The Committee on Banking Sector Reforms headed by Shri M. Narasimhan presented its Report to the Finance Minister yesterday. The Committee was required to review the progress in the reforms in the banking sector over the past six years with particular reference to the recommendations made by the Committee on the Financial Sector Reforms in 1991 and to chart a programme on Financial Sector Reforms necessary to strengthen the India's financial system and make it internationally competitive taking into account the vast changes in the international and financial markets, technogical advances and the experience of the other developing countries in adapting to such changes and to make detailed recommendations in regard to the banking policy, institutional, supervisory, legislative and technological dimensions.

    The Report will now be examined by Government for suitable follow up action. A summary of the main issues addressed by the Committee is enclosed.

1. A strong and efficient financial system, functionally diverse and geographically widespread, is critical to the attainment of our objectives of creating a market driven, productive and competitive economy and to support higher investment levels and accentuate growth. The creation of such a system has been the objective that has inspired the process of financial sector reform since 1992 as part of the broader programme of structural economic reform.

2. As part of this process, reform of the banking sector is now under way. The banking system is, by far, the most dominant segment of the financial sector, accounting as it does for over 80 per cent of the funds flowing through the financial sector and it is appropriate that reform measures taken in this area have followed the recommendations of the Committee on the Financial System (CFS), which reported in November 1991. That Report had made a number of recommendations aimed at improving the productivity, efficiency and profitability of the banking system on the one hand and providing it greater operational flexibility and functional autonomy in decision making on the other. It covered policy aspects, accounting practices institutional and structural issues and matters relating to organisational development. The report itself was conceived as a holistic exercise and its recommendations were accordingly symbiotically related to each other.

3. Since the submission of the Report several measures have been instituted in line with its recommendations. Accounting practices have been prescribed more in consonance with internationally accepted standards in this regard with the major objective of enhancing transparency and credibility and ensuring accuracy of financial statements.

4. Asset classification criteria have been prescribed and principles governing income recognition have been laid down with the aims of removing subjectivity in this regard and providing for measurable objectivity. Prudential norms have also been prescribed, most importantly, with respect to provisioning for various categories of market related and substandard assets. Capital adequacy requirements have also been laid down, directed towards enhancing the inherent strength of banking institutions. With regard to policy measures, the significant changes that have been effected in line with the recommendations of the CFS have been the progressive reduction of the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR) requirements as an aspect of correcting the impact of the high proportion of directed investments on profitability and operational flexibility. Another major step has been as suggested by the CFS , the progressive deregulation of the bewilderingly complex and detailed administered interest rate structure and to move interest rates more closely to a market-determined basis and to restore to the Bank rate its function of being an anchor or reference rate.

5. These have been very major and significant changes but it would be observed that while the `arithmeticals' of the CFS recommendations in relation to various ratios, rates and accounting have been accepted and put through the same measure of progress has not been made with regard to structural and systemic aspects of the reform agenda outlined by the CFS. Even with regard to `arithmeticals', an important recommendations relating to directed credit has not been accepted. In some cases, as for instance in respect of the ways to handle the problem of non performing assets (NPAs), while the problem has been recognised the approach adopted has differed.

6. Even as these measures are making their impact there have been major changes in the macro economic environment and policy and institutional developments. These may call for an examination of the problem issues anew and possibly for a review of some of the recommendations made earlier to see whether they continue to have the same relevance in the changed context. The most important change in the domestic macro environment has been the greater focus or the containment of the fiscal deficit the subsidence of inflationary pressures and the restoration to monetary policy of its defining function of regulating money and credit in the pursuit of its central objectives of price and exchange rate stability. For monetary policy itself to be effective we need a well knit and integrated financial system and active money and capital markets. The greater reliance on market instruments of monetary regulation and especially on the interest rate has been implications for the banking system in terms of expanding the scope and range of the risk management function especially as marking assets to market prices comes, as it should increasingly into vogue. Apart from the traditional concerns with credit risk, banks will thus increasingly need to manage market and liquidity risks and to develop the skills for this. The other development has been the much greater flexibility now available to banks and financial institutions with respect to forego exchange transactions. Indian banks are participating in growing measure in the foreign exchange markets both in India abroad with all the opportunities and risks that this entails. We could also expect derivative trading to play an increasing role with appropriate forms of risk management.

7. These changes in the domestic economic and institutional scene have coincided with the movement towards global integration of financial services. Financial autarky is not a viable or even a possible option. Global financial integration would call for a greater measure of competitive efficiency in our financial system if it is to be able to face successfully the challenge of increasing competition from abroad. This is more so in the context of our objective of moving in a phased manner towards a more liberal capital account regime. An open capital account would result in larger inflows and outflows with attendant implications for the management of the exchange rate and domestic liquidity. For the system to be able to handle such problems it would need to be strong and resilient. The recent developments in East and South East Asia have only underscored the importance of a strong domestic financial system. The experience has shown that despite strong economic fundamentals, such as high savings rate and prudent fiscal policies, weak banking policies and practices and the consequent fragility of the financial system can have a serious destabilising influence.

8. Recent developments have thus served to reinforce the point that a strong and efficient financial system is necessary both to strengthen the domestic economy and make it more efficient and also to enable it to meet the challenges posed by financial globalisation. Building such a system constitutes the unfinished agenda of banking and financial sector reform.

9. Action on strengthening the foundations of the system would necessarily involve improving the quality of bank assets. Nothing is more indicative of the quality of assets than the quantum and incidence of NPAs in relation to the total portfolio. The causes for a high proportion of NPAs are variea. Poor credit decisions by bank managements, difficult recovery environment and changes both cyclical and structural in the larger economic environment represent some of the micro and macro aspects of this. This is not all. Often, as international experience has shown, a high incidence of NPAs could be traced to policies of directed credit, not to speak of cruder forms of behest lending. In our own country, the `contamination coefficient' of directed credit has been shown to have a value above unity as the figure of NPAs emanating from priority sector credit testify. There is nothing inherently wrong in setting out social priorities for bank lending. Social banking need not conflict with canons of sound banking but when banks are required by directive to meet specific quantitative targets, there is as our own experience has shown the danger of erosion of the quality of the loan portfolio.

10. In the last few years the overall proportion of net NPAs to the total porfolio has come down. Gross NPAs amounted to a little under twice the proportion of net NPAs. The reduction in the level of NPAs partly reflects banks efforts at recovery and the write-offs of losses and provisioning for non performing loans which banks were enabled to do as a result of infusion of Government funds as part of a recapitalisation programme. The figure of NPAs, however, remains uncomfortably high as an average even as it conceals wide individual variations with the position of some banks being quite disconcerting. The NPA figures incidentally do not include advances covered by Government quarantees which have turned sticky. It is also important to ensure that the classificatory norms for NPAs are strictly adhered to in letter and spirit and to see that the phenomenon of ever greening does not mask the true situation.

11. An important aspect of the continuing reform process is thus to reduce further the high level of NPAs as a means of institutional strengthening. While there is reason to expect that with a combination of policy and institutional development, new NPAs could in future be lower than hitherto, the problem remains of the huge backlog of existing NPAs which impinges severely on banks performance and their profitability. Several approaches are possible. The earlier Committee had suggested the creation of an Assets Reconstruction Fund (ARF) to take these assets off banks books at a discount. Recapitalisation through infusion of capital is another approach and has been used in the case of some banks. In the last six years massive budgetary funds have been used for recapitalisation of public sector banks. This a costly and over time, not a sustainable option. The problem, however, remains and consideration would need to be given to revisiting the concept of an ARF.

12. Another measure intended to enhance the inherent financial strength of the system is the enhancement of capital funds of banks. At the time of the earlier Committee reported the desirable and feasible target for capital adequacy seemed to be the level set by the Basle Committee of BIS. Several developments have taken place since. We now have a better idea of the nature and volume of risk weighted assets. As observed earlier, with greater volatility in exchange markets and the greater use of interest rate variations as instruments of monetary policy the market of asset price risk of both foreign assets and domestic investments is now quite considerable. Banks have also been getting more exposed to off balance sheet risks. Banking is essentially an exercise in risk management. All these considerations suggest the need to review anew the minimum prescriptions for capital adequacy with a view to their possible enhancement.

13. Another important measure of the strength of the system is its profitability levels. The high level of NPAs has been a proximate cause for the low profitability levels of our public sector banks. Other factors have been the large number of unremunerative branches, low productivity, over manning and arcane methods of operations apart from the impact of directed credit and high pre-emptions of funds. Spreads in the Indian banking system remain high and yet profitability levels are low. There has been some improvements in recent years is net profits for Public Sector Banks (PSBs) as a group (partly as a result of some recapitalisation in some of them). With increasing competition from foreign and private banks, margins will come under further pressure and issues of customer orientation productivity and efficiency in relation to profitability will come to the fore.

14. Action on strengthening the foundations of the system by improving asset quality enhancing capital and improving profitability would need to go along with structural changes in the system. One of the more important developments that has been taking place in international banking is the revival of the phenomenon of universal banking in terms of which the distinction between commercial investment and development banking is getting blurred. In this country also we are moving towards this concept. Commercial banks have been making in larger measure than before, term finance to industry and providing investment banking services apart from setting up subsidiaries in such diverse areas as mutual funds securities trading and factoring. At the other end of spectrum the development finance institutions (DFIs) are increasingly getting into the areas of working capital finance and have also set up banking and mutual fund subsidiaries. The financing requirements of Indian corporates, whether from the DFIs or from the banks, are now being seen as an integrated operation. Non-banking financial companies (NBFCs) have proliferated in India in areas like consumer finance, hire purchase, equipment leasing and housing finance. How their activities should be integrated into the financial system and regulated is an issued which needs to be examined.

15. The financial structure is thus evolving towards a continuum of institutions rather than discrete specialisation and the facilities that are being provided are to be seen as aspects of a spectrum of financial services in keeping with relationship banking. Universal banking in fact provides for a cafeteria approach or, if one were to vary the metaphor it would take on the role of a one stop financial supermarket. These developments also have implications for the framework are content of regulation.

16. With regard to the structural framework of the banking system, there is a need to help move towards a structure as the CFS suggested, with a few large Indian banks with an international character, some large national banks and the rest consisting basically of regional/local banks. There is also a need to impart greater competition as between public sector banks and private sector banks.

17. In recent year, there have been a large number of mergers in international banking and in the process large institutions have become ever larger as a response to the challenges of competition and as an aspect of synergising operations and achieving scale economics. Mergers should in the normal course, be driven by business needs and should lead to the growth of larger banks both in public and private sector. There is general recognition now that size is an important determinant of banking strength. Mergers amongst strong units can be both a means of strengthening them as also providing for greater opportunities for competition.

18. A merger of strong units would indeed have, to borrow a phrase from another discipline, a force multiplier effect. it is sometimes argued that mergers could provide for a strong bank taking over a weak one. On the other hand, such mergers could well result in an adverse impact on the asset quality of the stronger unit as a result of acquiring the contaminated portfolio of the weaker unit in the absence of any system of writing off the NPAs of the latter before the merger.

19. It needs however to be recognised that mergers to be meaningful and useful should not be a mere arithmetical merger of balance sheets and staff of the banks but should yield benefits in terms of staff and branch network rationalisation. Unless these benefits can become available, mergers of public sector banks would tie down managements with operational issues and merely distract attention from the real issues without giving any commensurate benefits.

20. The problem of the weak banks is a separate and important issue and needs to be addressed squarely. As a working definition, a weak bank could be regarded as one whose accumulated losses and net NPAs exceed its capital funds or in respect of PSBs whose operating results less income from recapitalisation bonds reveal losses for three consecutive years. Some public sector banks fall in this category and, if the depositors funds are not at risk (as they would otherwise have been ) it is because of the implicit guarantee provided by State ownership of the institutions. There could be some weak banks which are potentially viable with some weak banks which potentially viable with some corrective measures being applied even as there would be those whose affairs are not capable of early or complete correction. In the latter case, the costs and implications of various alternative approaches, not excluding closure in some cases, would need to be carefully examined. In this connection, the concept of narrow banks has been suggested as a possible solution for the short term. Narrow banks could be allowed as an opportunity to facilitate their rehabilitation. The strategic revival plans formulated by some weak banks and approved by Government and Reserve Bank of India (RBI) as well as the Memoranda of Undertaking (MoUs) entered into by Management and Staff Unions is indicative of this approach. The issue of closure would need to be examined if it were concluded that the narrow banks approach does not enable rehabilitation of some banks.

21. One of the more significant measure instituted since 1991 has been the permission for new private banks to be set up and the more liberal approach towards foreign bank offices being opened in India. These steps have enhanced the competitive framework for banking - the more so as the new private and foreign banks have higher productivity levels based on newer technology and lower levels of manning. The increasing share in total banking business of the foreign and private banks in the last few years is reflective of their competitive edge and their potential.

22. While two or three banks with an international orientation and 8 to 10 large national banks should take care of the needs of large and medium corporate sector and the larger of the small enterpises; there will still be need for a large number of local banks. This third tier banks should appropriately be confined to smaller geographical regions, namely states, or cluster of districts and it is this class of banks that should appropriately serve the needs of local trade, small industry and agriculture with strong correspondent relationships with larger national and international Indian banks. A measure of specialisation by size and regional character would in keeping with experience abroad and is particularly appropriate in a country as large and diverse as ours. The issue of evolving a viable and efficient framework for rural credit has defied solution despite and efficient framework for rural credit has defied solution despite our long experience of the felt needs for rural credit and an examination of this issue by several committees and experimentation with various policies and institutions. One of the major issues before this Committee is to attempt an integration and linkage of rural credit facilities with the other constituents of the financial system and more particularly the banking sector.

23. The next set of issues before the Committee relate to streamlining the procedures and operational methods in banks. Modern banking abroad rests on the twin pillars of information technology and instant electronic funds transfer systems. Neither of these has made any worthwhile impact in our country through some small beginning have been made. We cannot, afford to neglect these aspects if Indian banking has to face the challenges of not only increasing global competition but of serving our domestic economy better. Technologically upgradation, both at the level of central offices and even more so through branch networking and in respect of retail banking services has to be given high priority. The programme of branch computerisation has been making slow progress and clearly needs to be speeded up. Priority would need to be given to the needs of the larger banks in this areas and over time such technological upgradation must cover all the constituents of the banking system. Upgradation of technology through widespread computerisation would obviously enhance the productivity and efficiency of the system, reduce costs and improve customer service. Banking is first and foremost a service industry and the international trend is towards what has been termed "relationship banking" suggesting a customer and client specific orientation to provision to services. Electronic banking is increasingly replacing conventional banking instruments abroad. Digital cash has also made its appearance. The implications for our banks of these developments will need attention. The possibility of outsourcing some services which lend themselves to computerisation needs also to be explored.

24. As regards modernisation and technology upgradation the pace and reach of computerisation will need to be accelerated. In these endeavours, there is no reason to expect that employees will not agree to cooperate or welcome efforts in enhancing the productivity and efficiency of banks. The earlier Committee had drawn particular attention to the aspect of enhancing professional skills and the need for professional competence at the executive and decision making levels. As banking gets more technology intensive the type of skills that would be required particularly in those banks which could increasingly face internal and global competition would be of different order emphasizing new forms of risk identification and management liquidity and credit appraisal in areas like infrastructural finance, to give an example, and Treasury management, avoidance of asset-liability mismatch in terms of maturity, currency and value as well as developing expertise in derivative trading and associated risk management . These specialist requirements and indeed the need of recruitment procedures and training and remuneration policies in bank especially in the PSBs.

25. An aspect of human resource management in banks is the perception of low morale amongst banking personnel as a result of actual or perceived threat of action by vigilance and other investigative authorities in respect of what should normally be regarded as commercial decisions. This may have led to some risk aversion with its impact of a denial in some case of legitimate productive credit. This an issue which the committee has sought to address.

26. Fundamental to the reform process is the issue of ensuring greater operational flexibility to the public sector banks. This is also closely related to their functional autonomy. The CFS laid great store by this and took the view that restoration of functional autonomy was not inconsistent with public ownership and that the productive efficiency and profitability of the system was ownership neutral as long as Government's role was only that of an investor and banks were given freedom of action within a well devised framework of regulation and prudential norms. Autonomy has its corollary in accountability and even as autonomy is sought and given, we need to evolve transparent procedures to fix accountability for non performance The dichotomy between ownership and management is regarded as the hallmark of modern corporate organisation and though in theory functional autonomy could be ownership neutral as indicated by the CFS, the major rider it added viz., the requirement that for this to be so the owner should allow the management to function with flexibility and autonomy has not been totally fulfilled. The more general case is where ownership has itself become an instrument of management. Such micro management of banks is not calculated to enhance autonomy and flexibility, indeed the wider question whether real autonomy is consistent with public ownership needs to be re-examined in the light of experience in the last few years.

27. One of the more significant recommendations aimed at improving the flexibility and autonomy of banks was that relating to the depoliticisation of appointments to the Boards of banks and of their Chairmen. Such a depoliticisation would be a corollary to encouraging professionalism in bank management and board appointments. The issue of depoliticisation is obviously linked to the question of autonomy in decision making. A measure of depoliticisation has been effected with respect to appointments of Chairmen and Managing Directors and Executive Directors of public sector banks. Though the appointing authority is the Government, the decisions regarding appointments are based on the recommendations of a separate Appointments Board headed by the Governor of RBI. The same is not the case with appointments of non-official directors on the Boards and this is an aspect which needs correction.

28. A high degree of professionalism needs to be introduced as much at the Board level as in Management. The composition of the boards should reflect this. The respective functions of the boards and the management require to be reviewed so that the boards remain responsible for enhancing shareholder value through formulation of corporate strategy and not get involved in credit decision making and other aspects of day-to-day management which should be the concern of a Committee of Executives.

29. Efforts have been made by banks in the direction of strengthening internal controls. In view of the more open environment in which the banks would now be required to function and the attendant proliferation of risks banks would have to put in place appropriate systems for asset-liability and risk management.

30. Another major issue for consideration is that related to the arrangements for regulation and supervision. Regulation should appropriately be concerned with the formulation of policy with regard to prudential norms, capital adequacy and the like, while the function of supervision should be regarded as the instrumentality for ensuring that the regulatory norms are compiled with. This could take the form of either both off-site oversight by scrutiny of periodical returns and on-site inspection. A Board for Financial Supervision has been established and one of the critical issues here is whether the Board should be an autonomous body as recommended by the CFS or as is the case now, apart of the Reserve Bank of India. Regulation and associated supervision, whether off-site or on-site should be concerned with laying down prudential and disclosure norms and sound procedures and ensure adherence to these and not get involved in aspects of day-to-day management of banks. Regulation and supervision of DFIs and NBFCs is appropriately now the responsibility of the agency charged with exercising this function over banks. In discussing issues of regulation and supervision, the new core principles set out by the BIS in this regard should need to be kept in view, especially in respect of surveillance of cross boarder transactions.

31. There has been a perception and not without reason, that our legal system have not kept pace with measures of financial sector reforms and indeed economic reforms more generally. As far as the banking sector is concerned, there is continuing need for an appropriate legal framework to help enforce contracts and protect the interests of secured creditors especially in bankruptcy proceedings. Some of our laws are outdated and legal procedures are cumbersome and time consuming. Even where Court decrees are obtained their enforcement has been marked by delays. Our experience with the Debt Recovery Tribunals has not been altogether satisfactory in view of the legal issues that have been raised. Our laws indeed seem marked by a basic asymmetry in their protection of creditors as distinct from borrowers which comes in the way of the proper and smooth functioning of banking and credit systems. There are also a host of Banking Sector Laws like the RBI Act. Banking Regulation Act, Nationalisation Acts, State Bank of India Act and so on which are in urgent need of review and amendments to Bring some of the provisions in line with the current needs of the banking industry in the country. The Sick Industrial Undertakings (Special Provisions) Act or the Bankers' Book Evidence Act also need to be reviewed.

32. As we move into the second phase of financial and banking sector reform, the emphasis would thus increasingly have to be on enhancing the inherent strength of banks, review the structure of the system, the internal organisation of banks and streamlining their procedures, taking into account institutional and technological dimensions, it would also call for an analysis of banking policy in the new milieu. The second generation of reform, therefore, could be conveniently looked at in terms of three broad inter-related issues :- Actions that need to be taken to strengthen the foundations of the banking system : Related to the above streamlining procedures, upgrading technology and human resource development and Structural changes in the system.

33. These would cover aspects of banking policy, institutional, supervisory and legislative dimensions.

34. The foregoing paragraphs set out the broad issues that the Committee has addressed itself to with a view to the development of a healthy, competitive market-oriented efficient and professionally managed financial system, which would make its distinctive contribution to the growth of the Indian economy and its closer integration with the international economy in the challenging decades ahead.