Credit Policy for the year 2003-2004

Annual Monetary and Credit Policy for the year 2003-2004

Statement by Dr. Bimal Jalan, Governor,
Reserve Bank of India on Monetary and Credit
Policy for the year 2003-04

The Statement consists of three parts:
(I) Review of Macroeconomic and Monetary Developments during 2002-03,
(II) Stance of Monetary Policy for 2003-04, and
(III) Financial Sector Reforms and Monetary Policy Measures.

III. Financial Sector Reforms and
Monetary Policy Measures

67. A vibrant, resilient and competitive financial sector is vital for sustaining the reform process in the real sector of the economy. As such, the annual policy Statements as well as mid-term Reviews of RBI have been focusing on the structural and regulatory measures to strengthen the financial system. These measures have been guided by the objectives of increasing operational efficacy of monetary policy, redefining the regulatory role of the Reserve Bank, strengthening prudential norms, and developing technological and institutional infrastructure.

68. A key element of financial sector reforms has been the strengthening of the regulatory and supervisory framework on an ongoing basis. With a paradigm shift from micro-regulation to prudential regulation and macro-management, emphasis has been placed on promoting financial stability through developing sound risk management systems and enhancing transparency and accountability. While progress has been made in setting out signposts for what needs to be done, it has to be recognised that macroeconomic and financial conditions tend to change swiftly, posing new challenges. It is, therefore, important to put in place corrective strategies along with implementation and enforcement mechanisms.

69. In order to achieve the above objectives, RBI has been adopting a policy of extensive consultations with experts and market participants before introducing policy measures. Such discussions help in ensuring timely and effective implementation of the measures in accordance with international best practices.

70. Against this background, this section reviews the progress of implementation of the measures initiated so far and proposes some further measures to meet the emerging challenges in the financial sector.

Monetary Measures

71. In view of macroeconomic and overall monetary conditions and consistent with announcements made by the Finance Minister regarding certain administered interest rates, RBI reduced the interest rate on savings account from 4.0 per cent to 3.5 per cent effective from March 1, 2003. The repo rate under LAF made available on March 3, 2003 was reduced from 5.5 per cent to 5.0 per cent and thereafter the cut-off rate is being decided at each auction.

(a) Bank Rate

It is proposed to reduce the Bank Rate by 0.25 percentage point from 6.25 per cent to 6.0 per cent with effect from the close of business today (April 29, 2003).

72. The Bank Rate has been reduced from 11.0 per cent to 6.0 per cent, i.e. by 500 basis points in the last five years. This is the sharpest reduction in the Bank Rate since independence. Unless the domestic and international circumstances change, the policy bias in regard to the Bank Rate is to keep it stable until the mid-term Review of October 2003.

(b) Cash Reserve Ratio

73. The Reserve Bank has been pursuing the medium-term objective of reducing cash reserve ratio (CRR) of banks to the statutory minimum level of 3.0 per cent. In this direction, CRR was gradually reduced from 11.0 per cent in August 1998 to 4.75 per cent by November 2002. In line with this medium-term objective, it is now proposed to:

Reduce CRR further from 4.75 per cent to 4.50 per cent effective fortnight beginning June 14, 2003.

74. With this reduction, CRR would have been reduced by 4.0 percentage points in the last three years. It may be mentioned that in case there is an unexpected change in the liquidity conditions in the next few weeks, RBI may advance the effective date of the above reduction.

(c) Payment of Interest on eligible CRR Balances on Monthly Basis

75. In the mid-term Review of October 2002, in response to a suggestion made by banks, RBI had announced that interest on eligible CRR balances maintained by banks with RBI would be paid on monthly basis, with effect from an appropriate date, as against the present practice of quarterly rests. Accordingly, the first such interest payment will be made for the month of April 2003 covering the fortnights ended April 4, 2003 and April 18, 2003 in the month of May 2003. Pursuant to this, RBI has suitably modified the interest claim statement to be submitted by banks.

(d) Export Credit Refinance Facility

76. In the mid-term Review of October 2002, it was indicated that interest rates on post-shipment rupee export credit beyond 90 days and up to 180 days would be deregulated with effect from May 1, 2003. In response to the suggestion received from the exporting community, in the present uncertain geopolitical environment, it has been decided:

To continue extending refinance facility to eligible export credit remaining outstanding under post-shipment rupee credit beyond 90 days and up to 180 days.

This measure will be reviewed again in October 2003.

(e) Back-stop Facility

77. Banks are eligible for standing facilities (export credit eligible for refinance) and PDs are eligible for collateralised liquidity support from RBI subject to certain limits. These limits are split into a "normal" facility (constituting one-half of the total standing facility), which is available at the Bank Rate, and a "back-stop" facility (constituting the remaining half of the standing facility) available at a variable rate determined by RBI from time to time. At present, the "back-stop" interest rate is higher than the repo/reverse repo/ NSE-MIBOR rates.

78. In order to increase the efficacy of liquidity adjustment facility (LAF) operations, it is desirable to rationalise the multiplicity of rates at which liquidity is absorbed/injected. Accordingly, it is proposed that:

The "back-stop" interest rate will be at the reverse repo cut-off rate at which funds were injected earlier during the day in the regular LAF auctions.
Where no reverse repo bid is accepted as part of LAF auction, the "back-stop" interest rate will generally be 2.0 percentage points over the repo cut-off rate of the day under LAF.

On the days when no bids for repo or reverse repo auctions are received/accepted, the "back-stop" interest rate will be decided by RBI on an ad hoc basis.

79. With the above changes, it is expected that the "back-stop" interest rate will be lower by 1.0 percentage point over the present "back-stop" rate. This should benefit banks (as well as borrowers) using this facility.

80. Over time, LAF has evolved as an effective mechanism for absorbing and/or injecting liquidity on a day-to-day basis in a more flexible manner. Nevertheless, in some very rare and unusual circumstances, a situation may arise when a bank faces a sudden and unforeseen liquidity problem particularly outside the normal LAF auction timings and on days on which such auctions are not held. In such exceptional and unforeseen circumstances, RBI at its discretion, may extend liquidity support to such a bank if the said bank is otherwise financially sound, and after taking into account other relevant factors. The liquidity support in such exceptional circumstances will be made available only for a minimum number of days required to overcome the unexpected liquidity pressure. As this exceptional financing has to be availed only in rare circumstances, an interest rate of 4.0 percentage points above the reverse repo rate prevailing on that day (or a rate as may be decided by RBI) will be charged. Such liquidity support will be available against eligible securities with adequate margin and other conditions as RBI may consider appropriate.

Interest Rate Policy

(a) Prime Lending Rate and Spreads

81. At present, commercial banks decide the lending rates to different borrowers (with credit limit of over Rs.2 lakh) subject to the announcement of prime lending rate (PLR) as approved by their Boards. In order to enhance transparency in banks’ pricing of their loan products as also to ensure that the PLR truly reflects the actual costs, banks are advised to consider the following suggestions for determination of their benchmark prime lending rate:

Banks should take into account their (i) actual cost of funds, (ii) operating expenses and (iii) a minimum margin to cover regulatory requirement of provisioning/capital charge and profit margin, while arriving at the benchmark PLR. Banks should announce a benchmark PLR with the approval of their Boards.

As is already the case, the benchmark PLR would continue to be the ceiling rate for credit limit up to Rs.2 lakh.

Since all other lending rates can be determined with reference to the benchmark PLR arrived at, as above, by taking into account term premia and/or risk premia, the system of tenor-linked PLR may be discontinued. These premia can be factored in the spread over or below the PLR. The effective date for discontinuation of the tenor-linked PLR would be further discussed with banks and a decision will be announced separately in due course.

82. In the interest of customer protection and to have greater degree of transparency in regard to actual interest rates charged to borrowers, banks should continue to provide information on maximum and minimum interest rates charged alongside the benchmark PLR.

83. The Reserve Bank proposes to review the system of determination of benchmark PLR by banks and the actual prevailing spreads around the benchmark PLR in September 2003.

(b) Non-Resident External (NRE) Deposits

84. At present, banks can offer FCNR(B) deposits in foreign currency and non-resident external (NRE) deposits in domestic currency to non-resident Indians. Both schemes are now fully repatriable. Whereas the maturity period in case of FCNR(B) scheme is 1-3 years, in case of NRE deposits, the minimum maturity is 6 months. Banks are free to offer fixed and floating rates in both the schemes. The interest rates on FCNR(B) deposits are subject to a ceiling of LIBOR/Swap rates for the corresponding maturities minus 25 basis points, and thus conform to global interest rates in foreign currency deposits in US dollars, pound sterling, euro etc. Similarly, the interest rates offered by banks on NRE rupee deposits are also more or less at par with domestic interest rates on rupee deposits.

85. In order to provide uniformity in the maturity structure for all types of repatriable deposits whether they are in foreign currency or in rupees, it is proposed that:

The maturity period of fresh NRE deposits, with immediate effect, will be 1 to 3 years in line with FCNR(B) deposits. This will also apply to NRE deposits renewed after their present maturity period.

Credit Delivery Mechanism

(a) Priority Sector Lending

(i) Liberalisation of credit for drip irrigation/sprinkler irrigation system/ agricultural machinery

86. In the mid-term Review of October 2002, the limit on advances granted to dealers in drip irrigation/sprinkler irrigation system/agricultural machinery, located in rural/semi-urban areas was increased from Rs.10 lakh up to Rs.20 lakh under priority sector lending for agriculture. As the scheme has been of benefit to the farming community, the following further liberalisation is proposed:

Dealers in drip irrigation/sprinkler irrigation system/agricultural machinery, irrespective of their location, would be eligible for such advances, under priority sector lending for agriculture.

(ii) Housing loans

87. At present, the quantum of direct housing loans for construction of houses by individuals to be counted under priority sector advances is Rs.5 lakh in rural and semi-urban areas and Rs.10 lakh in urban and metropolitan areas. In view of increasing demand for housing in rural and semi-urban areas, and to improve financing to housing sector in these areas, it has been decided that:

Banks, with the approval of their Boards, will be free to extend direct finance to the housing sector up to Rs.10 lakh in rural and semi-urban areas as part of priority sector lending.

(b) Survey on KCC

88. As indicated in the mid-term Review of October 2002, a survey for assessing the impact of kisan credit cards (KCC) Scheme has been awarded to the National Council of Applied Economic Research (NCAER), New Delhi. The impact assessment survey would cover all regions.

(c) Relief for Drought affected Farmers

89. Guidelines for relief measures by banks in the districts notified by the state governments as drought affected were issued in November 2002. Accordingly, banks were advised: (i) not to recover any amount either by way of principal or interest during the year 2002-03 in respect of Kharif crop loans, (ii) to convert the principal amount of crop loans into term loans to be recovered over a minimum period of five years in the case of small and marginal farmers and four years in the case of other farmers and (iii) to defer interest due on crop loans and not to charge interest on the deferred interest.

90. In order to mitigate further the hardship of farmers in drought affected states, the Government has decided, as a one-time measure, to waive completely, the first year’s deferred interest liability on Kharif loans in those states. This instalment of deferred interest, which is to be waived by banks would be reimbursed by the Government. No interest would be charged on the deferred interest, and the balance of the deferred interest would be recovered in reasonable instalments.

(d) Guidelines on Infrastructure Financing – Relaxation in
Regulatory and Prudential Aspects

91. In view of the critical importance of the infrastructure sector as also the high priority being accorded to this sector, certain relaxations relating to regulatory and prudential aspects were allowed to banks to boost credit flow to this sector. These measures, inter alia, include: (i) enhancing the scope of definition of infrastructure lending, (ii) relaxing the prudential single borrower exposure limit from 15 per cent to 20 per cent of capital funds in respect of infrastructure companies providing infrastructure facilities, (iii) assigning a concessional risk weight of 50 per cent on investment in securitised paper satisfying certain conditions pertaining to an infrastructure facility, (iv) permitting lending to special purpose vehicles (SPVs) in the private sector, registered under Companies Act for directly undertaking viable infrastructure projects subject to certain conditions and (v) lending to promoters, with certain safeguards and where appropriate, for acquiring a controlling stake in existing infrastructure companies. Detailed instructions in this regard to banks have already been issued by RBI.

(e) Micro-finance

92. Micro-credit institutions and self-help groups (SHGs) have been recognised as important vehicles for generation of income and delivery of credit to self-employed persons. The Reserve Bank has been ey environment, as indicated in the mid-term Review of October 2002, RBI had a wide-ranging interface with a cross-section of micro-finance providers. Pursuant to these interactions, four informal Groups have been set up by RBI to look into various issues relating to: (i) structure and sustainability; (ii) funding; (iii) regulations and (iv) capacity building for micro-finance delivery. The Reserve Bank will discuss the recommendations of the informal Groups in a wider forum for possible implementation.

Money Market

(a) Moving towards Pure Inter-bank Call/Notice Money Market

93. It may be recalled that the annual policy Statement of April 2001 highlighted the intention to move towards a pure inter-bank call/notice money market in four stages by gradually phasing out non-bank participation. In stage I, non-bank participants were allowed to lend, on average in a reporting fortnight, up to 85 per cent of their average daily lending during 2000-01. The implementation of stage I has not caused any strain on the market or created undue volatility in call/notice money rate. Except for the Life Insurance Corporation of India, which has large liquid funds and is also subject to certain prudential constraints in investing its large surpluses in other non-bank institutions, by and large, most non-bank institutions have not faced any difficulty in adhering to the stage I guidelines.

94. Subsequently, in the annual policy Statement of April 2002, it was stated that RBI would announce the date of effectiveness of stage II, wherein non-bank participants would be allowed to lend, on average in a reporting fortnight, up to 75 per cent of their average daily lending in call money market during 2000-01, depending on the date when NDS/CCIL becomes fully operational. In view of the encouraging developments in NDS/CCIL, it would be desirable to accelerate the process of moving towards a pure inter-bank call/notice money market and facilitate further deepening of repo market. Accordingly, it is proposed that:

Stage II of the transition to a pure inter-bank call/notice money market will be effective from the fortnight beginning June 14, 2003, wherein non-bank participants would be allowed to lend, on average in a reporting fortnight, up to 75 per cent of their average daily lending in call/notice money market during 2000-01.

95. However, in case a particular non-bank institution has genuine difficulty in developing proper alternative avenues for investment of excess liquidity because of its size, RBI may consider providing temporary permission to lend a higher amount in call/notice money market for a specific period on a case by case basis.

(b) Reporting of Call/Notice Money Market Transactions on NDS Platform

96. Negotiated dealing system (NDS), which has become operational since February 2002, enables on-line dealing and dissemination of trade information relating to instruments in money, government securities and foreign exchange markets. Membership in NDS is open to all institutions which are members of INFINET and are maintaining subsidiary general ledger (SGL) Account with RBI. These include banks, financial institutions (FIs), primary dealers (PDs), insurance companies, mutual funds and any other institution as admitted by RBI. At present, all deals in government securities, call/notice/term money, CDs and CP executed among NDS members have to be reported automatically through NDS, if the deal is done on NDS and within 15 minutes of concluding the deal, if done outside NDS. However, it has been observed that a very sizeable proportion of daily call/notice money market deals is not reported by members on NDS as stipulated. With a view to improving transparency and strengthening efficiency in the market, it is proposed that:

From the fortnight beginning May 3, 2003, it would be mandatory for all NDS members to report all their call/notice money market deals on NDS. Deals done outside NDS should be reported within 15 minutes on NDS, irrespective of the size of the deal or whether the counterparty is a member of the NDS or not.
Full compliance with the reporting requirement to NDS will be reviewed in September 2003. In case there is repeated non-reporting of deals by an NDS member, it will be considered whether non-reported deals by that member should be treated as invalid with effect from a future date.

(c) Introduction of New OTC Rupee Derivatives

97. Following the announcement in the mid-term Review of October 2002, RBI had constituted a Working Group on Rupee Derivatives (Chairman: Shri Jaspal Bindra) with appropriate representations from Securities and Exchange Board of India (SEBI), banks, PDs, mutual funds and RBI. The scope of the Group was later expanded to cover the issues relating to exchange-traded interest rate derivatives in addition to the issues on over-the-counter (OTC) interest rate derivatives. The Group felt that in order to further deepen the money market and enable market participants to manage and control interest rate risk, certain new rupee derivative instruments could be introduced – both OTC and exchange-traded. Accordingly, it is proposed that, to begin with:

Less complex OTC interest rate rupee options should be permitted in the first phase which include vanilla caps, floors and collars, European Swaptions, call and put options on fixed income instruments/ benchmark rates and unleveraged structured swaps based on overnight indexed swaps (OIS) and forward rate agreements (FRAs) where the risk profile of such structure is similar to that of the building blocks.
Scheduled commercial banks, financial institutions and PDs would be allowed to both buy and sell options; corporates may sell options initially without being the net receivers of premium.

98. Detailed guidelines for operationalising the recommendations of the Working Group would be issued in consultation with market participants.

(d) Commercial Paper

99. Banks and FIs have the flexibility to provide credit enhancement for a commercial paper (CP) issue by way of standby assistance/credit, back-stop facility etc., based on their commercial judgment subject to the prudential norms as applicable and with specific approval of their Boards. Further, the present guidelines do not provide for credit enhancement for a CP issue in the form of an unconditional and irrevocable guarantee to be given by non-bank entities such as a corporate. In order to provide further flexibility to both issuers and investors in the CP market, it is proposed that:

Non-bank entities including corporates may provide unconditional and irrevocable guarantee for credit enhancement for CP issue as long as (i) the issuer fulfils the eligibility criteria prescribed for issuance of CP, (ii) the guarantor has at least one notch higher credit rating than the issuer by an approved credit rating agency, (iii) the offer document for CP should properly disclose: the networth of the guarantor company; the names of the companies to which the guarantor has issued similar guarantees; the extent of the guarantees offered by the guarantor company and the conditions under which the guarantee will be invoked.

Banks are allowed to invest in CP guaranteed by non-bank entities provided their exposure remains within the regulatory ceiling as prescribed by RBI for unsecured exposures.

Detailed guidelines on procedures and documentation in this regard will be issued by Fixed Income Money Market and Derivatives Association of India (FIMMDA).

(e) Collateralised Borrowing and Lending Obligation

100. The mid-term Review of October 2002 had announced the proposal to promote collateralised borrowing/lending operations by market participants to reduce their reliance on call/notice money market. Accordingly, collateralised borrowing and lending obligation (CBLO) has been operationalised as a money market instrument through Clearing Corporation of India Limited (CCIL) on January 20, 2003. The regulatory provisions and accounting treatment for CBLO are the same as those applicable to other money market instruments, but the operations in CBLO are exempted from CRR, subject to the bank maintaining minimum CRR of 3 per cent. In addition, securities lodged in the gilt account of the bank maintained with CCIL under constituents’ subsidiary general ledger (CSGL) facility for CBLO remaining unencumbered at the end of any day are reckoned for SLR purposes by the concerned bank. As on March 31, 2003, 32 members have been admitted in CCIL’s CBLO segment, of which, 23 members have been activated by CCIL. The total volume in CBLO during January-March 2003 stood at Rs.1,703 crore amounting to an average daily volume of Rs.30 crore.

Foreign Exchange Market

(a) Overseas Investment by Mutual Funds – General Permission

101. At present, mutual funds are allowed to invest in ADRs/GDRs of Indian companies and rated foreign debt instruments/equity within an overall cap of US $ 1.0 billion with the permission of SEBI and RBI. In order to simplify the procedure and to facilitate expeditious processing of investment proposals, it is proposed:

To accord general permission to mutual funds for their overseas investments within the cap, once SEBI’s approval has been obtained. This general permission will be available until further notice.

(b) Investment by Indian Corporates/Individuals in Rated Bonds/Fixed Income Securities

102. At present, Indian corporates and resident individuals are permitted to invest in equities of listed companies abroad subject to certain conditions. It is proposed to extend this facility to debt instruments. Accordingly:

Indian corporates and resident individuals will also be permitted to invest in rated bonds/fixed income securities of listed eligible companies abroad subject to certain conditions.

(c) Forward Cover for Inflows under Foreign Direct Investment

103. General permission has been accorded to banks to offer forward contracts to overseas investors to hedge their Foreign Direct Investment (FDI) to the extent of investments made in India. However, such FDI inflows are not permitted to be sold forward to banks. In order to provide greater flexibility to overseas investors and encourage flow of FDI, it is proposed:

To allow overseas investors making long-term investments to hedge their forex exposures in India, pending investment, by entering into forward sale contracts with banks in India.

(d) Forward Cover for Forex Exposures where Settlement is in Rupees

104. At present, resident entities are not allowed to book forward cover in case of transactions denominated in foreign currency but settled in rupees. Keeping in view the exposures of such entities to exchange rate risk, it is proposed:

To permit entities which have transactions denominated in foreign currency but settled in rupees to book forward contracts. Such contracts should be held till maturity and cash settlement would be made on the maturity date.

(e) Cross Currency Forward Cover for FCNR Deposits

105. At present, non-resident Indians (NRIs) and overseas corporate bodies (OCBs) can enter into forward contracts with rupee as one of the currencies to hedge the balances held in FCNR(B) or NRE Accounts. However, cross currency covers are not permitted for such deposits. In order to facilitate better risk hedging by NRIs and OCBs, it is proposed:

To allow NRIs/OCBs to book cross currency forward contracts to hedge the balances held in their FCNR(B) accounts. However, contracts once cancelled cannot be rebooked.

(f) Forex Clearing

106. One of the major functions of CCIL is clearing and settlement of inter-bank dollar-rupee transactions. It offers a multilateral netting mechanism through a process of novation for inter-bank spot and forward dollar-rupee transactions. Live operations for clearing and settlement of spot and forward dollar-rupee transactions commenced on November 12, 2002. While the US dollar leg of transactions is settled through CCIL’s account with its settlement agent in the US, the rupee leg is settled through the member banks’ current accounts maintained with RBI, Mumbai.

107. During the period November 12, 2002 to March 31, 2003, 91 settlements have taken place covering 98,206 transactions amounting to over US $ 65 billion. CCIL has lines of credit amounting to US $ 275 million from a foreign bank and Rs.800 crore from 7 Indian banks to take care of any unforeseen contingency. This new facility for clearing and settling dollar-rupee transactions in India is likely to provide substantial cost and time benefits to banks.

Government Securities Market

108. The Reserve Bank has taken a number of initiatives in the recent past in developing and deepening the government securities market. Further, NDS has been made operational for enabling on-line trading and dissemination of trade information on a near real-time basis. The supervision of PDs was strengthened with prescription of certain minimum disclosure norms and extending repo eligibility to CSGL/gilt account holders. The progress and recent developments in these directions are reviewed in the Annex.

Urban Co-operative Banks

109. As indicated in the mid-term Review of October 2002, a Committee set up by the Government (Chairman: Hon. Shri Anant Geete) had made a number of recommendations in its report on problems faced by Urban Co-operative Banks (UCBs). In pursuance of the recommendations made by the Committee and in consultation with the Government of India, certain relaxations are proposed in respect of gold loans, placement of deposits with other scheduled UCBs and limits on unsecured advances.

(a) 90 days Norm for Recognition of Loan Impairment – Exemptions

110. With a view to moving towards international best practices and to ensure greater transparency, commercial banks (including RRBs) and UCBs were advised to adopt 90 days norm for recognition of loan impairment from the year ending March 31, 2004. In response to the difficulties expressed by the UCBs and their federations in adopting this norm in respect of the large number of small loans and gold loans granted by them, it is proposed:

To exempt both gold loans and small loans up to Rs.1 lakh from the 90 days norm for recognition of loan impairment. These loans would continue to be governed by the 180 days norm for classification as NPA.

(b) Facility for Placement of Deposits with other Scheduled UCBs

111. It was indicated in the annual policy Statement of April 2001 that UCBs would not be permitted to increase the term deposit balances with other UCBs and the outstanding deposits had to be unwound before end-June 2002. In view of the difficulties expressed by UCBs in managing their short-term surplus funds while adhering to this prescription, it is proposed:

To permit UCBs to place deposits with strong scheduled UCBs (other than banks classified as weak or sick) with certain conditions. Detailed guidelines in this regard are being issued separately.

(c) Enhancement of Limit in the Ceiling on Unsecured Advances

112. At present, a ceiling of Rs.25,000 for UCBs with demand and time liabilities (DTL) of less than Rs.10 crore and Rs.50,000 for UCBs with DTL of Rs.10 crore and above has been prescribed for granting unsecured advances to a single borrower/connected group. In order to provide greater flexibility, it is proposed to revise the ceiling on the unsecured advances by the UCBs as under:

Type of UCB		Ceiling on unsecured advances
(a)	Non-scheduled UCBs with DTL of less than Rs.10 crore	Rs.50,000
(b)	Non-scheduled UCBs with DTL of more than Rs.10 crore	Rs.1 lakh
(c)	Scheduled UCBs	Rs. 2 lakh

The enhanced ceiling would not be applicable to weak/sick UCBs.

113. The aggregate of unsecured advances granted by a UCB to its members as a whole, would continue to be within the overall ceiling of 33 _^1/3; per cent of the bank’s DTL as hitherto.

(d) Timely Compliance with Inspection Reports

114. At present, UCBs have to prepare a compliance report on the inspection report in a prescribed proforma and submit the same to the regional office of Urban Banks Department within a period of six months from the date of receipt of the inspection report. The Joint Parliamentary Committee (JPC) which enquired into the stock market scam and matters relating thereto, recommended that:

"RBI must introduce a system whereby the irregularities pointed out in the annual inspection reports are removed by the banks and compliance report is submitted within a period of six months from the date of inspection".

In line with the above recommendation of the JPC, it has been decided that UCBs would be given a maximum period of six months from the date of the inspection report to remove the irregularities pointed out in the inspection report in all respects, failing which RBI will invoke the penal provisions.

(e) Mandatory Concurrent Audit

115. At present, all scheduled and other UCBs with deposits of over Rs. 50 crore are required to introduce the system of concurrent audit. The JPC has recommended that:

"As an apex body, though it is not possible for RBI to monitor each and every transaction, it is essential that concurrent audit is conducted in the banks on a regular basis. The RBI may consider making this mandatory".

In line with the above recommendation of the JPC, all UCBs are advised to introduce concurrent audit with immediate effect.

(f) Loans and Advances by UCBs to their Directors

116. In regard to loans and advances or other financial accommodation by UCBs to their directors, the JPC has recommended that:

"In order to prevent irregularities of the type surfaced in the case of some of the cooperative banks which were examined by the Committee, they are of the view that full ban on granting of loans and advances to the directors and their relatives, or the concerns in which they are interested needs to be imposed. Appropriate legal procedures may be initiated to ensure that there is no conflict of interest in the grant of loans and advances to the directors and their relatives and the concerns in which they are interested".

In line with the above recommendation of the JPC, UCBs, with immediate effect, should not grant loans and advances (both secured and unsecured) to directors, their relatives and firms/concerns/ companies in which they are interested.

Existing advances extended prior to April 29, 2003 may be allowed to continue up to the date when they are due. These advances should not be renewed or extended further.

Supervision and Monitoring

117. Progress made in respect of certain announcements made in the mid-term Review of October 2002 is reviewed below.

(a) Risk Based Supervision

118. It was indicated in the mid-term Review of October 2002 that certain management processes were initiated by RBI for switching over to risk based supervision (RBS) of banks during 2003. These processes included circulation of the risk profile template (RPT) for use by banks, training on RBS and compilation of RBS manual. In this context, a number of banks had undertaken an assessment of risks as per the RPT. A review of these assessments revealed that banks are capable of adopting the risk-profiling system on their own and the template can be used for risk analysis and in facilitating the process of switching over to RBS. An internal Group was also set up at the instance of Board for Financial Supervision (BFS) to assess the preparedness of banks to switch over to RBS regime. The Group concluded that in terms of preparedness, banks could be segregated into three groups. The first group, where RBS can be implemented immediately, could include banks that have developed advanced risk management architecture, MIS and IT, internal control system and trained manpower. The second group which may require about six months to one year for implementing RBS, could comprise banks that have taken steps to remove the identified gaps in their systems, but are not yet fully ready. The third group would consist of banks which require more time than their counterparts in the second group. It is proposed to implement RBS of a few select banks on pilot basis during April-June 2003. Based on the experience gained, RBS would be extended to all banks in a phased manner.

(b) Prompt Corrective Action

119. As indicated in the mid-term Review of October 2002, an internal Group was set up to study the impact of the prompt corrective action (PCA) framework on select weak banks. On the basis of the impact study, the scheme of PCA was announced in December 2002 with the approval of Board for Financial Supervision (BFS) and the Government. In terms of the scheme, RBI would initiate certain structured action in respect of banks which have hit the trigger points in terms of capital to risk-weighted assets ratio (CRAR), net non-performing assets (NPA) and return on assets (ROA). The Reserve Bank, at its discretion, would also resort to additional discretionary actions under each of the trigger points. However, the PCA framework does not preclude RBI from taking any other action, as it deems fit, in addition to the corrective actions prescribed in the framework. The scheme of PCA has been put in place initially for a period of one year and would be reviewed in December 2003. Banks have been advised to place the scheme before their Boards and take necessary steps in advance in order to ensure that as far as possible, they do not come within the scope of PCA framework.

(c) Consolidated Accounting and Supervision

120. It was indicated in the mid-term Review of October 2002 that guidelines on consolidated accounting and supervision were being finalised in consultation with banks. On the basis of the feedback received, the guidelines were modified, wherever necessary. The final guidelines have been issued and banks were advised to ensure strict compliance commencing from the year ended March 31, 2003. The guidelines would be reviewed after one year from the date of implementation.

(d) Macro-prudential Indicators

121. It was indicated in the mid-term Review of October 2002 that the scope and coverage of macro-prudential indicators (MPIs) were enhanced in the review for the half-year ended March 2002 and the salient features of the MPI report would be published. Accordingly, the salient features of the MPI review for March 2002 was published in the Report on Trend and Progress of Banking in India 2001-02.

(e) Other Supervisory Initiatives

122. Other supervisory initiatives are as under:

The Reserve Bank has issued, in December 2002, a guidance note on risk-based internal audit system to banks. Banks are advised to place the same before their Boards for initiating necessary steps for transition to the system in a phased manner.
Detailed guidelines for preventing slippage of NPA accounts from sub-standard to doubtful/loss category were issued to banks suggesting, inter alia, that banks can introduce a new asset category of "special mention accounts" in between "standard" and "sub-standard" accounts for their own internal monitoring and follow-up.
A comprehensive check-list for conducting computer audit recommended by the Committee on Computer Audit was circulated to banks and FIs. In addition, an Information System Audit Cell has been formed in RBI to scrutinise annual financial inspection (AFI) reports for initiating corrective action, if any, at an early stage. The Cell has also been entrusted with the work of updating the check-list with latest developments, revision of guidance notes for banks on risks and controls in computer and communication systems, and updating the Manual for inspection of banks in computerised environment on an ongoing basis.

Prudential Measures

123. The prudential norms are aimed at imparting strength to banks and financial institutions, inculcating greater accountability and market discipline and creating a secure and conducive environment for the smooth and effective functioning of the financial system. These norms cover not only capital adequacy, asset classification and provisioning but also exposure rules, accounting standards, transparency and disclosure, risk management and asset-liability management system. In this context, RBI’s approach has been to benchmark the norms with international standards and introduce the same after extensive consultations. It has also been a standard practice to allow the participants to absorb changes incrementally without causing any major dislocation.

124. The New Capital Accord, presently under consideration of the Basel Committee, aims at capturing major risks inherent in a bank’s operations and envisages enhancement of risk sensitivity. In order to equip banks to identify, measure, monitor and control the various types of risks assumed by them, RBI has, over a period, issued various guidelines and guidance notes taking into account the overall ability of banks to adopt them. The Reserve Bank has also taken a number of proactive steps and rationalised various prudential norms to prepare banks to understand the complexity and lessen the burden of costs involved in adhering to the international standards. These steps include phased provisioning, building up of investment fluctuation reserve (IFR) to guard against interest rate risks, refining asset-liability management systems with tolerance levels, assessing the impact of the proposed New Capital Accord on banks by conducting quantitative impact studies (QIS), relaxing exposure norms and permitting concessional risk weights in critical areas of importance and putting in place a sound ‘know your customer’ (KYC) policy and adopting anti-money laundering measures.

125. Taking into account the preliminary results of the QIS, the Basel Committee is fine-tuning risk weights assigned to banks’ exposures to retail customers, small and medium enterprises (SMEs), residential mortgages, securitisation transactions, past due loans etc., reflecting the risk characteristics of these exposures. The Basel Committee is also considering entrusting the supervisors with discretion for estimating capital charge for operational risk appropriate to risk profile of the bank.

126. In view of global competition and progressive liberalisation in the external sector of the economy along with increasing capital account convertibility, banking sector will be facing new challenges. This process requires banks to build up effective and well co-ordinated long-term strategies to keep pace with reforms. Further measures in this direction are indicated below.

(a) Investment Fluctuation Reserve

127. At present, the investment fluctuation reserve (IFR) is treated as Tier II capital up to a maximum of 1.25 per cent of the total risk-weighted assets. As suggested by banks, and to give further relaxation in building IFR, it is proposed that:

While IFR would continue to be treated as Tier II capital, it would not be subject to the ceiling of 1.25 per cent of the total risk-weighted assets. However, for the purpose of compliance with the capital adequacy norms, Tier II capital including IFR, would be considered up to a maximum of 100 per cent of total Tier I capital.

(b) Branch Licensing

128. In the recent period, the policy for commercial banks has been substantially liberalised. Banks’ Boards have been empowered to decide on the policy and strategy for setting up of new branches, closing and shifting of existing branches, subject to certain conditions. In order to encourage more efficient banking services all over the country, it is proposed to provide further flexibility in the branch licensing policy. Accordingly:

RBI will consider favourably any proposal for transfer of branches in rural and semi-urban centres from one commercial bank to another by mutual agreement. Banks will be expected to ensure that such mutually agreed transfers do not adversely affect the available banking services in that area.

(c) Policy for Raising Long-term Bonds by Banks

129. At present, banks are permitted to issue long-term subordinated debt in the nature of unsecured redeemable bonds which qualify for inclusion in Tier II capital. Apart from raising resources through Tier II capital bonds, in order to realign the portfolios from the asset-liability management angle, and to honour the long-term commitments, banks have expressed their desire to raise long-term resources from the market which are not in the nature of subordinated debt. It is proposed to accept this suggestion, and suitable policy guidelines for banks in this regard will be worked out in consultation with them.

(d) Provisioning in respect of NPAs which would be sold to
Securitisation/Asset Reconstruction Companies

130. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, allows securitisation/reconstruction companies created under the Act, to purchase non-performing assets (NPAs) from banks. In order to facilitate sale of NPAs to securitisation/reconstruction companies, guidelines to banks and FIs have been issued covering, inter alia, (i) policy for sale of assets to securitisation/reconstruction companies approved by the Board; (ii) accounting treatment of sale of NPAs and investment in bonds, debentures, security receipts which may be offered by the securitisation/ reconstruction companies and valuation thereof; (iii) capital adequacy requirements and exposure norms applicable to the above investments; and (iv) disclosure requirements. It is envisaged that banks would be able to sell their NPAs to securitisation/ reconstruction companies at considerable discount and the resultant shortfall, if any, in the net book value after deducting provisions held, would be required to be debited to the profit and loss account. Banks are, therefore, advised to build up provisions, significantly above the minimum regulatory requirements, for their NPAs particularly for those assets which they propose to sell to securitisation/reconstruction companies.

(e) Country Risk Management

131. It was indicated in the mid-term Review of October 2002 that draft guidelines on country risk management together with a ‘Note for Discussion’ were forwarded to banks and were also placed on the RBI website seeking comments and views. The guidelines were finalised in consultation with banks and have since been issued. These guidelines are applicable only in respect of countries where a bank has exposure of 2.0 per cent or more of its assets. Banks are advised to place the guidelines before their Boards and take appropriate steps for implementation. A review would be made after one year taking into account the experience of banks in implementing the guidelines.

Technology Upgradation

132. The Reserve Bank has assigned priority to the upgradation of technological infrastructure in the financial system. In this direction, the Payments System Vision Document, giving the nature and direction of reforms needed to achieve the vision, was set out. Substantial progress has been made since then for developing a modern, efficient, integrated and secure payment and settlement system for the financial services sectors. Modernisation of clearing and settlement through MICR based cheque clearing, popularising electronic clearing services (ECS) and integration of RBI-EFT scheme with funds transfer schemes of banks, introduction of centralised funds management system (CFMS) are significant milestones in this regard. Introduction of cheque truncation and imaging of paper-based cheques had also been envisaged to reduce the time lags in realisation of cheques. An efficient, cost-effective and dependable communication backbone – the INFINET – was established on which the structured financial messaging solution (SFMS) is being implemented. Further, RBI is monitoring on an ongoing basis the progress in respect of implementation of core banking solutions by banks, as the future of banking and finance revolves around meeting the challenges arising out of large scale growth in technology. This requires concerted efforts by all participants in the financial system to maximise efficiency and reduce costs. Further developments in this direction are reviewed in the Annex.

Developments in Currency Management System

133. Over the years, the growth in volume of currency has posed serious problems in regard to the currency management function of RBI in the areas of supply of notes, quality of notes and withdrawal of notes from circulation. Further, RBI has adopted a Clean Note Policy since 1999 towards improving the quality of notes in circulation. In order to maintain the quality of growing volume of notes in circulation, as a long-term measure, mechanisation of the note processing and destruction activity was taken up at all issue offices of RBI. As this requires notes in an unstapled condition, RBI has advised banks not to use wire stapling.

134. Further, as part of customer service, banks have been advised to open certain currency chest branches on Sundays for providing note exchange facility and distribution of coins. Banks have also been advised to install note counting/note sorting machines at currency chests/major bank branches of adequate size. A Currency Link was set up at RBI website which covers various aspects related to Indian currency and coinage, images and security features of contemporary bank notes in the Mahatma Gandhi series, frequently asked questions (FAQs) and press releases on currency issues. Banks are advised to give wide publicity to the initiatives in the area of currency management for convenience of the public as also provision of good quality bank notes.

Legal Reforms

135. In the recent past, changes in the financial markets and advancement in information technology have necessitated changes in the legal structure. The mid-term Review of October 2002 listed out various proposals submitted to the Government for making the legal system more efficient to manage the emerging scenario. While legislative action has been completed in respect of certain proposals, some of the proposals are under consideration. Progress made in this direction is given in the Annex.

Mid-term Review

136. A review of the monetary and credit developments in the first half of the current year will be undertaken in October 2003. The mid-term Review will be confined to a review of monetary developments and to such changes as may be necessary in monetary policy and projections for the second half of the year.

Mumbai

April 29, 2003