Mid-Term Review of the Annual Policy Statement for 2008-09, RBI Credit Policy, Reserve Bank of India: Banknet India

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Mid-Term Review of the Annual Policy Statement for 2008-09

Part B. Mid-term Review of Annual Statement on Developmental and Regulatory Policies for the Year 2008-09

IV. Prudential Measures

(a) Cross-border Supervision

171. An Internal Working Group (Chairman: Shri S. Karuppasamy) was constituted to lay down the roadmap for adoption of a suitable framework for cross-border supervision and supervisory cooperation with overseas regulators, consistent with the framework envisaged by the Basel Committee on Banking Supervision (BCBS). The Working Group consulted both Indian banks with overseas branches and foreign banks with Indian operations to elicit the practices followed relating to cross-border activities, inspection methodology and frequency adopted by overseas supervisors, systems followed for securing of supervisory rating and progress made in implementation of Basel II. The Group sought information from various overseas regulators/supervisors on the practices adopted by them on information sharing/policies on cross-border supervisory cooperation and the existing legal framework in those jurisdictions. The Group examined the legal position on cross-border supervision arrangements and also explored the feasibility of executing memoranda of understanding (MoUs) with overseas supervisors. The Group is expected to submit its report by mid-November 2008.

(b) Consolidated Supervision and Financial Conglomerates

172. The Annual Policy Statement of April 2008 had proposed realignment of various internal supervisory processes for implementing an improved consolidated supervision process in order to enhance the effectiveness of the banking supervisory system for bank-led conglomerates. Accordingly, an ‘approach paper’ on the supervision of financial conglomerates is expected to be finalised by end-November 2008.

(c) Supervisory Review Process on Activities of the Trusts/SPVs Set up by Banks

173. Special purpose vehicles (SPVs) and trusts set up by banks are generally unregulated and are subject to inadequate independent board oversight. As the activities of these entities could be a potential risk to the parent bank and could also pose systemic risk, the Annual Policy Statement of April 2008 proposed to study and recommend a suitable supervisory framework for activities of SPVs/trusts set up by banks. Accordingly, a Working Group (Chairman: Shri S. Sen) has been constituted in October 2008 with representatives from the Reserve Bank, banks and credit rating agencies which is expected to submit its report within three months. The Group would study various types of trusts/SPVs set up by banks, management control by parent banks, related regulatory/supervisory issues and recommend a suitable supervisory framework.

(d) New Model of Risk-Based Supervision: Evolution

174. With a view to evolving an appropriate model of risk-based supervision (RBS), a departmental Group was set up to study international practices on such systems. The Group studied the RBS mechanism adopted by various supervisory authorities across certain jurisdictions (the US, the UK, Australia, France, Hong Kong, Singapore, Thailand and Malaysia) with a view to evolving a suitable RBS framework without diluting the intensity of the existing supervisory framework. An approach paper in this regard is under preparation and is expected to be finalised by mid-December 2008.

(e) Overseas Operations of Indian Banks: Review of Existing Off-Site Monitoring Framework

175. The Inter-departmental Group constituted to review the existing regulatory and supervisory framework for overseas operations of Indian banks held consultations with Indian banks having large overseas presence. An appropriate supervisory framework, including a revised off-site surveillance system for overseas operations of Indian banks, is expected to be finalised by end-November 2008.

(f) Supervisory Review Process Related to Banks’ Credit Portfolio

176. The First Quarter Review of July 2008 had indicated that the Reserve Bank would consider undertaking a supervisory review of select banks which are over-extended in terms of their credit portfolios relative to their sources of funds. Accordingly, banks were identified based on their off-site returns and detailed information from these banks was sought regarding the sources and deployment of their funds. Detailed discussions with the top management of banks were held and concerns were conveyed to them for taking appropriate action.

(g) Review of Banks’ Exposures to Agricultural Commodities

177. In view of the current public policy concerns in regard to trading in food items, the Annual Policy Statement of April 2008 had urged banks to review their advances to traders of agricultural commodities including rice, wheat, oilseeds and pulses as also advances against warehouse receipts. Banks were advised to forward the first such review to the Reserve Bank for carrying out supervisory review of banks’ exposures to the commodity sector. A supervisory review of banks’ exposures to agricultural commodities as on March 31, 2008 was carried out on the basis of data submitted by banks. The review revealed that banks’ advances to traders in agricultural commodities and advances against warehouse receipts constituted less than one per cent of their gross advances. Banks also confirmed that they are exercising due caution while extending advances to agricultural commodities so as to ensure that bank finance is not used for hoarding. A further review of the position as on June 30, 2008 was also made and no significant change was observed in such exposure of banks.

(h) Implementation of Basel II Framework in India: Status

178. Indian banks with overseas presence and branches of foreign banks functioning in India have migrated to Basel II Framework with effect from March 31, 2008. Considering the level of sophistication of risk management techniques and availability of data, these banks have been advised to follow the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk. All banks in India follow the Standardised Measurement method for computation of capital charge for market risk since June 2004. With the issuance of guidelines on Pillar II in March 2008, banks are also required to have an Internal Capital Adequacy Assessment Process (ICAAP) to ensure that they have adequate capital to support all risks in their business and are encouraged to develop and use better risk management techniques in monitoring and managing risks. The evaluation of the ICAAP of individual banks is being taken up by the Reserve Bank in conjunction with the annual financial inspection of banks. As planned, the remaining banks are required to migrate to the Basel II framework with effect from March 31, 2009.

(i) Introduction of Credit Derivatives in India: Review of Status

179. The Reserve Bank had issued draft guidelines on credit default swaps (CDS) in May 2007, followed by a revised version in October 2007 for another round of consultation. However, in view of certain adverse developments in international financial markets, particularly credit markets, resulting in considerable volatility, it was not considered opportune to introduce the credit derivatives. Accordingly, the issuance of final guidelines on the introduction of credit derivatives was kept in abeyance. This decision was taken so as to be able to draw upon the experience of the financial sector of some of the developed countries, particularly in the current circumstances in which the entire dimensions of the credit market crisis have not yet been gauged. The Reserve Bank would draw from lessons from the recent turmoil and review the proposal to introduce the CDS at an appropriate time.

(j) Strengthening of Risk Management in Banks: Liquidity Risk

180. The on-going turmoil in international financial markets has brought the management of liquidity risk in banks to the fore front. It is clear that even the most sophisticated banks had not considered the amount of liquidity they might need to satisfy contingent obligations, either contractual or non-contractual, as they viewed funding of these obligations to be highly unlikely or regarded the availability of resources to meet such funding requirements as stable over future periods. Many international banks had envisaged severe and prolonged liquidity disruptions as highly unlikely and did not conduct stress tests that factored in the possibility of market-wide strain or the severity and duration of disruption. The Reserve Bank had issued guidelines on asset-liability management in February 1999 which created a sound framework for liquidity risk and interest rate risk management in banks. These guidelines were modified in October 2007 to bring about granularity of time buckets and recognised the impact of cumulative outflows on liquidity across time buckets. The Reserve Bank is in the process of significantly revising these guidelines, especially in the light of a paper entitled ‘Principles for Sound Liquidity Risk Management and Supervision’ published by the Basel Committee on Banking Supervision in September 2008, to ensure that banks’ liquidity risk measurement and management capabilities are in tune with the level of complexity of their operations.

(k) Stress Testing

181. Stress testing has evolved as a practical risk management tool and its applications are expanding. As observed in the Committee on Global Financial System (CGFS) Report, 2005 stress testing works as a complement rather than as a supplement to major risk management tools such as value-at-risk. It is, therefore, becoming an integral part of the risk management frameworks of banks and securities firms. In an increasingly complex financial environment where banks are facing new risks and markets are becoming more global, stress testing benefits from its flexibility, comprehensibility and the responsibility that it puts on managements to evaluate the risks that a bank is currently running. The stress tests are increasingly being integrated into risk management frameworks of financial institutions.

182. The Reserve Bank had issued guidelines to banks on stress testing in June 2007 which require banks to have a sound stress testing policy which will determine the liquidity risk, interest rate risk, credit risk and foreign exchange risk under stressed scenarios. It is proposed to upgrade these guidelines appropriately to provide further guidance to banks in the matter. Banks are also encouraged to improve their management information systems (MIS) and risk management skills for conducting stress tests and make full use of the insights gained from such tests.

(l) Financial Stability Forum Report: Status

183. The Annual Policy Statement of April 2008, while presenting the status on the implementation of the proposals of Financial Stability Forum (FSF), indicated that the Reserve Bank has put in place regulatory guidelines covering many of these proposals and in other cases, actions are being initiated. In the ensuing period, the Reserve Bank has issued guidelines on prudential norms for off-balance sheet exposures of banks which are set out below:

(i) Exposure Norms: Method of Computation

184. Banks shall compute their credit exposures arising on account of their interest rate and foreign exchange derivative transactions and gold using the ‘Current Exposure Method’. Banks may exclude ‘sold options’ provided that the entire premium/fee or any other form of income is received/realised while computing the credit exposure.

(ii) Capital Adequacy: Computation of the Credit Equivalent Amount

185. For the purpose of capital adequacy, all banks, both under Basel I and under Basel II frameworks, shall use the ‘Current Exposure Method’ to compute the credit equivalent amount of the interest rate and foreign exchange derivative transactions and gold.

(iii) Provisioning Requirements for Derivative Exposures

186. Credit exposures computed as per the current marked-to-market value of the contract arising on account of the interest rate and foreign exchange derivative transactions and gold shall also attract provisioning requirements as applicable to the loan assets in the ‘standard’ category of the counterparties concerned. All conditions applicable for treatment of provisions for standard assets would also apply to the provisions for derivatives and gold exposures.

(iv) Asset Classification of the Receivables Under the Derivatives Transactions

187. In respect of derivative transactions, any amount due to the bank which remains unpaid in cash for a period of 90 days from the specified due date for payment will be classified as non-performing assets as per the prudential norms on income recognition, asset classification and provisioning pertaining to the advances portfolio.

188. These modifications would come into effect from the financial year 2008-09. Banks would, however, have the option of complying with the additional capital and provisioning requirements arising from these modifications in a phased manner over a period of four quarters ending March 31, 2009.

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