India
Financial Sector Assessment Program—Detailed Assessments Report on Basel Core Principles for Effective Banking Supervision

This paper discusses the findings of the assessments on Basel Core Principles for Effective Banking Supervision in India. The Reserve Bank of India is to be commended for its tightly controlled regulatory and supervisory regime, consisting of higher than minimum capital requirements; frequent, hands-on, and comprehensive onsite inspections; and a conservative liquidity risk policy and restrictions on banks’ capacity to take on more volatile exposures. Despite this strong performance, several gaps and constraints in the implementation of the regulatory and supervision framework remain. The most significant gaps are in the area of international and, to a lesser extent, domestic supervisory information sharing and cooperation.

Abstract

This paper discusses the findings of the assessments on Basel Core Principles for Effective Banking Supervision in India. The Reserve Bank of India is to be commended for its tightly controlled regulatory and supervisory regime, consisting of higher than minimum capital requirements; frequent, hands-on, and comprehensive onsite inspections; and a conservative liquidity risk policy and restrictions on banks’ capacity to take on more volatile exposures. Despite this strong performance, several gaps and constraints in the implementation of the regulatory and supervision framework remain. The most significant gaps are in the area of international and, to a lesser extent, domestic supervisory information sharing and cooperation.

I. Summary, Key Findings and Recommendations

A. Summary

1. The Reserve Bank of India (RBI) is to be commended for its tightly controlled regulatory and supervisory regime, consisting of higher than minimum capital requirements, frequent, hands-on and comprehensive onsite inspections, a conservative liquidity risk policy and restrictions on banks’ capacity to take on more volatile exposures. The Indian banking system remained largely stable during the global financial crisis. Since then, the government of India and RBI have taken additional measures to enhance the soundness and resilience of the banking system, such as the establishment of a Financial Stability and Development Council (FSDC), the implementation of a countercyclical provisioning regime, and the development of a roadmap for the introduction of a holding company structure.

2. Despite this strong performance, several gaps and constraints in the implementation of the regulatory and supervision framework remain. The most significant gaps are in the area of international and, to a lesser extent, domestic supervisory information sharing and cooperation. In addition, some previously observed weaknesses in the financial architecture, particularly with regard to the independence of RBI and the inherent conflict of interest when supervising state owned banks, remain. Also, the assessors identified a number of opportunities to better align current supervisory policies and procedures to international best practice. These include suggestions for improved coordination between the central office and the regional offices, increased interaction with auditors and private sector banks, more focused attention to banks’ internal risk-management models, a gradual move to more risk-based supervision and a revision of the RBI rotation policy to foster stronger supervisory expertise.

3. Indian banks have established significant overseas operations in more than 45 jurisdictions, but RBI has Memoranda of Understanding (MOUs) with only 2 jurisdictions and limited informal arrangements with several others, leading to material gaps in the flow of information. Although RBI has made some progress since the 2009 self-assessment, a significant informational gap remains—a gap that has not been filled through other means such as conducting its own overseas inspections (none since 2008). Importantly, Indian banks operate in a number of countries in unstable regions where it cannot be assumed that strong supervisory practices are in place. The assessors also noted gaps in the licensing process, as it was not clear that there was a systematic analysis of the quality of host-country supervision in reviewing overseas expansion proposals, nor a rigorous and consistent review of whether the home countries of foreign banks seeking to open offices in India practice consolidated supervision. As a home supervisor, it would also be good practice to establish and host supervisory colleges for the Indian banks that are internationally active.

4. The authorities have identified 12 financial conglomerates that are subject to a supplementary monitoring framework, but some areas for strengthening consolidated supervision practices remain. For instance, RBI cannot order inspections of other subsidiaries it does not regulate, carry out transaction testing at such subsidiaries, or obtain copies of inspection reports directly from their regulators. A proposed amendment to the BR Act would, if enacted, address this deficiency. In the immediate term, the assessors believe that RBI should look for ways to ensure it receives inspection reports directly from its peer supervisory agencies to reduce any delays in receipt. The current practice is to obtain such reports from the parent bank at the time of the inspection. Other opportunities for enhanced consolidated supervision include limiting the participation at a segment of interagency meetings to regulators only, thus creating a forum for frank and candid conversation without bank representatives present. Finally, the methodology for rating banking companies should be reconsidered so that the rating methodology explicitly provides for a mechanism to reflect contagion risk from nonbanking subsidiaries in a systematic way.

5. Although no instances of de facto government interference were observed, several legal provisions in the RBI Act and the BR Act limit the de jure independence of RBI. Some legal provisions in the BR Act and RBI Act allow the central government to give directions to RBI, to require it to perform an inspection, to overrule its decisions, and to supersede the Central Board of RBI. While, in practice, these have never been used, the removal of these provisions would provide greater legal certainty regarding the independence of RBI. Also, the formal grounding of RBI independence in the RBI Act would further strengthen its autonomy. Finally, the reasons for the removal of the head of the supervisory agency during his/her term are not specified in law.

6. With regard to state-owned banks, an employee of RBI still acts as a nominee director on each of their Boards. RBI’s remedial powers are also more limited. After the 2006 amendment to the Banking Companies (Acquisition and Transfer of Undertakings) Act 1970/1980, central government, on the recommendation of RBI, nominates a person possessing necessary expertise and experience in regulation or supervision of commercial banks, as a director of a nationalized bank. The provision does not mandate that such person should be an employee of RBI. In practice, however, the nominee director is a current employee from RBI from a department other than bank supervision. From the assessors’ discussion with banks, it appears that this director takes a rather active role in the Board’s discussions and is sometimes implicitly relied upon to ensure regulatory compliance. This blurs the lines between the supervisory role of RBI and its assumed role as the Board’s compliance guardian. The authorities should consider providing greater clarity to the limitations of the nominee director’s role in order to avoid the appearance of RBI becoming involved in a bank’s internal control processes. As the statutes constituting public banks empower them to do banking business, there is no provision empowering RBI to disempower such banks from carrying on banking business. RBI can also not remove officers/directors of a public bank, except directors appointed by shareholders other than the central government. Furthermore, as a more general observation, there remains considerable discretion in the Prompt Corrective Action (PCA) regime to allow a bank to continue to operate for, potentially, in excess of a year, with extremely low capital; given the capital to risk-weighted asset ratio (CRAR) is a total capital concept, a 3 percent total capital level could involve very little (common) equity. If such discretion were exercised regarding a public bank, the government would presumably take action at some point.

7. RBI has a large number of regional offices, each in charge of supervising its assigned banking population, leading to coordination challenges. That the off-site monitoring function (at central office) is largely separated from the on-site supervision function at the regional offices presents some challenges that RBI acknowledges. We also believe that it should build on the current program of interaction among the regional office inspectors as a group and the central office by establishing a regular forum for inspectors to go through findings, insights, and questions, particularly when new supervisory approaches or regulations are being introduced. Doing this in a structured and consistent way would not only support strengthened supervisory judgments made by RBI examiners, but also the capacity to develop a broader horizontal perspective on bank’s risk-management practices. More generally, increasing the focus in the annual financial inspection (AFI) process on critically assessing risk-management practices is encouraged, including a stronger focus on assessing the quantity of people and skill level of people in risk management and control functions.

8. Indian banks are increasing their risk-management sophistication and RBI has announced its timetable for the move toward the implementation of the Basel II advanced approaches. Comprehensive and robust internal supervisory guidance for the assessment of the Internal Capital Adequacy Assessment Process (ICAAP) was developed and banks have submitted their ICAAPs. That said, discussions with banks reveal that many challenges remain for migration to the Basel II advanced approaches. Most relate to constraints on data, tools, and methodologies, and the required skills for the quantification and modeling of risks as well as the validation of these models. The RBI will have to consider how to address a range of practical implementation issues consistently. Going forward, it will also have to reflect if, and how, current supervisory policies and practices have to be strengthened for effective supervision of banks applying the Basel II advanced models on an ongoing basis.

9. With the increased use of risk modeling, there is a need to devote more supervisory attention to risk models that are used for risk-management purposes, even if they are not generating inputs for the regulatory capital calculation. A formal regulatory requirement for banks to develop and implement a sound model validation policy would be a first step in that direction. RBI examiners should then also develop a system of periodic validation and independent testing of models in banks.

10. RBI is looking to take various action steps that could address a number of the concerns outlined above:

  • RBI has proposed changes in the banking law. These changes would provide it access to information from banking companies about their associated enterprises (including nonbank financial companies) on a more timely and certain basis, and give it an ability to order inspections of nonbank subsidiaries of banking companies, that would address many of the domestic coordination challenges.

  • RBI is moving ahead on putting in place more MOUs to address some of the concerns on home/host coordination.

  • RBI has taken initial steps toward a more risk-based supervision approach. Risk-based supervision attempts to vary the scope and intensity of supervision according to the level of risk individual institutions pose. In the medium term, risk-based supervision can optimize supervisory resources. The assessors recommend RBI continue its phased approach toward implementation by gradually integrating more forward-looking elements in the supervisory process and focusing attention beyond the rectification of deficiencies observed during the onsite inspection.

11. RBI has launched an initiative to consider modifications of elements of the supervisory process for the largest banking groups. We have been advised that a steering group, led by a deputy governor, began a year-long review process in April 2011 to consider a range of potential changes. As the review began, the Department of Banking Supervision (DBS) announced some restructuring of its operations to move the off-site monitoring process closer to the on-site inspection process. We were also advised orally (although we have not seen documentation to this effect) that the DBS will establish a new supervisory regime for the largest (12) banking companies, which have been designated as systemically important in India, involving such elements as (a) supervisory responsibility being moved from the regional offices (including from the Mumbai regional office) to the central office; and (b) the central office planning to shift away from the current once a year approach to a supervisory approach that is more continuous, with targeted reviews conducted of an individual banking company or a cross-section of firms, focusing on areas of potential concern that have been seen through the monitoring process. We believe such a program, if it is well developed and well implemented, has the potential to improve a number of our areas of concern such as increasing the risk focus of supervision, linking monitoring and on-site inspections more effectively, enhancing the consistency and effectiveness of the supervision of systemically important firms, and helping to develop specialized expertise that will be increasingly necessary as Basel II and III are adopted.

12. Further steps to enhance the specialized expertise of supervisory personnel should also be taken—specifically, to review the current rotation policy for supervisory staff, which limits the build-up of expertise in banking supervision and regulation. In view of the intensity of changes in financial regulation (particularly Basel II and Basel III), as well as the increased complexity and globalization of supervised entities, the assessors are of the opinion that RBI’s rotation policy is outdated and should be revised. This could be achieved in a phased manner; for example by narrowing rotation areas for supervisors to similar areas of expertise, i.e., limited to DBS, Department of Banking Operation And Development (DBOD) and other departments involved in the supervision of NBFIs. To address concerns of regulatory capture, rotations of supervisors assigned to specific supervised entities should be implemented.

13. Finally, and very broadly, with RBI now represented on the G-20, the FSB, and the Basel Committee on Banking Supervision, it has the opportunity to influence the direction of the global policy debate. The capacity to do that would be enhanced with some structural changes within RBI to prepare representatives at the various meetings more effectively, through better coordination and focus between Departments within RBI.

B. Information and Methodology Used for the Assessment

14. This assessment of the current state of compliance with the BCPs in India has been undertaken as part of the joint IMF-World Bank Financial Sector Assessment Program (FSAP).1 The assessment was conducted from June 15 till July 1, 2011. It reflects the banking supervision practices of RBI as of the end of May 2011 and covers only commercial banks.

15. The assessment is based on several sources: (i) a complete self-assessment prepared by the RBI in 2011 as well as in 2009;2 (ii) detailed interviews with the RBI staff at the head office as well as the regional office in Delhi; (iii) a review of laws, regulations, and other documentation on the supervisory framework and on the structure and development of the Indian financial sector; (iv) a review of a number of on-site and off-site examination reports and correspondence with banking companies and auditors; and (v) meetings with the Ministry of Finance, state-owned banks, private sector banks, foreign banks, and an external auditor, as well as the banking association.

16. The assessment was performed in accordance with the guidelines set out in the Core Principles (CPs) Methodology.3 It assessed compliance with both the “essential” and the “additional” criteria, but the ratings assigned were based on compliance with the “essential” criteria only. The methodology requires that the assessment be based on the legal and other documentary evidence in combination with the work of the supervisory authority as well as its implementation in the banking sector. The assessment of compliance with the CPs is not, and is not intended to be, an exact science. Banking systems differ from one country to the next, as do their domestic circumstances. Furthermore, banking activities are changing rapidly around the world, and theories, policies, and best practices of supervision are swiftly evolving. Nevertheless, it is internationally acknowledged that the CPs set minimum standards.

17. This assessment is based solely on the laws, supervisory requirements, and practices that were in place at the time it was conducted. However, where applicable the assessors made note of regulatory and supervisory initiatives which have yet to be completed or implemented. The assessment team enjoyed excellent cooperation with its counterparts and, within the time available to perform their work, reviewed all the information provided. The assessors thank the authorities for their openness and active involvement in the process.

C. Institutional and Macroprudential Setting, Market Structure Overview

18. India has recovered strongly from the fallout from the global financial crisis. GDP grew by 8¼ percent in 2010 and is forecast to grow at 7¾ percent in 2011, driven by domestic demand. A number of reforms related to infrastructure finance have been successful, but progress on the broader structural agenda, including in the financial sector, has been slow. Inflation remains a key concern, with headline inflation above 8 percent annually since mid-2008. While the RBI has gradually lifted policy rates over the past year, real interest rates remain negative and markets are increasingly worried about inflation. Continued inflation and higher policy rates could affect growth prospects and ultimately have an impact on financial stability. With foreign direct investment and equity flows falling, concerns about excessive inflows and rupee appreciation have diminished, and recent strong export performance has helped contain the current account deficit. On the other hand, a trend toward short-term capital inflows raises concerns about sustainability. Going forward, high oil prices, inflation, and weaknesses in governance represent risks to the balance of payments and could impact financial stability.

19. The financial sector is diversified, highly interconnected, and expanding rapidly. It comprises commercial banks, cooperative banks, nonbanking financial institutions, insurance companies, and mutual funds, with overall assets of about 150 percent of GDP. Commercial banks are the largest group, comprising nearly 60 percent of total financial assets. Financial firms are interconnected through ownership and funding relationships. Major banks own insurance companies, fund management companies, and securities firms. Banks, nonbank financial companies (NBFCs), and mutual funds are linked through the wholesale funding market.4 Industrial companies are not allowed to own banks, but the authorities are looking at new norms for bank licensing and proposals for a holding company structure that would permit mixed conglomerates.

20. Public banks dominate the banking sector, and the government plays an active role in banks’ asset allocation. Majority government-owned banks account for nearly three-fourths of total banking assets. The government’s share in the capital of public sector banks is now close to the 51 percent statutory minimum, limiting the banks’ ability to raise additional private equity (unless the government purchases additional shares). A sizable portion of banking assets is held in government securities under a 24 percent minimum statutory liquidity requirement. Banks are an important conduit for lending to priority sectors—such as agriculture, small-scale industries, and exports—with lending targets to priority sectors at 40 percent of total loans and advances for domestic banks and 32 percent for foreign banks. Lending to infrastructure and real estate has grown rapidly in recent years, the former actively promoted by the authorities, including through a relaxation of prudential standards.

21. Increasing access to finance in a prudent, sustainable, and responsible manner is a key priority for the authorities. A large section of India’s population has little or no access to financial services. Measures to promote access to banking services include ‘no frills’ accounts; simplified know-your-customer rules for small accounts; incentives for banks to open bank branches in under-served areas; business correspondent/agent models; and mobile phone banking. There is a large institutional framework to promote financial inclusion, which includes rural cooperative banks; specialized regional rural banks sponsored jointly by public sector banks and the government; and a number of development finance institutions such as the National Bank for Agriculture and Rural Development (NABARD) and the Small Industries Development Bank of India (SIDBI).

22. There is a strong institutional framework for financial oversight. The RBI regulates banks and some nonbank financial companies (NBFCs). The Insurance Regulatory and Development Authority (IRDA) regulates insurance. The Securities and Exchange Board of India (SEBI) regulates the spot and derivatives markets of various financial instruments, and the Forward Markets Commission (FMC) regulates the commodity futures market. The Pension Fund Regulatory and Development Authority (PFRDA) is meant to regulate the nascent pension fund industry, though its enabling legislation is yet to be approved. In rural finance, NABARD is both a credit provider and a supervisor of cooperative banks (other than primary cooperative banks) and regional rural banks. Jurisdiction of the major regulators is generally well demarcated, but there remain gaps and areas of overlap. The government has recently established a Financial Stability and Development Council (FSDC), comprising the financial regulators and chaired by the Union Finance Minister.

D. Preconditions for Effective Banking Supervision

23. RBI is tasked with the regulatory oversight of the payment and settlement systems in the country. The smooth functioning of the payment and settlement systems is a prerequisite for the stability of the financial system. The legal framework for the oversight role of RBI is provided by the Payment and Settlement Systems (PSS) Act, 2007 and the Payment and Settlement System Regulations. Following this Act, RBI has been provided a sound and well-founded legal basis for regulation and oversight of payment and settlement systems. The Act clearly defines settlement finality and provides an explicit legal basis for multilateral netting. The findings of the 2009 CPSS Core Principles self-assessment are that the existing payment system operates cheaply and efficiently, with minimal systemic risk.

24. Nevertheless, a number of measures have been suggested to further strengthen the efficiency of payment and settlement systems. These include (i) shifting high-value transactions to a more secure electronic payment system, like real time gross settlement system (RTGS); (ii) combating credit card fraud; and (iii) steps to optimize the utilization of the electronic payments infrastructure and reduce the charges for such transactions. The current low utilization of the electronic payments infrastructure can be increased with the use of technology to make the facilities more accessible to customers, thus optimizing the use of this infrastructure and achieving greater financial inclusion.

25. Despite numerous recent legislative changes, significant weaknesses in the insolvency framework remain. Insolvency is governed by a multiplicity of laws in India and the process of registering security interests remains difficult. For creditors seeking to recover debts from borrowers, the primary tools are the Debt Recovery Tribunals (DRT) and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI, 2002), both of which present significant limitations. Both tools result in relatively low returns for creditors and long time periods needed for liquidation. Delay in the recovery proceedings result in a slow-down of credit growth and the drying up of funding for creditworthy borrowers, which prevents its proper utilization and recycling.

26. The accounting profession appears to be well established and convergence with IFRS is planned for 2013. The India Institute of Chartered Accountants of India (ICAI) sets the accounting standards, but RBI can, in agreement with the ICAI, require specific carve-outs or modifications for commercial banks. This has been done in the area of provisioning and disclosure. RBI is in the process of preparing prudential guidelines for alignment of Indian accounting standards with international accounting standards by 2013. Convergence with IFRS is even more important, given that a number of Indian banks are expanding globally. That said, more awareness should be created about international finance reporting standards (IFRSs) among auditors and all others who are involved in the process, as well as to ensure that they are able to put in place systems and procedures to comply with IFRS.

27. India is one of the earliest countries to have adopted International Standards on Auditing, but it needs to take some proactive steps in implementing them more effectively. This can be achieved by issuing more technical guidance and other literature to help small and medium practitioners to understand standards. The functioning of the Quality Review Board should start at the earliest, and steps need to be taken to accelerate the process of making the Board of Discipline and Disciplinary Committee functional. The Quality Review Board also needs to play a more proactive role as an independent oversight body for the auditing profession in India. The principal auditor of the company should have access to the working papers of auditors. Finally, there is a need to give functional independence to Auditing and Assurance Standards Board (AASB).

28. The legislative framework for AML/CFT has been set out in the Prevention of Money Laundering Act (PMLA) 2002. The respective regulators have issued guidelines for entities regulated by them. A number of initiatives have been taken by various regulators in the financial sector, such as issuance of guidelines for submission of Currency Transaction Report (CTR)/ Suspicious Transaction Report (STR) to the Financial Intelligence Unit (FIU), and preservation of records as well as guidelines on wire transfers to banks. Major areas where action needs to be taken to further strengthen the AML/CFT practices and align them with international standards are the effective implementation of record-keeping requirements and a robust regime for submission of STRs.

Effective market discipline

29. Listed companies are subject to a modern continuous disclosure regime, and banks are subject to specific disclosure requirements, which include publication of their annual reports. RBI prescribes key elements to be disclosed, including the entities’ governance and risk-management arrangements, as well as audited financial statements. The RBI also publishes financial statement information on the industry. There is a need for strengthening the disclosure mechanism to bring about greater transparency in ownership structures, and stringent penal action needs to be taken where nontransparent practices are unearthed. The implementation of IFRS in India is generally expected to further reinforce effective market discipline.

Mechanisms for providing an appropriate level of systemic protection (or public safety net)

30. RBI has broad and strong lender-of-last-resort (LoLR) powers, but they are under review to assess international lessons learnt during the global financial crisis. Under section 17 and 18 of the RBI Act (‘war-time’ powers), RBI has wide discretion to lend to economic agents in support of its policy goals. In this respect, RBI has enormous powers and a wide variety of instruments to meet crisis situations. That said, given the increasing integration of global markets, the global financial crisis has necessitated the need for a re-look at the conventional role of LoLR. Accordingly, RBI has constituted a working group to look into issues relating to liquidity with a specific mandate to examine (i) the powers available as per the provisions with RBI as regards its role of LoLR; (ii) the scope for putting in place a mechanism whereby the same can be activated at the shortest possible notice; and (iii) the scope for expanding the instruments that can be permitted for providing liquidity.

31. The existing instruments are considered adequate and RBI does not encourage a system of providing, ex-ante, any assurance about its emergency support. An ex ante assurance would be a source of moral hazard. RBI’s interventions depend on specific circumstances and judgment about contagion and systemic stability. Furthermore, RBI has at present the choice of using conventional and unconventional measures as needed. Any blueprint for LoLR has the potential to constrain RBI from using unconventional measures in times of extreme market distress, as many central banks did to bail out afflicted firms in the current crisis.

32. A deposit insurance system is in place. The Deposit Insurance and Credit Guarantee Corporation (DICGC) is a wholly owned subsidiary of the RBI. Deposit insurance extended by DICGC covers all commercial banks, including local area banks, regional rural banks, and urban cooperative banks in all the states and union territories (UTs).

33. The governance arrangements for domestic crisis management are being strengthened. Even as RBI has implicitly been the systemic regulator in India, other financial sector regulators, too, have important responsibilities. Beyond the regulators, the global crisis has demonstrated the importance of the coordinating role the government has to play, especially in times of stress. The post-crisis focus on establishing an institutional mechanism for coordination among regulators and the government has culminated in the establishment, in December 2010, of the Financial Stability and Development Council (FSDC) to be chaired by the Union Finance Minister. The FSDC is to be assisted by a sub-committee to be chaired by the governor of RBI. This structure attempts to strike a balance between the sovereign’s objective of ensuring financial stability to reduce the probability of a crisis and the operative arrangements involving the central bank and the other regulators. While the sub- committee is expected to evolve as a more active, hands-on body for financial stability in normal times, the FSDC would have broad oversight and would assume a central role in crisis times.

34. Steps to reinforce contingency planning and coordination among regulations in times of stress remain. While the governance structure has been agreed upon, contingency plans and action plans are not yet established. It is essential that extensive cross-sectoral cooperation takes place to identify threats to the stability of the Indian financial sector and to test contingency plans and structures to mitigate such threats. Also, responses in the resolution of potential financial crises should be coordinated among participating authorities.

E. Main Findings

Objectives, Independence, Powers, Transparency and Cooperation (CP 1)

35. The independence of the RBI is not enshrined in the law and there are some legal provisions that could seriously undermine the independence from the government. In practice, however, the assessors have not come across evidence of government or industry interference. Legal provisions in the Banking Regulation Law and the Reserve Bank of India Act allow the central government to give directions to RBI to require it to perform inspections, to overrule decisions, and to supersede the RBI Board. Although these provisions have never been used in practice, it would be beneficial to remove them from the law so as to provide greater legal certainty. Finally, RBI does not have the power to disempower a public bank to carry on banking activities. The reasons for the removal of the governor of RBI are not specified in the law, although there have been no instances where the governor has been dismissed without a valid reason and the rules of natural justice apply, the explicit specification of the reasons for dismissal in the law would be better aligned with good international practice. The governor is also not appointed for a minimum term but for a maximum term, with the possibility of reappointment.

36. In public sector banks, which make up a major part of the financial system, an RBI representative still acts as a Director on the Board. In practice, this representative is a current employee from RBI from a department other than banking supervision. It appears that this person takes on an active role in the Board discussions and is sometimes implicitly relied upon to ensure regulatory compliance. This provision has the potential to blur the distinction between RBI’s legal powers as a banking supervisor and its involvement in actively managing a bank. Hence, at a minimum, greater clarity should be provided to the banks as to the limitations of the role.

37. Legal protection for bank supervisors is in place and, as a matter of practice, the employees costs of defending actions made while discharging their duties in good faith are borne by RBI. Some enhancements could be made to the current arrangements. Ideally, the Act should specifically state that the legal protection provided to RBI employees is not limited in time (i.e., provides protection beyond the termination of appointment or employment). Also, at a minimum, it is necessary that protection against incurring the costs of defending the actions of supervisors is stated clearly and explicitly (at least at the level of internal procedures), including the financing of any expenses since the start of the legal proceedings.

38. RBI has entered into MOUs with other foreign supervisory authorities and has received approval from the central government for this purpose. It does, however, lack extensive formal or informal supervisory information-sharing arrangements. Given the large and growing dimension of overseas activities of Indian banks in many foreign jurisdictions, including some unstable and high-risk countries, the absence of arrangements for supervisory information sharing should be addressed as soon as possible. RBI also does not have direct access to call for information for any entity in the banking group. The proposed amendment to Section 29A of the BR Act under the Banking Law Amendment Bill 2011 is expected to remedy this gap in the future.

Licensing and Structure (CPs 2–5)

39. India has a sound framework for granting banking licenses and overseeing prospective ownership changes, and intended expansion of banks. There is a clear line of demarcation between bank and nonbanks, and a well-defined set of activities that banks can engage in directly or indirectly. Improvement opportunities exist in aspects of controlling foreign bank entry and Indian bank expansion overseas, as well as ensuring in the licensing process that strong risk-management programs will be implemented by new banks.

Prudential Regulation and Requirements (CPs 6–18)

40. RBI has set prudent and appropriate minimum capital adequacy requirements and has defined components of capital in accordance with internationally agreed guidelines. That said, many challenges remain for migration to the Basel II advanced approaches. Most relate to constraints on data, tools, and methodologies, and the required skills for the quantification and modeling of risks, as well as the validation of these models. RBI will also have to consider how to address a range of practical implementation issues consistently, and how supervisory policies and practices may have to be enhanced for effective supervision of banks applying the Basel II advanced models on an ongoing basis.

41. The assessors identified several other areas for strengthening of prudential regulation. One relates to the establishment of a requirement for periodic and rigorous risk model review and validation by banks, even for risk models that are not used as input for regulatory capital purposes. There is also a need to ensure that prudential guidance is issued and applied to the consolidated banking group rather than just to the bank.

42. The prudential framework in India is characterized by concentration limits that are significantly higher than international best practice and a too-general definition of connected counterparties. The default of a borrower or a group of connected borrowers can cause a serious loss to a banking group. The current large exposure limit is a maximum of 55 percent of a banking groups’ capital. The assessors also recommend that more guidance and more frequent and detailed onsite verification of the criteria for the determination of “connected exposures” is required. This could take the form of a broadening of the guiding principles; for example, by including cross-guarantees between entities or financial interdependency that result in the entities becoming one single risk.

43. Some other areas for strengthening the prudential framework were identified. These include the definition of related parties as well the requirements for arm’s-length transactions. Furthermore, a formal legal or regulatory requirement to inform RBI immediately of any adverse developments in operational risk should be introduced. The internal control framework in banks can be enhanced by ensuring that updates on developments affecting the fit-and-proper test for existing directors are received, as well as ensuring a stronger focus in the AFI process on assessing the quantity of people and skill of people in risk management and control functions.

Methods of ongoing banking supervision (CPs 19–21)

44. RBI supervises the direct activities of banks with a well-defined set of on-site supervisory practices, extensive regulatory reporting, and improvement of off-site monitoring techniques. Emerging global practices are being introduced, although more structured interaction between the in-house regulatory areas and field inspectors would enhance the rigor and consistency of new procedures being introduced. RBI largely defers to functional supervisors of nonbank affiliates domestically, and to foreign supervisors of overseas offices and subsidiaries, for hands-on supervision of operations subject to their jurisdiction, although regulatory reports to RBI do cover such operations. There are also challenges in ensuring that appropriately specialized supervisory expertise is developed and maintained, particularly in light of RBI-wide rotational policies.

Accounting and disclosure (CP 22)

45. There is room for improvement in the frequency and intensity of interaction between RBI and external auditors and the access rights to the external auditor’s working papers. Although RBI does not have direct authority to rescind the appointment of the external auditor, it can, and has in the past, withdrawn the approval of the appointment of the external auditor.

Corrective and remedial powers of supervisors (CP 23)

46. RBI has broad discretion in the range of remedial actions it can take to address problem situations, a prompt corrective action regime, and a set of tools to use in problem bank resolution. This architecture is sound in relation to private sector banks, but is not generally applicable in practice to dealing with problems in public sector banks, which make up the largest percentage of the Indian banking market.

Consolidated and cross-border banking supervision (CPs 24–25)

47. RBI has begun efforts to improve its focus on consolidated supervision on cross-border banking supervision. It has established more structured forums for interaction with domestic functional regulators and beginning the process of improved information flow and coordination with foreign supervisors through executing MOUs. RBI could broaden its supervisory focus domestically through changing its practices for obtaining information from firms, using a more appropriate construct for evaluating consolidated firms, and interacting more effectively with functional regulators; a proposed statutory amendment would also improve consolidated information access by the RBI.

Table 1.

India: Summary of Compliance with the Basel Core Principles

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Table 2.

India: Recommended Action Plan to Improve Compliance with the Basel Core Principles

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F. Authorities’ Response

48. RBI welcomes the comprehensive review of banking regulation and supervision in India by the joint IMF-World Bank team. The deliberations leading to this assessment have been quite extensive, comprehensive and productive. The assessment has been with respect to the highest international standards and we welcome the opportunity to comment on it.

49. The assessment recognizes that the Indian banking system remained largely stable on account of tightly controlled regulatory and supervisory regime by RBI. Notwithstanding our strong performance in the recent past, the assessment identifies several gaps and constraints in the implementation of regulatory and supervisory framework. The most significant gaps identified are in the area of international, and to a lesser extent, domestic supervisory information sharing and cooperation. Consolidated supervision of financial conglomerates, and some limits on the de jure independence of RBI are the other major gaps identified in the assessment. Nevertheless, the assessment also recognizes that RBI has been striving to address these gaps and, while RBI lacks de jure independence, there has been no de facto interference from the government.

50. As regards these observations, we recognize that there is no room for complacency, even as India has emerged relatively unscathed from the crisis. As a member of Financial Stability Board, Basel Committee on Banking Supervision, and IMF, India is actively participating in post crisis reforms of the international regulatory and supervisory framework under the aegis of G-20. India remains committed to adoption of international standards and best practices, wherever necessary, and in a phased manner and calibrated to local conditions to suit our best interests. However, it is our intention not only to implement the international standards and best practices, but also be ahead of the minimum requirements. We have taken several steps in the past to address systemic risk issues which are now becoming the international norms.

51. With regard to the recommendation regarding the supervisory information sharing and cooperation, efforts are vigorously on to establish information sharing mechanisms with various jurisdictions where Indian banks are operating. We have information sharing arrangements with four jurisdictions and MOUs with another 12 jurisdictions are expected to be reached shortly. Further, RBI also has informal arrangements with major jurisdictions for information sharing. Nevertheless, we recognize the importance of establishing information sharing arrangements with other jurisdictions. However, this is a time consuming process and we hope to establish appropriate information sharing networks as quickly as possible. Efforts are also on to establish supervisory colleges, so as to increase the efficacy of supervision.

52. RBI recognizes the importance of addressing the interconnectedness issue posed by financial conglomerates. RBI has taken several steps toward their effective supervision. Some of the important steps are: (i) prudential limits have been put in place on aggregate interbank liabilities as a proportion of their net worth; (ii) access to uncollateralized funding market is restricted to banks and primary dealers and there are caps on both lending as well as borrowing by these entities; (iii) investment in the capital instruments of other banks and financial institutions is restricted to 10 percent of investing banks’ capital funds, in addition to the stipulation that a bank cannot hold more than 5 percent of other bank’s equity; (iv) banks’ exposure to NBFCs is subject to tight limits and NBFCs have been increasingly subjected to more stringent prudential regulation; and (v) we have also put restrictions on exposures to complex activities and products and have a system for intensive monitoring of financial conglomerates and for common exposures in sensitive sectors.

53. Regarding the appointment of an RBI officer as a nominee director on the Board of banks, RBI recognizes the moral hazard issues posed by this practice. However, this system has served us well and ensured more effective compliance of RBI regulations from the banks’ side. Nevertheless, keeping the moral hazard issue in mind, sometime back, the respective Acts were amended to provide for appointment of one director possessing necessary expertise and experience in matters relating to regulation and supervision and regulation of commercial banks, by the central government on recommendation of RBI. This gave RBI latitude for not putting its serving officers on Boards of banks. The serving officers were replaced by retired RBI officers. However, as this transition was not particularly satisfactory, currently serving officers are being nominated. Nevertheless, RBI is sensitive to the issue and this has since been taken up with Government of India for amendment of the enabling provisions of the Act under which RBI nominee directors are appointed.

54. We reiterate that in India the regulations are completely ownership neutral and that same level of scrutiny is applied to both public and private sector banks. Even the foreign banks, unlike in many other countries, have the same amount of freedom as the domestic banks have (except regarding expansion) and are treated exactly on par with the domestic banks for prudential purposes. When we impose penalty on a public sector bank, we do not consult the government and we place penalty imposed in public domain just as we do for the private sector banks.

55. With regard to the issue of large exposure limits, RBI does recognize that the group borrower limit is different from the single borrower limit and is significantly larger than the international norms. However, this deviation is on account of our needs to meet the development needs of the country. Some of the major corporate groups, which are also the drivers of growth in Indian economy, have grown very rapidly compared to banks. Keeping the group borrower limit at the level of single borrower limit would severely constrain the availability of bank finance, which is major source of finance in India, to these corporate groups. A reduction in lending to these groups would hamper the growth of the economy. Moreover, banks would be left with surplus lendable resources which may result in adverse selection. Thus, while RBI is aware of the deviation of Indian practice from the currently accepted international norms, this deviation is more on account of credit needs to due to compulsions of robust growth, investment needs of infrastructure and the demand ushered in by increasing financial inclusion.

56. Finally, while RBI may have some differences of opinion, RBI recognizes the importance of the FSAP in promoting financial stability and serving Indian interests. As stated earlier, RBI is committed to meet the best international practices that are appropriate for us. RBI wishes to express its strong support for the role FSAP plays in promoting the soundness of global financial system and looks forward to a continuing dialogue with the IMF/World Bank and other global counter parts in seeking to improve the stability and effective supervision of global financial system.

II. Detailed Assessment

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