a particular node waiting to be downloaded but could be exchanged directly between the branches. The added advantage would be the settlement of interbank funds, as the Bank would be the service provider. The approach paper added that in February 1996, officials from SWIFT held a meeting with the top management of the Bank, spread over two days, on the issue of domestic use of SWIFT. SWIFT was requested to provide its systems and application software to the Bank on payment of one-time licence fees, which would then run on INFINET. This proposal had the advantage of 293

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the reserve bank of india incorporating both settlement services as well as point-to-point delivery of messages. The officials from SWIFT, however, expressed their reservations on licensing their software as it would directly eat into their revenues. In February 1996, the Department of Telecommunications, while renewing the licence for operation of the SWIFT network, removed all restrictions on the use of SWIFT, throwing it open for domestic as well as international message transfer. The Bank as the main hirer, while conveying its acceptance of the terms and conditions of the Department’s licence, reiterated that its formal acceptance was subject to the Department retaining the clause that SWIFT would be used for only international financial messages. The information gathered by the DIT revealed that there were no restrictions on the use of SWIFT in most countries. However, a meeting with S. Ramani, Director, National Commission on Science and Technology, Mumbai, brought out the fact that permitting the domestic use of SWIFT would starve INFINET of message traffic, make the expenditure incurred on setting up the network redundant and compromise national security by exposing domestic banking transactions to foreign scrutiny. It was, therefore, decided that INFINET needed to be operationalised and stabilised; the users of INFINET be made conversant with all aspects of its functioning; and after these aims were met, the Bank would examine whether SWIFT along with INFINET could be used for domestic messages. A final decision would be taken thereafter. In February 1998, the Department of External Investment and Operations mooted the idea of using SWIFT for Asian currency unit transactions, but the proposal was rejected by the DIT. On several occasions of exchange with other banks and SWIFT itself, the Bank stuck to its position that it would be appropriate to use SWIFT for international messages only. Meanwhile, a group of Members of Parliament (MPs) opposed the Bank’s stance on the issue.15 In separate letters, MPs Ghulam Nabi Azad and D. P. Yadav wrote to the Finance Minister expressing apprehensions about the Bank’s move to set up its own communication backbone. D. P. Yadav sent letters to thirty-four members of the telecom consultative committee. The government seemed to have received similar letters from other MPs too. The letters stated that the central bank wanted to set up a proprietary VSAT network to monitor operations at its branches and that the Bank, which was essentially a central bank and not a telecom company, might not be able to operate and maintain the network system at optimum efficiency levels. Such levels of efficiency on a special network could only be maintained by specialist operators or organisations with proven track records. 294

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the payment and settlement systems In 1998, the DIT and IDRBT progressed in their mission to set up a wide-area satellite-based network using VSAT technology. The network was inaugurated by Deputy Governor Talwar and went live on 19 June 1999. To evolve a common approach to tackle issues of mutual interest, an INFINET user group of member banks was constituted. In the first phase, the network was made available to all public sector banks and the Bank. Membership was soon extended to private banks, cooperative banks and branches of foreign banks and financial institutions, such as primary dealers (PDs) in government securities, which merited connectivity to the network. A subgroup on standardisation of message formats set by the INFINET user group recommended SWIFT message format for all interbank and intrabank applications with modifications to take care of Y2K compliance. INFINET became a milestone in the way banking transactions were to be conducted in the future. It was significantly supported by the user group, which made a number of key recommendations that achieved standardisation of message formats and facilitated interbank applications. The Working Group on Design of Message Formats (October 1999), for example, recommended message formats for applications, such as customer payments and cheques, financial institution transfers, cash management and customer status, and common group and system messages, which would be implemented in the first stage. The working group’s recommendations for message formats for government transactions, currency chest transfers and some segments of government securities transactions were taken up in the second stage. The INFINET user group of member banks met on a regular basis. They set up the Working Group on Design of Message Formats and a subgroup to identify interbank applications and vendors, and another subgroup on structured financial messaging backbone solution. An important prerequisite for a complete communication system was the message transfer utilities. The structured financial messaging solution (SFMS), which provided this facility on INFINET, was launched on 14 December 2001 by extending the facility to the three banks (Canara Bank, Punjab National Bank and Bank of Maharashtra) that participated in the trial run. The SFMS used message formats similar to those of SWIFT to enable banks to use the SFMS with ease. Banks were urged to take necessary steps to further strengthen their infrastructure base with respect to standardisation, high levels of security, and communication and networking to make full use of these resources. 295

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the reserve bank of india The development of the CFMS, which was initially available for use only by the public sector banks, was extended to all banks and financial institutions as part of a closed user group. The NDS and the CFMS were common interbank applications running over INFINET, introduced during 2001–02. Implementation of a terrestrial network in the form of leased lines, connecting twenty-one important financial centres of the country had been completed during this period.16 Although INFINET had been functioning as an efficient and cost-effective communication backbone for the banking and financial sectors, there was a concern that its usage continued to be limited.17 To provide security in messages transmitted over INFINET, a ‘public key infrastructure’ was developed for the SFMS and for common interbank applications. The public key infrastructure matched international standards and was equipped with smartcard-based access control systems at the user end. During 2002–03, INFINET was upgraded with higher capacity intercity terrestrial communication lines. INFINET membership continually increased, and the bandwidth of the network was considerably enhanced to meet the growing demand and for improving performance and availability. INFINET had become a hybrid network with satellite, terrestrial and integrated service digital network connectivity. Wireless connectivity in the form of radio frequency links was also being tested to enhance its robustness. To address each constituent of the INFINET/SFMS system uniquely, a system of Indian Financial System Code (IFSC) was designed during 2002–03, similar in approach to that of SWIFT (Box 8.1). In 2004–05, the bandwidth of the intercity telecommunication links, which were part of INFINET, was upgraded. This resulted in the existence of 2 megabytes per second (mbps) links across all the offices of the Bank. Technical improvements were made to minimise downtime in the event of any disruption of services at any of the centres, and periodical testing of the systems at the backup centre was also undertaken during the year. In 2005–06, in major offices of the Bank, the bandwidth of telecommunication links was upgraded to 8 mbps. In 2006–07, the IDRBT initiated the move from the closed user group network of INFINET to multi-protocol label switching with further development in network-based computing. It provided for virtual private networks to communicate in a secure manner. This improved efficiency and reduced costs, while ensuring adequate safety and security levels. This activity gained further momentum in 2007–08. By the end of the reference period, 296

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the payment and settlement systems Box 8.1 Indian Financial System Code INFINET, a VSAT-based satellite and leased line network, is for the exclusive use of the banking and financial sectors. Standardisation of message formats is a concurrent objective along with optimising the use of INFINET. Consequently, the SFMS has emerged as the electronic data interchange system for banks, allowing the exchange of secure and structured messaging within the banks and between banks using INFINET. After a detailed study of message formats available in other systems, such as SWIFT, United Nations/Electronic Data Interchange for Administration, Commerce and Transport, and computerised message transfer standards, the choice has devolved on SWIFT message formats for intrabank and interbank communication message transmission with suitable modifications. Alongside, the IFSC, a uniform coding structure, was developed to uniquely identify every bank branch in the country in the routing of payment messages and ‘straight through processing’. The pattern adopted has also been drawn from that used by SWIFT. The IFSC system can also be effectively used for national routing of SWIFT international messages with the help of a suitable interface at INFINET. The IFSC has been designed as an eleven-digit alphanumeric routing number. This is in consonance with the number of digits in the SWIFT coding system, which follows the ISO standard (9362) for identifying banks/branches. The composition of bank code and branch code is as follows: The four-digit alphanumeric codes for banks are the same as registered with SWIFT. In the last six spaces, most banks use the ‘basic statistical returns’ codes allotted by the Bank for reporting statistics while some use their own existing internal branch codes. As a member of INFINET, the Bank would use SFMS for financial and non-financial communication between its own offices and the banking and financial sectors. For this purpose, the Bank has assigned IFSC codes for its own departments in the central office and regional offices.

various interbank and intrabank applications were being implemented using INFINET as the backbone.

Legal Issues The Indian payment system did not satisfy the principle that ‘the system should have a well-founded legal basis under all relevant jurisdictions’.18 297

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the reserve bank of india There were several problems. First, all payment and settlement operations were contractual in nature, governed by the Indian Contract Act, 1872, which provided weak statutory backing. Second, ‘netting’ and ‘settlement privately’ had no legal backing. Third, there were no legal provisions for electronic cheques and cheque truncation. Fourth, the Bank was not empowered statutorily to regulate and supervise the payment and settlement systems. These issues had to be resolved. The Negotiable Instruments Act, 1881, defined promissory notes, bills of exchange and cheques but did not recognise electronic means of transfers and payments. The Information Technology Act, 2000, provided the legal basis for activities related to electronic transaction processing. It also stipulated the security features that were necessary to maintain the confidentiality, integrity and authenticity of such transactions, provided legality for digital signatures and encryption of data, and enabled electronically stored information to be equivalent to documentary evidence. A committee under the chairmanship of the Principal Legal Adviser of the Bank suggested amendments to the Negotiable Instruments Act to the government. Accordingly, after the enactment of the Information Technology Act, amendments were made to the Negotiable Instruments Act to provide for electronic cheques and cheque truncation. Recognising the need for a legal basis for electronic transactions introduced in 1995, an expert committee had been appointed.19 The committee prepared draft regulations to be made under Section 58 of the Reserve Bank of India (RBI) Act. Many rounds of deliberations among the Bank, the Ministry of Finance, the Law Ministry and the Legislative Department, Government of India, followed. The government finally cleared the Bank EFT Regulations on 28 August 2001. N. R. Narayana Murthy, the Chairman of Infosys, was asked by the Central Board to examine the regulations, and these were finalised after considering his suggestions. With the Information Technology Act in place, an amendment to the RBI Act was made by inserting a clause, adding future regulation of funds transfer through electronic means. The BPSS, in its first meeting on 8 June 2005, suggested the framing of separate regulations for electronic funds transfer under the RBI Act, pending the enactment of the Payment and Settlement Systems Bill. The draft of the EFT Regulations was placed before the Central Board in its meeting held on 4 March 2006. The EFT Regulations would eventually be denotified on the enactment of the Bill, and fresh regulations for each of the payment systems 298

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the payment and settlement systems would be framed. The regulations specified the conditions subject to which banks and other financial institutions would participate in funds transfer, the manner of such transfer, and the rights and obligations of the participants. By far, the most important legislation governing the payment and settlement systems was the Payment and Settlement Systems Act, 2007, and the Payment and Settlement Systems Regulations, 2008. The Act and the Regulations came into effect in August 2008, but much of the groundwork had been done during the reference period. The passing of this Act was prompted by two important considerations. First, there was no explicit legal basis for the regulation and supervision of the payment and settlement systems in the country. And second, there was no legal basis for multilateral netting and settlement finality, which were the twin pillars for the deferred net settlement systems in vogue. The Indian Contract Act set forth the principles of contracts in India. Clearing systems operated by the Reserve Bank and the banks were governed by the Uniform Regulations and Rules of Bankers’ Clearing Houses. The rules covered the operation of clearing houses.20 Originally, the rules and each system’s local procedural guidelines were contractually agreed between the clearing house and its members. Under this arrangement, multilateral netting had no sound legal backing and settlements were not guaranteed.21 These contracts gained full legal recognition under the Payment and Settlement Systems Act, 2007. Furthermore, the payment and settlement systems lacked a sound legal framework. These gaps were rectified by the passage of the Act and the associated regulations. The drafting and passage of the Payment and Settlement Systems Act went through an elaborate process. The BIS in its core principles for Systemically Important Payment Systems (SIPS) insisted on a well-founded legal base for netting systems (Appendix 8A.2).22 They also incorporated the responsibilities of the central bank in applying the principles, the important one being that the central bank should oversee compliance with the core principles. Based on the experiences of other countries where such legislation existed, the Bank decided in 2000–01 to initiate payment system legislation.23 A Task Force on Legal Issues set up by the NPC examined the need to frame new laws for the regulation of multiple electronic payments. Simultaneously, work on drafting a Payment Systems Act to provide for all the requirements of payment and settlement systems was undertaken. The DIT prepared a draft Payment and Settlement Systems Bill in 2003– 04 in coordination with the Legal Department. It was sent to the Ministry 299

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the reserve bank of india of Finance and approved by the BPSS at its first meeting on 8 June 2005. The draft Bill was discussed with officials of the Ministry of Finance and the Ministry of Law and Justice on 23 December 2005.24 The Parliament’s Standing Committee on Finance recommended the enactment of the Bill after certain modification to which the Bank agreed. The Bill became an Act on 20 December 2007. Following this, the regulations under the Act were framed and forwarded to the government. The Payment and Settlement Systems Act designated the Bank as the authority that regulates payment and settlement systems and empowered the Bank to determine standards, call for information, reports and documents, and audit and conduct on-site and off-site inspections of payment systems, among other powers. A few other laws had an important influence on payment and settlement systems. While Sections 20 and 21A of the RBI Act gave powers to the Bank to act as a debt manager to the central and state governments by statute or by agreements, before 2006 the Public Debt Act, 1944, provided the framework for regulating transactions in the government securities market (see Chapter 7). This Act was superseded by the Government Securities Act, 2006, from 1 December 2007. Some of the changes brought about by the Act were legal recognition to the lien, pledge and hypothecation of government securities, simpler procedural formalities with regard to the transfer of title in the event of the death of the titleholder, and legal recognition for constituent subsidiary general ledger accounts. The RBI Act was amended to insert a separate Chapter III D in 2006 to provide clarity over regulation by the Bank, empowering it to regulate and determine policy and give directions to all or any agencies dealing in government securities, money market instruments, foreign exchange, derivatives or other such instruments as the Bank might specify. The Securities Contracts (Regulation) Act, 1956, conferred powers on the Government of India to regulate and supervise all stock exchanges and securities transactions. This Act also applied to government securities. The central government had delegated its powers under the Act to the Bank in March 2000 (Chapter 6). These powers related to contracts in government securities, money market securities, gold-related securities and derivatives, as well as repurchase agreements in bonds, debentures, debenture stock, securitised debt and other debt securities. All other segments of the securities market were regulated by SEBI.

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the payment and settlement systems

Formation of the BPSS and the DPSS On 15 December 2003, the Central Board approved the formation of a committee called the Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) and of a Department (DPSS) for making regulations on its behalf.25 The BPSS would lay down policies and standards, authorise payment and settlement systems, oversee rules and guidelines, and create the necessary infrastructure for ensuring effective regulation and supervision, pending enactment of the Payment and Settlement Systems Act.26 The BPSS started functioning in March 2005.27 In 2005–06, the BPSS provided direction to the vision document for 2005–08, the draft Bill relating to payment and settlement systems, EFT Regulations, standards of operational efficiency for MICR cheque processing centres, the comparative study of India’s position vis-à-vis a few developed countries on best practices, RTGS systems, and the move from cash/paper-based payment systems to electronic payment systems. In 2006–07, the main thrust was on this last issue. Specific directions of the Board related to migration from paper-based funds transfer to electronic payment systems; bringing RTGS-enabled branches under the national electronic funds transfer (NEFT); a low-cost cross-border remittance system with neighbouring countries, especially Nepal; and the feasibility of a few large banks providing associate membership to the smaller banks to participate in the cheque truncation system (see later). The BPSS met five times in 2007–08. The thrust was on law, risk mitigation and customer service.28 Following the directions of the Board, the consolidated information on service charges was available on the Bank’s website, with links provided to the websites of the respective banks. The regulatory circulars on customer charges for use of ATMs and the mandatory use of the electronic mode of payment for a transaction above a certain size between the Bank-regulated entities and markets were issued and implemented by banks, despite some misgivings on the part of the IBA (Appendix 8A.3). Draft guidelines on mobile payments were also placed on the website.

Oversight The need for a formal structure for oversight was felt following the enactment of the Payment and Settlement Systems Bill.29 The annual report of the BPSS for 2006–07 noted that the oversight of payment systems was recognised as a core responsibility of central banks. Oversight meant putting in place systems 301

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the reserve bank of india and procedures that (a) defined the power and capacity of the central bank to carry out oversight, (b) ensured the smooth and efficient provision of payment services to all participants, (c) minimised the risk of transmitting shocks through the economy caused by failures of individual participants to settle their obligations and (d) ensured development of infrastructure to meet the growing needs of the country. As a step in the direction of better oversight of payment systems, the Minimum Standards for Operational Efficiency of MICR cheque processing centres were framed, and the MICR cheque processing centres were required to submit a quarterly self-assessment report on compliance to these standards. There were 1,047 clearing houses in the country, of which MICRbased cheque processing centres were available at only 59 centres. The other centres operated manually. The Bank took the initiative of computerising of the settlement by implementing the magnetic media-based clearing system (MMBCS) at centres where there were more than thirty participant banks. The MICR clearing system had stabilised over a period of time and people had confidence in the system. However, to ensure business continuity in case the bank managing the clearing house was not able to provide service, the need for a system at the second-largest bank in the centre was felt. The annual report of the BPSS for the year 2007–08 noted that the Bank did not yet have explicit legal sanction to perform oversight of payment and settlement systems and that it had been using its regulatory and supervisory powers over banks for the purpose.30 Further, for clearing houses, a structured approach for conducting oversight, the minimum standards for operational efficiency of MICR cheque processing centres were framed.31 A self-evaluation of RTGS revealed that the system was compliant with the core principles. The Payment and Settlement Systems Act empowered the Bank to regulate and supervise all payment systems in the country. The Bank had framed the minimum standards for MICR and non-MICR clearing houses, as well as for operation of ECS and NEFT. The oversight process relied on off-site surveillance and need-based on-site inspection, data and information collection, compilation and analysis, and a system of alerts complemented by market intelligence.32

Inspection of CCIL On 17 December 2003, the Department of External Investment and Operations raised the issue of inspecting foreign exchange clearing operations 302

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the payment and settlement systems of the CCIL with the DIT, and the scope of such an inspection. The DIT responded saying that the Reserve Bank, in the role of the regulator and supervisor, could carry out on-site inspection. The Bank felt that while supervision could be facilitated using off-site data collated from the CCIL, an on-site inspection would also be of utilitarian value. The issue came up for discussion in the Financial Markets Committee in its meeting on 13 March 2004. The committee decided that on-site inspection of the CCIL might be undertaken by a group of officials drawn from different departments. The inspection, headed by an official from the Internal Debt Management Department, would focus on systems and procedures, and risk management policies and practices of the CCIL. The BIS would provide a benchmark for the purpose of evaluating the current state of affairs in the CCIL. Although there were no specific legal provisions, the Bank’s regulatory authority over the functions and operations of the CCIL was a recognised fact. Accordingly, a team of officials visited the CCIL on June 2004. Based on the report, the CCIL framed a ‘settlement bank risk management policy’. The second assessment of clearing systems run by the CCIL was carried out by a team of officers in August 2006. The assessment report was made available to the CCIL for compliance and was discussed by the BPSS in February 2008.

Real Time Gross Settlement System In early 1997, the DIT had recognised the need for the introduction of a countrywide large-value funds transfer facility. Preferably, the system would be on RTGS basis, similar to Fedwire in the USA or BOJ-NET in Japan. The existing system of interbank fund transfers and settlement had several problems. Banks’ current accounts in various Deposit Account Department offices were settled at different times during the business hours each day. The settlement arising out of the local, high-value and interbank clearing was done on a net basis, and at periodic intervals through the day. Banks could transfer funds between different Deposit Account Department accounts by means of telex transfers. These were usually done once in a day. At the end of the day, a statement of accounts was sent to banks, giving their current account position as on that day. As banks’ current accounts were distributed over sixteen Deposit Account Departments, funds management in banks was seriously affected by the absence of a consolidated picture of the availability of funds on a realtime basis. The settlement system based on a netting system also had inherent 303

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the reserve bank of india counter-party and liquidity risks. It was necessary that the settlement occurred instantaneously in the books of the central bank (on a real-time basis) and was gross (on a transaction-by-transaction basis). This was the RTGS. The RTGS was envisaged to be implemented in several stages to provide for the stable and smooth transition from the then existing independent Deposit Account Departments to a centralised one. The DIT prepared a note in early 1997 on the ‘RTGS Payment System in India – Requirement Analysis and Design Options’. It also prepared a Business Requirement Document. An interdepartmental meeting discussed this on 16 October 1997 and agreed on some of the broad features of the system. Executive Director A. Vasudevan conveyed to the IDRBT that the system would be implemented by them. Some of the members of the Payment Systems Group were deputed to various countries to study the functioning of the RTGS system internationally. System requirement specifications considered the international best practices and the specific requirements of Indian banking. In the mid-term review of the monetary and credit policy announced in October 1998, Governor Jalan announced that the Bank would take a major initiative in establishing an RTGS system under the guidance of the NPC, which would be set up soon.33 The role of the NPC was to lay down the broad policy parameters for designing and developing state-of-the-art and robust payment and settlement systems for the country. During the period, the NPC met on two occasions and took policy decisions on the introduction of RTGS, and discussed technology solutions as the gateway to RTGS.34 The implementation of RTGS was a complex project involving many challenges, preconditions and reorientation of the users. It needed an industry-wide communication network, reliable computer platform, facilities for electronic-based payment and settlement, standardisation of message formats, security of international standards, proper business process reengineering by each RTGS participant, and facilities for advanced liquidity management.35 The implementation of RTGS, therefore, went through several rounds of discussions with banks and other market participants and covered several operational issues. The full system, which went operational in early 2004, consisted of a combination of an integrated accounting system (IAS) and RTGS, including interfaces with SSS, the CFMS and the SFMS.36 In addition to being the service provider, the Bank was also a participant in the system. In developing it, the implicit policy preference of the Bank was that as long as it could afford to spend money on equipment and consultants, it 304

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the payment and settlement systems would not accept assistance from multilateral institutions, for such assistance came with conditions.37 The implementation of RTGS was a milestone. The settlement of both large-value and retail interbank payments in India had been predominantly cheque-based. RTGS made it possible for large-value payments to be transacted in a faster, efficient and secure manner. After the stabilisation of RTGS, the need for continuing the deferred-net-settlement-based interbank clearing was examined and it was decided that interbank clearing should be done away with. Interbank clearing was discontinued in Mumbai in November 2004, followed by other centres.38 Based on the satisfactory operations, migration to the total system took place on 12 August 2006. There was a significant rise in the number and volume of RTGS transactions. The average daily processing volume rose to about 15,000, aggregating to a value of about 600 billion. Proposals were underway to shift small-value transactions to other electronic modes such as EFT and NEFT. Due to certain architectural deficiencies, the migration resulted in disruptions. The IT officers and treasury officers of about 110 banks had to stay late until updating at all banks were completed and a test run for the day was done. This happened on several occasions during August and September 2006. Following this, the Maharashtra unit of the All India Bank Officers’ Confederation represented on 17 October 2006 to the Governor, requesting for immediate remedial action. Meanwhile, the DIT prepared a status report and actions taken to solve these teething problems in coordination with the vendor. Although the measures taken yielded results and the system had been showing satisfactory performance, it was observed that the total solution offered by the vendor did not meet the performance requirement of the Bank and the current performance was one-third of the agreed one. It was felt that an independent performance audit of the system could be performed. The idea was to identify bottlenecks in the way of expansion of capacity. This task was assigned to Infosys Technologies Ltd. The relevant inputs from the report were forwarded to the vendor, Logica CMG, for implementation (February 2008). The system was also subject to an external information system audit. On 10 July 2008, the DIT reported to the Central Board that one of the achievements during 2007–08 had been the stabilisation of RTGS. The system handled an all-time high volume of 48,500 transactions on a single day (31 March 2008), compared to a normal daily average volume of about 30,000.39 Since the introduction of the RTGS system, large-value and interbank transactions had progressively migrated to the RTGS system. Settlement

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the reserve bank of india of securities, foreign exchange, and collateralised borrowing and lending obligation (CBLO) transactions was also done in the RTGS system. The settlement of foreign exchange transactions had evolved from the direct settlement of transactions on a gross basis between trading members to multilateral net settlement with a guarantee from the CCIL, a central counterparty. The rupee side of the trade was settled in the RTGS system too. In addition, the CCIL had introduced FX-CLEAR, a foreign exchange trading system which offered both order-matching and negotiation modes for dealing. RTGS operations were governed by the RTGS (Membership) Regulations, 2004, and the RTGS (Membership) Business Operating Guidelines, 2004.40 Membership was open to banks, PDs (market-makers in the government securities market) and any other institution at the discretion of the Bank. Members were classified into different categories based on certain criteria.41 To settle transactions submitted to the RTGS system, members had to maintain an RTGS settlement account with the Bank in Mumbai. This account had to be funded at the beginning of each RTGS processing day from the member’s current account with the Bank, and at the end of the day, the balance in the settlement account was transferred back to that current account. Since banks maintained current accounts with different offices of the Bank, they were allowed to transfer funds during the RTGS day between these current accounts and the RTGS settlement account.42 Transactions that had passed all validity checks were taken up for settlement. All such transactions based on available balances in the settlement account were duly settled by debiting the account of the sending bank and crediting the account of the receiving bank. Settlement finality on a gross basis in real time was achieved when this process was complete. Members could obtain intra-day liquidity from the Bank (fully collateralised by government securities held by the members) free of interest to augment their available liquidity in the RTGS system. Settlement of transactions in RTGS on a gross basis eliminated credit risk. Liquidity risk was mitigated by the provision of intra-day liquidity, which facilitated the smooth settlement of transactions in the system. As the RTGS system became operational, the priority was to integrate other payment systems through RTGS to mitigate credit and liquidity risks present in those systems as well as to promote efficient liquidity management by participants. To this end, interfaces were built with the SSS and the foreign exchange transactions settlement mechanism. The settlement of these transactions took place in the 306

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the payment and settlement systems RTGS system, as also the settlement for the CBLO. The settlement of the clearing operations at Mumbai for cheque-based and electronic clearing was made in RTGS. The system’s development cost was borne by the Bank. The Bank levied no charge for transaction processing or intra-day liquidity usage until the end of the reference period, though the RTGS Regulations provided for such charges.43 The RTGS system embodied settlement of transactions instantaneously, that is, on a gross basis, thereby obviating the need for any clearing arrangement in the transaction. The advantage of the deferred net settlement system was a lower level of collateral requirement for effecting payment transactions, but credit risk in the event of default was higher under the deferred net settlement. The Bank, as mentioned, provided intra-day liquidity to participants, which eliminated liquidity risk but the credit risk was transferred from participants to the central bank. The underlying principle in an intra-day credit facility was that participants must extinguish it by the close of the day. Thus, the stock of reserve money, which expanded during the day, returned to its initial level. Following the recommendations of the Working Group on Intra-day Credit Facility to minimise credit risk, intra-day liquidity would be provided against government marketable securities. It was imperative that there existed a firewall between intra-day and inter-day funds. Accordingly, if a participant was unable to extinguish its intra-day repo position during the day, the outstanding amount would attract a penal rate pegged at twice the Bank Rate or twice the corresponding day’s maximum call money rate, whichever was higher.44 By the end of the reference period, the RTGS system had been in operation for nearly four years. The system had stabilised and witnessed a substantial increase in coverage in terms of bank branches and transaction volume.45

Clearing Corporation of India (CCIL) The setting up of the CCIL was a major development in the process of improving the technological infrastructure. The CCIL was set up under the Indian Companies Act and registered on 30 April 2001 with the SBI and five other banks and financial institutions as shareholders. The CCIL started working in February 2002. It guaranteed settlement of foreign exchange clearing operations. Before the CCIL, transactions in foreign exchange markets were settled bilaterally by trading members through their 307

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the reserve bank of india correspondent banking arrangements. The introduction of the guaranteed settlement facility for USD–INR trades through novation (substitution of one contract with another) by the CCIL with itself as the central counterparty in 2002 substantially increased the efficiency of such trades. Foreign exchange transactions that were not settled through the CCIL still made use of corresponding banking arrangements. In June 2003, the CCIL set up a wholly owned subsidiary, Clearcorp Dealing Systems (India) Ltd, to provide dealing systems and platforms for CBLOs, repos and money market instruments of any kind, as well as for foreign exchange. The Reserve Bank played an instrumental role in setting up the CCIL. The Bank served as the custodian and central securities depository for government securities. To facilitate faster settlement of trades in government securities in dematerialised form, the Bank, in February 2002, introduced an electronic negotiation-based trading and reporting platform called the NDS (see Chapter 7). To enhance the trading infrastructure in the government securities market, the Bank introduced in August 2005 an electronic order-matching system (NDS-OM). The NDS and NDS-OM were both parts of the SSS known as the ‘negotiated dealing settlement system’. The system provided final settlement for government securities transactions, facilitated monetary operations of the central bank, especially the liquidity adjustment facility, and transmitted interest rate signals to Indian money markets. All secondary operations in government securities where the CCIL acted as the central counter-party were also settled in the system. The CCIL soon occupied a significant position in the country’s payment system. It functioned as a central counter-party, guaranteeing settlement of a substantial portion of transactions in the money, foreign exchange and government securities markets. This reduced risks in the payment systems and encouraged more transactions in the money market and the repo market. The CCIL operated a settlement guarantee fund made up of contributions from its members and backed by lines of credit from commercial banks. The Reserve Bank regulated the clearing and settlement of these instruments by the CCIL. Since it provided guaranteed settlement to participants in these markets, the respective regulatory departments within the Bank were in close contact with the CCIL concerning its policies and procedures. It also reported all exceptional activities to the Bank. Participants in these markets had to become members of the CCIL for each segment separately and contributed 308

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the payment and settlement systems to CCIL’s settlement guarantee fund. It offered a platform for the settlement of foreign exchange trades through the Continuous Linked Settlement Bank, using the third-party services of a settlement bank. It offered a multilateral netting mechanism through a process of novation for interbank spot and forward USD–INR transactions. While the US dollar leg of transactions was settled through the CCIL’s account with its settlement agent in the US, the rupee leg was settled through the member banks’ current accounts maintained with the Bank in Mumbai. The CCIL also provided non-guaranteed settlement facilities for transactions routed via the National Financial Switch, which was the main switch for ATM transactions. In this case, the CCIL neither acted as a central counter-party nor did it provide a guaranteed settlement. The settlement file was routed through the CCIL to the Bank where the final settlement took place in central bank money. The CCIL, thus, reduced the number of transactions for settlement.

Securities Settlement Systems and Related Developments The development of the market for government securities necessitated the setting up of the SSS, which was a software-driven trading and settlement system. Two basic modules were developed, the NDS and the SSS, both of which envisaged the setting up of a centralised Public Debt Office software. The access to the modules by the constituents, including the primary dealers, in government securities, was through INFINET. Until 2001–02, transactions in government securities were required to be settled on the trade date or next working day unless the transaction was through a broker of a permitted stock exchange, in which case the settlement could be on ‘T+5’ working days basis (transaction date plus five days). With the progress made in computerisation of the Public Debt Office, it was possible to have a pooled terminal facility located at regional offices across the country, and member-terminals paving the way for an NDS. In short, this was an integrated project of computerisation of the Public Debt Office and NDS, set up to facilitate online negotiated dealing in money and government securities.46 Live operations of the NDS commenced on 15 February 2002 after a threemonth testing period. Membership in the NDS was open to all institutions that were members of INFINET and were maintaining subsidiary general 309

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the reserve bank of india ledger accounts with the Bank. The NDS provided for screen-based trading in government securities to member banks and PDs, with a facility to strike online deals anonymously. The process involved the reporting of deals to the CCIL, which generated the settlement. At the end of the day, the settlement information was transmitted to the Bank.47

Centralised Funds Management System The Bank being the banker to banks, the Deposit Account Department maintained the current accounts of scheduled commercial banks and other institutions. The Department was the nucleus of the Bank’s accounting system where all the classified accounts of the Bank were maintained in a systematic manner. Some common cash withdrawals, clearing adjustments, interbank transfers, and purchase and sale of foreign exchange remittance facilities were also performed through the current accounts of constituents at the Department. The Bank maintained the accounts in the form of principal current accounts, and subsidiary and secondary current accounts at various regional offices. One of the tools for efficient funds management was information on the balances at all regional offices of the Bank where current accounts were maintained. Until 1999–2000, there was no mechanism to provide the balances in various accounts at different locations in a central place. Therefore, it was not possible for the fund manager of a bank to know on a real-time basis his/her bank’s overall current account balance with the Bank. This gap affected the efforts of the fund managers of banks to make optimum use of the available funds. The CFMS envisaged the creation of an intermediate service facility to the funds and treasury managers to obtain a consolidated position of their balances with all Deposit Account Departments. This was an achievable objective with INFINET, which had many banks as its user members.48 The project was formally approved the same year. It consisted of a ‘centralised funds enquiry system’ based on the accounts maintained with the Bank and a ‘centralised funds transfer system’ to enable movement of funds across various offices. The first phase of the project was implemented in 2000–01. The funds transfer facility came into operation since 2005–06. The coverage of the system extended to seventy-one member banks and all Reserve Bank offices by 2007–08. 310

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the payment and settlement systems

Retail Payment Systems Retail payments are defined as mainly consumer payments of relatively low value. A retail funds transfer system is defined as a system that handles a large volume of payments of relatively low value in the form of cheques, credit transfers, direct debits, ATM and EFT at point-of-sale transactions.49 Clearly, the user base for retail payment systems is very large as they touch every economic activity. In terms of volumes, paper-based and electronic retail payment systems far exceed large-value payment transactions. Retail payment systems in India at the close of the reference period included cheque clearing, various electronic fund transfer systems and various modes of card payments.

Cheque Clearing The main medium for non-cash payments in India was the cheque. Other paper instruments included banker’s cheques and payment orders. Cheque volumes had risen substantially over the three decades prior to 2007–08, owing to the expansion of banking branch networks and banking services. The share of cheque payments in the total value of cashless payments had, however, declined since 2004–05, as large-value interbank and some customer transactions were settled through the RTGS system. As we have seen, under the Negotiable Instruments Act, cheques must be presented physically to the bank branch on which they are drawn, causing delays in payments. Automated cheque processing was introduced from the mid-1980s when the first MICR cheque processing centres were set up. Intercity clearing started in the early 1990s and by 2003–04, the coverage of inter-city cheque clearing was expanded to cover fourteen cities in all. From the mid-1990s, the MMBCS helped substantially reduce clearing and settlement times. It provided for an electronic settlement based on electronically submitted settlement data, although processing was manual. The Negotiable Instruments Act was amended in 2001 to allow scanned cheque images, paving the way for cheque truncation initiative (see later). The bankers’ clearing houses were the nodes in the retail payment system. Before 1986, there were no uniform rules governing the clearing houses, which made dispute settlements difficult. In 1986, the Bank formulated a set of guidelines, the Uniform Regulations and Rules of Bankers’ Clearing Houses, to harmonise the framework governing the conduct of the clearing houses. These guidelines had also become necessary in the backdrop of increasing 311

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the reserve bank of india computerisation in the banking industry. In its early stage of development, the rules represented a significant step forward in providing a formal institutional framework for the payment system in the country. Reduction of the time taken to process paper-based instruments had drawn the Bank’s attention. To the extent that the physical instruments needed to be transported from the collecting bank branch to the drawee bank branch, the delay was in-built into the paper-based mechanism. The cheque truncation system was one of the measures adopted in several countries to remove this handicap. Payment instruments did not get transported all the way but stopped or were truncated at a point in the cycle and, thereafter, only information about the instrument and/or its image flowed electronically to the drawee bank branch for payment. The cheque truncation system enabled the realisation of cheques on the same day, thereby improving the operational efficiency of the clearing process. It was also a more cost-efficient mode of settlement than manual and MICR clearings. Necessary amendments were, therefore, made to the Negotiable Instruments Act for providing legal recognition to the electronic image of the truncated cheque.50 Based on a working group report, an action plan was agreed.51 The Bank accepted the plan. But there was resistance from commercial banks. They felt that printing of new cheque books and setting up of specified computer terminals in branches would add to their costs. Further, they were not sure if the counter staff would be able to use the system. Nevertheless, preparatory steps for the implementation of the cheque truncation system on a pilot basis were initiated in the National Capital Region (NCR) during 2003–04. The technical and commercial evaluation phase of the project was over in 2004–05. The contract for the project was signed on 16 June 2006 with M/s NCR Corporation of India Pvt. Ltd for supply, installation and operationalisation of cheque truncation solution in Delhi. By the terms of the contract, the project was to be implemented by December 2006. The technology, which was already used in small city nations such as Singapore and Hong Kong, would need an enormous scaling up in India. M/s NCR took time. On their request, the implementation was postponed to April 2007, again to July 2007, when another postponement was sought. The ‘user acceptance test’ was to start from 10 September 2007 but called off at the last minute. The DPSS on 14 September 2007 sent a letter to the legal counsel of M/s NCR, expressing extreme displeasure at the pace of progress of the project. Finally, the DPSS certified completion of installation 312

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the payment and settlement systems and operationalisation on 30 January 2008. The cheque truncation system was launched on a pilot basis in Delhi on 1 February 2008 with the participation of ten banks.52 In a meeting held at Delhi on 10 November 2004, it was decided that the Comptroller General of Accounts would form a committee to consider amendments to the Civil Accounts Manual and Central Treasury Rules, governing payment of physical instruments.53 By the end of the reference period, however, the implementation of the system was still a work in progress. High-value clearing (HVC) was a service introduced in the 1980s where select branches located in close proximity to the clearing house, service branch or central commercial district presented instruments with a value of 0.1 million and above, deposited by their customers within the specified time to the clearing house. HVC at some centres had been extended in 2004–05 to cover the entire jurisdiction of the clearing house. The settlement was carried out through the MMBCS. The return clearing was also held on the same day, which resulted in the final settlement being concluded on that day. HVC was a deferred net settlement system. A working group looked into the associated risks and made several recommendations.54 As of August 2007, HVC was in operation in twenty-seven centres and the volume and value of transactions continued to be quite substantial, notwithstanding significant developments in electronic modes of funds transfer. However, it posed significant operational risks to banks since the time available to them between presentation and return of high-value cheques was less than three hours. The Bank, therefore, started taking steps towards the end of the reference period to discontinue HVC.55 During the reference period, several other steps were taken to improve the efficiency and oversight of MICR. As late as in 2007–08, cheques continued to be the predominant mode of retail payment, though the share of retail electronic mode of payment increased during 2007–08. To improve efficiency in the non-MICR centres, more than 800 clearing houses were computerised where the settlement was done electronically, while the instruments continued to be sorted manually. To further improve paper-based clearing, the BPSS recommended ‘cluster clearing’ – linking major cities to the nearest metro to form a cluster. A pilot scheme was launched linking Mumbai and Pune.56 Speed clearing, a new method of clearing intercity cheques drawn on core banking branches of banks, was introduced on a pilot basis in June 2008. This had been started in Kolkata. This would be part of the main MICR clearing, in which cheques drawn on core branches would be cleared locally irrespective 313

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the reserve bank of india of the location of the drawee branch. Cheques were routinely used for bulk and repetitive payments, such as collection of utility payments or payment of dividends. The Bank took several steps to develop and promote retail electronic payments infrastructure, as discussed earlier. The ECS had two variants – credit clearing and debit clearing. While credit clearing operated on the principle of ‘single-debit-multiple-credits’, and was used for making payment of salary, pension, dividend and interest, debit clearing functioned on the principle of ‘single-credit-multiple-debits’ and was used for collecting payments by utility service providers like electricity, telephone bills as well as by banks for housing and personal loan repayment. The ECS package was developed in-house by the DIT. It was subjected to external audit by the National Institute of Bank Management and additional security features were incorporated as suggested by the institute. The debit scheme was the only direct debit scheme in India for payments to electricity, telephone, insurance or credit card companies, or payments of loan instalments. It aggregated a large number of debits into a single credit to the beneficiary. The system worked on pre-authorised debits, which is a signed mandate obtained from the customers by the utility company. The account holder’s account was debited on the agreed date and the amounts were credited to the beneficiary. Final settlement took place both in central bank money and in commercial bank money (in those centres where the Bank did not have an office). In Mumbai, the settlement took place in RTGS.

Electronic Funds Transfer/National Electronic Funds Transfer EFT was a mechanism for effecting payments on a one-to-one basis electronically from one originating branch of a bank to a destination branch of any other bank.57 While ECS-Credit and ECS-Debit systems were for bulk payments akin to the automated clearing houses elsewhere, the EFT system was for individual transactions. In 2003–04, multiple daily settlements for EFT were introduced. The Bank was in the process of implementing the NEFT system from 2002–03 onwards. As a first step, a special electronic funds transfer (SEFT) system was implemented with effect from 1 April 2003. This helped increase the coverage of the EFT scheme and provided for funds transfers in a quicker manner. SEFT was available across branches of banks that were computerised and connected through a network so that electronic messages could travel 314

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the payment and settlement systems to the receiving branch straight. The system was designed to provide for same-day interbank transfer of funds between accounts maintained in any of the designated participating branches, which were networked, so that SEFT messages could be transmitted electronically. This facility was available across identified computerised branches at various cities and towns having last-mile connectivity. SEFT provided for multiple daily settlements and had outreach much larger than Reserve Bank centres. It facilitated electronic retail transfers between bank branches using the SFMS and secured by ‘public key infrastructure’ technology. The EFT system that was previously in use had been discontinued effective February 2006 except for government payments. In the case of EFT, all branches of banks in fifteen locations were part of the scheme, irrespective of whether they were networked or not. To broad-base the facilities of EFT and to provide for integration with the SFMS of INFINET, it was decided to implement a new variant of EFT called NEFT in November 2005. NEFT used the SFMS for EFT message creation and transmission from a branch to the bank’s gateway and to the NEFT centre, considerably enhancing the security in funds transfer operations. To increase the coverage of NEFT to bank customers in semi-urban and rural areas, an enhancement of NEFT called the NEFT-X was proposed, where the last-leg connectivity would continue to be either through electronic mode or paper-based. The RTGS system, which was used mainly for large-value payments, settled both interbank and customer transactions. A threshold value had been prescribed for customer transactions in RTGS, while there was no such limit under NEFT. It was envisaged that all RTGS-enabled bank branches would also be NEFT-enabled and the customer would have a choice between the RTGS and the NEFT systems.58 At the end of the reference period, the National ECS was being developed by the Bank to enable centralised processing of ECS transactions, in contrast to the previous system that had decentralised operations at seventy locations all over the country. Under the National ECS, the processing of all the ECS transactions would be centralised at the National Clearing Cell at Nariman Point, Mumbai, and sponsor banks would need to only upload the relative files to a web server that had online data validation facility. Destination banks would receive their inward clearing data, or file, at a central location through the web server. The National ECS would leverage the ‘core banking’ platform of the commercial banks, to enable around 50,000 branches of the various banks to make use of this service. 315

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Card Transactions Card-based transactions registered phenomenal growth during the latter part of the reference period. Cards, especially debit cards, were becoming the preferred electronic payment mode for both consumers and retailers. Credit cards were introduced in India in the late 1980s and had since gained large-scale acceptance. During the reference period, debit card issuance and usage had grown much faster than those of credit cards. Banks in India also offered combined ATM and debit cards. The number of cards issued by banks increased from 26.9 million (end of December 2003) to 43.3 million (end of December 2004). The increased use of cards highlighted the need for the introduction of measures to meet the best customer service standards.59 The major ATM networks in India were National Financial Switch, Cash Tree, BANCS, Cashnet, and the SBI Group network. In addition, most ATM switches were also linked to Visa or MasterCard gateways. The terminals were interoperable except for the terminals belonging to American Express. The National Financial Switch was the largest of these networks. It was set up by the IDRBT and started operations from 28 August 2004. Banks could connect to the National Financial Switch either from their own switches or through the switch of their group. It was operated by the NPCI after it was set up in 2008. The CCIL was the settlement agent for all transactions routed through the National Financial Switch. The Bank partnered a pilot project on smart cards in 1999 to provide for large-scale use of smart cards for financial transactions.60 The pilot project, known as the SMART Rupees System, explored the viability and standards suited to the Indian context. Following up the project, the Bank set up a working group.61 Its recommendations were the source for the standards proposed in the new system. The report also recommended that banks and service providers could enter into contractual agreements, all players needed to be encouraged to adopt the standards, and there was a need for a payments oversight or surveillance body, among other measures. The report was forwarded to the BIS with a request that the standards proposed therein might be adopted as National Standards by the Bureau. The Bank had issued detailed operational guidelines for banks issuing credit cards based on the recommendations of the working group. The guidelines required that the banks and NBFCs issuing credit cards should have a well-documented policy and a Fair Practices Code for credit card 316

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the payment and settlement systems operations. Adherence to know-your-customer (KYC) norms and adequate internal control and monitoring systems were also stressed in the guidelines. The number of ATMs increased from 800 to 34,789 between 1999 and March 2008. However, non-transparent service discouraged the customers from making more use of this facility. The Reserve Bank examined the issues related to the use of the banks’ own ATMs and ATMs of other banks and issued new guidelines. These included making the use of own bank’s ATMs free (from 10 March 2008), and setting limits on charges for use of other banks’ ATMs (from 1 April 2009). The Bank was especially concerned about depositors like pensioners. Large banks with a substantial share of ATMs felt that the use of their ATMs by customers of other banks would eat into their profits. The Bank pointed out to them that they got a substantial transfer fee from smaller banks in such transactions.62

E-Commerce The BPSS in its annual report of 2006–07 stated that the rapid growth of e-commerce and the use of the internet had led to the development of new payment mechanisms capable of exploiting the internet’s unique potential for speed and convenience. Similarly, the broader use of mobile phones encouraged banks and non-banks to develop new payment services for their customers. Internet and mobile payments were defined by the channel through which the payment instruction was entered into the system. The use of this mode of transaction was often preferred as it could be done from anywhere at convenience. The Board directed a study of this mode of payment to make it cheaper and widely used. Several state governments introduced social welfare programmes that involved payment to beneficiaries. Payments were made either through government offices or banks, or through instruments like money orders. The transfer system required the identification of the beneficiaries correctly. A committee was appointed in 2007–08 to study the feasibility of an electronic benefit transfer system for adoption by all the state governments.63 The committee examined the advantages and disadvantages of three models of electronic benefit transfer: bank-branch model, bank-led model and non-bank model. It preferred a bank-led model over the other two models of disbursement of government benefits. The committee felt that to easily implement and monitor the feasibility of electronic benefit transfer systems, 317

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the reserve bank of india one district-one-bank approach could be adopted. The places where the onedistrict-multiple-banks approach was already working satisfactorily, the same arrangement could continue. Elsewhere, the government needed to identify the bank in consultation with the Reserve Bank. Delivery of government benefits at the place of habitation of the beneficiary should be the ultimate desirable goal. A two-stage approach was preferable. Initially, disbursements could be made at gram panchayat level through the bank or its business correspondents. Subsequently, disbursement could move to individual villages. The feasibility of e-governance kiosks could be considered. Payment information should flow electronically from end to end so that a database was created for policy purposes. Many countries encourage the use of the mobile phone as a tool for delivery of banking services. With the rapid growth in the number of mobile phone subscribers in India, banks had been exploring the feasibility of using mobile phones as an alternative channel of delivery of banking services. A few banks had also started offering, through the mobile phone, information-based services like balance enquiry, stop-payment instruction of cheques, a record of last five transactions, and so on. There were about 265 million mobile phone connections in the country (end of March 2008) and about 8 million new connections were being added every month. Considering that the use of this technology for the banking services was relatively new and called for appropriate safeguards to ensure the security of transactions, the Bank formulated the ‘Draft Operating Guidelines for Mobile Payments in India’ in June 2008. The guidelines were placed on the Bank’s website for public comments. The availability of a reliable communication network was an important prerequisite for facilitating electronic modes of payment. However, the nonavailability of a terrestrial communication link in many parts of the country, such as the hilly areas, was an obstacle to greater penetration of electronic payment services. For such terrain, satellite connectivity was an appropriate mode of connecting the branches. A paper prepared by a member of the BPSS, on the use of satellite communication technology, made a proposal on this point. A technical group examined the proposal and recommended the use of satellite connectivity in these regions. However, the cost of the policy was high. The Bank considered the provision of a financial incentive to banks for adopting this technology. The Bank would bear a part of the leased rentals for the satellite connectivity, provided banks used it for connecting their branches.64 Trends in retail payments transactions were impressive, as shown in Table 8.2, especially after 2003–04. 318

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Table 8.2 Trends in Retail Payment Transactions  

 

Electronic

ECS-Credit

NonElectronic

Volume in Million

2003–04 2004–05 20.30

2005–06

2006–07

2007–08

2003–04

2004–05

(13.5)

 

(97.3)

 

(29.6)

44.22

69.02

 

(97.3)

(10.4)

(56.1)

 

(93.7)

(135.0)

(109.1)

 

(211.0)

 

(29.2)

ECS-Debit

7.90

EFT/NEFT

0.82

Credit Cards

100.18

Debit Cards

37.76

Cheques

1023

Source: RBI Bulletin, various issues.

40.05 15.3 2.55

129.47 41.53

35.96 3.07

(20.4)

156.09 (20.6) 45.69

78.37

127.12

22.54

4.78

13.32

171.25

228.2

176.63

88.31

48.74

1461

115960

(69.0)

(55.7)

(178.7)

(8.6)

(34.6)

169.54 60.18

(10.0)

(10.0)

(31.7)

(46.7)

 

(14.1)

(10.3)

(6.2)

(6.9)

1287

102.28

75.2

 

1167

Value in Billion 

1367

Notes: 1. Figures in brackets are percentage change over the previous year.

2. Debit card figures for 2003–04 and 2004–05 are estimated on the basis of 2005–06 figures. 3. Card payments figures pertain only to Point of Sale (POS) transactions.

201.8 29.21

546.01

 

(218.8)

 

(45.4)

   

256.86 53.61

(10.0)

104589 (-9.8)

2005–06 2006–07 323.24

7,822.22

254.41

489.37

(60.2)

(157.6)

(344.6)

(95.9)

129.86

2007–08

832.73

(839.3) (92.4)

612.88

774.46

1,403.26

338.86

413.61

579.85

81.72

125.21

120424

133961

(12.2) (31.9) 58.97

(10.0)

113291 (8.3)

(26.4) (22.1) (38.6) (6.3)

(81.2) (40.1) (53.2)

(11.2)

the reserve bank of india

Umbrella Organisation for Retail Payments The DPSS issued a discussion paper (‘Constituting an Umbrella Organisation for Operating All Retail Payment Systems in India’) on 25 April 2005. The paper brought out the rationale for setting up an umbrella organisation for retail payments. The goal was to consider bringing all retail payment systems in India on to a robust technology platform and a single organisation. The retail payment system was fragmented and did not have sufficient electronic and national connectivity. There were other issues to consider. For example, the Bank, the regulator, was also the service provider for the cheque clearing system at the Bank centres. It was held by many that the regulator should not be the service provider. Second, the various clearing houses in the country tended to function in an autonomous manner, and the local practices varied from place to place. Third, skill development in the existing set-up was low. Fourth, despite MICR cheque processing centres being profitable, the profits were accruing to the managing banks instead of being utilised for product development and new service offerings. In these circumstances, there was a case for a single organisation that would achieve uniformity and connectivity and enable the Bank to withdraw from its role as a retail service provider. The retail payment system could be ideally operated by commercial banks. The note discussed two existing models of umbrella retail payment systems, one practised in Sweden and the other in France. The discussion paper led the IBA to recommend setting up a company with twenty banks as shareholders, to take over the cheque processing centres with no bank holding more than 10 per cent of the shares.65 The IBA asked the Bank for clearance to set up this umbrella organisation.66 The Executive Director, R. B. Barman, advised (6 October 2005) that the IBA could go ahead with the proposed organisation, and made a few additional recommendations.67 But now an industrial dispute broke out to oppose what was seen as an attempt to outsource the Bank’s jobs to private parties. RBI Workers Union Kolkata was the first to file a dispute with the Regional Labour Commissioner, Kolkata, quoting a ‘Notice’, published in the Free Press Journal dated 2 March 2006, about the formation of a company (NPCI) to carry on the activities of banks’ clearing houses. The notice said that it was a surreptitious move by the Bank and in contravention of the RBI Act. It feared that the transfer of clearing cells to a private limited company would threaten many jobs. The United Forum of Reserve Bank Officers and Employees wrote to the Bank’s Governor on 10 March 2006 on similar lines. They added that the formation 320

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the payment and settlement systems of the NPCI was not in the interest of smooth functioning of the payment and settlement systems. Many letters were received from the All India State Bank Officers’ Federation and other banks’ employees’ unions. There were also more than twenty letters received from the public, raising objections to the ‘Notice’ published in the Free Press Journal. There were Parliamentary questions on the issue and a reference was received from the Standing Committee on Finance by Deputy Governor Leeladhar dated 30 May 2006. Economists like Amiya Kumar Bagchi and Ratan Khasnabis criticised the plan.68 The United Forum launched an agitation programme from 15 May 2006 to 7 August 2006 and decided that if no positive change in the approach of the Bank was seen, they would follow up with a day’s token strike in the second half of August 2006. The All India Reserve Bank Employees Association and the All India Reserve Bank Workers’ Federation representing class III and IV employees, respectively, had raised industrial disputes in connection with the setting up of the NPCI before the local Regional Labour Commissioner (Central) at four centres, Kolkata, New Delhi, Mumbai and Chennai, through their local units. The unions had two main concerns. First, there would be a retrenchment of about 2,000 employees and, second, foreign and private banks would share ownership of the NPCI. The Bank clarified during discussions that there were about twenty employees in five MICR clearing centres operated by the Bank. Second, clearing services would cover places with a minimum of five branches and there were not that many branches in a single village. The Bank also assured that the major part of the shareholding would be held by public sector banks and that there would be a cap on the ownership by foreign banks. Explaining the facts behind this dispute, the Human Resources Development Department of the Bank said that the ‘Bank’s efforts were for consolidation, rationalization and streamlining the operation for enhancing the efficiency under one organization and not for reducing the jobs as has been perceived by the unions. There is no outsourcing or transfer of work….’ The Bank held meetings with the four unions separately to explain its stand, which was that there would be no outsourcing or transfer of work, as the work in the National Clearing Cells will be carried on by the Bank’s staff as before, who would be on deputation with the proposed NPCI. A meeting with the representatives of the United Forum was held in Mumbai on 2 June 2006. Following this, there were a series of reconciliation meetings with the Deputy Chief Labour Commissioner, Mumbai. During one of these (28 November 321

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the reserve bank of india 2007), the Bank insisted on the closure of the case, whereas the unions’ representatives requested for adjournment, claiming that the matter had been taken up before the highest forum (Parliament) and was nearing finality. In a letter issued to members on 10 December 2007, the United Forum claimed success in their endeavours: Our joint efforts to protect RBI servicing and managing Metro Clearing Houses, continuing payment service in Regional Offices, operating RTGS system, etc. as hitherto have fully succeeded. Discussing Payment and Settlement Systems Bill 2006 Hon’ble Finance Minister Shri P. Chidambaram announced these categorically and repeatedly in Lok Sabha on 26 November 2007 and Rajya Sabha on 3 November 2007 which are also circulated in Public Domain. He further states that RBI is empowered to license and regulate all payment and settlement systems existing as well as prospective if any, proposed National Payment Corporation of India will manage other clearing houses run by PSBs which will be a public sector corporation owned by PSBs, to be licensed and regulated by RBI. For NPCI staff will continue to be drawn from PSBs for long. We are extremely grateful to MPs from left parties in particular and some other wellwishers for this splendid achievement.

Towards the end of our reference period, during the final conciliation meeting held on 26 March 2008, before the Deputy Chief Labour Commissioner (Central), Mumbai, the management of the Bank submitted a written statement stating: The Hon’ble Finance Minister has during the course of consideration and passing of the Payment and Settlement Systems Bill 2006 (in November 2007), made the following statement: ‘Sir, to-day, RBI operates the payment system in four metros. It also provides a number of payment services in the 14 cities or so, where it has regional offices…. That will continue in the foreseeable future. The Reserve Bank has accordingly noted to comply with this assurance given by the Hon’ble Finance Minister to the Parliament. The representatives of the All India Reserve Bank Employees Association and All India Reserve Bank Workers’ Federation after going through above submissions stated that they agree with the same and requested to treat this issue as settled.’

In view of this submission, the industrial dispute was treated as closed by the Labour Commissioner. The United Forum of Reserve Bank Officers and Employees issued a circular to members dated 3 April 2008, titled ‘NCC 322

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the payment and settlement systems Remains with RBI – Our Jobs Protected’, and it was treated as a unique achievement of their collective endeavours. While our reference period ends with the Bank and the IBA’s joint efforts, it took several months more for the NPCI to become a reality.69

Assessment of the Indian Payment and Settlement Systems with Reference to International Standards The Standing Committee on International Financial Standards and Codes, set up by the Bank and the Government of India in 1999, constituted an advisory group70 to assess the observance of standards and codes relevant to the payment and settlement systems.71 In respect of SIPS, the focus of the group was on the introduction of Lamfalussy standards72 as a minimum benchmark and to develop appropriate mechanisms for an RTGS system. Compliance with G3073 recommendations on SSS was the focus for the equity and debt segments, while for the foreign exchange segment, the group made recommendations entailing actions that could facilitate the CCIL in conforming to international practices and principles. The observance of Core Principles for Systemically Important Payment Systems was a part of the International Monetary Fund and the World Bank’s Pilot Financial Sector Assessment Programme of 2001. The assessment stated that, though the Bank played a pivotal role in the payment system, both as a participant and as a regulator, India’s compliance with the core principles was only partial, particularly with regard to the lack of legal and contractual framework relevant to the payment and settlement systems, multilateral netting arrangements used in clearing not being backed by legislation, and real-time finality not being assisted by bankruptcy legislation. The assessment highlighted that procedures in the event of a default – ‘partial unwind[ing]’ of transactions of defaulting institutions – could have serious systemic implications. Though the limits on the maximum amount of risk that could be taken by the participants in the payment system were clearly defined, it said that they did not meet the required standards. The report also stated that the security of SIPS in India was low. It concluded that the introduction of RTGS, which would handle all large-value payments, would greatly enhance compliance, boost efficiency and lower the risks in the payment system. In 2004, the Bank undertook a review of the recommendations of the advisory group. It noted that significant progress had been made in the 323

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the reserve bank of india implementation of the recommendations. Enactment of the legislation covering payment and settlement systems could help strengthen the legal framework and help make further advances towards meeting the best practices advocated as part of the international financial standards and codes. The committee noted that the operationalisation of RTGS marked significant progress in respect of some important recommendations made by the advisory group.74 The BPSS carried out a study in 2006 to examine the compliance of the Indian payment systems with the core principles of systemically important payment systems. The study revealed that eight out of ten principles were broadly or fully complied with. The principles partially complied with related to legal basis (the system should have a well-founded legal basis under all relevant jurisdiction) and settlement of multilateral netting systems (the multilateral netting system to complete daily settlement in time even in event of the failure to settle by participation with the largest settlement obligation).75 In most countries, the general trend had been to reduce the use of cheques as a payment instrument and introduce the cheque truncation system to reduce the settlement cycle. The cheque clearing system in India ranked above all countries in terms of the settlement cycle. However, the HVC in India was unique. No country provided a system that enabled same-day settlement of high-value cheques as India did. There were, however, deficiencies, mainly in the outstation cheque collection process. While a centralised ECS had been provided, this was available only for the Reserve Bank centres. To address this deficiency, a National Electronic Clearing Platform was implemented in September 2008. The other deficiency in the system was that the benefits of facilities like ECS and RTGS were not shared by the lower end of the customer segment, who still used expensive informal channels. There was a need to develop solutions using newer technologies that allowed all segments of society to gain access to the benefits offered by these facilities. The utilisation of the electronic payments infrastructure could be increased by using technology to make the facilities more accessible to customers.

Conclusion The Bank played a large and pivotal role in the development of India’s payment and settlement systems for both large-value and retail payments during the reference period, specifically in the areas of electronic funds transfer and electronic clearing service. The RTGS system was introduced in March 2004 324

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the payment and settlement systems and the NEFT system in November 2005. The former replaced the paperbased interbank clearing system and settled a sizeable volume of largevalue transactions. The Bank mandated the use of electronic payments for transactions between the Bank-regulated entities and markets in March 2008. The Bank also managed the clearing houses (for paper-based and electronic clearing) in seventeen large cities, while operating the clearing houses at four major locations. It was the settlement banker in these cities. In the paper-based clearing system, cheque truncation aimed to achieve efficiency. The market microstructure for settlement of money, government securities and foreign exchange transactions was also strengthened with the operationalisation of the CCIL as a central counter-party in February 2002. IT played a particularly important role behind many of these steps to strengthen the infrastructure, but this chapter has shown that technology was not by itself sufficient. A great deal of the initiative involved institutions for the protection of consumer interest and security of transactions while achieving greater speed and more volume. This was made possible also by addressing various legal issues and, more importantly, by passing the Payment and Settlement Systems Act, 2007.

Notes

1. The use of information technology in the financial sector took roots in the reports of the Rangarajan Committee on Mechanisation in Banks (1984). Further developments among the public sector banks had been based on the recommendations of the Rangarajan Committee (1989), the Saraf Committee (1994) and the Vasudevan Committee (1998). 2. In India, cash continued to be the most widely used medium of exchange even at the end of the reference period. This chapter does not deal with cash as a mode of payment in detail (see Chapter 9 on this subject). 3. VSAT is an acronym for very small aperture terminal, but more simply put, it describes a small satellite terminal that can be used for one-way and/or interactive communications via satellite. 4. The clearing house settlements were carried out as per the Uniform Regulations and Rules of Bankers’ Clearing Houses, 1986, framed by the Bank and adopted by the general bodies across the country. The practices in vogue were of long-standing and conventional usage and hence enjoyed a great measure of public acceptance. 5. The global conference on ‘Managing Change in Payment Systems' was cohosted by the BIS and CPSS on 10–11 December 1997. The compendium 325

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6.

7.

8. 9.

10. 11.

12.

of presentations made at the conference is available at https://www.bis.org/ publ/plcy04.pdf. With A. Vasudevan as the Chairman. The heads of the departments of Banking Operations and Development, Banking Supervision, Government and Bank Accounts, Legal Department and Information Technology were the members. The note also redefined the role of the DIT. It would continue to monitor the operations of the MICR cheque processing centres and the clearing house operations, work on standardisation of formats and software and Bankwide networking, interconnectivity among the departments and extension of EFT throughout the country within the next two years. The DIT would be actively associated with the RTGS work that could be carried out at the technical level, by the IDRBT, and constantly monitor the risks involved in the payment systems as well as in the technology applications related to settlement procedures. Consisting of a team drawn from within the Bank, from the areas of law, banking operations and supervision, economics and foreign exchange operations. Chairman A. Vasudevan, with representation from the government (Ministry of Finance and Department of Electronics), the Bank, the Indian Banks’ Association (IBA), the National Institute of Bank Management and IDRBT. The Chief General Manager, DIT, was the member-secretary. The detailed report can be accessed at https://www.rbi.org.in/Scripts/ PublicationReportDetails.aspx?FromDate=07/17/99&SECID=1&SUBSECID=0. The membership at the time of constitution were: S. P. Talwar, Deputy Governor, Chairman; other members were M. Damodaran, Joint Secretary, Ministry of Finance, V. Janakiraman, Managing Director, SBI, A.T. Pannir Selvam, Chairman, IBA, Rashid Jilani, Chairman and Managing Director, Punjab National Bank, R. H. Patil, Managing Director, National Stock Exchange, O. P. Gahrotra, Senior Executive Director, SEBI, David P. Connor, Chief Executive Officer, Citibank, H. N. Sinor, Managing Director and Chief Executive Officer, ICICI Banking Corporation, D. S. Pendse, Managing Director, Tata Finance Ltd.; S. R. Mittal was the member secretary. Of the thirty-seven major tasks listed for the department, action had been completed to a large extent in the case of thirty-three items. Only two aspects – introduction of variants of e-money (electronic money) and linkage of the Bank managed clearing houses – had not been completed. The latter would be completed while the introduction of e-money products would have to interface with other areas. The European Central Bank defines e-money as the ‘amount of money value represented by a claim issued on a prepaid basis, stored in an electronic medium (card or computer) and accepted as a means of

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13.

14.

15. 16.

17. 18. 19. 20.

21. 22. 23. 24.

payment by undertakings other than the issuer’. Three major issues of concern for the Bank were related to issuance of e-money, status of the issuers of e-money (that is, the participants to be allowed) and the norms to be followed for preserving the effectiveness and integrity of this methodology. For this, the Bank appointed a working group on e-money under the chairmanship of Zarir J. Cama, Chairman, HSBC, which submitted its report in July 2002. INFINET, an acronym for the Indian Financial Network, uses a blend of communication technologies such as VSATs and terrestrial leased lines. The hub of the VSAT network is situated at the IDRBT. The INFINET was a wide-area satellite-based network using VSAT technology, which could serve funds and management information service applications for the banking and financial sectors. The INFINET project was conceived in October 1996. The task of setting up the INFINET was entrusted to the IDRBT. SWIFT is a cooperative society under Belgian law owned by its member financial institutions with offices around the world. It also provided a network that enabled financial institutions worldwide to send and receive information about financial transactions in a secure, standardised and reliable environment. SWIFT was founded in Brussels in 1973 and was supported by 239 banks in fifteen countries. It started to establish common standards for financial transactions and a shared data processing system and worldwide communications network. Reported in Business Standard, 5 September 1997. As on 31 March 2002, there were ninety members of INFINET, including banks and other financial institutions such as term lending institutions, PDs and mutual funds. The VSATs stood at 890 at the end of March 2002, compared with 700 at the end of March 2001. Vepa Kamesam, ‘Changing Faces of Banking: Banking with Technology’, Inaugural address at the conference of Chairmen and Managing Directors of Public Sector Banks at IDRBT, Hyderabad, 2 November 2001. BIS, ‘Core Principles for Systemically Important Payment Systems’, 19 January 2001. Headed by K. S. Shere, Principal Legal Adviser of the Bank. Such as membership criteria, suspension from or termination of membership, and the procedures related to clearing and settling claims among members. Individual clearing systems, such as the cheque clearing system, ECS and EFT system, operated under the governing covenants of these regulations and rules as adopted by each clearing house. Netting is an arrangement among parties that transactions be aggregated, rather than settled individually. BIS, January 2001. M. G. Bhide Advisory Group, 1999. K. D. Singh, Additional Secretary, Ministry of Law and Justice, asked whether 327

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the reserve bank of india the existing Indian Contract Act was not adequate for dealing with payment and settlement systems, and why the Bank was seeking to regulate these systems. He also observed that in case any amendment was required, it could be made in the RBI Act instead of passing a new law. The Bank explained the background, including the R. H. Patil Committee’s recommendations and the core principles of the BIS. It was pointed out that similar separate legislations were prevalent in countries such as Australia, Canada and South Africa. The discussion was followed up by a detailed note to the government. On 28 November 2005, the government wrote to the Bank that the Ministry of Law and Justice suggested that ‘it will be appropriate if disputes are redressed by arbitration through the International Centre for Alternative Disputes Resolution, which is an institution established by the Central Government’. The Bank replied that the disputes that might arise between the system participants and the system providers would be of a technical nature, calling for early settlement. Therefore, it was appropriate that such disputes were heard and settled by persons with specialised knowledge in the area of payment and settlement. The Bank also pointed out the limitations of engaging International Centre for this purpose. While the Bank’s view prevailed on this issue, on another point, that the Bank should not decide a dispute where it was a party, the draft was amended to make the government the final authority. 25. This move was a step towards complying with the recommendations of the Joint Parliamentary Committee ( JPC) on Stock Market Scam and Matters Relating Thereto (2002). 26. The Board comprised the Governor (Chairman), Deputy Governor in charge of the payment and settlement systems as Vice-Chairman, other Deputy Governors as members, and two members from the Central Board of Directors to be nominated by the Governor. The Executive Director in charge of payment and settlement systems, the Executive Director in charge of Financial Markets Committee and the Principal Legal Advisor of the Bank were permanent invitees to the meetings, and persons with experience in the field could be inducted as either permanent or temporary invitees. 27. With the following members with tenure of two years: Governor Reddy, Deputy Governors V. Leeladhar, K. J. Udeshi and Shyamala Gopinath, and Central Board Members H. P. Ranina and N. R. Narayana Murthy. In addition, P. S. Shenoy, who had recently demitted office as the Chairman and Managing Director of Bank of Baroda and had experience in the field of payment systems, was a permanent invitee. As mentioned earlier, the report of the JPC on stock market scam was a trigger in pushing reforms in payment and settlement systems. Prominent among the measures recommended by the Committee on Technology Upgradation (1999) were introduction of the EFT, RTGS, CSMS, NDS and SFMS, which will provide the backbone for all message-based communication over INFINET. The committee felt that 328

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the payment and settlement systems

28.

29.

30.

31.

32. 33.

34.

the Bank had a long way to go in this area. This comment of the JPC was cited in a background note prepared during the formation of the BPSS, indicating that the setting up of the BPSS was a part of the action taken on the report of the JPC. The Board discussed issues such as preparation of a framework for payments through mobile phones, extension of jurisdiction of the MICR clearing houses, computerisation of non-MICR clearing houses, surveys to ascertain whether extension of RTGS business hours met the customers’ needs, and expansion of NEFT system to make all RTGS branches NEFT-enabled, among other specific issues. The first annual report of the BPSS for 2005–06 noted that the Bank had identified RTGS, the interbank government securities clearing system, the interbank foreign exchange clearing system and the high-value clearing (HVC) system as SIPS. The term applies to systems the failure of which can endanger the financial system. The DPSS carried out a study to examine the compliance of the Indian payment systems, including the RTGS, with the core principles of SIPS internationally. The study revealed that eight out of ten principles were broadly or fully complied with. The partially complied principles related to legal basis (the system should have a well-founded legal basis under all relevant jurisdiction) and settlement of multilateral netting systems (the multilateral netting system to complete daily settlement in time, even in event of the failure to settle by participation with the largest settlement obligation). To gauge the status of the Indian payment systems, an assessment was made against the core principles for systemically important payments systems. The findings were published in the first report on oversight of payment systems in India in November 2007. MICR cheque processing centres were submitting quarterly self-assessment reports on compliance to these standards. Minimum Standards at the Magnetic Media-Based Clearing System were also prepared and issued in October 2007. A self-assessment report indicating compliance with the guidelines had to be carried out every half year by the clearing houses. BIS (Committee on Payment and Settlement Systems), Red Book (Basel: BIS, 2011). The NPC would have a Deputy Governor as the Chairman and included a Regional Director, IBA Chairman, Joint Secretary of the Banking Division, Chairmen and Managing Directors of two public sector banks, one private bank, and one foreign bank, and one large NBFC. The National Stock Exchange Managing Director and the SEBI Executive Director were the other members. To facilitate the introduction of RTGS, a working group was chaired by Executive Director A. Vasudevan. Two vendors, TCS and 329

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the reserve bank of india

35. 36. 37.

38.

39. 40.

41.

PricewaterhouseCoopers (PwC), were shortlisted and PwC was appointed as consultant for the RTGS project. Vepa Kamesam, ‘Roll Out Strategy for RTGS Implementation’, Inaugural address at a meeting with CMDs of banks, July 21 2003. The IAS is the accounting system of the Bank (members’ current accounts are in IAS). Between May and October 2003, the DIT prepared a comprehensive draft of the RTGS (Membership) Regulations and Rules and circulated it among banks and other stakeholders, such as the Fixed Income Money Market and the Derivatives Association of India, and invited feedback before finalising it. Implementation of RTGS commenced live operations with a soft launch on 26 March 2004 in four banks, SBI, Standard Chartered Bank, HDFC Bank and Saraswat Co-operative Bank, for interbank transactions. Customer transactions started on 29 April 2004. The integrated system, when fully implemented in late 2005, provided significant additional advantages, including automated start-of-day funding of the RTGS settlement account (transfer of funds based on standing instruction from the current account to the settlement account); automated end-of-day flushing of the RTGS settlement account (transfer of funds from the settlement account to the current account to make the settlement account zero); message-based own account transfer between the RTGS settlement account and the current account in IAS or two current accounts in IAS in the Deposit Account Department of the Bank; multilateral settlement; automated intra-day liquidity facility; and gridlock resolution mechanism. It reported that the IAS had also stabilised well and was ready to be used as the primary accounting system at Mumbai. The annual closing of accounts for 2007–08 was performed using the IAS. These were previously contractual in nature but were later notified under the Payment and Settlement Systems Regulations. The regulations provided for the oversight of the RTGS system, a standing committee for the management of the system, and an admission procedure for members. The RTGS guidelines detailed business operations, including the use of settlement accounts and funding accounts, transaction types, communication, message formats, settlement of transactions, intra-day liquidity facility, queue management and gridlock resolution. The Bank and commercial banks belonged to category A, and PDs to category B. Members of categories A and B were direct members of the system. Banks and PDs that were in neither category were eligible to belong to category C, though there were no such members. Clearing houses and clearing agencies (including CCIL) formed category D membership. Members of categories A and B could submit their own interbank transactions, but only category A

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the payment and settlement systems

42.

43. 44.

45.

46.

47.

members could submit transactions on behalf of their customers. Category D members could submit only net settlement batches to the RTGS system. For this purpose, there was an interface between the RTGS system and the IAS of the Bank. The banks used the option available in their participant interface (PI) to transfer funds from one account to another in Mumbai, or use the CFMS if the transfer was between accounts from one office of the Bank to another. BIS, Red Book. An internal group constituted by the Bank in 2006–07 examined various aspects of payment systems, particularly relating to switching over to electronic modes. Based on the recommendations of the group, the minimum value for customer-based RTGS transactions was enhanced to 0.1 million from 1 January 2007. Other measures implemented during 2007–08 included mandating all interbank transactions for settlement only through the RTGS mode; review of the norms relating to membership of INFINET to facilitate larger participation in electronic payment-based message transfers; effecting the settlements arrived at by the CCIL and the National Stock Exchange and the Bombay Stock Exchange as RTGS batch settlements; implementation of the national settlement system (NSS) for processing the clearing settlements of the major clearing houses as RTGS batch settlement; implementation of NEFT for greater coverage and reach for the common man; gradual upward revision of the per-transaction limit for customer-based transactions to a level of 100 million; and migration of government-based payment and receipt transactions to electronic means. The multilateral net settlement batch mode to facilitate settlement of various CCIL-operated clearings (interbank government securities, interbank foreign exchange, CBLO and national financial switch) was operationalised through RTGS in Mumbai in 2006–07. For example, between March 2005 and March 2008, the value of transactions increased from 5,826 billion to 47,118 billion. Of the total value in March 2008, customer transactions accounted for 17,988 billion, interbank transactions for 9,784 billion and interbank clearing for 19,346 billion (Source: RBI, Database on Indian Economy). In the proposed NDS, all trades between members of the NDS would have to be reported on the NDS, which would be directly linked to the settlement system. So that market participants prepare themselves for the NDS, it was proposed that with effect from 2 June 2001, all transactions settled through the DvP system of the Bank would be on T+1 basis. As this would provide certainty to market participants in respect of demand for settlement funds for securities transactions on the day of settlement, it was expected to improve cash and liquidity management among money market participants. The implementation of the project resulted in the integration of markets, automation, inter-connectivity and electronic maintenance of record. It helped 331

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48. 49. 50. 51.

52. 53.

54.

in increased geographical participation in primary issuance of government securities from terminals located at regional Public Debt Offices and member terminals connected with the system. The total volume of the CCIL-operated systems increased from 0.06 million to 0.09 million between 2004–05 and 2007–08, and the corresponding value from 7,291 billion to 26,783 billion. The CFMS project was discussed in the 11th meeting of the Payments Systems Advisory Committee held on 26 March 1999, and in the subsequent meeting of the advisory committee held on 5 May 1999. Shyamala Gopinath, ‘Retail Payment Systems – Select Issues’, Inaugural address at the Regional Seminar on Payment Systems, jointly organised by RBI and BIS at Mamallapuram, Chennai, 17 March 2009. See the section on Legal Issues. Working Group on Cheque Truncation and E-cheques (Chairman: R. B. Barman, Executive Director) was constituted on 10 January 2003 to recommend a suitable model of cheque truncation for India. The group submitted its report in July 2003. The recommendations were the following: The physical cheque would be truncated within the presenting bank. Within the presenting bank, the point of truncation could be decided by each individual member bank providing for service bureau models where banks can approach or set up service bureaus for capturing images and MICR data. Settlement would be generated on the basis of current MICR code line structure. Electronic images would be used for payment processing. Grey scale technology would be deployed for imaging. Images would be preserved for eight years. A centralised agency for a clearing location would act as an image warehouse for the banks. The group recommended norms for agencies to provide the service. Public key infrastructure would be deployed to protect images and data flow over the network. SBI, Bank of India, Punjab National Bank, Syndicate Bank, Dena Bank, ICICI Bank, HDFC Bank, Standard Chartered Bank, Bank of America and Karur Vysya Bank Ltd. The committee in its meeting held on 13 April 2005 took the following decisions: (a) while the Reserve Bank and banks should take action in regard to ensuring security checks, the National Informatics Centre (NIC) should study security aspects of the proposed system and on behalf of the government, satisfy themselves and certify that it had sufficient checks built therein, (b) a meeting of various non-civil departments/ministries would be held to ascertain their level of comfort and, additionally, they would identify various changes in manuals/procedures and (c) a cheque truncation system would be introduced on pilot basis in Delhi in those departments and ministries which were well prepared, and extended to other departments in a phased manner. Working Group on Risk Mitigation Mechanism (Chairman: R. Gandhi) was set up during 2004–05. The group recommended limiting the number

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the payment and settlement systems

55. 56.

57. 58. 59.

60.

61.

62.

of banks participating in the clearing system to a few low-risk ones. In the short to medium term, risk mitigation measures were to be introduced. The group felt that all high-value cheques should be presented in HVC twice or more a day or expand the geographical jurisdiction of HVC to make it coterminus with the full or substantial part of the clearing house. The group also felt that on an immediate basis, HVC needed to be made more secure, and that a guarantee fund be introduced at a centralised location for the HVC systems. The contribution to the guarantee fund would be based on the risk profile of the member bank. In the case of a settlement failure in the HVC system, recourse to the guarantee fund would be made on the principle of ‘defaulter pays’. The Bank decided ultimately to withdraw HVC from November 2009. Exploring connection of major cities with the nearest metro to achieve faster clearing and settlement. This is the concept of extending the jurisdiction of MICR cheque processing centres across cities (cluster approach to clearing) and leveraging the CBS infrastructure available across banks (speed clearing). DPSS, Cheque Clearing Newsletter, vol. 2, January 2008. The scheme, primarily meant to cater to small-value funds transfers, had an initial cap of 25,000 per transaction. This was increased to 0.1 million in 1997, 0.5 million in 1999 and 20 million from 1 October 2001. Customers could choose to make payments through either RTGS (if they were above the threshold limit of 0.2 million at the end of the reference period) or NEFT. A Working Group on Regulatory Mechanism for Cards explored the issue in March 2005, and concluded that the existing eligibility criteria for the issue of credit cards were appropriate and did not warrant allowing access to non-banking entities in this business. On issues relating to customer services, the group made detailed recommendations relating to transparency and disclosure, customer rights protection and code of conduct. The Multi-Application Smart Card Project was in the nature of a commercial pilot conducted jointly by the Indian Institute of Technology, Mumbai, and the IDRBT, Hyderabad. It had participation from banks and industry stakeholders, such as card manufacturers, terminal providers and network service providers. To study the recommendations for SMART Card based Payment System Standards (Chairman: A. Vasudevan, Executive Director) in September 1999. The group submitted its report on 30 January 2000 and the recommendations were accepted by the Bank. Explaining the Bank’s position on making ATM withdrawals free, Deputy Governor Leeladhar mentioned: ‘The commercial banks are racing against each other to post hundreds of crores of rupees (billions) as profits and therefore they must not be fussy about meagre costs involved in cash withdrawal from 333

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the reserve bank of india

63. 64.

65.

66. 67.

68. 69.

70. 71. 72. 73. 74.

75.

their ATM by customers of other banks’, adding that even the cost involved in installing an ATM had come down from 3 million to 0.6 million. Some element of cross-subsidisation, therefore, was justified. Chairman: R. B. Barman, Executive Director. A discussion paper on this scheme was placed on the Bank’s website in June 2008 for public comments. The satellite communication link was also disaster-proof. It was, therefore, considered suitable for use as a back-up communication link for the major centres in the country. A working group (Chairman: S. Natarajan, SBI) discussed the legal status of such a body, options regarding technology and roadmap, and implementation issues. The IBA working group report was discussed in its meeting on 19 August 2005. Letter to Deputy Governor Leeladhar, 19 September 2005. That the company should necessarily be a Section 25 company, that is, such a corporation would not be driven by the profit motive to ensure larger dividends; registration of the company could be completed by 31 December 2005; the appointment of the non-executive chairman and the chief executive officer should be in consultation with the Bank; expansion of the ECS and EFT systems should be a priority; and the organisation would be supervised by the Bank. Economic Times, 22 June 2006. The NPCI was incorporated in December 2008 and the Certificate of Commencement of Business was issued in April 2009. Incorporated as a company, its aim was to create infrastructure of large dimensions and operate on high volumes, resulting in payment services at a fraction of the present cost. Chairman: M. G. Bhide. The advisory group submitted its report in three parts in September 2000, December 2000, and July 2001, covering clearing house operations, settlement in equity and debt markets and foreign exchange transactions. An approach and guidelines on regulation of financial services adopted by the European Union in 2001 to make the regulatory process quicker and more effective. The Group of Thirty is an international consultative group of financiers and academics. The introduction of same-day and intra-day settlement helped in significantly complying with the international standards. The Bank had identified RTGS, the interbank government securities clearing system, the interbank foreign exchange clearing system and the HVC system as SIPS. A Committee on Financial Sector Assessment (Chairman: Rakesh Mohan, Deputy Governor, Reserve Bank, and Secretary, Government of India, 2009), through the Advisory Panel set up on Institutions and Market Structure, looked into the adherence to the standards and codes in payment and

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the payment and settlement systems settlement systems prescribed by the Committee on Payment and Settlement Systems for SIPS and CPSS-International Organisation of Securities Commission Recommendations for the Securities Settlement Systems and Central Counter-parties. Its findings were favourable. The assessment showed that the standards were observed by participants with some departures. No significant weakness was identified with respect to either high-value payment systems or SSS, while the shortcomings in the functioning of the central counter-parties were relatively minor. Greg Johnston, Head of Banking, Reserve Bank of Australia, peer reviewed the Panel’s report on payment and settlement systems. He agreed that significant progress was made in the development of India’s payment and settlement infrastructure and suggested that the RTGS and HVC systems be treated as SIPS. He stated that the legislation supporting the legal certainty of settlement finality in SIPS and netting in financial markets was a very important step. The overall findings of the CPSS Core Principles assessment were that the existing payment system operated cheaply and efficiently, with minimal systemic risk.

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9 Currency Management

Introduction Currency management involves matching the supply of currency (notes and coins) to levels of demand, efforts to achieve self-sufficiency in the production of notes and coins, creating appropriate denomination mix, improvement in distribution networks, withdrawal and destruction of notes, and enhancement in the security features of currency notes. These responsibilities are discharged by the Department of Currency Management (DCM). The function of note issue and currency management is performed through the Reserve Bank’s regional issue offices and sub-offices, and a wide network of currency chests maintained by banks and government treasuries spread across the country. The Bank also coordinates with various agencies such as the note printing presses, mints, railways, police, Indian Airlines (subsequently known as Air India) and the Indian Air Force. The activities of the Bank in this field encompass both policy matters and institutional measures. The former includes forecasting annual requirements of coins and notes, liaising with the printing presses and mints, and dealing with security issues and counterfeits jointly with other agencies of the government. The latter includes periodic allocation of notes and coins amongst the Bank’s regional offices, extending currency chest facilities to banks, processing and destruction of soiled notes, revision of policy and procedural guidelines on note exchange facility, adjudication of notes and responding to queries received in this regard, and various customer service issues. Notwithstanding the decline in the share of currency in broad money after the nationalisation of banks ( July 1969, see Figure 9.1), cash remained an important mode of payment in the Indian economy. During the reference period, currency in circulation was an important indicator of economic activity, especially in rural India. Cash demand tended to increase at the beginning of the month, when salaries were spent, and tapered off towards the end of the 336

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currency management month. Similarly, currency seasonality, by and large, mirrored events, such as festivals, elections and the seasonality of economic activity. The importance of cash in the economy made currency management a particularly significant operation as these impacted the economic and social fabric of a vast segment of the population in one form or other. The long-run secular decline in the share of currency in broad money, however, continued. The ratio had declined steadily from 40 per cent at the end of March 1971 to 16 per cent at the end of March 2001, and thereafter gradually to 14 per cent at the end of March 2009. The trend reflected financial deepening, increased use of credit and debit cards, and more liquid financial markets. Consistent with this trend, during the reference period, the thrust of currency management saw a shift from managing volumes to improving the quality of notes in circulation, tackling counterfeit notes and making note exchange easier. The chapter starts with a brief account of trends in the circulation of banknotes, followed by a description of the currency chest mechanism. Three major areas of activity are taken up for discussion in the four subsequent sections: improvement of supply, management of quality, and avoidance and detection of counterfeits, partly by enhancing security features. The trends in supply and availability of coins and certain issues that surfaced in this regard are also narrated. The process of introduction of the post-print coating of notes and polymer notes, to improve the life of banknotes, forms the topic of the next section. The chapter ends with short sections on customer service and computerisation.

40

75000

30

60000

45000

20

30000

10

15000 0

Currency/Broad Money (left scale)

2007-08

2004-05

2001-02

1998-99

1995-96

1992-93

1989-90

1986-87

1983-84

1980-81

1977-78

1974-75

1971-72

0

Number of Bank Branches

Per Cent

Figure 9.1 Share of Currency in Broad Money

Number of Bank Branches (right scale)

Source: RBI, Annual Report 2007–08.

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Notes in Circulation: Annual Trends The Bank performs the function of note issue and currency management and acts as the sole currency authority for the issuance of banknotes. Notes in circulation ( 2 and above) increased by 10 per cent in 1998 over the previous year (at the end of March). In October 1997, the Bank introduced 500 notes in the Mahatma Gandhi series. With this, the introduction of the new family of banknotes in the Mahatma Gandhi series was complete except for notes in 20 denomination. To meet the demand–supply gap, 2,000 million pieces of 100 and 1,600 million pieces of 500 notes were imported. At the end of 1999 and 2000, notes in circulation in terms of value rose by 16 per cent and 12 per cent, respectively. Against the increase of 11 per cent at the end of 2001, notes in circulation went up by 15 per cent at the end of 2002 due to the resurgence of agricultural activity. The growth in the share of various denomination groups during 1996–2001 (in terms of value and volume) showed a gradual shift towards higher denomination notes. However, a slowdown in rural economic activity in 2002–03 resulted in a deceleration in the value of notes in circulation (12 per cent at the end of 2003). In volume terms, there was a decline of 3 per cent in the circulation of notes, mainly because of the Bank’s efforts to increase notes of 20 and 500 in lieu of the 10 and 100 denomination notes, respectively. The supply of fresh notes improved during the year through better capacity utilisation of the two printing presses of the Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL), a wholly owned subsidiary of the Bank, and augmentation of capacity of the two government presses. During 2003–04, the total value of notes in circulation recorded a robust growth of 16 per cent. Efforts to keep pace with the rising volume of currency demand took the form of judicious distribution of available supplies, increase in the percentage of higher denomination notes, and ensuring recirculation of notes by use of machines for processing, verification and sorting. In the 2000s, the demand for 500 denomination notes increased sharply due to the growing network of automated teller machines (ATMs). Notes of 100 and 500 denomination together accounted for 76.4 per cent of the total circulation in terms of value at the end of March 2004. During 2004–05, the value of notes in circulation registered growth of 12 per cent. However, in volume, there was a reduction of around 4 per cent, mainly due to change in the denomination-wise mix of banknotes based on region-wise and currency-chest-wise demand, an increasing number of ATMs, and a 338

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currency management gradual rise in the number of users of e-banking. In each of the years 2005– 06, 2006–07 and 2007–08, the value of banknotes in circulation recorded a growth of around 17 per cent. There was a consistent and gradual shift towards higher denomination banknotes, particularly of 500 and 1,000. The demand for 500 notes picked up sharply due to the growing network of ATMs (see Box 9.1). It may be observed from Table 9.1 that during the three years 2005– 06, 2006–07 and 2007–08, there took place a consistent compositional shift (in terms of value) from lower denomination to higher denomination banknotes in circulation. The shift was evident in favour of 500 and 1,000 denominations. In contrast, the circulation of 5, 10, 20 and 50 denomination notes declined. The consistent shift from lower denomination to higher denomination banknotes could be attributed to the technological advancements (see Box 9.1), together with rising income levels. Table 9.1 reports the value of banknotes supplied by the presses in the last five years of the reference period. Figure 9.2 illustrates the process in which notes and coins entered the economic system, and were withdrawn from it. The trend in compositional shift in notes is summarised in Figure 9.3. Box 9.1 Growth of ATMs and Demand for Higher Denomination Banknotes Ever since the first ATM was introduced, its usage grew exponentially. The cash dispenser and the ATMs gradually became the electronic face of banking. Foreign banks in India were the first to introduce experimental ATMs in 1988. Usage picked up in the 1990s. Although a number of services were offered through fully functional ATMs, about 98 per cent of the people used the ATMs primarily for withdrawing cash (2004–05 estimate). Banks devised competitive strategies around the ATMs, recognising that ATMs could be a potent source of value-added service to consumers through access to banking services at any time and in many places. With the increase in the usage of ATMs, a shift took place towards stocking higher denomination banknotes – particularly 100 and 500 denominations – as banks did not find it commercially viable to stock the machines with all denominations. Lower denomination banknotes ran out sooner and increased both capital cost and operating costs. The Reserve Bank, accordingly, faced an increasing demand for fresh banknotes in 500 and 100 denominations. Given the increased demand for banknotes fit for use in ATMs, the emphasis was laid on banks using desktop sorters to salvage good quality banknotes for use in their ATMs. Incidentally, there were about 53,000 ATMs at the end of November 2007. 339

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the reserve bank of india Table 9.1 Value of Banknotes ( Billion) Supplied by the Presses Denomination

2003–04

2004–05

2005–06

2006–07

2007–08

10

30.70

43.32

11.83

34.80

41.93

50

106.45

93.10

53.16

72.92

60.65

500

584.00

5

7.35

20

19.18

100 1,000

Total

0.90

15.10

0. 25

0. 25

14.12

-

8.76

12.72

416.10

395.60

320.84

403.48

419.90

209.00

257.00

129.60

589.10

699.00

1,372.78

626.00 1,431.02

Source: RBI, Annual Report, various years.

330.65 860.45

736.55 1,845.86

902.50 2,136.70

Note: The shortfall in supply during 2005–06 was due to the delay in arrival of the cylinder mould vat watermarked bank notes (CWBN) paper with revised specifications for the printing of banknotes with new/additional security features and the decision to commence printing of new design banknotes only on exhausting old design paper to avoid mixing of old and new notes and to salvage the maximum number of old design notes from semiprocessed sheets.

Figure 9.2 Currency Management Cycle Chest Branches (4,301) and RBI Offices(16)

Chest Branches (4,301)

RBI Offices (20)

4 Mint Linked RBI Offices

Public

4 Presses (Notes)

4 Mints (Coins) Fit notes/coins

Unfit notes/coins

Source: RBI, Annual Report 2006–07.

Note: This reflects the position as at the end of March 2007.

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currency management Figure 9.3A Banknotes in Circulation: End of March 2001 500500 3%3%

Volume Volume

1000 1000 Neg. Neg.

Value Value 2, 2,5 5 Neg. Neg.

1000 1000 2%2%

2, 2,5 5 12% 12%

10 10 6%6% 20 20 1%1%

100100 30% 30%

500500 25% 25%

50 50 15% 15%

10 10 35% 35%

50 50 19% 19%

20 20 1%1%

100100 51% 51%

  

Figure 9.3B Banknotes in Circulation: End of March 2008

Volume Volume

500 12%

1000 3% 500 12%

1000 3%2, 5 17%

2, 5 17% 1000 24%

100 30%

50 12%

20 5%

50 12%

20 1%10 2%

50 5%

20 1%

20 5%

  

500 45%

500 45%

Sources: 9.3A: RBI, Annual Report 2000–01; 9.3B: RBI, Annual Report 2007–08.

While on this subject, two major limitations in forecasting of issue requirements of various denominations of currency notes may be mentioned. First, the effect of technological changes occurring in the payment system (introduction of plastic money) could not be modelled, as there was hardly any information on the relevant variable. Second, forecasts for denominational mix did not reflect the demand for various denominations by the general public, as the observed mix was more determined by the supply constraints, and changes in supply conditions could lead to different denominational mix.

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50 5% 100 23%

100 23%

1000 24%

10 21%

10 21%

100 30%

Value

Value

2, 10 5 2% Neg.

2, 5 Neg.

the reserve bank of india

Currency Chest Mechanism The currency management function of the Reserve Bank grew with the number of issue offices of the Bank (including two sub-offices) increasing to eighteen in 1998–99, from seventeen in 1997–98, and the number of currency chests operated by commercial banks and treasuries increasing to 4,163 from 4,140 in 1997–98. In all, the number of currency chests functioning at the end of March 1999 stood at 4,181. The Bank has agency agreements mainly with scheduled commercial banks (SCBs), under which a currency chest facility is granted to them at select branches. The currency chest branch is an extended arm of the Bank’s Issue Department. It issues fresh banknotes and coins, retrieves soiled notes, and exchanges notes and coins, including mutilated notes. During the reference period, the total number of currency chests held with the state treasuries fell, whereas there was an increase in the number of currency chests with public and private sector banks (Table 9.2). The network of currency chests maintained by the banking sector and with the state treasuries enabled a wider geographical reach, which otherwise would not have been possible. The stock of notes and coins held by the currency chests was taken into account for working out the cash reserve ratio (CRR) requirements of the bank concerned and allowed bank branches to operate on a lower cash balance. To elaborate: The banks holding currency Table 9.2 Currency Chests: 1997 and 2008 Agency Treasuries State Bank of India and its associates Nationalised banks Private sector banks Cooperative banks Regional rural banks Foreign banks RBI (offices and currency chests) Total

Source: RBI, Annual Report, various years.

Number of Currency Chests at the End of March 1997 423 2,877 791 19 0 0 0 17 4,127

June 2008 19 3,074 1,084 101 1 0 4 20* 4,303

Note: *These include 18 issue offices of the RBI, the sub-office of the RBI Issue Department in Lucknow, and a currency chest at the RBI office in Kochi. 342

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currency management chests incur considerable capital expenditure at the time of establishment of currency chests. They also incur various types of recurring expenses for the maintenance of currency chests. On the other hand, these banks derive several advantages out of currency chest maintenance, most importantly in the area of cash management. Maintenance of currency chests enables them to withdraw cash as and when necessary, and deposit cash into the currency chest for receiving instant credit to their account with the Bank without actually visiting the Bank premises. This enables them to operate with very low cash balances. The balance with the Bank is used for meeting the CRR and for making investments on a day-to-day basis. Further, the banks with currency chests enjoy free transfer of funds under the Bank’s Remittance Facilities Scheme, which results in a substantial saving in cost of transfer of funds between the chest branches. Had the currency chest network not been there, banks would be incurring a lot of expenditure for visiting the Bank’s offices at frequent intervals for withdrawal and deposit of cash. Thus, the maintenance of currency chests results in the saving of costs involved in the physical movement of cash from and to the Bank. Currency chests also provide space for stocking fresh/re-issuable currency notes to meet the demands for payment to the public without blocking the bank’s own resources. Similarly, soiled notes accepted from the public, which are not fit for circulation, are also deposited into the currency chests and credit is immediately received against the deposit. This aspect was important because the Bank had only eighteen issue offices situated in state capitals and a few in other important towns. In order to further improve the functioning of the currency chests, as well as to help the non-chest bank branches to credit their surplus cash to their accounts to maintain a low level of cash balances, the currency chests had been allowed to charge a levy of 1 per packet of notes received from the non-chest branches from June 2002. State Bank of India (SBI) and its associate banks maintained the bulk of these currency chests (70 per cent of total currency chests), followed by other commercial banks (19 per cent). The dominance of SBI and its associate banks in this area reflected historic circumstances. This group had about 23 per cent of its branches as currency chest branches, whereas other nationalised banks had only 3 per cent of their branches operating as currency chests (as in 2001–02). Nevertheless, the Reserve Bank had been persuading public sector banks to open more currency chests for broadening the distribution network. 343

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the reserve bank of india In 2003–04 and 2004–05, the Bank followed a twofold strategy: to increase the number of currency chests in relation to ‘cash management’ requirements of individual banks and to progressively convert treasuries and sub-treasuries into currency chests. Foreign banks were permitted in 2003–04 to operate currency chests. Mechanisation of sorting activity of currency chests was given importance in 2004–05. Banks were required to provide desktop note-sorting machines of appropriate capacity at all their chest branches over a period. Banks with up to 100 currency chests were to install these machines by the end of May 2005, and those with more than 100 were to do so by the end of November 2005. As a further move, the Bank initiated the exercise in 2007–08 to procure and install desktop note-sorting machines in certain non-currency chest branches, based on the volume of cash handled, proximity to the international border and quantum of detection of counterfeit notes.

Improvements in Supply and Quality of Notes Improving the supply and quality of notes and coins in circulation, and avoidance and detection of counterfeits were the two major goals of currency management during the reference period. Specific measures undertaken included mopping up of soiled and mutilated notes, withdrawal of lower denominations from circulation and their destruction, direction to banks to stop stapling note packets, mechanisation of note processing and eco-friendly destruction of soiled notes, widening of the currency chest network (see previous section), computerisation of the currency management information system, and speeding up the process of handing over and taking over of remittances by the chests. Anti-counterfeit measures were continued in coordination with the government and through public awareness campaigns. Mechanisation of note processing and destruction of non-issuable currency notes became major thrust areas of the Bank as a part of its ‘Clean Note Policy’. It commissioned two systems to facilitate the process, the currency verification and processing system (CVPS), and the shredding and briquetting system (SBS). CVPS is an electronic mechanical device designed for examination, authentication, counting and sorting, and ‘online’ destruction of notes unfit for further circulation. The system can sort the notes on the basis of denomination, 344

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currency management design and level of soilage. Generally, the system sorts the notes into ‘fit’, ‘unfit’, ‘reject’ and ‘suspect’ categories. The unfit notes are shredded ‘online’. The fit notes are retrieved from the system in packets of 100 pieces. These packets are banded by the system and relevant information, such as denomination, date of processing, the name of the office, and operator code, is printed on the label to facilitate easy identification. The notes under the reject and suspect categories are segregated for manual examination and verification. The SBS replaced the process of incineration of notes, which was not considered to be environmentally friendly. The system first cuts the notes into small pieces and then converts them into fine shreds. These shreds are then automatically channeled into the briquetting system where they are compressed under high pressure, resulting in the formation of briquettes. The SBS are of two types – online and offline. The online systems accept the shreds of notes for briquetting both from its shredder and from the CVPS. The offline systems accept shreds of notes for briquetting only from the shredder. In 1998–99, four CVPS were installed at two offices, Bhopal and Chandigarh, as a pilot project. These systems sorted the notes into issuable and non-issuable categories, detected counterfeit notes, and destroyed the nonissuable notes in an eco-friendly manner through shredding and briquetting systems. The issue offices in Belapur, Kolkata, Mumbai and New Delhi were provided with SBSs during 1999–2000. SBSs obviated the need for incineration of cancelled notes and thus addressed the issues raised by State Pollution Boards. In July 1997, a Forged Note Vigilance Cell was set up in the DCM. Besides building up a database on forgeries, the cell closely monitored major forgeries. Banknotes of 1,000 were reintroduced in October 2000 in unregistered form, following an amendment to the High Denomination Bank Notes Demonetisation Act, 1978. The 1,000 notes, along with 500 and 10,000 notes in registered form, had been demonetised in 1978. Further, new notes of 500 were introduced in November 2000 with a revised colour scheme to facilitate easy distinction from 100 denomination notes. In addition to the usual security features, these notes incorporated additional overt security features, such as optically variable ink, or OVI (or colour-shifting ink) and readable security threads. Five-rupee notes in the existing design with the Ashoka Pillar watermark were introduced to supplement the supply of coins of the same denomination. 345

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the reserve bank of india Banknotes are printed at four note presses, of which the Currency Note Press (CNP), Nashik, and Bank Note Press (BNP), Dewas, are owned by the Security Printing and Minting Corporation of India Ltd., a union government enterprise. The other two presses at Mysore and Salboni are owned by the BRBNMPL. The presses at Mysore and Salboni were made fully operational from March 1999 and September 1999, respectively. With these systems in place and improvements in distribution, the perennial problem of short supply of fresh notes had been solved to a great extent. In 2000–01, the Bank launched or continued various measures as a prelude to ushering in clean notes in circulation. The printing capacity of the four note presses was augmented. For the first time in recent years, the Bank’s indent for fresh notes was met by the printing presses fully in 2000–01. The Government of India was importing rupee coins at times to supplement indigenous production. Automated coin dispensing machines were commissioned at select regional offices on a pilot basis to cater to lowvolume requirements. The feasibility of expanding the channels for distribution of coins beyond the banking system was explored, which became a reality a few years later. Consequent to the amendment to Section 43A of the Companies Act, the BRBNMPL became a private limited company from 24 February 2002. After the modernisation of the presses at Nashik and Dewas, the combined capacity of the four presses was augmented. The BRBNMPL was awarded the ISO 9001:2000 certification by RheinischWestfalischer TUV, Germany, in March 2001. It became one of the first banknote presses in the world to be so certified.

Cost of Printing Banknotes The cost of printing notes escalated towards the second half of the reference period (Table 9.3). However, in view of the rise in the average denomination and better quality of printed notes, there was an overall increase in efficiency in the production of notes. The selling rate of banknotes was intimated by the presses for each financial year (April–March). The rates fixed by the government presses were in accordance with the formula laid down by the Ministry of Finance, whereas the BRBNMPL had constituted an internal cost committee for finalising selling rates. The rates fixed by the government presses continued to be higher than those fixed by the BRBNMPL. 346

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currency management Table 9.3 Supply and Cost of Banknotes: 2003–08 Year

2003–04 2004–05 2005–06 2006–07 2007–08

SPMCIL

Supply (million pieces) 5,065 4,622 2,697 5,136 5,442

Cost ( billion)

Source: RBI, Annual Report, various years.

8.94 7.83 4.06 10.42 9.08

BRBNMPL

Supply (million pieces) 8,101 7,971 4,194 7,348 8,488

Cost ( billion) 8.15 6.60 6.29 9.78 11.48

Notes: SPMCIL: Security Printing and Minting Corporation of India Ltd.

In the 15 July 2002 meeting of the Central Board of Directors held in Chennai, the following statement was made by the DCM in reply to a query as to why there was a substantial variation in the rates for the supply of banknotes during 2001–02 – even for the same denomination – from different presses. During 2001–02 (April–March), the BNP was mostly occupied in printing 50 notes (45.6 per cent of its total production) while the CNP mostly printed 10 notes (48.5 per cent of its production). The BRBNMPL presses printed a reasonable mix of denominations. The higher denominations had more security features and, hence, involved more expensive inputs and processes. Normally, payments to the government presses were made by the Bank in respect of the notes supplied on the basis of provisional rates. The final rates for the relevant period were generally determined by the government after a lapse of two to three years, after which the Bank paid the differential. The BRBNMPL, however, determined its rates during the relevant period itself. Therefore, the rates charged by government presses and those of the BRBNMPL are not strictly comparable, though there was a difference in the rates charged by the different presses even with the same denomination.

Accumulation of Soiled Notes in Bank Vaults

While the mechanical processing of distribution of currency notes was pursued, the Bank took a number of steps to improve the quality of notes in circulation. In this context, it became essential that soiled notes be simultaneously withdrawn from circulation. In order to achieve these objectives, the Bank introduced various changes in the systems and procedures relating to currency management,

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the reserve bank of india beginning from 2001–02. These included mechanisation of currency processing operations in the issue offices of the Bank, instructions to currency chest branches to send soiled note remittances to the issue offices in unstapled condition (which was a prerequisite for processing of notes on these machines), and delegation of full powers to the currency chest branches of SBI and its associate banks and other public sector banks in regard to handling soiled notes lying with them. One important aspect of the implementation of the Clean Note Policy was to make available reasonably good quality notes to the public and withdraw soiled notes from circulation. The soiled notes, accumulated in the vaults of currency chests with banks over a period of time, were removed, examined and destroyed expeditiously. The Reserve Bank had adequate stock of fresh and re-issuable notes but could not deliver them to the public as bank branches with many currency chests were choked with soiled notes. Due to this, the bank branches did not sort clean notes that were fit for re-issue and apparently issued soiled, cut and mutilated notes to the public. By 2000–01, with the perennial problem of short supply of fresh notes from the presses having been resolved, the Bank’s efforts were directed towards replacing the soiled notes in circulation with fresh and reasonably good quality notes. The first effort was to mop up the circulation of soiled and mutilated notes by liberalising their acceptance and payment in exchange. Second, soiled notes withdrawn by bank branches were quickly removed from their currency chests. Third, the Bank adopted special measures (within the Bank) for disposal of lower denomination notes up to 10 by counting only bundles and packets. Such special measures, as well as random sample checks, were also occasionally applied for 20 and 50 notes. The CVPSs installed at the issue offices were used for extended hours for processing soiled notes received from government departments (major customers of the Bank). The adoption of these measures on a continuous basis increased the disposal capacity of the systems, so much so that during 2007–08, as many as 10,696 million pieces of soiled notes (24 per cent of banknotes in circulation) were processed and removed from circulation. Within the category of soiled notes, 100 notes constituted the largest share, followed by 10 notes.

Non-Stapling of Note Packets

Another major initiative to improve the quality of notes in circulation was the decision to discontinue stapling banknote packets, which, however, became a complete reality only after November 2001.

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currency management Stapling was an old practice. A stitched note packet was equated with the assurance that there were 100 notes in a packet and made counting money easier in bank branches. However, stapling these 100-piece bundles reduced the life of notes, and imposed hardship on customers who had to struggle to remove the staples. The general rule was that a packet, whether stitched or banded, must contain 100 note pieces. In 1996, the Bank issued advice to all banks to stop stapling fresh note packets. In 1998, the instructions were reiterated in the case of re-issues. However, this issue assumed a sense of urgency in March 2000 when, answering a parliamentary question, the Minister of State for Finance expressed the view that the Reserve Bank would need to issue instructions to banks and all financial institutions to avoid stapling note packets. This was conveyed to the Bank for necessary action in April 2000. In pursuance thereof, the DCM requested the Department of Banking Operations and Development (DBOD) to issue a directive to all commercial banks to stop the practice of stapling banknote packets. The DBOD, in consultation with the Legal Department, issued a directive to commercial banks on 7 November 2001. This directive, on being satisfied that it was necessary and expedient in ‘public interest to do so’, directed banks, inter alia, to (a) do away with the stapling of fresh/re-issuable/ non-issuable note packets and instead secure note packets with paper bands, (b) sort notes into issuable and non-issuable categories, (c) issue only clean notes to the public, (d) tender soiled notes in unstapled condition to the Bank in inward remittances through currency chests and (e) forthwith stop writing of any kind on the watermark window of banknotes. To implement these instructions, it took some time. Initially, banks did not evince keen interest in implementing the provisions of the directive. Added to this, some major trade unions in the banking industry had a few misgivings about the new dispensation, mainly on grounds of security considerations (involving the staff handling the note packets) and the possible retrenchment of labour. However, the Bank was able to successfully remove these misconceptions and impress on them the need for compliance, which was in any case mandatory on the banks’ part. In this endeavour, Deputy Governor Vepa Kamesam, who was in charge of the currency management portfolio, played a major role. As a follow-up, after the issue of the 7 November 2001 Directive, Deputy Governor Kamesam, in his letter dated 21 December 2001 to the chairmen of banks, advised them to initiate necessary steps to implement the directive. The banks were informed that the Reserve Bank had started installing CVPS for speeding up the disposal process of soiled notes received in its issue offices and 349

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the reserve bank of india improving the quality of notes in circulation and that this necessitated these notes to be fed in the machines in a loose condition, that is, without any wire staple or binding aid. In his letter dated 13 March 2003 to the chairman of the Indian Banks’ Association, Deputy Governor Kamesam stressed that it was the responsibility of the banks to implement the Clean Note Policy as envisaged by the Bank from time to time, failing which, revocation of currency chests would commence apart from other measures under the Banking Regulation Act. There are several other instances where strict adherence to the procedure was stressed upon by Deputy Governor Kamesam. In other words, the process of implementation of the directive was not smooth, and faced resistance from banks, even though the response from the general public was supportive. For example, the bank employees’ unions from some public sector banks expressed concerns over the shift to the new system. In two letters to the Reserve Bank dated 11 and 20 May 2002, the Bank Employees Federation of India, Kolkata, contended that the new system exposed the bank cashiers to financial risk. The Federation wanted to revert to the old practice of issuing new notes in stitched packets. The letter also contended that the high risk involved in the handling of cash in unstapled packets could not be removed by installing more note-counting machines. The United Forum of Bank Unions in a letter to the Reserve Bank (18 February 2003) voiced similar concerns. There were complaints from bank branches as well. Newspapers (for example, Financial Express on 5 June 2003), too, reported the widespread reluctance to implement the Reserve Bank decision. Deputy Governor Kamesam in a letter (27 March 2003) to V. Leeladhar, Chairman and Managing Director of Union Bank of India, wrote, ‘I am increasingly convinced that many of our frontline operating staff including branch managers are the persons responsible for raising excuses’ for not implementing the policy and for carrying imaginary fears. Banks eventually came round to using the new system of banding rather than stapling notes. But there were occasional lapses. To cite an instance, in March 2004, Governor Jalan, after his retirement, was given a stapled bundle of currency notes by a bank branch in New Delhi.

Some Incidental Matters The Reserve Bank of India (Note Refund) Rules, 1975, were last amended in 1980 to enlarge the scope of services provided to the public. With a view 350

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currency management to further simplify and liberalise the Note Refund Rules, it was proposed to make comprehensive changes therein. After obtaining the approval of the Committee of the Central Board at its meeting on 11 April 2007, the draft of the revised Note Refund Rules, 2007, was sent to the government. The government’s approval was conveyed in November 2007. The Note Refund Rules came into force on 4 August 2009. The revised rules were easy to comprehend and administer, especially by the designated banks and their branches and, therefore, were expected to bring about better customer service.

Supply of Coins Trends in Supply

The authority to issue 1 notes and all coins is vested with the Government of India in terms of the provisions of the Reserve Bank of India (RBI) Act, 1934, and the Indian Coinage Act, 1906. Under Section 38 of the RBI Act, the central government cannot put into circulation any rupee coin except through the Bank. In the first few years of the reference period, there was a persistent shortage of coins. The regional offices of the Bank took several initiatives in 2001–02 for better distribution of coins by installing coin vending machines in the banking hall of the Issue Departments as also by encouraging banks in their jurisdiction to install such machines in their premises. The regional offices continued with the practice of sending coin bags to city centres to distribute coins directly to the public. The availability of coins in 2002–03 was not a cause for concern due to the satisfactory supply of coins by the mints. With the improvement in the supply position, the Bank made special efforts to deliver coins to the people, particularly in rural areas. The banks were directed that their currency chests in the rural areas should issue coins of at least 0.1 million daily. Public sector enterprises like the railways and the postal department, SCBs and regional rural banks (RRBs) were also involved in the distribution of coins. A service charge of 250 per bag was paid to banks to meet the holding and distribution costs. The mints at Mumbai and Hyderabad started supplying coins packed in sachets of 100 pieces. The demand for 25 paise and 50 paise coins sharply declined. Therefore, the Bank requested the government (in January 2005) to stop minting these. Further, as part of the Long Term Coinage Policy, the Bank had earlier suggested to the government (in December 2003) to introduce 10 coins to 351

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the reserve bank of india reduce dependence on the small value and low life of 10 notes. A decision was taken to issue coins (including 10) in a new metallic form in January 2005. Two developments, with respect to the circulation of coins among the public during the last few years of the reference period, are worth mentioning here. The total value of coins in circulation during 2004–05 declined by 2 per cent against an increase of 4 per cent in 2003–04, mainly due to falling demand for small denomination coins. The demand for 5 coins recorded subdued growth due to the parallel issue of 5 banknotes. Coins of smaller denominations, such as 5, 10 and 20 paise, were no more in demand. Consequently, the Bank decided to phase out from circulation all coins of denominations below 1. There was a reverse flow of coins during the year, which compensated for the shortfall in supply. In response to complaints from the public regarding non-acceptance of coins by bank branches, the Bank advised all banks to accept coins of all denominations and make arrangements with the mints to take back coins in excess of public demand. The overall stock of coins with the Bank increased considerably, causing strain on storage and distribution of coins. This trend continued for almost the next two years. In view of the comfortable stock of coins at currency chests/small coin depots and the Bank itself, the Bank did not place any indent for coins with the mints for 2005–06 and 2006–07. However, there was a reversal of this trend from October 2006 due to a sudden spurt in the demand for 2 coins. In view of the reported melting of 2 cupro-nickel coins on account of rising metal prices, the government, in consultation with the Bank, decided to mint all denomination coins in ferritic stainless steel (FSS). An indent of 700 million pieces was placed in December 2006 for 2 FSS coins and these coins were issued. For 2007–08, the Bank placed an indent of 300 million pieces, which was subsequently raised to 500 million pieces for 1 coins; 1,500 million pieces for 2 coins; and 300 million pieces for 5 coins. The total value of coins (including small coins in circulation) increased by 11 per cent during 2006–07 (2 per cent in 2005–06). In volume terms, the increase was 6.5 per cent in 2006–07 (2 per cent in 2005– 06). The value of coins relative to the value of banknotes remained fairly small. An independent survey commissioned by the Bank during 2002–03 through the Administrative Staff College of India (ASCI), Hyderabad, revealed a satisfactory level of availability of coins in Maharashtra, Madhya Pradesh, Gujarat and Karnataka. On the other hand, it was found that banks were either reluctant to distribute the coins or the public preferred to obtain these coins from private distributors for the sake of convenience. 352

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currency management During 2003–04, the Bank experienced a reverse flow of coins, for the first time, to such an extent that the overall stock of coins increased considerably, causing a strain on their storage capacity and distribution. The Bank was also forced to drastically reduce the indent for fresh coins from the mints. There had been no regular or even cyclical pattern of growth in circulation of coins and, in all probability, the large increases and decreases from year to year reflected the large fluctuations/variations in the minting of coins plus imports of coins. To tackle the situation, the Bank made special arrangements, removed the monetary incentive for distribution of coins, advised commercial banks to accept coins, published public advisories to the effect that small coins continued to be legal tender and advised banks to remit to the mints all coins of 1 paise, 2 paise, 3 paise, 5 paise and cupro-nickel coins of 25 paise, 50 paise and 1. With adequate availability of coins from the mints, in 2003–04, the Bank made intensive efforts to ensure that the shortage of coins that happened in the recent past was not repeated. The Bank allowed its offices to engage private transport operators for remittance of coins to the interior parts of the country. Coins were distributed through mobile vans. Banks were persuaded to distribute coins in marketplaces and to keep their branches open on Sundays in certain places. Services of postal authorities, RRBs, cooperative banks, and state transport undertakings were utilised for distribution of coins. In 2005–06, the Bank commissioned a study, ‘The Need and Use Behaviour for Small Coins’, by S. K. Velayudhan of the Birla Institute of Technology and Science (BITS), Pilani. The study reaffirmed that there was no shortage of coins. However, in the case of small denomination coins, especially 25 paise, the problem was more of acceptance than of availability. The production of coins by the mints, their collection and their dispatch by the mint linked offices were closely monitored by the Bank to ensure that the entire quantity produced by the mints was lifted and dispatched to various destinations. Banks were also advised to identify additional locations at prominent places to install coin vending machines. The mints were requested to pack coins in pouches of 100 pieces to enable easier retail distribution.

Correspondence with the Government The Government of India is the issuing authority of coins and supplies coins to the Reserve Bank on demand and the latter puts coins into circulation on 353

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the reserve bank of india behalf of the government. The division of responsibility in respect of supply and distribution of coins sometimes created irksome situations, especially when perceptions about demand and supply differed. Since 2003, the Ministry of Finance on several occasions raised the issue of the Bank not collecting coins promptly from the mints for disbursement during the indent year. In November 2003, the Ministry was of the view that there was no correlation between the denomination-wise indents placed by the Bank and the actual production by the mints. This distorted the requirement of coins in value terms. The Bank clarified (letter of 20 November 2003) that its regional offices had in the past lifted the entire production from the mints, but agreed that the pace of lifting was slightly hampered by the sudden lack of demand for coins from the public. The Bank’s offices on 20 November 2003 had almost 800,000 coin bags in their vaults and there was no space to accommodate additional coin bags. The reverse flow of coins aggravated the situation. In fact, the Bank had been receiving a large number of complaints about non-acceptance of coins by banks. On 9 December 2003, the Bank reported to the government that due to several measures taken, there was an abundant supply of coins. The reintroduction of 5 note by the government, against the advice of the Bank, affected and altered the demand pattern of coins, and the Bank had during April–November 2003 lifted more than 2 billion coins of all denominations. In a meeting (12 December 2003) between Deputy Governor Kamesam and D. C. Gupta, Finance Secretary, the latter expressed apprehension that if the Bank did not accept coins from the mints it would lead to stockpiling of raw materials and worsen industrial relations in the mints. In another meeting (9 February 2004), the Bank reiterated that it would be able to manage without the 10 coins since all its issue offices (as well as most of the currency chests and small coin depots) were holding large stocks of coins. Further, the reverse flow of coins of all denominations continued, which made it difficult for banks to accept fresh supply. The public preferred 5 notes against the coins and, therefore, it was preferable not to print 5 notes and encourage the demand for 5 coins to increase. In view of these factors, the Bank submitted a revised indent for 2004–05. The problem did not end there though. Finance Secretary Gupta, in his letter to Governor Reddy (22 September 2004), conveyed the concerns of the government over the Bank not lifting coins from the mints. Moreover, frequent revisions of the indents adversely affected the production programme 354

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currency management of the mints and the procurement of stores. The mint labour unions had gone to court against a reduction in working hours and curtailment of overtime resulting from a reduction in indents. Large stock of coins had accumulated. The Finance Secretary requested the Governor to make more reliable coin estimates and to lift the coins minted as per the indent. Deputy Governor K. J. Udeshi responded (25 October 2004), explaining the circumstances under which the Bank had to balance the supply and distribution cycle of coins. The long-term projection of coins for 2003–04 and 2004–05 were based on the anticipated gross domestic product growth, inflation and notes in circulation. It was also presumed that the printing of 5 notes, restarted by the government in August 2002, would be discontinued, which did not happen. Mints had been earlier unable to meet the Bank’s requirements in full. In this context, the Bank had, in October 2002, suggested to the government to consider the import of coins to meet the demand–supply gap. With the import of coins and special efforts made by the Bank to reach coins to rural and semi-urban areas, the shortage disappeared by the middle of 2003. By that time, the Bank had also put in circulation about 4,300 million pieces of 5 notes. Further, the transport undertakings, railways and traders had adjusted prices in multiples of the full rupee. These factors combined to reduce the demand for coins. The Bank had kept the government informed about the ongoing decline in demand and issued instructions to its regional offices to lift the maximum number of coins from the mints. But the regional offices had not been able to push coins into circulation for lack of demand. In January 2005, the Bank and the Secretary (Economic Affairs) agreed that fresh small denomination coins need not be minted. In February 2005, a committee consisting of representatives from the Ministry of Finance and the Bank conducted a demand-study of coins for five years starting from 2006–07. The study became necessary in view of the uneven trend in demand for coins since 1993–94, and occasional mismatches between supply and demand. Further, the simultaneous issue of notes and coins in the same denominations complicated public preferences towards notes and coins. There was also in general a decline in the demand for and use of small denomination coins. The study recommended a system of reviews at six-monthly intervals so that fine-tuning could be done based on the latest available data. The production of 10 coins was important, for their availability had been factored in while projecting the printing requirement of 10 notes. 355

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the reserve bank of india In April 2005, the Ministry of Finance (Currency and Coinage Division) forwarded a copy of a letter written by Gurudas Dasgupta, Member of Parliament, to the Finance Minister. The letter raised three points. First, the problems of production of coins in the government mints were due to the ‘inconsistency’ in demands from the Bank upon mints. Second, in the event of the Bank not placing an indent, it would slow down the functioning of the mints and eventually result in import of coins as in the past. Third, the assessment of the requirement of coins made by the Bank was often found to be ‘incorrect’ and ‘wrong’. Under the circumstances, the recommendation of the Bank that there was no need for a supply of coins by the mints, the letter stated, should be held in abeyance. The Bank, in its response sent on 13 August 2005, clarified its position on why it believed that the existing stock was sufficient to meet the demand for coins, and discussed the findings of the joint study. The findings of the BITS Pilani study mentioned earlier were also relevant in this context. The letter to the government concluded that the Bank had advised its regional offices to lift the maximum number of coins from the mints (out of the indent for 2004–05), but they were unable to push the coins into circulation due to a lack of demand.

Avoidance and Detection of Counterfeits The Indian economy was predominantly cash oriented, even though rapid strides were made in other modes of payment. The volume of notes in circulation being relatively large, counterfeiting was a serious problem for currency management. The geographic spread of the country and the size and composition of the population handling the notes added to that difficulty. A further complication was the political nature of the problem. It was stated that notes were counterfeited not only for commercial reasons but also sometimes with the objective of destabilising the economy.1 Indian currency notes incorporated – and continue to do so – certain security features. A special type of paper made from cotton and cotton rag, containing a secret watermark and optical fibres visible under ultraviolet (UV) lamp, was used for printing. All the notes being issued had a threedimensional watermark with the portrait of Mahatma Gandhi. Intaglio printing of various portions of the note (including an identification mark on different denominations for the visually impaired) was done for the denominations of 20 and above. Notes up to 50 contained a readable 356

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currency management but fully embedded security thread, while the higher denomination notes had a readable and windowed security thread. The OVI feature in 500 and 1,000 notes meant that a colour shifting ink was used for printing the denominational numerals. Other main features incorporated included frontto-back perfect registration of some portions, micro-lettering, latent image and fluorescence of certain sections of the note, including the security thread. A counterfeit note could be detected by checking if all these features were present or not (see Box 9.2). The designing of Indian banknotes is normally done by a committee constituted by the government, which includes the Bank and the printing presses. The security features in banknotes are reviewed by the Bank periodically and changes are made in them from time to time with the approval of the government. Counterfeit notes posed a serious problem for the authorities in detecting them and in prosecuting the culprits. The number and value of counterfeit notes detected in different Reserve Bank offices increased over the period 1996–97 to 2002–03. In volume terms, the share of detected forged notes to the overall notes in circulation worked out to around five per 1 million notes (2003). This was a small ratio. But it was disconcerting that the quality of counterfeiting was improving. Before 2003, counterfeiting was normally done by criminals by the offset printing method. These were detected and nabbed relatively easily. With the advent of high-quality digital technology, there was a great improvement in the quality of counterfeit notes during the latter half of the reference period, particularly in the denominations of 100, 500 and 1,000. If such notes were included inside a packet or accepted in a hurry, or under semi-dark conditions, detection was difficult. In fact, after 2003, technology improved so much that even the OVI feature was successfully replicated in some cases, and the quality of the paper and ink used were comparable to the genuine notes to a reasonable extent. In 1996, a major revision of the security features in Indian banknotes was carried out. In July 1997, a Forged Note Vigilance Cell was set up in the DCM, central office. Besides building up a database on forgeries, the Cell closely monitored major forgeries. The Bank also launched a public awareness campaign on the security features of banknotes and introduced additional security features (see Box 9.2). Banks were advised to equip their branches with UV detectors and the staff from banks, government departments, police and other enforcing agencies were regularly familiarised with security features in banknotes so as to facilitate detection of forgery. 357

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the reserve bank of india Box 9.2 Security Features in Indian Banknotes Watermark: The Mahatma Gandhi series of banknotes contained the Mahatma Gandhi watermark with a light and shade effect and multidimensional lines in the watermark window. Security thread: 1,000 notes introduced in October 2000 contained a readable, windowed security thread alternately visible on the obverse with the inscriptions ‘Bharat’ (in Hindi), ‘1000’ and ‘RBI’, but totally embedded on the reverse. The 500 and 100 notes had a security thread with similar visible features and inscriptions ‘Bharat’ (in Hindi) and ‘Reserve Bank of India’. When held against the light, the security thread on the 1,000, 500 and 100 notes could be seen as one continuous line. The 5, 10, 20 and 50 notes contained a readable, fully embedded security thread with the inscription ‘Bharat’ (in Hindi) and ‘Reserve Bank of India’. The security thread appeared to the left of Mahatma Gandhi’s portrait. Notes issued prior to the introduction of the Mahatma Gandhi series had a plain, non-readable fully embedded security thread.

Latent image: On the obverse side of the 1,000, 500, 100, 50 and 20 notes, a vertical band on the right side of Mahatma Gandhi’s portrait contained a latent image showing the respective denominational value in numerals. The latent image was visible only when the note was held horizontally at eye level.

Microlettering: This feature appeared between the vertical band and Mahatma Gandhi’s portrait. It contained the word ‘RBI’ in 5 and 10 notes. The notes of 20 and above also contained the denominational value of the letters in microletters. This feature could be seen better under a magnifying glass.

Intaglio printing: The portrait of Mahatma Gandhi, the Reserve Bank’s seal, the guarantee and promise clause, the Ashoka Pillar emblem on the left, and the Bank Governor’s signature were printed in intaglio, that is, raised prints, which could be felt by touch, in 20, 50, 100, 500 and 1,000 notes. Identification mark: A special feature in intaglio was introduced on the left of the watermark window on notes of 20 and above denomination. This feature was in different shapes for different denominations ( 20–vertical rectangle, 50–square, 100–triangle, 500–circle and 1,000–diamond) and helped the visually impaired to identify the denomination. Fluorescence: Number panels of the notes were printed in fluorescent ink. The band at the centre portion of the notes was also printed in fluorescent ink. The notes had optical fibres. Both could be seen when the notes were seen under UV lamp. The security thread in 5, 10, 20 and 50 notes fluoresced in blue

(Contd.) 358

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currency management (Contd.) colour from the obverse and reverse when seen under an ultraviolet lamp. In 100 and 500 notes, the security thread fluoresced in blue colour on the visible portion of the windows from the obverse and as a continuous line from the reverse. In 1,000 note, the security thread fluoresced in rainbow colour on the visible portion of the windows from the obverse and as a continuous line from the reverse.

Optically variable ink: This was a new security feature incorporated in the 500 notes with revised colour scheme introduced in November 2000, and in 1,000 notes issued from October 2000. The numerals 1,000 and 500 on the obverse of 1,000 and 500 notes, respectively, was printed in optically variable ink. The colour of the numeral 1,000 and 500 appeared green when the note was held flat but would change to blue when the note was tilted. Notes of 500 issued before November 2000 and which were in circulation as legal tender did not have this feature. See-through register: The small floral design printed on both the front (hollow) and the back (filled up) of the note in the middle of the vertical band next to the watermark has an accurate back to back registration. This appeared as a floral design when seen against the light.

Between 1997 and 2000, a decision was taken to withdraw 500 denomination banknotes in the Ashoka Pillar series as counterfeit notes of this particular design was reported on a large scale (Box 9.3). In 2000, the government formed a High-Level Committee of Experts headed by the Joint Secretary, Department of Economic Affairs, and with representatives from the Bank, presses and security agencies, and other experts. The committee submitted its report in May 2002. Their recommendations included the adoption of India-specific machine-readable magnetic colour shift, security thread and machine-readable M-feature (mixing specific pigment ink with printing ink). These features would allow for authentication of notes without any mechanical aid. A technical subcommittee constituted by the government fine-tuned the specifications in consultation with the manufacturers. All currency chest branches of banks, and certain identified non-chest branches, which were close to international borders and had heavy cash transactions, were equipped with note-sorting machines to detect and curb the circulation of counterfeit notes. The note-sorting machines helped detect counterfeit notes at the time of entry into the banking channel. Thus, the 359

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the reserve bank of india installation of these machines at currency chests proved to be helpful in the early detection of counterfeit notes. The Reserve Bank coordinated with the investigating agencies as well as state police authorities for information sharing. In January 2008, state level committees headed by the Director Generals of Police were formed to deal with the issue. The Bank conducted training programmes for employees of banks and other organisations handling bulk quantities of cash and placed extensive information on security features of Indian banknotes on its website. Posters on ‘Know Your Banknotes’ were displayed at bank branches and a film on ‘Know Your Banknotes’ was prepared by the Bank through the Films Division and supplied across all its issue offices, currency chests, public utilities, theatres and other media for screening. In 2002–03, the Ministry of Finance constituted a committee, comprising officials from the CNP, Nashik, BNP, Dewas, BRBNMPL, Mysore, Security Paper Mill, Hoshangabad, and the Bank, for preparing a technical profile of high-quality and low-quality fake Indian currency notes (FICN), headed by a senior officer from the DCM. In 2003, there were press reports that these forged notes were printed in a neighbouring country and were released in India by underworld elements, thus posing a challenge to national security. Security had become an absolute priority. On 20 October 2003, the DCM made a presentation on forged notes in the Ministry of Home Affairs. On 25 November 2003, the Department, in association with the Central Bureau of Investigation (CBI), organised a day’s seminar in Delhi on the subject. The seminar was attended by the nodal officers in-charge of the economic offences wings of the state police authorities. In 2003, the DCM, central office, detected large volumes of counterfeit notes that were in circulation in Bihar, West Bengal and the northeastern states and enquired with the Kolkata office about the steps taken. The latter, in its reply dated 16 October 2003, mentioned that investigation was delayed because the response from the CNP and the Central Forensic Laboratory – the agencies authorised to offer expert opinion on forged notes – had been delayed. They agreed that such authority may be extended to the BRBNMPL to facilitate a quick follow-up action by the police. Under Governor Reddy’s initiative, in February 2004, a Task Force was formed by the Patna office to study matters relating to forged notes detected by that office during 2003– 04. The Task Force in its report of 31 March 2004 said that of 203 currency chests (31 December 2003) under the jurisdiction of the Patna office, 129 contained forged notes numbering 22,321 pieces. The major share of forged 360

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currency management notes was of 100 in the old design notes of Ashoka Pillar series. Forged notes appeared mainly in bank branches in Patna, Purnea, Muzaffarpur, Ranchi and Gaya. The main method of forgery was the direct printing of fake notes, followed by photocopying and computer scanning and printing. The report pointed out that there were many cashiers and other officers in currency chest branches who were still not familiar with the security features of banknotes. The police investigation was a slow process for genuine reasons. As of 24 October 2003, there were more than 240,000 cases pending with various police authorities, some for more than ten years, and there was no conviction. Due to the long delay in getting an expert opinion from the CNP, the police found it difficult to prosecute culprits. The government decided to authorise forensic laboratories and other note printing presses to give an expert opinion regarding suspected notes. The Ministry of Finance constituted a committee for recommending an infrastructure for setting up forensic laboratories for the purpose under the Criminal Procedure Code. A senior officer from the DCM was in the committee. The committee prepared a manual of procedure to be followed by forensic laboratories and printing presses for examining suspected notes and giving their opinion. The committee also recommended the purchase of equipment required for examination of forged notes. Given these problems with the prosecution, the Bank suggested that a nodal agency, preferably the CBI or the Intelligence Bureau, might be designated for reporting the cases. Such an agency would coordinate with other regulatory bodies, including the state police, forensic laboratories and printing presses. In October 2003, the government nominated the CBI as the nodal agency to monitor currency counterfeiting. At the state level, one senior police officer was designated as the nodal officer to coordinate efforts against currency counterfeiting. The government, however, was yet to amend (by 2003–04) the Indian Penal Code and the Criminal Procedure Code to strengthen the procedure regarding certification of counterfeit currency and penal provisions. On 10 August 2004, the CBI Joint Director advised that no purpose would be served by lodging first information reports (FIRs) when only a few fake currency notes were detected in bulk remittances sent by banks to the Reserve Bank. But when such notes were detected at the counter itself and their number was substantial, registration of an FIR by the local police would be useful. 361

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the reserve bank of india The Chief General Manager, DCM, RBI, in a letter dated 18 June 2004 to the Economic Offences Wing, CBI, drew attention to the problem faced by the Bank’s regional offices in filing FIRs and handing over the fake notes to the local police station for further investigation. Due to the increase in fake note detection, the local police stations were sometimes reluctant to deal with these cases. When Reserve Bank offices could prevail upon the local police authority to register FIRs, the fake notes handed over to the police in such cases were not returned to the Bank’s offices. In turn, the police had their own difficulties in conducting an investigation because fake notes were detected in the bulk remittances received from distant bank branches. The Box 9.3 The Shift from the Ashoka Pillar Series to the Mahatma Gandhi Series Notes The replacement of the Ashoka Pillar series notes with the Mahatma Gandhi series is the most important instance of phasing out during the reference period. The former had deteriorated in quality. Moreover, in the absence of advanced security features in the Ashoka Pillar series notes, the public was finding it difficult to identify counterfeit notes. The government and the Reserve Bank, therefore, decided to phase out the series. Accordingly, the Bank’s issue offices and currency chest branches of commercial banks were instructed not to reissue these notes to the public. These notes, however, continued to be legal tender. Furthermore, the Ashoka Pillar emblem, a national symbol and pride, continued to be printed on the notes of the Mahatma Gandhi series. Portraits of human beings have been recognised as a strong security feature on banknotes all over the world. The watermark with a human face is a unique and inimitable feature, which provides the desired light and shade effects. A human face brings into focus the shine/gleam in the eyes. The portraits involve deep engravings with very minute details and are difficult to counterfeit. The choice of the personality from the security point of view should be such that the face should be expressive and should have lots of lines and folds, so that there is ample scope for engravings of different depths, which would be difficult for counterfeiters. The Mahatma Gandhi series was introduced in 1996. Some additional security features, such as the windowed security thread, latent (hidden) denominational image, microprinting, registration mark and raised identification mark for identification of a denomination by the visually impaired, were also incorporated in these notes as anti-counterfeiting measures. The printing of notes with the Ashoka Pillar emblem was then discontinued. 362

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currency management Bank had, in October 2003, instructed the offices not to file FIRs with the police and retain the fake notes with them. It had simultaneously taken up the matter with the Ministry of Home Affairs. The police could not conduct a meaningful investigation as these forged notes were from the bulk receipts and the individual tenderer could not be traced or identified. A meeting with the Chairmen and Managing Directors of commercial banks and cooperative banks was held in June 2006. Banks were advised to disseminate the Reserve Bank’s instructions on counterfeit banknotes to branches, monitor implementation of these instructions, compile data on the counterfeit banknotes, ensure installation of note-sorting machines of appropriate capacity at all currency chests and report the steps taken in this regard. From 16 April 2006, the Criminal Procedure Code was amended to include the officers of all the note printing presses, the security printing press and forensic science laboratories as experts for rendering evidence on suspected fake currency notes. This reduced, to a considerable extent, the time lag experienced in getting an expert opinion by the law enforcement authorities. An updated master circular on detection and impounding of forged notes was placed on the Bank’s website on 2 July 2007. Instructions to issue offices of the Bank reiterated the need to create public awareness of the security features of banknotes. All banks were advised to lay more emphasis on imparting training to members of staff in the detection of counterfeits so that detection took place at the entry point itself. Steps taken by the Bank to check counterfeit included planned phased withdrawal of banknotes of earlier series (pre-2005) that were being counterfeited the most, advice to regional offices to liaise with law enforcement agencies, as also to step up training to various agencies and stakeholders. The nodal agency would examine the legal aspects of moving away from the current system of reporting and recording FIR, and the Prevention of Money Laundering Act (PMLA), 2002, now included FICN offences. Against the backdrop of the persistent increase in seizures of FICN and the growing nexus between FICN and other crimes, the Central Economic Intelligence Bureau organised a workshop on 30 October 2007 in New Delhi. The Bank’s Executive Director, in a letter to Leela K. Ponappa, Deputy National Security Adviser, requested the government’s urgent intervention in certain issues that had emerged at the meeting. The workshop noted that the offence pertained not simply to the possession of counterfeit notes but to 363

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the reserve bank of india Table 9.4 Detection of Fake Notes through Banking Channels: 1999–2000 to 2007–08 Year

10

20

50

100

500

1,000

Total Pieces

Total Value ( million)

1999–2000

729

125

887

19,001

16,781

-

37,523

10.3

2000–01

752

127

1,832

43,082

56,888

6

102,687

32.9

2001–02

588

72

3,013

67,168

53,661

13

124,515

33.7

2002–03

198

34

3,488

172,597 35,398

39

211,754

35.2

2003–04

77

56

4,701

182,361 17,783

248

205,226

27.6

2004–05

79

156

4,737

161,797 14,400

759

181,928

24.4

2005–06

80

340

5,991

104,590 12,014

902

123,917

17.7

2006–07

110

305

6,800

68,741

3,151

104,743

23.2

2007–08

107

343

8,119

110,273 66,838 10,131 195,811

55.0

25,636

Source: RBI, Annual Report, various years.

Note: Data do not include seizures made by the police and other enforcement agencies.

the possession thereof ‘with the intention to use them as genuine’. This legal position needed to be reiterated to the police. The Bank was of the view that there had been cases where officials from bank branches where counterfeit notes were detected were arrested based on FIRs filed by the Bank, and such bank officials typically moved the courts for relief. Also, in some cases, the bank officials were reported to have destroyed counterfeit notes to avoid police harassment. As a result, prompt reporting on counterfeits was not done. The combined effect of these efforts was a gradual fall in the total value of counterfeits detected after 2003 until 2006–07, as Table 9.4 shows.

Security Features Security features of banknotes need to be reviewed and upgraded from time to time to take advantage of changing technology. The notes issued in any series/ design by the Bank continue to be legal tender for all time, although, over a period, notes in a particular series/design may not be seen anymore because of discontinuation of printing. In some countries, where the volume of notes in 364

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currency management circulation is small, a new design replaces an old design once every five to six years, and the old design is discontinued as legal tender. In such a situation, the prevention of counterfeiting is relatively easier. In India, while it was difficult to remove an old design by way of withdrawing its legal tender, the Bank attempted to phase out the old design by not reissuing it once it came to the currency chests or the Bank’s offices. Although the predominant reason for new security features is to make counterfeiting difficult, they also assume importance in the context of the mechanised cash processing activities. The success of these systems depends greatly on the notes having machine-readable security features. In 2002, the Bank, in association with the Ministry of Finance, decided to introduce additional security features in Indian notes. The existing security features were in place for about seven years. Based on the suggestions of a highlevel committee, the government approved (February 2004) incorporation of additional security features. A Price Negotiation Committee, headed by Executive Director P. K. Biswas, was constituted to conduct negotiations with the suppliers of exclusive security features for Indian banknotes. The committee, after conducting a series of discussions with the suppliers, signed the exclusivity agreement for India-specific security features, namely M-feature, a chemical to be incorporated in the paper-making stage, and colour shift thread for notes of 100 and higher denomination. The Bank introduced banknotes with new/additional security features in a phased manner from 24 August 2005. The details of the security features are given in Box 9.2.

Post-print Coating and Polymer Notes A longer circulation lifetime of banknotes should lead to lower demand for new banknotes. Cost reduction in the supply of notes, therefore, can be achieved by increasing the durability of notes. There are several factors that are responsible for the decreased longevity of Indian banknotes: method of handling, varied climatic conditions and pollution. The physiological factors include contact with sweat and saliva or soiling. Banknotes handled in fresh vegetable or fish markets, or as puja offerings, bring them routinely in contact with moisture and organic substances. The acidic environment also reduces the life of the banknotes to a great extent.2 The major denominations which suffer from reduced life are 10, 20 and 50, which are especially common in small-value transactions. 365

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the reserve bank of india

Post-print Coating In December 1999, a committee formed by the government examined the option of coating the notes after printing. The committee requested SICPA (Switzerland), BCS Security Private Ltd (India), Louisenthal (Germany), Joh. Enschedé (Netherland) and Oberthur Fiduciaire (France) to supply chemical solutions for conducting trials on the post-printing coating. The trials were carried out on sample notes of 10 and 100 denominations. These notes were subjected to laboratory tests at the Security Paper Mill, Hoshangabad. The committee recommended that printing of Indian banknotes on a paper substrate and carrying out post-printing coating was the best option to increase the life of banknotes in the Indian environment. The member from the Bank, while agreeing with the recommendation, suggested that the option to introduce polymer notes for 10 should not be foreclosed in view of ongoing developments in polymer research. The Joint Secretary, Ministry of Finance, in a letter of 16 April 2002 to Deputy Governor Kamesam, informed that the government had examined the proposal to introduce post-print coating of 5 and 10 denominations, with the proposal to coat 500 million pieces each of these denominations. In a letter of 29 April 2002, the Bank stated that it was not in favour of coating, but was open to trials. On 11 June 2002, the government pointed out that the stand taken by the Bank was contrary to the recommendations of the expert committee, which also included officers from the Bank. Deputy Governor Kamesam responded on 27 June 2002, citing three reasons for the Bank’s reluctance. First, in view of the adequate availability of note-printing capacity, the coating of banknotes was not necessary. Second, the Bank preferred to replace 5 and 10 notes with coins within three to four years. Third, it was desirable to ascertain the credentials, capabilities and security arrangements of the firms considered before taking this step. Governor Reddy, in his noting dated 2 July 2004, raised queries on the selection of this particular product only. In view of this comment, the matter of choice of appropriate chemical was examined further. It was learned that a few countries, such as Hong Kong, Jordan, Malaysia, South Africa and Tanzania, did use varnish coating on post-printed notes. But no information on the material used was forthcoming. In August 2004, the Ministry of Finance clarified that in 2000–01, the technical committee had witnessed the presentations made by twelve firms, compared the advantages and the disadvantages of cotton-based and polymer-based substrates and also carried 366

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currency management out certain tests on all the coating materials. It was concluded that BCS Security showed exceptionally good performance. In November 2004, the BRBNMPL was asked to prepare and forward a project report for setting up testing facilities. They prepared the report and identified the machines that would be needed. Correspondence on the matter dragged on until 2005. On 19 October 2005, the Deputy Governors’ meeting stressed the need for trial coating of post-printed banknotes in view of the counterfeit problem. In December 2005, the Bank formed a technical group to carry out the tests. At the end of February 2007, the Swiss company SICPA had already coated the specimen banknotes and plain sheets at their works in Switzerland and returned these to the Bank along with their report. Giesecke & Devrient and Joh. Enschedé en Zonen had collected the plain banknote sheets and specimen banknotes for varnishing at their works. The supply of coated samples was expected by the end of February 2007. BCS Security had not collected the specimen for coating despite reminders, nor did the firm give any time frame for carrying out the coating. Specimens were sent in the last week of June 2007 to the Central Institute of Plastic Technology, Chennai, and the Central Pulp and Paper Research Institute, Saharanpur, for laboratory testing. The test results were forwarded to the National Chemical Laboratory (NCL), Pune, in January 2008 for comments. Their reply was received in March 2008. The main observations of the NCL were that the plastic banknotes performed better than paper or coated paper banknotes in most mechanical properties except tear resistance, where the paper-based banknotes performed better. Also, the new coated paper banknote samples showed considerable improvement in chemical resistance and soiling resistance compared to both uncoated paper and previous coated paper banknote samples.

Polymer Notes At a senior management committee meeting held on 3 August 1999, it was decided that the Bank should consider printing 10 note on an experimental basis using polymer substrates supplied by two firms. The polymer notes supplied by both the firms were used at the Mysore press of the BRBNMPL to print notes on a trial basis. However, there were problems with regard to simulating the watermark and security thread in the substrates. 367

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the reserve bank of india In January 2000, the Ministry of Finance referred the Bank’s proposal to the committee of experts constituted by them. The committee, in their report of 28 March 2001, suggested that the testing of the polymer product in the Indian environment should be done in ‘totality’ and, therefore, decided that a three-member subcommittee be formed. The subcommittee conducted the tests, and their report was against the introduction of polymer notes, and for post-print coating on paper. The Ministry of Finance wrote to the Bank (in November 2004) to have a ‘fresh look’ into the matter. The Bank informed (letter dated 8 December 2004) that information from the countries using poly-substrate banknotes was being collected. The survey found that all the countries received technical assistance from a single company called Securency. However, the number of polymer banknotes issued in these countries was considerably smaller than the number of banknotes in circulation in India. The matter came up for consideration in the meeting of the committee of the Reserve Bank’s Central Board held on 28 September 2005. It was decided to study the experience of Singapore and Australia closely. In reply to the concerns of the Ministry of Finance (November 2005), the Bank stated that the test results of the BRBNMPL samples will finally determine the introduction of polymer notes – the 10 denomination notes. The laboratory tests conducted by the Central Pulp and Paper Research Institute and the Central Institute of Plastic Engineering and Technology showed that the properties of polymer banknotes were indeed much better compared to paper banknotes. In September 2006, discussions took place on production agreement, whereby Securency would provide technology for the substrate and the Bank would undertake manufacture. The draft memorandum of understanding (MoU) and the mutual confidentiality deed received from Securency were vetted by the Legal Department in April 2007. In July 2007, a draft MoU was prepared to be signed by the BRBNMPL with Securency for technology transfer, for both production of substrate and printing of polymer notes. In May 2008, the Bank’s officials made study visits to three countries that had introduced polymer notes on a trial basis. Thereafter, the Bank recommended to the government to go for polymer notes of 10 or smaller denomination on a field trial basis. The Ministry of Finance, in its letter dated 7 October 2008, left it to the Bank to decide upon the procurement procedure.3 368

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currency management

Customer Service

The Bank made efforts to conduct currency management operations with a view to ensuring an optimal supply of good quality and secure banknotes and coins in the country. In this process, improvement of customer service with reference to issue and acceptance of notes and coins from the public and exchange of soiled and mutilated banknotes became a priority. Modernisation of the technological infrastructure, diffusion of information technology initiatives in computerisation of bank branch operations (relating to note processing) and advances in communication facilities were intended to improve customer satisfaction and create the necessary environment for improvement in currency management. Some of the more prominent features during the period under review are highlighted below. •

• •

• •

The regional offices of the Bank took several initiatives for better distribution of coins by installing coin vending machines in the banking hall of the Issue Departments, and by encouraging banks to install such machines in their premises. During 2001–02, the Bank issued a master circular for the guidance of the general public on the note exchange facility. Various measures were initiated for mopping up soiled and mutilated notes of 1, 2 and 5 denominations and distribution of coins. The issue offices launched campaigns through mobile vans and bank branches to encourage people to get such notes held with them exchanged. Currency chests were instructed to stop reissuing soiled and mutilated banknotes in these small denominations. The Bank’s ‘Currency Link’ on its website covered various aspects relating to Indian currency and coinage, images and security features of contemporary banknotes in the Mahatma Gandhi series, frequently asked questions (FAQs), and press releases on the issue of currency.

The Bank introduced a ‘single window customer service’ at its issue offices whereby coins and notes of all denominations were either issued or accepted at one counter. Similarly, mutilated notes were accepted in a drop box (even beyond normal banking hours) without any limit. A noteworthy development in 2003–04 was the constitution of a Committee on Procedures and Performance Audit on Public Services (CPPAPS)4 to study, inter alia, the services relating to currency management. The major recommendations of the committee, which were accepted, were, 369

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the reserve bank of india steps to improve transparency in currency management, early introduction of 10 coins, phasing out of 5 notes, revision of Currency Chest Agreement to incorporate a provision for monetary penalty for non-compliance with the Bank’s instructions, a Systems Study of Banking Hall arrangements in the Mumbai office of the Bank in the interest of smooth flow of transactions, introduction of measures to separate location/time for services to money changers, Citizens’ Charter for Currency Exchange Facilities to be made available to customers, bank branches to exhibit permanently a notice that soiled and mutilated notes were freely exchanged at the branch, the Bank’s Note Refund Rules to be written in easily understandable language, the practice of pasting of mutilated notes when these were exchanged should be reviewed, and action to be taken against violation of instructions by banks on exchanging soiled and mutilated notes. By 2004–05, all issue offices had implemented the major recommendations of this Committee. Based on the recommendations of the CPPAPS, the Bank revised the ‘Citizens’ Charter’ and placed it on its website, opted for ISO Certification on Currency Management, instructed its regional offices to initiate necessary steps to achieve international standards in customer service in currency management (2004–05) and, in association with the National Film Development Corporation, developed a film on the security features of banknotes (2007–08). All commercial banks, cooperative banks and RRBs were advised (through the regional offices of the Reserve Bank) to disseminate information on the availability of exchange facilities of both coins and notes prominently in their banking premises. The regional offices were advised to conduct surprise checks to ensure that such facilities were made available by the bank branches. The Citizens’ Charter was updated during 2006–07. Further, during 2003–04, the procedures and practices followed in the issue offices for the exchange of notes in the Claims Section and access to the public counters were simplified.

Integrated Computerised Currency Operations and Management System (ICCOMS) In the early 2000s, the Bank took the decision to design, develop and implement an integrated computerised currency operations and management system (ICCOMS), both in the regional offices of the Bank and in the DCM, central office. ICCOMS comprised three components: currency chest 370

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currency management Table 9.5 Components of ICCOMS Currency Chest Reporting System

Issue Department

The general purpose is to facilitate prompt and accurate reporting and flow of information. This component enables the currency chests to transmit and receive data to and from the Issue Departments and their link offices through INFINET or the respective bank’s network. Similarly, the link offices of the banks submit consolidated data on currency transactions of the chests of the region to the respective Issue Department. Its implementation has facilitated prompt, efficient and error-free reporting and accounting of the currency chest transactions and seamless flow of information.

This component facilitates automation of all the operations of the Issue Department. The package consists of twenty-four modules. Of these, the chest accounts module is the key to the receipt and transmission of data to chest/link offices of the banks.

Currency Management Information System (CMIS) in the Department of Currency Management

This component provides for online monitoring of all issue offices and for collection and processing of information/data electronically received from all the issue offices. It facilitates trend analysis at the DCM.

reporting system (CCRS), ICCOMS-Issue Department (ICCOMS-ID), and currency management information system (CMIS) in the DCM, central office, Issue Departments in regional offices and currency chests maintained by various banks (Table 9.5). The ‘live run’ of the CCRS component under ICCOMS, which commenced in 2006–07, stabilised in 2007–08. It enabled the Bank to account for currency transfer transactions efficiently.

Conclusion The reference period, especially the last six years of the period, witnessed a continuation and strengthening of initiatives to improve technology and 371

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the reserve bank of india distribution to mitigate shortages of notes and coins, deal with counterfeits, and improve the quality of notes. Chronic supply shortages of coins were mitigated, and a gradual shift occurred in the denominations of banknotes with the increasing popularity of ATMs. Anti-counterfeit measures were continued in coordination with the government and through public awareness campaigns and paid off in the progressive reduction in the value of counterfeits detected. Finally, a major initiative was started on introducing polymer notes, though no definite progress was made during the reference period.

Notes

1. Meeting of the High-Level Technical Committee of Experts for examination of the problems caused by the circulation of Fake Currency Notes, 17 April 2008, New Delhi, convened by the Ministry of Finance, Department of Economic Affairs. 2. Government of India, The Report on Increasing the Life of Indian Bank Notes (New Delhi: Ministry of Finance, 2000). 3. This stand was reiterated by the Finance Ministry in a letter dated 19 June 2009. 4. Chairman: S. S. Tarapore.

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10 Regulation of the Financial System Part I: Commercial Banks

Introduction In keeping with the financial market reforms, the period covered in this study saw the Reserve Bank move away from development banking, which focused on channelling credit to desired fields, towards managing competition, new entry and corporate governance of institutions. This chapter, or Part I of Chapter 10, describes changes in the regulation of commercial banks. Part II deals with the regulation of other financial institutions. The supervisory function will be covered in Chapter 11. The next section outlines the broad pattern of reforms in the regulation of banks. Subsequent sections deal with prudential norms; private sector banks; governance issues; public sector banks; foreign banks; rehabilitation of weak banks, amalgamations and mergers; branch licensing; customer identification; deregulation of credit regime, mortgage debt and global crisis; and miscellaneous regulatory issues. The concluding section considers what was achieved and what was left unfinished during the reference period.

Broad Patterns of Regulatory Reform In March 1997, there were four categories of commercial banks: the public sector, the old private sector, the new private sector and foreign banks. Their asset shares were 83 per cent, 7 per cent, 2 per cent and 8 per cent, respectively. The dominance of the public sector declined markedly by the end of the reference period. From several years before the reference period, regulatory practices were beginning to change to give these banks more freedom of operation and allow them to become more efficient market players. These efforts strengthened in 1997 and 1998. In 1997, an in-house working group reviewed the guidelines and instructions issued by the Department of Banking Operations and 373

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the reserve bank of india Development (DBOD). In April 1998, a further review by Deputy Governor S. P. Talwar indicated that more areas of micro-management should be left to the banks, with a greater focus on monitoring compliance. On 3 June 1998, in a meeting between Governor Jalan and the Deputy Governors, it was decided to delegate freedom to banks in many areas.1 And in April 2000, the Governor had a meeting with the chief executive officers (CEOs) of major commercial banks to discuss autonomy. Structural reforms were undertaken at the same time with the same broad aim to allow banks more freedom while improving corporate governance. Following the report of the Narasimham Committee II, an expert group formed by the government in 1998 suggested amendments to key banking statutes.2 The Bank approached the group for making amendments to the Banking Regulation Act, 1949, to give it more power to monitor corporate governance. In the wake of the East Asian crisis of 1997–98, measures were announced to improve capital adequacy, income recognition, provisioning norms, and disclosure and transparency practices in banking operations. The cash reserve ratio (CRR), which was essentially an instrument of monetary policy, was reduced.3 The statutory liquidity ratio (SLR) was also reduced.4 These changes gave greater flexibility both in the operation of the banks and to the Reserve Bank to administer its monetary and regulatory policies. There had been a gradual move away from an administered interest rate regime to a flexible interest rate one. Among other specific areas, freedom was given to banks to set the minimum maturity of term deposits, penal interest rates, higher interest rates on deposits by senior citizens, the hiring of selling agents, and rationalisation of operational guidelines pertaining to deposits. In April 2003, a Working Group on Interest Rates on Deposits and Procedure recommended that the Bank discontinue its Manual of Instructions issued in 1998 and retain only the Master Circular on Interest Rates on Deposits issued in July 2002.5 The recommendations were implemented with some modifications over a period. More flexibility was offered to banks mobilising funds through certificates of deposit (CDs) and commercial paper (CP) and on the prime lending rate (PLR, also see Chapter 3). The selective credit controls, which aimed to control the prices of some agricultural commodities, had been removed (except sugar and, briefly, wheat) from 1996. This paradigm shift in the approach to regulation involved frequent interactions with international agencies and market participants. For example, India first participated in the Pilot Program on Financial Sector Assessment 374

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regulation of the financial system in 2001 conducted by the International Monetary Fund (IMF) and the World Bank and was also associated with the independent assessment of standards and codes by these bodies. Market participants were invited to join several committees and working groups. Faith in a more consultative approach was reflected in a 2000 speech by Governor Jalan where he said, ‘[W]e do not have the monopoly of wisdom.’6 The initiative by Governor Reddy to start a users’ consultative panel was further evidence of the shift. The panel for commercial banks was constituted with representatives from banks, the Indian Banks’ Association (IBA) and the Fixed Income Money Market and Derivatives Association of India (FIMMDA) in June 2004. All draft regulatory guidelines (except market sensitive circulars) were e-mailed to members of the panel for comments and suggestions before implementation. The top management followed media reports on the Bank and banking-related matters more closely during the reference period. A cornerstone of the new approach was to make banks conform to prudential norms.

Prudential Norms Prudential norms were introduced in 1992 and their strengthening continued into the period of study. The performance of banks in meeting these norms was somewhat uneven at the start of the reference period.

Capital Adequacy In March 1997, twenty-five of twenty-seven public sector banks had achieved the minimum stipulated capital to risk weighted assets ratio (CRAR) of 8 per cent. Only Indian Bank with a negative CRAR and UCO Bank with 3.2 per cent CRAR had not achieved the minimum norm. Among old private sector banks, four out of twenty-five banks had not achieved the minimum of 8 per cent; of these four, three banks – Bareilly Corporation Bank Ltd, Lord Krishna Bank Ltd and Benares State Bank Ltd – merged with other banks subsequently. The fourth, Catholic Syrian Bank Ltd, achieved the stipulated level of CRAR by March 2002 through rights issues and internal accruals. In October 1998, the CRAR requirement was raised to 9 per cent, and the risk weights of assets were revised.7 In February 1999, banks were given the freedom to raise Tier II capital through subordinated bonds. In the same 375

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the reserve bank of india year, seven old private sector banks of relatively small size (capital funds of less than 0.5 billion) were advised to reach a size of 0.5 billion within three years. State Bank of India (SBI) was called upon to augment the share capital of its associate banks to maintain the required CRAR. The Reserve Bank encouraged banks to plough back their earnings as much as possible. Given the differences between segments of the banking system, in the implementation of Basel I norms,8 a three-track approach was followed. Commercial banks were required to maintain capital for both credit and market risks, cooperative banks for only credit risk, and the regional rural banks (RRBs) were required to maintain a level of capital not on par with the Basel I framework. The large holding of SLR securities was one of the reasons that banks could comfortably maintain the required CRAR.9 In 2003, as a step towards attaining convergence towards Basel I risk-weighted capital charges and facilitate the transition to Basel II norms, the Reserve Bank issued instructions and guidelines to banks to provide capital charge for market risk in a phased manner over a two-year period. The Basel II framework had three ‘pillars’, namely minimum capital requirement, supervisory review process and market discipline. Basel II had more comprehensive coverage of risks than Basel I, which addressed only credit and market risks. The framework offered two general approaches to assess capital against operational risk. The Basic Indicator Approach linked capital charge for operational risk to a single risk indicator (for example, gross income) for the whole bank. And, under the Advance Measurement Approach, banks would use the results of their internal operational risk measurement systems subject to standards set by the Basel Committee on Banking Supervision (BCBS). In October 2004, a committee formed with representation from banks considered the process of migration to Basel II. It was decided that from March 2007, all banks would use ratings from external credit rating agencies to quantify the required capital for credit risk, and use the Basic Indicator Approach (for operational risk), eventually implementing more complex systems with increasing capability. Following these discussions, a New Capital Adequacy Framework (NCAF) was announced in February 2005. To facilitate the transition, the Bank issued a guidance note, helped in accreditation of rating agencies, and trained bank personnel. To provide banks with an adequate menu of options for raising capital, operational guidelines were issued in 2005. Banks were permitted to issue innovative hybrid debt instruments (Tier II capital) and short-term 376

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regulation of the financial system subordinated debt instruments (Tier III capital). Subordinated debt is a loan taken by a company that ranks below all other liabilities relating to claims on its assets or earnings.10 In October 2007, after receiving the government’s clearance, the Reserve Bank permitted banks to issue preference shares of different variants to raise Tiers I and II capital. The dates for migration to Basel II were adjusted according to the preparedness of different categories of banks. Following the international best practices to minimise contagion risks, the Bank stipulated prudential limits for cross-holding of capital among banks. In September 2003, investment in Tier II bonds issued by banks was subjected to a ceiling of 10 per cent of the investing bank’s capital funds (Tiers I and II). In July 2004, the ceiling was made applicable to banks’ investments in all types of instruments of other financial institutions. Banks were also advised to not acquire a fresh stake in a bank’s equity shares if, by such acquisition, the investing bank’s holding exceeded 5 per cent of the investee bank’s equity capital. The investments in instruments issued by banks and eligible for capital status would attract a risk weight of 100 per cent for credit risk.

Investments In 1992–93, the Reserve Bank had advised banks to categorise their investments into ‘permanent’, which were likely to be held until their maturity, and ‘current’, which were likely to be traded before maturity. Initially, banks were allowed to keep not more than 70 per cent of their total investments in the permanent category. Current investments had to be ‘marked to market’, that is, valued at market rates, and if there was depreciation, it had to be provided for. The share of permitted ‘current’ investments was raised, from 50 per cent in 1996–97 to 60 per cent in 1997–98 and 75 per cent in 1999–2000. In respect of securities for which market quotations were not available, banks could value them by yields, provided by the Bank, for different maturities while drawing up their balance sheets. In 2000, new guidelines were issued on the classification of investments into held to maturity (HTM), available for sale (AFS) and held for trading (HFT) categories. The HTM category, where marking to market was not necessary, would not exceed 25 per cent of total investments, as they were intended to be held until their maturity. The yields of securities rose sharply in 2004 and a business daily estimated losses of the banking sector at 500 377

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the reserve bank of india billion. The Reserve Bank arranged a meeting in August 2004 with the IBA, FIMMDA, the Foreign Exchange Dealers’ Association of India (FEDAI) and other bodies to discuss the situation. In September 2004, the Reserve Bank permitted banks to exceed the limit of 25 per cent in HTM, subject to conditions, including permission to shift SLR securities to HTM as a temporary measure to protect banks from depreciation in bond prices.11 In September 2004, an internal group reviewed these guidelines in relation to the global best practice and submitted new draft guidelines to the Standing Technical Advisory Committee on Financial Regulation (STACFR) (Box 10.1.1).12 To mitigate the risk from a reversal of interest rates, banks were advised (March 1999) that they should appropriate the provision towards depreciation on investments, rendered excess due to fall in interest rates, to an investment fluctuation reserve (IFR) account instead of capital reserve. Banks could utilise the IFR to meet future interest rate shocks without jeopardising their capital. In September 2004, it stood at an aggregate average of 3 per cent against the prescribed level of 5 per cent of investment in AFS and HFT categories. Only seventeen out of the eighty-eight banks had attained the prescribed level of 5 per cent of investments held in these categories, and thirteen private banks had drawn down their IFR balance in September 2004. Banks were asked to reach 5 per cent by March 2006. Box 10.1.1 Standing Technical Advisory Committee on Financial Regulation The STACFR was set up by Governor Reddy in late 2003 ‘to simplify and rationalise the regulatory regime to move towards a clear unambiguous framework’, with the Deputy Governor of the regulatory department as the Chairperson, and CEOs of a few major banks (in the public sector, new private sector banks and foreign banks), the Chairman of IBA and Professor N. L. Mitra as members. Mitra was the former Vice-Chancellor of the National Law School of India University, Bangalore, and National Law University, Jodhpur. He had also been the chairman of several important Government of India committees. Two other Deputy Governors were permanent invitees. The committee met as and when required and not at stipulated intervals. It served as a think-tank of experts to advise the Bank on policy issues. The committee discussed issues such as branch licensing policy, exposure norms, concentration risk, interbank liabilities, parabanking activities, accounting standards, transparency and disclosure norms, diversion of funds and wilful defaulters, and unhedged forex exposures. 378

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regulation of the financial system With a substantial decline in yields of securities after 2004, banks could build up sizable balances in the IFR. The IBA proposed to the Reserve Bank that the IFR should be treated as Tier I capital as it was created out of profits after meeting tax liabilities and appropriation to statutory reserves. The Bank had at first allowed the IFR to be reckoned as Tier II capital. Banks were permitted to set off depreciation against the IFR if they held the IFR above 5 per cent. In October 2005, a conditional relaxation of the rule was allowed. SLR securities carried a sovereign guarantee; non-SLR investments did not, and yet there was little appraisal by banks before investing. In February 1999, following an internal working group report, the Reserve Bank drafted guidelines that stated that the banks’ investments in ‘unlisted’ non-SLR securities should not exceed 10 per cent of their total investments in nonSLR securities. Limits were fixed for non-rated instruments and measures were taken to make the acquisition of investments through private placements transparent. In 2001, another review showed that some banks had made significant investments in privately placed unrated bonds, and in bonds issued by corporates who were not their borrowers. Since these investments were not regulated, the Reserve Bank wanted the boards of banks to fix prudential limits on these and instructed banks to show more diligence about privately placed or unrated instruments. In 2001–02, based on a working group report, the Bank issued revised guidelines.13 In October 2001, banks were asked to make fresh investments only in dematerialised form. This measure gained urgency in the wake of the irregularities in the government securities market in early 2001. Later they were advised to convert their equity holdings to demat form by December 2004. The guidelines on non-SLR investments were revised in 2003.14 Banks and the media did not react favourably to the new guidelines. To this reaction, the Reserve Bank responded stating that they had time until March 2004 to comply with these. In December 2003, another circular clarified that some segments of the market were exempted from the guidelines and that assetbacked securities and mortgage-backed securities would not be reckoned as unlisted non-SLR securities.15

Asset Classification and Provisioning The asset classification norms introduced in the mid-1990s were progressively tightened. There were four asset categories – standard, sub-standard, doubtful 379

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the reserve bank of india and loss assets. Banks that had difficulty classifying small advances in this way were given time until March 1998 to comply. They were required to provide a flat provision of 15 per cent in respect of such unclassified small advances. An account was treated as a non-performing asset (NPA) if the principal or interest was not paid within 180 days from the due date (reduced to 90 days from March 2004). Earlier, substandard assets migrated to ‘doubtful’ category after twenty-four months. This period was reduced to twelve months in March 2005. In June 2004, graded provisioning was introduced according to the age of the NPAs. Advances guaranteed by state governments were earlier treated as riskfree, but after some states refused to honour guarantees, they were treated on a par with general advances. Since the advances portfolio tended to grow faster during an expansionary phase, there was a tendency to underestimate the level of inherent risk. A general provision of a minimum of 0.25 per cent was advised to banks in October 1998 and introduced from March 2000. The provision for standard advances was raised to 0.40 per cent in October 2005, and in specific sectors, such as personal loans, capital market exposure, housing loans over 2 million, and commercial real estate loans, to 1 per cent in April 2006. Agricultural advances and advances to small and medium enterprises continued to attract provisioning at 0.25 per cent. In June 2002, prudential limits for lending in the call money market were introduced.16 From 30 April 2005, the benchmark for fixing prudential limits on exposures to call/notice money market was linked to the capital funds (sum of Tier I and Tier II capital).

Liabilities For financial stability, mitigation of counter-party concentration risks and regulation of interbank liabilities were necessary. Counter-party concentration occurs when a significant percentage of a portfolio has exposure to the same or related counterparties. Although limits were in place for call money borrowings, these covered only a portion of the interbank liabilities. In 2005, an interdepartmental group recommended that total interbank liabilities be limited to 200 per cent of the net worth of a bank, to begin with, and the limit lowered to 150 per cent by September 2006. The STACFR, however, held that the concept of fixing limits on interbank liabilities was not an appropriate one, and did not have a parallel in the world. 380

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regulation of the financial system It was again proposed to fix appropriate limits for interbank liabilities within a band of 200 to 400 per cent of their net worth. But the Board for Financial Supervision (BFS) did not favour the band and in March 2007 the limit was set at 200 per cent of net worth, and for banks with CRAR above 11.25 per cent, at 300 per cent.

Asset–Liability Management and Risk Management Systems An in-house working group formed in November 1997 prepared a discussion paper on asset–liability management (ALM).17 The suggested framework gave freedom to banks to lay down gap limits based on their own asset–liability profile. The IBA responded that the Bank ‘is giving undue importance to Credit–Deposit ratio as an index of risk evaluation which is not much relevant in today’s environment’.18 The Business Standard criticised the Reserve Bank on 29 September 1998 for a ‘one size fits all’ prescription. The Bank accepted that a uniform ALM system for all banks was not feasible. The guidelines were, it clarified, to serve more as a benchmark. In the final guidelines issued in February 1999, banks were to ensure coverage of at least 60 per cent of their liabilities and assets by September 1999, and 100 per cent by April 2000.19 In the wake of the subprime crisis and its impact on the liquidity position of Indian banks, the Bank further revised its guidelines in October 2007, taking into account international practices (see Chapter 11).

Capital Market Exposure The Reserve Bank’s approach to banks’ exposure to the capital market was conservative. Guidelines issued in May 1994 stated that acquisition of corporate shares and debentures should be below 5 per cent of the incremental deposits of the previous year. Banks were permitted to sanction bridge loans to companies up to one year against expected proceeds from equity issues, subject to limits. A further limit was prescribed for banks’ direct investment in shares, convertible debentures and units of equity-oriented mutual funds at 20 per cent of the bank’s net worth. Limits and margins were also set for advances against equity shares, debentures and bonds for individuals. These guidelines were reviewed jointly by the Bank and the Securities and Exchange Board of India (SEBI).20 Limit applicable to individual banks was extended in 2004 to consolidated banking groups to ensure that banks did not use group entities to assume 381

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the reserve bank of india exposure in areas where prudential limits were applied to banks. The aggregate capital market exposure limit for a bank was 5 per cent of the bank’s advances; this was modified to 2 per cent of the total assets for a consolidated bank, since it was likely that the other entities in the group might not have ‘advances’ as a balance sheet item. The limit on direct investment in equity for the consolidated bank group was reduced to 10 per cent of net worth (from 20 per cent of the individual bank’s net worth). The banks campaigned to raise the capital market exposure limit above the 5 per cent ceiling, with some success. The Budget speech of 2004–05 announced that ‘banks with strong risk management systems’ would be permitted ‘greater latitude in their exposure to capital market’. Banks wishing to take exposure above the ceiling could apply to the Reserve Bank, which would assess the merits of the application based on their risk management system, CRAR, return on assets and net NPA. On 17 May 2004, the cautious stance was vindicated when the stock market (Sensex) fell 13 per cent in one day. Little intervention was possible to arrest the fall.21 For banks, this was a high-risk area. In December 2006, the norms were liberalised, and banks’ aggregate exposure to capital markets in all forms was fixed at 40 per cent of banks’ net worth.22 For direct exposure to equity, the ceiling was fixed at 20 per cent.23 In February 2007, the aggregate capital market exposure of banks was only 2.3 per cent of gross advances. Of eighty commercial banks, three had exceeded the limit. The aggregate direct investments in equity were at 11 per cent of banks’ net worth as against the limit of 20 per cent.

Real Estate Exposure Real estate was an area where both returns and risks were high. This was a socially important activity. But the growing exposure of banks to the real estate sector, including housing loans, caused anxiety because of weaknesses in the valuation practices in vogue, among other problems. The Bank followed a cautious policy on banks’ exposure. In December 2002, it carried out a study of asset–liability mismatch caused by exposure to real estate and NPA levels in the real estate sector. The study revealed that the share of real estate exposure was modest in the overall loan portfolio (2.5 per cent) and the asset quality was reasonably good (NPA at 1.2 per cent) for select banks. In December 2004, the risk weight for housing loans was raised 382

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regulation of the financial system from 50 per cent to 75 per cent while for commercial real estate, retained at 100 per cent. The increase in risk weights was reflective of the anxiety. In July 2005, banks were asked to formulate a policy for such lending and to send monthly reports to the Bank. The risk weights assigned to commercial real estate were higher than that of housing loans and, therefore, the definition of the term (that is, commercial real estate exposure) mattered to banks. Until 2005, the Bank did not clearly define the term. In June 2005, a circular did this, and in the following month, the risk weight was raised to 125 per cent, and in 2006, given the rapid expansion in credit to commercial real estate, to 150 per cent. Banks resented these steps and questioned the definition of commercial real estate. The Reserve Bank did not relax the norms; in fact, it further tightened them by bringing real estate in special economic zones (SEZ, export processing zones) within the definition in September 2006.

Single Borrower/Group Exposure Norms Another sensitive area was concentration risk in banks’ advances, which resulted from large advances to big borrowers. From 1 April 2000, the ceiling on a bank’s exposure to the individual borrower was lowered from 25 to 20 per cent of the capital funds as per last balance sheet to take the limit nearer the international standard of 15 per cent. Banks were advised to take this to 15 per cent by 31 March 2002. Group exposure limit was reduced from 50 per cent to 40 per cent of the capital funds from 31 March 2002. With infrastructure projects, the group exposure limit was extendable by an additional 10 per cent.24 The Annual Policy Statement for 2004–05 announced that banks facing difficulties with exposure limits could approach the Reserve Bank for approval. Such difficulties arose frequently with credit extended to public sector companies. Some corporate borrowers sought permission directly from the Reserve Bank for exceeding the prudential limits but the latter insisted the requests come from banks.25 Banks were still required to make appropriate disclosure of the exposures in excess of the limits. In June 2005, the exposure of 61 banks to 233 borrowers had exceeded the ceiling of 15 per cent, and that of 20 banks to 64 borrowers exceeded the enhanced ceiling of 20 per cent. A few banks did not disclose the excess over the limits in the Notes on Accounts, and in some other cases, the disclosures were inadequate. Indian Bank, which had negative net worth from the mid-1990s, 383

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the reserve bank of india was unable to comply with exposure norms. The bank was allowed as a special case to continue with its self-prescribed single and group borrower limits.26 The Oriental Bank of Commerce, whose CRAR declined sharply after its merger with loss-ridden Global Trust Bank Ltd (GTB), was also permitted to continue its normal lending activities during 2004–05. Others were asked to comply.

Unsecured Advances In 1967, a 15 per cent ceiling on unsecured advances had been introduced in view of the risks involved in such lending. Banks wanted the ceiling to be revised. In 2001, many had exceeded the ceiling. As credit card dues increased, the question came up if these should be treated as unsecured advances. In April 2002, credit cards were excluded from the definition. Advances given to self-help groups against group guarantees were also excluded. More broadly, the banks’ increased exposure to the service sector made a revision of the rule necessary. In January 2004, a working group considered requests for exemption from the norm on a case-to-case basis. The BFS advised (March 2004) that the Bank should refrain from micro-management. By June 2004, the ceiling was dispensed with taking into account that the Bank had by then prescribed stringent prudential norms.

Off-Balance-Sheet (OBS) exposures Banks enter into off-balance-sheet (OBS) transactions for extending nonfund-based facilities to their clients and for balance sheet management. The OBS exposures take the form of contingent liabilities and derivatives and expose a bank to several risks. Hence, the Reserve Bank had advised the banks to hold defined regulatory capital on all outstanding OBS exposures. Banks were also required to make full disclosure in the balance sheets apart from periodically reporting to the Reserve Bank the data on these exposures. The risk management guidelines covered non-fund-based business too. The OBS exposure of banks increased sharply, by around 31 per cent and 51 per cent in March 2003 and March 2004, respectively, compared to growth of total assets (on balance sheet) of 12 per cent and 16 per cent. The deregulated interest rate regime, accompanied by a decline in rates during the period and volatility in the foreign exchange market, had contributed to the increase in hedging and trading activities by banks. Fee-based activities complemented 384

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regulation of the financial system banks’ income. The gradual opening of the derivatives market also facilitated the process. In March 2005, banks were, therefore, asked to disclose qualitative and quantitative aspects of their derivative portfolio and provide a clear picture of the exposure to risks in derivatives, and how these were managed.27

Private Sector Banks

From 1993, the private sector could set up banks. The Reserve Bank received sixty-seven applications. Ten applicants were issued licences; nine started operations. One cooperative bank, Development Credit Bank (DCB), converted to a commercial bank. The licensing conditions prescribed a high level of promoters’ holding initially and diversified ownership eventually. The majority shareholder in DCB, which was a foreign body corporate, had a shareholding of over 58 per cent for ten years, brought down to 30 per cent in 2007. IDBI Bank sought time until September 2002 to reduce promoters’ equity. Others complied. Did the entry of private banks increase competition in the business? An in-house working group formed in January 1998 reviewed the situation and suggested that ‘large industrial houses’, whose applications had been pending with the Bank, ‘may not be excluded from prima facie consideration for setting up of banks’.28 The entry of large industrial houses was disallowed (by the government), ‘to obviate the problems of connected lending’, but their minority participation was allowed. In 2001, a set of ten applications were considered by, among others, an advisory committee consisting of eminent specialists, including former Governor and economist I. G. Patel, and two approvals were issued. One of these was Kotak Mahindra Finance Ltd, already a non-banking financial company (NBFC), which was asked to convert into a bank, instead of setting up a new one. The other approval was given to Ashok Kapur and two other banking professionals along with Rabobank (with 20 per cent stake) on 7 February 2002.29 YES Bank commenced operations in August 2004. No further applications were entertained in the next three years. There were significant differences between new and old private sector banks, on minimum paid-up capital, branch opening policy, dilution of promoters’ holdings, remuneration of management, and Reserve Bank nominees on the boards, among others. In a meeting with the Reserve Bank in March 2004, heads of banks urged that these distinctions should be removed. Not much progress, however, occurred during the reference period. 385

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the reserve bank of india In May 2001, the government announced that foreign direct investment (FDI) up to 49 per cent would be permitted in the banking companies. Foreign institutional investors were already allowed to invest up to 49 per cent in private banks. Governor Jalan preferred that a combined ceiling should be set such that a minimum of 26 per cent holding was with resident Indian investors. ‘Our banks,’ he said, ‘should not become a branch of a foreign entity and should have an Indian character and orientation.’30 The Reserve Bank issued a single class of banking licence. All banks could carry on both retail and wholesale banking. In January 1998, the Stock Holding Corporation of India Ltd applied for a licence to set up a limited purpose bank. The company wanted to offer limited banking service to its custodial clients. The Legal Department of the Bank held that the concept was not legally feasible because the Banking Regulation (BR) Act stipulated that the bank would provide services to the general public. In 2004, the government proposed to the Bank that with the development of the financial market and services, ‘the one-size-fits-all’ approach needed a rethink. The Bank declined to do so in view of the provisions of the BR Act. In November 2006, the Clearing Corporation of India Ltd wanted to become a ‘Limited Purpose Bank’ following a study and recommendation by the Indian Institute of Management, Bangalore. The idea was that it would help in providing an enhanced level of assurance to the members in the event of unforeseen market shocks. Again, the Reserve Bank did not consider the request. In 2007, the IBA suggested the issue of Differentiated Bank Licence by the Bank. An internal study reviewed the current policy and international experience and practice on limited bank licensing. Governor Reddy, thereafter, announced in the Annual Policy Statement for 2007–08 that in the interest of efficiency in the banking system, ‘a graded approach of licensing may be appropriate which can be equally applicable to both domestic and foreign banks’. A Technical Paper on Differentiated Bank Licences was prepared by the Bank and put on the public domain in October 2007. The IBA sent its suggestions but no progress was made until 2013.

Transfer of Shares and Voting Rights The Reserve Bank had earlier issued instructions that transfer or allotment of banks’ shares in the name of the transferee should occur only after obtaining the Reserve Bank’s acknowledgement. This was meant to avoid attempts by 386

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regulation of the financial system individuals or groups to acquire a controlling interest in a bank. The rule was applied when such a transfer would take the aggregate shareholding of the individual or group to 1 per cent or more of the total paid-up capital. The limit was raised to 5 per cent in 1999. Further, a provision in the BR Act said that ‘no person holding shares in a banking company shall, in respect of any shares held by him, exercise the voting right in excess of 10 percent of the total voting rights of all the shareholders of the banking company’. In October 2001, the IBA asked for the ceiling of 10 per cent on voting rights to be raised.31 The Reserve Bank proposed to the government that this section of the BR Act should be deleted. The intention of restricting voting rights was already met by the restriction on the acquisition of shareholdings. The draft amendment Bill was presented in the Lok Sabha in April 2003 and was referred to the Standing Committee on Finance. In the deposition before the committee on 29 July 2003, it was submitted by the Bank that ‘the amendment was necessary to enable foreign banks to set up subsidiaries’. The matter, however, did not end there. On reconsideration, Deputy Governor K. J. Udeshi wrote to the Ministry of Finance in November 2003, expressing concerns about cross border flows to sensitive sectors, like banking, from tax havens as the identities are difficult to establish (see Appendix 10A.1.1). In December 2003, in a subsequent letter, the Bank informed the Ministry that as 74 per cent foreign equity in banks was allowed, it was essential to have restrictions on both shareholdings and voting rights and there was no compelling reason to allow foreign firms to have a controlling stake in Indian banks via the FDI route. After further discussions, the government agreed to drop the proposal to remove the restrictions on voting rights.32

Governance Issues The criteria that the directors on the boards of banks should meet were called ‘fit and proper’. The criteria included qualifications, expertise and track record. In 2004–05, draft guidelines on ‘ownership and governance for private sector banks’ stated that the large shareholders, directors and the CEOs should be persons who could command trust, and that no single entity or group (other than a bank) have shareholding in excess of 10 per cent of the paid-up capital. In case of restructuring of weak banks, the Reserve Bank reserved the right to permit a higher level of shareholding. Until 2008, it had not identified any bank for restructuring.33 387

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the reserve bank of india SEBI had a Committee on Corporate Governance and circulated the recommendations to all stock exchanges for implementation by listed entities as part of the listing agreement in 2000. SEBI had at that time exempted banks and financial institutions and left the matter to the Reserve Bank. The Bank issued these guidelines for the listed banking companies in June 2002. SEBI guidelines of July 1998 had authorised the Reserve Bank to approve share issues and pricing by banks. In May 1998, the Reserve Bank announced that listed banks need not seek its prior approval for public and rights issues, but bonus issues would be subject to prior approval.34 There were representations from banks and associations for freedom on this clause. The Reserve Bank did not agree, on grounds that the issue of bonus shares would imply a higher payout ratio of dividend in future and it would benefit only the shareholders and not the bank. In the light of the wide variation in the pricing of rights, the matter was reviewed in March 2002, in terms of which banks were required to obtain the Reserve Bank’s approval for initial public offerings (IPOs), but after listing on stock exchanges, banks were free to price their subsequent issues. Later in the reference period, a matter of wider political implications came before the Reserve Bank. The International Finance Corporation (IFC) had made an investment of 4.99 per cent each in two old private sector banks.35 The Reserve Bank was not in favour because it was not happy with the track record of the IFC. The IFC had earlier acquired 9.62 per cent in Centurion Bank and 12.15 per cent in GTB and then offloaded the stake in both (in 2003) when the two banks were going through difficult times. Since it had acquired the shares under the FDI route, the Bank was of the view that the IFC ought not to operate like a portfolio investor or a fund manager. The IFC complained to the government, and the government sought an explanation. In its response (in April 2006), the Bank explained its position, following which the government left the decision to the Bank. The World Bank, of which the IFC was a part, essentially agreed to the Reserve Bank’s decision. The IFC divested its holdings by September 2008. With dematerialisation of shares and securities, and setting up of depositories, SEBI made it compulsory for financial investors with a minimum portfolio of 100 million to settle all transactions through depositories from 15 January 1998. Accordingly, the Reserve Bank advised all banks to settle transactions in securities through the National Securities Depository Limited (NSDL). Legally (that is, in terms of the Depositories Act, 1996), the transfer of shares in listed banks would be effected automatically in the depository. 388

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regulation of the financial system Banks would come to know only afterwards and so they were unable to comply with the Bank’s instructions to obtain its acknowledgement ‘before’ effecting the transfer. Initially, the Bank tried to keep banking companies outside the ambit of the Depositories Act but it was not acceptable to SEBI and the government. A meeting in January 1999 held that the Depositories Act and the Companies Act could be amended to empower the Bank to rectify the register of banks and regulate the voting powers of transferees of shares.36 The Legal Department suggested amending Section 12 of the BR Act instead, to which SEBI objected. A committee to look into this issue recommended (in March 2000) that in the long term, the BR Act should be amended; the short-term measure would be that banks amend their Articles of Association to the effect that acquisition of shares by a person or group, which would take individual holdings to 5 per cent or more, were carried out with the prior approval of the Bank. The Bank accepted the recommendation.37 In the case of American depository receipt and global depository receipt issues by banks, overseas investors would hold only the depository receipts and the underlying shares would stand in the name of the depository in the bank’s books. The Reserve Bank held that these banks had to obtain its acknowledgement for allotment of shares if the depository’s holding was 5 per cent or more. As banks applied for acknowledgement, the Reserve Bank would assess the ‘fit and proper’ status of the depository, and grant acknowledgement only after the depository agreed not to exercise voting rights. Three cases of acknowledgement received between November 2005 and April 2006 were kept pending until July 2007 because of ambiguities in this regard.38 The Bank had been nominating additional directors to serve on the boards of private sector banks.39 The Ministry of Finance advised the Bank in December 1997 that appointment of serving Reserve Bank officers on the banks’ boards could lead to a conflict of interest, especially when such officers were drawn from Reserve Bank offices having territorial jurisdiction over the headquarters of the banks concerned. Agreeing to the suggestion, the Bank nominated its officers from offices that had no direct jurisdiction over the banks concerned. It was also decided that the Bank nominee would not be in any board committee except the Audit Committee unless specifically approved in exceptional cases of grave supervisory concern. The matter was reviewed in January 1998 and the Bank withdrew its officials from the boards of private banks whose performance and the quality of management were satisfactory.40 The Bank did not nominate its officials to the boards of new private sector 389

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the reserve bank of india banks as these banks were licensed under a different set of conditions and were professionally managed.

Public Sector Banks Banks had been nationalised under the Banking Companies (Acquisition and Transfer of Undertaking) Acts of 1970 and 1980. In October 2000, the government sent to the Bank the proposal of an amendment to this law, which would enable, among other changes, reduction in the government’s stake from 51 per cent to 33 per cent in public sector banks and empowerment of the Bank to assume more regulatory and supervisory powers over them. The amendments, however, did not materialise as the Bill lapsed on the dissolution of Parliament in 2004. The need for reform in the Reserve Bank’s oversight of public sector banks remained. In June 2004, the Bank sent to the Ministry of Finance a draft of a policy framework for public sector banks, on the lines of ownership and governance guidelines issued to private sector banks. The government sent its own draft guidelines on appointment of part-time non-official directors.41 The Bank persisted with the matter and approached the government on the need to apply stricter criteria on nominee directors.42 In response, the government asked the Bank in October 2005 to formulate statutory amendments to include ‘fit and proper’ criteria for elected shareholder directors and procedure for removal of shareholders if not found fit. Section 9(3) of the Banking Companies (Acquisition and Transfer of Undertakings) Act said that the government would nominate an officer of the Bank on the board of each nationalised bank. The Narasimham Committee I recommended the discontinuance of the practice, the Joint Parliamentary Committee (1993) agreed, and the Narasimham Committee II reiterated the recommendation. Being the regulator or supervisor, it was not appropriate for the Bank to participate in board decisions. The Bank, therefore, informed the government of its readiness to withdraw its nominees. Given the legal position that it was mandatory to have an officer as a nominee on the board of public sector banks, an amendment to the relevant Acts became necessary. The amendment was carried out in 2006. Thereafter, the nominee would be chosen by the government in consultation with the Reserve Bank.43 Despite the broad agreement between the Reserve Bank and the government on the point that nominees were on the boards in the aid of 390

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regulation of the financial system corporate governance, there were occasional differences between them. On one such occasion in January 2008, SBI brought a proposal to the board for investment in a private equity firm. Both the nominee directors did not attend the meeting that discussed the matter. The next day, the Reserve Bank nominee wrote to the bank’s Chairman that ‘private equity venture ... involves high risk for the bank and is not advisable’, and asked the board to seek approval of the government. On a copy of the letter sent to the government nominee, who was a Secretary with the Ministry of Finance, the officer concerned wrote by hand that ‘these are commercial decisions which can best be taken at the Board level. It need not be referred to the government. This is for future guidance as the government would like to leave all these decisions to the Board of Directors’, and faxed the message back to the Bank. But the Bank had the last word. SBI had to come to the Bank for approval as per instructions and did not get it.44

Foreign Banks In July 1998, the Government of India wanted the Bank to examine whether wholly owned subsidiaries of foreign banks could be allowed in India. The proposal was in line with the Narasimham Committee II recommendation. The Bank examined the issue and decided that the existing policy of allowing foreign banks to have branches in India should continue. In March 2001, the government reopened the issue and wanted the Bank to consider the proposal. In June 2001, the Bank again advised the government against the proposal. The argument was that although the BR Act did not disallow subsidiaries of foreign banks, a subsidiary by definition would require a minimum shareholding of 51 per cent, whereas foreign investment in banking was then permitted only up to 49 per cent. Besides, the ceiling on voting rights would be an inhibiting factor in setting up subsidiaries. The issue returned in the Inter-Departmental Committee (IDC) meetings during 2000–01. The members of the IDC were drawn from various departments of the government and the Bank, which approved the proposals for opening of branches of foreign banks in India. The French Trade Minister criticised the lack of clarity in Indian policy. The IDC wanted the Bank to reconsider its stand. After further discussion, the Bank advised the government in February 2002 that foreign banks could be allowed to set up subsidiaries, but a foreign bank would not be allowed to set up both branches and a subsidiary. The letter added that the government might consider revising the FDI policy 391

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the reserve bank of india in banks, allowing 100 per cent ownership, and removing the ceiling on voting rights. The Finance Minister in his Budget speech for 2002–03 announced both these changes. But the necessary notifications were not issued.45 In April 2003, ABN Amro approached the Bank for permission to set up a 100 per cent subsidiary in India, but the application was not processed for over a year for want of government notification in this regard. In November 2003, as discussed earlier, the Bank advised the government of its changed stance to retain the restriction of 10 per cent on voting rights. Since the government eventually agreed with the Bank on this matter, there was no question of considering a 100 per cent subsidiary promoted by a foreign bank. Nor would ABN Amro want to have a ‘subsidiary’ with only 10 per cent voting rights. On 28 February 2005, the Reserve Bank released a roadmap for the presence of foreign banks in India. The roadmap had two phases. During the first phase, from March 2005 to March 2009, foreign banks would be permitted to establish a presence by way of operating through branches, or conversion of an existing branch into a wholly owned subsidiary with a minimum capital of 3 billion. The Reserve Bank would prescribe market access and national treatment limitations consistent with the World Trade Organization and international practices. In Phase II, after 2009, foreign banks would be permitted mergers with and acquisitions of Indian banks, subject to certain restrictions. The roadmap revealed the Bank’s general approach to this issue. The Bank was essentially pursuing a two-track and gradualist path, to first consolidate the domestic banking system, while enhancing the presence of foreign banks.46

Rehabilitation of Weak Banks In December 1998, the Bank initiated a study of the weak public sector banks.47 The study identified three weak banks (Indian Bank, United Bank of India [UBI] and UCO Bank), and six others that were distressed and facing the risk of becoming weak. The three banks were under restructuring since 1992–93. Their high level of NPAs had been caused by indiscrete lending and poor credit management. UBI and UCO Bank also suffered from trade union activism. Other country supervisors like the Monetary Authority of Singapore and the Hong Kong Monetary Authority pressured Indian Bank and UCO Bank to raise their capital or face withdrawal of licences given to branches operating 392

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regulation of the financial system in those countries. The restructuring had two components: recapitalisation, and improvements in operational efficiency. The three banks had received substantial recapitalisation funds from the government until 1998. While extending such assistance, conditions were imposed on the reduction of costs, recruitment and branch expansion. While the banks could achieve targets for deposit mobilisation and housekeeping, there was not much progress in reduction of NPAs and costs. The strategy, therefore, was abandoned and these banks were brought under ‘Strategic Revival Plans’ from 1997–98. The Verma Committee recommended further infusion of funds and the establishment of a Financial Restructuring Authority, which would represent the government as owners. The committee also recommended the setting up of an Asset Reconstruction Fund for taking over the NPAs of weak banks. The Reserve Bank studied the recommendations and sent a note to the government. The government accepted these, provided viable restructuring programmes were drawn up by the three banks acceptable to the government as the owner and to the Reserve Bank as the regulator. The Financial Restructuring Authority would comprise experts and professionals and be given powers to supersede the Board of Directors on the recommendations of the Bank.48 The recommendation to sustain weak banks drew critical comment from the IMF Mission under Article IV Consultation, which said that ‘the assumption that all banks are too big to fail is likely to exacerbate weaknesses in governance that have contributed to the problem’. In December 2000, the government constituted a committee to examine the restructuring plans of the three banks.49 The committee’s report concluded that the banks could not be restructured through merger, privatisation, management lease or narrow banking.50 Capital infusion by the government was unavoidable. In February 2001, Governor Jalan desired that the memoranda of understanding and the quarterly monitoring reports of the three banks should be made public ‘so that there is some pressure on the management/government to act’. The Bill to amend the relevant Act to establish a Financial Restructuring Authority, among other things, lapsed with the dissolution of the Lok Sabha in 2004. By then, the performance of weak banks had begun to improve. The turnaround was achieved primarily through large doses of recapitalisation or infusion of funds. The CRAR improved proportionately, in turn, providing additional room for asset growth. The banks acquired safe and interest-earning government bonds on the asset side. While these measures contributed to increased growth and profitability, the banks also improved their operations. 393

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the reserve bank of india They closed unviable branches. The changed leadership instilled confidence. By 2003–04, the three banks had achieved the turnaround and were no longer considered weak.

Non-Performing Assets The gross NPAs of scheduled commercial banks declined sharply from 15.7 per cent in March 1997 to 2.3 per cent in March 2008.51 The improvement in asset quality of the Indian banking system was driven by improved credit risk management practices, favourable macroeconomic environment, and institutional measures that were taken to address loan recovery.52 The Bank had an important role in facilitating this improvement. For example, in 1998, a working group set up with representatives from large public sector banks and the Reserve Bank examined the issue of writeoffs by banks. Based on the report and subsequent discussion, in May 1999, guidelines on a Settlement Advisory Committee was issued to public sector banks. At that time, the public sector banks had 0.53 million pending court cases amounting to 239.15 billion for loan defaults. Some of the banks had constituted Settlement Advisory Committees to review all cases of NPAs, processed compromise proposals speedily, and recommended to the competent authority for settlement and write off. A later circular, however, mentioned that ‘a review of compromise settlements of NPAs through SACs made by us has revealed that the progress of recovery of NPAs through this mechanism has not been encouraging’. In July 2000, the Bank issued revised guidelines to public sector banks on ‘one-time settlement’ for recovery of NPAs relating to all sectors except in cases of fraud and wilful default. The circular provided a simple settlement formula for cases with outstanding balance up to 50 million. The scheme evoked a moderate response. Only 19 per cent of the eligible borrowers applied for settlement.53 In November 2001, the Finance Minister in a meeting with the heads of public sector banks suggested a scheme for recovery of dues pertaining to small loans. Accordingly, the Bank advised public sector banks to formulate a policy and encouraged banks to adopt one-time settlement for such loans. In January 2003, the Bank issued revised guidelines to public sector banks to adopt compromise or one-time settlement in chronic NPA cases with outstanding up to 100 million. In December 2006, there was a significant 394

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regulation of the financial system change in approach as the Bank withdrew all the guidelines issued in the past. Banks were given the freedom to design and implement their own policies for recovery and write-offs. Wilful defaulters posed a different set of issues, which are examined in Chapter 11. Why were NPAs such a persistent problem for the banks? Since the share of NPAs in priority sector and non-priority sector advances was almost equal, priority sector lending requirements would not have been the main reason for NPA. From the Bank’s documents, the immediate reason for the accumulation of NPAs seemed to be the way projects were implemented. There was an allegation of diversion of funds; frequent time and cost overrun; business, product, marketing failure; inefficient management; strained labour relations; and choice of inappropriate technology. Recessions and changes in government policy contributed to the problem. The Bank carried out another study through an in-house group in August 2002 on NPA management, following which, in September 2002, further guidelines were issued.54 To contain the problem, the Reserve Bank advised banks to design loan policy and loan recovery policy, undertake periodic review of NPA accounts, make staff accountable, review top 300 NPA accounts by the Management Committee of the board, and strengthen risk management systems. In May 2007, the IBA was advised that banks might enter compromise settlement even with wilful defaulters or fraudulent borrowers without prejudice to the ongoing criminal cases. In March 2001, the Reserve Bank allowed banks to restructure or reschedule credit facilities extended to industrial units which were fully secured by tangible assets. Later that year, a Corporate Debt Restructuring system was put in place (see Part II of this chapter). In September 2005, the Bank issued guidelines for the restructuring of debts of small and medium enterprises and rationalised the prudential norms applicable to such accounts. In view of a large number of pending court cases, and the slow process of the courts, a Lok Adalat had been created in 1987 as an alternative dispute redressal mechanism.55 In June 2000, the Ministry of Finance asked the Governor to formulate guidelines to enable banks to settle disputes of smaller amounts by this mechanism. In August 2000, the Bank sent these guidelines. Between 2000 and 2004, negotiations continued on the appropriate ceiling amount for cases eligible to be brought to the Lok Adalat. While the government was in favour of a low ceiling, the Bank favoured a higher one. Eventually, the Bank’s position prevailed. As of May 2003, all twenty-seven 395

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the reserve bank of india public sector banks were making use of Lok Adalats with the filing of 232,000 cases involving 10.49 billion. However, only fourteen private sector banks out of the twenty-nine were using this mechanism. A working group formed to examine debt recovery tribunals (1998) recommended legislative amendments to strengthen the tribunals and overcome legal hurdles in their functioning.56 All public sector banks were advised to set up special Debt Recovery Tribunal Cells and to keep a close liaison with the standing counsel who appeared before the tribunals. By March 2008, of 79,169 cases involving 1,263.78 billion filed with the tribunals by banks, 45,088 cases (involving 587.19 billion) had been adjudicated and 215.41 billion recovered from adjudicated cases. In 2002, the government set up a committee to formulate guidelines for securitisation, asset reconstruction and enforcement of security interest by banks and financial institutions.57 The Bank later issued guidelines for the setting up of asset reconstruction companies regulated by the Bank (see Part II).58

Amalgamation and Mergers In June 1997, there were eighty-eight banks in various stages of liquidation.59 The procedure was that the Bank made an application for winding up a banking company under Section 38 of the BR Act, and on a High Court passing orders for the winding up, the bank was placed under liquidation. The government appointed an official liquidator attached to the High Court to oversee the realisation of assets. The liquidation process was time-consuming. Although the Bank had the powers to be an official liquidator under Section 39 of the Act, it did not take up the role, since it did not have the appropriate machinery or staff to handle the process. Instead, the Bank monitored the process. Excluding cooperative banks, the last commercial bank to be placed under liquidation in India (in reference to the period under review) was Bank of Karad Ltd, at the instance of the Reserve Bank in 1992, following a securities scam. After the process was completed, Bank of India took over the fortyeight branches of the bank in 1994. Since 1993, the Bank preferred voluntary mergers with strong banks for the closure of weak banks. The procedure for amalgamation was the following: Under Section 45 of the BR Act, the Reserve Bank made an application to the government 396

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regulation of the financial system to issue a moratorium on a bank for a period up to six months. During the moratorium, the Bank would prepare a scheme for amalgamation of the bank with another one. The draft scheme, after discussion with both banks, would go to the government for approval. Whereas most cases of such mergers involved weak banks and an element of compulsion, the discussions in the Reserve Bank recognised the prospect of voluntary mergers led by business interests.60 Small banks posed a particular problem. The Reserve Bank was not comfortable with the existence of several very small and under-capitalised banks. There were seven private sector banks with net-owned funds of less than 0.25 billion in 1997. These banks were reluctant to raise further capital by public issue of shares fearing takeovers. A BFS meeting held in February 1998 decided that of the fifteen small old private sector banks, seven banks should be allowed to continue on standalone basis provided they increased their capital to 1.0 billion within three to five years. The others should merge. The banks were informed of the decision, but the matter was not pursued vigorously. Between 2002 and 2004, further guidelines were prepared on mergers. Draft guidelines on mergers between NBFCs and commercial banks were prepared when the proposal for merger of Ashok Leyland Finance Ltd, an NBFC, with the new private sector IndusInd Bank was placed before the BFS in January 2004. During the reference period, several notable cases of mergers occurred. In the case of Benares State Bank, the promoters defaulted to other banks, and the income tax department attached their shareholding. When the Mumbai police took the chief promoter into custody for alleged dishonour of cheques, the Bank had to remove him from the board in July 1998, exercising its powers under the BR Act. The Reserve Bank appointed two more additional directors, raising the number of the Bank nominees to four in December 1998. Its accumulated losses of 0.55 billion had eroded the entire net-owned funds. The Sahara Group showed interest in acquiring a major portion of the shareholding but no agreement could be reached on share pricing. In March 2000, the government was approached for winding up of Benares State Bank. The Cabinet Committee approved the proposal. To avoid a run on the bank, the Reserve Bank issued a directive in September 2001 placing restrictions on withdrawals. After further consultation, in June 2002, the bank merged with Bank of Baroda.61 A proposal to merge the Bareilly Corporation Bank Ltd with its parent bank, Bank of Baroda, was not received kindly by the Government of Uttar 397

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the reserve bank of india Pradesh. Bareilly Bank was one of the few banks headquartered in that state. Despite this misgiving, the merger went through and was completed in June 1999. The Nainital Bank Ltd was a good candidate for a merger because of its small size, and the fact that 98 per cent of its shares were held by Bank of Baroda. But local residents of the state of Uttarakhand wanted the bank to continue as an independent entity as it was founded by the noted nationalist Pandit Govind Ballabh Pant. The Reserve Bank asked Bank of Baroda (in April 2007) to infuse additional capital into the bank, whereas the parent was inclined to disinvest its holding. The status quo continued until the end of the reference period. Sikkim Bank Ltd commenced business in 1987 and applied for a licence in 1988. The application was kept pending because the bank did not satisfy the conditions stipulated in the BR Act. By 1997, its NPAs stood at 95 per cent, and 56 per cent of the deposits had been eroded. Finally, a moratorium was imposed in March 1999 for three months. Notwithstanding court cases, its merger with Union Bank of India was completed in September 1999. Ganesh Bank of Kurundwad Ltd (GBK) did not want to raise its paid-up capital fearing takeover. The Reserve Bank wanted a merger but the government was not initially in favour because the bank had no major supervisory concern. In the early years of the new millennium, its NPAs increased to 26 per cent and the bank was placed under monthly monitoring. It was placed under a moratorium in January 2006 and amalgamated with the old private sector Federal Bank. There was considerable interest from several other private banks. Some of these rivals challenged the merger with Federal Bank in court, and the Bombay High Court issued a stay order. The Reserve Bank and Federal Bank then went to the Supreme Court against the stay order, and the Supreme Court asked the Bombay High Court to take a final decision. In April 2006, the High Court dismissed all writ petitions, maintaining that the amalgamation was in order, though it expressed some reservations on the process.62 The merger was effected in September 2006. Nedungadi Bank Ltd, a private bank in Kerala, ran a scheme from September 1999 involving purchase and sale of shares to take advantage of the price differential between the National Stock Exchange, the Bombay Stock Exchange and other exchanges. All transactions were routed through three firms controlled by stockbrokers who had been co-opted as directors to the board of the bank. The bank financed the brokers and they took investment decisions on behalf of the bank. In the process, the bank incurred losses that 398

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regulation of the financial system eroded its entire net worth. In view of this incident, in May 2001, the Bank cautioned all banks against conducting arbitrage operations of this sort and initiated steps to restructure the board. The bank was placed under moratorium in November 2002, and in January 2003 amalgamated with the public sector Punjab National Bank. The Dutch ING Group acquired substantial equity in the old private sector Vysya Bank Ltd in 2002 and, consequently, the name was changed to ING Vysya Bank Ltd. There were several cases of voluntary mergers. The Bharat Overseas Bank Ltd, a private sector bank promoted by public sector Indian Overseas Bank and owned by six other banks was embroiled in an IPO scam in 2005–06. The board of the bank asked the Chairman to go on leave. In March 2007, a proposal to merge with the promoter bank materialised. A newly licensed bank in the private sector, Times Bank Ltd, voluntarily merged with HDFC Bank in February 2000. An old private bank, Bank of Madura Ltd, merged with ICICI Bank in February 2001. Sangli Bank Ltd, another small private sector bank, voluntarily merged with ICICI Bank in April 2007. The case of Centurion Bank was more complex. Twentieth Century Finance Corporation Ltd, an NBFC, proposed to merge with the private sector Centurion Bank Ltd in 1999. The NBFC was the promoter of the bank with 45 per cent shareholding. In April 1999, the scheme was approved by shareholders, and the merger became effective from May 1999. The step, however, failed to strengthen the bank. Its asset quality deteriorated; the bank made heavy losses and the CRAR slipped to 1.95 per cent in March 2003. In April 2003, the bank received a proposal from a group of investors for the restructuring of capital through a rights issue and additional investment from Bank of Muscat, which was leaving Indian operations. The restructuring went through, and the bank achieved a CRAR of 9 per cent by September 2004. Later, Centurion Bank merged with another new private sector bank, Bank of Punjab Ltd, in October 2005 to become Centurion Bank of Punjab (CBP). In September 2006, the two boards of Lord Krishna Bank Ltd (LKB), which was under the directions of the Reserve Bank, and CBP, approved a voluntary merger plan, but a shareholder challenged the plan in the Kerala High Court. The employees of LKB in Kerala went on strike, and political leaders from Kerala represented to the Reserve Bank their dissatisfaction with the plan and preference for a merger of LKB with a public sector bank. The petition, however, was dismissed by the High Court, and the merger went through in 2007. Subsequently, in 2008, CBP merged with HDFC Bank. 399

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the reserve bank of india The development finance institutions (DFIs) were keen to reverse merge with the banks that they had set up. The DFI model was becoming obsolete for several reasons. The ICICI Bank approached the Reserve Bank in October 2001 with an application for the reverse merger of ICICI Ltd. The merger was approved on 26 April 2002. IDBI was converted into a commercial bank through a Parliamentary Act and without the issue of Reserve Bank licence. In terms of the provisions of the IDBI (Transfer of Undertaking and Repeal) Act, 2003, a new company in the name of Industrial Development Bank of India Limited (IDBI Ltd) was incorporated as a government company under the Companies Act on 27 September 2004. Thereafter, the undertaking of IDBI was transferred to and vested in IDBI Ltd from 1 October 2004 (see Part II). In the following year, the scheme of the merger of IDBI Bank Ltd with IDBI Ltd came into effect. In 2006, loss-making United Western Bank merged with IDBI Ltd. The name was changed to IDBI Bank in May 2008. The board of SBI approved the proposal for merger of State Bank of Saurashtra (SBS) with SBI in August 2007, and the board of SBS also approved the merger. The Reserve Bank suggested a few changes to the draft scheme, which were incorporated. The acquisition was officially notified by the government in August 2008. The failure of GTB and its merger with Oriental Bank of Commerce is of a different order and discussed in Chapter 11.

Branch Authorisation and ATMs Branch Authorisation

The BR Act restricts banks from opening branches without the Reserve Bank’s permission. Though the word ‘licensing’ is not present in Section 23 of the Act, the Bank had been using the term ‘branch licensing’ until 2005. Its branch licensing policy in the immediate post-nationalisation period emphasised the extension of banking services to rural centres. In the 1980s and 1990s, the policy was restrictive on the opening of branches in cities and was still in favour of rural and semi-urban areas. The policy during the reference period changed and gave banks more freedom to use their commercial judgement in opening new branches. The Reserve Bank considered proposals on merits, taking into account the overall financial position of the bank, quality of its management, its internal control system, profitability, and availability of other banks in the area. The Narasimham Committee I had recommended the 400

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regulation of the financial system abolition of ‘branch licensing’, and banks wanted this, too, but the policy did not go that far.63 With the spread of ATMs, this piece of regulation had outlived its utility. In 1994, banks were given freedom to install off-site ATMs except that they were required to obtain from the Bank an ex post facto licence after installation, to comply with the Act. In 1995, freedom to open branches was given to banks, which met a set of criteria relating to CRAR, NPA and profitability. Only three nationalised banks met the criteria. However, those three banks opened as many as 536 branches in three to four years and risked their profitability and internal controls. Since such speed of branch expansion was not safe, the freedom given to the three banks was withdrawn. Similar cautionary observations were made also about branch expansion in private banks.64 The permissible number of new branches, however, was to depend on the rating of the bank. On 14 November 2002, the IBA in a letter sought more flexibility to banks to rationalise their branch networks. The Reserve Bank responded that the present system was flexible enough, but the IBA insisted on a review. When suggestions were sought from banks before the Annual Monetary Policy Statement for 2004–05, they wanted ‘the entire issue of opening branches could be left to the banks’. The Reserve Bank tended to be conservative not only on branch licensing but also on ATM licensing. Internal discussions showed that banks opened ATMs driven by competition alone and without due regard to cost–benefit considerations. The case was put up before Deputy Governor Udeshi, who convened a meeting of STACFR to review the branch licensing policy. In the meeting, in October 2004, bankers favoured more freedom to open ATMs and branches, whereas the Reserve Bank executives favoured a more cautious policy. P. J. Nayak, member, and Chairman of UTI Bank, observed, ‘[T]he definition of place of business needs to be re-examined. Physical branch presence is not the only channel today for customer interface, door-step banking, call centres, and internet banking should be considered as a relationship/distribution function in the modern context.’ Another member suggested that the BR Act should be amended to expand the scope of banking. The response from the Bank was the issuance of a new branch licensing policy in 2005. Several other related issues were also considered during these years, and on several of these the Bank took a cautionary stance.65 The Bank’s caution reflected the fact that a new policy was on its way after a new Governor took office in 401

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the reserve bank of india September 2003. The Revised Branch Authorisation Policy was announced in September 2005. For the first time, the word ‘licensing’ was not used in the circular. By the new rules, banks were required to send their detailed plans for opening branches to the Reserve Bank to obtain aggregate approvals on an annual basis. A ‘branch’ would include a satellite office, an extension counter, off-site ATM, service branch or an administrative office. Soon after the revised policy was announced, the Reserve Bank began to receive Annual Branch Expansion Plans from banks. The Reserve Bank held discussions on the banks’ Basel preparedness, the status of a compilation of know-your-customer (KYC) and anti-money-laundering norms (see later), financial parameters, quality of customer service and measures to promote financial inclusion. Banks were still not happy. The promised freedom was seen, by one nationalised bank, as ‘illusory’. In response to views like these, in December 2005, the Governor approved certain operational flexibility, and this was followed in January 2006 by revised guidelines. According to the revised policy, instead of individual licences, a consolidated letter of authorisation or permission would be issued to meet the requirements of the BR Act. More freedom was given to banks for shifting of branches, subject to conditions, and conversion of specialised branches and extension counters to full-fledged branches. The Bank adopted a more liberal approach to branch licences in underbanked areas. However, a letter from the Ministry of Finance of 26 May 2006 stated that ‘some visiting foreign dignitaries have indicated to the senior officials in government that in some cases the applications of foreign banks for opening of branches in under-banked areas are not being approved by RBI’. After further reminders, the Bank responded that the applications concerned happened to be for opening branches in under-banked areas in close proximity to a big city.

ATMs The media commented on the Bank’s role with ATMs in a generally negative light.66 On 29 September 2006, the Finance Minister had an unusual meeting with the Governor to discuss pending applications for opening branches and ATMs. In a follow-up, the Secretary to the Ministry of Finance wrote to the Deputy Governor (17 October 2006) specifying the dates for disposal of all applications by the Bank (see Appendix 10A.1.2) The Bank did not adhere to the prescribed deadlines. 402

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regulation of the financial system The controversy boiled down to the definition of a branch. The IBA in a letter to the Bank requested that ‘offsite ATMs, extension counters, satellite offices, service branches, credit card centres, and administrative offices to be excluded from prior authorization and might be allowed by way of post-facto reporting to RBI’. But the Bank would not agree with this proposal because, in the interpretation of its Legal Department on Section 23 of the BR Act, all outlets and offices were counted as branches. The Annual Branch Expansion Plans submitted by banks for 2007–08 were not taken up for approval ‘as the progress in opening of branches/ ATMs in respect of authorizations issued against the previous year’s plans was not satisfactory’. Banks were advised to complete the actual opening of branches for which approvals had already been given. When the case was put up to the Governor, he noted that annual plans need not be kept in abeyance for this reason. The ATM controversy continued into 2007–08. Already, banks had been trying to use ATMs for a range of marketing services. For example, there was keen interest among banks that had incurred sizable capital expenditure in installing ATMs to use them as a kiosk to provide services such as mail facility to banks, utility payments such as power and phone bills, and product information to their customers. But the Reserve Bank, when approached, was not willing to give permission. A new generation private sector bank and a foreign bank, which had set up a large number of ATMs, approached the Reserve Bank in 2001 to allow flashing of third-party advertisements in ATMs, while the customers’ transactions were being processed. The Reserve Bank did not agree and issued a circular to banks in January 2002 that advertising was not a permitted activity. In October 2004, a new generation bank wanted to arrange for cricket scores, horoscope and movies to be shown on ATMs. The Reserve Bank turned down the suggestion. Some public sector banks, partnering with Indian Railways, wanted to install ATMs in major railway stations, which could also issue railway tickets. The Reserve Bank’s Legal Department came back (April 2001) stating that ‘banks cannot engage in selling railway tickets’. The BR Act expressly forbid banks from selling goods. The Department of Information Technology pushed the scheme. In 2005, the Legal Department offered the modified view ‘that railway tickets cannot be classified as goods/movable property as envisaged under Section 8 and therefore the prohibition provided under said Section is not attracted in issuing railway tickets by the banks’. 403

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the reserve bank of india

Policy on Cross-Border Branch Authorisation Since 1972, it had been a convention (not legally binding) that opening of overseas branches by Indian banks would be referred to the government, as it had geopolitical implications. The interdepartmental committee referred to earlier in this chapter investigated applications from public sector banks for opening of branches abroad, apart from dealing with applications of foreign banks to open branches in India. The Reserve Bank prepared guidelines for the opening of branches by foreign banks in India and also Indian banks abroad and sent them to the government in February 2005. It sought to simplify the procedures and speed up the clearance. The policy for the opening of branches abroad was further rationalised in 2006–07. A Comprehensive Economic Cooperation Agreement was signed between the Governments of Singapore and India in June 2005. In terms of the agreement, India would allow three Singapore-based banks to open fifteen branches in India over four years. In turn, Singapore would grant Qualifying Full Bank licence to two Indian banks in Singapore. The Agreement did not mention the conditions set by the Reserve Bank and the Monetary Authority of Singapore, and therefore correspondence and negotiations began, which continued until the end of the reference period.

Know-Your-Customer Norms and Anti-Money-Laundering Standards To discuss steps to prevent criminals from utilising banks and financial institutions, in 1999, the Bank formed a working group.67 The report recommended setting up an agency that would collect information from banks and store in a database. In September 2000, the Bank suggested to the government that a technical group should design an institutional framework for inter-agency cooperation in this field. However, this was not done. The 9/11 incident in 2001 prioritised the issue for the government and the Bank. Until then, anyone could open an account with a bank in India on the strength of an ‘introduction’ by another customer of the bank or the bank staff. There was no need to produce any document to the bank to establish one’s identity. This practice now came into question. In December 2001, the Bank forwarded a list of suspected organisations (received from the government) and advised commercial banks to keep a watch on the transactions of the listed organisations and report to 404

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regulation of the financial system appropriate authorities. In March 2002, an Internal Coordination Committee on Prevention of Money Laundering and Financing of Terrorism was constituted. The Governor had an internal meeting in June 2002 to discuss the role and responsibility of the Bank in dealing with money laundering and financing of terrorism. Thereafter, the Reserve Bank issued guidelines to banks in August 2002 on the customer identification procedure for opening accounts, monitoring transactions of a suspicious nature and reporting them to the government. As part of the process, the Bank conducted trial runs of the system and formed an illustrative list of suspicious transactions. Banks were advised to upgrade their computer software to enable automatic reporting of transactions above a certain limit and to make cheque transactions mandatory for large remittances and transfers. In January 2003, the Prevention of Money Laundering Act (PMLA), 2002, was enacted. On the Reserve Bank’s insistence, a new set of rules were framed for the banks to follow, in view of the provisions of the Act.68 The introduction of KYC norms was a major element of the new rules. KYC consisted of a set of identity documents every bank account holder needed to furnish. The norms led to complaints from bank customers of harassment, in view of which banks were advised (in 2003–04) to ‘exercise care’, not to insist on unnecessary information, respect the privacy of the customer and maintain confidentiality. A further set of guidelines was issued in November 2004 based on international standards and domestic legislation. In November 2004, the government set up the Financial Intelligence Unit–India as an independent body and as the central national agency for receiving and processing data on suspicious financial transactions. Banks were to report suspicious transactions to this agency. The KYC and other guidelines and standards were extended to the NBFCs and financial institutions regulated by the Bank in January 2004 and May 2006. Provisions, however, were made of a simplified procedure for small-value accounts.

Deregulation of Credit Regime In line with the Reserve Bank’s policy to give operational freedom to banks in the matter of credit management, between April and December 1997, the Reserve Bank withdrew the numerous instructions relating to maximum permissible bank finance (MPBF), guidelines on the mandatory formation of a consortium of lenders, and Credit Monitoring Arrangement.69 Quantitative 405

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the reserve bank of india ceilings on bank credit to NBFCs were also withdrawn in May 1999. The Reserve Bank began to focus instead on macro-level policies on credit to industries, exports and housing. Among new areas of focus, infrastructure, bill discounting, mortgage guarantee, forward markets and derivatives assumed special importance.

Infrastructure In September 1997, the ceiling of 5 billion for term loans by banks for a single infrastructure project and 10 billion for power generation projects was dispensed with. During the meetings that the Governor had with the chairmen of select banks and financial institutions in 1999 and 2000, financing infrastructure and coordination between banks and financial institutions in this field were discussed. In 2002, a group of officials from different departments attempted to define the term ‘infrastructure’ and frame prudential norms for infrastructure financing. In February 2003, new guidelines on infrastructure lending by banks covered the definition, financing criteria and risk weight for securitised paper, among other issues. Banks could (from June 2004) raise long-term bonds with a minimum maturity of five years, to the extent of their lending to the infrastructure sector. The definition of ‘infrastructure lending’ was expanded in November 2007 to include projects involving oil and gas pipelines and their maintenance. The asset classification norms were rationalised in March 2007 and, in response to representations made in respect of delayed completion of projects, the asset classification norms were further modified in March 2008.

Mortgage Guarantee Companies Banks and housing finance companies that lent against mortgages would benefit if the mortgage was guaranteed by a three-way contract among borrower, lender and guarantor. A working group was set up in December 2003 jointly by the Bank and the National Housing Bank (NHB) to suggest a regulatory framework to enable such guarantee. The NHB proposed to promote an India Mortgage Guarantee Company in 2006. But who should regulate mortgage guarantee companies? There was a case for the Bank to regulate them since mortgage guarantee was linked to credit expansion and credit quality. Accordingly, in 2007–08, mortgage guarantee companies were 406

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regulation of the financial system included as a separate category of NBFC under Section 45 of the Reserve Bank of India (RBI) Act. Towards the end of the reference period, the Bank was evolving a separate regulatory framework for these companies taking into account the lessons of the subprime crisis. The government wanted the NHB to examine the possibility of introducing reverse mortgage loans – one in which the owner relinquishes equity in the property in exchange for regular payments. The scheme would provide for refinancing and guarantee to banks and housing finance companies for reverse mortgage loans to be extended by them. A few major banks came up with schemes to grant such loans to the targeted group. There was, however, a legal obstacle to this. As IDBI Bank pointed out, the BR Act did not encourage banks to acquire property except for administrative purposes. As expected, the response from banks was lukewarm.

Derivatives To hedge interest rate risks, in July 1999, the Reserve Bank allowed banks and financial institutions to undertake forward rate agreements and interest rate swaps. Exchange-traded interest rate derivatives were permitted from June 2003. Final guidelines on derivatives (other than forex derivatives) were issued in April 2007. In 2002, the Forward Markets Commission (FMC), set up under the Ministry of Consumer Affairs, Food and Public Distribution, asked the Bank to permit banks to participate in commodity derivative markets. Trading in equity-based or commodity derivatives by banks was not permitted under Section 6(1) of the BR Act. While banks in India offered hedging products to corporates in foreign exchange and money markets, products to hedge commodity price risk were not offered. Some private banks had approached the FMC to take up the matter and push for necessary amendments to the BR Act. An informal group in the Bank deliberated on the proposal. Pending amendment to the BR Act, in 2003, the Coffee Board under the Ministry of Commerce was permitted to hedge price risk on behalf of coffee growers through a price insurance scheme. A public sector bank acted as a facilitator to the arrangement. A major shipping company was also allowed to cover freight risk in a similar manner. A public sector bank sought permission in February 2004 to participate in commodity trading transactions of Multi Commodity Exchange of India Ltd by becoming an institutional trading-cum-clearing 407

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the reserve bank of india member. The National Commodity and Derivatives Exchange Limited wanted a regulatory framework that allowed banks to become members of commodity exchanges. In the backdrop of these developments, the mid-term review of the Annual Monetary Policy 2004–05 announced setting up of a working group to examine the role of banks in providing loans and advances against warehouse receipts and evolving a framework for the participation of banks in the commodity futures market.70 While the draft report recommended participation, a notification under the BR Act was required to make it effective. At the end of the reference period, the Bank was in correspondence with the Ministry of Finance on the matter. The Annual Policy Statement for 2007–08 mentioned that as a part of the process of financial sector liberalisation, it would be appropriate to introduce credit derivatives in a calibrated manner. Despite some progress in discussions, after the financial crisis of 2007–08, the matter was shelved.

Mortgage Debt and the Global Crisis In November 2003, the NHB sent a proposal for securitisation of residential mortgage debts. Securitisation is a process by which assets are sold to a special purpose vehicle (SPV) in return for an immediate cash payment. Recognising the need to provide Indian banks the option to securitise their assets such as housing loans, the Bank set up a group in May 2004 to create the draft rules on asset securitisation.71 The report observed that unregulated securitisation activity was already taking place. Asset-backed securities and mortgagebacked securities were being issued by trusts.72 These securities did not come under the scope of SEBI or the Reserve Bank. The banks were active in the market both as originators and as investors. The move by Governor Reddy to frame regulatory measures drew an adverse response from the press.73 But the attempt to frame appropriate rules on securitisation continued. The final guidelines were issued in February 2006, which covered the true sale of assets by the originator, criteria to be met by the SPV, credit enhancement facilities to be provided to the SPV, provision of liquidity support, and underwriting facilities. The Bank was again criticised by market players for its conservative approach, specifically for the restriction on immediate profit recognition. It was only later, after the global financial crisis of 2007–08, that the Bank’s caution in the matter was appreciated. 408

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regulation of the financial system By insisting on adequate risk assessment and provisioning, the Bank had slowly but steadily built up firewalls against the financial crisis. Hindsight revealed that the Indian financial system was less susceptible to the global credit market crisis due to the relatively small exposure to non-transparent and structured financial products. A study undertaken by the Bank on the impact of the subprime crisis on Indian banks revealed that the limited overseas exposure of Indian banks comprised credit default swaps, credit-linked notes, collateralised debt obligations, commercial papers, and asset- or mortgagebacked securities. Fourteen banks had reported exposures to Lehman Brothers and its related entities either in India or abroad. Only one private sector bank had a mark-to-market loss of 3.60 billion. Other banks had negligible losses. Of the two Lehman group entities operating in India, Lehman Brothers Fixed Income Securities, operating as a primary dealer, had settled all outstanding interest-rate swap transactions with the counter-parties in India. Further, its entire assets were found to be sourced out of its equity with no borrowings from the market. The other one, Lehman Brothers Capital, registered as an NBFC, had not raised funds in India.

Miscellaneous Regulatory Issues

Para-Banking Activities/Bank Subsidiaries Para-banking activities would include bank participation in mutual funds including money market mutual funds, merchant banking, insurance, credit cards, factoring, derivative trading and funds management. Early in the reference period, banks showed keen interest to enter these areas. In July 1999, the Reserve Bank reminded them that they should not do so without ‘specific approval’. As Governor Jalan observed, with public sector banks, the Bank had a special responsibility to ensure prudence before approving any risk-based new business. Commercial banks were free to undertake activities like equipment leasing, hire purchase business, factoring services, money market mutual funds, and underwriting shares and debentures without the Reserve Bank’s prior approval. In other words, banks were free to undertake these activities departmentally (that is, by the bank itself and not through another entity established by the bank). But if they were to set up a separate subsidiary or invest in the equity of a joint venture to undertake the same para-banking activity, then banks had to obtain permission from the Reserve Bank. 409

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the reserve bank of india In 2000, the government at the instance of the Bank notified ‘insurance’ as a form of business which a bank could engage in. In August 2000, the Bank issued guidelines to banks to act as agents of insurance companies with prior approval for distribution of insurance products without risk participation. Later, the restriction was withdrawn but banks were still prohibited from undertaking insurance business departmentally. According to the Bank guidelines, the maximum equity contribution a bank can hold in a joint venture with a foreign company would ‘normally be 50 percent of the paid-up capital of the insurance company’, allowing for flexibility on a selective basis. The government considered the limit too high, in view of prescribed limits in the BR Act, and the provision to relax norms on selective basis inappropriate. The matter was subject to discussion during the next three years. Meanwhile, the Bank received applications from thirty banks for entry into the insurance business through joint ventures, on a risk participation basis, as a strategic investment, or as an agency business. Except for a few cases, approvals were granted, subject to certain criteria being met. In 2002–03, the Reserve Bank allowed banks to undertake referral business, through their network of branches. That is, insurance companies could sell their products to banks’ customers, and banks would earn referral fees on the basis of the premia collected.74 The department came out with a proposal to grant general permission with stringent conditions. On further intervention from Deputy Governor Udeshi, the conditions were relaxed. It transpired later that some banks were disclosing customer profile information to insurance companies with whom they had referral arrangement without the consent of the customers. In 2004, a group went into the question of customer confidentiality, and in May 2004, fresh instructions were issued to banks in this matter. All mutual funds were regulated and supervised by SEBI. The money market mutual funds, which were initially governed solely by the Reserve Bank, were also brought under the purview of SEBI regulations in April 1998. Thereafter, on a few issues where the mutual funds wanted reform of regulation – such as removal of the restriction on lending in call and term money market, participation in repo auctions, and third-party cheque writing – the Bank and SEBI needed to discuss matters jointly. These discussions did not always end in agreement. Many public sector banks launched mutual funds through subsidiaries. Some of them promised ‘assured returns’. Most had been launched before 1993. 410

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regulation of the financial system Thereafter, regulatory control shifted from the Reserve Bank to SEBI, and the subsidiaries did not need to seek the Reserve Bank’s approval to sponsor schemes with assured returns. As the boom in the stock market ended, they were unable to pay up the assured return. SEBI insisted on payment, forcing the parent banks to step in and undertake a heavy financial burden as a result. Reviewing this disaster, the Standing Committee on Finance (SCF) on Demands for Grants (Ministry of Finance) in its sixth report recommended that bank-sponsored mutual funds should not be allowed to float assured return schemes. SEBI has since disallowed assured return schemes. Credit card was another business the banks were keen to enter. In June 1998, banks were permitted to issue credit and debit cards either independently or in tie-up arrangements with other card-issuing banks without the Reserve Bank’s prior approval. Banks needed prior approval of the Reserve Bank only for setting up a subsidiary to issue cards. In 1999, prudential norms were announced for the card issuer. Meanwhile, business boomed. By March 2000, public sector banks had issued 1.06 million credit cards, and foreign banks had issued 2.38 million cards. Clearly, the Reserve Bank needed to step in with safeguards. In October 2000, it became necessary for banks to have a minimum net worth of 1 billion to be eligible for the business. Later, the Reserve Bank waived this condition for debit cards. In 2001, following a review and discussion with stakeholders, additional safeguards were announced. Following receipt of complaints from card users about levy of unconscionably high rates of interest and charges, a meeting of card-issuing banks was convened in December 2004. Subsequently, some progress was made towards prioritising customer complaints and evolving a code of conduct. In the aftermath of the securities scam of the early 1990s, no bank was permitted to offer portfolio management services to its constituents. However, ten banks were permitted, on application, to offer non-discretionary investment advisory services without acceptance of funds and without guaranteeing customers any return on their funds. In the non-discretionary type, the decision to invest the funds remained with the client. Actual investing was done by the bank along with the provision of transaction support, besides custodial services for the securities. Banks designated these services as ‘private banking’ and ‘wealth management services’. In the case of portfolio management services, banks accepted funds from customers and parked them in a nominal account, the client’s account, whereas, in the case of investment advisory services, the funds remained in the customer’s account. 411

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the reserve bank of india In 2005, when a foreign bank’s proposal to offer private banking services was put up to the Governor, he ordered a review of all such services and regulatory provisions. An internal group on Investment Advisory Services studied the issues and concluded that there were no regulatory concerns and, therefore, the existing practice might continue. The proposal was passed in May 2005. After opening up the insurance sector, the government wanted to open up the pension market as well. It asked the Insurance Regulatory and Development Authority of India (IRDAI) to suggest a scheme especially suitable for those in the unorganised sector. Pension business was so far treated as part of the life insurance business in India, and Life Insurance Corporation of India was the sole provider of pensions. While discussions with banks and the IRDAI continued, the government of India issued the Pension Ordinance in December 2004 and the Pension Fund Regulatory and Development Authority (PFRDA) was set up in January 2005 to regulate the new system. The PFRDA was authorised to grant a licence to pension fund managers, subject to eligibility criteria. When this was discussed in the Bank, the Legal Department said that pension fund management was not a permissible form of business for banks to undertake in terms of the BR Act. However, opinion within the Bank was in favour of entry of banks into this low-risk business. In March 2005, the Bank conveyed to the government its decision to allow banks to act as pension fund managers and requested the government to notify it as a permissible activity under the BR Act. The eligibility conditions, however, were subject to further discussion until draft guidelines were finally issued in May 2007. Later, three banks were accorded permission to set up subsidiaries for undertaking pension fund management. In August 2006, the Reserve Bank issued prudential norms on banks’ investment in venture capital funds (VCFs). Banks needed to obtain prior approval for making a strategic investment in VCFs, that is, in excess of 10 per cent of the equity or unit capital. As a matter of policy, the Bank granted approvals to banks to invest in VCFs, subject to the ceiling of 10 per cent of the bank’s capital and reserves. All exposures to VCFs would be deemed to be on par with equity and, hence, would be within the ceiling fixed for capital market exposure. The exposure to VCFs had to be assigned a risk weight of 150 per cent. In February 2002, Deputy Governor Kamesam wrote to the Ministry of Finance with a proposal for setting up offshore banking units (OBUs) by banks 412

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regulation of the financial system in SEZs. The Bank wanted to treat OBUs on a par with the overseas branches of Indian banks in the matter of reserve requirements. The government accepted the proposal. These units would be exempt from maintaining CRR and SLR and were expected to provide finance to units in SEZs at global rates. The sources of foreign currency funds would be external and the balance sheet would be in foreign currency. The Bank would be the sole regulator. It accorded ‘in principle’ approval to ten banks (eight public sector and two private sector) for setting up fourteen OBUs, of which 90 per cent were to be located in Mumbai. In due course, only six banks (five public sector and one private sector) operated seven units in three SEZs. They were not doing good business. Banks felt that the Reserve Bank norms were too restrictive, but the Reserve Bank did not relax the norms.

Amendments to the BR Act and RBI Act Finance Minister Yashwant Sinha in his Budget speech for 2000–01 announced a plan to amend the BR Act to give the Bank more operational flexibility in the regulation of the financial system. The Bank submitted a draft of these amendments to the Ministry in May 2001. The amendments addressed avoidance of connected lending by banks, licensing of bank acquisitions, the power to supersede the board of a bank when potentially dangerous decisions had been taken, consolidation of accounts and inspection of subsidiaries, among others. The RBI (Amendment) Bill, 2001, was also drafted, following the recommendations of the Narasimham Committee II, but it was not presented to Parliament and was later replaced by the Amendment Bill, 2005. In a draft Cabinet Note (August 2001) on the proposed amendments to the BR Act, the government mentioned specifically the need to address the problem of dual control over cooperative banks, by state governments as well as by the Bank. On 28 January 2003, the Bank wrote to the Ministry of Finance recalling the recommendations of the Joint Parliamentary Committee for more powers to the Bank to remedy the problem (also see Chapter 11). A revised draft Amendment Bill sent to the government in March 2003 became the basis for the Banking Regulation (Amendment) and Miscellaneous Provisions Bill, 2003, tabled in Parliament in August 2003. During the discussions, the Bank submitted a note on the rationale for amendments to have uniform application of the provisions of the BR Act to both commercial and cooperative banks. State governments were up in arms against the proposal. The convention of State Ministers for Cooperation, held in Kolkata on 17 413

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the reserve bank of india December 2003, passed a resolution demanding the withdrawal of the Bill. The Chief Minister of Odisha wrote to Finance Minister P. Chidambaram in June 2004 expressing concerns about the impact of the proposed amendments on cooperative banking in his state, in particular, the introduction of higher entry-level norms for cooperative banks and provision of powers to the Reserve Bank to remove the management of cooperative banks. The Chief Ministers of West Bengal and Bihar wrote similar letters. In July 2004, the Ministry wrote to the Bank urging a rethink on the controversial provisions. In April 2005, the Bank forwarded to the Ministry revised drafts of the Banking Regulation (Amendment) Bill, 2005, and the RBI (Amendment) Bill, 2005. They were introduced in the Lok Sabha in May 2005 and were referred to the Standing Committee on Finance (SCF). The first Bill contained new provisions for the Bank to enforce measures ensuring the prudent functioning of banks and financial institutions, among other interventions. The second Bill provided for removing the ambiguity in the legality of over-the-counter derivatives and covered repo transactions, money market and CRR. The SCF gave its reports on both Bills in December 2005. However, the BR (Amendment) Bill, 2005, was allowed to lapse, and only the RBI (Amendment) Act, 2006, was passed by Parliament in May 2006. The subsequent Banking Regulation (Amendment) Ordinance, 2007, had only two amendments. One of the changes was that the prescriptions of minimum SLR of 25 per cent and the type of assets to be held were dispensed with, giving flexibility and freedom to the Bank to specify such assets. The other significant change enabled the setting up of banking units within SEZs. The Ordinance was later replaced by the BR (Amendment) Act, 2007.

Statutory Reserve, Accounting Standards, Data Sharing, Tax Issues and Regulatory Overlap In several specific areas, the Reserve Bank exercised its regulatory powers to improve the health and capability of banks. One of these occurred in respect of the statutory reserves banks maintained to meet contingencies. With effect from March 2001, the Reserve Bank stipulated that not less than 25 per cent (as against the statutory minimum of 20 per cent) of net profits should be transferred to reserves every year. Between 1997 and 2003, certain banks were allowed to draw down part of such reserves to meet provisioning requirements and, thereby, avoid posting net losses in their profit and loss accounts. 414

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regulation of the financial system The BR Act allowed banks to appropriate sums from the statutory reserve fund with only ex post facto reporting to the Bank. It was observed that some banks appropriated and utilised these funds for purposes like writing off of NPAs and for making fresh provisions for NPAs. Banks were, therefore, advised in September 2006 to take prior approval from the Reserve Bank before any appropriation was made.75 To facilitate the adoption of international financial standards, the Reserve Bank, in consultation with the government, formed a standing committee.76 The committee identified action points and disseminated the information and the proposed actions widely. India was one of the countries requested to help the Financial Stability Forum in the Task Force on the Implementation of Standards. The Bank was also represented in the follow-up Group on Incentives for Implementation of Standards instituted by the Forum following the submission of the task force report. During the reference period, the Bank set up several committees to study accounting norms.77 The process of convergence between Indian practice and international best practices, however, was slow, and subject to continuous dialogue between the Bank, the FEDAI, the Financial Stability Forum, the Institute of Chartered Accountants of India (ICAI), the IBA and of course, the banks themselves. The Income Tax Department and the government investigating agencies sometimes needed information from commercial banks on specific clients. Sharing of information was, however, bound by a secrecy clause. The Reserve Bank advised banks in February 1998, outlining their obligation to maintain secrecy as part of the contractual relationship with their customers while furnishing such information under different statutes. Banks were advised not to respond to ‘fishing and roving enquiries’ from the Income Tax Department and enforcement agencies. In March 1999, Deputy Governor Talwar wrote to the Finance Secretary suggesting that a technical group should look into the principles of data sharing. The Ministry at first did not respond. On pursuing the matter, in 1999, the government advised that the Reserve Bank should ask banks not to disclose information in response to general enquiries. In 2000–02, income tax authorities complained that bank customers split and transferred their deposits to different branches to avoid tax deduction at source (TDS). The Reserve Bank observed that the practice did not violate any law, nor were the banks actually assisting the practice, effectively refusing to intervene. 415

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the reserve bank of india In May 1998, Governor Jalan wrote to the Finance Secretary suggesting that, in line with the recommendations of the Narasimham Committee II, the government might increase the ceiling of deduction of general provision against NPAs from the taxable income of banks. An amendment to the Income Tax Act was accepted by the government in this regard. Some other areas that saw reform and discussions between the banks and the Reserve Bank were the declaration of dividends, voluntary retirement scheme of banks, outsourcing of services, rationalisation of regulations and gold-related issues. Of these, gold and regulatory overlap issues deserve longer treatment. Under the Gold Import Authorisation Scheme, the Reserve Bank had been authorising banks (called ‘nominated banks’) to import gold for sale to jewellery manufacturers, exporters and domestic users. The nominated banks were advised in December 1998 that gold loans should be given only to jewellery exporters. Traders opened long-period usance letter of credit for import of gold. The sale proceeds, realised within a short period, were kept in fixed deposits with banks for opening further letters of credit. Therefore, in July 2004, the Reserve Bank reduced the maximum usance period for import of gold to ninety days. In September 2005, banks authorised to import gold were allowed to extend gold metal loans to domestic jewellery manufacturers who were not exporters, subject to the tenor of the loan not exceeding ninety days and compliance with KYC requirements. In 2006, there were seventeen banks authorised (nominated) to import gold. The authorisations had to be renewed annually. In March 2006, with a view to enhancing competition, the Reserve Bank invited applications from banks with unimpaired total capital of 3 billion or more, and complying with certain other parameters, for being considered for authorisation to import gold. Banks reportedly imposed excessive interest and charges, particularly in respect of credit card dues. In 2007, the Monopolies and Restrictive Trade Practices Commission (MRTPC), an organ of the Ministry of Corporate Affairs, advised the Ministry of Finance that several banks had violated the Reserve Bank’s guidelines on credit cards and action was taken against them by the MRTPC. The MRTPC had also released to the media the findings of its preliminary investigations without giving an opportunity to the banks to explain. The banks complained to the IBA, which reminded the Reserve Bank in August 2007 that ‘it is for RBI to decide whether there is a need 416

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regulation of the financial system for regulatory intervention’. When the Reserve Bank wrote to the Ministry of Finance in January 2008 on the overlap of regulatory powers between the MRTPC and itself, the Ministry replied that the MRTPC, being a judicial body, had the powers to investigate and adjudicate in such matters and that the banks should deal with the MRTPC. Clearly, this was not to the Bank’s liking, nor consistent with its interpretation of the law.78 In October 2003, the Competition Commission of India was set up, and banking and financial sectors were covered under the Competition Act, 2002. In a presentation before senior officers of the Reserve Bank in January 2007, the MRTPC members questioned the appropriateness of a range of restrictions, such as administered interest rates in a few sectors, branch licensing, SLR and priority credit, and uneven treatment of public, private and foreign banks, among others. The Reserve Bank responded that these restrictions reflected the Bank’s obligations under the BR Act to the depositors and in the public interest. The MRTPC did not pursue the matter. Box 10.1.2 Reflections on Regulation and Deregulation … RBI was much more control-oriented in my view than is consistent with giving a lead for an emerging, a growing capital market in the modern financial structure. 

Montek Singh Ahluwalia, economist

We have lost a lot of opportunities in developing our capital markets and I guess I would hold the RBI responsible for that; we have been very very conservative. 

Surjit Bhalla, economist

It is better not to move forward at all rather than step forward and then step back. In pursuing deregulation or liberalization policies, it is important therefore for the Governor to be sure, in the 99 percent confidence interval, that the policy will not be reversed. That I think contributes to conservatism. 

D. Subbarao, former Finance Secretary, and former Governor of RBI

... the Reserve Bank has badly failed in looking at the requirements of long-term finance for industry, or for manufacturing in particular. They allowed the development financial institutions (DFIs) to collapse. The policy of universal banking in this respect was a disastrous step. The RBI did not think in terms of providing an alternate source of finance for the industry. The bond market has not developed nor was it capable of closely evaluating large projects for their healthy promotion.  S. L. Shetty, economist 417

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Conclusion The history of banking regulation in India brings out the fact that even though the Reserve Bank was the regulator of banks, in practice, regulatory reform involved a carefully calibrated negotiation with the government. After all, the government owned by far the largest segment in the banking system. As the Competition Commission noted, public sector banks were advantaged in many ways, and both the government and the Reserve Bank were trying to level the field of competition between public and private banks. The general preference among people and public agencies for government-owned banks due to the implicit sovereign guarantee enabled them to out-price other banks in the market. On the other hand, these banks faced political interference, loan waivers, low staff productivity and active trade unionism. Despite this skewed playing field, private sector banks raised their share of deposits fast. Starting with a clean state, and with full computerisation of all branches from the start, these banks were better placed to introduce stateof-the-art technology, deliver better customer service and offer innovative products to meet the changing needs of bank customers. Their staff had a younger age profile and were more customer-friendly and less bureaucratic as decision-making was faster in these banks. Because of the need to coordinate steps with the government, the Bank’s stance may appear to be overly conservative and cautious at times (see Box 10.1.2). And yet regulations and wide-ranging reforms were undertaken during the reference period, and these did produce significantly positive results. One indication of this was the limited impact that the 2007–08 subprime crisis had on India. More substantially, by all performance indicators, commercial banks improved their performance during the period.79 Notwithstanding this improvement, intervention could do more to encourage financial innovation and competition. The reforms delivered but left scope for further improvement.

Notes 1. Such as payment of travelling and halting allowances and sitting fees to board members of banks, acquiring and disposing of immovable property by banks, rent and rent advance payable to the landlords of bank premises, induction of members to local advisory boards by foreign banks, remittance of profit by foreign banks, issue of bonds eligible to be reckoned as Tier II capital, 418

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2. 3. 4.

5. 6. 7.

8. 9.

10.

11. 12.

and donation by banks for social and charitable purposes up to 1 per cent of previous year's profits. Chairman: T. R. Andhyarujina, former Solicitor General of India. At 10 per cent of banks’ net demand and time liabilities in March 1997, and stood at 7.50 per cent by March 2008 (see Chapter 3). Refers to essentially public deposits. To 25 per cent in October 1997 (from 31.5 per cent fixed in October 1994), which was the floor rate as per the statute and remained at 25 per cent until March 2008. In practice, banks maintained a much higher level of SLR (except between 2004 and 2007). The ceiling and floor rates for the CRR and the floor rate for SLR were removed (retaining the SLR ceiling rate at 40 per cent) by carrying out amendments to the Reserve Bank of India (RBI) Act and the Banking Regulation (BR) Act in 2006–07. Chairman: H. N. Sinor, Chief Executive of the Indian Banks’ Association (IBA). Bimal Jalan, Inaugural speech at the Conference of Bank Chairmen, National Institute of Bank Management, Pune, 6 January 2000. In February 1999, the Bank assessed the capital requirement of public sector banks for the next six years (1999–2004), based on the trend in the growth of risk-weighted assets and retained earnings, and sent it to the Ministry of Finance. Basel norms refer to norms for managing risks, issued by the Basel Committee on Banking Supervision (BCBS), a body established by leading central banks. Basel I refers to a set of norms announced in 2004. In February 2000, a working group (Chairman: A. Ghosh) set up to examine the proposals of the Basel Committee on Banking Supervision (BCBS) on the New Capital Adequacy Framework (NCAF) submitted its report recommending the modalities for implementing the Framework. In the same year, the Bank wrote to the government suggesting amendments to the statutes, to enable banks to issue perpetual non-cumulative preference shares (Tier I) and perpetual redeemable cumulative preference shares (Tier II). Banks were later required to provide capital for market risks for investments, held in HFT category from March 2005 and in AFS category from March 2006. The group relied mainly on International Accounting Standard (IAS) 39 (which sets out the principles for recognising and measuring financial assets and financial liabilities). In October 2005, its report was sent to the Institute of Chartered Accountants of India (ICAI) for comments. In July 2006, the draft guidelines, modified after taking into account the views expressed in the STACFR meeting, was sent to all banks for feedback. Another internal group developed guidelines for derivatives accounting. The group submitted 419

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13. 14. 15. 16.

17. 18.

19.

20. 21.

its proposals in June 2006, which were largely based on the principles of IAS 39. Subsequent to the subprime crisis in the USA, IAS 39 came in for criticism and, therefore, this matter remained unresolved until the end of the reference period. The group found that the offer documents for private placement had varying disclosure levels, limited company information and no auditors’ comments. These covered regulatory requirements, rating and listing requirements, prudential limits, internal assessments, role of boards, disclosure, and trading and settlement in debt securities. Including equity-oriented mutual funds, venture capital funds, CP, certificates of deposit (CDs) and investments in security receipts of asset reconstruction companies (ARCs). Such lending on a fortnightly average basis should not exceed 50 per cent of owned funds (paid-up capital plus reserves) as at the end of the previous financial year. The ceiling was reduced to 25 per cent in December 2002. Further, call borrowings by scheduled commercial banks were not to exceed 100 per cent of their owned funds or 2 per cent of aggregate deposits, whichever was higher. Chairman: S. Gurumurthy. The relationship between asset–liability management and the credit–deposit ratio may need a clarification. The mismatch in assets and liabilities in banks was more often due to an abnormal credit–deposit ratio. After taking into account CRR and SLR requirements, the credit to deposit ratio should be around 65 to 70 per cent. If it is higher, there is a possibility of loans (long term assets) being funded by short-term borrowings (liabilities). Therefore, the credit–deposit ratio is an important variable in asset–liability management. Banks were advised in 1999 to set up an Asset Liability Management Committee. Statements of Interest Rate Sensitivity were to be sent to the Reserve Bank initially on a quarterly basis, and later on a monthly basis. Banks were allowed to undertake forward rate agreement and interest rate swap transactions to hedge their interest rate risk in their balance sheets. Further, in January 2001, Executive Director G. P. Muniappan met the heads of the old private sector banks to discuss areas of improvement in risk management. Based on the recommendations of two internal groups, guidance notes on risk management covering credit and market risks were issued (2001–02). Subsequently, a questionnaire-based survey to review the progress in the implementation of risk management systems by banks was carried out and the responses analysed. A joint technical committee reviewed bank financing of equity in May 2001 and revised instructions issued redefining aggregate exposure. Internal office noting put up to the top management of the Bank in May 2004. Roughly 85 per cent of the equity market was in the hands of day

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22. 23. 24. 25.

26. 27.

28. 29. 30.

31. 32.

traders and speculators who did not take possession of the stocks, traded on margins, and squared up the positions by end of the day. On individual and consolidated basis as on 31 March of the previous year. The definition of capital market exposure was widened by including advances for any other purpose for which shares and convertible debentures/bonds and units of equity-oriented mutual funds were taken as security. Subsequently the guidelines were slightly modified to include funds in the nature of capital which had accrued to banks after the last balance sheet date for arriving at exposure limits. Effectively, the new limits were 20 per cent and 45 per cent for single and group borrowers, respectively, and 25 per cent and 55 per cent for advances to infrastructure. With delegation of powers to banks’ boards, the number of references to the Bank for approval declined substantially. Of 1.40 billion and 2.40 billion and 2.50 billion for group exposure to infrastructure projects until March 2003 when the bank could achieve minimum capital adequacy norms. Some foreign banks had activities concentrated only on OBS business such as issue of guarantees, letters of credit and hedging products. Such banks were required to lend 40 per cent of credit equivalent amount of their OBS exposure to the priority sector. Chairman: S. Gurumurthy. The in-principle approval was given on the strength and reputation of Rabobank, Netherlands, which had expertise in agricultural lending. Since the Indian promoters’ equity in new private banks was restricted to 40 per cent, there was a concern that the liberal norms for foreign investment created an uneven playing field. In 2003, the Finance Ministry agreed to the Bank’s position, and capped foreign investment from all sources at 74 per cent. The Narasimham Committee II held a similar view. In May 2004, Deputy Governor Udeshi wrote to the Ministry that our internal review of the functioning of private sector banks, both old and new, reveals that when bank’s ownership is diversified either directly or indirectly, the supervisory concerns have been less. In this background, we are of the view that there would be no need for removal of the ceiling on voting rights as originally envisaged, at this stage.

33. Soon after issue of the guidelines, the Reserve Bank entered into dialogue with individual banks to ensure compliance. By May 2005, dialogues with nineteen private banks had been completed. In August 2005, private sector banks were further advised that they should report to the Reserve Bank the details of share transfers that had resulted in change of shareholding to the extent of 0.5 per cent or more of the bank’s paid-up capital whenever such transfers took place. The Bank did not like to be taken by surprise and wanted 421

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34.

35. 36. 37. 38. 39. 40.

41.

42.

to monitor the position so that pre-emptive action could be taken as soon as necessary. This advice to banks became necessary after the two depositories and SEBI expressed their inability to provide information on share transfers. Banks, however, found it difficult to report change in shareholdings as there were shares in both demat and scrip form. There were many queries from banks for clarification and guidance on the matter. The Reserve Bank’s policy was that the pricing of public issue of shares should not be less than the one determined according to the Controller of Capital Issues (CCI) formula and that preferential allotment of shares at preferential prices would be discouraged. Bonus issues could be decided by banks, provided they were issued along with public/rights issues. Two other old private banks proposed to allot preferentially 4.99 per cent and 4.80 per cent to the IFC in 2006 and approached the Reserve Bank for its acknowledgement of the allotment. The meeting was called by SEBI; other participants included the two depository companies and stock exchanges. The BFS directed in October 1999 that a group be set up with representatives from SEBI, the Reserve Bank, NSDL and Deutsche Bank. The depositories were Deutsche Bank Trust Company Americas and J. P. Morgan Chase Bank. Provided in Section 36 AB of the BR Act. Nominee directors were to be appointed only in cases of banks making losses for more than one year, having CRAR below 8 per cent, gross NPAs exceeding 20 per cent, and where there were disputes in management. In other words, the presence of a nominee director became an indication of some supervisory concern. It was further decided in September 2005 that barring one private sector bank, which had certain management issues, nominee directors from all private sector banks would be withdrawn and appointment of ‘observer’ in the status of a ‘permanent invitee’ to board meetings would be considered. On the boards of public sector banks, the Reserve Bank, the National Bank for Agriculture and Rural Development (NABARD) and the National Housing Bank (NHB). Its guidelines issued in September 2004 did not refer to a draft document sent earlier by the Reserve Bank. The Bank requested the government to refer to its draft and made procedural suggestions on appointment of directors. In August 2005, the Bank suggested to the government that the criteria relating to ‘fit and proper’ status might be made applicable to the nominated directors on the boards of nationalised banks as in the case of private sector banks. In September 2005, the Bank advised the government that the elected directors of public sector banks also should satisfy the criteria applicable to nominated directors. The Bank cited two examples to show why having a formal procedure mattered so much

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43.

44.

45.

46.

47.

to the Bank. ‘Recently,’ the letter stated, ‘we had come across a complaint from the Investors’ Grievance Forum regarding a film director contesting the election for director’s post in a public sector bank and eventually being elected as a director.’ In another case, one of the directors of another bank was found to be associated with two companies figuring in the defaulters’ list. The government advised the said bank to persuade him to relinquish his directorship. But the director disputed the contentions raised and declined to resign. Pending legislative changes, only moral suasion could be resorted to in such cases. In November 2006, the Bank set up a committee (Chairman: Janki Ballabh) to finalise the modalities and frame the guidelines for such appointments, which submitted its report in January 2007. It held that in view of the legal requirements of the nominee directors having necessary experience and expertise, they had to be from the pool of the Bank’s retired officials. Accordingly, in February 2007, the Bank replaced the serving officers by nominating retired officials to various public sector banks. ‘In view of the performance of PE [private equity] funds during the last two years internationally, the fact that these are generally unregulated entities and also the issues regarding the investment by foreign PE funds in India, SBI should consider structuring such investments as VCFs [Venture Capital Funds] which should be registered with SEBI.’ In June 2002, an internal working group was formed to draw guidelines for the setting up of banking subsidiaries by foreign banks. The guidelines took into account cross-country experiences and provisions of the General Agreement on Trade in Services (GATS). The draft guidelines were sent to the government, proposing that the Bank would process the applications for setting up subsidiaries without separate clearance from the Foreign Investment Promotion Board. The government’s stand on these issues was not quite clear and, therefore, the guidelines were not issued. An issue of concern with foreign banks in India was that several of them operated in niche services, did not offer full banking services for all types of clients, were not required to conduct priority sector lending and, therefore, did not meet one of the objectives of banking regulation, that banks should foster financial inclusion. Reviewing the situation, an in-house Technical Paper on Differentiated Banking Licences concluded in October 2007 that ‘it is necessary that all banks offer certain minimum service to all customers’ and ‘it will be prudent to continue the existing system for the time being. The situation may be reviewed after a certain degree of success in financial inclusion is achieved’. A committee of outside experts was formed under the Chairmanship of M. S. Verma, who had just retired as SBI Chairman. 423

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the reserve bank of india 48. A draft amendment to the Banking Companies (Acquisition & Transfer of Undertakings) Acts of 1970 and 1980 was sent to the government by the Bank in April 2000. 49. High-level group headed by Deputy Governor S. P. Talwar, with Deepak Parekh and two Joint Secretaries from the Ministry of Finance as members. 50. ‘Narrow banking’ is a term used to describe a very restricted form of banking, where the institution is not allowed to take risks. Funds are placed only in risk-free and liquid assets like government securities and asset–liability duration mismatch is also avoided. 51. RBI, Basic Statistical Returns. 52. Such as setting up of Debt Recovery Tribunals, Lok Adalats, ARCs, corporate debt restructuring mechanism, and the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002, among other measures. 53. In 2001, a study carried out for putting in place an early warning system in banks concluded that a software could be developed for the purpose. The Reserve Bank advised the IBA to arrange for and develop such a software. No definite progress in this field was reported, presumably because banks ran different IT platforms for their operations. 54. Covering early recognition of the problem, introduction of special mention accounts (as a category between standard and substandard to serve as an early alert system), identification of borrowers with genuine intent, timeliness and adequacy of response, consortium/multiple financing, legal issues, and auditors’ responsibility. 55. This was a forum where disputes pending in the court of law or at the prelitigation stage were settled amicably without payment of court fees. 56. Chairman: N. V. Deshpande, to examine the working of Debt Recovery Tribunals, which submitted its report in August 1998. 57. Chairman: M. R. Umarji. 58. This was a major step in addressing the issue of NPAs in the banking sector. In April 2003, another set of guidelines was sent to banks on sale of financial assets to ARCs, and in 2005, guidelines were issued on purchase and sale of NPAs among banks, financial institutions and NBFCs to develop a secondary market for NPAs where ARCs were not involved. The boards were required to lay down policies on valuation procedure. In October 2007, banks selling NPAs were advised to work out the net present value of the estimated cash flows associated with the realisable value of the available securities, and net expenses. The sale price should generally not be lower than the net present value so derived. By March 2008, commercial banks had issued 279,796 notices under the SARFAESI Act, involving NPA cases with outstanding amount of 560.60 billion and had recovered an amount of 154.15 billion from 172,809 cases. 424

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regulation of the financial system 59. RBI, Report on Trend and Progress of Banking in India 1996–97 (1997), p. 57. 60. The Narasimham Committee II, for example, considered that all public sector banks should be brought under the Companies Act so that mergers driven by business interests would become easier and a routine matter. The government, however, was not keen on the idea. 61. When informally approached by Bank of Baroda expressing interest in taking over the bank, the Reserve Bank made an application to the government in October 2001 for a moratorium. 62. The court was referring to the amount mentioned in Section 22 of the BR Act, which was 0.50 million, as against the Reserve Bank’s administrative fiats to private sector banks enhancing the minimum net-owned funds to first 0.50 billion and then to 3 billion. The Reserve Bank, however, resorted to issuing directions in public interest, deriving powers from the enabling provisions of the Act, as frequent amendments to the statutes was time consuming. 63. There was no restriction on opening of extension counters, satellite offices, and so on. Specialised branches and service branches could also be opened without prior permission from the Bank except that its formal ‘licence’ had to be obtained to comply with the law. 64. Nevertheless, in July 2000, Deputy Governor Talwar recommended that private sector banks meeting the criteria of CRAR of over 10 per cent, net NPA below 3 per cent, return on assets above 1 per cent and the Reserve Bank’s inspection rating of ‘A’ be allowed to open twenty-five to thirty branches in a year and others eight to ten branches in a year. Governor Jalan broadly agreed and added that ‘it would be desirable to promote greater competition among good private sector banks’. 65. SBI sought the Bank’s approval in May 2000 for opening ‘sub-branches’, or small offices offering specialised services, in cities covering remittance, deposits and loan products, setting up of full-fledged branches being expensive. The Bank rejected the proposal. Private and foreign banks outsourced some of their activities and appointed franchisees for marketing of loan products. The Bank held that in keeping with the spirit of the BR Act, banking needed to be done in the branches. In July 2002, the Exchange Control Department took up with the regulatory department, the Department of Banking Operations and Development, the question of allowing ‘cash back’ by merchant establishments against credit cards, which would potentially help foreign tourists. After some discussion, the Bank disallowed the move. A proposal from foreign banks to open Financial Service Centres or Limited Service Branches in 2003–04 was similarly turned down. A nationalised bank wanted to open 100 Retail Boutiques (kiosks) in May 2004, but the plan was rejected by the Bank. In September 2004, at a Federation of Indian Chambers of Commerce and Industry conference, there was a suggestion that the Bank should permit the South African microfinance institution TEBA Bank model (see Chapter 425

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66.

67. 68.

69. 70. 71. 72. 73. 74.

75.

76.

77.

13 for more details on this institution). The Reserve Bank’s negative stand in this regard drew critical comments from the United States Agency for International Development, in a review of the Indian financial sector in 2005. On 6 September 2006, Financial Express ran a four-column headline, ‘Banks ATM Plans Go Awry as RBI Sits on Applications’, and three days later ran an editorial captioned ‘Control Mania: Let a Thousand ATMs Sprout’. The editorial said that by including ATMs in the definition of bank branch, the Reserve Bank had merely extended its control over banks. The group was to prepare a framework for a reporting system on transactions connected to economic crime. In performing this task, the Bank made use of recommendations made by the Financial Action Task Force (FATF) on Anti-Money-Laundering (AML) standards and on Combating Financing of Terrorism. The FATF was conceived by the G-7 countries. See Reserve Bank of India, The Reserve Bank of India, Vol. 4: 1981–1997 (New Delhi: Academic Foundation, 2013). Chairman: P. Saran. It had members from IBA, NABARD, three major banks, FMC, and different departments of the Reserve Bank. Chairman: V. S. N. Murthy. Guidelines were given to banks for investment in mortgage-backed securities in May 2002. For example, Business Today, April 2004. In August 2003, Deputy Governor Udeshi suggested that ‘in the present liberalised scenario, it would now be appropriate for RBI to prescribe standard norms on agency/referral arrangement and grant general permission to banks’. From statutory reserve or any other reserve. Banks were also advised that such draw-down was to be effected only after arriving at the year’s profit or loss and also to report the draw-down in the ‘Notes on Accounts’ on the balance sheet. On International Financial Standards and Codes under the chairmanship of Deputy Governor Reddy, and the Secretary in the Ministry of Finance as alternate Chairman. The standing committee constituted advisory groups in ten core subject areas, which broadly encompassed the key areas prescribed by the Group of Seven (G7) body the Financial Stability Forum. These advisory groups would study the relevance of standards and codes, review the feasibility of compliance and compare the levels of adherence in India in comparison with other countries. Consistent with the spirit of an independent enquiry, the advisory groups were chaired by experts not generally holding official positions. One of these was a working group with members from the ICAI, the Reserve Bank and banks formed by the Reserve Bank to study accounting standards

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regulation of the financial system in relation to the international best practice. The Advisory Group on International Accounting and Auditing (Chairman: Y. H. Malegam), subject to some exceptions, endorsed the Institute’s practices. Banks, however, did not necessarily follow these standards. Therefore, a working group (Chairman: N. D. Gupta, former President of the ICAI) was formed to recommend better compliance by banks. Based on the group’s recommendations, a set of guidelines was issued in March 2003. 78. The Reserve Bank sent a letter to the Ministry in December 2008 stating that the stand taken by the Commission does not appear to have complete statutory backing. It would not be in the best interest of the banking system or in public interest for the MRTPC to release reports in the media. MoF may like to suitably take up the matter with MRTPC.

79. The Committee on Financial Sector Assessment (2009) concluded that commercial banks have shown a healthy growth rate and an improvement in performance as is evident from capital adequacy, asset quality, earnings, and efficiency indicators. In spite of some reversals during 2008–09, the key financial indicators of the banking system do not throw up any major concern or vulnerability and the system remains resilient. (Para 3.2.49, Volume III)

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10 Regulation of the Financial System Part II: Other Financial Institutions

Introduction In the decades after Independence, a set of financial institutions other than commercial banks were established under the government’s encouragement.1 The three most important types, which will form the subject of this chapter, were those known as all-India financial institutions or development financial institutions (FIs), non-banking financial companies (NBFCs) and urban cooperative banks (UCBs). The cooperative banking institutions in rural areas are covered later in the chapter on rural credit. These served specific types of clients, some of whom had inadequate access to commercial banks. The relative share of assets of scheduled commercial banks (SCBs), FIs, NBFCs and UCBs as of March 1998 (comparable figures are not available for March 1997) and 2008 are shown in Table 10.2.1. Though the assets of these three categories had increased in absolute terms during the reference period, there was a fall in their market share and a rise in the market share of commercial banks. The commercial banks accounted for 94.3 per cent of public deposits in March 2008. During the reference period, the regulatory framework applicable to these institutions underwent fundamental changes. Some FIs converted into banks, and the others tried to reinvent themselves. NBFCs and UCBs were subjected to regulations aimed at improving governance. The Bank, despite limited jurisdiction on these institutions, played a pivotal role in the transition. This chapter outlines the transition. The three main sections of the chapter deal with FIs, NBFCs and UCBs. The next section gives a brief overview of the three types of institutions and their relationship with the Reserve Bank.

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regulation of the financial system Table 10.2.1 Share of Assets ( billion) Sector

31 March 1998

31 March 2008

FIs

1,612.16 (15.4)

1,799.12 (3.7)

SCBs a

NBFCs UCBs Total

7,955.06 (75.8) 455.08 (4.3)

475.63 (4.5) b

10,497.93 (100)

43,261.66 (90.4) 990.14 (2.1)

1,794.21 (3.8)

47,845.13 (100)

Source: Compiled from Reserve Bank of India (RBI), Report on Trend and Progress of Banking in India, various years.

Notes: a. Data for 1998 pertains to seven FIs and for 2008 to four FIs (SIDBI, NABARD, NHB and EXIM Bank). See text for the full forms of these abbreviations. Figures in brackets indicate percentage share. b. Total of owned funds, deposits and borrowings.

Financial Institutions, Non-Banking Financial Companies and Urban Cooperative Banks Financial Institutions (FIs)

The FIs were set up to extend long-term loans directly, and indirectly through banks and other agencies to meet the financial needs of industrialisation. Banks, on the other hand, supplied mostly working capital loans. Of these, the Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI) and Industrial Investment Bank of India (IIBI) were set up by the government primarily for industrial finance; EXIM Bank for exports; National Bank for Agriculture and Rural Development (NABARD) for agricultural and rural development, Infrastructure Development Finance Company (IDFC) for infrastructure finance, Tourism Finance Corporation of India (TFCI) to promote the tourism industry, National Housing Bank (NHB) to promote the housing sector, Small Industries Development Bank of India (SIDBI) for finance to small industries, and Industrial Credit and Investment Corporation of India (ICICI, a joint private–public company) for providing industrial finance. Of the ten, five (ICICI, IFCI, TFCI, IIBI and IDFC) were registered under the Companies Act, and the other five were incorporated under the respective statutes. These were governed by the relevant statutes and by the government as owners. But the Reserve Bank had 429

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the reserve bank of india been entrusted with the responsibility of ‘regulating’ them under Sections 45L and 45N of the Reserve Bank of India (RBI) Act, though the powers were not specific and sweeping as in the case of banks under the BR Act. There was no statutory mandate for protecting the interests of depositors or investors. Public deposits held by them were not covered by the Deposit Insurance and Credit Guarantee Corporation. NABARD, SIDBI and NHB were essentially refinance institutions with some direct lending activities. The FIs grew rapidly in the 1990s as there was good demand for their term lending and refinancing operations. The Industrial Credit and Investment Corporation of India was renamed ICICI Ltd in 1991. The Shipping Credit and Investment Corporation of India merged with ICICI Ltd in 1997, and ICICI Ltd effected a reverse merger with ICICI Bank Ltd in 2002. The merger of IDBI Ltd with IDBI Bank Ltd was completed in 2005.

Non-Banking Financial Companies (NBFCs) An NBFC is essentially a financial company without a ‘banking’ licence from the Reserve Bank. This is a negative definition, which has served well because it appears to caution the consumer that an NBFC is potentially less secure than a bank. For example, deposit insurance is available to banks but not to NBFCs. Unlike banks, which can open chequable demand deposit accounts, NBFCs can open only term deposits. A deposit-taking NBFC is relatively more closely regulated and supervised. If a non-deposit taking NBFC is big in size (in terms of assets), it is considered ‘systemically important’ because ultimately all funds other than the share capital are public funds (bank borrowings and other debts), and such companies are, therefore, brought under closer scrutiny. In short, there are three main categories of NBFCs, with the regulatory order being different in each case – these are deposit-taking, non-deposittaking and systemically important. Somewhat distinct is the residuary nonbanking company (RNBC), which only takes deposits and does not engage in investment or asset financing. The asset reconstruction companies (ARCs) specialize in enforcing or encashing mortgaged securities of bankrupt firms. They are regulated under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act), and the RBI Act as a class of NBFCs.

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regulation of the financial system

Urban Cooperative Banks (UCBs) UCBs are member driven and community based. However, they are permitted to accept deposits from non-members. There is much heterogeneity among them in terms of size, geographical distribution, performance, financial strength and human resource endowment. At one end, there are small neighbourhood unit banks and, at the other end, there are several large UCBs with a wide network of branches and a large number of depositors and borrowers. For the latter, while the cooperative structure exists as an organisational arrangement, the business model is like that of commercial banks. Though a highly differentiated group, the UCBs were largely subjected to uniform regulation. In March 1997, there were 1,653 UCBs with aggregate deposits of 307.14 billion. At the end of the reference period, there were 1,770 UCBs with deposits of 1,384.96 billion.2 Maharashtra and Gujarat had the major share of UCBs in the country, followed by Karnataka and Andhra Pradesh. Tamil Nadu and Kerala also had a sizable share of UCBs. Twenty UCBs had a presence in more than one state in 1997, which increased to twenty-five by 2008. In 1997, 250 UCBs were categorised as ‘weak banks’ that had suffered erosion of owned funds to the extent of 25 per cent. In March 2008, there were 496 weak UCBs.

Financial Institutions In 1998, the Reserve Bank was monitoring the operations of ten FIs (IDBI, ICICI, IFCI, EXIM Bank, IIBI, TFCI, NABARD, SIDBI, NHB and IDFC). In 1997, the Bank formed a working group to suggest measures to harmonise the roles of FIs and commercial banks.3 The group recommended a gradual move towards universal banking through mergers between banks and FIs. This would allow for one regulator to oversee both types of institutions. The Narasimham Committee II (1998) made a similar recommendation. In January 1999, the Bank brought out a discussion paper containing draft proposals based on these recommendations. It did not envisage any specific time frame or compulsion for the conversion of FIs into banks or NBFCs. The decision would be left to their own strategic planning, commercial prudence and business synergies, and the complementarities that could be derived from such conversion. 431

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the reserve bank of india The Bank issued a circular in April 2001 to the FIs, highlighting the issues that would need to be addressed in the process. The Confederation of Indian Industry (CII) brought out the practical problems in the process of FIs converting into banks. In the pre-reform era, the FIs had access to certain concessional sources of funds that had been withdrawn. This increased their cost of funds. The enactment of the Fiscal Responsibility and Budget Management Act, 2003, constrained the government from subsidising these institutions. A commercial bank, the CII pointed out, had to keep aside 32.5 per cent (cash reserve ratio [CRR] plus statutory liquidity ratio [SLR] applicable at that time) of its non-equity liabilities as CRR–SLR, which was a costly option. They would have to borrow funds at 9 per cent to achieve this and earn an average of 7 per cent. The CII suggested that CRR–SLR should apply only for public deposits and not for other liabilities of the FIs. Pending such conversion, the Bank concentrated on governance. In early 1999, the Bank, in consultation with the government, constituted an informal advisory group,4 with members from industry, to examine the regulation and supervision of FIs. The advisory group recommended prudential norms on income recognition, asset classification, provisioning and capital adequacy, and revised guidelines for export credit, bridge loans and exposure norms. Though the Bank had prescribed a minimum capital to risk-weighted assets ratio, or CRAR, of 9 per cent for the FIs, no specific guidelines were issued for the adoption of Basel I or II norms for those FIs that were primarily refinancing institutions. Efforts were also made to improve the quality of asset and liability management, to address such chronic problems as non-performing assets (NPAs), state guaranteed advances and connected lending.

Asset Management From June 1997, these institutions were subjected to credit exposure norms. The exposure limit – defined to include both funded and non-funded credit limit, underwriting and other commitments – was linked to the institution’s capital funds (paid-up capital and reserves as per published accounts).5 As for asset classification, they were required to classify an asset as NPA if the interest was overdue for 180 days and principal for 365 days from November 2000. In April 2001, this became 180 days for both interest and principal. It was reduced to 90 days from March 2006 (applied to commercial 432

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regulation of the financial system banks from March 2004). The Reserve Bank sent out the guidelines issued to banks on compromise and one-time settlements of chronic NPAs (see Part I) to FIs as well.6 In July 2003, the Bank advised the FIs on prevention of the slippage of accounts from standard to substandard and from substandard to doubtful category based on a study by an in-house group. Between standard and substandard, a new category – ‘special mention’ – was introduced, which could serve as an early alert. The Bank also issued guidelines for sale of financial assets to ARCs. The guidelines addressed a few other subjects as well, such as investment in SLR, categories of investment, and connected lending.7 In December 1997, it was clarified that although government-guaranteed advances need not be classified as NPAs for provisioning, such advances were to be treated as NPAs if the concerned state government repudiated its guarantee. In November 2006, in line with the instructions issued to commercial banks, FIs were advised that government-guaranteed advances should be treated as any other advance from March 2007. The impact of this decision was significant, for 41 per cent of the advances of FIs were guaranteed by state governments. Since the change would impact NABARD severely due to its high exposure to state-guaranteed advances, it was permitted at their request to make additional provisioning over a period of three years from 2007, with a minimum of 25 per cent each year.

Liability Management Until 1997, the Reserve Bank set instrument-wise annual limits for each financial institution for raising resources from the market. The instruments were term deposits (1 to 5 years), term money borrowings (3 to 6 months), CP (15 days to 1 year), CD (1 to 3 years), and inter-corporate deposits. In May 1997, an overall or umbrella limit was introduced, equivalent to 100 per cent of net-owned-funds. The choice of instruments was left to the institution. These institutions were prohibited from issuing SLR bonds and from accessing longterm funds from the Bank on concessional terms. On the asset side, they faced competition from banks and were exposed to asset–liability mismatch, interest rate risk and adverse selection risk.8 In July 2007, a master circular was issued on prudential guidelines for bonds and debentures, whereby the outstanding of total resources mobilised by an FI, including funds mobilised under the umbrella limit, should not exceed ten times its net-owned funds. The FIs were also subject to capital adequacy norms, which indirectly restricted the total quantum of resources to 433

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the reserve bank of india be mobilised for a given level of regulatory capital. Since the capital adequacy norms, as well as the resource raising norms for the FIs, sought to address the same prudential concern relating to the extent of leverage deployed by them, there was an element of regulatory overlap. In 2004–05, the three refinancing institutions (NABARD, SIDBI and NHB) raised substantial amounts as capital gains bonds.9 In September 2005, the Reserve Bank wrote to the government urging a review of the bond issued by FIs, and suggesting a cap on total funds during a year in tranches and duration of the tap (at that time, the FIs were issuing the bonds on tap at fixed rates and unlimited amounts). The facility of issuing capital gains bonds was discontinued following the withdrawal of tax benefits in the Union Budget in 2006–07. In December 2000, FIs were advised to introduce asset liability management systems from April 2001. Based on feedback received from ICICI Ltd, the guidelines were fine-tuned in August 2001.10 In June 1999, the Chairman of ICICI Ltd wrote to the Governor seeking permission from the Bank for lending and issuing guarantees to joint ventures and wholly owned subsidiaries of Indian companies abroad. The CII also wanted FIs to lend to overseas Indian entities. Whereas banks had a diverse resource base for foreign exchange, borrowing was the only recourse for FIs to mobilise foreign exchange. On this ground, in October 2000, the Bank rejected the proposal. The government convened a meeting in February 2001, following which the Finance Secretary wanted the Bank to reconsider the decision. On 22 February 2001, the government asked the Bank for a proposal with necessary safeguards. In June 2001, the Bank reiterated its reservations but suggested that ‘if the government is keen’, loans up to 50 per cent of external commercial borrowings and not exceeding 5 per cent of Tier I capital could be allowed to overseas entities if the net NPA of FIs was below 5 per cent. In a meeting convened by the government in July 2001, the Finance Secretary wanted the net NPA to be fixed at 7–10 per cent. But the Bank stuck to its position on this point and there was no further communication from the government. The jurisdiction of the Bank over FIs was partly a legislative matter, and the law was a subject of frequent deliberations.

Review of Regulatory Framework The Reserve Bank initially considered amendments to the RBI Act to vest powers of regulation of FIs to itself. In May 2001, however, the Bank 434

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regulation of the financial system sent proposals for extending certain provisions of the BR Act to FIs. Correspondingly, the supervisory powers over FIs in the RBI Act could be deleted. In 2003, Governor Reddy, who had taken charge in September that year, observed that in the emerging architecture of the Indian financial system, there could be only two intermediaries, banks and NBFCs, and hence it was not necessary to provide for specific statutory provisions in the BR Act for regulation and supervision of FIs. Another issue that figured in discussions on regulatory reform was the debenture redemption reserve (DRR). Under the Companies Act, 1956, any company that issued debentures needed to create a reserve to protect investors against the possibility of default. In 2001, the Bank and the Ministry of Finance requested the Department of Company Affairs (Ministry of Law) to exempt public financial institutions, which were within the regulatory domain of the Bank, from this condition. The advantage for these institutions was that the bonds issued by them and certain other liabilities were treated as eligible investments for insurance companies, provident funds and mutual funds. The NBFCs also represented to the Bank seeking a similar exemption. The subsequent meetings showed that the Department of Company Affairs was convinced and exempted FIs fully, and NBFCs partly (50 per cent DRR) from this condition.11 In 2002, the Bank sent a proposal to the government to transfer the loans and investments out of the National Industrial Credit (Long Term Operations), or NIC(LTO), funds to the government, to enable the Bank to focus on its core functions.12 A revised scheme envisaged the transfer of 37.92 billion of NIC(LTO) loans and advances to IDBI, IIBI, SIDBI and EXIM Bank from the Bank’s books to the Government of India in exchange for 10.25 per cent securities of twenty years’ maturity. The Finance Minister in his Budget speech for 2002–03 announced the strengthening IDBI’s capital by converting NIC(LTO) loans into appropriate long-term instruments.13 In 2006, an internal working group reviewed the future role of refinancing institutions, which regulated and supervised cooperative banks and regional rural banks (RRBs), and found that the four refinancing institutions, NABARD, NHB, SIDBI and EXIM Bank, had faced little competition until the end of the 1990s since they had a captive clientele, but thereafter, while access to concessional funds was withdrawn, demand for refinance fell with the availability of alternative sources of funding.14 435

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the reserve bank of india

Other Regulatory Issues: Corporate Debt Restructuring and Reserve Bank’s Ownership of FIs The need for better coordination between financiers in large-value projects jointly financed by banks and FIs was stressed from time to time both within the Reserve Bank and the government. In 1999, a standing coordination committee was formed. Further, the Bank issued guidelines in March 2001 allowing banks and FIs to restructure or reschedule credit facilities extended to industrial units that were fully secured by tangible assets. An institutional mechanism for restructuring of corporate assets in the form of a corporate debt restructuring (CDR) system was proposed. There were, however, impediments to its efficient functioning. These problems were discussed in 2001 and 2005, based on which the guidelines were revised. The Reserve Bank had shareholdings in various proportions in NHB (100 per cent), NABARD (72.5 per cent), Discount and Finance House of India (10.59 per cent), Securities Trading Corporation of India (14.4 per cent), IDFC Ltd (15 per cent), and State Bank of India (SBI) (59.73 per cent).15 In May 1999, the Reserve Bank wrote to the government with a proposal to transfer the Bank’s shareholding in SBI and proposed the method of transfer of the Bank’s shares in NHB and NABARD. The government replied in April 2000 that these transfers would be considered later. Between 2005 and 2007, the Bank did transfer its shares in IDFC Ltd and SBI to the government. The transfer of the shares in NABARD and NHB would require legislative amendments. The Reserve Bank had to be empowered to regulate and supervise housing finance companies, rural cooperative banks and RRBs, and limit the two FIs to developmental and refinancing activities because regulation and supervision of the financial system was essentially the Bank’s responsibility. That the financing agency should not also regulate was obvious. The issue became more critical when the divestment of the Bank’s ownership of NHB and NABARD was under consideration. The Bank wanted these issues to be resolved before effecting the transfer of ownership or at least to be synchronous with the changes in the regulatory set-up. But these issues were not resolved and the transfer of shareholding not effected until the end of the reference period. Although all FIs were subject to similar pressures, and a need to adapt to market competition, their situation differed considerably depending on their own histories and the nature of the business. The next section describes the circumstances of the major FIs. 436

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regulation of the financial system

Notes on Individual FIs IFCI was the first development finance institution promoted by the government. Originally the Industrial Finance Corporation of India, it was renamed and corporatised as IFCI Ltd in 1993. At the start of the reference period, IFCI was beset with a high level of NPAs and approached the Reserve Bank for permission to set up an ARC in 2002. This was not granted, ARC being as yet an untried concept in India. Instead, the government extended several financial packages and concessions. Despite this, the financial position of IFCI deteriorated. Gross NPAs of IFCI stood at 86.21 billion. In 2004, there was a proposal to merge Punjab National Bank with IFCI. The Bank conducted an impact study on the proposal and found that the gross NPA of the merged entity would be 30 per cent, net loss for the year ended March 2004 was 17.92 billion and CRAR was 4.51 per cent, which would attract prompt corrective action (PCA). Therefore, the proposal did not go forward. IFCI managed to declare a net profit in 2006–07 by the sale of shares in FIs it held. It was classified as an NBFC but exempted from NBFC directions until August 2007. Banks and other FIs that had exposure to IFCI were, in turn, a cause for concern. The Reserve Bank gave permission to IDBI Ltd (which had become a bank) for retention of its investment in IFCI in ‘standard’ category despite IFCI having a negative net worth of 47.73 billion in March 2005 and incurring a net loss of 3.24 billion in 2004–05. Several banks were exempted from prudential norms in respect of restructured IFCI liabilities in 2002–03, 2003–04 and 2005–06. The aggregate exposure of banks and FIs to IFCI by way of investments and loans stood at 69.51 billion in March 2006. The Reserve Bank advised banks that the regulatory forbearance would be withdrawn from March 2007, and they should value the investment in bonds of IFCI Ltd at market rates from June 2007. However, on a representation from the IBA, banks were given time until 31 March 2008 to do this. In 2007, the government’s stake in IFCI fell to less than 51 per cent. All facilities to IFCI as an FI ceased and it was reclassified as a systemically important nondeposit taking NBFC (NBFC-ND-SI, see section later on NBFCs) governed by relevant directions of the Reserve Bank. As mentioned earlier, in 2001, the government offered a package to augment the capital of IDBI using the NIC(LTO) fund. In the same year, IDBI submitted a proposal to the government for its restructuring, through a merger with a bank, to convert itself into a universal bank. The government favoured the proposal and intended to issue an ordinance to effect the 437

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the reserve bank of india transformation. Before doing so, the government sought the Reserve Bank’s views. The Bank had already placed in the public domain the operational and regulatory issues that needed to be addressed in the process of conversion of an FI into a universal bank. Full compliance with prudential norms was a condition. Subsequently, the Finance Minister in his Budget speech for 2002– 03 proposed to make legislative changes to corporatise IDBI. In March 2002, Deputy Governor G. P. Muniappan wrote to the Finance Secretary stating that the Board for Financial Supervision (BFS) had ‘taken specific note of the inactivity of the Board of IDBI’. In October that year, the Ministry of Finance convened a meeting with the Bank and the Law Ministry to discuss proposals for conversion of IDBI into a bank. Several options were considered. The Union Cabinet decided in November 2002 that the IDBI Act would be repealed and the undertaking of IDBI be vested in, and transferred to, a company to be incorporated under the Companies Act, which could be deemed to be a banking company under Section 5C of the BR Act. Thus, IDBI would be converted into a universal bank but not be required to obtain a licence.16 IDBI was converted into a bank through an Act from October 2004 (see Part I) after the transfer of NPAs of 90 billion to a stressed asset stabilisation fund.17 The Industrial Reconstruction Corporation of India Ltd was set up in 1971 for rehabilitation of sick industrial companies and was reconstituted as the Industrial Reconstruction Bank of India (IRBI) in 1985 under the IRBI Act, 1984. To convert the institution into a full-fledged FI, IRBI was incorporated under the Companies Act, 1956, as Industrial Investment Bank of India Ltd (IIBI) in March 1997. The new entity had a high level of NPAs and did not comply with prudential norms. It was facing default on payment obligations, including on SLR bonds. The government subscribed to 1 billion in 2001–02 towards preference shares of IIBI, and the latter invested a similar amount in government securities. The government and IIBI wanted the amount to be treated as Tier I capital but the Reserve Bank did not agree, stating that there could be ‘perverse implications if the fiscal neutral injection of funds by the government is treated as Tier I capital’. In July 2003, the Bank advised the government to either rehabilitate or close IIBI.18 The company’s CRAR stood at -46.2 per cent in March 2006. In May 2007, IIBI informed the Bank that the government had agreed to wind up IIBI. The Tourism Finance Corporation of India, or TFCI, was set up in 1989 to contribute to the growth of tourism infrastructure by providing a dedicated 438

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regulation of the financial system line of credit on a long-term basis to tourism-related projects. The public had 39 per cent shareholding besides substantial shareholdings by SBI, Life Insurance Corporation of India (LIC) and General Insurance Corporation of India. The company was beset with increasing NPAs. Though registered as a non-deposit-taking NBFC, it was granted exemption from the provisions of directions and prudential norms up to June 2005, and the company sought an extension of the exemption. The exemption was withdrawn in November 2007 as TFCI came under NBFC directions. The Reserve Bank had no regulatory concern with TFCI. SIDBI was set up in 1990 through an Act of Parliament. It was incorporated initially as a wholly owned subsidiary of IDBI. Later, the ownership was transferred to government-owned/controlled institutions. Beginning as a refinancing agency to banks and state-level FIs for their financial assistance to small industries, it expanded its activities with direct lending through its 100 branches across India. The erstwhile IDBI transferred its supervisory functions over the State Finance Corporation (SFC) to SIDBI. The ad hoc borrowing facilities to SFCs provided in the RBI Act were discontinued from 2004–05. They were permitted to raise public deposits, subject to the approval of the Bank, on a case-to-case basis and these permissions were routed through SIDBI, the monitoring agency for SFCs. In the context of the SFCs’ precarious financial condition and the need to protect the integrity of public deposits, the Bank advised SIDBI in July 2003 that only well-managed SFCs be permitted to raise public deposits. Besides, the Bank decided in July 2003 that the bonds issued by SFCs should not be given the SLR status. SFCs ceased to be part of the market borrowing programme since 2003–04. The Bank was not directly involved in the regulation and supervision of SFCs. From the systemic angle, there was no cause for concern as they were not part of the payment system. However, the Bank was concerned about the possible impact on the stability of the financial system since a large component of their liabilities was accounted for by SLR bonds issued in the past. As the regulator and supervisor of SIDBI, the Bank was also concerned about SIDBI’s huge exposure to SFCs. The exposure to SFCs amounted to 46 billion by 2006, when thirteen of the eighteen SFCs were making losses. The government announced a package to be implemented by SIDBI. The Bank prepared a draft model memorandum of understanding, or MoU, between SIDBI, SFC and the state government concerned. SIDBI signed eleven such MoUs with SFCs by September 2007. 439

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the reserve bank of india At the time of transfer of the erstwhile IDBI’s investments in SFCs to SIDBI in March 2007, the Bank insisted on booking the loss to absorb the diminution in value while taking them on to SIDBI’s balance sheet. In January 2008, the revaluation of investments in SFCs was a drain on SIDBI’s resources. SIDBI’s exposure to SFCs formed 25 per cent of its total assets. The NPAs of SFCs averaged around 60 per cent. The deeper problem with the SFCs was that they functioned with little regulation, and the SFC Acts did not mention regulation by SIDBI. State governments had the powers to direct the SFCs. The powers exercised by SIDBI over the SFCs were contractual arrangements between a lender and a borrower. To instill better management in the SFCs, the Bank needed to work with SIDBI. In January 2007, the Bank sought confirmation from SIDBI that prudential norms on asset classification and income recognition, and accounting standards issued by SIDBI to SFCs were in line with guidelines issued by the Reserve Bank to banks. SIDBI sought certain regulatory relaxations for SFCs on provisioning norms, which were allowed only up to March 2007. Since SIDBI was being regulated and supervised by the Reserve Bank, prescription of prudential norms for SFCs was considered necessary, as the Reserve Bank did not want SIDBI to be financing insolvent SFCs that had no possibility of turning solvent in the near future. Further, the Bank tightened its regulation of SIDBI in June 2007, and advised that ‘for all direct exposures, prudential norms, accounting standards and risk management guidelines as applicable for banks will henceforth be applicable to SIDBI’. The Bank increased the risk weight from 100 to 125 per cent for SIDBI’s exposure to SFCs and advised SIDBI to make full provision in respect of SFCs that had defaulted. In June 2007, a committee constituted by the Ministry of Finance made a presentation on the restructuring of SIDBI to the Reserve Bank. There were two proposals: SIDBI to register as a new public sector bank or SIDBI to acquire an unlisted public sector bank that would function as a 100 per cent subsidiary. The Bank responded that it could not give licence for the formation of a weak bank and that, SIDBI being the regulator, supervisor and stakeholder in SFCs, the issue of conflict of interest needed to be resolved. When SIDBI stopped refinancing SFCs with negative net worth, many SFCs and other affected bodies approached the Reserve Bank requesting restoration of refinancing. Their ground was that the small manufacturing 440

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regulation of the financial system firms, which many SFCs had as main clients, faced difficulties. In July 2007, the Ministry of Finance wrote to state Chief Secretaries to extend necessary support to SFCs. The government also repeatedly asked the Reserve Bank to restore SIDBI refinance to SFCs. The Bank held its ground and did not relent. In January 2008, the Bank expressed its inability to review the direction issued to SIDBI. In February 2008, the Ministry of Finance informed the Bank that four state governments had taken steps and committed to providing funds to the respective SFCs. The Bank agreed to change its position and advised SIDBI to extend refinance to four states, Haryana, Himachal Pradesh, Karnataka, and Tamil Nadu, if the state governments kept their commitments.19 In January 2008, the government permitted SIDBI to issue Deferred Payment Guarantee in foreign currency to individual concerns. The Reserve Bank advised the government to keep this on hold until the true financial position of SIDBI was revealed. In February 2008, the government wanted to channel Rural Infrastructure Development Fund (RIDF) funds to SIDBI but the Bank did not agree and, in turn, suggested to the government to grant SIDBI exemption from payment of income tax. The NHB was set up in 1987 by an Act of Parliament and was wholly owned by the Bank. The entry of banks in housing finance without dependence on NHB refinance required the NHB to redefine its functions. In 2006, the NHB sought a general line of credit for 10 billion from the Bank for rural housing. This was not approved, but the NHB was allowed to borrow eleven times (instead of the stipulated ten times) from the market for one year. In 2007, the BFS considered a Technical Paper on the future framework of the NHB. The paper recognised that the NHB had multiple roles, and proposed to transfer the regulatory and supervisory functions of the NHB to the Bank and convert the former into an NBFC. But despite much correspondence with the government, the proposals had not materialised until 2008. The EXIM Bank was established in 1982 to help institutions engaged in the financing of foreign trade. In January 2001, the government sent a proposal to the Reserve Bank to convert it into a bank. The Reserve Bank did not think it was a good idea and suggested other options. NABARD came into existence in July 1982 by taking over the agricultural credit functions of the Reserve Bank and the refinance functions of the then Agricultural Refinance and Development Corporation. The Reserve Bank was the majority shareholder. NABARD refinanced, regulated and supervised rural cooperative banks and RRBs. To avoid conflict of interest, the Reserve 441

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the reserve bank of india Bank proposed to take over the regulatory and supervisory functions and to transfer its shareholding in NABARD to the government. IDFC, in which the government had 23 per cent shareholding and the Reserve Bank, IDBI and other banks also held shares, was set up as a company in January 1997 to provide infrastructure loans. In July 1998, IDFC was brought under the regulatory framework of the Reserve Bank after its notification as a public FI. It was also registered as a non-deposit-taking NBFC in April 2002. The Reserve Bank as the regulator decided to treat it as a non-deposit-taking NBFC rather than as a development FI. When the Bank introduced the New Capital Adequacy Framework in April 2007, the company faced a problem. The risk weights for corporate borrowers with a credit rating of ‘AAA’, ‘AA’, ‘A’, and BBB and unrated corporate debt obligations were fixed at 20 per cent, 30 per cent, 50 per cent and 100 per cent, respectively. IDFC pointed out to the Bank in October 2007 that an exception to this principle had been made in respect of systemically important non-deposit-taking NBFCs. These attracted a risk weight of 125 per cent regardless of the credit ratings. IDFC actually had the highest ratings from all rating agencies for its debt instruments. The Bank, however, did not make any change during the reference period.

Non-Banking Financial Companies Pitfalls of Limited Regulation

The Reserve Bank exercised limited regulation of the NBFCs until the 1990s. The NBFCs were not permitted to accept demand deposits and were not part of the payment system and the CRR was not prescribed for them. The regulations in force until 1997 mainly dealt with rules concerning deposits and the protection of depositors. However, the NBFC sector had grown in size and diversity in the 1990s. In March 1997, the aggregate public deposits with the NBFCs stood at 12.3 per cent of bank deposits.20 There were also certain disquieting developments. Some companies offered exorbitant interest rates on deposits and were unable to service such funds. Clearly, the regulatory framework needed to be strengthened. The concept of registration of NBFCs by the Bank was introduced in 1993 for companies with net-owned funds in excess of 5 million. Until 1997, the system of registration was without statutory support, and registration was optional. Prior to 1997, the Bank could prohibit a company from accepting 442

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regulation of the financial system fresh public deposits, but could not ensure repayment of existing deposits. Since NBFCs did not need a licence from the Bank for opening branches, they had an incentive to open many branches. They used the services of agents and brokers who could mobilise deposits. The Bank did not have powers to evaluate the assets side of the balance sheet, that is, loans and advances, which left open a major loophole. The case of the CRB Capital Markets Ltd (CRB) served as a reminder of the weakness of the system. In 1994, the company had made an application to set up a commercial bank, and the Reserve Bank made a reference to the Securities and Exchange Board of India (SEBI). Although there were some issues in the past, SEBI had closed enquiry proceedings against CRB in December 1995. In May 1996, SEBI allowed CRB to launch its mutual fund, and on 4 July 1996, the Reserve Bank granted a conditional ‘in-principle’ approval to CRB to set up a banking company. With owned funds of 4 billion and public deposits of 1.86 billion, CRB had also applied to the Bank for registration as an NBFC, which could not be processed because of inadequate information. After two years, the company again applied in October 1996 for registration but in view of the adverse findings of a Reserve Bank inspection, and other complaints, the company was issued a show-cause notice on 24 February 1997. The Bank’s scrutiny revealed that the major segment of the company’s shares was held by its group companies. The group companies were accommodated by CRB through loans and advances. Also, CRB held a major segment of its group companies’ equity and, in turn, received loans and advances from them. The paid-up capital of 4 billion was created in this manner. Since their reply of 31 March 1997 to the show-cause notice was not satisfactory, orders were issued on 9 April 1997 prohibiting the company from accepting deposits. In line with these developments, the in-principle approval given to the company to set up a commercial bank was withdrawn on 9 April 1997.

New Regulatory Framework Designing an appropriate institutional set-up for the regulation of NBFCs was a key area of concern for the Bank for a long time. This received new emphasis in 1996, when the Supreme Court in its judgment in the case of RBI vs Peerless General Finance and Investment Company observed that the Bank being engaged in multiple activities, the government could create ‘a separate 443

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the reserve bank of india instrumentality’ entrusted with the task of supervision and enforcement of NBFCs. The Bank, in consultation with the government, set up a working group21 in September 1996 to examine the proposal. The group concluded that the Bank should continue to monitor the NBFCs as before. To avoid situations like the CRB episode, the RBI Act was amended by an Ordinance on 9 January 1997 and eventually replaced by an Act, effecting major changes in the regulation of NBFCs. The new provisions had cast certain obligations on the NBFCs and certain responsibilities on the Bank. The amendments empowered the Bank to determine policy and issue directions to NBFCs on entry point norms, minimum net-owned funds, compulsory registration, prudential norms and disclosure practices. The Bank was vested with powers to act against NBFCs that did not comply with the provisions of the Act. However, the Bank did not have the power to order a company to repay deposits as this power was given to the Company Law Board of the government. The Bank could lodge a criminal complaint in the case of noncompliance with the Board’s orders, cancel certificate of registration and, in worst cases, cause the winding up of the company. All existing NBFCs were now required to obtain a certificate of registration from the Bank to continue in business.22 Existing companies were required to raise their owned funds to the new limit by January 2000, which was later extended. Interest rate ceiling was fixed for deposits. The ceiling was not applicable to well-rated companies. For others, it was fixed at 15 per cent in 1997 and gradually reduced in line with market trends. The revised regulatory framework for NBFCs was announced on 2 January 1998. The regulations set an upper limit on public deposits that an NBFC could accept. This limit was linked to the credit rating by an approved rating agency. The requirements of minimum investment-grade credit rating, and/or higher capital adequacy ratio, were prescribed for deposit-taking companies. The NBFCs with a rating of less than ‘A’ or equivalent thereof would not be entitled to receive public deposits. Companies were permitted to regularise their excess deposits by December 1998. Within this period, NBFCs were expected to shore up their net-owned funds, or improve their credit rating, or substitute public deposits by borrowings. Deposit-accepting NBFCs were required to maintain a capital adequacy ratio of 10 per cent effective from March 1998, and 12 per cent from March 1999. This was higher than the 9 per cent CRAR fixed for commercial banks because the Bank wanted only financially sound NBFCs to accept public deposits. Deposit insurance did not apply in this case.23 444

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regulation of the financial system Disclosure requirements were strengthened and responsibilities cast on the Board of Directors and auditors of the companies to ensure that the operations of NBFCs conformed to deposit regulations and prudential norms prescribed by the Bank. The disclosure requirements were widened. The requirement of transferring 20 per cent of net profit to a statutory reserve fund every year applied to both deposit-taking and non-deposit-taking companies. Although the focus of regulations was deposit acceptance activities, the non-deposit-taking companies were subjected to prudential norms of income recognition, accounting standards, asset classification, and provisioning for bad and doubtful debts. But they were exempt from capital adequacy and exposure norms. The compliance with the regulatory framework by these companies was watched on the basis of exception reports. The stipulation of maintenance of liquid assets, credit rating, and credit and investment concentration norms were not applicable to NBFCs not accepting public deposits. With the amendments, stock-broking companies were brought under the Bank’s directions. But with a view to avoiding dual control on them by both the Bank and SEBI, the Bank granted an exemption to these companies from its directions. It was suggested to SEBI in June 1997 to place some restrictions on their capacity to raise public deposits under SEBI regulations. Insurance companies, merchant banking companies and chit funds were given exemption. With the comprehensive changes taking place in the statutory provisions governing NBFCs, including their compulsory registration, the Department of Non-Banking Supervision (DNBS) was created in July 1997 by carving out the Financial Companies Division from the erstwhile Department of Supervision.

Response Subsequent to the regulation, some NBFCs substituted public deposits by debentures and attempted to escape the Bank’s regulation. They repaid the deposits but the debentures were outstanding. SEBI was empowered to regulate the issue of debentures, both public and private issues, secured and unsecured. There was regular consultation between the Bank and SEBI in this regard. NBFCs were advised that debentures that were partly secured or secured by third-party assets and matured for redemption or were overdue would be treated as public deposits. A similar approach was taken with preference shares. 445

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the reserve bank of india In August 1997, bank trade unions struck work for two days, seeking ‘immediate ban on deposit acceptance by NBFCs from the public’, and the government sought the Reserve Bank’s comments. The Bank explained that since the deposits mobilised by them was just 5 per cent of bank deposits (annually), it did not support the ban. It was expected that more than 8,000 companies would seek registration with the Bank. In fact, the Bank received 37,478 applications from financial companies seeking a certificate of registration. Of these applicants, companies with net-owned funds of 2.5 million and above, fulfilling the primary eligibility criteria, numbered 8,938. The method of computation of net-owned funds sought to ensure that there was no diversion of funds by an NBFC to other companies within the group (as was the case with CRB).24 A committee was formed to issue certificates of registration.25 The committee’s mission was to maintain fairness.26 The government set up an Appellate Authority to consider appeals against the Bank’s rejection orders. The Authority held hearings and could order the Bank to reconsider an application. The process was fair, but not a smooth one. In a letter dated 24 November 1997, the President of the Hire Purchase and Lease Association complained to the Bank of delay in deciding the applications for certificates of registration. Bankers to NBFCs, the letter said, were not willing to sanction credit facilities without the certificate. Media, too, complained of the tight regulatory norms by the Bank. The Bank, however, remained committed to the screening process that it had designed. Industry’s reaction to the new regulations was very critical. In view of the criticisms, consultations with NBFCs were held, and certain provisions relaxed.27 Notwithstanding the relaxations, the requirement of minimum credit rating and linking of the quantum of deposits to the level of credit rating had hit the leasing and hire purchase companies. They were generally small in size, neither rated nor considered for rating by rating agencies. The representatives from the industry met the Governor in New Delhi in February 1998. In a seminar in March 1998, speakers protested mandatory credit rating and linking the quantum of public deposits to the rating. Two associations of NBFCs filed writ petitions in the High Courts of Chennai and Hyderabad for setting aside the relevant Reserve Bank directions. The government also wanted the Bank to review the stipulation of compulsory credit rating for acceptance of public deposits. The Bank replied in June 1998 stating that such de-linking was neither prudent nor in public interest. 446

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regulation of the financial system In April 1998, the Bank initiated a review of the regulations.28 Representations from industry stated that the provisioning norms were too harsh. The Institute of Chartered Accountants of India (ICAI) pointed out inconsistencies between accounting for investments prescribed by the Bank on the valuation of unquoted shares and the accounting standards issued by ICAI. Accordingly, directions issued in May 1998 sought to bring the prudential norms in alignment with the accounting standards of ICAI. New prudential norms were issued.29 One of the issues raised by NBFCs with the Bank in several forums was the discrimination by commercial banks in lending to NBFCs. When the matter was taken up with the banks, they responded that with the entry of banks in the retail business, NBFCs were their competitors and they would not fund competitors. In 1998, the Ministry of Finance had set up a Task Force on NBFCs to review the legislative framework and to suggest improvements in the procedures relating to customer complaints.30 The government accepted the recommendations of the Task Force, but some of the recommendations required amendments to the RBI Act. The Reserve Bank had given effect to the recommendations relating to deposit acceptance norms for NBFCs by issuing a notification in December 1998. The requirement of credit rating for acceptance of public deposits up to 100 million or 1.5 times of their netowned funds, whichever was less, was done away with, provided CRAR of the NBFC was 15 per cent or above. Later, the linking of the quantum of public deposits with the level of credit rating was removed.31 There were thousands of court cases. NBFCs or their associations or the investor groups filed petitions against the Bank, challenging the new provisions of the RBI Act or the directions issued. Besides, the prohibition on unincorporated bodies from accepting deposits was challenged in various High Courts. In the Karnataka High Court alone, the Bank faced 2,300 petitions. The Court upheld the Constitutional validity of the provisions. The Bank appealed to Supreme Court to bunch the cases from all High Courts and hear them out together. The matter was heard in the Supreme Court in March 2000 and a decision pronounced in May 2000, upholding the Constitutional validity and reasonableness of the provisions. Though the Bank claimed that it had ‘never been our intention to stifle the operations of the NBFC sector’, a few companies opted out of the NBFC business subsequent to the regulations. Some offered to repay the public 447

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the reserve bank of india deposits and decided to downsize their balance sheets. But those companies that had asset–liability mismatch because of excessive short-term deposits faced liquidity shortage. Some companies migrated from deposit-taking to non-deposit-taking category. They were allowed to park an amount equivalent to the outstanding public deposits together with the present value of future interest differentials in an escrow account by investing in government securities or in term deposits with commercial banks. Through a process of negotiations and consultations with the financial industry and other stakeholders, the NBFC regulations/directions were amended from time to time.

Further Interventions Subsequent to the 1997–98 reform, several specific areas saw further intervention by the Bank. As the minimum net-owned fund for new companies had been raised, some entities or individuals were expected to take over existing companies. Such sale or transfer of financial stake could be done only with the prior permission of the Bank, and with three months’ notice. Further amendments to NBFC regulations allowed exemption of deposits from relatives of the director of an NBFC from the definition of public deposits and introduced mechanisms to protect the interests of depositors of companies whose applications had been rejected to avoid asset stripping. To protect depositors’ interest, the Bank advised the NBFCs accepting public deposits (February 2005) to ensure that full asset cover was available for public deposits accepted by them. The assets for this purpose should be valued at book or market value, whichever was lower. They were further directed to create a floating charge on SLR investments in favour of depositors and be registered in accordance with the requirements of the Companies Act. In view of the practical difficulties in creating such a charge in favour of a large number of depositors, it was decided that companies could do it through a trust deed. Companies found it difficult and uneconomical to enter into trust deed arrangements with banks or their trusteeship associates for the creation of charge on their liquid assets. In Kerala, no company could create a floating charge on its assets due to the non-availability of a bank or institution engaged in trustee business. Most small companies in Kerala had to repay their deposits since they could not make any progress in this regard. The Kanpur office 448

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regulation of the financial system reported that twenty-six of the thirty-six deposit-taking NBFCs were not able to create a floating charge because no commercial bank was willing. Microfinance institutions (MFIs) that did not accept deposits and provided credit not exceeding 50,000 per borrower were exempted from certain provisions of the RBI Act, including the requirement of registration as NBFCs. There were demands from some quarters to permit exempted MFIs to accept public deposits. This was not accepted. There was a suggestion from the Prime Minister’s Office for reducing the entry capital norm in respect of new microfinance companies. The Bank’s Rural Planning and Credit Department also wanted relaxations in entry-level norms for microfinance companies as they served the rural poor on a ‘not-for-profit’ basis. This was not acceded to either, as it would not be possible for the Bank to regulate or supervise a large number of small microfinance companies. However, in 2005, a new class of NBFCs undertaking microfinance activities was recognised and subjected to relaxed regulatory norms. Though the minimum net-owned fund was kept unchanged at 20 million, they were allowed to issue preference shares. In framing these proposals, international standards laid out by the Consultative Group to Assist the Poor (CGAP), a global organisation working to promote financial inclusion, as well as other country experiences were taken into account. Even in 2007, there were a large number of deposit-taking NBFCs that had not attained the minimum net-owned fund. They were given two more years to meet the condition, after which any NBFC still not able to fulfill the condition would be automatically converted to non-deposit category and the deposits held by them were to be repaid within three years. The NBFC federations represented that the policy was harsh and could lead to a liquidity crisis. The proposal was modified to extend the time to three years.32 A separate set of updated prudential norms in supersession of the previous Non-Banking Financial Companies Prudential Norms (Reserve Bank) Directions of 1998 were issued for deposit-taking NBFCs (including RNBCs) and non-deposit-taking NBFCs in February 2007. These directions covered income recognition, investments, accounting standards, capital adequacy, asset classification, provisioning requirements, disclosure requirements and auditors’ certificate.33 All non-deposit-taking NBFCs with an asset size of 1 billion (reduced from 5 billion under the earlier framework) and above would be considered as systemically important NBFCs, and subject to different rules. 449

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the reserve bank of india

Systemically Important NBFCs The non-deposit taking NBFCs as a category expanded sharply with the advent of foreign direct investment (FDI). In April 2001, the government placed FDI in NBFC under the automatic route, subject to minimum capitalisation norms. Several foreign firms showed interest in acquiring stakes in NBFCs.34 The interest was due to the arbitrage opportunities available in the sector vis-à-vis the banking sector, and the light regulatory framework for non-deposit-taking NBFCs. The inflow of money also gave an opportunity to the companies to diversify into activities like real estate through subsidiaries where FDI was prohibited. Because of the restrictions imposed on the opening of branches by foreign banks, some foreign banks were using the NBFCs to operate as their branches. Domestic funds by way of debentures and bonds, which the foreign banks were disallowed from tapping, were accessible to their NBFC arms. By September 2005, there were twenty-seven foreign-owned NBFCs (of these, nineteen were from the United States) operating in India.35 This development worried the Bank. Taking into consideration an internal group’s recommendations and feedback thereon, a revised framework pertaining to systemically important non-deposit taking NBFCs (NBFCND-SI) was announced in the Mid-Term Review of the Annual Monetary Policy for 2006–07.36 One option on the table was the introduction of capital adequacy ratio requirements for such NBFCs to limit the leverage of capital funds. The final guidelines issued in December 2006 created a tighter regulatory regime for systemically important non-deposit-taking NBFCs.37 Two other important subcategories of NBFCs were the RNBCs and the ARCs.

Residuary Non-banking Companies (RNBCs) During the reference period, there was a sharp growth in public deposits with RNBCs and a steep decline of deposits with other NBFCs. The absence of any ceiling on the quantum of deposits that could be accepted by the RNBCs and the absence of linkage with a credit rating or net-owned funds were the reasons behind this trend. As of January 1999, 100 RNBCs had applied for certificate of registration but only one company, India Financial Corporation Limited, Lucknow, was issued the certificate. A discussion paper was prepared in 1999 containing proposals to ensure that their financial position was sound, 450

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regulation of the financial system and there was a substantial improvement in accountability and transparency of their operations. In a speech delivered at a seminar in the RBI Staff College, Chennai, on 4 March 1999, former Deputy Governor Tarapore said, ‘What totally hamstrings RBI is that those NBFCs which cannot adhere to the regulatory framework can take cover under the RNBCs framework which has inherent weaknesses.’38 Deputy Governor Talwar wrote to the Ministry of Corporate Affairs in 2000 to work out a mechanism so that no new company took up the business of RNBC in the country. In 2000, Peerless General Finance and Investment Company Ltd (Peerless) and Sahara India Financial Corporation Ltd (Sahara) were the two major RNBCs with deposits comparable to those of medium-sized banks. These two companies were distinct in that no other category of NBFCs had ever held deposits of the magnitude that these two had raised. The fact that there was a regulatory vacuum of sorts in this case, therefore, was particularly disturbing. The RNBCs were required to invest 80 per cent of their deposit liabilities in government-guaranteed securities, term deposits with commercial banks, and bonds and debentures of companies and mutual funds.39 In view of the supervisory concerns, it had become necessary to improve their capital structure on par with commercial banks. In stages, the level of investment in government securities was enhanced, and rating and listing requirements of the approved instruments made mandatory. The RNBCs’ investment in bonds, debentures and certificates of deposit (under ‘directed investments’) needed a rating not less than AA+ grade or its equivalent by an approved rating agency. Besides, they were restricted from investing in equity-oriented mutual funds and allowed to invest only in debt funds. The ‘discretionary investments’ of an RNBC was limited to 20 per cent. The percentage of discretionary investment was to be reduced to 10 per cent by April 2005 and 0 per cent by April 2006. The RNBCs represented against the revised prudential norm on directed investments and the chief executive officers (CEOs) met the Governor. Both the RNBCs made several representations to the Bank for relaxations in ‘discretionary/directed investments’. The Bank, therefore, deferred implementation by a year to April 2007. The Bank also issued instructions to improve the transparency of operations, connected lending, corporate governance and minimum rate of interest. However, inspection of these companies revealed continued non-compliance with the core provisions of the directions, forfeiture of the 451

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the reserve bank of india depositors’ money on one pretext or the other, diversion of money to sister and associate concerns, investment in illiquid assets, and violations of investment requirements jeopardising the interests of depositors (see Chapter 11). An internal working group in December 2006 examined the viability of RNBCs, and suggested strategies for a smooth transition out of the current business model. Both Peerless and Sahara were advised to exit the business model. The matter was under correspondence at the close of the reference period.

Asset Reconstruction Companies (ARCs) In 2000, the Bank, in consultation with the government, formulated a scheme for setting up ARCs to take over the NPAs of weak banks. The draft scheme was sent to the government in April 2000. The Finance Minister had a meeting with the CEOs of public sector banks for resolution of NPAs. The Minister desired that the participants could explore the possibility of setting up ARCs without waiting for specific legislation. To facilitate this, the Ministry of Finance formed a committee to explore the possibility of setting up ARCs within the existing legal framework.40 Based on its report, the Finance Minister decided that an ARC would be formed in the public sector as a company and registered with the Bank as an NBFC. IDBI would be the main promoter and the capital would be contributed by banks and FIs. Since the regulations applicable to non-deposit-taking NBFCs would not be relevant to an ARC, the Governor wrote to the Finance Secretary in January 2002 that it was ‘neither feasible nor legally appropriate for RBI to “regulate” or to lay down prudential norms for the ARC’. The Ministry replied that the ‘regulatory framework for the ARC will be decided in consultation with RBI’. The pilot ARC, the Asset Reconstruction Company of India Limited (ARCIL), was incorporated in February 2002. The central government later asked the same committee to finalise the draft legislation, combining the provisions of the draft Bill for Enforcement of Securities Interest by Banks and Financial Institutions, the draft Securitisation Bill and the legal framework concerning ARCs. In 2002, the draft SARFAESI Bill became law. The Act would enable banks and FIs to securitise long-term assets, manage problems of liquidity and asset–liability mismatches, and improve recovery by exercising powers to take possession of securities, sell them without going through the judicial process and reduce NPAs by adopting measures for recovery or reconstruction. The Act also created a framework 452

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regulation of the financial system for licensing companies that would undertake activities of securitisation and asset reconstruction. The Act did not give any direct power to the Bank to inspect or supervise ARCs. However, the Act did cast responsibility on the Bank to frame guidelines on registration of ARCs and securitisation companies, prudential norms for these companies, and for the acquisition of assets and enforcement of security interest.41 The Bank set up two working groups in July 2002 to fulfill this mandate.42 Following these discussions, on 7 March 2003, the format of the application form for grant of certificate of registration was released by the Bank. By 24 March, six applications from existing companies and three from proposed companies were received. The draft guidelines and guidance notes were sent to the Ministry of Finance on 10 March 2003. On receiving the government’s approval, on 23 April, the Bank issued the circular. In August 2003, the Bank exempted ARCs registered with it under the SARFAESI Act from certain provisions of the RBI Act, concerning compulsory registration, maintenance of liquid assets, and compulsory transfer of a part of the profit to a reserve fund. Banks were not to invest in unrated non-SLR securities. Therefore, to make security receipts eligible for investment by banks, a rating of security receipts was made conditional. The guidelines for the takeover of management (of the NPA borrower) and sale or lease of the business concerned, though provided for by the Act, were still pending. Therefore, ARCs were advised to refrain from the takeover of management. The second working group43 was reconvened in 2003 to discuss the two issues in detail. The group prepared draft guidelines for change or takeover of management, and sale or lease of the borrower’s business. However, pending a decision in a case filed in the Supreme Court questioning the validity of the SARFAESI Act (Mardia Chemicals vs Union of India), further action was kept in abeyance until 2006. The Bank set up an External Advisory Committee (EAC) to examine the applications received and make recommendations to the Bank on certificate of registration.44 The first certificate was issued in August 2003 to ARCIL. For another four years, no other certificate for an ARC was issued. In order to ensure that the size of capital had some relationship to the value of assets acquired by the ARC, the External Advisory Group recommended in a meeting in February 2004 that the minimum paid-up capital for ARCs should be (instead of 20 million fixed for generic NBFCs) fixed at 15 per cent of the assets acquired or to be acquired or 1 billion, whichever was 453

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the reserve bank of india lower. To ensure that the ARCs held stake in the asset acquired by them, that the mechanism of securitisation did not result in only parking of NPAs, and that they gave comfort to the qualified institutional investors, it was decided in September 2006 that the ARCs should invest in the security receipts an amount not less than 5 per cent issued by them under each scheme. The government sought the Bank’s views on foreign investment in ARCs and in security receipts issued by ARCs. The government convened a meeting in September 2004 and favoured a liberal approach to FDI in ARCs. The Bank and the government came to an understanding, and the government issued a notification in June 2005 permitting FDI up to 49 per cent in ARCs with the approval of the Foreign Investment Promotion Board and giving ‘general permission’ to foreign institutional investors to invest up to 49 per cent of each tranche of scheme of security receipts issued by ARCs. The draft guidelines on calculation and declaration of the net asset value (NAV) of security receipts were ready in October 2006 and final guidelines were issued in May 2007. The ARCs were advised to declare NAVs of security receipts at periodic intervals so that qualified institutional buyers could value their investment in security receipts. A concept paper on the guidelines for a change in or takeover of the management of the business of the borrower under the provisions of the Act was put up to the EAC in May 2006. After prolonged deliberations in the EAC over a period of time, the draft guidelines were issued in September 2008. Until March 2008, the Bank had received twenty-seven applications for grant of certificate and six had been granted.45

Government-Owned Institutions The non-banking financial institutions sponsored by state governments did not have to obtain certificates of registration from the Bank. They were also exempted from provisions of NBFC prudential norms directions because these entities were governed by norms prescribed by their own government department or ministry or a nodal agency like IDBI for State Industrial Development Corporations (SIDCs). A letter from Deputy Governor Talwar raised the issue with the Government of India in September 1999 and urged a comprehensive review of the rules (see an extract of the letter in Appendix 10A.2.1). There was no further communication between the government and the Bank in this matter. 454

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regulation of the financial system In 2006, the Bank proposed to bring all government-owned companies under the provisions of the prudential norms directions of the Bank for NBFCs. Such companies were advised to prepare a roadmap for compliance in consultation with the state government and submit to the Bank by March 2007. However, little progress was made in this area. The SFCs were governed under the provisions of SFC Acts. They were not companies as defined by the Companies Act, nor were they NBFCs. Instead of regulations relevant to either one of these categories, they were subject to prudential norms prescribed by IDBI and later by SIDBI. But the SIDCs were engaged in extending loans and this activity came within the purview of financial business defined in the the Bank Act. The SIDCs sought exemption from the Bank on the ground that they performed social functions and the objective of setting them up was distinct from NBFCs in the private sector. There was not much concern about depositors’ interest as they were functioning under the respective state governments with an implicit guarantee for the repayment of deposits.

Financial Companies Regulation Bill, 2000 In 2000, the government was advised that the Bank was in the process of designing new legislation for the regulation of NBFCs. The Bill was later drafted by the government, in consultation with the Bank, to take care of the concerns of the Bank in regulating NBFCs.46 Similar in spirit to the BR Act, the proposed Act was expected to provide for a comprehensive legal framework. The Bill was referred to the Standing Committee of Parliament. In the sitting on 29 January 2003, there was a divergence of views regarding the jurisdiction of the Bank. The standing committee, in its report of July 2003, observed that the Bank should concentrate on the regulation of those incorporated bodies that were accepting deposits. Non-deposit-taking financial companies, investment companies and special purpose vehicles should be excluded from the purview of the Bill. Five years after conceptualisation, the Bill did not take a final shape and lapsed with the dissolution of the Lok Sabha in 2004.47 Following the CRB episode, there were demands from several quarters that insurance protection should be extended to the depositors of NBFCs. This issue was examined in 1997 by a working group set up by the Bank.48 While recognising the need for insurance cover to NBFCs, the group suggested that deposit insurance could be considered only for registered NBFCs complying with all regulatory and supervisory norms, that too only after a period of six 455

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the reserve bank of india years when the process of consolidation of the NBFC sector was expected to be completed. Opinion within and outside the Bank sided with the view against insurance.49 The Bank conducted many workshops and seminars to inform and engage stakeholders in NBFCs, provided training, and made publicity campaigns for creating awareness. State governments were requested to frame legislation on the lines of the Tamil Nadu Protection of Interest of Depositors Act, 1997. The Act provided for action against FIs that failed to return deposits, arrest of persons responsible and special courts for speedy trial, attachment and sale of properties, and distribution of the money to the depositors. Other areas where the Bank intervened included an extension of nomination facility, additional interest paid to senior citizens, foreign exchange operations by NBFCs, mutual funds operations and fraud prevention. The Bank also regulated and supervised primary dealers (PDs). The system of PDs was introduced in 1996. Their operations have been covered in Chapter 7. The period witnessed a marked qualitative change in the sector, with a general decline in overall deposit acceptance by NBFCs (excluding the two RNBCs whose share rose) and the emergence of large systemically important NBFCs.50 The overall approach of the Bank was to protect the depositors, prevent systemic risk, avoid regulatory arbitrage and, over a period of time, replace public deposits with other resources. The Bank had broadly succeeded in meeting these objectives. The bank borrowings of NBFCs were not significant and so the systemic risk was not much. The low NPA level, less dependence on deposits and bank borrowings, and stable business indicated a move towards consolidation of the sector but with a sharp decline in the sector’s market share.

Urban Cooperative Banks UCBs recorded substantial growth in the 1990s, thanks to deregulation of interest rates, a liberal licensing policy, focus on small depositors, and a shift in the focus from accepting deposits from members to actively soliciting deposits from the public.51 The entry norms for UCBs were revised in April 1998. The low entry point norms facilitated the mushrooming of UCBs. The number of UCBs increased from 1,306 in 1991 to 2,050 by 2000. At the same time, UCBs suffered from a lack of professionalism and lack of modern technology and technical support. The capital build-up was 456

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regulation of the financial system inadequate as they had low retained earnings, and raising additional capital from members was not easy. Corporate governance was an issue. When many shareholders/directors were also borrowers, the management had a conflict of interest. State governments and the Bank both had regulatory powers. State governments had jurisdiction over management and audit, and the Bank over banking operations. For the Bank, the major impediment to regulating UCBs was political involvement in their operations. The directors were often political figures. For instance, whenever a new political party came to power in Tamil Nadu, the state government would issue orders to supersede all elected boards of cooperative banks/societies and appoint administrators. The practice was not confined to Tamil Nadu alone. The dual jurisdiction did not work well.52 Another problem was the proliferation of unlicensed banks. Under Section 22 of the BR Act (As Applicable to Cooperative Societies), or BR Act (AACS), if a primary credit society’s share capital and reserves reached a level of 0.1 million, it would get automatically converted into a UCB. They continued to transact banking business without a licence as no decision had been taken on their licence applications by the Bank for years – over thirty years in many cases. Subject to these constraints, a series of steps were taken during the reference period to improve the operations and transparency of UCBs.

Inclusion in the Second Schedule of the RBI Act The inclusion of a bank in the second schedule of the RBI Act enabled the bank to have access to refinance facilities from the Reserve Bank, free remittance of funds from the Bank, and enhanced public confidence in it. There was also a greater acceptance of guarantees issued by a scheduled bank. Between 1997 and 2003, thirty-three UCBs were scheduled by the government at the recommendation of the Bank, taking the total number of scheduled UCBs to fifty-seven. An in-house working group recommended an increase of minimum share capital from 0.5 million to 200 million. The Reserve Bank made it a condition that the urban bank should have a licence from the Reserve Bank and have deposits of 1 billion or more and the affairs of the bank be conducted prudentially. Subsequently, the condition that gross NPAs should not exceed 15 per cent of the advances was also added. In August 2001, the Governor approved additional conditions for scheduling.53 457

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the reserve bank of india In May 2002, there were seventy-two applications pending with the Bank for scheduling. A group was set up by the Bank to study the experiences in regard to the inclusion of UCBs in the second schedule and recommend revised criteria. Based on the recommendations of the group, the government issued a notification in October 2003 stating that only such UCBs which were licensed and whose deposits were not less than 2.50 billion would qualify for the purpose of inclusion in the second schedule. The high bar kept many UCBs out. In July 2004, UCBs were advised by the Reserve Bank that no bank would be included in the second schedule of the RBI Act until proper legislative framework was brought about. This policy continued until 2008. In May 1999, a Reserve Bank committee had discussions with industry federations, the UCB sector and state government officials on the regulation of UCBs.54 It made recommendations on revision of the licensing policy for new UCBs, with increase in entry point norms, rationalisation of branch licensing policy, extension of areas of operation, methodology for dealing with unlicensed and weak banks, application of capital adequacy norms, conversion of cooperative societies into UCBs, and measures to overcome the dual control by amending the relevant statutes. The Bank implemented the recommendations and revised them over a period.55 The committee had also suggested a dual criteria of strong start-up capital, professional background of promoters with proven track record, and licensing of the 181 unlicensed UCBs (as of June 1999), subject to compliance to the stipulated criteria, and to weed out other weak banks by initiating action through moratorium, reconstruction, amalgamation or rejection of application for banking licence by March 2002. Since unlicensed banks had been granted enough time to fulfil the norms, the Reserve Bank decided that they should either be granted a licence if they fulfilled the norms or their licences should be refused by March 2002.56 Subsequently, CRAR norms were adopted for compliance by UCBs. Other recommendations relating to branch licensing, the opening of extension counters, an extension of the area of operations and the new definition of weak banks were also implemented. The bigger UCBs were advised to set up the audit committee of the board. The issue of dual control would require legislative changes. The subject ‘cooperative societies’ came under both the union and state lists in the Constitution, and, therefore, the duality of control was inevitable. The committee had recommended an amendment to the BR Act 1949 (AACS) and the Cooperative Societies Acts of state governments to demarcate the 458

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regulation of the financial system banking related functions, to be regulated by the Bank, and other administrative areas regulated by the Registrar of Cooperative Societies (RCS) representing the state government. The recommendations were forwarded to the state governments in December 1999, for carrying out amendments to the State Cooperative Societies Acts. This being a sensitive issue with a bearing on centre–state relations, the Bank also wrote to the union government in March 2000 requesting amendment of the relevant union law and pursuing the matter with the state governments. The Bank proposed that until amendments were carried out, licences for new UCBs and branch expansion should be on hold. In August 2000, the policy was revised to allow opening of new banks where revised entry norms were complied with. Preference was given to states that had carried out the recommended legislative changes. However, the efforts to persuade state governments to amend laws did not succeed. The central government indicated that they could not force state governments to do this, and suggested that the Bank should assume more powers by amending the BR Act. The Legal Department of the Bank held that the Bank could not assume more powers unless amendments to the BR Act were carried out together with amendments in the State Cooperative Societies Acts. In the end, however, amendments to the BR Act were drafted and sent to the government in December 2003. The changes would bring regulatory and supervisory powers of the Bank over UCBs on a par with that over commercial banks. The state governments opposed the amendments in a concerted way (see Part I of Chapter 10) and the government allowed the Bill to lapse with the dissolution of Parliament in 2004.

The 2001 Crisis The Madhavpura Mercantile Cooperative Bank, the largest UCB in Gujarat, was lending out money to stockbrokers in violation of the Bank’s instructions. In March 2001, following rumours of it lending a large sum to a stockbroker who lost heavily in the stock market crash that year, depositors began to withdraw their deposits from the bank, which at that time held about 6.34 billion from 282 UCBs in Gujarat and from other states. The withdrawal of deposits within a short time resulted in severe liquidity problems for the bank. (The episode is discussed in detail in the next chapter.) While attending to the crisis, the Reserve Bank took further measures to strengthen the regulatory 459

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the reserve bank of india framework for UCBs. Such measures covered CRAR for scheduled and non-scheduled banks, investments in government and approved securities, restrictions on investment in other UCBs and institutions, restrictions on call market operations, management structure, access to uncollateralised funds, and lending against volatile assets like shares, among others. A series of steps and recommendations to improve the functioning of the UCBs followed this episode.57 In 2002, another major crisis broke out in Andhra Pradesh. One of the largest banks in the state, Charminar Cooperative Urban Bank Ltd, faced a run following a newspaper report of an inquiry into the affairs of the bank by the State Registrar of Cooperative Societies. The bank was in a weak position, and after attempts to revive it failed, its licence was cancelled by the Bank (also see next chapter). Following this episode, the Bank norms were again revised and some flexibility was introduced.58

Other Issues in Regulation On several occasions, the Bank was dealing with regulatory and operational problems of UCBs, and sometimes its actions set a precedent. For example, the Gujarat government issued an order in 1997 under the State Societies Act to UCBs to invest in the non-convertible bonds of Gujarat Small Industries Corporation, a state government undertaking and not guaranteed by the state government. About forty banks invested substantial amounts and the corporation defaulted in repayment. The banks appealed to the Reserve Bank with a request to be allowed to make provisions for the non-performing investments in a phased manner, but the Reserve Bank did not accede to their request. Under the provisions of Section 24 of the BR Act (AACS), both scheduled and non-scheduled UCBs could maintain their SLR funds in the form of deposits with central cooperative banks and SCBs. However, the aforementioned committee had commented that ‘keeping SLR funds with cooperative/commercial banks in itself is an indefensible dispensation’. Therefore, the switch from bank deposits to government securities was initiated by the Bank in a phased manner and completed by March 2003 despite intense lobbying by the industry and federations against the move. Restriction on UCBs placing deposits with other UCBs continued.59 From 2002 to 2007, several banks defaulted in the maintenance of reserve requirements, mainly due to the heavy withdrawal of deposits. They sought 460

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regulation of the financial system a waiver of penalty.60 A framework for examining the requests for waiver of penal interest was drawn up and implemented. The Joint Parliamentary Committee ( JPC) on the stock market scam of 2002 had recommended a ban on the grant of loans and advances to directors, their relatives and the firms in which they were interested. The Bank issued instructions in April 2003 to UCBs not to sanction any fresh loans, including ‘loan against deposits’, to the directors and their associates. There were representations in protest from the industry, including one from the National Federation of Urban Cooperative Banks. They questioned the ban on ‘loans against deposits’, which even commercial banks granted to its directors. The JPC did not specifically mention ‘loan against deposits’ in their recommendation. Some banks in Kerala, Karnataka and Gujarat filed writ petitions in High Courts against the Reserve Bank’s decision. The Bank recognised the risk that the directors might withdraw their deposits if they were not allowed to take loans against the security of deposits. It approached the Ministry of Finance in February 2006 for relaxation of the ban on loans against deposits and LIC policies. In March 2007, after further consultation with the government, UCBs were allowed to lend against deposits to their directors. Despite the relaxation, of the twenty-five UCBs penalised for different reasons in 2007–08, ten were penalised for violating the Bank’s directives on loans and advances to directors. In 2001, four new UCBs were set up in Kozhikode district of Kerala without the Bank’s licence. They were registered under the Kerala Cooperative Societies Act, 1969. Their entry in the banking business without a Reserve Bank licence was a violation of the BR Act. Since the Government of Kerala refused to take any action, the Bank issued a notice in leading newspapers cautioning the general public that the Bank had not granted licence and that the depositors were at their own risk. The RCS, Kerala, issued a rejoinder in the press stating that the banks did not require a licence from the Reserve Bank to conduct banking operations and the public should not be carried away by malicious propaganda by the Reserve Bank. The Reserve Bank initiated criminal proceedings against these banks and their directors and took up the matter with the Chief Secretary, Finance Secretary and the Registrar in December 2001. The existing UCBs filed writ petitions against the new banks and state government authorities. The High Court in its order dated 29 November 2002 observed that the process of registration and licensing, as far as cooperative banks were concerned, was complimentary to each other. 461

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the reserve bank of india Though the registering authority was the RCS, the purpose of registration was the transaction of banking business, which was regulated under the provisions of the BR Act. The Reserve Bank was the authority with supervisory powers over banking institutions. The Court concluded that the Kerala Cooperative Societies Act and the associated rules did not permit registration of a cooperative society as an ‘unlicensed urban bank’ and directed the Registrar not to permit any unlicensed UCB to function. 

Resolution of Weak Banks The reasons for weakness in UCBs were poor credit management, connected lending, heavy reliance on high-cost deposits and adverse selection of borrowers, all resulting in a high level of NPAs. The BR Act (AACS) did not prohibit granting of secured loans to the directors, their relatives or the firms in which they were interested. The procedure for dealing with weak banks involved advice to draw up a time-bound action plan. They were given reasonable time for a revival, and if revival was not found possible, then amalgamation with a strong bank would be considered. If even that was not possible, then the Reserve Bank would have to take the extreme step of cancelling their licences or rejecting applications in the case of unlicensed banks and take them to liquidation. The State Level Rehabilitation Review Committees convened by regional offices of the Reserve Bank at half-yearly intervals monitored the performance and progress of weak banks in the states. The committees were reconstituted in 1998. The CEOs of the weak banks had to be invited for discussing revival plans and to chalk out a time-bound plan, failing which merger or liquidation would be unavoidable. In 1999–2000 alone, twenty-one licences were cancelled and the banks taken to liquidation. In February 2005, the Bank initiated measures for consolidation of UCBs and exit of weak and insolvent banks, and issued guidelines for merger and amalgamation. To smoothen the process of mergers in the sector, it was decided to permit the acquirer UCB to amortise the losses taken over from the acquired UCB over a period of five years. The federations of UCBs represented that the provisions relating to carry forward and set-off of accumulated losses, envisaged under Section 72AA of Income Tax Act, in case of amalgamation of a banking company should be made applicable in case of mergers among cooperative banks. This was taken up with the government in September 2006 462

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regulation of the financial system and reminded in March 2007 and the government amended the Income Tax Act in the following year. The Reserve Bank decided that banks with negative net worth or without minimum capital should wind up. This approach was followed in a staggered manner with some consideration for weak UCBs. The Deputy Governor had meetings with seven scheduled UCBs with negative net worth in August 2006. The banks were advised that if they did not attain positive net worth by March 2007, the Reserve Bank would be constrained to consider withdrawing their scheduled status and even cancelling their banking licence. The banks did not take these threats seriously, presuming that the Bank would avoid such steps to prevent panic withdrawal of deposits.

Multi-State Cooperative Societies Act

UCBs that had a presence in more than one state were governed by the Multi-State Cooperative Societies Act, 1984, under a Central Registrar of Cooperative Societies (CRCS). There were thirty-three multi-state cooperative banks (MSCBs) in 2002. The Reserve Bank suggested several amendments to the Act, or to replace it with a new Act, and forwarded draft proposals to the Ministry of Finance. In July 2002, the government notified a new Multi-State Cooperative Societies Act (MSCS), repealing the old Act of 1984. The new Act made several changes with implications for banking regulation without consulting the Reserve Bank. Section 17 of the new Act dispensed with the provision for sanction in writing from the Bank before the Central Registrar approved an amalgamation or reconstruction of an MSCB. The provision of the Central Registrar passing an order for supersession of a cooperative bank, if so required by the Reserve Bank, available in the earlier Act was omitted. Further, there were no provisions in the new Act empowering the Reserve Bank or the government to declare waiver or write-off and, hence, the CRCS did not consider it appropriate to issue guidelines to MSCBs as it was done by the State Registrars of Cooperative Societies. The Bank proposed filling these gaps through amendments to the BR Act. Because of a Supreme Court ruling in the case of Apex UCB for Maharashtra that the provisions of the BR Act did not apply to MSCBs, the Reserve Bank had no authority under the BR Act to issue guidelines to these banks. An ordinance was issued by the government in September 2004 amending the BR Act as advised by the Reserve Bank. The ordinance removed ambiguities in the Bank’s regulatory and supervisory powers over MSCBs. 463

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Vision and Medium-Term Framework for UCBs In 2004, Governor Reddy initiated steps to prepare a draft ‘vision document’ for the sector.61 The document advocated a state-specific policy proposing an MoU to ensure convergence of approach between the Bank and state governments. It also suggested the constitution of the state-level Task Force on Cooperative Urban Banks (TAFCUB) in five states with a large presence of UCBs. Based on this, a draft ‘medium-term framework’ was designed. After revisions, the framework was placed on the website (March 2005) for comments and received thirty responses. A retired bank executive wrote to the Governor that the document contained ‘the sad story of inability or disability or incompetence of RBI to supervise this small sector of the economy’. Stating that the MoU was pointless, the letter ended with the lament, ‘Only God can save poor depositors.’ The other responses were similarly cynical. It was decided that after the signing of the MoU, a TAFCUB would be set up in each state with senior officers of the Bank and the state government as members. The TAFCUB would also have representatives from the industry and associations and chaired jointly by the Regional Director of the Reserve Bank and the RCS. The idea was to settle problems through dialogue. Deputy Governor Leeladhar wrote to the Chief Ministers of Gujarat, Andhra Pradesh and Maharashtra, the three states that had the largest share of UCBs in the country, to impress upon them the need for signing the MoU. He also personally met the Chief Ministers and held a discussion with them. After the Deputy Governor’s presentation in Gujarat, the then Chief Minister, Narendra Modi, appreciating the initiative of the Bank, observed that the draft MoU needed to be reformulated to make it more acceptable to both signatories without losing its main thrust. Taking these and other feedback into consideration, a revised draft of the MoU was placed before the Settlement Advisory Committee (SAC) on 31 May 2005. The Andhra Pradesh and Gujarat governments signed the MoU on 27–28 June 2005, followed by Karnataka and Maharashtra. The Ministry of Agriculture in the Government of India signed the MoU with the Bank with regard to MSCBs in January 2007. The TAFCUBs were operationalised soon after the MoUs were signed. The TAFCUBs identified potentially viable and non-viable weak UCBs in the state and suggested a revival path for the former and a non-disruptive exit route for non-viable banks. Being a consultative process, such decisions received greater acceptability. The positive impact of a consultative platform was seen in the decline in the number of weak and sick banks in the three 464

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regulation of the financial system states that were the first to sign the MoU. The process eliminated the pitfalls of dual control and facilitated decision-making. In the TAFCUB meetings, the Bank members impressed upon the RCS to appoint only professional chartered accountants and law firms as liquidators of failed cooperative banks. By January 2008, MoUs had been signed with fourteen state governments and with the central government for multi-state UCBs. This had effectively covered 83 per cent (1,514) of the total UCBs and 92 per cent of the deposits of the sector. Public confidence in the UCB sector in Gujarat was restored to a large extent after the formation of TAFCUB. Many UCBs in the state recovered and stabilised quickly. Overall, in March 2005, 725 of the 1,872 UCBs were in Grades III and IV. The number came down to 496 in March 2008 and the number of banks in Grades I and II had gone up correspondingly. Arising out of the comfort of coordinated regulation in states that had signed the MoU with the Bank, certain additional business opportunities were extended to eligible UCBs in such states. These included the permission to set up currency chests, sell mutual fund products, open ATMs and granting of a licence to deal in foreign exchange, sell insurance products and convert extension counters into branches, subject to conditions. TAFCUBs enabled more informed decision-making and better implementation, expeditious approvals for revival plans, and consolidation of the sector through mergers with local-level inputs. Since TAFCUB was taking a view on UCBs in Grades III and IV in states that had signed the MoU, the Bank acted on the basis of its recommendations. Unlicensed banks were accorded preferred treatment in the MoU states on the basis of TAFCUB’s recommendations, as entry point norms were not applied for the grant of licences to these banks. The functioning of TAFCUBs was not without problems. In one case in 2007, the Bank took a course of action in respect of a weak bank that was contrary to TAFCUB’s recommendation. The Bank justified its action arguing that it was ‘not only based on inputs from TAFCUB but also from other sources based on regulatory and supervisory experience, knowledge of domestic and international best practices and the socio-economic objectives’. However, the Urban Banks Department happened to retrieve an earlier paper in which Governor Reddy had noted, ‘It is not a good signal for Central Office to reject any recommendation of TAFCUB.... I have no issue with the conclusion, either way … but the process?’ Subsequently, all such cases where the Bank held a different view were sent back to TAFCUB for review. 465

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Prudential Norms The mid-term review of monetary and credit policy for 2001–02 observed that ‘the prudential norms and the regulatory system prescribed for UCBs have traditionally been relatively soft, in comparison with those for commercial banks. This is partly on account of historical reasons, and partly due to their size being generally small and the preferential treatment of co-operative structure in general’.62 In April 1999, UCBs were advised to make a general provision of 0.25 per cent on standard assets from March 2000, which was raised to 0.40 per cent in November 2005. The guidelines for the valuation of investments were issued in February 2000. UCBs were advised to bifurcate their investments into ‘current’ and ‘permanent’ and to make provision for the depreciation in ‘current’ investments. In October 2001, a meeting with the Governor was convened by the Union Finance Minister at the request of the Urban Cooperative Banking sector in Maharashtra. The industry representatives wanted more time for compliance with prudential norms. Governor Jalan said in that meeting that as long as the responsibility of protecting depositors’ interest was cast upon the Bank, the sector should learn to live within a prudential regulatory framework. By June 2004, the prudential norms as applicable to commercial banks in respect of NPA classification were extended to UCBs.63 UCBs were granted time to meet the provisioning requirements progressively over a five-year period commencing from March 2005. UCBs operating on a small scale within a district were allowed to classify NPAs based on 180-day norm until March 2007, whereas, for other banks, the norm was 90 days. The federations asked the Bank why ‘global norms’ had to be applied to cooperative banks and pointed out drought conditions in many states. There were several representations from Members of Parliament, and other public representatives demanding that the government and the Bank should reduce the rigours of prudential norms.64 Generally, the Bank set norms for UCBs in line with those for other regulated entities. Late in the reference period, a working group was set up to examine the applicability of Basel II norms to Reserve Bank regulated entities other than commercial banks (2007).65 In 2001, a working group discussed asset–liability management guidelines for UCBs. The group’s report was circulated among select UCBs. The Deputy Governor desired further simplification of the guidelines. The College of Agricultural Banking (CAB) in Pune conducted workshops for officials of UCBs in January 2002. The recommendations were then modified and final guidelines made applicable to scheduled UCBs from July 2002. 466

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regulation of the financial system NPAs were a potentially serious concern in the case of the UCBs. We now turn to this topic.

Non-Performing Assets The level of NPAs with UCBs was higher than that of commercial banks because of inadequate credit appraisal and follow-up skills, concentration risk due to their limited geographical areas, and connected lending, among other problems. In May 2000, the Ministry of Finance advised the Bank to examine whether SAC guidelines could be extended to the cooperative banks. The RCS, Maharashtra, also requested the Bank in June 2000 to formulate guidelines for the write-off of NPAs. The Bank prepared draft guidelines and proposals for recovery of dues in NPA accounts of UCBs. Governor Jalan noted that ‘in view of differing powers for RCS in different states, [we] leave to RCS to decide rather than a uniform guideline from RBI which in any case does not have adequate powers’. In February 2001, therefore, the Bank sent the draft proposals on guidelines for recovery of dues in NPA accounts to all the RCSs for suggestions. Since the Bank did not have the powers to directly advise UCBs, state governments were advised to issue notification or administrative orders in the respective states under the state laws. Following the issue of revised guidelines to commercial banks for compromise settlement of chronic NPAs up to 100 million in January 2003, draft guidelines on the same lines were issued to all RCSs’ and Chief Secretaries for consideration and implementation in respective states. The guidelines were issued to ensure non-discretionary and non-discriminatory treatment of NPA borrowers. The guidelines on ‘one time settlement’ for small and medium-sized enterprises, distressed farmers and small borrowers with less than 25,000 principal outstanding were sent to state governments in 2006 for necessary action. The guidelines on the debt restructuring mechanism for such enterprises were issued to UCBs in August 2006. A few larger banks participated in the CDR mechanism.

Conclusion The Bank’s overall approach towards the non-bank institutions was driven by a desire to improve governance and transparency to make them more efficient as market players and more responsive to the users of their services. Despite 467

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the reserve bank of india occasional frictions and differences with the Bank, the government too shared that broad aim. It was still a complicated transition, because of differences in the circumstances of individual institutions, regional economic conditions and local political pressure, dual control over state-level banks, and limited jurisdiction of the Bank over these entities. The legislative reform in this sphere was a story of modest success at best. Whenever there were a consultative approach and negotiated decision-making, the efforts delivered good results.

Notes

1. ‘Commercial banks’ refer to scheduled commercial banks, excluding regional rural banks. 2. Until 1997, twenty-four UCBs were included in the second schedule of RBI Act, which increased to fifty-three by March 2008. They were relatively larger and more like commercial banks. 3. Chairman S. H. Khan. 4. Chairman: Y. H. Malegam. 5. The exposure limit was not to exceed 20 per cent of capital funds in the case of individual borrowers and 50 per cent for group borrowers. For lending to infrastructure, 10 per cent additional limit for group borrower was fixed. The exposure norms were fine-tuned in June 2001 and fixed at 15 per cent, 40 per cent and 50 per cent of Tiers I and II capital for individual, group and ‘infrastructure-group’ borrowers, respectively. From April 2002, capital fund was defined under capital adequacy standards and non-fund-based limit was to be reckoned at 100 per cent value (not 50 per cent as before). Later, the boards of FIs were authorised to allow an additional 5 per cent, subject to instances of such exposures being disclosed in the annual financial statements. The ‘refinance’ extended by FIs was not subject to exposure norms. 6. For uniform implementation in July 2000, and again in February 2003, as desired by the Ministry of Finance. 7. An informal group in the Bank reviewed these instructions on the classification and valuation of the investment portfolio for FIs and submitted a report in October 1999. The guidelines (November 2000) contained instructions to have three categories of investments (held to maturity, available for sale and held for trading), as in the case of commercial banks. Subsequently, in response to suggestions from IDBI and ICICI, the guidelines were fine-tuned in 2001 and 2002. The final guidelines on investments in non-SLR debt securities were issued in January 2004 and enforced from 1 April 2004. In July 1999 and in June 2002, the Bank wrote to the Ministry of Finance seeking the government’s approval for restrictions to avoid connected lending. Connected 468

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8. 9.

10.

11.

12.

13.

14. 15.

16.

lending by an institution is lending to its own directors, including whole-time directors, and companies, firms and individuals associated with them. Usually, directors would also be directors of other group companies. After some delay, the government approved the proposal in November 2002. The restrictions imposed were on the lines of prohibition contained in Section 20 of the BR Act for banks. Adverse selection refers to the case when, competing with banks in lending, the FIs do not get prime borrowers and end up lending to subprime borrowers. Capital gains on sale of assets are taxable unless reinvested in another similar asset or invested in capital gains bonds. These bonds have a minimum lockin period (say, five or seven years) and carry interest rates lower than that for bank deposits. It is a source of low-cost funds to the issuing governmentowned FIs. They had to prepare statements on liquidity gap and interest rate sensitivity at fortnightly/monthly intervals, respectively, for being placed before their asset–liability management committees. In July 2003, FIs were advised to submit these two statements at quarterly intervals to facilitate monitoring of their compliance to prudential norms. Among other issues, the government wanted FIs to be part of the scheme of collection of information on defaulters, which was implemented and progressively extended. The treatment of restructured accounts for the purpose of asset classification was discussed during an informal meeting the Governor had with select FIs, banks and the IBA in 2001. In 2001 and 2002, discussions were also held on delays in project implementation. The NIC(LTO) fund was created out of the profits of the Bank; it is a source of low-cost funds for the development financial institutions. The proposal envisaged the transfer of NIC(LTO) loans aggregating 37.92 billion granted by the Bank to IDBI, EXIM Bank, IIBI and SIDBI, and the subordinated debt of IDFC Ltd for 3.50 billion subscribed to by the Bank to the government. These four FIs were allowed to issue twenty-year redeemable, convertible bonds, which could be reckoned as Tier I capital, subject to the conditions laid down. The Governor agreed to relax certain conditions for deeming it as Tier I capital because of the special circumstances of the case. There was a consequent portfolio shift in favour of treasury operations. The Narasimham Committee II was of the view that the Reserve Bank should not own the institutions it regulated. This was also the view expressed in the International Monetary Fund Article IV Consultation Discussions in November 1999. The suggestions not considered were: (a) exemption from SLR should be available only in respect of the inherited liabilities, and not incremental liabilities of the new banking company, (b) the SLR exemption should be available so long as the government remained the majority shareholder of the 469

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17.

18. 19.

20. 21. 22.

23. 24. 25. 26.

new banking company and (c) resultant amendments to the Companies Act and BR Act should be provided in the Bill. The sources do not explain why the government did not include these suggestions. The cash-neutral assistance would flow from the government to an asset management trust, which would manage the stressed assets stabilisation fund (SASF). The assistance of the government was in the form of twentyyear non-interest bearing bonds. The IDBI transferred stressed assets with a net value of 90 billion to the SASF and received in exchange bonds that had been received by the SASF from the government so that IDBI could commence its banking operations with a clean slate. In 2005, the merger of IDBI Bank Ltd with IDBI Ltd was completed. In April 2004, various options for restructuring were analysed and the results conveyed to the government. The government informed that it proposed to merge IIBI with another FI or bank. The A. S. Ganguly Working Group on Flow of Credit to SSI Sector, 2004, had recommended that some of the more active SFCs might be converted into state-level NBFCs. The Working Group on Development Financial Institutions (Chairman: N. Sadasivan) recommended in May 2004 that SFCs had outlived their utility and should be phased out within a definite timeframe. SIDBI had communicated these views to all state governments and SFCs in October 2004, advising them to arrange for recapitalisation of SFCs to raise the level of capital adequacy to a minimum of 9 per cent. RBI, Annual Report 1997–98. Data on deposits with NBFCs from subsequent years in the Reserve Bank’s publications show a drastic decline. Chairperson: K. S. Shere. The Narasimham Committee II had recommended that the minimum net worth of NBFCs for registration be increased from 2.5 million to 20 million progressively. The ordinance of January 1997 specified the limit at 5 million, but Parliament reduced the limit to 2.5 million at the time of passing the Bill in March 1997, with the provision that the entry barrier could be raised to 20 million. It was left to the Bank to prescribe higher limits for new companies. The Bank fixed the minimum paid-up capital at 20 million for new companies. It was also announced that the liquid asset requirement would be uniform for all NBFCs at 12.5 per cent of public deposits from April 1998. This was further raised to 15 per cent in 2008. The net-owned fund was arrived at only after deducting the investments made in subsidiaries and group companies. With an Executive Director as chairman and three other senior officers as members. In respect of applications from ineligible companies, a transparent procedure of rejection was followed through issue of public notice in a newspaper,

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27. 28. 29.

30. 31.

32. 33.

followed by a show-cause notice served on the company. After the expiry of the notice period, applications of NBFCs that did not respond and those that were not traceable were rejected by issue of a speaking order. For example, the limits on public deposits were raised, and the time to regularise the excess deposits was extended. Informal Advisory Group on NBFCs, with members from industry, NBFC associations and ICAI. Fixed at 15 per cent of net-owned funds for single borrower and 25 per cent for groups. Investment in real estate was not to exceed 10 per cent of netowned funds of the NBFC. Investment in unquoted shares was also not to exceed 10 per cent of net-owned funds. Chairman: C. M. Vasudev, Special Secretary, Banking. A Deputy Governor was a member of the Task Force. The Task Force had recommended that the Bank should have a separate Executive Director for this purpose. In compliance, the Bank appointed M. R. Umarji in September 1999 as Executive Director in charge of the Department of Non-Banking Supervision. The stipulated period for attaining the minimum net-owned fund was extended up to 2010 instead of 2009. Several other measures were taken to regulate NBFCs and make their business practices more efficient and transparent. The Governor announced in the Annual Monetary and Credit Policy for 2001–02 that a system of asset liability management for NBFCs would be put in place. The draft guidelines were circulated among the members of the informal advisory group in July 2000. In June 2001, Asset Liability Management Guidelines for NBFCs with assets above 1 billion was issued. The Bank was aware that there were registered NBFCs that had ceased to undertake NBFC business since long. But they continued to hold the certificate of registration. The certificate had an intrinsic value insofar as companies not engaged in financial business could still use the certificate as a mark of credibility in non-financial business activities. The regional offices were advised to identify such companies and follow due procedure for cancellation. A circular was issued in September 2006 to effect this. In January 2004, the Bank issued know-your-customer guidelines to NBFCs akin to those issued to commercial banks. It included customer identification, ceiling and monitoring of cash transactions, internal control system, internal audit and inspection, and record-keeping. The boards of NBFCs were advised to adopt the Customer Due Diligence Guidelines issued by the Basel Committee on Banking Supervision with suitable modifications. The industry demanded parity with banks on deposit insurance, liquidity support, lender of last resort, and entry to call money market. The Reserve Bank could not offer complete parity with banks, which were more tightly regulated, but did allow some flexibility. For example, guidelines for entry of 471

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34. 35. 36.

37.

38.

39.

40.

NBFCs into insurance business as agents of insurance companies was issued in June 2000. NBFCs were also permitted to set up joint ventures for insurance business with risk participation. The industry sought separate status for asset financing companies (leasing and hire purchase), which were different from investment companies. The Mid-Term Review of the Annual Monetary Policy for 2006–07 announced a separate segment for asset financing companies. From then onwards, there were three NBFC categories – asset financing, investment companies and loan companies. The inflows into the NBFC sector in the next three years amounted to $223 million, $206 million and $363 million, respectively. The total assets of eighteen of these NBFCs, with an asset size of 1 billion and above, was 214.21 billion. An internal group of Chief General Managers of regulatory departments examined the ‘Issues relating to Level Playing Field, Regulatory Convergence and Regulatory Arbitrage in the Financial Sector’ and recommended a policy framework. The group submitted its report in March 2006. The regulatory framework for these companies included leverage ratio (borrowings up to ten times their net-owned funds), CRAR of 10 per cent and single/group borrower exposure limits for lending and investment at 15 per cent and 25 per cent of owned funds. Reporting formats of monthly returns were prescribed for these companies for the purpose of comprehensive monitoring. There were 147 NBFC-ND-SIs in December 2006. These companies were further advised to attain a minimum CRAR of 12 per cent by March 2009, and 15 per cent by March 2010. Certain disclosure requirements relating to CRAR, exposure to real estate sector, and maturity pattern of assets and liabilities, along with reporting requirements on short-term dynamic liquidity, structural liquidity and interest rate sensitivity in specified formats for monitoring asset–liability management, were also prescribed. ‘In any mature system,’ Tarapore continued, ‘we cannot countenance a situation wherein an RNBC in its very constitution is allowed to take on unlimited liabilities without any reference to its owned funds. The system of RNBC is dangerous for the financial system and frustrating for the regulators/ supervisors.’ A sub-limit of 10 per cent, and later 15 per cent, was prescribed for government securities within the limit of 80 per cent. A major portion could be invested in papers of public sector undertakings and corporates with a rating of AA+ or above. The limit of 15 per cent fixed for liquid assets in the form of government-guaranteed securities was low as even commercial banks with deposit insurance cover kept 25 per cent of deposits in SLR securities. High-level committee (Chairman: M. R. Umarji), with participation of the government, banks, FIs and Reserve Bank officials.

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regulation of the financial system 41. Security interest refers to the interest of the creditor on the security taken from a borrower for the loan extended. The SARFAESI Act was passed to make enforcement of this security interest speedy and less cumbersome, without the intervention of the courts. However, banks did not have the core competence to enforce security in respect of NPAs, which activity could, therefore, be outsourced. ARCs were specialised in reconstructing a stressed asset and in enforcing the security and, hence, banks found it expedient to sell NPAs to ARCs, which would either facilitate turnaround of the asset or encashment of securities (that is, enforcement of security interest). 42. Both groups had members from outside the Bank and the government. The first group (Chairman: C. S. Murthy) examined issues relating to registration, prudential norms and accounting, and disclosure standards; and the second group (Chairman: N. Sadasivan) framed guidelines for acquisition of assets by ARCs and enforcement of security interest. The ARCs raised money by issue of ‘security receipts’ to qualified institutional buyers, or QIBs (banks and FIs). The group consulted SEBI on issues relating to security receipts as these would be issued on private placement basis by the ARCs. Both groups submitted their reports in October 2002. Before framing the draft rules under the Act, the Bank consulted select bankers and financial institutions and obtained their views in a meeting. The draft guidelines were sent to the Ministry of Finance on 17 December 2002, and placed on the website the following day for feedback. 43. Chairman: N. Sadasivan. 44. With three outside experts, the Economic Adviser for the government, and a nominee from the Bank. 45. Several other miscellaneous issues concerning NBFCs engaged the Bank. These bear a brief mention. The Bank’s discomfort with non-bank entities accepting and holding public deposits was no secret and made known to all concerned including the government. In the Mid-Term Review of the Annual Monetary Policy for 2004–05, it was announced by the Governor that NBFCs would be encouraged to move out of public deposits in line with international practices. The Bank even discussed this with NBFC industry bodies. However, there had not been much progress in this regard until the end of the reference period. The public deposits with NBFCs, including RNBCs, increased from 196.44 billion in March 2004 to 243.95 billion in March 2008. From 2000 onwards, the Bank had been recommending to the government to extend the benefits of debt recovery tribunals (DRTs) to NBFCs. In June 2005, the Bank’s view was communicated to the Ministry of Finance that the Bank ‘does not have objection to extending benefits of DRT Act to NBFCs’. But Deputy Governor Leeladhar observed in September 2005 that ‘it is true in the past we have supported the case of NBFCs getting the benefits of DRTs. 473

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the reserve bank of india However, the operations/experience with DRT had not been satisfactory.... Without strengthening the DRT infrastructure giving them additional work of NBFCs also will be counterproductive’. Subsequently, there was a meeting with the government to discuss the issue and a working group was set up by the government to examine it. The working group did not favour bringing NBFCs under the purview of DRT. 46. The draft Bill was sent back to the Ministry of Finance in March 2000 with the Bank’s comments. 47. In March 2007, the Bank’s views were conveyed to the government in these words: NBFC sector has stabilised during the period and the sector as a whole has undergone change with deposit taking NBFCs on decline and wherever there is a need for enhanced legislative powers the same can be incorporated in the existing legislation through amendment to RBI Act. Therefore, ... a separate legislation for regulating deposit taking NBFCs may not be necessary at this stage.

48. Chairman: K. S. Shere. 49. The Narasimham Committee II had also advised against insurance of NBFC deposits. The Bank constituted in April 1999 an advisory group (Chairman: Jagdish Capoor) to look into this issue. The group concluded that deposit insurance ‘could be considered after the regulatory and supervisory system is stabilised’. Another internal working group (Chairman: N. Sadasivan) was of the same view. Since the group was internal with all members from the Bank and the Deposit Insurance and Credit Guarantee Corporation, a second working group with external members was set up to offer its views, with the Chairman and Managing Director of the New India Assurance Company chairing the group. This group also agreed that there was no case for providing insurance cover to depositors of NBFCs. 50. In March 2008, there were 376 registered deposit-taking NBFCs with aggregate deposits of 243.95 billion, which included the two RNBCs with total deposits of 223.58 billion. There were 11,642 non-deposit-accepting NBFCs, including systemically important NBFCs with total assets of 990.14 billion. 51. Following the Marathe Committee recommendations (1992), a liberal policy was adopted regarding new UCBs. 52. The Joint Parliamentary Committee (2002) observed that it did not work well because ‘the State Registrars of Cooperative Societies do not always act expeditiously on directions received from RBI with the result that the management of these banks are enabled to take advantage of existing loopholes to commit irregularities’. 53. Such as the maintenance of good track record of continuous net profit, net NPA of less than 10 per cent, and conditions relating to management,

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54. 55.

56.

57.

58.

prudential requirements, methods of operation, and liquid assets. A letter stated that these conditions ‘should be complied with by the bank on a continuous basis and failure on the part of the bank to do so will result in de-scheduling’. Despite the monitoring, three UCBs in Maharashtra that were included in the second schedule turned weak within a short time, and placed the Bank in an embarrassing position. High Power Committee (Chairman: K. Madhava Rao) was formed by the Bank to review the regulatory framework for UCBs. The licensing policy for new banks was revised in August 2000. Entry point norms were reset for four categories of banks depending on the population size as recommended by the high power committee. The Bank set up in May 2001 a committee to look into licence applications from proposed UCBs. The independent external Screening Committee (Chairman: G. Ramachandran) had member-representatives from banking, finance and cooperation fields. Many of these unlicensed banks held large public deposits. Placing a large number of banks under moratorium or liquidation could have a contagion effect, and the Bank decided to follow a gradualist approach in this regard. The cut-off date was, therefore, extended in phases up to March 2006. In March 2001, the Bank wrote to the Chief Secretaries of states to prioritise professionalism in the management of UCBs and tone up the audit system. In April 2001, placement of deposits by UCBs with other cooperative institutions and other UCBs, except for maintaining current accounts for clearing and remittance purposes, was banned on account of contagion risk in a reaction to the crisis. For scheduled UCBs, the SLR was raised to 20 per cent from 15 per cent in April 2001. For non-scheduled banks with deposits over 250 million, it was raised to 15 per cent from 10 per cent and for non-scheduled UCBs with deposits less than 250 million, the SLR was introduced for the first time and fixed at 10 per cent. Later in April 2003, it was raised to 25 per cent for scheduled UCBs. In March 2002, the norms of classifying weak and sick banks were modified. Soon after, another high power committee was formed by the government under the chairmanship of the Minister of State for Finance, Anant G. Geete. In line with the committee’s recommendations, the Bank made relaxations on placement of funds by smaller banks with scheduled UCBs, in granting unsecured advances, and in NPA norms for small loans. The federations of UCBs and the Geete Committee informed the Bank that the new norms for identifying weak or sick banks were too stringent and needed to be reviewed. It was also suggested that the negative terms (‘weak’, ‘sick’) affected the reputation of banks. The negative classification continued for some more time, but was eventually replaced by a new categorisation of all UCBs as Grades I, II, III and IV in 2003–04. The restrictions on ‘weak’ banks would by and large apply to UCBs classified as Grade III and restrictions on ‘sick’ 475

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60. 61.

62.

63. 64.

banks would apply to UCBs classified as Grade IV. In March 2004, there were 900, 318, 511 and 191 banks categorised under Grades I, II, III and IV banks, respectively. UCBs were permitted in May 2003 to place deposits with strong (Grade I) scheduled banks. However, scheduled UCBs were advised not to place deposits with another UCB. The UCBs were advised in July 2004 to obtain a certificate from statutory auditors certifying that the bank had not placed any deposit with any ineligible bank during the year and to forward the auditor’s certificate to the Reserve Bank. Interest as the amount of penal interest levied but not recovered aggregated 1.60 billion by March 2004. It was reduced to 1.12 billion by March 2006, mainly on account of liquidation and mergers. The committee preparing the draft submitted its report in December 2004. The vision was that UCBs must emerge as a sound and healthy network of jointly owned, democratically controlled and ethically managed banking institutions providing need-based quality banking services, essentially to the middle and lower middle classes and marginalised sections of society. The vision document recognised the heterogeneity of the UCB sector in terms of size, geographical distribution, financial soundness and technology absorption, and prescribed a multi-layered regulatory regime. Prudential norms on income recognition, asset classification and provisioning were made applicable with some relaxations to UCBs from 1992–93 in a phased manner. CRAR was not made applicable to UCBs as these banks could not raise equity by public issue since only members could contribute to share capital. These norms were in different stages of implementation by 1997. Minimum level of CRAR, exposure norms, restrictions on unsecured advances and call money operations, and disclosure requirements were made applicable to UCBs with some relaxations as compared to commercial banks. Prudential exposure limits were fixed at 15 per cent and 40 per cent of the capital funds for single and group borrowers, respectively, as in the case of commercial banks. Since there were many UCBs with negative net worth or accumulated losses, these banks had to approach the Bank for relaxation. The risk weights for commercial real estate and capital market exposure were raised to 125 per cent from 100 per cent in July 2005, following the direction to commercial banks. The risk weight for commercial real estate was further raised to 150 per cent, again in line with commercial banks. The federations sought lower risk weight and relaxation in provisioning norms for gold loans. Twice in 2006, the Bank rejected the demand. According to the State Cooperative Societies Acts, UCBs were required to transfer 20 per cent of their net profits for appropriation to reserve fund. However, UCBs were advised by the Bank to appropriate not less than 50 per cent of their net profits to reserve

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regulation of the financial system fund or general reserve, if the prescribed CRAR had not been attained. Until 2002, the Bank was fixing the floor rate for interest charged on advances by UCBs. In April 2002, UCBs were permitted to determine their lending rates, taking into account cost of funds and transaction cost. Later in May 2007, UCBs were advised to lay down appropriate internal principle and procedure so that usurious interest rates were not levied on loans and advances. 65. As per the group’s recommendations, scheduled UCBs undertaking foreign exchange business were required to comply with Basel I norms by March 2009 and Basel II norms by 2010. A working group was set up to examine the methods of capital augmentation of UCBs. The recommendations for alternate instruments/avenues for augmenting capital funds of UCBs were considered, and in 2008, UCBs were allowed to issue preference shares and long-term deposits with a minimum maturity of fifteen years, subordinate to the claims of depositors.

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11 Supervision of the Financial System

Introduction While regulations provide the policy framework to ensure solvency and liquidity of banks and financial institutions (FIs), supervision refers to the instruments used to ensure compliance to this framework.1 Internationally, different models are followed in the performance of these two functions. In some countries, the two functions are entrusted to different agencies. In the Reserve Bank, the two functions were kept apart in respect of commercial banks, and these were handled by two different departments. However, in respect of non-banking financial companies (NBFCs), FIs and urban cooperative banks (UCBs), there was one department/division each responsible for both regulation and supervision during the reference period. The National Bank for Agriculture and Rural Development (NABARD) exercised supervisory powers over regional rural banks (RRBs) and banks in the rural cooperative structure. As the previous chapters have shown, major changes happened in the Indian financial sector during the period covered in this volume. These changes offered consumers a broader range of products, complex and new business processes, and a reformed financial system. The changes also led to a blurring of the distinction between banking and non-banking businesses. Supervision, as this chapter shows, needed to adapt to these changes. The chapter discusses the supervisory role of the Bank in four segments: commercial banks, NBFCs, UCBs and FIs. It also discusses how important episodes involving individual banks and institutions under stress led to changes in supervisory practices and policies.

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Supervision of Commercial Banks The Framework of Supervision

While conventionally the Reserve Bank relied on periodic on-site inspection of banks as the main instrument of supervision, the system was modified from time to time.2 In December 1993, the Bank bifurcated the regulatory and supervisory functions by entrusting the supervisory function to a newly created Department of Supervision. The setting up of the Board for Financial Supervision (BFS) in November 1994 was a milestone. The jurisdiction of the BFS, which originally covered commercial banks, was extended to FIs, NBFCs, UCBs, local area banks and primary dealers (PDs). The BFS laid down broad policies for on-site supervision and off-site monitoring, modalities for follow-up of inspection reports, and correction strategies for weaknesses observed in the functioning of banks and FIs. An Advisory Group on Banking Supervision (2001) laid the future roadmap for the Bank in banking supervision.3 Its recommendations covered corporate governance in banks, Basel core principles, internal controls, credit risk, transparency and disclosures, financial conglomerates, supervision of cross-border banking, and internal rating practices adopted by banks. The proposed actions were classified under three categories – actions that already existed or could be implemented within one year, recommendations that required a longer time frame for implementation, and recommendations not possible to implement or which would require action by the government. As one of the supervisory agencies consulted by the Basel Committee on Banking Supervision (BCBS) in the drafting of the twenty-five core principles of effective banking supervision, the Bank had carried out an exhaustive review of the existing supervisory framework in the country, and found that most of the principles were already enshrined in statutes and regulations. The Bank had constituted seven working groups within the Bank to suggest measures for bridging the gaps observed in the areas of risk management practices, consolidated supervision, and cooperation with domestic and international regulators. The groups’ recommendations (1998) were implemented, reinforcing the risk management guidelines. Formal systems of cooperation and coordination with other regulators were also gradually put in place.

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On-site Inspection On-site inspection continued to be the primary supervisory tool for the Bank during the reference period, but it underwent several changes. The BFS adopted a new approach to on-site inspection of banks from July 1997.4 Onsite inspections began to focus on statutorily mandated aspects of solvency, liquidity, and financial and operational health, based on a modified version of the CAMEL model. The five letters of the acronym CAMEL stand for capital adequacy, asset quality, management, earnings and liquidity. The new model was named CAMELS in 1998, where the added letter ‘S’ stood for systems and controls. The new rating model combined the quantitative as well as qualitative aspects of soundness to arrive at a composite rating under the six components.5 In the wake of irregularities in the loan portfolio of Indian Bank in 1995, the Reserve Bank introduced a system of conducting checks through periodic visits to head offices of banks and verifying discretionary lending by senior executives. However, as the first round of scrutiny did not bring out any serious transgressions by bank officials and as such examination was covered in the annual inspection of banks, the practice was discontinued in April 1997. An internal communication reached the media. The Statesman ran a piece on 16 April 1997 titled, ‘RBI to Do Away with On-Site Inspection System.’ The Economic Times (12 April 1997) commented, ‘RBI Not to Vet Lendings by Bank Top Brass’ and ‘Decision Fuels Apprehensions over Free Flow of Funds to Political World’. When the government sought the Bank’s clarification, the Bank restored the practice of half-yearly visits to head offices. The matter was reviewed again in December 2002 when regional offices were advised to conduct such scrutiny only if considered necessary by the central office on the basis of off-site analyses and market intelligence. As part of moving away from transaction-based inspection, the Bank attached more importance to auditing the systems, including risk management in banks, at the corporate level. Consequently, inspection of bank branches was kept at the bare minimum. Until 1997, the Reserve Bank took up branches of banks for on-site scrutiny during the annual inspection of the banks concerned, as branches were treated as independent units for surveillance. This approach was gradually discarded in favour of CAMELS rating. The Bank decided that branch inspection reports need not be sent to banks and followed up. Reports of scrutiny of branches, if any, were to serve only as inputs for the Principal Inspecting Officer of the Reserve Bank at the head office. 480

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supervision of the financial system The decision to reduce the number of branch inspections also reduced demands on scarce supervisory resources. The Bank, however, undertook quarterly monitoring on-site visits to newly licensed private sector banks in their first year of operation. Such visits continued in respect of new and old private sector banks that had weaknesses. The annual financial inspection findings and observations were categorised as ‘major’ or ‘minor’. The major findings concerning the health of banks, such as solvency, capital adequacy, asset quality, management, systems and controls, including frauds, were followed up with the banks concerned for rectification. The Reserve Bank decided not to pursue the ‘minor’ findings, which were procedural deficiencies, in the follow-up process. One of the issues that came up during inspections was the substantial divergence between the assessment of non-performing assets (NPAs) and provisioning estimated by banks’ auditors and the Reserve Bank inspectors. The assessment made by the latter was usually more than the estimates of banks’ auditors. A working group,6 set up in January 1997 to examine the reasons for divergence, concluded that the divergence was largely due to the different interpretations of the Bank’s guidelines on asset classification and provisioning. The group’s recommendations were accepted and the necessary circular to banks and guidelines for inspecting officers were issued in July 2001. A working group was constituted to review the existing on-site rating model in April 2000. The new model was tried first on four public sector banks with past data. The model was also tested in parallel with the existing model and the difference in ratings awarded to the banks examined. Then, changes were made to the model before it was put into operation in 2002. The four categories of rating styled as A, B, C and D were retained. Later, Reserve Bank officers and a representative from Fitch Ratings recommended a revised supervisory rating model and had it back-tested on three banks. The Reserve Bank implemented the new model from March 2006. The new major parameters included in the model were the effectiveness of risk management systems and quality of assessment. The broad parameters were advised to banks for their information. The rating assigned by the Bank was conveyed to the top management. The rating was shared with other departments in the Bank, other regulators in case of financial conglomerates and home/host country regulators.7 481

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Off-site Surveillance The objective of off-site monitoring was to assess the financial condition of banks in between on-site examination of banks and to optimally use scarce supervisory resources. A comprehensive Off-site Monitoring and Surveillance (OSMOS) system based on prudential supervisory reporting framework was introduced in 1996. Quarterly returns were received from all banks in electronic format and stored in a database. The data were analysed and supervisory concerns arising out of the analysis were taken up with the banks. Depending upon the seriousness of the concerns, top executives, including the chief executive officers (CEOs) of the banks concerned, were called to the Reserve Bank for one-to-one personal discussions with the Deputy Governor or the Executive Director. The exercise covered capital adequacy, risk-weighted assets and exposures, asset quality, loan concentration, operational results, connected lending, profile of ownership, control, management, liquidity, and interest rate risks. The format used for OSMOS returns was revised in December 1998. In July 1999, the second tranche of returns covering liquidity risk, interest rate risk and foreign exchange risk was introduced. Banks were required to prepare and forward the statement of structural liquidity, statement of interest rate sensitivity, statement of maturity, and position of foreign currencies to the Bank. There were provisions for penalties and reprimands for late filing of returns and for poor data quality. However, the Bank had not imposed a penalty on any bank during the reference period. In 2002, a Joint Parliamentary Committee ( JPC) on a stock market scam observed that neither the regulators (the Reserve Bank and the Securities and Exchange Board of India, or SEBI) nor the Ministry of Finance took steps to carefully monitor and effectively regulate the flow of foreign as well as domestic funds into the stock market. In compliance to this observation of the JPC, the Bank introduced from May 2003 weekly monitoring of purchases, sales and the outstanding balance of equity shares from select major banks to track the flow of funds to the capital market. Several other significant steps taken between 2003 and 2008 improved the effectiveness of off-site monitoring.8 The Bank was monitoring growth in loans to the real estate sector because the long-term nature of mortgage loans and short-term nature of banks’ liabilities posed a potential asset–liability mismatch. An analysis of interest rate sensitivity of investments held by banks in HTM (held to maturity) and 482

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supervision of the financial system AFS (available for sale) categories was carried out in September 2007. Five outlier banks, four foreign and one old private sector, were made aware of their vulnerability to rise in yields. To monitor and regulate banks’ activities in the call and money markets, the Governor directed the designing of a surveillance framework. An interdepartmental group formed in 2007 identified banks with a high level of net fortnightly borrowings in the call, repo, collateralised borrowing and lending obligation (CBLO), liquidity adjustment facility (LAF) and term money markets. Concerns, if any, were taken up with the identified banks. Risk management was one area where major changes were introduced during the reference period.

Interest Rate Risk and Liquidity Risk Management The Supervisory Department conducted a quarterly review of interest rate sensitivity of banks’ investment portfolio and monthly reviews of banks’ exposure to sensitive sectors. The reviews were carried out to determine the interest rate risk using ‘duration gap method’ prescribed by the Basel Committee. Banks were advised of the results of the study along with a guidance note for their use. Since September 2003, under instructions from the Reserve Bank, banks carried out quarterly ‘impact analyses’ of an interest rate rise on banks’ capital. The interest rate sensitivity analysis was done applying the modified duration approach, assuming an interest rate shock of 100 basis points (bps). It was observed in 2003 that the banking industry could withstand the impact of 72-bps increase in interest rates without having any erosion on their capital (thanks to the buffer of investment-fluctuation reserves and provisions). In October 2003, the Governor directed the preparation of a technical paper to examine the impact of 100 per cent marking to market of all investments on the financial position of banks. It was found that the impact would not be significant; the combined impact was estimated at 0.11 per cent of the total investments. At the aggregate level, the impact would be about 0.75 per cent of the regulatory capital of the banking system. An IMF paper on interest rate risk of Indian banks also concluded that there was no threat to the core capital of banks because of the existence of sufficient cushion in the form of unrealised gains, together with the accumulated provision for depreciation and investment-fluctuation reserves.9 483

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the reserve bank of india The frequency of the ‘statement of structural liquidity’ was revised from monthly to fortnightly in terms of instructions issued under Asset Liability Management Guidelines in October 2007. Banks were to estimate the required liquidity under market crisis scenarios, prepare contingency plans and fix the tolerance levels for various maturities. Banks were advised to undertake dynamic liquidity management and prepare the statement of structural liquidity on a daily basis and adhere to prudential limits as per Reserve Bank guidelines. The framework for intervention by the Bank based on inspection findings and other parameters is discussed in the next section.

Prompt Corrective Action The BFS desired in May 1999 that the Bank should draw up an intervention prescription schedule which should set trigger points for different types of concerns. A study group, which was set up to move towards risk-based supervision, prepared a schedule. This system of prompt corrective action (PCA) was to be based on three parameters, capital to risk-weighted assets ratio (CRAR), net NPAs and return on assets, with pre-determined trigger points. The scheme was placed before the BFS in 2000. After consultations with the government, the PCA framework was introduced on an experimental basis for one year. Foreign banks were not covered by the framework. The scheme was reviewed in 2004 and continued without change. Six banks had hit the trigger points based on their financial results of March 2002. Of these six, three banks were under restructuring. The other three were not formally placed under the PCA framework but they were put on advance notice. By December 2002, more private banks had hit the trigger points. When informed of this, the banks represented informally that if placed under the formal PCA framework, they would be constrained to advise SEBI and stock exchanges, which could scare prospective investors. In that case, they would not be able to raise capital. Considering this point, the banks were put on alert but not formally placed under PCA. The Reserve Bank recognised that publicising the matter could have wider and adverse implications. It was, therefore, decided that when a bank hit any of the trigger points, ‘structured and discretionary actions’ would be taken against it.10 In 2004 and 2005, one bank each (GTB and United Western Bank) had triggered structured/discretionary action against them by the Reserve Bank. 484

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supervision of the financial system Both banks got merged with other banks subsequently. During the remaining years of the reference period, no bank had triggered such action on the part of the Reserve Bank. Banks differed in their risk profile, which required supervision to be riskbased, as we see next.

Risk-Based Supervision The risk-based supervision (RBS) approach was based on the principle of adapting supervision to the risk profile of the supervised entity. RBS involved continuous monitoring through off-site analysis of critical data impacting the risk profiles of the entities. On-site inspections looked into compliance with the BR Act, and the systems and procedures in place to deal with the risks. RBS was a step towards the transition to Basel II. The cornerstone of the supervisory process under Pillar II was ‘risk-based capital assessment’. In 1999, the Deputy Governor in charge of supervision set up an informal study group on international best practices in this field, to prepare an approach paper on RBS. The BFS approved the proposal to engage international consultants to develop the framework and suggest the sequencing of implementation. In 2000, the Bank used the services of the Department for International Development, United Kingdom (UK), to facilitate a move towards RBS. The organisation funded the international consultancy effort involved, and awarded the project to PricewaterhouseCoopers (PwC), London. PwC submitted its report in three instalments: a review of the existing supervisory approach, actions required for adopting RBS, and the synopsis of the Supervision Manual to be used in the RBS approach. The Project Implementation Group set up for the RBS project prepared a discussion paper titled ‘Strategy and Road Map for Implementation of Risk-Based Supervision Project’.11 The paper, prepared with inputs from PwC reports, was released to the banks in August 2001, and consultations with the banks took place thereafter. The RBS process was rolled out in 2002–03. Banks were advised to set up a comprehensive risk management system, adopt a risk-based audit system and upgrade management information technology systems. A set of pilot studies led to further fine-tuning of the system. It was found that mapping of risks under RBS was generally in agreement with CAMELS rating. Implementation of risk-based internal audit was crucial to the success of RBS. In November 2000, the Bank set up a working group to suggest modalities for 485

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the reserve bank of india introducing risk-based internal inspection/audit system in banks.12 The group found that a risk-based audit had not commenced or stabilised. In February 2005, banks were advised to fine-tune their audit process accordingly. However, in view of the various constraints faced by banks, the progress towards fullfledged inspection under RBS was slower than anticipated. While the pilot run of the RBS continued parallel with the CAMELS model of supervision, studies were undertaken to evolve an appropriate model for the Indian banking system based on the experience gained from the RBS pilot runs. Efforts were made to align CAMELS and RBS into a single supervisory approach, incorporating the best features of both. One of the key principles of Pillar II in the New Basel Capital Accord was the supervisory review process, which is considered next.

Supervisory Review Process The principle, in the words of the Consultative Document ( January 2001) of the BCBS, was that the ‘[s]upervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process’. The Governor announced the introduction of the supervisory review process (SRP) for banks in the Annual Policy Statement for 2005–06. A framework to initiate SRP was evolved in February 2006 with twelve systemically important banks. In the first review, banks with significant exposure to sensitive sectors like real estate, highly leveraged NBFCs, venture capital funds and capital market were taken up. A special feature of the framework was to carry out ‘stress testing’ to assess how vulnerable the financials of a bank were under certain assumptions. The framework attempted to capture in a nutshell the overall risk profile of a bank having a bearing on its liquidity and solvency position. A pilot study of a new private sector bank was completed in March 2006. The findings of the study were presented in the Regulated Institutions Group (RIG) meeting and, after some refinements, the pilot study served as a template for tracking other identified banks.13 The second review of SRP in January 2007 was split into two phases. Ten outlier banks were identified as having the largest capital market exposure 486

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supervision of the financial system and real estate exposure both in absolute terms and in relation to their net worth. In Phase I, besides data available from off-site returns, information on exposure to sensitive sectors was collected, analysed and discussed with bank officials. Phase II focused on on-site examination to assess the risk exposure of individual banks. The analyses suggested prima facie that the banks under review had proper risk management policies, systems and controls in place. However, certain minor deficiencies were observed, which were circulated among all banks advising them to initiate the corrective processes. In June 2005, the definition of real estate exposure of banks was modified to include individual housing loans. This, together with a sharp increase in lending by banks to this sector, raised the exposure to real estate as a percentage to banks’ total advances from 12.9 per cent in March 2005 to 19.4 per cent in September 2006. After a study of the emerging trends, banks were advised to lay down internal limits to ensure rating for builders, a minimum share of promoters’ contribution, requisite security cover, guarantee from the originator, and have a panel of approved valuers. The exposure being long term in nature with interest rate risk, liquidity risk and credit risk, the Bank issued instructions and guidance notes for banks. Banks with high capital market exposure were advised to bring it down by December 2007 to 40 per cent of their net worth. In December 2007, only two banks had capital market exposure greater than 40 per cent. They were given time up to March 2008 to bring it below the stipulated limit and the two banks later reported having done so as instructed. It was proposed in March 2008 that SRP might from then on be conducted once a year on a regular basis. Also in March 2008, guidelines were issued to banks for implementing the Internal Capital Adequacy Assessment Process (ICAAP), which was part of Pillar II of Basel II accord. A further area of discussion and improvement during the reference period was consolidated supervision.

Consolidated Supervision Consolidated supervision refers to a supervision system that encompasses subsidiaries. Its absence creates incentives for banks to divert problem loans and losses to subsidiaries that are under weak supervision. From March 2001, banks were required to voluntarily build in riskweighted components of their subsidiaries into their own balance sheets on 487

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the reserve bank of india a notional basis, and earmark additional capital in stages. As a further step, public sector banks were asked to annex the accounts and reports on each of their subsidiaries to their balance sheets. State Bank of India (SBI) and a few other banks said that a large number of subsidiaries under them would make the annual reports unwieldy and that the overseas subsidiaries, which had different accounting years, would pose further problems. They were then asked to attach only the latest available balance sheets of overseas subsidiaries. In November 2000, a working group identified three components of consolidated supervision: consolidated financial statements for public disclosure (CFS), consolidated prudential reports for supervisory assessment of risks (CPR) and application of prudential regulations on a group basis.14 The group recommended that initially consolidated supervision could be targeted only for groups where the parent was a supervised institution. All banks under the purview of the Reserve Bank’s consolidated supervision, whether listed or unlisted, were required to prepare and disclose consolidated financial statements from the financial year 2002–03 in addition to solo financial statements. Effective supervision entails sharing information among stakeholders and regulators, which is discussed next.

Coordination and Information Sharing An internal study group set up in 1998 recommended that a shared database should be created to serve the regulators and enforcement agencies. As suggested by the BFS, the Bank wrote to the Ministry of Finance to form a technical group to look into data sharing between regulators. These issues were considered in different discussions held with the government on the setting up of a Serious Frauds Office and a credit information bureau, and the introduction of suspicious transactions reporting. In 1999, a High-Level Coordination Committee on Financial and Capital Markets (HLCCFCM) was set up, with the Governor as Chairman, the chiefs of SEBI and the Insurance Regulatory and Development Authority of India (IRDAI) and the Secretary in the Ministry of Finance as members, to iron out the regulatory gaps and overlaps. The HLCCFCM constituted three standing technical committees in respect of entities regulated by the Bank, SEBI and IRDAI. These technical committees discussed issues relating to capital market exposure and developments in the financial markets relevant to the task. 488

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supervision of the financial system The HLCCFCM decided in 2004 that the three technical subcommittees set up to monitor banks, capital market and insurance companies would work as Crisis Management Groups in case of any unusual developments concerning their areas. Financial conglomerates posed a specific set of supervisory issues.

Financial Conglomerates The entry of some of the bigger banks into merchant banking and insurance made them into financial ‘conglomerates’. The monitoring mechanism in India had three components: off-site surveillance; the standing technical committee with members from the Bank, SEBI and IRDAI on concerns arising out of the analysis of data from surveillance and exchange of information; and halfyearly discussion with the CEO of the conglomerate, in association with other regulators, to address supervisory concerns.15 The Mid-Term Review of Monetary and Credit Policy for 2003–04 announced the establishment of a special monitoring system for ‘systemically important financial intermediaries’. An inter-regulatory working group16 was constituted to identify such intermediaries and advise on a monitoring and reporting system for them covering intra-group transactions. In May 2004, based on the recommendations of this group, a financial conglomerate cell was set up in the Bank. Twelve conglomerates were identified, of which, the Bank, IRDAI and SEBI would supervise eight, three and one, respectively, from March 2007. The number subsequently increased to twenty-two, with the Bank as the principal regulator for seventeen, IRDAI for four and SEBI for one financial conglomerate. From 2004, the technical committee on Reserve Bank–regulated entities monitored an integrated system of alerts, which was put in place jointly by the Bank and SEBI. The system provided for furnishing of information by SEBI received from stock exchanges and depositories to the Bank on transactions of large sales and purchases of stocks and securities for further investigation. However, the Bank could not establish a direct link between these transactions and flow of bank funds to the capital market in most of the cases. The technical committee also had oversight on the joint study of books of accounts and other operations of major entities in a financial conglomerate. Trusts and special purpose vehicles (SPVs) of the group (including mutual funds and venture capital funds) were brought under the financial conglomerate reporting 489

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the reserve bank of india framework. In fact, the definition of the financial conglomerate was debated at length and was left open-ended to allow for some flexibility. The financial conglomerate return format was revised and implemented from the quarter ending in March 2007. In addition to the intra-group transactions and exposures, it also captured critical information such as gross and net NPAs, provision held against impaired assets, frauds and ‘other assets’ and information on regulatory violations noted by other regulators.17 To facilitate smooth cooperation between the Bank, IRDAI, SEBI and NHB, a memorandum of understanding (MoU) was drawn up in 2007–08.18 Considerable efforts were made to improve corporate governance and transparency of banks’ operations during the reference period, with supervision in view, as discussed in the next section.

Corporate Governance, Disclosure and Housekeeping A committee report of 2001 pointed out that the government performed multiple functions as ‘owner, manager, quasi-regulator, and sometimes even as the super-regulator of public sector banks’, which was not conducive to good governance.19 A Consultative Group of Directors of Banks and Financial Institutions reviewed the supervisory role of boards of banks and FIs in 2002.20 In June of the same year, banks were asked to adopt and implement the recommendations of the group. In May 2007, private banks were advised that their memoranda and articles of association should conform to the BR Act provisions and the recommendations of the group. The Reserve Bank’s supervisory strategy included strengthening the internal control system of banks, the introduction of risk-based internal audit, and increased use of statutory auditors for verification and certification of certain aspects. Banks were to constitute an audit committee of the board of directors, with such members who had prior experience in management, finance, accountancy or auditing. Banks were also required to have a committee of executives for overseeing the internal audit function. In July 1997, banks were instructed to appoint Compliance Officers to monitor compliance with all instructions, directives and guidelines issued by regulatory bodies. Guidelines on compliance functions were issued to banks in November 2006. A committee set up in 1997 to review the formats of final accounts of banks led to fresh guidelines on disclosure.21 Based on the committee’s note on disclosure and transparency in final accounts, banks were advised to make additional disclosures, 490

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supervision of the financial system such as the percentage of shareholding of the government in nationalised banks, capital adequacy ratios, the percentage of net NPAs, provision made towards NPAs, and the gross and net value of investments. Further directives were issued in January 1998 and February 1999 for additional disclosure. The BFS monitored fraud-prone areas like inter-branch reconciliation, clearing differences, reconciliation of Nostro account, and long-pending entries for adjustment and balancing of books. The reporting system under OSMOS included data on housekeeping position in banks. A technical assistance group in 1998 recommended changes in housekeeping.22 To ensure that banks paid close attention to inter-branch accounts, they were asked to make 100 per cent provision for the net debit position in the inter-branch accounts, arising out of unreconciled entries (credit and debit) outstanding for more than three years as of 31 March every year.23 The Reserve Bank would impose penalties on the banks with unsatisfactory performance in inter-branch accounting. Subsequently, the period was reduced to one year and further to six months. To ascertain the reasons for clearing differences, an in-house study group was set up in August 2002 that discussed the issue with banks and service branches. The recommendations of the group were sent to banks for necessary action. Guidelines were issued in July 2003 for netting off old and small value entries of less than 500 outstanding for more than three years.24 The entire system of appointment of auditors for public sector banks was reviewed in 1998 and the procedure was streamlined. The Reserve Bank recommended a list of audit firms and auditors to the public sector banks for their appointment as statutory auditors by the Government of India. The selection was made out of a panel of firms received from the Office of the Comptroller and Auditor General of India. Private sector and foreign banks were required to take prior approval of the Reserve Bank for appointing their statutory auditors. For this purpose, a panel of three audit firms was submitted by each of these banks. The Reserve Bank recognised that the eligibility norms for the statutory central auditors were lax and formed a working group in 2003 to review the list. Based on the recommendations, the empanelment norms were revised and implemented from 2004–05. In 1999, a Committee on Technology Upgradation in the Banking Sector recommended development of in-house capabilities (instead of outsourcing) by banks for auditing their information technology departments.25 In June the same year, banks were advised to create electronic data process audit cells in their inspection departments.26 491

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the reserve bank of india The Reserve Bank had to step in on occasions as the lender of last resort, which role is discussed below.

Lender of Last Resort (LOLR) The Reserve Bank is empowered to act as the lender of last resort (LOLR) to rescue banks and FIs in temporary distress. For example, in the case of Global Trust Bank Ltd (GTB), there were two episodes when the Bank extended LOLR support facility.27 In 2001, in the wake of a liquidity crisis faced by cooperative banks in Gujarat following the failure of Madhavpura Mercantile Cooperative Bank (discussed later), the Reserve Bank issued a press release announcing a special collateralised liquidity facility to cooperative banks in the state as a temporary measure to protect well-managed cooperative banks. The support under LOLR was always extended at interest rates much higher than market rates. Among non-banks, the Reserve Bank had extended LOLR support to UTI Asset Management Company during 1996–2000 and to the Deposit Insurance and Credit Guarantee Corporation (DICGC) in 1999. Support was extended to Canara Bank in 1998 when it had to rescue its mutual fund arm by buying up the units called Canstar issued with a high fixed rate of return. The Gujarat State Cooperative Bank was helped with a special liquidity facility in 2001. The need for extending LOLR support did not arise in subsequent years during the reference period because banks maintained securities in excess of their SLR requirement and insurance companies and mutual funds stayed active as lenders in collateralised financial markets. The Reserve Bank, however, did need to take confidence-building measures on certain other occasions. For example, in 2003, certain automated teller machines (ATMs) of ICICI Bank in Gujarat went cash-dry in a period of consecutive holidays, prompted by rumours that the bank was going bust. In addition to providing liquidity support on a holiday, the Reserve Bank’s regional office in Ahmedabad issued a formal statement to assure the public of the viability of the bank, which stopped panic withdrawals. On another occasion, a branch of UTI Bank in Vadodara, Gujarat, was closed down on 11 August 2004 because the municipal commissioner had authorised the demolition of the third floor of the building, which 492

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supervision of the financial system was constructed without proper approval. Since the branch functioned in the ground floor of the same building, it was asked to vacate the premises immediately, giving rise to the rumour that the bank had been ordered to close down, and led to panic withdrawals by depositors from ATMs. The Regional Director of the Reserve Bank at Ahmedabad opened the vaults early in the morning next day to make cash available to the bank. The Reserve Bank spared no efforts in mobilising the required currency notes, including accessing the nearby chest of a nationalised bank when there was a shortage of 500 notes. The Reserve Bank deputed its officers to the ATMs and branches of the bank where large crowds had gathered for withdrawals to clarify the position and reassure them. The Regional Director also took up the matter with the Chief Secretary to arrange for the lifting of the closure order. The panic withdrawals subsided the next day. Effective supervision requires an effective penalty system for noncompliance, a discussion on which follows.

Penal Measures The BR Act was amended in 1994, in terms of which the penalty that could be levied on banks in respect of a contravention of the provisions of the Act was enhanced from a maximum of 2,000 to 500,000. The Reserve Bank issued ‘letters of displeasure’ for capital market exposure beyond the prudential limit and non-compliance to know-your-customer, or KYC, norms. In 1997, the Reserve Bank imposed a penalty on fifteen banks of 500,000 each for short-selling of securities, excess utilisation of export credit refinance and violation of KYC norms. The banks needed to obtain approval of their board of directors for payment of the fine to the Reserve Bank, which acted as a deterrent. An in-house group was set up in 1999 to recommend the criteria for levying penalties under the BR Act, keeping in view gaps between the existing systems and the ‘core principles for effective banking supervision’. The idea was to avoid arbitrariness involved in the imposition of different penalties for similar violations. The group held that penal action on banks should not be publicised or circulated among other banks. This was agreed to by the BFS. The group suggested denial of branch expansion, denial of access to refinancing, raising CRR and denial of access to the money market as penal measures. While the Bank resorted to denial of licenses for new branches for 493

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the reserve bank of india temporary periods against certain banks, measures such as raising of CRR were not used. In 2002, the Enforcement Directorate informed the Bank of certain high-value and suspicious cash transactions undertaken by one C. Surendran and his fourteen associates with banks in Kerala and Mumbai. The large cash deposited in Mumbai branches was immediately transferred to branches in Kerala and Coimbatore and was again withdrawn mostly in cash. Reserve Bank investigations revealed that ten banks (four public sector, five private sector and one foreign bank) were involved, which had not exercised diligence in undertaking the transactions. Show-cause notices were issued to three public sector and four private sector banks for imposing a monetary penalty and they were advised to take appropriate disciplinary action against delinquent officials, file criminal complaints where their involvement was established, and freeze the bank accounts concerned. A penalty of 500,000 each was imposed on all seven banks for not adhering to the Reserve Bank’s instructions on KYC in the handling of high-value cash transactions. One private sector bank was issued a letter of displeasure and the foreign bank a cautionary letter. No action was taken against the fourth public sector bank because the amount involved was very small. The Standing Technical Advisory Committee on Financial Regulation (STACFR) discussed whether or not penalties should be publicised. Recognising the role of market discipline under Basel II, and in the interest of enhancing transparency, from October 2004 the Bank imposed penalties and would place the information in the public domain. It was also proposed to advise banks to incorporate a paragraph in the Annual Report, indicating the findings of the latest Reserve Bank inspection regarding divergence in provisioning requirement and CRAR. However, a notice would be sent to the bank giving an opportunity for a hearing before taking a decision to place the information in the public domain. The impact that suspected frauds had on supervisory practices is discussed next.

Initial Public Offering Scam and Bank Frauds In December 2005, SEBI informed the Bank that certain bogus or benami (fictitious name) demat accounts had been opened in the banks, and requested the latter to investigate the role of banks in opening accounts in favour of 494

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supervision of the financial system such entities. SEBI was concerned because these accounts were used to fund initial public offering (IPO) applications. The Reserve Bank found that some brokers, with the help of depositories, had approached banks for opening multiple accounts in the names of purported applicants and requested banks to fund IPOs in fictitious names. Banks granted loans without KYC and antimoney-laundering (AML) safeguards, and to multiple accounts with the same name. The IPO refund amounts were parked in mutual funds for brief periods. Banks were advised to credit the proceeds of individual ‘account payee’ refund orders into accounts of brokers. Brokers had made use of bank funds by devious methods for cornering the retail portion of primary issues. Reviewing this case, Deputy Governor V. Leeladhar reflected that ‘what was disturbing was that our inspection carried out some six months back of the same bank branches which were involved in the IPO related irregularities had not brought out anything in this regard though the transactions had already taken place’.28 The Reserve Bank fixed accountability and took action against those inspecting officers under Staff Regulations. Show-cause notices were issued to banks, and their replies and oral submissions were not found acceptable. Several banks were subjected to penalties. Banks were required to report all actual or suspected frauds involving 100,000 and above to the Reserve Bank. All individual cases of fraud involving amounts of 10 million and above were monitored at the Fraud Monitoring Cell in the central office, while frauds of less than that value were monitored by the Bank’s regional offices. The cell facilitated an integrated approach to monitoring of frauds in the financial sector and to coordinate with other agencies (such as the Central Bureau of Investigation, or CBI). When frauds were reported by banks, the Reserve Bank issued caution advice to all banks giving details of delinquent borrowers and their associates, so that other banks were put on guard. A study group set up in 1998 analysed 107 bank frauds reported during the previous three years. The group’s report was sent to banks for their information and guidance. In September 2000, N. L. Mitra, retired director of the National Law School, Bangalore, was appointed by the Bank as a consultant to advise on banking law reforms.29 He also chaired an expert committee which recommended a separate Act to deal with financial frauds. In May 2002, banks were asked to report compliance with those recommendations of the committee that could be implemented without any legislative changes. The second part of the report, relating to legislative amendments to the Indian Penal Code, Indian Evidence Act and 495

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the reserve bank of india Criminal Procedure Code and enactment of the proposed Financial Frauds Act, was forwarded to the government for necessary action. The Reserve Bank sought to align the supervisory oversight on frauds with the Supervisory Review and Evaluation Process (SREP) under Pillar 2 of Basel II by factoring in the increase in frauds while profiling the operational risks faced by the banks. An Advisory Board on Bank Frauds was set up by the Reserve Bank in March 1997 to advise on cases referred to by the CBI (more details in Chapter 15). The collapse and merger of GTB was one of the major episodes in the Indian financial sector during the period covered by this volume as discussed below.

Global Trust Bank Ltd This new private sector bank was set up in 1994 and its founders included Ramesh Gelli, who was its first chairman. In August 1997, in the 30th meeting of the BFS, Governor Rangarajan stated that ‘in view of the adventurous style of functioning of the present chairman (Ramesh Gelli) and various irregularities ... the bank might be kept under close watch’. Next year, inspecting officers observed that ‘there was concentration of power at the level of chairman (who was also the CEO)’. In January 1999, critical supervisory concerns were noticed by the Department of Banking Supervision relating to credit appraisal, NPAs, CRAR and the internal control systems. In the same year, the regional offices were advised not to issue fresh branch licenses to GTB. However, in October 2000, the order was reversed in view of the bank’s satisfactory performance. Another crisis developed in 2001. There were reports that ‘certain overseas corporate bodies’ were lending support to a prominent stockbroker who was cornering the shares of GTB. The bank did not seek the Reserve Bank’s acknowledgment for transfer of its shares in excess of 5 per cent. In view of SEBI investigations into the scandal, the bank’s application for a merger with a new private sector bank was kept on hold. Before the Reserve Bank could take a decision, the proposed merger was called off by the parties concerned. In the same year, the bank’s capital market exposure was 31 per cent of its total advances as against the prescribed limit of 5 per cent. The bank’s reliance on interbank deposit was high. It was also found that GTB had lent heavily to a particular stockbroker and affiliated entities. Some of these investments 496

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supervision of the financial system became problem assets. When the bank came to the Reserve Bank for LOLR facility in April 2001 without having approved securities to offer as collateral, the Reserve Bank provided funds against public sector undertaking bonds as a special case but on condition that the chairman and the CEO submit his resignation. It was also made clear that he should not be on the board of the bank as a director. As directed, he did not seek re-election in the next General Body meeting. GTB attracted the proposed PCA, or ‘prompt corrective action’, on all the three counts: CRAR, NPA and return on assets. The Reserve Bank took the view that supervisory action had to be balanced when public deposits were involved because supervisory intervention itself could precipitate a run. It avoided such an outcome by extending liquidity support and also ensured the appointment of a new chairman in April 2001, who had earlier served in a public sector bank. In December 2001, the BFS members recommended the merger of GTB with another bank. In March 2002, the bank’s gross NPAs stood at 58 per cent, as assessed by Reserve Bank inspectors. If full provisioning were to be made as required, it would have led to the declaration of loss and negative net worth, which could have shaken the confidence of depositors and caused a possible run on the bank. The publication of GTB’s financial results for the year ending in March 2003, after much delay in September 2003, revealed a net loss of 2.72 billion with CRAR at 0.02 per cent and net NPA at 20 per cent. Since this disclosure was expected to create panic among depositors, the Bank took the unusual step of issuing a press release on 30 September 2003 stating that the [bank’s] present management had made special efforts in the recovery of non-performing assets relating to the previous years…. The Reserve Bank of India welcomes the decision of the Global Trust Bank Ltd., and its Board of Directors to clean up the balance sheet … for sound functioning of the bank and for the good health of the financial system.

Besides, there was a large divergence between Reserve Bank inspection and audited accounts for the year ending in March 2003 as well. While the bank and its auditors had estimated the gross NPAs at 9.16 billion, the Reserve Bank inspecting team estimated it at 16.89 billion. Actions were taken against the two statutory auditors of GTB, who had certified the accounts for March 2002 and March 2003, in view of the grave discrepancies which neither the bank nor the auditors were able to explain. The explanation furnished by 497

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the reserve bank of india one of the auditing firms was seen as unsatisfactory. Hence, the matter was referred to the Institute of Chartered Accountants of India (ICAI) in August 2004 for necessary action. Pending the outcome of the enquiry taken up by the ICAI, the Reserve Bank advised banks in October 2004 that they might consider awaiting further advice from it before engaging the auditing firm. Four cases were filed against the Reserve Bank at four different High Courts by the firm, challenging the Reserve Bank’s advice. The Calcutta High Court passed an interim injunction against the Bank in May 2005. The stay order, however, did not have any bearing on the Bank as it had not ‘banned’ the audit firm from being engaged by banks. Eventually, the case filed against the Bank was dismissed and the Bank withdrew its advice to banks in April 2008.30 The ICAI probe against the audit firm remained inconclusive.31 In February 2004, Gelli was re-inducted onto the board via co-option (taking the number of his family directors to three in a total of eight). The Reserve Bank expressed serious discomfort, and he resigned again in March 2004. The bank was then planning to come out with a rights issue; it was advised to report its true financial position in the offer document for the information of potential investors. In May 2004, GTB informed the Reserve Bank that a foreign private equity fund, Newbridge Capital Ltd, United States (US), had expressed interest in taking up a stake by investing US$200 million in the bank, subject to the Reserve Bank’s approval. But the proposal did not find favour as the Reserve Bank was not comfortable with investment by a private equity firm whose antecedents were not known and, therefore, could not be said to be in compliance with the ‘fit and proper’ criteria. On an application made by the Reserve Bank, the government notified the moratorium on GTB on 24 July 2004. For the first time, the moratorium order covered the ATMs as the bank had a good network of ATMs across the country. Despite the Reserve Bank disabling the ATM switch as per the moratorium order, there were queues of bank customers seen at the ATMs and the Reserve Bank had to despatch its officers to the branches, especially in Andhra Pradesh, to assure them. The next day, despite it being a Sunday, the Reserve Bank issued a press release reassuring the depositors of GTB about the safety of their funds and the arrangement being made to bring back normalcy. The draft scheme of amalgamation between GTB and the public sector Oriental Bank of Commerce (OBC), which had expressed its interest in the matter, was put in the public domain by the Reserve Bank through a 498

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supervision of the financial system press release on the very next day, 26 July 2004. The merger came into effect on 14 August 2004, making the entire transition smooth and swift. OBC filed complaints with the CBI in respect of fifty borrower accounts involving 13.09 billion. Former chairman Gelli was implicated in fourteen cases. The Deputy Governor wrote to the Ministry of Finance in July 2004 pleading for an income tax benefit to OBC to set off the GTB losses as it was technically a compulsory merger under Section 45 of the BR Act, 1949. The Reserve Bank pointed out that it was incongruous to extend tax benefits to voluntary mergers but to deny it for compulsory mergers. The government agreed and extended income tax benefit to OBC. When analysing the GTB affair, the BFS cited criticisms in the media based on the impression that the Reserve Bank had acted late. For example, Sucheta Dalal published an article titled ‘RBI’s Shoddy Role in the GTB Saga’ in Financial Express on 2 August 2004. Another commentator, Dilip Dasgupta, was more moderate in his assessment: ‘While most people accepted the efficacy, swiftness and fairness of RBI action, … it could have come much earlier’ (Treasury Management, December 2004). The Reserve Bank was criticised because the shareholders of GTB lost their entire invested capital. The Reserve Bank, however, was concerned only with the interests of depositors as mandated in the BR Act. From the Reserve Bank’s viewpoint, any hasty intervention could have pushed GTB into bankruptcy, jeopardising depositors’ interest, but with the nature of action taken by the Reserve Bank, all the depositors were fully protected. Wilful defaulters posed a particular challenge to supervision and this issue is taken up next.

Wilful Defaulters and Credit Information Bureau In 1999, the Chief Vigilance Commission advised the Reserve Bank to publicise the names of all wilful defaulters. However, under the provisions of banking laws, such disclosure was permissible only in suit-filed accounts. The Bank was circulating the list of suit-filed accounts of 10 million and above and the list of suit-filed accounts of wilful defaulters with outstanding advances of 2.5 million and above every year among banks, and the information was also placed on the Reserve Bank’s website. In June 1999, an internal working group recommended that a Credit Information Bureau be set up under the Companies Act, 1956, with equity 499

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the reserve bank of india participation from commercial banks, FIs and NBFCs. SBI, in association with other institutions, set up the Credit Information Bureau (India) Ltd (CIBIL) in January 2001. Another working group32 examined the role of credit information bureaus in collecting data on wilful defaulters. Based on its report ( January 2002), further instructions were issued to banks for data collection on wilful defaulters. When the names of the directors on the boards of defaulting companies were reported and shared, the professional and independent directors protested that they should not be treated on a par with promoter directors. Therefore, banks and FIs were advised (in April 2000 and December 2001) that while reporting the names of directors of borrowing companies, banks must identify and mark the nominee, independent and professional directors so as to distinguish them from promoter directors.33 In April 2004, the Bank advised the Indian Banks’ Association (IBA) that progress in data collection and sharing through CIBIL had not been satisfactory. Some banks pointed out that there was no data protection guarantee from CIBIL, and suggested that in the agreement between CIBIL and banks, a data protection clause could be incorporated. The Bank advised the IBA to arrange for inclusion of such a clause. The Parliamentary Standing Committee on Finance in its eighth report expressed concerns over the persistence of wilful defaults. A working group in November 2001 and an in-house group in January 2002 considered the definition of wilful defaulters.34 Six indicators were identified: deliberate nonpayment of dues despite having adequate cash flow and net worth, siphoning off funds, assets sold/not purchased, falsification of records, disposal of securities, and fraudulent transactions. Banks and FIs were advised to consider initiating criminal action against wilful defaulters in fit cases under the provisions of the Indian Penal Code. In response to observations made in the JPC report (2002) regarding diversion of funds by borrowers with mala fide intention, the Bank wanted STACFR to examine the issue. The committee opined that banks should advise the borrower of their intention to classify him as a wilful defaulter and provide a reasonable time for making an appeal before actually declaring him as such. Accordingly, the process was clarified to banks in June 2004. In May 2005, the Credit Information Companies (Regulation) Act, 2005, was passed. The rules and regulations for the implementation of the Act were framed by the Reserve Bank based on the recommendations of an 500

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supervision of the financial system internal working group. In April 2007, applications were invited for the issue of certificate of registration from companies wishing to start the business of credit information. The applications received in response were kept pending until the government issued a notification on foreign direct investment (FDI) in this business. In 2007, the government permitted 49 per cent FDI in credit information companies, following which, in 2008–09, the Bank granted inprinciple approval to four credit information companies, including CIBIL. As Indian banks operated branches abroad, and foreign banks did the same in India, overseas operations and compatibility of regulation became a concern, as we see next.

Overseas Operations and Cross Border Supervision A monthly reporting system for host country regulatory violations was prescribed for Indian banks with an overseas presence, for submission to their board of directors and to the Reserve Bank. In 1999 and 2000, there were bilateral discussions between the Financial Services Authority (FSA) of the UK and the Reserve Bank about Indian banks in the UK. The FSA identified certain concerns relating to UK subsidiaries of four public sector banks, such as inadequate provision for outstanding settlements, failure of assessment of risk on a group basis, and lack of common operating or information technology standards across the group. The FSA also expressed concerns about the rationale and viability of two public sector banks’ branches operating in London. In respect of foreign banks operating in India, a group set up in 2002 recommended that specific supervisory concerns such as penalty imposed by the Reserve Bank, letter of displeasure issued, and any other serious supervisory concern should be conveyed to the home country supervisors with a copy to the head office of the foreign bank. A working group was constituted in late 2007 to prepare a roadmap for adoption of a suitable framework for cross-border supervision and supervisory cooperation with overseas regulators. The report recommended the signing of a bilateral MoU with overseas regulators and supervisors and introducing a regular system of on-site inspection of overseas offices of Indian banks. However, the signing of the MoU by the Reserve Bank, which required sharing the findings of on-site inspections with overseas supervisors, was not feasible. The Prevention of Money Laundering Act, 2002, had certain provisions that prevented the sharing of information on financial crimes. 501

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the reserve bank of india The Office of the Comptroller of Currency of the US Government, as the home country supervisor, wanted access to the books and records of the Indian branches of the US banks which were under the Comptroller’s supervision in 2005. The officials had a meeting at the Reserve Bank headquarters in May 2006 where they informed the Bank that they would prefer informal arrangements relating to supervisory cooperation and sharing of information. The Bank agreed to deal with them on a reciprocal basis. In November 2006, the Comptroller stated that they would coordinate with the other US banking regulatory agencies for an information exchange agreement. The consent for such an agreement was received from the Comptroller in April 2008. Two other incidents were noteworthy. A public sector bank had to pay a fine of US$7.5 million in November 2001 to US authorities for the reported failure of their branch in New York to maintain correct and accurate records of customers. Prompt action taken by the Reserve Bank avoided undue publicity, but the bank had to pay the penalty. In the second case, after one of the branches of an Indian private sector bank was penalised by the Hong Kong Securities and Futures Commission in 2007 for allegedly carrying on private banking business without a licence, the BFS directed that commercial banks having overseas operations should report such incidents to the board of directors and the Reserve Bank on a monthly basis.

Miscellaneous Matters Governor Jalan convened a meeting of the CEOs of nine banks in October 1999 to get feedback on the existing supervisory system. One of the action points to follow was a system of ‘quarterly informal discussion’ by officials of the Reserve Bank’s regional offices with the executives of banks whose head offices were located in their jurisdiction on issues emerging from on-site inspections and off-site data.35 A fragile banking sector and weak supervision were seen to have precipitated the Asian crisis. In 2000, the Governor directed that an interdepartmental group be set up for compilation and review of micro-prudential indicators. The Bank began to analyse macroeconomic indicators together with microprudential indicators of the health of the individual financial institutions to arrive at macro-prudential indicators, which reflected the health and stability of the financial system. Macro-prudential indicators were being compiled since March 2003 as part of the Bank’s initiatives in adopting best international 502

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supervision of the financial system practices for monitoring the stability of the financial system.36 The exercise showed the potential vulnerabilities in the financial system. A review was done in September 2007 to study the impact of the developments in global financial markets to assess the exposure of the Indian financial system to the US subprime mortgage market. In the same month, the Bank convened meetings with senior officials of select banks to sensitise banks to the weaknesses in the domestic financial sector. In the case of public sector banks, no unusual movement in delinquency trends was reported. As for the new private sector banks, the feedback was of an increasing trend in delinquencies and an increase in credit cost to borrowers. This was taken up with four banks individually for a review of their credit portfolio, given the sharp rise in their retail NPAs. Reserve Bank officials met with the senior representatives of the four domestic rating agencies in late 2007 to elicit their views on the crisis and its domestic implications. As per their feedback, the subprime crisis in the US was unlikely to be replicated in India due to more stringent and prudent underwriting standards followed by Indian banks.37 The Bank’s guidelines on derivatives focused on ‘suitability’ and ‘appropriateness’ of derivative products. There were media reports since November 2007 about some corporate clients of banks suffering significant mark-to-market losses on account of their derivative transactions as well as reports of bank clients complaining of mis-selling of derivative products to them. The Reserve Bank, therefore, carried out a scrutiny of select banks. It came to light that banks had not followed ‘suitability and appropriateness’ requirements. A series of meetings followed to discuss and sort out the issue.38

Non-Banking Financial Companies Until the mid-1990s, the supervision of NBFCs was restricted to finding out whether the companies were complying with the directions issued on deposits and related activities. In 1996, an expert group had made certain recommendations for upgrading the existing supervisory system over NBFCs.39 Thereafter, the supervisory framework for NBFCs included, apart from on-site inspection and off-site surveillance, scrutiny of market intelligence and auditor’s reports. In 1997, the Department of Supervision in the central office was bifurcated into two entities, the Department of Banking Supervision and Department of Non-Banking Supervision. 503

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the reserve bank of india The number, diversity and geographical spread of NBFCs made on-site inspection a challenge. It was, therefore, decided that supervision would mainly focus on deposit holding or accepting companies. Chapter III of the RBI Act was amended in January 1997, which vested considerable powers with the Reserve Bank for effective supervision over NBFCs. The Reserve Bank also brought the companies’ asset side of the balance sheet to scrutiny during on-site inspections. It involved the assessment and evaluation of the financial health of a company on CAMELS pattern, which was almost on the lines of examination of commercial banks.40 In 2001 and 2002, a system of supervisory rating was introduced on the basis of the recommendations of the expert group,41 and a manual for on-site inspection of NBFCs was made available to the Bank’s inspecting officers. The regional offices were advised in October 2007 to take up scrutiny of systemically important non-deposit-taking NBFCs (excluding government companies) to verify compliance with prudential norms and directions. On off-site surveillance, the Bank created a website to be exclusively used by NBFCs for filing regulatory returns directly from their offices. In 2000, the Bank introduced the Computerised Off-site Surveillance and Monitoring System (COSMOS) for the NBFC sector. In March 1999, NBFCs were instructed to submit a return on liquid assets. The Bank issued advertisements in major newspapers cautioning these companies. The reaction to these instructions was intriguing. Some companies requested the Bank to allow them to withdraw their applications for issue of certificate of registration, while many others decided not to file applications for grant of the certificate. Some non-deposit-taking companies filed ‘nil’ returns. Altogether, 15,000 NBFCs filed liquid asset returns with the Bank. The Bank issued show-cause notices to the NBFCs that did not submit these returns. For example, the Bank’s Hyderabad office had advised 1,477 companies to submit the return, of which 657 companies did not respond, 362 letters were returned undelivered and 458 companies submitted the return. In 2005, a separate format was devised for closer monitoring of top fifty deposit-taking NBFCs. A core group of officers was formed for monitoring their functioning. The supervision of non-deposit taking financial companies (other than the ‘systemically important’ ones with assets above 1 billion) was essentially done through market intelligence and auditors’ reports, as they were not submitting regulatory returns. The system was strengthened by designating suitable officers at the Bank’s central office and at each of its sixteen regional offices as Market Intelligence Officers. A close rapport was established with

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supervision of the financial system credit rating agencies, and they informed the Bank the credit ratings assigned by them to investment instruments of NBFCs. In view of the shortage of inspecting staff with the Bank, inspection of all deposit-taking NBFCs with public deposits between 5 million and 50 million, regardless of their net-owned funds, was entrusted to chartered accountant firms whose names appeared in the Comptroller and Auditor General panel or in the Reserve Bank–approved list of branch auditors. Around 2,560 NBFCs were thus covered. The audit fees were borne by the Bank. A set of reports on the lines of the long form audit report in vogue for banks was introduced, wherein the auditors gave their opinion on the compliance of the company with regulatory and prudential norms. The statutory auditors of NBFCs were directed to furnish to the Bank ‘exception reports’, containing violations of statutory provisions and directions. Not many such reports, however, were received by the Bank.42 In January 1999, regional offices were asked to closely interact with state governments and other agencies concerned for coordinated oversight over NBFCs. This was in addition to the formal body, the State Level Coordination Committee, functioning in every state under the chairmanship of the Regional Director.43 The Bank also filed complaints with the Economic Intelligence Wings of state police authorities against unincorporated bodies that accepted public deposits. Several states had taken steps to put in place legislation, as suggested by the Bank, for effectively dealing with unauthorised acceptance of public deposits by NBFCs and unincorporated bodies engaged in financial business. A Special Cell with a Joint Legal Adviser was constituted in the Bank for taking legal action against defaulting NBFCs. It was imperative to prevent the flight of depositors’ money from companies that had been issued prohibitory orders and, therefore, the Bank posted observers or special officers to act as ‘watchdogs’. It appointed special officers on contract basis for one to three years to oversee the affairs of five problem NBFCs in 1999–2000. These officers were required to furnish periodic reports to the Bank.44 The BFS regularly reviewed and individually monitored the position in respect of problem NBFCs and weak NBFCs, those NBFCs whose certificates of registration had been cancelled or rejected, and holding public deposits of 0.10 billion and above. There were thirteen such companies in 2006. The problem companies were those that had been defaulting in repayment of deposits, while the weak companies were those that had liquidity or other 505

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the reserve bank of india problems but were not defaulting in repayment. By March 2008, there were eight such companies. There was yet another category called vanishing companies, which referred to companies that had become untraceable at the addresses available with the Bank. Though some had applied for certificates of registration, the communications from the Bank were returned undelivered. In 2000, the Bank furnished the lists of such companies to the relevant departments of state governments for taking legal action against the promoters and directors, and to protect the interests of depositors. SEBI had sent a list of eighty defaulting companies to the Bank. Of the eighty companies, twenty-seven were found to be NBFCs. Offices of these companies were found locked and promoters were not available. The information was shared with regional offices to add to their database so that the promoters concerned and directors were not allowed to start new NBFCs. State governments were asked to take penal action against these companies. In November 2005, the regional offices were advised to ascertain the activities of non-deposit-taking companies, to monitor their overall functioning and to hold meetings at quarterly intervals or at reasonable intervals with them to stay informed. In February 2006, it was advised that these meetings would help validate the judgement regarding ‘fit and proper’ character of the management of the companies. The deposit-taking NBFCs with deposits above 0.20 billion and systemically important non-deposit-taking companies were advised to frame their internal guidelines on corporate governance. There were around thirty residuary non-banking financial companies (RNBCs), of which only two were large, and the Bank had stopped registration of new RNBCs. During the reference period, the Bank stepped up supervision of these two companies (Peerless and Sahara). These two cases, therefore, deserve a longer description.

Residuary Non-Banking Financial Companies In March 1997, the net worth of Peerless General Finance and Investment Ltd (Peerless) was negative at 12.32 billion. The Bank advised the company to fully comply with the statutory provisions and directions. Though the company earned operating profit, the net worth was negative (until 2001) and, in the normal course, such NBFCs would be debarred from accepting 506

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supervision of the financial system public deposits. However, deposits continued to increase. Following a meeting between the Bank and the company representatives, an extension of one year was granted up to January 2002 for attainment of minimum net-owned funds for grant of certificate of registration, subject to investment of entire fresh deposits in eligible securities, recovery of dues from the group and connected companies, and reduction in NPAs. The company was given another extension of time up to January 2003 to fulfil these conditions. The company in October 2002 reported that it had since achieved the minimum net-owned funds, albeit with several qualifications in the auditor’s report. The cost of regularising discontinued and lapsed accounts for the depositors was prohibitive; it involved making arrears payments with 8–10 per cent interest compounded yearly, against the 5 per cent interest paid by the company on recurring deposits and 3.5 per cent on daily deposits. No KYC was done by the company for two-thirds of the deposit accounts. In 1998, the Bank inspection and special audit of Sahara India Financial Corporation Ltd (Sahara) revealed holding of huge public deposits and asset–liability mismatch. Its credit rating had been downgraded and liquidity affected, leading to default and failure in repayment of deposits. Orders of the Company Law Board were not honoured, and several complaints were received from depositors. The Bank’s inspection in 1999–2000 revealed contravention of several provisions of RNBC directions and NBFC prudential norms. The company was advised to desist from investment in real estate and withdraw the investment made in Amby Valley Lake City Project. The Bank’s inspection in 2000–01 assessed Sahara’s net loss at 1.32 billion as against net profit of 0.16 billion reported by the company. In May 2003, there were concerns arising out of deposit funds held in transit for a longer period than necessary with a group company acting as an intermediary. The Bank directed the company in January 2004 that the deposit funds should not remain with the agent for more than one day. Sahara sought more time to submit an action plan. By March 2004, the income tax claims made on the company amounted to 11.12 billion and if they devolved, its entire net worth and a substantial portion of deposit could get eroded. The annual inspections of the company revealed adverse features such as unjustified forfeiture of deposits, interest unpaid on lapsed deposit accounts, unpaid or unclaimed deposits not disclosed, agent (a group company) enjoying float funds in 1,439 bank accounts, and so on. 507

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the reserve bank of india The public deposits with the company continued to rise, however, and stood at 135.55 billion in September 2005, rising further to 184.55 billion by June 2007. It defaulted in maintaining ‘directed investments’ from April 2006 to March 2007. It was found that the company had included income tax refund claims as ‘directed investments’. Defaulted deposit accounts constituted 77 per cent of the total deposit accounts. The KYC done on agents and field workers were deficient. As the Bank was not sure of the truthfulness of the company’s records, it engaged one of the audit firms to carry out a forensic audit of Sahara, which had not been done by the Bank before. The firm verified the authenticity of the records in 2007 and assisted the Bank officers in carrying out an inspection of the RNBC. Following this, the Bank took steps to familiarise its supervisory staff with the basics of forensic audit, which was also built into the Bank’s inspection exercise. The Bank called the executives of the company for a meeting in January 2008. The company wrote to the Bank after the meeting that it would comply with the Bank’s directive of limiting the deposits at 168 billion by April 2009, and not by April 2008 as asked for. The company also wanted permission to accept public deposits for another seven years. The Bank directed the company to scale down its deposit acceptance activity and to map an orderly exit from the RNBC business model. As the company failed to comply with the Bank’s directions on freezing the deposit level and other directions, the company was issued a show-cause notice on 9 May 2008, as to why the company should not be prohibited from accepting fresh deposits. Later, an order was served (4 June 2008) prohibiting the company from accepting further deposits from the public. The company filed a writ petition before the Lucknow Bench of the Allahabad High Court on the next day, and obtained a stay order. The Bank moved the Supreme Court through a special leave petition for setting aside the order of the High Court. The Supreme Court passed an order holding that the Bank had complied with the rules of natural justice but added that an opportunity of personal hearing would be appropriate. The Court directed the company to appear before the Bank on 12 June 2008. Based on submissions made by the company, the earlier order was modified by the Bank and the company was directed not to accept any deposit maturing beyond June 2011.45

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supervision of the financial system

Primary (Urban) Cooperative Banks The guidelines for inspection of UCBs were thoroughly revised in 1999 on the pattern of annual financial inspection of commercial banks. In the new system, the assessment was on the CAMELS pattern. Revised guidelines were issued to regional offices in August 2001 for on-site inspection of UCBs. In 2001, certain stockbrokers used cooperative bank funds to speculate in the capital market. The brokers were operating through a network of ‘overseas corporate bodies’, foreign institutional investors, banks and mutual funds. The presence of various layers in the transactions made it difficult to trace the source of funds. When the stock market crashed in 2001, the financial losses had to be borne largely by certain UCBs. After this episode, the JPC (2002) suggested that the Bank should improve the quality of both on-site and off-site supervision of UCBs by making it more bank-specific. An internal working group (2003) recommended that all scheduled UCBs in ‘weak’ and ‘sick’ categories should be inspected annually, and other well-managed banks once in two years. The recommendation was accepted. A rating mechanism for UCBs was necessary. A working group was set up in October 2001 to develop such a rating model, especially for UCBs.46 The group suggested a framework of rating based on the CAMELS model. In the process, it was revealed that the UCBs had to do a lot to improve their internal systems before they could be subjected to the proposed rating model and that they needed assistance for improving their management information systems and technology. Due to an increase in the number of UCBs, the system of on-site periodic inspection came under stress. A system of off-site surveillance was, therefore, introduced for scheduled UCBs in April 2001. Initially, there were ten quarterly returns.47 These were replaced by a set of one annual and seven quarterly returns for the scheduled UCBs from March 2004.48 A database was built with inputs from on-site inspections too. Suitable software was developed to facilitate the preparation and submission of returns by UCBs electronically. This was followed by the installation of the application software in banks during 2004 for preparing and forwarding the returns. Weak banks posed a persistent problem. The policy was to segregate those banks whose net worth was negative and whose deposits had been eroded to the extent of 5 to 10 per cent. As per the new norms for classification of UCBs introduced from March 2002, banks were categorised as Grades I, II, 509

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the reserve bank of india III and IV based on their financial position. While Grade I and II banks had no major supervisory concerns, the other two grades indicated the presence of supervisory concerns of varying degrees. So far, supervisory actions were being taken on a case-to-case basis and there was no prescribed policy regarding quantitative signposts or trigger points. The classification rationalised such actions to focus on certain grades. The graded supervisory action in respect of scheduled and non-scheduled UCBs in Grades III and IV was implemented from April 2003 and April 2005, respectively. The Bank was to apply the course of action with some flexibility in respect of UCBs in states that had signed the MoU (see the previous chapter). It was later decided not to implement the graded supervisory action in states that had signed the MoU, but to make decisions based on the recommendations of the Task Force on Cooperative Urban Banks (TAFCUB). By the end of the reference period, MoUs had been signed with fourteen state governments and with the central government for multi-state UCBs. This had effectively covered 83 per cent of the UCBs and 92 per cent of the deposits of the sector. The TAFCUB mechanism had a positive impact on the functioning of UCBs, as mentioned in Chapter 10. In March 2005, 725 out of 1,872 UCBs were either weak or sick. The number was down to 496 by March 2008.49 UCBs were generally not permitted to invest their resources outside the cooperative sector. They were not allowed to have direct capital market exposure except in the bonds of public sector units, bonds and equity of all-India FIs, and Tier II bonds of public sector banks. On becoming aware of irregularities in securities transactions, the Reserve Bank conducted scrutiny of twenty-five major UCBs in 2001–02. Some of the banks had not adhered to the prudential norm of 5 per cent limit fixed for individual brokers. There were buying and selling of securities at off-market rates. Instead of accessing the interbank market either directly or through brokers, transactions were undertaken with brokers as counterparties (principal), at rates unfavourable to banks. There were buying and selling of government securities, with broker firms virtually acting as a front office (dealing room), and brokers using cooperative banks for funding or offloading their proprietary positions. Some transactions were fictitious. A total of thirteen UCBs, eight in Gujarat, four in Maharashtra and one in West Bengal, had incurred financial losses from transactions in securities. In view of these findings, the Bank advised the UCBs (April 2002) that the role of the broker should be limited to bringing two banks together. 510

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supervision of the financial system All future transactions (from July 2002) had to be done through subsidiary general ledger or dematerialised accounts. The Bank advised the Government of Gujarat to supersede the boards of nine UCBs for irregularities in securities transactions, which resulted in financial losses. Seven of the nine UCBs filed writ petitions in the High Court of Gujarat against the action. The Minister of Cooperation wrote to the Governor not to insist on the supersession of the boards, which might undermine public confidence in the urban bank sector and sought a year’s time to correct things. But there was no recovery from the broking entities, and the financial position of the nine banks deteriorated further. The Gujarat government proposed reconstruction schemes for these banks but the Reserve Bank was not in favour after the unsatisfactory experience of implementing reconstruction schemes in other cases. At least in the case of three of the nine banks, the Bank wanted the government to take them to liquidation to enable at least the small depositors to receive some money. The financial strength of the five other banks gradually improved and the ninth bank was merged with a strong bank. By April 2002, thirteen UCBs were issued show-cause notices for their exposure to the capital market by way of advances to stockbrokers and related irregularities.50 Seven banks were issued letters of displeasure. In June 2002, a penalty of 500,000 (maximum as per statute) was imposed on five UCBs for sanctioning credit facilities to share brokers. These UCBs were also denied the issue of branch licences for one year. The banks represented against the imposition of penalty and brought pressure on the Reserve Bank through the Government of India. But the Bank advised the government that there was no case for going back on the decision. The banks, after a long delay, paid the fine. A working group (1996) recommended that state governments should give autonomy to UCBs on audit, including selection and appointment of auditors.51 However, implementation was slow and uneven. Matters relating to the audit of the UCBs, including the appointment of auditors, were outside the purview of the Bank because the relevant Section 30 of the BR Act was not applicable to UCBs. The Reserve Bank’s inspecting officers, therefore, were required to comment on the quality of audit and the rating accorded by the state government auditors. The MoUs signed with states provided for a statutory audit of UCBs with deposits of over 250 million by chartered accountants in place of officers of the state cooperation departments and application of ‘fit and proper’ criteria for CEOs of UCBs based on the guidelines of the Bank.52 511

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the reserve bank of india A key episode in the process of improving supervision of UCBs was the case of the Madhavpura Mercantile Cooperative Bank (MMCB), Ahmedabad. The MMCB was set up in 1968, granted a license by the Reserve Bank in 1994, included in the second schedule in 1996, and registered under the Multi-State Cooperative Societies Act in 1998. It had twenty-eight branches, including two in Maharashtra, and had been one of the popular and the biggest UCBs in Gujarat. Chairman R. N. Parikh and CEO and managing director D. B. Pandya continued at the helm almost since inception, until it was placed under the administrator in 2001. Its financial reports indicated a steady and healthy growth until then. Early in 2001, the bank got involved in financing stockbroking firms belonging to Ketan Parekh and his associates in a big way, in contravention of the Reserve Bank guidelines. As the share market fell in February–March 2001, the brokers could not mobilise funds to pay for deliveries in March 2001. In April 2001, against sanctioned limits of 2.05 billion, the outstanding balances amounted to 8.88 billion. The stockbrokers and their associates owed the bank 10.80 billion without adequate collaterals. The figure represented 68 per cent of total advances. On 9 March 2001, there was a sudden rush of depositors at the bank’s Ahmedabad branches, which increased steadily until the 12th (the 10th and 11th being bank holidays), on the rumour of the bank’s exposure to the Ketan Parekh group. The bank continued to meet the heavy demand of depositors by extending its working hours until the morning of 13 March. At that point, it had to close down all its branches without notice, as it was no longer able to cope with the demand for withdrawal of funds. This also triggered a run on the deposits of several other banks in Gujarat. The board of the bank was superseded on the very next day, 14 March, at the Bank’s instance and an administrator was appointed on the same day. The media alleged laxity on the part of the Reserve Bank. The JPC observed (in response to Question No. 1157) that the Reserve Bank’s inspection before this episode did reveal several major irregularities. ‘RBI though enormously empowered under the BR Act to enforce strict discipline on the bank, ... stated to have taken recourse to simply writing to the bank seeking rectification.’53 The Reserve Bank defended itself in its reply that as per inspection findings, the bank had the capacity to pay its depositors in full and hence cancelling the license was not an option, which would have had systemic effects impacting public confidence. The adverse developments in MMCB took place during the 512

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supervision of the financial system period between two Reserve Bank inspections, which was one of the reasons for the delay in taking action. The government formed a group in April 2001 to work out a rehabilitation plan for MMCB. To prevent a run on a large number of UCBs that had kept deposits with MMCB, a bail-out plan was suggested. The Reserve Bank was not convinced about the viability of the scheme, which envisaged restructuring of MMCB over a period of ten years, mobilising deposits of 8 billion, with focus restricted to the liabilities side, but went along with it so that at least funds could be released to small depositors by the DICGC. The Gujarat government was advised to either extend its guarantee for repayment of deposits by MMCB or to issue subordinated debts to UCBs having deposits with MMCB. If there was no positive response from the state government, the UCBs would be required to make disclosure of their deposits with MMCB by way of ‘notes on accounts’ of their balance sheets. The reconstruction scheme for MMCB was discussed in the first meeting of TAFCUB for multi-state banks in March 2007. Based on the recommendations of TAFCUB, the Reserve Bank conveyed its no-objection to the Central Registrar of Cooperative Societies (CRCS) to the issue of a notification modifying the scheme of reconstruction, so as to defer all payment by a year, pending revision of the scheme. Considering the difficulty in realisation of dues of MMCB if taken to liquidation, it was decided that the licence should not be cancelled, and the decision to liquidate should be taken later. But the scheme failed to take off as it could not effect significant recoveries in NPA accounts, especially from big brokers. Still, the contagion effect of the MMCB debacle had been largely contained by March 2008. The DICGC filed a suit in 2007 against MMCB in the Bombay High Court for recovery of 4.01 billion plus interest at 6 per cent, being the amount released earlier by the DICGC. Left with no hope of reviving the bank, liquidation seemed to be the only option. But the decision came only in 2012, when the Bank had to revoke the licence and order the winding up of the bank and appoint a liquidator. The fallout from the MMCB episode extended to a public sector bank. Three companies belonging to the Ketan Parekh group maintained current accounts with the bank’s Stock Exchange Branch, Mumbai. Though the companies did not enjoy any credit limits, pay orders of other banks were regularly discounted in these accounts. From November 2000, it started discounting banker’s cheques and pay orders issued by UCBs. The branch 513

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the reserve bank of india discounted as many as 1,504 of these for 65.50 billion, including 251 banker’s cheques favouring the three Ketan Parekh group companies, involving 42.14 billion issued by MMCB, between January and March 2001. The proceeds of all the thirteen pay orders discounted were credited to the group companies. But the pay orders were returned unpaid to the bank as MMCB failed to meet its clearing liabilities. The Reserve Bank scrutiny carried out between 30 March and 3 April revealed the failure of internal control and risk management systems in the bank. Though the bank refused to admit any lapse on its part, a letter of displeasure was issued by the Reserve Bank. Another landmark case was the Charminar Cooperative Urban Bank Ltd, Hyderabad (Charminar). Charminar was registered and licensed in 1985, had seventeen branches in the twin cities of Hyderabad and Secunderabad, and was profitable since inception. The bank had deposits of 1.29 billion in 1998 when it applied to the Reserve Bank for inclusion in the second schedule. The bank brought pressure on the Reserve Bank from various quarters for a favourable decision in this regard. The Reserve Bank carried out an inspection in December 1998. The inspection revealed that 42 per cent of the deposits held by the bank were from institutions. Guidelines on prudential norms had not been followed in many cases. It had violated the Reserve Bank directives on credit exposure norms and unsecured advances. Therefore, the Reserve Bank advised the government in January 2000 that the bank ‘was not considered favourably for inclusion in the second schedule since its CRAR in March 1999 was low at 2.86 percent’. The bank’s published loss for 2000–01 was 19.2 million. Had it followed the extant provisioning norms, the loss would have been 79.7 million. The failure of another cooperative bank in Andhra Pradesh (Krushi Bank) had a contagion effect on Charminar. Besides, it faced liquidity problems since April 2001. The bank was placed under directions in February 2002. The state government came forward with a reconstruction scheme for the bank. There was a difference of opinion between the Reserve Bank and the state government in regard to the manner and the ratio in which the realisations made by the bank would be shared between the DICGC and the depositors. Discussions were held with the officials of the state government and these issues were sorted out and a consensus was reached that the recoveries would be shared on a pro-rata basis between DICGC and the bank. Thereafter, the Bank accorded approval for the scheme and the order of reconstruction became effective from March 2003. 514

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supervision of the financial system In a meeting between the state government and Reserve Bank officials, the Chief Minister of Andhra Pradesh directed his officials to approach the two public sector banks based in Andhra Pradesh to explore the possibility of merging Charminar Bank with them. However, the legal opinion was that a cooperative bank could not be amalgamated with a nationalised bank. In August 2004, the Reserve Bank wrote to the Chief Secretary of the state expressing supervisory concern on the deteriorating financials of the bank. The response of the government was found inadequate. The bank was again prohibited from accepting fresh deposits. The TAFCUB for Andhra Pradesh reviewed the reconstruction scheme and a revision was deliberated and taken up. 54 The Reserve Bank inspected another bank, the South Indian Cooperative Bank, Mumbai, in March 2002, and found its financial position satisfactory and assigned a Grade I rating (lowest risk). The statutory auditors appointed by the Registrar of Cooperative Societies (RCS) did not detect any wrongdoing in March 2003 and classified it ‘A’ (lowest risk). But the inspection carried out by the Reserve Bank in December 2003 revealed gross irregularities, which was contested by the bank. The financial results for 2003–04 brought out huge losses. In August 2004, the bank, which had public deposits of 2.30 billion, was placed under a moratorium, and as requested by the Reserve Bank, the RCS superseded the board of directors in the same month. By March 2005, there was an erosion of 43 per cent of its deposits. The CRAR was negative at 273 per cent, and gross NPAs amounted to 84 per cent of the total advances. The bank was issued a show-cause notice for cancellation of licence in October 2005. However, in view of the appointment of a retired professional banker as the new administrator by the RCS in March 2006, cancellation of licence was not pursued. In August 2008, the Reserve Bank approved a scheme of amalgamation with another UCB, which became effective from September 2008. The Krushi Cooperative Urban Bank Limited, Secunderabad, was another bank, like MMCB, where the chairman had continued since inception and the bank was taken to liquidation in October 2001. The move had a contagion effect on other UCBs in Andhra Pradesh, including the Charminar Bank. In the case of City Cooperative Bank Limited, Lucknow, the bank faced a heavy rush for withdrawal of deposits on 20 March 2001 in all four branches, triggered by a news report in a local daily about defaults by a stockbroking firm. On 22 March 2002, directions were issued, and on 9 April 2002, the board was superseded, the bank’s license cancelled, and an administrator appointed. 515

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Financial Institutions The Financial Institutions Division was created in June 1997 within the Department of Banking Supervision and was entrusted with both regulatory and supervisory functions over FIs.55 The first round of inspection of nine institutions (IDBI, ICICI, IFCI, EXIM Bank, IIBI, TFCI, NABARD, SIDBI and NHB) was completed in 1997–98. A draft inspection manual was prepared in the Reserve Bank in 2000 and made available to the Bank’s inspecting officers. To introduce a rating system for FIs, an internal group of senior officers was formed in 2001 that evolved a rating model and it was tested with the past inspection reports. The new rating model was implemented with effect from March 2002. An off-site surveillance system was introduced in 1998 and in the following year, the prudential supervisory reporting system was put in place. In 1999, disclosure norms were introduced. They were advised to disclose additional information by way of notes on accounts to financial statements. The Bank also looked into the guidelines for auditing.56 In 2004, a working group looked into the regulatory and supervisory issues relating to term lending and refinancing institutions and improvements in the flow of resources to the FIs.57 On the basis of the group’s recommendations, supervision of NABARD, SIDBI, NHB and EXIM Bank, which were deposit-taking FIs, would continue. But FIs not accepting public deposits and classified as NBFCs having an asset size of 5 billion and above would be subject to limited off-site supervision. Non-deposit-taking FIs were not subjected to annual inspection from 2004–05 onwards.58

Conclusion The Reserve Bank enjoyed more autonomy in ‘supervision’ of commercial banks as compared to ‘regulation’, where the government had to be consulted before taking new initiatives and major decisions. The Bank had been proactive in exercising supervision. It sharpened its tools taking cues from global developments and best practices and adapting them to the Indian context. During the reference period, off-site surveillance of banks was broadened and made more focused, and the system handled and analysed more information than before. After the UCB crisis of 2001 and failure of GTB in 2004, the Reserve Bank strengthened its supervisory function. There were continuous 516

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supervision of the financial system innovations. The earlier total dependence on on-site inspections lessened, early warning systems were introduced, and the system became more efficient in processing information and taking timely action. The Bank’s supervision of NBFCs was less of a challenge as they moved away from public deposits; off-site monitoring became the primary instrument of supervision, supplemented by external audit. With UCBs, along with regulatory initiatives (see the previous chapter), TAFCUB proved to be an effective mechanism for coordinated supervision. As for the FIs, the supervisory role of the Reserve Bank continued to be limited and transitory.

Notes

1. The legal basis for both regulation and supervision is provided by the Banking Regulations Act (BR Act), 1949, in respect of commercial banks and cooperative banks, and the Reserve Bank of India (RBI) Act, 1934, for non-banking financial companies (NBFCs) and all-India FIs. 2. Based on the recommendations of expert groups, of which the Pendharkar Working Group (1985) and Padmanabhan Working Groups (1991 and 1995) were important. 3. Chairman: M. S. Verma. This was one of the ten groups and expert committees constituted by the Standing Committee on International Financial Standards and Codes. 4. In accordance with the recommendations of the Padmanabhan Working Group (1995). 5. The rating system is explained in Ranjana Sahajwala and Paul Van den Bergh, ‘Supervisory Risk Assessment and Early Warning Systems’, Basel Committee on Banking Supervision Working Papers, 2000. 6. Chairman: P. R. Khanna. 7. The issue of sharing the supervisory rating with external rating agencies was examined in 2007. But the rating and the methodology remained confidential, as it was observed that the world over, no regulator published or made public the supervisory ratings assigned by it to its regulated entities. 8. For example, in September 2003, an interdepartmental ‘core group’ was formed to help evolve an analytical framework to track certain critical financial parameters of systemically important banks. In 2005, Governor Reddy directed that an analysis be carried out of the movement of select balance sheet items of commercial banks between January and March that year. The analysis found that the incremental credit–deposit ratio overall stood at 157 per cent in that quarter. Certain outlier banks had recorded as high ratios as 935 per cent, 676 per cent and 300 per cent. The sources of funds were: 517

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9.

10.

11. 12. 13.

14. 15.

16. 17.

drawing down of excess statutory liquidity ratio (SLR) investments, accretion to owned funds and overseas borrowings. In March 2008, the net erosion in the value of securities held in the trading book for assumed rise in yields by 100 bps, 125 bps and 150 bps accounted for 2.22 per cent, 2.83 per cent and 3.44 per cent, respectively, of the total regulatory capital at the system level. This did not pose any concern as fiftyfour banks of the seventy-eight scheduled commercial banks had capital to risk-weighted assets ratio, or CRAR, of 12 per cent and above, and the aggregate average CRAR of all seventy-eight banks was 13.01 per cent, with no bank having CRAR below the stipulated minimum of 9 per cent as of March 2008. Only one bank’s CRAR would have dropped below 9 per cent level for an assumed rise in yields by 100 bps. The proposed structured actions included placing restrictions on (a) expansion of risk weighted assets, (b) entry into new lines of business, (c) on declaration of dividends, and so on. Discretionary actions envisaged included ordering of recapitalisation of banks and disallowing banks from (a) increasing their stake in subsidiaries, (b) incurring capital expenditure, (c) expansion of staff and filling up of vacancies, and so on. The group had as member the Executive Director and the Heads of Banking Regulatory and Supervisory Departments. Chairman: President of the Institute of Chartered Accountants of India, or ICAI. The RIG was set up in 2004 with members drawn from the regulatory and supervisory departments of the Bank. It was to periodically meet and discuss regulatory issues, keeping in view the financial products and services in the market, and the market intelligence reports available. Groups were set up in regional offices too and the proceedings of the meetings were sent to the central office, and issues which needed the attention of the RIG in the central office were put up to them. The group in the central office had seven meetings in 2007–08. Chairman: Vipin Malik, Director, Central Board, RBI. The framework was based on the principles set forth by the Joint Forum of BCBS, the International Organization of Securities Commissions and the International Association of Insurance Supervisors. It covered issues of capital adequacy (at solo as well as group level), conduct of intra-group transactions, exposures consistent with arm’s length principles, implementation of ‘fit and proper’ and corporate governance principles, and risk management guidelines. Chairperson: Shyamala Gopinath. The thresholds for fund-based and non-fund-based transactions were increased for focused monitoring. The dominant/major entity in the group, called the ‘designated entity’, collected and collated financial conglomerate information and forwarded them to the principal regulator for analysis.

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supervision of the financial system 18. A team of Reserve Bank officials visited the United States, the United Kingdom and the De-Nederlandsche Bank, the central bank of the Netherlands, to study the financial conglomerate monitoring mechanism in these countries. The team prepared in December 2007 an approach paper on supervision of financial conglomerates in India with suggestions to further strengthen the supervisory framework. 19. An advisory group set up by the Standing Committee on International Financial Standards and Codes on corporate governance (Chairman: R. H. Patil, Chairman, UTI-AMC). 20. Chairman: A. S. Ganguly, Director, Central Board, RBI. 21. In line with BCBS guidelines, with representatives of ICAI, banks and the Reserve Bank. 22. Members were from the Reserve Bank, ICAI and select banks. 23. Starting from the accounting year ending in March 1999. 24. Banks had to ensure that at least 50 per cent of a bank’s business operations (both advances and deposits separately) and 100 per cent of treasury transactions were covered under the concurrent audit system. A working group was set up to study the scope and effectiveness of the existing concurrent audit system in commercial banks, which recommended that the risk-based internal audit system should cover all ‘high risk’ areas of operation of banks. 25. Chairman: A. Vasudevan, Executive Director. 26. Another working group (Chairman: R. B. Barman, Executive Director) finalised the standards and procedures for information systems audit and security guidelines for banking and financial sector in 2001. 27. First, to the extent of 4.63 billion in 2001 against the collateral of public sector bonds as a special case because the bank did not have government securities in excess of SLR requirements and, thereafter, a special liquidity facility of 1.80 billion in July 2004 when it was placed under moratorium. 28. 12 April 2007, in-house ‘Conference on Bank Supervision’, Mumbai. 29. He also chaired the Advisory Group on Bankruptcy Laws (set up by the Standing Committee on Standards and Codes) and the Expert Committee on Legal Aspects of Bank Frauds constituted by the Reserve Bank. 30. Incidentally, it came to light in January 2009 that the said firm was also auditor to another company which crashed out due to an accounting fraud. 31. At the time of writing in 2018, the case was being heard by the Disciplinary Committee of the Institute of Chartered Accountants of India. 32. Chairman: S. R. Iyer, Chairman, CIBIL. 33. A few minor problems needed to be addressed in this regard. For example, banks had been asked (October 1999) to obtain the consent of the borrowers and their guarantors for disclosure of their names in case of default. ITC Ltd, and a few other big borrowers, expressed their dissatisfaction on this. The 519

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34. 35.

36. 37.

38.

Bank, therefore, made the requirement of consent clause in the agreement prospective, applicable only to those loan sanctions and renewals effected after the issue of circular. The working group was set up under the chairmanship of the IBA chairman, S. S. Kohli. These quarterly meetings, which served as an important supervisory tool, commenced from the January–March 2000 quarter in regional offices, and attended by the CEOs and executive directors of banks, which were presided over by Regional Directors. The system enabled a continuous assessment of a bank to provide, among other things, the needed background canvas for undertaking annual on-site inspection. The analysis which was put up to the BFS covered macroeconomic aggregates and financials of commercial banks, NBFCs, UCBs, all-India FIs, PDs, RRBs and cooperative banks. Bank credit, which logged significant growth during the three year period from 2004 to 2007, recorded a distinct deceleration in growth in 2007–08, one of the reasons being the regulatory interventionist measures taken by the Reserve Bank. There was periodic stress testing of credit risk and interest rate risk to assess the vulnerability embedded in bank balance sheets and strategies. Supervisory action was initiated with identified outliers. A few other measures and action points bear a quick recap. A system of monthly monitoring was put into effect from 2001 onwards of banks that were financially weak. In 1998, banks were advised to monitor unhedged foreign currency exposure of their corporate clients. In 2001–02, banks were advised to put in place a system for monitoring such unhedged external exposures. Considerable discussion took place on ‘principle-based supervision’ during the reference period. Principle-based supervision is an approach that provides for regulation by the underlying principles, rather than target- and productspecific rules. The approach, however, places greater reliance on the discretion of the supervisors in interpreting the principles. During the reference period, some discussion occurred in the Reserve Bank on these alternatives. Subsidiaries of banks did not come under the purview of the BR Act but they were regulated by SEBI, NHB, the Reserve Bank and IRDAI. The Reserve Bank’s guidelines suggested that the parent bank should inspect and audit the books and accounts of the subsidiaries at appropriate intervals. Finally, the Reserve Bank considered the introduction of generally accepted accounting principles (US GAAP) in Indian banks for loan loss provisioning. An internal working group set up to examine the effect of its implementation (December 2002) suggested a roadmap and a time frame. But the IBA and the ICAI were not in favour of its introduction, since the US GAAP required much higher provisioning compared with Indian norms, substantial documentation and the generation of historical data.

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supervision of the financial system 39. Chairman: P. R. Khanna, chartered accountant. 40. In 1999, on a sample basis, 20 per cent of non-deposit taking companies were inspected with particular attention paid to companies on which there were adverse market reports. 41. Chairman: P. R. Khanna. 42. Three audit firms were issued show-cause notices for deficiencies and inconsistencies in their reports of special audit of NBFCs. The matter was also taken up with the ICAI for appropriate action at their end. Further, the Bank decided not to consider these audit firms for any other assignments. 43. The committee met once in six months, and its members included the Registrar of Companies, Company Law Board, a representative from ICAI, state government officials and industry representatives. 44. The Bank wanted to ensure that such appointments were not seen as the Bank assuming a controlling or management role, as the special officer was posted basically to monitor the company’s affairs. Therefore, the Governor instructed that the officers be recruited from outside the Bank. 45. These two RNBCs were advised by the Bank to shift to another viable business model and to stop accepting any new deposit maturing beyond 2011. Peerless reported having stopped accepting fresh deposit and renewal of deposits from 2011. Until the writing of this volume, Sahara had not submitted an alternative business plan and the Bank was receiving complaints that the company was accepting deposits from the public without authorisation. 46. Chairperson: V. S. Kaveri, Professor in the National Institute of Bank Management, Pune. 47. These included those designed to ascertain the banks’ assets and liabilities position, profitability, NPAs, loans to directors, and large exposure. 48. The information covered in these returns pertained to balance sheet, offbalance sheet exposures, profit and profitability, asset quality, sector-wise concentration of advances, connected lending, and capital adequacy. 49. Among other measures taken, a system of quick scrutiny of the loan portfolio of UCBs was put in place. Observing the bullish trend in the stock market, regional offices were advised in January 2004 to conduct quick scrutiny and special inspection of the banks that had recorded unusual credit expansion. Further, to achieve regulatory convergence between commercial banks and cooperative banks and to comply with one of the core principles of BCBS, a PCA framework was proposed for UCBs with effect from March 2005, based on five parameters: CRAR, net NPA, return on assets, history of losses/ profits, and non-compliance with CRR and SLR. 50. Some UCBs had issued guarantees to stockbrokers. One UCB alone had issued 278 guarantees to stockbrokers. When questioned, the banks replied that the Reserve Bank’s instructions did not prohibit non-fund facilities like 521

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51. 52.

53.

54. 55.

56.

57. 58.

guarantee, as the circular mentioned only ‘credit facilities’. The banks were instructed to regularise the position by ‘recalling such guarantees, if still outstanding’. The banks pointed out that existing/outstanding guarantees could not be cancelled unilaterally as they were irrevocable. Chairman: V. M. Chitale, chartered accountant. The Bank took a few other steps to tone up the quality of corporate governance in UCBs. For the purpose of licensing new UCBs, it was prescribed that their boards should have at least two directors with professional qualifications or adequate experience in banking. A few instances of problems with the urban cooperative banks are discussed later. The Bank appointed a one-man committee in January 2003 under P. V. A. Rama Rao (former Managing Director, NABARD) to look into the involvement, if any, of Reserve Bank officers in the wrongdoings of MMCB and take action). The scheme, however, failed to yield the desired results. Subsequent inspections revealed no improvement in its financial position. Its licence was cancelled by the Reserve Bank in 2011 and liquidation ordered. The Informal Advisory Group (IAG) (Chairman: Y. H. Malegam) on Regulation and Supervision of Financial Institutions submitted its report in 2000. The IAG had suggested refinements in the existing system of onsite and off-site supervision. An internal group was set up to examine the recommendations of the IAG. The views of FIs were also obtained and suggestions accepted. The scope of the annual on-site inspection of FIs was widened to include risk management. The Bank circulated to the FIs the standardised check-lists prepared by the Committee on Computer Audit (April 2002). The FIs were advised to set up an audit committee of the board. The draft guidelines on ‘consolidated accounting and consolidated supervision’ (on the lines issued to banks) were sent to FIs in September 2002 and, based on feedback, final guidelines were issued in August 2003. Chairman: N. Sadasivan. Even the off-site surveillance system for these FIs was dismantled and replaced with a simplified information system from December 2005. Half-yearly reviews of the performance of the FIs were done based on data collected from returns.

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12 Rural Credit

Introduction The preamble to the Reserve Bank of India (RBI) Act enjoins the Bank to operate the credit system to the advantage of the country, a country where most of the population lives in rural areas. Further, the Bank is required to ‘study various aspects of rural credit and development’ as it may consider necessary to do so for promoting integrated rural development. From the 1970s, this aim was achieved by means of directed credit, mainly ‘priority sector lending’. The policy directed banks to lend to agriculture, small enterprises, retail trade, microcredit, education and housing, subject to certain conditions. It started with nationalised banks in 1974 and was extended to private banks in 1978. In 1985, 40 per cent of bank credit was directed to flow to priority sectors, within which 25 per cent (10 per cent of the total advances) was to go to the ‘weaker sections’ of society. Weaker sections included small and marginal farmers with landholdings of less than 5 acres, landless labourers, artisans and ‘tiny’ enterprises with loan limits up to 50,000, beneficiaries of the government’s poverty alleviation programmes, Scheduled Caste/Scheduled Tribe (SC/ST) borrowers and members of self-help groups (SHGs). A separate sub-target of 16 per cent was fixed for agriculture in 1985 and raised to 18 per cent in 1990. The financial sector reforms from 1992 underscored that banks and other financial institutions (FIs) had to become strong and efficient (see Chapter 10.1). The report of the Committee on the Financial System (Narasimham Committee I, 1991) recommended that the directed credit programme, being an anomaly in a ‘free market competitive system’, should be phased out. The Committee on Banking Sector Reforms (Narasimham Committee II, 1998) observed that ‘a high incidence of NPAs [non-performing assets or advances] could be traced to policies of directed credit’.1 Other reviews also recommended reforms and scaling down.2 But neither the government nor the Reserve Bank was ready to deprioritise the priority sector. 523

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the reserve bank of india Still, as more emphasis was laid on operational freedom and profitability of banks, the Reserve Bank was under pressure to pause or go soft on directed lending and its rural focus. While it avoided a reversal of its policies, occasional wavering in its resolve could be observed. As seen in this chapter, the Bank managed a tight-rope walk with some success, trying to balance the aim of reinventing the banking system as a strong market player while serving the not-easily-bankable rural poor. The chapter will outline the steps taken to increase the flow of credit to the rural sector through the institutional purveyors of credit, namely commercial banks, cooperative banks and regional rural banks (RRBs), which included much-needed reforms in institutions, financing, governance and technological standards.

Objectives of Banking Policy with respect to Rural Credit The directed credit policy was based on an implicit ideology that banking service was a public good because banks depended on the support of the government – after they were nationalised in 1969 – and were institutions of public trust. They ought to function in the common man’s interest. Once it was defined as a public good, no citizen could be excluded from its consumption or use. Creating a strong and vibrant banking system could not be an end in itself but only a means to bring about the good of all, especially the poor. In 2004, the government reiterated the conviction that ‘the fruits of the improved performance of the financial sector … should not be denied to farmers and weaker sections’.3 There was possibly another belief behind directed credit, which was that the private sector operators were somehow incapable of serving the rural poor. The distrust of the ‘moneylender’ was widespread and deeply entrenched and apparently based on impressions because little concrete information was known or collected on the institutional aspects of private providers of rural credit. Together, the two beliefs translated into a policy of directing the banks to fund the needs of specific groups in society. Maintaining the public goods perspective was a difficult proposition in the post-reform environment while the Reserve Bank was at the same time trying to make banks more profit-oriented. Before the economic reforms, commercial banks followed the ‘accommodation principle’. But now assets were created on risk–return considerations as the ‘profit maximising principle’ dominated their portfolio behaviour. With the application of stringent income recognition and asset classification norms, the gross NPAs of commercial banks 524

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rural credit were disconcertingly high at 15.7 per cent in March 1997. This, together with inadequate headroom in the capital to risk-weighted assets ratio (CRAR) at that time, made banks reluctant to undertake high-risk activities and directed credit was perceived to be risky. The impounding of banks’ resources through reserve requirements was also sizeable in April 1997 with the cash reserve ratio (CRR) at 10 per cent and the statutory liquidity ratio (SLR) at 31.5 per cent, though reduced later to 25 per cent. The profit motive sometimes impacted regulatory behaviour as well. For instance, the thrust of the Bank’s branch licensing policy immediately following nationalisation of large banks in 1969 was towards opening more branches in unbanked semi-urban and rural areas. But there was a shift since 1991 as the Bank allowed banks to close ‘persistently loss-making branches’ or merge with other branches. The revised branch licensing policy stated that ‘further growth of bank offices should be guided only on the well-established need for offices and financial viability of proposed branches’. This shift resulted in the reduction of rural branches of commercial banks from 35,206 to 32,915 and to 31,076 as at the end of March 1991, 1997 and 2008, respectively. The ratio of rural branches to all branches fell from 52 per cent in March 1997 to 41 per cent in March 2008.4 No doubt reclassification of settlements from ‘rural’ to ‘semi-urban’ in the successive decennial census contributed to the reduction in the number of ‘rural’ offices, but the fall also owed to shifts in policy. However, the branch authorisation policy was again modified in 2006–07 as the Reserve Bank prioritised financial inclusion, which entailed ensuring availability of banking service in almost every village of the country. With the setting up of the National Bank for Agriculture and Rural Development (NABARD) in 1982 as the designated apex institution for agricultural and rural development, the direct responsibility of the Reserve Bank to promote rural credit eased substantially. One area of adjustment was a change in the relationship between these two bodies.

The Reserve Bank and NABARD The Bank was earlier providing refinance to state cooperative banks against production credit financed through their lower tiers, namely the district central cooperative banks and primary agricultural credit societies. Since 1982, this function was vested with NABARD. 525

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the reserve bank of india From 1992–93, the Reserve Bank did not transfer any money to the National Rural Credit (NRC) Fund maintained with NABARD. The government assured NABARD (a telex message on 14 May 1992) that ‘they would consider providing explicit budgetary subsidy for the additional cost in case NABARD raised resources from the market, corresponding to the level of support expected from NRC funds’. NABARD could raise low-cost funds from the market by issuing ‘capital gain’ and ‘priority sector bonds’. This was disallowed from April 2006. The Reserve Bank was not very accommodative in its dealings with NABARD. Since 1997–98, the development financial institutions (DFIs) came under an ‘umbrella’ annual limit for raising resources from the market. The Monetary Policy Department (MPD) was about to fix an umbrella limit for NABARD too.5 But the regulatory department for NABARD, the Rural Planning and Credit Department (RPCD), was not in favour and suggested that the existing practice of scrutinising each proposal of NABARD to raise resources from the market should continue.6 In January 2000, however, NABARD was sanctioned with the umbrella limit on a par with other FIs. In March 1995, and again in March 1999, NABARD had requested the Reserve Bank to sanction a short-term facility of 5 billion and 4 billion, respectively, to meet refinance and repayment commitments. It was also requested that the rate of interest be fixed at 7 per cent as their average earnings on refinancing worked out to just over 7 per cent. In 1995, the Reserve Bank sanctioned 3 billion at an interest rate of 14 per cent. In 1999, the Bank did not sanction the facility and asked NABARD to ‘raise resources by selling their surplus government securities’. The reason given was that the short-term facility would lead to an increase in reserve money and money supply. To enable NABARD to provide concessional finance to RRBs and cooperatives to support their seasonal agricultural operations, the Reserve Bank extended a general line of credit since its inception in 1982.7 From the late 1990s, there was much uneasiness in the Reserve Bank on continuing the general line of credit, in the context of efforts to raise NABARD’s resources.8 Between 1996 and 1999, the government and the Reserve Bank had contributed annually to raise its paid-up capital. Office notes revealed the fear that large and highly-subsidised accommodation from the Bank would ‘breed inefficiency’ and ‘moral hazard’. Further, the Bank continued to maintain that lines of credit to FIs led to ‘an expansion of money supply’. One of the tenets of the financial reform process was that concessional finance 526

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rural credit should be gradually phased out. Therefore, NABARD, like other DFIs, must borrow from the market. In April 2006, the Bank took the view that ‘direct lending to governmentowned FIs would amount to indirect borrowing by the government and would be in contravention of FRBM Act [Fiscal Responsibility and Budget Management Act, 2003], in terms of which RBI cannot subscribe to government borrowing in the primary market’. The general line of credit limit was reduced in 2005–06, and the Bank advised NABARD that from July 2006–07, the general line of credit support would not be available. The requests for reconsideration of the decision were not heeded.9 Thus, during the time span of the book, NABARD was forced to borrow from the market. Its market borrowings formed 5.5 per cent of its total liabilities in 1997, which increased to 33 per cent in June 2008. The Reserve Bank formed an advisory committee in 2004 with V. S. Vyas, a noted agricultural economist, as chairman, to study the flow of credit to agriculture and related activities from the banking system. The committee held that NABARD should have full autonomy in the areas of credit and developmental interventions. By the provisions of the NABARD Act, NABARD had to seek approval of the Reserve Bank for adding to eligible purposes, institutions and bodies for extending its finance, and the committee wanted powers to be vested with the board of NABARD.10 The committee also said that NABARD need not be driven by commercial considerations alone. The Reserve Bank did not agree because, ‘considering that NABARD has to access market for funds, the need and importance of strong financials cannot be ignored’. NABARD was subjected to Reserve Bank inspection under the RBI Act, 1934. At the end of the inspection exercise, there would be a supervisory discussion at the senior executives’ level in which one of the points invariably raised was an increase in NABARD’s average cost of funds.11 In a meeting held in March 2004, the then Executive Director, Usha Thorat, suggested to NABARD officials that in case they needed funds, they ‘may approach other banks for getting funds at market rates and not to depend too much on RBI funds.’ In 2008, the union cabinet approved the government’s acquisition of the Reserve Bank’s stake in NABARD, in line with the view of the Narasimham Committee II that the ‘regulator owning the institution it governed was inconsistent with the principles of effective supervision’. Although NABARD was under pressure throughout, it had conceptualised two of the most significant innovations in rural credit during the 1990s – 527

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the reserve bank of india the SHG–bank linkage programme and the Kisan Credit Card (KCC). The Reserve Bank implemented these schemes (see later). But first, let us consider the priority sector lending policy and changes therein.

Lending to the Priority Sector Compliance with the priority sector guidelines was an important issue. For example, a differential rate of interest scheme (DRI scheme), in operation since 1972, required banks to lend 1 per cent of the total advances to borrowers falling below the poverty line at a concessional interest rate.12 Banks in general and private banks in particular did not take the target seriously.13 In March 1997, commercial banks had fallen short of the target set for priority sector lending. The shortfall was larger with agricultural credit. The position did not improve for the next three years. On 22 November 2000, the Financial Express ran an article, ‘Data Shows Social Banking Getting a Burial’. The record was worse for lending to weaker sections. When the Reserve Bank took up the issue with the banks, they pointed out the high level of NPAs, recoveries and write-offs. When a bank effected substantial recoveries or write-offs in the accounts, the aggregate outstanding came down, and bankers pointed that out as one of the reasons for not meeting the target. The Reserve Bank did not consider introducing a penalty or disincentive for not meeting the targets. However, banks did somewhat improve their performance in lending to weaker sections by March 2008.14

Advisory Committees In 1997, a committee recommended simplifying the procedures at the branch level, and to enhance the flow and quality of credit to agriculture.15 The major recommendations included imparting more flexibility and discretion for the lending banks, the delegation of powers to the branchlevel officials, the introduction of composite cash credit type of facility, the introduction of simpler loan procedures, disbursement of loans in cash, and simplification of procedures for loan agreements. The Reserve Bank accepted the recommendations and asked the banks to implement them.16 A second review was done by the Vyas Committee, to which mention has been made before. The committee found that only a few banks had implemented the recommendations, that the poor often shied away from 528

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rural credit formal institutions for want of information about procedures, and that the borrower worried about, in addition to the cost of credit, the timeliness and adequacy of credit. The committee recommended that banks should be asked to waive margin and security requirements for small agricultural loans. This was implemented, along with a series of other procedural changes.17

Components of Lending What should be a good indicator of a bank’s performance when credit targets were set? Linking the targets to ‘outstanding credit’ was not a good idea because a portion of the outstanding credit could be NPAs. Therefore, the Reserve Bank saw disbursement during a given period to be a better indicator of performance. Though the disbursement was monitored through the mechanism of special agricultural credit plans introduced for public sector banks, by and large the Bank continued to rely on outstanding credit to measure performance.18 The target of 18 per cent fixed for lending to agriculture was bifurcated in 1993, with a minimum of 13.5 per cent for direct loans and a maximum of 4.5 per cent for indirect loans. Since then, the scope of activities under ‘agriculture and allied activities’ expanded significantly, particularly under the indirect category. Loans for financing distribution of inputs for allied activities in agriculture, such as cattle feed and poultry feed, were included in indirect credit and the loan limits were raised. Loans to dealers in drip irrigation systems, sprinkler irrigation systems and agricultural machinery were included. Until 2003, only the dealers located in rural or semi-urban areas fell within the definition of indirect credit, but thereafter, all dealers, irrespective of their location, were included. Advances for construction and maintenance of storage facilities for storing agricultural produce were considered as indirect lending to agriculture from 2002. Financing of ‘agriclinics’ and ‘agri-business centres’ were included first under the indirect category and, from August 2002, under direct lending.19 Trends in outstanding direct and indirect credit to agriculture and allied activities are set out in Table 12.1. The Reserve Bank decided in April 2000 that lending by banks to nonbanking finance companies (NBFCs) for on-lending to finance agricultural activities should be classified as indirect lending to agriculture. Lending through the cooperative credit institutions and state-sponsored corporations for onward lending to agriculture and weaker sections, and 50 per cent of refinancing to RRBs by the sponsored banks were treated as indirect lending to agriculture. 529

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Table 12.1 Credit Outstanding to Agriculture and Allied Activities (Short Term and Long Term) as of End of March ( billion) SCBs

1997

263.27

1999

298.19

1998 2000 2001

284.45 334.42 382.7

2002

451.06

2004

681.03

2003 2005

RRBs

Cooperatives

46.83

213.90

40.38 53.89 59.91 72.49 82.86

538.04

102.61

955.19

167.09

2006

1356.03

2008

2027.96

2007

Direct Finance

1690.18

117.21 215.1

274.52 332.16

205.56 221.99

SCBs

49.86 63.35 81.17

419.50

129.68

521.10

182.38

461.35 590.64 714.03 788.22 823.27 894.43 656.66

188.25 236.90 285.20 360.71 571.75 825.64 934.43

Source: RBI, Handbook of Statistics on the Indian Economy.

Indirect Finance

Total Credit to Agriculture and Allied Activities

RRBs

Cooperatives

0.13

208.17

347.8 0 (42.6)

673.61

464.10 (28.7)

0.49 0.25 0.29 Nil Nil Nil

197.04 220.22 795.67 890.92 929.2

54.14 (6.2)

570.95 (30.1) 633.44 (29.8)

1412.02 (66.3)

1363.92

2515.82 (49.8)

1479.82

1927.78 (46.3) 2962.39 (54.5)

442.21 (50.5)

82.86 (3.9)

72.49 (3.8)

167.09 (4.9)

1199.32

422.07 (51.6) 1093.11 (67.6)

1315.90 (39.0)

966.23 (34.3)

Cooperatives

402.60 (53.2)

60.20 (3.7)

1101.32

Nil Nil

379.36 (43.3)

47.01 (5.8)

102.61 (4.3)

1023.07

Nil

RRBs

40.87 (5.4)

774.94 (32.3)

Nil Nil

SCBs

313.13 (41.4)

117.21 (4.2) 215.10 (5.2) 274.52 (5.4) 332.16 (6.1)

Notes: Figures in brackets are the percentage of the total. SCBs: scheduled commercial banks. RRBs: regional rural banks.

1257.02 (66.1) 1519.84 (63.4) 1737.10 (61.5) 1889.54 (56.1) 2022.59 (48.5) 2258.35 (44.8) 2136.48 (39.4)

rural credit Lending by banks to food and agro-processing sectors was brought under priority sector in February 1999. The government did not specify any loan limit for advances to this sector despite references from the Reserve Bank. This led bankers to claim that advances to big companies, such as Britannia Industries, ITC and Hindustan Lever, could be classified as a priority sector, which drew criticisms from the media. From August 2001, units in food and agro-based processing sectors with investments in plant and machinery below 50 million would only be covered under priority sector.20 The Bank introduced the General Credit Card Scheme in December 2005 to cover the general credit needs of banks’ clients up to 25,000 in rural and semi-urban areas. The objective of the scheme was to provide hassle-free credit based on the assessment of cash flow without insistence on security, purpose or end-use of the credit. It was in the nature of overdraft or cash credit and the cardholder was entitled to draw cash from the specified branch of the bank up to the limit sanctioned. The entire advances under the scheme came under ‘indirect finance to agriculture’. It served two goals: promoting the product and enabling banks to meet the target for agriculture. Following these relaxations, portfolios of many banks expanded. Six public sector banks and eleven private sector banks had exceeded the limit of 4.5 per cent as of March 2000. They were advised that advances in excess of 4.5 per cent would not be reckoned for computing their performance under agriculture. Despite requests from banks to relax the sub-limit of 4.5 per cent, the Reserve Bank did not relent but allowed indirect agricultural advances in excess of 4.5 per cent to be treated as part of priority sector advances. There were relaxations in respect of direct lending to agriculture as well. Apart from crop and working capital loans, all medium- and long-term loans extended to farmers for allied activities, such as dairy, fishery, piggery and poultry, were included in the direct category. Financing of plantations and horticulture were included. Loans to farmers for purchase of land was treated as direct lending to agriculture, subject to certain conditions. Loans extended to distressed farmers who were indebted to non-institutional lenders were included. The Reserve Bank was not unaware of the implications of these changes. As early as in 2001, Y. V. Reddy, Deputy Governor, commented in a speech that ‘coverage of definition of priority sector lending has been broadened significantly in the recent years, thus overestimating credit flows to actual agricultural operations in recent years’.21 531

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the reserve bank of india Broadening the scope of agricultural credit by including new activities and increasing the loan limits brought about four disquieting outcomes. First, the share of institutional credit to total credit in rural areas declined between 1991 and 2002 from 64 per cent to 58 per cent, and the share of non-institutional agencies went up correspondingly. As per the findings of the Debt and Investment Survey, carried out as part of the 59th round of the National Sample Survey in 2002, while 13 per cent of all rural households were indebted to institutional agencies, 16 per cent were indebted to noninstitutional agencies. However, the next survey, in 2013, showed a higher share of institutional credit of 60 per cent, with 64 per cent among all rural cultivator households and 52 per cent among all rural non-cultivator households.22 Second, the share of agricultural credit disbursed by urban and metropolitan bank branches (against rural and semi-urban branches) was increasing. Their share in direct and indirect agricultural credit went up from 14 and 60 per cent, respectively, in March 1997 to 22 and 77 per cent in March 2008.23 This indicated that more loans were being sanctioned to borrowers outside the traditional definition of the agricultural sector. Third, and somewhat strangely, loans sanctioned tended to bunch in March, which was not the sowing or the harvesting season in large parts of India. Fourth, the share of bigger loans in total agricultural credit increased over the period under review.24 A government task force (2010) observed that despite ‘the doubling of agricultural credit, [credit] did not reach a large number of small and marginal farmers’.25 The Reserve Bank recognised that bank transaction costs were high and took several steps to reduce these costs.26 It also wanted the banks to be considerate towards loan defaults in the farm sector due to crop failure and factors beyond the control of the farmers.27 The Reserve Bank advised banks to give fresh loans to farmers even if the previous loan was closed through settlements involving write-offs. As for farmers affected by natural calamities, such as drought, cyclones or floods, the Reserve Bank had advised in 1984 relief measures to be considered by banks. These guidelines were modified in June 1998 by incorporating specific facilities such as the conversion of short-term production loans into medium-term loans, rescheduling or postponement of term loan instalment, provision of additional crop loans, and relaxations in security and margin norms. The Reserve Bank advised banks in November 2006 that they should frame transparent one-time settlement policies for farmers who had suffered natural calamities. The initiatives in legislative and institutional reforms are as outlined in Box 12.1. 532

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rural credit Box 12.1 New Directions in Legislative and Institutional Reforms Money-Lending Activities

In 2006–07, the Reserve Bank Governor announced in the Annual Policy Statement that a technical group would be set up to review the existing legislative framework governing money-lending. The technical group (Chairman: S. C. Gupta) had, apart from senior Reserve Bank officials, three members from the Governments of Bihar, Andhra Pradesh, and Rajasthan. There were also eleven invitees from eleven other state governments. A survey was conducted using a structured questionnaire, covering 177 districts in 25 states, through focus-group discussions with bankers, borrowers, moneylenders, formal institutions and nongovernmental organisations (NGOs) and district administrations. The group recommended a model law. The group also recommended some modifications in the existing legislation to create an informal and speedy dispute resolution mechanism and insert mandatory provisions for registration to undertake money-lending activity in states that had no such provisions. It recommended that the word ‘licence’ may be substituted by ‘registration’ as the expression ‘licence’ carried the connotation of control, that registration be made compulsory and that the prescription of interest rates under the statute may be done away with, and a provision be made to the effect that the maximum rates of interest that could be charged by moneylenders are to be notified by the state government from time to time. Rural Cooperatives

In terms of the memorandum of understanding (MoU) proposed to be signed by the state governments with the Government of India and NABARD, the state governments were to carry out certain legal and institutional reforms, undertake to supersede the boards or wind up a cooperative bank at the request of the Reserve Bank, and to take steps to generally empower the boards, ensure audits through chartered accountants, appoint qualified executives and improve technological standards.

Rural Infrastructural Development Fund (RIDF) Although priority sector targets for public sector and private sector banks were prescribed in 1974 and 1978, respectively, no penalties were imposed on banks for not achieving them. The RIDF provided an escape route instead. In 1995, the government announced the setting up of the RIDF for the purpose of assisting state governments and state-owned corporations to fund projects of 533

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the reserve bank of india rural infrastructure. The RIDF was established with NABARD. Commercial banks made contributions to the RIDF equivalent to their shortfall in agricultural lending.28 The deposits by banks were for five years at a relatively attractive interest rate. The period of deposits for later tranches was increased, whereas the interest rates were reduced. In 2001, the interest rate was inversely linked to the extent of shortfall in agricultural lending of the bank concerned. Two banks ran up arrears of payment to RIDF. The Jammu and Kashmir Bank Ltd ( J&K Bank) and ING Vysya Bank Ltd had arrears for many years. In the case of the former, the state government wanted to appropriate the funds directly instead of their being routed through the RIDF. ING Vysya Bank said that the deposits would exceed the prudential exposure ceiling fixed for single borrower though the Reserve Bank had specifically relaxed single borrower limits for RIDF deposits kept with NABARD. On being threatened with regulatory action, ING Vysya Bank deposited the defaulted amount of 1.95 billion with NABARD on 3 July 2008. The chief executive officer of J&K Bank made certain submissions to the Reserve Bank in his letter dated 30 June 2008 addressed to the Deputy Governor. Among other things, the bank sought time up to five years to clear the backlog of arrears. However, the bank was advised in July 2008 to deposit the arrears.29

Foreign Banks and the Small Industries Development Bank of India (SIDBI) Small-scale industries were a component of the priority sector. Foreign banks were not given any targets for agricultural lending, but they were required to lend 32 per cent of the total advances to priority sector, within which 10 per cent and 12 per cent were fixed as sub-targets for small-scale industries and export sectors, respectively. The amount equivalent to the shortfall had to be deposited with the Small Industries Development Bank of India (SIDBI) for one year.30 From the start of the scheme in 1995 until 2000, the interest rate paid by SIDBI to the foreign banks was an attractive 10 per cent and, thereafter, it was reduced to 8 per cent when the Bank Rate was 7 per cent. Interestingly, some banks deposited more than the required amount with SIDBI, and the Reserve Bank had to call for clarification. SIDBI, on the other hand, repeatedly requested the Reserve Bank to reduce the rate of interest payable on such deposits. As the Reserve Bank was unwilling to relent, SIDBI sought 534

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rural credit government intervention. The Secretary in the Ministry of Finance wrote to Deputy Governor Rakesh Mohan on 14 May 2003 that ‘such rates of interest will be an incentive giving an impression that we may be favouring foreign banks’ (see Appendix 12A.1). The Parliamentary Standing Committee on Finance expressed the fear that foreign banks would borrow cheaply from the market, invest at profitable rates and still fulfil priority sector obligations. The committee felt that the inability of private or foreign banks to fulfil priority sector obligations should attract a penalty.31 In the following month, interest payable by SIDBI was made equal to the Bank Rate, which was 6 per cent at that time. The Economic Times (23 March 2004) carried a story with the headline ‘Foreign Banks Hit A Jackpot for Going Short on Priority Lending’, which mentioned that the deposits with SIDBI were still seen as an incentive for some banks. It was only in 2005–06 that the interest rate structure for deposits placed with SIDBI was treated in a similar fashion to the system followed for deposits of domestic banks with NABARD.

Priority Sector: New Activities The Reserve Bank recognised the difficulties faced by banks in achieving moving targets. Since the targets were unclear and variable until the last day of the financial year, non-priority advances usually surged in the last month of the financial year. To overcome this difficulty, the Bank considered an absolute target, based on the total advances of the previous year-end instead of the current year, which could facilitate better credit planning by banks. However, the idea was dropped, ‘as it is likely’, said Deputy Governor Jagdish Capoor, ‘to invite criticism in view of reduction in absolute terms’. Deputy Governor Y. V. Reddy said in April 2000 that the priority sector policy had lost its rationale, but if the Bank could not change the policy, ‘it is better to let sleeping dogs lie still, rather than attempt improvements’. Governor Jalan, too, observed that ‘for the present let us leave things as they are’. A change came nevertheless, mainly in the form of relaxations made in the definition and scope of priority sector. New activities such as software and venture capital funds were brought under the priority sector in 1999 (subject to conditions). Direct subscriptions made by banks and purchases in the secondary market of bonds issued by SIDBI, Khadi and Village Industries Commission, National Small Industries Corporation Ltd, Housing and Urban 535

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the reserve bank of india Development Corporation, State Financial Corporations, State Industrial Development Corporations, and National Housing Bank were allowed to be classified as priority sector lending until 2007. Following the recommendations of Narasimham Committee II (2000) and Vyas Committee (2004), investments by banks in securitised assets, representing loans to various categories of the priority sector, would be eligible for classification under respective categories of the priority sector.32 While submitting the ‘action taken report’ to the government on Narasimham Committee II, the Bank stated that this would ‘not help in augmenting the flow of credit to the priority sector nor will it help in addressing the question of regional imbalances’. On a decision taken to treat bank credit to NBFCs for financing truck operators as lending to the priority sector, one of the leading NBFCs pointed out in a representation to the Reserve Bank that the decision had ‘not really benefited the NBFC sector or the transport sector. It had only helped banks to reach the target for priority sector without any additional flow of funds.’ Further, outright purchases of any loan asset eligible to be categorised under priority sector from banks and FIs, and investments by banks in ‘interbank participation certificates’ on a risk-sharing basis would also be eligible for classification under certain conditions. In fact, there were continuous and insistent demands from various quarters, government departments, pressure groups, diverse associations and federations to include new industries and activities to the priority sector. In May 1999, there were demands to treat credit to infrastructure and tourism under priority sector, which was firmly turned down by the Reserve Bank as they involved ‘large outlays’ which might ‘result in shrinkage’ in other components of the priority sector. There were also demands to exclude certain advances such as loans to infrastructure from total credit (numerator) while computing percentage of priority sector advances. Again, the Reserve Bank did not accept these (Box 12.2). Education loans for pursuing studies in India and outside India, subject to conditions, were treated as lending to the priority sector. The Supreme Court, while delivering an order in a case in 1998, directed the Bank to formulate a scheme for granting education loans to students undertaking studies in private professional colleges, which was submitted to the Court and brought into effect from August 1999. Banks were advised by the Bank in April 2001 to implement the new education loan scheme prepared by the Indian Banks Association (IBA) and approved by the government. The rate of interest was 536

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rural credit not to exceed the prime lending rate of the bank. Housing loans sanctioned to borrowers up to 2 million were considered as lending to the priority sector. But banks found it advantageous to lend to large housing companies. For example, State Bank of Hyderabad advanced 5.10 billion to the Housing Development Finance Corporation (HDFC) and classified it as lending to the priority sector and the Reserve Bank deemed it to be in order. If the priority sector presents a mixed picture, there was good news for rural credit in the shape of new institutional innovations and products. Box 12.2 Revised Guidelines on the Priority Sector – 2007 The Reserve Bank constituted an internal working group, with the Chief General Manager of its RPCD as Chairman, to examine, review and recommend changes in the existing policy on priority sector lending. After examining the recommendations made by the group in a technical paper and placed on the Reserve Bank’s website in September 2005, and after considering the feedback and suggestions received from the banks, FIs, the public and the IBA, the Reserve Bank issued the revised guidelines in April 2007. The government was not consulted as the Bank deemed it as not necessary. The highlights of the new guidelines were the following three. • •

•

First, the treatment of banks’ investment in bonds issued by various government corporations and deposits kept with NABARD under the RIDF as priority or agricultural lending was withdrawn. Second, the targets and sub-targets under the priority sector were linked to adjusted net bank credit, or ANBC (which is arrived at by adding banks’ investments in non-SLR bonds held in ‘held to maturity’ category to total advances). It was also decided not to deduct the outstanding non-resident deposit balances from total bank credit for computation of ANBC. Third, and arguably the most significant decision, was to arrive at the priority sector targets with reference to the total credit outstanding as on 31 March of the previous year instead of the current year, as was done until then. This was no doubt favourable to banks in terms of credit planning as the target was known beforehand. As already mentioned, banks were not able to predict the advances as would be at the end of the year because a lot of lending and window dressing activities happened at the year-end and, therefore, it was a challenge for banks to achieve moving targets. However, as there was no simultaneous upward revision in the targets to neutralise the effect of this change, it was seen as a retrograde step, which did not receive the attention it deserved from stakeholders, media and the government.

537

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the reserve bank of india

Two Innovations: Self-Help Groups–Bank Linkage Scheme and Kisan Credit Card Despite nationalisation, banks were unable to cater to the credit needs of the poor. A strategy had to be evolved to make the poor bankable and to render banking services in a cost-effective manner. In response to this need, NABARD conceptualised the self-help group, or SHG, and bank linkage programme in 1992. The SHGs facilitated collective decision-making and ‘doorstep banking’ and banks in turn provided credit and other services. This model proved to be a cost-effective, transparent and flexible mechanism. Recoveries were better and it reduced transaction costs for banks and borrowers. Studies revealed that group members tended to shift to more productive activities. In 2000, the Reserve Bank set up a Micro Credit Cell to liaise with NABARD and microfinance institutions better. Based on this experience, the Reserve Bank issued guidelines to banks in February 2000.33 It asked banks to incorporate microcredit in the branch-, block-, district- and state-level credit plans. Though no target was fixed for microcredit, the Reserve Bank wanted it to become an integral part of a bank’s corporate credit plan and be reviewed at the highest level on a quarterly basis. Banks were given the freedom to formulate their own models and choose any conduit or intermediary for extending microcredit. Governor Jalan directed the RPCD in August 2002 that a fresh impetus be generated for microfinance, and that it should be an area of priority for the next year. The Reserve Bank arranged a meeting with the chief executives of banks and microfinance institutions in October 2002.34 In that meeting, Ela R. Bhatt, Chairperson of the NGO Self-Employed Women’s Association (SEWA), referred to the positive impact the Reserve Bank guidelines had made on microcredit provision. By then, 2,155 NGOs were associated with the SHG–bank linkage programme, which continued to be the dominant microfinance dispensation model in India. Between 1997 and 2008, this scheme witnessed significant growth and, as of March 2008, there were 3.62 million SHGs linked to banks, with aggregate loans outstanding at 170 billion. The share of public sector banks in lending to SHGs stood at 64.3 per cent, followed by cooperative banks at 26 per cent. The intermediaries organised the poor into groups, built capacities and facilitated their transactions with banks. Some ‘non-profit’ entities began to purvey microcredit to SHG members from their own funds. When they found themselves unable to raise adequate resources for rapid growth, they converted 538

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rural credit themselves into ‘for-profit’ organisations and raised loans from banks. In 1999–2000, the Reserve Bank announced that the interest rates on loans the banks gave to microcredit organisations or these organisations gave to their members and beneficiaries would be left to their discretion. This relaxation was one of the reasons for the proliferation of microfinance institutions. The spread available between bank interest rates and the rates charged to the beneficiaries was an attraction. From early on, the Reserve Bank did not want to regulate microfinance institutions.35 Only microfinance institutions registered with the Reserve Bank as NBFCs were regulated by the Bank. The minimum net-owned funds limit fixed by the Bank for all non-deposit-taking NBFCs was 20 million. The government wanted the Bank to lower the entry capital norms for microfinance institutions that did not accept public deposits as a separate category of NBFCs. This was not acceptable to the Bank. The microfinance institutions incorporated as ‘not-for-profit NBFCs’ were exempted from registration and prudential requirements.36 In 1998, the government announced that NABARD would design a scheme for the issue of Kisan Credit Cards (KCCs) to farmers based on their landholdings. NABARD prepared a scheme, and the Reserve Bank issued a circular to banks for implementation. KCC enabled the small farmer to get loans over a three-to-five-year timeframe as revolving credit entitlement. It greatly reduced transaction costs for the client, and at the branch reduced workload. Both made for better banker–client relationship.37 Initially, KCC covered only crop loans and working capital but in October 2004 the scheme was enlarged to include term credit for agriculture and allied activities, including a reasonable component for consumption needs.38 The government was dissatisfied with annual monitoring of achievement and wanted the Reserve Bank to set monthly targets for banks and report the performance to the government on a monthly basis. On receiving monthwise targets from the Reserve Bank, several banks, including State Bank of India (SBI), wrote to the Reserve Bank asking for a reduction of the target as they were not based on past performance. On investigating the matter, the Reserve Bank found that the target was 75 per cent of the number of cards issued by the banks in the previous three years and was higher than the eligible borrower accounts. By March 2008, public sector banks alone had issued cumulatively over 31.22 million cards, involving disbursement of 1,542.94 billion. 539

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Small-Scale Industry In 1998, the government set up a committee to suggest improvements in the delivery of credit to the small-scale industry.39 The Reserve Bank accepted the major recommendations, which were: delegation of more powers to branch officials for grant of loans to small industrial units, simplification of loan application forms, opening of specialised small industries branches, grant of composite loans (term loan and working capital), greater attention to backward states, training of branch managers in credit appraisal, and transparent machinery for redressing borrowers’ grievances.40 The Bank conducted its own review of flow of credit to the sector.41 Between 2000 and 2006, the Reserve Bank framed guidelines in several related areas, such as loans to ‘tiny’ units, sick units, medium-scale units and the institutional set-up to monitor the flow of credit to the small and medium enterprises.42 In response to demands by the borrowers and pressure groups that creditworthy borrowers should not be deprived of bank credit for want of collateral, the collateral rules were relaxed. The problem of wilful default remained unresolved. Apparently, the Reserve Bank had relaxed collateral rules not out of conviction but under duress. Governor Reddy wrote on 14 January 2004, ‘Is there any justification at all for any instruction from us on collateral; should it not be left to the Boards concerned?’ The prescriptions, however, continued. A letter to the editor in Financial Express (1 January 2002) on the guidelines issued by the Reserve Bank on the rehabilitation of sick small-scale industry units pointed out that ‘there have been rampant violations of these guidelines by banks since the guidelines do not have any penalty clause in case of violations’. The government wanted the Bank’s comments. The Bank’s reply (2 May 2002) was that the circulars issued by RBI are either mandatory or directory or advisory depending upon the tenor, contents, intent, and provisions under which they are also expected to be followed by banks. In the guidelines under reference [rehabilitation of sick small-scale industry units] RBI permits banks to exercise their own commercial judgment, discretion and operational flexibility in the matter. The discretion thus exercised by banks in the light of guidelines will not expose the banks to any regulatory action.

The response clarified that priority sector guidelines were ‘advisory’ in nature. There was, however, a note at the end of the guidelines which indicated that 540

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rural credit ‘non-achievement of priority sector targets and sub-targets will be taken into account while granting regulatory clearances/approvals for various purposes’. A similar ambiguity could be observed in monitoring. The Reserve Bank monitored priority sector lending on a half-yearly and annual basis through statements submitted by banks. Letters were issued to banks that did not achieve targets. There was, however, no system in place to check the accuracy of classification and reporting by banks. The RPCD did not carry out on-site scrutiny or audit of banks. The Lead District Officers attached to regional offices did undertake ‘visits’ to rural and semi-urban branches on a random basis, spending a day or two on each occasion. The Reserve Bank decided in March 1998, at the behest of the Bank’s Inspection Department, that the follow-up action on such visit reports should be dealt with by the controlling offices of the banks concerned. The regional offices were instructed to advise the banks that they need not furnish the compliance report to the Reserve Bank. The Economic Times (13 March 1998) printed an article, ‘Priority Sector Lending Not a Priority for RBI’. The article was a critique of the decision of the Department of Banking Supervision (DBS) not to cover performance on priority sector lending during their inspection of banks. In August 2004, the DBS came to know that some of the banks were sanctioning advances to agro-processing units whose investments in plant and machinery were above the then limit of 50 million and classifying them as priority sector advances. Instructions were, therefore, issued to the regional offices of the DBS to carry out quick scrutiny. The investigation revealed widespread irregularities in the classification of priority sector lending by banks. In the case of Punjab National Bank, for example, of 11.88 billion sanctioned to food and agro-based industries and classified under priority sector, 9.92 billion was sanctioned to units whose investments in plant and machinery were above 50 million. Vijaya Bank had treated all housing loans, including those above the cut-off limit, as priority sector lending. On further discussions regarding the implications of the wrong classification of priority sector advances, the RPCD wrote that they had already advised the domestic commercial banks which have not achieved priority and agricultural lending targets, their share of contribution to RIDF. The special scrutiny done by the officers of the Department of Banking Supervision was only in respect of some areas of priority sector lending. We may therefore not change the allotment under RIDF, even if the banks submit the revised returns.

In effect, no action was taken against the banks.43 541

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Lead Bank Scheme The lead bank scheme introduced in 1969 provided for the allotment of districts to banks to enable them to assume leadership in bringing about banking development in the districts. The designated lead bank would identify credit gaps and evolve a coordinated programme for credit deployment in the district, in concert with other banks. A three-tier structure was created at the block, district and state levels for coordination of activities of commercial banks and other financing agencies on the one hand, and government departments on the other. The Reserve Bank, through its Lead District Officers, monitored the preparation and consolidation of annual credit plans at all three levels and reviewed the achievement on a quarterly basis. There were 160 Lead District Officers to cover 580 districts in the country. Though the norm was to have three districts for one officer, in practice it worked out to an average of four districts per officer. There were instances of Lead District Officers handling up to six districts apart from functioning as the Reserve Bank’s nominee director on the board of an RRB. In some cases, the same Lead District Officer was on the board of two or three RRBs. Several studies were taken up at the regional office level mostly of their own volition. The Lead District Officers had been proactive and received commendation of the government officials and media for their work in the aftermath of the 1999 super cyclone in Odisha and the 2004 tsunami in Tamil Nadu. For all the additional responsibility and deployment of manpower and infrastructure devolving on the lead banks, there was no compensation or inbuilt incentive mechanism in the scheme. As a result, whenever new districts were formed by subdivision of larger districts, there were generally no takers for assuming the lead responsibility and the Bank had to thrust it on banks that had more branches in that district. Discussions on the lead bank scheme often focused on the credit–deposit ratio. The Reserve Bank advised that the State-Level Bankers’ Committee should monitor the credit–deposit ratio and identify measures to improve it.44 But then states and regions had their peculiarities that needed to be given weight when assessing the performance of banks. For example, in the state of Kerala, 40 per cent of bank deposits were from expatriate Keralites as nonresident deposits, which kept the state’s credit–deposit ratio down. In Bihar, too, the issue came to the fore periodically from the state government officials and elected representatives. In north-eastern India, the credit absorptive capacity was low and, hence, the Reserve Bank gave special attention to the region. 542

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rural credit It appointed task forces in Bihar, Uttar Pradesh, West Bengal, Rajasthan and Kerala and their recommendations were implemented. The Bank also set up a Committee on Financial Sector Plan for the North Eastern Region to examine the issues and recommend action plans for improving credit flow in the region. The Regional Director of the Reserve Bank, Guwahati office, followed up with banks on the implementation of the committee’s recommendations. Private sector banks, such as ICICI Bank, HDFC Bank and Axis Bank, did not take an interest in the lead bank scheme. The Reserve Bank could not take any effective measure to ensure their active involvement. In fact, HDFC Bank told the Reserve Bank that priority sector targets were to be achieved only at the national level and not at the district or block level. This caused heartburn among public sector banks as they had to share the extra burden at state and district levels in implementing government schemes. In April 2002, Governor Jalan expressed concern about reported complaints regarding refusal by bank branches to open accounts and suggested that bankers’ committees comprising middle-level officials study the problems faced by customers by visiting a cross-section of branches.45 An attempt was made to consolidate the findings and suggestions, and the case papers moved between officers of the Rural Planning and Credit Department for about a year. The suggestions did not merit any action in their opinion except for one suggestion relating to simplification of know-your-customer guidelines. Elected representatives wanted to be associated with the meetings on the lead bank scheme. The Ministry of Finance asked the Reserve Bank to ensure that they were invited to the biannual meetings of the District-Level Review Committee. The Reserve Bank issued a circular to the banks asking them to comply. The lead banks were advised to fix the dates of the District-Level Review Committee meetings after checking the convenience of Members of Parliament (MPs) and Members of the Legislative Assembly. In 2001, the Bank reported to the government that the attendance of peoples’ representatives was ‘very poor’. They attended one out of five meetings in the second and third quarters of 2002. In October 2002, the MPs complained in the House Committee that banks fixed the dates of meetings without consulting them. In January 2003, the Reserve Bank instructed banks to take note of these remarks. The matter dragged on and resurfaced in 2006.46 There were other frictions. The regional offices of the Bank reported that some MPs insisted on chairing the meetings, though the District Collector was the chairman according to the guidelines of the scheme.47 After the bifurcation of Madhya Pradesh 543

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the reserve bank of india and formation of Chhattisgarh, the Reserve Bank recommended (December 2000) to the government that Central Bank of India should carry on being the convener bank of the State-Level Bankers’ Committee for Madhya Pradesh, a responsibility the bank had held for several years. But the Ministry of Finance advised that Bank of India would be the new convener of the state. The move faced many protests from the state and the decision was dropped.48 Was the lead bank scheme useful at all? In March 2001, former Reserve Bank Governor I. G. Patel suggested that the Bank ‘examine the need for continuation of the Lead Bank Scheme as they are operating in a different competitive environment as compared to pre-liberalisation days’.49 The matter did not progress at that time. It was only in October 2007 that the Reserve Bank decided to form a committee to review the lead bank scheme in the light of developments in the banking sector. The committee, chaired by Deputy Governor Usha Thorat, submitted its report in August 2009, highlighting ‘the need for enhancing the scope of the Scheme, measures to be taken for its strengthening and suggesting a decentralised approach for facilitating financial inclusion’.

Cooperative Institutions Rural cooperative credit institutions have a wide outreach in the rural and vulnerable segments of society. Institutions providing short-term credit were arranged in three tiers at the state, district and block levels, namely state cooperative bank, district central cooperative bank and primary agricultural credit society. There were 31 state cooperative banks, 371 district central cooperative banks and 94,942 primary agricultural credit societies at the end of March 2008. The long-term credit structure had two tiers with 20 state cooperative agriculture and rural development banks and 697 primary cooperative agriculture and rural development banks as of March 2008. Of the total credit outstanding with the cooperative structure in 2007–08, the shortterm credit structure had a dominant share of about 88 per cent. With the nationalisation of large commercial banks in 1969 and 1980, their presence in rural areas expanded. At the same time, the share of cooperatives in agricultural credit declined, which was due to the structural and financial weaknesses in the cooperative system. The average cost of funds of these banks was high on account of the multi-tier structure. They suffered from excessive governmental interference and lack of professionalism and good governance. 544

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rural credit The Registrar of Cooperative Societies of the state governments looked after management-related activities of these banks, whereas the Reserve Bank and NABARD regulated banking and related activities. The former’s record was poor. In many states, elections to the boards had not been held for several years and the cooperatives were run by government officials. The elected boards had been superseded by the state governments concerned in 11 state cooperative banks and 159 district central cooperative banks as on 31 March 2008. The cooperative banks were often found to be diverting their funds to the state government under orders and the Reserve Bank issued directives to these banks to desist from such practice. A fresh infusion of capital was needed but not made, and technology was behind the times. Operational efficiency and solvency were in poor shape.50 A change did come. Prudential norms for asset classification and income recognition were made applicable to state cooperative banks and district central cooperative banks from 1996–97. In 1999–2000, a committee recommended restructuring of cooperatives, business diversification, recovery management, professionalisation, and a supervisory and regulatory framework.51 However, formal acceptance of the recommendations was apparently not received from the government. Instead, after four years, the government formed another committee.52 The report called for sweeping reforms to convert cooperative banks into democratic, member-driven, self-reliant, self-governing and professional bodies. Based on the report, the government approved a package for revival of the rural cooperative credit structure. The states willing to implement the package had to sign an MoU with the government and NABARD, which was the designated agency for overseeing the implementation. In terms of the MoU, state governments had to carry out certain legal and institutional reforms. The revival package included a financial outlay to be shared by the central government, state governments and cooperative institutions in the ratio of 68:28:4.53 Until June 2008, twenty-five states and union territories had executed MoUs with the Government of India and NABARD, as envisaged under the package. Eight states had made necessary amendments to the Cooperative Societies Acts. An aggregate amount of 33.48 billion had been released by NABARD as the central government’s share and state governments had released their shares aggregating 3.39 billion to seven states for recapitalisation assistance of primary agricultural credit societies. A task force was set up in each state for monitoring the implementation of the revival package in which the Reserve Bank’s Regional Director was a member.54 545

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the reserve bank of india The government entrusted the study of the long-term cooperative credit structure to the same committee in 2006.55 The Bank agreed with the view of the task force that there was no justification for having two parallel cooperative credit structures and ideally both the short- and long-term credit structures should converge and merge, but not through a forced merger. The task force had recommended that the Bank might be associated with the monitoring of the implementation of the financial package suggested for the long-term structure levels. But since the Reserve Bank was neither the regulator nor the supervisor, it did not want to associate with its implementation.56 By the end of the period, the cooperative banks were urgently in need of revival.57 The Union Budget 2008–09 stated that the central and state governments had reached an agreement on the content of the package for the revival of the long-term structure. As an agent of the Reserve Bank, NABARD was entrusted with the power to carry out on-site and off-site supervision and surveillance of these banks. However, the combination of supervisory and refinancing functions posed a conflict of interest, which remained unaddressed.

Regional Rural Banks The RRBs were established not as another set of commercial banks, but with the mandate to make available affordable institutional credit to the weaker sections of society, who would form the sole clientele of these banks. They were to combine the local feel and familiarity of cooperative banks with the sound organisation and resource base of the commercial banks. There were originally 196 RRBs in the country, promoted and sponsored by 28 sponsor banks, of which 25 were public sector banks. The central government, the sponsoring bank and the state government concerned held share capital in each RRB in the ratio of 50:35:15. Their transformation began in the 1980s and speeded up in the 1990s, which brought them almost on a par with commercial banks. Their targets were relaxed, target groups expanded, and interest rates charged by them deregulated. They were no longer low-cost FIs as their cost of funds and salary bill increased, thanks to active trade unionism.58 The Reserve Bank liberalised the branch licensing policy for RRBs as they were permitted to merge, relocate, open branches and also convert branches into satellite offices. Freedom was given to adopt appropriate information technology solutions including setting up of ATMs and switching over to core banking models. 546

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rural credit They were permitted to make use of lines of credit from sponsor banks and access repo and collateralised borrowing and lending obligation (CBLO) markets (see Chapter 3).59 In 2007, the Reserve Bank advised the sponsor banks to extend support for expanding the business activities of their RRBs.60 The Reserve Bank took several other measures to improve the performance of these banks.61 Despite these measures, the RRBs had to reckon with their ambiguous identity. The guarantees issued by them were not accepted by government departments and agencies as they were not ‘nationalised’ banks. Government funds were not deposited with them. The RRBs were not covered under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. Further, proposals to merge them with sponsor banks, convert them into wholly owned subsidiaries of sponsor banks, consolidate all RRBs into one National Rural Bank, and so on, were brought to the table time and again, which impacted the morale of the rank and file in these banks. The Reserve Bank introduced capital adequacy norms in 2007. RRBs needed to disclose the level of CRAR in their balance sheets and notes on accounts to their financial statements. The asymmetrical implementation of the ratio among different categories of banks did lead to some problems. For example, the risk weights to be assigned by commercial banks for loans given to banks with negative net worth were high. In March 2008, twenty-two RRBs had a negative net worth. SBI, which had given refinance assistance to the RRBs sponsored by it, pointed out that in one case, it had to buffer up its own capital for a loan to an RRB. When the RPCD raised the issue with the Department of Banking Operations and Development, the latter replied that ‘the remedy would seem to lie in strengthening the Regional Rural Banks sponsored by the public sector banks rather than trying to dilute the rigour of the CRAR norms’. The sponsor banks were, however, allowed to value their investments in RRBs at carrying cost without recognising diminution if any in the value of such investments.

Local Area Banks In January 1993, the Reserve Bank issued guidelines for setting up new private sector banks with a minimum start-up capital of 1 billion and ten ‘new generation’ banks received licenses and commenced operations, catering mostly to metropolitan and urban areas. It was in this context that 547

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the reserve bank of india the proposal for setting up new private banks in rural areas was mooted. In 1996, the Union Finance Minister in his Budget speech announced that ‘it has been agreed with RBI to promote the setting up of new private local banks with jurisdiction over two or three contiguous districts. This would enable the mobilization of rural savings by local institutions and at the same time make them available for investments in local areas’. These banks were expected to bridge the gaps in credit availability, enhance the institutional credit framework in rural and semi-urban areas and provide efficient and competitive financial intermediation. The Reserve Bank issued guidelines in August 1996 inviting applications for the setting up of local area banks. The minimum start-up capital was fixed.62 The banks would be subject to prudential norms. The Reserve Bank received 227 applications. There was pressure from the government to expedite approvals. There were at the same time letters of protest from trade unions, cooperative bodies and associations. The Cooperation Minister from Kerala wrote to the Union Finance Minister that ‘merely adding a new institution like the Local Area Banks will make the present mess [in rural credit] more confounded. It could even prove counter-productive. Let it be noted that the government and the people of Kerala are totally opposed to the sanctioning of any Local Area Bank in the State at this juncture’. Eventually, six local area banks started functioning. Meanwhile, in June 2000, the Reserve Bank wrote to the Special Secretary (Banking) in the Ministry of Finance suggesting a review of the scheme, and added that ‘pending such a review, we propose to discontinue receipt of further applications for setting up of Local Area Banks and issue a press release’. The government replied in February 2001, stating that ‘it was perhaps too early for a review’. The Reserve Bank nevertheless appointed a review group in July 2002.63 The group drew attention to the weaknesses in the concept of local area bank mode, particularly its size and capital base. The group added that until a more sound framework was implemented, ‘there should be no licensing of the new Local Area Banks’.64 The other recommendations were that the four local area banks must raise their capital, and ‘need to be treated like any other commercial bank’ for the purpose of regulation.65 This was accepted and implemented in 2004. A proposal to convert the four local area banks into NBFCs was considered but given up. As of March 2008, the four banks had forty-four branches and aggregate assets of 6.54 billion, of which Capital Local Area Bank Ltd alone had 4.66 billion. 548

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rural credit The decision not to license any more local area banks had its share of criticism. In its report entitled ‘A Hundred Small Steps’, the Committee on Financial Sector Reforms appointed by the government in 2009 and chaired by Raghuram G. Rajan observed, ‘The Local Area Bank scheme was never given a serious try.’66 With Raghuram G. Rajan joining the Reserve Bank as Governor in 2013, guidelines were issued in 2015 for setting up ‘small banks’. The largest among the four local area banks, the Capital Local Area Bank Ltd, applied for conversion to a small bank and it was accorded approval.

Conclusion It is tempting to conclude from this narrative that rural credit regulation has been, to cite the Cooperation Minister of Kerala again, ‘a mess’. But that would be a harsh judgement. The mission to find a way through the mess, revive banks, and supply credit to the priority sectors was challenging, to say the least. How well this balance was achieved will have to be judged against several benchmarks. The continuing problem of bank NPAs and reports of farmer distress suggest a broadly negative assessment, whereas diversification of priority sector borrowers, reforms initiated in key local players, including cooperatives and local area banks, and technological and institutional changes, such as microfinance and the KCCs, suggest a more positive assessment. An impartial review will take us beyond the period of the study.

Notes

1. Government of India, Report of the Committee on Banking Sector Reforms (New Delhi: Ministry of Finance, 1998), p. 2. 2. In the same vein, the working group appointed by the Bank in 1997 for Harmonising the Role and Operations of Development Financial Institutions and Banks (Chairman: S. H. Khan, Chairman and Managing Director, IDBI) recommended an alternative mechanism for priority sector lending ‘[r]ather than imposing the priority sector obligation on the entire banking system.…’ (Annexure I of the RBI discussion paper on the subject released on 28 January 1999). The Asian Development Bank (ADB), while extending a loan to India in 1992, had stipulated that the Reserve Bank should undertake a ‘review of the priority sector credit program toward a rationalization of the priority credit’. In the Program Completion Report filed in November 1997, the ADB observed that the ‘efficiency gains of banking sector could have been 549

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3. 4. 5. 6. 7. 8.

9.

10.

11.

12.

also augmented if RBI had taken a more aggressive approach to dismantle the priority credit programs’. Letter dated 5 April 2004 from N. S. Sisodia, Secretary (Financial Sector), Ministry of Finance, Government of India. RBI, Basic Statistical Returns of Scheduled Commercial Banks in India, various years. The limit was fixed at 100 per cent of their net-owned funds and NABARD had net-owned funds of 22.80 billion at that time. In June 1998, NABARD was sanctioned a term money limit of 2 billion and a term deposit limit of 3 billion. NABARD was not allowed to raise certificates of deposit or inter-corporate deposits at that time. The credit limit, which was 12 billion in 1982–83, rose to 66 billion by 2000–01, proportionate to the refinancing requirements of NABARD. The Executive Director in charge of the Rural Planning and Credit Department (I. D. Agarwal) had recorded in June 1999 that ‘the present arrangement cannot continue in its present form indefinitely. NABARD should make a beginning of involving itself in meeting the short term credit needs of the cooperative sector out of its own resources’. But the Reserve Bank allowed the operation of the line of credit for six more months until December 2006, which was extended up to January 2007 in view of the difficulties faced by NABARD in raising the required funds from the market at that time. When the request for extension was referred to the MPD, they observed, in a note put up to the Governor in May 2006, that their ‘estimates showed that delaying GLC repayment [by NABARD] would expand primary liquidity beyond the projected level for nearly six months and would imply an increase of nearly 0.6 percent to 0.7 percent in money supply (M3) during the deferred period, which is within the tolerable limits’. Had this recommendation been acted upon, the protracted correspondence on NABARD’s proposals to include specific institutions for extending refinance (RABO India Finance Ltd, National Cooperative Development Corporation, EXIM Bank of India) could have been avoided. Such requests were not usually agreed to by the Reserve Bank. There was a joint coordination committee ( JCC) between the Reserve Bank and NABARD officials at the level of Chief General Managers for sharing of views and taking a coordinated approach to policy. Though the committee was to meet every six months, after a lapse of three years, it met in February 2000, and thereafter it met again only in October 2004. Subsequently, it met in June 2005, September 2006 and June 2008. There were coordination meetings at the regional office level as well. Loan limit was kept at 6,500 (for housing loans 20,000), with a repayment period of five years, and no margin money or security could be taken by banks. The scheme continued without effective enforcement.

550

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rural credit 13. As of March 2008, the performance of public sector banks was 0.05 per cent. According to bankers, there were no takers for the loans under DRI as the potential beneficiaries preferred to take loans under subsidy-linked government-sponsored schemes where the loan quantum was much higher. The government was not in favour of scrapping the DRI scheme. 14. With effect from April 2009, the shortfall in lending to weaker sections would also be taken into account for the purpose of allocating amounts for contribution to the Rural Infrastructure Development Fund (RIDF) (see later). 15. High-level committee (Chairman: R. V. Gupta, Deputy Governor) set up in 1997 to suggest measures for improving the credit delivery system and simplification of procedures for agricultural credit. The committee submitted its report in April 1998. 16. Banks do not normally pay interest on the credit balances in the cash credit accounts. However, in respect of such accounts of farmers, the Reserve Bank permitted banks in 2000 to consider payment of interest on credit balances. The committee also recommended giving discretion to banks to fix the scale of finance for different crops. NABARD, however, was not agreeable to this, when the matter was referred to them, as they had the technical expertise to fix the scale of finance for crops on a yearly basis. 17. In regard to NPA norms for crop loans, the Bank accepted the committee’s recommendation that two crop seasons instead of two half years should be reckoned for determining default. The committee stated that the ‘service area approach’ introduced in 1989 might be dispensed with for all lendings other than loans under government-sponsored schemes. This was done in December 2004. Of the ninety-nine recommendations of the committee, only four were not accepted. Banks were advised to implement the accepted recommendations. 18. This was also in line with the observation by the Vyas Committee that ‘fixing targets on the basis of disbursements would not establish a link between the total advances of the bank and its lending to agriculture’. 19. The deposits kept with NABARD under the RIDF scheme were treated as indirect lending to agriculture. This provision was withdrawn from April 2007 in respect of fresh deposits with NABARD, and outstanding deposits were reckoned as indirect finance to agriculture until maturity or March 2010, whichever was earlier. 20. With the revised guidelines on priority sector lending issued in April 2007, loans sanctioned to these units were brought under indirect finance to agriculture, and ceiling limit for plant and machinery increased to 100 million from 50 million. 21. Address at the Conference of Indian Society of Agriculture Marketing, Visakhapatnam, 3 February 2001, p. 5. 551

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the reserve bank of india 22. Government of India, Debt and Investment Survey: NSS Forty-Eighth Round (New Delhi: Ministry of Statistics and Programme Implementation, 1991); Government of India, Debt and Investment Survey: NSS Fifty-Ninth Round (New Delhi: Ministry of Statistics and Programme Implementation, 2003); Government of India, Debt and Investment Survey: NSS Seventieth Round (New Delhi: Ministry of Statistics and Programme Implementation, 2013). The Reserve Bank constituted a technical group in 2006 to review the efficacy of the existing legislative framework that governed money-lending. The model legislation proposed by the group was sent to state governments in 2007 for considering enactment. State governments, however, did not exhibit much enthusiasm to enact or replace the existing statutes. 23. RBI, Basic Statistical Returns, 1997, 2008. 24. The outstanding credit in respect of scheduled commercial banks with limits above 100 million as a percentage to total agricultural (direct and indirect) credit had gone up from 3.8 per cent in March 1997 to 18.4 per cent in March 2008. 25. Report of the Task Force on Credit Related Issues of Farmers (Chairman: U. C. Sarangi, Chairman, NABARD). 26. For agricultural advances, banks were advised not to compound interest on current dues as well as on instalments not falling due in respect of term loans. Further, banks had to ensure that the amount of total interest debited to an account did not exceed the principal amount in respect of short-term advances to small and marginal farmers, and banks should charge interest on agricultural advances only at annual or longer rests. Banks were advised that all loan applications up to a credit limit of 25,000 should be disposed of within a fortnight and those up to 500,000 within four weeks. 27. Public sector banks were advised in March 2002 to formulate a scheme of the hassle-free settlement of chronic overdue of defaulting farmers, with loans up to 50,000, with appropriate relief on accumulated interest. 28. Subject to a maximum of 1.5 per cent of their total credit. 29. Of 10.83 billion forthwith and the balance amount of 4.56 billion in two equal instalments on 1 April 2009 and 1 April 2010. The J&K Bank Ltd did not deposit any amount and on a request made by the bank for permission to deposit the arrears in four equal instalments, the bank was advised in December 2008 to pay the arrears in three instalments in December 2008, March 2009 and June 2009 but the bank again defaulted. By April 2009, the aggregate shortfall in the contribution under various tranches of the RIDF increased to 26.83 billion. It was, therefore, decided in May 2009 vide Deputy Governor Usha Thorat’s orders to ‘take regulatory action including holding back the applications for branch licences’. The regulatory department in the Reserve Bank was advised accordingly in the matter. 552

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rural credit 30. Since NABARD also had schemes for non-farm activities, they asked for these funds to be kept with them but it was not acceded to by the Reserve Bank for the reason that ‘it was more in the nature of punitive measure than a resource mobilisation exercise for FIs’. 31. The Secretary (Financial Sector) wrote to Governor Reddy on 15 October 2003 stating such interest rates should be disadvantageous to the banks so as to act as a deterrent. 32. Direct or indirect, depending on the underlying assets, provided the securitised assets were originated by banks and FIs and fulfilled Reserve Bank guidelines on securitisation. 33. Also useful were the recommendations of the Task Force on Supportive Policy and Regulatory Framework for Micro Credit set up by NABARD. 34. Presided over by Vepa Kamesam, Deputy Governor. 35. In the Central Board meeting of the Bank held in December 1999, Governor Jalan mentioned that microfinance institutions would not be regulated or supervised by the Bank. 36. The government introduced in the Lok Sabha in March 2007 the Micro Financial Sector (Development and Regulation) Bill, 2007, which sought to promote the sector and regulate microfinancial organisations. NABARD was identified as the regulator for the microfinance sector. However, the Bill was not passed and was allowed to lapse. Taking advantage of the regulatory vacuum, ‘not-so-fit and proper’ entities entered the space and in the wake of problems faced by borrowers in Andhra Pradesh and certain other states, a new Bill was mooted in 2011. It was revised and redrafted many times before it took shape as the Micro Finance Institutions (Development and Regulation) Bill, 2012. The Bill was considered and rejected by the Standing Committee on Finance in 2013–14, and it also lapsed eventually. 37. ‘Report of the Internal Group to Examine Issues Relating to Rural Credit and Microfinance’, July 2005, para 2.21. 38. SBI and its associate banks wanted to be exempted from the revised KCC as they had their own Kisan Gold Card scheme, which was not acceded to by the Bank. 39. Chairman: S. L. Kapur. 40. The banks were advised to calculate working capital limits to small-scale industrial units based on the turnover of the unit. To ensure an adequate level of credit, banks were instructed to sanction working capital limits equivalent to 20 per cent of the annual turnover for small-scale industrial units with turnover up to 40 million. 41. Working Group on Flow of Credit to Small-Scale Industries Sector under the chairmanship of A. S. Ganguly, member of the Reserve Bank board, which submitted its report in 2004. Its recommendations for facilitating 553

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the reserve bank of india credit flow and availability of timely finance to the sector at the right price were commended to the banks for implementation. 42. With a view to ensuring that the smaller units within small-scale industries were not squeezed out, banks were advised to lend 40 per cent of their total lending to small-scale industries to ‘tiny’ units with plant and machinery costing up to 0.5 million and 0.2 million for manufacturing and service enterprises, respectively. A further 20 per cent of the small-scale industries advances were earmarked for units with plant and machinery valued between 0.5 million and 2.5 million and 0.2 million and 1 million for manufacturing and service enterprises, respectively. In August 2000, a group of ministers decided that the Bank should draw up transparent and nondiscretionary guidelines for the rehabilitation of sick and potentially viable small-scale industrial units. The Bank appointed in November 2000 a highlevel working group on rehabilitation of sick small-scale industrial units, with S. S. Kohli (Chairman and Managing Director, Punjab National Bank) as Chairman and a Deputy Governor as one of its members, to review the existing guidelines on the subject. Based on the group’s recommendations, the Bank issued detailed guidelines in January 2002 for providing timely assistance to potentially viable sick units. When the government enacted the Micro, Small and Medium Enterprises Development Act, 2006 (April 2007), the Reserve Bank advised banks that loans given to medium enterprises (defined as those manufacturing units with value of plant and machinery from 50 million to 100 million, and service enterprises with cost of equipment between 20 million and 50 million) would not be covered under priority sector lending. A ‘standing advisory committee’ under the chairmanship of one of the Deputy Governors was monitoring the flow of institutional credit to the small and medium enterprises, or SMEs. The committee met regularly to take stock of the developments, analyse the problems being faced by the sector, and suggest corrective measures. The Bank constituted ‘empowered committees’ at its regional offices to review the progress in SME financing by banks and rehabilitation of sick units. It also formulated a one-time settlement scheme for NPAs below 100 million and issued detailed guidelines to public sector banks for implementation. A debt restructuring mechanism for units in the SME sector, on the lines of the corporate debt restructuring (CDR) mechanism, was formulated and guidelines issued for implementation. 43. Not surprisingly, inspecting officers from the DBS again noted, in 2007, that Federal Bank Ltd – a private sector bank based in Kerala – had granted fiftynine loans to borrowers who were not small and marginal farmers for purchase of tea estates and agricultural land, and classified them as direct lending to agriculture. On being asked to clarify, the bank maintained the classification was indeed in order. Inspecting teams also came across instances of preshipment and post-shipment credit to corporates in food and agro-processing 554

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rural credit

44.

45.

46.

47.

48.

sectors being wrongly classified as direct finance to agriculture. A random check during the annual inspection of the Indian Overseas Bank revealed that seven accounts amounting to 7.90 billion were wrongly classified as indirect advances to agriculture. The bank, which had reported having achieved the targets for agriculture and priority sectors, would be falling short of targets by 1.5 per cent if this amount were to be excluded. The banks were also advised to set up special subcommittee of the District Consultative Committee in districts with a credit–deposit ratio of less than 40 per cent in order to draw action plans to increase it. In State-Level Bankers’ Committees and District-Level Review Committee meetings, the elected representatives, and sometimes the government officials, were labouring on this issue. This was unnecessary as the Reserve Bank had advised that ‘while it is not necessary that this ratio should be achieved separately branch-wise, district-wise and region-wise, the bank should, nevertheless ensure that wide disparity in the ratios between different states and regions is avoided’. It was accordingly decided to take three districts in each state and ten branches in each district for detailed enquiry. Forty-five committees were formed in fifteen states, with the Lead District Officers acting as conveners, and 450 branches were visited by the team of officials and roughly 4,500 customers were met during the study. Detailed reports containing the findings of the committees, along with their suggestions, were received in the central office in June–July 2002. In December 2006, the Ministry wrote to the chairman of NABARD that ‘it had been brought to our notice that banks while organising functions do not consult the concerned public representatives in advance and banks are not suitably inviting them to attend such functions. The Finance Minister has taken a serious view on this’. On receipt of the letter from NABARD, the Reserve Bank again took it up with the banks. The Madhya Pradesh government wanted the chairman of the zilla parishad and the Kerala government wanted the chairperson of the district panchayat committee to head the District Consultative Committee in place of District Collector. The Reserve Bank, however, did not agree to such demands. There were a few other administrative issues discussed in relation to the scheme. For example, in August 2005, the Reserve Bank through its College of Agricultural Banking, Pune, conducted two workshops for the benefit of ‘lead bank managers’ of commercial banks. In their feedback, the ‘lead district managers’ informed the college that many of them had not been provided with separate offices and infrastructure support. They were often asked to do other ad hoc items of work by the controlling offices. It also transpired that the StateLevel Bankers’ Committee had over time become an unwieldy forum with too many members, besides a number of permanent invitees and special invitees, which was not conducive to meaningful deliberations and decision-making. 555

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the reserve bank of india 49. I. G. Patel asked SBI to take up the matter with the Reserve Bank. He was a director on the board of SBI, which had lead bank responsibility in roughly one-third of the districts. 50. It was commented by the International Monetary Fund team during the Article IV Consultation with India in October 2004 that ‘the strength of the banking system should not be undermined by the weakness of the cooperative banking system’. 51. Task Force to Study the Cooperative Credit System and Suggest Measures for Its Strengthening, under the chairmanship of Jagdish Capoor, Deputy Governor. It had also recommended a revival package covering financial, operational, organisational and systemic issues. 52. Task Force on Revival of Rural Cooperative Credit Institutions (Long Term) with A. Vaidyanathan, economist, as chairman. The Reserve Bank was not part of the task force except that two officials were included as permanent invitees. The task force submitted its final report on the short-term structure in February 2005. 53. The government also set up a National Implementing and Monitoring Committee under the chairmanship of the Governor in April 2006 to oversee the implementation of the revival package. The committee had three meetings which were chaired by the Governor. But the committee was reconstituted in 2007 with the Secretary (Financial Sector) in the Ministry of Finance as chairman in place of the Governor. 54. As on March 2008, only 14 state cooperative banks and 75 district central cooperative banks had been issued licences by the Reserve Bank and 16 state cooperative banks were included in the second schedule to the RBI Act. Six state cooperative banks and 121 district central cooperative banks did not comply with Section 22(3)(a) of the Banking Regulation Act, 1949, with respect to their capacity to pay their depositors in full and 14 state cooperative banks and 342 district central cooperative banks did not comply with Section 22(3)(b) of the Act as the affairs of these banks were stated to be conducted in a manner detrimental to the interests of their depositors. The aggregate accumulated losses of state cooperative banks and district central cooperative banks as on 31 March 2008 were 4.29 billion and 61.06 billion, respectively. 55. With A. Vaidyanathan as chairman. 56. The government was further advised that as long-term structure had aggregate public deposits of only 10.45 billion with a highly diverse structure comprising 717 banks, the cost of regulating and monitoring them would be disproportionately high. 57. The accumulated losses of the state cooperative agriculture and rural development banks and primary cooperative agriculture and rural development banks as of 31 March 2008 were 13.54 billion and 32.83 billion, respectively. NABARD, Annual Report 2008–09 (Mumbai: NABARD, 2009), p. 78. 556

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rural credit 58. Initially, RRBs were permitted to finance borrowers outside the target group to the extent of 40 per cent. This was raised to 60 per cent in April 1997, and they were required to lend only 40 per cent of their advances to the priority sector. The Narasimham Committee II had ‘strongly urged’ that ‘the basic feature of Regional Rural Banks as low-cost credit delivery institutions should not be diluted any further’. In 2002, the target for lending to the priority sector was reviewed again and restored at 60 per cent. 59. With the process of consolidation and amalgamation of state-level sponsorbank-wise RRBs commencing from September 2005, the number of RRBs had declined to 91, with 14,788 branches by 31 March 2008. 60. The RRBs were allowed to introduce facilities such as remittances at par and issue of demand drafts and also participate in consortium financing in collaboration with their sponsor banks. They were allowed to open and maintain non-resident external/non-resident ordinary (NRE/NRO) accounts in rupees. They were permitted to act as authorised dealers for handling limited foreign exchange transactions. Approvals were given to RRBs on merits to issue debit/credit cards, handle pension and government business as sub-agents, and set up currency chests, subject to conditions. They were also permitted to undertake, without risk participation, distribution of insurance products. 61. The Reserve Bank constituted empowered committees in its regional offices with members drawn from NABARD, sponsor banks, RRBs in the state, conveners of State-Level Bankers’ Committees and the state government with Reserve Bank’s Regional Director as the chairperson. The committee was required to ensure that RRBs in the state adhered to good governance and complied with prudential regulations. The committee was advised to focus on operational constraints and provide clarification on regulatory issues. In 2004, the Governor had a series of meetings with officers of RRBs and the sponsor banks to inform the officials of the need for improving governance and also to enhance the flow of rural credit. To address the governance issues in RRBs, the Reserve Bank set up a task force under the chairmanship of NABARD managing director, K. G. Karmakar, to deliberate on empowering the RRB boards. The task force submitted its report in February 2007. 62. At 50 million to be brought upfront by the promoters. 63. With G. Ramachandran (former Finance Secretary) as chairman which submitted its report in September 2002. 64. The Reserve Bank submitted the recommendations before the Board for Financial Supervision and decided to accept them for implementation, including the recommendation not to license any new local area bank. Before the issue of the press release, the Reserve Bank referred the matter to the government in February 2003, which accorded its approval in April. The press release was issued in August 2003. 557

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the reserve bank of india 65. From 50 million to 250 million over a period of five to seven years, and maintain a minimum CRAR of 15 per cent. 66. Government of India, A Hundred Small Steps: Report of the Committee on Financial Sector Reforms (New Delhi: Planning Commission and Sage Publications, 2009), p. 74.

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13 Financial Inclusion

Introduction The Banking Regulation Act, 1949, or the BR Act, vested sweeping powers with the Reserve Bank to regulate banking companies, essentially to protect the ‘interests of depositors’. Customer service, however, was a neglected field in banking, especially after the nationalisation of banks, as the number of bank branches and clients increased manifold. The Reserve Bank recognised the problem early, but service quality continued to be a matter of concern.1 It was common in the 1970s for a customer to wait for twenty to thirty minutes to withdraw cash from the account or to make repeated visits to the branch to have the passbook updated. It took two days to get a cheque book, six hours to get a demand draft and at least one week to get a local cheque and four to six weeks to get an outstation cheque cleared. The Bank constituted a committee in 1990 to look into the causes of the persistence of poor customer service in banks.2 The recommendations of the committee included an extension of business hours for non-cash transactions, uninterrupted service at the counters, introduction of ‘may I help you’ desks, and a customer complaint book, among other measures. The onset of the financial sector reforms in the 1990s gave greater operational freedom to banks. This, together with the introduction of technology, led to general improvement in services. New channels of delivery of service meant that the time taken for delivery of service was reduced. Increased competition, with the entry of new private banks in 1994–95, reinforced the tendency. But the entry of new players did not serve consumer interest significantly better than before. In the rural areas, often a single bank served a large number of people so that the benefits of competition remained limited. Further, the legal processes for establishing customer rights and entitlements were unaffordable in time and money. 559

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the reserve bank of india As competition depressed interest income, there was pressure on banks to increase their non-interest income, and new charges were levied on the customer, such as the penalty for not maintaining a minimum balance in deposit accounts, using the service at a non-home branch, and premature loan repayment. The entry of ‘new generation’ banks (fully computerised from the start) and the adoption of new technology by all banks led to new problems. The non-human interface, unsolicited marketing of products, including misselling and cross-selling, and ever-increasing length of fine prints created some problems. The Reserve Bank had thus far issued only circulars, essentially on an ad hoc basis, to banks on customer service. But in 2004–05, it took comprehensive measures to empower the customers and improve the quality of service rendered by banks, as brought out in this chapter. The Bank also launched a drive to bring about greater financial inclusion and financial literacy, a relatively unchartered territory. This chapter will discuss the measures taken by the Reserve Bank during the period covered in the book to improve customer service and consumer protection. It will emphasise the efforts to empower the consumer and to extend institutional and basic financial services to the unbanked population, and measures to promote financial education of the common man and schoolchildren. These large themes – consumer protection, financial inclusion and financial literacy – appear in the Reserve Bank history volumes for the first time.

Customer Service and Consumer Protection The general approach of the Bank earlier had been to sensitise banks on customer service and encourage the involvement of the boards of banks, especially in matters relating to banks’ grievance redressal machinery. At the same time, there was more emphasis on transparency, the reasonableness of pricing, adherence to self-imposed codes, and dispute resolution. The intention was to encourage self-regulation as far as possible. While reducing the scope of direct micro-management of banks’ affairs in the 1990s, the Reserve Bank began to pay more attention to customer service. It advised the banks to observe the 15th of every month as ‘customer day’. Bank branches were required to conduct a customer survey on a half-yearly 560

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financial inclusion basis in a specified format covering twenty-five main subjects. The survey findings were to be put up to the board of directors and a copy of the board note sent to the Reserve Bank. In early 1999, banks were advised to extend certain relaxations and facilities to the old, the sick and the incapacitated customers in operating their bank accounts. In 2000, and again in 2002, banks were advised to simplify the formalities for payment of balances in the accounts of deceased customers to the survivors and claimants. In 2002, banks had come out with ‘zero per cent interest finance scheme’ for the purchase of consumer durables by adjusting the discount offered by the manufacturers of such durables. Since such schemes lacked transparency, and the pricing of the loan product got distorted, the Reserve Bank instructed the banks to refrain from offering such products. In 2002 again, the Reserve Bank advised banks to ensure immediate credit of outstation and local clearing cheques and also introduced ceilings for collection charges levied for such services. When faced with complaints from customers on seemingly arbitrary penal charges levied for not maintaining a minimum balance in savings accounts, the Reserve Bank asked banks in December 2002 that they should inform customers regarding the requirement of minimum balance at the time of opening of an account, and subsequent changes should also be intimated well in advance. Regarding reversal of erroneous debits on account of fraudulent transactions, the Reserve Bank advised banks that in cases where they were at fault (such as breach of security) they should compensate customers without demur, and even where neither the bank nor the customer was at fault, banks should compensate the customers up to a limit, as part of their customer relations policy. When entries in computerised bank statements and passbooks were ambiguous, and transaction details were inadequate, banks were advised, in April 2004, and again in December 2006, to provide full information by remodelling their software to include details of each transaction. The Reserve Bank advised banks in September 2006 to write the address and telephone number of the branch in passbooks and statement of accounts issued to account holders for ready reference. In April 2007, it asked banks to streamline the safe deposit locker facility and not insist on the placement of fixed deposits with them as a condition for extending the locker facility. 561

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Voluntary Codes In March 2002, a voluntary Best Practices Code (BPC) was introduced for adoption by commercial banks. Later, on a scrutiny of the BPC documents of certain banks, the Reserve Bank noted that there was no uniformity in their content and coverage. In March 2004, therefore, further guidelines were issued. In 2002, the government constituted a working group to study Lenders’ Liability Laws of the United States and to recommend similar legislative proposals in India. An interdepartmental group examined the recommendations for preparing draft guidelines for framing a code meant for lending institutions. The draft guidelines were placed on the Bank’s website in December 2002 for feedback from the public. After a meeting with banks and financial institutions (FIs) in January 2003, the guidelines on Fair Practices Code (FPC) for lenders were issued in May 2003 for banks and FIs. They were given freedom to enhance the scope of the FPC without sacrificing the spirit underlying the guidelines.

Committee on Procedures and Performance Audit on Public Services The setting up of the Committee on Procedures and Performance Audit on Public Services (CPPAPS), under the chairmanship of former Reserve Bank Deputy Governor S. S. Tarapore, was a major step towards customer protection and service. The Governor in the Mid-Term Review of Monetary and Credit Policy for 2003–04 announced the formation of the committee. The committee submitted four reports relating to individuals covering foreign exchange transactions, government transactions, banking operations relating to deposit accounts and other facilities, and currency management. The CPPAPS in its reports brought out the inadequacies in service persisting in the areas examined by the Goiporia Committee.3 Based on the recommendations of the committee on banking operations, the Reserve Bank implemented five measures. These were: introduction of the facility for acknowledgment of cheques at branch counters, in addition to cheque drop box option; cheque books to be delivered over the counters on request; a statement of account to be issued at monthly intervals; existing account holders to be informed at least one month in advance of any change in the minimum balance to be maintained in savings accounts, and charges for 562

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financial inclusion non-maintenance thereof; and non-resident Indians being allowed to open non-resident ordinary (NRO) accounts in banks, jointly with residents. The commercial banks were asked (December 2003) to form ad hoc committees to undertake procedures and performance audit on public services rendered by them. The committees, to be chaired by the chief executive officer (CEO) or executive director of the bank, would look into simplification of procedures and practices with a view to safeguarding the interests of clients from unfair practices. The various instructions issued to banks on the subject of customer service were codified and put in one place in the form of a master circular in 2003 and was reissued by the Reserve Bank every year subsequently. These appeared on the Reserve Bank’s website so that the customers could easily find out their rights and entitlements. In August 2004, the banks were asked to constitute a customer service committee of the board to oversee all aspects of customer service. In August 2005, banks were further advised to convert the existing ad-hoc committees into standing committees on customer service and, as a result, banks were required to have both the board committee and the standing committee addressing customer service issues in a complementary manner. Several banks approached the Bank since 2002 to permit them to extend the facility of ‘doorstep banking’ by undertaking delivery and receipt of cash to their customers at their doorstep. The Reserve Bank, adopting a technical interpretation of Section 23 of the BR Act, which stipulated that no bank might open a place of business without prior permission from the Reserve Bank, took a stand that doorstep banking could not be allowed without a licence. Therefore, the Reserve Bank did not consider requests to commence doorstep banking. A working group studied the issue among others and recommended a more liberal stance in April 2003.4 The group felt that the spirit of the legal provision was permissive rather than restrictive. The Reserve Bank, therefore, advised banks (April 2005) to formulate a scheme for providing services at the premises of a customer and submit it to the Reserve Bank for approval. The applications received from banks were kept pending as there were no stipulated criteria to assess the different schemes proposed by banks. After many rounds of deliberations, a circular was finally issued with general guidelines in February 2007 for banks to undertake doorstep banking without prior approval from the Reserve Bank. 563

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Complaints Redressal Mechanism In the 1990s, at the instance of the Reserve Bank, the Indian Banks’ Association (IBA) arranged to publish the list of officers of public sector banks responsible for dealing with public grievances in leading newspapers and display it on the notice boards of every branch. On 13 June 2000, the Finance Minister in his meeting with the chief executives of public sector banks said that the Reserve Bank should, in consultation with the IBA, set up ‘local advisory panels’ to examine customer’s complaints. However, the Reserve Bank and the IBA, after examining the matter, advised the government that setting up of such panels might be kept in abeyance. When the matter was placed before the Minister of State, he considered it ‘a pity that both RBI and IBA do not find any necessity to change the existing method of customer grievance redress’. No further steps seem to have been taken until early 2005 when the Reserve Bank asked the IBA to suggest to member banks that a suitable system of grievance record and redress needed to be put in place. This was done in April 2005. Two years later, in February 2007, banks were asked to improve the effectiveness of the grievance redressal mechanism by placing a statement of complaints before their boards and customer service committees along with an analysis of the complaints. Banks were expected to involve customers, including senior citizens, in the committees. On 28 April 2007, the Standing Committee of Parliament on Finance noted that between July 2005 and June 2006, the Reserve Bank received 5,772 complaints against public sector banks, 1,492 against private banks and 879 against foreign banks. The complaints mostly related to credit cards and charges levied by banks. The committee urged the Reserve Bank to play a more effective role in dealing with complaints. The Reserve Bank had actually issued detailed guidelines to banks on credit card operations in November 2005 and did not initiate any specific action in response to the standing committee’s observations. Unlike other regulatory authorities, such as the Financial Services Authority of the United Kingdom (UK), the Reserve Bank did not impose penalties on banks for misleading promotion of products and for customer grievances. To further strengthen the complaint redressal machinery in the sector, the Banking Ombudsman Scheme introduced in 1995 was further fine-tuned, which is discussed at length later in this chapter. 564

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Pricing of Products and Services In June 1999, banks were given freedom to fix service charges for various types of services to customers. (The IBA had set benchmark service charges on behalf of member banks from 1994 to 1999.) Banks were also asked to ensure that the charges were in line with the average cost of providing these services. The rationale was that the competition would force them to price their services competitively. In November 2004, citing the same rationale, the Reserve Bank withdrew three of its previous instructions to banks relating to (a) immediate credit of local and outstation cheques, (b) time frame for collection of local and outstation cheques and (c) interest payment for delayed collection, ‘leaving it to the individual banks to formulate policies and ensure that the interest of the small depositors are fully protected’. How the depositors would be protected was left to the banks’ discretion. These expectations were belied. Several representations and complaints were received over unfair practices and unreasonable charges. The Reserve Bank, in response, appointed a working group in 2006 to formulate a ‘scheme for ensuring reasonableness of bank charges’.5 The group identified and listed twenty-seven services related to deposit accounts, loan products, remittance facilities and cheque collection as ‘basic banking services’. The group recommended lower rates for individuals compared to non-individuals and, among individuals, larger concessions for senior citizens, rural customers and pensioners. The Reserve Bank communicated several action points to the banks based on the recommendations of the group.6 In the Annual Policy Statement for 2006–07, the Governor announced that ‘it has been made obligatory for banks to display and update in their branches as also on their websites, the details of various service charges. RBI would also place such details on its website’. However, an internal working group was not in favour of the move because ‘display of stale/wrong information resulting from non-receipt of updated information from banks would lead to reputational risk for RBI’. It was, therefore, decided to provide only a web link to banks’ sites. In November 2006, the Principal Secretary to the Government of Gujarat brought to the notice of the Reserve Bank that for a loan of 100, a credit card holder paid 44.40 as interest and other charges. The issuer of the card, a private sector bank, explained that the high transaction cost, high risk and absence of security justified an interest rate of 48 per cent per annum. Though banks enjoyed immunity from the provisions of the Usurious Loans Act, 1918, 565

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the reserve bank of india Section 21 of the BR Act empowered the Reserve Bank to issue directions to banks on interest rates, and here there was a case for the Bank to use the powers. In May 2007, in response to similar complaints, banks were advised that ‘though interest rates have been deregulated, rates of interest beyond a certain level may be seen to be usurious.... An appropriate ceiling may be fixed on the interest including processing and other charges that could be levied on such loans which may be suitably publicised’. The Reserve Bank also issued instructions regarding credit cards.7

Monitoring and Enforcement From March 1996, the inspecting officers of the Reserve Bank conducted customer audit of branches of commercial banks during the annual financial inspection and submitted a special report. The Board for Financial Supervision (BFS) directed in 1999 that the assessment of customer service should be de-linked from the CAMELS (capital adequacy, asset quality, management, earnings, liquidity and systems) system of evaluation and left to be carried out by the IBA at periodic intervals. While customer service was taken out of the purview of on-site prudential supervision, the IBA did not appear to have taken up the evaluation of banks. According to the recommendations of the CPPAPS, the customer service issue again came under the purview of the Reserve Bank’s inspection of banks from August 2004. The inspection teams were to visit a few branches, rate them for the quality of customer service, and submit reports, which would not, however, form part of the main inspection report. These reports were to be put up to the standing committees on customer service of the respective banks for action and follow-up by the regional offices of the Reserve Bank. The rating on customer service for a bank as a whole was to be incorporated in the confidential part of the inspection report and communicated to the bank’s top management. The regional offices of the Reserve Bank were advised in 2004 to depute their officers, including senior officers, to commercial banks incognito, as decoy customers for ‘mystery shopping’, to make an on-the-spot assessment of the level and quality of customer service provided by branches. The Reserve Bank discussed the findings with the senior officials of the banks in the quarterly supervisory meetings taken by the Regional Directors concerned. In September 2007 a revised checklist to be used during incognito visits was sent to regional offices. 566

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financial inclusion

Customer Service Department In the meeting of the Committee of the Central Board (CCB) on 6 June 2006, Deputy Governor Usha Thorat told the committee that on a review, it was found that there were multiple points where customer service issues were being handled in the Bank. In order to bring about better monitoring and also to provide better focus to customer service, the entire range of customer-related activities in the Bank was being brought under a single roof by hiving off these units from different departments.

Accordingly, the Customer Service Department (CSD) came into being on 1 July 2006. Until then, the work relating to customer service was handled in three different departments. The new department was entrusted with the work of (a) administration of the Banking Ombudsman Scheme (BOS), (b) customer complaints and complaint redress and (c) functioning as the nodal department for Banking Codes and Standards Board of India (BCSBI). More on BOS and BCSBI later in the chapter. The CSD coordinated with the regulatory and supervisory departments and other organisations, such as the IBA and banks, regularly. In 2007, the CSD called for information from all Banking Ombudsmen relating to common types of complaint handled by them, categorised these into 11 groups, listed 150 specific deficiencies, and forwarded those to banks in July 2007 for taking corrective action and ‘to circulate among staff to sensitize them’. The CSD further examined certain questionable practices followed by banks and intervened. Two cases will illustrate. One new private bank had an agreement to be signed by customers which stated that ‘the bank shall not be liable for any loss or delay arising when communications are sent by courier or messenger or mail. All despatches [by any mode at bank’s discretion] will be at my risk and consequences and I shall not hold the bank liable’. In another case, the terms and conditions for the provision of net banking facility were loaded in favour of the bank. In April 2007, the Reserve Bank’s Kolkata office suggested opening separate Customer Services Cell in the regional offices, which could ‘function as a nodal agency, corresponding to CSD in Central Office’. When the Shimla sub-office opened in July 2007, the Department of Administration had decided to set up the CSD in the proposed sub-office ‘to leverage technology for improving banking services and facilities to customers of Himachal Pradesh’. 567

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the reserve bank of india However, the top management of the Bank did not favour opening CSDs in regional offices. Instructions were given to banks to display information in their branch offices, such as service charges, interest rates, services offered, product information, time norms for various banking transactions and grievance redressal mechanism. However, many banks did not adhere fully to the instructions, nor was the information displayed in a standard format. Keeping in view the need to ensure transparency and yet avoid overload of the display, an internal working group was constituted by the Reserve Bank to optimise the display. Based on their recommendations, the Reserve Bank issued instructions to banks in August 2008.

Complaints Resolution: Banking Ombudsman Scheme (BOS) The word ‘ombudsman’ is of Swedish origin and translates to ‘representative’. The role of an ombudsman is to protect people against violation of rights, abuse of powers, error, negligence, unfair decisions, and to make the government and its servants more accountable to members of the public. In 2004, the Ombudsman’s office was in existence in more than 120 countries. The BOS was notified by the Reserve Bank on 14 June 1995 to provide a similar system of redressal of grievances against banks. All scheduled commercial banks (except regional rural banks, or RRBs) and scheduled primary cooperative banks (commonly known as urban cooperative banks, or UCBs) were covered under the scheme. It started with the appointment of three Banking Ombudsmen (BO) in June 1995, and by September 1997, fifteen BO offices were in place in the major state capitals. The BO was expected to be ‘a person of high standing in the legal, banking, financial services, and public administration or management sectors’. The BOs were required to submit an annual report to the Governor. The BO mainly relied on settling complaints through reconciliation. An award was issued only as a last resort. The BO had complete functional autonomy, and there were no provisions for interference by the Reserve Bank in the adjudicatory process. The secretariat of the BO’s office was, in addition to the Reserve Bank staff, manned by convener banks of the State Level Bankers’ Committee concerned. The cost of running the BO’s office, including the secretarial staff, was recovered from banks in such proportion as determined by the Reserve Bank. 568

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financial inclusion How well did the scheme function? A few BOs said that the level of efficiency of the deputed staff was found to be low, with some of them facing disciplinary action or suffering from serious health problems. Limited publicity was another issue. In the third annual conference of BOs in August 1997, the Governor said that the number of complaints received was low and that the scheme should be strengthened. The Reserve Bank repeatedly requested the IBA to give publicity to the BOS. The IBA feared that the content of the advertisement would give ‘negative publicity’ to the banks. In subsequent exchanges between them, there was similar reluctance. But the government desired that the BOS should get wide publicity. Accordingly, from 2002, banks were required to display salient features of the scheme with names and addresses of the BO at all branches. In the early years, banks often challenged the decision of the BOs in law courts. The Executive Director had to advise the chief executives of banks in February 1998 that it is expected that the award of BO is accepted and implemented by banks. In very exceptional cases where the implementation of the award is likely to create bad precedents for the bank and the banking system, banks should refer the matter to RBI before contesting in any manner the award given by BOs.

In March 1999, of the 266 awards issued until then, only 180 had been implemented by banks. A private company from Kochi wrote to Governor Jalan in December 1999, ‘Unfortunately Lokpal [ombudsman in Hindi] hardly gets an opportunity to study or take any remedial measures for any deficiency of service in banking. Ultimately the matter is pushed to the courts and ombudsman can wash his hands saying that the matter is subjudice. Thus ombudsman becomes a helpless figurehead….’ The Governor, in his address at the 4th conference of the BOs on 11 November 1999, said that ‘the expenditure incurred in administering the Scheme was on the high side’ and, moreover, that the scheme had not met the objectives for which it was instituted. The customers either did not know of it or were not happy. ‘There was a general impression among the bankers that some of the awards given by BOs were not based on sound principles and practices of banking.’ One of the reasons for this was the appointment of individuals who had retired from civil service without any background in banking. The financial daily Business Line reported in a story on 2 January 2002, ‘BO Role under Review’, that 569

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the reserve bank of india in the north-east, the position is held by one employed in the private sector while in Bihar it is a university professor. In some States, retired officers are playing the role of BO while in others, retired income tax officials. In the majority of States, the post was held by retired IAS officers.

Furthermore, the job was not necessarily a full-time one. On March 2003, the Reserve Bank informed all BOs that they could continue to take up part-time honorary work, subject to certain conditions.

Disagreement with the Government An internal group was set up in 1999 to review the BOS and make it more effective.8 In June 1999, the government wanted a copy of the recommendations of the group along with the status of the action taken. The Reserve Bank did not send a copy but stated that the decisions would be conveyed ‘in due course’. In July 1999, the Minister of State for Finance wanted to know the output of the BOs and the expenditure incurred, which was duly furnished. Based on the recommendations of the internal group, amendments to the scheme were approved by the Governor in April 2000. The group had considered bringing all cooperative banks under the BOs’ ambit but did not favour it because of the prospect of ‘political interference in the affairs of cooperative banks’. The group suggested that BOs would have arbitration powers in disputes among banks up to 1 million. The government added that ‘it would be necessary for RBI to ensure that persons with the right background are appointed as BOs’. While the amendments were pending, in September 2000, the government wanted the Bank to examine ‘whether there was a need and necessity for statutory ombudsman’. The Bank took the view that though the BOS might lack statutory powers, it had not hampered the functioning of BOs and the government was advised that the scheme was under review. The government in two letters addressed to the Deputy Governor in February and March 2001 advised the Reserve Bank that the government should be consulted before finalising the revision of the BOS. In April 2001, the Minister of State for Finance again wanted the Bank to supply data on performance and expenditure related to the offices of the BOs. The Bank forwarded the relevant data without any comments. The government’s position was becoming clearer. On receipt of the amendment proposals from the Bank, Deputy Governor Vepa Kamesam was

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financial inclusion called to New Delhi for a meeting with the Minister of State for Finance on 21 August 2001. During the meeting, the minister remarked that ‘reportedly it is a costly scheme with little work for disposal and enquired as to why only retired officials are being appointed’. Based on the suggestions of government officials during the presentation, the modified draft scheme was again submitted to the government for clearance. On 11 September 2001, the Ministry of Finance informed the Bank that, pending a revised scheme, ‘RBI may be directed to refrain from effecting any more fresh appointments’. Governor Jalan was unhappy and noted in a letter on 14 September that ‘if Government wants to have a say in running/administering the scheme, it may be best for them to take full responsibility for running it. We should not accept a situation where the government interferes and issues directions, but the responsibility is that of RBI’. The Deputy Governor advised the Additional Secretary (Financial Sector) on 11 September 2001, I am somewhat surprised at the contents of your letter.... The power to appoint ombudsmen vests with RBI and it follows well established due procedures for such appointments. I would request you to let me know whether the government wishes to take over the appointments and administration of the Scheme. If so, we shall not proceed in the matter of filling the upcoming vacancies and initiate steps to fully transfer the administration of the Scheme to Government.

There followed another letter from the Deputy Governor in a similar vein on 1 October 2001. In October 2001, there were more letters on the subject, and both the Reserve Bank and the government reiterated their position. The Economic Times on 5 November 2001 published a piece that called the situation a ‘Government RBI standoff ’. The Deputy Governor again wrote to the government in January 2002 stating that ‘we ... propose to terminate the Scheme in the exercise of the powers vested in the Bank under the Act. Alternatively, Government may like to take over the entire scheme as suggested earlier’. The Ministry replied that a decision would follow, but despite reminders from the Deputy Governor in February and March 2002, there was no lifting of the embargo on new appointments. By then, six posts of BOs were vacant, and New Delhi was without a BO for over seven months. The Bank pointed out to the government in April 2002 that the operation of the scheme was severely affected and suggested discontinuation to avoid public criticism. The government finally gave its consent in May 2002 with a few recommendations, which could be implemented by way of administrative

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the reserve bank of india instructions without amendment to the scheme. The revised BOS came into effect on 14 June 2002. The important changes included the provision of a ‘review authority’ to review the awards issued by BOs. It allowed a bank to file an appeal to the Deputy Governor and seek a review of a BO’s award. The BO was also authorised to function as an arbitrator on disputes between banks and their customers, and between banks. The RRBs also came under the BOs’ purview. Regarding arbitration between banks, the government wrote to all banks in July 2002 to approach BOs for disputes among banks. Later Deputy Governor Kamesam issued a letter to bank chiefs advising them to use the arbitration process more fully. Only a few cases until then had been referred for arbitration, presumably because both the disputing parties (banks) would rarely agree on the same arbitrator.

Review of Scope of the Scheme The Reserve Bank examined the issue of extending the scope of the BOS to the sixteen scheduled state cooperative banks in April 2003. But the fear of political interference was present. Deputy Governor Kamesam remarked that ‘we may end up trying to chew more than what we can digest’. The conference of BOs discussed the issue in November 2004 (there was no conference of BOs between 1999 and 2004), but the consensus was not to extend the scope of the BOS to cooperatives. The Deputy Governors’ committee reviewed the matter in October 2006 and had accorded ‘in-principle’ approval for bringing in non-scheduled UCBs under the BOS. But given the threefold increase in the number of complaints received in 2006, shortage of staff because of the exodus of lead bank staff, and the staggering number of urban banks (over 1,800), their inclusion under the BOS was deferred. The Reserve Bank was aware of the resentment of the participating banks for the recovery of the cost of administering the BOS from them. Deputy Governor Kamesam had justified the recovery of cost from banks as it ‘should be seen as a penal fee for the banks for their lack in customer service’. In January 2004, the Committee of the Central Board observed that the average cost per complaint was high and, therefore, the Governor suggested a review of the working costs and benefits of the scheme with a view to exploring the possibility of each bank having its ombudsman. Deputy Governor K. J. Udeshi, however, commented that 572

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financial inclusion left to banks, I am not sure how each bank’s ombudsman is going to decide against the bank’s customer. The man who pays the piper calls the tune. Banks would most certainly agree to have their own ombudsmen for their own reasons and not for the customer. We may instead review the scheme in order to make it more cost efficient.

The scheme was reviewed in 2004–05. Certain proposals were first discussed in the Committee of Executive Directors in September 2004 and then deliberated in the BOs’ conference in November. On 30 June 2005, the Reserve Bank placed the draft of the revised scheme on its website for comments and suggestions. The feedback received was carefully examined. The proposals were discussed in the Committee of Deputy Governors in August 2005, and sent to the government in September 2005. The scheme was implemented in 2006.9 The operation of the scheme vindicated the credibility of the Reserve Bank and its track record in protecting customers’ interest after the revision. The decision to post their own serving Chief General Managers and General Managers as BOs turned out to be a prudent one, as the number of complaints increased sharply in the following years. The average cost of disposal per complaint also declined (Table 13.1). However, in smaller centres, the cost was relatively higher. Some notable omissions in the operation of the scheme in 2006 were the exclusion of complaints related to internet banking, which was expanding, violation of Reserve Bank guidelines on the engagement of recovery agents, and powers to BOs for awarding compensation for mental anguish and harassment because of deficiencies in service in cases other than credit card complaints. In April 2005, the BO, Ahmedabad, wrote to the Reserve Bank seeking legal protection and immunity as the Fast Track Criminal Court in Jamnagar, Gujarat, issued a summons. The criminal case arose out of a petition filed by an auto-rickshaw driver who belonged to a scheduled caste and whose loan was denied by a public sector bank as his earlier loan was not paid. The BO had rejected his complaint as non-maintainable, and the complainant filed a case in the criminal court for discrimination against his caste and implicated the BO for rejecting his complaints. The Reserve Bank’s Legal Department held that the BO could be construed as an ‘officer’ of the bank, and therefore, covered by Section 54 of the BR Act. The provision said that ‘no suit or other legal proceeding shall lie against the Central Government, the Reserve Bank or any officer for anything which is in good faith done or intended to be done 573

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the reserve bank of india Table 13.1 Number of Complaints Handled by Banking Ombudsmen and the Expenditure Incurred Year 1995–96 1996–97 1997–98 1998–99

1999–2000 2000–01 2001–02 2002–03 2003–04

Total Number of Complaints Dealt With

Total Cost ( million)

3,358

32.3

1,904

20.4

7,268

49.3

7,464 6,800 6,978 7,022 6,506 9,483

2004–05

12,034

2006–07

44,766

2005–06 2007–08

53.1 61.5

Average Cost Incurred per Complaint ( )

Awards Issued

9,619

51

10,714 6,783

116

9,050

74

7,114

69.9

10,020

63.6

9,776

59.1 70.3 76.0

33,363

101.6

54,992

125.0

98.1

7

8,425

92 52 44 47

7,413

121

3,045

146

6,315 2,191 2,273

165 84 70

Source: Compiled from various annual reports of the Banking Ombudsman Scheme, Reserve Bank of India.

in pursuance of this Act’. The move to have only the Reserve Bank officers appointed as BOs was clearly in the right direction. After 2005, creating awareness about the BO had become a regular exercise for the BO offices. Advertisements and briefings were issued through local newspapers, television and radio. They also convened seminars, held meetings with ‘nodal officers’ of banks and delivered lectures to bank officials. The BO at Hyderabad ran a weekly feature in a vernacular newspaper to answer questions from the readers relating to deficiencies in banking service. The Governor remarked favourably on the practice and wanted other BOs to emulate it. A system of quarterly letters from BOs addressed to the Deputy Governor was introduced from March 2006.The letter contained information on the nature of complaints dealt with, systemic issues observed and awareness campaigns. It served as an important tool at the central office for obtaining feedback from BOs, which was forwarded to regulatory departments for action. Banks were 574

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financial inclusion advised in February 2007 to disclose the details of customer complaints and awards passed by the BOs in the annual reports and their websites. The Rural Planning and Credit Department (RPCD) in the Reserve Bank had the responsibility of administering the BOS from 1995 to 2006. The CSD administered it thereafter. The Department of Banking Supervision (DBS), which was inspecting branches, was sending a report to the RPCD and later to the CSD containing a list of branches that had not displayed the notice about the BO in their premises. The CSD, being a non-regulatory department, was unable to take stringent action against the defaulting banks. In January 2008, the Governor said that assessment of the performance of the BOs by an external rating agency would be a good idea, but this was not taken up during the period covered in this volume.

Analysis of Complaints The customers from big cities had generally taken advantage of the scheme. In 2007–08, 68 per cent of the complaints originated in metropolitan and urban areas. Apparently, knowledge about the scheme was limited outside the cities. Individual complainants constituted 88 per cent in 2007–08, and the remaining complaints were received from firms and organisations. Thirty-one per cent of the total complaints were received online and by e-mail in BO offices in 2007– 08. Comparable data are not available for years prior to 2007–08. The public sector, the private sector and foreign banks accounted for 55 per cent, 29 per cent and 13 per cent, respectively, of the complaints received during 2007–08. In the same year, these banks handled 73 per cent, 12 per cent and 2 per cent, respectively, of the total banking business in the country. In other words, public sector banks caused fewer complaints from their customers compared to the other two. In 2007–08, complaints pertaining to credit cards formed 21.2 per cent of the total number of complaints. ‘Failure to meet commitments’ (13.3 per cent), loans and advances (12.6 per cent), deposit accounts (11.7 per cent) and remittances (10.9 per cent) were the other major complaint generating segments.

Banking Codes and Standards Board of India The CPPAPS concluded in 2004 that there was an institutional gap for measuring the performance of banks against a benchmark that would reflect the 575

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the reserve bank of india best practices (code and standards). Therefore, the committee recommended the setting up of the Banking Codes and Standards Board of India (BCSBI). The BCSBI was set up by the Reserve Bank on the lines of UK’s Banking Code Standards Board, in collaboration with banks. It was registered as a society on 18 February 2006 in Mumbai. Later it was also registered as a charitable trust under the Bombay Public Trust Act, 1950. It was an autonomous and independent body, adopting the stance of a self-regulatory organisation. The Reserve Bank wanted it to be an initiative of the banking industry and not as a regulatory initiative. Governor Reddy queried in the CCB in June 2005 whether the Bank could be made a permanent invitee in the governing council. But the CCB was against it as it wanted an arm’s length relationship in order to secure the autonomy of BCSBI. Initially, there were twelve members, comprising six public sector banks, three private sector banks, two foreign banks and the CEO of the BCSBI. Fresh membership was open to all banks who could register themselves as members with the board, under a formal covenant that indicated the mutually agreed benchmarked norms and standards that would be observed by them. The membership fee or annual subscription was fixed in proportion to their gross domestic assets. The aims of the BCSBI were to prepare and publish voluntary codes and standards for banks for providing fair treatment to customers, function as an independent watchdog to ensure that the codes were followed, undertake research of codes and standards, and enter into covenants with banks on the observance of codes and train their employees. The Reserve Bank had agreed to finance the entire expenses of the BCSBI for the first five years of functioning. The core staff could initially be deputed from the Bank, including its CEO. The management of the board was entrusted to the Governing Council under the chairpersonship of former Deputy Governor K. J. Udeshi.

BCSBI Gets Going The BCSBI evolved a comprehensive code of banks’ commitment to customers. This was released by the Reserve Bank Governor on 1 July 2006. The code provided protection to individual customers by setting minimum standards of banking practices for banks to follow. In the words of the chairperson, ‘the Code is in effect a Charter of Rights’ of the individual 576

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financial inclusion customer.10 The full text of the code was published by the Bank in leading newspapers in English, Hindi and thirteen regional languages. All bank branches were required to have a copy of the code and ensure that notices were displayed about its availability. Banks’ compliance to the code was monitored by the BCSBI through the Annual Statement of Compliance submitted by member banks. The code was to be reviewed within three years. Banks that were not signatories to the code would run a reputational risk in not submitting to the code. A separate ‘Guidance Note to the Code’ was finalised in consultation with the Reserve Bank and the IBA. It was approved by the Governing Council in October 2006 and circulated among all member banks and BOs. It was advisory in nature and represented a general interpretation of the provisions of the code. It was illustrative and could be amended or modified by banks. The guidance note was not put in the public domain. In 2006, the IBA prepared four model policy documents on (a) collection of cheques and instruments, (b) grievance redress, (c) compensation policy and (d) collection of dues and repossession of security. These were vetted by the IBA’s managing committee. The BCSBI wrote to banks in February 2007 that ‘certain provisions in those policy documents were not reflective of your Code of Bank’s Commitment to Customers’, and that the documents needed to ‘truly reflect’ the spirit of the code. The operation of the code faced a challenge in February 2007, when Sucheta Dalal, columnist and consumer activist, pointed out that banks did not make available to borrowers a copy of the loan agreement for their record. According to the code, the document needed to be made available only if requested by the borrower. The Reserve Bank wanted the BCSBI to amend the code so as to make the practice mandatory for banks. However, having taken a decision by consensus not to review the code for three years, the BCSBI did not consider any amendment. A working group constituted by the Reserve Bank to formulate a ‘scheme for ensuring reasonableness of the bank charges’ in its report (September 2006) recommended inclusion of basic banking services identified by the group and the principles of reasonableness in fixing service charges in the code. When the Bank forwarded the recommendations to the BCSBI, the CEO replied (17 October 2006) that the recommendations would be considered at the time for review of the code. The Bank insisted ( January 2007) that ‘the issues are too important’. The Governing Council of the BCSBI, however, was not in favour of amending the code as suggested. 577

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the reserve bank of india The Governing Council did express concerns over the fact that the code was not internalised even in the Reserve Bank. For example, the master circular on credit card operations of banks issued by the Reserve Bank (in July 2007) had several references to the IBA’s FPC issued in March 2005 but not the BCSBI’s code, which had replaced the former. The chairperson of the board expressed ‘utmost anguish’ in a letter to the Reserve Bank pointing out the lapse. The initial response of commercial banks to the code was not satisfactory. But by September 2006, sixty-eight scheduled banks had registered with the BCSBI, and only three public sector banks had not applied. The matter was followed up with the banks that had not registered with the BCSBI. By November 2006, the BCSBI advised the Reserve Bank that only four private sector banks and eleven foreign banks had not registered with them, and, further, two public sector, two private sector and five foreign banks, though ‘registered’ with the board, had not applied for ‘membership’ of the BCSBI. The IBA wrote on 16 April 2007 to the BCSBI that banks were ready to fund the latter fully. The IBA had also proposed that pending this arrangement, a practising banker nominated by the IBA be inducted to the Governing Council. The Reserve Bank responded that it was too early to consider transferring the responsibility to banks. Inducting a practising banker to the Governing Council was also not acceptable as it was decided to stick to the CPPAPS’ recommendation that a review needed to be undertaken only after five years. In 2007, the BCSBI surveyed banks’ branches to ascertain the extent of implementation of the code.11 The findings of the survey were not very encouraging and revealed several deficiencies. The chairperson suggested to the Bank in August 2007 setting up an informal mechanism for a coordinated approach towards financial inclusion and customer service. The CSD could convene structured meetings quarterly to discuss common issues such as financial inclusion and customer service by banks, she added. The Reserve Bank accepted the suggestion, and the first meeting was convened on 5 November 2007. This forum would serve as ‘an institutional arrangement for a coordinated approach to customer service and exchange of views on systemic issues’. Despite discussions on ratings of banks, the board did not develop a formal rating system for banks. Instead, ‘the BCSBI’s approach is to adopt a collaborative and consultative approach towards rectification of systems rather than through penal action’.12 578

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financial inclusion

Financial Inclusion ‘Improving access to financial services,’ the BCSBI chairperson stressed, ‘is [a central bank’s] responsibility.’13 The reports of the 59th Round of the National Sample Survey Organisation showed that in 2005, 51.4 per cent of farmer households had no access to credit from any source, institutional or non-institutional. Besides, the share of institutional credit to total credit in rural areas had declined during the previous decade. The initiatives taken by the Bank to address this issue had two dimensions, fiat and guidelines issued to banks, and to work at the ground level through regional offices and lead banks.

Regulatory Guidelines on Financial Inclusion While announcing the Annual Policy for 2005–06, Governor Reddy emphasised the need to make financial inclusion a priority.14 In August 2005, the Bank had decided to simplify the know-your-customer (KYC) procedure for opening accounts by persons of small means who intended to keep balances not exceeding 50,000 in all their accounts taken together, and the total credit in all the accounts taken together was not expected to exceed 100,000 in a year. As the first major step to facilitate financial inclusion, banks were advised in November 2005 to offer a ‘no frills’ account either with ‘nil’ or very low minimum balances as well as charges. The nature and number of transactions in such accounts could be restricted but made known to the customer in advance. All banks were urged to give wide publicity to the facility of ‘nofrills’ account. On 27 December 2005, the Bank announced measures to widen the scope of RRBs, which were advised to open ‘no frills’ accounts without elaborate documentary requirements, permitted to set up automated teller machines (ATMs), issue credit and debit cards, and handle pension and other government businesses. Measures were also announced to strengthen their financial base. The issue of general credit cards (GCCs) by banks to their customers in rural and semi-urban areas was also announced. The GCC would operate like the Kisan Credit Card (referred to in Chapter 12), and there would be no linkage to purpose or end-use of funds or security. The Reserve Bank came out with a new branch authorisation policy in line with its financial inclusion strategy which encouraged banks to open branches 579

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the reserve bank of india in under-banked areas. It approved opening new branches for any bank only on the condition that at least half of such new branches were opened in underbanked areas as notified by the Reserve Bank. The Finance Minister stated in the Budget speech for 2005–06 that he was requesting the Reserve Bank to examine the issue of allowing banks to adopt the ‘agency model’, that is, using the services of civil society organisations, rural kiosks and village knowledge centres to provide credit support to rural and farm sectors. Soon after, the Reserve Bank constituted an internal group to examine issues relating to rural credit and microfinance.15 It recommended the adoption of the agency model after studying a few pioneering models outside India. In 1997, Brazil created a network of ‘correspondentes bancarios’ or ‘banking correspondents’ that offered basic banking services. An additional 4 million Brazilians had begun using banks for the first time through 27,000 banking correspondents. This model used kiosks or ATMs set up by the correspondents to accept payments, open accounts without cheque book facility, take small deposits, provide microcredits, and sell saving bonds and insurance. In South Africa, Teba Bank was granted a licence to operate as a microfinance bank in 2000. The bank engaged agents who were given handheld mobile point-of-sale devices. This wireless device had a built-in GSM modem, card reader and a micro-printer. The customer could use their debit card at the terminal to deposit and withdraw cash, make a balance enquiry, and transfer funds. Under this arrangement, physical cash could be deposited with or disbursed by agents, and their accounts at the bank were instantaneously debited or credited. Banking correspondents (BCs) essentially provide services such as disbursal of small value credit, recovery of principal, collection of interest and sale of other financial products. In respect of all such transactions, the correspondents would be authorised to accept or deliver cash either at the doorstep of the customer or at any other convenient location, subject to the cap fixed by the parent bank. A customer wishing to deposit cash might visit the BC and deposit the cash along with a deposit slip. The BC would access an internet-based system through a wireless device to process the deposit transaction. The system would validate the balance in the BC’s account and debit the same with an amount equivalent to the transaction amount and credit the customer’s account. The system would generate a transaction receipt with details of the transaction, such as the transaction ID, account number debited, account number credited, amount and the date. The BC would give 580

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financial inclusion the customer a receipt generated and the counterfoil of the deposit slip after putting his or her stamp and acknowledgment on it. A similar procedure is followed for cash withdrawal, too. After consulting the government and obtaining feedback from the IBA, guidelines were issued by the Reserve Bank to banks in January 2006 to use the services of non-government organisations (NGOs) and self-help groups (SHGs), microfinance institutions, non-deposit-taking non-banking financial companies (NBFC-NDs) and other civil society organisations such as business facilitators (BFs) and BCs. However, banks were not allowed to engage ‘individuals’ as agents. Although the Reserve Bank did not ordinarily encourage payment of commission to an intermediary, it made an exception in this case. But neither banks nor the intermediaries were permitted to charge any fee to the customers. An unexpected reaction to the circular came from banks’ trade unions, who condemned it as veiled outsourcing of bank jobs and gave a strike notice for 28 February 2006. The Reserve Bank had to convene a meeting with the union leaders in March 2006, and the Bank’s Executive Director clarified to them that the idea was not to substitute what banks were doing at present but to reach out to more people. He also referred to the Budget speech where the Finance Minister had announced the use of agency model by banks. Following the meeting with unions, Deputy Governor V. Leeladhar observed that the resistance seemed to be to the appointment of NBFCs as intermediaries and a circular was issued to banks not to engage NBFCs as BFs or BCs.

Ground-Level Initiatives Governor Reddy, while visiting the union territory of Puducherry on 21 November 2005, had an informal meeting with K. C. Chakrabarty, Chairman and Managing Director (CMD) of Indian Bank, which was the StateLevel Bankers’ Committee convener for the union territory. The Governor mooted the idea of undertaking a pilot project on 100 per cent financial inclusion in Puducherry because it had a good network of branches, high level of literacy, good coordination between bankers and government officials, good infrastructural facilities and a compact area (293 square kilometres). Chakrabarty welcomed the proposal, and the two met the Chief Minister and senior government officials. The Chief Minister supported the proposal. The Governor addressed the bank officials of Puducherry later in the day and 581

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the reserve bank of india explained the project, stating that the goal should be to ensure a bank account for every willing household. The National Pilot Project on Financial Inclusion was launched in a Puducherry village on 30 December 2005. Indian Bank and the Chennai regional office of the Reserve Bank monitored the implementation of the project. The bankers surveyed the area allotted to each branch and collected data on the eligible population. After that, a door-to-door campaign was conducted by bank officials for the opening of savings bank accounts in respect of every household that did not have a bank account. All banks cooperated in the exercise except for certain new private sector banks despite the Reserve Bank instructions. Consequently, major public sector banks had to do more than their allotted share of work with a view to meeting the deadline. While giving feedback to the central office, the Chennai regional office reported that ‘educating the target group or creating awareness in their minds as to the need for a bank account is a critical task’. The central office did not initially respond positively to the proposal as there was no precedent for giving publicity or issuing advertisements for such purposes. But it was an idea whose time had come and the Reserve Bank took several initiatives in that direction, as we will see later in the chapter. As the pilot project was on course in Puducherry, the Reserve Bank advised all State-Level Bankers’ Committee convener banks to identify one district in each state to implement 100 per cent financial inclusion on the lines of the initiative taken in Puducherry and also to allocate villages to the banks in the state. On 23 December 2006, the CMD of Indian Bank wrote to the Governor that ‘all the banks in Puducherry have accomplished the task’ of completing the exercise of financial inclusion. Meanwhile, in December 2005, the Governor visited Assam, Meghalaya, Nagaland and Tripura. During the visit, the view was expressed that there was a need for ‘a separate category of Financial Sector development plans for special category states’. Subsequently, the Bank set up a Committee on Financial Sector Plan for the North-Eastern Region.16 It urged banks to increase their outreach and to use information technology (IT) for greater financial inclusion. The committee further suggested opening bank branches in under-served areas and conducting awareness campaigns for increased financial inclusion. The committee constituted state-level task forces for each of the seven states in the region and for Sikkim to find out how banking services could expand. The enthusiasm became infectious as the Bank’s regional offices and certain public sector banks pushed for implementation of 100 per cent financial 582

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financial inclusion inclusion in the identified districts with missionary zeal. The CMD of one bank wrote to the Governor that his bank was considering ‘financial inclusion less as an obligation but more a viable business opportunity’. Later in May 2007, the Reserve Bank advised its regional offices to give attention to districts with concentration of scheduled castes, scheduled tribes and minority populations. In 2007, the Governor visited Lucknow and Patna and held discussions with banks on the expansion of banking facilities and the opening of branches in unbanked areas. Following a meeting with the Government of Uttarakhand, as well as banks and FIs, a working group was formed to draw an action plan for improvement of banking services in the state. Deputy Governor Thorat visited Jaipur in response to the state government’s proposal to implement 100 per cent financial inclusion in Rajasthan. In Andhra Pradesh, she reviewed the government’s financial inclusion project, as it wanted a banking outpost in every village under the BC model. She also met officials in Odisha to discuss 100 per cent financial inclusion.17 The drive towards bringing the unbanked to the banking fold was far from a total success, however.

Assessment A study conducted by the New Delhi regional office in October 2006 revealed that the scheme of the no-frills account had not fully percolated to the grassroots level. Banks had taken two to four months from the date of the Reserve Bank circular to advise their branches, district-level cooperative banks were disinterested, and the schemes framed by the new private banks had restrictive clauses in their policies. The study also concluded that wide publicity through electronic media to create awareness and financial counselling to people belonging to economically and financially downtrodden was necessary. NABARD Consultancy Services, a wholly owned subsidiary promoted by the National Bank for Agriculture and Rural Development (NABARD), came to similar conclusions on the implementation of the project in seven districts of Karnataka in January 2008. Most of the no-frills accounts had remained inoperative, few came with GCCs, some pockets of households remained excluded, moneylenders were still doing business and bank officials displayed a lack of involvement and not taking these up as a business opportunity. One of the suggestions was that financial education should be an integral part of financial inclusion. 583

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the reserve bank of india Evaluation studies by external agencies also revealed that most of the new accounts had remained inoperative.

Committee on Financial Inclusion In June 2006, the Ministry of Finance announced the setting up of the Committee on Financial Inclusion.18 The committee defined financial inclusion ‘as the process of increasing outreach to vulnerable and excluded groups through timely and adequate delivery of appropriately designed financial products and services at an affordable cost’. The committee suggested that excluded households should be mapped at the district level and aggregated to arrive at state-level exclusion levels. After that, targets would be allocated to all the agencies for credit delivery.19 The committee further suggested that banks could appoint individuals as BFs or BCs. Though the Reserve Bank was of the view that the move raised issues of conflict of interest, it was open to reviewing its stance. Meanwhile, one of the public sector banks went ahead and appointed thirty-one individuals as BCs and informed the Reserve Bank of this on 31 December 2007. Deputy Governor Thorat observed that the bank should be permitted to do this; ‘it is a question of risk management and the bank has to manage the risk’. The Finance Minister in his Budget speech on 29 February 2008 accepted the recommendation of the committee. Banks demanded that they should be allowed to recover a service fee from customers to pass on the additional cost of engaging a BF or BC. The Reserve Bank was reluctant to agree, as the additional cost or burden on the small customer could defeat the very purpose of financial inclusion. But in April 2007, Deputy Governor Thorat noted that ‘the BC model is not taking off because of the fact that after paying commission to the agent, the net return does not make it worth the while for the bank’. In due course, the Reserve Bank allowed banks to recover reasonable service charges for providing doorstep banking facility from the beneficiaries.

IT Solutions for Financial Inclusion Various committees constituted by the Reserve Bank noted that in under-banked states, such as Uttarakhand, Bihar, Chhattisgarh and the northeastern region, developments in banking technology and expansion of 584

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financial inclusion the telecommunication network provided the possibility to open banking outposts in remote locations without having to open brick and mortar branches. Further, NGOs and microfinance institutions that functioned as BCs were already inclined to use innovative products and processes to reduce the cost of operations. Partnering with such entities provided banks with an opportunity to look at technology-based and low-cost delivery mechanisms. The North Eastern Financial Sector Plan suggested that the Institute for Development and Research in Banking Technology (IDRBT), established by the Reserve Bank in March 1996 as an autonomous centre at Hyderabad for development and research in banking technology, should draw up a plan for the region. Having received the assignment from the Reserve Bank, the IDRBT convened meetings in August 2006 with bank officials for finalising a possible model. The Reserve Bank also constituted an Advisory Group on IT-Enabled Financial Inclusion in September 2006 with senior officials from different departments of the Reserve Bank, the IDRBT, major commercial banks and experts from the Indian Institute of Technology, Mumbai. The group’s mandate was to suggest common and comparable standards for IT-based solutions for financial inclusion. The group favoured the multiapplication and interoperable smart card model, with BCs using a mobile authentication device connecting live to the customers’ bank accounts through wireless networks and a secure payment gateway. Accordingly, the IDRBT prepared a plan for the pilot project to be implemented in the northeast. Simultaneously, banks and technology providers began to adopt different strategies to launch IT-enabled financial inclusion in various parts of the country. State Bank of India (SBI) started in Aizawl in Mizoram and then in Medak district in Andhra Pradesh, Union Bank in Pithoragarh district of Uttarakhand, and Indian Bank in Dharavi in Mumbai. ICICI Bank was operating in Odisha and Assam through Kas Foundation, and HDFC Bank was operating its branch ‘hub and spoke’ model in Gujarat and Maharashtra using cooperative banks as BCs. All these initiatives enabled customers to undertake transactions in their bank accounts, including cash deposits and withdrawals, without having to visit the branch. The Government of Andhra Pradesh launched a pilot project in April 2007 using the model developed by the IDRBT for social security payments, including pensions to widows, handicapped, old and eligible weavers and wages under the National Rural Employment Guarantee Scheme (NREGS), with SBI and five other banks. Initially, the coverage was limited to certain 585

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the reserve bank of india villages in two districts and later extended to around 9,000 villages in six districts. The transactions were to be done by way of biometric smart cards using biometric identification of customers through handheld point-of-sale device using personal identification numbers (PINs). The state government met the major portion of the cost of the smart cards and other related capital expenditure. The officials of the Andhra Pradesh government favoured an electronic benefit transfer (EBT) framework outside the banking system, but the Reserve Bank indicated its comfort with the banking system for handling the government payment mechanism. The Maharashtra government wanted in May 2007 to replicate the Andhra Pradesh project for distribution of wages to labourers under NREGS through the smart card and mobile technology in any of the taluks of the state and requested the Reserve Bank to make a presentation to its officials (done in June 2007). The lead banks were advised to take up with the respective state governments routing of small and routine payments through BCs using smart card technology. Deputy Governor Thorat wrote to all state Chief Secretaries in October 2007 requesting them to consider direct credit of all social security payments, including pension and wages under the NREGS, to the bank accounts of the beneficiaries. There followed another letter in January 2008 to all state governments. A few states enthusiastically responded and channelled some of the government payments through banks, after the period covered in this volume.

Technology Funds Following on the recommendations of the Committee on Financial Inclusion, the Finance Minister announced in his Budget speech in February 2007 the establishment of a Financial Inclusion Fund for meeting the cost of developmental and promotional interventions, and a Financial Inclusion Technology Fund to meet the cost of technology adoption. Both funds were to be constituted with NABARD with an overall corpus of 5 billion each, to be shared by the government, the Reserve Bank and NABARD in the ratio of 40:40:20. For 2007–08, there was to be an initial contribution of 0.25 billion each to the two funds. In May 2007, SBI sought allocation of a suitable amount from these funds. Deputy Governor Thorat wrote to the Ministry of Finance in June requesting 586

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financial inclusion ‘early response’ on guidelines for the use of funds. The government did not respond until November 2007. Meanwhile, NABARD had prepared an action plan listing out the activities to be financed out of the two funds, though the government had wanted the Reserve Bank and NABARD together to frame the operational guidelines. Ten days later, the Bank prepared draft operational guidelines and sent it to the Ministry of Finance. The Bank suggested that while the Financial Inclusion Fund could be set up in NABARD, the Financial Inclusion Technology Fund might be set up in the IDRBT. The Ministry of Finance then convened a meeting in December 2007 to finalise the guidelines for the funds. The government approved the constitution of the funds in March 2008. Both the funds would house with NABARD, and the three stakeholders contribute 0.25 billion to each fund for 2007–08 in the ratio of 40:40:20. The government and NABARD duly released their share to the funds upfront by the end of March 2008. As regards the Reserve Bank’s share, the proposal to contribute to the funds was put up to the CCB in May 2008. The CCB had indicated that only banks should be made eligible beneficiaries of the funds while NABARD and the government wanted NGOs and SHGs to be eligible as well. The Bank, therefore, expressed its inability to release its share of 0.10 billion each to the funds and demanded to be part of the subcommittee formed to vet the proposals received from banks for assistance from the two funds. Faced with an impasse, NABARD took up the matter with the government in December 2008. The Reserve Bank, as a matter of principle, was not in favour of directly funding NGOs and SHGs, as verifying their credentials was next to impossible. The Bank recognised that the mobile phone was an important means to achieve financial inclusion. The number of mobile phone subscribers in the country was 261 million in March 2008. But a substantial percentage of mobile users did not have a bank account.20 The Consultative Group to Assist the Poor (CGAP), a global partnership of thirty-four leading organisations, in its ‘Country Diagnostics’ commented ( January 2008) that the restrictions applicable to the bank agent model have impeded its use. Also, the potential for payment and mobile banking services to be provided by mobile banking operators and other non-banks has not yet been realised due largely to restrictions on non-banks accepting funds from the public and the prohibition on e-money issuance of non-banks. 587

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the reserve bank of india

Financial Literacy Initiatives The Organisation for Economic Co-operation and Development (OECD) defines financial education as ‘the process by which financial consumers/ investors improve their understanding of financial products, concepts and risks and through information, instruction and/or objective advice develop the skills and confidence to become more aware of financial risks and opportunities to make informed choices’.21 Within the Reserve Bank, there was the sense that financial education was not only an integral component of consumer protection, but also a way to protect the common person from market failure.22 The Bank saw financial education as a component of financial inclusion, as the lack of awareness about banks and their products was one of the biggest barriers to financial inclusion. The challenges are enormous in India, given the size of the country, its twenty-two major languages and a high level of general illiteracy. The individual departments of the Bank had made efforts to promote financial education all along. The Department of Non-Banking Supervision, for example, had undertaken a nation-wide campaign to educate NBFC depositors on what to look for in a company before placing deposits with them. It had released advertisements in twenty-four newspapers and in thirteen languages in 2000–01. Films were produced and telecast on four television channels. The Foreign Exchange Department had carried out a campaign to educate the users on the Foreign Exchange Management Act, 1999. The Department of Currency Management had taken up periodic campaigns to inform the public on the security features of genuine currency notes. A virtual monetary museum appeared on the Reserve Bank’s website in December 1998, and later a monetary museum was set up in Mumbai close to the Bank’s central office and opened to the public from 1 January 2005. It covered subjects like money, Indian coinage, Indian paper money, Reserve Bank functions, and so on, in Hindi and English, with panels and an interactive screen. The Reserve Bank management envisaged a critical role for its ‘Regional Offices to promote financial education in their respective jurisdictions’. The Chennai regional office, encouraged by the Bank’s recent focus on financial inclusion and the launching of a pilot project in Puducherry, put up a pavilion at the India Tourism and Trade Fair in Chennai for the first time in January 2006. Though government departments such as Railways, Post and Telegraph, and Tourism were known to be putting up stalls in all major fairs and exhibitions, the Reserve Bank had not done this before. The pavilion provided 588

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financial inclusion information and reading material to the general public on the functions of the Reserve Bank, BOS, awareness about NBFCs, and security features of genuine currency notes. The other regional offices took similar initiatives. In the meeting of the Committee of Central Board of Directors on 8 February 2006, Governor Reddy wanted a primer for the layman, starting with Monetary Policy Statement and expressed his desire to reach out to ‘the common man’. He also desired that the Press Relations Division (PRD) undertake a time-bound programme on financial education. An action plan was accordingly prepared by the PRD (later renamed as Department of Communications) in April 2006. The plan included preparation of ‘frequently asked questions’ and ‘Know Your ...’ series, and dissemination through leaflets, brochures, and films and videos in English and Hindi not only in mass media but also in schools, colleges and libraries. To carry out this action plan, a Working Group on Reaching out to the Common Man was formed.23 The group, later enlarged with the induction of more senior officials including two heads of regional offices, was to frame basic guidelines for preparing materials for reaching out to the common person. The group was to act as the authority for screening the ideas and materials for financial education and would be responsible for designing, printing and publishing the material. The project was renamed Project Financial Literacy by the Governor in March 2007 with two modules, one on the Reserve Bank and the other on general banking. While the Bank module was to be developed by the PRD, the banking module was entrusted with the RPCD. Five regional offices of the Bank were asked to prepare basic material related to banking for groups, such as rural population, school children, urban poor, senior citizens, women and defence personnel, within two months. The New Delhi regional office prepared three comic books in 2007 on ‘banking’, with Raju as the central character. They are called Raju and the Money Tree, Raju and the Sky-ladder and Raju and the Magical Goat. These dealt with subjects of saving in a bank and deposit products and loan products of banks, and were translated into thirteen Indian languages, as well as converted into braille. The regional offices distributed these. The PRD prepared two comic books on the Reserve Bank – Money Kumar and Monetary Policy and Money Kumar and Caring for Currency. The Bank launched a multilingual section on its website in thirteen Indian languages on all matters concerning ‘banking and the common person’ on 18 June 2007. A ‘Financial Education’ site link on the Reserve Bank’s website was activated on 14 November 2007. 589

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the reserve bank of india To commemorate the 150th anniversary of India’s First War of Independence, Azadi Express, a train exhibition, was launched by the government’s Publicity Division in August 2007, which travelled throughout India for about a year. The Bank participated in it through its Hyderabad Office by putting up displays. The PRD conducted seminars and workshops exclusively for media persons in metro cities during 2006 and 2007 on contemporary subjects related to the Reserve Bank’s policies. The Bank also organised essay competitions for school children on the subject of banking and finance and encouraged the inclusion of a financial literacy module in the school curricula. The other initiatives included encouraging and arranging for visits of college and school children to Reserve Bank offices and conducting of quiz programmes in schools. The Bank announced the Young Scholars Award Scheme in December 2007, with the objective of generating interest and awareness about the Indian banking sector and the Reserve Bank. One hundred and fifty Young Scholars during their summer vacation worked for two to three months on projects in the Bank offices. The Young Scholars were chosen through a country-wide competitive examination from students aged between eighteen and twenty-three, pursuing their undergraduate studies. Two officers attached to the New Delhi office, Shailaja and Manoj Kumar Singh, ran a weekly column entitled ‘Real Simple’ in the financial daily Mint from April 2007 until March 2010 in which complex financial subjects were explained in simple language. The regional offices initially exhibited great enthusiasm in promoting financial education in innovative ways. However, the enthusiasm appeared to wane after the Deputy Governors’ Committee decided that the central office must ‘clear all ideas, scripts, and products’ and vet every financial literacy material prepared at regional offices before their distribution. In May 2007, the regional offices were advised to arrange with banks to set up a ‘financial literacy-cum-credit counselling centre’ (FLCC) on a pilot basis in any one district in the state under their jurisdiction. With experience gained, FLCCs were to be opened in other districts of the state in due course. Separate advices went to the lead banks. By the middle of 2008, banks had set up or were in the process of setting up 109 counselling centres. As indicated by the Governor in the mid-term review of the annual policy for 2007–08, a concept paper on financial literacy and counselling centres was uploaded on the Reserve Bank’s website for obtaining feedback from the public. Based on the feedback, the Reserve Bank prepared and circulated a model 590

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financial inclusion scheme for FLCC to the banks, which indicated that ‘most of the centres were not performing the intended role’. Banks indicated that they favoured freedom and flexibility in setting up FLCCs instead of being constrained to accept standardised models.

Credit Counselling Borrowing beyond one’s capacity to repay is always a risk in a country with high levels of poverty. The syndrome became a national crisis in the case of indebted farmers. A working group to suggest measures for assisting distressed farmers had recommended (2006) credit counselling for them.24 Another Working Group to Examine the Procedures and Processes of Agricultural Loans recommended (2007) that banks should actively consider opening counselling centres.25 Bank of India was the first commercial bank to launch ‘Abhay’, a credit counselling centre, in Mumbai through a trust in September 2006, and later in Wardha and Chennai. Its mission was to counsel people and to help debt resolution and rehabilitation of borrowers in distress. By February 2007, about 500 persons had been counselled. ICICI Bank set up a trust named DISHA and established seven financial counselling centres between April and October 2007 in big cities.

Conclusion Did these initiatives by the Reserve Bank make a difference to consumer protection, financial inclusion and financial literacy? There is no question that these did succeed in making bank managements take the customer more seriously than before. As the Reserve Bank started publishing bank-wise complaints received by the BOs, it put pressure on banks to strengthen their own internal grievance redressal machinery to avoid complaints getting escalated. Financial inclusion measures did see millions of new accounts opened. By comparison, the initiatives on financial education and credit counselling only scratched the surface, though they were timely. These were at best sporadic though wellintended activities. Three departments of the Bank, namely the CSD, RPCD and PRD (later renamed Department of Communications), were involved in the activities concerning financial inclusion and financial education, apart from the regulatory departments. There was an overlapping of boundaries, depending on the drive and commitment of the Head of Department concerned. 591

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the reserve bank of india The customer and common-man orientation made a difference to perceptions about the Reserve Bank. Until the 1990s, the Bank tended to be seen as an elite institution not known for its openness but feared for its regulatory reach. As the Bank let go of its iron grip on its regulated entities and turned its attention to individuals and households, the public perception of the Bank changed. Two Governors, Jalan, and Reddy, repeatedly stressed in their messages to the staff that the Bank was accountable to the taxpayers. As the contact between the Reserve Bank and members of the public increased, its communication policy liberalised. The Heads of Departments and Offices could communicate with media persons. Students were encouraged to visit the Bank’s offices and, in turn, the Bank officers visited schools and colleges. Though the Bank engaged in developmental functions such as rural credit since its inception, this new role of direct service to people through the initiatives narrated in this chapter brought about a positive transformational change to the organisation.

Notes

1. A committee under the chairmanship of R. K. Talwar, then Chairman of State Bank of India (SBI), was set up in 1975 to give recommendations on customer service. The Reserve Bank’s follow-up with banks for implementing the committee’s recommendations was not very effective. 2. Chairman: M. N. Goiporia, Chairman, SBI, Committee on Customer Service in Banks. 3. See note 2. 4. Chairman: H. N. Sinor, Chief Executive, and Secretary, Indian Banks’ Association (IBA), comprising members drawn from select banks and the Reserve Bank. 5. Chairman: N. Sadasivan, which submitted its report in September 2006. 6. Communicated to banks in February 2007, these points were: (a) banks to identify additional ‘basic banking services’ on the basis of broad parameters indicated by the group, (b) banks to make available basic banking services at reasonable charges and the basic services to be delivered outside the scope of the bundled products, (c) the principles for ensuring reasonableness in fixing and communicating the service charges as indicated by the group to be adopted/followed and (d) banks to take steps to ensure that customers were made aware of the service charges upfront and changes in the service charges were implemented only with prior notice to the customers. 592

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financial inclusion 7. The Reserve Bank advised the banks and NBFCs in November 2005 that while issuing [credit] cards, the terms and conditions for issue and usage of a credit card should be mentioned in clear and simple language (preferably in English, Hindi and the local language) comprehensible to a card user. The Most Important Terms and Conditions (MITCs) termed as the standard set of conditions … should be highlighted and advertised/sent separately to the prospective customer/customers at all the stages i.e. during marketing, at the time of application, at the acceptance stage (welcome kit) and in important subsequent communications…. Card issuers should quote annualized percentage rates (APR) on card products…. The late payment charges, including the method of calculation of such charges and the number of days, should be prominently indicated…. Even where the minimum amount indicated to keep the card valid has been paid, it should be indicated in bold letters that the interest would be charged on the amount due after the due date of payment.

8. Under the chairmanship of C. Harikumar, Executive Director, with the IBA as a member. 9. The major changes in the revised scheme were: (a) inclusion of new grounds of complaints, such as credit card issues, non-adherence to fair practices code, and levying of excessive charges without prior notice; (b) the prescribed application format was no longer mandatory, and complaints were allowed to be lodged online and by email; (c) only serving senior officers of the Reserve Bank were to be appointed as BOs (one of the reasons for this was to expose them to the grievances of customers at the ground level and to develop sensitivity to their problems); (d) the entire cost of running the scheme would now be borne by the Reserve Bank as the secretarial and other staff for the BO offices would be drawn solely from the Bank; (e) banks were required to appoint nodal officers in their zonal offices for liaising with BOs; (f) the complainants were also permitted to appeal against the award of BOs; (g) consumer organisations were allowed to represent the complainants before the BOs; and (h) the interbank arbitration work was removed. Further, while dealing with complaints from credit card holders, the BO had been given powers to consider aspects such as harassment and mental agony suffered by complainants when deciding the amount of compensation to be paid by the card issuer. 10. K. J. Udeshi, Speech at the IV International Forum on Financial Consumer Protection and Education at Budapest, Hungary, 15–16 October 2007. 11. The survey was conducted in Mumbai, New Delhi, Kolkata, Chennai and Hyderabad. It covered 702 branches of 57 member banks. 12. K. J. Udeshi, Speech at the IV International Forum on Financial Consumer Protection and Education at Budapest, Hungary, 15–16 October 2007. 593

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the reserve bank of india 13. Ibid. 14. ‘There are legitimate concerns in regard to the banking practices that tend to exclude rather than attract vast sections of population, in particular pensioners, self-employed and those employed in unorganised sector.... RBI will implement policies to encourage banks which provide extensive services while disincentivising those which are not responsive to the banking needs of the community, including the underprivileged’ (emphasis added). 15. Chairman: H. R. Khan, 2005. 16. Chairperson: Usha Thorat. 17. By March 2008, 340 districts (out of a total of 610) were identified for implementation of 100 per cent financial inclusion, and the task was completed in 154 districts. All districts of Haryana, Himachal Pradesh, Karnataka, Kerala, Uttarakhand, Goa and the union territory of Puducherry reportedly achieved 100 per cent financial inclusion. The total number of nofrills accounts opened by all banks from 2005 onwards stood at 23 million as at the end of March 2008. 18. To be chaired by C. Rangarajan, the then chairman of the Economic Advisory Council to the Prime Minister. The members were officials from different ministries with the chairman of NABARD as member-secretary. Notably, no representative was nominated from the Reserve Bank as a member. However, the committee chairman decided to have one of the Deputy Governors from the Bank as a permanent ‘invitee’. 19. The committee suggested a lower entry norm of 2.5 million paid-up capital for non-deposit-taking NBFCs engaged exclusively in microfinance activities instead of the 20 million fixed by the Reserve Bank for all NBFCs. However, the BFS did not favour the dilution of entry norms. The committee wanted the Bank to revisit the concept of local area banks (LABs) and keep the option open to license new LABs. The Reserve Bank did not accept this. The chairman of the BFS stated in the meeting on 7 February 2007 that ‘the four LABs [which were functioning at that time] as an institutional arrangement on experimental basis had not succeeded the test’. 20. Detailed guidelines on mobile banking were issued in October 2008 with a clause that all transactions had to originate from one bank account and terminate in another bank account. 21. The definition of financial education developed by the OECD in 2005 and endorsed by Group of Twenty (G20) leaders in 2012 is used in a majority of countries 22. Y. V. Reddy, Inaugural address at the International Conference on Financial Education organised by OECD and co-hosted by Pension Fund Regulatory and Development Authority, New Delhi, 21 September 2006.

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financial inclusion 23. With senior officials from the PRD, Department of Economic Analysis and Policy, RPCD, and the Bank’s training establishments. The working group was reconstituted in July 2006 and renamed Steering Group, to be chaired by an Executive Director. 24. Chairman: S. S. Johl, agriculture economist. 25. Chairman: C. P. Swarnkar, CMD, Syndicate Bank.

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14 Communication Policy

Introduction In keeping with international trends, the Reserve Bank made significant changes to make its communication policy more transparent during the reference period.1 Global trends, together with domestic factors, such as liberalisation, increasing reliance on market-based instruments and the opening of financial markets, led the Bank to disseminate more information to stakeholders and to the public and at the same time avoid disrupting financial markets. While maintaining transparency, quality and timeliness, the Bank sought to achieve clarity on its own roles and responsibilities, manage expectations, promote two-way flow of information, collect statistics and conduct research.2 Over the years, the communication strategy was strengthened. At the beginning of the reference period, existing communication channels consisted of periodic publications of monthly monetary and credit information reviews, Reserve Bank of India (RBI) Monthly Bulletins, Annual Reports, speeches of senior executives, circulars and notifications, data series, pamphlets and other reports to make information available to bankers, academics and general public. The launch of its own website in 1996 marked the beginning of electronic dissemination of information. Internally, the Governor’s New Year Letters, RBI newsletters, in-house magazines, monthly demi-official letters to the Governor by Regional Directors, internal manuals, and conferences of Regional Directors served well to disseminate information and communicate to the staff. During the reference period, the communication policy became more transparent, interactive and receptive to feedback (also see Box 14.1). The communication process engaged market participants. Draft reports, circulars and notifications were placed on the website, and comments on these were invited from the public before the reports became final. The Technical Advisory Committee for Monetary Policy (TACMP) created a platform 596

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communication policy for greater interaction with the outsiders in the process of monetary policy formulation. At the same time, data dissemination improved, partly by adhering to the International Monetary Fund (IMF) standards. Increased interactions with media followed the announcement of the monetary policy. The Bank responded to media reports more than before. The speeches of the executives became more comprehensive and transparent in content and reach. Box 14.1 Reflections on Communications Policy So, if you look at any communication that has come from the RBI, you would not find anything which is secretive, or which influences the market. It is just giving confidence to the public that what we are doing is this, and then the media can criticize or not – whatever they want to do. So to be open on big policy matters has been a high priority. 

Bimal Jalan, former Governor, Reserve Bank of India

… when you move from a planning to a market economy, more communication is required. Second, almost all over the world, communication by the central bank as a general trend …, clearly … [on] monetary policy … communication becomes more important. 

Y. V. Reddy, former Governor, Reserve Bank of India

The Bank’s communication policy had two components, external and internal.3 External communication was conducted by means of press releases, speeches, publications, notifications, circulars, frequently asked questions (FAQs), advertisements, media interviews and the website, and focused on areas such as the macroeconomic situation, monetary and fiscal policies, banking, financial markets, payment systems and external sector developments. The channels of internal communication were training colleges, in-house magazines, newsletters, circulars and letters addressed by the top management. Internal communication processes facilitated two-way communication and, during the period of reference, these were made more transparent. Both internal and external communication of the Bank received impetus during this period. Governor Bimal Jalan indicated that internal office notes should not generally exceed two pages and should be clear. The Bank officials were encouraged to engage more closely with market participants, with an emphasis on providing prompt response to the media and the general public. 597

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the reserve bank of india The present chapter discusses how policies and practices in this area evolved during the period of the study. It is divided into two sections – external communication and internal communication.

External Communication External communication had two main components, monetary policy and regulatory-related (banking and financial) communication, which was central to the Bank’s functions, and other communication.

Monetary Policy and Regulatory Communication Monetary policy communication is, of course, an important tool for any central bank for monetary management. The Reserve Bank reviewed its monetary policy twice a year, issued statements twice a year until 2005–06 and thereafter issued quarterly statements. The statements outlined the monetary policy stance and measures, prefaced by an analysis of domestic and global developments, and an overall assessment of the economy. These policy statements were placed on the Bank’s website for wider dissemination immediately after the announcement. The policy statements discussed not only monetary policy but also financial sector policy issues. In addition to the policy statements, the annual policy and the mid-term review contained discussions on the measures relating to the financial sector. In the associated process, the Bank organised a meeting with the chief executive officers of select banks, a press conference, video conference with media persons, and individual interviews given to the electronic and print media by the Governor and Deputy Governors. The Bank’s monetary policy communication underwent frequent improvements. From October 2001, in addition to issuing the statements, the Bank introduced a live telecast of the Governor’s press conferences during annual policy and mid-term reviews. The clarifications sought by newspersons in relation to monetary policy as well as financial sector policies were answered in the press conference, which created a direct communication channel between the top management and market participants. Subsequently, the Bank extended its communication on monetary and financial sector regulatory policies to six of its regional offices – Ahmedabad, Bengaluru, Chennai, Hyderabad, Kolkata and New Delhi – apart from Mumbai, through the video conferencing facility, 598

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communication policy which provided an opportunity to the regional media to interact with the Governor. The telecast was also placed on the Bank’s website. Apart from these, the Bank also published from 2005–06 first- and thirdquarter policies and reviews of the economy, increasing the frequency, ‘to provide an opportunity for structured communication with markets on a more frequent basis while retaining the flexibility to take specific measures as the evolving circumstances warrant’. From April 2006, the Bank conducted interactive seminars on monetary policy for media in Mumbai and regional centres. The issue of transparency remained central to monetary policy communication strategy and was assessed more than once both internally and by outside agencies. In 1998–99, the IMF announced a set of standards and codes to assess transparency and data dissemination policies of member countries. The Bank, in consultation with the government, set up a Standing Committee on International Financial Standards and Codes (SCIFSC)4 to address these issues in the Indian context. The findings of the Financial Sector Assessment Programme, a joint IMF and World Bank initiative introduced in 1999, and the IMF’s Report on the Observance of Standards and Codes (ROSC, 2002)5 helped in improving monetary policy transparency. In 2006, the Government, in consultation with the Bank, constituted a Committee on Financial Sector Assessment (CFSA) to undertake self-assessment of financial sector stability and development. The committee set up an Advisory Panel on Transparency Standards.6 The terms of reference of the panel were, inter alia, to identify and consider the relevant standards and codes as currently prescribed and applicable for transparency in monetary and financial policies, and identify gaps and suggest a possible roadmap. The panel’s recommendations formed part of the CFSA report submitted in 2009 and were considered for implementation subsequently. The formation of various technical advisory committees (TACs) with representatives from market participants and experts was another important step in providing a platform for interacting with outsiders in the process of policy formation.7 While TACs for money, foreign exchange, and government securities markets, and on regulation, were already in place, the one on monetary policy was set up in 2005, after the recommendation of the Advisory Group on Transparency in Monetary and Financial Policies.8 These committees acted as platforms where the Bank was informed of the needs of market players and where it could communicate its stance in a manner not always possible using formal circulars. Resource management discussions that occurred before the annual policy deliberations acted as a forum for dialogue between commercial banks and the Reserve Bank management. 599

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Other External Communication Channels The Reserve Bank has been a major agency for data dissemination on macroeconomic situation, banking, monetary and fiscal policies, financial markets, external transactions and payment systems issues. Analyses of macroeconomic developments were provided in the Monthly Bulletin, Annual Report, the Report on Trend and Progress of Banking in India, and the Report on Currency and Finance. Other publications, such as the Weekly Statistical Supplement (WSS) to the Reserve Bank of India Bulletin, occasional papers, staff studies, and Functions and Working of RBI, also provided useful data. As of end of March 2008, there were 3,943 subscribers to Reserve Bank publications. Circulars and notifications communicated revisions in the monetary and regulatory policies. The Bank also brought out Hindi editions of its various regular publications. Further, Monetary and Credit Information Review, Banking Chintan and Anuchintan, RBI Legal News and Views, and CAB Calling (College of Agricultural Banking) aided information dissemination.9 Memorial lectures,10 speeches, press meets and economic editors’ conferences were some of the other initiatives that contributed to the communication process. The history volumes provided systematic accounts of institutional developments based on internal documents. In March 2006, The Reserve Bank of India, Vol. 3: 1967–1981 was released by the then Prime Minister, Manmohan Singh.11 Annual meetings with the state Finance Secretaries were another platform of communication, introduced from 1997. The Reserve Bank staff, particularly research staff attached to the Department of Economic Analysis and Policy and the Department of Statistical Analysis and Computer Services (DESACS), provided inputs into the policy-making process as well as analyses of issues. In addition, speeches of the Governors and Deputy Governors provided rationale and explanations behind the policy decisions. The Governor met financial editors regularly, over informal lunch sometimes, to share the thinking behind policies.

Data Dissemination Apart from information contained in the monetary policy announcements, the Bank’s communication strategy included data dissemination. The Bank is the ‘primary data source’ for monetary statistics, the balance of payments statistics, state finances, payment systems and banking data. The modes of data releases that were in existence already included, among others, a daily 600

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communication policy press release on money market data, details of repos and reverse repos as part of the liquidity adjustment facility, the US dollar–rupee and euro–rupee reference rates, and monetary, banking, fiscal, external and financial data. India was one of the few countries that became members (1996–97) of the IMF’s special data dissemination standards and general data dissemination standards. India started posting its metadata on IMF’s dissemination standards bulletin board from 30 October 1997. The data coverage of the WSS, which provided regular updates on various economic variables, was expanded and its format substantially revised in April 1997. In 1998–99, the Bank introduced a publication called the Handbook of Statistics on the Indian Economy, which provided historical data and current statistics on a wide range of variables. The Report on Currency and Finance became thematic in scope from 1998–99. The surveys conducted by the Department of Statistical Analysis and Computer Services were an important source of data. From October 2002, the negotiated dealing system’s (NDS’s) real-time information on trades in government securities (including treasury bills and repos) and call, notice and term money were made available through the Bank’s website. From February 2003, the website published information on the banks’ minimum and maximum interest rates on rupee export credit and other credit. Updated on a quarterly basis, the information included bank group-wise range of median interest rates. From 2000 to 2002, the IMF carried out assessments of India’s compliance with its transparency code. Its ROSC data module (2002) provided a review of India’s data dissemination practices against these standards, complemented by an in-depth assessment of the quality of country data, including monetary and balance of payments statistics released by the Reserve Bank. The recommendations of the report, including dissemination of monetary aggregates based on residency criterion, a time-series on components of money at a disaggregated level, and supply of more detailed data on services in the balance of payments statistics, were implemented subsequently. A major initiative on building a centralised database management system (CDBMS) as a decision support system was undertaken during 1999–2000. The project was completed in 2002–03. The related webpage was opened to users from within the Bank. In November 2004, the Bank provided web-based access to time series data on key macroeconomic aggregates of the Indian economy to the public in a user-friendly manner through dynamic web-based applications, such as the Database on Indian Economy. In December 2005, the Bank joined the databank hosted by the Bank for International Settlements (BIS). 601

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the reserve bank of india As per the recommendation of the Standing Advisory Group12 and Technical Committee on CDBMS,13 a common webpage called ‘Database on Indian Economy: RBI’s Data Warehouse’ for both internal and external users was implemented on 29 February 2008. For senior managers to track the latest developments on the Indian economy, dashboards were implemented in the Bank’s ‘data warehouse’.

Other Initiatives Some important changes were introduced in the external communication system during 1997–2008. The regular publications of the Bank and circulars and notifications mentioned earlier were the main vehicles of the Bank’s dissemination activity. In addition, the Bank brought out handouts occasionally for the benefit of the general public. For example, in May 1998, the Bank published a handbook of policies and procedures for Indian overseas investment and began notifying ‘citizen’s charters’ in its different departments and offices. In October 1998, a booklet on payment systems was published. Current issues often figured in communication. For example, a Y2K awareness programme was launched in the latter part of 1999. On the midnight of 31 December 1999, a video shoot of the smooth rollover to 2000 was arranged at its national clearing cell in Nariman Point, Mumbai, which was followed up by issuing a press release at 12.15 a.m. on 1 January 2000. Similarly, when the Foreign Exchange Management Act (FEMA) was introduced, related press release in June 2000 carried changes and revisions in the forex management and rules in simple language. FAQs were placed on the website about forex, banking and other related activities. Regional offices, too, held press briefings and issued clarifications on issues of local importance. One such example was the Ahmedabad office during the crisis of Madhavpura Mercantile Cooperative Bank Ltd in 2001 (see Chapter 11). An education drive for depositors of non-banking financial companies (NBFCs) was initiated in 1999–2000. The objective was to inform and empower the depositors of NBFCs so that they could make good investment decisions. Efforts were undertaken to familiarise the public with the security features of genuine currency notes. The Bank held several currency awareness programmes. When a new 500 note was issued in November 2000, some confusion arose regarding the legal tender status of the ‘green colour 500 rupee 602

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communication policy notes’ issued in 1987. Public awareness campaigns, in different languages, were organised to dispel confusion. Security features of various currency notes were given wide publicity in the media, including vernacular newspapers. The Reserve Bank management desired that the awareness programmes use simple content and language to reach out widely. For example, reacting to a design of an advertisement highlighting the key features of genuine notes in May 2001, Governor Jalan pointed out that ‘the communication should capture only those key features ... that would distinguish the genuine ones from the fake notes … [and which the] common man could easily remember’. The Bank also held the Banking Ombudsman Scheme (BOS) publicity campaigns. In 2003– 04, an education campaign on forex facilities was launched. In particular, after the Foreign Exchange Management Act, 1999 (FEMA), provisions of buying properties were publicised in Goa, where there were some irregularities in property dealings by non-residents. For some departments like the Department of Currency Management, the Department of Non-Banking Supervision and the Foreign Exchange Department, such campaigns and publications served well the purpose of dissemination of information.

Interactions with the Public A new initiative was taken by several offices and departments in setting up helpdesks to answer questions from the public. In 2001–02, some regional offices installed an information kiosk to facilitate access to information relating to their offices as well as general information to the public visiting their premises. Wide publicity was given at the regional level to the grievance redressal mechanism. The mechanism provided a forum to the public to seek redressal of their complaints against any department of the Bank. Some regional offices regularly organised workshops on adjudication of defective notes, and detection of forged notes for bankers and officials, representing the police, the Criminal Investigation Department, the Income Tax Department, Railways, Post and Telegraphs, Customs and the chambers of commerce. Notice boards, put up at strategic points in the Bank’s various premises, displayed information of interest to customers. Complaint boxes and public display of the ‘citizens’ charter’ also performed a similar role. The external relations cell in the central office continued to attend to queries received from the media and the public. With a view to establishing a more transparent and effective system of interaction with the 603

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the reserve bank of india members of the public and responding to their queries, a senior officer in the rank of Deputy General Manager was nominated as a nodal officer in some regional offices. In 2000–01, when the Government authorised branches of commercial banks to sell and service relief bonds, information was provided to the public by releasing films through the electronic media. To instil interest in central banking among the wider public, the Bank facilitated visits of students, children and members of the public to its premises. The visitors were offered interactive sessions with the officers, a tour of the monetary museum and a visit to the National Clearing Cell where cheques were processed. Cadet officers from defence institutions were also offered educational visits. For example, in January 2007, around ninety such officers from the Army War College, Indore, visited the the Bank. In July 2007, a multilingual site was launched for the general public (www.rbi.org.in/commonman) with information about the rights to receive efficient banking services at reasonable cost. The site, available in eleven regional languages apart from Hindi and English, gave information on the Bank’s regulations, service charges, lending rates and cheque collection policy, and the BOS. As part of the financial education programme, the Bank participated in October 2007 in a ‘Train Exhibition’. One of the compartments of the train (Azadi Express) displayed information on the evolution and changing role of the the Reserve Bank, Indian currency from 1857 to 2007, and banking: then and now. To mark Children’s Day on 14 November 2007, the Bank created a web page (www.rbi.org.in/financial education) dedicated to financial education for children. This explained banking and central banking concepts through comics and games. Two characters were created for this purpose – Raju, who learns all about banking and shares his learning with his friends in the village, and Money Kumar, who explained central banking. The site also had films explaining security features of currency notes and was available in several regional languages in addition to Hindi and English. Again for schoolchildren, the Bank conducted state-level essay competitions through its regional offices, which evoked an enormous response. Apart from cash prizes, the children were invited by some offices to visit the Bank. The award-winning essays were placed on the Reserve Bank’s website (see Chapter 13). A Young Scholars Award Scheme designed at giving college-going students an opportunity to work as interns in the Bank was also put in place. 604

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Interactions with the Media

The Reserve Bank’s policy regarding communication with the media was revised in 2004. In October 2004, a part of the deliberations in a seminar by General Managers was cited by the media as a policy announcement. Deputy Governor Rakesh Mohan pointed out the inappropriateness of such practices and, in response, in November that year, the rules of communication with the media were revised. From then on, besides the Governor, only Deputy Governors and Executive Directors would make policy announcements on behalf of the Bank; Regional Directors and Chief General Managers in charge of central office departments could make statements on the status of different policies and programmes of the Bank; officers below these ranks could make statements with specific authorisation. While data dissemination was handled by the Department of Economic Analysis and Policy and the Department of Statistical Analysis and Computer Services, the Press Relations Division (PRD) was responsible for information release and handled issues relating to communication.14 The division was upgraded to Department of Communication from 1 March 2008. In January 2006, the Bank, for the first time, included regional media in its customary press conference held after the monetary policy announcement. This was done through video conferencing. In 2006 and 2007, the PRD conducted interactive seminars on banking regulations, monetary policy, securitisation of standard assets, new capital instruments for banks, and commercial banks’ balance sheet, among other subjects. Such seminars, which were conducted earlier on an ad hoc basis, were now a part of the Bank’s regular outreach activity. In 1999, on the initiative of Governor Jalan, steps were taken to point out misreporting in the media to the editors of the newspapers concerned. Similarly, in 2005, the Bank decided to publish on its website rejoinders to the comments and reports that appeared in the media. The Bank arranged, from time to time, interactive seminars for media persons to familiarise them with the basic concepts of central banking. An interactive seminar for senior journalists was also arranged in May 2007, a first of its kind. The workshop was arranged in the College of Agricultural Banking, Pune. The aim was to discuss international best practices in central banking with reference to the Reserve Bank. The Bank also interacted with the international media, for example, with the editor of the Financial Times in December 2003, journalists from The Economist in February 2005, the Italian media in March 2006 and the Indonesian media in June 2006. 605

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Circulars and Notifications The Bank tried continuously to improve the clarity in its publications, particularly circulars and notifications. For example, on a draft circular of the Internal Debt Management Cell (September 2002), Governor Jalan remarked, ‘[L]et us try and make all our circulars more friendly and courteous in tone.’ Similarly, prior to the release of regulations made by the Bank in connection with FEMA, he remarked on a note (13 May 2000), ‘[C]ould we attempt a “citizen friendly” Press Note on the main benefits for Persons/Corporates from the new bill after it comes into effect?’ The various departments in the Bank began consolidating and issuing annual master circulars from 2003–04. The Bank periodically issued instructions to its regulated entities regarding rules and regulations relevant to their operation. To enable them to have all instructions in one place, a master circular was issued, as recommended by the Regulation Review Authority. These were a one-point reference of instructions issued by the Bank on a subject between July and June (the financial year) with a sunset clause (also see Chapter 15). These were issued on 1 July every year and automatically expired on 30 June the next year. The Bank introduced continuous serial numbering of the circulars issued by its operational departments from January 2004, based on the recommendation of the Advisory Group on Financial Regulations,15 enabling them to track the circulars more easily. In December 2006, Governor Reddy met representatives of the financial media to discuss the communication strategy of the Bank. The media responded that the language used by the Bank in its circulars was archaic, neither very clear nor direct, and that the jargon used took time to understand. They recommended a simpler language and more direct and briefer documents. An attempt was made to fine-tune the communication policy based on the feedback received in this meeting. A change was also needed in the timing of circulars. Generally, important press releases and circulars, which had a bearing on the market, were released after the market was closed. In the senior management meeting held on 15 April 2004, Deputy Governor Mohan emphasised the need for issuing press releases and circulars well in time to be covered in next day’s newspapers, which was put into practice subsequently.

Website The Bank extensively used its website for dissemination of information. Access to notifications, press releases, speeches and data was provided 606

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communication policy through the website. Efforts were made to create portals of information on the Indian economy, banking and finance through the website. The Bank also used the website to obtain feedback on its policies from market participants. From 1997, the Bank placed draft regulations, guidelines and reports of various committees in the public domain before they were finalised to elicit their views. The Bank’s website, http://www.reservebank.com (later renamed https:// www.rbi.org.in), became operational on 17 September 1996. Several regional offices maintained their own web pages. The Bank’s periodical publications were placed on the website. In September 1998, a search engine was added on the site. On 11 December 1998, the monetary museum website was inaugurated, presenting India’s monetary heritage to Indian and international viewers. The website in Hindi was launched on 2 January 2001. During 2001–02, the Bank added two new features to its website to make it more user-friendly. Visitors could register on the website and receive the desired information through e-mail as soon as these were published online. Visitors could also personalise the site to access the sections that they wanted to view regularly. A query facility was provided for exchange rates. In September 2002, the Bank’s website was upgraded and, soon after, a comprehensive study to evaluate the content and quality was undertaken through a London-based firm. The study rated the Bank’s website in relation to the websites of eight central banks and major international financial institutions, using parameters such as effectiveness, design, navigation, content, use of technology, contact information and the home page as a gateway to information. The overall rating of the site was satisfactory. However, it was not found to be very useful and friendly for the bank customers and the public at large. Inconsistent navigation, confusing search engines, breadcrumb tracking system, lack of adequate summaries and non-specialised material were some of the areas suggested for improvement. The Bank refurbished the site and the new website was launched in August 2005. To make the website more useful for the general public, it was made multilingual and made available in all major regional languages. The multilingual website was released in June 2007, which had instructions issued by the Bank on banking matters, customer grievance redressal mechanism and the Right to Information Act. The website also had a section explaining the role and functions of the Bank, interesting aspects of currency, and the Bank’s history. 607

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Response to Communication Quality The users of the Bank’s communication included financial institutions (FIs), market participants, media, the public, academics and researchers, among others. Their assessment of quality and coverage of the Bank’s monetary policy communication was mixed. There were suggestions and criticisms, which the Bank tried to address. For example, the IMF suggested in 2007 that the ‘monetary policy reviews could elaborate further on the inflation and demand– supply outlook, including through eventual publication of the inflation expectations survey, to guide expectations’.16 Hélène Poirson of the IMF wrote that the review of monetary policy (2006–08) had ‘reduced transparency and weakened the policy signals introducing confusion among market participants’, suggested a shorter review of under two pages (implemented subsequently), and recommended more efforts to clarify the Bank’s approach to associations such as the Fixed Income Money Market and Derivative Association of India (FIMMDA).17 Market participants, too, sometimes felt that the Bank needed to clarify its approach on exchange rate policy and forex.18 The assessment of other publications of the Bank, too, was not without adverse observations. On the macroeconomic and monetary development statement, which accompanied monetary policy statements, the IMF noted that ‘the discussion … tends to be backward looking’, and recommended inflation forecasts.19 The language followed in the circulars, notifications and other publications came in for criticism, as we have seen (see the earlier discussion on ‘circulars’). Over the years, the Bank took note of the comments and tried to improve its communication.

The Monetary Museum The Bank set up a monetary museum in Mumbai open to the public. The museum exhibits representative collections of coinage, paper currency, financial instruments and curiosities down the ages across Indian history. The main exhibit sections of the museum relate to concepts, ideas and curiosities; coinage – from coins to bank notes – and the advent of banking in India; the Reserve Bank’s functions; and currency management. The monetary museum website was inaugurated on 11 December 1998. The site was the culmination of the Bank’s endeavours to document and present India’s rich monetary heritage. The site aimed at depicting the evolution of money and banking in India. It includes representative Indian coinage from ancient times 608

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communication policy to the present, a retrospect of Indian paper money and other facets of India’s financial history, like indigenous banking, financial instruments like hundi, share certificates and early general promissory notes. The President of India, A. P. J. Abdul Kalam, inaugurated the museum on 18 November 2004, which was thrown open to the public from 1 January 2005 onwards.

Internal Communication Governor’s Letters

The Governor’s New Year Message to the members of staff was a channel of internal communication. For example, Jalan’s letters discussed reorientation towards customer service (1998), improvement in work culture and measures taken to improve interaction with staff members (2000), and the need to reduce unproductive paperwork (2002). Reddy’s messages reminded staff members of the need to focus on the quality of work, and to ensure clear and comprehensible communication (2004), highlighted work–life balance, teamwork and financial inclusion (2006), and urged more professionalism and team spirit (2007). His last letter of 2008, which stated, ‘… during the year we may cease to be colleagues but we will continue to be friends’, struck an emotional chord.

Handbooks and Manuals Following a recommendation by an internal group, the Bank issued in 1998 a handbook on usage and style in written communication. The handbook was meant to be followed in all of the Bank’s written communication. The internal manuals of the Reserve Bank laid down the rules and regulations of work processes in different departments. The manuals of the Public Debt Office and the Public Accounts Department were revised in 1999 and that of the Deposit Accounts Department in 1998, which were the constituents of the Banking Department. Similarly, the general administration manual, which provides guidelines for accounting, establishment and administrative procedures to be followed by all departments, was revised in 2000. When the Right to Information Act came into force in 2005, a seminar was organised in Mumbai for nodal officers on the need for improving communication protocols to ensure compliance with the provisions of the Act. 609

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Regional Directors’ Conference The Bank organised a Regional Directors’ conference every year to achieve an effective interface mechanism between the top management, and the heads of regional offices and of its central office departments. The focus of the conferences in the 1980s used to be the industrial relations climate, discipline in the offices and housekeeping. In the 1990s, the emphasis was on technological upgrade and computerisation of offices. From the mid-1990s, the conferences discussed and debated policy issues, and thus provided regional perspectives and useful inputs for designing policy initiatives. In 2005, the Regional Directors’ conference was, for the first time ever, held off-site at Madh Island, Mumbai. Eminent speakers from corporate and academic fields were invited. The informal atmosphere and surroundings aided free and frank discussion. In November 2006, Governor Reddy, along with the Deputy Governor Mohan, discussed with senior journalist T. C. A. Srinivasa Raghavan issues relating to the Bank’s communication policy and the approach to media relations. One of the points discussed was that the Regional Directors could play a greater role in the dissemination of information to the media. To enable the Regional Directors to interact often with the management, Deputy Governor Mohan suggested in this meeting the introduction of video conferencing facility in a few offices of the Bank. All the major offices were linked to a teleconferencing facility subsequently.

Library The central library of the Bank in Mumbai, attached to the Department of Economic Analysis and Policy, played an important role in the storage and provision of information services within the Bank. The library provided information support to various departments, training colleges and libraries in the regional offices. The library had a collection of about 64,686 books, 25,938 government publications, 4,425 working papers and 12,633 back volumes of journals at the end of June 2008. It also maintained electronic databases (offline), besides an online database of 29,148 journal articles, and received 368 technical journals. While the number of books and documents in physical form came down almost by half, electronic access to such publications increased manifold from 1997 to 2008. 610

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RBI Newsletter and Without Reserve The RBI newsletter contained information on various developments taking place in different departments and offices. It started in November 1974 and was published fortnightly. The senior management committee, in a meeting held in August 1998, decided that a column, ‘Letters to the Editor’, should be introduced in the RBI newsletter to publish letters from individual staff members about their observations relating to work. The first letter to the editor was published in the newsletter on 15 October 1998. Without Reserve, an in-house magazine, commenced in 1968, which provided a platform for the staff to share their views, experiences and writings, improved its content and canvas during the period. Some of the regional offices had their own in-house magazines. For example, the Chennai office, under the leadership of Regional Director F. R. Joseph, launched an in-house journal titled Horizon in 2005.

Other Channels Periodic letters called ‘monthly demi-official letters’ addressed by the Regional Directors to the Governor apprised the top management about the regional issues. Similarly, heads of the departments of the central office wrote monthly letters to their counterparts in the regional offices, explaining the rationale of policy and regulatory measures initiated during the month. During 2007–08, the Bank initiated a regular interface mechanism in the form of knowledge-sharing lectures wherein leaders from the financial and corporate world were invited to share their knowledge and experience with the Bank’s officials on a wide range of critical issues. This knowledge-sharing helped not only broaden the perspective but also enabled the Bank’s officers to reinvent themselves to meet the dynamics of new roles and functions. Several interactive lectures were organised by the Bank under the ambit of this series.

Conclusion The communication policy of the Bank received special impetus during the period covered in the book. The Bank tried to become more transparent and less opaque. Besides, the dissemination policy placed emphasis on quality, clarity and timeliness of information release. The Bank management, being conscious of the crucial role of communication in the conduct of its monetary, 611

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the reserve bank of india regulatory and supervisory initiatives, focused on enhancing the coverage, quality and format of information dissemination. Both external and internal communication received importance.

Notes

1. Rakesh Mohan, ‘Communication in Central Banks: A Perspective’, RBI Bulletin, October 2005. 2. See https://www.rbi.org.in/scripts/CommunicationPolicy.aspx. 3. Reserve Bank of India (RBI), The Reserve Bank of India, Vol. 4: 1981–1997 (New Delhi: Academic Foundation, 2013) provides a detailed account of communication channels from 1935 to 1997. 4. Under the chairmanship of Deputy Governor, RBI and Secretary, Economic Affairs, Government of India as alternate chairman. 5. International Monetary Fund (IMF), ‘India: Report on the Observance of Standards and Codes (ROSC) – Data Module’, 2 April 2004, available at https://www.imf.org/en/Publications/CR/Issues/2016/12/30/India-Reporton-the-Observance-of-Standards-and-Codes-ROSC-Data-Module-17309. 6. Chairman: Nitin Desai. 7. Mohan, ‘Communication in Central Banks’. 8. To assist the SCIFSC, the Advisory Group on Transparency in Monetary and Financial Policies was constituted with M. Narasimham as chairman and S. S. Tarapore as a member. 9. See RBI, The Reserve Bank of India, Vol. 4, for details. 10. There were three important lecture series, namely C. D. Deshmukh Memorial Lecture (since 1984), L. K. Jha Memorial Lecture (since 1990) and P. R. Brahmananda Memorial Lecture (since 2004). 11. Reserve Bank of India, The Reserve Bank of India, Vol. 3: 1967–1981 (Mumbai: Reserve Bank of India, 2005). 12. Chairperson: R. B. Barman. 13. Chairperson: K. S. R. Rao. 14. The current names of these departments are Department of Economic and Policy Research (DEPR), Department of Statistics and Information Management (DSIM) and Department of Communication, respectively. 15. Chairperson: K. J. Udeshi. 16. IMF, ‘India: 2007 Article IV Consultation – Staff Report; Staff Statement; Public Information’, IMF country Report No. 08/51, February 2008. 17. Hélène K. Poirson, ‘Monetary Policy: Communication and Transparency’, in India: Managing Financial Globalisation and Growth, ed. Kalpana Kochhar and Charles Kramer, 221–43 (New Delhi: BS Books, 2009). 612

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communication policy 18. Money Market Review, July 2009; EPW Research Foundation, ‘Whither Exchange Rate Policy?’ Mumbai, 2009. 19. IMF, ‘India: Selected Issues’, Country Report No.08/52, February 2008.

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15 Organisational Change

Introduction During the period under reference, globalisation, rapid economic growth, advances in information technology (IT), new responsibilities and increasing public scrutiny of its policies and functions posed enormous challenges to the Reserve Bank’s organisational set-up. At the same time, there was a fall in staff size. The Bank addressed new challenges by trying to upgrade the skills, technical expertise and professionalism of its employees, by means of in-house and external training, and strategic changes in placement and recruitment policy. Employee welfare measures received special attention, and efforts were undertaken to make the Bank’s compensation package competitive and attract talented individuals to its service. Mechanisation and computerisation, especially in the operational departments, were accorded top priority. A few new regional offices were opened after the formation of new states. And new departments were carved out to address emerging challenges. The system of internal inspection and audit was changed to adopt a risk-based approach of surveillance. Alongside, accounting norms were strengthened, and annual accounts of the Bank became more transparent in terms of dissemination of information relating to the composition of the balance sheet, valuation practices, changes in accounting practices, and different sources of income and expenditure. The present chapter outlines these changes. The chapter is divided into ten main topics: the boards and committees, central and regional offices, new departments, human resource and staff matters, IT, rationalisation of systems and procedures, audit, inspection, balance sheet and ownership of institutions.

Boards and Committees The Central Board of Directors carries out the general superintendence and provides direction to the affairs of the Bank. The Board is appointed by 614

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organisational change the Government of India in keeping with the provisions of Reserve Bank of India (RBI) Act. There are official and non-official Directors. While the former comprises the Governor and the Deputy Governors, the latter consists of Directors nominated by the government. Of these, ten are drawn from various fields, one is a government official and four are nominated from the local boards.1 There are four local boards – Western, Eastern, Northern and Southern. These boards are set up to advise the Central Board on local matters, to represent territorial and economic interests of local cooperatives and banks, and to perform such other functions as delegated by the Central Board from time to time. The Central Board holds about seven meetings in a year, the prescribed minimum being six, and at least one in each quarter. In terms of operational significance, two of these meetings are particularly important. One of these is the meeting in August in Mumbai to finalise the annual accounts.2 The second is held in New Delhi soon after the presentation of the union Budget. In this meeting, the Finance Minister discusses implications of budgetary measures, especially for the Reserve Bank. Since the Central Board meets about once in two months, the Bank has set up a Committee of the Central Board (CCB) to address administrative issues more frequently. The CCB meets every week (generally on Wednesdays). The members of the CCB are the Deputy Governors and one or two Directors of the Central Board. The Governor chairs both the Central Board and the CCB meetings, while the Executive Directors are invitees to the meetings. Besides the CCB, the Bank has set up two boards – the Board for Financial Supervision (BFS) and the Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) – to assist the Central Board. Three subcommittees provide support to the Central Board on matters internal to the organisation. These are the Staff Subcommittee, dealing with staff related issues; the Building Subcommittee, dealing with building projects; and the Inspection and Audit Subcommittee for monitoring the internal audit and inspection exercises. Directors of the Central Board are made members of these subcommittees. The chairpersons of the subcommittees are generally the non-official Directors. The proceedings of the meetings of the subcommittees were earlier reported only to the CCB. In 2007, for the first time, the Central Board reviewed their work at its meeting held in Ranchi in October. Reports on the working of the BFS are now reviewed by the Central Board at half yearly intervals while that of the BPSS, annually. 615

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the reserve bank of india The major policy decisions are taken at the level of the Central Board, CCB, the Governor or the Deputy Governors, while decisions relating to other issues are generally taken at the levels of Executive Directors or Chief General Managers in charge of the central office departments. Powers of decision-making are also delegated to lower level officers, depending upon the nature and importance of the matter. In addition, there are several committees and subcommittees to address the day-to-day administrative and policy issues. For example, the senior management meeting is held frequently, which is attended by the Governor, Deputy Governors, Executive Directors, select Chief General Managers and Regional Directors (RDs) on a rotation basis. The Deputy Governors’ Committee meets weekly to address matters related to more than one department. The inspection reports of offices, branches and central office departments of the Bank are discussed in an Executive Directors’ Committee for follow up. Committees of select Chief General Managers are also in place to address specific technical matters. Annual Regional Directors’ conference is another forum where important issues are deliberated upon and decisions are taken subsequently. Financial powers under the Expenditure Rules, 2005, were exercised by the Executive Directors’ Committee. The powers to be exercised are clearly defined in the relevant circulars, manuals, rules and other aiding documents in the case of certain functions, such as passing of bills and making payments as well as the compounding of contraventions in the Foreign Exchange Department. Level jumping is not uncommon in certain work processes where an element of urgency is involved. During the reference period, the functions of local boards were reviewed. In the past, different views had emerged on the role of local boards; one view was that they were not very significant and should be abolished while others held that they provided useful feedback to the Central Board on local issues and played an advisory role.3 But the local boards continued to exist. In a Central Board meeting held in Chennai on 15 July 2002, a proposal was made to redefine their role and have uniformity in their working. In the new arrangement, the local boards were relieved of the burden of administrative work, including financial sanctions, and made responsible for the review of the urban cooperative banks (UCBs), non-banking financial companies (NBFCs) and customer service in regulated entities and within the Reserve Bank. It was also decided that detailed inspection reports of UCBs falling in their jurisdiction would be made available to them. By January 2003, the new frame of responsibilities for the local boards was in place. 616

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organisational change

Central Office and Regional Offices The central office of the Reserve Bank is in Mumbai, with twenty to twenty-six operational departments during the period of study. There are regional offices and sub-offices in almost all state capitals (except a few in the northeastern states) and more than one office in some states such as Maharashtra, Uttar Pradesh and Kerala. During the period under reference, the Bank opened sub-offices in Dehradun and Raipur on 30 June 2006 and 2 January 2007 for the states of Uttaranchal (since renamed Uttarakhand) and Chhattisgarh, respectively.4 The sub-offices were intended to focus on issues relating to rural credit and cooperative banks in the respective states. The sub-offices initially had two departments, the Rural Planning and Credit Department (RPCD) and the Urban Banks Department (UBD). In October 2006, the Lucknow sub-office was granted the status of an independent office of the Bank, with the creation of an independent jurisdiction of the issue circle at Lucknow and clear demarcation of functional jurisdiction between the Kanpur and Lucknow offices. The Bank opened sub-offices in Shimla and Ranchi on 2 July and 15 November 2007 for the states of Himachal Pradesh and Jharkhand, respectively. The sub-offices initially had only one department, the RPCD with a Financial Inclusion Cell. In the 4th senior management meeting held on 2 June 1998, it was decided that the regional offices of the Bank, instead of acting as branch offices, should act as full-fledged offices of the Bank. That is, there should be a delegation of more powers. The heads of regional offices were, so far, placed at the level of Chief General Managers. It was felt that the posts of heads of these offices should be made more attractive, including the change in names of the heads of regional offices from ‘Manager’ to ‘Regional Director’ (RD). During the Chief General Managers’ conference of December 1998, participants were asked to suggest what powers could be delegated. At the same time, an internal group was set up within the Department of Administration and Personnel Management (DAPM) to suggest the delegation of powers to RDs with respect to subject matters ranging from leave sanctioning to welfare and medical-related matters. Although the regional heads oversaw their respective regional offices, some of the departments earlier directly reported to the central office. From April 1998, this system came to an end, and the RDs assumed responsibility for all the departments in their offices. The re-designation of the heads of regional offices as RDs came into effect from January 1999. Monetary and non-monetary benefits to RDs were enhanced so that the posting was accepted willingly. 617

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the reserve bank of india In mid-2001, a review of the delegation of powers revealed that the process of the delegation did make the functioning of the regional offices more independent and effective and that the decentralisation had strengthened the authority of the RDs in the areas under their jurisdiction and in banking circles. To improve the interface between heads of the regional offices and the central office departments, the Bank held the Regional Directors’ conference every year. From 2005, the conference was organised outside the Bank premises either in Mumbai or other places in an exclusive setting. While brainstorming sessions were held on many internal issues, distinguished speakers and management experts were invited to share their experiences on topics of interest to the Bank. These helped change the approach and attitudes of senior officers. They became more open and more freely exchanged views; all participants wore casual clothing. The informality of the atmosphere and the cultural programmes organised during the events enhanced their sense of belonging to the institution. As the heads of the Bank’s central office departments also participated in the conference and the focus of the discussion and debate at the conference was both on the issues of regional offices as well as on central office departments, it was decided to re-designate this annual meet as Senior Management Conference (SMC) from 2007. The Reserve Bank staff also benefited from the several technical committees that were set up during this period, comprising eminent members from outside, to understand the issues better and refine the Bank’s response. In fact, Governor Reddy’s initiative of relying more on the contribution of committees, working groups and external experts brought about a discernible organisational shift towards more participative, transparent and collaborative work, which reflected in the Bank’s policies as well as in its working and functions.

Organisational Realignment and New Departments As the economic liberalisation process unfolded in the 1990s, the Bank was in need to restructure its organisation and play a more effective role. Although some efforts were made by the Bank to realign its organisational structure in the mid-1980s, a comprehensive planning exercise was undertaken only in 1992. A consultancy firm was engaged for the purpose. The objective was to set out a roadmap to redefine the role and to review internal organisational structure and improve managerial efficiency. 618

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organisational change Several old departments were either wound up or merged with other departments as their functions became redundant. At the same time, many new departments were set up. For example, as the credit authorisation scheme (called Credit Monitoring Arrangement subsequently) was abolished, the Industrial and Export Credit Department was closed (1 July 2004) and its functions were distributed among other departments. Banking supervisory functions became important because of the rise in banking activities, technological advancement and sophistication in financial instruments. Therefore, the Department of Supervision, which was set up in 1993, was converted into the Department of Banking Supervision in July 1997. And the Department of Financial Companies was transformed into the Department of Non-Banking Supervision as statutory provisions governing the NBFCs changed. The Credit Planning Cell, responsible for the formulation of monetary policy and other policy initiatives, was expanded into a Monetary Policy Department on 1 January 1998 in view of the ever-increasing complexity in monetary policy formulation. The Financial Markets Department was set up in July 2005. The FMD would undertake monetary and liquidity management operations as well as regulation and development of money market instruments and over time would cover the Bank’s operations in the domestic foreign exchange market, while the IDMD would largely focus on managing the market borrowing programmes of the central and state governments. The Bank constituted a Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) as a committee of the Central Board in February 2005 in order to strengthen the institutional framework for regulation, and supervision of payment and settlement systems that form the basis of the financial system. It then became necessary to create a separate administrative set-up for carrying out the functions entrusted to the BPSS. A new department – the Department of Payment and Settlement Systems (DPSS) – was constituted with effect from 7 March 2005 for this purpose, taking over the related work from the Department of Information Technology (DIT). Another new department, the Customer Service Department, was created in July 2006 to bring together all activities relating to customer service.5

Matters Relating to Human Resources Recruitment and Staff Size

The Staff Subcommittee generally decided the number of employees to be recruited, with the help of inputs received from the Human Resources 619

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the reserve bank of india Development Department (HRDD). There were two streams of recruitment of officers – one for operational departments, commonly called the ‘general side’, and another for specialised departments such as Economic, Legal, Premises, Rajbhasha, Security and Statistics. These streams had their own seniority and promotional avenues. During the latter part of our reference period, there was an effort to explore the possibility of unifying the cadres under a common recruitment and seniority system. The issue was also deliberated in the Regional Directors’ conference in 2004. However, the proposal did not find favour. For, the departments dealing with operational aspects and specialised departments were presumed to be in different verticals requiring distinct job skills; combining them, and the consequent unavoidable interdepartmental transfers, would render it difficult for the staff to acquire specialisation, which would eventually impinge on the discharge of their duty effectively. The Reserve Bank of India Services Board (RBSB) was responsible for the recruitment of officers for the Bank. Officers were placed in six grades (A–F). Class III and IV employees were recruited at the regional level. The number of vacancies at each regional office, the scheme of the written examination, and other related matters were communicated to the regional offices by the HRDD, after analysing the inputs received from the regional offices. The Bank experimented with recruiting specialised staff on a contract basis to meet the changing needs. While reviewing the recruitment exercise of officers, Governor Jalan directed (26 June 1998) that the Bank should recruit an adequate number of specialists with professional qualifications, such as chartered accountancy or business management, for performing off-site surveillance-related tasks. In June 1999, the CCB approved a scheme whereby campus recruitment and appointment of specialists on a contract basis was introduced. In November 2002, terms and conditions for engaging the services of experts and specialists on a contract basis were standardised. However, only in 2006 fifteen IT experts were recruited, and no one was appointed under the scheme of campus recruitment during the period under reference. During the period covered in this book, the practice of recruiting officers only at Grade B level at the entry stage was continued. The yearly average intake of Grade B officers remained around eighty during the period. Grade A positions were filled up by promoting Class III employees. Class III recruitment was in single digits from 2004 to 2006. The recruitment of Class III staff was kept limited to the special recruitments, such as under sports quota and on compassionate grounds. This was partly because of the reduced 620

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organisational change need for clerical work of posting, checking, computing, typing and manual passing of vouchers with the growing use of computers. Mechanisation received impetus at the beginning of the 2000s, especially in the area of currency note processing, as the declining staff strength of Class III affected the functioning of some departments, such as the Issue Department (Kolkata office in particular), which posed a challenge to the Bank. Also, the Bank was trying to make the institution ‘officer oriented’, as service conditions of officers provided more flexibility. New entrants under Class IV, too, were lower in tune with the changed work processes. Recruitment of Classes IV and III came down also because the families of the deceased preferred the option of compensation package to employment in the Bank after the monetary benefits were improved significantly. With these changes, the overall staff strength of the Bank declined from around 33,000 in 1997 to 21,000 in 2008, while the size of the officers’ category initially decreased but subsequently went up, mainly through internal promotion and fresh recruitment (Table 15.1). In August 2003, an ‘Optional Early Retirement Scheme’ was initiated. The scheme was closed by the end of December 2003.6 The scheme made Table 15.1 Staff Strength and Staff Recruitment    

Class I

1998

6,953

1997 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

7,024 7,481 7,881 7,342 7,261 6,128 5,208 5,885 6,819 7,760 8,760

Staff Strength at End of December Class III

Class IV

15,123

9,550

16,007 14,641 13,837 13,324 12,570 10,644 9,810 8,773 7,522 6,268 4,908

Staff Recruitment during Year Ending December

Total

Class I

Class III

Class IV

Total

31,626

60

103

299

462

80

90

10,053

33,084

9,615

31,737

128

29,922

40

9,557 9,256 9,053 8,222 7,709 7,534 7,569 7,466 7,284

Source: RBI, Annual Report, various years.

31,275 28,884 24,994 22,727

62

76 68 88

22,192

106

21,494

29

21,910 20,952

140 91

19

267 69 13 22 9 7

345 225 201 105 45 37 44 34

8

212

2

81

10

97

426 620 371 214 134 127 141 147 360 136 174

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the reserve bank of india the Bank slimmer. At the same time, the number of Grade F officers under the general side (Common Seniority Group) was doubled during 1997– 2008 because of the creation of additional posts in the regional offices, and the upgrading of a few Banking Ombudsman positions to Grade F. These measures further increased the ratio of officers to workmen.

Promotion

The responsibility for promotion was shared between the RBSB and the top management. Promotions up to the Grade C level were handled by the RBSB. While the chairman of the RBSB chaired the interview board for promotion to Grade D, others in the interview board included members of the top management. Officers of Grades E and F, as well as Executive Directors, were selected exclusively by the top management. The parameters for selection and the weights assigned to them were not similar across cadres. For promotion to Grade B, supervisory skills, initiative and job-related knowledge were tested. For Grade C, communication skills, decision-making and analytical abilities were added. Grades D and E required additional qualities, such as leadership, skills of interpersonal relations, and good personal etiquette. Promotion to Grade F was based on the candidate’s interview before a panel comprising the Governor and the Deputy Governors. In January 2001, the procedure of promotion to the post of Executive Directors was reviewed, and it was decided that the committee of Governor and Deputy Governors would review the contribution and achievements of the eligible Grade F officers in the ratio of 1:2, and call for an interview, if necessary, before selection. In 2007, the minimum residual service of three years became one of the eligibility criteria for promotion to the post of Executive Directors. The promotion policy for officers in the general departments was broadly based on the recommendations of the Marathe Committee (Expert Committee on Human Resources Development, 1994), which recommended, inter alia, replacing the existing selection process based on ‘seniority-cum-suitability’ by a system of ‘seniority-cum-merit’. Between 1996 – when a promotion policy for officers was framed – and 2007, the policy and associated rules were reviewed and reformed many times to make the process more attuned to the needs of the organisation and profiles of the individuals. For example, in August 1999 the promotion policy was revised, introducing, inter alia, (a) a system of personal promotion (drawing salary of next higher grade with no change in designation and job responsibility) 622

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organisational change for officers in Grades A and B to Grades B and C, respectively, (b) two-stage promotion scheme from Grades D to E, providing for a personal promotion after two years and a merit promotion thereafter, and (c) increase in the weight of interview marks. The performance appraisal system or confidential reports were revised several times during 1997–2008, in line with changes in the role of the Bank. In the new system, the staff members were assessed more objectively, informed of adverse remarks, if any, and counselled. The practice of taking into account performance appraisal reviews of three years created distortions in the final selection, as marking and rating systems were not uniform across centres and officers, and caused some discontent with regard to promotion to Grade C in 2001.7 Therefore, it was decided (2002– 03) that the best three reports of the immediately preceding five years in the same grade would be considered for promotion. From 21 November 2005, an assured personal promotion (after five years of service) would replace promotions up to Grade C. In 2006–07, a new performance appraisal review system was introduced for members of staff in the Class III cadre to improve transparency and objectivity of the process of appraisal. Claims to promotion caused occasional controversy at top-level appointments. A notable episode was the appointment of K. J. Udeshi, the first woman Deputy Governor, on 10 June 2003. On the same date, Executive Director K. L. Khetarpaul sought voluntary retirement. Both had been Executive Directors of the Bank, Khetarpaul being technically senior to Udeshi. A Parliamentary question sought clarification on why the former was superseded.8 The appointment of Deputy Governor was made by the Government of India at its discretion. It was explained in the response that ‘the post of Deputy Governor was outside RBI cadre, and seniority in RBI was not a deciding factor in such appointment’. Another notable episode occurred during the appointment of Usha Thorat as Deputy Governor in 2005. Executive Director P. K. Biswas, who was superseded, filed a writ petition in the High Court of Delhi for setting aside and quashing the government’s notification dated 10 November 2005. The writ was dismissed and, subsequently, an appeal before a Division Bench of the High Court was also dismissed. The court explained that ‘it is clearly established from the provisions of Section 8 [of RBI Act, 1934] that it is not a promotional post but is an appointment to be made by the Central Government’. There was another instance. The Bank had introduced a scheme of granting personal promotion to the deserving officers who could not be promoted in the normal course. Under this scheme, the officer would receive the benefits of pay and perquisites 623

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the reserve bank of india applicable to the immediate higher grade, but without any up-gradation of job content and change in functional designation. In November 2005, recognising his contribution, the Bank promoted Executive Director R. B. Barman as Deputy Governor in ‘personal capacity’. This led to his becoming the fifth Deputy Governor. The RBI Act, 1934, provides for not more than four Deputy Governors and the power to appoint Deputy Governors in the Reserve Bank is vested with the government. Therefore, the government objected to the elevation of Barman as Deputy Governor. The order of promotion was subsequently modified to state that Barman would continue as Executive Director but draw the emoluments of a Deputy Governor. The promotion avenues available for Class III employees were (a) within the cadre, (b) to non-clerical/technical cadres, (c) to officers (merit-based fast track) and (d) to officers (seniority-cum-merit). However, the waiting period for a Class III employee to become an officer was long. The Bank maintained that its career progression could not be compared with that of banks and companies as promotions and their periodicity were organisation-specific. Following the Bank’s decision to confine direct recruitment only to Grade B posts, 10 per cent of the vacancies in Grade A earlier allocated for direct recruitment was distributed between the qualifying and merit channels for promotion to Grade A in September 1998. An internal study group considered the career progression of Class III employees and discussed the matter with the All India Reserve Bank Employees Association (AIRBEA). After this process, the promotion scheme of Class III was modified to make it more liberal and performance oriented. Class IV employees, too, had an opportunity of progressing within the cadre as well as being promoted to Class III and further. There were several attempts to rationalise and improve promotional chances for employees of the specialised cadre. For example, in 1996–97, a working group was set up to review the career progression of security and protocol, lounge, Rajbhasha, and technical staff. A similar committee was formed in March 2000 to examine and suggest career progression for pharmacists. The avenues for promotions for the specialised cadre of staff were since then gradually expanded by either upgrading some of the positions in the existing stream or allowing them to switch over to the general side.

Transfer and Deputation

The Bank’s transfer policy by and large was based on the recommendations of a committee under the chairmanship of M. S. Patwardhan, former Director 624

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organisational change of the Central Board, which submitted its report in 1996. The aim of the transfer was to fill up vacancies and provide the officers exposure to different work environments and functional areas. Transfers to ‘hardship centres’ such as Guwahati were incentivised. In August 2000, the policy was revised in an attempt to convert transfer into a policy instrument, minimise dislocation and the associated inconvenience, and dovetail placement with the transfer. A further review was undertaken on 6 June 2002 by Governor Jalan, and Deputy Governors Reddy and Vepa Kamesam, and it was decided that the system be maintained. The policy was again taken up for review in 2005 but no major change was effected. The policy of deputation underwent a major change during 1997–2008. Earlier, a deputation of officers to outside agencies did not follow a well-defined policy, though the Bank regularly deputed its officers to the government, other financial institutions (FIs), the IMF and other central banks. The Bank also deputed individuals as Chief Vigilance Officers in banks and FIs on requests received from the Ministry of Finance. The scheme remained selective as the provisions under the Reserve Bank of India (Staff ) Regulations, 1948, were restrictive. In a departmental review meeting in 1998, Governor Jalan stressed the need for a flexible and ‘open-door’ policy for its officers to leave the Bank for better prospects elsewhere. Such officers, in his view, could be permitted either to retain lien against their job, or treated as if on deputation, for a period of three to five years. In June 1999, a scheme of exchange of officers between the Reserve Bank and public sector banks was introduced. From 1 March 2000, the scheme for deputation and secondment was streamlined and rationalised by amending the RBI (Staff ) Regulations. The revised scheme allowed, in addition to existing schemes of the deputation, self-sought secondment. Many officers made use of the opportunity of serving in foreign central banks and FIs. From 1997 to 2008, sixty-one officers were sent on foreign deputation and secondment.

Training The Bank had schemes for higher studies (sabbaticals), including distance education courses, for officers, which was revised. Norms for officers going abroad for training, study visits, seminars, conferences and workshops were liberalised. Foreign training opportunities were earlier few and far between and concentrated in specialised activities of the Bank. 625

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the reserve bank of india Since 1998, the focus of foreign training was shifted from ‘Broad Spectrum Programmes’ to ‘Functional Programmes’. Governor Jalan directed in June 1999 to expand the scope of foreign training to include some of the elite universities in the United States (US) and the United Kingdom and emphasised that officers in regional offices and women officers should be given preference. As the practice of departments directly dealing with the deputation of officers for foreign training caused multiple nominations, in June 2000, the related work was centralised in the Training Division of the HRDD, which tried to ensure that all officers were given an equal opportunity. A condition was applied that the nominated officer should not have attended a foreign training before. Governor Jalan wrote on a note put up by the Department of Economic Analysis and Policy (DEAP) in September 2000 and nominating an officer for an IMF course ‘on the basis of his not having any foreign exposure earlier’ that ‘the main criterion should be that the training should help the officer in doing his present or future job in RBI’, and not whether he or she had been on another foreign training programme before. With these changes, the number of officers sent abroad for training, sabbatical and scholarship gradually rose from around 100 in 1997–98 to 520 in 2007–08. Although the expenditure rose, too, per capita annual spending for training was below 7,000, and the proportion of officers trained abroad remained less than 5 per cent of officers in Grade B and above in any year. A number of officers who received training in the Bank training establishments rose from 119 in 1997–98 to 895 in 2007–08. Special efforts were made to circulate ‘Aide Memoirs’ of foreign training. On a feedback report submitted by G. S. Bhati, Adviser, MPD, on a course in US monetary policy implementation held in June 1999, Governor Jalan asked, ‘How do we make available these papers to a wider audience? Should we think of a shelf in the Library where the background papers can be parked for 3-6 months and then returned to the officer concerned?’ This suggestion was implemented immediately. Subsequently, such reports were also made available through the intranet. In November 2004, a new incentive structure was designed whereby employees who acquired professional qualifications relevant to the job became eligible for fee reimbursement up to 200,000. In early 2006, the training needs and other related issues were addressed by an ‘organisational climate survey’ at the instance of Governor Reddy.9 As for domestic training, the Bank had three colleges. These were the Bankers’ Training College (BTC), Mumbai; the Reserve Bank Staff College 626

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organisational change (RBSC), Chennai; and the College of Agricultural Banking (CAB), Pune. The BTC was meant to train personnel of commercial banks and other FIs in India, particularly middle- and senior-level officers. Reserve Bank officers, too, attended programmes relevant to them. The RBSC was established (1963) to impart training to the Bank’s own officers in junior and middle management cadres. Specialised programmes were also held for skill development of the senior management cadre. The CAB was originally set up with a focus on training senior- and middle-level officers of rural and cooperative credit sectors. The CAB subsequently diversified into areas relating to NBFCs, human resource management and IT. A committee consisting of the principals of the three training colleges, the Chief General Manager, HRDD, and a faculty member from each college was in place to discuss matters of mutual interest. Besides these institutions, four zonal training centres (ZTCs) conducted training of Class III and IV staff of the Bank. Officials from foreign countries, including central banks of Bhutan, Bangladesh, Iran, Maldives, Nepal, Nigeria, Philippines, Sri Lanka, Sudan, Tanzania and Uganda, were provided training and study attachment facilities at the Bank’s training establishments or central office departments. The Bank played a significant role in holding workshops and seminars for the participants from the South Asian Association for Regional Cooperation, or SAARC, countries.10 Besides, some departments of the central office organised department-specific training programmes, sometimes inviting foreign speakers. The Bank was also associated with the promotion of four institutions – Indira Gandhi Institute of Development Research (IGIDR), Mumbai; the National Institute of Bank Management (NIBM), Pune; the Indian Institute of Bank Management, Guwahati; and the Institute for Development and Research in Banking Technology (IDRBT), Hyderabad. The Bank extended financial support to these bodies from time to time. An external review committee under the chairmanship of former Governor Jalan was formed in August 2007 to evaluate the progress made by the IGIDR, and suggest a roadmap for the future. The committee submitted its report in June 2008. The two major developments in training to take place in 1997–2008 were the start of the Joint India–IMF Training Programme at NIBM in Pune (2006) and the decision to close the BTC. The programme was commissioned with a view to positioning India as a global training provider in banking and finance. The programme was the seventh such facility of the IMF Institute in the world. It was expected to impart policy-oriented training to nominees of 627

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the reserve bank of india governments and central banks of the participating SAARC and East African countries, apart from India, in areas such as macroeconomic management and policies, financial programming, monetary policy, bank supervision, financial sector issues, public finance, exchange rate policy, and foreign exchange operations and statistics. The programme also included in its curriculum seminars on topical issues for senior officers. Faculty support was provided by the IMF Institute, Washington D.C. The inaugural course at the programme was held from 24 July to 4 August 2006. The BTC was established in 1954. Its mandate was to impart practical training in banking to the supervisory staff of commercial banks. As the financial sector reforms gained momentum, it became necessary to reconsider the role of the BTC. In the meantime, almost all the major banks and FIs in India had set up their own training institutes. A committee of external experts was set up in 2006 to reconsider the role of the BTC. The committee held that the BTC may give up its traditional role of a training provider and become a think tank or policy analysis centre. Following this suggestion, a Centre for Advanced Financial Learning was proposed. The centre was expected to promote the study and dissemination of knowledge on banking and finance and conduct research and training for senior executives of banks and FIs from a multidisciplinary perspective. The centre was inaugurated by Prime Minister Manmohan Singh on 18 March 2006. The BTC was closed down on 1 April 2008. The Bank provided incentives to staff members to acquire computer skills. The scheme of base level computer training for officers and Class III employees was first introduced in November 1995. The recommendations made by the Working Group on Training Needs/Plans in the Context of Technology, set up in 2001, were accepted and an action plan was drawn up to achieve 100 per cent computer literacy by the end of 2003. All training centres added computer-related training programmes in their curricula. The training scheme was liberalised in 2002 by delegating the power to regional offices and central office departments to depute officers and Class III employees to reputed external computer training institutions. In order to improve their IT skills, several officers were trained in leading external training institutions such as Administrative Staff College of India, Hyderabad; NIBM, Pune; Management Development Institute, Gurgaon; Xavier Labour Relations Institute, Jamshedpur; IDRBT, Hyderabad; and Indian Institute of Management (different centres). 628

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Staff Regulation: A Dispute with the Government RBI (Staff ) Regulations became a contentious issue during the reference period. The regulations were framed by the Bank under the permitted delegation of authority in terms of Section 7(2) of the RBI Act, 1934. The regulations vested the powers of general superintendence and the direction of the affairs and business of the Bank in the Central Board. The Parliamentary Committee on Subordinate Legislation (Rajya Sabha), which visited the Bank in 1989, 1993 and 1995, insisted that these regulations should be framed under Section 58 of the RBI Act, which would allow the Parliament the opportunity to scrutinise the regulations and the amendments thereof. The issue was examined and placed before the Central Board. The Board did not accept the suggestion, maintaining that the Supreme Court upheld the validity of the existing practice in 1982. The Parliamentary Committee, however, pursued the matter. In the Central Board meeting held in Gangtok on 29 May 1997, Governor Rangarajan said that this had become an unseemly controversy, and as the Parliamentary Committee was due to visit shortly, the Board could consider giving him the freedom to deal with the matter in the ‘best possible’ manner. A Director observed that the Bank should not give up on the issue. If the staff regulations were to be framed under Section 58 of the Act, the government should first change the law. He suggested that the Bank could refer the case to the Advocate General and obtain his opinion on the matter before taking a stand at the meeting of the next Parliamentary delegation. The Parliamentary Committee, which visited the Bank on 26 June 1997, insisted the Bank reconsider its stance. The RBI Act and the RBI (Staff ) Regulations, according to them, belonged to a time before the Constitution was adopted, and all other public sector FIs had adopted statutory regulations in case of their officers. In the Central Board meeting held at Chennai on 10 July 1997, it was resolved that the issue be referred to the retired Chief Justice of India for a legal opinion. The matter was referred to Y. V. Chandrachud, who concurred with the Board and gave a strong opinion for not framing the regulations under Section 58. Accordingly, the Board decided to retain the existing RBI (Staff ) Regulations framed under Section 7(2) of the Act and the government was advised accordingly in the matter. In reply, the Ministry of Finance in its letter dated 11 June 2001 restated their view. Again, the matter was discussed and the proposal was rejected by the CCB (29 August 2001). The Directors reiterated that the existing staff 629

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the reserve bank of india regulations had stood the test of time and that the administrative, practical and legal advantages of the present arrangement were obvious, but the issue could be referred to the Central Board for a final decision. The full Board discussed the issue in Lucknow on 18 October 2001. The Board was unanimous in endorsing the views of the CCB; it strongly felt that any change in the existing practice would be prejudicial to the effective management and administration of the Bank, and had a potential for adverse consequences for the efficient functioning of the Bank, which needed to be considered by all concerned. The unanimous view of the Board was communicated to the government. The government (letter dated 28 October 2002) advised that they agreed with the views of the Bank. Still, the matter did not end there. The government remained unconvinced. When the government was informed in 2007 about the legal opinion offered by senior advocates Dipankar Prasad Gupta and Harish N. Salve (also see the next section titled ‘The Pension Updating Debate’) that the updating of pension fell within the powers of the Central Board under the RBI (Staff ) Regulations, which were framed under Section 7 of the RBI Act, the government was quick to argue that the RBI service regulations were a misnomer as they were never notified by the government and, therefore, the Bank should frame service regulations under Section 58 of the RBI Act as advised earlier.

The Pension Updating Debate The RBI Pension Regulations, 1990, were framed in terms of Section 58(2)(j) of the RBI Act, with prior approval of the government. Therefore, any amendment thereto required the approval of the government, according to the government. The Central Board of the Bank, however, considered that pension updating for its own employees should follow the government pattern, that is, follow the recommendations of the Pay Commission, and that the Bank had the authority to decide on the matter. This difference led to a dispute between the Bank and the government in the 2000s. The government was reluctant to give permission, fearing that an updating of pension in the Bank would lead other financial institutions to follow suit, with wider implications for the industry. When pension options were opened in view of wage revisions in 1995 and 2000, the government’s permission was obtained. But the government rejected such a proposal in 2002 (letter dated 4 February 2002) saying that ‘since RBI 630

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organisational change has already given four options to the employees after the initial option given in 1990, no fresh option be given in future even after the conclusion of the fresh wage settlement’. It was perceived that the question of updating pension did not require an amendment and, therefore, the government’s approval was not required. The approval of the CCB was enough to effect the update. On an earlier occasion in November 1990 when the revised pay scales were introduced (November 1987), the pensions of employees who had retired between 1 January 1986 and 31 October 1987 were updated by the Bank without recourse to an amendment of pension regulations and, therefore, no government approval was obtained. The Fifth Central Pay Commission report submitted in January 1997 provided for the updating of pension for pre-1996 government pensioners besides revision of commutation factor and family pension.11 While the latter required the government’s approval, in its meeting held on 21 March 2001, the CCB approved certain amendments to the pension regulations to effect a revision of family pension and improvement in commutation factor, which were forwarded to the government for final approval. Some of them were not acceptable to the government. Deputy Governor Kamesam, in a letter dated 5 February 2003 to the Finance Secretary, explained that the Bank’s pension scheme was drawn on the lines of the government’s pension scheme. However, in its reply (by Vineeta Rai, Secretary, Banking and Insurance) dated 10 March 2003, the government stated that since the negotiations for the next wage settlement were in progress it was not desirable for the Bank to make any change in the pension regulations that had a financial impact. The Central Board was apprised of the matter on 10 July 2003, in its meeting held in Chennai. The Bank took up the updating of pension of pre-1997 retirees in late 2003, on the lines of the updating of pension by the government of their pre-1996 pensioners, as recommended by the Fifth Pay Commission. After consultation with its Legal Department, it was decided to introduce the updating of pension with the final approval of the CCB. The offices and departments re-fixed the pension from 1 November 2002 and arrears were paid to those who had retired before 1 November 1997. In the meantime, after the revision of pension of government employees based on the Fifth Pay Commission, a few retired employees of the National Bank for Agriculture and Rural Development (NABARD) filed a writ petition in the late 1990s before the Lucknow Bench of the Allahabad High Court 631

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the reserve bank of india demanding updating of pension, as their pension regulations were also based on the Government Pension Rule, 1972. The government, a respondent in the case, maintained that the NABARD pension rules were based on those of public sector banks and not the government. The management of NABARD had decided that the updating of pension would be done only if it was done in the Reserve Bank. In the meeting held between the government and the Reserve Bank subsequently, on 6 April 2005, G. C. Chaturvedi, Joint Secretary (Banking and Finance), mentioned that it was difficult for the government to accede to the updating of pension for the Bank pensioners as other FIs, notably NABARD, were asking for parity with the Bank. The government, in its letter to the Bank dated 8 August 2005, termed the Bank updating as ‘not in conformity’ with the RBI Pension Regulations and demanded the withdrawal of the circular by which pension was updated. The matter was examined by the Legal Department of the Bank. Independent legal opinions were also sought separately from Dipankar Prasad Gupta and Harish N. Salve, both being senior advocates and former Solicitor Generals. The legal opinions concurred with the Bank’s views that the updating was justified in law. The matter was brought before the CCB at its meeting held on 21 December 2005. Governor Reddy explained that the government’s views appear to have been based on the premise that initially the Bank’s superannuation facility had remained on a standalone basis but after the nationalisation of banks in 1969, the Bank could not be de-linked from the national wage policy. Governor Reddy further stated that a recent survey done by the Bank for International Settlements (BIS) found that central banks the world over received the tacit approval of their governments while making changes in the pay and allowances and other benefits of their staff. Governor Reddy, in the CCB meeting held on 12 January 2006, noted that while the legal position was clear, the key issue was the intent of the government from the public policy angle. Deputy Governor V. Leeladhar stated that there were systemic implications in the implementation of the updating policy in the Bank since insurance and commercial banks were expected to follow suit, which would result in a rise in the wage bill. Therefore, though legally in order, it was advisable not to go ahead with the updating of pension. In the end, Governor Reddy deferred the decision. The CCB in its meeting of 1 February 2006 resolved that while there would be no future updating of pension as and when the pay scales of serving 632

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organisational change employees were revised, there was no need to withdraw the pension update circular of 1 September 2003. However, the government reiterated its stance and insisted that the said circular be withdrawn. Vinod Rai, Secretary, Department of Financial Services, Ministry of Finance, wrote a strongly worded letter to Governor Reddy (8 January 2007) to this effect. In the CCB meeting held on 12 July 2007, Governor Reddy suggested that the Bank write to the government again explaining the position, rationale and recommendations of the Central Board based on the practical ramifications as well as the legal position. Secretary Rai wrote (20 August 2007) that the FM [Finance Minister P. Chidambaram] directed that the decision of the Government stands…. Government is unable to comprehend the intent and reasons for placing the matter before the Central Board for deliberations, especially, on account of the fact that the Central Board of the Bank is not within its competence to carry out the amendments in RBI Pension Regulations, 1990 without the previous sanction of the Government. (See Appendix 15A.1)

The legal opinion that the pay of the Bank’s employees was governed by the RBI (Staff ) Regulations, and the Board acted within its powers under Section 7 of the RBI Act, was turned down on grounds that RBI service regulations were a misnomer as they were not notified and the administrative orders could not override the provisions of the statutory regulations. After a further exchange on the subject, the matter was finally discussed by the Central Board in its meeting held on 14 August 2008 in Mumbai. Before the meeting, the government nominee, Finance Secretary D. Subbarao, spoke directly to a few Directors at the behest of the Finance Minister impressing on them the stance of the government. In the meeting, he reiterated the government’s stance on the lines of the letter dated 8 August 2005 addressed by Ashok Jha, Secretary, Department of Economic Affairs, Ministry of Finance, to Governor Reddy, which mainly stated that (a) to follow the procedure for enhancement of pension on the pattern of central government by the Bank for its employees was not legally correct and that (b) the Bank is a statutory body and its employees cannot be equated with the employees of the central government. The Finance Secretary further stated that pension of the Bank’s employees is governed by the Pension Regulations, 1990, framed under section 58(2)(j) of the RBI Act, 1934, with the prior approval of the Government of India. Therefore, any amendment thereto requires the consent of the Government of India. Eventually, the Board decided to rescind the 633

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the reserve bank of india scheme, and the circular was withdrawn on 10 October 2008. This deprived the retired employees of the benefit of the update. Subsequent to this step, the government agreed to a proposal of not recovering the excess pension already paid to retired employees between October 2003 and September 2008. However, the Bank did not give up its efforts and continued the pension dialogue with the government. Why this tussle? Why did the government not agree to the legal opinion provided by Gupta and Salve? Why was the government so insistent if the issue was not substantive but one of procedural concern? There are no clear answers. As such, the issue of updating pension remained unresolved until the end of the reference period.

The Issue of Service Tax On 16 July 2001, the government imposed service tax on banking and other financial services. In September the same year, the Bank was informed that financial services rendered by the Bank were liable to be taxed. The Bank replied that it did not render taxable services as it was neither a banking company nor a financial institution. However, as the scope of the service tax expanded in 2004–05, different centres of the Bank started receiving notices from the Customs and Central Excise. In 2005, in response to a letter from the Directorate General of Service Tax demanding that the Bank pay service tax on charges collected from member banks for its clearing house functions, Deputy Governor Shyamala Gopinath requested exemption on the ground that ‘services’ rendered by the Bank were statutory in nature and a kind of public goods. Besides, a tax on the Bank amounted to taxing the government since the balance of the Bank’s profits was transferred to the government. The government, however, did not agree. Further exchanges followed, and finally Governor Reddy met the Finance Minister Chidambaram. Following this meeting, the government indicated that a self-assessment by the Bank would be acceptable. The Bank, however, pursued the matter. Eventually, on 1 March 2006, the government agreed that the Bank was exempted from the whole of service tax leviable, but that the exemption was only prospective. Accordingly, an amount of 273 million payable towards service tax by the Bank on account of service charges recovered from member banks at five magnetic ink character recognition, or MICR, centres, Mumbai (BKC and Nariman point), Chennai, Kolkata and Delhi, for the period from 16 July 2001 to 28 February 2006 was paid to the government on 13 June 2006. 634

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organisational change As the government insisted, interest on delayed payment of 64 million was paid on 8 December 2006. Meanwhile, in 2003, the CAB, Pune, had received notices for payment of service tax on the fees collected from the non–Reserve Bank participants of certain training programmes. The Reserve Bank argued that the CAB is an integral part of the Reserve Bank and not a ‘commercial training or coaching centre’. At the end of a protracted correspondence, exemption (termed as ‘ad hoc’) was granted on 1 January 2008.

Miscellaneous Staff Matters Five-Day Week

In February 1991, the government had sought the Bank’s views on the introduction of a five-day week in government departments, public sector undertakings (PSUs) and other related departments and institutions. The Bank replied that the move would require consultation with unions and the Indian Banks’ Association (IBA), besides amendment of, among other laws, the Industrial Dispute Act and the Negotiable Instruments Act. Even as the government introduced a five-day week in their departments, the IBA was not in favour of the proposal as it apprehended adverse criticism from the public, as noted by S. P. Talwar, Deputy Governor, who ordered on 31 October 1995 that the matter need not be pursued. Ten years later, the issue was reopened in March 2005 by Sandip Ghose, Chief General Manager, HRDD. After internal processing, the proposal was submitted to the Deputy Governors’ Committee, which on 19 July 2005 agreed in principle to the proposal, citing the practice of many central banks around the world. There followed extensive consultations within the Bank, with the Legal Department and with trade unions and associations on the operational issues that may arise in the working of money, securities and foreign exchange markets. A small group of interdepartmental officers, called the Implementation Group, went into the modalities of implementation. The consensus was that the front offices should remain open while the middle and back offices could be closed on Saturdays. Among the front offices, the National Clearing Centre and clearing houses and real time gross settlement may function with the full complement of staff, and the Deposit Accounts Department (DAD), the Public Accounts Department (PAD), the Public Debt Office (PDO) and the Cash Department may require only skeletal staff. 635

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the reserve bank of india A single officer was sufficient in the Internal Debt Management Department (IDMD) on Saturdays. Governor Reddy approved the proposal on 19 September 2005, subject to no reduction in the total number of working hours in a week.

Facilities to Employees The facilities for employees, both monetary and non-monetary, improved during the reference period, especially after Governor Jalan took office. In May 1998, housing loan limits were raised by 50 per cent in line with revisions in other public sector undertakings and the ever-increasing cost of real estate; unavailed casual leave could be credited to a special sick leave account, subject to certain conditions; deputation allowances were enhanced wherever necessary; medical reimbursements were streamlined; and professional qualification allowances were introduced. The facilities were reviewed in subsequent years. There were three wage settlements (1997, 2002 and 2007). The residential accommodation scheme was regularly reviewed and improved. At the same time, stricter rules were introduced in enforcing discipline. For example, on a note put up by the DAPM in November 1998 regarding unauthorised absence and overstaying of an employee deputed abroad, Governor Jalan indicated that persons who were absent for more than six months would be considered for dismissal. Similarly, there was a case of missing gold weighing 1,050 grams at the New Delhi office under the National Defense Gold Bond Scheme, 1980. Several rounds of investigation and reconciliation exercises were attempted for more than twenty years to match the records but in vain. The Executive Director’s Committee suggested that the transaction may be regularised, stating that the difference had arisen due to an ‘accounting error’, as surmised by inspection reports. Consequently, the Inspection and Audit Subcommittee of the Central Board was inclined to consider the option of a write-off. However, as insisted by Deputy Governor Udeshi, the subcommittee directed in its meeting held in June 2004 to fix staff accountability and to take disciplinary action against those who were involved, which finally led to the recovery of the missing gold. Retirees received attention. Medical facilities for retirees and the process of settlement of dues improved. These reforms eventually led to revised medical and hospitalisation facilities for retirees and their spouses wherein thirdparty administrators provided medical cover under a group mediclaim policy. 636

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organisational change While the retirees were required to pay a one-time premium on retirement, the Bank made financial contributions to the scheme periodically.

Grievance Redressal Cell In 1997, a Grievance Redressal Cell (GRC) was set up within the framework of the RBSB. Redress of grievances of individual officers against the decision of the Bank on service matters as defined by the Bank was attended to by the RBSB. There were about 141 individual grievance cases received in the cell from 1997 to 2008, with the cases dropping to single digits after 2001–02 when the Bank issued instructions to all its offices in February 2000 that no application can be entertained by the GRC regarding performance appraisal reports. The Bank also sought the views of the GRC in the individual disciplinary cases involving officers. The Bank’s vigilance unit had a two-tier arrangement, where the Central Vigilance Cell functioned in the DAPM in the central office, and small cells in the regional offices, including the Deposit Insurance and Credit Guarantee Corporation (DICGC). The basic framework of preventive vigilance in the Bank was provided in Chapter IV of the RBI (Staff ) Regulations. The cells investigated all the complaints received from within and outside the Bank with regard to the employees, including complaints made by persons who preferred not to reveal their identities.

Prevention of Sexual Harassment Complying with the guidelines laid down in the Supreme Court judgment (Vishaka and Others vs. State of Rajasthan (1997) SCC 241), a complaints redressal mechanism for prevention of sexual harassment of women at workplaces was put in place in 1998. A Central Complaints Committee (CCC) headed by a woman officer in Grade F was created in the central office. In offices located in other places, additional complaints committees were subsequently formed. These committees were also headed by senior women officers. The CCC and the regional complaints committees (RCCs), besides having a member each from a non-governmental organisation, had more than 50 per cent women members. The CCC acted as the focal point for all the complaints committees. Several seminars were conducted within the Bank to enhance awareness among women employees about the 637

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the reserve bank of india redressal system. The CCB in its meeting held on 13 February 2002 decided to insert a new sub-section, 41C, in the RBI (Staff ) Regulations defining and prohibiting sexual harassment. From 1998 to 2008, twenty-nine cases were dealt with.

Cooperative Guarantee Fund A Cooperative Guarantee Fund was formed in 1935 on the establishment of the Bank. The objective of the fund was to inculcate a sense of collective responsibility among the staff of the Cash Department. Whenever the amount of loss caused by an employee was large and beyond his or her capacity to meet from own resources, the loss was borne by the fund to the extent of the guarantee cover available. Over the years, the fund had outlived its utility. For, the recovery of cash losses from the resources of employees for their negligence or dishonesty was found to be a better deterrent than claiming from the Guarantee Fund. Further, the maximum amount available from the fund was simply inadequate for the purpose. After obtaining the approval of the government, the Central Board in its meeting held on 27 October 2005 in Bhopal issued the order to close the fund. The balances in the fund were distributed among the eligible serving employees.

Organisational Climate Survey The Bank conducted its first ‘organisational climate survey’ in 1996. The objective was to find out staff satisfaction levels. There were three subsequent surveys conducted between 1997 and 2008 (in 1998, 2003 and 2006). Surveys were canvassed amongst the staff in Classes I and III and the aim was to gauge the impact of policy initiatives and welfare measures undertaken by the Bank. The survey conducted in January 2006 received a response level of approximately 44 per cent against a response of 40 per cent to the survey conducted in 2003 and 17 per cent in 1998. The survey results showed general improvement in different indicators of job satisfaction level. In 2006, the satisfaction level of Class III employees was lowest at just 23 per cent because of slow career progression path but Grade F officers showed a satisfaction level of above 66 per cent. The Bank tried to boost the morale of the staff through better financial packages, improved working conditions, and efforts to ensure proper work–life balance. 638

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organisational change

Information Technology Capability The DIT dealt with the computerisation and development of IT in the Bank. With the formation of the DPSS in 2005, the work relating to payments and settlements were taken from the DIT, which then focused on IT implementation in the Bank and related issues in the banking sector at large. The IDRBT funded by the Bank also lent support. The computerisation strategy in the Bank had four elements – standardisation of hardware, operating systems, system software, NetWare platforms and databases; development of human resources; outsourcing of development and maintenance of software and facilities management; and establishment of a disaster recovery management system and business continuity plan. In February 1998, after the start of the VSAT (very small aperture terminal)-based wide area network, the recommendations of a Sub-group on Networking Products12 helped to ensure the effective functioning of the VSAT communication network. The electronic clearing service (ECS), which facilitated the settlement of bulk small-value transactions without exchange of paper-based instruments, was introduced to ensure better customer service, efficient housekeeping by banks, corporate bodies and FIs. The ECS, which in 1998 covered Mumbai, Kolkata, Chennai, New Delhi, Bengaluru, Hyderabad, Ahmedabad and Pune, was extended to other centres such as Guwahati, Patna, Kanpur, Nagpur, Jaipur and Thiruvananthapuram. The DIT attempted modification of several software packages for the RPCD, the Central Accounts Section, Nagpur, and the DAD. Computerisation was extended in the Department of Government and Bank Accounts (DGBA) in 1999–2000. Computerisation of the PDO started with the development of software for subsidiary general ledger transactions, the operationalisation of the delivery versus payment (DvP) system of settlement, and providing connectivity with the DAD for funds transfer. A software package for the full computerisation of the activities of the PAD in COBOL was installed in several large cities. Under the interactive voice response system (IVRS), which was in operation since 1998–99, a new value-added product, called ‘easy term’, helped account holders obtain transaction details in electronic form and communicate short messages between account holders and the Bank. This was installed in the DAD, Chennai, to begin with (3 June 2000), and subsequently in other centres. The software was developed for operationalising the recently introduced liquidity adjustment facility (LAF), which was installed in the Mumbai office. 639

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the reserve bank of india The year 2000 was expected to bring problems to all older computerised systems, where the ‘system date’ was of significance or whose applications used calendar date in their calculation. As a large part of transactions in the financial sector was computerised, the Year 2000, or Y2K, problem assumed significance as it could seriously impair operations. The Bank adopted a two-pronged approach to Y2K. First, it took steps to ensure that the Bank’s own computers and IT systems were millennium-compliant. Second, it monitored and guided banks and other FIs on Y2K compliance. As early as 1998, a working group,13 which had representatives from banks, the IBA, the NIBM, and heads of the regulatory and supervisory departments of the Bank, addressed Y2K compliance for hardware, operating systems and application systems’ software. The group guided users and provided information on the solutions that were available in the market. Monthly progress reports were introduced and actual compliance was checked in the regional offices and in the departments of the Bank by deputing inspection teams from the central office. Regional offices and the departments concerned were asked to keep a record of tests conducted. With respect to commercial banks, not only banks but also corporate borrowers were ensured to be Y2K compliant. In the end, Y2K did not pose any problem. In 2001, a sophisticated human resources information system (HRIS) application package was developed in-house. The ORACLE-based HRIS, with a client–server architecture, was introduced in the Bank’s central office and installed subsequently at the regional offices and other central office departments. In 2002, the creation of a data centre, a back-up support for all processing capabilities of the Bank, was prioritised as part of disaster recovery systems (DRS) and business continuity plans. The back-up project became important after the event of 11 September 2001. With the help of relational data base management system (RDBMS)–based solutions, the central office departments were integrated. The off-site monitoring and surveillance system (OSMOS) and the computerised-OSMOS (COSMOS) were strengthened. The Bank constituted a Committee on Information Systems Audit and Information Systems Security14 in 2001. The committee gave guidelines on standards and procedures, which eventually led to obtaining BS7799 Certification in 2003, confirming that the Bank’s information security policies conformed to international standards. Subsequently, Certification of Quality Management System (QMS):ISO 9001-2000 and Standards Information Security Management System (ISMS): ISO 27001:2005 Standards were 640

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organisational change acquired as recommended by the Committee on Procedures and Performance Audit on Public Services. Some departments were required to obtain the certification on a regular basis. For the PDOs and the internal debt management system, a centralised system encompassing the PDO, the negotiated dealing system (NDS) and the securities settlement systems was implemented during 2002–03. The centralised database management system (CDBMS), a data warehouse, was also implemented in 2003. Its first phase involved key functional areas such as external investments and operations, regulation and supervision of urban banks, human resource development, and general administration; and subsequently included the areas of monetary policy operations, exchange control, and currency management, including issue offices. In terms of hardware, the installation of common shared, high-end and high-availability servers at each Regional Office were completed by 2003. Local area networks were made operational in each building of the Bank in all centres. Communication across different buildings of the Bank took place through the wide area network facilities provided by the Indian Financial Network (INFINET). A corporate mail system was provided to all functional units, different functionaries and various offices. A system of Indian Financial System Codes (IFSC) was designed during 2003. Under the Information Technology Act, 2000, the Bank became the registration authority to assist the certification authority, the IDRBT, thereby associating itself with public key infrastructure. An intranet of the UBD acted as a common platform for communication between the regional offices and the central office from 2003. The centralised PDO module was implemented in fourteen PDOs of the Bank. Live operations on the Primary Market Operations Module commenced from 20 October 2003. In its Central Board meeting held on 12 August 2004 at Mumbai, the Bank decided to set up a committee to review the overall status of IT in the Bank, including e-security issues. Accordingly, an Information Technology Advisory Committee was constituted under the chairmanship of R. H. Patil to provide guidance and steer the IT drive in the Bank. A ‘strategic information technology plan’, a vision document, was prepared to provide the framework for the management of IT resources in the Bank. To provide for increased availability of telecommunication capabilities and accessing internet on desktops, the bandwidth of the inter-city telecommunication links, which were part of INFINET, was upgraded in 2005. The year 2005 also witnessed 641

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the reserve bank of india the commencement of parallel runs using the new integrated account system (IAS) for the DAD at Mumbai, which was fully operationalised in all DADs subsequently. To bridge the gap in communication across various offices of the Bank, a video conferencing facility was implemented from 2 January 2006. The Governor’s New Year address was broadcast using this facility. To track the movement of cases, letters and notings within and across departments, an in-house document management, and inward–outward system were made operational during 2005–06. A multi-application smart card-based access control system for the Bank staff was also introduced during the year in the central office. The Banking Ombudsmen software system, which provided for a web-based complaint tracking system, was implemented in September 2005. The process of unified procurement of hardware and software, localised at the DIT, was strengthened. The mechanisation of the cash processing activity and disposal of soiled banknotes was one of the major thrust areas of the Bank in currency management. With a view to augmenting the banknote processing capacity, and to equip all the offices with mechanised processing capabilities, currency verification and processing systems and the shredding and briquetting system, introduced as pilot projects in 1998–99 and 1999–2000, respectively, were installed in almost all offices. Towards the end of our reference period, there were fifty-four currency verification and processing systems and twentyeight shredding and briquetting systems in operation in nineteen issue offices. A knowledge box was started from 1 January 2006. This was an intranet site where materials of common sharable value for the employees of the Bank were published. During 2006–07, all offices of the Bank commenced a ‘live-run’ on the currency chest reporting system (CCRS) and the chest accounting module (CAM) of the integrated computerised currency operations and management system–Issue Department (see later). The DAD at Mumbai migrated to the use of the new IAS, by applying the package to annual closing of accounts for the financial year ended June 30, 2006. The new centralised PAD system was made operational at Chennai, Thiruvananthapuram, New Delhi and Hyderabad, and extended to all the offices in 2007. The centralised PDO system was in use for more than three years and then upgraded. In 2007, in tune with developments in the field of network-based computing, the move from the closed user group network of INFINET to multi-protocol label switching was initiated by the IDRBT. The smart-cardbased access control system at the central office was extended to all locations of the Bank as well as to all its employees. Specific guidelines on information

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organisational change systems and security policy, to be followed by all IT users in the Bank, were issued and widely disseminated. Disaster recovery drills were done regularly. Corporate mail, which functioned in a network-based system, migrated to a centralised system called ‘single forest-based mail messaging system’ in 2008. At the beginning of new millennium, the Bank introduced an integrated computerised currency operations and management system (ICCOMS) to facilitate its note issue function, which was stabilised by 2007–08. The ICCOMS had three components, currency chest reporting system, ICCOMS–Issue Department (ICCOMS-ID) and currency management information system in the central office, Issue Departments in regional offices, and currency chests maintained by various banks, respectively.15 The project included computerisation and networking of over 4,300 currency chests with the Reserve Bank’s issue offices to facilitate efficient reporting and accounting of currency chest transactions. The system provided a uniform computing platform across all the regional offices for transaction processing, accounting, and management information system (MIS) relating to currency.

Rationalisation of Systems, Rules and Procedures On 19 February 1998, a steering committee was constituted under the chairmanship of B.S. Sharma, Executive Director, to examine rules and procedures governing administrative, establishment and housekeeping matters, and to recommend measures for their rationalisation and simplification. The recommendations of the committee covered wide ground, including transparency and decentralisation. To overcome staff shortage posed by the Optional Employees Retirement Scheme (2003), a Committee on Job Realignment and Job Consolidation was formed under the chairmanship of A. V. Sardesai, Executive Director, which again made a set of recommendations on a reorganisation of work, which were accepted. Customer service received special focus during the period under reference. The HRDD suggested in 1998 that it was necessary to have one ‘meeting-less’ day in a week to attend to the public and hear their grievances. Wednesday, it was decided, would be observed as such a day. Subsequently, the Committee on Procedures and Performance Audit on Public Services (2003),16 was assigned, inter alia, the job of assessing customer service. Its report (May 2004) made several recommendations on procedures, rules and work processes which were implemented. 643

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the reserve bank of india While travelling in a train from New Delhi to Chandigarh in February 1999 for a board meeting, Deputy Governor Reddy read a book on regulatory practices in Mexico, which induced him to suggest to Governor Jalan that the Bank’s rules and procedures required reviewing. Governor Jalan, who did not react at that moment, announced next day in the meeting of the Central Board (18 February 1999) that it was decided that a Regulatory Review Authority (RRA) would be set up under the chairmanship of Deputy Governor Reddy within the Bank. Through it, any person or organisation inside or outside the Bank could suggest changes in rules. The RRA was independent of any department in the Bank and was the sole authority to take a final view on the suggestion. The RRA, as a one-time exercise, started working from 1 April 1999 with Deputy Governor Reddy as the authority for a year. The term of the RRA was extended by one more year and was wound up on 31 March 2001. Though the RRA ceased to exist, the Bank decided to make the review exercise an integral part of its internal system and put in place an alternate mechanism under the charge of an Executive Director for dealing with such applications from 1 April 2001. During the two years it worked, the RRA received 254 applications with substance, containing more than 500 suggestions. Of these, 47 per cent of the suggestions were accepted for implementation. The implementation of the suggestions helped in reducing duplication of work, simplification of rules and better customer service. The RRA took several initiatives on compliance and reporting, based on recommendations from other committees. The most important achievement of the RRA was a consolidation of circulars issued by the Bank into master circulars with a view to facilitating easy reference. Another important decision was decentralisation of the arrangement for working out benchmark service charges, which were earlier attended to by the IBA and the Foreign Exchange Dealers Association of India. In the wake of the IMF’s working paper on ‘Central Bank Governance: A Survey of Board and Management’ and deliberations in the BIS on the subject, the Bank set up an internal working group to examine the structure and practices of central bank governance in India vis-à-vis best international practices. The group reviewed existing practices and, though found many of the best practices being followed, made several suggestions to enhance the quality of governance. Some suggestions required changes in statutes. For example, the Governor and Deputy Governors should not be on the boards of other 644

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organisational change institutions regulated or supervised by the Bank as it could lead to conflict of interest; Board members should have staggered terms to ensure continuity; need for a risk assessment structure for the Bank, including well-defined procedure for recapitalisation; and requirement of legal protection against arbitrary dismissal of members of boards to ensure central bank autonomy. Other suggestions, which did not require changes in statutes, were on the need for comprehensive strategic planning, and strengthening the financial stability report and setting up a financial stability unit. After deliberations in the Central Board in its meeting held on 15 December 2005 at Kolkata, the Bank decided to take up the issue with the government. Subsequently, some of the recommendations were implemented. The Reserve Bank is a public authority as defined in the Right to Information Act, 2005. As such, the Bank is obliged to provide information to members of the public. Procedures to facilitate this service were initiated and implemented in 2005. From 2005 to 2008,17 the total number of requests for information received was 5414.

Other Initiatives Reserve Bank grants funded several professorships in universities. In the CCB meeting held on 30 December 1998, Governor Jalan proposed to phase out these grants and replace these with capital support, where appropriate. As part of its capacity building and knowledge management initiatives, the Bank signed a memorandum of understanding (MoU) with the London School of Economics and Political Science (LSE) for creating an LSE India Observatory and the I. G. Patel Chair to be based at the Asia Research Centre at the LSE. The Chair – which was set up in honour of the late I. G. Patel, a former Governor of the Reserve Bank, and who later held the post of Director at the LSE – was a fully endowed permanent professorship and its holder led the LSE India Observatory. The Bank, as part of a sponsoring consortium, provided £100,000 per annum to the LSE for a period of ten years beginning January 2007. The MoU was signed on 7 December 2006 in New Delhi in the presence of Prime Minister Manmohan Singh. Like other major central banks, the Reserve Bank developed its own research capabilities, particularly on matters relating to central banking. Two departments, namely the DEAP and the Department of Statistical Analysis and Computer Services, provided analytical inputs for the formulation of monetary, 645

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the reserve bank of india regulatory and other policies of the Bank. To strengthen research, the Bank commissioned in March 2003 a study under Raghuram Rajan, University of Chicago, and T. N. Srinivasan, Yale University. Some of the recommendations made in their study, titled ‘Research at RBI: An Assessment and Suggestions for Strengthening the Process’, such as creating working paper series, holding annual retreat and research conferences, facilitating greater staff mobility across divisions, and assigning a weight for research work in performance appraisal were implemented over the years. An Advisory Board on Bank Frauds (ABBF) was established on 1 March 1997, with S. S. Tarapore as chairman, to address the issues relating to bank frauds. As bank lending involved risks, a distinction was required to be made between bona fide commercial judgement leading to loss and acts of criminal negligence with the intention to misappropriate money. With a view to ensuring that cases were examined from their proper perspective, and bank officers at the appropriate decision-making level were able to function objectively and fearlessly, it was decided that it should be made incumbent upon the investigative agencies, including the Central Bureau of Investigation (CBI), to first obtain the concurrence or approval of the relevant authority. The Bank, in consultation with the Ministry of Finance, decided to set up an ABBF to deal with the cases referred by the CBI for investigation against accused bank officers of the rank of General Manager and above, and no such CBI investigation was possible without the approval of the board.18 Based on the merit of each case, the ABBF, after due deliberations, decided on the cases to be further investigated by the CBI. While the majority of the cases were recommended for CBI investigation, departmental actions were proposed in a few and the others were dismissed. The Bank strived to promote the use of Hindi as the required language under the provisions of the Official Languages Act, 1963, and the Official Language Rules, 1976. During 1997 and 1998, efforts were made to implement the annual programme circulated by the government. The use of bilingual publications, such as Monthly Bulletin, Annual Report and the Report on Trend and Progress of Banking in India, and other publications, including Chintan-Anuchintan brought out by the Bankers’ Training College, continued. The Bank conducted essay competitions in Hindi besides organising symposiums on Rajbhasha for senior officers. A Committee on Bilingualisation of Computers, headed by R. P. Pathak, was formed in 1997–98. In 1997, a Computer Paribhasha Kosh, an explanatory English–Hindi dictionary on computer terms, was published. These and other initiatives took the project forward. 646

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organisational change In 2000–01, the Golden Jubilee Year of Rajbhasha in the Bank, three publications containing major achievements of the Bank in various fields were brought out, including the compilation of important decisions of the Official Language Implementation Committee. The Bank launched its website in Hindi. The first issue of Hindi Interface, a quarterly newsletter on computer bilingualisation, was also brought out. The use of Hindi through computers was the focus during 2001–02. For bilingual computerisation, a computer lab was set up. In 2003–04, the recommendations of the Hindi Salahakar Samiti of the Ministry of Finance were implemented. In 2004–05, in pursuance of the recommendations of the Committee on Style and Usage, Hindi templates were prepared and forwarded to all regional offices. In 2005–06, the BTC brought out a few books in Hindi, which included useful articles on current topics on banking. Other training colleges also promoted the use of Hindi through their magazines. Regional offices published regular magazines; Chandigarh and Bengaluru offices published Pravahini and Pradipti, respectively. During 2006–07, the Bank prepared a three-year action plan for effective use of Hindi. An Expert Group on Bilingualisation of Computers was set up in order to advance bilingualisation. A translation workshop was conducted, and a Translation Review Committee was constituted. Guidelines regarding the use of Hindi in Banking Ombudsman offices were issued in November 2006. Many programmes were conducted at the time of the Hindi fortnight observed from 14 September 2007. The Bank’s central office published the bilingual in-house journal Without Reserve. The Rajbhasha Department started the publication of a quarterly journal, Rajbhasha Samachar, from January 2007. The journal dealt with developments in the area of implementation of the Official Language policy. Understanding new banking concepts was also a part of its aim. During the year, the Bank decided to implement the use of Hindi Unicode fonts for Bank’s correspondence in Hindi. The revised sixth edition of the Bank’s Glossary (English–Hindi) was published, and an ‘Online Banking Glossary’ was launched in April 2008.

Inspection, Audit, Balance Sheet and Accounting Inspection and Audit

In discharge of its obligation, and exercise of its powers under Section 50(1) and (2) of the RBI Act, the government appointed six chartered 647

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the reserve bank of india accountant firms as statutory auditors of the Bank every year who carried out a comprehensive audit, and, thereupon, submitted a report to the President. The report of the statutory auditors formed part of the published Reserve Bank balance sheet. Internally, inspection and audit functions were carried out by the Inspection Department, Regional Audit Cells, Central Audit Cells and through the concurrent audit, control self-assessment audit (CSAA) and information systems audit. In 2004, the Committee on Job Realignment and Job consolidation suggested that the Regional Audit Cells and Central Audit Cells be wound up and the respective functions taken over by the control selfassessment and concurrent audit. The recommendation was implemented on 1 July 2004. The documentation, rules, procedures and processes were streamlined during this period. For example, a revised and updated version of the Issue Department manual was brought out during 2004. The manual was first documented in 1937 and subsequently revised and updated in 1952 and 1972. As per the directions of Inspection and Audit Subcommittee of the Central Board, a Working Group to Review the Organisational Set-up of the Inspection Department and Methodology of Inspections was set up in October 1995 which submitted its report in October 1998. The group made several recommendations to improve the monitoring of banking operations and strengthen internal control mechanism. From April 2000, management audit was introduced. Subsequently, CSAA was started, and activity-wise risk analysis was introduced. Eventually, risk-based inspection replaced the conventional inspection system. The Bank initiated the International Organization for Standardization (ISO) certification process in 2004. Initially, operational departments such as Currency Management, PDO, PAD, DAD and DAPM were taken up for certification. Gradually all departments were covered. The 20th meeting of the Inspection and Audit Subcommittee of the Central Board (6 April 1998) in New Delhi decided to set up a committee for an in-depth study of surplus space available in various offices and the departments that could be considered for relocation of offices outside Mumbai. The committee, with Executive Directors V. Subrahmanyam and C. Harikumar, and Chief General Manager–Premises, B. S. Sharma, as members, submitted its report in October 1998, recommending that the DGBA be shifted to Nagpur, the Inspection Department and the UBD to Bhopal, the Department of Currency Management to Bangalore and the DIT 648

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organisational change to Hyderabad. After deliberations, only the operations of the Byculla office (Issue and Banking Departments) were terminated and transferred to Belapur office on 14 January 2001

RBI Balance Sheet A distinctive feature of the Bank’s financials since its inception was the preparation of two separate balance sheets – one for the Issue Department and the other for the Banking Department. The practice originated in the recommendations of the Royal Commission on Indian Currency and Finance 1925–26 following the practice of Bank of England. The Bank, however, prepared a single consolidated profit and loss account. Another unique practice was the preparation of unaudited accounts separately for these two departments every week and their transmission to the government. The annual audited accounts, again in bifurcated fashion, were prepared at the end of June followed by transfer of profit to the government.19 The backing of high-quality assets with an independent balance sheet was felt necessary for the issue function. The specified eligible assets were mainly gold coins and bullion, certain types of foreign securities, government securities and rupee coins. Internal bills of exchange and commercial papers, though prescribed as eligible assets, were not held. The balance sheet of the Bank underwent changes in line with shifts in its functional focus. There was a structural transformation during 1997–2008 when foreign assets replaced government rupee securities as the major source of money creation. Both the Issue Department and the Banking Department balance sheets held foreign currency reserves. Transfers of foreign exchange assets were made from one to the other when required. Foreign securities were one of the eligible assets for backing the note issue. However, all types of foreign exchange assets were not eligible to be held in the Issue Department. For example, agency placements, certain foreign currency deposits held with foreign banks, and BIS and Society for Worldwide Interbank Financial Telecommunication (SWIFT) shares were not eligible. Some varieties of foreign currency investments, which were high yielding but ineligible for the Issue Department, were held under the Banking Department. To maximise the return, an amount of foreign exchange reserves was maintained under the Issue Department and the rest held in the balance sheet of the Banking Department, and deployed in relatively high-yielding instruments. The former 649

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the reserve bank of india had the smaller share before 1990, as rupee securities of the government accounted for the major share. The dominance of rupee securities in the assets of the Issue Department declined due to the combined effects of the elimination of ad hoc treasury bills, the reduced stock of government securities held by the Bank on account of sterilisation exercises and the swelling of foreign currency assets (Table 15.2; also see Chapter 3). Thus, maintenance of a critical minimum balance of foreign securities in the Issue Department on a day-to-day basis assumed special importance not only from the standpoint of the fulfilment of the statutory requirement of maintaining minimum reserves for the note issue backing but also from the angle of foreign exchange management. Operationally, the DGBA generally advised the Department of External Investments and Operations (DEIO) on the rupee equivalent of foreign securities to be maintained in the Issue Department, based on the level of other eligible assets available, such as gold and rupee securities. The DEIO, in turn, maintained the amount with an additional cushion, which was revised periodically. The cushion was 450–500 billion in the early 2000s, which was brought down to 200 billion in 2005, following an internal Investment Committee meeting on 15 December 2005. The DEIO began monitoring the cushion on a daily basis from 20 January 2006, entrusting the job to its foreign exchange dealers. The practice of maintaining two balance sheets by the Bank was debated both within the Bank and outside.20 Internal reviews in the past could not Table 15.2 Issue Department – Balance Sheet  Liabilities

Notes Issued

Total Liabilities Assets

1990–91

1996–97

2001–02

2005–06

2007–08

579

1,434

2,591

4,410

6,123

579

1,434

Gold Coins and Bullion

74

117

Rupee Coins and Notes

1

1

Foreign Securities

Govt. Rupee Securities Total Assets

( billion)

2

502 579

Source: RBI, Annual Report, various years.

2,591

133

4,410

233

452

1,690

4,165

864

766

10

1,434

2

2,591

650

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2

4,410

6,123  

323

5,789 1

10

6,123

organisational change conclusively recommend the unification of two balance sheets. In early 2001, a group of chartered accountants (M/S Lodha & Co., Kolkata, Brahmayya & Co., Chennai, M. Anandam & Co., Secunderabad, and Chhajed & Doshi, Mumbai), appointed to review the accounting policies and procedures of the Bank to align them with international standards, recommended that the balance sheets be combined. The Inspection and Audit Subcommittee at its meeting held on 17 October 2001 approved the merger. The matter was submitted for the approval of the Central Board at its meeting held on 20 December 2001 in Panaji. After further deliberations, the existing practice of preparing two different balance sheets was continued as it separately presented the picture of assets and liabilities of the Issue and Banking Departments, accounting for the issue of currency and other central banking functions distinctly, in conformity with the RBI Act. The merger, with no value addition, would go against the disclosure and transparency of the note issue function of the Bank. The accounts of the Bank conformed to the prescribed standards of income recognition on an accrual basis, periodic revaluation of the investment portfolio, and annual external audit as prescribed by the international accounting standards. The Bank followed more stringent norms. For instance, the Bank marked its investments at the lower of book or market value, thereby adjusting unrealised losses against income without recognising unrealised gains. In case of foreign currency assets, revaluation arising out of exchange rate changes was symmetrically transferred to an adjustment account, denominated as the currency and gold revaluation account. Thus, the Bank followed conservative principles of bookkeeping but less transparent dissemination of details, particularly prior to the 1990s. Former Deputy Governor Tarapore noted, ‘The levels of internal reserves were not clearly revealed and clubbed under other liabilities.’21 After 1996, there were changes in accounting practices as well as balance sheet disclosures. The disclosure of details of accounting was gradually made more liberal. Annual accounts of the Bank disseminated information on the composition of the balance sheet, valuation practices, changes in accounting practices and different sources of income and expenditure. The Annual Reports carried ‘notes to accounts’ incorporating details of accounting policies and procedures, besides information relating to components of ‘other liabilities’ and ‘other assets’. Joining the special data dissemination standards and general data dissemination system of the IMF in the latter part of the 1990s brought in a discernible improvement in the release of data. 651

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the reserve bank of india

Reserve Adequacy and Profit Transfer The Bank created several reserves and strengthened them over the years. There were three types of reserves: Contingency Reserve (CR), to meet unforeseen losses and contingencies that could arise on account of foreign exchange, revaluation of foreign currency assets, depreciation of domestic and foreign securities, exchange guarantees, monetary and exchange rate operations, systemic risk or internal frauds; Asset Development Reserve (ADR), created in 1997–98 to meet internal capital expenditure requirements of the Bank and to make investments in its subsidiaries and associate institutions; and the Currency and Gold Revaluation Account (CGRA), carrying the adjustment for all revaluation gains or losses on account of changes in the exchange rates and gold prices.22 There was no regular allocation of resources to the CR before the crisis of 1991. The significant withdrawals under the ‘exchange rate guaranteed’ foreign currency non-resident account, or FCNR (A), scheme resulted in drawdown of a huge amount ( 48 billion) under the CR to meet the commitment on exchange loss under the scheme. Therefore, to hedge against risk, the Bank decided to strengthen the CR. During the period under reference, with the shift in the Bank’s balance sheet towards foreign currency assets that yielded a lower rate of return, the concern over reserve adequacy assumed greater significance. The Bank initiated several measures to ensure revaluation of both domestic and foreign assets and to build up adequate contingency reserves. Consequently, the issue of adequacy of internal reserves and the policy for transfer of surplus to the government was regularly reviewed. Based on the suggestion of the statutory auditors in 1994–95, the Central Board had fixed an immediate target of the CR at 5 per cent of the size of the Bank’s assets. The adequacy of reserves was examined subsequently by two internal working groups, under V. Subrahmanyam (Executive Director) in 1997 and Usha Thorat (Executive Director) in 2004. The Subrahmanyam group recommended that the CR should be built up to 12 per cent of the total assets (5 per cent each for risks in the foreign exchange market and the domestic market, and 2 per cent for systemic risks and development outlays). The recommendations were approved by the Central Board and implemented. The Central Board observed in July 2003 that the composition of assets held in the Bank’s balance sheet had undergone a significant change and, therefore, the earlier target of 12 per cent may be revised. Accordingly, an internal working group was set up with Usha Thorat as chairperson. The group, which submitted its report in 2004, recommended that the reserves maintained 652

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organisational change under CGRA, CR and ADR should be at 18 per cent. Meanwhile, an informal note to the Central Board (meeting held on 11 August 2005 at Mumbai) stated that the indicative target of 12 per cent could not be achieved by the given deadline (end of June 2005), and had in fact declined from 11.7 per cent in 2001–02 to 10.1 per cent at the end of June 2005 even after transferring a major share of net income to these reserve accounts (Table 15.3). It became clear that reaching 18 per cent would be even more difficult. Furthermore, the CGRA, considered as one of the reserve accounts in the Thorat group report in addition to the CR and ADR, was an adjustment account and not a ‘reserve’ in a real sense. Therefore, it was decided not to accept the 18 per cent target but to continue with the 12 per cent norm. There was a debate about whether the balances in the ‘reserve accounts’ could be transferred to the government. The argument was that since any loss to a central bank has to be made good by the state, central banks need not build internal reserves. But in practice, though there are no standard international norms on the right level of reserves, most central banks do transfer a part of Table 15.3 Balances in Contingency Reserve and Asset Development Reserve ( billion) As on June 30  

1

Balance in CR*

Balance in ADR†

2

3

138

12

299

32

 

1997

112

1999

230

1998 2000 2001 2002 2003 2004 2005 2006 2007 2008

365 484 552 562 623 733 938

1,272

Source: RBI, Annual Report, various years.

Total

Percentage to

 

(2 + 3)

-

112

4.5

25

255

7.6

39 47 56 58 65 76 95

128

4

150 331 404

Total Assets 5

5.1 9.2 9.9

531

11.7

620

10.2

608 688 809

1,033 1,400

11.7 10.1 10.0 10.3 9.6

Note: *Contingency Reserve, †Asset Development Reserve. 653

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the reserve bank of india their income to the reserves, the Reserve Bank being no exception. Section 47 of the RBI Act provides for such transfers. Internal reserves act as a cushion for possible losses arising out of exchange and interest rate movements and other factors including systemic issues. The Bank had used internal reserves in the past to meet unexpected losses and payments. For example, exchange loss liabilities under the FCNR(A) and loss on account of revaluation of gold and foreign currency assets in the early 1990s; and extending a loan of 7 billion to the National Housing Bank (NHB) in 1996–97. It was argued that since rise and fall in the reserve accounts are obvious and no separate provision is made for known risks such as market, exchange and interest rate in the Bank’s balance sheet, the balances under reserve accounts cannot be transferred to the government. Furthermore, balances under CGRA, which carries the adjustment for all revaluation gains or losses on account of changes in exchange rates and gold prices, cannot be considered for transfer as these do not represent realised gains or losses and are notional. Another issue addressed during the period was the possibility of paying an interim dividend or transfer of profit to the government. The Bank transfers the surplus to the government annually after the closure of accounts in June. The government desired that such transfers could be made more than once. The issue of whether the Bank could transfer the profit on the date of the transaction itself was examined by the Legal Department of the Bank. The Department noted that a reading of the provisions of Sections 47, 52 and 53 of the RBI Act, together with the Expenditure Rules, would indicate that the Bank would be able to determine the ‘balance of profit’ at the end of the accounting year after making provisions for the items listed out in Section 47, and the same items forming part of the annual accounts had to be verified and certified by the auditors before being considered as final and transferred to the government. Although Section 47 did not indicate any period within which profits had to be transferred, in effect profits could be transferred only on an annual basis at the end of the accounting year of the Bank.

Profit and Loss Account

The RBI Act states that after meeting all the expenses and making provisions for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation funds, the balance of the profits may be transferred to the government. 654

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organisational change Details of income, expenditure and transfers are given in Table 15.4. The major sources of income were interest earned on domestic and foreign securities and foreign deposits, discount and rediscount charges, and commission on the management of public debt. During the latter part of the reference period, while the total expenditure of the Bank was rising due to agency charges and security printing expenses, the establishment expenditure showed a fall as a percentage of total expenses because of compression in staff strength. Table 15.4 Reserve Bank Accounts ( billion) Year

Income Expenditure

1 1997–98

2 140.8

3 47.6

Net Income (2 - 3) 4 93.2

1998–99

192.2

45.5

146.7

1999–2000

219.6

53.4

166.2

2000–01

218.5

55.9

162.6

2001–02

246.9

65.4

181.5

2002–03

231.8

67.2

164.6

2003–04

143.2

77.6

65.6

2004–05

190.3

68.1

122.2

2005–06

263.2

58.5

204.7

2006–07

410.4

71.6

338.8

2007–08

577.5

61.0

516.5

Source: RBI, Annual Report, various years.

Transfer Transfer Total to CR‡ to ADR† Transfers (5 + 6) 5 6 7 21.6 11.8 33.4 (23.2) (12.6) (35.8) 89.2 12.7 101.9 (60.8) (8.7)’ (69.5) 65.5 7.1 72.6 (39.4) (4.3) (43.7) 62.0 7.0 69.0 (38.1) (4.3) (42.4) 70.0 8.3 78.3 (38.6) (4.5) (43.1) 67.3 8.9 76.2 (40.9) (5.4) (46.3) 9.7 1.9 11.6 (14.8) (2.9) (17.7) 61.3 6.9 68.2 (50.2) (5.6) (55.8) 109.4 11.3 120.7 (53.4) (5.5) (59.0) 204.9 19.7 224.6 (60.5) (5.8) (66.3) 334.3 32.1 366.4 (64.7) (6.2) (70.9)

Surplus Paid to Govt 8 59.8 (64.2) 44.8 (30.5) 93.5 (56.3) 93.5 (57.6) 103.2 (56.9) 88.3 (53.7) 54.0 (82.3) 54.0 (44.2) 84.0 (41.0) 114.1* (33.7) 150.1 (29.1)

Notes: ‡Contingency Reserve, †Asset Development Reserve. *Excluding profit on account of sale of shares of SBI. Figures in brackets indicate the percentage of net income (column no. 4). 655

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the reserve bank of india In mid-2001, one of the Directors of the Central Board desired that functional classification of expenditure be made for the past year to show the cost structure of the working and functions of the Bank more clearly. Accordingly, Deputy Governor Reddy constituted an informal working group, drawing officers from various departments, to examine the activitywise and function-wise cost and employee structure of various functions of the Bank. The group identified the following major functions: currency management; banker to the government; banker to banks; management of public debt and foreign exchange reserves; monetary management; exchange control; development functions; and regulation and supervision of financial sector. In terms of functions, currency management took away around 26 per cent, banker to the government 22 per cent, monetary policy operations 29 per cent, support functions 14 per cent, and others 9 per cent of total expenditure. The study showed that currency management and in-house support functions engaged the services of the most significant proportion of the total available workforce. While currency management pre-empted around one-third, the support functions required 28.5 per cent of the total staff. The group also concluded that the total expenditure of the Bank could be divided into three categories: direct staff cost, exogenous cost and other costs, with exogenous cost constituting over 68 per cent of the total cost.

Ownership of Institutions The Bank held shares in State Bank of India (SBI), the NHB, the Infrastructure Development Finance Company (IDFC), the DICGC, NABARD, the Bharatiya Reserve Bank Note Mudran Private Ltd. (BRBNMPL), the Discount and Finance House of India (DFHI) and the Securities Trading Corporation of India (STCI). Narasimham Committee II (1998) observed that the regulator and owner cannot be the same entity and, therefore, the Bank should divest its holding in banks and FIs to avoid conflicts of interest. The Advisory Group on Banking Supervision headed by M. S. Verma held a similar view. A discussion paper prepared by the Bank in January 1999 on harmonising the role and operations of development financial institutions and banks suggested that the Bank could transfer the ownership to the government. The Bank had already started the process of disinvestment in the DFHI in September 1994, and the STCI in 1997. The Bank had held 51 per cent of the share capital of the DFHI, which 656

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organisational change was brought down by disinvestment to 37 per cent at the end of March 1995, 12 per cent at the end of March 1996 and 10.5 per cent at the end of March 1997. Similarly, it had held 50.18 per cent of the share capital of the STCI since its inception in May 1994, which was diluted to 14.4 per cent in 1997 after a CCB decision in its meeting held on 29 October 1997. The Bank in its Annual Monetary and Credit Policy statement for the year 2001–02 dated 19 April 2001, announced its intention to (a) divest its remaining holding in the DFHI and the STCI during that year, (b) initiate the process of transfer of shares in respect of the IDFC at an appropriate time, (c) pursue with the government the issue of the transfer of the Bank’s shareholdings in SBI, NABARD and the NHB to the government, (d) not divest its holdings in the BRBNMPL as there was no regulatory implication and (e) follow up with the government on the proposal of a new Act on the DICGC. Accordingly, the Reserve Bank completed the divestment of its stake in the DFHI and the STCI to other existing shareholders before March 2002 and sold its stake of 15 per cent in the IDFC in January 2005 to the Government of India. With regard to the transfer of the Bank’s shareholding in SBI to the government, the Reserve Bank had in fact written to the government in May 1999 on a proposal of transferring the Bank’s shareholding in SBI, for which the government had replied in April 2000 that these transfers would be considered later. After the announcement of the monetary policy statement in April 2001, the Reserve Bank set up an internal working group under the chairmanship of P. B. Mathur, Executive Director, to finalise the modalities of such transfers. Based on the recommendations of the report, the proposal for amendments to the SBI Act, the NHB Act and the NABARD Act for disinvestment of the Bank’s holdings in these institutions was sent to the government in 2002. As there was no development on the issue, the Reserve Bank again requested the government in 2005 to take over the Reserve Bank’s shareholding in SBI. Eventually, after sorting out procedural issues, the government promulgated an ordinance on 21 June 2007 carrying out certain amendments to the SBI Act to enable the transfer of shares. The Reserve Bank sold its stake of 59.73 per cent of paid-up capital of SBI on 29 June 2007 to the government. The stake sale in NABARD was effected subsequently. The accounting of the SBI transaction came in for criticism. The former Deputy Governor S. S. Tarapore called the transaction a ‘fiscal fudge’ and the worst kind of financial engineering. The government showed the purchase of SBI shares from the Reserve Bank as a capital expenditure, but the Bank’s capital 657

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the reserve bank of india gain transferred to the government along with the Bank’s profit was recorded under the government’s revenue receipt. As a result, the gross fiscal deficit remained unchanged while the revenue deficit shrank.

Conclusion This chapter is about the journey of the Reserve Bank, not a smooth journey, to become a leaner, dynamic and resilient organisation capable of handling a more diverse and challenging range of tasks with a smaller workforce. The keys to this process were human capital formation, incentivising training and professionalism, equality of opportunities at the workplace, and a restructuring of the workforce. At the same time, the Bank reduced its commitment to ownership of subsidiaries. The outcome was a more skill-oriented organisation than before. Many corporate groups needed to become more efficient after the economic reforms of the 1990s began. But whereas companies did so because they were subject to competitive market forces, the Bank took this road thanks to proactive leadership.

Notes

1. The number of government officials was increased to two with effect from 1 February 2012, as amended in the RBI Act. 2. This was during the reference period. Also see note 19. 3. Reserve Bank of India (RBI), The Reserve Bank of India, Vol. 3: 1967–1981 (Mumbai: Reserve Bank of India, 2005), pp. 467–70. 4. The units operating in the four metros – Mumbai, Kolkata, Delhi and Chennai – are known as offices, while the units located at other cities and towns are called branches. Sub-offices are those working under the overall charge of one of the offices. 5. The reorganisation of the departments is discussed in related chapters. 6. Employees who had completed twenty-five years of full-time regular service and were fifty years of age as on 1 August 2003 were eligible. The scheme was closed on 31 December 2003. About 4,468 employees opted for voluntary retirement. Of which, Class I staff (officers) comprised 2,058, accounting for a major share of 46 per cent. 7. Ramesh Chander, Regional Director, Jaipur, ‘Letter to Central Office’, 2001. 8. Rajya Sabha Question Dy. No. 631 for answer on 22 July 2003, tabled by Raj Kumar Dhoot. 658

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organisational change 9. See the section titled ‘Organisational Climate Survey’. 10. Under the staff exchange programme of SAARCFINANCE, a network of central bank governors and finance secretaries. 11. See http://www.cgspublicationindia.com/5th_Pay_Commission.aspx. 12. Chairman: D. B. Phatak. 13. Chairman: S. P. Talwar, Deputy Governor. 14. Chairman: R. B. Barman, Executive Director. 15. See Chapter 9. 16. Chairman S. S. Tarapore. 17. End of June. 18. In the light of observations made by the Supreme Court in one of its judgments, after the term of the board was over in February 1999, the board was renamed as the Central Advisory Board on Bank Frauds (CABBF) and brought under the Central Vigilance Commission (CVC), in order to advise the CBI on bank frauds. In August 2000, the board was renamed the Advisory Board for Bank, Commercial and Financial Frauds (ABBCFF) to cover central PSUs and FIs. There were twenty-four cases referred for advice by the Bank to the ABBF, fifteen cases by the CBI to the CABBF, and ninettwo cases (up to March 2008) by the CBI/CVC to the ABBCF, including nine Unit Trust of India cases referred by the CVC in 2002–03. 19. The Bank’s accounts were maintained on the basis of financial years that ran from 1 July to 30 June, while the government’s financial year ran from 1 April to 31 March. The Bank’s financial year was changed to 1 April to 31 March with effect from 2021–22, with the previous financial year, that is, 2020–21 running from 1 July to 31 March, as a transitional arrangement. The Central Board meeting to finalise the Bank’s accounts for 2020–21 was held on 21 May 2021. 20. Narendra Jadhav, Partha Ray, Dhritidyuti Bose and Indranil Sen Gupta, ‘Financial Sector Reforms and the Balance Sheet of RBI’, Economic and Political Weekly 40, no. 12 (2005): 1142–43 and 1145–50. 21. S. S. Tarapore, ‘Strengthening the Reserve Bank of India Balance Sheet’, First Seminar on RBI Balance Sheet Management, Bankers’ Training College, Mumbai, 1997. 22. The ‘Exchange Fluctuation Reserve’ was renamed ‘Currency and Gold Revaluation Account’ in 2001–02.

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appendices Appendix 8A.1  Vision Documents: Implementation Vision Document: 2001–2004 Under the approach to computerisation and networking, with the definitive role of technology in facilitating large-scale developments in payment and settlement systems, the main requirements of the Indian Financial Network (INFINET) becoming the secure, dedicated communication backbone for the banking and financial sector, namely a generic architecture model for connectivity, standardisation of hardware, operating systems, systems software, application software and messaging middleware, prescribing a common minimum requirement level for hardware and networking requirements for payment gateways, secured connectivity between the internet and INFINET, and a link between the Society for Worldwide Interbank Financial Telecommunication (SWIFT) and INFINET had all been achieved; facilities for e-mail and secured file transfer were available on INFINET; and applications for automated teller machine (ATM) transactions, intra-bank transactions like remittances and foreign exchange transactions used INFINET. The setting up of the Credit Information Bureau of India Ltd. (CIBIL) facilitated the banking industry to carry out a credit check on credit card holders and, thus, reduced the incidence of frauds and default by individuals. As regards the design, development and implementation of critical payment system projects, the following were the major accomplishments: • Extension of magnetic ink character recognition (MICR) based clearing to cover forty major commercial centres, thereby facilitating faster clearing of cheques at more centres. • Operationalisation of real time gross settlement (RTGS) system (RTGS service available at more than 4,800 branches at 398 centres as at the end of April 2005). • Risk mitigation in wholesale payment systems by way of creating enabling conditions for establishment of the Clearing Corporation of India Limited (CCIL) as a central counter party and settlement guarantee organisation for settlement of government securities trading amongst the negotiated dealing system (NDS) members and interbank foreign exchange transactions. • Introduction of the NDS for government securities and migrating to delivery versus payment (DVP) III mode of settlement. • Implementation of the structured financial messaging solution (SFMS) and the centralised funds management system (CFMS). Using CFMS, 679

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• • •

• • • •

• •

•

•

680

banks maintaining accounts with the Reserve Bank at its various offices were in a position to know their balances at each location from their treasury branch. Increase in scope and coverage of electronic clearing service (ECS) in both its variants – credit clearing and debit clearing. Implementation of centralised ECS. Enhancement in scope and coverage of the electronic funds transfer (EFT) system had been achieved through the special EFT and the proposed national EFT; many banks had integrated EFT with their own product offerings. Removal of the per transaction limit for ECS and EFT transactions Participation of a few banks in electronic data inter-change (EDI) projects initiated by the Government of India. Launching of pilot project of multi-application smart cards as a prelude to setting standards in smart cards. Creating conditions for competition in financial switch service for interconnecting ATMs, leading to establishment of the national financial switch by the Institute for Development and Research in Banking Technology (IDRBT). Initiating steps for the cheque truncation pilot project in New Delhi. For the customer, there had been definitive benefits. Internetbased banking, which was one of the goals to be achieved, had been implemented in twenty-six banks. The need for core banking solutions at banks, which was at the base of many centralised initiatives such as internet and mobile banking, was also being implemented by banks and as many as thirty-nine banks had implemented core banking solutions while twenty-nine were at various stages of implementation. The delivery channels for customers had also improved with ATMs taking over a large number of cash-related functions. Recognising the potential of this delivery channel, the Reserve Bank not only set the direction for banks to share ATMs but also helped the settlement process in the form of an ATM switch, which had been set up and operated by the IDRBT, Hyderabad. Thus, card holders of any bank among the group can use their cards at the ATMs of any bank in the group. With regard to the upgrading of the processing environment, banks were undertaking business process re-engineering (BPR) as a part of implementing core banking, security standards had been prescribed, public key infrastructure (PKI) based digital signatures were used for security and legal protection.

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On the legal front, the Negotiable Instruments Act, 1881, had already been amended to enable cheque truncation and to define e-cheque. A Payment and Settlement Systems Bill had been drafted. Consequent upon the Government of India gazette notification dated 18 February 2005 of the Reserve Bank of India (Board for Regulation and Supervision of Payment and Settlement Systems) Regulation, 2005, a Board for Payment and Settlement Systems had been constituted with effect from 7 March 2005.

Vision Document: 2005–08 •

• •

•

• •

•

The Payment and Settlement Systems Act, 2007 (the Act), had been enacted and the regulations under the Act, namely the Board for Regulation and Supervision of Payment and Settlement Systems Regulations, 2008, and the Payment and Settlement Systems Regulations, 2008, had come into effect from 12 August 2008. The National Payments Corporation of India Ltd. (NPCI), a company to operate retail payments, had been set up. The centralised funds management system (CFMS), which facilitates own account funds transfer across offices of the Bank, had been operationalised at all Reserve Bank centres. Use of the CFMS as a mode of funds transfer to achieve a national settlement system (NSS) was recommended by the committee set up to finalise the modalities for implementation of the NSS. Availability of the RTGS and national electronic funds transfer (NEFT) systems at more than 55,000 branches across the country had surpassed the target of 500 capital market intensive centres identified by the two stock exchanges (Bombay Stock Exchange and National Stock Exchange). NEFT settlement timings were rationalised. A separate new gateway for NEFT was also successfully operationalised. Back-up arrangements at the Reserve Bank data centre were activated. Extending NEFT beyond India was also achieved with the implementation of the Indo-Nepal Remittance Facility Scheme, a low-cost alternative for Nepali migrants in India to remit periodic sums back to Nepal. National ECS (NECS) was successfully launched in 2008. The NECS leverages on the core banking enabled network of bank branches with access from a centralised location (in Mumbai), thus providing pan-India 681

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•

•

•

•

• •

• •

•

coverage. The launch of the NECS was yet another attempt to provide a national character to critical and popular payment systems. Local ECS availability was extended to seventy-six major locations in the country. The clearing cycle for local ECS was successfully brought down from T + 5 to T + 1. T + 1 clearing cycle is operational uniformly at all ECS centres in the country. The cheque truncation system (CTS) was successfully implemented in the National Capital Region of New Delhi. All member banks of the New Delhi Bankers’ Clearing House were participating in the CTS. MICR clearing in New Delhi was discontinued. MICR-cheque processing centres (MICR-CPCs) were set up at thirtyone more centres during the period, taking the total number of MICRCPC locations to sixty-six and the number of MICR-CPCs to seventyone. At centres with low cheque volume but where there were five or more bank branches or at district headquarters where there were three or more bank branches, clearing houses (CHs) had been opened, with settlement arrived at by using the magnetic media based clearing system (MMBCS). Computerisation of CHs at over 90 per cent of the locations had been achieved. Improvements in outstation cheque collection – operationalisation of speed clearing to provide a facility for realisation of outstation cheques at the local centre of deposit was conceptualised and implemented in 2008. Minimum standards of operational efficiency at MICR-CPCs and other CHs operating with the MMBCS package were framed and put in place. All CHs were required to submit quarterly/half yearly self-assessment reports to the respective regional offices of the Bank. Benchmark indicators of efficiency for ECS (Credit and Debit) operations were formulated. Apart from the mechanism of Banking Ombudsmen to handle payment system related complaints, arrangements were put in place to look into queries and redress grievances of stakeholders by way of a NEFT help desk at NCC-Nariman Point, placing contact details of RTGS participants on the Bank’s website, and so on. List of centres offering ECS, locations where speed clearing is operational, consolidated links to cheque collection policies (CCPs) of banks, comprehensive list of CHs, details of branches with Indian Financial System Code (IFSC) and MICR codes, particulars of branches offering

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•

•

RTGS and NEFT products, frequently asked questions, or FAQs, on various payment system products, and, were placed on the Bank’s website for wider dissemination and stakeholder awareness. The Department of Payment and Settlement Systems also participated effectively in various international and national events relating to payments systems. The Bank was actively represented in the SAARC Payments Council deliberations and a meeting of the council was also organised in the country. A world-class data centre with an on-city and off-city back-up had been set up. Back-up arrangements for RTGS, CFMS, NEFT and other critical payment systems had been put in place.

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appendices Appendix 8A.2 Core Principles for Systemically Important Payment Systems A robust and efficient payment system is a key requirement in promoting financial stability since payment systems are a major channel through which shocks may be transmitted across domestic and international financial systems and markets. In recognition of this, the Committee on Payment and Settlement Systems of the Bank for International Settlements had in January 2001 published a paper, ‘Core Principles for Systemically Important Payment Systems’. The core principles, ten in number, were a common set of universal international standards and best practices. These principles were aimed at reducing risks, achieving safety, measuring the efficiency of the financial systems and encouraging the development of appropriate strategies for the operation of safer and more efficient systemically important payment systems worldwide. They also incorporated the responsibilities of the central bank in applying these principles.

Core Principles 1. The system should have a well-founded legal basis under all relevant jurisdictions. 2. The system’s rules and procedures should enable participants to have a clear understanding of the system’s impact on each of the financial risks they incur through participation in it. 3. The system should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain those risks. 4. The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day. 5. A system in which multilateral netting takes place should, at the minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement exposure. 6. Assets used for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk.

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appendices 7. The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion of daily processing. 8. The system should provide a means of making payments that is practical for its users and efficient for the economy. 9. The system should have objective and publicly disclosed criteria for participation, which permit fair and open access. 10. The system’s governance arrangements should be effective, accountable and transparent.

Responsibilities of the Central Bank in Applying the Core Principles 1. The central bank should define clearly its payment system objectives and should disclose publicly its role and major policies with respect to systemically important payment systems. 2. The central bank should oversee compliance with the core principles. 3. The central bank should oversee compliance with the core principles by systems it does not operate and it should have the ability to carry out this oversight. 4. The central bank, in promoting payment system safety and efficiency through the core principles, should cooperate with other central banks and with any other relevant domestic or foreign authorities.

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.

. Photographs

Photograph 1  Governor Dr C. Rangarajan thenFinance Union Photo 1 governor Dr C. Rangarajan and thenand Union Finance Secretary Shri M. S. Ahluwalia exchanging documents Secretary Shri M. S. Ahluwalia exchanging documents of ‘ways of ‘ways andadvances means advances agreement’ in New1997 Delhi, 1997 and means agreement’ in New Delhi,

Photograph 2  Governor Dr Jalan Bimal Jalan inaugurating the Photo 2 governor Dr Bimal inaugurating the currency currency verification and sorting system at RBI, Chandigarh, verification and sorting system in RBI, Chandigarh, 18 February 18 February 1999 1999 699

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PHOTOgRAPHS photographs

Photograph P. J. Kalam, Abdul Kalam, President India,his during visitMumbai, to RBI, Photo 3 Dr3  A. Dr P. J.A. Abdul President of India,ofduring visit tohisRBI, Mumbai, in connection with the inauguration of the Monetary Museum, November in connection with the inauguration of the Monetary Museum, November 2004 2004

Photo 4 Inauguration of the Centre Advanced Financial Learning BTC)(earlier by the Photograph 4  Inauguration of thefor Centre for Advanced Financial(earlier Learning Prime Minister, Dr Manmohan in RBI,Singh, Mumbai, 18 March 200618 March 2006 BTC) by the Prime Minister, DrSingh, Manmohan at RBI, Mumbai,

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photographs

Photograph 5  Finance Minister Shri P. Chidambaram’s visit in connection with the inauguration of the state-of-the-art integrated dealing room at RBI, Mumbai, 21 December 2007

Photograph 6  Deputy Governor Dr Y. V. Reddy meeting with Mr Phil Croft, Minister of Foreign Affairs and Trade, New Zealand, 5 March 2001

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Photograph 7  Deputy Governor Dr Y. V. Reddy meeting with Mr Rob Wright, Deputy Minister of Trade, Canada, 19 March 2001

Photograph 8  Governor Dr Y. V. Reddy welcomes Mr Timothy Geithner, then President, Federal Reserve Bank of New York, during his visit to the Bank on 26 July 2006

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Photograph 9  Visit of Prime Minister Dr Manmohan Singh in connection with the inauguration of the Centre for Advanced Financial Learning (earlier BTC) at RBI, Mumbai, 18 March 2006

Photograph 10  Finance Minister Shri Yashwant Sinha and Governor Dr Bimal Jalan in a Central Board meeting, March 1998

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Photograph 11  Finance Minister Shri Yashwant Sinha and Governor Dr Bimal Jalan in a Central Board meeting, 13 March 1999

Photograph 12  Finance Minister Shri Jaswant Singh and Deputy Governor Dr Rakesh Mohan in a Central Board meeting, 19 December 2002

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Photograph 13  Finance Minister Shri P. Chidambaram and Governor Dr Y. V. Reddy in a Central Board meeting at RBI, Mumbai, 9 August 2007

Photograph 14  Interaction with Dr C. Rangarajan in Ahmedabad on 14 April 2018 for recording oral evidence

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Photograph 15  Interaction with Dr Bimal Jalan in New Delhi on 19 December 2017 for recording oral evidence

Photograph 16  Interaction with Dr Y. V. Reddy in Hyderabad on 4 January 2018 for recording oral evidence

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Photograph 17  Deputy Governor Dr Y. V. Reddy participating in the auction of state government debt in RBI, Chandigarh, 13 January 1999. For the first time, RBI permitted state governments to raise a part of their borrowing from the market in a flexible manner; earlier the rate of interest was decided by the Bank.

Photograph 18  The Public Accounts Committee is seen having a meeting with Governor Dr Bimal Jalan in Mumbai, 19 June 2002

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Ahluwalia, Montek S. ‘Economic Reforms in India since 1991: Has Gradualism Worked?’ Journal of Economic Perspectives 16, no. 3 (2002): 67–88. Bhoi, Barendra Kumar and Harendra Kumar Behera. ‘India’s Potential Output Revisited’. RBI Working Paper Series 05/2016, 2016. Buiter, Willem H. and Urjit R. Patel. ‘Fiscal Rules in India: Are They Effective?’ NBER Working Paper Series, Cambridge, MA, 2010. EPW Research Foundation. ‘Downward Sticky Lending Rates’. Economic and Political Weekly 44, no. 25 (2009): 25–31. ———. ‘Whither Exchange Rate Policy?’ Economic and Political Weekly 44, no. 34 (2009): 25–31. Government of India. The Report on Increasing the Life of Indian Bank Notes. New Delhi: Ministry of Finance, 2000. ———. Report of the Committee on Financial Sector Reforms. New Delhi: Planning Commission, 2009. ———. Debt and Investment Surveys: National Sample Survey 1992 (48th Round). New Delhi: Ministry of Statistics and Programme Implementation, 1998. ———. Debt and Investment Surveys: National Sample Survey 2003 (59th Round). New Delhi: Ministry of Statistics and Programme Implementation, 2005–06. ———. Debt and Investment Surveys: National Sample Survey 2013 (70th Round). New Delhi: Ministry of Statistics and Programme Implementation, 2014. International Monetary Fund. ‘India: Selected Issues’. Staff Country Reports, Issue 112. 1998. ———. ‘India: 2007 Article IV Consultation’. Country Report No. 08/51. 2008. Jadhav, Narendra, Partha Ray, Dhritidyuti Bose and Indranil Sen Gupta. ‘Financial Sector Reforms and the Balance Sheet of RBI’. Economic and Political Weekly 40, no. 12 (2005): 1142–43 and 1145–50. Jangili, Ramesh and Sharad Kumar. ‘Determinants of Private Corporate Sector Investment in India’. Reserve Bank of India Occasional Papers 31, no. 3 (2010): 67–89. Kanagasabapathy, K. ‘Post-Reform Performance of the Private Corporate Sector’. EPW Research Foundation, Mumbai, 2009. 708

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Index

‘Abhay’ credit counselling centre, Mumbai, 591 ABN Amro, 392 ‘account payee’ refund orders, 495 account performance appraisal, 623 Act of Parliament, 439, 441 Administrative Staff College of India (ASCI), Hyderabad, 256, 352, 628 Advisory Board for Bank, Commercial and Financial Frauds (ABBCFF), 659n18 Advisory Board on Bank Frauds (ABBF), 646 Advisory Group on Banking Supervision, 479 on Transparency in Monetary and Financial Policies, 280n17 agricultural credit, 531–532 credit societies, 525, 545 loans, 529 Agricultural Refinance and Development Corporation, 441 Ahluwalia, Montek Singh, 73, 173 All India Reserve Bank Employees Association (AIRBEA), 624 All India State Bank Officers’ Federation, 321

amalgamation and mergers, 396–400 American depository receipts (ADRs), 39, 101, 389 Annual Branch Expansion Plans, 403 Annual Monetary Policy Statement, The, 124, 224n9, 236, 401 Annual Report, 1998–99, 118, 278n4 anti-money-laundering (AML), 402, 404–405, 495 Financial Action Task Force (FATF), 426n68 approval route, of ECBs, 130. See also external commercial borrowing (ECB) A. S. Ganguly Working Group on Flow of Credit, 470n19 Ashok Leyland Finance Ltd, 397 Asian Crisis, adverse effects of, 149–150 Asian financial crisis, 1, 15–16 NDF market, 222 SWIFT for unit transactions, 294 Asian Development Bank (ADB), 104, 251, 549n2 Asian Tigers, 26 Assam. See also state government debt, management of loan suspension, 257 tranche loan, 258 asset classification, 524 norms for, 545 711

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Index Asset Development Reserve (ADR), 652 asset–liability management (ALM), 68, 195, 198, 223n8, 381, 418, 420n18, 452, 482, 484 for commercial banks, 206 asset reconstruction companies (ARCs), 396, 420n15, 430, 452–454, 453 Asset Reconstruction Company of India Limited (ARCIL), 452 Asset Reconstruction Fund, 393 auction-based instruments, 8 auctions in government securities mechanism of conducting, 212 with T-bill, 220 auditors, for public sector banks, 491 audits, 647–649 authorised dealers (ADs), 94, 106, 115–117, 191 for gold, 170–171 permission to Indian branches, 104–105 Sodhani Committee’s recommendation for, 100 automated coin dispensing machines, 346 automated teller machines (ATMs), 288, 338, 339, 401–403, 492, 498, 546, 579 Bank’s role with, 402 automated value-free transfer of securities, 201 automatic route, of ECBs, 130. See also external commercial borrowing (ECB) autonomy, of the Reserve Bank, 4 available for sale (AFS), 377, 483 Axis Bank, 543 Azadi Express, 590 712

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back-stop facility, 52, 54 balance of payments, 15, 21, 60, 86, 600 indicators of, 39 balance sheet, 413, 488, 648, 649–651, 652 bank credit growth in, 25 money supply and, 31, 32 pricing of, 6, 44 regulation of, 4, 45 Bank Employees Federation of India, Kolkata, 350 Bankers’ Training College (BTC), Mumbai, 626 Bank for International Settlements (BIS), 16, 162, 292, 601, 632 bank frauds, 494–496 banking Banking Chintan and Anuchintan, 600 industry, 483 license, 386, 430, 463 technology, 585 Banking Codes and Standards Board of India (BCSBI), 11, 567, 575–578 aims of, 576 Charter of Rights, 576–577 circular on credit card operations, 578 Code of Bank’s Commitment to Customers, 577 Guidance Note to the Code, 577 membership of, 578 model policy documents, 577 rating system for banks, 578 scheduled banks registered with, 578 Banking Code Standards Board, UK, 576

Index Banking Companies (Acquisition and Transfer of Undertaking) Acts, 390 banking correspondents (BCs), 580 Banking Department, gold under, 172 Banking Ombudsman Scheme (BOS), 572, 575, 603, 622, 642 complaints handled by, 567, 574 complaints resolution through, 568–570 credit card complaints, 573 disagreement with the government, 570–572 Fast Track Criminal Court, 573 guidelines regarding the use of Hindi in, 647 Lokpal, 569 redressal of grievances against banks, 568 Banking Regulation Acts, 350 Banking Regulation Act (1949), 3, 77, 79, 517n1 Banking Regulation Act (2007), 47, 386 Banking Regulation (Amendment) Act (2007), 77 Banking Regulation (Amendment) and Miscellaneous Provisions Bill (2005), 77, 414 Banking Regulation (Amendment) Ordinance (2007), 414 banking sector, clean-up of, 26 BANKNET telecommunication network, 288 Bank Note Press (BNP), 346 banknotes cash processing activity, 642 disposal of soiled banknotes, 642

security features of, 364–365 Bank of America, 67, 332n52 Baroda, 328n27, 397, 398, 425n61 England, 184n42, 185n54, 280n16, 649 India, 544 Japan, 166 Karad, 396 Madura, 399 Nova Scotia (BNS), 178 Punjab, 399 bank rate, 5, 44–45, 510 announcement of, 65 changes in, 66 Internal Group on, 63, 64 as a reference rate, 65 signalling effect of, 65 banks, 446, 509–510 for accepting gold deposits, Reserve Bank approval, 171 authorised for gold import, 175 investment in bonds, 537 subsidiaries, 409–413 Bank’s Annual Report for 2007–08, 217 Bareilly Bank, 398 Bareilly Corporation Bank Ltd, 375, 397 Barman, R. B., 624 Basel Committee on Banking Supervision (BCBS), 376, 479, 483 Basel I norms, 376, 432, 477n65 Basel II norms, 16, 376, 432, 477n65, 485, 494 Pillar 2 of, 496 basic banking services, 565, 592n6 Basic Indicator Approach, 376 Benares State Bank Ltd, 375, 397 benchmark prime lending rate (BPLR), 6, 70, 71 713

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Index Bernanke, Ben, 86 Best Practices Code (BPC), 562 Bharatiya Janata Party (BJP), 21 Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL), 338, 656 Bharat Overseas Bank Ltd, 399 Bhati, G. S., 626 Bhatt, Ela R., 538 bilateral currency swap, with Bank of Japan, 166 Birla Institute of Technology and Science (BITS), 353 Biswas, P. K., 623 blanket approval to Indian companies, grant, 102 Board for Financial Supervision (BFS), 216, 381, 438, 479, 566, 615 jurisdiction of, 479 Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), 9, 287, 298, 301, 615, 619 Bombay Public Trust Act (1950), 576 Bombay Stock Exchange, 398 bond markets, 417 borrowing categories of, 68 cost of, 30 programme of states, 265 by states, 262–263 branch authorisation, 400–402 branch licensing, 400–401 breach of security, 561 BRICS countries, 20 bridge loans, 432 broad money, share of currency, 337 Broad Spectrum Programmes, 626 Bureau of Indian Standards, on gold hallmarking, 174–175 714

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business continuity plan, 639–640 business facilitators (BFs), 581, 584 Business Line, 82, 234, 569 Business Standard, 234, 381 ‘buy-and-hold’ investors, 250 CAB Calling (College of Agricultural Banking), 600 call market, PDs in, 193–194 call money, 57 market, 187, 190–197 CAMELS, 480, 504, 509, 566 Canara Bank, 492 Canstar, 492 capital account convertibility, 6 liberalisation, 40 transactions, 55 capital account management, RBI in, 119–125 external commercial borrowings, 129–131 Indian investment abroad, 134–135 NRI deposits, 129–133 portfolio investment, 125–129 rupee debt, 134 short-term credits, 133–134 capital adequacy ratios, 491 capital gain, 526 Capital-Indexed Bonds (CIBs), 211, 217–218 capital inflows, 15, 40, 119–123 issues causing surge, 151–152 and reserves, 162 sterilisation of excess, 124 capital intensity of firms, 30 Capital Local Area Bank Ltd, 548 capital market exposure, 381–382, 486 capital–output ratio, 33 capital to risk-weighted assets ratio (CRAR), 117, 375–376, 384,

Index 393, 399, 460, 484, 494, 525 Capoor, Jagdish, 140n35, 535 card-based transactions, 316–317 card-issuing banks, 411 cash and debt management, monitoring group, 253–255 demand, trends in, 336–337 in payment settlement, 287 cash flow ratio, 30 cash-neutral assistance, 470n17 cash reserve ratio (CRR), 3, 45, 77, 82, 98, 192, 342, 432, 525 minimum and maximum statutory rates, 87n3 Catholic Syrian Bank Ltd, 375 ceilings on FII investments, 125–126 Central Advisory Board on Bank Frauds (CABBF), 659n18 central and state governments dated securities, ownership of, 243–244 debt management, Reserve Bank in, 227 Central Bank of India, 544 Central Bureau of Investigation (CBI), 360, 495, 646 Central Complaints Committee (CCC), 637 Central Economic Intelligence Bureau, 363 central government dated securities, maturity profile, 248 central government debt, management, 239–240, 243–249 debt consolidation, 251–253 debt swap 2003–04, 250–251 FRBs and bonds with call and put options, 249 group on cash and debt management,

monitoring, 253–255 ways and means advances to, 241–242 Central Government Securities Market, 219 centralised database management system (CDBMS), 601–602, 641 centralised funds management system (CFMS), 292, 296, 310, 332n48 Central Registrar of Cooperative Societies (CRCS), 463, 513 Central Vigilance Commission (CVC), 637, 659n18 centre–state relations, 459 Centurion Bank of Punjab (CBP), 399 certificates of deposit (CDs), 203–204, 206, 420n15 certificates of registration, 446, 453, 507 Chakrabarty, K. C., 581 Chakravarty Committee report (1985), 33 Chandrachud, Y. V., 629 Chandrasekhar, C. P., 234 channel of internal communication, 609 Charminar Cooperative Urban Bank Ltd, 460, 514 chartered accountancy, 620 Chaturvedi, G. C., 632 Chaudhuri, Saumitra, 234, 279n10 Chauhan, V. S., 252 chequable demand deposit accounts, 430 cheques clearing, 311–314 as payment system, 288 truncation system, 312–313, 332n51 715

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Index chest accounting module (CAM), 642 Chidambaram, P., 111, 151, 177, 414 chief executive officers (CEOs), 451, 482, 563 Chief General Managers, 616 Chief Vigilance Commission, 499 Officers, 625 circulars and notifications, 606 citizen’s charters, 370, 602–603 City Cooperative Bank Limited, Lucknow, 515 Civil Accounts Manual and Central Treasury Rules, 313 civil society organisations, 580–581 Clean Note Policy, 344, 348, 350 Clearing Corporation of India Ltd. (CCIL), 8, 76, 191, 292, 302–303, 386 CBLO, 194, 201, 212, 220, 288–289, 307–309, 311 in interbank dollar–rupee transactions settlement, 222 client–server architecture, 640 coins supply, 351–356 collateralised borrowing and lending obligation (CBLO), 8, 35, 190, 194, 201–202, 212, 220, 288, 289, 306, 307–309, 311, 483 collateralised financial markets, 492 collateralised lending facility (CLF), 51 withdrawal of, 65 College of Agricultural Banking (CAB), Pune, 466, 605, 627 colour shift thread, for notes, 365

716

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commercial bank’s financial system, regulation of, 373–374, 401–402 accounting standards, 414–417 amalgamation and mergers, 396–400 amendments to the BR Act and RBI Act, 413–414 anti-money-laundering standards, 404–405 bank subsidiaries, 409–413 policy on cross-border, 404 data sharing, 414–417 deregulation of credit regime, 405–407 infrastructure project, 406 mortgage guarantee companies, 406–407 derivatives, 407–408 foreign banks, 391–392 know-your-customer norms, 404–405 non-performing assets (NPAs), 394–396 para-banking activities, 409–413 private sector banks, 385–386 governance issues, 387–390 transfer of shares and voting rights, 386–387 prudential norms, 375–385 public sector banks, 390–391 regulatory overlap, 414–417 rehabilitation of weak banks, 392–394 statutory reserve, 414–417 tax issues, 414–417 commercial banks and commercial papers markets, 204–206 dependency on call money market, 196

Index Advisory Group on Banking Supervision, 479 consolidated supervision, 487–488 coordination and information sharing, 488–489 corporate governance, disclosure and housekeeping, 490–492 financial conglomerates, 489–490 interest rate risk and liquidity risk management, 483–484 lender of the last resort (LOLR), 492–493 miscellaneous matters, 502–503 off-site surveillance, 482–483 on-site inspection, 480–481 overseas operations and cross border supervision, 501–502 penal measures, 493–494 prompt corrective action (PCA), 484–485 risk-based supervision (RBS), 485–486 supervisory review process (SRP), 486–487 wilful defaulters and Credit Information Bureau, 499–501 commercial bill market, 206–207 commercial borrowings, in gross disbursements, 129 commercial papers (CPs) market, in India, 204–206 and certificate of deposits market, 206 issuances of, 225n22

Committee(s) appointed by Reserve Bank, 99–100 on Banking Sector Reforms (1998) (see Narasimham Committee II [1998]) on Capital Account Convertibility, 97–98, 237 of the Central Board (CCB), 567, 615 meetings of, 169 of Central Board of Directors of the Bank, 206 for Development of the Debt Market, 221 on Financial Sector Assessment (CFSA), 28, 33, 36, 334n75, 599 on Financial Sector Plan for the North-Eastern Region, 582 on Financial System (1991) (see Narasimham Committee I [1991]) on Foreign Exchange Reserve Management, 162 on ‘Fuller Capital Account Convertibility,’ 125 on Information Systems Audit and Information Systems Security, 640 on Procedures and Performance Audit on Public Services (CPPAPS), 6, 99, 369, 562–563, 641 recommendations of, 566, 578 to Review the Working of Monetary System (1985) (see Sukhamoy Chakravarty Committee [1985]) 717

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Index on Rupee Interest Rate Derivatives, 210 on Technology Upgradation in Banking Sector, 291, 328n27, 491 Common Seniority Group, 622 communication policy, of RBI, 596–598 external communication, 600–605 monetary museum, 608–609 monetary policy and regulatory communication, 598–599 other external communication channels, 600 website for dissemination of information, 606–607 internal communication Governor’s Letters, 609 handbooks and manuals, 609 RBI newsletter, 611 Regional Directors’ conference, 610 Without Reserve (in-house magazine), 611 issue of transparency, 599 communication skills, 622 Companies Act (1956), 74, 215, 438, 499 competition, between banks, 72 Competition Commission of India, 417–418 complaints redressal mechanism, 564 Comprehensive Economic Cooperation Agreement, 404 Comptroller General of Accounts, 313 computer-based trading system, 21 computerised bank statements, 561 718

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Computerised Off-site Surveillance and Monitoring System (COSMOS), 504, 640 computer literacy, 628 Computer Paribhasha Kosh (1997), 646 computer-related training programmes, 628 Confederation of Indian Industry (CII), 432 Conference of State Finance Secretaries, The, 16th, 283n38 confidence-building measures, 492 confidential reports, 623 conflict of interest, 9, 239, 389, 440, 441, 457, 546, 584, 645 consolidated financial statements (CFS), for public disclosure, 488 consolidated prudential reports (CPR), for supervisory assessment of risks, 488 consolidated sinking fund (CSF), 55, 254, 282n37 consolidated supervision, 487–488 Consultative Group of Directors of Banks and Financial Institutions, 490 Consultative Group to Assist the Poor (CGAP), 449, 587 Contingency Reserve (CR), 652 Continuous Linked Settlement Bank, 309 Controller of Capital Issues (CCI), 21, 422n34 control self-assessment audit (CSAA), 648 Cooperative Guarantee Fund, 638 cooperative institutions, 544–546 Cooperative Societies Acts, 458 coordination and information sharing, 488–489

Index Core Principles for Systemically Important Payment Systems, 323 corporate debt restructuring (CDR) system, 395, 436 corporate governance, 490–492 corporate mail system, 641, 643 corporate sector, in India constraints on its financing choices, 28 investment decisions, 30 performance of, 30 tax rate, 28 Corporation Bank, 67 correspondentes bancarios, 580 counterfeit notes, avoidance and detection, 356–364 credit, 538 agriculture and allied activities, 530 authorisation scheme, 619 counselling, 591 credit–deposit ratio, 381, 420n18, 517n8, 542 Credit Monitoring Arrangement, 405, 619 Credit Planning Cell, 48 delivery, agencies for, 584 refinance, 51, 55 regime, deregulation of, 405–407 supply, deregulation of, 5, 45 credit cards, 411 for payment, 216 Credit Information Bureau (India) Ltd (CIBIL), 499–501, 500 Credit Information Companies (Regulation) Act (2005), 500 Credit Suisse First Boston (CSFB), 174 Criminal Procedure Code, 361, 496 criminals, in note counterfeiting, 357

cross-border capital flows from 1997 to 2008, 148 cross-border policy on branch authorisation, 404 cross-border supervision, 501–502 crude oil prices, 122 Currency and Gold Revaluation Account (CGRA), 164, 652 currency chests Currency Chest Agreement, 370 mechanism, 342–344 reporting system (CCRS), 370–371, 642 currency management, 11, 336–341, 345, 608 coins supply, 351, 353, 356 cost of printing notes, 346–347 counterfeits avoidance and detection, 356–364 currency chest mechanism, 342–344 customer service, 369–370 ICCOMS, 370–371 incidental matters, 350–351 non-stapling of note packets, 348–350 post-print coating and polymer notes, 365–368 security features of, 364–365 soiled notes accumulation in bank vaults, 347–348 currency management information system (CMIS), 371, 643 Currency Note Press (CNP), 346 currency verification and processing system (CVPS), 344, 345 customer service, in banks, 1, 11–12, 616 Committee on Procedures and Performance Audit on Public Services (CPPAPS), 562–563 719

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Index complaints redressal mechanism, 564 consumer protection and, 560–568 Customer Service Department (CSD), 567–568 on notes and coins, 369–370 quality of, 566 standing committees on, 566 voluntary codes, 562 cylinder mould vat watermarked bank notes (CWBN), 340 Dalal, Sucheta, 499, 577 Dasgupta, Dilip, 499 data collection and dissemination, 118–119 dissemination, 112, 118, 597, 600–602, 605 sharing, principles of, 414–417, 488 warehouse, 641 Database on Indian Economy, 601 debit card, issuance and usage, 216 Deb, P. K., 176 debt consolidation, 251–253 Debt and Investment Survey, 532 debt–equity ratio, 25 debt swap scheme (DSS), 242 finance, supply of, 28 and investment management units (DIMUs), 285n50 management, 74, 76, 227–228, 641 functions of the Reserve Bank of India, 230 and monetary management, separation, 237–239 and monitoring group on cash, 253–255 strategy, 228–229 720

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in well-developed financial markets, 280n14 markets in India, classification, 211 raising, in foreign currency, 228 recovery tribunals (DRTs), 473n45 restructuring mechanism, 554n42 servicing, cost of, 28 stock, consolidation of, 229 swap of high-cost debt, 261–262 Reserve Bank proposal on, 250–251 Debt Management Office (DMO), 239 decision-making, 622, 646 power of, 47 decision support system, 601 default risk in money market, 207–208 Defence of India Act (1939), 96 deferred-net-settlement-based interbank clearing, 305 Deferred Payment Guarantee, 441 delivery-versus-payments (DvP) system, 191, 287, 639 denomination notes demand increase, 338 limitations in forecasting, 341 Department of Administration and Personnel Management (DAPM), 617, 636–637, 648 Department of Banking Operations and Development (DBOD), 178, 349, 374 Department of Banking Supervision (DBS), 541, 575 Department of Currency Management (DCM), 336 Department of Economic Affairs, 173 Department of Economic Analysis and Policy (DEAP), 626

Index Department of External Investments and Operations (DEIO), 175, 179n1, 183n34, 244, 302, 650 Department of Government and Bank Accounts (DGBA), 244, 639 Department of Information Technology (DIT), 619 in draft preparation, 299–300 and IDRBT, 295 in SWIFT application, 294 Department of Non-Banking Supervision (DNBS), 445, 619 Department of Payment and Settlement Systems (DPSS), 287, 301, 619, 639 Department of Telecommunications, 288, 294 deployment of foreign currency assets, 162–164 Deposit Accounts Department (DAD), 288, 303, 310, 635 integrated account system (IAS), 642 deposit and term money market, certificate of, 35 deposit insurance, 444 Deposit Insurance and Credit Guarantee Corporation (DICGC), 430, 492, 513, 637, 656 Depositories Act (1996), 213, 388 Deputy Governors’ Committee, 178 Deve Gowda, H. D., 21, 22 Development Credit Bank (DCB), 385 development financial institutions (DFIs), 400, 417 differential rate of interest scheme (DRI scheme), 528 Differentiated Bank Licence, 386

directed credit, policies of, 523 directed investments, 508 Directors of RBI, 615 disaster recovery systems (DRS), 640 drills, 643 management system, 639 Discount and Finance House of India (DFHI), 436, 656 dividend payout ratio, 30 dollar–rupee exchange rate, 53 domestic investment level, reserves for increasing, 168 domestic jewellery manufactures, gold loan, 178–179 Domestic Use of SWIFT’, 293 dot.com bubble (2000), 16 Draft Operating Guidelines for Mobile Payments in India’, 318 dual route, of ECBs, 130 duration gap method, 483 Dutch ING Group, 399 East Asia economic growth model, 26 export-oriented strategy, 26 financial crisis, 15–16, 28, 87 easy term, 639 e-commerce, growth of, 317–318 economic growth, impact on balance sheet of RBI, 33 economic liberalisation, 1, 14, 45, 618 reflections on managing, 3 economic reforms, 15, 28, 40, 41n10, 80, 524, 658 and the political environment, 20–23 Economic Times, 246, 480, 535, 541, 571 Economist, The, 605 effective supervision, principles of, 527 721

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Index efficient funds management, tools for, 310 electronic benefit transfer (EBT) advantages and disadvantages, 317 framework of, 586 systems, monitoring, 317–318 electronic bidding in auctions, 212 electronic clearing service (ECS), 9, 287, 639 electronic funds transfer (EFT), 8, 287, 314–315 clearance, 298 electronic payment system, 288 electronic transaction processing, legal basis, 298 e-mail, 607 emerging economies, 16, 19, 72, 86, 119, 152 emerging market countries, 16–17 Employees’ Provident Fund Organisation (EPFO), 259 Enforcement Directorate, 108, 112–113, 494 equity markets, in India, 34 erroneous debits, reversal of, 561 e-security, 641 euro, 122, 126, 150 adoption as single common currency in Europe, 16 euro–rupee reference rates, 601 Exchange Control Department, 139n21 exchange earners’ foreign currency (EEFC), 102, 136n2 Exchange Fluctuation Reserve Account, 164, 172 exchange rate management, RBI in, 147–148 chronological account 1997–98 to 2002–03, 148–151 2003–04 to 2007–08, 151–152 debates and practices, 152 722

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appreciating rupee, 153–154 autonomy of RBI, 155–156 impossible trinity, dealing, 155 monitoring tool, 156–158 system, for India, 153 foreign exchange reserves, management of, 159–161 non-deliverable forward market, 158–159 exchange rate of rupee appreciation of, 153–154 Reserve Bank in setting, 97 EXIM Bank, 429, 431, 435, 441, 469n12, 516, 550n10 Expenditure Rules, 654 Expert Group on Foreign Exchange, 97 export credit refinance, 53, 64 Export–Import (Exim) policy for 1997–2002, 175 for 2004, 175 announcement, 185n52 export processing zones, 383 export refinance facility (ERF), 5, 46 ex post facto reporting, 415 External Advisory Committee (EAC), 453 external asset managers (EAMs), 165–166 external commercial borrowing (ECB), 63, 101, 129–131 dual route of, 130 guidelines revision of, 102 principal elements of policy for, 130, 131 Reserve Bank’s approach towards, 129–130 external sector policies, 6–7 facilities for employees, 636–637 Fair Practices Code (FPC), 562

Index for credit card operations, 316–317 fake Indian currency notes (FICN), 360, 363 fake note detection role of local police, 361–363 through banking channels, 364 Federal Bank, 398 Federal Reserve Bank, New York, 168 fee reimbursement, 626 ferritic stainless steel (FSS), 352 Fifth Central Pay Commission report (1997), 631 Fifth Pay Commission, 36, 43n24, 631 Financial Companies Regulation Bill (2000), 455–456 financial conglomerates, 489–490 definition of, 490 financial education programme, 588, 604 Financial Express, 70, 234, 499, 528 financial inclusion, 11–12, 559–560 assessment of, 583–584 Banking Codes and Standards Board of India (BCSBI), 575–578 barriers to, 588 Committee on, 584 complaints resolution analysis of complaints, 575 Banking Ombudsman Scheme (BOS), 568–575 disagreement with the government, 570–572 credit counselling, 591 customer service and consumer protection, 560–561, 567–568 Committee on Procedures and Performance Audit on Public Services (CPPAPS), 562–563

Complaints Redressal Mechanism, 564 monitoring and enforcement, 566 pricing of products and services, 565–566 voluntary codes, 562 financial literacy initiatives, 588–591 ground-level initiatives, 581–583 IT solutions for, 584–586 technology funds, 586–587 regulatory guidelines on, 579–581 Financial Inclusion Fund, 587 Financial Inclusion Technology Fund, 587 financial institutions (FIs), 110–111, 428, 429–430, 431–442, 478, 492, 516, 523, 562, 608, 625 asset management, 432–433 conversion into banks, 431 corporate debt restructuring of, 436 data collection and dissemination reforms, 118–119 hedging and its instruments, 115–117 legal and institutional framework, 112–115 liability management, 433–434 Reserve Bank ownership of, 436 review of regulatory framework, 434–435 Financial Intelligence Unit–India, 405 financial literacy, 590 financial literacy-cum-credit counselling centre (FLCC), 590–591 financial market 7–9 components, 188 major developments, 1997–2008, 190–191 723

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Index regulatory structure in, 189 Financial Markets Committee (FMCRBI), 56, 80, 89n22, 148, 232, 303 Financial Markets Department (FMD), 236, 619 Financial Restructuring Authority, 393 Financial Sector Assessment Programme, 599 Financial Services Authority, of the United Kingdom (UK), 501, 564 financial stability, 1 Financial Times, 605 Financial Transaction Plan, of IMF, 124 first information reports (FIRs), 361–364 First War of Independence, 590 fiscal deficit, 21 monetisation of, 10 fiscal developments, in India, 35–38 fiscal fudge, 657 Fiscal Reforms Unit of the Department of Expenditure, 265 Fiscal Responsibility and Budget Management (FRBM) Act (2003), 3, 11, 36–37, 47, 73, 93n51, 185n48, 211, 227, 232, 236, 432, 527 Bill, 2000, passage, 233–235 debt and monetary management, separation, 237–239 fiscal responsibility legislation (FRL), 75, 278n4 at state level, 269 fiscal rule, in FRBM Act, 234 ‘fit and proper’ criteria, 498 Fitch Ratings, 481 five-day week, introduction of, 635–636 724

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fixed exchange rate, 7 Fixed Income Money Market and Derivatives Association of India (FIMMDA), 34, 89n19, 143n58, 191, 375, 378, 608 fixed-to-floating exchange, 225n25 floating rate bonds (FRBs), 8, 217– 218, 246, 249 floating rate loans, benchmarking of, 69–70, 164–165 central banks, 625 in currency chests operation, 344 foreign banks, 391–392, 501 foreign commercial and central bank deposits (FCBs), 168 wholly owned subsidiaries of, 391 foreign currency foreign currency assets (FCA), 159 foreign currency convertible bonds (FCCBs), 131, 145n72 foreign currency non-resident (banks) (FCNR[B]), 68, 104 investments, 649 foreign direct investment (FDI), 39, 96, 386, 450, 501 foreign equity participation, increase, 126 foreign exchange (forex) assets of Reserve Bank, 168 clearing settlement, 222 management of, 602 market (See foreign exchange market) regulation in India, genesis of, 96 remittance, limitation, 106 requirements, for crude oil import, 122 services liberalisation for residents, committees for, 99–100

Index transactions, 306Foreign Exchange Dealers’ Association of India (FEDAI), 191, 378 Foreign Exchange Department, 100, 113, 175 Foreign Exchange Management Act (FEMA, 1999), 2, 94, 114–115, 221, 588, 602–603 foreign exchange market, 2, 5, 7, 34, 44, 53, 95–103, 191, 221–222 and call money market, 187, 190 exchange rates movements, goals, 153 link with domestic money, 8 non-residents, 104–105 restrictions on residents, 105–107 Foreign Exchange Market Technical Advisory Committee, 100 Foreign Exchange Regulation Act (FERA, 1973), 2, 114–115 foreign exchange reserves, 7, 182n30, 159–161, 649, Foreign Institutional Investors (FIIs), 2, 103 equity investments by, 126 in government securities market, 190, 212 inflows of, 127–128 investment in Indian market, 125–126 Foreign Investment Promotion Board (FIPB), 102 foreign nationals in India, immovable property purchase, 107–108 foreign portfolio investment (FPI), 39 forex. See foreign exchange (forex) forex market development and regulation, RBI in, 94, 96–97, 101–103, 110–111, 118

capital account management, 119–125 external commercial borrowings, 129–131 Indian investment abroad, 134–135 NRI deposits, 131–133 portfolio investment, 125–129 rupee debt, 134 short-term credits, 133–134 hedging and its instruments, 115–117 legal and institutional framework, 112–115 on non-residents, 104–105 restrictions on residents, 105–107 reviews and recommendations, 97–101 forged notes Forged Note Vigilance Cell, 345, 357 methods for making, 361 ‘for-profit’ organisations, 539 Forward Contract (Regulation) Act (FCRA), 1952, 173 forward market and hedging instruments in India, 115–116 Forward Markets Commission (FMC), 407 Forward Rate Agreement (FRA), 116, 208 Fraud Monitoring Cell, 495 free capital movement, 7 free market competitive system, 523 Free Press Journal, 321 frequently asked questions (FAQs), 597, 602 Fuller Capital Account Convertibility, 99 Functional Programmes, 626 Functions and Working of RBI, 600 725

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Index fund management, by banks, 290 Gandhi, Rajiv, 21 Ganesh Bank of Kurundwad Ltd (GBK), 398 Gelli, Ramesh, 496 General Agreement on Trade in Services (GATS), 423n45 general credit cards (GCCs), 531, 579 General Insurance Corporation of India (GIC), 193, 282n37, 439 generally accepted accounting principles (GAAP), 520n38 Ghose, Sandip, 635 Ghosh, Jayati, 234 global depository receipts (GDRs), 39, 101, 389 global economy, 19 global financial crisis (2007–08), 4, 7, 10, 35, 87 currency management, 11 customer service, rural credit and financial inclusion, 11–12 external sector policies, 6–7 financial market developments, 7–9 financial meltdown during, 16 monetary management, 4–6 mortgage debt and, 408–409 organisation, 12–13 public debt management, 10–11 regulation and supervision, 9–10 global financial markets, 503 Global Trust Bank Ltd (GTB), 384, 492, 496–499 Goa, immovable property in, 107–108 Goiporia Committee, 562 Gold Bond scheme, 172 Gold Control Act (1968), 175 Gold Deposit Scheme (GDS), 171 726

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Golden Corridor infrastructure scheme, 168 Golden Quadrilateral, 23 Gold Import Authorisation Scheme, 416 gold loans, 416 gold management, RBI in assaying and hallmarking, 174– 175 gold hedging, 171–174 gold policy, 170–171 import of gold, 175–178 loan for domestic jewellery manufactures, 178–179 standardisation and upgrading of gold reserves, 171 good governance, 9–10, 143n62, 170, 239, 318, 373, 374, 387, 388, 390, 391, 393, 428, 432, 451, 457, 479, 490, 506, 524, 544, 557n61, 644 Gopalan, R., 178 Gopinath, Shyamala, 176, 178, 183n37, 239, 634 government bond, with call and put options, 249 government borrowing programmes, 45 government deficits, monetisation of, 45 government-guaranteed securities, 451 Government of India, 59, 74, 170, 276, 298, 323, 454, 533, 633 appointment of Board, 614–615 authority to issue 1 notes and coins, 351 for coins and supplies coins, authority to RBI, 353–356 in foreign exchange reserves management, 159 in forward contracts, 213

Index in FRBM Act formulation, 278 FRBs issuance, 249 in guarantee fund creation, 233 in issuance of ad hoc Treasury Bills, 232 management of public debt, 10 on MBP allocation to state government, 255 MoUs with NABARD, 545 in rupee coins import, 346 signing of Letter of Exchange, 134 and state government, tripartite agreement with, 272 in stock exchanges and securities transactions regulation, 300 treasury bills, 5 government-owned companies, 454–455 Government Pension Rule (1972), 632 government securities, 7 borrowing/lending mechanisms in, 34 collateral of, 51 foreign institutional investors in, 8 mandatory holding by banks, 45 market, 34, 44 non-marketable special securities, 57 reverse repo auctions in, 93n53 short-selling in, 34 Government Securities Act (2006), 212, 213, 229 government securities market, 210–213 retailing of, 214–215 STRIPS in, 218–219 Government Securities Regulations (2007), 229 Governor’s Letters, 609 Grey scale technology, 332n51 Grievance Redressal Cell (GRC), 637

gross disbursements, under commercial borrowings, 129 gross domestic product (GDP), 14, 27–28, 31, 33, 38, 62, 96, 278n4 gross tax–GDP ratio, 36 liabilities to GDP ratio, 36 trade to GDP ratio, 38 gross market borrowings, of central government, 239–240 Group of Seven (G7), 426n76 Group of Thirty, 334n73 Group of Twenty (G20), 16 Group on Monitoring of Cash and Debt Management, 253 growth–inflation trade-off, 33 Guarantee Fund, 233, 308–309, 333n54, 638 Guarantee Redemption Fund (GRF), 55, 284 Gujarat State Cooperative Bank, 492 Gujral, I. K., 21, 120, 149 Gupta, D. C., 175 Gupta, Dipankar Prasad, 630, 632 Similar correction needs to be corrected in the draft volume as well ‘haircut’, 224n19 hallmarking, of gold jewellery, 174–175 Handbook of Statistics on the Indian Economy, 601 hardship centres, 625 Hawala transactions, 113, 141n41 HDFC Bank, 330n37, 332n52, 399, 543, 585 hedging in international commodity markets, 115–117 held for trading (HFT), 377, 468n7 held to maturity (HTM), 377, 482 portfolios, 250 727

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Index ‘herd mentality’, 228 High Denomination Bank Notes Demonetisation Act (1978), 345 High-Level Committee on Banking Sector Reforms, 139n31 on Capital Markets, 111, 213–214 of Experts, 359 High-Level Coordination Committee on Financial and Capital Markets (HLCCFCM), 101, 488 high-quality digital technology, 357 high-value cash transactions, 494 high-value clearing (HVC), 313, 329n29 Hindi Interface, 647 Hindu temples, as gold depositor, 171 History of RBI, Volume 3, The, 125 Housing and Urban Development Corporation, 535–536 Housing Development Finance Corporation (HDFC), 537 housing loans, 380, 382, 487, 636 human resources, 639 account performance appraisal, 623 confidential reports, 623 job responsibility, 622 matters relating to pension updating debate, 630–634 recruitment and staff size, 619–622 promotion, 622–624 service tax, 634–635 staff regulation, 629–630 training, 625–628 transfer and deputation, 624–625 Optional Early Retirement 728

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Scheme, 621 performance appraisal system, 623 recruitment of classes IV and III staffs, 621 seniority-cum-merit, 622 seniority-cum-suitability, 622 staff strength and staff recruitment, 621 Human Resources Development Department (HRDD), 321, 619–620 Training Division, 626 human resources information system (HRIS), 640 hundi, 609 hybrid debt instruments, 376 ICCOMS–Issue Department (ICCOMS-ID), 371, 643 ICICI Bank, 326n11, 332n52, 399–400, 429–430, 492, 543, 585 IDBI Bank, 79, 385, 400, 407, 430, 454 import policy of gold, 170–171, 175–178 impossible trinity problem, dealing with, 155 income recognition, norms for, 545 Income Tax Act (1961), 107, 416, 462–463 Index of Industrial Production, 29 India Financial Corporation Limited, Lucknow, 450 India Infrastructure Company Ltd. (IIFCL), 169 India Millennium Deposits (IMDs), 58 issuance of, 122 redemption of, 61 and Resurgent India Bonds, redemptions, 167–168

Index rupee depreciation against dollar, 150 India Mortgage Guarantee Company, 406 Indian Bank, 383, 392, 582 loan portfolio of, 480 remittances charges, 99 Indian banknotes designing of, 357 security features in, 358 Indian Banks’ Association (IBA), 6, 70, 89n19, 191, 375, 403, 500, 536, 564, 635 local advisory panels, 564 Indian branches of ADs, permission to, 104–105 Indian Coinage Act (1906), 351 Indian companies investments in, 125–126 issuing rights to, 101–104 Indian Contract Act (1872), 298–299, 328n24 Indian debt market, 125–126 Indian direct investment abroad, conduits, 103 Indian Express, 234 Indian financial market, 187 Indian Financial Network (INFINET), 213, 292–297, 327n13, 641 Indian Financial System Codes (IFSC), 641 Indian foreign exchange (forex) market, 95–97, 148 growth, 180n6 Reserve Bank’s role in development and regulation, 94 on companies, 101–104 on non-residents, 104–105 restrictions on residents, 105–107

reviews and recommendations, 97–101 turnover in, 96 Indian Institute of Bank Management, Guwahati, 627 Indian Institute of Management, Bangalore, 386 Indian Institute of Technology, Mumbai, 585 Indian investment abroad, rise in, 134–135 Indian Oil Corporation, 122 Indian Overseas Bank, 70, 399 Indian payment and settlement systems, RBI in, 286–289, 302–306 assessment with reference to international standards, 323–324 BPSS and the DPSS formation, 301 CCIL, 307–309 centralised funds management system, 310 early institutional arrangements, 290–292 legal issues, 297–300 retail payment systems, 311–319 securities settlement systems and related developments, 309–310 umbrella organisation for retail payments, 320–323 VSAT technology and INFINET, 292–297 Indian Penal Code, 361, 495, 500 Indian rupee conversion, 94 and US dollar, exchange rates of, 148–152 Indian Securities Act (1920), 229 729

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Index Indian stock markets and overseas investors, FIIs in, 127 Indian students, facilities for, 106 India, slot of investment grade, 120–121 India Tourism and Trade Fair, Chennai, 588 indigenous banking system, 609 Indira Gandhi Institute of Development Research (IGIDR), Mumbai, 627 Indo-Japan currency swap agreement, 166 IndusInd Bank, 397 Industrial Credit and Investment Corporation of India (ICICI), 224n14, 429, 430 Industrial and Export Credit Department, 619 Industrial Development Bank of India Limited (IDBI Ltd), 193, 400, 429 industrial dispute, 320 Industrial Dispute Act, 635 Industrial Finance Corporation of India (IFCI), 429, 431, 437, 516 bonds, 79 Industrial Investment Bank of India Ltd (IIBI), 93n54, 429, 438 industrial licensing, 21 Industrial Reconstruction Bank of India (IRBI), 438 Industrial Reconstruction Corporation of India Ltd, 438 inflation, 32 Chakravarty Committee report (1985), 33 forecasting of, 49 growth in, 30 growth–inflation trade-off, 33 inflation-indexed bond, 8 730

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threshold level, 33 wholesale price index (WPI), 31 inflation control, objectives of, 47 inflation targeting, 48–49, 89n14 Information Security Management System (ISMS), 640 information sharing, on financial crimes, 501 information systems audit, 519n26, 640, 648 information technology (IT), 2, 9, 18, 614 Advisory Group on IT-Enabled Financial Inclusion, 585 Information Technology Act (2000), 298, 641 information technology-enabled services (ITeS), 22–23, 26 solutions for financial inclusion, 584–587 strategy of Bank, 290 usage in financial sector, 325n1 Infrastructure Development Finance Company (IDFC), 429, 436, 656 infrastructure lending, definition of, 406 ING Vysya Bank Ltd, 399, 534 initial public offerings (IPOs), 388, 495 scams in, 494–496 inspection, 647–649 Institute for Development and Research in Banking Technology (IDRBT), Hyderabad, 287, 292, 585, 587, 627 model for social security payments, 585 Institute of Chartered Accountants of India (ICAI), 415, 447, 498

Index institutional and legal framework, for public debt management, 229–231 instrument development floating rate bonds and capitalindexed bonds, 217–218 Mumbai Interbank Offered Rate, 221 short-selling, 219 STRIPS, 218–219 ‘when-issued’ trading, 219–220 Insurance Regulatory and Development Authority of India (IRDAI), 140n33, 412, 488 integrated accounting system (IAS), 304, 330n36 Integrated Computerised Currency Operations and Management System (ICCOMS), 370–371, 643 Intelligence Bureau (IB), 108, 361, 363 interactive voice response system (IVRS), 639 interbank call money market, 50, 195 dollar–rupee transactions settlement, 222 market, 8, 50, 54 participation certificates, types of, 206–207 payment settlements, 288 transactions, 95, 137n4, 305, 330n37, 331n44 inter-branch accounting, 491 inter-city telecommunication links, 641 bandwidth upgradation, 296 Inter-Departmental Committee (IDC), 391 interest-free loans, from NRIs, 105 interest rates, 69

deregulation of, 35, 456 impact analyses of rise of, 483 liberalisation of, 47 market-driven, 45 in money market, 198 regulation of, 45 risk, 483–484 on WMA, 242, 284n49 interest rate swap (IRS), 208 interim liquidity adjustment facility (ILAF), 50–51 Internal Capital Adequacy Assessment Process (ICAAP), 487 internal control system, of banks, 400, 490 Internal Coordination Committee on Prevention of Money Laundering and Financing of Terrorism, 405 Internal Debt Management Cell (IDMC), 244, 606 Internal Debt Management Department (IDMD), 52–53, 79, 179n1, 252, 281n29, 303, 619, 636 Internal Group on Bank Rate, 63, 64 on Payment Systems, 290 Internal Technical Group on Central Government Securities Market, 236–237 on Forex Markets, 6, 99 Internal Working Group on Currency Futures, 6, 99 International Bank for Reconstruction and Development, 251 international capital market access, 129 international commodity markets, hedging in, 115–116 International Finance Corporation (IFC), 104, 388 731

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Index International Monetary Fund (IMF), 17, 36, 49, 124–125, 136n1, 375, 556n50, 597 Articles of Agreement, 119 data dissemination system of, 599, 651 dissemination standards bulletin board, 601 India as member of, 118 invitation to India, 124–125 Mission under Article IV Consultation, 393 Report on the Observance of Standards and Codes (ROSC, 2002), 599 standards and codes to assess transparency, 599 trinity issue recognition, 181n18 working paper on ‘Central Bank Governance: A Survey of Board and Management,’ 644 International Organization for Standardization (ISO), 648 international standards, for payment and settlement systems assessment, 323–324 Investment Advisory Services, 412 investment fluctuation reserve (IFR), 378, 483 Investment Information and Credit Rating Agency of India Limited, 234 investment limits, for foreign institutional investors, 228 investor base, diversification of, 243–245 investor-friendly legal framework, 229–231 Issue Departments of the Bank, 289 732

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Jalan, Bimal, 2, 111, 156, 164, 167, 238, 375, 386, 393, 416, 466, 502, 597, 603, 605, 625–627 Jammu and Kashmir Bank Ltd ( J&K Bank), 534 Joint Coordination Committee ( JCC), 550n11 Joint Parliamentary Committee ( JPC), 101, 328n25, 390, 461, 482 joint venture, 103, 134, 174, 409–410, 434, 472n33 Joseph, F. R., 611 Kalam, A. P. J. Abdul, 609 Kamesam, Vepa, 273, 327n17, 349–350, 354, 366, 570, 572, 625 Kanagasabapathy, K., 53 Kargil conflict (1999), 21, 121 Karnataka Fiscal Responsibility Act (2002), 269 Kelkar, Vijay, 111, 174 Kerala Cooperative Societies Act (1969), 461 Kerala Fiscal Responsibility Act (2003), 269 Khadi and Village Industries Commission, 535 Kisan Credit Card (KCC), 528, 538–539, 579 know-your-customer (KYC), 317, 402, 404–405, 493–495, 507, 579 Kotak Mahindra Finance Ltd, 385 Krishna, Sanjay, 183n37 Krushi Cooperative Urban Bank Limited, Secunderabad, 515 Lamfalussy standards, introduction of, 323 lead bank scheme, 542–544 Leeladhar, V., 70, 495, 581, 632

Index Legal Department of the Bank, 171, 174, 654 legal issues, on Indian payment system, 297–300 legislation for payment and settlement systems, enactment of, 324 legislative framework for government securities market, 213 Lehman Brothers Capital, 4, 409 lender of the last resort (LOLR), 492–493, 497 Lenders’ Liability Laws (United States), 562 lending, 66 agricultural, 537 collateralised lending facility (CLF), 51 on consumer credit, 69 to food and agro-processing sectors, 531 infrastructure, 406 to the priority sector, 528–533, 535–537, 541 Foreign Banks and the Small Industries Development Bank of India (SIDBI), 534–535 Rural Infrastructural Development Fund (RIDF), 533–534 rate of interest, 537 sector-specific, 51 letters of displeasure, 493, 511 liberalisation in capital accounts, misuse, 101 of gold import, 177 of mutual funds investment in overseas markets, 111 in note refund rules, 351 of outflows, 103 of rupee–foreign currency swaps,

137n4 Liberalised Exchange Rate Management System, 97, 179n2 Liberalised Remittance Scheme, 63 LIBOR lending, 91n37 life insurance business, in India, 412 Life Insurance Corporation of India (LIC), 192, 243, 412, 439 Limited Purpose Bank, 386 lines of credit, 526, 547 liquid and active government securities market, 211 liquidity of banks, 478 crisis, 492 management, 120, 289 risk management, 165, 483–484 liquidity adjustment facility (LAF), 5, 8, 44, 45, 50–52, 76, 236, 483, 639 bank rate before and after, 63–66 Internal Group on, 57, 91n34 non-food credit, 60 reviews of, 56–59 operation, 53–54 second LAF (SLAF), 58 second stage of, 54–56 liquidity management, 5, 46, 55, 120, 289 operating procedure for, 63 listed banking companies, 388 live run’ of CCRS component, 371 loans delivery system, 67 against deposits, 461 portfolio, 71, 382, 480, 521n49 prepayment of, 102–103 for state governments, 260 Local Area Bank, 547–549 local area networks, 641 Lok Adalat, 395–396 733

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Index Lokpal, 569 Lok Sabha, 387, 455 London Bullion Market Association, 172 London Good Delivery Bars (LGDB), 172 London Good Delivery List, 172 London Interbank Offered Rate (LIBOR), 63, 131, 138n19, 184n38 London School of Economics and Political Science (LSE), 645 Lord Krishna Bank Ltd (LKB), 375, 399 M3 (broad money), 46 macroeconomic transformation, 31 macroeconomic trends external sector, 38–40 fiscal developments, 35–38 growth, savings and investment, 24–25 money and financial markets, 34–35 money supply, 31 prices, 31–33 structural change, 26–31 macro-prudential indicators, 502 Madhavpura Mercantile Cooperative Bank (MMCB), Ahmedabad, 459, 492, 512–513, 602 magnetic ink character recognition (MICR) technology, 287, 289 magnetic media-based clearing system (MMBCS), 302 management information system (MIS), 643 management information system and risk management, practices of, 165 734

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Manipur, loan suspension, 257. See also state government debt, management of Mansingh, L., 176 Marathe Committee (1994), 474n51, 622 marketable dated securities into special securities, conversion of, 244, 245 market-based monetary instruments, 63 repo, 46 market borrowing programmes (MBPs), 73–74, 227, 255–261, 259 additional market borrowing sanction to states, 262, 283n40 market capitalisation, 34 market-determined zero coupon yield curve, development of, 218 market development, process of, 8 market-driven interest rates, 5 market integration, advantages, 187 market intelligence, 302, 480, 503– 504, 518n13 market interest rate movements, 63 market repo, 35, 190, 198, 202, 236, 271 market reverse repo operations, 57 Market Stabilisation Scheme (MSS), 5, 44, 56, 58, 60, 124, 151, 200, 236 auctions of T-bills under, 61 issuance of MSS securities, 59 short-term and long-term securities under, 61 Mathur, P. B., 657 maximum permissible bank finance (MPBF), 405 Mehta, Lalitbhai, 168 Members of Parliament (MPs), 543

Index Members of the Legislative Assembly, 543 memorandum of understanding (MoU), 59, 368, 490, 533, 645 message transfer utilities, for communication system, 295 M-feature, in notes, 365 Micro Credit Cell, 538 microcredits, 580 microfinance, 580 microfinance institutions (MFIs), 449, 538, 581, 585 Micro Finance Institutions (Development and Regulation) Bill (2012), 553 Micro Financial Sector (Development and Regulation) Bill (2007), 553n36 micro-prudential indicators, 502 micro-regulation of banks, 92n40 Micro, Small and Medium Enterprises Development Act (2006), 554n42 Mid-Term Review of Monetary and Credit Policy (2003–04), 216, 489, 562 Minerals and Metals Trading Corporation (MMTC), 175 Minimum Standards at the Magnetic Media-Based Clearing System, 329n31 Minimum Standards for Operational Efficiency, 302 Minister of State for Finance, 349, 475, 570–571 Ministry of Company Affairs, 451 Ministry of Finance, 230, 390, 408, 412, 438, 441, 447, 453, 467, 488, 625, 646 in debt management, 253

demand-study of coins, conduct of, 355 Hindi Salahakar Samiti, 647 liaison group constituted by, 281n30 on Payment and Settlement Systems Bill, 299–300 in post-print coating introduction, 366 and the Reserve Bank amendments to the RBI Act, 239 coordination, 231–232 in setting additional security features in Indian notes, 365 in setting up forensic laboratories, 361 stapling note packets avoidance, 349 technical profile of Indian currency notes, 360 testing of polymer product on notes, 368 West Bengal government, 264 Mitra, N. L., 495 mobile phones in banking services, 318 Mohan, Rakesh, 60, 71, 91n34, 535, 605 monetary aggregate, 48 Monetary and Credit Information Review, 600 Monetary and Credit Policy, 54, 195, 196, 238 monetary and debt management, strategies for, 73 Monetary Authority of Singapore, 392, 404 monetary management, 2, 4–6 Bank Rate before and after LAF, 63–66 735

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Index changes in process and procedure interface with markets, 80–81 legal reform, 76–80 relationship with the government, 73–76 technical advisory committee on monetary policy, 81–87 forecast-based policy process, 86 instruments of, 45–46 liquidity adjustment facility (LAF), 50–59 mode of monitoring economic activity, 46 multiple indicators approach in, 46 objectives of, 44 open market operations (OMOs), 45 pricing of credit, 66–72 process of policymaking, 46–47 shift from monetary targeting to multiple indicators multiple indicators approach, 46, 47–50 monetary museum, 608–609 monetary policy formulation of, 597, 619 objectives of, 44 transmission mechanism of, 49, 67 Monetary Policy Department (MPD), 47, 179n1, 196, 526 monetary policy measures, reversal of, 120 monetary targeting, 6, 48, 88n6 rule of, 46 monetisation, of government deficits, 45 money and financial markets, 8, 34–35 components of, 35 deterioration in fiscal deficits, 37 development of, 74 evolution of, 40 736

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fiscal indicators, 37 interest rate deregulation in, 35 as major channel of resource mobilisation, 34 reforms in, 34 transmission channel for monetary policy, 34 volatility of, 35 Money and Government Securities Markets, 196 money at call, 191 moneylenders, 192–193, 524 money market, 52, 191 call money market, 192–197 CBLO market, 201–202 Certificates of Deposit, 203–204 commercial bills, interbank participation certificates and money market mutual funds, 206–207 commercial papers, 204–206 components of, 192 default risk and policy norms, 207–208 derivatives, 208–210 instruments, 77 mutual funds (MMMFs), 206– 207 repo or repurchase agreement, 202–203 segments, activity, 197 term money market, 197–198 Treasury Bills, 198–201 money supply, 31, 32 ‘Money Supply: Analytics and Methodology of Compilation’ working group, 49 Monitoring Group on Cash and Debt Management, 239, 253–254 monitoring tool, for exchange rate assessment, 156–158

Index Monopolies and Restrictive Trade Practices Commission (MRTPC), 416 Monthly Bulletin, 118 monthly demi-official letters, 611 Moody’s Investors Service, 180n14 mortgage debt, 408–409 guarantee companies, 406–407 loans, 482 securities, 379 Most Important Terms and Conditions (MITCs), 593n7 Multi-Application Smart Card Project, 333n60 Multi Commodity Exchange of India Ltd, 407 multilateral netting systems, settlement of, 324, 327n21 multi-state cooperative banks (MSCBs), 463 Multi-State Cooperative Societies Act (1984), 463 Multi-State Cooperative Societies Act (1998), 512 Mumbai Interbank Offered Rate (MIBOR), 54, 64, 221 Muniappan, G. P., 420n19, 438 mutual funds, 489, 492 equity-oriented, 381 Nainital Bank Ltd, 398 Narasimham Advisory Group on Transparency in Monetary and Financial Policies (2000), 81 Narasimham Committee I (1991), 45, 390, 400, 523 Narasimham Committee II (1998), 50, 195, 391, 416, 425n60, 431, 469n15, 470n22, 474n49, 523, 527, 536, 656

action taken report, 536 recommendations of, 202 National Bank for Agriculture and Rural Development (NABARD), 193, 422n41, 429–430, 436, 441, 478, 516, 533, 538, 545, 586, 631, 656 Consultancy Services, 583 deposits kept under the RIDF scheme, 551n19 management of, 632 Micro Credit Cell, 538 MoUs with the Government of India, 545 pension rules, 632 Reserve Bank inspection under the RBI Act (1934), 527 setting up of, 525–528 National Chemical Laboratory (NCL), 367 National Clearing Cells, 321, 604 National Clearing Centres, 288 National Commission on Science and Technology, 294 National Commodity and Derivatives Exchange Limited, 408 National Defense Gold Bond Scheme, 636 National Democratic Alliance (NDA), 21 National Electronic Clearing Platform, implementation, 324 National Electronic Funds Transfer (NEFT), 301, 314–315 National Federation of Urban Cooperative Banks, 461 National Film Development Corporation, 370 National Financial Switch, The, 316 National Foundation for Consumer Awareness and Studies, 174 737

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Index National Housing Bank (NHB), 406, 422n41, 429, 441, 536, 654, 656 National Informatics Centre (NIC), 332n53 National Institute of Bank Management (NIBM), Pune, 314, 627 Joint India–IMF Training Programme, 627 National Institute of Public Finance and Policy (NIPFP), 279n6 nationalisation of large banks, 525 nationalised banks, 401 National Payments Council (NPC), 291, 304 National Pilot Project on Financial Inclusion, 582 National Rural Credit Fund, 526 National Rural Employment Guarantee Scheme (NREGS), 585–586 National Sample Survey Organisation, 579 National Securities Depository Limited (NSDL), 388 National Settlement System (NSS), 331n44 National Small Industries Corporation Ltd, 535 National Small Savings Fund (NSSF), 251 National Stock Exchange (NSE), 21, 198, 398 interest rate futures, 209 MIBOR calculation, 221 NDS-Order Matching (NDS-OM) module, 212 Nedungadi Bank Ltd, 398 Negotiable Instruments Act (1881), 288, 298, 311, 635 738

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negotiated dealing system (NDS), 191, 279n13, 292, 331n46, 601, 641 and CFMS, 296 in electronic bidding in auctions, 212 role of, 212–213 net asset value (NAV), of security receipts, 454 net foreign assets, of RBI, 124 NetWare, 639 New Basel Capital Accord, 486 New Capital Adequacy Framework (NCAF), 376, 442 ‘new generation’ banks, 547, 560 new market loans of central government, weighted average maturity, 248 NIC(LTO) fund, 437, 469n12 ‘no frills’ account, 579 nominal effective exchange rate (NEER), 156, 158 nominated banks, 171, 178–179, 416 Non-Agricultural Market Access, 178 non-banking financial companies (NBFCs), 9, 131, 143n62, 201, 228, 291, 385, 409, 428, 430, 441, 444, 447, 449, 478, 503–506, 529, 581, 602, 616 Asset Reconstruction Companies (ARCs), 452–454 capital adequacy ratio requirements for, 450 Computerised Off-site Surveillance and Monitoring System (COSMOS), 504 deposit-taking, 449, 505–506 diversity and geographical spread of, 503–504 Financial Companies Regulation Bill (2000), 455–456 further interventions, 448–449

Index government-owned institutions, 454–455 investment instruments of, 505 legal action against defaulting, 505 need for insurance cover to, 455 net-owned funds, 505 new regulatory framework, 443–445 non-deposit-taking, 449–450, 452 on-site inspection of, 504 pitfalls of limited regulation, 442–443 public deposits, 505 regulation of, 455 Residuary Non-banking Companies (RNBCs), 450–452 residuary non-banking financial companies (RNBCs), 506–508 response, 445–448 special audit of, 521n42 supervision of, 503, 517 systemically important, 450 non-bank institutions from call money, access of, 194 non-bank participants, access, 193 non-competitive bidding, introduction, 214 non-deliverable forward (NDF) market, 158–159, 222 non-deposit-taking companies, 506 non-food credit, 30, 60, 62 non-government organisations (NGOs), 533, 581 non-interest income, 560 non-issuable currency notes, destruction of, 11 non-performing assets (NPAs), 72, 98, 380, 394, 432, 481, 497, 513, 523, 528

‘one-time settlement’ for recovery of, 394 share of NPAs in priority sector, 395 with UCBs, 467 of weak banks, 452 non-resident external rupee (NRE[R]), 68 non-resident Indians (NRIs), 63, 94, 107–109 cost of rising reserves, 166–167 deposits, 131–133 import of gold and silver, 176 RIBs for, 121 non-resident ordinary rupee (NRO) accounts, 104, 563 non-resident special rupee (NRSR) account, 104 non-SLR investments, 379 North Eastern Financial Sector Plan, 585 Nostro accounts of currencies, 183n34, 491 note issue and currency management, Bank’s function, 338 note packets, non-stapling of, 348–350 note processing, mechanisation of, 11 Note Refund Rules, The, 351 notes quality and supply, improvements, 344–351 not-for-profit NBFCs, 539 notice money, 50, 54, 57, 191, 193, 196, 224n9, 380 nuclear tests (Pokhran, May 1998), 2, 25 obsolete telex by banks, usage, 293 off-balance-sheet (OBS) transactions, 384–385 Official Language Implementation Committee, 647 Official Language Rules (1976), 646 739

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Index Official Languages Act (1963), 646 offset printing method, 357 offshore banking units (OBUs), 412–413 off-site monitoring and surveillance system (OSMOS), 216, 482, 640 off-site surveillance, 482–483 oil-exporting countries, 19 one-time settlement policies, for farmers, 532 Online Banking Glossary, 647 on-site inspections, 480–481, 485 of PDs, 216 ‘open-door’ policy, 625 Open General Licence (OGL) Scheme, 175 open market operations (OMOs), 45, 236 Optional Early Retirement Scheme, 621 Optional Employees Retirement Scheme (2003), 643 organisational changes, in RBI Boards and Committees, 614–616 central office and regional offices, 617–618 in information technology capability, 639–647 other initiatives, 645–647 rationalisation of systems, rules and procedures, 643–645 inspection and audit, 647–649 matters relating to human resources pension updating debate, 630–634 recruitment and staff size, 619–622 responsibility for promotion, 622–624 740

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service tax, issue of, 634–635 staff regulation, 629–630 training, 625–628 transfer and deputation, 624–625 miscellaneous staff matters Cooperative Guarantee Fund, 638 facilities for employees, 636–637 five-day week, 635–636 Grievance Redressal Cell (GRC), 637 organisational climate survey, 638 prevention of sexual harassment, 637– 638 organisational realignment and new departments, 618–619 ownership of institutions, 656–658 profit and loss account, 654–656 RBI balance sheet, 649–651 reserve adequacy and profit transfer, 652–654 organisational climate survey, 638 organisational realignment and new departments, 618–619 Organisation for Economic Cooperation and Development (OECD), 119, 588 Oriental Bank of Commerce (OBC), 384, 400, 498 outflow transactions, restrictions on, 102 output gap, 33 outsourcing, 26, 639 overseas links between markets and domestic money, 191 offices of Indian banks, 501

Index operations, 501–502 Overseas Citizens of India (OCIs), 109 Overseas Corporate Bodies (OCBs), 101–102 overseas direct investments (ODIs), 63, 116 subsidiaries, 488 oversight of payment systems, 301–302 Palanimanickam, S. S., 168 Pandya, D. B., 512 Pant, Govind Ballabh, 398 paper-based payment systems, 288, 289 para-banking activities, 409–413 Parekh, Ketan, 512–514 Parikh, R. N., 512 Parliamentary Committee, 629 Parliamentary Standing Committee on Finance, 109, 233, 500, 535 participatory notes (PNs), 127, 144n64 Patel, I. G., 385, 544 Pathak, R. P., 646 Patil, Balasahib Vikhe, 123 Patwardhan, M. S., 624 Payment and Settlement Systems Bill (2008), 287, 298, 299, 330n40 payment systems Advisory Committee, 290 cheque as, 288 definition, 286 group, establishment of, 290 Peerless General Finance and Investment Ltd (Peerless), 451, 506 penal measures, 493–494 Pendharkar Working Group, 517n2 pension

Government Pension Rule (1972), 632 NABARD pension rules, 632 Pension Regulations (1990), 630 RBI Pension Regulations, 632–633 updating debate, 630–634 Pension Fund Regulatory and Development Authority (PFRDA), 412 Pension Ordinance (2004), 412 performance appraisal system, 623 personal identification numbers (PINs), 586 personal loans, 380 persons of Indian origin (PIOs), 104, 109 plain vanilla bonds, 217 point-of-sale devices, 580, 586 Poirson, Hélène, 608 policy norms in money market, 207–208 polymer notes, 367–368 Ponappa, Leela K., 363 portfolio investment in India, 125–129 longer maturity of, 228 scheme, 102, 126 post-print coating, of notes, 365–367 poverty alleviation programmes, 523 Pradipti, 647 Pravahini, 647 Press Relations Division (PRD), 589, 605 Prevention of Money Laundering Act (PMLA, 2002), 110, 363, 405, 501 price discrimination, 71 PricewaterhouseCoopers (PwC), 485 pricing of credit, 66–72 primary (urban) cooperative banks, 509–515 741

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Index primary dealers (PDs), 46, 190, 215–217, 456, 479 in call market, 193–194 call money market borrowing restriction on, 223n8 expansion, Reserve Bank guidelines on, 236–237 in Government securities market, 213–215 limits for individual, 51 liquidity support to, 64 in securities market, 5, 7 strengthening of, 212, 213 in T-bill auctions, 199–200 Primary Dealers’ Association of India (PDAI), 52, 89n19, 191 primary market Bank’s role in, 236 operations module, 641 prime lending rates (PLRs), 6, 46, 66–67, 224n16 practice of providing loans below, 69 requirement to treat, 69 tenor-linked, 68 prime term lending rate (PTLR), 65, 68 Principal Legal Adviser of the Bank, 298 printing banknotes, cost of, 346–347 priority sector bonds, 526 lending to, 12, 541 Advisory Committees, 528–529 components of lending, 529–533 Foreign Banks and the Small Industries Development Bank of India (SIDBI), 534–535 742

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Rural Infrastructural Development Fund (RIDF), 533–534 revised guidelines on, 537, 551n20 share of NPAs in, 395 private banking, 411 private capital flows, taking advantage, 119–120 private sector banks, 385–386 governance issues, 387–390 transfer of shares and voting rights, 386–387 private sector mutual funds, in call money market, 193 products and services, pricing of, 565–566 profitability of banks, 67 of Indian companies, 28 profit and loss account, 654–656 profit maximising principle, 524 profits after tax (PAT), 28 Project Financial Literacy, 589 promissory notes, 609 promotion account performance appraisal, 623 claims to, 623 confidential reports, 623 responsibility for, 622–624 prompt corrective action (PCA), 437, 484–485, 497 prudential benchmarks for call money market operations, 196 Public Accounts Department (PAD), 635 Public Debt Act (1944), 229 public debt management system, 10–11, 76 central government debt, management, 239–240 debt consolidation, 251–253

Index debt swap 2003–04, 250–251 diversification of investor base, 243–245 FRBs and bonds with call and put options, 249 group on cash and debt management, monitoring, 253– 255 liquidity of securities, 249–250 maturity structure, changes in, 245–249 ways and means advances to, 241–242 coordination between government and the Reserve Bank, 231–232 FRBM Act (2000) changes by the Reserve Bank following, 236–237 debt and monetary management under, 237–239 making of, 232–233 passage of, 233–235 government guarantees, 274–276 institutional and legal framework, 229–231 objectives of, 227–228 power bonds, 272–274 related measures, 276–277 special securities, 269–272 in state government debt management, 255–269 additional borrowing issue, 262–263 debt swap of high-cost debt, 261–262 market borrowing programme, 255–261 model fiscal responsibility legislation at state level, 269

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special category states, 265–266 states’ surplus balances, 268–269 WMA and overdrafts, 266–268 strategy, 228–229 Public Debt Office (PDO), 53, 58, 635 of Bank, 289 computerisation of, 309, 639 public deposits, 507 public limited companies debt–equity ratio for, 28 non-financial, 29 non-government, 29 public sector banks, 390–391, 488, 490, 564, 625 appointment of auditors for, 491 branches operating in London, 501 Debt Recovery Tribunal Cells, 396 policy framework for, 390 Tier II bonds of, 510 UK subsidiaries of, 501 public sector savings–investment gap, 2, 25, 36 public sector undertakings (PSUs), 233, 635 bonds of, 497 Punjab Fiscal Responsibility and Budget Management Act (2003), 269 Punjab National Bank, 281n23, 291, 295, 399, 437, 541 Qualifying Full Bank licence, 404 Quality Management System (QMS), 481, 640 Rabobank, 385 Raghavan, T. C. A. Srinivasa, 610 Rai, Atul Kumar, 79

743

Index Rai, Vinod, 633 Rajan, Raghuram G., 549 Rajbhasha, 624 Golden Jubilee Year of Rajbhasha, 647 Rajbhasha Samachar, 647 Ramani, S., 293 Ramaswamy, S., 178 Rangarajan, C., 2–3, 63, 73, 74, 97, 173 Rangarajan’s Committee on Balance of Payments, report, 162 Rao, P. V. Narasimha, 21 rating system for banks, 578 RBI (Amendment) Bill (2001), 413 RBI Bulletin, 278n4 RBI Legal News and Views, 600 RBINET communication software, 288 RBI Staff College, Chennai, 451 RBI vs Peerless General Finance and Investment Company, 443 RBI Workers Union, Kolkata, 320 Real Effective Exchange Rate (REER), 156, 158 real estate, 382–383 Real Time Gross Settlement (RTGS) System, 53, 191, 292, 303–307, 329n29 Reddy, Y. V., 2, 17, 31, 59, 86, 148, 150, 170, 173, 175, 176, 179n3, 180n9, 221, 262, 268, 464, 531, 535, 579, 581, 656 refinance risk, mitigation, 228 Reforms, in market infrastructure development, 190 regional complaints committees (RCCs), 637 Regional Directors (RDs), 610, 616–617 conference, 610 delegation of powers to, 617–618 heads of regional offices as, 617 744

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regional rural banks (RRBs), 228, 351, 376, 478, 524, 546–547, 557n58, 568, 579 branch licensing policy for, 546 business activities of, 547 Registrar of Cooperative Societies (RCS), 459, 515, 545 Registration Act (1908), 107 Regulated Institutions Group (RIG), 486 regulatory legislations, in India, 3 Regulatory Review Authority (RRA), 644 relational data base management system (RDBMS), 640 reliable communication network, availability of, 318 Remittance Facilities Scheme, 288, 343 remittances route, from NRIs, 99 repayment of deposits, 455 repo market development of, 8 non-bank participation, 194 repurchase agreement, 202–203 repo rate, 5, 45 definition of, 77 revisions in, 58 use of, 65 Report of the Committee on Banking Sector Reforms, The, 193 Report on Currency and Finance, 601 repurchase agreement clause (repo), 5 repurchase (repo) transactions, 164 reserve accounts, 653 reserve adequacy and profit transfer, 652–654 Reserve Bank Governors, 3, 22, 615 Reserve Bank Legal Department, 106 Reserve Bank of India (RBI), 1 Annual Report 1996–97, 48 balance sheet, 31

Index credit to the government, 31 economic growth, impact of, 33 financial market, 221–222 foreign capital flows, 31 government securities market, 210–211 phases of reform in, 211–214 retailing of, 214–215 Inspection Department, 541 instrument development floating rate bonds and capital-indexed bonds, 217–218 Mumbai Interbank Offered Rate, 221 short-selling, 219 STRIPS, 218–219 ‘when-issued’ trading, 219–220 issue of ‘overheating’ of the economy, 31 Legal Department, 573 Monetary and Credit Policy, 49 net foreign exchange assets, 31 Non-Banking Financial Companies Prudential Norms, 449 organisational set-up of, 614 payment and settlement systems, 286–287 in 1997–98, 287–290 assessment with reference to international standards, 323–324 BPSS and the DPSS formation, 301 CCIL, 307–309 centralised funds management system, 310 early institutional arrangements, 290–292 legal issues, 297–300

oversight, 301–307 retail payment systems, 311–319 securities settlement systems and related developments, 309–310 umbrella organisation for retail payments, 320–323 VSAT technology and INFINET, 292–297 payment of interest on CRR balances, 77 policy statements, 36 primary dealers, 215–217 public debt management system in central government debt management, 239–255 FRBM Act, 232–239 government and the Reserve bank, coordination, 231–232 government guarantees, 274–276 institutional and legal framework, 229–231 objectives, 227–228 power bonds, 272–274 related measures, 276–277 special securities, 269–272 in state government debt management, 255–269 strategy, 228–229 regional offices of, 566 Report on Currency and Finance (2005), 71 Rural Planning and Credit Department, 449 supervisory strategy, 490 Urban Banks Department, 93n54 745

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Index Reserve Bank of India (RBI) Act (1934), 3, 57, 77, 430, 527 Reserve Bank of India (RBI) Act (2006), 47, 77 Reserve Bank of India Bulletin, 600 Reserve Bank of India (Staff ) Regulations (1948), 625 Reserve Bank of India Services Board (RBSB), 620, 637 Reserve Bank of India, Vol. 3: 1967– 1981, The, 600 Reserve Bank Staff College (RBSC), Chennai, 626–627 reserve management, gold role in, 159–160 reserve management policy, evolution, 161 adequacy of reserves, 162 deployment and rate of return, 162–164 deposits with foreign commercial banks, 164–165 external asset managers, 165–166 Indo-Japan currency swap agreement, 166 level of domestic investment and SPV, increase, 168–170 objectives, 161 redemption of RIBs and IMDs, 167–168 repo and reverse repo, 164 rising reserves cost, 166–167 risk management and management information system, practices of, 165 Sovereign Wealth Fund, creation, 170 reserve money, 31 reserves adequate level of, 162 cost of rising, 166–167 investment, scope of, 162 746

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management of, 159–161 rise in, 163 special purpose vehicle, 168–170 reserve tranche position (RTP), 159 residential accommodation scheme, 636 residential flats purchase by foreign nationals, 108 residuary non-banking financial companies (RNBCs), 430, 450–452, 506–508 discretionary investments of, 451 Resurgent India Bonds (RIBs) and India Millennium Deposit, redemptions, 167–168 launch of, 150 for NRIs and overseas corporate bodies, 121 retail market promotion, in government securities, 214–215 retail payment systems card-based transactions, 315–317 cheque clearing, 311–314 e-commerce, 317–318 electronic funds transfer, 314–315 trends, 319 umbrella organisation for, 320–323 return on assets, 484 reverse mortgage loans, 407 reverse repo, 46, 57, 58, 64, 77, 164 Revised Branch Authorisation Policy, 402 Right to Information Act (2005), 609, 645 risk evaluation, index of, 381 risk-free yield curve, 7 risk management systems, 34, 381, 382, 480, 483, 584 audit system, 485 for capital assessment, 485 for internal audit, 490

Index risk-based supervision (RBS), 485–486 Royal Commission on Indian Currency and Finance, 649 rule-based fiscal reforms, 14 rupee debt, 134 derivatives, working group on, 210 volatility of, 180n4 rupee derivatives, in India, 35 rupee–foreign currency swaps, 7 rupee securities, dominance of, 650 rural cooperative credit institutions, 544 structure, 545 rural cooperatives, 533 rural credit system, 1, 11–12 cooperative institutions, 544–546 issues relating to, 580 Kisan Credit Card (KCC), 528, 538–539, 579 lead bank scheme, 542–544 lending to the priority sector Advisory Committees, 528–529 components of lending, 529–533 foreign banks, 534–535 priority sector, 535–537 Small Industries Development Bank of India (SIDBI), 534–535 local area banks, 547–549 National Rural Credit Fund, 526 objectives of banking policy with respect to, 524–525 priority sector lending, 523 private providers of, 524 Regional Rural Banks (RRBs), 546–547 Reserve Bank and NABARD, 525–528

self-help groups–bank linkage scheme, 538–539 small-scale industry, 540–541 rural development banks, 544 Rural Infrastructural Development Fund (RIDF), 441, 533– 534, 551n14 rural kiosks, 580 Rural Planning and Credit Department (RPCD), 526, 541, 575, 617 Russia crisis, effects on Indian markets, 150 and Latin American crises, effect, 121 rupee debt repayments in India, 134 R.V. Gupta Committee on Hedging through International Commodity Exchanges (1997), 100, 173–174 Sahara India Financial Corporation Ltd (Sahara), 451, 507 Salve, Harish N., 632–634 Sangli Bank Ltd, 399 satellite-based network, in banking system, 292, 295 Scheduled Caste (SC), 523 scheduled commercial banks (SCBs), 342, 428 Scheduled Tribe (ST), 523 second liquidity adjustment facility (SLAF), 58 Securities and Exchange Board of India (SEBI), 34, 76, 101, 381, 410–411, 443, 482, 495 Advisory Committee on Derivatives and Market Risk Management, 210 747

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Index Committee on Corporate Governance, 388 for mutual funds registration, 207 role in excess capital flows, 130 Securities and Exchange Board of India (SEBI) Act (1992), 21 Securities Contracts (Regulation) Act (1956), 21, 76, 194 amendments, 212 on stock exchanges and securities transactions regulation, 300 securities liquidity, in government securities, 249–250 securities settlement systems (SSS), 292, 309–310, 641 Securities Trading Corporation of India (STCI), 191, 436, 656 Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act (2002), 424, 452, 453, 547 Select Indicators of External Sector, 95 Self-Employed Women’s Association (SEWA), 538 self-help groups (SHGs), 523, 581 collective decision making, 538 concept of, 538 doorstep banking, 538 self-help groups–bank linkage scheme, 528, 538–539 Senior Management Conference (SMC), 618 Separate Trading of Registered Interest and Principal Securities (STRIPS), 8, 218–219 September 11 attack, 17 Serious Frauds Office, 488 748

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service relief bonds, 604 services sector growth in, 26 non-tradable outputs of, 26 service tax Directorate General of, 634 issue of, 634–635 Settlement Advisory Committee, 394 settlement, definition, 286 sexual harassment, prevention of, 637–638 shareholdings, acquisition of, 387 shares certificates, 609 dematerialisation of, 388 issue of bonus shares, 388 and securities, 388 transfer of, 386–387 Sharma, B.S., 643 short-term credits (debt), 133–134 show-cause notices, 494 shredding and briquetting system (SBS), 344, 345 Shukla, Shyamala, 177 Sikkim Bank Ltd, 398 Singapore government’s Investment Corporation, 170 Singh, Manmohan, 21, 99, 600, 628, 645 single forest-based mail messaging system, 643 Sinha, Yashwant, 93n51, 413 Sinor, H. N., 70 skill-intensive production, 26 small and medium-sized enterprises (SMEs), 117 Small Industries Development Bank of India (SIDBI), 429, 439, 455, 516, 534–535 exposure to SFCs, 440 restructuring of, 440 small-scale industry, 540–541

Index small value credit, disbursal of, 580 smart card-based access control system, 642 SMART Card based Payment System Standards, 333n61 SMART Rupees System, 316 social security payments, 586 Society for Worldwide Interbank Financial Telecommunication (SWIFT), 292–297, 327n14, 649 Sodhani Committee report, 99, 100 software applications, for online monitoring, 165 soiled banknotes, disposal of, 642 soiled notes in bank vaults, accumulation of, 347–348 solvency of banks, 478 sources of funds, classification of, 30 South Asian Association for Regional Cooperation (SAARC), 627–628 South Indian Cooperative Bank, Mumbai, 515 sovereign debt portfolio, 228 Sovereign Wealth Fund, creation of, 170 sovereign zero-coupon bonds, 218 special category states, MBP of, 265–266 Special Drawing Rights (SDRs), 159 special economic zones (SEZ), 383 special electronic funds transfer (SEFT) system, 314 special purpose vehicles (SPVs), 263, 408, 489 bank finance through, 263–265 reserves for increasing, 168 spot exchange rate, factors affecting, 150–151 staff regulation, 629–630

standardisation and upgrading, of gold reserves, 172 Standing Committee of Parliament on Finance, 564 Standing Committee on Finance (SCF), 387, 411, 414 Standing Committee on Gold and Precious Metals (SCGPM), 170 Standing Committee on International Financial Standards and Codes (SCIFSC), 323, 599 Standing Technical Advisory Committee of Financial Regulation (STACFR), 378, 380, 401, 494, 500 start-up capital, 458, 547, 548 State Bank of Hyderabad, 537 State Bank of India (SBI), 70, 91n37, 375, 436, 488, 539, 585, 656 in auctions of government securities, 197 in currency chests maintenance, 343 in customer transactions accountability, 96 customer transactions value, 96 Nostro account, 168 State Bank of Indore, 91n37 State Bank of Saurashtra (SBS), 400 State Cooperative Societies Acts, 459 state development loans (SDLs), 257 State Financial Corporations (SFCs), 439, 536 IDBI’s investments in, 440 regulation and supervision of, 439 SIDBI’s exposure to, 440 state government debt, 255–260 additional borrowing issue, 262–263

749

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Index bank finance through special purpose vehicles, 263–265 debt swap of high-cost debt, 261–262 management of states’ surplus balances, 268–269 model fiscal responsibility legislation, 269 special category states, 265–266 WMA and overdrafts, 266–268 State Industrial Development Corporations (SIDCs), 454, 536 State-Level Bankers’ Committee, 542, 582 State Level Rehabilitation Review Committees, 462 statement of structural liquidity, 484 state-owned corporations, 533 state-owned development banks, 28 State Registrar of Cooperative Societies, 460 Statesman, The, 480 states’ surplus balances, 268–269 statutory liquidity ratio (SLR), 3, 45, 194, 243, 432, 525 differential requirement for regional rural banks, 80 maintenance of, 79 stock-broking companies, 445 Stock Holding Corporation of India Ltd, 386 stock market indices, 86 strategic capital account management, 15 stressed assets stabilisation fund (SASF), 470n17 structured financial messaging solution (SFMS), 295 Subbarao, D., 633 subprime mortgage 750

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crisis in U.S., 180n11, 381, 418 market, 16, 503 subsidiary general ledger (SGL) accounts, 194 Sukhamoy Chakravarty Committee (1985), 48, 88n6 Supervisory Review and Evaluation Process (SREP), 496 supervisory review process (SRP), 486–487 surplus balance investment, 242 surplus cash balance maintenance, 242 Systemically Important Payment Systems (SIPS), 299 systems, rules and procedures, rationalisation of, 643–645 taluks, 586 Talwar, S. P., 291, 635 Tamil Nadu Fiscal Responsibility Act (2003), 269 Tamil Nadu Protection of Interest of Depositors Act (1997), 456 Tarapore, S. S., 70, 206, 562, 646, 657 Tarapore Committee I, 98 Tarapore Committee II, 6 Task Force, 99–100 on Cooperative Urban Banks (TAFCUB), 464–465, 510, 513, 517 on Implementation of the FRBM Act (2003), 279n9 on Rationalising and Simplifications of Forex Regulations, 6 tax corporate tax, 28 deduction at source (TDS), 415 exemptions for mutual funds investment, 226n32

Index service tax, 634–635 tax–GDP ratio, 25 Teba Bank (South Africa), 580 Technical Advisory Committee for Monetary Policy (TACMP), 81–87, 191, 223n1, 596, 599 Technical Committee of SEBIregulated entities, 144n66 Technical Group on Money Market (2005), 196 technology funds, 586–587 technology improvement, 213 telecommunication network, 585 telegraphic transfer, of funds, 287 term money market, 197–198 Thorat, Usha, 52, 79, 527, 544, 567, 623, 652 Tier I capital, 438 Tier II capital, 379 Times Bank Ltd, 399 Tourism Finance Corporation of India (TFCI), 429, 438 tourism infrastructure, 438 trade liberalisation, 16 trade-related short-term credits, 133 trade unions, 349, 392, 418, 446, 546, 548, 581, 635 trading facilities, in NDS, 212 trading, in government securities, 212 Train Exhibition (2007), 604 training of staffs, 625–628 ‘Aide Memoirs’ of foreign training, 626 zonal training centres (ZTCs), 627 transaction-based inspection, 480 transactions irregularities in securities, 290 reconciliation of, 289, 290 settlement in RTGS, 306–307 transfer and deputation, policy of, 624–625 transfer of profit, 649

reserve adequacy and, 652–654 treasury bills (T-bills), 3, 35, 54–55, 104, 199–201 182-day, 199, 226n36 364-day, 199–201, 224n17 ad hoc T-bills, 73 committee to examine the modalities of phasing out of, 75 elimination of, 650 discontinuation of 91-day tap, 74 Government of India, 5, 59 increased issuance, 242 issuance of ad hoc, 232 long-term, 61 short-term, 61 termination of, 74 Twelfth Finance Commission (TFC), 260, 262, 285n56 UCO Bank, 375, 392 Udeshi, K. J., 175, 355, 387, 572, 576 umbrella organisation for retail payments, 320–323 uniform price auctions, 53, 55, 200 Uniform Regulations and Rules of Bankers’ 299, 311, 325n4 Union Bank of India, 70, 350, 398 Union Budget 2008–09, 546 Union of Soviet Socialist Republics (USSR), 134 United Bank of India (UBI), 392 United Progressive Alliance (UPA), 22 United Western Bank, 400, 484 Unit Trust of India (UTI), 192, 269, 659n18 unlicensed banks, 457 Urban Banks Department (UBD), 617 urban bank sector, 511 urban cooperative banks (UCBs), 10, 69, 195, 428, 431, 456–467, 476n59, 478, 568, 572, 616 751

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Index 2001 crisis, 459–460 asset–liability management guidelines for, 466 autonomy of, 511 consolidation of, 462 ‘fit and proper’ criteria for CEOs of, 511 functioning of, 510 inclusion in the Second Schedule of the RBI Act, 457–459 issue of branch licences, 511 Multi-State Cooperative Societies Act, 463 non-performing assets, 467 other issues in regulation of, 460–462 prudential norms, 466–467 rating mechanism for, 509 reasons for weakness in, 462 resolution of weak banks, 462–463 scheduled and non-scheduled, 510 show-cause notices, 511 statutory audit of, 511 supervision of, 512 vision and medium-term framework for, 464–465 US dollar and INR trades, settlement facility, 308, 309 net sales and purchases of, 152 and rupee, exchange rates of, 148–152 US dollar–rupee reference rates, 601 UTI Bank, 401, 492 Uttar Pradesh Fiscal Responsibility Act (2004), 269 Vaidyanathan, C. S., 173 Vajpayee, Atal Bihari, 21, 156 value-added product, 639 752

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Vasudevan, A., 48, 304 Venkitaramanan, S., 48 venture capital funds (VCFs), 101, 412, 486, 489, 535 Verma Committee, 393 very small aperture terminal (VSAT), 289, 292–297, 325n3, 327n13, 639 video conferencing, 598, 605, 610, 642 Vijaya Bank, 541 village knowledge centres, 580 Vishaka and Others vs. State of Rajasthan, 637 vision documents, for payment systems, 292 voting rights, 386–387 restrictions on, 387 Vyas Committee (2004), 528, 536, 551n18 Vyas, V. S., 527 wage settlements, 631, 636 ways and means advances (WMA), 64, 74, 232 to central government, 241–242 limits for states, revisions, 267 rationalisation of, 266 to state governments, 266 utilisation of, 267 weak banks rehabilitation of, 392–394, 431 Strategic Revival Plans, 393 Verma Committee on, 393 resolution of, 462–463 web-based complaint tracking system, 642 Weekly Statistical Supplement (WSS), 118, 600 West Bengal Industrial Development Corporation, 264

Index West Bengal Infrastructure Development Finance Corporation (WBIDFC), 264 ‘When, As and If Issued’ Trading (WI Trading), 220 ‘when-issued’ market, development of, 219–220 wholesale banking, 386 wholesale price index (WPI), 31 wide area network, 639, 641 wilful defaulters, 499–501 winner’s curse’ problem, 200 Without Reserve (journal), 611, 647 working capital facilities, 67 Working Group Inter-regulatory, 489 on Bills Rediscounting by Banks, 225n24 on Design of Message Formats, 295 to Examine the Procedures and Processes of Agricultural Loans, 591 on Rationalising Remittances, 6 on Regulatory Mechanism for Cards, 333n59

on Risk Mitigation Mechanism, 332n54 on Separation of Debt Management from Monetary Management, 74 on Training Needs/Plans, 628 work–life balance, 609, 638 World Bank, 17, 238, 323, 375, 388, 599 World Trade Organization (WTO), 178, 191, 392 Y2K awareness programme, 602 scare, 23, 640 YES Bank, 385 Yield To Maturity (YTM), 210 Young Scholars Award Scheme, 590, 604 zero-coupon bonds, 8 zero per cent interest finance scheme, 561 zonal training centres (ZTCs), 627

753

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