BANKING AND MONEY MARKET

BANKING SYSTEM – CHALLENGES

As per Invest India, India is set to become the third-largest domestic banking sector by 2050. Further, the total banking assets are expected to cross $28.5 Tn in 2025.

Challenges in Existing Banking Sector

1. Operational

• Asset Quality: With Non-Performing assets (NPAs), asset quality of the banks, especially the public sector banks, is poor in nature.
• Declining bank profitability: Lower REPO Rates fixed by RBI, Provisioning norms in case of NPAs, and the wrath of the pandemic has resulted in sharp decline of profitability of the bank.
• Instances of Collusion in frauds: For eg, Punjab National Bank Fraud Case relates to fraudulent letter of undertakings.
• Human resource: Most banks do not have adequate skilled workforce to meet new age banking requirements.
• Double financial repression:
  • Asset side: low availability of loanable funds due to SLR, CRR and PSL norms.
  • Demand side: declining deposits due to low saving rates and poor return on investment.
• Government schemes: Schemes like Jan dhan yojana, norms for opening branches in unbanked areas results into more financial pressure on banks.

2. Structural

• High Interest rates: Poor transmission of Repo rates cut by RBI impacts domestic borrowers negatively.
• Wilful Defaulters: Like Vijay Mallya, Nirav Modi who suck out crucial credit and do not return the loans.
• Diversion of Funds: Taken as loans and diverted towards non-capital investment activities.
• Liquidity Crunch: There is a frequent liquidity crunch generated due to the lack of funds for banks to operate and lend.
• Management Issues: These create a challenge for the bank’s future profitability and balance sheets. Eg: ICICI’s management issues.
• Priority Sector Lending: These norms restrict the bank from extending credit to more profitable sectors.
• Declining Capital Adequacy: Due to the problem of rising NPAs, especially due to the pandemic, resulting in less capital to meet BASEL III norms.
• Privatisation: This can reduce the social sector mandates of the banks and make them more profit-seeking at the cost of the social sector.
• Insolvency: The Insolvency and Bankruptcy Board has reported more delays in resolving bank insolvency cases.
• Four Balance Sheet Problem: The Four Balance Sheet challenge includes the original two sectors – infrastructure companies and banks, plus NBFCs and real estate companies.

3. COVID Related

• Extending Moratorium: Bankers have extended loan moratoriums which have disrupted their revenue and profit cycles.
• Liquidity Crunch: Upheavals usually turn people more cash reliant and thus deposits will reduce as more people withdraw cash.
• Inflation: Since more money will flow into the economy in terms of relief packages, there will be inflation, especially food and consumer goods related.

4. Other Challenges

• Cyber threats: These threats frequently disrupt the banking system through hacking and ransomware issues.
• Geopolitical risks: Ongoing pandemic and economic slowdown will increase risks to banks.
• Crypto Currency: These have gained popularity and pose a threat to traditional banking and financial services.
• Regional disparity: Smaller states and union territories, and southern states, lead in terms of bank branches per capita. On the other hand, north-eastern states, Uttar Pradesh, Bihar, and Jharkhand are the worst off in terms of access to banking services.

Government Initiatives

1. Insolvency and Bankruptcy Code: It helped in taking away control of the defaulting company from promoters/owners and debarring willful defaulters from the resolution process.
2. Fugitive Economic Offenders Act, 2018: This has been enacted to enable confiscation of fugitive economic offenders’ property.
3. National Financial Reporting Authority: This has been established as an independent regulator for enforcing auditing standards and ensuring audit quality.
4. Banks Board Bureau (BBB): This has been created for arm’s length selection of non-executive Chairman and whole-time directors.

1. Loan Management Systems: For faster processing of loan proposals, Loan Management Systems have been put in place for personal segment and MSME loans.
2. Mission Indradhanush: It aims at revamping the functioning of the Public Sector Banks to enable them to compete with the Private Sector Banks.
3. Project Sashakt: It is a five-pronged strategy to resolve bad loans and bring credit discipline in the banking sector.
4. RBI’s PCA: Prompt Corrective Action helps RBI takeover the functions of a bank showing distress.
5. 4R Strategy: To resolve NPAs, the 4Rs strategy of recognition, resolution, recapitalisation, and reforms were introduced.
6. EASE Reforms Agenda (Enhanced Access and Service Excellence): EASE has evolved over four annual editions from FY19 to FY22 and has catalyzed reforms in diverse areas in Public Sector Banks.

EASENext [2022]: It would comprise 2 major initiatives:

• EASE 5.0 (common PSB reforms agenda): It will focus on digital customer experience, and integrated & inclusive banking, with emphasis on supporting small businesses and agriculture.
• Bank-specific strategic 3-year roadmap (based on individual bank’s business priorities): It will entail strategic initiatives beyond EASE 5.0. The initiatives will be across diverse themes – business growth, profitability, risk, customer service, operations, and capability building.

Way Forward

1. Lending

• Strict enforcement of Provision Coverage Ratio: Provisioning Coverage Ratio (PCR) refers to the funds to be set aside by the banks as a fraction to the loans.
• PCA: Prompt Corrective action must be taken by the RBI in initial stages when banks show signs of distress.
• Avoid Evergreening: There is a need to curb evergreening of NPAs, which lead banks to write off many losses.
• Asset Restructuring Companies: ARCs will help restructure the assets, define haircuts, and transfer their ownership to one or more asset management companies.

2. Structural

• Governance Reforms: Reforms in the corporate governance of PSBs, including independent directors and audit committees, will ensure operational autonomy.
• Strengthening Bond Market: The well-developed corporate bond market and variant fixed income structure can also aid in the growth of banks.
• Protecting Depositors: The financial sector reforms in India seldom prioritized the protection of depositors and investors in the event of market failure.
• Blockchain Banking: Risk management can be more specific, and the neo-banks can leverage technology to further financial inclusion.
• Differentiated Banks: Essentially, these specialized banks would ease the access to finance in areas such as RAM (retail, agriculture, MSMEs).
• Risk Management: There should be a complete external benchmarking of loans to all the market-based floating rates that will promote natural interest-rate sensitivity on bank balance sheets.

3. Moily Committee Recommendations

• Lowering of Capital to Risk-weighted Assets Ratio (CRAR) requirement.
• RBI should provide a roadmap to banks to enable them to come out of PCA and resume normal operations.
• It recommended that National Company Law Tribunals resources be increased to enable them to dispose of such cases swiftly.
• Decentralise RBI powers like granting licenses, appoint and removal of directors etc.
• Incentives and higher remuneration for PSB employees.

4. Project Sashakt Recommendations

• Alternate Investment Funds: Alternative investment fund-based resolution approach for loans above Rs. 500 crores, under which an AIF would raise funds from institutional investors.
• Asset Management Company: The AMC will be set up by state-run banks for resolution of loans above Rs 500 crore.
• Bank Led Resolution Approach: For loans ranging between Rs 50 to 500 crores, institutions will enter into an intercreditor agreement to authorize and implement a resolution plan in 180 days.

The Banking system in India plays a vital role for growth of industries and also benefits the common person. Thus, it is important to resolve the underlying issues that pester in the sector and hinder the growth prospects of the nation.

NON-PERFORMING ASSETS

A non-performing asset (NPA) refers to a classification for loans or advances that are in default or in arrears. A loan is in arrears when principal or interest payments are paid late or missed.

Reasons of NPAs

1. Economy Related

• Global Economic Slowdown: Global markets were already facing issues of slow growth at both domestic and global levels.
• Challenges Posed by Pandemic: Such as low demand, reduction in consumption, which in turn may aggravate the risk of rise in NPAs.
• Economic slowdown: The slowdown causes poor corporate profits, which in turn leads them to not pay back the loan amounts.

2. Borrowing Related

• Low Profit and Effects of Lockdown: Due to low economic activity during lockdowns, many borrower groups have declared bankruptcy and insolvency.
• MSMEs: Have faced severe losses during the crisis, making it hard to compete with e-commerce, which rather grew in the lockdown period.
• Delayed Projects: Delayed projects increase project cost, making them unviable.
• Rise in Frauds: These frauds have been increasing, with no instances of high-profile fraudsters being penalized.

3. Bank Related

• Bad Lending Practices: Loans to borrowers with bad credit history and interference in loan approval procedures in general.
• Ineffective Recovery: Delays in dispute resolution and thus untimely recovery by banks and tribunals.
• Poor Monitoring: Bankers say there is a lack of rigour in loan appraisal systems and monitoring of warning signals at state-run banks.
• Priority Sectors: PSL sector has contributed substantially to the NPAs. NPAs for education loans stood at 7.61% in FY20.
• Loan Moratorium: Loan moratoriums have caused extra pressure on bank’s balance sheets.
• Evergreening: Fresh loans were given to some promoters to enable them to pay off their interest.

Impact of Rising NPAs

1. Economy

• Poor Ease of Doing Business: Rising NPAs can deter investors and entrepreneurs, damaging the business ecosystem.
• Poor Economic Growth: Risk-averse nature of banks leads to fewer new loans, hence reducing investment in the economy.
• Reduced FDI: The weak financial and banking system of the country is not preferred by investors. For example, in 2019, there was a reduction in NPAs, and in the same year, India was featured for the first time in the top 10 countries for receiving FDI.
• Reduced Growth and Increased Unemployment: Due to decreased investments in the economy.
• Credit Crunch: Many individual and corporate clients are unable to access credit through loans, hampering economic activity.
• Sectoral Growth: Many sectors rely on banking credit for their investments, and thus those sectors are impacted.

• Hurts Agro-based sectors: Food processing also accounted for 5.3% of total NPAs. Food processing is one of the most employment-intensive industries, and its growth also pushes the growth of agriculture.

2. Social

• Unemployment: Without NPA resolution, companies end up winding up, and thus workers are laid off.
• Priority Sector suffers: Banks may become apprehensive in lending to lower profiting sectors and thus impact the PSL norms.
• Developmental Projects: Many infrastructure projects in the social sector have been stalled due to cash crunch and impacted social welfare.

3. RBI

• Credibility Questioned: Since RBI has a regulatory role in the Indian banking sector, improper functioning of the banking sector raises questions on the credibility of RBI.
• Introduction of more rules and regulations: Stricter rules and regulations need to be set up to deal with the rising issues. Example: Prompt Corrective Action.
• Government vs RBI Tussle: The government looks to intervene to mitigate the impact of NPAs on the economy.

4. Banks

• Lower Profits: Due to increased provisioning norms and evergreening of assets.
• Risk to depositors: It can create mass hysteria as depositors fear their money will be lost.
• Reduce Profit Margin: The cost of funds increases, and the lending banks do not make any profit and, in some cases, do not receive the principal amount as well.
• High Interest Rates: The banks increase their interest rates in an effort to neutralize the effects of the NPAs.

Government Initiatives

1. SARFAESI Act 2002: Allows banks and financial institutions to auction properties (commercial/residential) when the borrower fails to repay their loans.
2. Fugitive Economic Offender Act: Seeks to confiscate properties of economic offenders who have left the country to avoid facing criminal prosecution or refuse to return to the country to face prosecution.
3. Debt Restructuring 2005: Aims to reduce the burden of debts on the company by decreasing the rates paid and increasing the time the company has to pay the obligation back.
4. Lok Adalats: Lok Adalat institutions help banks to settle disputes involving accounts in the “doubtful” and “loss” category, with an outstanding balance of Rs. 5 lakh.
5. Insolvency and Bankruptcy Code: This led to fundamentally changing the creditor-borrower relationship, taking away control of the defaulting company from promoters/owners.
6. 4R Strategy: Consisting of recognition of NPAs transparently, resolution and recovery of value from stressed accounts, recapitalisation of PSBs, and reforms in PSBs.
7. PSBs Reforms Agenda
   • More Scrutiny: Board-approved Loan Policies of PSBs now mandate tying up necessary clearances/approvals and linkages before disbursement.
   • Settlements: To ensure timely and better realization in one-time settlements (OTSs), online end-to-end OTS platforms have been set up.
   • Data: Use of third-party data sources for comprehensive due diligence across data sources has been instituted, thus mitigating risk on account of misrepresentation.

1. Joint Lenders Forum, 2014: It was created by the inclusion of all PSBs whose loans have become stressed.
2. RBI’s PCA: Prompt Corrective Action is a framework under which banks with weak financial metrics are put under watch by the RBI.
3. Mission Indradhanush: It helped create the Bank Board Bureau and recapitalisation.
4. New Bad Bank Structure: National Asset Reconstruction Company Limited (NARCL) and India Debt Resolution Company Ltd (IDRCL) – Budget 2021 proposed the establishment of a bad bank, NARCL, which will acquire stressed assets worth about Rs 2 lakh crore from various commercial banks in different phases, while IDRCL will then try to sell the stressed assets in the market.
5. Project Sashakt:

• Alternate Investment Funds: Alternative investment fund-based resolution approach for loans above Rs. 500 crores, under which an AIF would raise funds from institutional investors.
• Asset Management Company: The AMC will be set up by state-run banks for resolution of loans above Rs 500 crore.
• Bank Led Resolution Approach: For loans ranging between Rs 50 to 500 crores, institutions will enter into an inter-creditor agreement to authorize and implement a resolution plan in 180 days.

Way Forward

1. Operational
   • Resolution of Existing NPAs: With effective implementation of various government measures like Assets reconstruction councils, Insolvency and bankruptcy code, etc., for speedy and time-bound resolution of NPA.
   • Strengthening the Recovery Process: The recovery process needs to be strengthened further with speedy and clear procedures in place.
   • Prevention of New NPAs: Fixing accountability of bank officials, ensuring faster clearances to various stalled projects, establishing development banks for infrastructure projects, etc.
   • Risk Management: Financial intermediaries should make risk management in tune with the emerging contingencies.
   • Recapitalisation Plan: To help Public Sector Banks (PSBs) and private banks, a proper recapitalisation plan is needed to absorb the losses.
   • Empowering Management: The government’s stake in appointments must be reduced, and banks be able to appoint their own directors based on individual assessment and needs.
2. Structural
   • Autonomy: To provide Public sector banks with greater autonomy, the shareholding of the government can be reduced to less than 50 percent or 33 percent.
   • Mergers: Mergers can reduce the cost of funds for the banks and also consolidate and neutralize each other’s losses.
   • Reforms: Reforms in the governance and loaning sectors in sync with the need of crisis times are needed.
   • Loan Resolution Authority: This can help as an oversight authority to look into all lending and recovering activities.
   • Capital Infusion: The government must infuse at one go whatever additional capital is needed to recapitalise banks.
   • Strict enforcement of Provision Coverage Ratio: Provisioning Coverage Ratio (PCR) refers to the funds to be set aside by the banks as a fraction to the loans.

Best Practice:

Many countries in the past have established such companies to resolve non-performing loans.

• Korea: KAMCO, established in Korea in 1997, played a key role in acquiring and resolving financial institutions’ bad loans and corporate restructurings.
• Malaysia: Danaharta in Malaysia had a lifetime loan recovery rate of 58%.

The economic growth in India is led by the availability of easy credit; however, with the NPA issues, banks have been reluctant to loan, thus hampering growth. The NPA framework must be revised to ensure that no structural reasons exist for the rise in such assets, and by doing this, the banks can also function efficiently.

BANK RECAPITALIZATION

Bank recapitalization is a method to infuse new and fresh capital into banks to strengthen their balance sheet.

Modes of Recapitalization

• Budgetary allocation: Prior to 2017, capital infusion was done by the government to a bank through cash outgo from the Consolidated Fund of India, which led to fiscal pressure.
• Recapitalization bonds: Government issues recapitalization bonds to a PSB which needs capital. In turn, banks subscribe to the bond against which the government receives the money. Now, the money received goes as equity capital of the bank. So, the government doesn’t have to pay anything from its pocket.
• Fund raising from market.

Need for Recapitalization

1. For Banks

• Capital Adequacy Ratio: In compliance with RBI guidelines, which are based on Basel norms requiring banks to maintain a certain amount of capital reserves.
  • For example: Recapitalization has helped state-owned lenders improve their capital adequacy to 14.3% by December 2021 [RBI].
• To keep the banks afloat: As the state-run banks were struggling to deal with burgeoning NPAs, the government from time to time kept on announcing recapitalization to keep the banks afloat.
• Increasing loss absorption capacity: This infusion of liquidity helps in increasing the loss absorption capacity of the business during the time the management figures out ways and means to address the structural issues affecting the performance.

• Improved financials of bank: For instance, the government had initially budgeted Rs 20,000 crore for bank recapitalization for the year but cut it to Rs 15,000 crore in the revised estimates in acknowledgment of the improving health of PSBs.

2. For economy

• To revive the economy: In terms of asset size, state-run banks account for more than 70% of the entire market share in the Indian banking industry. Therefore, bank recapitalization is “essential” for the country’s economic revival.
• Improve credit flow: Recapitalization of banks will help strengthen banks’ balance sheet and encourage banks to lend more, thereby improving the credit flow in the system.

3. Other reasons

• Responsibility of government: As the government is the biggest shareholder in public sector banks, the responsibility of bolstering banks’ capital reserves lies with the government.
• For better working of bad bank (NARCL): Evidence from 135 major banks across 15 European Union nations and Switzerland showed that segregation of impaired assets (into a bad bank) worked when done along with recapitalization of the banks [ADB].

Problems with Recapitalization

1. For Government
   • Postponement of expenditure: In total, the Centre has issued recapitalization bonds worth Rs 2.79 trillion so far. These bonds will mature from 2028 to 2036. When they mature, the money for repayment will have to come from that year’s budget. Hence, the government of the day postponed expenditure.
   • Fiscal deficit: As per CAG, if bank recapitalization is shown in the fiscal deficit, the gap between the Union government’s expenditure and revenue would have increased.
     • For example: For FY18, the fiscal deficit would have increased to 3.7% against 3.5% shown in the Budget. Similarly, the Centre’s fiscal deficit would have risen to 3.9% of GDP in FY19, against 3.4% shown in the Budget.
   • Increase in government debt: As per the Status paper on Government debt, the issuance of recapitalization bonds in 2017-18 led to an increase in government debt both in absolute terms and as a percentage of GDP.
     • For example: The total liabilities of the central government increased to Rs 77.98 lakh crore in 2017-18 (from Rs 70.07 lakh crore in the year-ago). Similarly, as a percentage of GDP, liabilities increased to 46.5% from 45.9% a year ago — a 0.6% points jump.
2. For economy
   • Moral hazard: The absence of market discipline, implicit government guarantees, and repeated and unconditional recapitalization of PSBs could pose a moral hazard problem in banks [RBI Report on Currency and Finance 2021-22].
   • Treatment of expenditure: The CAG has raised its concerns over the treatment of expenditure of bank recapitalization during 2017-18 and 2018-19, stating that it was against the provision of the FRBM Act. The government had failed to show that recapitalization done in FY18 and FY19 is fiscally non-neutral.
3. Other reasons
   • Lower spending on social sector: As per RBI working paper (2022), due to bank recapitalization, households may be worse off because of lower government expenditure in social sectors.

1. Impact on privatization of sector: It is necessary to wean away PSBs from their dependence on government recapitalization; this will be an important pre-condition to achieve greater privatization of the sector [RBI Report on Currency and Finance 2021-22].

Way Forward

• RBI Working Paper [March 2022]:
  • Flexible lending rate: Bank recapitalization is best done in a flexible deposit/lending rate environment, as it leads to better transmission. However, during an easing cycle, it may result in lower spending by consumers due to a decline in interest income. Therefore, public policy may need to balance this trade-off.
  • Optimal policy mix: It may be important to fine-tune demand revival policies (via tax cuts or monetary expansion through an interest easing cycle) with appropriate and calibrated supply-side reform measures to achieve an optimal policy mix.
    • For instance, in the face of a cyclical decline in interest income, consumers may be encouraged to invest in liquid assets that exhibit counter-cyclical returns (e.g., gold bonds).
  • Bringing down need for future recapitalization: On the banking reform side, policies such as further improvements in the banks’ governance and adequate capital buffers may be actively pursued to provide a cushion against black swan shocks and reduce the need for future bank recapitalization.
• Incentive mechanism: To avoid the moral hazard problem of government recapitalization of PSBs, an incentive mechanism should be established. Banks with better performance in terms of loan recovery and asset quality improvement should be given priority in terms of access to fresh capital [RBI Report on Currency and Finance 2021-22].

BANK NATIONALISATION

According to the IMF (International Monetary Fund), nationalization is a process by which the government takes over private assets and brings them under public ownership. Nationalization of banks means to take the banks under government undertaking. 2019 marked the 50th anniversary of Indian Bank Nationalisation.

Benefits/Need/Advantages

1. Economic
   • Prevention of Monopoly: It helped the banks come out of the control of corporate families and their monopoly.
   • Increased Capacity: After the nationalization of banks, the branches of the public sector banks in India rose approximately by 800%, and deposits and advances took a huge jump by 11,000%.
   • Use of Surplus Profit: Under state ownership, the profit earned by banking enterprises could be utilized for the greater public good.
   • Banking inclusion: RBI records show that per capita deposits increased from Rs. 88 in 1969 to Rs. 4242 by 1995 and have further increased over time.
   • Centralized management: Helped provide uniform services throughout the country.
2. Social
   • Social Responsibility: It enabled banks to undertake their social obligations and not be solely profit-seeking.
   • Public Interest: Public deposits in the bank have increased so much that leaving it completely to the private sector might pose a challenge.
   • Financial Inclusion: Through its social welfare mandate, nationalised banks play a far better role in enabling financial inclusion.
   • Removed regional disparities: Bank nationalisation helped in more equitable regional growth since the banking system was concentrated in urban centres.
   • Development of the agriculture sector: It provided increased finance to agriculture, helping reduce exploitation of farmers by money-lenders.
   • Development of Priority Sectors: An important change after the nationalisation of banks is the expansion of advances to the priority sectors.

Issues/Challenges/Disadvantages

1. Structural
   • Non-Performing assets: Nationalisation increased the burden of government in bailing out banks due to NPA issues.
   • Lack of Autonomy: Management and working of these banks are not objective and are heavily influenced by political parties.
   • Multiplicity of rates and policies: Most banks offer different rates and different policy products.
   • Bureaucratic attitude: Employees are treated as government employees, and thus such an attitude leads to inefficiency.
   • Politicised: Such activities can benefit the government by concentrating finances under their supervision.
2. Operational
   • Poor Governance: Due to a lack of performance audits of banks, policy-making failed to ensure that finance was productively used.
   • Uncompetitive: Nationalization of banks has led to less competition between the public sector and private sector banks.
   • Unprofitable: Priority sector lending usually results in lending to risky and less remunerative sectors, which hampers revenue levels of the bank.
   • Failed in objectives: The Estimates Committee of Lok Sabha stated that nationalised banks have largely failed in achieving the main objectives of bank nationalisation, like removing regional disparities.
   • Increasing NPAs: Government pressure from the top for implementing even loss-making schemes or full waiver of loans for electoral benefits has led to an increase in NPAs to a dangerous level.

Way Forward

• Autonomy: It has been observed that banks operate much more efficiently when they have autonomy in their internal affairs.
• Privatisation: The government should reduce its stake in banks with a good track record. The Narsimhan committee had recommended 33%.
• Increase CSR: Increasing the corporate sector responsibilities can help the social sector, without the need for government nationalised norms.
• Rationalise Priority Sectors: Priority sectors must be rationalised and diverted to areas that have traditionally been under-productive.

Conclusion

Although bank nationalisation has its issues, the solution must be in consolidating the various irregularities within and making the system more transparent, autonomous, and uniform. Privatisation can be an option; however, in India, profit-making must not be a panacea but an exception.

PRIVATIZATION OF BANKS

Privatization is the process whereby the private sector assumes operational or financial control of public institutions.

Nationalization to Privatization

• Nationalization: In 1969, the government made the decision to nationalize the fourteen major private banks and six more in 1980.
• Objective: The objective was to harmonize the banking sector with the government’s socialist stance at the time.
• Privatization: In 2015, the government proposed privatization.

Impact of Nationalization

• Banking in Rural area: The nationalization of private banks in 1969 resulted in the opening of tens of thousands of branches in remote corners of the country.
• Employment: Job opportunities were created for a large section of educated youth.
• Increase in account opening: Forty-two crore ordinary people have opened bank accounts as a result of the immense contribution of state-owned banks in opening Jan Dhan Yojana accounts, a recent government initiative.
• Credit for all: Only after the nationalization of banks could small borrowers get credit, and there was a shift from class banking to mass banking.
• Free from moneylender: The nationalization of banking services also resulted in a decrease in reliance on private moneylenders in more remote areas.

Need for Privatization

1. Efficiency of private banks: Private sector banks are far more efficient, productive, and less corrupt than public sector banks.
2. Frauds in PSBs: Public sector banks have been disproportionately guilty of fraud the majority of the time.
3. NPA in PSBs: Numerous PSBs have a greater proportion of NPAs than private banks and lag behind private banks in profitability, market capitalization, and dividend payment history.
4. Recommendation of committees: Numerous committees had advocated reducing the government’s share in public banks to less than 51%.
   • The Narasimham Committee proposed 33%.
   • The P J Nayak Committee recommended a figure below 50%.
   • An RBI Working Group has proposed the incorporation of commercial enterprises into the banking industry.
5. Poor Performance in rural areas: Due to high operating costs and the existence of the barter system in most rural areas of India, the majority of rural branches operate at a loss.
6. Fail to respond: Public sector banks have not seen a major improvement in their financial standing despite years of capital infusions and governance changes.
7. Ease the burden of government: In order to lessen its burden of assistance, the government is attempting to privatize the weaker banks and bolster the stronger ones.
8. To reduce red-tapism: Banks’ seamless operation has been plagued by red-tapism, protracted delays, a lack of initiative, and an inability to make timely decisions.

1. Increase in market share of private banks: The market share of private banks for loans has increased to 36% in 2020 from 21.26% in 2015, while the market share of public sector banks has decreased to 59.8% from 74.26%.
2. Private sector banks are increasing employment: Private banks have not only expanded their branch network but have also generated new employees, whereas public sector banks have seen reductions in both categories.
3. Protect government exchequer: The government is attempting to lower the cost of its assistance by privatizing the weaker banks and bolstering the stronger ones.

Methods to Privatization

• Competitive Bidding: In this method, the shares and assets of the company are sold via tender. A business may decide to sell a project instead of the entire enterprise.
• Public Flotation of Shares: In this process, the shares of a government-owned company are sold to the public by listing them on the stock exchange.
• Private Placement: Private placement refers to the transfer of ownership to a small group of private investors. The government may decide to transfer the public company’s ownership to select individuals who meet their requirements and criteria.
• Dilution of Capital: In this method, rather than selling the shares of the public company, they are issued to private investors in order to raise capital. Consequently, the government’s stake in these companies is diluted.
• Management Employee Buyout: This entails the sale of a stake in the entire or a portion of the business to the employees.
• Mass Privatization: It is a method for privatizing a large number of businesses simultaneously. For this, a combination of the aforementioned methods is utilized.

Advantages of Privatization of Banks

• Increase Credit availability: Private banks are a market-share competitor to PSBs. PSBs have lost savings and loans to commercial banks. Since 2014-15, private banks and the SBI have driven practically all banking sector development.
• RBI Autonomy: Government ownership inhibits the Reserve Bank of India’s (RBI) capacity to regulate the industry.
• Increase Efficiency: Private sector banks are more modern and operate more effectively than their public sector counterparts.
• Attract FDI: Privatization would attract FDI since foreign investors prefer to invest in private sector banks over public sector banks.
• Enhance quality of banking: Private sector banks are obedient and highly serious about their job and responsibilities, but the majority of public sector banks lack these qualities. Privatization would also lessen India’s government’s financial load.
• Economic stability: The privatization of banks will have a favorable effect on the economy by fostering macroeconomic stability.
• Innovation in the Banking Industry: Private sector banks are always attempting to create new product avenues (new schemes, services, etc.) and assist industries in becoming experts in their particular domains by providing superior service and direction.
• Technology upgradation: With innovations come new technologies in the banking business, and these institutions are the leaders in a number of emerging industries. For instance, computerization of processes, credit card business, ATM service, etc.

Disadvantages of Privatization of Banks

• Impact on poor: There will be a negative impact on the middle class and the poor as a result of the privatization of banks.
• Affect social benefits: The primary objective of public sector banks is societal benefit, while private sector banks are profit-driven.
• May lead to monopoly: There is a strong possibility that a few private companies may establish a dominant market in their favor.
• Underreported NPA: Many private sector banks, including Yes Bank, underreported NPAs when the RBI reviewed bank assets in 2015.
• Financial exclusion: Private sector banks concentrate on the wealthier sectors of the population and metropolitan/urban regions, leading to the financial isolation of the poorer elements of society, particularly in rural areas. Ex: “Jan-Dhan Yojana” and “Pension Yojana” in PSBs.
• Affect Monetary policy transmission: PSBs are more efficient in transmitting monetary policy, which helps countercyclical monetary policy measures acquire traction.
• Job Loss: Privatization will result in the loss of jobs, the closure of branches, and financial isolation.
• Bailout: Bank unions have referred to the privatization process as a “bailout operation” for corporate defaulters. The private sector is accountable for a substantial amount of problematic loans. In truth, they should be held responsible for their acts.
• Issue in governance: Private sector banks are governed by the whims of various groups of individuals, not by public agreement.
• Less focus on rural areas: Private banks are falling behind in the deployment of rural ATMs. Ex: As of the end of 2020, there were a total of 33,312 rural ATMs, but only 6,112 were owned by private banks.
• Affect Agricultural credit: The majority of loans from private banks would go to the industrial and service sectors, while agriculture will be neglected. Ex: Private sector credit allocation to agriculture is just 13.94%.
• Threat to social justice: It’s possible that the SC/ST/OBC categories may lose their reservation privileges.
• Bailout by PSBs: Nationalized banks rescued failed private banks. AIBEA’s collection shows that 25 private banks merged with PSBs from 1969 to 2020. Ex: The YES Bank’s rescue by the SBI.

Measures taken by government

1. Budget 2021-2022: The government stated its intention to privatize two PSBs (Public Sector Banks) in the Union Budget for 2021-22 and authorized a program of strategic disinvestment of public sector firms.
2. NITI Aayog: The government think tank NITI Aayog has already recommended two banks and one insurance business for privatization to the core group of secretaries.
3. Banking Laws (Amendment) Bill, 2021:
   • The purpose of this bill is to amend the banking companies’ acquisition and transfer laws of 1970 and 1980, as well as the Banking Regulation Act of 1949, to achieve the privatization of two PSBs in order to meet the disinvestment goals outlined by Finance Minister Nirmala Sitharaman in the Union Budget 2021-22.
   • Indian Overseas Bank and Central Bank of India are two contenders for privatization of PSBs.
   • This will reduce the government’s minimum stake in PSBs from 51% to 26%.

Recommendation of various committees

1. Report recommendations from the NCAER
   • The two banks selected for privatization must have the best returns on assets and equity and the lowest nonperforming loans over the previous five years.
   • Due to the “scarcity” of possible large-scale investors in banks, the report also argues for corporate ownership of banks with due diligence.
   • Any possible risk may be mitigated by allowing a consortium of firms to participate in the bidding process, with the interest of any one company restricted.
2. Recommendations of PJ Nayak Committee
   • The government authorized the Bank Board Bureau, but it must fund its operation. Chairman and Managing Director might be divided. They should have a 3-5-year set term.
3. Recommendations of Narasimham Committee
   • The government may examine the notion of Narrow Banking. Under this regulation, weak PSBs will only be permitted to invest in short-term, risk-free assets. The performance of PSBs will improve as a result.

Way forward

• Action against Wilful defaulters: Wilful defaults on bank loans must be considered a “criminal offense” within an appropriate legal framework, which must be enacted immediately.
• Better risk Management: The overall degree of risk management at PSBs must be raised. This demands the strengthening of PSB boards without question. We must increase the number of qualified experts on PSB boards and increase their compensation.
• More Autonomy: In the banking industry, increasing autonomy for state-backed banks and rigorous regulatory control by the banking supervisor are required.
• Cleaning up of balance sheet: The cleaning up of bank balance sheets and the revision of India’s antiquated bankruptcy legislation are positive measures, but they can only produce fruit if accompanied by enhanced governance and regulation.
• Better governance: Privatizing PSBs won’t be straightforward, since it requires consent from unions and lawmakers. Privatizing banks won’t prevent fraud or reduce risk without better regulatory controls and governance.

COOPERATIVE BANKS

Co-operative Banks, which are distinct from commercial banks, were born out of the concept of co-operative credit societies where members from a community group together to extend loans to each other at favorable terms. Co-operative Banks are broadly classified into Urban and Rural co-operative banks based on their region of operation.

Importance/Need of Cooperative Banks

1. Economic

• Credit Inclusion: The chief objective of catering to the banking and credit requirements of the urban middle class.
• Formalizing banking: Besides protecting the middle classes and men of modest means from the clutches of moneylenders.
• Local interests: The movement provides the frugal section of the community an opportunity to invest their savings and helps people tide over periods of stress and strain.
• Deposits: Public deposits help banks in also extending credit as the bank’s corpus increases.
• Empowering SMEs: These banks are popular with retail savers and small businesses because they offer attractive interest rates on deposits, often higher than commercial banks.

2. Social

• Deposits: Public deposits help the banks in also extending credit as the bank’s corpus increases.
• Empowering SMEs: They are quite popular with retail savers and small businesses because they offer attractive interest rates on deposits, far higher than commercial banks.
• Rural Development: It helps credit access for those in the rural regions and also extends financial inclusion.
• Boosts Agri Credit: They helped in the introduction of better agricultural methods. Cooperative credit is available for purchasing improved seeds, chemical fertilizers, modern implements, etc.
• Reduce Moneylender culture: It has reduced the presence of loan sharks to extort high rates of interest from the people.
• Inclusivity: Cooperative banks have helped bring in all sections of people into the banking fold.
• Women Empowerment: Since many SMEs are owned by women, Co-op banks help women to establish themselves financially.

Issues/Challenges

1. Operational
   • Reduced Numbers: The number of UCBs operating in India has shrunk from 1,926 in 2005 to 1,551 by 2018.
   • Limited Reach: Financial limitations of the primary credit societies considerably reduce their ability to provide adequate credit to the rural population.
   • Low Cycling of funds: Large amounts of loan overdue hamper fund circulation.
   • Autonomy: Political interference is high, especially by local and state political parties.
   • Competition from PSB: As scheduled banks grow in size and expense, UCB loses their client base and thus liquidity.
   • Low level of recovery: Co-op banks have very low rates of loan recoveries which usually result in hampering the balance sheets.
   • Technology: UCB usually has slow or no technology upgradation in their services.
2. Regulatory
   • Government Interference: Due to cooperative legislation and administration, government interference has become a regular feature in the administration.
   • RBI Oversight:
     • This can lead to the central bank and state governments often ending up in courts over the powers of the RBI in overruling the management of the lenders.
     • Prior approval of RBI is mandatory for the opening of new branches of SCBs.
   • Weak Corporate Governance: Due to this, they are unable to prevent fraud and inadequate systems of checks and balances.
   • Weak Regulations: Supervision over key aspects is weak compared to those in Scheduled Commercial banks.
3. Others
   • Regional Disparities: The cooperatives in Eastern and Northeastern India are not as well developed as the ones in Maharashtra and Gujarat.
   • Prone to Failure: The recent PMC bank failure in Mumbai caused issues for the depositors.
   • Poor Capacity: Limited ability to mobilize resources and function autonomously.

Way Forward

• Modernisation: The banks should adopt modern banking technologies like internet banking, credit cards, ATMs, etc.
• Attractive Schemes: The banks should plan to introduce new schemes for attracting new customers and satisfy the present ones.
• Transition: Conversion of UCBs into Small Finance Banks as suggested by the high-powered committee on UCB.
• Replacement of Board of directors: This body can be replaced with a Board of Management.
• Bank Licenses: Defunct banks that do not hold public interest should be de-licensed by RBI.
• Better governance structure: In terms of top management and regulatory oversight.
• Digitisation: This can help the banks to improve customer services to a better extent.
• Expansion: RBI must make expansion norms easier for the banks so they can tap into unbanked regions and help financial inclusion.

Rama Subramaniam Gandhi Committee Recommendations

• Large UCBs can convert themselves into commercial banks to minimize risk.
• Conversion of UCBs will not be compulsory for large UCBs, and they can continue operating as they are.
• Licenses for conversion to operate as UCBs will be issued to well-managed and financially sound cooperative credit societies with a minimum track record of 5 years.

Malegam Committee Recommendations

• Constitute Board of Management: The main functions of BoMs include recommending action for recovery of NPAs, one-time settlement, and assisting the board in monitoring the same.
• RBI Oversight: RBI has wide discretion under the Banking Regulation Act of 1949 to formulate conditions under which a license can be given to a cooperative society.
• Segregation functions: A solution to the problem of dual control lies in the segregation of the ownership of the UCB as a cooperative society from its functioning as a bank.

The Indian banking system is versatile with a wide arrangement of many types of banking organizations and arrangements. Cooperative banks are crucial in rural and suburban areas to extend credit and function as banks. Thus, it becomes imperative that managing such banks becomes a priority to avoid any loss to public money.

BASEL NORMS

Basel norms are international banking regulations issued by the Basel Committee on Banking Supervision (BCBS). The Basel norms are an effort to coordinate banking regulations across the globe, with the goal of strengthening the international banking system. The Basel Committee has issued three sets of regulations, as of 2018 known as Basel-I, II, and III.

Objectives

1. Basel I: These rules were introduced in 1988, focusing originally on the credit risk faced by banks.
   • Capital Adequacy Ratio:
     • According to these guidelines, all banks were required to maintain a capital adequacy ratio of 8% of the credit risk.
     • The capital adequacy ratio is defined as the ratio of capital to risk-weighted assets. India adopted these guidelines in 1999.
   • Classification: The classification of capital was done into two groups:
     • Tier 1 – Core capital.
     • Tier 2 – Supplementary capital.
2. Basel II: Basel II was introduced in 2004 and aimed at more regulation than Basel I. India is currently following Basel II guidelines.
   • 3 Pillars: It introduced three pillars upon which regulation is to be conducted by banks:
     • Minimum Capital Requirements: Banks must maintain a minimum capital of 8% of risk-weighted assets. It also introduced Tier 3 capital, i.e., short-term subordinated loans.
     • Supervisory Review Process: Banks face three kinds of risks, so better risk management techniques are required.
     • Disclosure & Market Discipline: This requirement increased banks’ disclosure and compliance requirements.
3. Basel III: The introduction of Basel III guidelines happened because of the 2008 financial crisis, which highlighted serious flaws in regulation and compliance mechanisms. It was introduced in 2010.
   • Liquidity Ratios: Basel III introduced two liquidity ratios: Liquidity Coverage Ratio (LCR) and Net Stable Funds Rate (NSFR).
   • 3 Pillars: The three pillars of Basel III norms were:
     • Enhanced Minimum Capital Requirements
     • Enhanced Supervisory Review Process
     • Enhanced Disclosure & Market Discipline

Need for Adoption

• Rising Non-Performing Assets: India’s banks have a stressed asset pile of almost Rs 10 trillion, which hampers their ability to issue fresh loans.
• Policy Changes: The banking sector faces challenges due to recent policy and economic regulations such as demonetization and GST rollout.
• Poor CAR of Public Banks: Public sector banks in India are falling short of the stipulated capital requirements. Reports suggest that Indian PSBs needed Rs 2.4 lakh crore capital by 2019 to meet the norms.
• Investor-Customer Expectations: Banks now face the challenge of meeting stakeholder and customer expectations while complying with stringent new regulatory requirements.

Importance of Basel Norms

1. Positive
   • Risk Management: Reduces systematic risk and absorbs any economic or financial stress.
   • Supervision: Increases the bank’s supervisory roles.
   • International Arbitrage: Increases opportunities for international arbitrage.
2. Negative
   • ROE: The increase in capital requirements impacts the bank’s Return on Equity (ROE), especially in public sector banks.
   • Mergers: Banks may need to merge to raise the corpus of funds required to meet capital adequacy ratios.
   • Recapitalisation: The government will be burdened to recapitalise banks to reach Basel norms.
   • Weak Banks: These banks may not be able to manage their CAR and may end up merging or declaring insolvency.

Way Forward

• Implementation: Although implementing these requirements will take time, faster implementation benefits the Indian banking-led economy.
• Data Gathering: Given the significant changes, it is essential to quantify bank-related data to enable interoperability with other banks.
• Management: The top levels of the banks must ensure alignment in operations with other banks to avoid operational drags.
• Global Image: Implementing Basel III norms would enhance the perception of Indian banks and central banks globally.

Implementing Basel III norms will, undoubtedly, insulate Indian banks against domestic and financial shocks, consequently reducing spillover risks from the financial sector to the overall economy. Indian banks should embrace this opportunity to emerge as stronger, more efficient, and future-proof organizations.

RESERVE BANK OF INDIA

The Reserve Bank of India (RBI) is India’s central bank and regulatory body under the jurisdiction of the Ministry of Finance, Government of India. It is responsible for the issuance and supply of the Indian rupee and the regulation of the Indian banking system.

Composition

• The RBI’s affairs are governed by a central board of directors appointed by the Government.
• The central board consists of the Governor, not more than 4 deputy governors, 10 non-official directors nominated by the Government, and 2 Government officials.

Functions of the RBI

1. Traditional Role

• Banker to the Government: Performs all banking functions of the State and Central Government and offers useful advice on economic and monetary policy.
• Public Debt Management: Manages the public debt of India.
• Currency: Has the sole authority to issue currency notes in India.
• Foreign Reserves: Manages the country’s foreign exchange and sets exchange rates.
• Clearing House: Enables interbank claim settlements economically.
• Monetary Policy: Responsible for maintaining and stabilizing monetary policy in India, working through the Monetary Policy Committee.
• Quantitative Functions: Uses quantitative controls like bank rate policy, cash reserve ratio, and open market operations. Qualitative controls include selective credit control and rationing of credit.
• Qualitative Functions: Discriminates between various credit uses, e.g., favoring export over non-essential credit.

2. Developmental Role

• Financial Inclusion: Promotes banking habits for economic development. Examples include institutions like Deposit Insurance Corporation (1962), UTI (1964), IDBI (1964), NABARD (1982), NHB (1988).
• Priority Sector Lending: Ensures targeted credit reaches welfare sectors.
• Credit to the Needy: RBI policies ensure credit access for all societal sections.

3. Supervisory Role

• Non-Bank Financial Institutions: Issues directives on NBFC operations and inspections.
• Bank Mergers: Supervises bank mergers, assesses feasibility, and advises the government.
• Bank Licenses: Grants licenses to banks for initiating services or branch expansion.
• Cooperative Banks: Recent ordinances brought cooperative banks under RBI supervision.

Issues with the RBI

1. Functional

• Four Balance Sheet Problem: Involves banks, infrastructure companies, NBFCs, and real estate.
• Liquidity Crunch: Due to limited funds, impacting lending operations.
• Non-Performing Assets: Substandard assets hinder credit movement in the economy.
• High-Interest Rates: Small savings interest rates are often higher than bank rates.

• Cost of Funds: Most deposits are taken at fixed rates, making the cost of funds rigid and inflexible.

2. Institutional

• Autonomy: There have been allegations that the government’s influence on RBI affairs is increasing, with examples like the transfer of surplus funds by the RBI to the government.
• Not Market Oriented: Bank rates are suggested to be linked to external benchmarks or market trends.
• Poor Surveillance: The CVC report on the Nirav Modi case blamed RBI for poor auditing. The CVC had previously warned about the misuse of Letters of Undertaking (LoU), which was ignored by the RBI.

Impact of COVID

• Inflation: With more money flowing into the economy through relief packages, inflation is expected, particularly in food and consumer goods.
• Liquidity Crunch: Economic upheavals make people more reliant on cash, leading to reduced deposits as more people withdraw cash.
• Monetary Policy: It will be challenging for the RBI to ensure that monetary policy reflects the post-COVID economy’s needs.
• Non-Performing Assets: Due to economic slowdown, many banking assets are likely to be impacted, affecting asset quality and flexibility.
• Pump Priming: This involves injecting small amounts of government funds into a depressed economy to stimulate growth, with the RBI ensuring that the economy reaches its normal position.

Way Forward

• Multiple Indicator Approach: Consider multiple macroeconomic and financial variables in monetary policy decisions, rather than relying solely on M3 aggregate as in the past.
• Bad Banks: Establishing a “bad bank” may support the restructuring efforts of existing asset reconstruction companies (ARCs).
• Debt Management Companies: These entities could take on RBI’s debt management responsibilities, allowing the RBI to focus on other policy matters.
• Independence: Strengthen the fiscal independence of the RBI, with limited government interventions.