Mid-Term Review of the Annual Policy Statement for 2007-08, RBI Credit Policy, Reserve Bank of India: Banknet India

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Part II. Mid-term Review of Annual Statement on Developmental and Regulatory Policies for the Year 2007-08

III. Prudential Measures

165. The Reserve Bank has been adapting regulatory and supervisory tools to facilitate appropriate evolution of the financial system. The endeavour has been to anchor public confidence, to engage in financial development to support accelerated economic growth and to adopt international best practices with regard to prudential regulations, disclosure standards and supervisory processes.

(a) Discussion Paper on Holding Companies in Banking Groups

166. In many countries, deregulation and financial consolidation has led to the development of financial holding companies (commercial banking, insurance, investment banking and other financial activities are conducted under the same corporate umbrella). Different financial services within the same organisation are purveyed using different conglomerate models, viz., the universal bank, the bank subsidiary and the bank holding company. These conglomerate models can have one or more layers of intermediate holding companies. Accordingly, a discussion paper on holding companies in banking groups has been placed on the Reserve Bank’s website for feedback. Guidelines in this regard would be issued by end-November 2007.

(b) Guidelines on Asset-Liability Management System: Amendments

167. The Reserve Bank had issued guidelines on the Asset-Liability Management (ALM) system in February 1999, which covered, inter alia, interest rate risk and liquidity risk measurement/reporting framework and prudential limits. Having regard to the international practices, the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management, these guidelines have been reviewed and amended with reference to the approach to the measurement of liquidity risk, mismatches and the structural liquidity as also the frequency of supervisory reporting. Operational guidelines in this regard have since been issued.

(c) Introduction of Credit Default Swaps

168. The recent amendments to the Reserve Bank of India Act, 1934 has provided legality of OTC derivative instruments, including credit derivatives, and accordingly the Annual Policy Statement of April 2007 proposed to permit banks and PDs to begin transacting in single-entity credit default swaps (CDS). The draft guidelines on CDS were placed on the Reserve Bank’s website for wider dissemination and comments. On the basis of the feedback, revised draft guidelines have been placed on the Reserve Bank’s website for a second round of consultation and final guidelines would be issued by end-November 2007.

(d) Bank Finance to Factoring Companies: Review of Existing Guidelines

169. In view of difficulties expressed by some banks, a Working Group has been constituted with representatives from banks, factoring companies and the Reserve Bank to review the existing guidelines regarding financing of factoring companies. The Group would submit its report by November 15, 2007.

(e) Differentiated Bank Licences

170. The Annual Policy Statement of April 2007 proposed to prepare a technical paper on differentiated bank licences with a view to directing the resources of banks to their niche areas and to sustain efficiency in the banking system which can be equally applicable to both domestic and foreign banks. The technical paper has been placed on the Reserve Bank’s website on October 19, 2007.

171. The paper examined the statutory background of licensing of banks, the existing policies of licensing of private sector banks and foreign banks, international experiences and practices, and pros and cons of the introduction of a differentiated bank licensing regime. The paper recommended that in order to enable the banking system to operate at optimum efficiency and in the interest of financial inclusion, it would be necessary for all banks to offer certain minimum services to all customers, while allowing sufficient freedom to function according to their own business models. The paper also recommended continuation of the existing system for the time being.

(f) Recovery Agents Engaged by Banks

172. In view of the rise in the number of litigations against banks for engaging recovery agents in the recent past, it is felt that the adverse publicity could result in serious reputational risk for the banking sector as a whole. An urgent need has, therefore, arisen to review the policy, practice, procedure involved in the engagement of recovery agents by banks in India. Accordingly, banks are urged to follow prescribed specific considerations while engaging recovery agents.

173. Complaints received by the Reserve Bank regarding abusive practices followed by a bank’s recovery agents would invite serious supervisory disapproval. The Reserve Bank would consider imposing a temporary ban (or even a permanent ban in case of persistent abusive practices) for engaging recovery agents on those banks where strictures have been passed/penalties have been imposed by a High Court/Supreme Court or against its Directors/Officers with regard to the abusive practices followed by their recovery agents. An operational circular in this regard would be issued by November 15, 2007.

(g) Cross-border Supervision

174. Cross-border supervision has assumed importance in view of rapid integration of financial markets as also the heightened pace of merger and acquisition activities worldwide. In this context, the present system of informal exchange of information and supervisory cooperation amongst regulators need to be enhanced and well structured, particularly for internationally active banks. Accordingly, it is proposed:

• to constitute a working group to lay down the road-map for adoption of a suitable framework for cross-border supervision and supervisory cooperation with overseas regulators, consistent with the framework envisaged in the Basel Committee on Banking Supervision (BCBS).

(h) Consolidated Supervision and Financial Conglomerate Monitoring Mechanism: Integration

175. Guidelines for consolidated accounting and other quantitative methods to facilitate consolidated supervision were issued to banks in February 2003, based on recommendations of the report of a multi-disciplinary working group (Chairman: Shri Vipin Malik). Consolidated supervision is undertaken through consolidated financial statements (CFSs) which are intended for public disclosure, consolidated prudential reports (CPRs) for supervisory assessment of risks that could be transmitted to banks by other group members, and compliance with prudential norms on group basis.

176. The financial conglomerates (FC) monitoring framework was put in place on the basis of the recommendations of the report of the Inter-regulatory Working Group (Chairperson: Smt. Shyamala Gopinath) on monitoring of Systemically Important Financial Intermediaries (Financial Conglomerates). The focus of the FC return is mainly on intra-group transactions and exposures (both fund-based and non-fund based transactions). The dominant/major entity in the group, called a ‘designated entity’ (DE), collects and collates FC data/information and forwards them to the principal regulator for analysis.

177. The evaluation of overall risks and possible transfer thereof within the group structure, however, needs to be evolved under the consolidated supervision process for bank-led conglomerates. Accordingly, in order to enhance the effectiveness of the banking supervisory system for bank-led conglomerates, it is proposed to integrate the process of consolidated supervision with the financial conglomerate monitoring mechanism. Draft guidelines in this regard would be placed on the Reserve Bank’s website by end-January 2008.

(i) Monitoring Banks’ Exposure to Derivatives

178. At present, supervision of derivatives transactions by banks is carried out through on-site inspection during the annual financial inspection of banks and off-site monitoring of exposures through specified returns. In view of the potential of derivatives instruments to amplify systemic risks, there is a need to put in place a comprehensive oversight structure targeting the credit risk and operational risk in addition to the market risk, as at present. Furthermore, supervisory oversight needs to include stress testing of derivatives portfolios of banks for credit risk, particularly in view of banks resorting to multi-lateral netting for their counter party exposures. In view of majority of derivatives being over the counter (OTC) products, it is proposed:

• to cover, besides general market risk, specific risk, especially the credit risk arising out of deficient documentation or settlement risk, under the supervisory process.

(j) Implementation of Basel II - Pillar 2

179. The Reserve Bank issued final guidelines on implementation of Basel II framework in regard to Pillar 1 and Pillar 3 in April 2007. As regards Pillar 2, banks were advised to put in place internal capital adequacy assessment process (ICAAP) to capture all material risks, including those that are partly covered or not covered under the other two Pillars, with the approval of their boards. The ICAAP of banks are required to be subject to a supervisory review evaluation process (SREP) for which the structure and methodologies for identification and quantification of various risks (not covered under Pillar 1) and provision of additional capital or controls/management actions are being worked out.

(k) Supervisory Review Process

180. The Mid-term Review of October 2005 had indicated the initiation of a supervisory review process (SRP) for select banks having significant exposure to some sectors, namely, real estate, highly leveraged NBFCs, venture capital funds and capital markets, in order to ensure that effective risk mitigants and sound internal control systems are in place. In the first round of SRP, a framework was developed for monitoring the systemically important individual banks. The second round of SRP analysed the exposure to sensitive sectors, in particular, to the real estate and capital market sectors of select banks. Ten banks were identified as outliers based on the real estate and capital market exposures in excess of 200 per cent and 25 per cent, respectively, of their net worth. The initial analysis revealed that prima facie, all banks under review had put in place risk management policies and systems and controls to manage risks arising from exposures to sensitive sectors. In case of exposures to real estate, certain irregularities were observed with regard to the implementation of banks’ own approved policies. Accordingly, banks were advised to improve risk management processes at operating levels. Furthermore, banks were provided with an indicative list of deficiencies and irregularities and were advised to explicitly spell out the required norms for lending to the real estate sector in their policies.

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