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THE BANKING SYSTEM IN INDIA

History and Evolution of Banking in India

• Banking in India has evolved significantly over the years, reflecting the country’s broader economic, social, and political transformations. From its nascent stages in the 18th century to its current status as the backbone of the economy, Indian banking has undergone three distinct phases. Each phase has been marked by unique challenges, reforms, and milestones, shaping the sector into a pivotal component of India’s financial system.

Phase 1: The Pre-Independence Era (Before 1947)

• Origins: The modern banking system in India traces back to the 18th century, with the Bank of Hindustan established in 1770. The era was dominated by agency houses performing banking functions.
• Presidency Banks: The 19th century witnessed the emergence of presidency banks, such as the Bank of Bengal (1806), the Bank of Bombay (1840), and the Bank of Madras (1843), which later merged to form the Imperial Bank of India in 1921.

Key Developments

• Swadeshi Movement: The early 20th century’s Swadeshi movement spurred the creation of banks owned and managed by Indians, like the Punjab National Bank (1894) and Bank of India (1906).
• Regulatory Need: The sector’s growth came with instability, highlighting the need for regulatory oversight due to numerous bank failures.

Phase 2: Post-Independence Era (1947-1991)

• Economic Reforms: Following independence in 1947, banking was integral to economic development and social equity, leading to significant reforms.
• Nationalization: A landmark reform was the nationalization of major banks in two phases (1969 and 1980), which expanded banking services across the country.

Key Developments

• Lead Bank Scheme (1969): Aimed to promote rural banking and ensure banking services reached all corners of the country.
• Regional Rural Banks (1975): Established to provide banking and credit facilities in rural areas.
• Regulations and Institutions: Introduction of banking regulations and institutions like NABARD to support sector development.

Phase 3: Liberalization and Beyond (1991-Present)

• Economic Reforms: The 1991 economic reforms aimed at liberalizing the economy brought transformative changes to the banking sector.
• Narasimham Committee: Its reports (1991 and 1998) were pivotal in recommending measures for increased efficiency, competitiveness, and stability.

Key Developments

• Private and Foreign Banks: Entry of these banks introduced competition, improving customer service, product innovation, and technology adoption.
• New Banking Models: Payments and small finance banks were introduced to serve niche interests and enhance financial inclusion.
• Technology Adoption: Online banking, mobile banking, and digital payment systems transformed service delivery and access.

Core Banking Solution (CBS)

• Core Banking Solution (CBS) represents a revolutionary shift in banking operations, enabling an unprecedented level of convenience and efficiency for customers. It offers a unified platform that connects various bank branches into a single network, allowing customers to manage their accounts and access a wide range of banking services from any location within the network. This innovation has significantly transformed the banking landscape, making banking services more accessible and streamlined for customers across the globe.

Key Features of CBS

• Centralized Banking Services: CBS operates on a centralized system where all banking transactions are processed and managed. This centralization ensures consistency in banking operations across all branches within the network.
• Location-Independent Banking: One of the hallmark features of CBS is its ability to allow customers to conduct banking transactions from any branch on the network, irrespective of where their account was originally opened. This flexibility has greatly enhanced the banking experience for users, especially those who travel frequently or relocate.
• Global Access: With CBS, customers can access their banking services from any part of the world. This global reach is facilitated through the integration of internet banking with the CBS network, ensuring that customers can perform banking transactions even when they are away from their home branch.
• Efficiency in Transactions: CBS has streamlined banking operations, making transactions faster and more efficient. This efficiency is achieved through the automation of various banking processes within the CBS framework, reducing the time and effort required for transaction processing.
• Enhanced Accessibility: The implementation of CBS has been particularly beneficial in extending banking services to rural and remote areas. By enabling branches in these locations to connect to the central CBS network, customers in less accessible areas can now enjoy the same level of banking services as those in urban centers.

Impact on Banking

• Improved Customer Satisfaction: The convenience and efficiency brought about by CBS have significantly improved customer satisfaction. Customers appreciate the flexibility of being able to access their accounts and conduct transactions from any branch, without geographical limitations.
• Financial Inclusion: CBS plays a crucial role in promoting financial inclusion by making banking services accessible to a broader segment of the population, including those in rural and underserved areas. This inclusivity supports the economic empowerment of more individuals and communities.
• Operational Efficiency: For banks, the centralized management of accounts and transactions through CBS has led to operational efficiencies, reduced errors, and lower costs. This operational improvement allows banks to offer better services to their customers and compete more effectively in the market.

Scheduled Commercial Banks

• Scheduled Commercial Banks are pivotal entities within the financial ecosystem of a country, particularly in India where they play a substantial role in economic development. They are defined and operate under specific regulatory frameworks set by the Reserve Bank of India (RBI), as outlined in the RBI Act of 1934.

Definition and Operational Scope

• Scheduled Commercial Banks are financial institutions that have been included in the second schedule of the RBI Act of 1934. Their operations encompass a broad spectrum of banking activities, including but not limited to, accepting deposits from the public, extending loans to individuals and businesses, and offering various other banking services.
• Regulatory Framework: These banks operate under the regulatory oversight of the Reserve Bank of India (RBI), which includes compliance with specific financial thresholds and operational standards. For instance, any bank, to qualify as a Scheduled Commercial Bank, must have a minimum paid-up capital and reserves of 5 lakh rupees and conduct its business in a manner that safeguards the interests of its depositors.

RBI and Scheduled Banks Interactions

• Financial Support: The RBI provides monetary assistance to Scheduled Banks at predetermined bank rates, facilitating these banks’ liquidity management and enabling them to meet their short-term funding requirements.
• CRR Requirements: Scheduled Banks are mandated to deposit a certain percentage of their deposits with the RBI as Cash Reserve Ratio (CRR), ensuring liquidity and stability in the banking system.
• Privileges and Benefits: These banks enjoy several privileges, including access to refinancing facilities from the central bank, automatic membership in the clearinghouse, and currency storage facilities, enhancing their operational capabilities and financial stability.

Classification

Scheduled Banks in India are broadly classified into two categories:

1. Commercial Banks: These form the backbone of the banking sector and are primarily focused on profit. Commercial Banks include public sector banks (where the government owns a majority stake), private sector banks, foreign banks operating in India, and regional rural banks (RRBs). They are the main source of credit for various sectors of the economy, including agriculture, where they contribute the largest share of credit.
2. Cooperative Banks: These banks operate on a cooperative model, focusing on serving their members’ interests. They play a significant role in providing credit, especially in rural areas, complementing the efforts of commercial banks.

Public Sector Banks (PSBs)

• Overview: Public Sector Banks (PSBs) are those where the majority stake is held by the government. They include the State Bank of India (SBI) and its associates, nationalized banks, and other banks where the government has a significant ownership.
• Role and Impact: PSBs have been instrumental in the banking sector’s expansion, especially in rural areas, ensuring financial inclusion and accessibility of banking services across the country. They offer competitive interest rates on deposits, low-interest loans, and have a vast network of branches to serve a large customer base.
• Recent Reforms: Initiatives like Enhanced Access and Service Excellence (EASE) and the empowerment of bank boards have been introduced to strengthen PSBs. These measures aim at driving customer-centric digital transformation, improving governance, and enhancing operational efficiency.

Private Sector Banks

• Private sector banks are financial institutions where the majority of the shares or equity are held by private entities or individuals, as opposed to government ownership. These banks are a crucial component of the banking industry, providing a wide range of banking services to the public.

Historical Context in India

• Initially, the Indian banking sector was predominantly controlled by public sector banks. However, the landscape began to change in the 1990s when private sector banks emerged. This shift was marked by the adoption of innovative approaches, the introduction of new financial instruments, and the leveraging of technology, which collectively fueled the rapid expansion of private sector banks in the country.

Categories of Private Sector Banks

In India, private sector banks are categorized into two types:

1. Old Private Sector Banks: These banks were established and operational before the wave of nationalization that took place in 1968. They have a long history and have contributed significantly to the banking sector’s development over the years.
2. New Private Sector Banks: This category includes banks that were established or started operations after the 1990s. The emergence of these new banks was facilitated by the liberalization policies and the regulatory framework provided by the Reserve Bank of India (RBI) in 1993, aimed at encouraging the establishment of new private banking entities.

Regulatory Framework

• The RBI issued guidelines and rules in 1993 for the opening of new private-sector banks in India. These guidelines were designed to ensure that the new entrants in the banking sector operate within a regulatory framework that promotes healthy competition, financial stability, and innovation.

Corporate Structure

• Private sector banks in India typically operate as limited liability companies, with their share capital primarily held by private shareholders. This structure allows them to be agile and responsive to market demands while ensuring the interests of their shareholders are protected.

Presence in India

• As of now, there are 21 private-sector banks operating in India, offering a wide array of banking and financial services to their customers.

Advantages and Disadvantages of Private Sector Banks

Advantages

1. Speedy Service: Private sector banks are known for their quick and efficient service delivery, ensuring customer transactions and requests are processed promptly.
2. Specialized Services: Many private banks offer specialized financial services tailored to the unique needs of their customers, enhancing customer experience and satisfaction.
3. Efficient Management: The management structure of private sector banks is often streamlined and efficient, enabling swift decision-making and operational agility.
4. Quick Financial Decisions: The autonomy and competitive nature of private sector banks allow them to make fast and effective financial decisions, contributing to their growth and customer satisfaction.

Disadvantages

1. Additional Costs: Banking services at private sector banks may come with higher fees and charges, making them more expensive compared to their public sector counterparts.
2. Urban Focus: Private sector banks tend to focus more on urban and metropolitan areas, which can make their services less accessible to the rural population.
3. Job Security: Employees of private sector banks may face less job security compared to those in public sector banks, reflecting the competitive and dynamic nature of the private banking sector.

Foreign Banks

• Foreign banks play a notable yet distinct role in the banking ecosystems of countries they operate in outside their home territories. They are identified primarily by their operational structure, where the headquarters and registration lie abroad, yet they maintain branches within the host country. Despite constituting less than 1% of the host nation’s total branch network, foreign banks significantly contribute to the financial landscape, holding about 7% of total banking assets and 11% of the profits. This disproportion highlights their efficiency and targeted approach to banking in foreign markets.

RBI’s Regulatory Framework for Foreign Banks in India

The Reserve Bank of India (RBI), as the central banking institution, governs the operation of foreign banks in India through a set of guiding principles and policy directives aimed at ensuring financial stability and promoting healthy competition:

1. Reciprocity Principle: This principle is foundational to the RBI’s approach towards foreign banks. It mandates that such banks receive treatment akin to national banks only if their home countries offer similar operational freedoms to Indian banks. This reciprocal arrangement ensures fairness and encourages open banking relationships between countries.
2. Single Mode of Presence: The RBI stipulates that foreign banks can establish their presence in India in one of two forms: either as a branch or as a wholly-owned subsidiary (WOS). This policy aims to streamline foreign banking operations and simplify regulatory oversight.

Additional Policy Directives

Beyond these principles, the RBI has set forth several specific directives that foreign banks must adhere to:

• Capital Adequacy: Following the Basel Accord standards, foreign banks are required to maintain a certain level of capital to safeguard against financial risk.
• Minimum Capital Requirement: A minimum capital threshold of INR 500 crore ensures that only financially robust foreign banks operate in India.
• Capital to Risk-weighted Assets Ratio (CRAR): Foreign banks must maintain their CRAR at 10% or below, promoting risk management and financial stability.
• Priority Sector Lending: A significant policy for foreign banks involves dedicating 40% of their lending to priority sectors identified by the RBI, underscoring the commitment to broader economic development in India.
• Adherence to RBI Regulations: In addition to these, foreign banks must comply with all other regulations set by the RBI, ensuring a level playing field and the integrity of India’s financial system.

Operational Footprint

Foreign banks often start their journey in a new country by opening representative offices. These offices, although not permitted to carry out banking operations, play a critical role in market research and building customer relationships. Representative offices are a strategic step for foreign banks to understand the local market dynamics and regulatory environment.

Current Landscape

As of the latest data, there are 34 representative offices and 45 branches of foreign banks in India. This setup indicates a substantial international interest in India’s banking sector, with foreign banks leveraging their global expertise and financial strength to cater to the Indian market, albeit within the stringent regulatory framework laid out by the RBI.

Regional Rural Banks (RRBs)

• Regional Rural Banks (RRBs) are a category of Indian financial institutions that were established in 1975, aiming to provide banking and financial services in rural areas, with a focus on agricultural and rural development. The inception of RRBs was part of a larger strategy to include rural populations in the banking ecosystem, ensuring they have access to credit, savings, and other financial services that are crucial for their economic development.

Establishment and Legal Framework

• Origination: The idea of RRBs materialized through an ordinance promulgated on September 26, 1975, followed by the enactment of the Regional Rural Banks Act in 1976. This legislative framework laid the foundation for the creation of RRBs across India.
• Recommendation: The establishment of RRBs was recommended by the Narasimham Committee, highlighting the need for banking institutions that specifically cater to the rural economy and agricultural sector.
• Purpose: The primary aim of RRBs is to enhance the financial inclusion of rural and agricultural sectors by providing them with essential banking services, including credit facilities, deposit schemes, and other financial products tailored to their needs.

Ownership and Structure

• Ownership: The ownership of RRBs is tripartite, divided among the Central Government of India (holding a 50% stake), the respective State Governments (15%), and a Sponsor Bank (35%). The Sponsor Bank is typically a major public sector bank that oversees the functioning and management of the RRB.
• First RRB: The first RRB to be established was the Prathama Grameen Bank, which was set up on October 2, 1975, marking a significant milestone in the banking sector’s outreach to rural areas.

Regulatory and Supervisory Framework

• Regulatory Body: The Reserve Bank of India (RBI) is the central regulatory authority for RRBs, ensuring they operate within the bounds of national banking regulations and policies.
• Supervisory Authority: The National Bank for Agriculture and Rural Development (NABARD) plays a pivotal role in the supervision and guidance of RRBs, focusing on their performance in agricultural and rural financing.

Operations and Coverage

• Functional Similarity: RRBs operate on a model similar to commercial banks but are distinct in their geographical focus and target clientele. Each RRB operates within a specific region, often covering a few districts, to ensure deep penetration of banking services in rural areas.
• Current Status: As of now, there are 43 RRBs in India, collectively serving 525 districts across the country. This extensive network underscores the critical role of RRBs in fostering rural development and financial inclusion.

LOCAL AREA BANK

Local Area Banks (LABs) are relatively small-scale, private financial institutions that operate within specific geographic confines. The concept behind these banks is to provide financial services, predominantly in rural and semi-urban areas, focusing on three major contiguous regions. Their main objectives include mobilizing local savings and offering investment opportunities within the local communities they serve. LABs were introduced in the Indian Union Budget of 1996, aiming to enhance financial inclusivity at the local level. As of the latest data, India hosts four LABs:

1. Coastal Local Area Bank Ltd
2. Krishna Bhima Samruddhi Local Area Bank Ltd
3. Capital Local Area Bank Ltd
4. Subhadra Local Area Bank Ltd, Kolhapur

LABs operate under the supervision of the Reserve Bank of India (RBI) but are categorized as non-scheduled banks. This unique status affects their operational norms and regulatory requirements.

Comparative analysis between Regional Rural Banks (RRBs) and Local Area Banks (LABs)

This comparative overview highlights the foundational, regulatory, and operational differences between RRBs and LABs, illustrating how each plays a distinct role in India’s financial inclusion strategy. While RRBs have a broader regulatory oversight with NABARD’s involvement and operate under specific legislative acts, LABs offer a more localized financial service, primarily targeting rural and semi-urban communities within limited geographical areas, under the direct regulation of the RBI.

Scheduled Co-operative Banks

Scheduled Co-operative Banks are unique financial entities characterized by their member-owned structure. Members are simultaneously owners and customers, creating a financial institution deeply rooted in cooperative principles. Originating from the Cooperative Societies Act of 1912, these banks are formally recognized as cooperative credit institutions.

Features of Cooperative Banks

• Democratic Control: Cooperative banks operate on the democratic principle of “one person, one vote,” ensuring equal rights for all members regardless of their investment size.
• Financial Inclusion: They play a significant role in extending banking services to unbanked rural areas, promoting financial inclusion among the rural populace.

Structure of Cooperative Banks:

Cooperative banks in India are structured across three levels:

1. Primary Credit Societies (PCSs): These are the foundation level, serving specific areas such as agriculture or urban sectors.
2. District Central Co-operative Banks (DCCBs): Operating at the district level, these banks serve as a bridge between PCSs and SCBs, ensuring regional financial integration.
3. State Co-operative Banks (SCBs): Positioned at the apex of the structure, SCBs oversee and support the entire cooperative banking network within a state.

Regulation

The operations of cooperative banks are under the dual regulation of the Reserve Bank of India (RBI) and respective state governments, guided by:

• The Banking Regulation Act of 1949
• The Banking Laws (Cooperative Societies) Act of 1955

These legislative frameworks ensure the cooperative banks adhere to banking norms while fostering their cooperative essence.

Advantages of Cooperative Banking in India

• Access to Affordable Credit: Cooperative banks provide essential financial services at more favorable terms compared to commercial banks, especially to rural sectors.
• Discouragement of Unproductive Loans: They play a crucial role in preventing loans for unproductive personal consumption, promoting more responsible borrowing.
• Promotion of Savings and Investments: By offering attractive saving schemes, these banks encourage individuals to save and invest rather than hoard money.
• Agricultural Advancement: The availability of credit for purchasing improved seeds, chemical fertilizers, and modern implements has significantly contributed to the revolutionization of agricultural practices.

Urban Cooperative Banks (UCB)

• Definition and Scope: Although not formally defined, Urban Cooperative Banks primarily operate in urban and semi-urban areas. They were initially restricted to non-agricultural lending but have since expanded their services beyond this limitation.
• Community Focus and Expansion: Traditionally focused on serving small borrowers and community-based enterprises, UCBs have broadened their operational scope to cater to a wider range of businesses.

Challenges Facing Urban Cooperative Banks (UCBs)

Urban Cooperative Banks (UCBs) in India face several challenges that threaten their sustainability and growth in the rapidly evolving financial sector. These challenges include:

Dual Control:

UCBs are subject to dual regulation by the state registrar of societies and the Reserve Bank of India (RBI), leading to complexities in governance and compliance. Although the RBI assumed complete control over all UCBs and multi-state cooperatives in 2020, the transition and oversight challenges persist.

Changing Financial Sector:

The advent of microfinance institutions, FinTech companies, payment gateways, e-commerce platforms, and Non-Banking Financial Companies (NBFCs) poses a significant challenge to UCBs. These entities often offer more diverse and accessible financial services, complicating the existence of UCBs, which are typically smaller, lack professional management, and have limited geographic operations.

Government Interference:

The cooperative movement has historically been subject to patronizing treatment by the government, akin to its administrative structures. This approach has sometimes hindered the autonomous and efficient functioning of cooperative institutions.

Money Laundering and Corruption:

Some cooperatives have been exploited for regulatory arbitrage, facilitating evasion of lending norms and anti-money laundering regulations. This undermines the sector’s integrity and poses reputational risks.

Declining Agricultural Credit:

Research by the RBI highlights a worrying trend of declining cooperative credit to the agricultural sector, from 64% in 1992–1993 to just 11.3% in 2019–20. This decline reflects the diminishing role of cooperatives in supporting agriculture, which is crucial for India’s rural economy.

Limited Exposure:

• Many cooperative societies are restricted in scope, serving only a small number of members and operating in limited geographic areas. Resource constraints prevent them from expanding their capabilities or operational areas.

Rural Cooperative Banks (RCBs)

RCBs are vital to rural livelihoods, offering both short-term and long-term cooperative credit systems. Unlike UCBs, RCBs have a more direct focus on rural and agricultural financing.

Regulation and Governance:

• Primary Agricultural Credit Societies (PACS) are not covered under the Banking Regulation Act of 1949 and, thus, are not directly regulated by the RBI. State Cooperative Banks (StCBs) and District Central Cooperative Banks (DCCBs), however, are subject to RBI oversight and are registered under the State Cooperative Societies Act.
• The National Bank for Agricultural and Rural Development (NABARD) is empowered to inspect State and Central Cooperative Banks, ensuring adherence to regulatory standards.

Recommendations

• A committee led by Dr. Prakash Bakshi recommended that RCBs allocate at least 70% of their loan portfolios to agricultural activities, emphasizing their critical role in supporting the sector.

Differentiation between Urban and Rural Cooperative Banks:

• Urban Cooperative Banks have variations such as scheduled or non-scheduled and single-state or multistate. Since 2018, the RBI has allowed them to voluntarily transition to small finance banks.
• Rural Cooperative Banks are categorized into long-term institutions like State Cooperative Agriculture and Rural Development Banks (SCARDBs) and Primary Cooperative Agriculture and Rural Development Banks (PCARDBs), as well as short-term entities such as StCBs, DCCBs, and PACS.

The distinction and challenges unique to both urban and rural cooperative banks underscore the complexity of India’s cooperative banking sector, highlighting the need for tailored regulatory and developmental strategies to ensure their sustainability and effectiveness in meeting their members’ needs.

District Central Co-operative Banks (DCCBs)

District Central Co-operative Banks (DCCBs) form a crucial part of the rural cooperative banking structure in India, which also includes State Co-operative Banks (StCBs) and Primary Agricultural Credit Societies (PACS). This three-tier structure plays a pivotal role in catering to the financial needs of the agricultural sector and rural areas.

3-Tier Structure of Short-Term Co-operative Banks:

1. State Co-operative Banks (StCBs)
2. District Central Co-operative Banks (DCCBs)
3. Primary Agricultural Credit Societies (PACS)

Despite their focus on rural and agricultural financing, the share of credit flow to agriculture from rural cooperatives stands at only 12.1%, in contrast to 76% from Scheduled Commercial Banks (SCBs) and 11.9% from Regional Rural Banks. DCCBs are instrumental in mobilizing deposits from the public and extending credit to both the public and PACS.

Cooperative Banks vs. Commercial Banks

Difference Between Scheduled Banks and Non-Scheduled Banks

Nationalization of the Banks in India
I. Introduction to Bank Nationalization

• The Indian financial landscape underwent a monumental transformation when, in 1969, the government led by Prime Minister Indira Gandhi nationalized 14 of the largest commercial banks. This move marked a significant departure from the market-based policies adopted by many Asian countries during the same period, underscoring India’s commitment to socialist principles. The initiative aimed to bring major financial assets under state control, shifting them from the private to the public sector to serve broader social and economic goals.

II. Concept and Purpose of Nationalization

Nationalization is defined as the process by which private sector assets are transferred to the state or central government, either for management or outright ownership. This strategic move towards nationalization in India was facilitated through the Banking Regulation Act of 1949, effectively transforming these privately operated banks into nationalized entities within the public sector. The primary objectives for nationalizing banks included:

• Social Welfare: Ensuring banking services are aligned with broader social goals rather than merely profit-oriented.
• Developing Banking Habits: Encouraging more widespread use of banking services among the population.
• Expansion of the Banking Sector: Broadening the reach of banking services to underserved areas.
• Controlling Private Monopolies: Preventing the concentration of financial power in the hands of a few private entities.
• Reducing Regional Imbalance: Ensuring equitable distribution of banking services across different regions.
• Prioritizing Sector Lending: Directing financial resources to sectors deemed as priority by the government, such as agriculture and small industries.

III. Driving Forces Behind Nationalization

The decision to nationalize banks was driven by India’s commitment to planned economic development post-independence and the necessity to respond to a series of economic and political challenges, including:

• External Conflicts: India faced military engagements with China and Pakistan, straining national resources.
• Economic Hardships: Successive years of drought and food shortages highlighted vulnerabilities, particularly the dependence on the U.S. PL 480 food aid program, which was seen as a compromise to national security.
• Investment Fluctuations: A “plan holiday” in the 3rd year resulted in reduced public investment and affected overall economic demand.
• Credit Allocation Imbalance: While industries saw their share of bank credit double from 1951 to 1968, agriculture received less than 2% of total credit, highlighting a skewed distribution of financial resources.

IV. Outcomes of Nationalization

The nationalization of banks yielded several significant benefits, fundamentally altering the banking sector’s landscape in India:

• Expansion of Banking Network: The number of bank branches surged by approximately 800%, significantly enhancing access to banking services across the country.
• Boosted Public Confidence: The public’s faith in the sustainability and reliability of banks increased, fostering a more stable financial environment.
• Wider Reach: Banking services were extended to the most remote corners of India, promoting financial inclusion.
• Growth in Public Deposits: There was a marked increase in public deposits in banks, indicating a growing trust in the banking system and an increase in financial savings among the population.

V. Current Debates and Conclusion

• In recent years, the banking sector has faced challenges, reigniting discussions around the privatization of banks. This debate is informed by both the historical context of nationalization and its long-term impacts on India’s economic and social fabric. While nationalization was pivotal in achieving significant strides in financial inclusion and supporting India’s development goals, the evolving global economic landscape and internal financial pressures have led to calls for reassessing the role and structure of banks in the country’s economy.

Banking Sector Reforms in India

The Indian banking sector has witnessed significant transformations aimed at promoting financial inclusion and facilitating social change. Despite its evolution, the sector has encountered various challenges impacting its efficiency, financial stability, and asset quality. In response to these challenges, several reforms and recommendations have been proposed and implemented over the years to enhance the sector’s robustness and efficiency.

The Four R’s Strategy

In the Economic Survey of 2015-16, the Ministry of Finance outlined a comprehensive approach to address the issues plaguing the banking sector, particularly the Non-Performing Asset (NPA) problem. This approach is encapsulated in the “Four R’s”:

1. Recognition: Acknowledging the extent and severity of NPAs in the banking system.
2. Recapitalization: Infusing additional capital into banks to strengthen their capital base and enable them to write off bad debts.
3. Resolution: Implementing measures to resolve NPAs through mechanisms such as asset reconstruction and restructuring.
4. Reform: Instituting structural reforms to prevent the recurrence of high levels of NPAs, including improvements in governance, risk management, and operational efficiencies.

Narasimham Committee Report (1991)

This committee was pivotal in shaping the early reforms in the Indian financial sector with significant recommendations:

• Three-tier Banking Structure: Proposed a hierarchical structure comprising state, district, and village level banks to improve financial inclusion.
• Capital Adequacy: Recommended increasing the Capital to Risk-weighted Assets Ratio (CRAR) to 10% to strengthen the financial health of banks.
• Liquidity Ratios: Suggested reducing the Cash Reserve Ratio (CRR) to 10% and the Statutory Liquidity Ratio (SLR) to 25% over time to free up resources for lending.
• Priority Sector Lending: Fixed at 10% of credit, to ensure funding for sectors considered crucial for economic and social development.
• Interest Rate Deregulation: Advocated for the deregulation of interest rates to give banks the autonomy to set their rates based on market conditions.
• Large Commercial Banks: Recommended the establishment of three to four major commercial banks with a strong domestic and international presence.

Recent Reforms

• Raghuram Rajan Committee (2007): Proposed a series of incremental reforms across the financial sector, emphasizing the need for continuous, small-scale improvements rather than a few large, politically sensitive changes.
• Internal Ombudsman (2015): The Reserve Bank of India (RBI) directed all Public Sector Banks (PSBs) to appoint an internal ombudsman to enhance customer service quality.
• Insolvency and Bankruptcy Code (IBC): Based on the recommendations of the TK Viswanathan Committee, the IBC was introduced to streamline the resolution of insolvency and bankruptcy cases, thereby improving the recovery of bad loans.
• PJ Nayak Committee (2014): Focused on reforming bank governance, recommending the repeal of certain acts to reduce government ownership in banks and suggesting the establishment of a Bank Investment Company (BIC) to hold government bank shares.

PJ Nayak Committee Recommendations

• Repeal of Bank Nationalisation Acts: Advocated for the repeal of legislation compelling government majority ownership in banks.
• Bank Investment Company (BIC): Proposed transferring government bank holdings to a BIC, functioning as a holding or core investment company.
• Bank Board Bureau: Suggested the establishment of a Bank Board Bureau as an interim measure to guide the appointment of bank boards, chairpersons, and executive directors, aiming to improve governance and oversight.

These reforms and recommendations represent a multifaceted approach to resolving the persistent issues within the Indian banking sector, focusing on enhancing financial stability, governance, and operational efficiency.

Consolidation of Public Sector Banks
Merger vs. Amalgamation

• Amalgamation refers to the process where one or more businesses are combined to form a new entity. This process is distinct from a merger because, in an amalgamation, neither of the combining businesses continues as a separate legal entity. Instead, they dissolve to create a new entity that holds all the combined assets and liabilities.
• Merger, on the other hand, involves the absorption of one entity by another. The acquiring entity retains its identity, while the merged entity ceases to exist as a separate legal entity.

The Procedure of Merger

• Regulatory Framework: Bank mergers in India are governed by the Banking Regulation Act of 1949. This act provides the legal basis for the consolidation process among public sector banks (PSBs).
• Initiation and Approval Process:
• Initiation: Any two public sector banking entities can start discussions for a merger.
• Finalization: The scheme of merger needs to be finalized by the Government of India, in consultation with the Reserve Bank of India (RBI).
• Parliamentary Oversight: Once a merger scheme is finalized, it must be presented before the Parliament. Parliament has the authority to modify or reject the proposed merger.
• Alternative Mechanism Panel: Recognizing the need for a streamlined and efficient process for PSB mergers, the Government of India has established an Alternative Mechanism Panel. This panel is chaired by the Finance Minister and oversees the proposals for the merger of public sector banks.

Evaluation Based on CAMEL Model

• CAMEL Model: This model is a recognized international banking standard used to evaluate the health of banks. It stands for Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to market risk.
• Performance Comparison:
• It has been observed that, based on the CAMEL model, private sector banks in India generally outperform public sector banks in terms of profitability and liquidity.
• However, the situation is somewhat reversed when it comes to capital adequacy and Non-Performing Assets (NPAs). In these areas, public sector banks tend to have a stronger performance compared to their private sector counterparts.

Differentiated Banks

• Differentiated Banks represent a tailored approach within the banking sector, aiming to address specific needs of diverse segments of the population. This concept has gained traction in regions like India, where a significant portion of the population lacks access to traditional banking services. As of 2019, approximately 20 crore people in India were without banking access, highlighting the critical need for differentiated banking solutions.

Payment Banks

Payment Banks emerged as a novel banking model designed to extend banking and financial services to the unbanked sectors of the society, including low-income individuals and small businesses. These banks, distinct from conventional banks, operate under a unique set of regulations:

• Services Offered: They provide services like net banking, ATM cards, debit cards, and mobile banking, but are restricted from lending and issuing credit cards.
• Deposit Limits: Payment Banks can accept demand deposits up to ₹1 lakh per customer.
• Operational Framework: Endorsed by the Nachiket Mor Committee, they require a minimum paid-up equity capital of ₹100 crores and must maintain a capital adequacy ratio of 15%.
• Liquidity Management: These banks are allowed to participate in the inter-bank call money market (without collateral) and access the repo and CBLO markets (with collateral).
• Eligibility for Promoters: Eligible promoters include existing non-bank Prepaid Payment Instrument issuers, NBFCs, corporate business correspondents, mobile phone companies, supermarket chains, public sector entities, and real sector cooperatives.

Small Finance Banks

Small Finance Banks (SFBs) cater to the financial needs of sections of society not sufficiently served by traditional banks, including small business units, small and marginal farmers, micro and small industries, and unorganized sector entities:

• Regulatory Foundation: These banks are established under the Companies Act, 2013, with a mandate that at least 25% of their branches be located in unserved rural areas.
• Focus on Priority Sectors: They are required to direct 75% of their total credit to priority sectors such as agriculture, micro, small and medium enterprises (MSMEs), export credit, education, housing, social infrastructure, and renewable energy.
• Loan Portfolio Requirements: At least 50% of their loan portfolio should consist of loans of ₹25 lakh or less.

Local Area Banks (LABs)

Local Area Banks focus on mobilizing rural savings and providing credit in localized areas:

• Operational Scope: These banks operate within a limited area, covering at least three contiguous districts, with a primary objective to promote rural savings and credit by local institutions.
• Capital Requirements: They are required to have a minimum capital of ₹5 crore.
• Priority Sector Lending: LABs must ensure that 40% of their total lending is directed towards the priority sector, with 25% specifically allocated to the weaker sections of society.
• Transition to SFBs: In 2014, the RBI introduced a policy enabling LABs to convert into Small Finance Banks, offering a pathway for expansion and broader service delivery.

Lead Bank Scheme

The Lead Bank Scheme (LBS), introduced in 1969, aims to facilitate efficient banking and credit delivery in rural areas through a service area approach:

• Objectives: The scheme envisions integrated banking facilities in unbanked areas, adopting an area-based approach to improve agricultural and supplementary income opportunities.
• Committee Recommendations: The scheme was informed by recommendations from the Prof. D R Gadgil Committee, Shri F.K.F. Nariman Committee, and Usha Thorat Committee, emphasizing the need for targeted banking services in district-level geographic units.

Microfinance

Microfinance services are crucial in empowering unemployed or low-income individuals or groups, enabling them to emerge from poverty through income-generating activities:

• Services and Providers: Besides Scheduled Commercial Banks (SCBs), Regional Rural Banks (RRBs), small finance banks, Cooperative banks, Non-Banking Financial Companies (NBFCs), and NBFC-Micro Finance Institutions (MFIs) offer microfinance services, including micro-loans, micro-savings, and micro-insurance.
• Loan Definition: In India, loans under ₹1 lakh are classified as microloans, targeting individuals lacking access to conventional banking services.

Difference between Payments Bank and Small Finance Bank

Universal Banking in India

• Definition: Universal Banking is a comprehensive system where banks offer a wide range of financial services including investment banking, commercial banking, development banking, insurance, and other financial services under one roof.
• Services Offered: These banks provide services beyond savings and loans, such as investment services, securities, credit cards, project financing, remittances, payment systems, and insurance, acting as a one-stop financial supermarket.
• Origination: The concept of Universal Banking in India was initiated based on the recommendations of the R.H. Khan Committee.

Advantages of Universal Banking

1. Increased Profitability and Diversification: By offering a broad array of services, universal banks can diversify their revenue sources, enhancing profitability.
2. Efficiency in Resource Utilization: These banks effectively allocate resources across various services, optimizing their use and generating higher returns.
3. Value-Added Services: Universal banks are capable of providing additional services that add value to customers, differentiating themselves from competitors.
4. Reduced Transaction Costs: The consolidation of financial services under one umbrella leads to lower transaction costs for consumers.

RBI Guidelines for Universal Banking

1. Compliance with CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio) Requirements: Ensuring banks maintain required reserves.
2. Compliance with Section 10 of the Banking Regulation Act, 1949: Requires at least 51% of directors to possess special knowledge and experience.
3. Shareholding Limitations: Banks cannot hold more than 30% of the paid-up share capital in any company.
4. Prohibition on Loans and Advances: As per Section 20 of the Banking Regulation Act, 1949, prohibiting loans against a bank’s own shares.
5. Branch Licensing Policy: At least 25% of branches must be opened in semi-urban and rural areas.
6. Annual Financial Reporting: Banks must publish an annual financial report in accordance with the Banking Regulation Act, 1949.

Universal Banks vs. Differential Banks

Marginal Cost of Funds Based Lending Rate (MCLR)

The Marginal Cost of Funds Based Lending Rate (MCLR) is a benchmark interest rate for banks, introduced to refine the lending rates offered by commercial banks. It came into effect as a successor to the base rate system, with the aim of creating a more responsive and transparent mechanism for determining interest rates on loans.

Definition and Purpose

• MCLR is the minimum interest rate below which a bank is not permitted to lend. Unlike its predecessor, the base rate, MCLR is a more comprehensive and sensitive approach to determining lending rates, directly tied to the current cost of funds.
• The objective of introducing MCLR was multifaceted:
• To ensure an effective transmission of policy rates into the banking system’s lending rates.
• To enhance transparency and uniformity in the calculation of lending rates by different banks.
• To guarantee that loans are more responsive to policy changes and are offered at rates that are fair and competitive for both borrowers and lenders, thereby fostering a healthy lending environment.
• To enable banks to become more competitive and enhance their value over time by aligning their lending rates more closely with the market rates.

Calculation and Components

MCLR is calculated based on four key components, which ensure that the lending rates are closely linked to the actual deposit rates and the cost of funds for the bank. These components are:

1. Marginal Cost of Funds: This includes the interest rate that banks pay for the deposits and borrowings. It reflects the current cost of raising new funds, which is essential for determining the lending rate.
2. Tenor Premium: It accounts for the risk associated with the loan duration. Longer loan periods are typically associated with higher uncertainty and, consequently, might carry a higher interest rate.
3. Operating Costs: These are the expenses involved in the banking operations, including the costs of raising funds and the costs related to lending activities.
4. Negative Carry on Account of Cash Reserve Ratio (CRR): Banks are required to maintain a certain percentage of their deposits as cash reserve ratio with the central bank. This component accounts for the opportunity cost of maintaining this reserve, which earns no interest, affecting the overall cost of funds.

Features

• Tenor-linked: MCLR rates are tenor-linked, meaning they vary depending on the repayment period of the loan. This feature allows banks to more accurately price loans based on their duration, which can affect the bank’s cost of funds over time.
• Internal Benchmark: MCLR serves as an internal benchmark for banks. Each bank determines its MCLR based on its unique costs and strategies, leading to potential variations in lending rates across the banking sector.

Objectives in Detail

• Enhancing Policy Rate Transmission: By closely linking lending rates to the marginal cost of funds, MCLR aims to improve the responsiveness of bank lending rates to changes in policy rates set by the central bank. This is crucial for the effective implementation of monetary policy.
• Increasing Transparency and Uniformity: The detailed framework for calculating MCLR fosters greater transparency. It allows customers to understand the factors influencing the changes in interest rates, promoting a more informed borrowing and lending environment.
• Ensuring Reasonable Rates for Loans: The MCLR system is designed to reflect the actual cost of funds more accurately, ensuring that loans are priced in a way that is fair to both the lender and the borrower.
• Promoting Competitiveness: By making lending rates more sensitive to market conditions, MCLR encourages banks to be more efficient and competitive, potentially leading to better services and products for consumers.

Difference between Base rate and MCLR

Transmission of Monetary Policy

• The transmission of monetary policy is a critical process through which changes made by the Reserve Bank of India (RBI) in the policy rates influence various economic activities, including lending rates, inflation, and overall economic growth. This process determines how effectively policy rate adjustments can achieve their intended outcomes, such as controlling inflation or stimulating economic growth.

Mechanism of Transmission

• When the RBI modifies policy rates, the objective is to influence the broader economy. A reduction in policy rates, for example, is aimed at making borrowing cheaper, encouraging spending and investment, which in turn should stimulate economic activity.

Channels of Transmission

1. Interest Rate Channel: This channel operates through the impact of policy rate changes on interest rates across various markets, including government debt, credit, equity, and currency markets. Lower policy rates can reduce borrowing costs, stimulate demand for loans, and influence asset prices.
2. Credit Channel: It involves the bank lending and balance sheet channels. Since India relies heavily on bank funding, changes in policy rates directly affect bank lending practices and the availability of credit.
3. Exchange Rate Channel: Adjustments in policy rates can lead to currency appreciation or depreciation, affecting import and export competitiveness and thus, inflation.
4. Asset Price Channel: Policy rates can influence stock prices and other asset values. However, the extent of this influence is generally less direct compared to other channels.

Challenges in Monetary Policy Transmission

1. Rigid Funding Costs: The predominance of customer deposits in India’s lending framework makes funding costs less responsive to policy changes, limiting the transmission’s effectiveness.
2. Non-performing Assets (NPAs): High levels of NPAs compel banks to maintain higher lending rates to offset potential losses, impairing transmission efficiency.
3. Four Balance Sheet Problem: Highlighted by Chief Economic Advisor Arvind Subramaniam, this refers to the interlinked issues of corporates, banks, infrastructure, and real estate, which have weakened credit growth and monetary policy transmission.
4. Non-linking of Policy Rates to the Market: Since the repo rate is set by the Monetary Policy Committee, it is not directly market-determined, which can impede the policy rate’s reflection in lending rates.
5. Absence of External Benchmark Linkage: Approximately 75% of outstanding loans are not tied to any external benchmark, reducing policy rate transmission to lending rates.

External Benchmark Lending Rate

In 2019, the RBI introduced a uniform external benchmarking system to enhance transparency and standardization in lending rates. Banks were offered four options for external benchmarking:

• The RBI repo rate
• The 91-day treasury bill yield
• The 182-day treasury bill yield
• Any other benchmark market interest rate published by the Financial Benchmarks India Pvt. Ltd.

Priority Sector Lending (PSL)

PSL mandates banks to allocate a portion of their lending to sectors deemed vital for the socio-economic development of the country, as identified by the Government of India and the RBI. Categories include agriculture, MSMEs, export credit, education, housing, renewable energy, and social infrastructure.

Sub-targets and Guidelines

• Scheduled Commercial Banks and Foreign Banks must allocate 40% of their total lending to PSL.
• Regional Rural Banks, Cooperative Banks, and Small Finance Banks are required to allocate 75% towards PSL.
• Failure to meet these targets results in mandatory contributions to the Rural Infrastructure Development Fund (RIDF) managed by NABARD.

Priority Sector Lending Certificates (PSLCs)

PSLCs offer a mechanism for banks to meet their PSL targets by allowing banks with surplus PSL achievements to sell these surpluses to banks with deficits. This system encourages further lending to priority sectors without actual transfer of assets or risks.

The Business Correspondent (BC) Model

• Facilitating Financial Transactions: BCs enable customers to perform basic banking transactions such as deposits, withdrawals, and money transfers.
• Government Assistance Disbursement: They play a crucial role in the direct transfer of government welfare benefits and social security payments to beneficiaries’ accounts, ensuring that the funds reach the intended recipients securely and efficiently.
• Financial Inclusion: By providing access to banking services in underserved areas, BCs help in bringing the marginalized sections of the society into the formal financial system.
• Customer Onboarding: BCs assist in opening new bank accounts, thereby expanding the banking network to include more individuals, especially those from economically weaker sections.
• Financial Literacy and Advisory: Besides transactional services, BCs also impart financial literacy, educating customers about the importance of savings, insurance, and credit products for their economic well-being.

Advantages of the BC Model

1. Extended Reach: The BC model significantly extends the reach of banking services to remote and rural areas, reducing the distance that customers need to travel to access financial services.
2. Cost-Effectiveness: It offers a cost-effective alternative to setting up traditional bank branches, which is particularly beneficial in sparsely populated or economically unviable areas.
3. Convenience: Customers enjoy the convenience of accessing banking services in their locality, saving time and resources.
4. Rapid Disbursement of Benefits: The model ensures the quick and secure disbursement of government benefits directly into beneficiaries’ bank accounts, minimizing leakages and delays.
5. Promotion of Financial Inclusion: By integrating more people into the banking system, the BC model promotes financial literacy and encourages the habit of savings and investment among the rural and urban poor.

Implementation and Impact

• The implementation of the BC model involves collaboration between banks and various entities who act as BCs, such as NGOs, microfinance institutions, and other organizations. These entities are equipped with the necessary technology, such as handheld devices, to carry out transactions securely and efficiently.
• Since its inception, the BC model has had a significant impact on improving financial inclusion in India. It has facilitated the opening of millions of new bank accounts and has been instrumental in the successful implementation of various government schemes aimed at providing financial support to the needy.

Challenges and the Way Forward

Despite its successes, the BC model faces challenges such as the sustainability of the BC operations, the need for continuous training and monitoring of BCs, and ensuring the security of transactions. Overcoming these challenges requires ongoing efforts from the banking sector, regulatory authorities, and the government to refine and strengthen the BC model.

Net Demand and Time Liabilities (NDTL)

• Net Demand and Time Liabilities (NDTL) represent a critical financial metric for banks, indicating the difference between the bank’s total liabilities in the form of demand and time deposits and any deposits it holds with other banks. This figure is crucial for understanding a bank’s liquidity position and its ability to meet withdrawal demands.

Formula:

• Bank’s NDTL=Demand and Time Liabilities (deposits)−Deposits with other

Example:

• Consider a bank with ₹10,000 in total demand and time liabilities, which includes a deposit of ₹5,000 with another bank. The NDTL for this bank would be calculated as:

NDTL=₹10,000−₹5,000=₹5

Thus, the bank’s Net Demand and Time Liabilities would be ₹5,000.

Importance:

• Liabilities Management: NDTL provides insight into the total liabilities a bank owes to its depositors minus the liquidity it has parked in other banks. This helps in managing liquidity risks.
• Regulatory Compliance: Regulators use NDTL to assess a bank’s financial health and compliance with statutory liquidity ratios.
• Financial Stability: Understanding NDTL helps banks in ensuring they have enough liquidity to meet the demand for withdrawals without compromising their financial stability.

Marginal Standing Facility (MSF) Rate

Introduction: The Marginal Standing Facility (MSF) is a mechanism introduced by the Reserve Bank of India (RBI) in 2011-2012 as part of monetary policy reform. It allows banks to borrow funds overnight from the RBI in emergency situations where interbank liquidity is completely dry.

Features:

• Emergency Fund Access: MSF serves as a last-resort funding window for banks facing acute liquidity crises.
• Penalty Rate: Borrowings under MSF occur at a rate higher than the repo rate, acting as a penalty rate to discourage routine reliance on this facility.
• Rate Setting: The MSF rate is typically set 100 basis points (or 1 percentage point) above the repo rate, making it costlier than normal borrowings under the Liquidity Adjustment Facility (LAF).
• Borrowing Limit: Banks are allowed to borrow up to 1% of their Net Demand and Time Liabilities (NDTL) under the MSF.
• Minimum Application Size: The RBI accepts MSF applications for funds starting at ₹1 crore, with increments in multiples of ₹1 crore.

Significance:

• Liquidity Support: MSF plays a crucial role in providing an additional liquidity support channel for banks during periods of acute stress, ensuring financial stability.
• Monetary Policy Tool: By setting the MSF rate above the repo rate, the RBI utilizes it as a tool to control short-term interest rates and manage liquidity in the banking system.
• Financial Safety Net: The MSF acts as a safety net for banks, allowing them to meet unforeseen fund requirements without facing the risk of default.

Demand and Supply of Money

Demand for Money

The demand for money, as per the Liquidity Preference Theory formulated by John Maynard Keynes, arises from three primary motives:

1. Transaction Motive: Individuals and businesses hold money to facilitate everyday transactions. This need stems from the timing gap between income receipt and its expenditure, necessitating a balance of money for daily purchases and payments.
2. Speculative Motive: This motive is based on the desire to hold liquid assets, such as money, over other types of investments (like bonds), which may be riskier. People speculate on interest rate movements; if rates are expected to rise (causing bond prices to fall), they prefer holding money to purchasing bonds at the current lower rates.
3. Precautionary Motive: Money is held to safeguard against unforeseen events or emergencies, such as sudden illness, accidents, or other unexpected expenses. This motive emphasizes the need for liquidity to meet unexpected financial demands without delay.

Supply of Money

The supply of money refers to the total amount of monetary assets available in an economy at a specific time. In India, the concept and measurement of money supply are categorized into four distinct aggregates: M0, M1, M2, M3, and M4, which are described as follows:

1. Reserve Money (M0): Also known as High Powered Money, it includes currency in circulation, bankers’ deposits with the Reserve Bank of India (RBI), and other deposits with the RBI. It represents the base from which other forms of money are created and is a direct liability of the monetary authority.
2. Narrow Money (M1): This category is comprised of highly liquid forms of money that are readily available for transactions. It includes currency held by the public, demand deposits within the banking system (excluding those of the central and state governments), and other deposits with the RBI. M1 is immediately accessible for spending and cannot be used by banks for lending.
3. M2: This aggregate extends M1 by including savings deposits with post office savings banks. M2 is a broader measure than M1, capturing a wider range of liquid assets available to the public.
4. Broad Money (M3): It encompasses a wider definition of the money supply, including M1 plus time deposits with the banking system. M3 represents the total money supply within the economy, capturing the breadth of assets that can be used to make payments or quickly converted into cash.
5. M4: This is an even broader category, adding all deposits with post office savings banks to M3. It represents the most inclusive measure of the money supply, encompassing a wide array of financial assets that can be used for transactions or converted into cash with varying degrees of ease.

Liquidity Hierarchy

The liquidity of these money supply categories is ranked in descending order from the most liquid (easily converted to cash) to the least liquid as follows: M1 > M2 > M3 > M4. This hierarchy reflects the varying degrees of readiness with which each category of money can be used for transactions or converted into cash.

Non-Performing Assets (NPAs) and Stressed Assets

• Non-performing assets (NPAs) and stressed assets are critical elements in the banking and financial sectors, influencing the health and stability of these institutions.

Non-Performing Assets (NPAs)

• Non-performing assets (NPAs) refer to loans and advances extended by banks or financial institutions where the repayment of principal and interest is delayed beyond 90 days. These assets no longer generate income for the lender, affecting the bank’s profitability and financial stability.

Classification

NPAs are primarily classified based on the duration of non-payment, the repayment status of the principal, and the payment of due interest. The classifications include:

1. Sub-standard Assets: Loans and advances that have been identified as NPAs for a period up to 12 months. These assets exhibit a heightened risk and indicate that the borrower is facing difficulties.
2. Doubtful Assets: When an asset remains in the sub-standard category for more than 12 months, it is termed as a doubtful asset. The chances of recovery for these loans are minimal, and they carry significant risk.
3. Loss Assets: These are considered the most severe category of NPAs, where the possibility of recovery is almost nil. The asset has been identified as a loss, but it has not been written off entirely by the bank.

Special Mention Account (SMA)

Before a loan becomes an NPA, it passes through the Special Mention Account (SMA) phase, categorized by the duration of overdue payment:

• SMA-0: 1-30 Days overdue
• SMA-1: 31-60 Days overdue
• SMA-2: 61-90 Days overdue

These classifications help banks monitor and manage loans that are at risk of turning into NPAs.

Reasons Behind NPAs in India

Several factors have contributed to the rise in NPAs in India, particularly:

• Huge Economic Growth (2004-2009): This period saw aggressive lending practices without adequate analysis of the financial health of companies or their credit ratings.
• Infrastructure Sector Investments: A significant portion of lending was directed towards infrastructure sectors such as roads, power, aviation, steel, etc.
• Regulatory and Environmental Issues: Banning of mining projects and delays in securing environmental permits led to increased raw material prices, affecting industries like power, steel, and iron. This, in turn, impaired the repayment capacity of companies.

Measures to Curb NPAs in India

To address the NPA issue, the Indian government and regulatory bodies have implemented several measures:

• Narasimham Committee Recommendations: Various recommendations of this committee have been adopted to improve the banking sector’s efficiency and reduce NPAs.
• Debt Recovery Tribunals (DRTs): Established to expedite the recovery process, though there are instances where cases have been pending for over two years.
• Statutory Provisions and Appellate Bodies: The establishment of comprehensive statutory provisions and appellate bodies like the Debt Recovery Appellate Tribunal (DRAT) to enhance the recovery process.

Limitations

Despite these measures, certain limitations persist, such as the lengthy judicial process, which can lead to the depreciation of asset value, sometimes to zero, before a resolution is reached.

(SARFAESI) Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002
SARFAESI Act, 2002:

The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act) is a pivotal legislation in the Indian financial landscape, designed to empower banks and financial institutions in dealing with non-performing assets (NPAs). This act allows for the swift recovery of loans without the need for court intervention, marking a significant step in addressing the challenges of asset recovery in India.

Key Provisions

• Acquisition and Disposal of Secured Assets: Banks are authorized to acquire and dispose of secured assets in NPAs with an outstanding balance of ₹1 lakh or more without court participation.
• Activation Criteria: The act is invoked when a borrower defaults on their payment for more than six months. After this period, the lender can issue a notice to the borrower demanding payment within 60 days. Failure to clear the dues allows the financial institution to take possession of the secured assets and manage, sell, or transfer them.

Objectives

• Legal Framework for Securitization: The act establishes a legal framework for securitization activities in India, providing a structured and enforceable process for dealing with NPAs.
• Transfer of NPAs to ARCs: It outlines the procedure for transferring non-performing assets to Asset Reconstruction Companies (ARCs) for the reconstruction of asset value.

Methods of Asset Recovery

1. Securitization: Converting illiquid assets into securities that can be sold in the market.
2. Asset Reconstruction: Reorganizing a

company’s assets to manage or dispose of NPAs effectively. 3. Enforcement of Security: Allows for the direct enforcement of security interests without the intervention of courts.

Other Related SARFAESI Facts

• Scope of Application: The act is applicable only to secured loans, enhancing the legal framework for dealing with NPAs.
• Empowering DRT: It empowers the Debt Recovery Tribunals (DRT) with enforcement laws, facilitating faster resolution of asset recovery cases.
• Operational Flexibility: Financial institutions can change the board of directors in defaulting companies, auction or sell such assets to ARCs, and Non-Banking Financial Companies (NBFCs), ensuring operational flexibility in recovering dues.
• Exclusions: SARFAESI Act does not apply to farm loans, safeguarding the interests of the agricultural sector.
• Eligibility for SARFAESI Powers: Banks, Housing Finance Companies (HFCs), and NBFCs with an asset size of ₹100 crore or more and loans of at least ₹50 lakhs are vested with SARFAESI powers.

Limitations of the SARFAESI Act

• Understaffing of DRTs and DRATs: The understaffing of Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs) has led to a backlog of over 1 lakh cases as of 2016, delaying the recovery process and diminishing asset values.
• Optimal Recovery Methods: In certain businesses, auction or liquidation may not yield the highest returns. Restructuring loans could potentially salvage more value, but the SARFAESI act does not facilitate such arbitration.
• Introduction of Insolvency & Bankruptcy Code: To address these limitations, the Government introduced the Insolvency & Bankruptcy Code, providing a comprehensive legal framework for the resolution of insolvency and bankruptcy.

Asset Reconstruction Companies (ARCs)

• Role of ARCs: ARCs play a crucial role in the reconstruction of assets, purchasing NPAs from financial institutions and employing various methods to recover the dues.
• Regulation: ARCs are regulated by the Reserve Bank of India (RBI) as a type of Non-Banking Financial Company (NBFC), ensuring compliance with financial norms and standards.

Insolvency and Bankruptcy Code (IBC), 2016
IBC, 2016

The Insolvency and Bankruptcy Code, 2016, was introduced as a landmark legislation to address the Chakravyuha challenge, reflecting the difficulty faced by Indian companies in exiting the market due to financial distress. It aims to consolidate and amend the laws relating to reorganization and insolvency resolution of corporate persons, partnership firms, and individuals in a time-bound manner, maximizing the value of assets, promoting entrepreneurship, and increasing the availability of credit.

Key Provisions of the IBC, 2016

1.  Resolution Process Trigger: If a company, individual, or partnership firm defaults on a business loan, financial creditors have the right to initiate insolvency proceedings by approaching the National Company Law Tribunal (NCLT).

2. Moratorium Period: Upon acceptance of the application by the NCLT, a moratorium period of 180 to 270 days is granted, during which the insolvency professional presents a resolution plan to a committee of creditors (CoC) composed mainly of financial creditors.

3. Lenders’ Consent for Restructuring: The code stipulates that if 75% of the lenders do not agree to a restructuring or resolution plan, the assets of the debtor will be liquidated.

4. Appeal Structure: The appeal structure under IBC varies based on the borrower’s nature:

Individuals and partnership firms approach the Debt Recovery Tribunal (DRT) and then the Debt Recovery Appellate Tribunal (DRAT).

Companies approach the National Company Law Appellate Tribunal (NCLAT).

5.  IBC Amendment 2021 – Pre-Packaged Insolvency Resolution Process (PPIRP): This amendment introduced a pre-arranged resolution process for MSMEs, allowing for an agreement between the debtor and creditors before initiating formal bankruptcy proceedings. It also permits the CoC to change the company’s management by a 66% vote, aiming to prevent fraud and mismanagement.

The Insolvency and Bankruptcy Board of India (IBBI)

The IBBI was established under the IBC, 2016, as the regulator overseeing the insolvency proceedings in India. It regulates the activities of Insolvency Professional Agencies, Insolvency Professionals, and Information Utilities, ensuring smooth execution of the insolvency process.

Timeline of NPA Management and Insolvency Reforms in India

• 1993: Formation of the Debt Recovery Tribunal.
• 2002: Introduction of the SARFAESI Act, Asset Reconstruction Company, and Prompt Corrective Action.
• 2014-2016: Various reforms including the PJ Nayak Committee, Indradhanush plan, establishment of the Banks Board Bureau, and introduction of strategies like Strategic Debt Recovery and S4A for managing stressed assets. The Insolvency and Bankruptcy Code was also enacted in 2016.
• 2017-2021: Continued efforts in resolving NPAs and strengthening the banking sector with measures like Recapitalisation Bond, Project Sashakt, and the establishment of the National Asset Reconstruction Company Limited (NARCL).

Prompt Corrective Action (PCA) Framework

The Prompt Corrective Action (PCA) framework is a supervisory strategy used by the Reserve Bank of India (RBI) to ensure the health and stability of financial institutions, particularly banks. It functions as an early intervention mechanism to identify and resolve issues in banks that show signs of distress due to poor financial metrics. The primary goal of the PCA framework is to prevent banks from becoming insolvent and to protect the interests of depositors and the financial system as a whole.

Key Features of the PCA Framework

1. Objective: The PCA framework is designed to facilitate the timely intervention by RBI in banks that show signs of financial stress. It aims to prompt banks to undertake corrective measures to restore their financial health.
2. Applicability: The PCA framework applies to all Scheduled Commercial Banks (SCBs) excluding Payments Banks and Small Finance Banks (SFBs). However, for Urban Cooperative Banks (UCBs), there is a separate mechanism known as the Supervisory Action Framework (SAF).
3. Basis for Supervision: Financial institutions are placed under the PCA framework based on certain financial metrics that indicate poor performance. These metrics typically include measures of capital adequacy, asset quality, and leverage.
4. Principles of PCA: The framework operates on two fundamental principles:

Early Identification: This involves the timely detection of banks that are experiencing financial distress.

Resolution Measures: Once a bank is identified under the PCA framework, appropriate measures are taken to address and resolve the issues causing the distress.

Risk Thresholds: The PCA framework defines three risk thresholds, which are based on critical parameters such as Capital Adequacy Ratio (CAR), Asset Quality (measured through Non-Performing Assets ratio), and Leverage. These thresholds help in categorizing the level of risk and determining the intensity of supervisory actions required.

Mechanism of Action

• The PCA framework initiates a series of corrective actions that a bank needs to take once it breaches one or more of the risk thresholds. These actions could include restrictions on dividend distribution, branch expansion, and executive compensation. The severity of these restrictions increases with the risk level.
• The PCA framework is structured to provide an early warning to banks about deterioration in their financial health, thus enabling them to take corrective measures in a timely manner. It also allows the RBI to take proactive steps to ensure the overall stability of the financial system.

Importance of PCA

• Ensures Financial Stability: By monitoring the financial health of banks and enforcing early corrective measures, the PCA framework helps in maintaining the stability of the financial system.
• Protects Depositors: Early identification and resolution of problems in banks ensure the safety of depositor’s money, thereby maintaining trust in the banking system.
• Promotes Discipline among Banks: The framework incentivizes banks to operate within prudential norms by imposing restrictions on poorly performing banks, thus encouraging healthy financial practices.

MISSION INDRADHANUSH

• Mission Indradhanush is a comprehensive reform initiative launched by the Ministry of Finance in 2015, targeting the transformation and revitalization of the public sector banking system in India. It was designed in response to the challenges faced by public sector banks (PSBs), aiming to improve their operational efficiency, governance, and ability to compete with private sector banks. The initiative draws its recommendations from the report submitted by the PJ Nayak Committee on the Governance of the Boards of Banks in India and addresses the economic imperative to enhance the asset quality of banks.

Objective

• The primary objective of Mission Indradhanush is to revamp the operational and governance structures of PSBs, enabling them to meet the challenges of the banking industry effectively and efficiently, thereby ensuring their robust participation in the economic growth of the country.

Components of Mission Indradhanush: Mission Indradhanush comprises seven key components, each aimed at addressing specific areas of reform within the public sector banking framework:

Appointment:

The government introduced global best practices in the appointment processes of PSBs by separating the roles of the chairman and the managing director (MD) to ensure more transparent and merit-based selection. This move was aimed at enhancing leadership quality and decision-making.

Bank Board Bureau (BBB):

The establishment of the Bank Board Bureau represented a paradigm shift in the appointment processes of whole-time directors and non-executive chairpersons in PSBs. Comprising eminent professionals, the BBB aimed to bring about professionalism and efficiency in the governance of banks.

Capitalisation:

To ensure that PSBs maintain a safe capital buffer above the Basel III norms, the government committed to adequately capitalising all banks. This was critical for maintaining financial stability and fostering confidence among depositors and investors.

De-stressing PSBs:

Measures were introduced to fast-track the recovery of bad loans, including the creation of new Debt Recovery Tribunals. Additionally, efforts were made to develop a vibrant debt market, reducing the lending pressure on PSBs and facilitating easier capital management.

Empowerment:

A robust grievance redressal mechanism was envisioned to empower customers, ensuring that their concerns are addressed in a timely and efficient manner. This aimed to improve the customer service standards of PSBs.

Framework for Accountability:

The introduction of a new framework of Key Performance Indicators (KPIs) for PSBs aimed to enhance accountability and performance evaluation. This framework was designed to measure and improve the banks’ operational efficiency, risk management, and overall performance.

Governance Reforms:

Gyan Sangam, a conclave of PSBs and financial institutions, was initiated to kick-start the process of governance reform. It facilitated focused group discussions on various topics relevant to effective banking and governance reforms.

Significance: Mission Indradhanush has been pivotal in setting a roadmap for the transformation of the public sector banking industry in India. By addressing critical areas such as governance, capitalisation, and accountability, the initiative aims to equip PSBs to face the competitive dynamics of the banking sector and contribute significantly to the country’s economic development.

Project Sashakt

• Project Sashakt represents a strategic initiative aimed at addressing and resolving the issue of non-performing assets (NPAs) within the Indian banking sector. Spearheaded by a panel led by the Chairman of Punjab National Bank (PNB), Mr. Sunil Mehta, the project seeks to consolidate and effectively manage stressed assets, thereby enhancing the overall health and efficiency of the banking system.

Core Components of Project Sashakt

Intercreditor Agreement (ICA)

A cornerstone of Project Sashakt is the mandatory formation of an Intercreditor Agreement (ICA) among lenders. This agreement is a pivotal mechanism designed to streamline and expedite the resolution process of borrowers’ accounts that show signs of financial stress. The guidelines stipulate that:

• For Loans up to 50 Crore Rupees: These are managed at the individual bank level, with a resolution timeframe capped at 90 days from the onset of the first default.
• For Loans exceeding 50 Crore Rupees: Banks are required to forge an intercreditor agreement, empowering the lead bank to spearhead the formulation and execution of a resolution plan within 180 days. Failure to achieve resolution within this period mandates the referral of the asset to the National Company Law Tribunal (NCLT) for further action.

Decision-Making Thresholds within ICA

Project Sashakt introduces pragmatic thresholds to facilitate decision-making within the ICA framework, significantly deviating from the erstwhile consensus-based model. The revised norms assert that:

• The agreement of lenders representing at least 75% of the debt value or 60% by the number of lenders is sufficient to sanction a resolution plan.
• The Lead Bank, defined as the lender with the most significant exposure to the stressed asset, is entrusted with the primary responsibility of initiating and driving the resolution process.

NPA-Related Terminologies
Interest Coverage Ratio

• The Interest Coverage Ratio (ICR) is a critical financial metric used to assess a company’s ability to service its debt obligations. Calculated by dividing the Earnings Before Interest and Taxes (EBIT) by the interest expenses over a given period, a higher ICR indicates a robust capacity to meet interest payments, reflecting positively on the company’s financial health.

Teaser Loans

• Teaser Loans represent a unique financial product characterized by an initially lower interest rate, intended to attract borrowers. This promotional strategy is widely employed across various loan categories, including adjustable-rate mortgages and credit cards. The State Bank of India’s introduction of teaser loans in the home loan segment in 2009 marked a significant milestone. While teaser loans are accessible to a broad spectrum of borrowers, including entrepreneurs and first-time homebuyers, they also constitute an element of subprime lending, targeting individuals with lower creditworthiness who are at a heightened risk of default.

Bad Banks

• A “Bad Bank” is a financial institution created for the specific purpose of purchasing non-performing assets (NPAs) from other banks. The primary goal of a bad bank is to clean up the balance sheet of these banks, thereby reducing their burden. This setup allows banks to focus on their core business activities, including lending to customers without constraints arising from carrying NPAs on their balance sheets.

National Asset Reconstruction Company Limited (NARCL)

• In the Budget announcement of 2021-2022, the Indian government unveiled the formation of the National Asset Reconstruction Company Limited (NARCL). The NARCL’s main objective is to buy bad loans from banks. Following the acquisition, these assets are managed by the India Debt Resolution Company Limited (IDRCL), which focuses on enhancing the value of these assets for better recovery. Significantly, public sector banks hold a 51% ownership stake in NARCL, symbolizing a collective effort to address the issue of non-performing assets in the banking sector.

India Debt Resolution Company Limited (IDRCL)

• The IDRCL was established as a collaborative initiative between the public and private banking sectors. Its primary role is to assist NARCL by managing and attempting to improve the value of the acquired distressed assets, aiming for an efficient resolution and recovery process.

Proposal for a National Bad Bank

• In 2020, the Indian Bank Association proposed the establishment of a national bad bank to the Reserve Bank of India (RBI) and the government. This proposed entity was aimed at initially managing approximately ₹75,000 crores worth of bad loans, illustrating a strategic approach to significantly mitigate the impact of NPAs on the banking sector.

The Economic Survey and PARA

• The Economic Survey of 2016-17 identified the ‘twin balance sheet’ problem, which highlighted the stress on banks’ and corporate balance sheets due to NPAs. It proposed the establishment of a government-owned asset reconstruction company, termed the Public Sector Asset Rehabilitation Agency (PARA), to tackle this pervasive issue.

Asset Reconstruction Company (ARC)

• An Asset Reconstruction Company is defined as an entity that acquires a bank’s rights or interests in the form of financial assistance, with the aim of realizing the value from these assets. ARCs are incorporated under the Companies Act and are registered with the RBI under section 3 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. Their role is pivotal in the asset reconstruction and recovery process, providing a systematic approach to handling NPAs.

Provisioning Coverage Ratio (PCR)

• The Provisioning Coverage Ratio is a regulatory norm set by the RBI, activated when an asset turns bad. It mandates banks to set aside a prescribed proportion of their bad assets. The PCR is inversely proportional to the quality of assets and the bank’s profitability, serving as a measure of the bank’s financial health in terms of its ability to cover potential losses from NPAs.

Basel Norms

• The Basel norms are a set of international regulatory frameworks designed to ensure the stability and health of the global banking system. They are developed by the Basel Committee on Banking Supervision (BCBS), which is composed of central banks from around the world. The primary aim is to foster financial stability and set common standards for banking regulation.

BASEL I:

Introduced in 1988, Basel I focused on credit risk and established a system for measuring capital. It set a required minimum capital ratio of 8% of a bank’s risk-weighted assets. The capital was classified into two tiers:

• Tier 1 Capital: This is the core capital of a bank, representing the primary measure of a bank’s financial strength. It includes equity capital and disclosed reserves.
• Tier 2 Capital: This serves as supplementary capital to Tier 1. It is considered less reliable and includes items such as revaluation reserves, undisclosed reserves, and subordinated term debt. Tier 2 capital is more difficult to liquidate.

BASEL II:

Basel II expanded on the first set of norms, introducing guidelines based on three pillars:

1. Capital Adequacy Requirements: Banks must maintain a Capital Adequacy Ratio (CAR) of at least 8%, ensuring sufficient capital to cover their risk-weighted assets and liabilities, regardless of whether assets become non-performing.
2. Supervisory Review: This pillar focuses on the oversight of credit, market, and operational risks, allowing regulators to evaluate and improve banks’ risk management practices.
3. Market Discipline: Requires banks to regularly disclose their CAR, risk exposures, and other relevant information, fostering transparency and accountability.

BASEL III:

The Basel III norms were introduced to enhance the resilience of the banking sector, focusing on capital, leverage, funding, and liquidity:

• Capital: Banks are required to maintain a higher CAR of 11%, with a Tier 1 capital ratio of 9% and a Tier 2 capital ratio of 2%. Additionally, a Capital Conservation Buffer (CCB) of 2.5% is mandated, and a Countercyclical Capital Buffer (CCCB) of 0-2.5% may be required during periods of high credit growth.
• Leverage: A minimum leverage ratio of 3% is set to control the scale of banks’ leverage, calculated as Tier 1 capital over the bank’s total consolidated assets.
• Liquidity: Basel III introduces two key liquidity ratios:
• Liquidity Coverage Ratio (LCR): Banks must hold a buffer of high-quality liquid assets to cover net cash outflows under a 30-day stress scenario.
• Net Stable Funding Ratio (NSFR): Ensures banks maintain a stable funding profile in relation to their assets and off-balance sheet activities.
• Capital Conservation Buffer (CCB): An additional layer of capital that banks are required to hold to withstand periods of stress. This brings the total capital requirement, including CAR and CCB, to 11.5%.
• Countercyclical Capital Buffer (CCCB): This buffer aims to protect the banking sector from cyclical risks, requiring banks to accumulate capital during boom periods that can be drawn upon in downturns.

The Basel norms play a crucial role in the global financial system, setting standards for banks to follow that aim to reduce risk and ensure stability. Despite their comprehensive nature, the implementation of these norms can vary by country, reflecting different stages of adoption and adaptation to local banking environments.

Systemically Important Financial Institutions (SIFIs)

• Systemically Important Financial Institutions (SIFIs) are vital components of the global financial system due to their significant influence and integral role in economic stability. Their classification arises from various characteristics that, combined, highlight their importance and the potential risks they pose to the financial system if they were to fail.

Definition and Characteristics

SIFIs are financial institutions whose failure could trigger a financial crisis or significantly hamper the overall economic system. They are distinguished by several key attributes:

• Size: The sheer volume of their assets makes their operations crucial for the financial system.
• Cross-Jurisdictional Activity: Their operations span across multiple countries, making their stability important for international financial health.
• Complexity: Their complex business models and financial services are difficult to replicate, adding to their systemic importance.
• Lack of Substitutability: There are few, if any, other institutions capable of providing the same services at a similar scale, which makes replacing them difficult.
• Interconnectedness: They have significant ties with other financial institutions, making the system vulnerable to a domino effect in case of their failure.

“Too Big To Fail” Notion

• A central aspect of SIFIs is the perception that they are “Too Big To Fail” (TBTF). This belief stems from the idea that the economic and financial consequences of allowing such an institution to collapse would be so severe that governmental intervention is almost guaranteed. In times of distress, these institutions might receive support from the government, further reinforcing the TBTF notion.

Criteria and Examples

• In some jurisdictions, quantitative thresholds are established to identify SIFIs. For instance, banks with assets exceeding 2% of the GDP of their home country might be classified as SIFIs. Examples include major banks like the State Bank of India (SBI), ICICI Bank, and HDFC Bank in India.

Impact and Regulatory Measures

The failure of a SIFI could disrupt essential services within the banking system, leading to broader economic difficulties. To address these concerns, regulatory bodies have put forward several measures:

• Domestic Systemically Important Banks (D-SIBs): In India, the Reserve Bank of India (RBI) has identified and disclosed the names of D-SIBs since 2015, placing these banks into categories based on their importance and risk level.
• Domestic Systemically Important Insurers (D-SIIs): Similarly, the Insurance Regulatory and Development Authority of India (IRDAI) has identified systemically important insurers to ensure the stability of the insurance sector.

Banking Ombudsman

Parallel to the management of SIFIs, the RBI has established the Banking Ombudsman Scheme to address grievances from the public against financial institutions. This scheme is noteworthy for several reasons:

• It includes a wide range of banking institutions, from public and private sector banks to rural and cooperative banks.
• The RBI’s integrated ombudsman scheme consolidates previous initiatives (Banking Ombudsman Scheme 2006, NBFC Ombudsman Scheme 2018, and Digital Transaction Ombudsman Scheme 2019) to offer a unified and efficient grievance redressal mechanism.
• It covers complaints against RBI-regulated entities, including non-scheduled primary cooperative societies with deposits of ₹50 crores and above, enhancing consumer protection and trust in the financial system.

Non-Banking Financial Institutions (NBFI)

Non-Banking Financial Companies (NBFCs) are crucial financial intermediaries, offering a variety of services and products that complement the traditional banking sector. They play a significant role in promoting inclusive growth in the economy by catering to the diverse financial needs of the unbanked and underbanked sections of society. This detailed explanation aims to provide comprehensive insights into NBFCs, their criteria, types, and regulatory framework.

NBFCs

An NBFC is a company registered under the Companies Act, 1956 (now governed by the Companies Act, 2013), engaged in the business of loans and advances, acquisition of shares, stocks, bonds, debentures, securities issued by the government, or local authority or other marketable securities. Unlike banks, NBFCs do not hold a banking license, yet they perform functions similar to banks.

Criteria for NBFC License

To operate as an NBFC, a company must meet the following criteria:

• Registration Requirement: The company should be duly registered under the Companies Act.
• Type of Company: It can be either a Private Limited Company or a Public Limited Company.
• Net Owned Funds: The company must have a minimum net owned fund of at least ₹2 crores.

Types of NBFCs

NBFCs can be categorized under three broad headings based on various criteria:

Based on Nature of Activity:

1.  Asset Finance Company (AFC)

2.  Loan Company (LC)

3.  Investment Company (IC)

4.  Systemically Important Core Investment Company (CIC-ND-SI)

5.  Infrastructure Finance Company (IFC)

6.  NBFC-Micro Finance Institution (NBFC-MFI), etc.

Based on the Basis of Deposits:

1.  Deposit Accepting NBFCs (NBFC-D)

2.  Non-Deposit Accepting NBFCs (NBFC-ND)

Based on Asset Size:

1.  Systemically Important NBFCs (NBFC-SI)

2.  Non-Systemically Important NBFCs (NBFC-NSI)

Regulation of NBFCs

The regulatory and supervisory framework for NBFCs is established with three primary objectives: depositor protection, consumer protection, and ensuring financial stability. The Reserve Bank of India (RBI) is the principal regulatory body overseeing the operations of NBFCs, and it exercises its powers under the RBI Act, 1934. Key aspects of NBFC regulation include:

• Punitive Action: In extreme situations, the RBI is empowered to take punitive actions against NBFCs under the RBI Act, 1934.
• Progressive Regulatory Approach: The RBI has proposed a progressive increase in regulatory intensity through a four-tier mechanism based on the size, activity, and perceived risk associated with an NBFC.
• NPA Classification: There has been a reduction in the classification of Non-Performing Assets (NPAs) for the base layer of NBFCs from 180 days to 90 days, aligning it more closely with banking standards.

Revised Scale-Based Regulatory (SBR) Framework

• The Scale-Based Regulatory (SBR) Framework introduces a tiered regulatory structure for NBFCs, categorizing them into four layers based on their size, activity, and perceived risk profile. This framework aims to tailor regulatory requirements more precisely to the risk profile and scale of operations of NBFCs, ensuring a balanced approach between mitigating systemic risks and encouraging financial sector innovation. The four layers are designed to enhance transparency, governance, and operational standards across the sector, fostering a more resilient and responsive non-banking financial sector.

Significance of NBFCs

Non-Banking Financial Companies (NBFCs) play a pivotal role in the financial ecosystem, especially in developing countries like India. They provide critical financial services that contribute to the economic fabric in the following ways:

• Accessibility: NBFCs significantly enhance access to financial services for individuals and businesses, especially in regions or sectors where traditional banking services are limited or absent.
• Serving Underserved Markets: They cater to market sectors that are considered to have higher risk and lower returns, which commercial banks often choose not to serve. This includes small and medium enterprises (SMEs), microfinance, and consumer loans.

NBFC vs. Commercial Banks

Categories of NBFCs Regulated by Various Authorities

NBFCs Regulated by RBI

• Investment and Credit Company: Introduced in 2019, merging previous categories like Asset Finance Company, Loan Company, etc.
• Core Investment Company: Focuses on long-term investments in companies, e.g., IL&FS owned by SBI, LIC, and corporates.
• Asset Reconstruction Company: Buys bad loans from banks and others to recover value from the underlying assets.
• Microfinance Institution: Created based on the recommendation of the Malegam Committee in 2010, regulated by RBI and Ministry of Corporate Affairs.
• Mudra Bank (2015): A non-deposit taking NBFC owned by SIDBI, providing indirect loans to microenterprises based on PM Mudra Yojana.

NBFCs Regulated by SEBI

• Stock Brokers: Help in buying and selling shares and bonds, e.g., Sharekhan.
• Mutual Funds: Pooled money is invested in shares and bonds, e.g., SBI’s Sharia Equity MF.
• REITs/InVITs: Investment in real estate and infrastructure projects.
• Venture Capital Funds: Provide equity finance to startup companies, e.g., IFCI.

NBFCs Regulated by Other Authorities

• IRDAI: Regulates life and general insurance companies, and policy aggregator platforms.
• PFRDA: Oversees pension funds, except EPFO and other statutory funds.
• National Housing Bank: The apex body promoting Housing Finance Institutions at both local and regional levels.
• Ministry of Corporate Affairs: Regulates Nidhi companies and Microfinance companies.
• State Registrar of Chit Funds: Manages chit funds, which are collective investment schemes with monthly contributions and borrowing by members.

SWIFT System: Society for Worldwide Interbank Financial Telecommunication

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) provides a secure and reliable global financial messaging service, enabling financial institutions to send and receive information regarding financial transactions. It serves as an intermediary that verifies transactional data but does not facilitate the transfer of funds. SWIFT does not manage accounts for individuals or financial organizations, hold external funds, or perform clearing or settlement duties.

SWIFT Code Identification

Each institution within the SWIFT network is identified by an eight-character SWIFT code, such as “UNCRITMM”, which includes:

• Institution Code: The first four characters represent the institution (e.g., “UNCR” for UniCredit Banca).
• Country Code: The next two characters denote the country (e.g., “IT” for Italy).
• Location/City Code: The subsequent two characters indicate the location or city (e.g., “MM” for Milan).
• Branch Code: The final three characters are optional and used by organizations to designate specific branches.

Impact of SWIFT Sanctions on Russia

The exclusion of banks from the SWIFT system can severely restrict their ability to conduct financial transactions with foreign entities, fulfill obligations, receive payments for exports, or offer short-term credit for imports. Such sanctions can disrupt all sectors of an economy engaged in international trade and banking, including Russia’s domestic payment systems, potentially affecting transactions with cards issued by major credit networks. This disruption poses risks not only to the imposing countries but also to the global economy, potentially affecting energy supplies to Europe and commodity exports worldwide.

Alternatives to SWIFT

SPFS

• The System for Transfer of Financial Messages (SPFS) is the Central Bank of Russia’s alternative to SWIFT, established following the invasion of Crimea in 2014. It serves as a domestic financial messaging system, offering a similar service to SWIFT.

CIPS

• The Cross-Border Interbank Payment System (CIPS) is China’s counterpart to SWIFT. Though substantially smaller, with around 1,300 participating financial institutions, CIPS facilitates international financial transactions for Chinese entities.

Cryptocurrencies

• Cryptocurrencies and the development of a ‘digital’ rouble in Russia represent another alternative for cross-border payments, bypassing traditional financial messaging systems like SWIFT.

Impact on India

The exclusion of Russian banks from SWIFT could lead to cancellations of supply orders by and to India, disrupting trade due to payment delays. However, the trade imbalance between India and Russia means that the long-term impact on India might be limited. India imports primarily petroleum products, diamonds, precious stones, and fertilizers from Russia, and exports capital goods, pharmaceuticals, organic chemicals, and automobile parts.

Alternative Mechanism for India

India could adopt a mechanism similar to the rupee-rial architecture used for transactions with Iran. This system allowed Indian refiners to use selected rupee accounts for crude oil imports from Iran, with Indian exporters being paid in turn. This mechanism continued until crude oil was removed from the US sanctions list, illustrating a potential framework for maintaining trade with sanctioned countries.

UPSC PREVIOUS YEAR QUESTIONS

1.  Consider the following statements: (2020)

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

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

2.  With reference to ‘Urban Cooperative banks’ in India consider the following statements: (2021)

1.  They are supervised and regulated by local boards set up by the State Governments.
2.  They can issue equity shares and preference shares.
3.  They were brought under the purview of the
4.  Banking Regulation Act, 1949 through an Amendment in 1966.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

3.  The Service Area Approach was implemented under the purview of ________________(2019)

(a) Integrated Rural Development Programme
(b) Lead Bank Scheme
(c) Mahatma Gandhi National Rural Employment Guarantee Scheme
(d) National Skill Development Mission

4.  Which of the following is not included in the assets of a commercial bank in India? (2019)

(a) Advances
(b) Deposits
(c) Investments
(d) Money at call and short notice

5.  The Chairman of public sector banks are selected by the __________ (2019)

(a) Banks Board Bureau
(b) Reserve Bank of India
(c) Union Ministry of Finance
(d) Management of concerned bank

6.  What is the importance of the term “Interest Coverage Ratio” of a firm in India? (2020)

1.  It helps in understanding the present risk of a firm that a bank is going to give a loan to.
2.  It helps in evaluating the emerging risk of a firm that a bank is going to give a loan to.
3.  The higher a borrowing firm’s level of Interest Coverage Ratio, the worse is its ability to service its debt.

Select the correct answer using the code given below.

(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3

7.  If you withdraw `. 1,00,000 in cash from your Demand Deposit Account at your bank, the immediate effect on aggregate money supply in the economy will be_________ (2020)

(a) to reduce it by `. 1,00,000
(b) to increase it by `. 1,00,000
(c) to increase it by more than `. 1,00,000
(d) to leave it unchanged

8.  If another global financial crisis happens in the near future, which of the following actions/policies are most likely to give some immunity to India? (2020)

1.  Not depending on short-term foreign borrowings
2.  Opening up to more foreign banks
3.  Maintaining full capital account convertibility

Select the correct answer using the code given below:

(a) 1 only
(b) 1 and 2 only
(c) 3 only
(d) 1, 2 and 3

9.  With references to the governance of public sector banking in India, consider the following statements: (2018)

1.  Capital infusion into public sector banks by the
2.  Government of India has steadily increased in the last decade.
3.  To put the public sector banks in order, the merger of associate banks with the parent State Bank of India has been affected.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

10.  What is/are the purpose/purposes of the ‘Marginal Cost of Funds based Lending Rate (MCLR)’ announced by RBI? (2016)

1.  These guidelines help improve the transparency in the methodology followed by banks for determining the interest rates on advances.
2.  These guidelines help ensure the availability of bank credit at interest rates which are fair to the borrowers as well as the banks.

Select the correct answer using the code given below.

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

11.  The establishment of ‘Payment Banks’ is being allowed in India to promote financial inclusion. Which of the following statements is/are correct in this context? (2016)

1.  Mobile telephone companies and supermarket chains that are owned and controlled by residents are eligible to be promoters of Payment Banks.
2.  Payment Banks can issue both credit cards and debit cards.
3.  Payment Banks cannot undertake lending activities.

Select the correct answer using the code given below.

(a) 1 and 2 only
(b) 1 and 3 only
(c) 2 only
(d) 1, 2 and 3

12. The term ‘Core Banking Solution’ is sometimes seen in the news. Which of the following statements best describes/describe this term? (2016)

1.  It is a network of a bank’s branches which enables customers to operate their accounts from any branch of the bank on its network regardless of where they open their accounts.
2.  It is an effort to increase RBI’s control over commercial banks through computerization.
3.  It is a detailed procedure by which a bank with huge non-performing assets is taken over by another bank.

Select the correct answer using the code given below.

(a) 1 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

13.  Which of the following grants/grant direct credit assistance to rural households? (2013)

1.  Regional Rural Banks
2.  National Bank for Agriculture and Rural
3.  Development
4.  Land Development Banks

Select the correct answer using the codes given below.

(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3

14.  The basic aid of the Lead Bank Scheme is that______ (2012)

(a) Big banks should try to open offices in each district.
(b) There should be stiff competition among the various nationalized banks.
(c) Individual banks should adopt a particular district for intensive development.
(d) All the banks should make intensive efforts to mobilize deposits.

15.  Consider the following statements: (2018)

1.  Capital Adequacy Ratio (CAR) is the amount that banks have to maintain in the form of their own funds to offset any loss that banks incur if the account holders fail to repay dues.
2.  CAR is decided by each individual bank.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

16.  Basel III Accord’ or simply ‘Basel III’ often seen in the news, seeks to ___________ (2015)

(a) Develop national strategies for the conservation and sustainable use of biological diversity
(b) Improve banking sector’s ability economic stress and improve risk management
(c) Reduce the greenhouse gas emissions but places a heavier burden on developed countries
(d) Transfer technology from developed countries to poor countries to enable them to replace the use of chlorofluorocarbons in refrigeration with harmless chemicals

17.  In India, which of the following has the highest share in the disbursement of credit to agriculture and allied activities? (2011)

(a) Commercial Banks
(b) Cooperative Banks
(c) Regional Rural Banks
(d) Microfinance Institutions

18.  Microfinance is the provision of financial services to people of low-income groups. This includes both the consumers and the self-employed. The service/ services rendered and microfinance is/are: (2011)

1.  Credit facilities
2.  Savings facilities
3.  Insurance facilities
4.  Fund Transfer facilities

Select the correct answer using the codes given below the lists:

(a) 1 only
(b) 1 and 4 only
(c) 2 and 3 only
(d) 1, 2, 3 and 4

19.  Pradhan Mantri Jan Dhan Yojana (PMJDY) is necessary for bringing the unbanked to the institutional finance fold. Do you agree with this for the financial inclusion of the poor section of Indian society? Give arguments to justify your opinion. (2016)