BANKING

FINANCE

KNOWLEDGE CONCENTRATE
FOR
YOUR EMPOWERMENT

A.K. JAGANNATHAN

OCTOBER 2013
BANKING FINANCE
A K Jagannathan
e-mail: [email protected]

First Edition: October 2013

Copyright: A K Jagannathan

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 PREFACE

A High Performance Organisation needs all its staff members to be highly

empowered. And,on a continuous basis, on contemporary developments and
current thinking on future scenarios.

The HR system does not have a complete answer for Continuous

Empowerment.

This book is one answer for Continuous Empowerment on contemporary

developments. It will enable you to stay tuned to today’s banking environment.
It will be a Knowledge Source for Bankers, MBA Students and Finance
Professionals.

So, the primary aim of writing this book is:

 Empowerment at the lowest/negligible cost

 An entire spectrum of Banking Finance is presented in a concise
manner including some of the best comments on the subject
 This book will save you enormous time and opportunity cost of
gaining this knowledge by other methods
Secondly, why this book needs to be written? All the information is available
in the public domain: websites, media, printed articles, opinions in various
journals and magazines, etc. A single topic on a website gives you 10/15
citings. RBI Master Circulars on the internet are elaborate and require extensive
reading. It is ‘Big Information’ like the ‘Big Data’. This book is information that
is distilled into a concentrate which will empower you at the least cost and
at the least time.

Thirdly, why this book is called Banking Finance?

My earlier books in similar style were titled

i) Developments in Banking and Finance (1993,1994, 1996,1997, 1999)

ii) Developments in the Financial market (1999)
Having been CEO of two banks, more maturity has dawned on me now. Finance
is a vast subject and what is dealt with in this book is Finance related to
Banking (of course, not exhaustive). So, it is titled Banking Finance. Possibly,
it is a new terminology.
Fourthly, I am sure that every reader will have at least one take away or get
enlightened in at least one area which he/she had not known earlier.

This knowledge will enable you to raise your standards for your betterment.

Finally,

i) No originality is claimed in the compilation of this book. Every effort

has been made to ensure that the information set out in this book
is as accurate as possible. Still, if there are omissions or
commissions, the same may be brought to the author’s knowledge
for necessary action in the next edition.
ii) I express my gratitude to my family: my wife, two sons and daughter-
in-law for extending their help and cooperation in bringing out this
book.

Bangalore A.K. JAGANNATHAN

 CONTENTS

PART A – SIGNIFICANT EVENTS

1. THE FINANCIAL CRISIS ...................................................................................................... 2

2. WHY BASEL-II (B II) FAILED? ............................................................................................. 6
3. SHADOW BANKING (SB) .................................................................................................... 8
4. EUROPEAN DEBT CRISIS (EDC) .................................................................................... 10
5. ICELAND GOES BANKRUPT ............................................................................................ 11
6. SOVEREIGN RISK .............................................................................................................. 12
7. THE LIBOR SCANDAL ....................................................................................................... 13
8. WHEATLEY REVIEW OF LIBOR ........................................................................................ 16
9. COMMITTEE TO STUDY BENCHMARK IN INDIA ........................................................... 18
10. PONZI SCHEME ................................................................................................................. 18
11. NSEL PAYMENT CRISIS .................................................................................................... 19
12. UNIQUE IDENTIFICATION NUMBER (UID) ...................................................................... 21
13. FINANCIAL SECTOR LEGISLATIVE REFORM COMMISSION
(CHAIRMAN : JUSTICE B N SRIKRISHNA) ..................................................................... 22
14. NEW BANKING LICENCE GUIDELINES .......................................................................... 24
15. RIGHT TO INFORMATION ACT 2005 (RTI) ...................................................................... 26
16. COMPANIES BILL 2013 ..................................................................................................... 28
17. CORPORATE SOCIAL RESPONSIBILITY (CSR), SUSTAINABLE
DEVELOPMENT (SD) AND NON- FINANCIAL REPORTING (NFR) ............................... 30
18. CORPORATE GOVERNANCE (CG) .................................................................................. 32
19. NIFTY TUMBLES DUE TO DEALER’S ERROR .............................................................. 36
20. ALL WOMAN BANK ............................................................................................................ 36

PART B – CUSTOMER SERVICE

21. THE BANKING CODES AND STANDARDS BOARD OF INDIA (BCSBI) ....................... 38
22. CODE OF BANK’S COMMITMENT TO CUSTOMERS (CODE) ...................................... 38
23. KNOW YOUR CUSTOMER (KYC) NORMS/ ANTI MONEY LAUNDERING (AML)
STANDARDS/COMBATING FINANCING OF TERRORISM (CFT) MEASURES/
OBLIGATION OF BANKS UNDER PMLA, 2002 ............................................................... 39
24. CUSTOMER IDENTIFICATION PROCEDURE .................................................................. 42
25. SMALL ACCOUNT .............................................................................................................. 44
26. FINANCIAL ACTION TASK FORCE (FATF) ....................................................................... 44
27. FIU-IND, CTR, STR, CCR ................................................................................................. 45
28. CTR/CCR /STR/OBLIGATIONS OF BANKS UNDER PMLA ............................................ 45
29. MONEY LAUNDERING ....................................................................................................... 47
30. COMBATING FINANCIAL TERRORISM (CFT) .................................................................. 47
31. MONEY MULES .................................................................................................................. 48
32. BANKING OMBUDSMAN SCHEME 2006 (BOS) .............................................................. 48
33. COMMITTEE ON CUSTOMER SERVICE IN BANKS (DAMODARAN COMMITTEE) ...... 50

PART C – THE MONEY MARKET

34. LIQUIDITY ADJUSTMENT FACILITY (LAF) ........................................................................ 55
35. MARGINAL STANDING FACILITY (MSF) ........................................................................... 56
36. CBLO VS REPO ................................................................................................................. 56
37. LAF & CALL MARKET ........................................................................................................ 57
38. GOI CASH MANAGEMENT BILLS (CMB) ......................................................................... 58
39. BANK RATE ......................................................................................................................... 58

PART D – THE CAPITAL MARKET

40. BONUS DEBENTURES (BD) ............................................................................................ 60

41. DEPOSITORY RECEIPTS (GLOBAL & AMERICAN) [DR] ............................................... 61
42. INDIAN DEPOSITORY RECEIPTS (IDR) .......................................................................... 63
43. EXCANGE TRADED FUNDS (ETF) .................................................................................. 64
44. CURRENCY FUTURES (CF) / CURRENCY DERIVATIVES ............................................ 65
45. COMMODITIES FUTURE TRADING .................................................................................. 66
46. INTEREST RATE FUTURES (IRF) .................................................................................... 67
47. US GAAP ............................................................................................................................. 68
48. INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) .................................. 68

PART E – THE CREDIT MARKET

49. BASE RATE (BR) ................................................................................................................ 70

50. LIMITED LIABILITY PARTNERSHIP (LLP) BILL, 2008 .................................................... 71
51. NATONAL COMPANY LAW TRIBINAL (NCLT) .................................................................. 74
52. FINANCIAL INCLUSION (FI) .............................................................................................. 75
53. PRIORITY SECTOR LENDING (PSL) TARGETS ............................................................. 81
54. MICRO, SMALL AND MEDIUM ENTERPRISES (MSME) ................................................. 84
55. CREDIT GUARANTEE FUND TRUST SCHEME FOR MICRO &
SMALL ENTERPRISES (CGTMSE) ................................................................................... 84
56. CODE OF COMMITMENT TO MICRO & SMALL ENTERRPRISES ................................ 85
57. REHABILITATION OF SICK MSES .................................................................................... 86
58. CREDIT RISK GUARANTEE FUND TRUST FOR LOW INCOME HOUSING
(CRGFTLIH) ........................................................................................................................ 87
59. INFRASTRUCTURE LENDING .......................................................................................... 88
60. INFRASTRUCTURE FINANCE COMPANIES (IFC) .......................................................... 89
61. INFRASTRUCTURE FINANCING – SECURED FINANCE .............................................. 90
62. NBFC - MICRO FINANCE INSTITUTION .......................................................................... 90
63. MICRO FINANCE INSTITUTIONS (MFI) ............................................................................ 91
64. NON PERFORMING ASSETS (NPA) ................................................................................. 94
65. GROSS NPA AND NET NPA .............................................................................................. 98
66. NPA RATIOS ........................................................................................................................ 99
67. FLOATING PROVISIONS AND THEIR ENDUSE .............................................................. 99
68. CORPORATE DEBT RESTRUCTURING (CDR) MECHANISM .................................... 100
69. GUIDELINES ON RESTRUCTURING OF ADVANCES ................................................. 103
70. SME DEBT RESTRUCTURING MECHANISM ............................................................... 108
71. PROJECT LOANS ........................................................................................................... 109
72. PROJECT LOANS FOR NON-INFRASTRUCTURE SECTOR ...................................... 111
73. PROJECT LOANS FOR COMMERCIAL REAL ESTATE ................................................ 113
74. CREDIT INFORMATION BUREAUS (CIB) ...................................................................... 113
75. SME RATING AGENCY OF INDIA LIMITED (SMERA) .................................................... 115
76. REVERSE MORTGAGE (RM) .......................................................................................... 117
77. RELIEF MEASURES TO BE EXTENDED BY BANKS IN AREAS AFFECTED
BY NATURAL CALAMITIES .............................................................................................. 118
78. THE SECURITISATION AND RECONSTRUCTION OF FINANCIAL ASSETS
AND ENFORCEMENT OF SECURITY INTEREST ACT, 2002 (SARFAESI) ................ 121
79. ASSET RECONSTRUCTION COMPANIES (ARC) ........................................................ 125
80. CENTRAL REGISTRY OF SECURITISATION ASSET RECONSTRUCTION AND
SECURITY INTEREST OF INDIA (CERSAI) .................................................................. 126
81. WILFUL DEFAULT ........................................................................................................... 128
82. DIVERSION AND SIPHONING OF FUNDS ................................................................... 129
83. CARBON CREDIT ........................................................................................................... 130
84. ACCOUNTING STANDARD - 22 (AS-22) ...................................................................... 131
85. INTEREST RATE SWAP (IRS) ........................................................................................ 134
86. ESCROW ARRANGEMENT ............................................................................................. 135
87. TRUST AND RETENTION ACCOUNT (TRA) ................................................................. 136
88. SUBORDINATE DEBT ..................................................................................................... 136
89. COMMITTEE ON DISPUTES .......................................................................................... 137
90. BLOOD DIAMONDS ........................................................................................................ 137

PART F – RISK MANAGEMENT

91. BASEL I AND BASEL II ................................................................................................. 140

92. HERFINDAHL HIRSHMAN INDEX (HHI) ....................................................................... 150
93. BASEL III CAPITAL REGULATIONS (B III) ..................................................................... 151
94. PRO-CYCLICALITY AND COUNTER CYCLICAL PROVISIONS ................................... 160
95. BASEL III GUIDELINES IN A NUTHSELL ..................................................................... 162
96. REGULATORY CAPITAL& ECONOMIC CAPITAL ........................................................... 164
97. HAIRCUT .......................................................................................................................... 165
98. CAPITAL SAVING OPTIONS ............................................................................................ 166
99. PROVISIONING COVERAGE RATIO (PCR) ................................................................... 169
100. RISK ADJUSTED RETURN ON CAPITAL (RAROC) &
RETURN ON RISK ADJUSTED CAPITAL (RORAC) ..................................................... 170
101. ALM SYSTEM ................................................................................................................... 171
102. ALM - LIQUIDITY RISK MANAGEMENT (LRM) .............................................................. 173
103. ALM - INTEREST RATE RISK (IRR) .............................................................................. 178
104. COUNTRY RISK MANAGEMENT (CRM) ....................................................................... 180
105. STRESS TESTING (ST) AND REVERSE STRESS TESTING ..................................... 182
106. REGULATORY LIMITS & EXPOSURE NORMS ............................................................. 184
107. FINANCIAL CONGLOMERATE (FC) ............................................................................... 186
PART G – THE FOREX MARKET

108. FOREX RESERVES (FXR) .............................................................................................. 190

109. TOBIN TAX (TT) ............................................................................................................... 194
110. PARTICIPATORY NOTES ................................................................................................. 194
111. NON DELIVERABLE FORWARDS (NDF) ...................................................................... 195
112. QUALIFIED FOREIGN INVESTOR (QFI) ........................................................................ 196
113. UNIFORM CUSTOMS AND PRACTICE FOR DOCUMENTARY CREDITS (UCP 600)197
114. STAND BY LC (SBLC) .................................................................................................... 198
115. SOVEREIGN WEALTH FUND (SWF) ............................................................................. 199
116. ALTERNATE INVESTMENT FUNDS (AIF) ...................................................................... 200

PART H – THE DEBT MARKET

117. OPEN MARKET OPERATIONS (OMO) ........................................................................... 202
118. MARKET STABILISATION SCHEME (MSS) .................................................................... 202
119. INFLATION INDEXED BONDS- 2013-14 (IIB) ............................................................... 203
120. ‘WHEN ISSUED MARKET’ .............................................................................................. 204
121. CREDIT DEFALT SWAPS (CDS) .................................................................................... 205
122. COLLATERALISED DEBT OBLIGATION (CDO) ............................................................ 206

PART I – BANKING OPERATIONS

123. NATIONAL ELECTRONIC FUNDS TRANSFER (NEFT) ............................................... 208

124. REAL TIME GROSS SETTLEMENT SYSTEM (RTGS) .................................................. 209
125. CHEQUE TRUNCATION SYSTEM (CTS) ....................................................................... 211
126. CHEQUE STANDARDISATION AND CTS 2010 ............................................................. 211
127. SB INTEREST RATE DEREGULATED .......................................................................... 212
128. UNCLAIMED DEPOSITS / INOPERATIVE ACCOUNTS ................................................ 213
129. DEPOSITOR EDUCATION AND AWARENESS FUND (DEAF) .................................... 214
130. ELECTRONIC BENEFIT TRANSFER (EBT) / DIRECT BENEFIT TRANSFER (DBT) 214
131. COMPLIANCE FUNCTION IN BANKS ........................................................................... 216

PART J – INFORMATION TECHNOLOGY

132. WORKING GROUP ON INFORMATION SECURITY, ELECTRONIC BANKING,

TECHNOLOGY RISK MANAGEMENT AND CYBER FRAUDS ..................................... 220
133. INTER BANK MOBILE PAYMENT SYSTEM (IMPS) ....................................................... 224
134. RUPAY .............................................................................................................................. 225
135. ATM-CASH RETRACTION ............................................................................................... 226
136. WHITE LABEL ATM (WLA) .............................................................................................. 227
137. INFINET ............................................................................................................................ 227
138. CLOUD COMPUTING ..................................................................................................... 228
139. DATA WAREHOUSE (DWH) ............................................................................................ 229
140. ANALYTICAL DATA WAREHOUSE (ADWH) ................................................................... 230
141. SECURITY THREATS - A GLOSSARY ........................................................................... 231

PART K – COMMITTEES
142. COMMITTEE ON FINANCIAL SECTOR REFORMS ...................................................... 235
143. COMMITTEE ON FINANCIAL SECTOR ASSESSMENT (CSFA) ................................... 236
144. TOWARDS FULLER CAPITAL ACCOUNT CONVERTIBILITY (TARAPORE II) ............ 238
145. WORKING GROUP ON BENCHMARK PRIME LENDING RATE
(CHAIRMAN: SHRI. DEEPAK MOHANTY) ...................................................................... 241
146. HIGH LEVEL COMMITTEE TO REVIEW LEAD BANK SCHEME (LBS) ...................... 243
147. A FEW IMPORTANT COMMITTEES/ WORKING GROUPS ........................................... 246

PART L – CONCEPTS

148. THE IMPOSSIBLE TRINITY ............................................................................................ 249

149. FOREIGN EXCHANGE INTERVENTION ........................................................................ 251
150. PURCHASING MANAGERS INDEX (PMI) ...................................................................... 253
151. CURRENT ACCOUNT DEFICIT (CAD) .......................................................................... 254

PART M – REFERRALS
152. RUPEE GETS DISTINCT SYMBOL ................................................................................ 256
153. SIX SIGMA ........................................................................................................................ 256
154. KEY STATISTICS ONE SHOULD KNOW ....................................................................... 257
 PART - A

SIGNIFICANT EVENTS

Banking Finance 1
 FRAME 1
THE FINANCIAL CRISIS

The global financial crisis burst on the scene in August, 2007. Things started unravelling
from then on.

 Threat of total collapse of large financial institutions

 Bail out of banks by national Govts
 Downturns in stock markets
 Prolonged unemployment
 The global recession (since the Great Depression of 1930s)
 Decline in consumer wealth in trillions of dollars
 European sovereign debt crisis

Housing Loan bubble → Liquidity crisis →Credit crisis → Economic Crisis

→ Global Crisis
 September 15, 2008 Lehman Brothers (one of the largest investment banking
firm) went bankrupt.
 Washington Mutual – taken over by JP Morgan Chase
 Bear Sterns – absorbed by JP Morgan Chase
 Northern Rock nationalized by UK Govt
 Merrill Lynch – absorbed by Bank of America
 AIG ‘saved’ with loans of $ 85 bn and ownership of 79.90% by US Treasury
and Federal Reserve System (when it collapsed under credit losses)
 Wachovia Corp – Citigroup acquired the banking operations
 Goldman Sachs Converted themselves into banks – to do business
 Morgan Stanley as deposit taking institutions
 Citigroup – US Government gave direct cash of $ 20 bn and provided back-stop
against any default in the bank’s real estate related securities that are worth
$ 306 bn.

After the stock market crash of 1929, in the financial sector reforms of US, came the Glass-
Steagall Act, 1933 which separated commercial banking from investment banking. This was
based on the premise that investment in markets was too risky for commercial banks to

2 Banking Finance
undertake. Investment Banks(I-banks) (the big five: Lehman Brothers (1850), Goldman
Sachs (1869), Merrill Lynch (1914), Bear Stearns (1923) and Morgan Stanley (1935) ruled
the day extending operations across the world. The Act was repealed by Gramm-Leach-
Bliley Act, 1999 in the US and commercial banks could do universal banking viz. can engage
in investment banking also.

[Figures in brackets above represent the year they were founded]

The story begins.

Asians saved. Their central banks invested in US dollar treasury bills. Americans were
spenders. Federal Reserve System also reduced interest rates to spur demand and boost
market sentiments. This led to huge borrowings by American households. Financiers
ventured to finance risky assets. Home loans were made by banks and non-banks to ‘sub-
prime’ category of borrowers. They were not worthy of financing. (NINJA: No Income, No
Job and No Assets). Unscrupulous mortgage lenders devised teaser rates of interest that
led to unsuspecting borrowers into a debt trap. A whole lot of unwise loans were made
when financial conditions were benevolent and everyone looked credit worthy. As Warren
Buffet said, ‘It is only when the tide goes out that you see who has been swimming naked’.

Then came financial innovation/engineering. These loans were pooled and packaged into
securities that can be sold to investors, reducing risk in the process. They were divided
into different tranches of varying risk, compensating holders of the riskier kind with higher
interest rates. Credit rating agencies rated these Mortgage Backed Securities (MBS).
Pension funds and insurance companies invested in these MBS. Collateralised debt
obligations (CDO) boomed. Derivatives allowed investors to purchase insurance against
default (Credit Default Swap - CDS) by issuers of those securities. CDS became an
instrument of speculation instead of insurance and reached an astounding $ 62 trillion.

This was called the most opaque slicing, dicing and bundling of numerous loans that were
sold to institutions/investors across the world. As Raghuram G Rajan says, ‘Essentially,
the US financial sector managed to package mortgages to low credit quality buyers and
issued highly rated securities against these packages that foreign investors were willing
to buy. They were putting lipstick on a pig. And hindsight suggests those were still pigs’.

Now poorer families became homeowners, investors made high returns, financial
intermediaries pocketed the fees and commissions. The party was on.

The crisis reached the scale because financial institutions of all types leveraged themselves
to the hilt in pursuit of higher returns.

Banking Finance 3
The I-banks raised money in the markets by way of commercial paper, bonds etc. That
is, short term funding for long term investments on mortgages. These funds were provided
by commercial banks, mutual funds and the public.

Fed had no control over I-banks. They were lightly regulated by Securities Exchange
Commission (SEC). Thus, I-banks were also highly leveraged.

Thus the vicious circle was formed. Banks lent to sub-prime borrowers, sold the loans to
I-banks/insurance companies, who borrowed from banks plus CDOs and CDS derivative
transactions undertaken by financial institutions.

Like any easing of the monetary policy will result in higher inflation, it forced the Fed to
reverse its decision and raise rates 17 times between June 2004 and June 2006 and the
rate touched a high of 5.25%. This led to massive credit defaults by the borrowers. Thus,
started the sub-prime saga.

Home Loan borrowers defaulted. Foreclosures followed. Asset prices came down. Loans
were higher than asset price. Homeowners abandoned the assets. They became toxic
assets.

FIs booked losses. Lines of credit were frozen. Trust was lost. Liquidity crisis loomed large.
There was a credit scarcity. A Credit crisis. Europe was also hit.

The financial crisis of the US was transmitted to the countries around the world. It impacted
the balance sheets of FIs that invested in MBS and their derivatives which turned toxic
following large scale defaults in US housing market. The US firms, to overcome their liquidity
crisis, pulled out their investments in stocks/bonds in other countries. The stock markets
went down. Foreign lines of credit dried up for Indian borrowers.

US demand for imports from other countries came down. All this led to an economic crisis.
There was a global slow down. A global financial crisis.

Who were the players in this game?

a. The Federal Reserve Board – Ignored the housing bubble

b. Fannie Mae and Freddie Mac – Govt. sponsored entities that bought or underwrote
80% of all US mortgages and enjoyed exemption from normal regulations
c. Financial Innovators – Introduced derivatives – CDOs, CDS
d. Regulators – Strict regulation on runaway growth of CDS, housing bubble, over-
leveraging, quality of assets was missing

4 Banking Finance
 e. Banks and mortgage lenders – Originate housing loans to downsell as MBS –
so relax norms. Teaser interest rates
f. Investment Banks – Leveraged. Borrowed money to trade on their own account
g. Rating Agencies – Did not alert the risks involved. According to the Financial Crisis
Enquiry Commission: ‘The three rating agencies were key enablers of the financial
meltdown. The mortgage related securities at the heart of the crisis could not
have been marketed and sold without their seal of approval. Investors relied on
them, often blindly’.
h. Incentive systems – To take on risks and get bonuses based on short term
performance

Wall Street and Main Street

Following the stepping-in of US Treasury/US Govt. to rescue AIG, Citi Group etc, a debate
has started on ‘too big to fail’ ‘systemically’ important entities. It is a matter of irony that
the US automakers who were in dire circumstances as the financial entities, did not get
the same support from the Govt. This has prompted people to wonder if those managing
the world’s largest economy regard Wall Street as more significant than Main Street (Main
Street stands for the real sector).

The number of banks that failed from 2008 to 2013 is 479. Year-wise details are given
hereunder:

Year Nos.
2008 26
2009 140
2010 157
2011 92
2012 51
2013 13
Total 479

Dodd Frank Act

To guard against recurrence of a similar financial tsunami in future, the Dodd-Frank Wall
Street Reform and Consumer Protection Act was enacted in July 2010.

It aims to promote the financial stability of the US by improving accountability and

transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer

Banking Finance 5
by ending bailouts, to protect consumers from abusive financial services practices, and for
other purposes.

It is interesting to note the following in the Dodd - Frank Act.

FUNERAL PLANS / LIVING WILL

Large complex financial companies should periodically submit plans for their rapid
and orderly shutdown, should the company go under. Companies will be hit with higher
capital requirements and restrictions on growth and activity, as well as divestment, if
they fail to submit acceptable plans. Plans will help regulators understand the structure
of the companies they oversee and serve as a roadmap for shutting them down if the
company fails. Significant costs for failing to produce a credible plan create incentives
for firms to rationalise structures or operations that can be unwound easily.

* * * * * * *

FRAME 2
WHY BASEL-II (B II) FAILED?

The financial crisis of 2007-2009, particularly in US, saw US government buying up impaired
assets and/or had to pump in more capital in insolvent financial institutions. This has raised
a serious issue of moral hazard. Profits have been privatised and losses have to be borne
by the tax payers. Also, shareholders of a bank had the benefit of higher than normal return
on capital by allowing the bank to take higher risk but escaped the pain of loss of their
capital in proportion to the benefit they enjoyed. This implicit sovereign guarantee of capital
might be construed as a licence to take undue risk.

Banks were at the epicentre of the recent financial crisis, despite implementation of B II.
The major deficiencies that have been identified by Basel Committee on Banking Supervision
are:

a. Leverage
The banking sector of many countries had built up excessive on and off balance
sheet leverage.

b. Level and quality of Capital

The crisis has demonstrated that credit losses and write downs came out of
retained earnings, which was part of bank’s tangible common equity base. This

6 Banking Finance
 reduced the core capital. It also revealed the inconsistency in the definition of
capital across jurisdictions and regulatory adjustments were not uniform.

c. Liquidity
Many banks were holding insufficient liquidity buffers. Also short term liability
(Commercial Paper) and long term assets (MBS) added to the woes. The banking
system could not absorb the resulting systemic trading and credit losses nor could
it cope with the reintermediation of large off-balance sheet exposures that had
built up in the shadow banking system.

d. Counterparty credit Risk

Off-balance sheet exposures were not properly regulated. The originate-to-
distribute model ended up in large banks holding complex and illiquid products
in their trading books and existing guidelines only covered default risk.

e. Securitised Products
The ‘slice and dice’ role played by securitised products like CDOs accentuated
the financial crisis. Risk capital computation for these products needed to be
strengthened. The shadow banking was largely unregulated and volumes had
increased to astronomical proportions which led to the massive crisis and failure
of a large number of banks.

f. Procyclicality
The crisis was amplified by a procyclical deleveraging process and a contraction
in credit. The market lost confidence in the solvency and liquidity of many banking
institutions. Thus, the crisis revealed that during boom period, credit growth is
more than normal and lesser provisions are made for bad debts. It is the reverse
during crisis times.

g. Disclosures
The level of B-II disclosures proved to be inadequate for comparative assessment
of the adequacy and quality of capital across banks in the same jurisdiction and
across jurisdictions.

h. Excessive credit growth

The need for counter-cyclical capital buffer during excessive credit growth has
become expedient because losses incurred in the banking sector can be
extremely large when a downturn is preceded by a period of excessive credit
growth. These losses can destabilise the banking sector and spark a vicious

Banking Finance 7
 circle, whereby problems in the financial system can contribute to a downturn
in the real economy that then feedbacks on the banking sector.

i. Systemic Risk
The interconnected nature of the banking system was not factored in B II. A need
for identification of systemically important financial institutions has arisen and so
macro prudential reforms have become necessary.
* * * * * * *

FRAME 3
SHADOW BANKING (SB)

Financial Stability Board (FSB) (an organization of financial and supervisory authorities from
major economies and international financial institutions) has identified SB as non-banks
carrying on bank-like activities such as credit intermediation, maturity transformation and
credit facilitation. It is said to include hedge funds, money market funds, pension funds,
investment banks, finance leasing and factoring companies, asset management companies
and structured investment vehicles (SIV). Since they are non-deposit taking institutions,
they were not subjected to strict surveillance as that of banks. The SB system also refers
to the unregulated activities (like CDS) by regulated institutions.

Shadow banks conducted credit intermediation without direct, explicit access to public
sources of liquidity and credit guarantees.

It is common practice for investment banks to conduct many of their transactions in ways
that don’t show up on their conventional balance sheet accounting and so are not visible
to regulators. For e.g. prior to the financial crisis, investment banks financed mortgages
through off balance sheet securitization (i.e. asset backed commercial paper) and hedged
risk through credit default swaps.

In the US, many of the SB entities were also typically bank subsidiaries or associates
and they had a close nexus with the banking system. Not regulated, they employed higher
credit risk, market risk and liquidity risk not commensurate with their capital.

Some of the regulated banks drew substantial income from SB activities. Further, these
large banks retained both credit and operational exposures to SB system both directly and
indirectly through business lines such as credit enhancement, backup liquidity line,
brokerage services, warehousing etc.

8 Banking Finance
Some experts say that regulated banking organizations are the largest shadow banks.

The estimated size of SB by 2011 was US$ 60 trillion.

Unregulated shadow institutions can be used to circumvent the strictly regulated main
stream banking system and therefore avoid rules designed to prevent financial crisis.
Shadow banks can cause a build-up of systemic risk indirectly because they are inter-
related with the traditional banking system via credit intermediation chains and problems
in the unregulated system can easily spread to the traditional banking system. Shadow
banks’ collateralised funding is also considered a risk because it can lead to high levels
of financial leverage. Leverage is considered to be a key risk feature of shadow banks.

Attempts are being made to regulate the SB system. In the US, the Dodd Frank Act was
passed in 2010. It stipulated that the Federal Reserve System would have the power to
regulate all institutions of systemic importance, for example, shadow institutions borrowed
in the short term liquid market (money market, CP) and invested in illiquid long term assets
(mortgage backed securities which were already ‘toxic assets’). When housing market
began to deteriorate, they could not raise funds for repayment of short term obligations.
Since they were highly leveraged, they had to pay off their debts by selling the long term
assets. The sell-off of assets caused further decline of those assets and further losses
and sell offs. Lehman Brothers collapsed in 2008.

The SB system also conducted enormous amount of trading on the OTC derivatives market.
The rapid growth mainly arose from credit derivatives:

 Collateralized debt obligations (CDO)

 Credit Default Swaps (CDS)
 Interest rate obligations derived from bundles of mortgage securities
 Customized innovations on CDO model, collectively known as synthetic CDOs
The market in CDS was insignificant in 2004 but it rose to $60 trillion in a few years. CDS
were not regulated. Companies selling them were not required to maintain sufficient capital
/ reserves to pay potential claims. Huge demand for settlement of CDS contracts issued
by AIG, the largest insurance company in the world, led to its financial collapse.

The SB system has been blamed for aggravating the sub-prime mortgage crisis and helping
to transform it into a global credit crisis.

* * * * * * *

Banking Finance 9
 FRAME 4
EUROPEAN DEBT CRISIS (EDC)
Five of the Europe’s countries - Greece, Portugal, Ireland, Italy and Spain (abbreviated as
PIIGS) have, to varying degrees, failed to generate enough economic growth to make their
ability to payback bondholders. They were in immediate danger of possible default.
The financial crisis of 2008-2009 slowed down the global economy and this exposed the
unsustainable fiscal policies of countries in Europe. Greece, which spent money heartily
for years and failed to undertake fiscal reforms, ran high budget deficit that exceeded the
size of the nation’s entire economy. Investors responded by demanding higher yields on
Greece’s bonds, which raised the cost of the country’s debt burden and necessitated a
series of bailouts by EU and ECB. In spring 2010, EU and IMF disbursed Euro 110 bn
to Greece. A second bailout in mid-2011 was made worth about Euro 157 bn. Lenders also
agreed for 50% haircut.
The markets also began driving up bond yields in the other heavily indebted countries in
the region, anticipating problems similar to what occurred in Greece.
Ireland and Portugal also received bailouts in Nov 2010 (Euro 85 bn) and May 2011
(Euro 80 bn) respectively.
Each of the 5 countries had its own problems but all ran an unsustainable govt debt levels.
The Euro zone member states also created the European Financial Stability Facility to
provide emergency lending to countries in financial difficulty.
The ECB announced a plan in Aug 2011 to purchase Govt bonds if necessary to keep yields
from spiralling to a level that countries such as Italy and Spain could no longer afford. In
Dec 2011, ECB made Euro 489 bn in credit available to the region’s troubled banks at ultra
low rates, then followed with a second round in Feb 2012. This programme was called Long
Term Refinancing Operation.
There were political implications also. In the affected nations, the push towards austerity
ie, cutting expenses to reduce the fiscal deficit and higher taxes led to public protests in
Greece and Spain and the removal of party in power in both Italy and Portugal. At the national
level, the crisis led to tensions between the financially sound countries such as Germany
and higher - debt countries like Greece.
The tension created the possibility that one or more European country would eventually
abandon the Euro (the region’s common currency). On one hand, leaving the euro would allow
a country to pursue its own independent monetary policy rather than subject to the common

10 Banking Finance
policy of 17 nations using the currency. But on the other, it would be an event of unprecedented
magnitude for the global economy and global markets. This concern contributed to periodic
weakness in the Euro relative to other major global currencies during the crisis period.
The Euro crisis also affected the US Govt budget. 40% of the IMF’s capital comes from
the US. So, if the IMF has to commit too much cash to bailout initiatives, US taxpayers
will eventually have to foot the bill.
How did the Euro zone get into the crisis?
1) There were no penalties for countries that violated debt-to-GDP ratio set by the
EU’s founding Maastricht criteria.
2) Euro zone countries initially benefited from the low interest rates and increased
investment capital made possible by the Euro’s power. This increased liquidity,
raised wages and prices, making their exports less competitive.
3) Because they were on the Euro, they could not have an independent monetary
policy (what most other countries do) to curb inflation by raising interest rates
or print less currency.
4) Public spending rose, tax revenues fell during the recession to pay for
unemployment and other benefits.
* * * * * * *

FRAME 5
ICELAND GOES BANKRUPT
In 2009, Iceland’s Govt collapsed as its leaders resigned due to stress created by the
country’s bankruptcy. Iceland took on $ 62 bn of bank’s foreign debt when it nationalised
the 3 largest banks. As a result of the banks’ collapse, foreign investors fled Iceland
prompting the value of the currency, Krona to drop 50% in one week.
The banks had made too many foreign investments that went bankrupt in the 2008 Financial
Crisis. Iceland’s GDP was only $14 bn.
Iceland nationalised the banks to prevent their collapse, which in turn brought about the
demise of the Govt itself.
Iceland negotiated a $10 bn bailout from IMF to insure the bank deposits. Iceland asked
its neighbours Luxembourg, Belgium and the UK to insure bank deposits of the branches
in their countries.
* * * * * * *

Banking Finance 11
 FRAME 6
SOVEREIGN RISK

Sovereign debt crisis is defined as the financial situation of a state where the Govt faces
a sudden rise in the interest rate due to the market perception that it will fail to honour
its debt.

Sovereign default is a failure by the Govt to pay back its debt in full.

Previous sovereign defaults/debt crises have been:

i) Mexico, 1994 – The peso crisis. Devalued 13%. In 3 months, the devaluation was
54%. Cause: Attributed to incorrect policies.
ii) East Asian Debt Crisis, 1997 – Started in Thailand. Thai Bhat was devalued 20%.
Though the central bank tried to defend the currency, the country went bankrupt.
The five countries which were adversely affected by the crisis were Indonesia,
Korea, Malaysia, Philippines and Thailand (East Asian Tigers). IMF stepped in
to bail out.
Cause: Believed to be creation of policies that distorted incentives within the
lender- borrower relationship.
iii) Russia, 1998 – The Russian Govt devalued the rouble. The country also defaulted
on its domestic debt and announced it will be unable to pay its foreign debts.
Within a few months, inflation had reached 84%. Banks which had invested in
public bonds incurred heavy losses and had to close down.
Reason: Political instability of the Govt to implement a coherent set of economic
reforms.
iv) Greece, 2009 – Budget deficit was revealed much higher than expected. Bailout
by EC and IMF. Lenders took 50% haircut.
Reason: Public accounting opacity of the Greek State. The spill-over effect was
on Portugal, Ireland, Spain and Italy.
Though devaluation was the only mechanism for resolution of the debt crisis in earlier days,
debt restructuring to contain sovereign defaults is of recent origin.

Sovereign risk was there in late 2009 when Dubai World declared its debt emergency,
announcing it will not pay the interest due on some of its debt. So also, when S &P
downgraded sovereign rating of USA from AAA to AA plus with negative outlook, a lot of
debate followed.

12 Banking Finance
Thus, sovereign risk is the most important factor in country risk management. Sovereign
risk analysis should include review of the economy, the banking system, political stability,
monetary policy, forex reserves etc.
According to IMF, there is a clear interconnectedness between sovereign risk and banking
sector stability.
From now on, sovereign debt has lost its risk free status and has to be subjected to greater
risk management scrutiny.

* * * * * * *

FRAME 7
THE LIBOR SCANDAL
Barclays Bank was fined $ 450 million by the British and American regulators (besides
removing CEO Mr. Bob Diamond) for its role in the rigging of the Libor (London Inter-bank
Offered Rate). UBS was fined $ 1.5 billion to settle charges of rigging of Libor which took
place over six years from 2005 to 2010 over three continents. Many other International Banks
are also under investigation by their regulators.
Libor scandal is one that involved banks either inflating or deflating Libor – the global bulk
money interest rate benchmark – to make a killing.
The Libor was manipulated for financial benefits; and/or for reputational concerns. You quote
a lower rate and thus appear to be better than what you are. In other words, it is lowballing
Libor submissions to give an appearance, they were having no difficulty borrowing money
during the 2008 market meltdown.
Nobody could imagine that Libor could be rigged by a few bankers to their own advantage
because every new banker who first came across Libor believed it to be an unassailable and
sacrosanct rate decided by Gurus of finance and his quote of rate of interest in his country
for his borrower was linked to Libor say, 100 bps above Libor, 250 bps above Libor etc. It is
USD Libor for dealings in US dollars and it is £ Libor for dealings in pound sterling etc. Libor
is being used as benchmark interest rates in estimated $300 trillion of financial products
worldwide. It was supposed to reflect the degree of trust in the financial system.
Rigging (manipulation) of Libor means trillions of dollars of financial products were priced at
wrong rates.
The investigation into Libor rates between 2005 and 2009 discovered that Barclays
employees regularly submitted quotes first too high and then too low during that period.

Banking Finance 13
They were responding to requests for assistance from colleagues playing the markets. The
Financial Services Authority’s (FSA) investigation followed whistle-blowing by the staffers
from Barclays responsible for submitting the rates. Barclays employees claimed that they
held out as long as possible when submissions from other banks were way off target –
and eventually started cooking the rates when the financial crisis grew acute. Some banks
submitted lower quotes to make it look like they were better off than they were, and they
submitted numbers to help their traders with whatever deals they were doing and more,
on a systematic basis for years.
FSA of UK had blamed Barclays Bank on breaching the principles of setting Libor during
January, 2005 and July, 2008 on the following misconducts:
a) Making submissions which formed part of Libor and Euribor setting process that
took into account requests from Barclays interest rate derivatives traders. These
traders were motivated by profit and sought to benefit Barclays’ trading positions.
b) Seeking to influence the Euribor submissions of other banks contributing to the
rate setting process.
c) Reducing its Libor submissions during the financial crisis as a result of senior
management’s concern over negative media comment.
The rigging has been discussed among the bank’s officials, in internal chat forums and
group e-mails.
The rigging of Libor to benefit a few banks has been a shock to the entire world.
Developing an alternative to Libor would be too disruptive to borrowers around the world
because the rate is so embedded in the financial system. Libor’s use stretches from US
adjustable-rate mortgage and floating rate bonds to OTC derivatives including interest rate
swaps. Initially, Libor was designed for pricing loans and advances. Over time, derivatives
based on Libor have become dominant.
The key money market rate in India is Mibor (Mumbai Inter-Bank Offered Rate) fashioned
after Libor and computed every day by the National Stock Exchange of India as a weighted
average of lending rates of a group of banks.

The benchmark rate Libor was incorporated in January, 1986 with the help of British
Bankers Association (BBA) and Bank of England. BBA site defines Libor ‘as a
benchmark giving an indication of the average rate at which a Libor contributor bank
can obtain unsecured funding in the London inter-bank market for a given period, in
a given currency’. Hence, Libor is the lowest real world cost of unsecured funding in
the London market. How is it calculated?

14 Banking Finance
 i. Every day every contributor bank is asked to submit the reply to the following
question to BBA. ‘At what rate could you borrow funds, were you to do so by
asking for and accepting inter-bank offers in a reasonable market size just prior
to 11 AM’ ?
ii. The rates received from panel banks for each currency are collected and passed
on to Thomson Reuters.
iii. Thomson Reuters then do the trimming procedure when highest and lowest 25%
of submission rates are excluded and remaining contributions are arithmetically
(usually 50% remaining mid values) averaged to create Libor rate. Typically top
highest 4 rates and lowest 4 rates are excluded and rest rates are used for
determining the Libor of the day.
iv. Foreign Exchange and Money Market Committee (Fx & MMC) verifies the quality
of data and compares it with the collected market intelligence and various
stakeholders. If found acceptable, the same is published.
The following points are to be noted:
i. Libor is an indicative average interest rate only and is not based on actual
transactions.
ii. It is based on the interest rate at which the contributor bank is interested to
lend on a particular day.
iii. Libor is announced every day at 11 AM (GMT) by Thomson Reuters on behalf
of BBA.
iv. The Selection of contributor banks are determined twice in a year by the BBA
with the assistance of FX & MMC of Britain. The selection of banks is based
on a market volume, credit rating and perceived expertise in the currency
concerned.
v. Libor is declared for the currencies viz, AUD, CAD, DKK, EURO, JPY, NZD,
GBP, SEK (Swedish Krona), CHF (Swiss Francs) and USD for 15 different
maturities (1 day i.e. overnight, 1 week, 2 weeks, 1 m, 2 m, 3 m, 4 m, 5 m,
6 m, 7 m, 8 m, 9 m, 10 m, 11 m and 12 m). So, 150 Libor rates are being
announced every business day.[ After the Wheatley Review , only 5 currencies
and 7 maturites (35 rates) are announced].
vi. For different currency, the number of contributor banks varies.
vii. All Libor rates are quoted as annualized interest rate i.e. if Libor is quoted 2%
then it means 2% divided by 365.
* * * * * * *

Banking Finance 15
 FRAME 8
WHEATLEY REVIEW OF LIBOR

The Wheatley review of Libor report was published in Sep 2012.

[Mr Martin Wheatley was then Managing Director of Financial Services Authority (FSA)
and currently Chief Executive of the Financial Conduct Authority (FCA) of UK]

The key recommendations are :

a) There is a clear case in favour of comprehensively reforming Libor, rather than

replacing the benchmark.
b) Transaction data should be explicitly used to support Libor submissions.
c) Market participants should continue to play a significant role in the production
and oversight of Libor.
Based on these three fundamental conclusions, a 10 point plan for comprehensive reform
of Libor has been enunciated :

a) Regulation of Libor
Statutory regulation of administration of, and submission to, Libor including an
Approved Persons regime, to provide the assurance of credible independent
supervision, oversight and enforcement, both civil and criminal.

b) Institutional Reform
BBA should transfer responsibility for Libor to a new administrator who will be
responsible for compiling and distributing the rate, as well as providing credible
internal governance and oversight.
c) The new administrator should fulfil specific obligations as part of its governance
and oversight of the rate, having due regard to transparency and fair and non-
discriminatory access to the benchmark.

d) Rules governing Libor

Submitting banks should immediately look to comply with the submission
guidelines presented in the report, making explicit and clear use of transaction
data to corroborate their submissions.
e) The new administrator should introduce a Code of Conduct for submitters,
systems and controls for submitting firms, transaction record-keeping
responsibilities and regular external audit.

16 Banking Finance
 f) Immediate improvements to Libor
Compilation and publication of Libor for those currencies and tenors for which there
is insufficient data to corroborate submissions may be ceased.
g) BBA should publish individual Libor submissions after 3 months to reduce potential
for submitters to attempt manipulation and to reduce any potential interpretation
of submissions as a signal of credit worthiness.
h) Banks, including those not currently submitting to Libor, should be encouraged
to participate as widely as possible in the Libor compilation process.
i) Market participants using Libor should be encouraged to consider and evaluate
their use of Libor, including the consideration of whether Libor is the most
appropriate benchmark for the transactions that they undertake, and whether
standard contracts contain adequate contingency provisions covering the event
of Libor not being produced.

j) International Coordination
The UK authorities should work closely with the European and international
community and contribute fully to the debate on the long term future of Libor and
other global benchmarks, establishing and providing clear principles for effective
global benchmarks.

International Organisation of Securities Commissions (IOSCO) has set up a Board Level

Task Force on Financial Market Benchmarks to look at other benchmarks.

Action taken on the Report

a) BBA Libor has since become a regulated activity under Financial Services and
Markets Act (FSMA) 2000. With effect from April 2, 2013, BBA Libor Limited will
be authorised and regulated by the FCA in the UK as a specified benchmark
administrator solely in respect of the Libor benchmark rates .Reuters continues
to calculate the Libor. Reuters is separately regulated by the FCA.
b) The number of Libor rates have been streamlined from 10 currencies and 15
maturities at the time of review (150 rates) to only 5 currencies and 7 maturities
(35 rates).
c) With effect from July 1, 2013, the publication of individual bank‘s submissions
to Libor will be embargoed for 3 months. Individual submissions will be published
after a period of 3 months.

Banking Finance 17
 This is to prevent manipulation of the rates and creation of incentives for
contributors to submit inappropriate rates.
d) BBA Board has voted unanimously to approve the transfer of the administration
of Libor to NYSE Euronext Rates Administration Limited, the bidder recommended
by the Hogg Committee. The transition is expected to be completed by early 2014.
* * * * * * *

FRAME 9
COMMITTEE TO STUDY BENCHMARKS IN INDIA

RBI has constituted a committee (Chairman : Shri P. Vijaya Bhaskar) to study various
issues relating to financial benchmarks in India. The terms of reference are :

 Their relevance/usage, fallback mechanisms in place in the event of benchmark

being rendered obsolete
 Governance mechanisms within the organisation computing the benchmarks,
enhancing transparency
 Need for regulators’ involvement in computation and dissemination of benchmarks
 To propose a system of supervisory oversight in respect of institutions involved
in computing /disseminating the benchmarks
* * * * * * *

FRAME 10
PONZI SCHEME

A Ponzi scheme is an illegal investment vehicle that pays off old investors with money from
new ones and is dependent on a constant stream of new investment. Because the invested
capital is not earning a sufficient return on its own, such schemes eventually collapse under
their own weight.

The Ponzi scheme usually entices new investors by offering abnormally higher returns than
other investments.

The scheme is named after Charles Ponzi who used the technique in 1920 and his operation
took in so much money that it was the first to become well known throughout the USA
and the world. It involved a swindle of $ 15 mn in 1920.

18 Banking Finance
The recent big Ponzi scheme which went bust in 2008 was that of B.L. Madoff to the tune
of $50 bn. [ Madoff’s firm was the first prominent practitioner of ‘paying for order flow’ viz.
paying a broker to execute customer’s order through Madoff].

* * * * * * *

FRAME 11
NSEL PAYMENT CRISIS
National Spot Exchange Ltd (NSEL) is engulfed in a payment crisis of Rs 5574.31 Cr after
it suspended trade on July 31, 2013 following Govt directives. It is accused of having
launched contracts that were beyond the mandate of the spot exchange. The Govt directed
the bourse to cease its controversial contracts and settle all outstanding positions. Rs
5574.31 Cr have to be repaid by 24 borrowers and clients who traded through the exchange
to around 13,000 investors which include High Networth Individuals (HNI).

In fact, NSEL has guaranteed performance of all contracts executed on the exchange
platform. For this purpose, the exchange has to maintain a Settlement Guarantee Fund
(SGF).Notwithstanding default of any member the payment has to be declared as per the
exchange schedule.

NSEL commenced operations pursuant to the gazette notification issued by the Ministry
of Consumer Affairs, GOI in 2007 allowing it to conduct trading in one day duration contracts
in commodities. Periodical returns were being sent to Forward Markets Commission (FMC).

FMC is the regulator for Commodity Exchanges including MCX, a group company of NSEL.
But the spot exchange, once it takes exemption under Sec 27 of the Forward Contract
Regulations Act from the FMC for offering intra-day netted spot contracts, FMC has little
oversight on it. In short, there is no regulator for NSEL.

But NSEL went beyond 1day contracts and it started forward contracts for 30-45 days.
Forward Contract (Regulations) Act defines a ‘ready delivery contract (spot contract) as
one that is settled immediately or within 11 days (T+10) through physical delivery of the
underlying assest.’ All contracts traded on NSEL with settlement period exceeding 11 days
are a violation of the provisions of the FC (R) Act.

Brokers encouraged investors to invest for a return of 14 to 15% pa. The return came from
the arbitrage opportunity between T+2 (buy) contracts and T+30 (sell) contracts. Actually,
the positions were being rolled over. The game was on. Investors pocketed the difference
between the buy rate and sell rate. Brokers made their commission. Borrowers got cheap

Banking Finance 19
funding. The collaterals were warehouse receipts of warehouses situated across the country.
The goods were sugar, wool, cotton etc.
The trading was suspended from July 31, 2013. Music stopped. Borrowers/NSEL owed Rs
5574.31 Cr to around 13,000 investors.
The SGF was not enough to ensure full payment. The stocks claimed to be over Rs 6000
Cr initially, turned out to be not so. There are accusations of fake warehouse receipts. Some
borrowers have disputed their liability with NSEL and instead of repaying to NSEL, they
have made claims on NSEL.
The MD and some officials of NSEL have been removed from their positions pending enquiry.
An Officer on Special Duty has taken charge of NSEL with the powers of CEO.
Under pressure for repayment, NSEL drew up a repayment schedule for the principal of
Rs 5574.31 Cr. in 30 weeks beginning Aug 20, 2013. Payouts will be on every Tuesday
i.e. Rs 174.72 Cr a week for the first 20 weeks. For the last 10 weeks, it would be
Rs 86.02 Cr every week. For the balance of Rs 1219 Cr, members would settle dues through
sale of commodities, fixed assets and other assets. 24 borrowers have the Rs 5574.31
Cr pay-in obligations. Under directions from FMC, the repayment programme was put on
NSEL website.
NSEL has appointed SGS to assess the quality and quantity of goods lying in various
warehouses. As per FMC’s directive, it has appointed a global audit firm Grant Thornton
for forensic audit to assess the exchange, members’ financial and settlement accounts,
including the delivery and collateral management system.
For the first payout, Rs 92 Cr was collected against obligation of Rs 174.02 Cr.
For the second payout, Rs 12.60 Cr was collected against obligation of Rs 174.02 Cr.
At this stage, NSEL has taken a bridge loan of Rs 177 Cr from FTIL, the promoter company.
For the third payout, Rs 15.37 Cr was collected against obligation of Rs 174.02 Cr.
The defaulters’ list has been put on the exchange’s website.
The investors have appealed to the Govt, SEBI, Police, CBI for suitable action for recovery
of their monies.
The Govt has appointed two groups to probe the NSEL crisis. One will examine if there
were violations of any laws or regulations by NSEL or associate companies. This group
is headed by Chairman of the Enforcement Directorate. The other group headed by a Deputy
Governor of RBI will suggest measures that could be taken to ensure no systemic impact
of the NSEL developments.

20 Banking Finance
Once the payment crisis was out, many independent directors of NSEL have resigned
including the Chairman (who is the Father-in law of the promoter of NK Proteins, a big
borrower from NSEL).

NSEL had also introduced e-series products in commodities for retail investors. These are
investment products that enable investors to buy and sell commodities in demat form and
to hold them in their demat accounts. It is T+2 settlement cycle. NSEL had launched e-
Gold, e- Silver, and e-Platinum.

Trading of contracts in e-series was suspended by NSEL with effect from Aug 6, 2013 till
further notice. The exchange has suggested that people holding stock can apply for
converting to physical or they can also continue to hold the stock in demat form.

The press release for NSEL on Sep 5, 2013 states that the stock positions of gold, silver
and platinum tallies with depository records as per the audit report of Sharp and Tannan
Associates.

NSEL and Multi Commodity Exchange (MCX) and MCX-SX (stock exchange) have been
promoted by Financial Technologies India Ltd (FTIL). FTIL has 99% stake in NSEL. FT is
a technology solutions provider for financial markets. MCX is the only listed Commodities
Futures Exchange in India. MCX-SX offers trading platforms for stocks, currency futures
and bonds. Mr Jignesh Shah is the promoter of FT.

* * * * * * *

FRAME 12
UNIQUE IDENTIFICATION NUMBER (UID)

The Unique Identification Authority of India (UIDAI) has been set up to issue Unique
Identification Number (UID) to all 1.2 billion Indian residents. It is headed by Shri. Nandan
Nilekani, former Infosys co-chairman. The UID number is called Aadhaar number.

The UID number does not confer citizenship or nationality. Its primary purpose is to establish
the identity of the person.

It is a lifetime number. The biometrics (includes fingerprints, face and iris recognition) contained
in the central database will have to be regularly updated. Children may have to update their
biometric information every five years while adults may have to do it every ten years.

The UID project is expected to become a catalyst to achieve financial inclusion. On line
authentication can be done even through a cell phone. And, banks can have Business

Banking Finance 21
Correspondents (BC) in villages, equipped with a mobile phone, a finger print reader and
an ATM kind of software, to enable cash transactions in the village itself. Any MGNREGA
worker can go to any BC and withdraw money. It gives millions of people the opportunity
to save, make investments and use products such as micro insurance. It helps even the
poorest to build a credit history.
The UID project is expected to save crores of rupees for the Govt by elimination of duplicate
and fake identities when subsidies are released to beneficiaries.
Authentication of identity will be done online. Such verification can take place anywhere
in India and through any device since the Aadhaar number and individual details are stored
in a central database.
The mobility it offers is unsurpassed and it gives the poor, same financial portability the
urban India has long had with ATMs and core banking services.

* * * * * * *

FRAME 13
FINANCIAL SECTOR LEGISLATIVE REFORM COMMISSION
(Chairman: Justice B N Srikrishna)

The commission was constituted in March, 2011.

The report on Financial Regulations has been released (Mar 2013).
Major reforms suggested are:
1) A draft ‘Indian Financial Code’ (IFC) for regulating financial institutions in the
country has been proposed This code is intended to replace the bulk of the
country’s existing financial laws. At present, laws and regulations often
differentiate between different ownership or corporate structure of financial firms.
There are several Acts like the SBI, LIC, NABARD Acts etc. The commission
has recommended that these entities be converted into companies to enable
ownership neutrality in regulation and supervision and to ensure a level playing
field between market participants.
2) The draft IFC spanning 450 sections is a ‘single unified and mutually consistent’
draft legislation that is meant to replace a large section of existing financial laws.
3) There will be two regulators:
a) Reserve Bank of India – Regulator of Banking and payments and monetary
policy management.

22 Banking Finance
 b) Unified Financial Regulatory Agency (UFRA) – Regulator for securities
market, insurance, pensions and commodities market (i.e. SEBI, IRDA,
PFRDA and FMC be merged into a new unified agency).
4) Both the new regulators have to do a cost-benefit analysis of any proposed
regulation and assign an external global agency to review their performance after
three years. There is far more accountability cast on them to cooperate with each
other through a MOU.
5) For long, the mandate of India’s financial regulators centered around regulation
for consumer protection and development as spelt out in their statutes. As part
of development objective, sector regulators often directed banks, insurance
companies to reach out to those without access to financial products or banking.
The new IFC breaks new ground in that it puts the onus on the Govt to subsidise
through cash or cash equivalent or tax breaks any such directed efforts aimed
at social inclusion.
6) India’s regulatory framework does not provide for compensation to buyers of
financial products who have been short-changed by those who sell such products.
The code provides for disgorgement of proceeds to compensate those investors
who have lost out because of violations by the financial service providers.
7) The code also provides greater leeway for review of regulations with a provision
for review by a new tribunal.
8) The IFC makes out a case for monetary policy committee which will vote on
monetary policies. This may clip the overwhelming powers of the RBI Governor to
set interest rates. In a bid to discourage the concentration of such powers, it has
chosen to provide leeway to the Govt to nominate members to the committee.
9) The commission has recommended that the RBI be subject to an audit by CAG
in line with the practice for other regulators.
10) Once the code becomes law, for RBI Governor, the current dilemma of inflation
versus growth may no longer be unsettling, because the elected Govt will have
clear powers to determine whether growth should get primacy with the tools and
execution left to the Central Bank.
11) Setting up of a single Unified Financial Redress Agency (FRA) which would serve
any aggrieved consumer across all sectors.
12) Establishment of a Resolution Corporation (RC) which will subsume the functions
of the existing DICGCI and will have the capability to resolve failing financial firms;

Banking Finance 23
 and a Financial Stability and Development Council which will analyse the entire
financial system and will also cooperate in proposing and implementing solutions.
13) The public debt management office, currently under the RBI, will need to become
an independent entity for getting an integrated picture of all onshore and offshore
liabilities of Govt and for better decisions.
14) The regulator should have control over the regulation and supervision of financial
cooperatives without having to rely on contractual arrangements with State Govts
(To avoid operational and governance challenges arising out of dual control by
Registrar of Cooperative Societies (ROCC) and the RBI).
15) To set up Financial Sector Appellate Tribunal which will replace the Securities
Appellate Tribunal (SAT) and will hear appeals against RBI for its regulatory
functions, the UFRA, decisions of FRA and some elements of the work of the
RC.
16) Setting up of single Financial Data Management Centre where all financial firms
will submit information filings electronically – data to be made publicly available.
17) Setting up of a ‘Council of Regulatory Agencies’ which allow it to combine the
expertise of multiple agencies involved in regulation, consumer protection and
resolution. The Board of the Council will include the Finance Minister as the
Chairperson.
The aspiration of the Commission is to draft a body of law that will stand the
test of time.
* * * * * * *

FRAME 14
NEW BANKING LICENCE GUIDELINES

The Reserve Bank of India is considering issuing fresh licences to private sector players.
It has issued final guidelines for starting new banks. The salient features are:

Attribute RBI Final Guidelines (2013)

Minimum capital INR 500 Cr

Capital adequacy ratio 13%

Branch expansion pattern 25% to be in tier 5 & 6 centres (unbanked rural centres
with population up to 9,999 as per the latest census)

24 Banking Finance
 Eligible promoters Corporate Groups, Financial Institutions and Public Sector
entities. Promoters need to be financially sound with a
track record of 10 years. Positive feedback from other
regulators and investigative agencies crucial.

Corporate Structure Promoters to set up through Wholly Owned Non-Operative

Financial Holding Company (NOFHC).

Promoter’s control Promoters to maintain 40% share in the bank for 5 years;
must be cut to 20% in 10 years, 15% in 12 years.

Foreign Shareholding Non resident shareholding 49% for five years.

Voting right An individual belonging to the promoter group along with

his relatives can hold up to 10% of the total voting equity
shares of the holding company.

Ring-fenced structure Neither the holding company nor the bank is allowed to lend
or invest in any entity belonging to the promoter group.

Board Composition At least 50% of the directors of the holding company must
be independent. The bank’s board must have a majority
of independent directors.

Listing Requirements New Banks must get listed within three years.

New Business Holding company is not permitted to set up any new

financial services entity for at least three years.

Priority Sector targets New Banks have to meet priority sector targets and build
priority sector lending portfolio after commencing
operations.

 Applications to be submitted by July 01, 2013

 RBI to issue in-principle approval after considering recommendations from a high
level advisory committee
 The in-principle approval will be valid for 18 months.

Further developments :
 26 applications have been received.
 The external advisory committee will be headed by Dr Bimal Jalan. The other
members of the committee are: Shri C.B. Bhave, former SEBI Chairman,

Banking Finance 25
 Smt. Usha Thorat, former Deputy Governor, RBI and Shri Nachiket Mor, Director
on RBI Board.
 The exercise is expected to be completed by Jan 2014.
* * * * * * *

FRAME 15
RIGHT TO INFORMATION ACT 2005 (RTI)

The Freedom of Information Act 2002 was revamped and a new Act called Right to
Information Act 2005 was enacted.

A few important dimensions of the Act are given below:

Main objectives:

a) Free flow of information under control of public authorities, to the citizens on a

statutory basis
b) Promotion of transparency and accountability in the working of every public
authority
c) Constitution of Central Information and State Information Commissions to deal with
matters relating to the above
‘Information’ has been defined as:

Sec 2 (f) : ‘Information’ means any material in any form, including records, documents,
memos, e-mails, opinions, advices, press releases, circulars, orders, logbooks, contracts,
reports, papers, samples, models, data material held in any electronic form and information
relating to any private body which can be accessed by a public authority under any law
for the time being in force.

Sec 2 (h): Public authority means any authority or body or constitution or institution of
self-Govt established or constituted

a) By or under the Constitution

b) By any other law made by the Parliament
c) By any other law made by State Legislature
d) By notification issued or order made by the appropriate Govt and includes any
i) Body owned, controlled or substantially financed,
ii) Non-Govt organisation substantially financed,

26 Banking Finance
directly or indirectly by funds provided by the appropriate Govt.

Public Sector Banks come under provisions of the RTI Act.

Any citizen of India shall have a right to any information as provided under the Act unless
prohibited/exempted therefrom.

Every public authority shall appoint Public Information Officers (PIO) in all administrative
units/offices to provide information to person requesting the same.

Procedure in dealing with request for obtaining information:

A person who desires to obtain information shall make the request in writing to the PIO
of the public authority. He shall not be required to divulge his personal details or reasons
for such information, but is required to provide the contact address. The PIO shall either
on payment of prescribed fee provide the information within a period of 30 days or if the
same is exempted under Sec 8 or 9 reject the same. Further if the information relates to
life or liberty of a person it shall be provided within 48 hours. If there be delay beyond the
prescribed time limit, the applicant is entitled for the information free of charge. Provided
if the information relates to a third party or supplied by him and has been treated as
confidential by him the PIO shall within 5 days give a written notice to such third party,
that he intends to disclose such information. Any objection by the third party shall be taken
into consideration while taking a decision as regards the disclosure.

Details to be contained in rejection of request for information:

Where a request is rejected, the PIO shall communicate the following to the applicant:

a. Reasons for rejection

b. Period within which appeal against rejection may be preferred
c. Particulars of Appellate Authority

Exemptions from disclosure:

a. Matters which affect sovereignty and integrity of India, or which affect security,
scientific, economic interests, relation with Foreign States or lead to incitement
of offence
b. Information prohibited from disclosure by any Court/Tribunal
c. Information causing breach of privilege of Parliament or Legislature
d. Commercial confidence, trade secrets, intellectual property unless larger public
interest warrants

Banking Finance 27
 e. Information which would endanger the life or personal safety of any person
f. Impending investigation on prosecution of offenders
g. Cabinet papers
h. Pure personal information which has no personal relation to public activity
i. Infringement of copyrights
j. Information received in confidence from foreign Govt
All complaints as to non-appointment of PIO, rejection of request for information, disclosure
of third party information under Sec 11 shall lie to Information Commission appointed by Central/
State Govt, where decisions/directions shall be binding, where appeal is against refusal to provide
information, the onus of proving that non-providing of information was justified is on the PIO.

Penalties

If the Information Commission is satisfied, that the PIO has without sufficient cause refused
to receive an application or provide information requested or not furnished information within
prescribed time limit, or gives incomplete/incorrect/misleading information or destroyed/
obstructed providing such information, the Commission shall impose a penalty of Rs 250/
for each day till the application is received or information is provided, the total penalty shall
not, however, exceed Rs 25,000/. Further, if the PIO is found to persistently act as above,
the Commission shall recommend disciplinary action against the PIO under the service
rules applicable to him.

This Act overrides all laws for the time being in force including Official Secrets Act 1923.

No suit or other legal proceedings shall lie against any person for anything done under
this Act or rules thereunder. No orders made under this Act shall be called into question
in any court of law.

* * * * * * *

FRAME 16
COMPANIES BILL 2013

The Companies Bill 2013 to replace the Companies Act 1956 has been passed by
Parliament. Rules are being framed and after notification by the Govt, it will become an
Act. It provides for better Corporate Governance, Investor protection, Corporate Social
Responsibility, Measures to check frauds, Transparency and closer oversight by Govt.

28 Banking Finance
Important provisions of the bill are:

a. The financial year of a company will be the period ending on Mar 31 every year.
b. The National Advisory Committee on Accounting Standards will be replaced by
the National Financial Reporting Authority.
c. The bill defines the term ‘financial statement’ to include:
i) Balance sheet at the end of the financial year
ii) Profit and loss for the financial year
iii) Cash flow statement for the financial year
iv) Statement of change in equity, if any
v) Any explanatory note forming part of the above statements
d. It redefines the terms ‘subsidiary’ ‘control’ and ‘associate company’.
e. A company can issue fully paid up bonus shares to its members out of free
reserves, securities premium and capital redemption reserve.
f. It has introduced the concept of valuation by a registered valuer.
g. Statutory status will be conferred on Serious Fraud Investigation Office (SFIO).
h. The prescribed class of companies to have at least one woman director on the
board.
i. Every listed company will have at least one third of total number of directors as
independent directors.
j. Rotation of auditors concept has been introduced. The auditor, who has completed
his term will not be eligible for reappointment in the same company for five years
from completion of his term.
k. A limit of 20 has been imposed on the number of firms which an auditor/firm can
undertake audit.
l. Merger process to be simplified.
m. Company law board (CLB) will be replaced by National Company Law Tribunal
(NCLT) and an Appellate Tribunal to deliver speedier justice and to reduce the
burden of company law cases in the High Courts.
n. It mandates that every company having a net worth of Rs 500 Cr or more or a
turnover of Rs 1000 Cr or more, or a net profit of Rs 5 Cr or more, during any
financial year, must spend at least 2% of the average net profit of the company
made during three previous financial years on CSR activities.

Banking Finance 29
 o. Provisions made to facilitate class action suits by the members against a
company/management/auditors.
p. Maximum number of members in a private limited company increased to 200.
q. Even one person can form a company.
r. Recognises maintaining books of accounts, statutory records in electronic form.
* * * * * * *

FRAME 17
CORPORATE SOCIAL RESPONSIBILITY (CSR), SUSTAINABLE
DEVELOPMENT (SD) AND NON-FINANCIAL REPORTING (NFR)
(Extract from RBI circular dated Dec 20, 2007)

CSR entails the integration of social and environmental concerns by companies in their
business operations as also in their interactions with their stakeholders on a voluntary basis.
SD refers to the process of maintenance of the quality of environmental and social systems
(E&S) in the pursuit of economic development.
NFR is a system of reporting by organisations on their activities in the context of CSR
and SD, especially as regards the triple bottom-line ie, the environmental, social and
economic accounting.
CSR is a process by which a corporation is able to reach out to its people. It is a vital
connect without which, over time, business will cease to have relevance.
A company’s financial health depends on much more than the financial statements.
Company’s reputation influences its financial health. It helps protect value. NFR is an
opportunity to communicate in an open and transparent way with stakeholders, an overview
of their environmental and social impact during the previous year.
Industrial and commercial sectors have the potential to influence social and environmental
welfare quality. Sustainable finance is financing that places importance on E&S
consequences of projects and financial products rather than just the economic impact.
International Scenario
a. UN Environment Programme Financial Initiative (UNEP FI)
160 signatory institutions from over 44 countries are in a constructive dialogue
about the nexus between economic development, environmental protection and
sustainable development.

30 Banking Finance
 b. Global Reporting Initiative (GRI)
The defacto international standard for NFR
c. Equator Principles
The principles have become the defacto standard for all banks and investors on
how to deal with potential E & S effects of projects to be financed (applicable
to projects over $ 10 mn)
d. Collevecchio Declaration on Financial Institutions
This declaration calls on FIs to embrace six main principles which reflect civil
society’s expectations of the role and responsibilities of the financial services
sector in fostering sustainability.
e. Stern Review
The Stern Review on the economics of climate change is a report on the effect
of climate change and global warming on the world economy compiled by Sir
Nicholas Stern (Head of UK Govt Economic Service and former Chief Economist
of the World Bank) for Govt of UK. Its main conclusions are that 1% of global
GDP is required to be invested in order to mitigate the effects of climate change
and that failure to do so could risk a recession worth up to 20% of global GDP.
Stern’s report suggests that climate change threatens to be the greatest and
widest ranging market failure ever seen, and it provides prescriptions including
environmental taxes to minimise the economic and social disruptions.
Indian Scenario
 India acceded to the Kyoto protocol in 2002. India can emerge as one of the largest
beneficiaries accounting for 31% of the world’s total carbon trade ($ 5 bn - $ 10
bn in value) over a period of time.
 E&S concerns have today become major considerations for determining the
viability of a project.
 Responsible banking is the new approach born out of the new market realities.
 Internal efforts to make day to day operations cleaner, more efficient and supportive
of social structures can help integrating E&S issues into strategic operations.
 Banks need to integrate the concepts of CSR & SD with their business strategy.
This can be done through:
i) Commitment to Sustainability
Banks must expand their missions from ones that prioritise profit maximisation
to a vision of social and environmental sustainability.

Banking Finance 31
 ii) Commitment to ‘Do No Harm’
Banks should commit to do no harm by preventing and minimising the
environmentally and/or socially detrimental impacts of their portfolios and their
operations.

iii) Commitment to Responsibility

Banks should bear full responsibility for the E & S impacts of their transactions.

iv) Commitment to Accountability

Banks must be accountable to their stakeholders, particularly those who are
affected by the activities and side-effects of companies they finance.

v) Commitment to Transparency
Banks must be transparent to stakeholders, not only through robust, regular and
standardised disclosure but also being responsive to stakeholder needs for
specialised information on bank’s policies, procedures and transactions.
[ The above 5 along with commitment to sustainable markets and governance
form 6 main principles of Collevecchio declaration on FIs. ]
* * * * * * *

FRAME 18
CORPORATE GOVERNANCE (CG)

Corporate Governance took center stage in early 2000 after the fall of venerable 233 year
old Barings Bank, masterminded single-handedly by Nick Leeson. He traded in derivatives,
hid the losses. Board was not aware of the risk. Audit failed to pin-point.

Bernard Ebbers, a former milkman and barbouncer borrower who helped found Worldcom
was convicted in 2005 of ordering subordinates to cook the books from 2000 to 2002 by
hiding debt and inflating revenue. He was sentenced to 25 years in prison.

Enron Corporation, Worldcom shut up due to accounting fraud.

We have the Harshad Mehta scam of 1992.

UTI had to be bailed out by the Govt.

All the above had CG issues. Investors lose. Tax payers are punished.

On the other-side, we have Infosys Technologies Limited which has created wealth and
distributed it among employees, shareholders and other stakeholders.

32 Banking Finance
CG is Ethics,Values. The tone of good CG should be set at the Top. Directors of the Board,
Senior Management personnel should pass the ‘fit and proper’ criteria. The Board has to
take an active role and its oversight should be effective.
Public investment is to be treated as capital. There should be control over and accountability
for safety and performance of assets entrusted to the operating team. They are not to be
siphoned off.
CG is

 Compliance with Regulations – Accountability

 Checks and balances
- Internal control system
- Internal and External Auditors
 Risk management
 Transparency – information
 Disclosure
 Integrity of Accounting practices
 No insider trading
 Protection of shareholders’ rights
 Enhancing shareholders’ values
 International best practices
CG has to be with power and accountability. The essence of CG is:

Who exercises power, on behalf of whom, and how the exercise of power is controlled.

OECD Definition of CG:

A set of relationships between a company’s management, its Board, its shareholders and
other stakeholders; CG also provides the structure through which the objectives of the
company are set and the means of attaining those objectives and monitoring performance
are determined.
Good CG should provide proper incentives for the Board and Management to pursue
objectives that are in the interest of the company and shareholders and should facilitate
effective monitoring, thereby encouraging firms to use resources most efficiently.
J. Wolfensohn, former President, World Bank says CG is about promoting Corporate
Fairness, Transparency and Accountability.

Banking Finance 33
CG Initiatives
 Adrian Cadbury Committee 1992
 OECD guidelines 1999, 2004
 CII Code - Rahul Bajaj - 1998
 Basel Committee on Banking supervision 1999
 Kumaramangalam Birla Committee 1999 (SEBI)
 Naresh Chandra Committee 2002 (DCA)
 Narayanamurthy Committee 2003 (SEBI)
 J.J. Irani Committee 2005 (MCA)
 Dr. A.S.Ganguly Committee Consultative Group of Directors of Banks & FIs - 2001
(RBI)
 Dr. R.H Patil – Advisory Group on CG 2001 (RBI)
Enforcing Agents of CG
 Companies Act
 Stock Exchange - Listing Agreement
 Regulations - SEBI, RBI, IRDA
 Auditors
 Creditors - Banks and FIs
 Shareholders
 Competition
 Takeovers
 Industry Associations
 Media
 FII e.g. Calpers, world’s largest shareholder activist fund
 Joint Ventures
 Raising GDR/ADR - Listing abroad
 Right to Information Act 2005 (for public sector entities)
Sarbans Oxley Act, 2002
 Introduced after the collapse of Enron and Worldcom.
 Section 404 of the Act requires Companies listed in the US to document the
effectiveness of their internal controls. The market will reckon any ‘material
weakness’ revealed in the internal controls.

34 Banking Finance
  CEO/CFOs are required to certify the correctness of financial statements. Severe
penalties have been prescribed for corporate (accounting) wrong-doers.

Clause 49 of the Listing Agreement to Stock Exchange: (Some important provisions)

a. The Board shall have at least one third of the Board as Independent Directors
where the Chairman is non-executive Chairman. In the case of Executive
Chairman, at least half of the Board should comprise of Independent Directors.
b. The Board will lay down a code of conduct for all Board members and Senior
Management of the company to compulsorily follow.
c. A qualified and independent Audit Committee shall be set up.
d. The CEO & CFO will certify the financial statements and cash flow statements
of the company. They will have to own responsibility for establishing and
maintaining internal controls.
e. Whistle Blower policy - Internal policy on access to Audit Committee.
f. A report on CG in the annual reports of the company with a detailed compliance
report.
g. The Board must meet at least 4 times a year with a maximum gap of 4 months
between meetings.
Regarding CG in Banks, the concept of ‘Fit and Proper’ criteria for Directors of banks has
been enunciated by RBI and it includes the process of collecting information, exercising
due diligence and constitution of a Nomination Committee of the Board to scrutinize the
declarations made by the bank Directors.

CG Rating

ICRA has introduced CG Rating (CGR) in 2002:

Rating Scale

CGR - 1 : Highest level

CGR - 2 : High Level
CGR - 3 : Adequate Level
CGR - 4 : Moderate Level
CGR - 5 : Inadequate Level
CGR - 6 : Poor

Banking Finance 35
The emphasis of ICRA rating is on ‘corporate business practices – the quality of disclosure
that addresses the requirements of the regulators and if they are fair and transparent for
its financial stakeholders’.

Studies indicate companies which have good CG practices are favoured by investors. Better
disclosure norms and better governance help in the valuation of companies.

Good CG is simply Good Business.

* * * * * * *

FRAME 19
NIFTY TUMBLES DUE TO DEALER’S ERROR

A dealer at brokerage house Emkay Global Financial Services punched a wrong order on
behalf of an institutional client. The dealer was supposed to sell shares worth RS 17 lacs;
instead he sold a basket of 17 lacs shares in number belonging to the Nifty, causing the
Nifty to tumble 900 points (17%) on Oct 5,2012, in 2 minutes, resulting in the index hitting
the lower circuit filter.

Emkay Global suffered a loss Rs 51 Cr in these trades. The firm requested NSE for
annulment of the trade terming it as one-off error. NSE had rejected the request. Emkay
has appealed to the Securities Appellate Tribunal to reverse the decision.

* * * * * * *

FRAME 20
ALL WOMAN BANK

RBI has given In-Principle approval to set up the country’s first All - Woman bank. It will
be the first ever commercial bank to be floated by the Central Govt. It is expected to start
operations by Nov 2013. The Head Office of the bank is likely to be at New Delhi. The
Govt will give Rs 1000 Cr as paid-up capital for the bank. It will lend mostly to women and
women-run business. It will be staffed mostly by women.

One of the key objectives of the bank is to focus on the banking needs of women and
promote economic empowerment.

* * * * * * *

36 Banking Finance
 PART - B

CUSTOMER SERVICE

Banking Finance 37
 FRAME 21
THE BANKING CODES AND STANDARDS BOARD OF INDIA (BCSBI)

Following the recommendations of the Committee on Procedures and Performance Audit

of Public Services (Tarapore Commitee) for setting up of an institution for measuring the
performance of banks against a benchmark reflecting the best practices (Codes and
Standards) so that the best quality of banking services can be extended to individual
customers, BCSBI was set up, on the lines of BCSB functioning in UK.

The BCSBI was registered as a society in 2006. It would function as an independent and
autonomous body. It is an independent banking industry watchdog to ensure that the
consumer of banking services get what they are promised by the banks. The Ombudsman
deals with individual complaints and not with systemic problems. The RBI too is not in a
position to carry out this function as it is preoccupied with regulatory and supervisory functions.

The BCSBI has evolved the following:

i) Code of Bank’s Commitment to Customers

ii) Code of Bank’s Commitment to Micro and Small Enterprises
BCSBI provides credit counselling to borrowers of member banks in the retail segment i.e.
personal loans/vehicle loans/home loans/credit card and MSE sector whose credit exposure
does not exceed Rs 50 lacs.

* * * * * * *

FRAME 22
CODE OF BANK’S COMMITMENT TO CUSTOMERS (CODE)(AUG 2009)

It is a voluntary code of commitment by members of Banking Codes and Standards Board

of India (BCSBI) to individual customers. The code has been evolved by BCSBI to which
member banks have committed to in writing. It sets minimum standards of banking practices
for banks to follow when they are dealing with individual customers.

The objectives of the code are to:

a. Promote good and fair banking practices by setting minimum standards in dealing
with customers.
b. Increase transparency so that customers can have better understanding of what
can be expected of banking services.

38 Banking Finance
 c. Encourage market forces, through competition, to achieve greater operating
standards.
d. Promote a fair and cordial relationship between the bank and customer.
e. Foster confidence in the banking system.
The standards of the code are covered by key commitments in deposit accounts, payment
services, Govt transactions, demat accounts, currency, collection of cheques, locker facility,
loans, guarantees, foreign exchange services, insurance, card products (ATM card, credit
card, smart card), fairness in dealings, information sharing, confidentiality, ‘Do Not Call’
service, information on interest rates, tariff schedule, collection of dues, repossession,
complaints, grievance redressal, claims settlement, phone/mobile banking, internet banking
etc.

A copy of the code is to be given to each customer, on request.

The code will be reviewed within a period of 3 years.

* * * * * * *

FRAME 23
KNOW YOUR CUSTOMER (KYC) NORMS / ANTI MONEY
LAUNDERING (AML) STANDARDS / COMBATING FINANCING OF
TERRORISM (CFT) MEASURES / OBLIGATION OF BANKS UNDER
PMLA, 2002

Care:

RBI guidelines on the captioned subject are detailed and available on RBI website.
Instead of reproducing the RBI circular, only important aspects are brought out in this
frame. For full details, RBI Master Circular may be referred to.

The RBI guidelines have been issued under Sec 35 A of the Banking Regulations Act, 1949
and Rule 7 of PML Rules 2005.Any contravention or non-compliance shall attract penalties
under Banking Regulations Act.

They have been issued to prevent the banks from being used, intentionally or unintentionally,
by criminal elements from money laundering or terrorist financing activities.

Banking Finance 39
KYC Norms

The key elements are:

a. Customer Acceptance Policy (CAP)

b. Customer Identification Procedures (CIP)
c. Monitoring of Transactions
d. Risk Management

Customer Acceptance Policy

a. No account is to be opened in anonymous or fictitious/benami name

b. Customers to be classified according to risk perception based on
i. nature of business activity
ii. location of customer and his clients
iii. mode of payments
iv. volume of turnover
v. social and financial status
as * Low Risk
* Medium Risk
* High Risk
c. Politically Exposed Persons (PEP) may be categorized as Very High Risk.
d. No account to be opened whose name matches with known criminals/criminal
background or found in the list circulated by RBI/ UN Security Council (UNSC) etc.
e. A customer profile for each customer is to be prepared based on risk
categorization. It should contain information relating to customer’s identity, social/
financial status, nature of business activity, information about his clients’ business
and their location etc. The nature and extent of due diligence should depend on
the risk perceived.

Low Risk category

 Individuals (other than High Networth Individuals) and entities whose identity and
sources of wealth can easily be identified.
 Transactions, in whose account, conform to information given in their profiles. Eg.
Salaried employees, low income group people, Govt Departments, Regulators,
Govt owned companies etc.

40 Banking Finance
Medium / High Risk Category

 Customers that are likely to pose a higher than average risk to the bank.
 Here branches should apply enhanced due diligence measures based on risk
assessment.
The following are to be categorized as High Risk:

 Accounts of bullion dealers and jewellers

 Accounts of real estate business

Customer Identification Procedure (CIP)

CIP means identifying the customer by verifying his/her identity by using reliable source
documents/data/information. The documents to be obtained from the customers for identity
purposes are given in the next frame.
Proof of address must also be taken.
Photograph and introduction from an existing customer having an account for at least 6
months with satisfactory operations or a well known person is to be taken.
In order that a customer should have only one identity within a bank and in the financial
system, a Unique Customer Identification Code (UCIC) should be allocated to identify new
customers and the process should be completed for existing customers by Mar 2014.
Walk-in Customers: For non-account holder, branch should verify the customer’s identity
and address when the amount of the transaction is Rs 50,000/and above.
The ultimate responsibility for knowing the customer lies with the bank.
There are detailed guidelines for customer identification regarding customers of medium
and high risk category, salaried employees, trust accounts, company accounts, client
accounts opened by professional intermediaries, accounts of PEPs resident outside India,
Non Face-to-Face customers, proprietary concerns, Correspondent Banks etc.
For ensuring Financial Inclusion, ‘Small Accounts’ have been introduced.
Strict adherence to KYC norms is required to minimize the risk of operations of ‘money
mule’ accounts.
[Small Account, Money Mules, CFT, CTR, CCR, STR, Obligations under PMLA, 2002 are
covered in separate frames].
A senior level officer is to be designated as the principal Officer for KYC/AML/CFT matters
who shall be responsible for implementation and compliance.

Banking Finance 41
Latest Developments

Full KYC exercise should be done at least:

i) Every 2 years for high risk

ii) Every 8 years for medium risk individuals and entities
iii) Every 10 years for low risk
iv) Positive confirmation (obtaining KYC related updates through e-mail/letter/phone/
visits) should be completed at least every 2 years for medium risk and at least
every 3 years for low risk individuals and entities.
v) Fresh photos should be obtained from minor customers on their becoming major.
* * * * * * *

FRAME 24
CUSTOMER IDENTIFICATION PROCEDURE

The following is an indicative list of features to be verified and documents that may be
obtained from the customers:

Features Documents

Accounts of Individuals 1) Passport 2) PAN card 3)Voter’s Identity card

* Legal name and any other 4) Driving License 5) Job card issued by MGNREGA
name used duly signed by an officer of the State Govt 6) Letter
issued by UIDAI 7) Identity card 8) Letter from a
recognised Public Authority or public servant verifying
the identity and residence to the satisfaction of bank

* Correct Permanent 1) Telephone Bill 2) Bank account statement 3) Letter

Address from any recognized public authority 4) Electricity bill
5) Ration card 6) Letter from employer (any one
document which provides customer information to the
satisfaction of the bank will suffice)

Accounts of Companies 1) Certificate of incorporation and Memorandum and

* Name of the Company Articles of Association 2) Resolution of the Board to
* Principal place of business open an account and identification of those who have
* Mailing address of the authority to operate the account 3) POA granted to

42 Banking Finance
 Company Managers/officers/ employees to transact business on
* Telephone/Fax number its behalf 4) Copy of PAN Allotment letter 5) Copy of
Telephone bill

Accounts of Partnership 1) Registration certificate, if registered 2) Partnership

Firms deed 3) POA granted to a partner/employee to
* Legal name transact business on its behalf 4) Any officially valid
* Address document, identifying the partners and the persons
* Names of all partners holding the POA and their addresses (5) Telephone
and their addresses bill in the name of firm/partners
* Tel. Nos. of firm & partners

Accounts of Trusts & 1) Certificate of registration, if registered 2) POA to

Foundations transact business on its behalf 3) Any officially valid
* Names of trustees, document for identification 4)Resolution of the
settlors, beneficiaries & Managing Body of the Foundation /Association
signatories 5) Telephone Bill
* Names and addresses of
the founder, managers/
directors and beneficiaries
* Tel. No.
Accounts of 1)Registration certificate(if registered) 2) Certificate/
Proprietorship licence 3)Sales/ IT returns 4) CST/VAT certificate
* Proof of name, address 5)Certificate/ registration Document issued by Sales
and activity of the concern tax /Service tax/Professional Tax Authorities
6) Licence issued by the concerned registering
Authority.
Any two of the above documents would suffice.

* * * * * * *

Banking Finance 43
 FRAME 25
SMALL ACCOUNT

As per notification of GOI on Prevention of Money Laundering Rules, a ‘small Account’

means a savings account in a banking company where

i) Aggregate of all credits in a financial year does not exceed Rs 1 lac

ii) Aggregate of all withdrawals and transfers in a month does not exceed Rs 10,000/
iii) Balance at any point of time does not exceed Rs 50,000/
An individual who opens a small account can do so on production of a self-attested photo
and affixation of signature or thumb print on the account opening form provided that

i) The bank officer certifies that the signature/thumb print was made in his presence
ii) No foreign remittances are credited to the small account
iii) Shall be initially operational for 12 months and thereafter for a further period of
12 months if the account holder provides evidence of having applied for any of
the officially valid documents and the relaxed provisions to be reviewed after 24
months
iv) Account is monitored and when there is suspicion of money laundering or financing
of terrorism or high risk scenarios, the identity of clients shall be established
through the production of officially valid documents
PML Rules have been amended to include job card issued by MGNREGA duly signed by
an officer of the State Govt or the letters issued by UIDAI containing details of name, address
and Aadhaar number as ‘officially valid document’. An account opened with any of the above
two documents for KYC norms, also shall abide by conditions i to iv prescribed for small
account as above.

* * * * * * *

FRAME 26
FINANCIAL ACTION TASK FORCE (FATF)

FATF is an inter-governmental policy making body, comprised of over 30 countries, that

has a ministerial mandate to establish international standards for combating money
laundering and terrorist financing.

44 Banking Finance
Over 180 jurisdictions have joined the FATF or FATF-style regional body and committed
at the ministerial level to implementing the FATF standards and having their Anti-Money
laundering (AML)/Counter -Terrorist Financing (CFT) systems assessed.

These standards help securing a more transparent and stable financial system.

* * * * * * *

FRAME 27
FIU-IND

Financial Intelligence Unit-India (FIU-Ind) was set up by GOI in Nov 2004 as the national
agency responsible for receiving, processing, analysing and disseminating information
relating to suspect financial transactions.

It is also responsible for coordinating and strengthening efforts of national and international
intelligence, investigation and enforcement agencies in pursuing the global efforts against
money laundering and related crimes.

In terms of PMLA Rules, banks are required to report information relating to cash and
suspicious transactions and all transactions involving receipts by non-profit organisations
of more than Rs 10 lacs to FIU.

* * * * * * *

FRAME 28
CTR, CCR, STR, OBLIGATIONS OF BANKS UNDER PMLA

Cash Transaction Report (CTR)

The Prevention of Money Laundering Act 2002 (PMLA) and Rules there-under require banks/
FIs to furnish FIU-Ind information relating to:

 All cash transactions of more than Rs 10 lacs or its equivalent in foreign currency
 All series of cash transactions integrally connected to each other which have been
valued below Rs10 lacs or its equivalent in foreign currency where such series
of transactions have taken place within a month and the aggregate value of
transactions exceeds Rs 1 lac.
The CTR should be reported to FIU-Ind every month by 15th day of the succeeding month.

Banking Finance 45
Counterfeit Currency Report (CCR)
All cash transactions, where forged or counterfeit Indian currency notes have been used
as genuine or where any forgery of a valuable security or a document has taken place
facilitating the transaction should be reported by the Principal Officer to FIU-Ind not later
than 7 working days from the date of occurrence of such transactions.

Suspicious Transaction Report (STR)

Suspicious transaction means a transaction whether or not made in cash which, to a person
acting in good faith –
 Gives rise to a reasonable ground of suspicion that it may involve the proceeds
of crime
 Appears to be made in circumstances of unusual or unjustified complexity
 Appears to have no economic rationale or bonafide purpose
 Gives rise to a reasonable ground of suspicion that it may involve financing of
the activities relating to terrorism
When a bank believes that it would no longer be satisfied that it knows the true identity
of the account holder, the bank should also file STR.
STR is to be submitted to FIU-Ind within 7 working days on being satisfied that the
transaction is suspicious.

Obligations of Banks under PMLA 2002

The obligations are:
a. Maintenance of records of prescribed transactions
b. Furnishing information of prescribed transactions to the specified authority
c. Verifying and maintaining records of the identity of its clients
d. Preserving records of i) ii) iii) above for a period of 10 years
Records should be maintained for at least 10 years from the date of transaction, both
domestic and international, which will permit reconstruction of individual transactions so
as to provide, if necessary, evidence for prosecution of persons involved in criminal activity.
Records pertaining to the identification of the customer and his address are to be preserved
for at least 10 years, after the business relationship is ended.
The maintenance of records pertains to transactions that get covered by CTR, CCR and
STR.
* * * * * * *

46 Banking Finance
 FRAME 29
MONEY LAUNDERING

Sec 3 of PMLA has defined the offence of money laundering as under:

‘Whosoever directly or indirectly attempts to indulge or knowingly assists or knowingly is

a party or is actually involved in any process or activity connected with the proceeds of
crime and in projecting it as untainted property shall be guilty of offence of money
laundering’.

Money launderers use the banking system for cleaning ‘dirty money’ obtained from criminal
activities with the objective of hiding/disguising its source. The process of money laundering
involves creating a web of financial transactions so as to hide the origin and true nature
of these funds.

* * * * * * *

FRAME 30
COMBATING FINANCIAL TERRORISM (CFT)

In terms of PMLA Rules, suspicious transactions should include inter-alia transactions,

which give rise to a reasonable ground of suspicion that these may involve financing of the
activities relating to terrorism.

As and when list of individuals and entities, approved by Security Council/Committee

established pursuant to various UN Security Council Resolutions (UNSCR), are received
from GOI, RBI, in turn, circulates the same to all Banks/FIs.

Branches are advised that before opening any new account, it should be ensured that the
name(s) of the proposed customer does not appear in the list. Further, banks should scan
all existing accounts to ensure that no account is held by or linked to any of the individuals
or entities included in the list.

* * * * * * *

Banking Finance 47
 FRAME 31
MONEY MULES

‘Money Mules’ can be used to launder the proceeds of fraud schemes (e.g. phishing and
identity theft) by criminals who gain illegal access to deposit accounts by recruiting third
parties to act as ‘money mules’. In some cases, these third parties may be innocent; in
some others, they may be having complicity with criminals.

In a money mule transaction, an individual with a bank account is recruited to receive cheque
deposits or wire transfers and then, transfer these funds to accounts held on behalf of
another person or to other individuals, minus a certain commission payment.

The risk arising from operations of money mules can be minimized with strict adherence
to KYC norms /AML standards/CFT measures/ Obligations of Banks under PMLA, 2002.

* * * * * * *

FRAME 32
BANKING OMBUDSMAN SCHEME 2006 (BOS)

The Banking Ombudsman Scheme (BOS) was first introduced in 1995 to provide an
alternative dispute redressal mechanism to bank customers.

It enables resolution of complaints of bank customers relating to certain services rendered

by all SCBs. The BO is a quasi-judicial authority and has the power to summon both the
parties – the bank and the customer – to facilitate resolution of complaints through
mediation.

RBI is appointing one of its serving senior officer (GM/CGM) as BO. BOS covers the whole
of India with their offices located mostly in the State Capitals.

Any person may file a complaint with the BO having jurisdiction on any one of the following
grounds (as at 2011, there are 27 grounds on which customers can approach the BO)
alleging deficiency in banking including internet banking or other services:

a. Non-payment/delay in payment of collection of cheques, drafts, bills etc/inward

remittances
b. Non-adherence to: prescribed working hours, provisions of Code of Bank’s
Commitment to Customers/ Fair Practices Code adopted by the bank
c. Non-observance of RBI directives on rates of interest on deposits

48 Banking Finance
 d. Complaints from NRIs regarding remittances and bank related matters
e. Levying of charges without adequate prior notice to the customer
f. Non-adherence to RBI instructions: on ATM /Debit card /Credit card operations;
engagement of recovery agents/Forced closure of deposit accounts without due
notice or without sufficient reason
g. Refusal to close or delay in closing the accounts

In respect of loans and advances:

a. Non-observance of RBI directives on: interest rates; on engagement of recovery
agents
b. Delay in sanction, disbursement or non-observance of prescribed time schedule
for disposal of loan applications
c. Non-acceptance of application for loans without furnishing valid reasons
d. Non-adherence to provisions of Fair Practices Code for lenders adopted by the
bank or Code of Bank’s Commitment to Customers
 A complainant can file a complaint with BO simply by writing it on a plain paper.
 The BO allows for online (at www.bankingombudsman.rbi.org.in) logging in of
complaints, or by sending of an e-mail to the Branch Manager.
 There is also a prescribed form for filing of a complaint, which is available with
various banks and their branches. However, it is not necessary to use this format.
It is a good idea though to incorporate all the required information.

No complaint to the BO shall lie unless:

a. The bank had rejected the complainant’s representation in writing or the
complainant had not received any reply within 1 month of his representation or
he is not satisfied with the bank’s reply.
b. The complaint is made within 1 year of receipt of bank’s reply to the representation
or where no reply is received, within 1 year 1 month after the date of representation
to the bank.
Any appeal can be made either by the complainant or the bank within 30 days of the receipt
of the BO’s award or rejection of the complaint before the Appellate Authority.
The Appellate Authority (Deputy Governor, RBI) may allow a further period of 30 days on
merits.
The BOS is a free service provided by the RBI for facilitating customer protection and
grievance redressal. The BO does not charge any fee for resolving customer complaints.

Banking Finance 49
The rejection of an award by the complainant does not affect any other recourse and/or
remedies available to the customers as per the law and he can approach Consumer Courts.

The Banks shall ensure that the purpose of the scheme and the address of the BO are
displayed prominently in all the offices and branches of the bank and to ensure that a copy
of the scheme is available with the designated officer of the bank for perusal in the premises
of the bank.

Banks shall appoint Nodal officers at their Regional/Zonal Offices.

The Damodaran Committee on Customer Service has recommended ‘Appointment of a Chief

Customer Service Officer as an Internal Ombudsman for a bank’.

The RBI had constituted a Working Group (Chairperson: Smt. Suma Verma) to review,
update and revise the BOS 2006 in the light of recommendations of Damodaran Committee.
The WG report is under examination.

* * * * * * *

FRAME 33
COMMITTEE ON CUSTOMER SERVICE IN BANKS
(Chairman: Shri Damodaran)

The RBI constituted a Committee (Chairman: Shri. M. Damodaran, former Chairman, SEBI)
to look into banking services rendered to retail and small customers, including pensioners
and also to look into the system of grievance redressal mechanism prevalent in the banks,
its structure and efficacy and suggest measures for expeditious resolution of complaints.

The Committee submitted its report in July 2011. It contained 232 recommendations. 107
have been implemented; 19 more accepted. Balance is under discussion with RBI, IBA,
IDRBT etc to find out the modalities of implementation.

Some of the major recommendations accepted for implementation are as under:

Deposit Accounts

a. Entry of name of payee as well as instrument number in case of debit entries

and the name of payee bank/drawer of instrument as well as instrument number
in case of credit entries, in the passbook / statement of accounts.
b. Mentioning gross interest credited and TDS debited explicitly in the TDS
statement.

50 Banking Finance
 c. Uniform account opening forms - common to all banks.
d. Check list of documents to be submitted by the customer, should be annexed
to opening form and placed in website.
e. Facility of account portability with same account number.
f. Non-insistence of KYC norms for opening account for existing account holders.
g. Basic saving account without any minimum balance to be opened. Banks are
advised to disclose annualised interest yield on deposits in all publicity materials.
h. Banks should not auto-renew the deposit accounts without customer consent in
writing.

Loans and Advances

i. Reason for penal interest on loan accounts, rates of interest charged in loan
accounts etc should be mentioned in passbook/statement of accounts.
j. CBS software should be enabled to generate Housing loan/Education loan interest
certificate for the purpose of IT.
k. Issuance of loans statements to borrowers periodically giving details of loan
disbursed, demand and repayments with details of charges.
l. Borrowers should be made aware upfront about various documents required to
be produced for processing of loan application, instead of asking in instalments.
m. Banks may ensure that communications to borrowers on delay in payment of
dues/instalment, invariably indicate that status reporting to Credit Information
Company is mandatory and any adverse remark could adversely impact their credit
score, which could affect their ability to raise loans on beneficial terms in future.
n. Title deeds should be returned to the customers within a period of 15 days after
closure of the loan account and a suitable compensatory policy for the delay to
be put in place.

Senior Citizens

o. There should be prioritised service to Senior Citizens, physically handicapped by

effective crowd management available at all branches.

SHGs

p. SHG members should not be forced to take insurance products.

Banking Finance 51
Other Aspects
q. A full and proper implementation of the Code is an urgent requirement to fulfil the
commitment made to the bank customers.
r. The staff manning positions in Customer Service Departments in banks should
receive specialised training so that customer complaints are professionally
handled and there is no cause of customer dissatisfaction.
s. There must be specific and proper queue management system at branches where
there is heavy crowd, with basic facilities of seating arrangements, drinking water
etc.
t. There must be a completely transparent process in the allocation of locker facility.
u. Banks should ensure full transparency to the customer in levying of various fees/
service charges and penalties.

Mobile Banking
v. All grievances of mobile banking should be addressed by the banks only, without
referring the customer to the service providers. The agreements of the banks with
the telecom service providers should incorporate suitable provisions to address
mobile banking grievances.

SMS / E-mail
w. Account statement in PDF format should be sent by e-mail if customer requests
so (password encrypted document).
x. Current account holders with high transactions should be sent e-mail giving the
balance position at agreed periodicity viz. daily, weekly, fortnightly etc.
y. SMS or e-mail alert informing the change in interest rate on loan availed due to
change in base rate etc.

Internal Grievance Redressal System

z. Bank should provide for online registration of grievance in its website. The online
system should provide access to the customer also for tracking and receiving
response from the bank.

Banking Ombudsman Scheme

aa. There is a need for banks in developing their Internal Grievance Redressal
Mechanism to ensure that only minimum a number of cases get escalated to
the Banking Ombudsman and the scheme is strictly utilised only as an appellate
mechanism.

52 Banking Finance
Role of Boards of Banks
bb. An agenda should be placed before the Customer Service Committee of the Board
every quarter on the level of implementation of the Bank’s Code of Commitment
to customers. The agenda should also correlate between the Code implementation
and the complaints received.

Customer Centricity
cc. Banks should codify annually all its policies/operational guidelines as that would
help the front line staff to serve the customers better.

Pensioners
dd. Pensioner may be allowed to submit the annual life certificate at any of the linked
branches and not necessarily at the home branch. All the life certificates may
be maintained in a centralised database.
ee. There must be hassle-free settlement of amount dues to the nominee/legal heirs
as and when required.
ff. Banks should create awareness about Reverse Mortgage Scheme among
pensioners/senior citizens.
gg. All joint accounts with either or survivor clause should become single accounts
of the survivor after the demise of the other joint account holder.

Business Process Re-engineering

hh. Banks should ensure that the CBS addresses the following major issues:
i) Minor customer turning a major
ii) cheques not being collected and honoured for the second account holder
iii) Specialised Govt Scheme accounts like PPF, Senior Citizens Special
Deposit Scheme etc, not being updated in the system resulting in fresh
deposits being collected even after expiry of Schemes
iv) TDS not being communicated to the IT department for appropriate credit
to the assessee’s account
v) Registering and issuing of acknowledgement to the account holders in
respect of nominees
vi) Diarisation for receipt and reminder for submission of Life Certificate by
pensioners
* * * * * * *

Banking Finance 53
 PART - C

THE MONEY MARKET

54 Banking Finance
 FRAME 34
LIQUIDITY ADJUSTMENT FACILITY (LAF)
REPO AND REVERSE REPO

LAF is a facility extended by RBI to SCBs (excluding RRBs) and primary dealers (PD)to
avail liquidity in case of requirement or park excess funds with RBI in case of excess liquidity
on an overnight basis against the collateral of Govt securities. Basically LAF enables
liquidity movement on a day-to-day basis.

The operations of LAF are conducted by way of repurchase agreements with RBI being
the counterparty to all the transactions. The interest rate on LAF is fixed by RBI from time
to time.

LAF is an important tool of monetary policy and enables RBI to transmit interest rate signals
to the market.

A repo or ready forward contract is an instrument for borrowing funds by selling securities
with an agreement to repurchase the said security on a mutually agreed future date at an
agreed price which includes interest for the funds borrowed. The reverse of the repo term
is called ‘reverse repo’ which is lending of funds against buying of securities with an
agreement to resell the said security at a mutually agreed future date at an agreed price
which includes interest for the funds lent.

There are two legs to the above transactions. The duration between the two legs is called
the repo period.

The overall effect of the repo transaction would be borrowing of funds backed by collateral
of Govt securities. All the above money market transactions have to be reported on the
electronic platform called the Negotiated Dealing System (NDS).

Repo transaction is usually undertaken when the call rate in the money market goes above
the repo rate. And, reverse repo is undertaken when the call rate goes below the reverse
repo rate.

The difference between repo rate (ceiling) and reverse repo rate(floor) provides a corridor
for call money rate to fluctuate. The corridor is generally 1% or as decided by RBI from
time to time.

Basic difference between repos and OMO is that while the former is undertaken for short
term adjustment of liquidity (and the transaction is reversed after a specified number of

Banking Finance 55
days), the latter is undertaken for long-term adjustment of liquidity (without reversing the
transaction).

* * * * * * *

FRAME 35
MARGINAL STANDING FACILITY (MSF)

 The MSF scheme was introduced with effect from 9 May 2011.
 Banks can avail funds from RBI overnight up to 2% (wef Apr 17, 2012) of their
NDTL against SLR GOI dated securities/T Bills and State Development Loans.
 The rate of interest on MSF will be 100 basis points (1%) above LAF or as decided
by RBI from time to time.
 A margin of 5% on GOI securities / T Bills and 10% on SDLs will be applied.
 In the event, the bank’s SLR holdings fall below the statutory requirement up to
2 % of their NDTL, banks will not have the obligation to seek a specific waiver
of default in SLR compliance arising out of use of this facility.
This is one more window through which banks can borrow (though costlier than
repo) when there is considerable shortfall of liquidity.
* * * * * * *

FRAME 36
CBLO VS REPO

CBLO stands for collateralised borrowings and lending obligations.

It is another money market instrument operated by Clearing Corporation of India Ltd (CCIL)
for the benefit of entities who have either no access to the inter-bank call market or have
restricted access in terms of ceiling on call borrowing and lending transactions. CBLO is
a discounted instrument available in electronic book entry form for the maturity period
ranging from 1 day to 90 days (up to 1 year as per RBI guidelines).

Membership to CBLO segment is extended to entities who are RBI –NDS members viz,
banks, FIs, cooperative banks, Insurance companies, MFs, PDs etc.

These entities can borrow or lend funds against collateral of eligible securities (Central Govt
securities, T-bills and other securities specified by CCIL).

56 Banking Finance
When Call money market is a market where banks/PDs lend and borrow money (without
any collateral), CBLO transactions are against Govt securities.

CBLO is different from repo on the following;

a. The drawback in the repo is that there is no flexibility, as the obligation can be
squared up only on the due date. Even if the borrower’s liquidity position improves,
he cannot ‘prepay’. If the lender’s position dries up and wants to call back the
money, he cannot do so. But a holder of CBLO can sell or an investor can buy
it, at anytime during its tenure.
b. CBLO works on principle of novation ie, CCIL acts as counterparty to the
transaction.
c. Screen based trading provides transparency and maintains anonymity of
counterparties.
There are arbitrage opportunities between call money, repo, reverse repo and CBLO.

* * * * * * *

FRAME 37
LAF & CALL MONEY MARKET

A bank, many times in a year, borrows from RBI against Govt securities at Repo rate and
lends it in call money market whenever the call rates are higher than repo rate. This leads
to profiting from arbitrage. Sometimes, during close of a financial year, call rates zoom to
50% or 60% due to high liquidity crunch.

Banks also invest funds borrowed from RBI’s repo window in liquid mutual fund schemes.

Since these arbitrages are genuine bonafide transactions and there is nothing wrong with
them, it is stated that for markets to develop and deepen these transactions have to be
allowed.

As per RBI press release dated 21st March, 2007, ‘ The intent of this advice is that recourse
to LAF by market participants should not be persistent, in order to fund balance sheets
for credit needs of customers; but banks can utilize the funds borrowed under this facility
for inter-bank lending. Such inter-bank lending is part of normal money market functioning
that enables daily liquidity management by market participants having temporary
mismatches’.

* * * * * * *

Banking Finance 57
 FRAME 38
GOI CASH MANAGEMENT BILLS (CMB)

The GOI, in consultation with RBI, had decided to issue a new short term instrument known
as Cash Management Bills to meet the temporary cash flow mismatches of the Govt. The
CMB will be a non-standard, discounted instrument issued for maturities less than 91 days.

The CMB will have the generic character of Treasury Bills.

CMB will have the following features:

a) Tenor: Less than 91 days

b) Issued at discount to face value through auctions (as TBs)
c) Settlement of auctions will be on T+1 basis
d) Non -competitive bidding scheme for TBs will not be extended to CMBs
e) CMBs will be tradable and will be treated as GOI TBs and accordingly shall be
treated as SLR securities
It may be noted that T Bills are issued with a tenor of 91 days, 182 days and 364 days.

* * * * * * *

FRAME 39
BANK RATE

Section 49 of RBI Act, 1934, requires the RBI to make public (from time to time) the standard
rate at which it is prepared to buy or rediscount bills of exchange or other commercial paper
eligible for purchase under the Act.

Bank Rate remained at 6% since April, 2003. A onetime technical adjustment was made
in March, 2012 to bring it in alignment with Marginal Standing Facility (and not as a signal
to banks to raise lending rates).

The Bank Rate acts as the penal rate charged on banks for shortfalls in meeting their reserve
requirements (CRR and SLR). The Bank rate is also used by several other organizations
as a reference rate for indexation purposes.

* * * * * * *

58 Banking Finance
 PART - D

THE CAPITAL MARKET

Banking Finance 59
 FRAME 40
BONUS DEBENTURES (BD)
Generally, company which has good accumulated reserves issue bonus shares, apart from
cash dividend. One way to make investors happy is to distribute deemed dividends in the
form of bonus debentures.
Hindustan Unilever was the first company to issue them in 2001.
Bonus Debentures are issued out of accumulated profits of the company (reserves and
surplus). Just like bonus shares, free debentures are credited to the shareholder. Interest
payment on the debentures can be received until date of maturity. On maturity, principal
can also be received (face value).
Even if the shares are sold before maturity of the debentures and you are no longer a
shareholder, still you will continue to receive the interest payment on debentures regularly
and the principal on maturity. Companies may choose to get the debentures listed on the
stock exchange. In such a case, these debentures can be sold at any time.
The issue of BD is treated as ‘deemed dividend’ under the provisions of the IT Act 1961.
Dividend distribution tax has to be paid by the company from reserves.
HUL, Dr Reddy’s Lab, Coromandel International, Brittania Industries have issued bonus
debentures.
Benefits to the Company:
 Annual interest payments (which will lower the profits of the company) will be
tax deductible. So, company can save on tax outgo.
 While dividend entails cash outflow in the same year, the cash outgo in the case
of BD is limited to interest payment for the year. The principal, which is bigger
in amount, is paid only at the time of redemption. In the interim, the cash accruals
can be used for funding expansion or working capital needs.
 Since the principal is charged to reserves, it improves return on equity.
This is in contrast to bonus shares which expands the equity base of the company and
leads to dilution in earnings per share.
The BD is subject to approval by the Board, shareholders, High Court and RBI.
Disadvantages:
When BDs are issued, it results in decrease in networth and a corresponding increase
in debt. This results in higher leverage.

60 Banking Finance
While bonus shares does not entail any cash outlay, BD involve 3 major cash outflows-
dividend distribution tax, interest payment and principal repayment at the time of redemption.
Since the scheme of arrangement of issuing BD is prepared under Sec 391 to 394 of the
Companies Act, it entails a lot of legal proceedings like approval of the High Court.

* * * * * * *

FRAME 41
DEPOSITORY RECEIPTS (GLOBAL & AMERICAN) [DR]
ADRs & GDRs

DRs are negotiable securities issued outside India by a Depository bank, on behalf of an
Indian company, which represent the local rupee denominated equity shares of the company
held as a deposit by a Custodian bank in India. DRs are traded on Stock Exchanges in
the US, Singapore, Luxembourg, London etc. DRs listed and traded in US markets are
known as ADRs and those listed and traded elsewhere are known as GDRs.
In the Indian context, DRs are treated as Foreign Direct Investment.
a) Indian companies can raise foreign currency resources abroad through the issue
of ADRs/GDRs.
b) A company can issue ADRs/GDRs, if it is eligible to issue shares to persons
resident outside India under the FDI scheme.
c) ADRs/GDRs are issued on the basis of the ratio worked out by the Indian company
in consultation with the Lead Manager to the issue. The proceeds so raised have
to be kept abroad till actually required in India. Pending repatriation or utilisation,
these funds can be invested in :
i) Deposits with or Certificate of Deposit or other instruments offered by banks
who have been rated by S&P, Fitch or Moody’s etc and such rating not being
less than the rating stipulated by RBI from time to time for the purpose.
ii) Deposits with branch/es of Indian ADs outside India.
iii) T-bills and other monetary instruments with a maturity or unexpired maturity
of one year or less.
d) There are no end use restrictions except for a ban on deployment of such funds
in real estate or the stock market. There is no ceiling for raising ADRs /GDRs.
e) Voting rights on shares issued under the scheme shall be as per provisions of
the Companies Act 1956.

Banking Finance 61
 f) A limited two way fungibility scheme has been put in place. Under the scheme,
a stock broker in India, registered with SEBI, can purchase shares of an Indian
company from the market for conversion into ADRs/GDRs based on instructions
received from overseas investors. Reissuance of ADRs/GDRs would be permitted
to the extent of ADRs/GDRs which have been redeemed into underlying shares
and sold in the Indian market.

Sponsored ADR/GDR issue

An Indian company can also sponsor an issue of ADR/GDR. Here, the company offers its
resident shareholders a choice to submit their shares back to the company so that on
the basis of such shares, ADRs/GDRs can be issued abroad. The proceeds are remitted
back to India for distribution to the resident investors who had tendered their shares for
conversion. These funds can be kept in Resident Foreign Currency (Domestic) Accounts
by the resident shareholders.

Reliance Industries Ltd was the first Indian corporate to come out with a GDR issue of
size US $ 150 mn in May 1992.

State Bank of India was the first Indian bank to float its GDR in Oct 1996. The bank of
New York was the Depository of the GDRs and ICICI Ltd was the custodian of the share
certificates. The GDRs were listed on the London Stock exchange.

Advantages to the Investors:

 Possibility of capital gains

 Liquidity
 Dividend and investment repatriable
 No lock-in period
 No currency risk or tax on GDRs traded abroad
 No registration with SEBI – no ceilings on holdings
 No custodial fee

Advantages to the issuer:

 No need for SEBI/Exchanges’ approvals
 Management control is safe
 Only dividend obligation
 Gain global recognition and credibility

62 Banking Finance
  Can obtain market related price and premium
 Cost of issue is very low
 Oversubscription can be retained
* * * * * * *

FRAME 42
INDIAN DEPOSITORY RECEIPTS (IDR)

As India is getting globalised, Indian investors are looking out for opportunities outside
India. In the last decade, many Indian companies have made overseas acquisitions. Indian
Depository Receipt (IDR) is an opportunity for the Indian investors to satisfy their appetite
for foreign equity.

IDRs are Indian counterparts of ADRs/GDRs through which several Indian companies have
raised funds from overseas investors. Through IDR, it is possible for foreign companies to
raise funds from Indian investors and for the Indian investors to invest in equity shares of
foreign companies. The IDRs will have the equity shares of the overseas issuer company
as underlying assets. The shares issued by the overseas company would be held by an
overseas custodian bank and on the basis of these underlying shares, the Indian depository
bank would issue IDR to residents in India as well as SEBI registered FIIs and NRIs.

FEMA regulations shall not be applicable to persons resident in India for investing in IDRs
and subsequent transfer arising out of transaction on a recognised stock exchange in India.

IDRs would be listed in Indian stock exchanges and denominated in Indian currency. This
way, foreign companies can get listed in Indian bourses.

IDRs shall not be redeemable into underlying equity shares before the expiry of one year
from the date of issue of IDRs.

At the time of redemption/conversion of IDRs into underlying shares, persons resident in

India holding IDRs shall comply with the provisions of FEMA.

So far only Standard Chartered Plc has come out with IDRs.

There are several restrictions on IDRs, stemming from India’s controls on inflows and
outflows of foreign capital. Though Indian citizens can own property and invest in overseas
securities, these come with limits. A limited two way fungibility for IDRs (similar facility
available for ADRs/GDRs) has been introduced, subject to certain terms and conditions.

* * * * * * *

Banking Finance 63
 FRAME 43
EXCHANGE TRADED FUNDS (ETF)
ETF is a security that tracks an index, a commodity or a sector like an Index Fund or
a sectoral fund but trades like a stock on an exchange. It is similar to a closed-ended
mutual fund listed on stock exchanges. ETFs experience price changes throughout the
day as they are bought and sold.
The types of ETFs are:
i) Equity ETF
ii) Gold ETF
iii) Liquid ETF
Equity ETF is a basket of stocks that reflects the composition of an index like S& P CNX
Nifty or BSE Sensex. The ETF trading value is based on the NAV of the underlying stocks
that it represents. It is akin to a MF that one can buy and sell at a price that changes
throughout the day.
Gold ETF is a special type of ETF that tracks the price of gold. It provides investors a
relatively cost efficient and secure way to participate in the gold bullion market without the
necessity of taking physical delivery of gold.
Liquid ETF are the money market ETF that provide money market returns.
A comparison of MF (closed ended) and ETF
Sl no. Parameter Closed ended Fund ETF
1 Fund size Fixed Flexible
2 NAV Daily Real Time
3 Liquidity provider Stock Market Stock Market / Fund Itself
4 Sale Price Significant Premium/ Very close to NAV of
Discount to NAV the scheme
5 Availability Through exchange Through exchange
where listed where Listed/Fund itself
6 Portfolio Disclosure Monthly Daily/Real Time
7 Uses Equitising cash Equitising cash /
Hedging/Arbitrage
8 Intra-day Trading Expensive Possible at low cost

* * * * * * *
64 Banking Finance
 FRAME 44
CURRENCY FUTURES (CF) / CURRENCY DERIVATIVES

Futures contract is a contractual agreement between two parties to buy or sell an asset
of a specified quantity and quality at a specific time in future at a specific price through
the exchange.

CFs are standardised contracts traded on a stock exchange to buy or sell one currency
against other on a specific future date at a price (exchange rate) specified in the date of
the contract.

CF contracts allow investors to hedge against foreign exchange risk.

CF was introduced in 1972 by the Chicago Mercantile Exchange. In India, it was started
on Aug 29, 2008.

CF is allowed in the following pairs:

USD/INR, Pound/INR, Euro/INR and Yen/INR

CF contracts are settled in rupee; no physical delivery will take place.

In CF, no underlying is required. Since contracts are short term, it is speculative in nature,
profit and loss made cannot be set off against any other income for tax purpose.

Banks (AD category) are permitted to become trading and clearing members of the CF
market of the recognised stock exchanges, on their own account and on behalf of their
clients, subject to fulfilling the following minimum prudential requirements:

a. Minimum net worth of Rs 500 Cr

b. Minimum CRAR of 10%
c. Net NPA should not exceed 3%
d. Made net profit for last 3 years
Currency options were introduced on Oct 29, 2010.

* * * * * * *

Banking Finance 65
 FRAME 45
COMMODITIES FUTURE TRADING

Just like trading in shares, bonds etc, one can trade in commodities like cotton, grains,
edible oils, base metals like gold, silver, tin etc on certain national exchanges.

The Forward Markets Commission (FMC) is the regulator for commodities in futures market
in India.

There are now 6 national commodity exchanges.

a. Multi Commodity Exchange (MCX), Mumbai

b. National Commodities and Derivatives Exchange (NCDEX), Mumbai
c. National Multi Commodity Exchange (NCME), Ahmedabad
d. ACE Derivatives and Commodity Exchange, Mumbai
e. Indian Commodity Exchange Ltd(ICEX), Mumbai
f. Universal Commodity Exchange Ltd, Navi Mumbai
Besides there are 16 commodity specific exchanges recognised for regulating trading in
various commodities approved by the Commission under the Forward Contracts (Regulation)
Act, 1952.

A typical future contract is an agreement to buy a certain quantity of a commodity at a particular

time in the future for a particular price. These contracts are traded on the above exchanges.

Hedgers, speculators and arbitrageurs are broadly the three types of players in this market.

Hedgers are players who physically possess a commodity facing an underlying risk of price
fluctuation. They can either be producers or consumers who want to transfer the price risk
onto the market. Producer-hedgers are those who want to mitigate the risk of prices
declining by the time they actually produce their commodity for sale in the market while
consumer-hedgers are those who would want to do exactly the opposite to insulate
themselves from possible rise.

Speculators are mostly investors and traders who serve as counterparties to hedgers and
accept the risk offered by them in a bid to gain from price changes. A speculator tends
to benefit from either going long or short.

66 Banking Finance
Arbitrageurs are those players who profit by taking advantage of in the inefficiencies in the
market system. They buy identical products from one market and sell in another to benefit
from price differentials.

Brokers are intermediaries for all these players facilitating buying or selling on the exchange
for a fee.

* * * * * * *

FRAME 46
INTEREST RATE FUTURES (IRF)

Derivatives are weapons of mass destruction. Still derivatives are here to stay. Interest Rate
derivatives arrived on NSE in Aug 2009. Currency Futures had been launched in Aug 2008.

An IRF is a futures contract (a financial derivative) with an interest bearing instrument as

the underlying asset.

IRF are standardised exchange traded derivatives.

In IRF, like in any derivative product, you take a position on the underlying asset based
on which way you feel the price will move. In IRF, the underlying security is not stocks
but a bond, 10 year Govt bond and it is essentially the interest rate you are speculating
on. The underlying asset is the notional 10 year GOI security with a 7% notional interest.

An IRF contract is an agreement to buy or sell a debt instrument at a specified date at

a fixed price. The minimum contract size is Rs 2 lacs.

This instrument will be very useful for anyone who wants to benefit from interest rate
movements and is a good hedging mechanism for investors who have invested heavily in
Govt securities. Corporates, MFs, PDs, FIIs, brokers, pension funds, insurance companies,
banks and retail investors exposed to interest rate risks will be the players in this market.

After the financial crisis, more regulators and markets are moving towards exchange traded
market (away from OTC) where counterparty payment is guaranteed and the system of
margining takes care of potential risks.

* * * * * * *

Banking Finance 67
 FRAME 47
US GAAP

GAAP is an acronym for Generally Accepted Accounting Principles. These principles are
the basis of preparation of accounts by US companies. It is considered the gold standard
- most conservative accounting standards in the world.

The Financial Accounting Standards Board (FASB) in the US has been designated as the
organisation for establishing standards of financial accounting and reporting.

* * * * * * *

FRAME 48
INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)

International Financial Reporting Standards (IFRS) are designed as a common global

language for business affairs so that company accounts are understandable and comparable
across international boundaries. They are a consequence of growing international shareholding
and trade and are particularly important for companies that have dealings in several countries.
They are progressively replacing the different national accounting standards.

The International Accounting Standards Board (IASB) is responsible for setting international
accounting standards. It was set up in 2001. European companies started using IFRS from
2005.

Why IFRS?

 Indian companies are trying to attract global investors/global capital. Hence, India
needs to adopt IFRS, as it brings uniform accounting standard for investors across
the globe to understand and comply with. It will be a uniform financial language.
It will bring down the cost of capital.
 Convergence to IFRS would help India to report disclosures better, improving
corporate governance.
IFRS is principle-based while the US GAAP is rule-based. US is also thinking of moving
over to IFRS.

Though the timeframe for convergence to IFRS in India has been postponed from April 2011,
a few companies like Infosys, Bharti Airtel, Dabur have voluntarily adopted it.

* * * * * * *

68 Banking Finance
 PART - E

THE CREDIT MARKET

Banking Finance 69
 FRAME 49
BASE RATE (BR)

Based on the recommendations of the Working Group on Benchmark Prime Lending Rate
(Chairman: Shri. Deepak Mohanty), RBI decided that banks switchover from BPLR system
to BR system. The BR system is aimed at enhancing transparency in lending rates of banks
and enabling better assessment of transmission of monetary policy.

BR system is effective from July 1, 2010. BR includes the following elements:

a) Cost of deposit/funds
b) Negative carry over CRR and SLR
c) Un-allocatable overhead cost
d) Average return on net worth
Banks are free to use any methodology to arrive at the BR, as considered appropriate,
provided it is consistent and is made available for supervisory review, when required.

Actual lending rates on loans and advances will be BR plus customer specific charges,
as deemed appropriate. It should be transparent and consistent.

BR will be the Minimum Rate for all loans.

Exceptions:

a) DRI advances
b) Loans to Bank employees including retired employees
c) Loans to depositors against their own deposits
d) Short term agricultural loans where subvention is available
e) Export Credit where subvention is available
f) Restructured loans having WCTL, FITL and there are recompense clauses
BR should be reviewed once in a quarter. It should be displayed at all branches and on
the bank’s website. Changes in BR should be conveyed to the public from time to time
through appropriate channels.

* * * * * * *

70 Banking Finance
 FRAME 50
LIMITED LIABILITY PARTNERSHIP (LLP) BILL, 2008

The Limited Liability Partnership Bill 2008 was passed by Parliament on 12.12.2008.

The salient features of LLP are as under:

 LLP provides for limited liability of partners to the extent of partner’s capital
contribution.
 LLP combines the features of partnership firm on the one hand and limited liability
provisions of shareholders of company on the other.
 LLP would be a body corporate with perpetual succession and legal existence
of its own. Once incorporated, an LLP would have a legal entity separate from
its partners. The LLP would have the words ‘Limited Liability Partnership’ or
acronym ‘LLP’ as the last word of its name.
 LLP can be incorporated with a minimum of two partners. No upper limit of number
of partners has been provided. Any individual or body corporate can be a partner
in an LLP. Every LLP is required to have at least two designated partners who
are individuals. These designated partners shall be responsible for doing of all
acts and things as are required to be done by the LLP under the Act.
 For incorporation of LLP, two or more persons are required to subscribe their
names to an incorporation document and the same would be registered with the
Registrar of Companies. On incorporation, these persons shall be its partners.
Any other person may become a partner in accordance with LLP agreement. This
agreement is also required to be filed with ROC.
 There is a provision for entering into LLP agreement to provide for mutual rights
and duties of partners and partners with LLP. A partner of an LLP may contribute
by way of tangible or intangible property or other benefits to the LLP. A partner’s
obligation to contribute shall be as per the partnership agreement.
 A partner may lend money to and transact other businesses with the LLP and
shall have the same rights and obligations with respect to the loan or other
transactions as a person who is not a partner.
 A partner’s economic rights in the LLP would be freely transferable. However, non-
economic rights of a partner would not be transferable unless specified by the
LLP agreement.

Banking Finance 71
  The LLP would not stand dissolved due to the death, retirement or insolvency
of one or more partners. A former partner would continue to be liable for the acts
done in his tenure.
 On death or retirement of a partner, his legal heirs/he shall be entitled to receive
an amount equal to the capital contribution actually made and his share in the
accumulated profit. However, his legal heirs/he shall not have any right to interfere
in the management of LLP.
 A partner of an LLP would be personally liable for his own wrongful acts and
omissions but will not be liable for the wrongful acts or omissions of other partners.
 The liabilities of an LLP would be met out of its property and the partners would
not be liable directly or indirectly for an obligation of an LLP to the unlimited extent
as is the case with a partnership firm.
 An existing partnership firm, private company or unlisted public company may
convert to an LLP by complying with the requirements as to conversion.
 The LLP may be wound up or dissolved either voluntarily or by the National
Company Law Tribunal constituted under the Companies Act, 1956 (yet to be
constituted)
 LLP does not require constitution of Board of Directors for decision making by
passing resolution at the meeting of the Board.
 An LLP shall be under obligation to maintain annual accounts reflecting true and
fair view of its state of affairs.
 The LLP shall file an annual solvency report with the Registrar.
 The management-ownership divide inherent in a company is not there in an LLP.
The compliance norms are much easier compared with companies.

72 Banking Finance
 Important differences between LLP and Partnership firm

Sl No Particulars LLP Partnership firm

1 Governing Law LLP Act, 2008 Indian Partnership Act, 1932
2 Registration Compulsory Optional
3 Separate legal entity Separate from the Partners are collectively
partnership/designated referred to as firm
partners
4 Perpetual succession Yes No perpetual succession
5 Purchase of property LLP can purchase Firms cannot purchase
immovable/movable property in its name. The
property in its name same must be purchased
in the name of partners only
6 Common seal Required Not required
7 Legal Proceedings Can sue and be sued Only registered partnership
can sue
8 Name Suffix LLP or Limited No such requirement
Liability partnership
has to be added to
the name
9 Ownership of assets LLP has ownership of Partners have joint
assets ownership of all assets
10 Liability Limited to partner’s Liability of partners is
capital contribution. In unlimited
case partner acts with
intention to defraud,
then he is personally
liable
11 Jurisdiction of CLB has jurisdiction CLB has no jurisdiction
Company Law Board over affairs of LLP
(CLB)
12 Number of members Minimum2 Minimum – 2
Maximum – No cap Maximum 20

* * * * * * *

Banking Finance 73
 FRAME 51
NATONAL COMPANY LAW TRIBINAL (NCLT)

The passing of the Companies (Second Amendment) Act, 2002 paved the way for setting
up the National Company Law Tribunal (NCLT) and the National Company Law Appellate
Tribunal (NCLAT).

NCLT is supposed to be one window quasi-judicial authority to deal with virtually all types
of corporate law related cases and ensure their speedy disposal. It will take over the
functions of BIFR and AAIFR with regard to rehabilitation and revival of sick industrial
companies. It will also deal with winding up process of companies.

It was expected that the setting up of NCLT will have the beneficial effects of reducing the
pendency of cases and reduce the period of winding up process from 20-25 years to about
2 years; would avoid multiplicity of litigation before various fora (the High Courts, the quasi-
judicial authorities like CLB, BIFR and AAIFR) as all can be heard and decided by NCLT;
and the appeals will be streamlined with an appeal against orders of NCLT to the Appellate
Tribunal (NCLAT), with a further appeal to the Supreme Court only on points of law, thereby
reducing the delay in appeals. It was envisaged that all the pending cases before the CLB
and all winding up cases before the High Courts be transferred to NCLT and thereby the
burden on the High Courts reduced and the BIFR and the AAIFR could be abolished.

The Madras High Court Bar Association in 2003 filed a writ petition challenging the
constitutional validity providing for the constitution of NCLT and NCLAT. In short, the
Supreme Court in May 2010 upheld the establishment of NCLT and NCLAT but had
suggested certain amendments to be carried out in the Companies Act to make them
functional.

NCLT will be set up once the new Companies Bill 2013, since passed by Parliament
becomes a Law shortly.

* * * * * * *

74 Banking Finance
 FRAME 52
FINANCIAL INCLUSION (FI)

FI is the delivery of financial services, at an affordable cost, to sections of disadvantaged

and low income segments of the society, in a fair and transparent manner, by regulated
mainstream institutional players,through financial education, leveraging technology and
generating awareness.

In India, the term FI first featured in 2005 when RBI, in its annual policy statement of 2005-
2006, while recognizing the concerns in regard to the banking practices that tend to exclude
rather than attract vast sections of the population, urged banks to review their existing
practices to align them with the objective of FI.

In India, FI is bank-led, though non-bank entities partner with banks in the FI initiatives.

As per census 2011, only 59% of the rural and urban households avail banking services
i.e. 41% are unserved.

Dr. Rangarajan committee on FI

Recommendations:

 Rural and semi-urban branches to target a minimum of 250 accounts per branch
per annum with emphasis on financing marginal farmers and poor non-cultivator
households.
 A national rural FI plan may be launched –to reach 50% of financially excluded
households with 100% inclusion by 2015.
 Two funds [as detailed hereunder] be set up.
FI Promotion Fund {Rs 500 Cr} {FIF}
Objective: support developmental and promotional activities, securing greater FI.
FI Technology Fund {Rs 500 Cr} {FITF}
Objective: To enhance investments in Information Communication Technology
{ICT}, stimulate the transfer of research and technology in FI i.e. support
technological intervention for facilitating financial inclusion.
These two funds have been set up by Govt of India and placed with NABARD.

Banking Finance 75
The dimensions of FI are :

1) Basic Financial Products

Savings

Insurance Payment & Remittance

(MF, Pension Fund)

Entrepreunerial credit
(GCC, KCC)

2) No Frills Account - now called Basic Savings Bank deposit Account

i. Banks are required to provide a basic savings account which should be considered
a normal banking service to all.
ii. No minimum balance requirement
iii. Will include deposit and withdrawal of cash at branch/ATM; receipt/credit of money
through electronic payment channels.
iv. No limit on number of deposit transactions. Maximum of 4 withdrawals a month
including ATM withdrawals.
v. Facility of ATM-cum-debit card
The above facilities are to be provided without any charges. Further no charges are to be
levied for non-operation/activation of inoperative Basic SB deposit account.

Simplified KYC norms have been prescribed. Introduction from another account holder who
has been subjected to full KYC procedure is accepted. Photo and address of the customer
need to be certified by the introducer.

3) Banking Correspondents (BC)

Role:
 Collection of small value deposits
 Identification of borrowers
 Post sanction monitoring

76 Banking Finance
  Follow up and recovery
 Recovery of principal and collection of interest
 Receipt and delivery of small value remittances
 Sale of micro insurance/mutual fund/pension products

Who
 NGOs/MFIs set up under Societies/Trust Act
 Cooperative Societies
 Sec 25 Companies
 Registered NBFCs not accepting public deposits
 Post Offices

4) General Purpose Credit Card { GCC }

 Loan facility up to Rs 25,000/ at rural and semi-urban branches

 In the nature of revolving facility
 Without insistence on security

5) Life Insurance

One example: Group insurance scheme for SHG members available. Life cover of
Rs 50,000/. Premium of around Rs 600/ p.a. Premium is to be paid for five years. 50%
of premium refundable as survival benefit. Death certificate is not required. A declaration
by Group leader is sufficient.

Many insurance companies may have their own schemes.

6) Micro Credit

Micro credit is given for SHG groups and Joint Liability Groups (JLG). Micro Finance
institutions (MFI) also play an important role in FI.

A SHG group consists of about 15/20 people forming a homogenous group. They are
encouraged to make voluntary thrift on a regular basis for about six months. The pooled
resources are lent to members. Financial discipline is built up. Then, banks extend credit
to the SHG.

JLG is similar to SHG but there is no thrift component. Like-minded people engaged in
a common activity come together and avail credit facility from a bank on each other’s
personal guarantee.

Banking Finance 77
7) Technology based solutions

The use of IT solutions for providing banking facilities at the doorstep holds the potential
for scalability of FI initiatives.

Smart Card

A bio –metric smart card using smart card technology is used to provide banking facility
to the customer in remote and unbanked areas. A computer chip embedded in a plastic
card with biometric identification like fingerprints is made use of. Services like deposits,
withdrawals, funds transfer are provided.

8) Mobile Banking

Mobile technology is used for balance checks, account transactions, payments and
transaction alerts.

9) Unique Identity Number (Aadhaar)

The Aadhaar number, being introduced by the Unique Identification Authority of India (UIDAI)
substantially reduces the risks inherent with the BC network - it enables the bank to easily
and instantly verify an individual’s identity, directly or through the BC. The person can verify
his identity through a number of means – through biometrics for maximum security as well
as through his demographic information or using a PIN number. Such verification can take
place anywhere in India and through any device since the Aadhaar number and individual
details are stored in a central database. The mobility it offers is unsurpassed, and it gives
the poor same financial portability urban India has long had with ATMs and core banking
services.

The welfare initiatives such as the MGNREGA and JSY which are offering the poor, cash
benefits and incentives are being brought under a combination of Aadhaar, a micro-ATM
and a BC.

10) Financial Literacy / Education

Financial education is particularly relevant for people who are resource poor, marginalized
and are vulnerable to persistent downward financial pressures. Financial literacy can
increase their confidence level and decision making capability and prepare them to cope
with the financial demands of daily life.

Financial literacy emphasizes on the skills and areas of knowledge that is necessary to
make informed judgements and resultant objective decisions. The support from FI Promotion
Fund for the financial literacy programme would be available for the following:

78 Banking Finance
 i) Trainers’ training programme
ii) Training of BCs, Farmers’ Club members, certified IT filing assistants etc who
assist in delivery of financial literacy related module
iii) Campaigns for reaching out to the rural population through various mass
communication channels
iv) Surveys to ascertain the degree of consumer awareness about financial products
and services

Financial Literacy and Counselling Centres (FLCC)

Banks have been asked to set up Trusts/Societies for running FLCC. The broad objective
is to provide free financial literacy/education and credit counselling. The centre would provide
awareness regarding cost of credit, availability of backward/forward linkages etc. Counselling
can also be done through the media, workshop and seminars.

11) Rural Self – Employment Training Institute (RSETI)

Every Lead bank in the country will set up one RSETI in each district. The Govt will give
financial support/physical support for land and building. The bank will conduct training
programmes for farmers and people below poverty line for developing skills. Bank loans
will be tied up by the Institute.

Twin aspects of FI

Financial Inclusion acts from supply side providing the financial market/services what people
demand.

Financial Literacy stimulates the demand side-making people aware of what they can
demand.

Financial Literacy Financial Inclusion

Demand Side Supply Side

Fin. Literacy and Credit Financial Markets
Counselling centre Banks, Services

Credit absorption Appropriate design of

Capacity Products and services
Knowledge of Products

Banking Finance 79
12) Ultra Small Branches (USB)

For furthering FI, banks have been advised to establish outlets in rural centres from which
BCs may operate. These BC outlets may be in the form of low cost simple brick and mortar
structures. So, it is felt necessary to have an intermediate brick and mortar structure (USB)
between the present base branch (which oversees the BC outlets) and BC locations so
as to provide support to a cluster of BC units at a reasonable distance. A USB can provide
support to about 8-10 BC units at a distance of 3-4 kms. These could be newly set up
or by conversion of BC outlets. USB should have CBS terminal linked to a passbook printer
and a safe for cash retention and managed by fulltime bank employee.

13) Additonal steps taken by RBI are:

 A Board approved Financial Inclusion Plan (FIP) was implemented over 2010-2013.
 Banks have been advised to prepare FIPs for 2013-2016 with Board approval.
The bank’s performance will be monitored by RBI against their FIPs.
 Bank have been advised to consider frontloading (prioritising) the opening of
branches in unbanked rural centres over a three year cycle coterminous with FIP.
 The target for provision of banking services through a banking outlet in every village
with population above 2000 by Mar 2012 was achieved successfully by banks.
Banks had covered 74,199 villages. Now SLBCs have been advised to prepare
a roadmap for provision of banking services in all unbanked villages with population
below 2000 in a time bound manner. SLBCs have identified 4,85,000 such villages
and the same have been allotted to banks.
 FLCCs and rural branches of SCBs have been advised to conduct outdoor
Financial Literacy camps at least once a month.
 Govt’s Direct Benefit Transfer (DBT) initiative is on, through bank accounts seeded
with Aadhaar number.
 25% of all new branches to be opened in unbanked rural centres.
14) FI Plan & New Bank Licenses : will be an important criterion for getting new bank
licenses in the private sector. 25% of the branches to be opened in unbanked rural
centres.

15) Metro Areas under LBS : Lead Bank Scheme is applicable to all districts in the
country excluding districts in metropolitan areas. However, the challenge of financial
inclusion is widespread in metropolitan areas also, especially among the disadvantaged

80 Banking Finance
 and the lower income groups. With an objective of providing an institutional mechanism
for coordination between Govt authorities and banks, facilitating doorstep banking to
the excluded segment of urban poor and to implement DBT, it has been decided by
RBI to bring all districts in metropolitan areas under the fold of Lead Bank Scheme.

‘Financial Inclusion is critical for achieving inclusive growth; which itself is required for
ensuring sustainable growth. Access to affordable financial services empowers the poor
to take charge of their lives’- Smt. Usha Thorat, Ex-Deputy Governor, RBI.

* * * * * * *

FRAME 53
PRIORITY SECTOR LENDING (PSL) TARGETS

In Nov 1974, banks were advised to raise the share of priority sector to 33.33% of aggregate
advances by Mar 1979.

It was raised to 40% by Mar 1985. Sub-targets for agriculture and weaker sections within
priority sector were also specified.

In Aug 2011, a committee (Chairman: Shri. M V Nair) was set up to re-examine the existing
classification and suggest revised guidelines with regard to PSL. Based on their
recommendations and in consultation with various stakeholders, revised guidelines were
made operational from July 20, 2012.

I Categories under PS

1) Agriculture
2) Micro & Small Enterprises
3) Education
4) Housing
5) Export Credit (related to Agri and MSE)
6) Others

Banking Finance 81
II Targets and Sub- Targets for PS

Total Priority Sector 40% of ANBC or CEOBE@, whichever is higher

Total agriculture 18% of ANBC or CEOBE@, whichever is higher
(Indirect agriculture) (Not more than 4.5% or CEOBE@, whichever is higher)
MSE 40% of total advances to MSE should go to Micro (Manu)
Units having investment in plant & machinery up to Rs10 lacs
and Micro (Service)units having investment in equipment up
to Rs4 lacs
20% of total advances to MSE sector should go to Micro
(manu) Units with investment in plant and machinery above
Rs 10 lacs up to Rs 25 lacs and Micro (service) enterprises
above Rs 4 lacs and up to Rs 10 lacs.
Export credit Export credit to eligible activities under agriculture and MSE
will be reckoned as PS.
Advances to 10% of ANBC or CEOBE@, whichever is higher
Weaker Sections
@
Credit Equivalent amount of Off-Balance sheet Exposure

The current year’s target/sub targets will be computed based on Adjusted Net Bank Credit
(ANBC) of preceding Mar 31.

ANBC

ANBC = Outstanding Bank Credit

MINUS Bills rediscounted with RBI/other approved FIs

MINUS Advances extended in India against the incremental FCNR (B)/NRE

deposit qualifying for exemption from CRR/SLR requirement ( with effect from
July 26, 2013)

PLUS Permitted non -SLR investments in HTM

PLUS Investments in other categories, which are eligible to be treated as PSL

(e.g. investment in securitised assets)

Deposits placed by banks with NABARD/SIDBI/NHB in lieu of non-achievement of PSL

targets will not be reckoned for ANBC computation.

82 Banking Finance
  Loans to individuals for education up to Rs 10 lacs for studies in India and Rs
20 lacs for studies abroad.
 Housing loans up to Rs 25 lakhs in metro centres with population above 10 lacs
and Rs 15 lacs in other centres (excluding loans to bank’s own employees).

There are more granularities in Agri - Direct and Indirect, MSE – Direct and Indirect,
Housing and others in RBI guidelines.

 Contingent liabilities/off-balance sheet items are not to be treated as part of PSL.

Any shortfall in lending to overall PS target/agriculture target/weaker sections target shall
be allocated amounts for contribution to the Rural Infrastructure Development Fund (RIDF)
with Nabard or funds with NHB/SIDBI.

Marginal and Small Farmers

Marginal Farmer : Farmers with landholding of up to 1 hectare.
Small Farmer : Farmers with landholding of more than 1 hec but less than 2 hecs.
For the purpose of Priority Sector loans, marginal and small farmers include landless
agricultural labourers, tenant farmers, oral lessees and share croppers.

Weaker Sections
a) Marginal and Small farmers
b) Artisans, village and cottage industries with individual credit limit up to Rs 50,000/
c) Beneficiaries of SGSY, now National Rural Livelihood Mission
d) SC/ST
e) DIR loans
f) SJSRY loans
g) Under scheme for rehabilitation of manual scavengers
h) Loans to SHGs
i) Loans to distressed farmers indebted to non-institutional lenders
j) Loans to distressed persons other than farmers not exceeding Rs 50,000/per
borrower to prepay debt to non-institutional lenders
k) Loans to individual women beneficiaries up to Rs 50,000/per borrower
l) Loans sanctioned under a) to k) above to persons of minority communities

For further details, RBI circular may be referred to.

* * * * * * *

Banking Finance 83
 FRAME 54
MICRO, SMALL AND MEDIUM ENTERPRISES (MSME)

Classification as per MSME Development Act, 2006:

Enterprises engaged in Enterprises engaged in

manufacturing or production, providing services
processing or preservation
of goods

INVESTMENT IN PLANT INVESTMENT IN

& MACHINERY EQUIPMENT

MICRO ENTERPRISE Does not exceed Rs 25 lacs Does not exceed Rs 10 lacs

SMALL ENTERPRISE Above Rs 25 lacs but Above Rs 10 lacs but

not exceeding Rs 5 Cr not exceeding Rs 2 Cr

MEDIUM ENTERPRISE Above Rs 5 Cr but Above Rs2 Cr but

not exceeding Rs 10 Cr not exceeding Rs 5 Cr

These will include small road and water transport operators, small business, retail trade,
professional and self-employed persons and other service enterprises.

Banks lending to Micro and Small enterprises is reckoned for priority sector advances.

* * * * * * *

FRAME 55
CREDIT GUARANTEE FUND TRUST SCHEME FOR MICRO &
SMALL ENTERPRISES (CGTMSE)

The Fund has been set up to facilitate flow of credit to the MSE sector without the need
for collaterals/third party guarantees. The main objective of the scheme is that the lender
should give importance to the project viability and secure the credit facility purely on the
primary security of the assets financed. The scheme seeks to reassure the lender that,
in the event of a MSE unit, which availed collateral-free credit facilities, fails to discharge
its liabilities to the lender, the Trust would make good the loss incurred by the lender up
to 85% of the outstanding in default.

84 Banking Finance
The CGTMSE would provide cover for credit facility up to Rs 100 lacs without any collateral
security and/or third party guarantee. A guarantee and annual service fee is charged by
the Trust Fund to avail of the guarantee cover. Presently, it is borne by the borrower.

* * * * * * *

FRAME 56
CODE OF COMMITMENT TO MICRO & SMALL ENTERRPRISES

This is a code which sets minimum standards of banking practices for banks to follow when
they are dealing with MSEs.

The objectives of the code are to:

a. Give a positive thrust to the MSE sector by providing easy access to efficient
banking services.
b. Promote good and fair banking practices by setting minimum standards in dealing
with MSEs.
c. Increase transparency – what MSEs can expect of the banking services.
d. Improve bank’s understanding of the business through effective communication.
e. Encourage market forces, through competition, to achieve higher operating
standards.
f. Promote a fair and a cordial relationship and to ensure timely and quick response.
g. Foster confidence in the banking system.

The standards of the code are covered by key commitments on

i) Various banking services – deposit accounts, payment services, Govt
transactions, demat accounts, currency notes, collection of cheques, loan
facilities (fund and non-fund), foreign exchange services, insurance, card products,
factoring and merchant banking services.
ii) Exchange of information, changes in terms and conditions, confidentiality, pre-
sanction requirements, credit assessment, sanction/rejection, post disbursement
activities, help in financial difficulties, nursing of sick SMEs and debt restructuring,
security repossession, complaints, grievance redressal.
The code will be reviewed every 2 years.
* * * * * * *

Banking Finance 85
 FRAME 57
REHABILITATION OF SICK MSEs

Timely and adequate assistance to MSEs and rehabilitation effort should begin on a
proactive basis when early signs of sickness are detected. This stage would be termed
as ‘handholding stage’ as defined below. This will ensure intervention by banks immediately
so that sickness can be arrested. An account may be treated as having reached the ‘hand
holding stage’ if any of the following events are triggered:

a. Delay in commencement of commercial production by more than 6 months for

reasons beyond the control of promoters.
b. The unit incurs losses for 2 years or cash loss for 1 year beyond the accepted
timeframe.
c. The capacity utilisation is less than 50% of the projected level in terms of quality
or sales are less than 50% of the projected level in terms of value during the year.
Branches should take timely action which includes an enquiry into the operations of the
unit and proper scrutiny of accounts, providing guidance, counselling services, timely
financial assistance as per established need and also helping the unit to sort out difficulties
which are non-financial in nature. The handholding support should be undertaken within a
maximum of 2 months of identification of sick units.

A Micro or Small Enterprise is said to be sick when any of the borrowal account of the
unit remains NPA for more than 3 months or there is erosion in net worth due to accumulated
losses to the extent of 50% of its net worth during the previous accounting year.

Any rehabilitation package should be fully implemented by banks within 6 months from
the date the unit is declared as potentially viable. During the 6 months of identifying and
implementing rehab package banks/FIs are required to do ‘holding operation’ which will allow
the sick unit to draw funds from the cash credit account at least to the extent of deposit
of sale proceeds.

The decision on viability of the unit should be taken at the earliest but not later than 3
months of becoming sick under any circumstances.

* * * * * * *

86 Banking Finance
 FRAME 58
CREDIT RISK GUARANTEE FUND TRUST
FOR LOW INCOME HOUSING (CRGFTLIH)
The Ministry of Housing & Urban Poverty Alleviation, GOI has set up the CRGFTLIH in June
2012. The Trust will be managed by National Housing Bank.
It covers housing loans up to Rs 5 lacs (size up to 430 sq ft) sanctioned without any
collateral and/or third party guarantee to borrowers in EWS/LIG categories.[Economically
Weaker Section – monthly household income up to Rs 1 lac per annum; Low Income group
– monthly household income between Rs 1 lac to Rs 2 lacs per annum].
Guarantee fee – 1 % of the loan amount. Banks may alter interest rate to cover up to 50%
of the guarantee fee.
The lender can invoke the guarantee only after the lock-in period of 24 months either from
the date of last disbursement of loan or the date of the guarantee cover coming into force
in respect of the particular HL or 2 months after completion of the house; whichever is later.
The loan should have been recalled and recovery proceedings should have been initiated.
The guarantee should be invoked :
 If the loan becomes NPA before the lock-in period expires, within 1 year of the
expiry of lock-in period.
 If the loan is NPA after the lock-in period, within 1 year from the date of NPA.

Extent of Guarantee
Category Maximum extent of guarantee where HL is

Up to Rs 2 lacs Above Rs 2 lacs &

up to Rs 5 lacs

HL to individual 90 % of the amount 85% of the amount

borrowers In default subject to In default subject to
the ceiling of 90% the ceiling of 85%
of the sanctioned amount of the sanctioned amount

75% of the guaranteed portion of the amount in default will be pad by the Trust within 60
days. Balance will be paid on conclusion of recovery proceedings.
Risk weight for the guaranteed portion is zero. For the excess portion, risk weight will be
as applicable to the counterparty.
* * * * * * *
Banking Finance 87
 FRAME 59
INFRASTRUCTURE LENDING

A credit facility extended by lenders to a borrower for exposure in the following infrastructure
sub sectors will qualify as ‘infrastructure Lending’.

Sl. No. Category Infrastructure Subsectors

1 Transport i) Roads & Bridges
ii) Ports including capital dredging
iii) Inland waterways
iv) Airports
v) Railway tracks, Tunnels, Viaducts, Bridges1
vi) Urban public transport (except rolling stock in
case of urban road transport)
2 Energy i) Electricity Generation
ii) Electricity Transmission
iii) Electricity Distribution
iv) Oil Pipelines
v) Oil/Gas/LNG storage facility2
vi) Gas pipelines3
3 Water and Sanitation i) Solid waste management
ii) Water supply pipelines
iii) Water treatment plants
iv) Sewerage collection, treatment, disposal system
v) Irrigation (dams, channels etc)
vi) Storm water drainage system
vii) Slurry pipelines
4 Communication i) Telecommunication (Fixed Network)4
ii) Telecommunication Towers
iii) Telecommunication & Telecom Services
5 Social and i) Educational institutions (capital stock)
Commercial ii) Hospitals (capital stock)5
Infrastructure iii) Three star or higher category classified hotels
located outside cities with population of more
than 1 million

88 Banking Finance
 iv) Common infrastructure for industrial parks, SEZs,
tourism facilities and agriculture markets
v) Fertiliser (capital investment)
vi) Post harvest storage infrastructure for agriculture
and horticultural produce including cold storage
vii) Terminal markets
viii) Soil testing Labs
ix) Cold chain6
1
includes supporting terminal infrastructure such as loading/unloading terminals, stations and
buildings
2
includes strategic storage of crude oil
3
includes city gas distribution network
4
includes optic fibre/cable network which provides broadband/ internet
5
includes medical colleges, paramedical training institutes and diagnostic centres
6
includes cold room facility for farm level pre-cooling, for preservation or storage of agriculture
and allied produce, marine products and meat (as per RBI Nov 2012 notification)

* * * * * * *

FRAME 60
INFRASTRUCTURE FINANCE COMPANIES (IFC)
RBI has classified NBFCs in the following categories:
i) Asset finance companies
ii) Loan companies
iii) Investment companies
iv) Infrastructure finance companies
v) Core investment company
vi) Infrastructure debt fund
vii) NBFC- Micro finance institution
viii) NBFC- Factors
An IFC is defined as non-deposit taking NBFC that fulfils the following criteria:
i) A minimum of 75% of its total assets should be deployed in infrastructure loans
ii) Net owned funds of Rs 300 Cr or more

Banking Finance 89
 iii) Minimum credit rating ‘A’ or equivalent
iv) CRAR of 15% (Minimum Tier 1 capital of 10%)
* * * * * * *

FRAME 61
INFRASTRUCTURE FINANCING – SECURED FINANCE

RBI has notified that in the case of PPP (Public Private Partnership) projects (mostly in
road and power sector), the debts due to the lenders may be considered as secured to
the extent assured by the project authority in terms of the concession agreement, if they
meet certain conditions.

The conditions include that the user charges, toll or tariff payments are kept in an escrow
account where senior lenders have priority over withdrawals by the concessionaire and there
is sufficient risk mitigation, such as predetermined increase in user charges or increase
in concession period, in case project revenues are lower than expected.

Among other conditions, the lenders are required to have right of substitution in case of
concessionaire default and also to trigger termination in case of default in debt-service; and
upon termination the project authority has an obligation of compulsory buy-out and
repayment of debt due in a predetermined manner.

Banks have also been allowed to treat annuities under BOT model in respect of road projects
and toll collection rights, where there are provisions to compensate the project sponsor
if a certain level of traffic is not achieved, as tangible securities.

* * * * * * *

FRAME 62
NBFC- MICRO FINANCE INSTITUTION

NBFC-MFI is non-deposit taking NBFC having not less than 85% of its assets which satisfy
the following criteria:

a) Loans disbursed to a borrower with a rural household annual income not exceeding
Rs 60,000/ or urban and semi-urban household income not exceeding Rs
1,20,000/.
b) Loan amount does not exceed Rs 35,000/ in the first cycle and Rs 50,000/ in
subsequent cycles.

90 Banking Finance
 c) Total indebtedness of the borrower does not exceed Rs 50,000/.
d) Tenor of the loan not to be less than 24 months for loan amount in excess of
Rs 15,000/ with no prepayment penalty.
e) Loan to be extended without collateral.
f) Loan is repayable on weekly, fortnightly or monthly instalments at the choice of
the borrower.
* * * * * * *

FRAME 63
MICRO FINANCE INSTITUTIONS (MFI)

Micro finance refers to small scale financial services – both credit and savings that are
extended to the poor in rural, semi-urban and urban areas. MFIs are uniquely positioned
to facilitate financial inclusion.

Since there was no comprehensive regulatory framework till 2011, MFIs exist in many legal
forms.

 Not for profit MFIs

 Mutual benefit MFIs
 For profit MFIs
MFIs usually adopt the group based lending model which are of two types:

a. Self-Help Group model (SHG)

b. Joint Liability Group model (JLG)
Under SHG-bank linkage model, 10 - 20 women form a homogenous group. All the members
of the group save regularly and form a pool from which small loans of low interest rates
are given to individual borrowers of the group. Here, the peer pressure serves as collateral.
Meetings are held periodically to collect savings, disburse loans and collect repayments.
A leader is elected and proper accounts are maintained. After 6 months, if the bank is
satisfied by the performance of the SHG in terms of group dynamics, cohesion and financial
maturity, then the bank lends to the group for on-lending to its members.

MFIs such as NBFCs, Trusts, NGOs etc are extending microfinance. Most of the lending
by NBFCs is done through JLG model. A JLG is an informal group of 5 to 10 individuals
coming together for the purpose of availing bank loans through mutual guarantee.

Banking Finance 91
Bank-SHG linkage programme started in 1992. In recent years, the tremendous growth of
the MFIs has been accompanied by various malpractices. When suicides were reported
due to high indebtedness in Andhra Pradesh, the Govt of AP promulgated the AP
Microfinance Ordinance followed by the bill APMFI (Regulation of Money Lending) Act.
In terms of the Act,
 Every MFI has to register before the Registering Authority of the district
 No one can be a member of more than one SHG
 All loans by MFIs have to be without collateral
 All MFIs have to make public the rates of interest being charged on the loans
 Recovery towards interest cannot exceed principal amount
 Loan recoveries to be made only by monthly instalments
 There are penalties for failure to register and for coercive acts of recovery
 plus others.

As a fall-out, the working of the MFIs came into sharp focus. The areas of concern are:

a. Abnormally high rates of interest around 30%

b. Multiple lending – a member has borrowed from several MFIs
c. High indebtedness of the borrowers
d. Coercive methods of recovery
RBI constituted a sub-committee of the Central Board of Directors (Chairman: Shri.Y.H.
Malegam) to study the issues and concerns in the MFI sector. The Committee submitted
its report in Jan 2011. Based on its recommendations, RBI guidelines are as under:

A new category of NBFC called NBFC-MFI has been created. Now RBI will be the direct
regulator for NBFC-MFIs.

All existing MFIs who can meet the new regulatory norms will have to register as NBFC-
MFIs before Oct 2012.Those who do not meet the norms, cannot lend more than 10% of
their total assets to the sector.

The conditions set for NBFC-MFIs include:

a. Minimum net owned funds of Rs 5 Cr (Rs 2 Cr if they operate in North East)

b. Not less than 85% of its net assets are in the nature of ‘qualifying assets’
‘Net assets are defined as total assets other than cash and bank balances and
money market instruments’.

92 Banking Finance
 ‘Qualifying asset’ means
i. A loan disbursed to a borrower with a rural household annual income not
exceeding Rs 60,000/ or urban and semi-urban households income not
exceeding Rs 1,20,000/.
ii. Loan amount does not exceed Rs 35,000/ in the first cycle and Rs 50,000/
in subsequent cycles.
iii. Total indebtedness of the borrower does not exceed Rs 50,000/.
iv. Tenor of the loan not to be less than 24 months for loan amount in excess
of Rs 15,000/ with no prepayment penalty.
v. Loan to be extended without collateral.
vi. Loan is repayable on weekly, fortnightly or monthly instalments.
c. CAR 15%
d. Pricing: to maintain an aggregate margin cap of not more than 12% till Mar 2014.
With effect from April 1, 2014 margin cap as defined by Malegam Committtee
may not exceed 10% for large MFI s (portfolio exceeding Rs 100 Cr) and 12%
for others.
e. Not more than 2 MFIs can lend to the same borrower while one borrower cannot
be a member of two groups simultaneously. The frequency of repayment
instalments can be decided by the borrower.
f. Every NBFC- MFI has to be a member of at least one Credit Information Company.
g. Recovery should normally be made only at a central designated place.
h. The Micro Finance Institutions (Development and Regulation) Bill 2012 is being
examined by the Standing Committee. Once cleared, it will be brought to
Parliament, whereafter, it will become Law.
Bank credit to MFIs for on-lending will be eligible for categorisation as priority sector lending
if the aggregate amount of the loan, extended for income generating activity, is not less
than 70 % (earlier 75 %)of the total loans given by MFIs.

* * * * * * *

Banking Finance 93
 FRAME 64
NON PERFORMING ASSETS (NPA)

Part A

NPA Definition

RBI introduced prudential norms for income recognition, asset classification and provisioning
for advances way back from 1st April 1992. Income recognition is based on record of
recovery. The assets have been classified under 4 categories based on which provisions
will have to be made.

a) NPA
NPA is a loan/advance where
i) Interest and/or instalment of principal remain overdue for a period of more
than 90 days in respect of a TL.
ii) The account remains ‘out of order’ in respect of overdraft/cash credit.
iii) The bill remains overdue for a period of more than 90 days in case of bill
purchased and discounted.
iv) The instalment of principal or interest thereon remains over due for 2 crop
seasons for short duration crops and 1 crop season for long duration crops.
(Securitisation and derivative transaction not covered in this frame)
In the case of interest payments, bank should, classify an account as NPA only if the interest
due and charged during any quarter is not serviced fully within 90 days from the end of
the quarter.

b) Overdue
An amount due to the banks under any credit facility is ‘overdue’ if it is not paid
on the due date fixed by the bank.

c) Out of Order
An account is treated as ‘out of order’
i) If the outstanding balance remains continuously in excess of the sanctioned
limit/ drawing power.
ii) In cases where the outstanding balance is less than the sanctioned limit/
drawing power but there are no credits continuously for 90 days as on the
date of balance sheet.

94 Banking Finance
 iii) In cases where the outstanding balance is less than the sanctioned limit/
drawing power but credits are not enough to cover the interest debited during
the same period.

d) NPA - Other Situations

i) The outstanding in the account based on drawing power calculated from stock
statements older than three months would be deemed as irregular.
A working capital borrowal account will become NPA if such irregular drawings
are permitted in the account for a continuous period of 90 days.
ii) An account where the regular/adhoc credit limits have not been reviewed/ renewed
within 180 days from the due date/date of adhoc sanction will be treated as NPA.

Part B

Income Recognition

i) Banks should not charge and take to income account interest on any NPA. This
applies to Government Guaranteed accounts also.
However, interest on advances against term deposits, NSCs, IVPs, KVPs and
life policies may be taken to income account on the due date, provided adequate
margin is available in the accounts.
ii) Reversal of Income:
If any advance becomes NPA, the entire interest accrued and credited to income
account for the past periods should be reversed, if the same is not realised.
iii) Appropriation of Recovery in NPAs :
Interest realised on NPAs should not be from fresh/additional credit facilities
sanctioned to the borrower.
In appropriation of recoveries in NPAs (i.e. towards principal or interest due) banks
should adopt an accounting principle which is uniform and consistent.

Part C
Asset Classification

NPAs are classified into three groups:

1. Sub-Standard Asset
is one, which has remained as NPA for a period less than or equal to 12 months.

Banking Finance 95
 2. Doubtful Asset
is one, which has remained in the sub-standard category for a period of 12 months.
3. Loss Asset
is one, where loss has been identified by the banks or internal or external auditors
or the RBI inspection but the amount has not been written off fully.

Guidelines for Classification

 Availability of security or net worth of borrower/guarantor should not be reckoned

for treating an advance as NPA or otherwise.
 Erosion in value of security/Fraud
Where there are potential threats for recovery due to erosion in value of security
or non-availability of security and existence of other factors such as frauds
committed by borrowers.
i) When the realisable value of security is less than 50% of the value assessed
by the bank or accepted by RBI during last inspection, such NPAs may be
straightaway classified as doubtful assets.
ii) If the realisable value of the security is less than 10% of the outstanding, it should
be straightaway classified as loss assets.
 All facilities granted to a borrower and investment in securities issued by the
borrower will have to be treated as NPA/NPI(Non Performing Investment) if one
account becomes NPA.
 Bills discounted under LC may not be classified as NPA when any other facility
granted to a borrower becomes NPA. However, if documents under LC are not
accepted on presentation or payment under LC is not made on the due date,
then this facility also will be NPA effective from the date when the other facilities
had been classified as NPA.
 Asset classification of accounts under consortium should be based on record of
recovery of individual member banks.
 ‘Long duration crops’ would be crops with crop season longer than one year and
crop which are not ‘long duration’ would be treated as ‘short duration’ crops.
 The credit facilities backed by guarantee of the Central Government though
overdue may be treated as NPA only when the Government repudiates its
guarantee when invoked. This exemption is not for the purpose of recognition of
income i.e. interest cannot be reckoned for income account unless it is realised.

96 Banking Finance
 Part D
Provisioning
Provisions should be made as NPAs as below:
i) Loss assets
The asset should be written off. If it remains in the books, 100% of the outstanding
should be provided for.

ii) Doubtful Assets

a) 100% of unsecured of portion plus

As DA Percentage of secured portion

(Realisable value)
Up to 1 year 25
1 to 3 years 40
More than 3 years 100
 NPAs above Rs.5 Cr : Stock audit at annual intervals by external agencies
is required.
 Collateral by way of immovable property: Valuation to be done once in three
years.

iii) Sub-Standard Assets

 A general provision of 15% on total outstandings needs to be done. No
allowance for ECGC guarantee cover and securities available.
 Unsecured exposures identified as substandard would attract additional
provision of 10% i.e. total 25% on the outstanding balance.
iv) Provisioning for Standard Assets
a) Direct advances to agriculture and Micro and 0.25%
small enterprises (MSE)
b) Commercial real estate 1.00%
c) Commercial real estate – residential Housing 0.75%
d) All other advances (Including Medium Enterprises) 0.40%
e) Housing Loans of ‘Teaser’ rates – 2%. It will revert back to 0.40% after
1 year from the date on which the rates are reset at higher rates if the
account remains ‘standard’.
f) Restructured advances carry different rates.

Banking Finance 97
Additional Provisions for NPAs
The regulatory norms for provisioning represent the minimum requirement. A Bank may
voluntarily make specific provisions for advances at higher rates than prescribed, to provide
for estimated actual loss in collectible amount, provided such higher rates are approved
by the Board and consistently adopted from year to year. Such additional provisions are
not to be considered as floating provisions.
Special Circumstances
 Provision on additional facilities sanctioned as per package finalised by BIFR and/
or term lending institutions need not be made for one year from the date of
disbursement.
 Similarly for SSI units, identified as sick and rehabilitation packages have been
drawn up by banks themselves, no provision is required for 1 year for the additional
finance.
* * * * * * *

FRAME 65
GROSS NPA AND NET NPA
Net NPA = Gross NPA MINUS
i. NPA provisions
ii. DICGC/ECGC claims received and held pending adjustment
iii. Part payment received and kept in suspense account or any other similar account
iv. Balance in Sundries account (Interest capitalisation – Restructured accounts) in
respect of NPA accounts.
v. Floating provisions (when not utilising it for Tier II capital)
vi. Provisions in lieu of diminution in fair value of restructured accounts classified as
NPAs.
vii. Provisions in lieu of diminution in fair value of restructured accounts classified
as standard accounts.
* * * * * * *

98 Banking Finance
 FRAME 66
NPA RATIOS
Slippage Ratio
Fresh accretion to NPAs during the year as a % of
Standard Assets at the beginning of the year

Recovery Ratio
NPAs recovered during the year as a % of
Gross NPAs at the beginning of the Year

Written Off Ratio

NPAs written off during the year as a % of
Gross NPAs at the beginning of the year

Provisioning Coverage Ratio

Ratio of provisions to Gross NPA (%)
* * * * * * *

FRAME 67
FLOATING PROVISIONS AND THEIR ENDUSE

Indian banks make the following types of provisions with regard to loan losses:

a. General provisions for standard assets

b. Specific provisions for NPAs
c. Floating Provisions
d. Provision against the Diminution in Fair Value (DFV) of Restructured Assets
Creation of Floating Provisions (FP) should be as per policy approved by the Board. FP
should be made separately for ‘advances’ and ‘investments’.

Principles for utilizing FP are:

a. The FP should not be used for making specific provisions for NPA or for making
regulatory provisions for standard assets. It can be used only for contingencies
under extra-ordinary circumstances for making specific provisions in impaired
accounts after obtaining Board’s approval and with prior permission of RBI. The
banks’ Boards should lay down an approved policy as to what circumstances
would be considered extra-ordinary.

Banking Finance 99
 b. To facilitate banks’ Boards to evolve suitable policies in this regard, it is clarified
that the extra-ordinary circumstances refer to losses which do not arise in the
normal course of business and are exceptional and non-recurring in nature. These
extra-ordinary circumstances could broadly fall under three categories: General,
Market and Credit. Under general category, there can be situations where bank
is put unexpectedly to loss due to events such as civil unrest or collapse of
currency in a country. Natural calamities and pandemics may also be included
in general category. Market category would include events such as a general melt
down in the markets which affects the entire financial system. Under credit
category, only exceptional credit losses would be considered as an extra-ordinary
circumstance.
Until utilization, FP can be netted off from gross NPAs to arrive at net NPA’s. Alternatively,
they can be treated as Tier II capital within the overall ceiling of 1.25% of RWAs.

* * * * * * *

FRAME 68
CORPORATE DEBT RESTRUCTURING MECHANISM

Corporates engaged in any type of activity and who are having credit facilities from more
than one bank/FI under multiple banking/syndication/consortium of Rs 10 Cr and above
(Fund-based and non-fund based) can approach CDR for debt restructuring.

CDR is a mechanism set up for speedy and transparent method of restructuring the
corporate debt of viable entities who are facing problems, outside the purview of BIFR, DRT
and other legal proceedings.

CDR system has a three tier structure:

 CDR Standing Forum(SF) and its Core Group(CG)

 CDR Empowered Group(EG)
 CDR Cell(Cell)
SF will lay down policies and guidelines. It will review and monitor the progress of
restructuring cases. It will take decisions on exceptional cases also.

Reference to CDR system can be made by one or more creditor who have minimum 20%
share in either working capital or term finance or by the corporate supported by a bank
or financial institution having stake as above.

100 Banking Finance

CDR Cell will make the initial scrutiny of the proposals received from borrowers/creditors
and put up the case to the EG within one month to decide admission to CDR and acceptance
for restructuring, if found feasible.

EG decides whether restructuring of the company’s debt is prima-facie feasible and

operations are potentially viable. If 75 per cent of creditors by value and 60 per cent of
the creditors by number agree to a restructuring package of an existing debt, the same
would be binding on the remaining creditors. This is in terms of Inter-Creditor Agreement.
Then a detailed rehabilitation proposal is worked out by the Cell in consultation with the
Lead Bank and the EG takes a final decision for approval. EG will have to dispose off the
proposal in 90 days(which can be extended to 180 days)from the date of reference to the
Cell. The decision of EG is final. If restructuring is not found viable, the creditors would
be free to take steps for recovery of their dues.

In Category 1 CDR system, standard and sub-standard accounts are considered. In case
an account is ‘doubtful’ in any bank and if it is ‘standard’ or ‘sub-standard’ in the books
of at least 90 % of the creditors (by value), the same would be treated as standard/
substandard, only for the purpose of eligibility under CDR.

Exceptional cases like ‘wilful default’ will be examined by the Core Group only.

BIFR cases may be eligible for restructuring if specifically recommended by the Core Group.
Approval from BIFR is to be taken before implementing the package.

CDR is a non-statutory voluntary mechanism based on Debtor-Creditor Agreement (DCA)

and Inter-Creditor Agreement(ICA).

One important element of DCA would be ‘stand-still’ agreement binding for 90 days, or 180
days by both sides. Under this clause, both the debtor and creditor(s) shall agree to a
legally binding ‘stand-still’ whereby both parties commit themselves not to take recourse
to any other legal action during the ‘stand-still’ period. This would be necessary for enabling
the CDR system to undertake the necessary debt restructuring exercise without any outside
intervention, judicial or otherwise. However, the stand-still clause will be applicable only to
any civil action either by the borrower or any lender against the other party and will not
cover any criminal action. The borrower will additionally undertake that during the stand-
still period the documents will stand extended for the purpose of limitation and also that
he will not approach any other authority for any relief and the directors of the borrowing
company will not resign from the Board of Directors during this period.

Banking Finance 101

Sharing of Additional Finance

Additional finance, if any, is to be provided by all creditors of a ‘standard’ or ‘sub-standard

account’ irrespective of whether they are working capital or term creditors, on a pro-rata
basis. In case for any internal reason, any creditor (outside the minimum 75 per cent and
60 per cent) does not wish to commit additional financing, that creditor will have an option
in accordance with the provisions detailed under exit option.

The providers of additional finance, whether existing creditors or new creditors, shall have
a preferential claim, to be worked out under the restructuring package, over the providers
of existing finance with respect to the cash flows out of recoveries, in respect of the
additional exposure.

Exit Option

A Creditor (outside the minimum 75 percent and 60 percent) who for any internal reason
does not wish to commit additional finance can either (a) arrange for its share of additional
finance to be provided by a new or existing creditor, or (b) agree to the deferment of first
year’s interest due to it after the CDR package becomes effective. The first year’s deferred
interest, without compounding, will be payable along with the last instalment of the principal
due to the creditor.

One Time Settlement can also be considered, wherever necessary, as a part of the
restructuring package. If an account with any creditor is subjected to one time settlement
(OTS) by a borrower before its reference to the CDR mechanism, any fulfilled commitments
under such OTS may not be reversed under the restructured package. Further payment
commitments of the borrower arising out of such OTS may be factored into the restructuring
package.

Under Category 2 of CDR, ‘Doubtful assets’ can be considered if a minimum of 75 %

of creditors (by value) and 60 % creditors (by number) satisfy themselves of the viability
of the account and consent for restructuring, subject to the following condition :

 The existing loans will only be restructured and it would be up to the promoter
to firm up additional financing arrangement with new or existing creditors
individually.
All other norms under the CDR mechanism such as the standstill clause, asset
classification status during the pendency of restructuring under CDR, etc. will continue to
be applicable to this category also.

102 Banking Finance

Right to recompense clause will be incorporated in all packages and a minimum of 75
% of the recompense amount should be recovered by the lenders. In cases where some
facility has been extended below base rate, 100 % of the recompense amount should be
recovered.

* * * * * * *

FRAME 69
GUIDELINES ON RESTRUCTURING OF ADVANCES

RBI has updated the guidelines (up to 30 June, 2013) on restructuring taking into account
the recommendations of the working group (Chairman: Shri B. Mahapatra) to review the
existing prudential guidelines on the restructuring of advances by banks/FIs. These norms
are applicable to all restructurings including those under CDR mechanism (except
restructuring on account of natural calamity).

Restructuring would normally involve modification of terms of the advances/securities which

would generally include alteration of repayment period/repayable amount/amount of
instalment/rate of interest (due to reasons other than competitive reasons).

Not a restructured account

1. Extension in repayment tenor of a floating rate loan on reset of interest rate,

so as to keep the EMI unchanged provided it is applied to a class of accounts
uniformly will not render the account to be classified as restructured account.
2. In case of roll over of short term loans, where proper pre-sanction assessment
has been made and it is need-based, with no concession due to credit weakness,
such roll over need not be treated as restructured account*.

*But if such accounts are rolled over more than two times, the third rollover will be
treated as restructured account.

Concepts

Repeatedly Restructured Account : A second restructuring is considered as ‘repeatedly

restructured account’.

Specified period: means a period of one year from the commencement of first payment
of interest or principal, whichever is later, on the credit facility with longest period of
moratorium under the terms of restructuring package.

Banking Finance 103

 Satisfactory Performance : means

 Agriculture: At the end of the specified period, the account should be regular.

 Cash credit (Non-agriculture): The account should not be out of order during
the specified period, for a duration of more than 90 days. In addition, there should
not be any overdues at the end of the specified period.

 Term loan (Non-agriculture): No payment should remain overdue for a period

of more than 90 days. In addition, there should not be any overdues at the end
of the specified period.

Eligibility Criteria for restructuring of advances

 Standard, Sub standard, doubtful categories advances can be restructured.

 Restructuring cannot be done with retrospective effect.
 The process of asset classification will not stop merely because restructuring
proposal is under consideration.
 Restructuring cannot take place without formal consent/application of the debtor.
 Restructuring can be done only after financial viability is established. Cash flows
have to be looked into and viability assessed on acceptable viability parameters
like DSCR, ROCE, Loan Life Ratio (LLR) etc.
 Generally, frauds accounts will not be eligible for restructuring. Regarding wilful
default, the reasons for such classification may be examined and restructuring
can be done with the Board’s approval.
 BIFR cases are not eligible for restructuring without their consent.

LLR

Present value of total available cash flow (ACF)

during the loan life period (including interest and principal)
Loan Life Ratio = ----------------------------------------------------------------------------------------------------
Maximum amount of loan

LLR should be 1.4 which would give a cushion of 40% to the amount of loan to be serviced.

Asset Classification

Restructuring of advances can take place

a) Before commencement of commercial production

104 Banking Finance

 b) After commencement of commercial production but before the asset has been
classified as ‘sub-standard’.
c) After commencement of commercial production and the asset has been classified
as ‘sub-standard’ or ‘doubtful’.
 Standard assets, on restructuring will be classified ‘sub-standard’ assets.
 NPAs upon restructuring would continue to have the same asset
classification as prior to restructuring and slip into lower categories with
reference to the pre-restructuring repayment schedule.
 Standard Accounts classified as NPA & NPA accounts retained in the same
category on restructuring should be upgraded only when all the loan/facilities
in the account perform satisfactorily during the specified period.
 If not, asset classification should be reckoned with reference to the pre-
restructuring payment schedule.
 Any additional finance may be treated as ‘standard asset’ during the
specified period under the approved restructuring package.

Provisioning Norms

 Restructured accounts classified as standard will attract a higher provision (as

prescribed) in the first two years from the date of restructuring.
 In cases of moratorium on payment of interest/principal after restructuring such
advances will attract the prescribed higher provision for the period covering
moratorium and two years thereafter.
 Restructured advances classified as NPA, when upgraded to standard category
will attract a higher provision as (prescribed) in the first year from date of
upgradation.
 The higher provisions on restructured standard advances (stock as on 31.5.2013)
are:
2.75% w.e.f. June 1, 2013
3.50% w.e.f. March 31, 2014 (spread over 4 quarters of 2013-14)
4.25% w.e.f. March 31, 2015 (spread over 4 quarters of 2014-15)
5.00% w.e.f. March 31, 2016 (spread over 4 quarters of 2015-16)
 For restructured advances (flow) with effect from June 1, 2013 provision is 5%.

Banking Finance 105

Provision for diminution in the fair value (DFV) of restructured advances.

 Reduction in the rate of interest and/or reschedulement of repayment of principal,

as part of restructuring, will result in DFV of the advance. Such DFV is an
economic loss for the bank, and will have impact on the banks’ market value of
equity. Hence, the DFV is calculated and provisions made for it.
The erosion in FV should be computed as the difference between the FV of the loan before
and after restructuring.
FV of the loan before restructuring will be computed as the present value of cash flows
representing the interest at the existing rate charged before restructuring and principal,
discounted at the rate equal to bank’s BPLR or Base Rate (whichever is applicable) as
on date of restructuring plus term premium and credit risk premium for the borrower category.
FV of the loan after restructuring will computed as the present value of cash flows
representing the interest at the existing rate charged on the advance on restructuring and
the principal, discounted at the rate equal to bank’s BPLR or Base Rate (whichever is
applicable) as on date of restructuring plus term premium and credit risk premium for the
borrower category.
If due to lack of expertise/infrastructure, a bank finds it difficult to ensure computation of
DFV of advances, as on alternative, banks will have the option of notionally computing the
amount of DFV and providing therefor, at 5% of the total exposure, in respect of all
restructured accounts where the total dues to the banks are less than Rs 1 Cr.
The total of provisions required against an account (normal provisions plus provisions in
lieu of DFV) are capped at 100% of outstanding debt amount

Risk weights

 Restructured housing loans carry additional risk weight of 25%.

 Unrated standard corporates whose obligations have been subjected to
restructuring should be assigned a higher risk rating of 125% until satisfactory
performance is established during the specified period.

Special regulatory treatment for Asset classification

This is available to borrowers but not for: a) Consumer and personal advances b) Capital
market exposure c) Commercial real estate exposure.

It has the following components:

a. Incentive for quick implementation of the restructuring package.

106 Banking Finance

 b. Retention of asset classification of the restructured account in the pre-restructuring
asset category.
If the approved package is implemented by the bank as per the following schedule, the
asset classification may be restored to the position which existed when the reference was
made to the CDR Cell in cases covered under CDR mechanism or when the restructuring
application was received by the bank in non-CDR cases:

a. Within 120 days from the date of approval under CDR mechanism.
b. Within 120 days from the date of receipt of application by the bank in non-CDR
cases.

subject to the following conditions:

a. The dues to the bank are ‘fully secured’ by tangible security, except
i) MSE borrowers whose outstanding is up to Rs.25 lacs
ii) Infrastructure Projects
b. Unit to be viable in 8 years, in case of infrastructure and in 5 years in other cases
c. Repayment period including moratorium does not exceed 15 years for
infrastructure advances and 10 years for others (not applicable to home loans)
d. Promoters’ sacrifice and additional funds brought by them should be a minimum
of 20% of bank’s sacrifice or 2% of the restructured debt, whichever is higher.
Bank’s sacrifice means the amount of ‘erosion in fair value of the advance’
e. Promoters’ contribution can be way of cash/derating of equity/conversion of
unsecured loan into equity/interest free loans.
f. The restructuring is not a ‘repeated restructuring’.

The above regulatory treatment (concessions) will be withdrawn from April 1, 2015 with the
exception of the provisions related to changes in DCCO in respect of infrastructure and
non- infrastructure project loans.

Miscellaneous

a. Convertibility (into equity) Option – Sec. 19 of Banking Regulation Act to be

complied with.
b. Conversion of debt into preference shares should be done as a last resort.
Conversion into equity/preference shares should be restricted to a cap of 10%
of the restructured debt. Conversion can be done only for listed companies.

Banking Finance 107

 c. Conversion (in such restructuring) even if it leads to breach of exposure norms,
prior approval of RBI is not required; but to be reported to RBI with DBS return.
d. Acquisition of non-SLR securities by way of conversion of debt is exempt from
mandatory rating requirement and prudential limit on investment in unlisted non-
SLR securities.
e. Right of recompense has to be incorporated. Minimum 75% of recompense
amount should be recovered. Where restructuring is extended at below base rate,
100% should be recovered.
f. A stipulation of personal guarantee will ensure promoters’ ‘skin in the game’ or
commitment to the restructuring package. It should be obtained.
* * * * * * *

FRAME 70
SME DEBT RESTRUCTURING MECHANISM

Apart form CDR mechanism, there exists a much simpler mechanism for restructuring of
loans availed by small and medium enterprises (SMEs). Unlike in the case of CDR
Mechanism, the operational rules of the mechanism have been left to be formulated by
the banks concerned. This mechanism will be applicable to all the borrowers which have
funded and non-funded outstanding up to Rs.10 Cr under multiple/consortium banking
arrangement. Major elements of this arrangement are as follows:

a. Banks may formulate, with the approval of their Board, a debt restructure scheme
for SMEs within the prudential norms laid down by RBI. Banks may frame different
sets of policies for borrowers belonging to different sectors within the SME.
b. The scheme, at the minimum, may include parameters indicated in CDR
guidelines.
c. The bank with the maximum outstanding may work out the restructuring package
along with the bank having the second largest share.
d. Banks should work out the restructuring package and implement the same within
a maximum period of 90 days from date of receipt of request.
e. This mechanism will be available to all borrowers engaged in any type of activity.
f. A quarterly review on the progress in rehabilitation and restructuring of SMEs
accounts may be put up to the Board.
* * * * * * *

108 Banking Finance

 FRAME 71
PROJECT LOANS

There are occasions when the completion of projects is delayed for legal and other
extraneous reasons like delays in government approvals etc. All these factors, which are
beyond the control of the promoters, may lead to delay in project implementation and involve
restructuring/ reschedulement of loans by banks. Accordingly, the following asset
classification norms apply for project loans before commencement of commercial operations.

For this purpose, all project loans have been divided into the following two categories:

a. Project loans for infrastructure sector

b. Project loans for non- infrastructure sector
‘Project Loan’ would mean any term loan which has been extended for the purpose of setting
up of an economic venture. Banks must fix a Date of Commencement of Commercial
Operations (DCCO) at sanction/financial closure.

Project Loans for Infrastructure Sector

a. A loan for an infrastructure project will be classified as NPA during any time before
commencement of commercial operations as per record of recovery (90 days
overdue), unless it is restructured and becomes eligible for classification as
‘standard asset’ in terms of paras (c) to (e) below.
b. A loan for an infrastructure project will be classified as NPA if it fails to commence
commercial operations within two years from the original DCCO, even if it is regular
as per record of recovery, unless it is restructured and becomes eligible for
classification as ‘standard asset’ in terms of paras(c)to (e) below.
c. If a project loan classified as ‘standard asset’ is restructured any time during the
period up to two years from the original DCCO, it can be retained as a standard
asset if the fresh DCCO is fixed within the following limits, and further provided
the account continues to be serviced as per the restructured terms.
i. Infrastructure Projects involving court cases
Up to another 2 years (beyond the existing extended period of 2 years i.e.
total extension of 4 years), in case the reason for extension of date of
commencement of production is arbitration proceedings or a court case.
ii. Infrastructure Projects delayed for other reasons beyond the control of
promoters

Banking Finance 109

 Up to another 1 year (beyond the existing extended period of 2 years (ie,
total extension of 3 years), in other than court cases.
d. It is re-iterated that the dispensation in (c) is subject to adherence to the provisions
regarding restructuring of accounts which would inter-alia require that the
application for restructuring should be received before the expiry of period of two
years from the original DCCO and when the accounts is still standard as per record
of recovery. The other conditions applicable would be:
i. In cases where there is moratorium for payment of interest, banks should
not book income on accrual basis beyond two years from the original DCCO,
considering the high risk involved in such restructured accounts.
ii. Banks should maintain following provisions on such accounts as long as
these are classified as standard assets in addition to DFV:
If revised DCCO is within 2 years from the original DCCO prescribed at the time
of financial closure: 0.40%
If the DCCO is extended beyond 2 years and up to 4 years or 3 years from the
original DCCO, as the case may be, depending on the reasons for delay:
Project loans restructured w.e.f. June 1, 2013:
 5% - from the date of such restructuring till the revised DCCO or 2 years
from the date of restructuring, whichever is later.

Stock of project loans classified as restructured as on June1, 2013:

 3.50 % - w.e.f. March 31, 2014, (spread over 4 quarter of 2013 - 14)
 4.25 % - w.e.f. March 31, 2015, (spread over 4 quarter of 2014 - 15)
 5.00 % - w.e.f. March 31, 2016, (spread over 4 quarter of 2015 - 16)
The above provisions will be applicable form the date of restructuring till the revised
DCCO or 2 years from the date of restructuring, whichever is later.

e. For the purpose of these guidelines, mere extension of DCCO would not be treated
as restructuring if the revised DCCO falls within the period of 2 years from the
original DCCO. In such cases the consequential shift in re-payment period by
equal or shorter duration (including the start date and end date of revised
repayment schedule) than the extension of DCCO would also not be considered
as restructuring provided all other T&C of the loan remain unchanged. As such,
project loans will be treated as standard assets in all respects, they will attract
standard asset provision of 0.40%.

110 Banking Finance

 f. In case of infrastructure projects under implementation where appointed date (as
defined in the Concession Agreement) is shifted due to the inability of the
Concessionaire to comply with the requisite conditions, change in the DCCO need
not be treated as restructuring subject to the following conditions:
i. The project is an infrastructure project under PPP Model awarded by a public
authority.
ii. The loan disbursement is yet to begin.
iii. The revised DCCO is documented by way of a supplementary agreement between
the borrower and lender.
iv. Project viability has been reassessed and sanction from appropriate authority has
been obtained at the time of supplementary agreement.
* * * * * * *

FRAME 72
PROJECT LOANS FOR NON-INFRASTRUCTURE SECTOR

a. A loan for a non-infrastructure project will be classified as NPA during any time
before commencement of commercial operations as per record of recovery (90
days overdue), unless it is restructured and becomes eligible for classification
as ‘standard asset’ in terms of paras (c) & (d) below.
b. A loan for a non-infrastructure project will be classified as NPA if it fails to
commence commercial operations within 1 year from the original DCCO, even
if it is regular as per record of recovery, unless it is restructured and becomes
eligible for classification as ‘standard asset’ in terms of paras (c) & (d) below:
c. In case of non-infrastructure projects, if the delay in commencement of commercial
operations extends beyond the period of 1 year from the date of completion as
determined at the time of financial closure, banks can prescribe a fresh DCCO,
and retain the ‘standard’ classification by undertaking restructuring of accounts
in accordance with the provisions contained in RBI guidelines provided the fresh
DCCO does not extend beyond a period of 2 years from the original DCCO. This
would, among others, also imply that the restructuring application is received
before the expiry of 1 year from the original DCCO, and when the account is still
‘standard’ as per the record of recovery.

Banking Finance 111

The other conditions applicable would be:
i. In case where there is moratorium for payment of interest, banks should not book
income on accrual basis beyond 1 year from the original DCCO, considering the
high risk involved in such restructured accounts.
ii. Banks should maintain provisions on such accounts as long as these are
classified as standard assets apart from provisions for DFV due to extension of
DCCO.
If the revised DCCO is within one year from the original DCCO prescribed at the
time of financial closure: Provisioning required : 0.40 %
If the DCCO is extended beyond 1 year and up to 2 years from the original DCCO prescribed
at the time of financial closure: Provisioning required :
Project loans restructured w.e.f. June 1, 2013:
 5.00% - from the date of restructuring for 2 years.
Stock of project loans as restructured before June1, 2013:
 3.50% - w.e.f. March 31, 2014, (spread over 4 quarters of 2013 - 14)
 4.25% - w.e.f. March 31, 2015, (spread over 4 quarters of 2014 - 15)
 5.00% - w.e.f. March 31, 2016, (spread over 4 quarters of 2015 - 16)
The above provisions will be applicable form the date of restructuring for 2 years.
d. For the purpose of these guidelines, mere extension of DCCO would not be
considered as restructuring if the revised DCCO falls within the period of one year
from the original DCCO. In such cases the consequential shift in repayment by
equal or shorter duration (including the start date and end date of revised
repayment schedule) than the extension of DCCO would also not be considered
as restructuring provided all other terms and conditions remain unchanged. Such
project loans will be standard assets attracting provision of 0.40%.
e. Other Issues
Any change in the repayment schedule of a project loan caused due to an increase
in the project outlay on account of increase in scope and size of the project, would
not be treated as restructuring if:
i) The increase in scope and size of the project takes place before
commencement of commercial operations of the existing project.
ii) The rise in cost excluding any cost-overrun in respect of the original project
is 25% or more of the original outlay.

112 Banking Finance

 iii) The bank re-assesses the viability of the project before approving the
enhancement of scope and fixing a fresh DCCP.
iv) On re-rating, (if already rated) the new rating is not below the previous rating
by more than one notch.
* * * * * * *

FRAME 73
PROJECT LOANS FOR COMMERCIAL REAL ESTATE

For CRE projects, mere extension of DCCO would not be considered as restructuring if
the revised DCCO falls within the period of 1 year from the original DCCO and there is
no change in other conditions except possible shift of the repayment schedule and servicing
of the loan by equal or shorter duration compared to the period by which DCCO has been
extended. Such CRE project loans will be treated as standard assets in all respects for
this purpose without attracting higher provisions applicable to restructured standard assets.
However asset classification benefit would not be available to CRE projects if they are
restructured.

In all above cases where regulatory forbearance has been extended, Boards should satisfy
themselves above the viability of the project and the restructuring plan.

* * * * * * *

FRAME 74
CREDIT INFORMATION BUREAUS (CIB)

Credit Information Companies (Regulation) Act, 2005 (CICRA) was enacted to regulate credit
information companies and is a milestone in the journey of Indian financial system towards
a fair, robust and non-monopolistic credit reporting infrastructure.

As on date, the following information bureaus are operative:

a. Credit Information Bureau (India) Ltd. (CIBIL): (Retail credit bureau and commercial
credit bureau)
b. Experian Credit Information Company of India Pvt. Ltd: (Helps business to manage
credit risk, prevent fraud, target marketing offers and automate decision making)
c. Equifax Credit Information Services Pvt. Ltd: (Consumer Bureau and Micro-
Finance Credit Bureau)

Banking Finance 113

 d. High Mark Credit Information Services Ltd: (Retail consumer finance, MSME,
Microfinance, Telecommunication & Insurance Sectors)
Credit information bureaus are agencies that collect, process, and maintain credit record
of borrowers and make them available to lending institutions in its network. This information
is distributed for a fee to lenders, who use it to decide whether to approve a given credit
application, how much credit to offer to a specific borrower, and on what terms. CIBs are
known as credit reporting, intelligence or reference agencies; and also credit registries.

Credit Reports help both the lenders and prospective borrowers. While lenders use them
to reduce default rates and applications processing time, borrowers use them to secure
expeditious credit sanctions and better loan rates by keeping their payment history in good
shape. Mostly used at credit origination stage, credit reports perform the secondary function
of limiting wilful default by increasing the cost of default for a borrower.
Credit Information Report (CIR):
 Is a summary of a customer’s loan related EMI and credit card payments
 Contains customer’s personal information and history of ‘enquiries’
 Makes customer’s repayment history (creditworthiness) available to lenders
 Helps customers in getting a loan or credit card

The credit score and CIR may help lenders differentiate between consumers who have
honoured their financial obligations responsibility and those who have defaulted. The former
thus builds up a ‘reputational collateral’ with lenders. This ‘reputational collateral’, in turn,
may help individuals to avail credit at better terms with a lender.
CIRs help in mitigating credit risk.
A CIB needs to obtain data on borrowers from various credit grantors (lending institutions).
It can supplement it with data in public domain (court judgements, records of the registrar,
published information on firms).
The key requirement is that the data collected by the bureau from any source should consist
of facts only and not opinions.
Credit bureaus as well as the institutions providing data, have to ensure the accuracy and
the completeness of data. This can be done by performing data integrity tests to identify
errors, in-consistencies and incompleteness in the data collected. Checks are done to see
that the status codes are applied correctly and that names and addresses are accurate
and consistent.

114 Banking Finance

The CIC Act provides statutory backing for sharing of credit information by credit institutions
with CICs and hence the ‘consent clause’ for the borrowers to agree to the banks sharing
of credit information with CIC is now no longer required to be taken.
In developed countries where credit bureau mechanism is well-entrenched, individuals have
to worry about having a good credit history, because for them, it not only impacts the cost
and access to credit across the financial system, but also the access to other services
like rental accommodation.

* * * * * * *

FRAME 75
SME RATING AGENCY OF INDIA LIMITED (SMERA)

SMERA is the country’s first rating agency that focuses primarily on the Indian Micro, Small
and Medium Enterprises (MSME) segment. Its primary objective is to provide ratings that
are comprehensive, transparent and reliable. The objective of the rating is to facilitate greater
and easier flow of credit from the banking sector to MSMEs and also as a tool to facilitate
self-improvement.

SMERA has been set up jointly by SIDBI & D&B Information Services India Pvt. Ltd and
several leading banks in the country.

Better ratings will benefit MSME by way of lower collaterals, reduced interest rates,
simplified lending norms, access to timely and adequate credit.

SMERA ratings categorise MSMEs on the basis of their size, thus enabling ease of
comparison of the rated unit with its peer within the industry. It also ensures smaller units
are not compared with larger units and thus put to any disadvantage.

The rating is a comprehensive assessment of the enterprise reckoning the overall financial
and non-financial performance of the unit vis-a-vis the other peers in the industry with similar
size. The rating methodology addresses the following areas:

i) Industry risk
ii) Business risk
iii) Management risk
iv) Financial risk
v) New project risk

Banking Finance 115

MSME rating is offered in two different scales.

A. SMERA MSME Scale (without NSIC subsidy)

SMERA’s rating scale consists of two parts, a composite Appraisal Indicator and a Size
Indicator.

Appraisal Indicator Size Indicator (based on net worth)

MSME 1 Highest
MSME 2 High A More than Rs 20 Cr
MSME 3 Above average B Between Rs 5 Cr and Rs 20 Cr
MSME 4 Average C Between Rs1 Cr and Rs 5 Cr
MSME 5 Below Average D Less than Rs 1 Cr
MSME 6 Inadequate
MSME 7 Low
MSME 8 Lowest

B. NSIC - D & B - SMERA Rating Scale (with NSIC subsidy)

It consists of two parts

1) Financial Strength Indicator
2) Performance Capability Indicator

Rating Indicators
Financial Strength
High Moderate Low
Highest SE 1A SE 1B SE 1C
Performance High SE 2A SE 2B SE 2C
Capability Moderate SE 3A SE 3B SE 3C
Weak SE 4A SE 4B SE 4C
Poor SE 5A SE 5B SE 5C

The rating is valid for one year and is to be renewed annually.

* * * * * * *

116 Banking Finance

 FRAME 76
REVERSE MORTGAGE (RM)

RM is so named because the payment stream is reversed ie, instead of the borrower making
monthly payments to the lender (as in conventional mortgage), a lender makes payment
to the borrower.

National Housing Bank guidelines on RM are as under:

Senior citizens need a regular cash flow stream for supplementing pension/other income
and addressing their financial needs. Conceptually, RM seeks to monetise the house as
an asset and specifically the owner’s equity in the house. It is a case of ‘rising debt and
falling equity’.

Under the scheme, senior citizens (above 60 years) can mortgage the house property to
the lender, who then makes periodic payments to the borrower during the latter’s lifetime.
The borrower is not required to service the loan during his lifetime and therefore does not
make monthly repayments of principal and interest to the lender. On the borrower’s death
or on the borrower leaving the house property permanently, the loan is repaid along with
accumulated interest, through sale of the house property. The borrower(s)/heir (s) can also
repay or prepay the loan and have the mortgage released without resorting to sale of the
property.

The amount of loan will depend on the market value of the property, age of the borrower
and interest rate. Equity to value Ratio (EVR) should not be below 10%. Revaluation may
be done every 5 years.

The nature of payment can be any or a combination of the following:

a. Periodic payments (monthly, quarterly, half yearly or annual)

b. Lump sum payments in one or more tranche
c. Committed line of credit within an availability period

The tenor of the loan should not exceed 20 years.

All RM loan products have to carry a clear and transparent ‘no negative equity’ or ‘non-
recourse guarantee’ i.e. the borrower(s) will never owe more than the net realisable value
of their property, provided the terms and conditions of the loan have been met.

Commercial property will not be eligible for RM loan.

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All payments under RM loan are exempt from income tax. Capital gains tax will be applicable
at the time of sale of the property to recover the loan.

Right of Rescission

As a customer-friendly gesture and in keeping with international best practices, after the
documents have been executed and loan transaction finalised, the borrower may be given
up to 3 business days to cancel the transaction, the ‘right of recission’. If the loan amount
has been released, the entire loan amount needs to be repaid by the borrower within this
3 day period.

* * * * * * *

FRAME 77
RELIEF MEASURES TO BE EXTENDED BY BANKS IN AREAS
AFFECTED BY NATURAL CALAMITIES

The RBI guidelines, as below, enable banks to take uniform and concerted action
expeditiously, particularly to provide financial assistance to agriculturists, small scale
industrial units, artisans, small business and trading establishments affected by natural
calamities like droughts, floods, cyclones, tidal waves etc.

 A suitable Board policy on the subject should be put in place.

 Upon occurrence of a natural calamity, special SLBC meeting may be convened
to review the position in the affected areas for necessary action.
 The convenors of District Consultative Committees of the affected districts should
convene a meeting after the occurrence of a natural calamity for further action.

Crop Loans

a. In case of droughts, floods etc the Govt authority would have declared ‘anewari’
to indicate to the extent to which the crops are damaged. However, where such
declaration has not been made, the District Collector’s certificate that crop yield
is below 50% of the normal yield, supported by the views of the DCC should be
sufficient for invoking quick relief arrangements. The Collector’s certificate should
be issued crop-wise. Alternatively, the District Collector may ask the Lead Bank
Officer to convene a DCC meeting and submit a report to DCC on the extent of
crop loss in the affected areas. The DCC can take a decision to provide reliefs
without declaration of ‘annewari’.

118 Banking Finance

 b. The requirement of financial assistance would include:
i. Consumption loans: May be sanctioned to existing borrowers up to
Rs10,000/ without any collateral. Beyond Rs 10,000/ at bank’s discretion.
ii. Fresh loans: To existing borrowers and to new eligible borrowers.

Restructuring of existing loans

The principal and interest due in the year of occurrence of natural calamity on short term
loans may be converted into term loan.

In the case of term loan, instalment of principal and interest due in the year of occurrence
of natural calamity may also be converted into term loan.

The restructured period for repayment may be 3-5 years. Where the damage is severe,
it can go up to 7 years. In extreme hardship cases, it may be done up to a maximum
of 10 years in consultation with the Task Force/SLBC.

Moratorium of at least 1 year should be considered. No additional collateral should be

insisted upon.

Asset Classification

a. Restructured portion to be treated as current dues and need not be classified

as NPA. They would become NPA if interest/instalment remains overdue for 2 crop
seasons for short term crops and for one crop season for long duration crops.
b. The unrestructured portion will be governed by the original terms and conditions.
Consequentially, the dues from the borrower may be classified under
different categories: standard, sub-standard, doubtful, loss.
c. Fresh finance may be treated as ‘standard asset’ and its future classification will
be governed by sanctioned terms and conditions.
Asset classification of the restructured accounts will continue if the restructuring is
completed within a period of 3 months from the date of natural calamity.

The accounts that are restructured for the second time or more on account of natural
calamities, would retain the same asset category on restructuring ie, the standard
asset classification will be allowed to be maintained.

Development loans

The existing term loan instalments will have to be rescheduled reckoning the repayment
capacity of the borrower and the nature of natural calamity viz.

Banking Finance 119

 a. Droughts, floods or cyclones etc where only crop for that year is damaged and
productive assets are not damaged.
b. Where productive assets are partially or totally damaged and borrowers need a
new loan.
For category a), banks may postpone the instalment due during the year of natural
calamity and extend the loan by one year subject to the following exceptions:
i. Those cultivators who had not effected the development or investment for
which the loan was obtained or had disposed off the machinery purchased
under the loan
ii. Those who are income tax payers
iii. In the case of drought, those who are having perennial source of irrigation
iv. Tractor owners
Also, instalments defaulted wilfully in earlier years will not be eligible for
restructuring. Interest payment may be postponed.
For category b), rescheduling may be determined by repaying capacity of the
borrower, reckoning the repayment under old term loans, the conversion loan (due
to postponement) and fresh crop loan. Maximum period: 15 years.
In case of agricultural machineries viz. pumpsets and tractors, maximum of 9
years from the date of advance.

Terms and conditions of Relief Loans

 Credit not to be denied for want of personal guarantee

 Assistance not to be denied for want of additional fresh security
 Margin may be waived or grants/subsidy to be considered as margin
 Rate of interest will be as per RBI guidelines. Within areas of bank’s discretion,
a sympathetic view to be taken and concession can be given.
 In respect of current dues in default, no penal interest to be charged. To defer
compounding of interest charges.
 Not to charge penal interest and waive penal interest already charged, if any, for
converted loans.

Artisans and Self-Employed Persons

Financial assistance may be extended to rural artisans and self- employed persons including
handloom weavers for repairs of sheds, implements, purchase of raw materials and stores.

120 Banking Finance

Small Scale and Tiny Units

Term loans for repairs to and renovation of factory buildings/sheds and machinery and
working capital may be provided for rehabilitation of units under village and cottage industry
sector, small scale industrial units and smaller of the medium sector.

Irregularity in working capital accounts due to loss of current assets may be converted to
term loan. Term loans may be rescheduled.

Rehabilitation should be based on viability.

Other Issues

Business Continuity Planning (BCP) assumes importance when natural calamity takes
place.

Applicability of the guidelines in the case of riots and disturbances

To ensure quick reliefs to the affected persons in riots, the District Collector may ask the
LBO to convene a meeting of the DCC and submit a report to the DCC on the extent of
damage caused to life and property in the affected areas. If the DCC is satisfied, the relief
as per above guidelines may be extended. If DCC is not there, SLBC can take the decision.

* * * * * * *

FRAME 78
THE SECURITISATION AND RECONSTRUCTION OF FINANCIAL
ASSETS AND ENFORCEMENT OF SECURITY INTEREST ACT, 2002
(SARFAESI)

The Act empowers Banks and FIs to directly enforce the security interest pledged to them
while sanctioning the loan, without intervention of the courts.

Rights of Secured Lenders

The most important section of the Act is Sec.13(2) which provides that if a borrower who
is under a liability to a secured creditor, makes any default in repayment of secured debt
and his account of such debt is classified as NPA, then the secured creditor may require
the borrower in notice in writing to discharge his liability within 60 days from the date of
notice with an indication that if he fails do so, the secured creditor shall be entitled to
exercise all or any of the rights in terms of Sec. 13(4) of the Act.

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The provisions of Sec. 13(4) are as under:

1) Take possession of the secured assets including the right to transfer by lease,
assignment or sale.
2) Take over the management of the secured asset.
3) Appoint any person as the manager to manage the secured asset.
4) Serve notice to anybody from whom any assets/money is due to the borrower
to pay the creditor directly, which shall be treated as valid discharge of his
obligation, as if he has paid the borrower.
Sec. 13(2) is a condition precedent to the invocation of Sec. 13(4) of the Act.

If there are more than one secured creditor, the exercise of any Act has to be agreed upon
by the secured creditors representing not less than three-fourth of the value of the NPA.

When dues of the secured creditor are not fully satisfied with the sale proceeds of the
secured asset, the creditor may file an application with the DRT for the recovery of the
balance amount.

On receiving the notice, no borrower can sell, lease or transfer the secured assets mentioned
in the notice, without the lender’s consent [Sec.13(13)]. Thus the notice under Sec 13(2)
in effect operates as on attachment/injunction restraining the borrower from disposing off
the secured asset.

If 75% by value of secured creditors agree, the secured creditors can act even in cases
which are pending before BIFR or with the Official Liquidator. If the requisite majority take
action under Sec 13(4), then automatically the reference to BIFR gets abated.

Rights of Borrowers

 On receipt of the notice under Sec. 13(2), the borrower can raise objections/make
representations about contents of the notice which the secured creditor must
respond within 7 days about the acceptance/non - acceptance in writing.
 A borrower can object to the measures taken under Sec. 13(4) of the Act within
45 days without depositing any amount with DRT (Sec. 17), seeking stay of
proceedings and to set aside the action initiated. However, for making application
at the second appeal stage with DRAT, 50% of the amount outstanding has to
be deposited which can also be reduced to 25% at the discretion of the DRAT.
 Limitation as prescribed under Limitation Act 1963 will be applicable even to this
Act.

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  Photographs of borrowers/guarantors with notice under Sec13(c), can be published
in a newspaper.

Where Act is Not Applicable

The provisions of this Act shall not apply to

 A lien on any goods

 A pledge of movables
 Creation of security in any aircraft/vessel/shipping
 Any conditional sale, hire purchase or lease or any other contract in which no
security interest has been created
 Any right of unpaid seller
 Any Security interest for securing repayment of any financial asset not exceeding
Rs 1 lac
 Any security interest created in agricultural land
 Amount due is less than 20% of the principal amount and interest thereon

After 60 days are over from the date of acknowledgement or publication in newspaper in
case of substituted service issued under Section 13(2), notice of possession and
enforcement of security interest is issued to mortgagor under section 13(4) of the Act.

The possession notice is also affixed at the immovable property in question. It is also
published in newspapers. On completion of these formalities, the immovable property is
deemed to be in symbolic possession of the Authorised Officer.

In case, the Authorised Officer intends to take physical possession of the property, he may
do so and in such a case he should take steps for insuring the property, engaging security
guards etc.

If the Borrower/Mortgagor does not prefer any appeal before the DRT, then the bank sends
an intimation to the mortgagor to sell the mortgaged property and gives 30 days notice
period to the borrower before proceeding with the sale. In the meantime the borrower can
arrange for repayment of the liability.

After expiry of 30 days, the bank arranges for sale of the mortgaged property by public
auction /private auction.

On receipt of the full amount of the auction from the highest bidder, a sale certificate is
issued in the prescribed format.

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Section 34 of the Act bars jurisdictions of civil court to entertain any suit in respect of any
matter, which a DRT or DRAT is empowered to determine.

Still the borrowers challenge the action taken under the Act in civil courts knowing fully
well there is a bar under Section 34 of the Act and get injunction orders. These are got
vacated at the High Courts.

Simultaneous Action at DRT and Action under SARFAESI

Initially, banks were taking action under the both the Acts. Different courts have given
different rulings on this Doctrine of Election between the 2 remedies.

Amendment to Recovery of Debts due to Banks & FI Act 1993

Amendment to Sec 19 of RDDBFI Act: The bank or FI may, with the permission of the
DRT, on an application made by it, withdraw the application whether made before or after
the Enforcement of Security Interest and Recovery of Debt Laws (Amendment) Act 2004,
for the purpose of taking action under the SARFAESI Act, if no such action had been taken
earlier under the Act.

Any application made as above shall be dealt with by it as expeditiously as possible and
disposed off within 30 days. In case DRT refuses to grant permission for withdrawal of the
application, it shall pass such orders after recording the relevant reasons.

The same provision was not made under SARFAESI Act.

Following the above amendment to DRT Act, the confusion on parallel proceedings under
SARFAESI Act and DRT Act arose. Ultimately, the Supreme Court settled the matter in
2006 in the matter of Transcore vs Union of India & others. It held that remedies under
both the Acts were complimentary to each other. Therefore the doctrine of election has
no application. Withdrawal of OA pending before the DRT is not a precondition for taking
recourse to SARFAESI Act.

Securitisation and Financial Assets

The process of enforcement of the securities can be done either by banks themselves or
through Securitisation Companies (SC) or Asset Reconstruction Companies - specialised
agencies that will be created and registered under the provisions of this Act. The bank now
has the right to directly sell the financial assets to these SC/ARCs. These companies will
pay the bank’s dues usually in the form of Security Receipts/cash (at a discounted value).

124 Banking Finance

After the acquisition from the bank, it is up to the SC/ARC to recover the asset from the
borrower and then to:

a. Either further sell off/auction off the assets

b. If the asset is a business, try to revive it i.e. reconstruct the asset

Central Registry (CR)

CR is basically intended to maintain centralized records of all Securitisation/Asset

Reconstruction as well as creation of Security Interest. This will be similar to Sub-Registrar’s
Office or ROC where all charges are registered.

All such transactions or any modifications therein must be informed to such CR within 30
days of such transaction.

* * * * * * *

FRAME 79
ASSET RECONSTRUCTION COMPANIES (ARC)

ARCs are a creation of Securitisation and Reconstruction of Financial Assets Enforcement

of Security Interest Act, 2002 (SARFAESI). They derive their asset resolution powers from
this Act. The Act provides full right to the lenders acting in majority (75% of the total debt
by value) to enforce the security interest without judicial intervention. Through buying out
major lenders having NPA asset, an ARC is able to have recourse to the Act and thereby
acquire legal muscle to force a settlement. The powers include effecting change of
management or sell or lease part of the whole of business for resolution.

Banks also use Sarfaesi Act for retail loans. For large NPA loans/consortium NPA accounts,
they sell the asset to ARC. ARC is in the business of reconstructing bad debts or resolution
and have acquired expertise over time. They will be in a better position to handle such NPAs.

ARCs acquire NPAs by way of true sale ie, once an NPA has been sold, the seller has
no further interest in that asset. The ARC sets up trusts for the purpose of acquiring NPAs
from banks. The valuation of the NPA and the price offered by the ARC depends on the
nature of the security available to the lender, realisable value and the time taken to realise
the same. After acquiring an asset, the trust issues Security Receipts (SR) to the banks
selling the asset. Now the trust becomes the legal owner of the asset and the SR holders
the beneficial owners. These are redeemed out of the realisation from the financial assets
held under the Trust and carry no fixed return.

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Asset Reconstruction Company of India Limited (ARCIL) was the first one to be set up.
Now there are about 15 ARCs in the country including SME Asset Reconstruction Co Ltd,
Pegasus Asset Reconstruction Pvt. Ltd., Reliance Asset Reconstruction company Ltd.

Latest Development

FDI in ARCs has been increased from 49% to 74% subject to the condition that no sponsor
should hold more than 50 % of the shareholding in an ARC either by way of FDI or by
routing through a FII.

This 74 % will be a combined limit of FDI and FII. The total shareholding of an individual
FII should not exceed 10 % of the total paid-up capital.

The limit of FII investment in SRs is enhanced from 49 % to 74 % of the paid-up capital
of each tranche of scheme of SRs issued by ARCs. The individual limit of 10 % for investment
of a single FII in each tranche of SRs issued by ARCs has been dispensed with. Such
investment should be within the FII limit on corporate bonds prescribed from time to time
and sectoral caps under the extant FDI regulations should be complied with.

* * * * * * *

FRAME 80
CENTRAL REGISTRY OF SECURITISATION ASSET
RECONSTRUCTION AND SECURITY INTEREST OF INDIA (CERSAI)

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security

Interest Act 2002 (SARFAESI) provides for setting up a Central Registry for registration of
transactions of Security Interest over property, Securitisation and Asset Reconstruction.
Accordingly, the CERSAI Limited was incorporated on March 31, 2011 under Section 25
of the Companies Act (not-for-profit company).

The objectives of CERSAI are:

a. Making security interests over property effective against third parties.

b. In the event of default by the borrower, rights of enforcement are available to the
secured creditor to realize the value of encumbered asset by sale of the asset.
c. Priority among security interests over same property to be determined by the order
of registrations.

126 Banking Finance

So far, SARFAESI Act has been in operation from 2002 without registration requirements.
Now, this registration is a public notice of security interest held by lenders. So any potential
lender can verify first whether the said property is already encumbered or not, before taking
it as security. Also, housing loan frauds can be avoided.

Sec. 20(4) of the Act provides that provisions pertaining to CR shall be in addition to and
not in derogation of any of the provisions contained in other Acts requiring registration of
charges.

It may also be noted that registration of security interest is not a condition precedent for
the purpose of exercise of rights of enforcement of securities conferred on banks and FIs
under Section 13 of SARFAESI Act.

In addition to secured creditors, the registration system is also applicable to securitisation

company and reconstruction company. ARCs acquire stressed assets from Banks/FIs and
such acquisition of assets require registration.

As of now, security interest created by way of mortgage of title deeds (i.e. equitable
mortgage) are required to be registered with CERSAI. The government has not prescribed
any form for other categories of charges on immovable properties and movable properties.

It is to be noted that the loans acquired by SC/RC for the purpose of securitisation or
reconstruction need not be secured by mortgage by deposit of title deeds. Any SC/RC
registered with RBI is also a secured creditor for the purpose of the Act.

The securitisation and reconstruction of financial assets and enforcement of security interest
(Central Registry) Rules 2011 provide for:

a. The particulars of every transaction shall be filed with the Central Registrar within
a period of 30 days from the date of such transaction.
b. In cases, where there is a delay in filing the particulars of transactions for
registration or modification or satisfaction within the time specified above, the
Central Registrar, on an application, stating the reasons for delay not exceeding
30 days from next following the period of 30 days provided as above may allow
filing of the particulars of transaction on payment of additional fees.
Any person interested in search of the records of the registry shall be entitled to do so
at a prescribed fee.

* * * * * * *

Banking Finance 127

 FRAME 81
WILFUL DEFAULT

RBI had introduced a scheme for collection and dissemination of information on cases of
‘Wilful Default’ of Rs 25 lacs and above effective from April 1, 1999.

Definition

a. The unit has defaulted in meeting its payment/repayment obligations to the lender
even when it has the capacity to honour the said obligations.
b. The unit has defaulted in meeting its payment/repayment obligations to the lender
and has not utilised the finance from the lender for the specific purposes for which
finance was availed of but has diverted the funds for other purposes.
c. The unit has defaulted in meeting its payment/repayment obligations to the lender
and has siphoned off the funds so that the funds have not been utilised for the
specific purpose for which finance was availed of, nor are the funds available with
the unit in the form of other assets.
d. The unit has defaulted in meeting its payment/repayment obligations to the lender
and has also disposed off or removed the movable fixed assets or immovable
property without the knowledge of the bank/lender.
The following measures should be initiated by the banks against the identified wilful
defaulters:

a. No additional facilities should be granted by any bank/FI to the WD. In addition,

the entrepreneurs/promoters of companies where banks/FIs have identified
siphoning /diversion of funds, misrepresentation, falsification of accounts and
fraudulent transactions should be debarred from institutional finance from SCBs/
FIs, Govt owned NBFCs, investment institutions etc for floating new ventures for
a period of 5 years from the date the name of the WD is published in the list
of WD by the RBI.
b. The legal process, wherever warranted, against the borrowers/guarantors and
foreclosure of recovery of dues should be initiated expeditiously. The lenders may
initiate criminal proceedings against WD, wherever necessary.
c. Wherever possible, the banks/FIs should adopt a proactive approach for a change
of management of the borrower unit.
d. A covenant in the loan agreements with the companies in which the notified FIs

128 Banking Finance

 have a significant stake, should be incorporated by the FIs to the effect that the
borrowing company should not induct a person who is a director on the Board
of a company which has been identified as a wilful defaulter and that in case,
such a person is found to be on the Board of the borrower company, it would
take expeditious and effective steps for removal of the person from its Board.
Banks/FIs should submit list of suit filed accounts of Wilful Defaulters of Rs25 lacs and
above as at end – Mar, June, Sep, & Dec every year to a Credit Information Company.
This will be put on the Credit Information Company’s website.

Where suits have not been filed, the quarterly list is to be submitted to RBI.

* * * * * * *

FRAME 82
DIVERSION AND SIPHONING OF FUNDS

The meaning of the above in the context of definition of Wilful Default is as under:

Diversion of funds would include any one of the following occurrences:

a. Utilisation of short term working capital funds for long term purposes not in
conformity with terms of sanction
b. Deploying borrowed funds for purposes/activities or creation of assets other than
those for which the loan was sanctioned
c. Transferring funds to the subsidiaries/group companies or other companies by
whatever modalities
d. Routing of funds through any bank other than the lender bank or members of the
consortium without prior permission of the lender
e. Investments in other companies by way of acquiring equities/debt instruments
without approval of lenders
f. Shortfall in deployment of funds vis-à-vis amounts disbursed/drawn and the
difference not being accounted for
Siphoning of funds is construed to occur when any funds borrowed from banks/FIs are
utilised for purposes unrelated to the operations of the borrower, to the detriment of the
financial health of the entity or of the lender.

* * * * * * *

Banking Finance 129

 FRAME 83
CARBON CREDIT
(Financing for carbon credit)

Global warming and its impact on climate change have become international concerns.
Global warming is a term applied to the rise of the mean temperature of the earth’s
atmosphere over the last century or so. The Kyoto protocol for the United Nations Frame-
work Convention on Climate Change (UNFCCC) requires developed countries (listed in
annexure of the protocol) to limit their Greenhouse Gas (GHG) emission to individual targets,
resulting in on an average 5.2% reduction during 2008-2012 over the base year of 1990.
The green house effect refers to the increase in the planet’s atmospheric temperature due
to the presence of gases such as carbon dioxide, water vapour, methane and ozone.

Under the Kyoto protocol, developed countries agreed that if their industries cannot reduce
carbon emissions in their own countries, they will pay others like India to do it for them
and help them meet their promised reduction quotas in the interest of worldwide reduction
of GHG.

The reduced amount of GHGs become credits called Certified Emission Reductions (CERs)
which are tradeable and purchased by developed countries to help meet their emission
reduction targets under the protocol. The basis of a CER is the reduction of one ton of
carbon dioxide equivalent by a Clean Development Mechanism (CDM) project.

This purchase and sale by CER has resulted in development of international market for
carbon credits and flow of overseas funds to developing countries in lieu of exports of carbon
credits to developed countries.

Banks/FIs are involved in:

a. Project funding to CDM projects by taking into account projected carbon credit
revenues while making viability assessment.
b. Funding against future CERs receivables i.e. loans against securitization of future
CERs receivables under Emission Reduction Purchase Agreement (ERPA)
* * * * * * *

130 Banking Finance

 FRAME 84
ACCOUNTING STANDARD - 22 (AS-22)

AS-22 refers to Deferred Tax.

Prior to the implementation of AS-22, companies were making provision for income tax
based on the amount payable to the Tax Authorities for the relevant accounting year. In
such cases matching the tax payments with revenue for the period becomes difficult as
the income/expenses actually charged to the P&L account by a company and those which
are recognized for the purpose of computing the tax are different in many cases. These
differences can be classified as under:

a. Permanent Difference: These are differences between Taxable income and

Accounting income which originate in one period and do not reverse subsequently.
Example – Donations under certain approved funds qualify for tax deduction under
Section 80G only to the extent of 50%.
b. Timing Difference: There are differences originating in one period which are capable
of reversal in one or more subsequent periods.
i. Depreciation on certain equipment/machinery can be claimed to the extent
of 100% for tax purpose while, for accounting purpose, the depreciation is charged
to the P&L account over the period of their useful life span (The applicable tax
on the difference in the depreciation amount would appear as DTL).
ii. Companies do sometime make provision in anticipation of a liability while the
income tax rebate on the amount is availed in a subsequent accounting year
when the liability is actually discharged. (The applicable tax rebate on the
provision would appear as DTA till it is actually claimed.)
AS-22 proposes an accounting system which would take into account these differences.
The tax effect of the timing difference originating during a period (Difference between
Accounting income & Taxable income) is referred to as Deferred Tax Asset/Deferred Tax
Liability depending on whether the tax rebate relating to the current accounting period would
be available in the subsequent accounting periods or the rebate available in the subsequent
accounting periods has been claimed in advance during the current accounting period.
Permanent Differences do not result in Deferred Tax Assets or Deferred Tax Liabilities.

AS-22 requires that the tax expenses for a period, comprising current tax and deferred tax,
should be included in the determination of net profit/loss for the period. Accordingly, this
would result in

Banking Finance 131

 a. Adjustment in the net profit/loss (PAT) to the extent of tax rebate claimed in
advance (DTL)/available in the future (DTA)
b. Timing difference in tax (DTA/DTL) appearing in the Balance Sheet

Deferred Tax from Banker’s point of view

Deferred tax is a non-cash expense/income

a. Tangible Net Worth (TNW):

DTA is arrived at through increasing the profits/reducing the loss. The eligible tax rebate
reflected as DTA can be recognized only if it is reasonably certain that the company will
earn adequate profits in the subsequent accounting period(s). Till such time, it is in the
nature of an intangible asset. Therefore, it should be reduced from the Net Worth to arrive
at TNW.

DTL represents tax benefits claimed in advance and there is no payment obligation attached
to it. Further, its reversal in the subsequent accounting period(s) will be only by way of
transfer to the surplus. Therefore, notwithstanding the DTL being shown separately, it can
be treated as a part of the Net Worth.

b. Cash Accruals:

Where DTA is figuring in the Balance Sheet, the taxable income is shown at a higher level/
loss is shown at a reduced level correspondingly. This is done through crediting P&L account
by debit to DTA account. Therefore, DTA which has the effect of increasing the profit/reducing
the loss should be deducted from the net profit for working out the cash accruals.

Though DTL is arrived at by debit to P&L account, it does not result in cash outgo. Therefore,
it should be added to the net profit for working out the cash accruals (DTA/DTL for this
purpose would only mean the amount recognized as such during the accounting year under
reference)
To the extent that there is a reversal in a particular accounting year of DTA/DTL either in
full or in part, in respect of DTA/DTL created in an earlier accounting period, the amount
of such reversal should be ignored for arriving of the cash accrual for the period.
c. Profits:
Profit Before Tax (PBT) – No change required.
Profit After Tax (PAT) – Since DTL and DTA are accounting treatments only, DTL is to be
added to, and DTA is to be subtracted from, the net profit for arriving at PAT (DTA/DTL for

132 Banking Finance

this purpose would only mean the amount recognized as such during the accounting year
under reference).
To the extent that there is a reversal in a particular accounting year of DTA/DTL either in
full or in part, in respect of DTA/DTL created in an earlier accounting period, the amount
of such reversal should be ignored.
Example
A company purchases a machine on 1.4.2002 at a cost of Rs.1,50,000. Life of machine
- 3 years. Scrap value zero. Eligible 100 % depreciation in first year for tax purposes. Straight
line method is considered appropriate for accounting purpose. Corporate Tax taken as 40
% each year.

Particulars 31-03-2003 31-03-2004 31-03-2005

PBD & Tax 200 200 200
Less: Depreciation 50 50 50
PBT 150 150 150

(A) Current Tax (TI): 200(PBDT)-150(DEP)

50 x 40% = 20 - -

200 x 40% - 80 80

(B) Tax Expenses 150 x 40% 60 60 60

(B – A) Deferred Tax 40 – 20 – 20

Deferred Tax Liabilities 40 20 —

Tax saving is Rs. 60,000/-. This is also spread over 3 years (as life of machine)

Taxable income < Accounting income DTL

50 150 (40) Year I

Accounting Income < Taxable Income

200 150 - 20 Year II

200 150 - 20 Year III

In 2003, P&L account is debited and DTL account is credited with Rs. 40,000/- being the
amount of tax on the originating timing difference of Rs.1,00,000. In the following two years,

Banking Finance 133

DTL is debited and P&L account is credited with the amount of tax on the reversing timing
difference of Rs. 50,000/.

When certain expenses considered in P&L account are not allowed in the computation of
taxable income, the taxable income exceeds accounting income. Therefore the tax liability
is higher than the tax calculated on the accounting profits. A DTA is created in such a
situation.

MATRIX OF DTA/DTL

Items in the year of occurrence Deferred Tax

having timing differences which
Liability Asset
Resulted in higher book income 
Resulted in Lower book income 
Resulted in higher taxable income 
Resulted in lower taxable income 
NB: Items, which resulted in permanent differences, do not result
in deferred tax

* * * * * * *

FRAME 85
INTEREST RATE SWAP (IRS)

An IRS is a derivative product and is a financial contract between two parties exchanging
or swapping a stream of interest payments on a ‘notional’ principal amount on multiple
occasions during a specified period. Such contracts generally involve the exchange of a
‘fixed to floating’ or ‘floating to fixed’ rates of interest. Accordingly, on each payment date,
that occurs during the swap period, a cash payment based on the differential between fixed
and floating rates, is made by one party to another. The principal is ‘notional’ because it
is the interest which is seen as the ‘product’.

Assume company XYZ borrowed USD 3 mn on Jan1, 2011, payable as a bullet payment
at the end of 3.5 years. The loan is at a rate of Libor +1.5% pa, payable half-yearly. The
Libor is to be reset every 6 months. Hence, Libor on July1 and Jan1 every year would be
used for calculating the interest liability that accrues after 6 months. In Jan-July, if the Libor
goes down, XYZ interest liability will be lower.

134 Banking Finance

If XYZ is of the view that Libor has bottomed out and will move higher before the next reset
date of Jan 1, they can hedge the risk of interest rates moving higher through an IRS. If
the 3 year IRS is quoting at 5.15%, XYZ would effectively pay interest of 5.15+1.5 = 6.65%,
irrespective of the prevailing Libor level on the reset dates.

XYZ would enter into an IRS with any bank. It would continue to pay the lending bank Libor
+ 1.5%under the loan agreement. However, under the IRS, it would pay or receive the
difference between 5.15 and Libor to the bank with whom it has done the IRS. Hence,
effectively XYZ will be paying 6.65% fixed on the loan. In the scenario of rising Libor, it
will make sense to hedge the interest rate using an IRS.

* * * * * * *

FRAME 86
ESCROW ARRANGEMENT

An escrow arrangement is an arrangement by which one party deposits an asset with a

third person (called escrow agent) who will in turn make delivery to another party if and
when the specified conditions of the contract have been met. The asset can be money,
securities, real estate or a deed.

The person/organisation that holds the asset is the escrow agent.

The account in which the asset is held is an escrow account. This is a risk mitigation
measure.

Eg. RBI had permitted Authorised Dealer Banks to open escrow account on behalf of non-
resident corporates for acquisition/transfer of shares of an Indian company through open
offers /delisting, subject to terms and conditions. This is to facilitate FDI transactions.

Eg. In financing of a power plant which sells its power to a SEB, the SEB would agree
to direct its identified collection centres to deposit the electricity charges received from
consumers into an escrow account. The escrow agent would then appropriate the funds
as per priority laid down in the escrow agreement.

* * * * * * *

Banking Finance 135

 FRAME 87
TRUST AND RETENTION ACCOUNT (TRA)

TRA mechanism is a common feature in financing of infrastructure projects.

It seeks to protect the lenders against credit risk (the risk of debt-service default) by
insulating the cash flows of the project company. This is done through shifting the control
over future cash flows from the hands of the borrower (project company) to a designated
bank who will maintain the TRA on behalf of all the project lenders.

Under this arrangement, the lenders, the borrower and the TRA agent (who may also be
a lender) enter into a tripartite agreement, which provides for all revenues of the project
to be directed into a single account maintained with the TRA agent. The lenders, in
consultation with the borrower, draw up a detailed mandate for the TRA agent as to periodic
transfer and utilisation of funds in the account.

Generally a ‘waterfall’ mechanism is followed for utilisation of the funds in order of priority.

 All operational and maintenance expenses

 Monthly dues of interest / principal payment
 After meeting all the foregoing obligations, the residual funds, if any, would be
available to the company for their disposal.
* * * * * * *

FRAME 88
SUBORDINATE DEBT

Subordinate debt (sub-debt) is used in financing of infrastructure projects. Since enough

equity is not available with the developers in India, sub-debt is resorted to. It is obvious
that sub-debt is subordinated to normal (senior) debt and carries a longer tenor of repayment
and a higher rate of interest.

Subordinate debt, called Mezzanine finance or Quasi-Equity is senior to equity capital but
junior to senior debt. It may be considered as equity by senior lenders for the purpose
of computing debt-equity ratio.

A sub-debt is often used by a sponsor to provide capital to a project, which will support
senior borrowings from third party lenders.

136 Banking Finance

The sources of mezzanine finance are finance companies, risk capital companies and risk
portfolio managers of insurance companies.

Sub-debt may be secured or unsecured. It can have pari-passu charge along with senior
lenders or can have second charge over the assets. Generally, a sub-limit is put on the
amount of sub-debt as a percentage of project cost (say 10% or 20%).

In India, sub-debt has been provided by the senior lenders themselves. Hence it is not really
quasi-equity, providing the lenders with the requisite amount of risk capital, but more as
a way to assist developers for quick financial closure.

* * * * * * *

FRAME 89
COMMITTEE ON DISPUTES

The Supreme Court of India in the case of ONGC & others vs. Commissioner of Central
Excise, held that it is obligatory on the part of every court and tribunal, where disputes
between public sector undertakings and departments are raised, to demand a clearance
from the Committee on Disputes in case it has not been so pleaded and in the absence
of clearance, the proceedings would not be proceeded with. The purpose of this decision
was to ensure that disputes between two departments of Govt are resolved by amicable
means of conciliation or arbitration and recourse to litigation should be avoided. Pursuant
to the above decision of the Supreme Court, a High Power Committee named ‘Committee
on Disputes’ (COD) was constituted in the Cabinet Secretariat. All public sector
undertakings are mandatorily required to get approval from the COD in case they decide
to resort to litigation against Govt Departments, failing which the High Court/Tribunal will
not entertain the litigation.

* * * * * * *

FRAME 90
BLOOD DIAMONDS

Diamonds mined in rebel-held areas are reaching the international diamond market. Conflict
diamonds from Liberia are also being smuggled into neighbouring countries and exported
as part of the legitimate diamond trade. The sale proceeds are used to finance insurgency.
This is called blood diamond/conflict diamond/war diamond.

Banking Finance 137

The Kimberly Process (a round of talks among the officials and diamond industry experts
from various countries at Kimberly in South Africa) is the diamond industry’s attempt to
stem the trade in illicit diamonds that fuel the war chests of rebels in gem-rich countries
such as Angola, Democratic Republic of Congo and Sierra Leone. There has been a broad
agreement on a certification scheme to ensure that exported diamonds carried proof that
they came from legitimate mines under the scheme. Certificates to verify the origin of each
package’s contents would accompany each shipment of stores, with additional certificates
from each country traversed.

This scheme is because the industry fears a potential consumer backlash against diamonds
if they became associated with funding rebel movements that fan destructive wars across
the world’s poorest continents.

* * * * * * *

138 Banking Finance

 PART - F

RISK MANAGEMENT

Banking Finance 139

 FRAME 91
BASEL I & BASEL II

The Basel Committee on Banking Supervision first adopted the frame work on capital
adequacy in 1988. In India, it was adopted in 1992. RBI prescribed capital adequacy ratio
for banks at 9% of risk weighted assets (Basel I) and introduced the concept of NPA and
Provisioning.

Basel II was introduced to strengthen the regulatory capital framework through minimum
capital requirement which is more sensitive to the risk profile and risk management of the
banks.

Basel II consists of three mutually reinforcing pillars which together would contribute to the
safety and soundness of the financial system.

140 Banking Finance

 PILLAR-1
CAPITAL ADEQUACY

Banks would need to determine regulatory capital requirement through an assessment of

credit risk, operational risk and market risk. There are three distinct options for capturing
capital requirement for credit risk and another three options for operational risk assessment.
These approaches are based on increasing risk sensitivity. Banks can leverage on the
benefits of the advanced approach, as a risk adjusted capital base would enable the good
banks to release excess capital and thereby improve their earnings ratio.

RBI had introduced the

 Standardized approach for credit risk

 Basic indicator approach for operational risk (formula- based)
 Standardized Duration approach for market risk
These have been implemented for the banks in India from March 31, 2009. Moving towards
advanced approach requires RBI approval. The time frame was as under:

S.No Approach Earliest date of Likely date of

Application to RBI approval by RBI

a. Internal Models Approach April 1, 2010 Mar 31, 2011

(IMA) for Market Risk

b. The Standardised Approach April 1, 2010 Sep 30, 2010

(TSA) For Operational Risk

c. Advanced Measurement
Approach (AMA) For
Operational Risk April 1, 2012 Mar 31, 2014

d. Internal Ratings Based (IRB)

Approaches for Credit Risk
(Foundation & Advanced IRB) April 1, 2012 Mar 31, 2014

Banking Finance 141

Minimum CAR = Capital Funds
= 9%
RWA

= Capital Funds (Tier I + Tier II)

= 9%
Credit Risk RWA+Market Risk RWA+Operational Risk RWA

Tier II can be up to a maximum of 100% of Tier-I

Elements of Tier I capital

a. Paid-up equity capital, statutory reserves, disclosed free reserves

b. Capital reserves arising out of the sale proceeds of assets
c. Innovative Perpetual debt instruments (limited to 15% of Tier I capital)
d. Perpetual Non-Cumulative Preference Shares (PNCPS)
(a) and (d) shall not exceed 40% of total Tier-I capital

Elements of Tier II capital

a. Revaluation reserves (at a discount of 55 percent)

b. General provisions and loss reserves
[Banks can include general provisions on standard assets, floating provisions,
provisions held for country exposures, investment reserve account and excess
provisions which arise on account of sale of NPAs in Tire-II capital. However, these
5 together is limited to 1.25 percent of total RWA. Banks have the option to net
off floating provisions from Gross NPA to arrive at net NPA or reckon it as part
of Tier-II capital]
c. Hybrid capital elements
d. There are certain debt capital instruments which combine certain characteristics
of equity and certain characteristics of debt. These can be classified as upper
Tier II capital subject to RBI’s regulatory requirements specified. Perpetual
Cumulative Preference Shares (PCPS), Redeemable Non-Cumulative Preference
Shares (RNCPS) and Redeemable Cumulative Preference Shares (RCPS) can be
treated as upper Tier II subject to conditions specified by RBI.
e. Subordinated Debts: Can be classified as lower Tier-II capital subject to conditions
specified by RBI. It will be limited to 50% percent of Tier I capital.
(Banks advised to raise such funds through public issue to retail investors with
a view to deepening the bond market through retail participation).

142 Banking Finance

 f. Innovative Perpetual debt instruments (IPDI) and Perpetual Non-Cumulative
Preference Shares (PNCPS)
[IPDI in excess of 15% of Tier I capital and PNCPS in excess of overall ceiling
of 40% can be included under Tier II Capital}

Capital charges for Credit Risk :

Central Govt guaranteed claims will attract zero risk weight.
State Govt Guaranteed claims will attract 20% risk weight.
Claims on Corporates shall be risk weighted as per the ratings assigned by the rating
agencies registered with the SEBI and accredited by RBI. The rating agencies are :
a. Credit Analysis and Research Ltd
b. CRISIL Ltd
c. ICRA Ltd
d. India Ratings and Research Private Limited (India Ratings)
e. Brickwork Ratings India Pvt Ltd (Brickwork)
f. SME Rating Agency of India Ltd (SMERA)

Rating AAA AA A BBB BBB & Below Unrated

Risk Weight % 20 30 50 100 150 100

The international credit rating agencies whose ratings can be used (where specified) are:
a. Fitch
b. Moody’s
c. Standard & Poor’s
Restructured advances, unrated, standard, attract a risk weight of 125% until satisfactory
performance for one year under the revised repayment schedule from the date when the
first payment of interest/principal falls due.

Regulatory Retail Portfolio (RRP) - 75%

The following are excluded for RRP:

a. Investments in Securities (Bonds, Equities)

b. Mortgage Loans
c. Loans to staff covered by Superannuation benefits/mortgage of Flat, house
d. Consumer Credit including personal loans and credit card receivable

Banking Finance 143

 e. Capital market exposure
f. Venture Capital funds
Maximum aggregate retail exposure to one party: Rs 5 cr.

Claims secured by residential property

As loans to residential housing (RH) projects under the CRE sector exhibit lesser risk and
volatility than the CRE sector taken as a whole, a separate sub-sector called CRE-RH has
been carved out. It would consist of loans to builders/developers for residential housing
projects (except for captive consumption). If at all, any commercial area (like shopping mall,
school etc ) are integrated into the residential project, then it should not exceed 10 % of
the total Floor Space Index of the project.

CRE-RH attracts a lower risk weight and provisioning as below:

Category of Loan LTV Ratio Risk Weight Standard Asset

(%) (%) Provisioning (%)

a) Individual Housing Loans

i) Up to Rs 20 lacs 90 50 0.40

ii) Above Rs 20 lacs 80 50 0.40

upto Rs 75 lacs

iii) Above Rs 75 lacs 75 75 0.40

b) CRE-RH NA 75 0.75

c) CRE NA 100 1.00

Restructured housing loans – Additional 25 % over the above.

Non Performing Assets

The unsecured portion of NPA (other than a qualifying residential mortgage loan) net of
specific provisions will be risk-weighted as follows:

 150% risk weight when specific provisions are less than 20% of the outstanding
amount of the NPA
 100% risk weight when specific provisions are at least 20% of the outstanding
amount of the NPA
 50% risk weight when specific provisions are at least 50% of the outstanding
amount of the NPA

144 Banking Finance

  Claims secured by residential property which are NPA will be risk weighted at
100% net of specific provisions
 If the specific provisions are at least 20% but less than 50% of the outstanding,
risk weight will be 75%
 If the specific provisions are 50% or more, risk weightage will be 50%
 Consumer credit (personal loans,
credit card receivables) – 125% or higher if
warranted
 Capital market exposure – 125% by external rating,
whichever is higher
 Loans to bank’s own staff covered by
superannuation benefits and/or
mortgage of flat/house – 20%
 Rupee loan to banks own staff – 75%

Non-Market related Off-Balance Sheet items

Risk Weighted off -Balance Sheet Credit Exposure = Credit equivalent x Risk Weight
= Exposure x CCF x Risk Weight
Credit Conversion Factors: (for a few items only)
S. No. Particulars %

1 Direct credit substitute e.g. General Guarantees of indebtedness

(including standby LCs serving as financial guarantees for loans
and securities etc.) credit enhancements, acceptances 100

2 Performance bonds, bid bonds, warranties, indemnities, Standby LCs 50

3 Short term self-liquidating trade LCs arising from movement of goods

for both issuing bank and confirming bank 20

Market related off-balance sheet items: (MROBSI)

i) Interest rate contracts

ii) Foreign Exchange contracts
iii) Any other related contracts specifically allowed by RBI.
The credit risk on MROBSI is the cost to a bank of replacing the cash flow specified by
the contract in the event of counterparty default.

Banking Finance 145

The credit equivalent of a MROBSI calculated using the current exposure method is the
sum of current credit exposure and potential future credit exposure of these contracts.
Current credit exposure is defined as the sum of the positive mark-to-market value of these
contracts.
Potential future credit exposure is determined by the notional principal amount of each of
these contracts by the relevant add-on factor (as below) according to the nature and residual
maturity of the instrument.
Credit Conversion Factor for MROBSI
CCF (%)
Time Period Interest Rate Contracts Exchange Rate Contracts
One year or less 0.50 2.00
Over 1 year to 5 years 1.00 10.00
Over 5 years 3.00 15.00

For assets in the bank’s portfolio that have contractual maturity less than or equal to one
year, short term ratings by CRA would be relevant. For maturity of more than one year,
long term ratings would apply.
Cash credit exposures, though generally sanctioned for one year, since they are rolled over,
these exposures should be reckoned as long term and long term ratings will apply.

Long Term Ratings Risk Weight %

AAA 20
AA 30
A 50
BBB 100
BB, B, C, D 150
Unrated 100

Short Term Ratings Risk Weight %

A 1 + 20
A1 30
A2 50
A3 100
A 4 & D 150
Unrated 100

146 Banking Finance

Credit Risk Mitigation

Banks in India are allowed full offset of collateral against exposures, by effectively reducing
the exposure amount by the value ascribed to be collateral while calculating capital
adequacy requirements. While calculating the adjusted exposure, banks are required to
adjust both the amount of exposure to the counterparty and the value of the collateral to
reckon possible future fluctuations in the value of either, occasioned by market movements.
These adjustments are referred to as ‘Haircuts’. The application of haircuts will produce
volatility adjusted amounts for both exposure and collateral. The haircut for the exposure
will be a premium factor and the haircut for the collateral will be a discount factor.

In India, RBI had advised to use the standard supervisory haircuts (and not bank’s own
internal estimates of market price volatility).

The exposure amount after risk mitigation will be multiplied by the risk weight of the
counterparty.

Capital charge for Market Risk (MR)

Market Risk is defined as the risk of losses in on balance-sheet and off-balance sheet
positions arising from movements in market prices. The market risk positions are:

a. Interest rate related instruments in the trading book, equities in the trading book.
b. Foreign Exchange risk (including gold and other precious metals) in both trading
and banking books.
Trading book will include:

a. Securities under HFT, AFS

b. Open gold position limits
c. Open Foreign exchange position limits
d. Trading positions in derivatives
e. Derivatives entered into for hedging trading book exposures
Standardised duration method is used to arrive at the capital charge for market risk.

Capital charge on Operational Risk (OR)

Operational Risk is defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. This includes legal risk but
excludes strategic and reputational risk. Legal risk includes exposures to fines, penalties
or punitive damages resulting from supervisory actions as well as private settlements.

Banking Finance 147

RBI has advised Basic Indicator Approach (BIA) be adopted. Under BIA, banking must hold
capital for operational risk equal to the average over the previous three years of a fixed
percentage (α) of positive annual gross income

α = 15% (set by BCBS)

Capital charge = ΣGI1 x α

n

GI = Annual Gross Income

n =3

PILLAR – 2
INTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS (ICAAP)
AND SUPERVISORY REVIEW AND EVALUATION PROCESS (SREP)

Every bank should have a Board approved policy on Internal Capital Adequacy Assessment
Process (ICAAP).

The ICAAP would include:

a. The risks that are not fully captured by the minimum capital ratio prescribed under
Pillar 1
b. The risks that are not at all taken into account by Pillar 1
c. The factors external to the bank
Illustratively some of the risks that the banks are generally exposed to but which are not
captured in the regulatory CRAR would be:

a. Interest rate risk in the banking book

b. Credit concentration Risk
c. Liquidity Risk
d. Settlement risk
e. Reputational risk
f. Strategic risk
g. Underestimation of credit risk under standardized approach/IRB approach
h. Weakness in credit mitigants
It is, therefore, only appropriate that banks make their own assessments of the various

148 Banking Finance

risk exposures, through a well defined internal process and maintain an adequate capital
cushion for such risks.

The ICAAP document will include the capital adequacy assessment and projections of
capital requirement for the ensuring year, along with the plans and strategies for meeting
the capital requirement.

A bank’s capital planning process should incorporate rigorous forward looking stress testing.

Pillar 2 also requires the supervisory authorities to subject all banks to an evaluation process
and to initiate such supervisory measures as considered necessary.

The ICAAP should be subject to regular and independent review through an internal or
external audit process, separately from the SREP conducted by the RBI.

PILLAR 3
MARKET DISCIPLINE

The aim is to encourage market discipline by developing a set of disclosure requirements

which will allow market participants to assess key pieces of information on the scope of
application, capital, risk exposures, risk assessment processes and hence the capital
adequacy of the institution. Both qualitative and quantitative Pillar-3 disclosures are to be
provided along with annual financial statements. The disclosures are to be put on the home
page of the bank’s website.

Aspect
DF 1 Scope of application
DF 2 Capital structure
DF 3 Capital adequacy
DF 4 Credit risk
DF 5 Disclosure for portfolios subject
to the standardized approach
DF 6 Credit risk mitigation
DF 7 Securitization exposures
DF 8 Market risk in trading book
DF 9 Operational risk
DF 10 Interest rate risk in banking book

Banking Finance 149

 The consolidated RBI master circular consists of 249 pages with full details. The above
frame touches only some of the significant aspects of Basel II.

* * * * * * *

FRAME 92
HERFINDAHL HIRSHMAN INDEX (HHI)

One of the commonly used approaches for measurement of credit concentration in bank’s
portfolio is computation of HHI.

Supposing the shares of exposures to 10 sectors in the credit portfolio is S1, S2……S10,

HHI = S1 2
+ S22 + S32 + ……..S102

If, for e.g. there is exposure to only one sector, then it is 100% concentration and

HHI = (1002) = 10,000

If the credit portfolio is well spread out across sectors, then S12 + S22 + S32 +……. +
S102 will add up to a small number. The lower the number, the lesser the concentration.

A risk concentration is any single exposure or a group of exposures with the potential to
produce losses large enough (relative to bank’s capital, total assets or overall risk levels)
to threaten a bank’s health or ability to maintain its core operations.

While there are RBI stipulations on single borrower exposure and a ‘Group’ exposure, bank
should consider the degree of credit concentration in a particular economic sector or
geographical area. The performance of specialized portfolios may, in some instances, also
depends on key individuals. This can give rise to concentration risk on their leaving the
bank. This impact on revenues should also be reckoned.

* * * * * * *

150 Banking Finance

 FRAME 93
BASEL III CAPITAL REGULATIONS (B III)
[This frame is based on RBI’s Master Circular dated July 1, 2013 (287 pages)]

PART A

Guidelines on Minimum Capital Requirement

ENHANCED BASEL II + MACRO PRUDENTIAL = BASEL III

FOCUS

Micro Prudential Regulation Macro Prudential Focus

(Bank Level) (System-wide)

 Quantity of capital  Procyclicality

 Quality of Capital

 Increased risk coverage  Capital conservation buffer

 Leverage ratio

 Raise standards for SREP  Countercyclical capital buffer

(Pillar 2)

 Disclosure (Pillar 3)

B III has been implemented from April 1, 2013 and it will be fully implemented as on Mar
31, 2018.

B III continues to be based on the 3 pillars of B II :

a. Minimum Capital Adequacy

b. Supervisory review of Capital Adequacy
c. Market Discipline
Since B III is being implemented, appropriate transitional arrangements have been provided.
In view of the gradual phase-in of regulatory adjustments to the Common Equity Tier 1 (CET
1), certain specific prescriptions of B II will continue to apply till Mar 31, 2017.

A bank shall comply with B III capital adequacy requirements at

1. Consolidated (Group level)

2. Standalone (Solo) level

Banking Finance 151

 Pillar 1 – Minimum Capital Requirement
Banks are to maintain a minimum Pillar 1 CRAR of 9% (other than CCB and CCCB)
RBI will consider prescribing a higher level of a minimum capital ratio under Pillar 2 on
the basis of a bank’s risk profile and its risk management system.
B III ratios are as under :
CET 1 capital ratio = CET 1 capital
Credit risk RWA + Market risk RWA + Operational risk RWA

Tier 1 capital ratio = Eligible Tier 1 capital

Credit risk RWA + Market risk RWA + Operational risk RWA

Total capital = Eligible total capital

Credit risk RWA + Market risk RWA + Operational risk RWA
Total regulatory capital = Tier 1 capital [CET 1 + Additional Tier 1( AT1) ] + Tier II capital
 CET 1 must be at least 5.5 % of RWA
 T1 must be at least 7 % of RWA
(AT 1 – Maximum of 1.5 %)
 Total capital [T1 + T2] must be at least 9 % of RWA
(T 2 Maximum of 2 %)
 If CET 1 and T 1 are complied with, then excess AT1 can be reckoned for minimum
CRAR of 9%
 CCB 2.5 %
Thus with full implementation of capital ratios and CCB, the capital requirements are as
under:
S.No. Regulatory Capital As % of RWA
1. Minimum CET 1 5.5
2. Additional Tier 1 Capital 1.5
3. Minimum Tier 1 Capital [1+2] 7.0
4. Tier 2 Capital 2.0
5. Minimum Total Capital (T1 + T 2) 9.0
6. CCB (Comprised of CE) 2.5
7. MTC + CCB 11.5

152 Banking Finance

  Capital Funds = CET1 + AT 1 + T 2 [ for Exposure norms ]
 CET 1 does not include CCB and CCCB [when activated]
Transitional Arrangements

Sl. Minimum Apr 1, Mar 31, Mar 31, Mar 31, Mar 31, Mar 31,
No. Capital Ratios 2013 2014 2015 2016 2017 2018
1. Minimum CET 1 4.5 5.0 5.5 5.5 5.5 5.5
2. CCB - - 0.625 1.25 1.875 2.5
3. Minimum CET 1 + CCB 4.5 5.0 6.125 6.75 7.375 8.0
4. Minimum T 1 6 6.5 7 7 7 7
5. Minimum Total Capital 9 9 9 9 9 9
6. MTC + CCB 9 9 9.625 10.25 10.875 11.5

Phase-in of all 20 40 60 80 100 100

deductions from
CET 1( in % )

Capital instruments which no longer qualify as non-common equity Tier1 or Tier 2 capital
( Eg. IPDI and Tier 2 debt instruments with step-up ) will be phased out from Jan 1, 2013.

Elements of CET 1 capital

1. Paid-up equity capital (Common shares issued by the Bank)
2. Stock Surplus (Share Premium)
3. Statutory Reserves
4. Capital reserves representing surplus arising out of sale proceeds of assets.
5. Other free disclosed reserves
6. Balance in the P & L account at the end of previous year.
7. Profits in current financial year for CRAR calculation on a quarterly basis subject
to specified condition.
8. While calculating capital adequacy at the consolidated level, common shares
issued by consolidated subsidiaries of the bank and held by third parties (ie,
minority interest) which meet the criterion for inclusion in CET 1 capital.
9. Less regulatory adjustments/deductions
 Common Equity is recognised as the highest quality component of Capital
and is the primary form of funding which ensures that a bank remains

Banking Finance 153

 solvent. Therefore, under B III, common shares to be included in CET 1
capital must meet the criteria as specified.

Elements of AT 1 capital

1. Perpetual non-cumulative preference shares (PNCPS)

2. Stock surplus (share premium) resulting from issue of instruments included in AT1
capital
3. Debt capital which comply with regulatory requirements specified
4. Any other type of instrument notified by RBI from time to time
5. Minority interest which meet the criteria for inclusion in AT 1 capital
6. Less regulatory adjustments/deductions
 Banks should not issue AT1 capital instruments to retail investors.

Elements of Tier 2 capital

1. General Provisions and Loss Reserves

Provisions held against future, presently unidentified losses, which are freely
available to meet losses which subsequently materialise, will qualify for T2 capital.
Accordingly, provisions on standard assets, floating provisions, provisions held
for country exposures, investment reserve account, excess provisions on account
of sale of NPAs and CCB will qualify for T2 capital up to a maximum of 1.25%
of RWAs under the standardised approach.
Under IRB approach, where the total expected loss amount is less than total
eligible provisions, banks may recognise the difference as T 2 capital up to a
maximum of 0.6 % of credit –risk weighted assets calculated under IRB approach.
[ Specific provisions, DFV in case of restructured advances, provision against
depreciation are excluded].
2. Debt capital issued by banks
3. PCPS/RNCPS/RCPS
4. Stock surplus (share premium)
5. Minority interest subject to eligibility criteria
6. Revaluation reserves at a discount of 55%
7. Any other type of instrument notified by RBI from time to time
8. Less regulatory adjustments/deductions

154 Banking Finance

Regulatory Adjustments / Deductions
1. Goodwill and other intangible assets
2. DTA
3. Cash flow hedge reserve
4. Shortfall in stock of provisions to Expected Losses
5. Gain-on-sale related to securitisation transactions
6. Cumulative gains and losses due to changes in own credit risk on Fair valued
Financial Liabilities
7. Defined benefit pension fund assets and liabilities
8. Investment in own shares (Treasury stock)
9. Investments in the capital of Banking, Financial and Insurance entities
[ Capital charge for credit risk, market risk, operational risk – Refer to Frame on Basel II.
RBI Master Circular of July1, 2013 may be referred to for the following :
 Counterparty credit risk, securitisation exposures, CDS
 Capital charge for Interest Rate Risk -
i) ‘Specific Risk’ charge for each security, which is designed to protect against
an adverse movement in the price of an individual security
ii) ‘General Market Risk’ charge towards interest rate risk in the portfolio
 Capital charge for credit default swap
 Capital charge for counterparty credit risk ]
PART B
Pillar 2 – Supervisory Review & Evaluation Process (SREP)
Refer Frame on Basel II.
The Basel committee also lays down the following four key principles in regard to SREP
1) Banks should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital levels.
2) Supervisors should review and evaluate bank’s internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their
compliance with the regulatory capital ratios. Supervisors should take appropriate
supervisory action if they are not satisfied with the result of this process.
3) Supervisors should expect banks to operate above the minimum regulatory capital
ratios and should have the ability to require banks to hold capital in excess of
the minimum.

Banking Finance 155

 4) Supervisors should seek to intervene at an early stage to prevent capital from
falling below the minimum levels required to support the risk characteristics of
a particular bank and should require rapid remedial action if capital is not
maintained or restored.
Principles 1 and 3 relate to the supervisory expectations from banks;

Principles 2 and 4 deal with the role of the Supervisors.

The ICAAP and SREP are two important components of Pillar 2.

PART C

Pillar 3 - Market Discipline (MD)

MD can contribute to a safe and sound banking environment.

Non-compliance with the prescribed disclosure requirements would attract a penalty,

including financial penalty.

The disclosures should be subject to validation and consistency.

Pillar 3 disclosures will not be required to be audited by an external auditor, unless specified.

Banks should have a formal disclosure policy approved by the Board that addresses the
bank’s approach for determining what disclosures it will make and the internal controls over
the disclosure process, including validation and frequency.

Pillar 3 disclosures under Basel III would become effective from July1, 2013. The first set
of disclosures under these guidelines should be made as on Sep 30, 2013.

Banks are required to make Pillar 3 disclosures at least on a half-yearly basis, irrespective
of whether the financial statements are audited, with the exception of the following
disclosures:

Table DF - 2 : Capital Adequacy

Table DF - 3 : Credit risk : General disclosures

Table DF - 4 : Credit risk : Disclosures for portfolios subject to the Standardised Approach

The above three disclosures will be made at least on a quarterly basis.

The above 3 disclosures should be made concurrent with the publication of financial results/
statements and must be disclosed on bank’s website.

156 Banking Finance

An archive for at least three years of all templates relating to prior reporting periods should
be made available by banks on their websites.

The disclosure requirements are set out in the form of prescribed templates – DF 1 to DF 15.

The templates are common across Basel member jurisdictions and this ensures
comparability of capital adequacy of banks across jurisdictions (particularly the common
template which will be used by banks to report the details of their regulatory capital after
Mar 31, 2017 ie. after the transition period for the phasing-in of deductions are over).

TABLE SUBJECT
DF 1 Scope of Application
DF 2 Capital Adequacy
DF 3 Credit Risk – General Disclosures
DF 4 Credit Risk – Disclosures for portfolios subject to the
Standardised Approach
DF 5 Credit Risk Mitigation – Disclosures for Standardised Approaches
DF 6 Securitisation Exposures Disclosure for Standardised Approach
DF 7 Market Risk in Trading Book
DF 8 Operational Risk
DF 9 Interest Rate Risk in Banking Book (IRRBB)
DF 10 General Disclosure for Exposures related to Counterparty Risk
DF 11 Composition of Capital
Part 1 : Template to be used only from Mar 31, 2017.This has been
designed to capture the capital positions of banks after the
transition period for the phasing-in of deductions ends on Mar 31,
2017.
Part 2 : Template to be used before Mar 31,2017 (ie. during the
transition period of B III regulatory adjustments)
DF 12 Composition of Capital – Reconciliation Requirements
DF 13 Main features of Regulatory Capital Instruments
DF 14 Full terms and conditions of Regulatory Capital Instruments
DF 15 Disclosure Requirements for Remuneration

Banking Finance 157

 Part D

Capital Conservation Buffer (CCB) Framework

CCB is designed to ensure that banks build up capital buffers during normal times (ie.
outside periods of stress) which can be drawn as losses are incurred during a stressed
period. This is designed to avoid breaches of minimum capital requirements.

Outside the period of stress, banks should hold buffers of capital above the regulatory
minimum. When buffers have been drawn down, one way to rebuild them is through reducing
discretionary distributions on earnings. This could include reducing divided payments, share
buybacks and staff bonus payments. Banks may choose to raise new capital from the
market as an alternative to conserving internally generated capital. However if a bank decides
to make payments in excess of the constraints imposed above, the bank, with the prior
approval of RBI, would have to use the option of raising capital from the market equal to
the amount above the constraint which it wishes to distribute.

The CCB can be drawn only when a bank faces a systemic or idiosyncratic stress. A bank
should not choose in normal times to operate in the buffer range simply to compete with
other banks and win market share. Such a bank will be required to bring the buffer to the
desired level within a time limit prescribed by RBI. The banks which draw down their CCB
during a stressed period should also have a definite plan to replenish the buffer as part
of their ICAAP process within a time limit agreed to with RBI during SREP.

The framework of CCB will strengthen the ability of banks to withstand adverse environmental
conditions, will help increase banking sector resilience both going into a downturn and
provide the mechanism for rebuilding capital during the early stages of economic recovery.
Thus, by retaining a greater proportion of earnings during a downturn, banks will be able
to ensure capital remains available to support the ongoing business operations/lending
activities during the period of stress. Therefore, this framework is expected to help reduce
procyclicality.

CCB required is 2.5% of CET 1 capital above the regulatory minimum capital of 9%. Banks
should not distribute capital (i.e. pay dividends or bonuses in any form) in case capital
level falls within this range. The constraints imposed are related to distributions only and
are not related to operations of banks. The constraints increase as the banks’ capital levels
approach the minimum requirements. The table below shows the minimum capital
conservation ratios a bank must meet at various levels of CET 1 capital ratios.

158 Banking Finance

 CET 1 ratio after Minimum capital
including current period conservation ratio
retained earnings (%) (% of earnings)
5.5 to 6.125 100
> 6.125 to 6.75 80
> 6.75 to 7.375 60
> 7.375 to 8.0 40
> 8.0 0

During B III transition period, RBI has given a timetable for Mar 31, 2015, Mar 31, 2016
and Mar 31, 2017 for meeting the minimum capital conservation ratios at various levels
of CET 1 capital ratios.
CCB is applicable both at solo level as well as at the consolidated level.

Part E
Leverage Ratio (LR) Framework
The LR is intended to achieve the following objectives:
a. Constrain the build up of leverage, help avoid destabilising deleveraging processes
which can damage the broader financial system and the economy.
b. Reinforce the risk based requirements with a simple, non-risk based ‘backstop’
measure.
The Basel Committee will test a minimum Tier 1 LR of 3% during the parallel run from
Jan 1, 2013 to Jan 1, 2017. Additional transitional arrangements are set out in last para.
During the parallel run, banks in India should strive to maintain their existing LR but, in
no case the LR should fall below 4.5%. A bank whose LR is below 4.5% may endeavour
to bring it above 4.5% as early as possible. Final LR requirement would be prescribed by
RBI after the parallel run taking into account the prescriptions of Basel Committee.
LR is to be maintained on a quarterly basis. It is ‘the average of the month-end LR over
the quarter based on the definitions of capital (the capital measure) and total exposure (the
exposure measure)’ specified below:

Capital Measure
a) New definition of Tier 1 capital is as per B III guidelines. T1 capital does not include
CCB and CCCB for the purpose of LR.

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 b) Items deducted from capital do not contribute to leverage and therefore to be
deducted from exposure also, for sake of consistency.
[Consolidated entities – refer RBI circular]

Exposure Measure

a) On-balance sheet, non-derivative exposures will be net of specific provisions and

valuation adjustments (e.g. prudent valuation adjustments for AFS and HFT
positions, credit valuation adjustments).
b) Physical or financial collateral, guarantees or credit risk mitigation purchased is
not allowed to reduce on-balance sheet exposures.
c) Netting of loans and deposits is not allowed.

All items of assets in the accounting balance sheet, securities financing transactions
(e.g. repo, reverse repo, CBLO) and derivatives and other off–balance sheet items are
to be reckoned for Exposure.

Transitional Arrangements

Based on results of the parallel run, any final adjustments to the definition and calibration
of the LR will be carried out in H1 of 2017, with a view to migrating to a Pillar 1 treatment
on Jan 1, 2018.

Bank level disclosure of LR and its components will start from April 1, 2015.

However, banks should report their Tier 1 LR to RBI on a quarterly basis from the quarter
ending June 30, 2013.

* * * * * * *

FRAME 94
PRO-CYCLICALITY AND COUNTER CYCLICAL PROVISIONS

When the economy is facing a downturn, the health of the banks’ loan portfolio gets
deteriorated posing problems for recovery of loans. As a result, the quantum of provisions
for such impaired loans increases whereas banking operating income starts declining.

When economic conditions are booming, loans increase, operating incomes increase and
provisioning requirements decrease. Profits increase. But additional provisions are not
made. There is a wide swing in the quantum of provisions made from one period to another.

160 Banking Finance

During downturn, banks will tighten the lending processes and additional controls which
will reduce the credit flow to the economy and this will have a multiplier effect. More NPAs
and more provisions in a recession period have been cited as culprits for the financial crisis
of most western economies.

Thus, in a period of recession, banks may be forced to incur losses (as had happened
in the financial crisis in USA/Europe) after providing for loan losses.

The banks’ fortune going down with a recession/downturn or going up with a boom is called
pro-cyclicality. To reduce the pro-cyclicality of the banking system, enter counter-cyclical
measures. Basel III has suggested a counter-cyclical capital buffer (CCCB) and a capital
conservation buffer(CCB). This is to achieve financial stability by improving the capacity
of banks to absorb shocks.

B III wants banks to hold 4.5% as common equity and 6% of Tier I capital of Risk Weighted
Assets (RWA) and total capital ratio of 8%.[ RBI’s prescription : 5.5 % as CET 1 and 7%
of Tier 1 and minimum total capital ratio of 9 % of RWA].

MTC + CCB = 8 + 2.5 = 10.5% [ RBI’s prescription 9 + 2.5 = 11.5% ]

Basel III has introduced additional capital buffers:

a) Capital Conservation Buffer (CCB):

CCB is designed to ensure that banks build up capital buffers during normal times (i.e.
outside period of stress) which can be drawn down when losses are incurred during a
stressed period.

By this method, the level of provisioning will be less subjected to wide fluctuations even
during changing economic conditions. The loan losses will impact the banks’ P&L accounts
more smoothly than at present.

Therefore, in addition to minimum total capital of 8%, banks will be required to hold a CCB
of 2.5% of RWA. CCB will be in the form of common equity.

CCB should be able to absorb losses so that there is no breach of minimum capital
requirement.

b) Counter Cyclical Capital Buffer (CCCB):

CCCB of 0% to 2.5% of RWAs to the form of common equity or other fully loss absorbing
capital will be implemented according to national circumstances. The purpose of CCCB
is to achieve the broader macro prudential goal of protecting the banking sector from periods

Banking Finance 161

of excess aggregate credit growth. For any given country, this buffer will only be in effect
when there is excess credit growth that results in a system-wide build up of risk. The CCCB,
when in effect, would be introduced as an extension to CCB.
This objective is different from that of CCB which focuses on individual bank’s financial
conditions. CCCB is related to risks to financial stability.

* * * * * * *

FRAME 95
BASEL III GUIDELINES IN A NUTHSELL

(Without RBI’s modifications for implementation in India)

Basel II was supposed to strengthen the financials of banks (at the micro level) and hence
on a sum total basis, ensure the financial stability of the banking system.
The financial crisis of 2007-2008 shook the very foundations of several banks, particularly
in USA and Europe and also affected the real economy.
The lessons learnt from the financial crisis have been incorporated in B III with an aim to
prevent future crises.
The objective of B III is to improve the banking sector’s ability to absorb shocks arising
from financial and economic stress, thus reducing the risk of spillover from the financial
sector to the real economy.

Basel III
1) Increases the quantity and quality of regulatory capital that banks must hold.
The minimum CET-1 and total capital requirements will be phased in between Jan
1, 2013 & Jan1, 2015 as below:

As a % to RWA Jan 1, 2013 Jan 1, 2014 Jan 1, 2015

Minimum CET1 Capital 3.5% 4.00% 4.5%
Minimum Tier1 Capital 4.5% 5.50% 6.0%
Minimum Total Capital 8% 8% 8%

2) Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) introduced.
Now under observation period.

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 For a sounder approach to managing and supervising liquidity risks, 2 new ratios
have been introduced: the short term LCR and NSFR for the medium to long term.
While the short term ratio will focus on cash inflow and outflow in relation to
available liquid assets – assets that would provide cash even in a high stress
scenario - the long term ratio weighs available funds with regard to stability and
compares the relationship to the refinancing needs of assets. The intention is to
limit maturity transformation to a reasonable level.

These 2 ratios will become binding on banks from Jan 1, 2015 and Jan 1, 2018
respectively.

3) Learning an important lesson of excessive leverage during the financial crisis, B

III has introduced a single transparent, non risk based regulatory leverage ratio
supplementing the risk based capital requirement.
Tier I Leverage Ratio (LR) introduced. LR at 3% is being tested.

4) Enhancing risk coverage through ‘strengthening’ counterparty credit risk capital

requirements arising from derivatives, repurchase transactions and securities
financing.

5) Capital Conservation Buffer (CCB)

CCB is designed to ensure that banks build up capital buffers during normal times
(i.e. outside periods of stress) which can be drawn as losses are incurred during
the stressed period. This is designed to avoid breaches of minimum capital
requirements.

So, in addition to minimum total capital of 8%, banks will be required to hold
a CCB of 2.5% of RWA in the form of CE to withstand future periods of stress
bringing the total CE requirement to 7% and total capital to 10.5%. The CCB in
the form of CE will be phased in over 4 years uniformly @ at 0.625% per year,
commencing from Jan 1, 2016.

6) Counter Cyclical Capital Buffer (CCCB)

Further, a CCCB within the range of 0 to 2.5% of RWAs in the form of CE or

other fully loss absorbing capital will be implemented according to national
circumstances. The purpose of CCCB is to achieve the broader macro-prudential
goal of protecting the banking sector from periods of excess aggregate credit
growth. For any given country, this buffer will be in effect when there is excess
credit growth that results in a system-wide build-up of risk.

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To ensure smooth implementation, regulators have provided transition periods during which
the new regulatory standards are to be introduced gradually.

ENHANCED BASEL II + MACRO PRUDENTIAL = BASEL III

FOCUS
Micro Prudential Regulation Macro Prudential Focus
(Bank Level) (System-wide)
 Increased quantity and  Address stability over time
quality of Capital - Procyclicality
 Liquidity Standards - Capital conservation buffer
 Leverage ratio - Countercyclical capital buffer
- Dynamic Provisioning
 Systemic risk and interconnectedness
 Enhanced risk coverage Specific treatment for systemically
( For trading book,counterparty important financial institutions
Credit risk,securitisation )
 Enhanced supervisory process
 Disclosure

* * * * * * *

FRAME 96
REGULATORY CAPITAL & ECONOMIC CAPITAL

Basel I and Basel II guidelines stipulate a minimum capital adequacy of 8% of risk weighted
assets (RWA). In India, RBI has stipulated capital adequacy ratio (CAR) of 9%. This is
regulatory capital, fixed by the Regulator. Basel II estimates a minimal level of capital
required, based on risk sensitivity of the assets (capital charges in Internal Ratings Based
approach of Basel II).

Economical capital(also called Risk capital) is the capital required to insulate a bank from
unexpected losses in its activities, up to a certain level of confidence (reserves are set
aside to absorb any expected loss on a transaction, during the life of the transaction). In
other words, it is the minimal capital required to ensure that the bank remains solvent when
faced with large unexpected losses.

164 Banking Finance

Expected Loss (EL) is linked to the probability of default estimate. It equals the default
probability times the loss in the event of default. This is a loss that is expected to devolve
on the bank in respect of an asset on the basis of historical data.

Unexpected Loss (UL) is the average loss that the bank can expect over the time horizon.
UL is computed on the basis of the fluctuations in the expected loss estimates. UL
represents volatality in the rate of recovery and deviations from the estimated probability
of default at certain confidence levels.

While Reserves and Provisions are expected to take care of the EL component, the UL
is to be covered by Economic Capital.

Economic Capital = Actual Loss – Expected Loss

* * * * * * *

FRAME 97
HAIRCUT

The securities given as collateral have a definite price and this price of securities is subject
to changes depending upon the market forces i.e. there may be a price volatility. In order
to take care of the fluctuations in the price, B II has prescribed certain cuts to the value
of the securities as also the exposures. This kind of cut in the security value is referred
to as Haircut.

It means that, for capital adequacy purposes, collaterals are valued somewhat less than
their market prices.

For securities like IVP, KVP, NSC, surrender value of insurance policy, bank’s own term
deposit, the collateral haircut is zero.

In case where the exposure and collateral are held in different currencies (Rupee demand
loan against FCNR deposit), standard currency haircut is 8%. The haircut is to take care
of the exchange rate fluctuations.

Thus there are three types of haircuts:

a. Exposure Haircut (He) - Haircut will be a premium

b. Collateral Haircut (Hc) - Haircut will be a discount
c. Currency Haircut (Hfx) - If exposure and collateral are on different currencies,
haircut will be a discount. If in same currency, haircut is zero.

Banking Finance 165

E* = Max {0, [E (1+He) – C (1- Hc- Hfx)}

Where E* = Exposure after risk mitigation

E = Current value of Exposure

C = Current value of Collateral

E* will be multiplied by the risk weight of the counterparty to obtain the risk weighted asset
amount for the collateral transaction.

* * * * * * *

FRAME 98
CAPITAL SAVING OPTIONS

Capital adequacy is a key parameter for a bank’s health. With Basel III in, capital planning
assumes more significance as more capital is required. Considerable amount of capital
can be released if deficiencies and inadequacies in housekeeping, asset quality, lack of
external credit rating, coverage of collateral securities etc. are overcome. Awareness at the
ground level is very essential.

The options are:

a. External Credit Rating of Corporate Exposures

The risk weights and corresponding capital requirements will be:

Rating AAA AA A BBB BB & Less Unrated

Risk Weight 20 % 30 % 50 % 100 % 150 % 100 %
Capital Rs 2.40 Rs 3.60 Rs 6.00 Rs 12.00 Rs 18.00 Rs 12.00
Required for a
CAR of 12%

If a corporate is rated AAA, the bank can save capital to the tune of Rs. 9.60 for an exposure
of Rs. 100 each to maintain capital adequacy of 12%.

Corporates have to be persuaded to improve their functioning so that they get better ratings.

Also, branches should canvas higher rated corporates.

166 Banking Finance

b. Unconditional Cancellabilty Clause
As per RBI guidelines, ‘commitments that are unconditionally cancellable at any time by
the Bank without prior notice or that effectively provide for automatic cancellation due to
deterioration in a borrower credit worthiness’ shall carry a credit conversion factor of zero
percentage. As such, the credit equivalent of all unutilized limits become zero and no capital
charge is required for such undrawn commitments.
Bank to ensure that such a clause as unconditional cancellation is in their documentation
and such undrawn limits can be cancelled to save capital.

c. Other Assets
‘Other Assets’ carry risk weight of 100%. These ‘Other Assets’ must be analysed and
brought to zero/minimum level - by reconciliation, realisation, completion of claims on State/
Central pension etc.

d. NPA
There is a three way impact on capital charge for NPA.
i) Loss of interest from the account
ii) Provision requirement
iii) Increase in risk weight
Only solution - reduce NPA particularly irregular accounts tending to become NPAs.
Realisable value of securities to be assessed and reckoned.

e. Guarantees
Where guarantees are direct, explicit, irrevocable and unconditional, bank can reckon such
credit protection in calculating capital requirements. Guarantees issued by the following
carry risk weights as under:
Type of Guarantees Risk Weight
1 By Central Government 0%
2 By State Government 20%
3 By CGTMSE 0%
4 By ECGC 20%
5 By CRGFTLIH 0%

The details have to be captured correctly to save capital.

Banking Finance 167

f. Financial Collateral (FC)

FCs are allowed to be netted from credit exposure while calculating CAR

i. Cash
ii. Gold (Bullion and Jewellery)
iii. Securities issued by Central and State Governments
iv. KVP and NSC provided no lock-in period is operational and if they can be
encashed within the holding period
v. Life Insurance Policies of an Insurance Company which is regulated by an
Insurance Sector regulator
vi. Debt Securities rated by a chosen CRA in respect of which the bank should be
sufficiently confident about the market liquidity
vii. Debt securities not rated by a chosen CRA in respect of which the bank should
be sufficiently confident about the market liquidity where these are
1. Issued By a Bank
2. Listed on a stock exchange
3. Classified as senior debt
4. All rated issues rated at least BBB(-) by a chosen CRA.
viii. Equities listed on a stock exchange and are included in Sensex, BSE- 200, S&P
CNX Nifty or junior Nifty.
ix. Units of MFs regulated by the securities regulator where:
- a price for the units is publicly quoted daily: Where daily NAV is available
in public domain.
- Mutual fund is limited to investing in instruments listed above.

g. Data Integrity

i) Advance accounts in zero balance/credit balance must be closed. Otherwise the

system may pickup the limits for computing CAR on unutilised limit.
ii) Security details of gold ornaments (taken for Gold Loan) must be fed into the
system for netting off exposure.
iii) For HL, market value of security must be correctly put so that correct LTV can
capture correct risk weight.
iv) Full details of paper-based securities (eligible financial collaterals) taken (Loan

168 Banking Finance

 against shares, KVP, IVP, Insurance policies, Govt securities, MF etc) must be
reckoned for netting off against exposure.
v) Sub-limits allotted to other branches should not be double counted.
vi) Bank is required to make available capital for the undisbursed portion of term
loans. As per RBI guidelines. bank needs to take only the next instalment due
for disbursement as the undisbursed portion. The second and remaining
instalments need not be taken in to account towards undisbursed portion.
So, the disbursement schedule of TLs should necessarily be given as per the
terms of sanction so that bank need not maintain capital unnecessarily for the
whole undisbursed portion.
vii) Expired LCs/Guarantees need to be closed in the system
* * * * * * *

FRAME 99
PROVISIONING COVERAGE RATIO (PCR)

PCR is the ratio of provisions to gross NPA and indicates the extent of funds a Bank has
kept aside to cover loan losses.

From a macro-prudential perspective, banks should build up provisioning and capital buffers
in good times i.e. when profits are good, which can be used for absorbing losses in a down-
turn. This will enhance the soundness of individual banks and also the stability of the
financial sector. Hence banks were advised earlier to achieve a PCR of 70% (by September
2010) (The provisioning included specific provisions for NPA and floating provisions).

Now Basel III has introduced countercyclical buffer to be built up. Until RBI introduces a
more comprehensive methodology of countercyclical provisioning taking into account the
international standards as are being currently developed by Basel Committee, banks have
been advised that:

a) PCR of 70% may be with reference to the gross NPA position in banks as on
September 30, 2010.
b) The surplus of the provision under PCR vis-à-vis as required as per prudential
norms should be segregated into an account styled as ‘countercyclical
provisioning buffer’ computation of which is shown here below.
c) This buffer will be allowed to be used by banks for making specific provisions
for NPAs during period of system-wide downturn, with prior approved of RBI.

Banking Finance 169

 Specific provisions for NPAs + provisions for diminution in fair
value of restructured advances (NPA) + technical write off +
floating provisions for advances (not used for Tier II capital) +
DICGC/ECGC claims received + part payment received.
PCR = —————————————————————————————— × 100
Gross NPA + Technical write off / Prudential write off

Countercyclical provisioning buffer =

a) If bank has achieved PCR Floating provisions for advances

of 70% (not used for Tier 2 capital)

b) If bank has not achieved Floating provisions (not used for II capital) +
PCR of 70% shortfall in provisioning to achieve PCR of 70%

* * * * * * *

FRAME 100
RISK ADJUSTED RETURN ON CAPITAL (RAROC) &
RETURN ON RISK ADJUSTED CAPITAL (RORAC)

RAROC is a risk based profitability measurement framework for analysing risk adjusted
financial performance. The concept was developed by Bankers Trust in 1970s.

RAROC = Risk Adjusted Return

Economic Capital

= NII + Fees – Expected Loss - Op. cost - Taxes

Economic capital

RAROC risk adjusts both the numerator and the denominator. It is a fully risk adjusted
metric. This use of capital based on risk improves the capital allocation across different
functional areas of banks.

RORAC = Return = Net Income

Risk adjusted capital Economic capital

RORAC does not add risk adjustments to the numerator.

* * * * * * *

170 Banking Finance

 FRAME 101
ALM SYSTEM

ALM system was introduced in banks by RBI from April 1, 1999.

It aims at maintaining good balance among spread, profitability and long term viability.

ALM is a continuous process of planning, organising and controlling asset and liability
volumes, maturities, rates and yields.

ALM has become necessary because banks are exposed to several risks in the course
of their business – credit risk, interest rate risk, foreign exchange risk, equity/commodity
price risk, liquidity risk and operational risks.

2. The ALM process rests on three pillars:

 ALM information system

Management information system
Information availability, accuracy, adequacy and expediency
 ALM organisation
Structure and responsibilities
Level of top management involvement
 ALM process
Risk parameters
Risk identification
Risk measurement
Risk management
Risk policies and tolerance levels

3. ALM Information System

Information is the key to the ALM process. It analyses information on the basis of
residual maturity and behavioural pattern.

4. ALM organisation

i. The Board will have overall responsibility for management of risks and should
decide the risk management policy of the bank and set limits for liquidity, interest
rate, foreign exchange and equity price risks.

Banking Finance 171

 ii. The Asset–Liability Committee (ALCO) consisting of the bank’s senior
management including CEO should be responsible for ensuring adherence to the
limits set by the Board as well as for deciding the business strategy of the bank
(on the assets and liabilities sides) in line with the bank’s budget and decided
risk management objectives.
iii. The ALM support group should be responsible for analysing , monitoring and
reporting the risk profiles to ALCO. The group should prepare forecasts
(simulations)showing the effects of the various possible changes in market
conditions related to the balance sheet and recommend the action needed to
adhere to bank’s internal limits.
The ALCO is a decision making unit responsible for balance sheet planning from risk
- return perspective including the strategic management of interest rate and liquidity
risks. The business issues that an ALCO would consider will include product pricing
for both deposits and advances, desired maturity profiles of the incremental assets
and liabilities etc. In addition to monitoring the risk levels of the bank, the ALCO should
review the results and progress in implementation of the decisions made in the previous
meetings. In respect of the funding policy, its responsibility would be to decide on
source and mix of liability or sale of assets. Towards this end, it will have to develop
a view on future direction of interest movements and decide on a funding mix between
fixed vs. floating rate funds, wholesale vs retail deposits, money market vs capital
market funding, domestic vs foreign currency funding etc.

Committee of Directors
A Board level sub-committee of 3 or 4 directors will oversee the implementation of the
ALM system and review its functioning periodically.

5. ALM process

The scope of the ALM function can be described as follows:

 Liquidity risk management
 Market risk management (including interest rate risk)
 Funding and capital planning
 Profit planning and growth projection
 Trading risk management
Liquidity Risk Management and Interest Rate risk are covered in separate frames.

* * * * * * *

172 Banking Finance

 FRAME 102
ALM - LIQUIDITY RISK MANAGEMENT (LRM)

Liquidity is a bank’s capacity to fund increase in assets and meet both expected and
unexpected cash and collateral obligations at reasonable cost and without incurring
unacceptable losses.

Liquidity Risk (LR) is the inability of the bank to meet such obligations as they become
due, without adversely affecting the bank’s financial condition.

Liquidity crisis, even at a single institution, can have systemic implications.

LR manifests as:
a. Funding liquidity risk: the risk that a bank will not be able to meet efficiently
the expected and unexpected current and future cash flows and collateral needs
without affecting either its daily operations or its financial condition.
b. Market liquidity risk: the risk that a bank cannot easily offset or eliminate a
position at the prevailing market price because of inadequate market depth or
market disruption.
The global financial crisis revealed several deficiencies in LRM by banks: insufficient holding
of liquid assets, funding risky or illiquid asset portfolios with potentially volatile short term
liabilities, and a lack of meaningful cash flow projections and liquidity contingency plans.
Based on BCBS published principles for sound LRM and Supervision, a sound LRM would
envisage that:
a. The Board is responsible for sound management of LR and should articulate a
LR tolerance appropriate for its business strategy and its role in the financial
system.
b. It should develop strategy, policies and practices to manage LR in accordance
with the risk tolerance and ensure that the bank maintains sufficient liquidity.
These must be reviewed annually.
c. Top management/ALCO should continuously review information on bank’s liquidity
developments and report to the Board on a regular basis.
d. A bank should have a sound process for identifying, measuring, monitoring and
controlling LR, including a robust framework for comprehensively projecting cash
flows arising from assets, liabilities and off-balance sheet items over an
appropriate time horizon.

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 e. The process should be sufficient to meet its funding needs and cover both
expected and unexpected deviations from normal operations.
f. A bank should incorporate liquidity costs, benefits and risks in internal pricing,
performance measurement and new product approval process for all significant
business activities.
g. A bank should actively monitor and manage LR exposure and funding needs within
and across legal entities, business lines and currencies, taking into account legal,
regulatory and operational limitations to transferability of liquidity.
h. A bank should establish a funding strategy that provides effective diversification
in the source and tenor of funding, and maintain ongoing presence in its chosen
funding markets and counterparties and address inhibiting factors in this regard.
i. Senior management should ensure that market access is being actively managed,
monitored and tested by the appropriate staff.
j. A bank should identify alternative sources of funding that strengthen its capacity
to withstand a variety of severe bank specific and market-wide liquidity shocks.
k. A bank should manage its intra-day liquidity positions and risks and its collateral
positions.
l. Stress tests should be conducted regularly for short term and protracted institution
specific and market-wide stress scenarios and use the outcomes to adjust its
LRM strategies, policies and position and develop contingency plans.
m. Senior management should monitor potential liquidity stress events by using early
warning indicators and event triggers. These may include negative publicity
concerning an asset class owned by the bank, increased potential for deterioration
in bank’s financial condition, widening debt or CDS spreads and increased
concerns over the funding of off-balance sheet items.
n. To mitigate the potential for reputation contagion, a bank should have a system
of communication with counterparties, credit rating agencies and other
stakeholders when liquidity problems arise.
o. A bank should have a formal contingency funding plan (CFP) that clearly sets
out the strategies for addressing liquidity shortfalls in emergency situations. A
CFP should delineate policies to manage a range of stress environments,
establish clear lines of responsibility and articulate clear implementation and
escalation procedures.

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 p. A bank should maintain a cushion of unencumbered, high quality liquid assets
to be held as insurance against a range of liquid stress scenarios.
q. A bank should publicly disclose its liquidity information on a regular basis that
enables all market participants to make an informed judgement about the
soundness of its LRM framework and liquidity position.

Organisation set up for LRM

 Board of Directors – decides strategy, policies and procedures

 Risk Management Committee – responsible for evaluating overall risks faced by
the bank including liquidity risk
 Asset Liability Management Committee(ALCO) – responsible for implementation
of LRM strategy
 ALM Support Group (ALM-SG) – responsible for analysing, monitoring and
reporting the liquidity risk profile to ALCO.
An LRM policy covering all the above dimensions should be put in place.

Liquidity can be measured through stock and flow approaches. Flow approach measurement
involves comprehensive tracking of cash flow mismatches. For measuring and managing
net funding requirements, the RBI format i.e. the statement of Structural Liquidity for
measuring cash flow mismatches at different time bands should be adopted. The cash flows
are required to be placed in different time bands based on the residual maturity of the cash
flows or the projected future behavior of assets, liabilities and off-balance sheet items. The
difference between cash inflows and outflows in each time period is a measure of bank’s
future liquidity surplus/deficit.

The buckets are: 1day, 2-7 days, 8-14 days, 15-28 days, 29 days-3 months, over 3 months
to 6 months, over 6 months to 1 year, over 1 year to 3 years, over 3 years to 5 years,
over 5 years.

The revised formats of Structural Liquidity comprise of:

a. Domestic currency – Indian operations

b. Foreign currency – Indian operations
c. Combined Indian operations – domestic and foreign currency (solo bank level)
d. Overseas branch operations – country-wise
e. Consolidated bank operations

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Tolerance levels/prudential limits for various maturities may be fixed by the bank. The net
cumulative negative mismatches in the domestic and overseas structural liquidity statement
during the next day, 2-7 days, 8-14 days, 15-28 days buckets should not exceed 5%, 10%,
15%, 20% of the cumulative cash outflows in the respective time buckets.

For assessing the liquidity mismatch in foreign currencies, as far as domestic operations
are concerned, banks are required to prepare Maturity and Position (MAP) statements. The
formats have been revised by RBI.

In order to enable banks to monitor their short term liquidity on a dynamic basis over a
time horizon of 1-90 days, banks have to estimate their short term liquidity profile on the
basis of business projections and commitments in the revised RBI format. The inflows and
outflows are put in next day, 2-7 days, 8-14 days, 15-28 days, 29-90 days buckets. The
format is equally applicable to bank’s overseas operations – both jurisdiction- wise and
overall overseas position.

Certain stock ratios are useful in monitoring LR at solo bank level.

a. [Volatile liabilities – Temporary assets] / [Earning Assets – Temporary assets]

Measures the extent to which volatile money supports bank’s basic earning assets.
Since the numerator represents short term interest sensitive funds, a high number
implies some risk of liquidity (Industry Average 40%).
b. Core deposits / Total assets
Measures the extent to which assets are funded through stable deposit base.(Industry
Average 50%).
c. [Loans +mandatory SLR +CRR] / Total assets
Numerator represents least liquid investments and hence a high ratio signifies the
degree of ‘illiquidity’ embedded in the balance sheet (Industry Average 80%).
d. [Loans + mandatory SLR +CRR + Fixed assets] / Core deposits
Measures the extent to which illiquid assets are financed out of core deposits (Industry
Average 150%).
e. Temporary assets / Total assets
Measures the extent of available liquid assets. A higher ratio could impinge on the
asset utilisation of banking system in terms of opportunity cost of holding liquidity
(Industry Average 40%).

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f. Temporary assets / Volatile assets
Measures the cover of liquid investments. A ratio of less than 1 indicates the possibility
of a liquidity problem (Industry Average 60%).
g. Volatile liabilities / Total assets
Measures the extent to which volatile liabilities fund the balance-sheet (Industry Average
60%)
Banks may fix their own limits based on their LRM capabilities, experience and profile.

Banks are required to adhere to the regulatory limits prescribed (like inter-bank liability limit,
call money borrowing and lending limit) to reduce the extent of concentration on the liability
side of the banks.

Banks have to frame policy to contain the LR arising out of excessive dependence on
wholesale deposits (Rs15 lacs and above) or a higher threshold as approved by the Board.

The cash flows arising out of contingent liabilities (off-balance sheet exposures like
derivatives, guarantees etc) in normal situation and its increase during stressed times should
also be estimated and monitored.

Intra-day LR is also to be monitored.

Stress testing is an integral part of LRM. A stress test is commonly described as an

evaluation of the financial position of a bank under a severe but plausible scenario to assist
in decision making within the bank. It alerts management to adverse unexpected outcomes
as it provides forward looking assessment of risk and facilitates better planning to address
the vulnerabilities identified.

Some of the broad norms for LRM are:

a. Banks should not normally assume voluntary risk exposures extending beyond
10 years.
b. Banks should try to broaden their base of long term (LT) resources and funding
capabilities consistent with their LT assets and commitments.
c. The limits on maturity mismatches shall be established within the following
tolerance levels:
i. LT resources should not fall below 70% of LT assets.
ii. Long and medium term (LMT) resources should not fall below 80% of LMT
assets.
(These controls are to be applied currency -wise)

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The definitions for this purpose are as under:

Short term Those maturing within 6 months

Medium term Those maturing in 6 months and longer up to 3 years
Long term Those maturing in 3 years and longer

For a full picture, RBI circular dated Nov 7, 2012 may be referred to.

* * * * * * *

FRAME 103
ALM - INTEREST RATE RISK (IRR)
IRR is the risk where changes in market interest rate affect a bank’s financial position.
Changes in interest rates also impact a bank’s Market Value of Equity (MVE) (here equity
would mean ‘net worth’) through changes in economic value of its interest rate sensitive
assets, liabilities and off-balance sheet (OBS) positions. The IRR, when viewed from these
two perspectives, is known as Earnings Perspective & Economic Value Perspective.

RBI Feb 1999 guidelines indicated approach to IRR from the Earnings Perspective, using
the Traditional Gap Analysis (TGA).

RBI Oct 2010 guidelines have indicated approach to IRR from the Economic Value
Perspective, using the Duration Gap Analysis (DGA). DGA is effective from April 1, 2011.DGA
is aimed at providing an indication of the IRR to which the bank is exposed. Accordingly,
the estimated drop in MVE as a result of the prescribed shock applied would indicate the
economic impact of the bank’s equity, should the shock materialise but would not be an
accounting loss as banking book is not marked to market.

The salient features of DGA are:

a. The framework should be applied to the global position of assets, liabilities and
OBS items of the bank, which are rate sensitive.
b. Since the computerisation processes and MIS are getting evolved in banks, a
simplified framework has been suggested which allows banks to:
i. Group rate sensitive assets, liabilities and OBS items under the broad
categories indicated by RBI in various time buckets.
ii. Compute Modified Duration (MD) of these categories of assets/liabilities and
OBS items using the suggested common maturity, coupon and yield

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 parameters. Banks which have the capability to compute the weighted
average MD of their assets and liabilities based on MD of each item of RSA/
RSL may do so.
c. Each bank should set appropriate internal limits for IRR based on its risk bearing
and risk management capacity, with prior approval of its Board.
d. Banks should compute the potential decrease in earnings and fall in MVE under
various interest rate scenarios.
This framework is aimed at determining the impact on MVE of the bank arising from changes
in the value of interest rate sensitive positions across the whole bank i.e. both the banking
and trading books. This requirement is in addition to the existing guidelines for assessing
capital adequacy requirement for interest rate sensitive positions in the trading book and
banking book (Pillar II) separately.

The TGA is used to measure the changes in bank’s earnings through changes in NII.
(Earnings Perspective). Earnings at Risk (EAR) i.e. loss of income under different interest
rate scenarios over a time horizon of 1 year is computed.

The DGA is used to measure the change in MVE or net worth through changes in economic
value of its RSA, RSL and OBS positions. Banks are to carry out both the analysis.

Relationship between MDG and sensitivity of MVE to interest rate changes:

a. MD of an asset or liability measures the approximate change in its value for a

100 basis point change in the rate of interest.
b. The MDG framework involves computation of MD of RSA (MDA) and MD of RSL
(MDL). MDA and MDL are the weighted average of the MD of items of RSA and
RSL respectively. The MDG can be calculated with the help of the following
formula:
MDG = MDA - (MDL x RSL /RSA)

The MDG as defined above reflects the degree of duration mismatch in the RSA
and RSL in a bank’s balance sheet. Specifically, larger this gap in absolute terms,
the more exposed the bank is to interest rate shocks.

c. The impact of changes in the interest rate on the MVE can be evaluated by
computing ΔE with the help of the following formula:
ΔE = – [ MDG ] x RSA x Δi

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In the above equation,

 Equity would mean net worth

 ΔE stands for change in the value of equity
Δi stands for change in interest rate in percentage points (1% change to be written
as 0.01)
Ideally, in the calculation of changes in MVE due to changes in interest rates, market values
of RSA and RSL should be used. However, for the sake of simplicity, banks may take the
book values of the RSA and RSL (both inclusive of notional value of rate sensitive OBS
items) as an approximation.

As per earlier RBI circular, a level of IRR which generates a drop in the value of equity
of more than 20% of MVE, with an interest rate shock of 200 basis points will be treated
as excessive and such banks would normally be required by RBI to hold additional capital
against IRRBB as determined during Supervisory Review and Evaluation Process (SREP).

However, under the circular of Nov 4, 2010, the shock of 200 bps will be applied to the
entire balance sheet including the trading book. Also, no calibration (like 20% mentioned
above) is envisaged for the decline in MVE at this stage.

Each bank should set appropriate internal limits on EAR and on the volatility of MVE with
Board approval. These limits may be linked to MVE for DGA and NII for TGA. Periodic review
of these limits are to be done.

Any significant difference in the assessment of IRR for the bank under 2 scenarios:

a. The bank as a whole.

b. Separately for banking and trading book with different shocks and their implications
for regulatory capital would be considered under SREP.
* * * * * * *

FRAME 104
COUNTRY RISK MANAGEMENT (CRM)
As per RBI guidelines, banks are required to put in place CRM system in respect of a
country, wherein a bank’s net funded exposure is 1% or more of its total assets with effect
from Mar 31, 2005 (earlier 2%).

To deal with country risk problems, banks should have in place contingency plans and clear
exit strategies which would be activated at times of crisis.

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The CRM policy should stipulate rigourous application of the KYC principle in international
activities which should not be compromised by availability of collateral or shortening of
maturities. Country risk element should be explicitly recognised while assessing
counterparty risk.
Further, banks should reckon indirect country risk. For e.g. exposures to a domestic
commercial borrower with a large economic dependence on a certain country may be
considered as subject to indirect country risk. And indirect exposures may be reckoned
at 50% of the exposure.
Till banks move over to Internal Rating systems, banks have been advised to use the 7
category classification followed by ECGC and making provisions for country risk exposures.
Banks’ Boards may set exposure limits in relation to banks’ regulatory capital (Tier 1 +
Tier 2). The exposure limit should not exceed its regulatory capital except in the case of
insignificant risk category.
RBI has stated that the rating accorded by a bank to any country should not be better
than the rating of that country by an international rating agency. The frequency of periodic
review of credit ratings should be at least once a year with a provision to review the rating
of a specific country based on any major events in that country where bank exposure is
high, even before the next review of rating is due.
Banks are to monitor their country exposures on a weekly basis before switching over to
real time monitoring.
Stress testing should be done and should include an assessment of the impact of alternative
outcomes to important underlying assumptions.
Provisions to be made

Sl no Risk category ECGC classification Provisioning

Requirement (%)
1 Insignificant A1 0.25
2 Low A2 0.25
3 Moderate B1 5.00
4 High B2 20.00
5 Very High C1 25.00
6 Restricted C2 100.00
7 Off-credit D 100.00

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The provision for country risk shall be in addition to the provisions required to be held
according to the asset classification status of the asset. In the case of Loss Assets and
Doubtful Assets, provisions held, including provision held for country risk, may not exceed
100% of the outstanding.

Banks may make a lower level of provisioning (25% of the requirement) in respect of short
term exposures (i.e. exposures with contractual maturity of less than 180 days).

This provision for country risk will be reckoned for Tier 2 capital subject to the ceiling of
1.25% of RWA.
Banks should disclose as a part of ‘Notes on Accounts’ to the balance sheet as on 31
Mar every year :
a) Risk category-wise country exposure
b) Extent of aggregate provisions held there against

Inter Bank Exposure and Country Risk

Regarding exposure on foreign banks, banks can use country ratings of international rating
agencies and classify the countries into low risk, moderate risk and high risk. The maximum
exposure should be subjected to adherence of country and bank exposure limits. While
the exposures should at least be monitored on a weekly basis, all exposures to problem
countries should be evaluated on a real time basis.

* * * * * * *

FRAME 105
STRESS TESTING (ST) AND REVERSE STRESS TESTING
ST is an integral part of bank’s risk management system. It is used to evaluate the potential
vulnerability to certain unlikely but plausible events or movements in financial variables. The
vulnerability is usually measured with reference to the bank’s profitability/capital adequacy.
It has a forward looking element.
ST is of two types:
a) Sensitivity Tests
Normally used to assess the impact of change in one variable (e.g. change in
exchange rate, movement in equity index, etc.) on the bank’s financial position.

182 Banking Finance

 b) Scenario Tests
Include simultaneous moves in a number of variables (e.g. equity prices, exchange
rate, interest rates, liquidity, etc.) based on a single event experienced in the past
(historical scenario-natural disasters, stock market crash) or a plausible market
event that has not yet happened (hypothetical scenario - collapse of
communication system, prolonged severe downturn) and the assessment of their
impact on the bank’s financial position.
ST enables banks to develop/choose appropriate strategies for mitigating and managing
the impact of these situations.

Banks should identify their major risks that should be subjected to stress tests. Banks,
in general, are exposed to credit risk, credit concentration risk, interest rate risk, price risk,
foreign currency risk, liquidity risk, operational risk, prepayment risk, macro-economic risk
and political risk.

From the ST, banks should estimate the financial resources needed to

a. Meet the risk as it arises and mitigating the impact

b. Meet the liabilities as they fall due
c. Meet the minimum CRAR requirements
Few stress factors/scenarios are: downturn, increase in NPAs, rating downgrades, default
by counterparties, interest rate changes, exchange rate changes, tightening of liquidity,
operational risk events etc.

The remedial action banks may consider when stress tolerance levels are breached:

a. Reduction of risk limits

b. Enhancing collaterals, hedging, seeking risk mitigants
c. Amend pricing policies to reflect enhanced risks/previously unidentified risks
d. Augmenting capital enhancing buffer to absorb shocks
e. Enhancing sources of funds through credit lines, altering liquid asset portfolio etc.

Reverse Stress Testing

BCBS consultative document on ST states ‘Supervisors may ask banks to use specific
scenarios or to evaluate scenarios under which their viability is threatened (reverse stress
testing scenarios)’.

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The Committee of European Banking Supervisors (CEBS) Guidelines on ST: ‘Reverse ST
consists of identifying a significant negative outcome and then identifying the causes and
consequences that could lead to such an outcome. In particular, a scenario or a combination
of scenarios that threaten the viability of the institution’s business model is of particular
use as a risk management tool for identifying possible combinations of events and risk
concentrations within an institution that might not generally be considered in a regular ST.
A key objective of such ST is to overcome disaster myopia and the possibility that a false
sense of security might arise from regular ST in which institutions identify manageable
impacts.’
* * * * * * *

FRAME 106
REGULATORY LIMITS AND EXPOSURE NORMS

a. Inter-Bank Liability (IBL) Limit

IBL of a bank should not exceed 200% of its net worth as on Mar 31 of previous year.
Banks whose CRAR is at least 25% more than the minimum CRAR (9%) i.e. 11.25%
as on Mar 31 of the previous year, are allowed to have a higher limit up to 300% of
NW for IBL. The limit will include only fund based IBL within India. This limit will not
include borrowings under CBLO and refinance from NABARD and SIDBI.
b. Call Money Borrowing Limit
This will be a sub-limit under IBL. On a fortnightly basis, such borrowings should not
exceed 100% of bank’s capital funds. However, banks are allowed to borrow a maximum
of 125% of their capital funds on any day, during a fortnight.
c. Call Money Lending Limit
Should not exceed 25% of its capital funds, on a fortnightly basis. However, banks
can lend to a maximum of 50% of their capital funds on any day, during a fortnight.

Exposure Norms

As a prudential measure aimed at better risk management and avoidance of concentration

of credit risks, certain exposure norms have been fixed by RBI. Exposure means funded
and non-funded credit limits and investment exposure. Sanctioned limit or outstanding shall
be reckoned, whichever is higher. In case of fully drawn Term Loan, where there is no scope
for redrawal of any portion of the sanctioned limit, banks may reckon the outstanding as
exposure.

184 Banking Finance

 Category Of Capital Funds

To a single borrower 15%

If additional credit exposure is to

infrastructure projects 20% (additional 5%)

To a borrower group 40%

If additional credit exposure is to 50% (additional 10%)

infrastructure projects

In exceptional circumstances:
 With approval of Board
To a single borrower Additional 5 %
To a borrower group Additional 10%
 Subject to borrower/borrower group
consenting to the Banks making
disclosure in their Annual Reports

Single NBFC 10%

Single NBFC – AFC 15%
If funds on-lent by above to Infrastructure sector:
Single NBFC 15%
Single NBFC – AFC 20%

Infrastructure Finance Company 15%

If on–lent to Infrastructure sector 20%

Bills discounted under LC

Where discounting/purchasing/negotiating bank and LC issuing bank are different entities,
such bills under LC will be treated as exposure on the LC issuing bank and not on the
third party /borrower.
If both are same bank, then exposure is taken on the borrower.

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Exemptions from exposure ceilings
a. Not applicable to existing / additional credit facilities granted to weak / sick
industrial units under rehabilitation package.
b. Food credit allocated directly by RBI.
c. Where principal and interest are fully guaranteed by GOI.
d. Loans and advances granted against the security of banks’ own term deposits.

Exposure to Capital Markets

a. No bank shall hold shares in any company, whether as pledgee, mortgagee or

absolute owner, of an amount exceeding 30% of the paid-up capital of that
company or 30% of its own paid-up share capital and reserves, whichever is less.
(Sec 19 (2) of Banking Regulation Act).
b. Exposure of a bank to capital markets (fund based and non-fund based) should
not exceed 40% of its net worth as on Mar 31 of previous year.
Within this ceiling, direct investment in shares, convertible bonds/debentures,
equity-oriented MF, VF should not exceed 20% of its net worth.
c. Loans against security of shares, convertible bonds, convertible debentures,
equity - oriented MF units to individuals from the banking system should not
exceed Rs 10 lacs per individual if the securities are held in physical form and
Rs 20 lacs per individual if held in demat form.
* * * * * * *

FRAME 107
FINANCIAL CONGLOMERATE (FC)

According to Wikipedia, ‘a conglomerate is a combination of two or more corporations

engaged in entirely different businesses that fall under one corporate group, usually involving
a parent company and many subsidiaries. Often, a conglomerate is multi-industry company.
They are often large and multinational’.

According to Inter-Regulatory Working Group Report (2004) [Convenor: Smt. Shyamala

Gopinath]:

A group is defined as an arrangement involving two or more entities related to each other
through any of the following relationships and a ‘Group entity’ as any entity involved in this
arrangement as indicated below:

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 a) Subsidiary – Parent (defined in terms of AS 21)
b) Associate (defined in terms of AS 23)
c) Joint Venture (defined in terms of AS 27)
d) Promoter – Promotee
e) A related party (as defined in terms of AS 18)
f) Common brand name and investment in equity shares 20% or more
A group would be designated as a FC if:

i) Any group entity coming under the jurisdiction of specified regulators and having
a significant presence in the respective financial market segment and
ii) The group is having operations in at least one more financial market segment.
(Specified Regulators: RBI, SEBI, IRDA for the present)

The framework includes foreign banks. Broking arms and HFC of identified groups will be
included for reporting purposes.

The following are kept out of the framework for the present: RRBs, Depositories, SPVs
(including Trusts), ARCs and Associates of SBI.

Significant presence in the respective financial market segment:

Financial market segment Threshold for significant presence

Banks Included in the top 70% of the segment in
terms of asset base
Insurance companies Turnover more than Rs 100 Cr
MF Included in the top 70% of the segment in
terms of AUM
NBFC (deposit taking) Included in the top 70% of the segment in
terms of deposit base
NBFC (non-deposit taking) Asset base more than Rs 2000 Cr
Primary Dealer Included in the top 70% of the segment in
terms of turnover

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12 FCs have been identified.

The list of banks under the supervisory purview of FC Monitoring Division (FCMD) of RBI
are:

1. State Bank of India 7. HDFC Bank

2. Bank of Baroda 8. Kotak Mahindra Bank
3. Bank of India 9. ICICI Bank
4. Canara Bank 10. Citibank
5. Punjab National Bank 11. HSBC
6. Axis Bank 12. Standard Chartered Bank

These 12 banks account for 52.7% of total assets of the banking system. The department
will have a close and continuous supervision of these 12 Systemically Important Financial
Institutions (SIFIs). This is to prevent any systemic fallout in case one of them falters.

* * * * * * *

188 Banking Finance

 PART - G

THE FOREX MARKET

Banking Finance 189

 FRAME 108
FOREX RESERVES (FxR)

Forex Reserves (FxR) of India was $ 275 bn as on Sep 13, 2013. A long way from the
forex crisis of 1991 when India had to pledge gold with international banks to avoid default.

Definition

The IMF defines FxR as external assets that are readily available to and controlled by
monetary authorities for direct financing of external payment imbalances, for indirectly
regulating the magnitudes of such imbalances through intervention in exchange markets
to affect the currency exchange rate and/or for other purposes.

FxR include:

As on 13-09-2013 (US $ bn)

Foreign currency assets (FCA) 2,47.2

Special Drawing Rights (SDR) 4.4
Gold 21.7
Reserve Tranche position (RTP) in the IMF 2.0
Total 275.3

FCA are maintained as a multi-currency portfolio comprising major currencies such as US

dollars, Euro, Pound Sterling, Japanese Yen etc and valued in terms of US Dollars.

RBI held 557.75 tonnes of gold forming about 9.0% of total FE Reserves as on Mar 29,
2013.

Objectives

 Maintaining confidence in monetary and exchange rate policies

 Enhancing the capacity to intervene and reduce volatility in foreign exchange
market (by maintaining supply-demand mismatch)
 Limiting external vulnerability by maintaining foreign currency liquidity to absorb
shocks during times of crisis
 Providing confidence to the markets especially to credit rating agencies that
external obligations can always be met

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  Adding to the confidence of the market participants, by demonstrating the backing
of domestic currency by external assets
It is possible to consider three motives for holding reserves:

a. Transaction motive – Banks hold foreign currency reserves to facilitate international

trade of goods and services. Such transactions require payments and/or receipt
of equivalent currency by the buyer/seller.
b. Speculative motive – Banks and Corporates also hold reserves to participate in
the speculative activities of the foreign exchange market. These speculations are
for hedging as well as booking profits.
c. Precautionary motive – RBI like any other Central Bank holds reserves primarily
as a last resort to counter unpredictable flows. Precautionary motive for holding
foreign currency, like the demand for money, can be positively related to wealth
and the cost of covering unplanned deficit and negatively related to the return from
alternative assets.
The official reserves are held for precautionary and transactional motives keeping in view
the aggregate of national interests, to achieve balance between demand and supply of
foreign currencies, for intervention and to preserve confidence in the country’s ability to carry
out external transactions.

RBI considers safety and liquidity as twin objectives of the reserve management in India
and return optimisation becomes an embedded strategy within this framework.

Sterilised Intervention

FxR arise when there is a current account surplus and there are capital inflows from abroad
(FDIs & FIIs). Ours is a case of more borrowed reserves than earned reserves.

Capital flows are broadly of two kinds – debt creating and non-debt creating (foreign direct
investment, portfolio investment or remittances) flows. The proportion of the two depends
on the capital needs of the country and its ability to attract debt and non-debt flows. While
debt is a long term flow having higher cost, non-debt flow is short term with moderate to
high volatility. Debt flows are productive and capacity generating while short term non-debt
flows can cause market disequilibria. The cost of debt would generally be higher than return
on reserves.

With the changing profile of capital flows, the traditional approach of assessing reserves
adequacy in terms of import cover has been broadened to include a number of parameters
which take into account the size, composition and risk profiles of various types of capital

Banking Finance 191

flows as well as types of external shocks to which the economy is vulnerable. In effect
‘liquidity risk’ has to be reckoned. The Committee on Balance of payment (chaired by Dr.
C. Rangarajan) had suggested that the due attention should be paid to payment obligations,
in addition to the practical measure of import cover of 3 to 4 months. Dr. Tarapore Committee
on CAC (1997) suggested alternative indicators of reserves adequacy and included money-
based and debt-based indicators. Recently one more new measure has been introduced i.e.
the usable foreign exchange reserves should exceed scheduled amortization of foreign
currency debts (assuming no roll-overs) during the following year (Guidotti-Greenspan rule).

This has implications both for the level of reserves and debt management since this implies
a limit on the size of the debt, in particular, short term debt and long/medium debt that
is falling due for repayment. Alan Greenspan has suggested a ‘Liquidity at Risk’ rule that
takes into account the foreseeable risks that a country could face. This approach requires
that a country’s foreign exchange liquidity position could be calculated under a range of
possible outcomes for the relevant financial variables, such as, exchange rates, commodity
prices, credit spreads etc.

With increased cross-border capital flows, the purpose of holding reserves by any Central
Bank is to meet an adverse balance of payments and maintain external value of its currency.

When capital flows increase, the rupee will appreciate. This will not be in the interest of
exports and Indian exports will become non-competitive. So, RBI intervenes in the foreign
exchange market to prevent the rupee from appreciating too fast. To that end, RBI buys
dollars from the market and sells rupees in return. The dollars, RBI buys, goes to FxR.

These extra rupees could spark off inflation or create asset bubbles in the stock, bond
and real estate markets. To prevent this, RBI has been selling some of the government
securities it holds to suck out the rupees, it has released into the economy. The entire
action – purchasing dollars, releasing rupees and then sucking them out through bond sales
is called ‘sterilised intervention’.

FxR also acts as a ‘confidence’ building measure among the investors’ community to
counter sudden and unforeseen changes that may be a destabilising factor for the internal
economy.

Countries keep FxR as an insurance against sudden financial panic. If imports were to shoot
up or if foreign investors were to withdraw their money from the stock market, RBI needs
to have enough to meet the dollar demands. Otherwise, the rupee will depreciate drastically.
This happened to East Asian countries in 1997.

192 Banking Finance

Cost - Benefit

There are costs in maintaining large currency reserves. Fluctuations in exchange markets
results in gains and losses in purchasing power of reserves. In addition to fluctuations in
exchange rates, the purchasing power of fiat money decreases constantly due to devaluation
through inflation. Therefore, a central bank must continually increase the amount of its
reserves to maintain the same power to manipulate exchange rates. Reserves of foreign
currency provide a small return in interest (investment in US Treasury Bonds).

The sterilisation process involves an economic cost. Continuous sterilisation would bid down
bond prices, implying upward pressure on interest rates. Such increase in interest rates
will only attract further inflows adding to the pressure on the rupee to appreciate. This is
another cycle of capital inflow – interest rate rigidity – rupee appreciation.

The benefits of holding FxR are not easy to quantify and is felt only during times of adversity.

Uses of FxR

RBI has been relaxing on the quantum of foreign exchange released for travel, education
and overseas health examination and other services. Removal of cap on royalties and
technology transfer fee is another step. Indian companies can invest abroad, takeover/
acquire foreign corporations.

There are various views to make use of the excess FxR.

1) Use FxR for infrastructure funding (Dr. Tarapore is of the firm opinion
through SPV that FxR should only be used to
meet forex liabilities and it just cannot
2) Give it to banks for extending be a substitute for domestic
FCNR (B) Loans resources)
3) Repay high cost external borrowings
4) Excess Reserves can be used in other Government’s funds (sovereign wealth
funds) like Singapore Temasek Holdings, Abu Dhabi Investment Authority etc.

Disclosure

RBI publishes half-yearly reports on management of FxR for bringing about more
transparency and enhancing the level of disclosure.

* * * * * * *

Banking Finance 193

 FRAME 109
TOBIN TAX (TT)

Tobin Tax (TT) – suggested by Nobel Laureate economist James Tobin in 1972- defined
as a tax on all spot conversions of one currency into another. His proposal was for a charge
of 0.1% to 1% on the conversion. The tax is intended to put a penalty over short term financial
round trip excursions into another currency. The tax would act as a deterrent to excessive
movement of short term funds and therefore reduce volatility in foreign exchange markets.

In other words, they are simple sale taxes on currency trades across borders. The proposal
is important due to its potential to prevent financial crises. This would discourage short
term currency trades, about 90% speculative, but leave long term productive investments
intact. The currency market would shrink in volume, helping to restore national economic
autonomy. Nations again could intervene effectively to protect their own currency from
devaluation and financial crisis.

The revenues from this tax would be very substantial. (The daily turnover in foreign exchange
markets is of the order of trillions of dollars). The revenues generated could go to fund
international priorities such as preventing global warming, poverty, diseases etc.

India is not in favour of Tobin Tax since it feels capital flows by way of direct investment
and portfolio investment have been at reasonable levels and are manageable.

* * * * * * *

FRAME 110
PARTICIPATORY NOTES

Participatory Notes (P-Notes) are instruments used by foreign funds and investors not
registered with the Securities and Exchange Board of India (SEBI) but who are interested
in taking exposure in Indian Securities. P-notes are generally issued overseas by associates
of India-based foreign brokerages and domestic institutional brokerages. They are, in fact,
offshore derivative instruments issued by FIIs and their sub-accounts against underlying
Indian securities.

P-notes are issued where the underlying assets are securities listed on the Indian bourses.
FIIs who do not wish to register with the SEBI but would like to take exposure in Indian
securities also use participatory notes. Brokers buy or sell securities on behalf of their
clients on their proprietary account and issue such notes in favour of such foreign investors.

194 Banking Finance

P-notes have attracted a lot of debate because of huge inflow of foreign funds into Indian
stock market through P-notes and the ultimate beneficiary of transactions carried out using
P-notes is not known to SEBI or the tax authorities. There is scope of misuse by way
of black money sent abroad through hawala transactions which can find its way back through
P-notes. Also since P-notes do not attract the attention of the market regulators in countries
where they are issued, the entities holding P-notes virtually go unregulated.

It is believed at one time nearly 50% of FII investment to India was through P-notes and
was / is considered to be ‘hot money’ or speculative funds.

Hedge funds are the primary movers of ‘hot money’. Hedge funds are alternate investment
avenues. These funds are basically a pool of capital which are often organized as a private
partnership and are subject to little or no regulation. Hedge fund will have around 25-50
high net worth investors and a fund may be managed by a single manager.

* * * * * * *

FRAME 111
NON-DELIVERABLE FORWARDS (NDF)

Non-deliverable forwards are derivatives for trading, with deals struck in all major non-
convertible Asian currencies without delivery of the underlying currency. Trading in NDF
generally takes place in off-shore centres (no physical delivery of currency). The final
settlement happens in US dollars on a net basis, the difference between the forward rate
and the spot rate at the time of settlement. The Singapore and Hongkong market being
the most active markets contribute to about 80% of the volumes with New York and London
accounting for the rest. The trades may or may not involve an underlying exposure in a
currency and could also be for pure speculative reasons on proprietary positions. The major
players are the banks and the brokers offering two way quotes for various tenors.

Besides speculators, the other players in the rupee market are the FIIs (equity funds), NRIs
and corporates with on shore currency exposure. Forward premia in NDF markets are driven
more by underlying demand-supply conditions than by interest rate differentials. The
difference between on-shore and off-shore premia does suggest an arbitrage opportunity
between the two markets.

The NDF market is an over-the-counter market. NDF markets developed for emerging
economies with capital controls, where the currencies, could not be delivered offshore.

Banking Finance 195

Being off-shore, the market has remained outside the regulatory purview of the local
monetary authorities.

The only exchange of cash flow is the difference between the NDF rate and the spot rate
applied to the notional amount.

Cash flow = (NDF rate – Spot rate) x Notional amount

An investor enters into a forward agreement to purchase a notional amount, N of the base
currency at the contracted forward rate, F and would pay NF units of the quoted currency.
On the fixing date, that investor would theoretically be able to sell the notional amount,
N, of the base currency at the prevailing spot rate S, earning NS units of the quoted currency.
Therefore the profit P, on this trade in terms of the base currency, is given by,

P = NS – NF/ S = N [1 – F/S]

The base currency is usually the more liquid and more frequently traded currency.

The main difference between the outright forward deals and NDFs is that the settlement
is made in dollars since the dealer or counterparty cannot settle in the alternative currency
of the deal.

* * * * * * *

FRAME 112
QUALIFIED FOREIGN INVESTOR (QFI)

QFI means a person from FATF recognised countries and not resident in India and not
registered with SEBI as FII or sub account or Foreign Venture Capital Investor and he is
allowed to invest directly in the markets. They can invest in equity shares of listed Indian
companies. The individual and aggregate investment limits by QFIs in equity shares are
5% and 10% respectively of the paid up capital of the Indian company. These limits are
separate/over and above that for FIIs and NRIs. They can invest in units of domestic MFs
and in eligible corporate debt securities i.e. NCDs, listed bonds, dated Govt securities/
Treasury Bills, Commercial Paper.

QFIs cannot issue offshore derivative instruments or Participatory Notes.

* * * * * * *

196 Banking Finance

 FRAME 113
UNIFORM CUSTOMS AND PRACTICE FOR DOCUMENTARY
CREDITS (UCP 600)
International Chamber of Commerce (ICC) had come out with the latest revision of UCPDC
titled UCP 600 effective from July 2007. This replaces UCP 500 which was in use from
Jan 1994 (UCP was first introduced in 1933). UCP 600 has 39 articles.

UCPDC 2007 (referred to as ICC publication No 600) are rules that apply to any documentary
credit also known as Letter of credit (including the extent to which they may be applicable,
any stand-by letter of credit) when the text of the credit expressly indicates that it is subject
to these rules.

Some of the important rules are as below:

A documentary credit has been defined as an irrevocable arrangement which constitutes

a definite undertaking of the issuing bank to ‘honour’ a ‘complying presentation’.

An LC for negotiation should contain it is subject to 2007 revision of UCP 600. Then UCP
600 rules are binding on all parties to the transaction.

In UCP 600, a credit is irrevocable even if there is no indication to that effect. ie, UCP
600 deals with irrevocable credits only.

In Article2, ‘complying presentation’ is defined. ‘It means a presentation that is in

accordance with the terms and conditions of the credit, the applicable provisions of these
rules and international standard banking practice’ (ISBP).

[A revised publication of ISBP, ICC Pub No 681 has come into effect along with UCP 600
which will serve as a useful supplement to UCP 600 for its effective implementation].

Article 4(b): ‘An issuing bank should discourage any attempt by the applicant to include,
as an integral part of the credit, copies of the underlying contract, proforma invoice and
the like’. The effect of this article makes scrutiny of documents in the credit easier.

Article 5 deals with ‘documents vs goods, services or performances’ and declares that
‘banks deal with documents and not with goods, services or performances to which the
documents may relate’. This article specifies that banks deal with documents and all others
may deal in goods / services or performances.

Article 14 (b) states ‘a nominated bank acting on its nomination, a confirming bank, if any,
and the issuing bank shall each have a minimum of five banking days following the day
of presentation to determine if a presentation is complying’.

Banking Finance 197

Article 2 defines a banking day as ‘a day on which a bank is regularly open at the place
at which an act subject to these rules is to be performed ’.

The ‘Acts of terrorism’ is added under ‘force majeure’ events during which operations of
banks remain suspended without any responsibility on their part. Banks will not honour
or negotiate under a credit that expired during the force majeure event.

* * * * * * *

FRAME 114
STAND BY LC (SBLC)

A SBLC is essentially a guarantee of payment issued by a bank on behalf of a client that

is used as a payment of last resort in the event that the client fails to fulfil a contractual
obligation with a third party.

The most common types of SBLCs are:

 Performance stand by (that guarantee performance of an obligation)

 Commercial stand by (that guarantee the payment of goods and services)
 Tender stand by (to secure execution of works on being awarded a contract)
 Insurance stand by (commonly used in insurance contracts)
 Advance payment stand by (where the beneficiary is a party who has made an
advance payment)

The SBLC may read as under:

‘Funds under this LC are available by payment against presentation of your draft(s) at sight
drawn on us and mentioning thereon our LC no. …….. Each draft must be accompanied
by your signed written statement that X company has failed to comply with the terms &
conditions of contract No… for the construction of the duct…’ specifying the clause(s) in default’.

When the applicant satisfactorily fulfils his obligations to beneficiary, then SBLC expires
unutilised.

The Bank’s commitment is contingent upon the presentation of the stipulated documents
within the terms & conditions of SBLC.

The Bank will not investigate the underlying facts of the transaction-whether or not there
was a default or contract breach. The standby basically fulfils the same purpose as a bank
guarantee.

198 Banking Finance

The SBLC is separate from and independent of the underlying contract.

The SBLC comes from the banking legislation of the US which forbids US credit institutions
from assuming guarantee obligations of third parties (most other countries outside USA
allow bank guarantees). To circumvent this US banking rule, US banks created SBLC which
is based on UCPDC. In 1998, the ICC added ISP 98 (International Stand by Practices 98)
and the rules to guide SBLC. These rules are slowly being adopted; however many of SBLC
continue to rely on ICC’s older guide UCPDC 600.

Letter of Credit and Stand by Letter of Credit

A LC is used as method to facilitate payment of international trade transactions (import/

export of goods/services).

Unlike a trade LC, SBLC is not meant to be used for payment. It is used as a form of
‘backup’ guarantee (hence the name stand by) used for a variety of purposes.

* * * * * * *

FRAME 115
SOVEREIGN WEALTH FUND (SWF)

Sovereign Wealth Fund (SWF) is a state owned investment fund commonly established
from a country’s reserves set aside for investment purposes, which are expected to benefit
the country’s economy or citizens. These funds may be invested in stocks, bonds, real
estate, precious metals and other financial securities.

The US Department of Treasury defines a SWF as a ‘government investment vehicle which

is funded by foreign exchange assets and which manages those assets separately from
the official reserves of the monetary authorities’.

The primary sources for SWFs are surplus foreign exchange earnings from exports, balance
of payments and the state’s budget surpluses. Given the long term nature of the investment,
SWF prefer high yield investments to liquid assets.

Major SWFs are owned primarily by commodity-rich and savings-rich countries.

The objectives of SWFs are:

 To hedge the economy from extreme fluctuations in exchange rates

 To diversify from non-renewable commodity exports
 To earn higher returns on forex reserves

Banking Finance 199

  To increase savings for future generations
 Political strategy
SWFs are not regulated entities and hence there is no regulatory obligation to disclose
information regarding their structure, size, performance etc.

Some of the well known SWFs are:

Temasek Holdings Pte Ltd Estd. 1974 * Real Estate

Wholly owned by Govt Assets: USD 157 bn * Infrastructure
of Singapore * Equities

Abu Dhabi Investment Estd. 1976 * Real Estate

Authority Assets: USD 627 bn * Infrastructure
* Equities
* Private Equity
* Sovereign Debt
* Corporate Debt

* * * * * * *

FRAME 116
ALTERNATE INVESTMENT FUNDS (AIF)

AIF means any fund established or incorporated in India which is a privately pooled
investment vehicle which collects funds from investors, whether Indian or foreign, for
investing in accordance with a defined investment policy for the benefit of its investors (as
distinct from Mutual Funds and collective investment scheme).

As per SEBI Rules, AIF can raise funds through private placement by way of issue of units.
Each scheme will have a corpus of at least Rs. 20 Cr ; minimum investment from an investor
is Rs.1 Cr ; maximum 1000 investors. The Manager / Sponsor shall have a continuing
interest in the AIF of not less than 2.5% of the initial corpus or Rs.5 Cr, whichever is lower.
A certificate of registration from SEBI is required.

An AIF invests in non-traditional assets that are not found in conventional investment
portfolios. Eg. real estate, stressed assets, private equity, social venture, venture capital,
hedge funds etc.

* * * * * * *

200 Banking Finance

 PART - H

THE DEBT MARKET

Banking Finance 201

 FRAME 117
OPEN MARKET OPERATIONS (OMO)

OMO are market operations conducted by RBI by way of sale/purchase of Govt securities
to/from the market with an objective to adjust the rupee liquidity conditions in the market
on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts
to sale of securities thereby sucking out the rupee liquidity. Similarly, when the liquid
conditions are tight, RBI will buy securities from the market, thereby releasing liquidity into
the market.

* * * * * * *

FRAME 118
MARKET STABILISATION SCHEME (MSS)

Market Stabilisation Scheme (MSS) is a new addition to the monetary policy instruments
of the RBI. Marketable Govt securities held by the RBI have been utilised for purposes like
conducting OMO, LAF and investing excess balance of the Govt with the RBI. With the
large inflow of foreign exchange and the consequent monetary expansion, it was necessary
for RBI to stabilise the monetary impact by sucking out the excess liquidity. The absorption
of liquidity was done through conducting OMO and LAF by selling securities. This resulted
in depletion in the stocks of Govt securities held by the RBI which in turn limited its ability
to conduct the above operations. Hence, an internal group, constituted in the RBI
recommended for introduction of MSS. MSS was introduced in April, 2004.

Under MSS, Govt would issue TBs and dated securities for absorbing liquidity from the
system. Correspondingly, Govt’s cash balances with the RBI will go up by corresponding
amount. However Govt cannot use that money as it will lead to monetary expansion. The
proceeds of the MSS account will be utilised only for redemption of TBs/dated securities
issued under MSS. Interest is paid by the Govt, which increases the cost of sterilisation
on its books.

* * * * * * *

202 Banking Finance

 FRAME 119
INFLATION INDEXED BONDS- 2013-14 (IIB)

IIBs have been introduced to protect savings of poor and middle classes from inflation and
incentivise household sector to save in financial instruments rather than buy gold. The initial
series is for all categories of investors including institutional investors and 20% is for the
non-competitive retail and mid-segment investors.

The details for first series of IIBs are as under:

 IIBs will be having a fixed real coupon rate and a nominal principal value that is
adjusted against inflation. Periodic coupon payments are paid on adjusted
principal. Thus these bonds provide inflation protection to both principal and
coupon payment. At maturity, the adjusted principal or the face value, whichever
is higher will be paid.
 Index ratio (IR) will be computed by dividing reference index for the settlement
date by reference index for issue date (i.e, IR set date = Ref. Inflation Index Set date
/ Ref Inflation Index Issue Date
)
 Final wholesale price inflation (WPI) will be used for providing inflation protection
in this product. In case of revision in the base year for WPI series, base splicing
method would be used to construct a consistent series for indexation.
 Indexation Lag: Final WPI with four months lag will be used, ie Sept 2012 and
Oct 2012 final WPI will be used as reference WPI for 1st Feb 2013 and 1st March
2013, respectively. The reference WPI for dates between 1st Feb and 1st March
2013 will be computed through interpolation.
 Issuance method: These bonds will be issued by auction method.
 Retail Participation: Non-competitive portion will be increased from extant 5
percent to 20 percent of the notified amount in order to encourage participation
of retail and other eligible investors.
 Maturity: Issuance would target various points of the maturity curve in order to
have benchmarks. To begin with, these bonds will be issued for tenor of 10 years.
 Issuance Size: Each tranche of IIBs will be for INR 1,000 Cr – 2,000 Cr and total
issuance would be for about INR 12,000 Cr – 15,000 Cr in 2013 – 14.
 Issuance Date: First such tranche will be issued on June 4, 2013 and the same
would be issued regularly through auctions on the last Tuesday of each
subsequent month during 2013-14.

Banking Finance 203

Second series of IIBs exclusively for retail investors will be issued in second half of the
financial year. First series of the IIBs will help in determining the coupon rate for the bonds
through auction. This will help in benchmarking IIBs. Based on the experience in the initial
issuances, second series of IIBs for the retail investors is proposed to be issued around
October. Terms of issuance of IIBs for retail investors would be announced in due course.

* * * * * * *

FRAME 120
‘WHEN ISSUED MARKET’

‘When Issued’, a short form of ‘when as and if issued’ indicates a conditional transaction
in a security authorized for issuance but not as yet actually issued. All ‘when issued’
transactions are on and ‘if’ basis, to be settled if and when the actual security is issued.
‘When Issued’ market has two basic advantages (a) it facilitates the distribution process
for Govt Securities by stretching the actual distribution period for each issue and allowing
the market more time to absorb large issues without disruption; and (b) It also facilitates
price discovery process by reducing uncertainties surrounding auctions.

Mechanics of Operation

Transactions in a security on a When Issued (WI) basis will be undertaken in the following
manner :

a. WI transactions will be undertaken only in the case of securities that are being
reissued.
b. WI transactions would commence on the notification date and it would cease on
the working day immediately preceding the date of issue.
c. All WI transactions for all trade dates will be contracted for settlement on the
date of issue.
d. At the time of settlement on the date of issue, trades in the WI security can be
netted off with trades in the existing security.
e. WI transactions may be undertaken only on NDS-OM.
f. Any WI trade must have a Primary Dealer (PD) as a counterparty (both
counterparties can be PDs). In other words, non-PDs cannot be both buyer and
seller in a WI transaction.

204 Banking Finance

 g. Only PDs can take a short position in the WI market. Non-PD entities can sell
the WI security only if they have a preceding purchase contract for equivalent
or higher amount.
h. Open position in the WI market are subjected to the following limits;
 Non-PD entities – Long position, not exceeding 5 per cent of the notified
amount
 PDs- Long or short position, not exceeding 10 percent of the notified amount
i. In case a PD is unable to deliver securities to the buyer after the auction on the
settlement (or issue) date, the transaction will be settled as per the default
settlement mechanism of CCIL.
j. In the event of cancellation of the auction for whatever reason, all WI trades will
be deemed null and void ab-initio on ground of force majeure.
* * * * * * *

FRAME 121
CREDIT DEFALT SWAPS (CDS)

CDS are derivative instruments that allow bond investors to pass on the risk of default to
another institution for a fee. If the issuer of the bond defaults, the receiver of the fee has
to make good the payment. RBI regulated lenders, MFs and listed companies can buy
credit protection on the bonds they hold.

The protection can be sold by banks and finance companies with a net worth of over Rs
500 cr and NPA of less than 3%. Banks that intend to sell protection need to have a capital
adequacy of 12% while for non-banks it would be 15%.

CDS is like an insurance cover.

Foreign banks and other lenders which have the appraisal skills but not the resources to
lend can gain by taking a credit exposure through CDS. The actual funding can come from
some other bank which has the resources but does not want to take any credit risk.

CDS got a bad name during the global financial crisis and it brought down the insurance
company AIG. AIG had provided protection for mortgage-backed securities. In India, the
criteria for housing loans are quite different.

* * * * * * *

Banking Finance 205

 FRAME 122
COLLATERALISED DEBT OBLIGATION (CDO)

CDO is an asset-backed security, backed by the receivables on loans (auto loans, credit
card debt, mortgages or corporate debt), bonds or other debts. CDO is a derivative.

Banks package and sell their receivables on debts to investors in order to reduce the risk
of loss due to default. Returns on CDOs are paid in tranches i.e. the individual loans backing
each CDO has different levels of risk and investors are paid according to the level of risk
they have acquired. Banks offer higher interest rates to investors willing to buy CDOs backed
by higher risk loans. Each tranche receives its own credit rating.

CDOs are securitisation of receivables. Advantages of CDOs are:

a. The debt is moved off the balance sheet through the issue of CDOs. The risk
on the balance sheet is reduced and transferred to the investors.
b. Capital requirements are reduced.
c. Liquidity increases by the funds received through issue of CDOs. New loans can
be made.
* * * * * * *

206 Banking Finance

 PART - I

BANKING OPERATIONS

Banking Finance 207

 FRAME 123
NATIONAL ELECTRONIC FUNDS TRANSFER (NEFT)

NEFT is a nation-wide payment system facilitating one-to-one funds transfer. Under this
scheme, individuals, firms and corporates can electronically transfer funds from any bank
branch to any individual, firm or corporate having an account with any other bank branch
in the country participating in the scheme.

Branches & walk in customers

List of NEFT enabled branches is available on RBI website. Even individuals who do not
have a bank account (walk-in customers) can also deposit cash to transfer funds. Such
remittances will be restricted to a maximum of Rs 50,000/ per transaction. Such customers
have to furnish full details like address, phone number etc.

Minimum & maximum

No minimum. Maximum up to Rs 2 lacs for customers having bank accounts.

Availability

NEFT operates on a deferred net settlement basis (DNS) which settles transactions in
batches. In DNS, the settlement takes place at a particular point of time. All transactions
are held up till that time. Any transaction initiated after a designated settlement time would
have to wait till the next designated settlement time. Contrary to this, in RTGS, transactions
are processed continuously throughout the RTGS business hours.

Information required

a. Beneficiary bank branch and centre

b. Beneficiary name
c. Account type (SB/CA) and account number
d. IFSC code of the beneficiary bank branch
e. Amount

Time Taken for credit

Same day or next day depending on the timing of the day

208 Banking Finance

Return of funds

For all uncredited transactions, customers can reasonably expect the funds to be received
back in around 3 / 4 hours time.

Acknowledgement

Remitters who have registered their mobile numbers/e-mail id with the branch will get a
confirmation from the originating bank advising of the credit.

Tracking

It is possible for the originating bank branch to track NEFT transactions at all times. Hence
the remitter can check with the originating branch.

* * * * * * *

FRAME 124
REAL TIME GROSS SETTLEMENT SYSTEM (RTGS)

The acronym ‘RTGS’ stands for Real Time Gross Settlement System. It is a funds transfer
mechanism where transfer of money takes place from one bank to another on a ‘real time’
and on ‘gross basis’. This is the fastest possible money transfer system through the banking
channel. Settlement in ‘real time’ means payment transaction is not subjected to any waiting
period. The transactions are settled as soon as they are processed. ‘Gross settlement’
means the transaction is settled on one to one basis without bunching with any other
transaction. Considering that money transfer takes place in the books of RBI, the payment
is taken as final and irrevocable.

Maximum and minimum

The minimum amount to be remitted through RTGS is Rs 2 lacs. No upper ceiling for RTGS.

Time taken

Under normal circumstances the beneficiary branches are expected to receive the funds
in real time as soon as funds are transferred by the remitting bank. The beneficiary bank
has to credit the beneficiary’s account within two hours of receiving the funds transfer
message.

Banking Finance 209

Acknowledgement

The remitting bank receives a message from RBI that money has been credited to the
receiving bank. Based on this, the remitting bank can advise the remitting customer that
money has been delivered to the receiving bank.

If beneficiary’s account is not credited

If the money is not credited for any reason, the receiving bank would have to return the
money within 2 hours. Once the money is received back by the remitting bank, the original
debit entry in the customer’s account is reversed.

Essential information required

a. Name of the beneficiary’s bank and Branch and Centre

b. Account number
c. IFSC Code of the receiving branch
d. Name of the beneficiary
e. Amount to be remitted

IFSC Code

Indian Financial System Code can be obtained from the beneficiary customer. It is available
on the cheque leaf. The code number and bank branch details can be communicated by
the beneficiary to the remitting customer. It is an alpha-numeric code that uniquely identifies
a bank branch that participates in the scheme. This is a 11 digit code.

RTGS enabled branches

All bank branches are not RTGS enabled. As on Sep 2013, there are 1,02,025 RTGS enabled
branches. The list of such branches is available on RBI website.

Tracking

It would depend on the arrangement between the remitting customer and the remitting bank.
This is possible with internet banking facility. Once the funds are credited to the account
of the beneficiary bank, the remitting customer gets a confirmation from his bank either
by e-mail or by sms on the mobile.

* * * * * * *

210 Banking Finance

 FRAME 125
CHEQUE TRUNCATION SYSTEM (CTS)

Instead of manually moving the cheque from one bank to another for payment, the image
of the cheque is sent electronically for clearing purposes. This will bring down the time
required for processing and cost of movement of the physical cheques. Instead of 2/3 days,
cheques will be cleared on the same day or the next day thereby bringing efficiency into
the entire banking system. The(funds) ‘floating’ time now stands reduced. Frauds can be
reduced. Automation will bring down the operating costs. Cheque truncation will benefit both
customers and banks.

Banks can also make analysis of the customers’ payment pattern (for cross selling) using
the images of the cheques.

CTS has been implemented in NCR, New Delhi and Chennai. All branches in Tamilnadu,
Kerala, Karnataka, AP and Puduchery will be brought under Chennai grid in a phased
manner.

Latest Development

Grid based CTS has been launched in Chennai and Mumbai covering several states/union
territories.

Under grid based CTS clearing, all cheques drawn on bank branches falling in the grid
jurisdiction are treated and cleared as local cheques on T+1 basis.

* * * * * * *

FRAME 126
CHEQUE STANDARDISATION AND CTS 2010

Standardisation of cheque leaves in terms of size, MICR band, quality of paper etc was
one of the key factors that enabled mechanisation of cheque processing. Over a period
of time, banks incorporated a number of security features to prevent cheque misuse,
tampering, alterations etc. With introduction of multi-city cheques, CTS, certain minimum
security features were incorporated. A Working Group of RBI was set up to examine further
standardisation of cheque forms and enhancement of security features therein. Accordingly
certain benchmarks were prescribed - quality of paper, watermark, bank’s logo, invisible
ink etc. This will be helpful in image-based processing scenario. The benchmark

Banking Finance 211

prescriptions are collectively known as CTS -2010 standard. IBA and National Payment
Corporation of India (NPCI) are coordinating with the banks in the implementation.

The timeline for withdrawal of residual non-CTS 2010 cheques was extended up to July
31, 2013.

Still a large volume of non-CTS cheques were being presented in image-based clearing.
Accordingly, RBI has decided to put in place the following arrangement:

Separate clearing session will be introduced in the three CTS centres (Mumbai, Chennai,
and New Delhi) for clearing of residual non-CTS instruments with effect from Jan1, 2014.
This separate clearing session will initially operate thrice a week up to April 30, 2014.
Thereafter, it will be twice a week up to Oct 31, 2014 and then, once a week from Nov
1, 2014 onwards.

During the transition period, ie, up to Dec 31, 2013, the existing clearing arrangements
will continue.

* * * * * * *

FRAME 127
SB INTEREST RATE DEREGULATED

With effect from Oct 25, 2011, interest rate on SB deposits has been deregulated.

Banks are free to determine their SB deposit rate subject to:

a) Each bank will have to offer a uniform interest rate on SB up to Rs 1 lac irrespective
of the amount in the account within this limit.
b) For SB deposits above Rs 1 lac, a bank may provide differential rate of interest,
if it so chooses, subject to the condition that banks will not discriminate in the
matter of interest paid on such deposits, between one deposit and another of
similar amount, accepted on the same date, at any of its offices.
The above is applicable to SB deposits of resident Indians only. The interest rate will be
applied on end-of-day balance up to Rs. 1 lakh and for any end-of -day balance exceeding
Rs 1 lac, banks may apply the differential rate as fixed by them.

[With effect from Apri 1, 2010, interest on SB accounts is being calculated on daily product
basis].

* * * * * * *

212 Banking Finance

 FRAME 128
UNCLAIMED DEPOSITS / INOPERATIVE ACCOUNTS

RBI instructions on Inoperative accounts are as under:

A SB/current account is inoperative if there are no transactions for over 2 years.

a. An annual review of accounts where are no operations (ie, no credit or debit other
than crediting periodic interest or debiting of service charges) for more than one
year is to be made. Banks may play a proactive role in contacting these customers
and find out the reasons for the same.
b. If the letters are undelivered, they may immediately be put on enquiry to find out
the whereabouts of customers or their legal heirs, in case, they are deceased.
c. In case the whereabouts of the customers are not traceable, to use all methods
- contacting the introducer, employer, telephone, e-mail to contact the customer.
d. In case any reply is given by the account holder giving the reasons for not operating
the account, the inoperative account may be continued for one more year during
which period the account holder may be requested to operate the account. If he
still does not operate the account during this period, the same may be classified
as inoperative account after the extended period.
e. The segregation of inoperative accounts is to reduce risk of frauds.
f. Operations may be allowed after due diligence as per risk category of the
customer. Due diligence would mean ensuring genuineness of the transaction,
verification of the signature and identity etc.
g. No charge for activation of the account to be levied.
h. Interest on SB accounts should be credited regularly. If fixed deposits have matured
and proceeds are unpaid, the unclaimed amount will attract SB rate of interest
A special drive to find the whereabouts of such customers/legal heirs may also be
conducted.

Banks have been advised to display the list of unclaimed deposits/inoperative accounts
which are inactive/inoperative for 10 years or more on their websites by June 30, 2012 with
name and address.

On the same website, information on the process of claiming the unclaimed deposit/
activating the inoperative account and necessary forms/documents for claiming the same
are to be provided.

Banking Finance 213

Banks have been advised to put in place a Board approved policy on classification of
unclaimed deposits, grievance redressal mechanism for quick resolution of complaints,
record keeping, and periodic review of such accounts.

Banks have been advised by RBI to allot a different ‘product code’ in their CBS to accounts
opened for the beneficiaries under various Central/State Govt schemes (Scholarship for
students, DBT,EBT, Zero balance accounts)so that the stipulation of inoperative account
due to non-operation does not apply while crediting proceeds to such accounts.

* * * * * * *

FRAME 129
DEPOSITOR EDUCATION AND AWARENESS FUND (DEAF)

Sec 26 A has been inserted in Banking Regulation Act 1949 {vide Banking Laws
(Amendment) Act} 2012 which empowers RBI to establish a Depositor Education and
Awareness Fund (DEAF).

Amounts in inoperative accounts with banks for more than 10 years and unclaimed deposits
for more than 10 years (and not claimed within 3 months from the expiry of 10 years) will
be credited to DEAF.

The Fund shall be utilised for promotion of depositors’ interest. Sec 26 A does not prevent
a depositor from claiming his deposit or operating his account after 10 years and banks
should pay the deposit amount and claim refund from DEAF. The modalities of setting up
DEAF will be finalised by Sep 2013.

* * * * * * *

FRAME 130
ELECTRONIC BENEFIT TRANSFER (EBT) /
DIRECT BENEFIT TRANSFER (DBT)

EBT is an electronic system that allows state welfare departments to issue benefits via
magnetically encoded payment card. This is being used in USA and UK.

Common benefits provided in USA via EBT are typically of two general categories: food
and cash benefits. EBT has been adopted nationwide in US since 2004.

214 Banking Finance

In India, there are at least 32 schemes of the Central Govt which involve transfer of benefits
to the beneficiaries. In addition, there are many more such schemes at the State level.
It has been estimated in the Report on Aadhaar-Enabled Unified Payment Infrastructure that
the combined volume of EBT, Direct transfer of subsidy (DTS), and other last mile Govt payments
in 2011-2012 was approximately Rs 3,00,000 Cr. This is expected to increase in future.

An efficient EBT system would include compilation of information on benefit transfer

compatible with the banking system, transfer of funds to the beneficiaries’ accounts and
facilities for drawal of the amount by the beneficiaries as per their requirement.

The GOI has advised the following strategy for EBT:

a. Service area of the banks may be revised, wherever required, to align it with Gram
Panchayats. Within the service area, the service area of the BCs must be
demarcated.
b. The banks must start mapping the list of beneficiaries under every scheme with
the bank account details. Lead District Manager will be responsible for overall
coordination. At the State level, the SLBC Convenor will be responsible for
completion of the exercise.
c. Only one bank account for receiving benefits under various schemes may be
opened.
d. Aadhaar number should be seeded to the bank account.
As regards Central Govt schemes, the Govt has already put in place the Central Plan
Scheme Monitoring System (CPSMS) which enables the implementing departments to
generate EBT at all levels of implementation.

The proposed arrangements envisage transfer of benefits from any bank to the account
holder of any other bank. (So, there is no need to adopt on district - one Lead bank - many
Banks model envisaged in 2011).

The grand plan is to extend EBT/DBT to extend to all the schemes in the entire country
in a phased manner.

* * * * * * *

Banking Finance 215

 FRAME 131
COMPLIANCE FUNCTION IN BANKS

The salient features of RBI guidelines issued in April 2007 are as under:

The compliance function is for ensuring strict observance of

 All statutory provisions contained in various legislations such as: Banking

Regulation Act, RBI Act, FEMA, PMLA
 Regulatory guidelines/directives from RBI
 Standards and Codes set by BCSBI, IBA, FIMMDA, FEDAI
 Listing agreements with stock exchanges
 Internal policies and Fair Practices Code
Compliance laws, rules and standards generally cover matters such as observing proper
standards of market conduct, managing conflicts of interest, treating customers fairly and
ensuring suitability of customer service.

The Basel Committee on Compliance Function defines Compliance Risk as ‘the risk of legal
or regulatory sanctions, material financial loss or loss of reputation a bank may suffer as
a result of its failure to comply with laws, regulations, rules, related self-regulatory
organisation standards and codes of conduct applicable to banking activities’.

This means: If you don’t comply, you’d face regulatory sanction, legal action, penalties and
loss of reputation.

The Guidelines

 Compliance starts at the top.

 Compliance should be a part of culture of the bank.
 A well documented compliance policy should be put in place.
 Independent compliance department with a Senior Executive heading it as Chief
Compliance Officer (CCO).
 Compliance function should be independent of Audit function.
 Organisation of Compliance function can be different in different organisations.
Large - located within operating business lines
Smaller - located in one unit

216 Banking Finance

  CCO will report to the senior management of the bank but has the right to report
directly to the ACB or Board.
 CCO is the nodal point of contact between the bank and the regulator.
 Compliance department plays an important role in the area of identifying the level
of compliance risk in each business line, products, processes and issues
instructions to operational functionaries.
 All guidelines/circulars are to be issued after vetting by Compliance function.
 It should ensure that regulatory guidelines/instructions are promptly issued/
disseminated within the organisation and implemented.
 The CCO should be a member of new products committee.
 Banks should develop function-wise compliance manual duly approved by the
CCO.
 The Compliance officers should have access to all information they require and
have the right to conduct investigation and report the findings to the CCO.
 The CCO should be a participant in the quarterly informal discussions being held
with RBI.
 The compliance function should monitor and test compliance by performing
sufficient and representative compliance testing and the results thereof should be
reported to the senior management.
 An annual report on compliance failures / breaches should be placed before the
ACB/Board.
 Non-compliance of any regulatory guidelines and administrative actions taken
against the bank with corrective steps taken to avoid recurrence should be
disclosed in the annual reports of the banks.
 The activities of the compliance function should be subject to annual review by
the internal audit.
 Banks should comply with the applicable local laws and regulations in all
jurisdictions of their business.

Banking Finance 217

To quote Ms Shikha Sharma, CEO of Axis Bank, ‘Compliance culture is vital to create an
organisation that is ‘built to last’.

Compliance Function acts as

Diagram Courtesy: Shri Sandeep Batra, Head - Compliance, ICICI Bank

* * * * * * *

218 Banking Finance

 PART - J

INFORMATION TECHNOLOGY

Banking Finance 219

 FRAME 132
WORKING GROUP ON INFORMATION SECURITY, ELECTRONIC
BANKING, TECHNOLOGY RISK MANAGEMENT AND CYBER FRAUDS
[Shri G. Gopalakrishna Committee]

(A Brief)

RBI has issued a circular for implementation of the recommendations of the captioned
committee. The recommendations are in 9 broad areas as under:

i. IT Governance
ii. Information Security
iii. IS Audit
iv. IT operations
v. IT services outsourcing
vi. Cyber Frauds
vii. Business Continuity Planning (BCP)
viii. Customer awareness programmes
ix. Legal issues
To implement these guidelines, a gap analysis is to be made first, then a time-bound action
plan for total compliance should be drawn up.

These guidelines are fundamentally expected to enhance safety, security, efficiency in

banking processes leading to benefits for banks and customers.

i) IT Governance
IT Governance will be an integral part of Corporate Governance. It is the
responsibility of the Board of Directors and Executive Management.

Organisation Structure:
 IT strategy committee at the board level with minimum of 2 directors as
members, one of whom should be an independent director to be set up. One
member should have substantial IT expertise.
Roles and responsibilities for Board, IT strategy committee, Risk Management
committee, Executive management, IT steering committee (to assist the executive
management in implementing IT strategy) have been recommended.

220 Banking Finance

 ii) Information Security (IS)
‘Information assets’ need to be protected.
The core principles of IS are confidentiality, integrity, availability, authenticity, non-
repudiation, identification, authorisation, accountability and auditability.
IS Governance consists of the leadership, organisational structures and processes
that protect information and mitigation of growing information security threats.

A Security programme includes the following activities:

 Development and ongoing maintenance of security policies
 Assignment of rules, responsibilities and accountability for IS
 Development/Maintenance of a security and control framework that consists
of standards, measures, practices, and procedures
 Classification and assignment of ownership of information assets
 Periodic risk assessments and ensuring adequately effective and tested
controls for people, processes and technology to enhance IS
 Ensuring security is integral to all organisational processes
 Process to monitor security incidents
 Effective identity and access management processes
 Generation of meaningful metrics of security performance
 IS related awareness, sessions to users/officials/Board members
There should be a senior official designated as Chief Information Security Officer
(CISO) who will report to Head of Risk Management and have a working
relationship with Chief Information Officer.
Banks should implement ISO 27001 Information Security Management System
(ISMS).

iii) IS Audit
For getting an assurance on the effectiveness of internal controls implemented,
IS audit is expected to provide an independent and objective view of the extent
to which the risks are managed.
A designated member of the Audit Committee of the Board needs to possess
the knowledge of information systems, related controls and audit issues.
Banks require a separate IS audit function within an internal audit department led
by an IS Head-Audit reporting to the Head of the Internal Audit. IS auditors should
posses qualifications like CISA, DISA or CISSP.

Banking Finance 221

 The audit policy should include inter-alia IS audit also.
iv) IT Operations
The functions covered as part of IT operations are:
 IT Service Management
 Infrastructure Management
 Application Life Cycle Management
 IT operations Risk Framework

v) IT services out-sourcing
Responsibilities for effective due diligence, oversight and management of
outsourcing and accountability for all outsourcing decisions rest with the bank’s
Board and its senior management. An effective governance mechanism and risk
management process should be put in place.
The Board and senior management are responsible for ensuring that quality and
availability of banking services to customers are not adversely affected due to the
outsourcing arrangements entered into by the bank.
Banks should ensure that their business continuity preparedness is not adversely
compromised on account of outsourcing. They, while framing the viable
contingency plan, need to consider the availability of alternative service providers
or the possibility of bringing the outsourced activity back in-house in an
emergency.

vi) Cyber Frauds

A Fraud is ‘a deliberate act of omission or commission by any person, carried
out in the course of banking transaction or in the books of accounts maintained
manually or computer system in Banks, resulting into wrongful gain to any person
for a temporary period or otherwise, with or without any monetary loss to the bank’.
Adequate steps have to be taken by banks to mitigate IT related frauds.

vii) Business Continuity Planning

BCP includes policies, standards, and procedures to ensure continuity,
resumption and recovery of critical business processes, at an agreed level and
limit the impact of the disaster on people, processes and infrastructure (includes
IT) or to minimise the operational, financial, legal, reputational and other material
consequences arising from such a disaster.

222 Banking Finance

 Effective business continuity management incorporates business impact
analyses, recovery strategies and business continuity plans, as well as a
governance programme covering a testing programme, training and awareness
programme, communication and crisis management programme.
A senior official will be the head of BCP function. There will be a BCP committee
or crisis management team consisting of officials from various departments like
HR, IT, Legal, Business and Information Security.
Adequate member of BCP teams are required at HO as well as at branch level-
incident response team, emergency action and operations team, team from
business functions, damage assessment team, IT team for hardware, software,
network support, supplies team, team for organising logistics, relocation team,
administrative support team, coordination team etc.

Testing of a BCP

Banks must regularly test BCP to ensure that they are up to date and effective.
 Internal auditors should be involved to audit the effectiveness of BCP.
 Banks should have a BCP drill along with the critical third parties.
 Banks should periodically move their operations to DR site to test the BCP
effectiveness.
 Banks should have unplanned BCP drill.

viii) Customer Education

With technology, the bank branch is on the desktop/laptop /mobile phone of the
customer. This is the age of self-service. The customer can transfer funds through
the internet. He can buy goods. The customer has to be empowered to do safe
banking through self-help. Spreading awareness among customers has become
imperative.
Security awareness is the understanding and knowledge of the threats to the
sensitive personal information of the customer and the protection measures to
be adopted. It is the basic component of the education strategy of an organisation.
Various communication channels like TV, media, radio, customer meets,
websites, bill boards, ATM Screens, E-mails, SMS texts can be used.
Awareness building collaterals can be created in the form of brochures,
educational material in account opening kits, safety tips in cheque book, account
statements, envelops, ATM receipts, Screen savers, electronic news letters etc.

Banking Finance 223

 ix) Legal Issues
Legal risk is part of operational risk. The Information Technology Act, 2000 and
IT Amendment Act 2008 deal with issues relating to information technology and
cyber crimes. Banks have to keep in view the provisions of these Acts and keep
abreast of the orders issued there-under pertaining to bank transactions and
emerging legal standards on digital signature, electronic signature, data protection,
cheque truncation, EFT etc as a part of overall operational risk management
process.
* * * * * * *

FRAME 133
IMMEDIATE PAYMENT SERVICE (IMPS)
[EARLIER INTER BANK MOBILE PAYMENT SYSTEM]

IMPS was launched by National Payments Corporation of India (NPCI) in Nov 2010.

IMPS is mobile based, bank-led payment mechanism. It is a safe, secure, 24 x 7 inter-

bank electronic fund transfer service through mobile phones with immediate confirmation
features. The facility is provided by NPCI through its existing NFS switch.

The service allows a customer in one bank to remit funds to an account holder in another
bank using mobile phone as a service delivery channel of the member banks.

Banks to participate in IMPS should have approval from RBI for Mobile Banking Service.

To receive money

 Register your mobile number with your bank to link to your account
 Get your MMID (Mobile Money Identifier from your bank)
 Share your mobile number and MMID with the remitter
 Ask the remitter to send money using your mobile number and MMID
 Check the confirmation SMS for credit to your account from the remitter
 Once the money is in your account, you can withdraw by any channel

To pay money

 Register yourself for mobile banking with your bank

 Get your MMID and MPIN(Mobile Banking Personal Identification Number)from
your bank

224 Banking Finance

  Download and activate the mobile banking application on your mobile phone or
use SMS or unstructured Supplementary Service Data (USSD) based application
provided by the bank
 Get beneficiary mobile number and MMID
 Send money to the beneficiary following the menu options, following bank’s
instructions to send money
 Check the confirmation SMS for debit to your account and credit to the beneficiary
account
IMPS has a huge potential in our country. It will be an enabler for financial inclusion.

Immediate Payment Service (IMPS), an inter-bank money transfer offered by NPCI is an

unique mobile remittance service in the world that facilitates 24 x 7 transaction processing
even on Sundays and holidays. This exceptional feature of IMPS has earned huge
appreciation amongst major central banks in the world.

The service allows a bank customer to transfer money in a few seconds time across 54
banks in India. The service which was initially launched as a mobile linked money remittance
service has now evolved as a channel agnostic to be available on net banking and ATM.

IMPS offers two options in which one can transfer funds :

i) Using MMID and Mobile Number

ii) Using IFSC Code and Account Number
* * * * * * *

FRAME 134
RUPAY

RuPay is a combination of terms ‘Rupee’ and ‘Payment’ and it is the name given to the
new domestic card payment scheme launched by NPCI on Mar 26, 2012. It is seen as
the domestic alternative to Master Card and Visa.

RuPay cards are acceptable at all ATMs across India under NFS. It is accepted in more
than 4.2 lacs POS terminals. On June 21, 2013 , NPCI enabled RuPay using PaySecure
for e-commerce or online transactions using RuPay debit cards.

Banking Finance 225

This card scheme :

 Will reduce overall transaction cost for the banks in India by introducing
competition to international card schemes
 Will be an enabler for financial inclusion
 Will enable the country to move to a ‘less cash’ society

RuPay roadmap is :

1. Acceptance at ATMs and Micro ATMs

2. Debit card, prepaid card, acceptance at POS terminals
3. E-commerce acceptance and Virtual Card
4. EMV* (Europay, Mastercard,Visa) and contactless
[ *A global standard for authentication using chip cards in ATMs and POS termials]
5. Credit card
NPCI has drawn up a plan to connect every Indian by 2020.

* * * * * * *

FRAME 135
ATM-CASH RETRACTION

In an ATM, when cash is dispensed, it has to be collected immediately; otherwise, the

bank notes will be sucked back by the machine. When this cash retraction facility was
in operation, there were several frauds committed pertaining to cash retraction facility. The
typical modus operandi has been to hold on to a few pieces of notes in ATM machines
that have cash retraction system, while allowing one or two pieces of notes to be retracted
and then claiming non-receipt of cash. Since retracted transactions are credited back to
the customer’s account, the balance in the fraudster’s account remains unaffected even
after collecting bulk of the delivered cash. The ATMs do not have the capability to count
the pieces of retracted notes thus leaving a loophole for committing such frauds.

As per RBI guidelines, the cash retraction facility has been disabled at all ATMs.

* * * * * * *

226 Banking Finance

 FRAME 136
WHITE LABEL ATM (WLA)
RBI has permitted non-bank entities incorporated in India under the Companies Act 1956
to set up, own and operate ATMs in India. These ATMs are called White Label ATMs. They
will provide the banking services to the customers of banks in India, based on the cards
(debit/credit/prepaid) issued by banks. The WLA operator’s role would be confined to
acquisition of transactions of all banks’ customers and hence they would need to establish
technical connectivity with the existing authorised shared ATM network operators/card
payment network operators.

RBI’s authorisation to operate WLA is required. The WLA operator should have a minimum
net worth of Rs 100 Cr.

Specific criteria for WLA operators, roles and responsibilities of the operators, sponsor
banks, network operators have been indicated by RBI.

The primary objective of permitting non-banks to operate WLA is to enhance the spread
of the machines in semi-urban and rural areas, where bank-run ATMs penetration was not
growing.

Tata Communications Payment Solutions and Muthoot Finance Ltd and a few others have
got the go-ahead from RBI to set up WLA.

* * * * * * *

FRAME 137
INFINET
The Indian Financial Network (INFINET) is the communication backbone for the Indian
banking and the financial sector. The Infinet is a closed user group network for the exclusive
use of member banks and financial institutions and is the communication backbone for
the National Payments System, which caters mainly to inter-bank applications like RTGS,
NEFT, Delivery vs Payment, Govt transactions, Automatic Clearing House etc.

IDRBT (Institute for Development and Research in Banking Technology) started the Infinet
with VSATs, later augmented it with point-to point leased lines. With availability of better
and more reliable technology, IDRBT migrated the Infinet backbone to Multi Protocol Label
Switching (MPLS).
* * * * * * *

Banking Finance 227

 FRAME 138
CLOUD COMPUTING

Cloud computing is internet based computing where virtual shared services provide software,
infrastructure, platform, devices and other resources and hosting to customers on a pay-
as-you-use basis.

Customers do not own the physical infrastructure; rather they rent the usage from a third
party provider.

The cloud makes it possible to access one’s information from anywhere at any time. The
cloud removes the need for one to be in the same physical location as the hardware that
store your data. The cloud provider can both own and house the hardware and software
necessary to run one’s home or business applications.

There is a lot of cost saving in hardware and software - purchase, maintenance etc. One
can hire it and pay as per use.

The different types of clouds are:

1) Public cloud - can be accessed by any subscriber with an internet connection

and access to the cloud space.
2) Private cloud – is established for a specific group or organisation and limits access
to just that group.
3) Community cloud - is shared among two or more organisations that have similar
requirements.
4) Hybrid cloud - a combination of two or more distinct cloud infrastructures (private,
public or community) that remain unique entities but are bound together by
standardised technology that enables data and application portability.

There are 3 types of cloud providers:

a. Software as a service (SaaS)

Subscribers get access to both resources and applications. Saas makes it
unnecessary for anyone to have a physical copy of software to install on his
devices.
b. Platform as a Service (PaaS)
Gives access to components that subscribers require to develop and operate
applications on the internet.

228 Banking Finance

 c. Infrastructure as a Service (IaaS)
An IaaS agreement deals primarily with computational infrastructure. Here the
subscriber completely outsources the storage and resources such as hardware
and software that they need.

Challenges

Security, privacy, data integrity, audit trails, business continuity etc are significant concerns
in cloud computing.

You have less control over who has access to your information and little to no knowledge
of where it is stored. Hence, successful initiatives rely on a high degree of trust including
confidence in the provider’s long term viability.

Benefits

 Reduction in upfront capital expenditure on hardware and software deployment

 Location independence so long as there is access to internet
 Allows the unit to focus on core business
 Increases competitive advantage
 Scalability
* * * * * * *

FRAME 139
DATA WAREHOUSE (DWH)

A DWH is a repository of processed data collected or captured from disparate sources

in an enterprise.

The DWH, which is insulated from the transactional or operational data of an organization,
is designed specifically for the use of decision makers. Once the data is stored in a
warehouse, decision support system (DSS) tools are used for querying and reporting,
analysis and interpretation and mining. This will enable better decision making and for the
organisation to be more responsive.

A DWH can be used for several purposes, depending on the nature of the business and
its objectives. At a macro-level, it can be used for understanding business trends and
identifying core competencies. At a micro-level, for making decisions about product-mix,
analysing profitability, estimating operational efficiencies etc.

Banking Finance 229

DWH is more relevant for companies that have to know the mind of the consumer. A good
DSS would help determine individual consumer preferences, forecasting consumer behaviour
and through slice and dice analysis, uncovering hidden trends and new business
opportunities.

For a manufacturing organisation, a DWH would help rationalise inventory and supply, weed
out poorly performing products, and manage all segments of the supply chain including
procurement, manufacturing, distribution and logistics.

* * * * * * *

FRAME 140
ANALYTICAL DATA WAREHOUSE (ADWH)

Banks have adopted core banking solutions. Banks have adopted technology in many of
their activities-remittances, HRM, risk management etc. Now technology is being aligned
with business outcomes. Today, technology deployment is for growth, efficiency and risk
management. Towards this, the creative management of information becomes a source of
competitive advantage. It is all about business transformation, business intelligence,
customer intelligence, customer relationship management (CRM) etc. So, a DWH becomes
an Analytical Data Warehouse. Analytics provides business intelligence and actionable
information.

Today pre-built data warehouse solutions that are based on analytics are available. These
solutions have been designed to meet analytical needs of banks in four key areas:

i) Customer intelligence
ii) Risk management
iii) Performance management
iv) Compliance adherence
So, analytical warehouses have become more important than data warehouses.

ADWH are platforms to deliver value-added analysis in executive decision making and to
maximise the business benefits.

* * * * * * *

230 Banking Finance

 FRAME 141
SECURITY THREATS - A GLOSSARY
a. Phishing

Phishing is a form of online identity theft that employs both social engineering and technical
tactics to steal consumers’ personal identity and financial account details.

In social engineering technique, an e-mail is sent to the user under any pretext and directs
the user to visit a website, giving a deceptive link in the email.

The webpage of the phishing site has the look and feel of the legitimate website. So, the
user logs into his account. Once the password, PIN code and account no. etc. are obtained,
the attacker could access and use the victim’s account for fraudulent purposes.

The technical tactics work by planting malware/spyware into PCs to steal credentials
directly, often using key/screen logging software to intercept consumers’ online accounts,
user names and passwords and send them to remote phisher server with the help of Trojan
horses.

The safeguards being taken by banks to curb phishing are:

1. Use multifactor authentication

2. Educating the customers about preventive measures
3. Intelligence tools to track illegal transactions, fraud prevention tools and risk
management tools help in identifying cases arising out of phishing
Phishing is a variation on fishing, the idea being that bait is thrown out with the hope that
while most will ignore the bait, some will be tempted to bite.

b. E-mail spoofing

E-mail spoofing is the creation of e-mail messages with a forged sender address. Spam
and phishing e-mails typically use such spoofing to mislead the recipient about the origin
of the message.

E-mail spoofing is possible because Simple Mail Transfer Protocol, the main protocol in
sending e-mail does not include an authentication mechanism.

c. E-mail spam

It is also known as junk mail. Spam is the use of electronic messaging system to send
unsolicited bulk messages, especially advertising, indiscriminately.

Banking Finance 231

A person who creates electronic spam is called a spammer.

Spamming remains economically viable because advertisers have no operating costs

beyond the management of their mailing lists. The costs such as lost productivity and fraud
are borne by the public and by internet service providers who have been forced to add extra
capacity to cope with the deluge.

Spamming has been the subject of legislation in many jurisdictions.

d. Skimming

Skimming is an act of using a skimmer to illegally collect data from the magnetic stripe
of a credit, debit or ATM card. This information, copied on to another blank card’s magnetic
stripe, is then used by an identity thief to make purchases or withdraw cash in the name
of actual account holder.

Skimming works by replacing a card reader like an ATM with a camouflaged counterfeit
card reader. The counterfeit card reader records all the data on a card as it passes through
the skimmer. In addition to ATMs, other locations where card skimming happens include
restaurants, taxis etc. In these instances, the thief has fitted the card reader with a skimmer
or uses a hand-held skimmer hidden in a pocket.

e. Hacking

Hacking is the act of gaining unauthorized access to a computer system or network and
in some cases, making unauthorized use of this access.

f. Vishing

The term is combination of ‘Voice’ and ‘phishing’. Vishing is the practice of using the
telephone system to gain access to private personal and financial information from the public
for fraudulent use.

g. Firewall

It is a technological barrier designed to prevent unauthorized or unwanted communications

between computer networks or hosts.

A firewall is a software or hardware based network security system that controls the
incoming and outgoing network traffic by analysing the data packets and determining
whether they should be allowed through or not, based on a rule set. A firewall establishes
a barrier between a trusted, secured internal network and another network (eg. the internet)
that is not assumed to be secure and trusted.

232 Banking Finance

A firewall is considered to be the first line of defence in protecting private information. For
greater security, data can be encrypted.

h. Salami attacks

These attacks are used for the commission of financial crimes. The alteration made is so
insignificant that in a single case it would go completely unnoticed. A Bank employee
inserted a program, into the bank’s server, that deducts a small amount (say, Rs.10 a month)
from the account of all customers to a designated account (under which name a bank
account with another bank is opened). No single account holder will notice this unauthorized
debit but it amounts to a good amount for the fraudster.

i. Virus Attacks

Viruses are programs that attach themselves to a computer or a file and then circulate
themselves to other files and to other computers on a network. They usually affect the data
on a computer either by altering or deleting it.

j. Worm attacks

A Computer worm is standalone malware computer program that replicates itself in order
to spread to other computers. Unlike a computer virus, it does not need to attach itself
to an existing program. Worms cause harm by consuming bandwidth in the network or
eat up the available space on a computer’s memory.

k. Trojan Attacks

A Trojan is an unauthorized program which functions from inside what seems to be an

authorized program thereby concealing what it is actually doing. A Trojan horse program
pretends to do one thing while actually doing something completely different.

* * * * * * *

Banking Finance 233

 PART - K

COMMITTEES

234 Banking Finance

 FRAME 142
COMMITTEE ON FINANCIAL SECTOR REFORMS
(Chairman : Dr. Raghuram G Rajan)

With a view to outlining a comprehensive agenda for evolution of the financial sector,
Planning Commission, Government of India, had constituted a Committee on Financial
Sector Reforms (CFSR) in August, 2007 under the Chairmanship of Shri. Raghuram G Rajan,
Professor, University of Chicago and Former Chief Economist, IMF (Presently Governor,
RBI). The Committee submitted its Report in Sep, 2008. The major recommendations of
the Committee are as under:

 RBI should have single objective of low inflation range for the medium term.
 Open up rupee corporate and Govt bond markets to foreign investors in an
increased manner.
 Allow more entry to private well-governed small finance banks with strict
supervision.
 Liberalize banking correspondent legislation to enable local agents to extend
financial services.
 Offer priority sector loan certificates to all entities that lend to this sector. These
certificates can be sold to banks having shortfall in priority sector lending.
 Liberalize interest rates that institutions can charge, ensuring credit reaches the
poor.
 Sell small under-performing PSBs to another bank/strategic investor.
 Create stronger boards for large PSBs with more powers to outside shareholders.
 Delinking banks from additional Govt oversight including CVC/Parliament since
the boards are already controlled by Government.
 Be more liberal in allowing takeovers and mergers including by subsidiaries of
foreign banks.
 Free banks to set up branches and ATMs anywhere.
 Allowing holding company structures with parent holding company owning
regulated subsidiaries.
 Encourage introduction of exchange traded interest rate and exchange rate
derivatives.
 Stop creating investor uncertainty by banning markets.

Banking Finance 235

  Create innovation-friendly environment in the market.
 Rewrite financial sector regulation with clear objectives and principles.
 Parliament should set remit for each regulator every five years.
 Regulatory actions should be subject to appeal to Financial Sector Appellate
Tribunal to be set up on the lines of Securities Appellate Tribunal.
 Supervision of all deposit taking institutions should be under RBI.
 Ministry of Corporate Affairs should review accounts of unlisted companies while
SEBI should review accounts of listed companies.
 Financial Development Council to be set up under the Finance Minister to focus
on macro-risk assessment and developmental issues.
 Office of Financial Ombudsman (OFO) to be set up incorporating all offices of
existing regulators.
 Strengthen DICGCI to monitor risk and resolve a failing bank. Insurance premia
to be risk based.
 Process of expediting creation of unique national ID number with biometric
identification.
 Land registration and titling including full mapping, reconciling various registries,
forcing compulsory registration of all land transactions, computerising land
records and providing easy remote access to land records to be expedited.
 Powers under SARFAESI Act (currently available to Banks, financial institutions
and housing finance companies) to be extended to all institutional lenders.
 Encouraging entries of better capitalised Asset Reconstruction Companies.
 A bankruptcy code to be formulated in the Indian context.
* * * * * * *

FRAME 143
COMMITTEE ON FINANCIAL SECTOR ASSESSMENT (CFSA)
(Chairman : Dr Rakesh Mohan)

The CFSA comprehensively assesses products, regulations and institutions in the financial
sector with regard to international benchmarks and suggests ways to overcome the
weaknesses that exist. The CFSA set up by the GOI and RBI undertakes a complete health
check-up of the country’s financial sector.

236 Banking Finance

This exercise has been undertaken under a financial sector assessment programme (FSAP)
initiated jointly by IMF & World Bank in 1999, partly in response to the Asian Crisis of late 1990s.
Based on Indian experience in the FSAP and self-assessments in 2001 & 2002 respectively
and a review in 2004, GOI, in consultation with RBI, decided in Sep 2006 to constitute
a Committee on Financial Sector Assessment (Chairman: Dr Rakesh Mohan) to undertake
a comprehensive self –assessment of India’s financial sector.
The CFSA, constituted in Aug 2007, four independent advisory panels respectively for
i) Financial stability assessment and stress testing
Covered macro-prudential analysis and stress testing of the financial sector.
ii) Financial regulations and supervision
Covered banking regulation and supervision, securities market regulation and
insurance regulation standards.
iii) Institutions and Market structure
Covered standards regarding bankruptcy laws, corporate governance, accounting
and auditing and payment and settlement systems.
iv) Transparency standards
Covered standards pertaining to monetary and financial policies, fiscal
transparency and data dissemination issues.
Overall, the assessment has found that the financial system is essentially sound and
resilient and that systemic stability is robust. Compliance with international standards and
codes is generally satisfactory. The assessment documents the area of non-compliance,
partial or otherwise.
Single factor stress tests for credit and market risks and liquidity ratio and scenario analysis
carried out showed no significant vulnerabilities in the banking system.
The CFSA has identified, based on some existing gaps, areas for further improvement. One
of the serious gaps in respect of adequate compliance is with regard to timely
implementation of bankruptcy proceedings. The average time taken in India for winding up
proceedings is one of the highest in the world. Improvements in effective enforcement of
creditor rights and insolvency systems are critical for strengthening market efficiency and
integration and for enhancing commercial confidence in contract enforcement. A quick
resolution of stressed assets of financial intermediaries is essential for the efficient
functioning of credit and financial markets.
The CFSA Reports were released on Mar 30, 2009.
* * * * * * *
Banking Finance 237
 FRAME 144
TOWARDS FULLER CAPITAL ACCOUNT CONVERTIBILITY
(Dr. S.S. Tarapore - II)

Tarapore I on CAC – the process took a backseat with the Asian currency crisis in the
following years.

RBI appointed a committee (Chairman: Dr. S.S. Tarapore) to set out a road map towards
fuller CAC in May 2006 in the context of the progress in economic reforms, the stability
of the external and the financial sectors, accelerated growth and global integration.

The link between capital account liberalisation and growth is yet to be firmly established
by empirical research. Nevertheless, the mainstream view holds that capital account
liberalisation can be beneficial when countries move in tandem with a strong macro-
economic policy framework, sound financial system and markets, supported by prudential
regulatory and supervisory policies.

The objectives of FCAC are:

a. To facilitate economic growth through higher investment by minimising the cost

of both equity and debt capital.
b. To improve the efficiency of the financial sector through grater competition, thereby
minimising intermediation costs.
c. To provide opportunities for diversification of investments by residents.
The committee had recommended a five year roadmap with three phases on the timing
and sequencing of measures. Phase I (2006-2007), Phase II (2007-2009), and Phase III
(2009-2011). After each phase, stock taking was to be done.

Concomitants for a move to FCAC

a. Fiscal Consolidation: Fiscal deficit to be reduced to 3% of GDP and revenue deficit

to be eliminated; The office of the Public Debt should be set up to function independently
outside the RBI.
b. Monetary Policy Objectives: A monetary policy committee to be set up to set out
the objectives in the medium term.
c. Strengthening of the banking system: All commercial banks should be subject to
a single banking legislation. All banks to be incorporated under the Companies Act;
Share of the Govt/RBI in capital of PSBs to be reduced from 51% to 33% (as

238 Banking Finance

 recommended by Narasimham Committee); Voting rights of investors should be in
accordance with the provisions of the Companies Act.
d. External service indicators: Greater attention is required to the concept of reserve
adequacy in relation to external liabilities.
e. Monetary Policy Instruments and Operations: RBI should activate variable rate repo/
reverse repo auctions or repo/reverse repo operations on a real time basis; RBI should
consider somewhat longer term LAF facilities.
f. Exchange Rate Management: REER should be a valuable input in the formulation
of Exchange Rate Policy; As recommended in 1997 report, RBI should have a
Monitoring Exchange Rate Band of +/- 5.0% around the neutral REER. RBI should
ordinarily intervene as and when the REER is outside the band; If the CAD persists
beyond 3% of GDP, the Exchange Rate policy should be reviewed.
g. Develpoment of Financial Markets: Different market segments should be well
developed and integrated (to absorb the shocks with minimal damage).
h. Regulatory and Supervisory Issues in Banking: The multi-dimensional operations
of commercial banks in situations of large inflows and outflows, their own exposures
to exchange rate risk, coupled with their exposures to corporates which are exposed
to similar risks, panning across national jurisdictions add to the multiplicity of risks
which need to be closely monitored and prudently managed. RBI should review the
prudential standards applicable to commercial banks and make regulations activity-
specific and not institution-specific; Enhance risk management capabilities in the
banking system supplemented by a regimen of appropriate stress testing framework.

Some of the important recommendations are:

1. Overall ECB ceiling as also ceiling for automatic approval should be gradually
raised. End-use restrictions should be removed.
2. Import-linked short term loans – per transaction limit of $20m should be reviewed
to avoid unlimited borrowing.
3. The limits for corporate investment abroad should be raised from 200% of Net
worth to 400% of Net worth.
4. EEFC account holders should be provided foreign currency current/savings
accounts with cheque writing facility and interest bearing term deposits.
5. Project exports to be provided greater flexibility.
6. FIIs should be prohibited from investing fresh money raised through PNs. Existing
PN-holders may be provided an exit route and phased out completely within one year.

Banking Finance 239

 7. Non-resident corporates should be allowed to invest in Indian stock markets
through SEBI registered entities including MFs and PMS.
8. All institutions (apart from multilateral institutions) to be allowed to raise rupee
denominated bonds (with option to convert into foreign exchange) subject to an
overall ceiling.
9. The limits for banks to borrow overseas to be linked to Paid-up capital and reserves
and not to unimpaired Tier 1 capital, as at present and substantially raised to
100%, by Phase III.
10. MF investments abroad to be liberalized further.
11. Remittances by individuals up to $25,000 to be raised to $2,00,000 in Phases.
12. Abolish the scheme of residents investing in overseas companies which has a
shareholding of at least 10% in an Indian company.
13. RFC and RFC (Domestic) accounts to be merged.
14. Non residents (other than NRIs) also should be allowed to open FCNR (B) and
NR (E) RA deposits. While NRIs enjoyed tax benefit, others will not get tax benefit.
15. All individual non-residents (apart from NRIs) should be allowed to invest in Indian
stock market.
To quote Shri M.Narasimham, former Governor, RBI (during the conference on FCAC at ASCI
on 18-19 Dec 2006) ‘CAC is a stern task master. To minimise, if not avert – the downside
risks and obtain its putative benefits, India needs to practise fiscal discipline on a continuing
basis and strengthen the financial system in keeping with the international norms such
as the forthcoming Basel II and also have flexible exchange rates, a particularly important
point in a situation of free inward and outward movement of capital, especially banking and
other short term speculative capital. The message, as can be seen from the Tarapore
Reports, is that the pursuit of the Holy Grail will have to be both cautious and gradual or
incremental. Hasten slowly seems to be the Tarapore Mantra, which one cannot quarrel
with’.

The RBI stand has been that India will ‘gradually’ move towards CAC only after preconditions
like fiscal consolidation are met. Otherwise, premature CAC can create macro-economic
imbalances with huge costs to growth and welfare. Preconditions for CAC are ‘fiscal
consolidation, more resilient financial sector, increased export competitiveness, imports
more price elastic and more liberal FDI policy with less bureaucratic interface and India
becoming a more friendly investment destination’.

240 Banking Finance

 EX - GOVERNOR SHRI D. SUBBA RAO’S REMARKS

[Extracts from the speech given at IMF Conference on Rethinking Macro Policy, Washington
DC on April 17, 2013]

‘The Financial crisis shattered the consensus on many macroeconomic issues and
shibboleths and nowhere is this more true than in the broad policy area of capital account
management. Before the crisis, the consensus was that every country should eventually
move towards a fully open capital account. The debate was only about the appropriate
strategy- sequencing and timing, in particular-for transitioning to full CAC. (In India), there
was general agreement that we should start with floating exchange rate and decontrolling
interest rates and with the capital account, on the rationale that this strategy will best
preserve macro stability.

Now the crisis has questioned the very imperative of CAC. The consensus that every country
should eventually move towards a fully free capital account is broken. The main argument
in support of the new view- that full CAC need not be an eventual goal – is that controls
prevented emerging markets from adopting some of the financial products that proved toxic
in advanced countries. So, there is merit, it is argued in retaining capital controls’.

* * * * * * *

FRAME 145
WORKING GROUP ON BENCHMARK PRIME LENDING RATE
(Chairman: Shri Deepak Mohanty)

The main recommendations are:

 Over a period of time, several concerns have been raised about the way the BPLR
system has evolved. These relate to large quantum of sub-BPLR lending, lack
of transparency, downward stickiness of BPLRs and perception of cross-
subsidization in lending. The group also noted that on account of competitive
pressures, banks were lending a part of their portfolio at rates which did not make
much commercial sense.
 There was merit in introducing a system of Base Rate to replace the existing
BPLR system.
 The proposed Base Rate will include all those cost elements which can be clearly
identified and are common across borrowers. The constituents of the Base Rate
would include:

Banking Finance 241

 a. The card interest rate on retail deposits (deposits below Rs. 15 lakhs) with
one year maturity (adjusted for current account and savings account
deposits);
b. Adjustment for the negative carry in respect of cash reserve ratio (CRR) and
statutory liquidity ratio (SLR);
c. Unallocatable overhead costs for banks which would comprise a minimum
set of overhead cost elements;
d. Average return on net worth.
 The actual lending rates charged to borrowers would be the Base Rate plus
borrower specific charges, which will include product-specific operating costs,
credit risk premium and tenor premium.
 In order to make the lending rates responsive to the Reserve Bank’s policy rates,
banks may review and announce their Base Rate at least once in a calendar
quarter with the approval of their Boards. The Base Rate alongside actual minimum
and maximum lending rates may be placed in public domain.
 With the proposed system of Base Rate, there will not be a need for banks to
lend below the Base Rate as it represents the bare minimum rate below which
it will not be viable for the banks to lend. Base Rate system will be applicable
for loans with maturity of one year and above (including all working capital loans).
 Banks may give loans below one year at fixed or floating rates without reference
to the Base Rate. Sub-Base Rate lending in both the priority and non-priority
sectors in any financial year should not exceed 15 per cent of the incremental
lending during the financial year. Of this, non priority sector sub-Base Rate lending
should not exceed 5 per cent.
 Exempted categories from linking to Base Rate are: Interest rates on
a. Loans relating to selective credit control
b. Credit Card receivables
c. Loans to Banks’ own employees
d. Loans under differential rate of interest (DRI) scheme
 In order to increase the flow of credit to small borrowers, administered lending
rate for loans up to Rs.2 lacs may be deregulated as the experience reveals that
lending rate regulations has dampened the flow of credit to small borrowers and
has imparted downward inflexibility to the BPLRs. Banks should be free to lend
to small borrowers at fixed or floating rates, which would include the Base Rate

242 Banking Finance

 and sector-specific operating cost, credit risk premium and tenor premium as in
the case of other borrowers.
 At present, the ceiling on interest rates on pre-shipment rupee export credit up
to 270 days and post-shipment rupee export credit up to 180 days has been
stipulated at BPLR minus 2.5 percentage points. The Group recommends that
the interest rate on rupee export credit should not exceed the Base Rate of
individual banks.
 The ceiling rate of interest rate on education loans up to Rs.4 lacs has been
stipulated at not exceeding BPLR. Interest rates on educational loans in excess
of Rs. 4 lacs are prescribed as BPLR+1 percent. In view of the critical role played
by education loans in developing human resource skills, interest rate on these
loans may continue to be administered. The Group recommends that the interest
rates on all education loans may not exceed the average Base Rate of five largest
banks plus 200 basis points.
* * * * * * *

FRAME 146
HIGH LEVEL COMMITTEE TO REVIEW LEAD BANK SCHEME (LBS)
(Chairperson: Smt. Usha Thorat)

LBS was introduced by RBI in 1969 when designated banks were given the responsibility
for each district in the country (622 districts) for identifying growth centres, assessing
deposit potential and credit gaps and evolving a coordinated approach for credit deployment
in concert with other banks and other agencies.

Service Area Approach (SAA) was introduced in 1989 and a group of villages was allotted
to a bank which alone will take care of their financial needs.

Subsequently, as it was observed that SAA restrictions were a limiting factor for credit
deployment, the restrictive provisions were removed in 2004, except for the Govt. sponsored
programmes.

A comprehensive review of LBS was made in 2009.

The major recommendations of the Committee are:

a. LBS is useful and needs to continue. The State Level Bankers Committee (SLBC)
and various fora under LBS should focus on addressing the ‘enablers’ and

Banking Finance 243

 ‘impeders’ in advancing greater financial inclusion and flow of credit to priority
sectors, while monitoring Govt Sponsored Schemes.
b. Penetration of banking in several parts of the country is still limited. Hence, it
is critical that banking services are seen as a public good and are also made
accessible to all sections of population and regions of the country at affordable
cost. The State development machinery has to ensure the availability of backward
and forward linkages to ensure that credit is gainfully deployed and income levels
enhanced.
c. The overarching objective of LBS shall be to enable banks and State Governments
to work together for inclusive growth.
d. It is necessary to broad base the scope of the scheme to cover initiatives for
financial inclusion, role of State Govts, financial literacy and credit counselling
as also ‘credit plus’ activities, formulate action plans to facilitate ‘enablers’ and
remove/minimize ‘impeders’ for banking development for inclusive growth, develop
grievance redressal mechanism etc.
e. Banks need to take the maximum advantage of available IT solutions. The funding
arrangements available under Financial Inclusion Technology Fund (with Nabard)
or other options such as the support offered for distribution of Govt. payments by
RBI may be explored for the purpose.
f. Concerted efforts may be made for using PACS as BCs where such PACS are
running well.
g. State Govts to ensure road/digital connectivity to all centres where penetration
by the formal banking system is required.
h. Lead banks to open a Financial Literacy and Credit Counselling Centre (FLCC)
in every district where they have lead responsibility.
i. Lead banks to set up Rural Self Employment Training Institute (RSETI).
j. Preparation of Potential Linked Plans (PLP) to be advanced to August to enable
State Govts to factor in the PLP projections.
k. Banks should reckon the PLPs of Nabard and plans prepared by LDMs for sectors
other than agriculture and allied activities in their performance budgeting.
l. The Annual Credit Plans prepared by the LDM should indicate coverage for SC/
ST, minorities and promotion of SHGs in the district.

244 Banking Finance

 m. The activities of NGOs in facilitating and channelling credit to the low income
households are expected to increase in the coming years. Bank’s linkage with
such NGOs/Corporate houses operating in the area may ensure that they provide
the necessary ‘credit plus’ services for inclusive growth. Success stories could
be presented in DCC/SLBC meetings to serve as models that could be replicated.
n. Private Sector banks to involve themselves more actively in LBS by bringing in
their expertise in strategic planning and leveraging on information technology.
o. Important issues/decisions of the BLBC, DCC and DLRC should be placed before
the next meeting of the SLBC, so that these receive adequate attention at the
State Level.
p. The role of LDM to cover convening of meetings of DCC and DLRC, facilitating
setting up of FLCCs, RSETIs by banks, grievance redressal, credit planning,
annual district plan and monitoring and implementation of ACP.
q. As soon as RBI, GOI, NABARD and IBA instructions are put on websites, banks
may communicate the same to branches electronically.
r. New LDMs may be given 2 to 3 weeks attachment to Zilla Parishad/collectorate
for familiarization with Govt’s role and functioning, related to developmental
programmes.
s. Bank Managers should also visit the SHG meeting places to help understand
SHGs better.
t. Functionaries of gram panchayats should be familiarised with preparation of
bankable schemes so that budgetary funds for livelihood promotion can be
leveraged for promoting financial inclusion and increase credit absorption capacity.
The LDM/DDM could take initiatives in this regard.
u. Every quarter, the lead bank may organize an awareness and feedback public
meeting in its district.
* * * * * * *

Banking Finance 245

 FRAME 147
A FEW IMPORTANT COMMITTEES / WORKING GROUPS
PART - A

No. Report Chairperson

1 To study the feasibility of implementation of Shri. G.Padmanabhan
Giro based payment system in India (May, 2013)
2 To study the issues related to gold imports and Shri. K.U.B. Rao
gold loans to NBFCs in India (February, 2013)
3 To review the existing prudential guidelines on Shri. B. Mahapatra
restructuring of advances by banks/FIs (July, 2012)
4 Review of Supervisory Processes for Dr K. C. Chakrabarty
Commercial Banks (June, 2102)
5 To re-examine the existing classification and Shri. M.V. Nair
suggest revised guidelines with regard to priority (February, 2012)
sector lending classification and related issues
6 On Customer Service in Banks Shri. M. Damodaran
(August, 2011)
7 Preparation of IT vision document 2011-2017 Dr. K.C. Chakrabarty
(February, 2011)
8 On Information Security, Electronic Banking, Shri. G. Gopalakrishna
Technology Risk Management and Cyber Frauds (January, 2011)
9 To study issues and concerns in the MFI Sector Shri. Y.H. Malegam
(January, 2011)
10 On Benchmark Prime Lending Rate Shri. Deepak Mohanty
(October, 2009)
11 To review Lead Bank scheme Smt. Usha Thorat
(Aug, 2009)
12 On Financial Sector Reforms Dr. Raghuram G Rajan
(Sep, 2008)
13 On rehabilitation of sick SMEs Dr. K.C. Chakrabarty
(April, 2008)
14 On making Mumbai an International Shri. Percy Mistry
Financial Centre (2007)

246 Banking Finance

 PART - B
1 On Fuller Capital Account Convertibility Dr. S. S. Tarapore
(July, 2006)
2 Report on monitoring of Financial Conglomerates Smt. Shyamala Gopinath
(June, 2004)
3 On procedures and performance audit on Dr. S.S. Tarapore
public services (May, 2004)
4 On legal aspects of Bank Frauds Dr. N.L. Mitra
(August, 2001)
5 On Banking Sector Reforms Shri. M. Narasimham
(1998)
6 On Capital Account Convertibility Dr. S.S. Tarapore
(June, 1997)
7 Inspection System of Banks Shri. R. Jilani
(1995)
8 Frauds and Malpractices in Banks Shri. A. Ghosh
(1992)
9 Customer Service in Banks Shri. M.N. Goiporia
(1991)
10 On the Financial System Shri. M. Narasimham
(1991)
11 On the Money Market Shri. N Vaghul
(1990)
12 On Service Area approach Shri. P.D. Ojha
(1988)
13 To review the working of the Monetary System Shri. Sukhmoy Chakravarty
(1985)
14 To review the system of Cash Credit Shri. K. B Chore
(1979)
15 To frame guidelines for follow-up of bank credit Shri. P.L. Tandon
(1975)
16 On customer service Shri. R.K. Talwar
(1975)

* * * * * * *
Banking Finance 247
 PART - L

CONCEPTS

248 Banking Finance

 FRAME 148
THE IMPOSSIBLE TRINITY

The formal model for this hypothesis is called the (Robert)Mundell-(Marcus)Fleming model.
Mundel-Fleming model helps us to understand the effectiveness of monetary policy and
fiscal policy in a country given free mobility (inflow and outflow) of capital.

The Impossible Trinity is the trilemma suggesting it is impossible to have all three of the
following at the same time:

a. Stable Exchange rate

b. Open Capital Account (growth with easy interest rate)
c. Independent monetary policy (Price stability – Low inflation)

Independent Monetary Policy Open Capital Account

(Price Stability) (Capital Mobility)

Stable Exchange Rate

A country must pick two out of the three:

 RBI hikes up interest rates to control rising inflation and overheating economy.
Higher interest rates would attract foreign investors, leading to inflow of capital.
Foreigners would demand local currency in exchange for their foreign money,
putting pressure on domestic currency to appreciate, if there is no intervention
by RBI. The exchange rate appreciation would lower exports, helping to cool the
overheating economy. It will also make imports cheaper, leading to lower inflation.
Since there is no intervention, the exchange rate is floating.
 Supposing RBI intervenes and mops up the dollars and supplies domestic
currency to keep the exchange rate fixed, then, the excess money supply leads
to higher inflation. This also increases the foreign currency reserves and there
is a cost to managing forex reserves.

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 If it is not sterilised, it nullifies the basic purpose of raising interest rates.
If it is sterilized, then RBI issues stabilization bonds. There is a cost for
sterilization.
Thus the trilemma is termed ‘impossible’ as given perfect market conditions, the
three cannot be managed together.

Then how are the 3 managed generally?

Capital inflow is important for growth of the economy. Liberalizing capital outflows benefits
the people to diversify their portfolios and take advantage of growth opportunities.

Most countries are going for floating exchange rate or versions of floating rates. A managed
float system is one in which the currency floats in the market but the central bank can
intervene in the market if there is abrupt movement in the currency.

Price stability and capital mobility are the preferred set of choices and managing the
exchange rate.

How India is managing ‘the Impossible Trinity’?

RBI has to manage the following three trinities:

a. Price stability (interest rate autonomy)

b. Exchange rate stability
c. Capital mobility
RBI is trying to manage all the three – along with free flow of capital, to have lower inflation
and low exchange rate volatility. How? Through:

a. Intervening in forex markets and then sterilizing the inflows.

b. Imposing capital controls (Refer Frame on Capital Account Convertibility)
c. Raising rate of interest
It is to be noted that there is a cost involved in sterilization and in intervention in forex
markets to prevent currency appreciation leading to increase in forex reserves.

India was growing at an average of 8%. This has led to huge capital inflows through FDI
and FII. And when interest rate is low in developed economies and ours is higher, FCNR
funds also flow in.

The way to absorb huge capital inflows is to strengthen the financial system.

With increasing capital inflows and floating exchange rates, the rupee should appreciate.

250 Banking Finance

Though rupee is not pegged to the dollar, the rupee was moving within a narrow band –
a managed float. This is to smoothen the volatility of exchange rate movements and RBI
intervenes selectively. The forex reserves had gone up for $ 200 bn in 2007 to $294 bn
by September, 2012.[As at Sep 13, 2013, it is $ 275 bn].

RBI is constantly battling to contain inflation below 5%. It raises the policy rates to rein
in inflation and inflation pressures and inflation is brought under control with a time lag.

RBI has done a fairly good job in managing the Trinity. There has been no crisis since
1991. The South East Asian Crisis 2001 and the financial crisis around the world of 2008
had not impacted the economy of the country. In fact, India is the second fastest growing
economy in the world. It has adopted a managed floating exchange rate and with some
restrictions in capital mobility.

To quote Dr Subba Rao, ‘ This means that RBI is on guard on all the three fronts with
relative emphasis across the three pillars shifting according to India’s macro-economic
situation’.

[What happened in July-Aug 2013 in India is that the trilemma is acting out.]

Euro Zone Crisis validates The Impossible Trinity

What we witnessed in the Euro Zone crisis was the validity of the impossible trinity principle.
With a fixed rate and open capital account, monetary independence was sacrificed. So,
when debt had to be repaid, the power to print money and honour the debt with a depreciated
currency was not there. So, default or bailout were the only alternatives. Finally, it was
a bailout through the European Financial Stability Facility/ECB.

The Maastricht Treaty possibly overlooked the Impossible Trinity.

* * * * * * *

FRAME 149
FOREIGN EXCHANGE INTERVENTION

[Extract from Remarks by Dr. D. Subba Rao, Governor, RBI at IMF conference on ‘Rethinking
Macro Policy II’ on April 17, 2013]

 The third important issue on which the pre-crisis consensus has dissolved is
foreign exchange intervention.
 The pre-crisis consensus, at any rate among advanced economies was that
intervention in the forex market is sub-optimal.

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  The consensus no longer holds with even some advanced economies defending
their currencies from the safe haven impact.
 Emerging markets, for their part, have had long and varied experience of struggling
with forex intervention. The policy dilemma in the event of receiving capital flows,
beyond the country’s absorptive capacity, can be quite complex.
 If you did not intervene in the forex market, then you would have currency
appreciation quite unrelated to fundamentals.
 If you intervened, but did not stabilise the resultant liquidity, you became vulnerable
to inflation pressures and asset price bubbles.
 If you intervened in the forex market and stabilised the resultant liquidity, you may
find interest rates firming up – which attracts even more flows- a classic case
of Dutch disease.
 What all this says is that there is really no benign option for dealing with volatile
capital flows.
 There is one other important issue relating to forex intervention. Both currency
appreciation and currency depreciation, quite unrelated to fundamentals, are
complex problems. But there is a significant asymmetry between intervention for
fighting appreciation and intervening for fighting depreciation.
 When you are fighting currency appreciation, you are intervening in your own
currency. Your capacity to do is, at least in theory, unlimited, quite simply because
you can print your own currency.
 But when you are fighting currency depreciation, you are intervening in a hard
currency. Your capacity to intervene is, therefore, limited by the size of your forex
reserves. What complicates the dilemma is that is that the market is aware of
this.
 So, there is the real danger that by intervening in the forex market, you could
end up losing forex reserves, and not gaining on the currency. The lower your
reserves dip, the more vulnerable you become. And the vulnerability can become
quite serious if your reserves go below the level markets perceive as necessary
to regain market access.
 It should also be clear that a failed defence of the exchange rate is worse than
no defence. So, when you are intervening in the forex market, it is important to
make sure that your intervention is successful.
* * * * * * *

252 Banking Finance

 FRAME 150
PURCHASING MANAGERS’ INDEX (PMI)

PMI are economic indicators derived from monthly surveys of private sector companies.
It is calculated separately for the manufacturing and services sectors and then a composite
index is constructed.

The Institute for Supply Management, Arizona began to produce the PMI report in 1948.
The data for the index are collected through a survey of a large number of purchasing
managers in the manufacturing sector from five different fields, viz. production level, new
orders, speed of supplier deliveries, inventories and employment level. For all these fields,
the percentage of respondents that reported better conditions than the previous month is
calculated. The five percentages are multiplied by a weighting factor and are added.

Index = (P1 x 1) + (P2 x 0.5) + (P3 x 0)

P1 = Percentage number of answers that reported an improvement

P2 = Percentage number of answers that reported no change

P3 = percentage number of answers that reported a deterioration

If 100% of the respondents reported an improvement, the index will be 100.

If 100% of the respondents reported no change, the index will be 50.

If 100% of the respondents reported deteriorations, the index will be 0.

So, an index above 50 means an expansion in business activity. An index below 50 denotes
contraction.

PMI is considered a good indicator of business confidence. Economists, Central bankers,

investors etc are keenly interested in PMI.

The seasonally adjusted HSBC PMI (India) was 49.6 in Sep 2013.

* * * * * * *

Banking Finance 253

 FRAME 151
CURRENT ACCOUNT DEFICIT (CAD)

A country’s current account consists of its visible (exports and imports of goods) and
invisible trade income and expenditure from export and import of services such as banking
and insurance, and profits earned on investments and remittances by workers from abroad.
The current account balance is the difference between the export and import of the two
trades (goods and services). It is net foreign savings inflow. If imports are more than exports,
the current account is in deficit. The deficit is usually measured as a percentage of GDP.

Deficit on the current account means a net outflow of foreign exchange. In India’s case,
this means a dollar outgo. Such a deficit could exhaust a country’s forex reserves if inflows
to make up the deficit do not materialize. Therefore, a country with a current account deficit
has to attract capital flows, which could be in the form of say, foreign direct investment,
to meet the shortfall. But when capital flows are insufficient to meet the deficit, the country’s
currency starts to depreciate on concerns that it may find it difficult to meet its international
commitments or fund its current purchases. This is why a current account deficit in excess
of 2.5% of GDP is seen as worrisome in case of India. In the last fiscal, despite getting
higher capital flows, the country is likely to have an overall balance of payments deficit
because of much higher current account deficit.

India’s large current account deficit at 4.8% of GDP for March 2013 has been fuelled by
heavy gold and crude oil imports. The rupee depreciation has served as an automatic check
on gold imports by making the yellow metal expensive. Although crude is softening, the
potential benefit may not materialize because of a slowdown in merchandise exports. As
a result, the current account deficit is expected to drop only marginally to about 3.5% of
GDP. For a sharper decline, India will need to push exports and slow down consumption
imports such as fuel and gold. Alternatively, India may have raise funds from abroad like
bonds.

* * * * * * *

254 Banking Finance

 PART - M

REFERRALS

Banking Finance 255

 FRAME 152
RUPEE GETS DISTINCT SYMBOL

The Indian Rupee has now a distinct, identifiable symbol:

Sign: ` Code: INR

It was presented to the public by Government of India on 15th July 2010. The Indian
currency joins an exclusive club of international currencies – the US Dollar, the British
Pound, the Japanese Yen and the Euro – that have their own symbols.

The new sign is a combination of the devanagiri letter ‘ ’ (ra) and the Latin capital letter
“R” without its vertical bar. The parallel lines at the top are said to make an illusion
to the tricolour Indian flag and also depict an equality that symbolizes the nation’s
desire to reduce economic disparity. The sign was designed by Shri. D. Udaya Kumar,
B.Arch and student of Visual Communication at Industrial Design Centre, IIT – Bombay.

* * * * * * *

FRAME 153
SIX SIGMA

Six Sigma is a quality tool, a bench mark, a profit improvement methodology to produce
defect free products/services.

Six Sigma level of quality is: Just 3.4 defects per million operations (DPMO) (a quality
standard of 99.99966 per cent).

The six sigma approach to quality ensures that the defects are eliminated progressively
by identifying the root causes and eliminating the source of variations. As the defects are
eliminated, the yield improves, work-in-process comes down, customer satisfaction
improves and the profitability of the company goes up.

Aptly put, ‘Six Sigma converts a business problem into a statistical problem and finds a
statistical solution. It then converts the statistical solution into a business solution’. The
distinct feature of six sigma is its analysis of the root causes and their systematic
elimination for achieving highest efficiency.

Sigma is the statistical measurement for variation in any output and when we talk of +
- six times the sigma within a specification, it means that 99.99967 percent of the products

256 Banking Finance

manufactured are within specification. A three sigma means 93.32 percent of the products/
processes are within specification.

The table for various levels of sigma defects is as under:

Sigma levels DPMO COMPETETIVE LEVEL

1 6,90,000 Non competitive
2 3,08,537
3 66,807 Industry average
4 6,210
5 233 World class
6 3.4

It was started by Motorola in 1985. The legendary Jack Welch of GE made it a corporate
vision.
* * * * * * *

FRAME 154
KEY STATISTICS ONE SHOULD KNOW
(2012-2013)

1 Real GDP (% Change) 5 % (Rs 89,749 bn)

2 Exports $ 300 bn (Rs 16,352 bn)
3 Imports $ 491 bn (Rs 26,731 bn)
4 Inflation Rate(Y-o-Y %)
WPI basis 7.4 %
CPI basis 10.21 %
5 Gross Domestic Saving Rate 30.8 % (2011-2012)
6 Gross Domestic Investment Rate 35 % (2011-2012)
7 Index of Industrial Production(%change) 1.1 %
8 Gross Fiscal Deficit 5.2 % of GDP
9 Current Account Deficit 4.8 % of GDP ($88 bn)
10 Govt Borrowing for the year Rs 5580 bn
11 Foodgrain Production 255 mn tonnes

Banking Finance 257

 12 Forex reserves
No Components 31-03- 2013 ($ bn)
1 Foreign Currency Assets 260
2 Gold 26
3 SDRs 4
4 Reserve Position in IMF 2
Total 292

13 ASCB Aggregate Deposits Rs 72,340 bn

14 Bank Credit Rs 49,641 bn
15 Gross NPA 3.42 %
16 Repo Rate 7.5 %
17 Reverse Repo Rate 6.5 %
18 Marginal Standing Facility 8.5 %
19 Bank Rate 8.5 %
20 CRR 4 %
21 SLR 23 %
22 Money Rates
Call (Weighted Average Rate) 8.30 %
Certificate of Deposit 8.80 – 10.12 %
Commercial Paper 8.05 – 13.42 %
23 10 Year Benchmark Yield 7.95 %
24 Dollar – rupee Rate 54.39
25 Sensex 18,835
26 Nifty 5,682

[All the above information is available in the RBI’s Annual Report(Appendix Tables),
Database of the Indian Economy, Weekly Statistical Supplement - put up on the RBI’s
website. These figures may be updated as and when required ]

*******

258 Banking Finance

 ABOUT THE AUTHOR

A.K.Jagannathan has worked in 5 Associate Banks of State Bank of India and one Private
Sector Bank.

He has M.Sc (Physics), CAIIB, PGDBM (NIBM, Bombay) qualifications. He was a rank
holder in College and the University (B.Sc).

He taught at Loyola College, Chennai for a year.

Joining State Bank of Mysore as a Probationary Officer in 1974, he rose to become Deputy
General Manager and was deputed to State Bank of Hyderabad.After elevation, he became
General Manager (Commercial & Institutional Banking) at State Bank of Hyderabad. Then,
he held the positions of General Manager (Credit) and General Manager (Operations) at
State Bank of Patiala. He was Chief General Manager of State Bank of Saurashtra and
became Managing Director of State Bank of Travancore, wherefrom he retired in April 2010.

He was holding charge of State Bank of Saurashtra and was the signatory to the Board
approval for the merger proposal of State Bank of Saurashtra with State Bank of India. He
was an active participant in the entire merger process.

He was with Tamilnad Mercantile Bank Ltd. as Managing Director and Chief Executive Officer
of the Bank from Sep 2010 to May 2012.

In all the six banks he worked, he was a constant Visiting Faculty to the Training Centres
throughout his career. He believes in sharing of knowledge and experience with others for
their empowerment.

He introduced Distance Learning Programme in State Bank of Mysore when he was Senior
Faculty in the Bank’s Training Centre. 1200 staff members participated in the year long
(monthly) programme.

Banking Finance 259

He had written articles in the Economic Times, The Financial Express, IBA Bulletin and
Prajnan (NIBM Journal) on Credit and Management.

He was Local Honorary Secretary of IBA - Bangalore Chapter 1992-1993.

Author of two books:

1. Developments in Banking and Finance (1993, 1994, 1996, 1999 Editions)

2. Developments in the Financial Market (1999)

He has wide experience in Corporate Finance, Planning (including Long Range Planning),
Agriculture, Risk Management and General Management.

He was a Guest Speaker at Trivandrum Management Association Annuals on two occasions

besides others like St Joseph’s College, Tiruchirapalli, ICFAI, Patiala Chapter etc.

During his tenure at State Bank of Travancore, the Bank recorded the highest net profit(Mar
2009); and it was ranked No 1 in Return on Equity by Business Today among all Public
Sector Banks.

Financial Express – Ernest & Young Survey of Best Banks 2011 ranked Tamilnad Mercantile
Bank as No. 1 among Old Private Sector Banks; and ranked the Bank as No. 2 for 2012.

Tamilnad Mercantile Bank was the winner of Assocham Social Banking Excellence Award
for the year 2012 under the Private Sector Category.

He was instrumental in the change of Logo of Tamilnad Mercantile Bank and the new Logo
was launched in May 2012.

*******