Financial Sector

Assessment
Rakesh Mohan
Deputy Governor
Reserve Bank of India
and
Chairman, CFSA
1
 What is an FSAP?
The Financial Sector Assessment Program is an
IMF-World Bank initiative
 A comprehensive health check of the financial
system
 A review of strengths, vulnerabilities and weaknesses
 Measures compliance with international financial
standards and codes
 Initiated after the1997 Asian financial crisis

2
 Presentation Outline
Part I: The FSAP and Self-Assessment
A. Background and Timing
B. Macroeconomic Outlook and Vulnerabilities
C. Stability Assessment & Stress Testing
Part II: Lessons and Issues from the Assessment
D-F. Financial Institutions, Markets and Infrastructure
G. Transparency and Developmental Issues
Part III: Transparent Reporting
H. Peer Reviewers’ Comments
I. CFSA and Advisory Panels – Some Differences
Part IV: Conclusions and Concerns
J. Summary of Assessment
K. Main Concerns

3
 Part I
The FSAP and Self-Assessment

4
A. Background and Timing

5
 Background and Timing (1)
The Story So Far
IMF-WB FSAP in 2001, self-assessment of
international standards and codes in 2002,
reviewed again in 2005
Set up CFSA in 2006
India among the first country to undertake
comprehensive and holistic self-assessment of
financial sector
Post-crisis, emphasis by the G-20

6
 Background and Timing (2)
Overview of Self-Assessment
Approach and Methodology
 Pillar I  Macro-prudential surveillance and

financial stability analysis

 Pillar II  Legal and institutional frameworks

review
 Pillar III  International financial standards and

codes: assessment and status of implementation

7
 Background and Timing (3)
The Process
 Benefits
 Composition of CFSA: ownership and commitment

 Regulatory cooperation: GoI, RBI, SEBI, IRDA, other agencies

 Involvement of experts: advisory panels

 Peer reviews: Impartiality

 Learning and capacity-building: involvement of professionals

 Execution
 Complex issues – approach with humility

 Broad directions instead of specifics in the current context

 Focus on Transparent Reporting : Differing opinions of CFSA

and Panels covered in the report

8
B. Macroeconomic Outlook and
Vulnerabilities

9
 Macroeconomic Outlook and Vulnerabilities (1)
The Growth Story
 Growth in recent period contributed by several factors
 High domestic demand
 Productivity

 Credit growth

 High levels of savings and investment

 Current global financial crisis: shift from benign outlook

to one of uncertainty
 8 %+ growth sustainable in the medium-term due to
high demand; deceleration in the short-term

10
 Macroeconomic Outlook and Vulnerabilities (2)
Pressing Challenges
Need for revival of growth in agriculture
Address restoration of the fiscal reform path
Continuation of financial sector consolidation and
development
Address the infrastructure deficit
 Complement bank financing with bond market

development
 Insurance and pension reforms

FCAC desirable, but with concomitant

macroeconomic and market developments

11
C. Stability Assessment and
Stress Testing

12
 Stability Assessment and Stress Testing (1)
Main Findings

Financial Institutions
 Commercial Banks: financially robust

 NBFCs and HFCs: healthy financial indicators

Some financing concerns

 UCBs and RRBs: improvements in financials

governance concerns

 Rural Co-operative Sector

significant weaknesses

13
 Stability Assessment and Stress Testing (2)
Financial Soundness Indicators
 Commercial Banks - Broad improvement in the post-
reform period
Financial Soundness Indicators 2000 2008
CRAR 11.1 13.0
Gross NPAs to Gross Advances 13.1 2.4
Net NPAs to Net Advances 7.1 1.1
Return on Total Assets 0.7 1.0
Return on Equity 12.7 12.5
Efficiency (Cost Income) Ratio 61.2 48.9

14
 Stability Assessment and Stress Testing (3)
Financial Soundness Indicators
 Other Institutions - Broad improvement in the post-
reform period – Rural Co-operative Sector – some
concerns
  NBFCs -  HFCs Scheduled  RRBs StCBs/
D UCBs DCCBs
  2004 2008 2004 2008 2005 2008 2005 2008 2005 2007

CRAR 26.8 22.4 15.0 18.1 12.7 11.9 ---- ----

---- ----
Gross  16.3 14.2
NPAs  8.2 1.5 3.6 2.2 24.8 14.2 8.5* 5.9* 19.9 18.5
Ratio
0.4 0.3
RoA* 2.5 2.9 1.9 2.2 0.3 0.7 1.0 1.1 0.7 0.02
* Ratio to Total Assets
15
 Stability Assessment and Stress Testing (4)
Stress Testing
 What is Stress Testing
 Techniques to assess vulnerability of the financial system

in the face of shocks;

 identifies how portfolios respond to changes in key

economic variables: e.g., interest rates, credit quality

 Coverage of stress tests
 Credit risk

 Market/interest rate risk

 Liquidity risk

 Open positions in foreign exchange much below regulatory

limits – Exchange rate tests not undertaken

16
 Stability Assessment and Stress Testing (5)
Credit Risk
Concerns about credit risk remain muted at
present
Need for close monitoring of such risks in
the current scenario

  Without Scenario - increase in

Stress NPA by:
100 per 150 per cent
cent
  CRAR (%) CRAR (%) CRAR (%)

Mar-08 13.0 11.6 11.0 17

Sept–08 12.5
Note: CRAR = credit to risk assets ratio 11.1 10.6
 Stability Assessment and Stress Testing (6)
Interest rate risk
 Higher the DoE (duration of equity), greater the
sensitivity of banks capital to interest rate shocks
 Calculates the erosion in accounting capital due to
unit increase in interest rate
Period Mar-06 Mar-07 Mar-08 Sep-08

DoE (yrs) 14.1 12.0 8.0 8.1

The annualised yield volatility is estimated at 244 bps

Given a DoE of 8.1 years, a 244 bps shock implies an
erosion of 20 per cent of capital and reserves.
=> Better management of interest rate risk by 18

commercial banks over time

 Stability Assessment and Stress Testing (7)
An Overview of Liquidity Ratios
Ratio Mar-05 Mar-08 Sep-08
(Volatile Liabilities –Temporary Assets) /34.7 43.9 49.3
(Earning Assets –Temporary Assets) (per
cent) (High and positive number implies
some risk of funding liquidity.)
(Core Deposits) / Total Assets (per cent) - 53.8 49.3 47.7
(Extent to which assets are funded through
stable deposit base)
(Loans + Mandatory CRR + Mandatory75.0 86.3 86.5
SLR + Fixed Assets) / Total Assets (per
cent) –
(Embedded illiquidity in the balance sheet)

(Loans + Mandatory CRR + Mandatory1.4 1.8 1.8

SLR + Fixed Assets) / Core Deposits – 19
(Dependence on purchased liquidity)
 Stability Assessment and Stress Testing (8)
Liquidity Risk Management

Gradual, growing dependence on purchased

liquidity
Increase in illiquid parts of banks’ balance
sheets
Greater reliance on volatile liabilities for
asset growth

20
 Stability Assessment and Stress Testing (9)
The Way Forward

In Sum:
 Commercial Banking System – Broadly Sound
 Can withstand significant shocks from large potential
changes
Possible Next Steps:
 Need to strengthen liquidity management

 Stress Testing by individual banks

 Periodic scenario testing by RBI

 Setting up of a Financial Stability Unit

21
 Part II
Lessons and Issues
From the Assessment

22
D. Financial Institutions

23
 Financial Institutions (1)
Regulation and Supervision
Inherent linkages across institutions
 Inter-bank

 Bank and non-banks

Basel Core Principles not applicable to:

 Co-operative Sector; Regional Rural Banks;

 NBFCs; HFCs

 But, Assessment done for health check

Results: Generally satisfactory

24
 Financial Institutions (2)
Basel Core Principles: A Compliance Summary

Assessment CB UCB StCB/ RRB NBFC HFC

DCCB

Compliant 7 4 3 4 1 2

Largely Compliant 11 11 10 8 13 10

Materially Non- 6 4 6 6 2 5
compliant
Non-compliant 1 2 2 2 8 8

Not applicable - 4 4 5 1 -

25
 Financial Institutions (3)
Basel Core Principles: A Compliance Summary

Major Gaps:
All Institutions: Risk management (for commercial banks the level of
compliance is comparatively lower in respect of banking groups); home-
host country regulation
Commercial Banks: Exposure to related parties; non-compliance in
respect to interest rate risk in banking book for which guidelines have
since been issued
Rural & Co-operative Banks: Dual Control; internal control; corporate
governance
NBFCs: Major acquisitions, transfer of significant ownership, internal
control
26
HFCs: Permissible activities; internal control
 Financial Institutions (4)
Commercial Banks Oversight
Government ownership poses dilemmas
 Possibility of conflicts of interest minimised

through even-handed regulation

Capital augmentation of PSBs is a challenge, but
could be managed through a variety of ways
 Amalgamation where commercial synergies exist

 Newer instruments

 Through selective dilution of government equity

27
 Financial Institutions (5)
Banking For The 21st Century
Capacity Building:
 Training

 Succession Planning

 Lateral Recruitment

 Improved remuneration – but discourage excessive risk

taking
Corporate Governance:
 Improve governance in PSBs

Roadmap for foreign banks –

 A guarded approach within the WTO norms

28
 Financial Institutions (6)
New Competition Act: Some Issues
 Power of Competition Commission to regulate combination
 Any combination required to be notified to Commission
 Maximum period of wait 210 days
 RBI may be able to give sanction only after getting order of
Commission or wait for 210 days
 Delays the process
 Possibility of regulatory conflict as order of any statutory
authority not binding on Commission
 Could lead to regulatory overlap and conflict
 Central Government could give necessary exemption under
Section 54 of the Competition (Amendment) Act 2007

29
 Financial Institutions (7)
Risk Management and Governance
 Conservative risk management matters
 Counter-cyclical prudential measures by RBI
 Off-balance sheet items: Better accounting, disclosure
 Capital charge if reliance on purchased liquidity beyond a threshold

 Consolidation
 Encourage market-based consolidation

 Co-operative and rural banks need better governance

 Dual control: improve corporate governance
 Regulation and supervision of rural financial sector: role for RBI and
NABARD

30
 Financial Institutions (8)
Non-Bank Financial Services
 NBFCs are key players in financial markets
 Corporate bond market development would ease funding constraints

 Development of regulatory structure for financial conglomerates

 Prudential regulations of NBFCs strengthened – some way to go

 Housing finance: growing and important segment

 National Housing Price Index, Housing Starts Index a priority

 Regulation of HFCs should be entrusted to RBI – Government’s stance –

status quo

31
 Financial Institutions (9)
An Assessment of Insurance
The level of compliance of the Insurance Sector to IAIS Core Principles

Assessment Number of
Principles
Observed 5

Largely Observed 13

Partly Observed 10

Not Observed -

32
 Financial Institutions (10)
An Assessment of Insurance
 Significant growth in size, penetration and diversified
products
 Comfortable solvency and capital adequacy
 But gaps/issues remain
 Increase supervisory powers of IRDA
 Group-wide supervision – effective policy to be put in place
 Risk Management
 Further requirement of skilled professionals – actuaries,
treasury managers

33
E. Financial Markets

34
 Financial Markets (1)
Regulation and Supervision
Systemic stability
 Importance of markets other than equity

market
IOSCO Principles extended to:
 G-Sec markets; Forex Markets; Money

Markets
Results: Generally satisfactory

35
 Financial Markets (2)
Foreign Exchange Market
 Fastest growing market globally
Total annual turnover increased from USD 1.3 trillion
during 1997-98 to USD 12.3 trillion during 2007-08
 Derivatives:
 High growth in forward market

 Forex futures introduced in 2008

 Need for monitoring and regulation

 Customer appropriateness and product suitability

36
 Financial Markets (3)
Sovereign Debt Market
Significant growth in volume and liquidity
Further diversification of investor base needed
Foreign investor participation: proceed with care
Increase in tradable assets desirable
 Large proportion parked in HTM category

37
 Financial Markets (4)
Equity Market
Significant improvement in market and settlement
infrastructure
Functions in robust regulatory environment
 Very high compliance with IOSCO Principles

Risk management by market participants

 Strengthening of inter-exchange surveillance

Need to improve IPO processes

 Setting up of Central Integrated Platform

38
 Financial Markets (5)
Money Market
Liquid market
 Increased share of repo and CBLO

Need for active interest rate futures market

 Being re-introduced
Development of term money market
 Development of short-end yield curve necessary

 Under examination in TAC Group

Development of the repo market

39
 Financial Markets (6)
Other Market Segments
Need to develop corporate bond market
Develop credit risk transfer mechanism
But with appropriate checks and
balances
Capacity building in financial
institutions with regard to securitisation
and credit derivatives
40
 Financial Markets (7)
Compliance With IOSCO
Markets/ Equities Foreign Govt. Money
exchange securities market
Assessment
Fully 20 16 19 19
Implemented
Broadly 8 - 2 4
Implemented
Partly 2 5 5 5
Implemented
Not applicable - 9 4 2
41
 Financial Markets (8)
Compliance With IOSCO
 Despite high compliance, some gaps remain
 Equities Market: Responsibilities and operational independence of
regulator; inspection and surveillance powers; capital and
prudential requirements for market intermediaries
 Foreign Exchange Market: Operational independence and
accountability of regulator; co-operation and detection of
manipulation and unfair trading practices
 G-Sec markets: Operational independence and accountability of
regulator; home-host co-operation; disclosure of financial results
 Money markets: Operational independence; regulatory co-
operation with foreign regulator

42
F. Financial Infrastructure

43
 Financial Infrastructure (1)
Regulatory Infrastructure
Multiple roles of regulators
 Consistent with financial development

 Needs effective coordination

Principles vs. Rules-based: complementary

Develop supervision of financial conglomerates
 Legislation, a new Act?

Develop Self -Regulatory Organisations?

Regulatory independence
 Panels have raised some issues

 But CFSA considered adequate

44
Financial Infrastructure (2)
Markets and Liquidity
Large capital movements
Volatility in overnight rates
 Strengthen government cash management
 Asset liability management of banks

Issues related to market integrity—

participatory notes
Term liquidity facility not required at this
stage
45
Financial Infrastructure (3)
Accounting and Auditing
More autonomy for Accounting Standards Board
Need to develop sector-specific guidance
Issues in auditing about convergence with ISAs
Need to give functional independence to AASB

46
 Financial Infrastructure (4)
Payment and Settlement
Payment & Settlement Act of 2007 fills a
major gap
Sub-optimal utilisation of electronic payment
infrastructure
 Delays in collection of outstation cheques

Financial resources with CCIL need

strengthening

47
 Financial Infrastructure (5)
Business Continuity Management
Ease of operations during crises
Areas for strengthening
 Human Resources management
 Business continuity processes of vendors

 Outsourcing risk

 Succession planning

48
 Financial Infrastructure (6)
Assessment of Bankruptcy Law Principles
Assessment Number
Observed 38
Broadly Observed 24
Partly Observed 12
Total 74
Major Gaps:
Implementation of bankruptcy laws – poor- average 10 years to
complete liquidation proceedings – ‘Doing Business Report’- World
Bank
Amendment to the Companies Act still pending – Setting up of
NCLT
Issues relating to Competition Amendment Act, 2007 49

Lack of a Central Registry for recording security interests

 Financial Infrastructure (7)
Depositor Protection
Independence of Deposit Insurance and
Credit Guarantee Corporation (DICGC)
(recommended by Advisory Panel)
Increase flat-rate premium
Involvement of DICGC in resolution process-
delink settlement of DICGC claims from
liquidation process

50
G. Transparency and
Development Issues

51
 Transparency and Development Issues (1)
Assessment of Transparency in Monetary
and Financial Policies
Assessment Transparency in Transparency in Financial
Monetary Policy Policies
RBI SEBI IRDA
Observed 40 32 33 29
Broadly Observed 1 - - -
Partly Observed 3 4 - -
Not Observed - - - 1
Not Applicable 2 - 3 6

Major Gaps/Issues:
Need for review of legislations- overhaul of legislations not required
Operational independence of RBI
Strengthening TACMP – requires ongoing review
Separation of debt management from monetary management – Chairman’s
dissent 52

Price index for measuring inflation – WPI/CPI debate

 Transparency and Development Issues (2)
Assessment of Fiscal Transparency
Assessment Centre States
Observed 36 22
Broadly Observed 4 6
Partly Observed 5 15
Not Observed - 2

Significant improvement following FRBM Act and Fiscal Responsibility

Legislations
Major Gaps/Issues:
Functional overlap by Central Government on issues relating to State Government
like health and agriculture
Mode of calculating FD does not capture off-budget items separately –augmented
FD required
53
Need for accrual-based accounting – guarded approach
 Transparency and Development Issues (3)
Assessment of Data Dissemination Standards
Assessment National WPI CPI-IW Government Monetary Balance of
Accounts Finance Statistics Payments
Statistics

Observed 6 15 18 9 22 19
Largely Observed 13 6 3 10 - 3
Largely Not 3 1 1 3 - -
Observed
Not Observed - - - - - -

Major Gaps:
Need for proper legal and institutional support for CSO
IIP data - need to adjust basket of commodities and weights assigned
Multiple agencies in collection of labour data
54
WPI – outdated weights
 Transparency and Development Issues (4)
Making Financial Inclusion Work

Rangarajan Committee on financial inclusion

Exploit synergies between local and national level financial
institutions
Finance consumption and household expenditure
Scale-up IT initiatives
 Biometric smart cards in rural areas

 Development of mobile banking

 Incentivise BCs

Urban poor
 Dilute KYC norms

55
 Part III
Transparent Reporting

56
H. Peer Reviewers’ Comments

57
 Peer Reviewers’ Comments (1)
Financial Stability Assessment and Stress Testing
V. Sundararajan
 Plausible shocks and vulnerabilities arising out of domestic
macroeconomic and external sectors should be systemically
linked to stress scenarios
 Growing use of purchased funds need analysis of second
round contagion effects
Andrew Sheng
 Creation of secondary mortgage market
 Setting up of Government sponsored secondary mortgage

vehicles
 On-site examination process should be supplemented by a
forensic “follow the evolution of the product” approach.
58
 Peer Reviewers’ Comments (2)
Assessment of BCP
Eric Rosengren
 Urgent need to improve co-ordination between regulatory agencies
 LoLR should have the ability to assess solvency and liquidity risks facing
institutions
 Report should elaborate on aspects relating to Central Government’s role in
operation of PSBs – whether it interferes with the regulatory role of RBI
Corporate Governance and
Transparency in Monetary Policy
Sir Andrew Large
 Higher corporate governance standards for the unlisted sector
 Mechanism to enable central bank to be adequately informed to handle
liquidity related events
 Improvements in transparency would enhance central bank independence

59
 Peer Reviewers’ Comments (3)
Bankruptcy Laws
Thomas Baxter
 Indian insolvency regime remains an enigma
 Special Insolvency regime for banks complement access to
credit facilities of central bank and deposit insurance
Fiscal Transparency
Vito Tanzi
 Better classification of expenditure central to fiscal policy
 Relevant fiscal target should be GFD and not revenue
deficit
 Relatively few countries have made a transition to accrual
based accounting
60
 Peer Reviewers’ Comments (4)

Accounting and Auditing

Ian Mackintosh
 Exercise caution while developing country specific and
sector specific accounting standards
 Important to give functional independence to AASB
N.P. Sarda
 Determining the role of the Quality Review Board to review
and improve the quality of audit service is required

61
I. CFSA and Advisory Panels –
Some Differences

62
 CFSA and Advisory Panels –
Some Differences
Regulatory Independence
 Panel view : Issues regarding independence of SEBI and IRDA
 CFSA view: Regulatory independence adequate
Review of Legislation
 Panel view : Review of RBI Act needed
 CFSA view : Requires to be viewed in a more comprehensive manner
Role of HLCCFM
 Panel view : Further formalisation and institutionalisation
 CFSA view: Not consistent with regulators’ autonomy
Prompt Corrective Action
 Panel view : Appropriate time-frame required
 CFSA view: Any rigidity in timeline unduly restrictive

63
 Part IV
Conclusions and Concerns

64
 Conclusions and Concerns (1)
Summary of Assessment
Financial Sector – Has expanded; acquired
greater depth and vibrancy
Macro economy – Short-term - Uncertainty;
Medium-term - high growth sustainable
Banks – Healthy and Robust
Financial Markets – Resilient and fairly liquid
Financial Infrastructure – Robust
Transparency – Significant improvements
65
 Conclusions and Concerns (2)
Main Concerns
 Macro economy –
 Fiscal Deficit

 Agricultural Growth

 Susceptibility to international commodity price movements

 Institutions –
 Emerging liquidity concerns

 Corporate governance in co-operative sector

 Health of rural co-operatives

 Funding constraints for NBFCs

 Lack of timely data to gauge household indebtedness

 Stress Testing
 Lack of database, techniques and capacity to conduct appropriate systemic

stress tests taking into account sectoral interlinkages as also contagion risk

66
 Conclusions and Concerns (3)
Main Concerns
Financial Markets –
 Risk of contagion

 Development of an appropriate risk free yield curve

 Corporate bond markets

 Issues relating to derivatives – knowledge

concentration and capacity building

Transparency –
 Some issues in fiscal transparency; Need to

strengthen data collection agencies

67
 Conclusions and Concerns (4)
Main Concerns
 Delay in bankruptcy proceedings and credit dispute resolution
 Time taken for winding up proceedings is highest in the
world
 Improvement in effective enforcement of creditor rights
required
 Faster resolution of stressed assets of financial
intermediaries
 Regulation of financial conglomerates and holding companies
 Role of SROs
 Regulatory co-operation – particularly cross border
 Management of capital account
 Deficiency in retail payment systems

68