Part II. Annual Statement on Developmental and
Regulatory Policies for the Year 2008-09
III. Prudential Measures
(a) Prudential Norms on Income Recognition, Asset Classification and
Provisioning pertaining to Advances: Infrastructure Projects
Involving Time Overrun
163. In terms of the current guidelines, banks had been advised that as regards industrial projects to be financed by them, the date of completion of the project should be clearly spelt out at the time of financial closure of the project and if the date of commencement of commercial production extends beyond a period of six months after the date of completion of the project as originally envisaged, the account should be treated as a sub-standard asset. For infrastructure projects, however, the period for recognising asset impairment was extended to one year with effect from March 31, 2007.
164. On a representation made in regard to delays in completion of infrastructure projects for legal and other extraneous reasons, the Reserve Bank undertook a review of select projects and concluded that there is merit in this representation. Accordingly, it has been decided that:
in case of infrastructure projects to be financed by banks, the date of completion of the project should be clearly spelt out at the time of financial closure of the project and if the date of commencement of commercial production extends beyond a period of two years (as against the current norm of one year) after the date of completion of the project as originally envisaged, the account should be treated as sub-standard. The revised instructions will be effective from March 31, 2008.
(b) Off-Balance Sheet Exposures of Banks
165. The Reserve Bank has, in the light of domestic developments, taken steps to strengthen the prudential framework in respect of on-balance sheet exposures of banks. Such measures included additional risk weights and provisioning requirements for exposures to specific sectors. In view of the recent developments in the global financial markets and drawing from suggestions for ensuring financial stability, it is proposed:
to review current stipulations regarding conversion factors, risk weights and provisioning requirements for specific off-balance sheet exposures of banks and prescribe prudential requirements as appropriate. The guidelines in this regard would be placed on the Reserve Bank's website by May 15, 2008.
166. In view of the risks associated with international financial developments impacting the balance sheets of corporates and banks, the Third Quarter Review of January 2008 had urged banks to review large foreign currency exposures and put in place a system for monitoring such unhedged exposures on a regular basis so as to minimise risks of instability in highly uncertain conditions. Banks were also urged to carefully monitor corporate activity in terms of treasury/trading activity and sources of other income to the extent that embedded credit/market risks pose potential impairment to the quality of banks' assets.
167. The Reserve Bank has also issued comprehensive guidelines on derivatives laying down broad generic principles for undertaking all derivative transactions, management of risks and sound corporate governance requirements as also adoption of suitability and appropriateness policy. Banks and their clients who have scrupulously followed the extant guidelines, including the Regulations framed under the FEMA, both in letter and spirit, would be well equipped to meet any potential consequences.
(c) Review of Loans to Commodities Sector by Banks
168. In view of the current public policy concerns in regard to trading in food items, banks are required to review their advances to traders in agricultural commodities including rice, wheat, oilseeds and pulses as also advances against warehouse receipts. They are further advised to exercise caution while extending such advances to ensure that bank finance is not used for hoarding. The first such review should be completed by May 15, 2008 and forwarded to the Reserve Bank for carrying out supervisory review of banks' exposure to the commodity sector.
(d) Prudential Norms for Housing
169. On a review of recent developments, it has been decided to enhance the limit of Rs.20 lakh to Rs.30 lakh in respect of bank loans for housing in terms of applicability of risk weights for capital adequacy purposes. Accordingly, such loans will carry a risk weight of 50 per cent.
(e) Credit Information Companies
170. The Reserve Bank had issued a press release on April 18, 2007 inviting applications from companies interested in continuing/commencing the business of credit information. The last date for submission of such applications was July 31, 2007. In response, 13 applications have been received. An external High Level Advisory Committee (HLAC) (Chairman: Dr.R.H.Patil) has been set up by the Reserve Bank for screening the applications and recommending the names of the companies to which certificates of registration can be granted by the Reserve Bank. After the announcement of the FDI policy for Credit Information Companies, the processing of applications has been taken up and the Reserve Bank would complete the process by June 30, 2008.
(f) Three-Track Approach for Basel II
171. The Reserve Bank has adopted a three-track approach to capital adequacy regulation in India with the norms stipulated at varying degrees of stringency for different categories of banks given the variations in size, nature and complexity of operations and relevance of different types of banks to the Indian financial sector, the need to achieve greater financial inclusion and to provide an efficient credit delivery mechanism. Accordingly, commercial banks, which account for a major share in the total assets of the banking system and are Basel II standards compliant, would be on Track I, banks which are Basel I compliant would be on Track II and banks which are in the nature of local community banks would be on Track III.
172. An Internal Technical Group (Chairman: Shri Prashant Saran) has been constituted to propose criteria for the applicability of Basel norms to State Cooperative Banks/District Central Cooperative Banks/RRBs. The Group is expected to submit its report by June 30, 2008.
(g) Cross-border Supervision
173. The Mid-Term Review of October 2007 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). Accordingly, an Internal Working Group (Chairman: Shri S.Karuppasamy) has been constituted which is currently studying the cross-country practices, including the legal issues in this regard.
(h) Consolidated Supervision and Financial Conglomerates
174. The Mid-Term Review of October 2007 proposed to integrate the process of consolidated supervision with the financial conglomerate monitoring mechanism in order to enhance the effectiveness of the banking supervisory system for bank-led conglomerates. Accordingly, realignment of various internal supervisory processes for implementing an enhanced consolidated supervision process would be completed by August 31, 2008.
(i) Supervisory Review Process on Activities of the
Trusts/SPVs Set up by Banks
175. Special purpose vehicles (SPVs) and Trusts are set up by banks to carry out a number of activities such as facilitating securitisation, asset management and investing in other entities. These entities are generally unregulated and are subject to inadequate independent board oversight. Besides, the downstream activities of these entities are normally not captured in the financial statements of the bank. As the activities of these entities could be a potential risk to the parent bank and could also pose systemic risk, there is a need for placing them under suitable supervisory oversight. Accordingly, it is proposed:
to constitute a Working Group to study and recommend a suitable supervisory framework for activities of SPVs/Trusts set up by banks.
(j) New Model of Risk-Based Supervision: Evolution
176. Risk-based supervision (RBS) was introduced on a pilot basis in eight selected banks in 2003-04, which was extended to 15 banks in 2004-05, four more banks in 2005-06 and eight more banks in 2006-07. On the basis of the experience gained from these pilot runs and with a view to evolving an appropriate model of RBS, a departmental Group has been set up to study international practices on such systems. The study would focus on impact assessment, periodic reviews of horizontal risks across the system, inclusion of supervisory review process prescribed under Pillar 2 of Basel II framework in the RBS assessment, simplification of the existing system of risk profiling and would recommend an appropriate RBS framework with a view to integrating the RBS system with the existing supervisory process based on capital adequacy, asset quality, management, earnings, liquidity, and systems (CAMELS) evaluation.
(k) Overseas Operations of Indian Banks: Review of
Existing Off-Site Monitoring Framework
177. In view of the rapid expansion of overseas operations, introduction of new products and processes, increasing off-balance sheet exposures including derivative products, a need has arisen for a review of the reporting system. Accordingly, an inter-departmental Group has been constituted to review the existing regulatory and supervisory framework for overseas operations of Indian banks and recommend appropriate changes, including off-site reporting systems.
(l) Financial Stability Forum (FSF) Report: Status
178. As already mentioned, in the wake of the turmoil in global financial markets, the FSF brought out a report in April 2008 identifying the underlying causes and weaknesses in the international financial markets. The Report contains, inter alia, proposals of the FSF for implementation by end-2008 regarding strengthening prudential oversight of capital, liquidity and risk management, enhancing transparency and valuation, changing the role and uses of credit ratings, strengthening the authorities' responsiveness to risk and implementing robust arrangements for dealing with stress in the financial system. The Reserve Bank had put in place regulatory guidelines covering many of these aspects, while in regard to others, actions are being initiated. In many cases, actions have to be considered as work in progress. In any case, the guidelines are aligned with global best practices while tailoring them to meet country-specific requirements at the current stage of institutional developments. The proposals made by the FSF and status in regard to each in India are narrated below:
1. Strengthened Prudential Oversight of Capital,
Liquidity and Risk Management
(i) Capital requirements:
Specific proposals will be issued in 2008 to:
Raise Basel II capital requirements for certain complex structured credit products;
Introduce additional capital charges for default and event risk in the trading books of banks and securities firms;
Strengthen the capital treatment of liquidity facilities to off-balance sheet conduits.
Changes will be implemented over time to avoid exacerbating short-term stress.
Supervisory guidance will be issued by July 2008 for the supervision and management of liquidity risks.
(iii) Oversight of risk management:
Guidance for supervisory reviews under Basel II will be developed that will:
Strengthen oversight of banks' identification and management of firm-wide risks;
Strengthen oversight of banks' stress testing practices for risk management and capital planning purposes;
Require banks to soundly manage and report off-balance sheet exposures;
Supervisors will use Basel II to ensure banks' risk management, capital buffers and estimates of potential credit losses are appropriately forward looking.
(iv) Over-the-counter derivatives:
Authorities will encourage market participants to act promptly to ensure that the settlement, legal and operational infrastructure for over-the-counter derivatives is sound.
179. The road-map for the implementation of Basel II in India has been designed to suit the country-specific conditions. The phased implementation process got underway with the Basel II Accord being made applicable to foreign banks operating in India and Indian banks having operational presence outside India with effect from March 31, 2008. All other commercial banks (except Local Area Banks and RRBs) are encouraged to migrate to Basel II in alignment with them but in any case not later than March 31, 2009. The process of implementation is being monitored on an on-going basis for calibration and fine-tuning.
180. The minimum capital to risk-weighted asset ratio (CRAR) in India is placed at 9 per cent, one percentage point above the Basel II requirement. Further, regular monitoring of banks' exposure to sensitive sectors and their liquidity position is also undertaken. In India, off-balance sheet vehicles in the form of SPVs for the purpose of securitisation are in existence for which extensive guidelines, in line with the international best practices, have already been issued. Liquidity facilities to such SPVs are subject to capital charge. Banks have been required to put in place appropriate stress test policies and relevant stress test frameworks for various risk factors by March 31, 2008.
181. In order to further strengthen capital requirements, it has been decided to review the credit conversion factors, risk weights and provisioning requirements for specific off-balance sheet items including derivatives. Further, in India, complex structures like synthetic securitisation have not been permitted so far. Introduction of such products, when found appropriate, would be guided by the risk management capabilities of the system.
182. The Reserve Bank had issued broad guidelines for asset-liability management and banks have flexibility in devising their own risk management strategies as per board-approved policies. However, in regard to liquidity risks at the very short end, the Reserve Bank has taken steps to mitigate risks at the systemic level and at the institution level as well. The Reserve Bank has introduced greater granularity to measurement of liquidity risk by splitting the first time bucket (1-14 days, at present) into three time buckets, viz., next day, 2-7 days and 8-14 days. The net cumulative negative mismatches in the three time buckets have been capped at 5 per cent, 10 per cent, 15 per cent of the cumulative cash outflows.
183. The Reserve Bank had recognised the risks of allowing access to unsecured overnight market funds to all entities and, therefore, restricted the overnight unsecured market for funds only to banks and primary dealers (PD). Since August 2005, the overnight call market is a pure inter-bank market. Accordingly, trading volumes have shifted from the overnight unsecured market to the collateralised market.
184. Greater inter-linkages and excessive reliance on call money borrowings by banks could cause systemic problems. The Reserve Bank has, therefore, introduced prudential measures to address the extent to which banks can borrow and lend in the call money market. On a fortnightly average basis, call market borrowings outstanding should not exceed 100 per cent of capital funds (i.e., sum of Tier I and Tier II capital) in the latest audited balance sheet.
185. Recognising the potential of 'purchased inter-bank liabilities' (IBL) to create systemic problems, the Reserve Bank had issued guidelines in March 2007 prescribing that IBL of a bank should not exceed 200 per cent of its net worth (300 per cent for banks with a CRAR more than 11.25 per cent).
2. Enhancing Transparency and Valuation
(i) Robust risk disclosures:
The FSF strongly encourages financial institutions to make robust risk disclosures using leading disclosure practices at the time of their mid-year 2008 reports.
Further guidance to strengthen disclosure requirements under Pillar 3 of Basel II will be issued by 2009.
(ii) Standards for off-balance sheet vehicles and valuations:
Standard setters will take urgent action to:
Improve and converge financial reporting standards for off-balance sheet vehicles;
Develop guidance on valuations when markets are no longer active, establishing an expert advisory panel in 2008.
(iii) Transparency in structured products:
Market participants and securities regulators will expand the information provided about securitised products and their underlying assets.
186. The Reserve Bank has, over the years, issued guidelines on valuation of various instruments/assets in conformity with the international best practices while keeping India-specific conditions in view. In order to encourage market discipline, the Reserve Bank has developed a set of disclosure requirements which allow the market participants to assess key pieces of information on capital adequacy, risk exposure, risk assessment processes and key business parameters which provide a consistent and understandable disclosure framework that enhances comparability. Banks are also required to comply with the Accounting Standard (AS) on Disclosure of Accounting Policies issued by the Institute of Chartered Accountants of India (ICAI).
187. In recognition of the fact that market discipline can contribute to a safe and sound banking environment and as part of the ongoing efforts to implement the Basel II Accord, the Reserve Bank issued guidelines on minimum capital ratio (Pillar 1) and market discipline (Pillar 3) in April 2007 and guidelines for Pillar 2 (supervisory review process) were issued in March 2008. Under these guidelines, non-compliance with the prescribed disclosure requirements would attract a penalty, including financial penalty.
3. Changes in the Role and Uses of Credit Ratings
Credit rating agencies should:
Implement the revised IOSCO Code of Conduct Fundamentals for Credit Rating Agencies to manage conflicts of interest in rating structured products and improve the quality of the rating process;
Differentiate ratings on structured credit products from those on bonds and expand the information they provide.
Regulators will review the roles given to ratings in regulations and prudential frameworks.
188. The Reserve Bank has undertaken a detailed process of identifying the eligible credit rating agencies whose ratings may be used by banks for assigning risk weights for credit risk. Banks should use the chosen credit rating agencies and their ratings consistently for each type of claim, for both risk weighting and risk management purposes. Banks are not allowed to ‘cherry pick’ the assessments provided by different credit rating agencies. If a bank has decided to use the ratings of some of the chosen credit rating agencies for a given type of claim, it can use only the ratings of those credit rating agencies, despite the fact that some of these claims may be rated by other chosen credit rating agencies whose ratings the bank has decided not to use. External assessments for one entity within a corporate group cannot be used to risk weight other entities within the same group.
189. Banks must disclose the names of the credit rating agencies that they use for the risk weighting of their assets, the risk weights associated with the particular rating grades as determined by the Reserve Bank through the mapping process for each eligible credit rating agency as well as the aggregated risk weighted assets as required.
190. In India, complex structures like synthetic securitisations have not been permitted so far. As and when such products are to be introduced, the Reserve Bank would put in place the necessary enabling regulatory framework, including calibrating the role and capacity building of the rating agencies.
4. Strengthening the Authorities' Responsiveness to Risks
A college of supervisors will be put in place by end-2008 for each of the largest global financial institutions.
191. In the Indian context, there have been exchange of supervisory information on specific issues between the Reserve Bank and few other overseas banking supervisors/regulators. Supervisory cooperation has been working smoothly and efficiently.
192. The Mid-Term Review of October 2007 had announced the constitution of a Working Group to lay down a 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). A Working Group has been constituted in March 2008 and would complete the work by August 2008. A number of overseas regulators of countries such as the USA, the UK, Canada, Hong Kong, Australia and Singapore have been formally approached to share systems and practices, including legal positions, in the matter of supervisory cooperation and sharing of information with overseas regulators. The response from a few countries has been received and is being examined. The 'Supervisory College' arrangement for this purpose is also being examined by the Group.
5. Robust Arrangements for Dealing with
Stress in the Financial System
Central banks will enhance their operational frameworks and authorities will strengthen their cooperation for dealing with stress.
193. In the Reserve Bank, there is an institutional arrangement in place to oversee the functioning of the financial markets on a daily basis. There is a Financial Market Committee monitoring and assessing the functioning of different financial markets. Based on such an oversight, appropriate and prompt action is taken, whenever necessary.
194. The Reserve Bank has the necessary framework for provision of liquidity to the banking system, in terms of Sections 17 and 18 of the Reserve Bank of India Act, 1934. The regular liquidity management facilities of the Reserve Bank include the LAF, OMO and MSS besides standing facilities such as export credit refinance (ECR) and the liquidity facility for standalone PDs. The Reserve Bank can undertake purchase/sale of securities of the Central or State Governments and can purchase, sell and rediscount bills of exchange and promissory notes drawn on and payable in India and arising out of bona fide commercial or trade transactions for provision/absorption of liquidity for normal day-to-day liquidity management operations as also for provision of emergency liquidity assistance to the banks under the lender of last resort function.
195. The Reserve Bank is empowered under the existing legal framework to deal with the resolution of weak and failing banks. The Banking Regulation Act provides the legal framework for voluntary amalgamation and compulsory merger of banks under Sections 44 (A) and 45, respectively. The Deposit Insurance and Credit Guarantee Corporation (DICGC) offers deposit insurance cover in India. The mergers of many weak private sector banks with healthy banks has improved overall stability of the system. Not a single scheduled commercial bank in the country has capital adequacy ratio which is less than the minimum regulatory requirement of nine per cent.
Click Here For Highlights of Annual Policy Statement for the Year 2008-09