Banking system in India and its evolution from barter system to digitalization. Banking to unbank help in reducing poverty and inclusive development. IAS Target

Indian Banking System

22 Feb 2020

Category : Economical Issue

Topic: Indian Banking System

Modern banking in India originated in the last decade of the 18th century. Among the first banks were the Bank of Hindustan, which was established in 1770. The largest and the oldest bank which is still in existence is the State Bank of India (S.B.I). Reserve Bank of Indi was established in 1935, under the Reserve Bank of India Act, 1934. In 1960, the State Banks of India was given control of eight state-associated banks under the State Bank of India (Subsidiary Banks) Act, 1959. These are now called its associate banks. In 1969 the Indian government nationalised 14 major private banks; one of the big banks was Bank of India. In 1980, 6 more private banks were nationalised. These nationalised banks are the majority of lenders in the Indian economy. They dominate the banking sector because of their large size and widespread networks.

The Indian banking sector is broadly classified into

  • Scheduled Banks
    The scheduled banks are those included under the 2nd Schedule of the Reserve Bank of India Act, 1934. The scheduled banks are further classified into:
    • Nationalised banks;
    • State Bank of India and its associates;
    • Regional Rural Banks (RRBs);
    • Foreign banks;
    • Other Indian private sector banks.
    The term commercial banks refers to both scheduled and non-scheduled commercial banks regulated under the Banking Regulation Act, 1949. Genrally the supply, product range and reach of banking in India is fairly mature-even though reach in rural India and to the poor still remains a challenge. The government has developed initiatives to address this through the State Bank of India expanding its branch network and through the National Bank for Agriculture and Rural Development (NABARD) with facilities like microfinance.

  • Non-Scheduled Banks
    The banks which are not included in the list of the scheduled banks are called the Non- Scheduled Banks. At present there are only 3 such banks in the country. Non- Scheduled Banks have to follow CRR conditions. These banks can have CRR fund with themselves as no compulsion has been made by the RBI to deposit it in the RBI. Non- Scheduled Banks are also not eligible for having loans from the RBI for day to day activities but under the emergency conditions RBI can grant loan to them. Example: All local area banks are called the Non-scheduled banks.

Basel System

Basel is a city in Switzerland which is also the headquarters of Bureau of International Settlement (BIS). BIS fosters co-operation among central banks with a common goal of financial stability and common standards of banking regulations. The Bank for International Settlements (BIS) established on 17 May 1930, is the world's oldest international financial organisation. There are two representative offices in the Hong Kong and in Mexico City. In total BIS has 60 member countries from all over the world and covers approx 95% of the world GDP. The Basel accord is a set of financial reforms that was developed by the Basel Committee on Banking Supervision (BCBS), with the aim of:
  • strengthening regulation,
  • supervision, and risk management within the banking industry.
Due to the impact of the Global Financial Crisis on banks, Basel was introduced to improve the banks’ ability to handle shocks from financial stress and strengthen their transparency and disclosure.

  • Basel I
    • In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. These were known as Basel I. It focused almost entirely on credit risk (default risk) - the risk of counter party failure. It defined capital requirement and structure of risk weights for banks.
    • Under these norms: Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of 0%(Cash, Bullion, Home Country Debt Like Treasuries), 10, 20, 50 and100% and no rating. Banks with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA) - At least, 4% in Tier I Capital (Equity Capital + retained earnings) and more than 8% in Tier I and Tier II Capital. Target - By 1992.
    • One of the major role of Basel norms is to standardize the banking practice across all countries. However, there are major problems with definition of Capital and Differential Risk Weights to Assets across countries, like Basel standards are computed on the basis of book-value accounting measures of capital, not market values. Accounting practices vary significantly across the G-10 countries and often produce results that differ markedly from market assessments.
    • Other problem was that the risk weights do not attempt to take account of risks other than credit risk, viz., market risks, liquidity risk and operational risks that may be important sources of insolvency exposure for banks.

    Note: India adopted Basel 1 guidelines in 1999.

  • Basel II
    • Basel II was introduced in 2004, laid down guidelines for capital adequacy (with more refined definitions), risk management (Market Risk and Operational Risk) and disclosure requirements.
    • Use of external ratings agencies to set the risk weights for corporate, bank and sovereign claims.
    • Operational risk has been defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk, whereby legal risk includes exposures to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements. There are complex methods to calculate this risk.
    • Disclosure requirements allow market participants assess the capital adequacy of the institution based on information on the scope of application, capital, risk exposures, risk assessment processes, etc.

  • Basel III
    • It is widely felt that the shortcoming in Basel II norms is what led to the global financial crisis of 2008. That is because Basel II did not have any explicit regulation on the debt that banks could take on their books, and focused more on individual financial institutions, while ignoring systemic risk. To ensure that banks don’t take on excessive debt, and that they don’t rely too much on short term funds, Basel III norms were proposed in 2010.
    • The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.
    • Requirements for common equity and Tier 1 capital will be 4.5% and 6%, respectively.
    • The liquidity coverage ratio (LCR) will require banks to hold a buffer of high quality liquid assets sufficient to deal with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. The minimum LCR requirement will be to reach 100% on 1 January 2019. This is to prevent situations like "Bank Run".
    • Leverage Ratio > 3%: The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total consolidated assets;.

Presently Indian banking system follows Basel II norms.
The Reserve Bank of India has extended the timeline for full implementation of the Basel III capital regulations by a year to March 31, 2019.

Important Points Regarding Implementation of Basel III

  • The government of India is scaling disinvesting their holdings in PSBs to 52 per cent.
  • The government will soon infuse Rs 6,990 crore in nine public sector banks including SBI, Bank of Baroda (BoB), Punjab National Bank (PNB) for enhancing their capital and meeting global risk norms.
  • This is the first tranche of capital infusion for which the government had allocated Rs 11,200 crore in the Budget for 2014-15.
  • The government has infused Rs 58,600 crore between 2011 to 2014 in the state-owned banks.
  • Finance Minister in the Budget speech had said that "to be in line with Basel-III norms there is a requirement to infuse Rs 2,40,000 crore as equity by 2018 in our banks. To meet this huge capital requirement we need to raise additional resources to fulfil this obligation.

Tier 1 Tier- I Capital is the core capital. Paid up Capital, Statutory Reserves, Other disclosed free reserves, Capital Reserves which represent surplus arising out of the sale proceeds of the assets, other intangible assets belong from the category of Tier1 capital.
Tier 2 Tier-II capital can be said to be subordinate capitals. Undisclosed reserves, Revaluation Reserves, General Provisions and loss reserves , Hybrid debt capital instruments such as bonds, Long term unsecured loans, Debt Capital Instruments etc belong from the category of Tier 2 capital.

Risk Weighted Assets

RWA means assets with different risk profiles; it means that we all know that is much larger risk in personal loans in comparison to the housing loan, so with different types of loans the risk percentage on these loans also varies.

Bank Run

A Bank Run occurs when a large number of customers of a bank or other financial institution withdraw their deposits simultaneously over concerns of the bank's solvency. As more people withdraw their funds, the probability of default increases, prompting more people to withdraw their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the withdrawals. The banking business has boomed since Independence, particularly after the LPG reforms. The sector is currently valued at Rs 115 lakh crore and expected to more than double at Rs 288 lakh crore by 2020. Out of this 70 per cent of business is being done by PSU banks. An interesting fact is that SBI’s market share out of total banking business is 22 per cent. Looking at the enormous size of the banking industry, the NPAs are a big cause of concern.

Non-Performing Asset (NPA)

A nonperforming asset (NPA) refers to a classification for loans or advances that are in default or are in arrears on scheduled payments of principal or interest. In most cases, debt is classified as non-performing when loan payments have not been made for a period of 90 days. While 90 days of non-payment is the standard, the amount of elapsed time may be shorter or longer depending on the terms and conditions of each loan.

Nonperforming assets are typically listed on the balance sheets of banks. Banks usually categorize loans as nonperforming after 90 days of non-payment of interest or principal, which can occur during the term of the loan or at maturity. For example, if a company with a $10 million loan with interest-only payments of $50,000 per month fails to make a payment for three consecutive months, the lender may be required to categorize the loan as nonperforming to meet regulatory requirements. A loan can also be categorized as nonperforming if a company makes all interest payments but cannot repay the principal at maturity.

Types of Nonperforming Assets

Although the most common nonperforming assets are term loans, there are six other ways loans and advances are NPAs:
  • Overdraft and cash credit (OD/CC) accounts left out-of-order for more than 90 days
  • Agricultural advances whose interest or principal installment payments remain overdue for two crop/harvest seasons for short duration crops or overdue one crop season for long duration crops
  • Bill overdue for more than 90 days for bills purchased and discounted
  • Expected payment is overdue for more than 90 days in respect of other accounts
  • Non-submission of stock statements for 3 consecutive quarters in case of cash-credit facility
  • No activity in the cash credit, overdraft, EPC, or PCFC account for more than 91 days

Banks are required to classify nonperforming assets in one of three categories according to how long the asset has been non-performing:

Sub-standard assets A sub-standard asset is an asset classified as an NPA for less than 12 months
Doubtful assets A doubtful asset is an asset that has been non-performing for more than 12 months
Loss assets Loss assets are assets with losses identified by the bank, auditor, or inspector and have not been fully written off.

Causes of NPAs:

Willful Defaults The Indian Public Sector Banks are worst hit by these defaults. It is a default in repayment obligation. Kingfisher Airlines Ltd. Is one among many of those willful defaulters. Other are Beta Napthol, Winsome Diamonds & Jewellery Ltd., Rank Industries Ltd., XL Energy Ltd etc.
Industrial Crisis Industries depend on banks to fulfill their projects. If industry is in crisis, it is bound to hit the banking sector and their NPA will rise.
Credit distribution Mis-management Often ill-minded borrowers bribe bank officials to get loans with an intention of default.
Lenient Lending Norms One of the main reasons of rising NPAs is the lenient Lending Norms especially for corporate honchos where their financial status and credit rating is not analysed properly.
Global issues Due to economic slowdown and trade war concern slow down global economy and reduce consumption. this causes lower demand of Indian products and affect India's export. At the same time China devalue its currency to overcome its domestic economic issues and slow down, this also affects India export. So these reason also affects India companies profitability and banks because companies unable to repay loans and interest payment
Environmental concern Some-times environmentalist group also protest against development project and delay in permission granted for project on Environmental concern also affects companies prospects and standstill projects. So they unable to fullfill their obligation to banks

Present NPA Scenario

Gross NPAs of domestic banks jumped to 4.2 % of total lending by the end of September 2013 from 3.6 % six months before, according to the Reserve Bank of India (RBI). As per a recent warning by the RBI, bad loans (NPAs) could climb to 7% of total advances by 2015. In absolute terms, gross NPAs are estimated to touch Rs 2.50 lakh crores by the end of March year 2015. This is equal to the size of the budget of Uttar Pradesh. The biggest chunk of the soured debts is with state-run banks (Public sector banks or PSBs), which account for two-thirds of loans but 80 % of the bad assets.
This is how the NPA curve has been moving in the recent years, as per a news report in the Business Standard: RBI’s financial stability report said the gross NPA ratio of all banks increased to 9.1% by September 2016 from 7.8% in March 2016. Public Sector Banks are worst hit as their gross NPA increased to 12.5% by March 2017 from 11.8% in September 2016. Private-sector and foreign lenders are better placed. Their NPAs in proportion of their lending is lesser than that of the PSBs.

The Effects of NPAs

  • Bank’s profit will come down which they earn in the form of interest.
  • Banks will become reluctant to lend thus affecting their borrowers.
  • Affects the liquidity position of banks.
  • Service to good customers may get affected.
  • Adversely affect the bank balance sheet.
  • Carrying nonperforming assets, also referred to as nonperforming loans, on the balance sheet places three distinct burdens on lenders.
  • The non-payment of interest or principal reduces cash flow for the lender, which can disrupt budgets and decrease earnings.
  • Loan loss provisions, which are set aside to cover potential losses, reduce the capital available to provide subsequent loans.
  • Once the actual losses from defaulted loans are determined, they are written off against earnings.
  • As the NPA of the banks will rise, it will bring a scarcity of funds in the Indian security markets. Few banks will be willing to lend if they are not sure of the recovery of their money.
  • The shareholders of the banks will lose a lot of money as banks themselves will find it tough to survive in the market.
  • This will lead to a crisis of confidence in the market. The price of loans, i.e. the interest rates will shoot up badly. Shooting of interest rates will directly impact the investors who wish to take loans for setting up infrastructural, industrial projects etc.
  • It will also impact the retail consumers like us, who will have to shell out a higher interest rate for a loan.
  • All of this will lead to a situation of low off take of funds from the security market. This will hurt the overall demand in the Indian economy. And, finally it will lead to lower growth rates and of course higher inflation because of the higher cost of capital.
  • This trend may continue in a vicious circle and deepen the crisis.

Recovering Losses

Lenders generally have four options to recoup some or all losses resulting from nonperforming assets:
  • When companies struggle to service debt, lenders take proactive steps to restructure loans to maintain cash flow and avoid classifying loans as nonperforming.
  • When defaulted loans are collateralized by borrowers' assets, lenders can take possession of the collateral and sell it to cover losses.
  • Lenders can also convert bad loans into equity, which may appreciate to the point of full recovery of principal lost in the defaulted loan. When bonds are converted to new equity shares, the value of the original shares is usually eliminated.
  • As a last resort, banks can sell bad debts at steep discounts to companies that specialize in loan collections. Lenders typically sell defaulted loans that are unsecured or when methods of recovery are not cost-effective.

Steps to solve problems which engulfed banking sector and industrial sector:

The simplest approach to cut down NPAs is to recover the bad loans. Apart from the regular guidelines released by the RBI, to strengthen further the recovery of dues by banks and financial institutions, Government of India promulgated:
  • The Recovery of Debts Due to Banks and Financial Institutions Act, 1993
  • The Securitization Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.

So, how can the banks legally recover their loans

  • The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002:
    The Act empowers Banks / Financial Institutions to recover their non-performing assets without the intervention of the Court, through acquiring and disposing of the secured assets in NPA accounts with outstanding amount of Rs. 1 lakh and above. The banks have to first issue a notice. Then, on the borrower’s failure to repay, they can:
    • Take possession of security and/or
    • Take over the management of the borrowing concern.
    • Appoint a person to manage the concern.

  • Recovery of Debts Due to Banks and Financial Institutions (DRT) Act:
    The Act provides setting up of Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs) for expeditious and exclusive disposal of suits filed by banks / FIs for recovery of their dues in NPA accounts with outstanding amount of Rs. 10 lac and above.

  • Lok Adalats:
    Section 89 of the Civil Procedure Code provides resolution of disputes through ADR methods such as Arbitration, Conciliation, Lok Adalats and Mediation. Lok Adalat mechanism offers expeditious, in-expensive and mutually acceptable way of settlement of disputes. Government has advised the public sector banks to utilize this mechanism to its fullest potential for recovery in Non-performing Assets (NPAs) cases.
    Among the various channels of recovery available to banks for dealing with bad loans, the SARFAESI Act and the Debt Recovery Tribunals (DRTs) have been the most effective in terms of amount recovered.

The recent controversy surrounding loan recovery in India – Views of the SC

Banks have been alleged to engage in coercive practices to recover the loans. Recently, there have been some judicial pronouncements by the apex court determining the scope of powers of enforcement of securities without the intervention of the courts, by the banks and FIs under the SARFAESI Act. The apex court has reiterated the need to protect the interest of borrowers, and emphasized that the exercise of extraordinary powers of recovery, by banks and FIs must be in compliance with the provisions of the SARFAESI Act.

As per the Supreme Court (SC)

Liquidity of finances and flow of money is essential for any healthy and growth oriented economy. But certainly, what must be kept in mind is that the law should not be in derogation of the rights which are guaranteed to the people under the Constitution. The procedure should also be fair, reasonable and valid, though it may vary looking to the different situations needed to be tackled and object sought to be achieved. But, these are steps which cure the disease of NPAs. “The issue of NPAs needs to be tackled at the level of prevention rather than cure.”

Therefore, the steps that can prevent the piling up of NPAs are as follows:

  • Conservatism:
    Banks need to be more conservative in granting loans to sectors that have traditionally found to be contributors in NPAs. Infrastructure sector is one such example. NPAs rise predominantly because of long gestation period of the projects. Therefore, the infrastructure sector, instead of getting loans from the banks can be funded from Infrastructure Debt Funds (IDFs) or other specialized funds for infrastructural development in the country.

  • Improving processes:
    The credit sanctioning process of banks needs to go much more beyond the traditional analysis of financial statements and analyzing the history of promoters. For example, banks rely more on the information given by credit bureaus. However, it is often noticed that several defaults by some corporate are not registered in their credit history.

  • Relying less on restructuring the loans:
    Instead of sitting and waiting for a loan to turn to a bad loan, and then restructure it, the banks may officially start to work to recover such a loan. This will obviate the need to restructure a loan and several issues associated with it. One estimate says that by 2013 there will be Rs 2 trillion worth of restructured loans.

  • Expanding and diversifying consumer base by Innovative business models:
    Contrary to popular perceptions, the NPA in non-corporate sector is less than that in the corporate sector. Hence, there is a need to reach out to people in remote areas lacking connectivity and accessibility. More and more poor people in rural pockets should be brought under the banking system by adopting new technologies and electronic means. Innovative business models will play a crucial role here. Otherwise, the NPAs may increase instead of decreasing. Looking at the giant size of the banking industry, there can be hardly any doubt that the menace of NPAs needs to be curbed. It poses a big threat to the macro-economic stability of the Indian economy.

An analysis of the present situation brings us to the point that the problem is multi-faceted and has roots in:

  • Economic slowdown;
  • Deteriorating business climate in India;
  • Shortages in the legal system;
  • The operational shortcoming of the banks.

Therefore, it has to be dealt at multiple levels. The government can’t be expected to rescue the state-run banks with tax-payer’s money every time they fall into a crisis. But, the kind of attention with which this problem has been received by policymakers and bankers alike is a big ray of hope. Right steps, timely and concerted actions and a revival of the Indian economy will put a lid on NPAs. Prevention, however, has to become a priority than mere cure.