Banking system in India was introduced towards the end of the 18th century. In 1770, Bank of Hindustan became the first bank to be incorporated in the Indian soil followed by the General Bank of India in 1786. However, both the banks were liquidated in 1832 and 1791 respectively. In the beginning of the 19th century, on 2nd June 1806, Bank of Bengal was inaugurated after being renamed from Bank of Calcutta. It became one among the other two Presidency banks – Bank of Bombay and Bank of Madras (incorporated on 1840 and 1843 respectively). Until 1861, all the three banks enjoyed the exclusive right of issuing paper currency. After the enactment of Paper Currency Act, the right to issue paper currency was taken over by the Government of India. On 27th January 1921, the Presidency banks were amalgamated and it was named as Imperial Bank of India. The Imperial Bank of India became the State Bank of India on 1st July 1955 and since then it is the largest and the oldest bank still in existence in India.
Presently, our banking system is split into commercial banks, cooperative banks and regional rural banks. The key role in the economy and financial system is played by the commercial banks. They allocate the funds from savers to borrowers, thereby bringing more efficiency in the overall economy.
Currently, Indian banking system requires efficient service delivery, stability, inclusion and transmission in monetary policy. Recognising this need, various reforms have been in introduced over the years by the government to enhance the banking system and create a robust environment.
A Synopsis on Present Scenario
The problems that banks are facing today are mostly due to the fundamental change that transpired post 2002. There were mainly two types of loan offered by Indian banks prior to that – (i) retail term loans to families for housing, and for durable goods (24% of banking portfolio); (ii) working capital loans to farmers, firms and production entities,(76% of banking portfolio). From then onwards, aggressive term loans have been made by banks to companies for fixed capital investments such as land, building and machinery. Now this sums up to 38% of the portfolio with retail at 20% and working capital at 42%. The majority of NPAs by value are because of long-term loans to corporates. NPA or non-performing assets is a loan provided by the banks to companies for which the principal or interest payment remains unpaid by the borrowers for a period exceeding 90 days.
There is a vast difference between de facto (behavioural) and de jure (contractual) tenors of bank deposits. The computation of de jure tenor is usually done by considering the weighted average of term deposits and contractual tenors of demand, which works for around 2 years. However, most of the term deposits and demand deposits usually remain with the bank for 14-15 years. Hence, the average de facto tenor is apparently more than 10 years which is possibly greater than the average loan portfolio maturity. This discrepancy between de facto and de jure insinuates that assets-liability mismatch develops into an issue only when there is a loss of confidence in depositors and withdrawal of deposits. The problem of NPA has arisen from four facets that characterised bank loan for formation of fixed capital.
Firstly, banks do not possess the capacity required to assess borrowers’ long term credit-worthiness. It depends on credit rating agencies which give ratings only when the distressed company desires to uplift its debt capital directly from the market.
Secondly, it’s a drawback of the bank that they cannot efficiently monitor the long-term loans from the borrowers. This is particularly hideous for project loans. As a result, the funds can be used by the parent company for various alternative purposes. Hence, whatever little assessment was done initially becomes vitiated.
Thirdly, these types of loans create an existential issue for borrowers since affixing such assets emphasizes on “winding up” the companies. It is natural that companies would fight back such an eventuality. As winding up of petitions, especially with many lenders, was a complicated legal procedure, which usually took 7-10 years, and promoters using each and every feasible trick to inhibit proceedings, alarming prospect are faced by bank for making huge loss of loan provisions which would remain in the books for multiple years with a little recovery at the end. It is no surprise that administration have allowed potential NPAs to multiply over the decades through myriad conventions of “ever-greening”. Forced recognition of NPAs by the Reserve Bank of India has now brought the hitch to light.
Fourthly, loans were mispriced by the banks. In most of the banks, the yield curve remained parallel or became flatter in respect of government securities. Even if banks failed to estimate the pertinent risk premium at independent tenors, because of (first) above, there is no rationalization why the illiquid essence of the of the underlying collateral was not attached to the premium, which also relates to (third) above.
Apart from these, successive government are equally responsible for this inflated exposure to companies in fixed assets particularly in project finance. In 1997, government took the decision to stop issuing tax free bonds through development finance institution. It was the foremost source of term finance for the corporates. The institutions were forced to convert themselves into commercial banks as it was the only source of proportionately low cost funds for them. As a result, the Indian commercial banks were compelled to fill the lacuna and convert themselves to “universal banks”—executing roles of commercial banks as well as investment banks.
While promoting public-private partnerships and drawing more focus on infrastructure during 2002-09, the problems escalated and consequently there was a sharp escalationin project financing among private infrastructure firms.
The first and the foremost answer to NPA issue should be providing rapid resolution to defaults as had happened earlier with working capital loans and was sorted through enactment of SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest) Act 2002. It had resulted in gross NPA decrease to 6% in 2006 from 19% in 2002.
Basel III norms have been adopted and implemented by the Reserve Bank of India. Basel III is an international regulatory protocol that infused a set of reforms designed to enhance the risk management, supervision and regulation within the banking sector. It is crucial that banks maintain a proper leverage ratio and undergo certain minimum capital requirements in response to credit crisis.
Apart from an enhanced capital structure and liquidity ratios like LCR (liquidity coverage ratio) and the upcoming NSFR (net stable funding ratio), the RBI has also been collaborating the supervisory and regulatory frameworks for co-operative banks, AIFIs (All India Financial Institutions) & Non-Banking Financial Company’s (NBFCs) with commercial banks to avoid regulatory arbitrage. Additionally, the Indian Accounting Standards (Ind-AS) recommendations suggested for commercial banks will be made obligatory for both NBFCs and AIFIs. A formal Prompt Corrective Action (PCA) stratagem has been implemented for NBFCs from March 30, 2017 and Information Technology (IT) framework from June 8, 2017. Various categories of NBFCs are also being simplified into fewer categories.
For examining the financial condition and its various components, a committee was set up the government of India for making recommendations to reform and improve the country’s financial sector. The chairman of the committee was M. Narasimham. The committee had submitted its report before the parliament in December 1991.
It’s main recommendations were:-
- Inception of a 4-tier hierarchy for banking sector-
- Around 4-5 commercial banks having international character. State Bank of India being one such bank;
- Around 8 to 10 national banks which would have nationwide branches involved in universal banking;
- Small banks which would be deal in specific regions;
- Rural banks whose business would be restricted to rural areas only.
- Terminating branch licensing system. Decision of opening or closing of branches will rest on banks themselves;
- Easing of restriction on foreign banks, entry of private banks and full restriction on further nationalisation of banks;
- Reduction of cash reserve ratio (CRR), from 15 % to 3-5 % over the next five years, phased curtailment of statutory liquidity ratio (SLR) from 38.5% to 25% over 5 years and payment of interest on cash reserve ratio to commercial banks;
- Phasing out of directed credit to precedence sectors down to 10% sum total of bank credit;
- Removing restrictions of interest rates and introducing them on government borrowing in accordance with the market-determined rates;
- Securing prudential standards and cementing banking supervision;
- Issue of prudential frameworkadministering the financing of financial institutions;
- Complete classification of assets and full revelation and transparency of accounts of financial institutionsand banks;
- Attaining a minimum of 4% capital adequacy ratio within 3years in reference to risk weighted assets;
- Intensified competition in advancing between banks &‘development financial institutions’;
- Establishing Asset Reconstruction Fund for addressing bad and doubtful debts.
Implementation of recommendations
RBI Governor Bimal Jalan, in 1998, notified the banks that within 3-4 years the recommendations of the committee would be implemented. Based on recommendation, ICICI bank became India’s first universal bank. Prudential measures for classification of assets, provisioning of bad debts and income recognition have been introduced. Previously, no uniform practices for income recognition, classification of assets into performing and non-performing ones, clauses for non-performing assets (NPAs), valuation for securities were followed by the banking industry of India. Even there had been no capital adequacy requirements. All the actions taken on recommendations were published by the RBI in its report on 31st October 2001. Most of the recommendations have been implemented while some are still awaiting for actions from government of India.
Recent Reforms by the Government:-
To bolster banks and promote a virtuous and responsible banking environment, the government implemented the 4 R’s approach — recognition, resolution, recapitalization and reforms.
Many steps including inter alia have been enforced for the smooth functioning of the PSBs. They are:-
- increasing access to banking services through digital banking and enhanced customer ease;
- instituting efficient conventions for effective coordination in huge consortium loans by restricting total number of lenders in consortium and by adopting standard operating procedures;
- enabling simpleaccessibility to senior people and the differently-abled persons, through online update of pension life certificates, etc.
- strict dissociation of pre- and post-sanction roles and responsibilities for improved accountability;
- implementation of transparent and vigorous one-time settlement framework with automated monitoring and escalation;
- rising-fencing of cash flows and use ofanalytics and technology for comprehensive diligence across data sources for prudent lending;
- loans above ?250 crore are monitored through specialised agencies for effective vigil;
- institution and implementation of a risk appetite mechanism for a structured approach to measure, manage and control risk and check imprudent and aggressive lending;
- for focused recovery and timely and effective management of stressed accounts, stressed assets management verticals have been established in banks;
- monetisation of non-core assets for enhancement of capital base;
- enabling proactive reach-out to borrowers as well as stepping-up cluster-based financing to MSMEs;
- enabling quicker bill realisation for MSMEs through discounting by banks on the Trade Receivables electronic Discounting System (TReDS)
- developing human resources by rewarding the best performers and enabling specialisation via job-families, and role based learning for executives.
Apart from the 4R’s approach, a few more steps were taken by the government to expedite and legalize the resolution of NPAs of PSBs. They are-
- Enactment of Insolvency and Bankruptcy Code in 2016 to manage the affairs of corporate debtor.
- Amendment of Banking Regulation Act of 1949, for providing authorisation to RBI for issuing directions to banks for initiating the insolvency resolution process under IBC.
- Amendment of Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act to make it more effective and bringing in provision for imprisonment of 3 months if the borrowers do not provide asset details and for the lender to get possession of mortgaged property within 30 days.
- Establishment of six new Debts Recovery Tribunals to expedite recovery.
- Stressed Asset Management Verticals have been created under the PSB Reforms Agenda for segregated pre- and post-sanction follow-up roles for effective and clean monitoring, stringent recovery, initiated creation of online one-time settlement platforms, and committed to monitor large-value accounts by specialized monitoring agencies.
In respect of the stress in the banking environment, banks can take lead of the IBC and the different steps undertaken by the Government to clear their balance sheets and improve performance to remain competitive. Instead of lingering for regulatory suggestions, it is better to file insolvency proceedings by the banks on their own to realise promptly the best price for their assets.