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Financial sector reforms ² current status

’ ©utonomy for commercial Banks
. Rating of Banks
’ Prompt corrective action
’ Best practices Code
’ Corporate Governance and Banks
’ Money laundering and KYC policy
’ Basic terms used in analysis of banks performance
Financial sector reforms ² current status
½ Banking sector has undergone significant changes ever since
Financial and Banking sector reforms were introduced in 1992.
½ Deregulation of interest rates ² Except for interest rates on
savings and NRI deposits and ceiling on export credit and loans
upto Rs 2 lakh and DRI advances, all other rates have been
deregulated. Banks have the flexibility to decide their deposit and
lending rate structure.
½ Statutory reserves: The SLR has been gradually reduced from a
peak of 38.5% to 24%. CRR was reduced from a high of 15% (
1989) to present level of 5%
½ Banking supervision: RBI has successfully put in place necessary
regulatory framework for effective supervision. In 1994, a Board
for Financial Supervision ( BFS) was constituted. RBI has set up a
state-of-the-art Off-site Monitoring and Surveillance (OSMOS)
system for banks in 1995.
½ Regulatory norms and prudent practices: Banks have the
regulatory norms for Capital adequacy, income recognition, asset
classification and provisioning. Banks in India are now fully geared
to move towards convergence with the international best
practices.
 These measures have enhanced the transparency of balance sheet
of banks. ( three pillars under B©SEL II ² minimum capital
requirement, supervisory review process, market discipline)
- measures to reduce the levels of NP©s
- improved risk management practices
- enactment of S©RF©ESI act, 2002
- establishment of DRTs, Lok ©dalats, CDR mechanism for
corporates and SMEs
½ Capital ©dequacy Ratio: Minimum CR©R prescribed for banks in
India is 9% ( internationally it is 8%). Separate capital charges
are fixed for market risks, operational risks.
½ Disclosures and transparency: Disclosure norms cover broadly
capital adequacy, asset quality, maturity distribution of assets
and liabilities, profitability, country risk exposure, risk exposures
in derivatives, segment reporting etc ( presently about 49
disclosures)
½ Risk management systems: The guidelines on asset-liability
management and risk management systems were issued by RBI in
1999. RBI has switched over to RBS system in place of
traditional methods of inspection.
½ New Private Banks: Guidelines were issued for establishment of
new banks in the private sector and since 1993, 12 new private
sector banks have been established. FDI in these banks is allowed
up to 74%.
½ Foreign Banks: In terms of WTO commitments( mar 2005), RBI
allowed foreign banks to establish presence in India to operate
through branches or set up 100% wholly owned subsidiaries.
- 2nd phase of allowing entry is to start in 2009
- WOS of foreign banks may be allowed to list and dilute their
stake so that, at least 26% of the paid up capital is held by
resident Indians at all times.
½ Credit information: In order to facilitate sharing of information
related to credit matters, a Credit Information Bureau ( India)
was set up in the year 2000.
½ Customer grievance redressal: The Banking Ombudsman Scheme
was set up in 1995. ( revised in 2002 and 2006) to provide for a
system of redressal of grievances against banks.
- an independent Banking Codes and Standards Board of India was
set up in Feb 2006, on UK model to ensure fair treatment of
customers.
½ Payment mechanism: RBI took several measures to develop
payment and settlement systems. The Board for regulation and
supervision of Payment and settlement systems( BPSS) aws set up
in 2005. RTGS was made operational with effect from March 26,
2004.
½ B©SEL II implementation: Foreign banks operating in India and
Banks with international presence were asked to move to B©SEL
II on 31st March 2008. ©ll other banks have to comply with the
norms with effect from 31st March 2009.
Future challenges for Indian Banks:
Globaliation
Opening up of capital account
Improving risk management systems
Corporate governance
Implementation of new accounting norms
Supervision of financial conglomerates
Consolidate supervision
©pplication of advance technology
Financial inclusion
©utonomy for commercial Banks:
In order to make Public sector banks more market driven and
create a level playing field where they could compete with new
generation private sector banks and foreign banks, Government
granted more operational freedom to PSBs during March 2005
Parameters: Banks would qualify for the autonomy subject to
compliance with four pre-conditions in case of normal
autonomy:
a) Capital adequacy ratio of 9% or more
b) Net NP© of less than 9%
c) Net profits continuously for the last three years
d) Minimum owned capital of Rs 100 crore
Parameters for additional autonomy:
In case of stronger PSBs the parameters are:
a) Capital adequacy ratio of 9% and above
b) Net NP© of less than 4%
c) Net profit continuously for 3 years
d) Minimum owned capital Rs 300 crore
Banks enjoying autonomy can do the following on their own:
Formulate HR policy as it deems fit and acceptable to its
employees
If a bank can afford, it can even pay salary and allowances
higher than industry level. This measure may help retain
talented manpower.
Can go for acquisition of businesses and entities based on
business wisdom and compulsions.
Close or merge unviable branches, open overseas offices, set
up subsidiaries and exit a line of business.
Can take independent decisions pertaining to staffing pattern,
recruitment, placement, transfer, training, promotions,
pensions etc.
Prescribe norms for categorisation of branches based on
volume of business and other factors.
Prescribe academic qualifications, minimum qualification,
standards and modalities of staff promotion and recruitment
Pursue new lines of business as part of overall business
strategy
   

 
Rating of banks:
    
      
©
RBI set up a working committee to look into banking supervision
under the chairmanship of S Padmababhan in the year 1995.
This committee suggested methods for on-site and off-site
supervision and subsequent rating of banks by RBI.
Rating criteria:
The committee suggested that supervision of banks should focus on
defined parameters of
’ Soundness
’ Financial health
’ Managerial efficiency
’ Operational efficiency
The committee recommended that the banks should be rated on a
five point scale of © to E, broadly on the lines of international
C©MELS rating model.
C ² Capital adequacy ratio E - Earnings
© ² ©sset quality L - Liquidity
M ² Management effectiveness S - Systems and Controls
Parameters for rating of a bank:
Each of these 6 components is weighted on a scale of 1 to 100
with a several sub parameters with individual weightage.
Rating symbols:
© ² basically sound in every respect
B ² fundamentally sound but with moderate weaknesses
C ² financial, operational or compliance weaknesses that give
cause for supervisory concern
D ² serious or immoderate financial, operational and managerial
weaknesses that could impair future viability
E ² critical financial weaknesses that render the possibility of
failure in near future
Rating parameters for foreign banks:
C ² capital adequacy ratio
© ² asset quality
C ² compliance
S ² system and controls
Prompt Corrective ©ction:
It is a system under which RBI can initiate corrective action in case
of a bank which is found to be having low capital adequacy, low
profits or high NP©s ( trigger points).
The system has been implemented under authority from Board for
Financial Supervision ( BFS) and Govt. of India.
Parameter Standard
’ Capital adequacy ratio less than 9%
’ Non-performing assets net NP©s over 10%
’ Return on assets below 0.25%
Structured and discretionary actions:
For low capital adequacy ratio the structured actions include the
following:
Submission and implementation of capital restoration plan by the
bank
Restriction on expanding risk-weighted assets
Not to enter into new lines of business
Not to access/renew costly deposits/CDs
 Reduce/skip dividend payments
Recapitalisation by RBI
Not to increase its stake in subsidiaries
Reduce exposure to sensitive sectors like capital market, real
estate, non-SLR securities
Restrictions by RBI on the bank on borrowings from inter bank
market, banks to revise its credit/investment strategy and
controls
For high NP©s:
Special drive to reduce the NP©s and contain generation of fresh
NP©s
Review its loan policy; take steps to upgrade credit appraisal skills
and systems
Strengthen follow-up of advances including loan review mechanism
for large loans
Follow-up suit filed/decreed debts effectively; put in place proper
credit risk management policies/procedures/prudential limits
Reduce loan concentration- individual. group,sector, industry etc
 Not to enter into new lines of business; reduce/skip dividend
payments
Not to increase stake in subsidiaries
For low return on assets:
Bank is not to renew/access costly deposits and CDs
Take steps to increase fee-based income
Take steps to contain administrative expenses
Launch special drive to reduce the NP©s and control fresh NP©s

In addition to PC© framework, RBI can direct a bank to take any

other action or implement any other direction in the interest of
the concerned bank or in the interest of its depositors.
Best Practices Code:
BPC relates to detailed procedural rules for entering into
transactional relations with banks. Banks· procedures, systems
especially those pertaining to fraud prone areas should be well
documented ,compared with national and international best
practices. There should be continuous experimentation and subject
to improvisation.
RBI guidelines on compiling the BPC: On the lines of recommendations
of Mitra Committee, RBI issued guidelines to banks so as to
ensure uniformity in the contents and coverage of BPC. ( Mar 15,
2004)
The BPC should be a comprehensive and homogeneous document.
BPC should cover or highlight the recommendations of various
committees such as Ghosh committee, Mitra Committee, Narang
committee, Narasimham Committee on banking reforms and so on.
The BPC should cover all the functional areas such as cash, safe
custody, deposit accounts, investment portfolio, advances,
remittances, foreign exchange, treasury operations, issue and
payment of demand drafts, clearing transactions
 It should be periodically revised and updated in the light of
experience gained , fresh instructions from RBI from time to
time, suggestions from internal and external auditors.

Corporate Governance and Banksè

In banking parlance, the Corporate Governance refers to conducting
the affairs of a banking organisation in such a manner that gives
a fair deal to all the stake holders. Stakeholders include
shareholders, bank customers, regulatory authorities, society at
large, employees and so on.
Why for banks?
Majority of the banks in India are in the public sector
They have to compete with other players in the markets ² local,
national and international.
Banks have to deal with and work co-existentially with FIs,
mutual funds, NBFCs and other intermediaries.
Banks have to work in a liberalised and globalised environment
Banks owe responsibility to society for reasons more than one.
Corporate Governance in day-to-day management:
Day-to-day management is the primary responsibility of operating
management consisting of CEO and top management. Corporate
governance enables the top management create an environment in
which stakeholders· values and wealth in enhanced within ethical
confines.
What does CG cover?
’ Protection of shareholders· rights
’ Enhancing their values
’ Issues concerning the composition and role of the board of
directors
’ Determining disclosure requirements and transparency
’ Prescribing accounting systems
’ Putting in place effective monitoring mechanism
How to judge the standard of Corporate Governance?
’ Model code for best practices Role of BOD and committees
’ Preferred internal system Reporting system
’ Recommended disclosure system Policies formulated BOD
 One can judge the efficacy of CG in a banking system by looking
into the following
Õ Constitution of the Board of Directors
Õ Transparency
Õ Policy formulation
Õ Internal controls
Õ Committees of the Board
Write a detailed note on each of the above and share in the class
room

Money Laundering:
Prevention of Money Laundering ©ct was enacted in 2002. Under
section 12,there are certain obligations on banks with regard to
preservation and reporting of customer account information. RBI
issued directives under section 35© of banking regulation act
1949 and rule 7 of PML©.
Banks are instructed to maintain records of transactions in
respect of the following:
- cash transactions of Rs 10 lac and above or its equivalent in
foreign currency
- series of cash transactions connected to each other of below
Rs 10 lac or its equivalent in foreign currency within a month and
the aggregate value exceeds Rs 10 lac
- cash transactions in forged or counterfeit currency notes and
where any forgery of a valuable security has taken place
Banks should maintain for at least 10 years from the date of
cessation of transaction between the bank and the client, all
necessary records of transactions, both domestic or
international, which will permit reconstruction of individual
transactions ( including the amounts and types of currency
involved if any) so as to provide, if necessary, evidence for
prosecution of persons involved in criminal activity.
Reporting to Financial Intelligence Unit ² India:
Banks have to report information relating to cash and suspicious
transactions to the Director, Financial Intelligence Unit ² India (
FIU-IND), New Delhi.
 - Cash Transaction Report( CTR) for each month should be sent
to FIU-IND by 15th of the succeeding month. Individual
transactions below Rs. 50000/= may not be included.
- Suspicious Transaction Report ( STR) should be submitted within
7 days of arriving at a conclusion that any transaction,
whether cash or non-cash, or a series of transactions integrally
connected are of suspicious nature. Even where STR has been
made, banks should put restrictions on the operations in the
account.

KYC( Know Your Customer) policy:

Dimensions of KYC policy
1. Customer acceptance policy
2. Customer identification procedure
3. Monitoring of transactions
4. Risk management
1. Customer ©cceptance Policy:
Banker should exercise utmost caution while letting a person open a
bank account.
u ©ccount should not be opened in anonymous or fictitious name
u Should not open an account or close an existing account where the
bank is unable to verify the identity and/or obtain documents
required as per the risk categorisation due to non cooperation of
the customer or non reliability of the data/information of the
data/information furnished to the bank.
Customer profile:
Banks may prepare a profile for each new customer based on the
risk categorisation.It is a confidential document an ddetails
contained therein should not be divulged.
Risk categorisation: The customers may be categorised into low and
medium/high risk categories.
Low risk customers: Individuals ( other than HNIs)and entities whose
identities and source of wealth can be easily identified may be
categorised as low risk.
- salaried employees, people in lower income strata, Govt.
departments, Govt. owned copanies, regulators and statutory
bodies
Medium/high risk customers: Customers that are likely to pose a
higher than average risk to the bank may be categorised as
medium or high risk. Banks are expected to exercise enhanced
due diligence measures. Examples of medium/high risk customers:
- non-resident customers
- high net worth individuals
- trusts
- NGOs and organisations receiving donations
- companies having close family shareholding or beneficial
ownership
- politically exposed persons (PEP) of foreign origin
- non-face to face customers
-Those with dubious reputation as per public information available
Risk re-classification: periodic review of risk categories is
mandatory. ©t least once in 2 years for high and medium risk
customers and once in 5 years for low risk customers, such review
exercise has to be undertaken.
Closure of accounts: Where the bank is unable to apply appropriate
KYC measures, it may consider closing the account or terminating
the banking/business relationship after issuing due notice to the
customer. Such decisions are to be taken at fairly a higher level.
2. Customer Identification procedure: It is identifying the customer
and verifying by using reliable, independent source documents,
data or information.
- for natural persons banks verify the identity of the customer,
his address/ location and also the recent photograph. For
customers that are legal persons or entities, banks should verify
the legal status of the legal persons through proper documents,
verify the authority given to a particular person/signatory,
understand the ownership and control structure of the customer.
©ppointment of Principal Officer: Banks have to appoint a senior
management officer designated as Principal Officer. He is to be
located at head/corporate office of the bank. He shall be
responsible for monitoring and reporting of all transactions and
sharing of information as required under the law.
Terms used in analysis of Banks· performance :

Burden efficiency Non interest cost less non interest revenue

ratio divided by total business * 100. ©n
increasing trend shows lack of burden
bearing capacity

Non performing Non performing advances divided by total

advances ratio or net advances * 100. ©n increasing trend
implies gradual increase in bad credit
portfolio
©ggregate
deposits Total deposits of a bank at the close of
the accounting year. They equal the total of
all demand and time deposits. © high deposit
figure signifies a bank·s brand equity, branch
network and deposit mobilisation strength.
indicator of G
    


 

productivity G
  

 


  


 





 

  

 

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Operating profits

  
 
 







 
 
 
 
  


  
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Net worth This is aggregate of core equity capital
and reserves and surplus. The net worth is
tangible which is net of accumulate losses
and unamortised preliminary expenses. It
stands for the core strength of a bank and
denotes a bank·s margin of safety, its
cushion for all creditors and its base
foundation.
Total debt to In a manufacturing company, it is termed
net worth as Debt-Equity ratio. In the context of a
bank, it indicates its degree of leveraging.
Total long term deposits and long term
borrowings if any, vis-à-vis net worth gives
rise to this ratio.

Gross advances These include overdraft, bills purchased,

cash credit, loans and term loans including
food credit.©ggregate advances include
advances inside India and outside India
Investments Investments include investments in
government securities , shares, bonds,
commercial papers and debentures and other
approved securities.

Interest income
the sum total of discount, interest from
loans, advances and investment and from
balance with RBI and interest flows.
Interest income to expressed as a %age. This ratio shows a
average working bank·s ability to leverage its average total
funds resources in enhancing its main stream of
operational interest income.

Non-interest income This is other income of a bank. This

includes exchange, commission, brokerage,
gains on sale and revaluation of investments
and fixed assets and profits from exchange
transactions.
Non interest income to This ratio denotes a bank·s ability
average working funds to earn from non-conventional
sources. In a liberalised environment,
this ratio assumes significance. For,
it mirrors a bank·s ability to take full
advantage of its operational freedom
Operating expenses Equals the non-interest expenses.
The operating expenses to ©WF ratio
explains the overall operational
efficiency of a bank. In fact, this
ratio is one of the indicators of
profitability of a bank.
Interest spread This is the excess of total interest
earned over total interest expended.
The ratio of interest spread to ©WF
shows the efficiency of bank in
managing and matching interest
expenditure and interest income
effectively. Interest spread is key to
banks· profitability
 Risk weighted assets The cumulative risk weighted value of
assets plus risk weighted credit
converted contingent liabilities, which is
used as the denominator for computing
the capital adequacy ratio of bank

Net profit to ©WF it is a foolproof indicator of excellent

utilisation of resources and optimum
leveraging of funds
Operating profits to It is a corollary to NP/NW ratio and
net worth is another indicator of shareholders·
return
Capital adequacy ratio This ratio relates a bank·s core net
worth to its risk-weighted assets. It is
an internationally accepted risk-driven
measure of a bank·s degree of
capitalisation