State Bank of India, ICICI Bank, and HDFC Bank have again been named as Domestic Systemically Important Banks (D-SIBs) by the Reserve Bank of India (RBI).

What are Systemically Important Banks (SIBs)?

• SIBs are perceived as certain big banks in the country/world. They enjoy a huge customer base and also engage in cross sector activities and are perceived as ‘Too Big to Fail (TBTF)’.
• The system of D-SIBs was adopted in the aftermath of the 2008 financial crisis where the collapse of many systematically important banks across various regions further fuelled the financial downturn.
• A failure of any of these banks can lead to systemic and significant disruption to essential economic services across the country and can cause an economic panic.
• As a result of their importance, the government is expected to bail out these banks in times of economic distress to prevent widespread harm.
• D-SIBs follow a different set of regulations in relation to systemic risks and moral hazard issues.

Types of SIBs

There are two types of SIBs:

1. Global SIBs: They are identified by BCBS (BASEL Committee on Banking Supervision)
2. Domestic SIBs: They are declared by Central Bank of the country

How are D-SIBs determined?

• Since 2015, the RBI has been releasing the list of all D-SIBs.
• They are classified into five buckets, according to their importance to the national economy.
• In order to be listed as a D-SIB, a bank needs to have assets that exceed 2 percent of the national GDP.
• The banks are then further classified on the level of their importance across the five buckets.
• ICICI Bank and HDFC Bank are in bucket one while SBI falls in bucket three, with bucket five representing the most important D-SIBs.

What regulations do these banks need to follow?

• Due to their economic and national importance, the banks need to maintain a higher share of risk-weighted assets as tier-I equity.
• SBI, since it is placed in bucket three of D-SIBs, has to maintain Additional Common Equity Tier 1 (CET1) at 0.60 percent of its Risk-Weighted Assets (RWAs).
• ICICI and HDFC on the other hand, have to maintain Additional CET1 at 0.20 percent of their RWA due to being in bucker one of D-SIBs.

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The volume of India’s soft loans to neighboring countries has increased from about $3 billion to almost $15 billion in the last eight years.

What are Soft Loans?

• A soft loan is a loan with no interest or a below-market rate of interest.
• Also known as “soft financing” or “concessional funding,” soft loans have lenient terms such as-

1. Namesake interest rate
2. Extended grace periods in which only interest or service charges are due
3. Interest holidays
4. Long tenure up to 50 years

• Soft loans are often made by multinational development banks such as the Asian Development Fund affiliates of the World Bank etc.

Why are soft loans popular?

• Diplomatic tool: Soft loans are often offered not only as a way to support developing nations but also to form economic and political ties with them.
• Economic benefit: Nations exchange credit in return of some important resources.
• Geopolitics: Soft loans have been an important diplomatic tool to sustain political influence in the neighborhood and beyond as well as counter the growing Chinese presence, especially in Africa.

Pros and cons of Soft Loans

• Pro: Breaks for Business– Soft loans offer favorable business opportunities.
• Con: Shaky Returns– The length of time it may take to repay a soft loan could mean the lender is tied to the borrower for an extended number of years.

Did India take any soft loan?

• For instance, in 2015, Japan offered a soft loan to India to cover 80% of the cost for a $15 billion fund a bullet train project at a less than 1% interest rate.
• This was done with the caveat that India would purchase 30% of the equipment for the project from Japanese companies.
• By the time the countries signed a formal agreement, Japan’s commitment increased to 85% of the cost, in the form of soft loans, for a then-estimated $19 billion project cost.

Using soft loans as a diplomatic tool

• The amount of development assistance India has offered to other nations in 2019-20 was more than twice what it had extended in 2011-12.
• However, such loans have usually gone to countries in Asia, Africa and Latin America that are lower down the economic strength ladder.
• India has extended a total of $27.8 billion in lines of credit since 2002-03.

Conclusion

• Extending development assistance is nothing new for India and about half of the foreign ministry’s budget is made up of grants and loans to foreign governments, especially India’s neighbours.
• For a country that for long had to rely on international loans to meet key development goals, India understands the diplomatic value of providing a helping hand.

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Last week, federal think tank NITI Aayog released a report on digital banks, offering a template for their licensing in India. It said India already has a technology stack to facilitate digital banks.

What are the planned Digital Banks?

• Digital Banks or DBs are full-scale banks to be licensed under the Banking Regulation Act.
• Unlike traditional banks, which require brick-and-mortar infrastructure or physical access points, digital banks simply leverage technology to provide banking services through mobile applications and internet-based platforms.
• DBs behave like any other scheduled commercial bank, accepting deposits, giving loans etc.
• They will follow prudential and liquidity norms at par with the commercial banks.
• Globally, terms like “digital banks”, “neobanks”, “challenger banks”, and “virtual banks” are often used interchangeably.

What about digital banking units then?

• The Union budget for FY23 proposed to establish digital banking units (DBUs) of scheduled commercial banks in 75 districts.
• The objective is to ensure that the benefits of digital payments, banking and fintech innovations reach the grass-roots.
• DBUs are treated as banking outlets, equivalent to a branch.
• These units do not have a legal personality and are not licensed under the Banking Regulation Act.
• Only existing commercial banks may establish DBUs. In contrast, digital banks will be licensed.
• These banks are expected to ensure credit penetration to underserved MSMEs and retail customers.

What purpose will digital banks serve?

• Digital banks are expected to further innovation and support the underserved segments.
• However, some believe that it will only cater to customers with some level of comfort with digital transactions.
• According to them, RBI too is not comfortable with this model as the central bank believes that cash handling and credit decisions require physical branches.

What does NITI Aayog suggest for DBs?

• In the first phase, a restricted digital bank licence may be given, with limits in terms of volume/value of customers. In the second stage, the licensee will be put in a regulatory sandbox.
• Finally, a ‘full-scale’ licence may be granted contingent on satisfactory performance.
• A digital bank will be required to have initial capital of ₹20 crore while in the regulatory sandbox.
• Upon progression from the sandbox, a full-stack digital business/consumer bank will be required to bring in ₹200 crore capital.

What has been the global experience?

• The UK has led the pack in terms of digital banks, with new entrants in the form of Monzo and Starling Bank.
• Several jurisdictions in the South East Asian region have witnessed the rise of digital banks.
• Hong Kong has issued separate licences for virtual banks.
• As of May 2020, the Hong Kong Monetary Authority has licensed 8 entities out of 33 applications.
• In South Korea, Kakao Bank and K Bank operate as internet banks licensed under the Banking Act.
• The Philippines has approved six licenses for digital banks.

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Last week, on July 19 was the 53rd anniversary of then Prime Minister Indira Gandhi nationalizing 14 banks.

Bank Nationalization: A Backgrounder

• In 1955 Imperial Bank of India was nationalized as RBI with State Bank of India to act as the principal agent  for extensive banking facilities on a large scale, especially in rural and semi-urban areas.
• The other banks of the princely states were acquired by SBI much earlier.
• However, the nationalization of banks in 1969 and later in 1980 was of a completely different scale.
• In 1969, the move covered 14 (followed by six in 1980) of the largest private sector banks—putting 85% of the deposit base into the hands of the government.
• This brought 80% of the banking segment in India under Government ownership.

Why Nationalization of Banks?

• After independence, the Government of India (GOI) adopted planned economic development for the country.
• Nationalization was in accordance with the national policy of adopting the socialistic pattern of society.
• The actual course came at the end of a troubled decade when India had suffered many economic as well as political shocks.

Other reasons

• Social welfare
• Controlling private monopolies
• Expansion of banking to rural areas
• Reducing regional imbalance to curb the urban-rural divide
• Priority Sector Lending
• Mobilization of savings

Immediate causes

• There were two wars with China in 1962 and Pakistan in 1965 that put immense pressure on public finances.
• Banks were failing largely due to speculative financial activities when Indira Gandhi became the prime minister in 1967.
• Two successive years of drought had not only led to food shortages but also compromised national security because of the dependence on American food shipments.
• Subsequently, a three-year plan holiday affected aggregate demand as public investment was reduced.
• Agriculture needed a capital infusion, with the initiation of the Green Revolution in India which aimed to make the country self-sufficient in food security.
• The collapse of banks was causing distress among people, who were losing their hard-earned money in the absence of a strong government support and legislative protection to their money.

Post-nationalization challenges

• Having ownership and operational control of the banks was a challenging task for the government.
• The banks were constantly challenged on their profitability parameters—particularly RRBs which had both geographical and portfolio concentration risks.

Establishing regional balance

• The objective of social control was about making banking sector accessible in areas where these services were not accessible.
• The state established 196 Regional Rural Banks (RRBs) between two nationalizations.
• While nationalization, branch licensing policy and priority sector lending targets helped the banks to go to rural areas and certain sectors, it did not achieve regional balance.
• Of the 20 banks that were nationalized, seven were concentrated in south India, six in west India, four in north India and three in east India.
• The expanded rural branch network followed the extant regional concentration, bringing more intensive banking in southern and western regions.

How was regional balance achieved then?

• This skew was partially set right by two initiatives. The first was an institutional intervention of opening 196 RRBs which had focused area of operation.
• The RRBs contributed significantly to reduce the regional imbalance with their expanding branch network in the 1980s.
• RRBs also had a greater proportion of their loans flowing to priority sector in general and agriculture in particular.
• The second was the policy on lead bank scheme where one bank was assigned as a lead for each district.
• The lead bank was responsible for the growth and penetration of banking in districts and had to achieve it in coordination with other banks and the state machinery.
• A “district credit” plan (euphemism for a banking plan), dovetailed with the government schemes, was to be prepared and monitored by the lead bank.

1. Regional Rural Banks

• RRBs are a shade better when it comes to rural lending.
• While they have deployed 72% of the rural and semi-urban deposits as credit in those areas, the figure for urban understandably is very low, and most of these funds have gone into investments.

1. Small Finance Banks

• The new small finance banks (SFBs) give an entirely different picture—a large number of them are MFIs that converted into banks.
• These institutions are trying to collect deposits from the middle and upper middle class and deploy those resources towards the poor.
• From a paradigm point of view, possibly SFBs are the most interesting institutions that have turned the tables and are trying to achieve from the private sector the objectives set out in the bank nationalization.

Public versus Private Banks

• A look at the broad performance ratios for 2017-18 shows that private sector banks score better on efficiency and profitability parameters.
• They have better return on assets, return on equity, net interest margin and a higher proportion of low-cost deposits.
• On the other hand, public sector banks (PSBs) have a better impact on priority sector lending achievement, and paid higher wages.
• Of the new Pradhan Mantri Jan Dhan Yojana accounts 77% were opened by state-owned banks, 20% by RRBs, and a mere 3.4% accounts were opened by private banks.
• From this perspective bank nationalization was indeed a good move at that time.

What benefits do we reap today?

• Banking under government ownership gave the public implicit faith and immense confidence about the sustainability of the banks.
• Banks were no longer confined to only metropolitan or cosmopolitan in India. In fact, the Indian banking system has reached even to the remote corners of the country.
• The present government has reached out to people through banks.
• Assistance for constructing toilets under Swachh Bharat programme, DBT, Crop insurance schemes etc was given through banks.
• The dispensing of Mudra loans to about 20 crore individuals, benefits under PM Kisan scheme for providing cash assistance to close to 15 crore farmers annually are only possible through this banks.
• Thus banks became the government’s dispenser of goodies due to the decision which was taken 50 years ago.

What about Financial Inclusion?

• The All India Debt and Investment Survey reports indicate that the formal sector has been losing ground to the informal sector in the rural indebtedness pie since 2001 onwards.
• This is worrying and indicates that the inclusion agenda is far from achieved.
• Some examples in the public sector banking system—particularly SBI—have shown that it is possible to achieve the double bottom line of being in the commercial market while continuing to achieve significant targets in inclusion, sectoral, spatial and geographical.

Way Forward

• From the larger perspective of efficiency and better utilization of capital, it may be a good idea to move state-owned banks towards more market-based framework.
• However, that call should be taken to achieve the residual task of inclusion.
• Making state-owned banks more autonomous and accountable to the market may be the first significant step that can be taken for now.

Also read:

[Burning Issue] Privatization of PSBs

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The Cabinet Committee on Economic Affairs (CCEA) has approved a proposal to digitise around 63,000 primary agricultural credit societies (PACS).

What are the Primary Agricultural Credit Societies (PACS)?

• PACS is a basic unit and smallest co-operative credit institutions in India.
• In 1904 the first Primary Agricultural Credit Society (PACS) was established.
• It works on the grassroots level (gram panchayat and village level).
• PACS is the final link between the ultimate borrowers, i.e., rural people, on the one hand, and the higher agencies, i.e., Central cooperative bank, state cooperative bank, and Reserve Bank of India, on the other.

Who regulates PACS?

• PACS are registered under the Co-operative Societies Act and also regulated by the RBI.
• They are governed by the “Banking regulation Act-1949” and Banking Laws (Co-operative societies) Act 1965.

Various objectives of PACS

1. To raise capital for the purpose of making loans and supporting members’ essential activities.
2. To collect deposits from members with the goal of improving their savings habit.
3. To supply agricultural inputs and services to members at reasonable prices,
4. To arrange for the supply and development of improved breeds of livestock for members.
5. To make all necessary arrangements for improving irrigation on land owned by members.
6. To encourage various income-generating activities through supply of necessary inputs and services.

Functions of PACS

• As registered cooperative societies, PACS have been providing credit and other services to their members.
• PACS typically offer the following services to their members:

1. Input facilities in the form of a monetary or in-kind component
2. Agriculture implements for hire
3. Storage space

Who can form PACS?

• A primary agricultural credit society can be formed by a group of ten or more people from a village. The society’s management is overseen by an elected body.
• The membership fee is low enough that even the poorest agriculturist can join.
• Members of the society have unlimited liability, which means that each member assumes full responsibility for the society’s entire loss in the event of its failure.

What capitalizes PACS?

• The primary credit societies’ working capital is derived from their own funds, deposits, borrowings, and other sources.
• Share capital, membership fees, and reserve funds are all part of the company’s own funds.
• Deposits are made by both members and non-members.
• Borrowings are primarily made from central cooperative banks.

Why need digitization?

• PACS account for 41 % (3.01 Cr. farmers) of the KCC loans given by all entities in the country and 95 % of these KCC loans (2.95 Cr. farmers) through PACS are to the small and marginal farmers.
• The other two tiers viz. State Cooperative Banks (StCBs) and District Central Cooperative Banks (DCCBs) have already been automated by the NABARD and brought on Common Banking Software (CBS).
• Majority of PACS have so far been not computerized and still functioning manually resulting in inefficiency and trust deficit.

Significance of digitization

• Computerization of PACS will increase their transparency, reliability and efficiency, and will also facilitate the accounting of multipurpose PACS.
• Along with this, it will also help PACS to become a nodal centre for providing services such as direct benefit transfer (DBT), Interest subvention scheme (ISS), crop insurance scheme (PMFBY), and inputs like fertilizers and seeds.

Try this PYQ from CSP 1999:

Q.The farmers are provided credit from a number of sources for their short and long term needs. The main sources of credit to the farmers include-

(a) the Primary Agricultural Cooperative Societies, commercial banks, RRBs and private money lenders

(b) the NABARD, RBI, commercial banks and private money lenders

(c) the District Central Cooperative Banks (DCCB), the lead banks, IRDP and JRY

(d) the Large Scale Multi-purpose Adivasis Programme, DCCB, IFFCO and commercial banks

 

Post your answers here.

12

Please leave a feedback on thisx

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Mortgage lender HDFC Ltd. and India’s largest private sector bank HDFC Bank on Monday announced a mega-merger.

Impact of the move

• Under the terms of the deal, which is one of the biggest in the Indian financial sector, HDFC Bank will be 100% owned by public shareholders.
• Existing shareholders of HDFC Ltd. will own 41% stake in HDFC Bank.
• Post-merger HDFC Ltd. will no longer be a separate mortgage lender, it will get folded into the bank.

What are the terms of the merger?

• The merger has to go through a series of regulatory approvals.
• It has to get approval from the shareholders of both companies.
• At this moment what has been announced by the two entities is that its an all-share deal, so there’s no cash transaction involved.
• The terms of the share swap are such that shareholders of HDFC Ltd. will receive 42 shares of HDFC Bank for every 25 shares they hold in HDFC Ltd.

What happens to existing customers and employees?

• As far as customers are concerned, HDFC Ltd.’s customers will become the bank’s customers as well.
• As for employees, HDFC Bank is planning to absorb and retain all the employees.
• Neither of the entities are very heavy on employee numbers and have been fairly conservative in their employee sizes.

What is the rationale behind this merger?

• HDFC have largely had a fairly conservative lending culture, both reasonably customer-friendly, customer-centric, culturally, there wouldn’t be a big challenge.
• The evolution of the regulatory framework for the NBFC (non-banking financial company) industry has been gradually moving closer, to harmonise with the banking sector’s regulatory framework.
• Earlier, NBFCs had a fairly different and a far more loose sort of framework for lending and deposits.
• This led to issues in the industry with some NBFCs struggling and going under or being taken over by others.
• As Basel III norms for capital adequacy are in place, the NPA (non-performing asset) book is very closely monitored.

What is in it for HDFC Ltd. and HDFC Bank?

• Post-merger, the mortgage lender, HDFC Ltd., gets access to HDFC Bank’s CASA (current and savings accounts) deposits, which are lower cost funds.
• For the mortgage lending business, the capital cost will come down. As the capital cost comes down, automatically it will have the ability to lend at a finer rate.
• For HDFC Bank, every home loan customer can be tapped to become a bank customer.

Impacts of the deal

• It’s possible that we might see more NBFCs seeking to merge with banks.
• There is already talk of the number of banks coming down.
• So in some ways, this merger may be a precursor to what is going to happen in the state-run banking space, where the government has said it is going to reduce the number of public sector banks.

Back2Basics: Basel Accords

• They refer to the banking supervision Accords (recommendations on banking regulations)—Basel I, Basel II and Basel III—issued by the Basel Committee on Banking Supervision (BCBS).
• They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there.
• These are a set of recommendations for regulations in the banking industry.
• India has accepted Basel accords for the banking system.

Let’s revise them:

[1] Basel I

• In 1988, BCBS introduced capital measurement system called Basel capital accord, also called as Basel 1.
• It focused almost entirely on credit risk. It defined capital and structure of risk weights for banks.
• The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
• RWA means assets with different risk profiles.
• For example, an asset backed by collateral would carry lesser risks as compared to personal loans, which have no collateral. India adopted Basel 1 guidelines in 1999.

[2] Basel II

• In June ’04, Basel II guidelines were published by BCBS, which were considered to be the refined and reformed versions of Basel I accord.
• The guidelines were based on three parameters, which the committee calls it as pillars:
• Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
• Supervisory Review: According to this, banks were needed to develop and use better risk management techniques in monitoring and managing all the three types of risks that a bank faces, viz. credit, market and operational risks.
• Market Discipline: This need increased disclosure requirements. Banks need to mandatorily disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are yet to be fully implemented.

[3] Basel III

• In 2010, Basel III guidelines were released. These guidelines were introduced in response to the financial crisis of 2008.
• A need was felt to further strengthen the system as banks in the developed economies were under-capitalized, over-leveraged and had a greater reliance on short-term funding.
• Also the quantity and quality of capital under Basel II were deemed insufficient to contain any further risk.
• Basel III norms aim at making most banking activities such as their trading book activities more capital-intensive.
• The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz. capital, leverage, funding and liquidity.

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1. Poor banking governance: Most frauds show that banks did not observe due diligence, both before and after disbursing loans. Poor level of checks and balances in the banking system is one of the reason.
2. Poor monitoring: Lack of technology and fraud monitoring agencies to detect frauds makes the problem more complex. There is an absence of an effective mechanism to monitor the credit flow. Flawed risk-mitigation design, which creates an excessive focus on credit or market risks, but focuses less on operational risks also leading to more breaches.
3. Technological backwardness: Excessive dependence on manual supervision, at both external and internal levels makes it impossible to manually control and supervise the sheer volume of transactions.
4. Immoral behaviour: The disintegrating moral fibre of Indian businessmen, bankers and other white-collar professionals, nepotism in internal committees of banks, unnecessary political interventions lead to increased frauds.
5. Political interference: The political pulls and pressures on investigating agencies, and long-drawn processes of legal system act less as a deterrent.

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Context

We have a situation in India today where the policy repo rate has been kept low. Banks are just about managing their non-performing assets (NPAs) and there is uncertainty in the air.

Mispricing of capital by banks

• There are different components of the cost of funds for banks, which are captured by the MCLR or marginal cost of funds-based lending rate.
• For every ₹100 deposits that enter the banking system, there are different accompanying costs for the system.
• These are deposit costs, provisioning for NPAs, return on assets (ROA or minimum profit), and the regulatory cost of cash reserve and statutory liquidity ratio balances (CRR and SLR) that perforce have to be held.
• Adding these components, the basic cost works out to be 8.9%, which should be the rate at which incremental lending should take place.
• By offering loans at a much lower rate of 7.23%, the system is actually mispricing capital.
• It may be noted that deposit rates have been compressed to a very large degree and so this cost of 4% is very low.
• Banks do have the advantage of getting free demand deposits and the right to offer differential rates on saving accounts.
• Clearly, deposit-holders are subsidizing borrowers quite significantly.

Issue of NPA provisioning in India

• In the past couple of years, provisions as a proportion of NPAs have averaged 30-40%.
• As NPAs increase, ideally, banks should load this cost onto their borrowers.
• But that rarely happens in India. Instead, it is taken on banks’ books and gets reflected in their balance sheets.
• If NPAs were kept in the region of, say, 4-5% of assets, it would have been possible to bring the cost down to 1.5% (from 3%), which would then have justified the present MCLR.

Low return on assets (ROA)

• The ideal return norm is 1%, which should be derived from all assets.
• This does not happen for banks’ investment portfolios, and the value imputed here is only for loans.
• The ROA for banks is abysmally low, as this aspect does not go into the pricing of products on the asset side.
• Deposit costs have been driven down as savers don’t have a choice.
• But a commensurate return does not materialize in the loan books of banks.

Cost of regulations

• The CRR component gets no compensation, while the SLR part earns around 6%, which is the average cost of fresh borrowing for the Union government.
• While these numbers vary across banks, the minimum rate of 8.9% would hold for the system, which will vary by the level of NPAs.
• The concept of linking benchmarks to certain loans further misprices fresh lending, as those loans are not ideal anchors to use, for they are being manually driven downwards by a deluge of liquidity in the system after the pandemic.
• Excess liquidity of ₹4-7 trillion a day since April 2020 has meant banks have been placing funds costing them 8.9% with the central bank which gives them just 3.35%.
• This is eventually borne by bank shareholders.

Implications

• With rather rigid policies on corporate lending to avert possible NPAs, banks have preferred lending to the retail segment, which is less risky, and small businesses, backed by the Centre’s credit guarantee.
• The central bank’s government-bond buying programme to provide liquidity has been successful.
• But in the absence of fructification of lending and a continuous rollover of funds at the reverse-repo window, Indian banks are bearing a negative carry trade, with a 6% return traded for just 3.35%.

Conclusion

Banks must price capital appropriately and not get overly influenced by arguments in favor of cheap credit or the fact that loans are cheaper in the West. We need to get practical on this issue.

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Maharashtra government has approved a plan to set up a task force to prepare an action plan against a recent change in the law that has brought cooperative banks under the supervision of the Reserve Bank of India (RBI).

What are Cooperative Banks?

• Co-operative banks are financial entities established on a cooperative basis and belonging to their members.
• This means that the customers of a cooperative bank are also its owners.
• These banks provide a wide range of regular banking and financial services. However, there are some points where they differ from other banks.
• They came into being with the aim to promote saving and investment habits among people, especially in rural parts of the country.

Structure of co-operative banks in India

• Broadly, cooperative banks in India are divided into two categories – urban and rural.
• Rural cooperative credit institutions could either be short-term or long-term in nature.
• Further, short-term cooperative credit institutions are further sub-divided into State Co-operative Banks, District Central Co-operative Banks, Primary Agricultural Credit Societies.
• Meanwhile, the long-term institutions are either State Cooperative Agriculture and Rural Development Banks (SCARDBs) or Primary Cooperative Agriculture and Rural Development Banks (PCARDBs).
• On the other hand, Urban Co-operative Banks (UBBs) are either scheduled or non-scheduled.

Who oversees these banks?

• In India, cooperative banks are registered under the States Cooperative Societies Act.
• They also come under the regulatory ambit of the Reserve Bank of India (RBI) under two laws, namely, the Banking Regulations Act, 1949, and the Banking Laws (Co-operative Societies) Act, 1955.
• They were brought under the RBI’s watch in 1966, a move that brought the problem of dual regulation along with it.

Now answer this PYQ in the comment box:

Q.Consider the following statements:

1. In terms of short-term credit delivery to the agriculture sector, District Central Cooperative Banks (DCCB) delivers more credit in comparison to Scheduled Commercial Banks and Regional Rural Banks.
2. One of the most important functions of DCCBs is to provide funds to the Primary Agricultural Credit Societies.

Which of the statements given above is / are correct?

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

How has The Banking Regulation Act been amended?

• Cooperative banks have long been under dual regulation by the state Registrar of Societies and the RBI.
• As a result, these banks have escaped scrutiny despite failures and frauds.
• The changes to The Banking Regulation Act approved by Parliament in September 2020, brought cooperative banks under the direct supervision of the RBI.

Changes brought

• The amended law has given RBI the power to supersede the board of directors of cooperative banks after consultations with the concerned state government.
• Earlier, it could issue such directions only to multi-state cooperative banks.
• Also, urban cooperative banks will now be treated on a par with commercial banks.
• And a cooperative bank can, with prior approval of the RBI, issue equity shares, preference shares, or special shares to its members or to any other person residing within its area of operation, by way of public issue or private placements.
• It can also issue unsecured debentures or bonds with a maturity of not less than 10 years.
• This essentially means non-members can become shareholders of the bank, and this will allow the RBI to merge failing banks quickly.

What triggered the need for the changes in the law?

• India has some 1,540 urban cooperative banks, with a depositor base of 8.6 crore and deposits of at least Rs 5 lakh crore.
• Finance Minister told Lok Sabha last year that the financial status of at least 277 urban cooperative banks was weak, and around 105 cooperative banks were unable to meet the minimum regulatory capital requirement.
• According to RBI’s latest financial stability report, the gross non-performing asset ratio of urban cooperative banks deteriorated from 9.89 percent in March 2020 to 10.36 percent in September 2020.
• Not only do these banks have high levels of bad loans, they also have a small capital base — something that the changes in the law have tried to address by allowing these banks to issue shares with RBI’s approval.
• Political interference in staff appointments is also a problem with these banks, which has added to inefficiencies.

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What the guidelines say

• The Reserve Bank of India recently issued certain instructions on the governance for banks.
• As per the instructions from the central bank, the post of Managing Director (MD) and Chief Economic Officer (CEO) MD or Whole Time Director (WTD) cannot be held by the same incumbent for more than 15 years.
• The individual will be eligible for re-appointment as MD&CEO or WTD in the same bank after a minimum gap of three years, subject to meeting other conditions.
• The upper age limit for MD & CEO and WTDs in private banks would continue to be 70 years.
• MD&CEO or WTD who is also a promoter/ major shareholder, cannot hold these posts for more than 12 years except in extraordinary circumstances.
• Banks are permitted to comply with these instructions latest by October 01, 2021.

Applicability

• These guidelines are applicable for banks, including private banks, Small Finance Banks (SFBs), Wholly Owned Subsidiaries of Foreign Banks.
• However, it added that this circular is not applicable to foreign banks operating as branches in India.

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The article explains the factors that resulted in the failure of several financial institutions created by the government.

Establishment of Development Finance Institution

• As promised in the Budget, the Lok Sabha recently passed The National Bank for Financing Infrastructure and Development (NBFID) Bill, 2021.
• The Bill seeks to establish a development finance institution (DFI) to fund infrastructure.

Providing finance to NBFID

• The government will initially own 100% of the proposed NBFID’s ₹20,000-crore share capital.
• The government’s stake will be reduced later to 26%.
• The government will also support NBFID in raising cheap, long-term finance.
• Apart from the initial share capital, the government will also provide a ₹5,000-crore grant at the end of its first financial year, presumably to defray initial costs.
• The government has also committed to guarantee NBFID’s borrowings and bond issuances in the domestic and overseas markets.
• In addition, the government will underwrite NBFID’s foreign exchange hedging costs.

Concerns and lessons from the past

• Studying the performance of IL&FS Ltd and IDFC Ltd, two infrastructure financing institutions, set up in the public sector, will be instructive.
• IL&FS had borrowed short-term loans to finance long-term infrastructure assets.
• Sustaining this became difficult when a slowing economy and political interference forced infrastructure borrowers to stop repaying loans.
• Also, it had grown unwieldy, was mismanaged, and escaped scrutiny for too long by handing out plum postings to select bureaucrats.
• Similarly, 1996 budget speech announced the setting up of IDFC to address the lack of long-term infrastructure financing.
• In 2004, interference by the bureaucrats to tackle slow growth of loan led to the resignation of several senior executives in IDFC.
• IDFC, created originally to finance infrastructure projects, has since then wound down its project finance book.
• 2021-22 Budget speech also mentioned the creation of another institution that will acquire the banking sector’s stressed assets.
• On the similar lines, Industrial Reconstruction Corporation of India was create in 1971.
• Mandated with nursing sick and weak companies, it collapsed under this onerous burden.
• The institution was eventually shut down in 2012.

Consider the question “Examine the role the National Bank for Financing Infrastructure and Development will play in the infrastructure development in the country. Also, examine the factors that led to the failure of development finance institutions in the past.”

Conclusion

The short lesson is this: Fix the distorted demand side before increasing supply. Any number of institutions can be launched, but cannot be expected to work miracles in a corroded system.

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The article discusses the advantages of central bank digital currency which could combine the advantages of both fiat money and cryptocurrency.

India’s suspicion of the cryptocurrencies

• In 2018, the Reserve Bank of India prohibited regulated entities from providing services to anyone who deals with or settles trades in any virtual currency.
• This was effectively banning Bitcoin trading in the country.
• The Supreme Court lifted this restriction in 2020.
• There were rumours earlier this year that a new law was in the works that would make it a crime to possess, issue, mine, trade or transfer crypto assets in India.

Thinking of digital currencies as asset not currency

• There are concerns over the speculative nature of cryptocurrencies.
• There are also law enforcement concerns around how digital currencies make it hard for the police to track down criminals.
• One of the most important attributes of a currency is that it should be a stable store of value, and Bitcoin is anything but.
• To deal with this difficulty, it will be helpful to think of digital currencies as just another asset—the digital equivalent of a scarce commodity that, like gold, certain collectors prize.

Difference between working of banks and cryptocurrencies

• Our financial system relies on banks to record transactions.
• It is a ‘permissioned’ ledger system in that only trusted intermediaries-registered banks under the supervision of the central bank-can make changes to the ledgers to certify that a given transaction has been completed.
• Cryptocurrencies, on the other hand, are ‘permissionless’ systems that need no intermediary.
• Instead of a centralized ledger, transactions are recorded on a distributed database.
• A purely permissionless system has no need of banks.

Role of banks in maintaining financial health

• Central banks are not just intermediaries managing the great big financial ledger of the country, they are responsible for its financial health.
• To perform this function, they need to be able to take money out of the system when required or put money back into economic circulation.
• None of this is possible in a purely permissionless system.

Advantages of digitally native currencies

• Digitally native currencies are programmable and capable of being incorporated into smart contracts, offering various opportunities for innovative digital solutions.
• Since they can be directly allotted to citizens who don’t have a bank account, they are ideal for financial inclusion.
• Being digitally auditable, transactions can be audited, reducing the scope for illicit activity.
• The challenge is one of integrating the best that digital currencies have to offer into the traditional financial paradigm.

Central bank digital currencies as an alternative

• CBDCs are a completely re-engineered form of money that use a distributed ledger as their underlying technology layer, but are backed by suitable amounts of monetary reserves, just like normal fiat currency.
• Many countries have been toying with the idea of a central bank digital currency (CBDC).
• They are run by central banks along with select financial entities responsible for managing the distributed ledger.
• The best CBDCs will converge the best of both worlds—the programability and security of cryptocurrencies and the reserve-backed stability of fiat currency.
• Several countries are already testing this concept.

How central bank digital currency differs from cryptocurrency? What are its advantages?”

Conclusion

Banning technology has never made it go away. Instead, let’s make an effort to better understand it, and having done so, do all we can to create the digital currency our country needs.

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The article deals with the stark differences in the performance of the public sector banks (PSBs) and private banks and suggests ways to deal with the issues.

Comparing PSBs with private banks

• The performance of PSBs over the years hasn’t been worth the money that the government has invested in them.
• As the Economic Survey of 2019-20 pointed out that over ₹4.3 trillion of taxpayer money is invested as government’s equity in PSBs.
• In 2019, every rupee of taxpayer money invested in PSBs, on average, lost 23 paise.
• In contrast, every rupee of investor money invested in New Private Banks—banks licensed after India’s 1991 liberalization—on average gained 9.6 paise.
• The combined market value of HDFC Bank’s shares is ₹8.56 trillion (as of 18 February), whereas the market capitalization of all PSBs is around ₹6.41 trillion (excluding IDBI Bank, which is now categorized as a private bank).
• Of course, if we add up the assets of PSBs, they are a lot bigger than HDFC Bank’s.

Dual regulation

• The private banks are regulated by the Reserve Bank of India (RBI).
• PSBs are regulated both by RBI and the department of financial services under the finance ministry.
• The P.J. Nayak Committee report of May 2014 had pointed out this issue of dual regulation.
• This is primarily because PSBs are used by the government to fulfil its social obligations and pump-prime the economy when it’s not doing well.
• The stock market discounts these factors while valuing them.

Way forward

• The policies for regulating and promoting industrial growth do not have any social content in them.
• Hence, PSBs should be run as proper banks irrespective of whether they are privatized or not.
• If they are not privatized, the government’s stake in these banks needs to come down to 33%, something which would help them raise more capital.
• Once investors see PSBs being run as proper banks their market capitalization will start to go up.
• Once PSBs are properly valued by the stock market, the government can sell some of its stake in them every year, and use that money to fund its social objectives.
• It can also use some of that money to incentivize all banks, not just PSBs, to deliver some of its social objectives.

Conclusion

The government should take these steps to let the PSBs realise their potential. At the end of the day, nothing improves service delivery more than some good competition.

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The article argues that instead of creating the Bad Bank, several steps taken by the government and the bank regulator could deal with the problem of NPAs and also improve the performance of the banks.

Challenge of NPA: Is Bad Bank and answer to it?

• Recently, RBI governor said that the RBI was open to considering setting up of a “bad bank”.
• India’s economic growth, unless pandemic risks resurface, should be good enough to largely take care of its non-performing assets (NPAs) in the coming years.
• It was the high economic and credit growth of the 2003-08 period that whittled down the NPA ratio.
• The provision coverage ratio at banks had gone up from 42% in 2016 to 72.4% in September 2020, and that net NPAs were down to 2.8% in March 2020.
• The bad loan legacy is almost done with.
• Consequently, the bad bank is a right idea at the wrong time.

Steps the government and RBI should take

1) Resume the operation of IBC

• The government should reinstate the operation of the Insolvency and Bankruptcy Code (IBC).
• The code had improved the recovery rate from NPAs in the banking system.
•  There is a need to create disincentives for deliberate delaying tactics, so that the original timeline of 270 days is honoured more in its observance than in breach.

2) Recapitalisation of banks

• The government should provide more than adequate capital to the strong banks it owns, and adequate capital to the not-so-strong ones, with well-defined performance criteria for them to receive more.
• If they don’t deliver, then the government should consolidate them or begin diluting its stake below 51% in such banks.

3) Level playing field improvement in compliance culture

• The government should level the regulatory playing field between private-sector and government-owned banks.
• The risk management and compliance culture in public-sector banks must improve.
• However,  public sector banks should not be subject to excessive oversight by government investigative and audit agencies.

4) Plug the sources of NPAs through policy changes

• More than these, there are two other important things that constitute the fountainheads of NPAs.
• The government should evolve a framework for passing on explicit development goals of the state for banks to achieve through the credit mechanism.
• The government should provide for them in the budget and compensate banks rather than direct credit by diktat.
• The cost of directed lending is not just the creation of NPAs, but morale and market-value erosion as well.
• In any case, recapitalization needs mean that the fiscal costs are not avoided. It is self-defeating.
• Then, governments (Union and states) should plug the other underlying sources of NPAs.
• Among things, they should ensure economic pricing of utilities, honour power purchase contracts and raw material purchase agreements, pay arrears to private counterparties, and stop being reflexive litigants.

Consider the question ” What is the Bad Bank? Do you agree with the view that India needs Bad Bank?”

Conclusion

The above measures would greatly help the country achieve high growth and sustain it. Setting up a bad bank may be unnecessary.

Back2Basics: Provisioning Coverage Ratio (PCR)

• Banks usually set aside a portion of their profits as a provision against bad loans.
• Provisioning Coverage Ratio (PCR) is essentially the ratio of provisioning to gross non-performing assets (NPA) and indicates the extent of funds a bank has kept aside to cover loan losses.
• A high PCR ratio (ideally above 70%) means most asset quality issues have been taken care of and the bank is not vulnerable.

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With the New Year, a new concept of Positive Pay System for Cheque Truncation System (CTS) will be introduced by the Banking regulator Reserve Bank of India (RBI) seeking to further augment customer safety in cheque payments.

Try this PYQ:

Q.Which of the following is the most likely consequence of implementing the ‘Unified Payments Interface (UPI)’?

(a) Mobile wallets will not be necessary for online payments.

(b) Digital currency will totally replace the physical currency in about two decades.

(c) FDI inflows will drastically increase.

(d) Direct transfer of subsidies to poor people will become very effective.

Positive Pay System

• The concept of Positive Pay involves a process of reconfirming key details of large-value cheques.
• Put simply, cheques will be processed for payment by the drawee bank based on information passed on by its customer at the time of issuance of the cheque.
• When the beneficiary submits the cheque for encashment, the cheque details are compared with the details provided to the drawee bank through Positive Pay.
• If the details match, the cheque is honoured. In case of mismatch in cheque details, the discrepancy is flagged by CTS to the drawee bank and the presenting bank, which would take redress measures.

For cheques above 50k

• The banks are advised to enable it for all account-holders issuing cheques for amounts of ₹50,000 and above.
• While availing of this facility is at the discretion of the account-holder, banks may consider making it mandatory in case of cheques for amounts of ₹5 lakh and above, the RBI had said.

Benefits of the system

• Under the Positive Pay system, the drawee bank is already aware of the issuer the details of the high-value cheque (above ₹50,000) he has issued.
• Without this intimation, if a cheque gets presented, then the drawee bank can reject payment and examine the case. Positive Pay is going to benefit both the issuer and the beneficiary.
• For the issuer, the benefit from this concept is that there cannot be fraudulent cheques encashed out of issuer’s account.
• For the beneficiary, the benefit is that the cheques handed out to him will mostly get honoured.

Is Positive Pay the same as ‘certified cheque’?

• The concept of ‘certified cheque’ was there long back — about 30 years back, long before technology swept across the Indian banking landscape.
• Whenever anybody issued a cheque, banks used to certify that money is there in their customer’s bank account and, therefore, the cheque will get honoured.
• This provided comfort to a beneficiary that cheque payment will get honoured and therefore did not insist on a pay order or demand draft.
• Drawee banks used to earmark the amount in the account of the issuer and then certify the cheque.
• This was adopted in an era when the cheque instrument used to travel physically for clearing.

Why need such a system?

• The RBI says the Positive Pay system is to augment customer safety in cheque payments and reduce instances of fraud occurring on account of tampering of cheque leaves.
• Banks had recently witnessed a rise in frauds involving high-value cheques.

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The article suggest 4 imperatives to the banks in India to emerge successful from pain inflicted by the pandemic.

Impact of pandemic on banking industry

• Unlike other shocks, covid is not a banking crisis; it is, instead, a crisis of the real economy.
• Globally, the average return on equity (RoE) for banks could go below 1.5% in 2021 before recovering to the 2019 pre-crisis levels of 9% by 2024
• This is effectively a loss of five years for the banking industry.
• This will likely play out in two stages:
• 1) Loan loss provisions over a period of 12-18 months.
• 2) Followed by a period where banking revenue growth lags gross domestic product growth, or GDP.

Important role played by banks in pandemic

• India has entered this crisis well-capitalized.
• Their provision coverage ratios improved to 65% in 2019-20, compared to 41% in 2016-17, and RoE (return on equity) has turned positive to 2.5% after two years of negative readings.
• The banking system is playing a critical role in the economic recovery by supporting businesses and individuals.
• New challenges, however, continue to emerge. These, if left unmitigated, will lead to severe losses in efficiencies gained.

4 Imperative to tackle the emerging challenges to banking

1) Need to increase productivity

• Indian banks start at a materially higher cost-to-assets ratio of 2.2% versus 1.4% globally.
• Regaining pre-covid RoE levels and negating higher risk costs and margin compression will, however, require that Indian banks improve productivity by over 30%.
• The Indian banking sector lagged in efficiency improvements; other industrial peers have leveraged a combination of digital adoption and analytics, and strong governance.

Suggestions for productivity transformation

• The productivity transformation will comprise multiple agendas.
• To start with, there will be a branch format and network re-configuration for custormers who has shifted to online mode.
• To drive a permanent digital shift, banks will need to accelerate digital engagement via contact centre transformations.
• In conjunction, there will be the equally important need to create minimum viable support functions (zero-based operations, demand management across human resources, finance, marketing).
• And, finally, there will be the need to re-skill the workforce for digital operations.

2) Pre-emptive risk management

• The second imperative is pre-emptive risk management.
• Banks must rapidly rewire their policies and analytical models such that they reflect fast- moving indicators of risk.
• This means investing in self-serve channels, digital nudges and frictionless journeys across payments, settlements and recoveries.
• The overall collections strategy will have to be underpinned by micro-segmentation, and also leverage analytical models to drive efficiency.

3) Technology imperative

• The third is the technology imperative that must scale with demand and analytical complexity.
• Banks are required to handle high digital traffic and process enormous data sets, and regulators getting increasingly sensitive on downtimes.
• This will requires modernizing core banking platforms, creating the data architecture that supports the analytics life-cycle, instituting modern engineering practices and moving towards automated infrastructure.

4) Capital management

• Banks with exposure to hard-hit sectors will face more of a challenge.
• And existing risk models are unlikely to be tuned to the differentiated impact the pandemic has had on various sectors.
• Risk teams will need to review critical models and add overlays to account for different credit risk in each sector.
• Scenario planning, stress testing and balance sheet optimization will need to become core to planning and management decisions.

Conclusion

In its own way, the pandemic has given banks a glimpse into the art of the possible. Banks should take this opportunity to embed their newfound speed and agility, reinvent their business model, and collaborate with the communities they serve to recast their contract with society.

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The article examines the implications of the Supreme Court order dealing with the loan waiver and ban on the recognition of the bad loan.

Significance of common man as a depositor

• India’s Rs 144 lakh crore in bank deposits make our Rs 110 lakh crore in bank loans possible.
• The “common man” is more likely a depositor than a borrower; banks have 21 crore deposit accounts but only 2.7 crore loan accounts.

Issues with the court order

• The Supreme Court has weighed in on the waiver scheme and recognition of the bad loan.
• Waiving interest dues or banning bad loan recognition is economically ignorant because more than 20 per cent of Indians are depositors while less than 2 per cent are borrowers.
• It has nothing to with economic justice defined as the greatest good for the greatest number.
• It sabotages economic justice because fiscally funding banking diverts money from education, health and skilling expenditure.
•  It’s commercially ignorant because any “annualised effective rate” is adjusted for interest payment frequency.
• Resources are finite with total central government expenditure at Rs 29 lakh crore, scarce as COVID creates a Rs 3 lakh crore GST shortfall and fragile our fiscal deficit may exceed 12 per cent.
• Also, it is hardly what our Constitution imagined as the role of courts.
• Our Constitution writers made a distinction between fundamental rights and directive principles was not a lack of ambition but a measured assessment of state capacity, resources and sequencing.
• The Constitution also envisaged distinct roles for the judiciary, executive and legislature to balance samaj (society), bazaar (markets) and sarkar (government).
• Courts have become less mindful of these two distinctions.

Cost of credit and availability issue in India

• One of the reasons for small size of Indian enterprises in the availability and cost of credit in India.
• India’s credit-to-GDP ratio stands at dismal  50 per cent  — Bihar is 12 per cent and Arunachal is 1 per cent.
• The MSME lending is stuck at Rs 20 lakh crore — needs to rise to 100 per cent.
• Despite lower inflation and fiscal discipline, most borrowers don’t get globally competitive interest rates due to high bad loans and financial statement uncertainty.
• The availability of credit will not rise and cost will not fall till our banking system has strong competition, consistent regulation, effective supervision and non-fiscal sustainability.

Consider the question “How the crisis in the banking sector is different from the crisis in other sectors? Also, examine the issues with the Supreme Court order on the loan waiver and recongnition of bad loan ban?” 

Conclusion

Institutional immunity needs balancing of independence and accountability; rising citizen concern about mandates and appointments should trigger court introspection.

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