Lecture Notes: Unit 4: Indian Banking System

Apoorva Gupta, Ramjas College

Introduction

• This unit is about how the crises situation arises and what actions govt or the central bank has
taken to overcome the crises situation.
• It mainly focuses on the situation that prevailed in India during 2007-08 financial crises, and
afterwards (mainly the recent crises situation) however, it compares this situation with previous
crises situations time and again.
• Definition of banking crises: insolvency and illiquidity. In India, crises have mostly manifested in
the form of high levels of NPAs and their impact on the capital adequacy levels of banks.
• Generally, it has been seen that almost all the financial crises have some common reasons
because of which crises type situation arise in the economy. And hence, the question comes up,
whenever crises happens, why can’t people (economists and those in govt) predict that crises
will happen and take necessary actions so that the problem does not become grave.
• The answer is that every crisis is different from the previous crises. People argue by saying: “This
time is different”, when actually it is not. It has been seen that in almost all the episodes of
financial crises, the causes were more or less same, yet we are unable to predict the causes of
the next financial crises.
• “History repeats itself, not because it is inherent trait of history, but because we don’t learn
from history and let the repeat occur”.
• For instance, whenever India has faced financial distress situation, it always pledges its gold
reserves against any bailout package (even after knowing that in the previous bailout package,
there was huge opposition on emotional ground that India’s gold has been sold out.)
• Few things that are always worrisome during any financial crises are:
1. Trade-off between growth and inflation: People believe that growth is subject matter
of govt, while price stability is the target of RBI. And given the Phillips curve argument,
there is always a tradeoff between growth and inflation. However, the argument given
by RBI officials is that any monetary policy taken by RBI has three main objectives: price
stability, growth and financial stability. “The Reserve Bank is committed to inflation
control, not because it does not care for growth, but because it does care for growth.”
Low and stable inflation is a necessary precondition for growth.
2. Fiscal dominance of monetary policy: This means that the degree of freedom of
monetary policy is constrained by the govt’s fiscal stance. That is, though RBI is a
separate entity from GoI, yet RBI may not be fully free to conduct an independent
monetary policy.
3. Managing policy in a globalizing world: The biggest challenge that central bank faces is
to manage both economic and regulatory policies in a globalizing world. “…Monetary
policy is also about reducing hunger and malnutrition, putting children in school,

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 creating jobs, building roads and bridges and increasing the productivity of our farms
and firms. KEEP YOUR EAR TO THE GROUND.”

Causes of Financial Crises

• If any country faces a financial crisis, certain solutions are implemented. Solutions to one
financial crisis are the cause for another financial crisis.
• The major cause of Global Financial Crisis of 2007-08 were the solutions of East Asian Crisis of
1997-98; and the causes of East Asian Crisis of 1997-98, were the result of the LPG reforms of
1991.
• However, it does not mean that reforms should not be taken to rectify the situation of crisis. It
simply means that appropriate steps need to be taken so that one crisis does not lead to
another crisis.
• To understand the causes of financial crisis fully well, it is important to understand Basel Norms.

Basel Norms
• A committee of central bankers from around the world met in 1988 in Basel, Switzerland, called
the Basel Committee on Banking Supervision (BCBS). This is known as the 1988 Basel Accord,
and was enforced by law in the Group of Ten (G-10) countries in 1992, also called Basel I. They
published a set of minimum capital requirement norms by the banks so that they can meet any
situation of financial crisis. Thus, after 1991 crisis, India followed the norms of Basel I. However,
these norms could not stop the East Asian Crisis of 1997-98. Hence Basel II was introduced.
• The second Basel Accord, called the Revised Capital Framework, or simply called as Basel II was
introduced. It focused on three main areas: minimum capital requirements, supervisory review
of an institution's capital adequacy and internal assessment process, and the effective use of
disclosure as a lever to strengthen market discipline and encourage sound banking practices
including supervisory review. Together, these areas of focus are known as the three pillars.
• However, Basel II were criticized by some for allowing banks to take on additional types of risk,
which was considered part of the cause of the US subprime financial crisis that started in 2008.
Thus, Basel III was introduced in response to the financial crisis; it does not supersede either
Basel I or II, but focuses on different issues primarily related to the risk of a bank run.
• In this unit, we will study some details of Basel III norms because they are the most recent ones.

1991 Crisis
• 1991 crisis were the major crisis which the Indian economy has faced till date.
• Post liberalization in 1991, govt took many micro level prudential norms to recommend changes
in the Indian banking system. These were laid down in the Narasimham Committee I and II.
• Major reforms undertaken were:
o Adoption of risk based capital standards
o Uniform accounting practices for income recognition
o Provisioning against bad and doubtful debts.

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 o Following the recommendations of Basel I norms
o Setting up of Asset Reconstruction Companies (ARCs) that would take over the stressed
assets from banks
o Issuance of new licences to private sector entities to set up banks.
o Interest rate deregulation
o Allowing PSU banks to raise up to 49% of their equity in the capital market
o Gradual reduction of the statutory liquidity ratio (SLR) and cash reserve ratio (CRR) to
improve banks’ profitability.
• Results of these reforms:
o Banking sector grown manifold
o Dependence on bank finance increased
o Share of HH savings in bank deposits increased
o Credit to private sector increased
o Size and depth of the banking sector gone up.
o Share of private sector banks has increased, but their number has reduced. This implies
that few licenses were given to private sector
o PSU banks are still a major component of Indian banking system.
• Implications of huge PSU banks on Indian banking system:
o Put constraint on banks recapitalization. Govt has to bear a lion’s share of the burden
to recapitalize the PSU banks
o Creates Principal-Agent problem, as this is public’s money used by the govt.
o PSU banks are under less scrutiny compared to private counterparts. PSU banks in India
are not governed by the Companies Act 1956. This means that the requirements on
disclosures, board governance, etc, that arise from the Companies Act do not apply to
the PSU banks.
o Influenced by govt and political parties
o Public sector banks have an explicit and implicit govt guarantee that they won’t fail and
if they fail, then govt will give your money bank.
• Thus, given the design of the Indian banking system, a run on the bank is rarely witnessed,
because there is always a govt guarantee.
• Thus, despite LPG, there was huge public sector banking in India, which had more risky assets,
and eventually led to the cause of 1997 crisis.

1997 Crisis
• Though public sector share was huge in the Indian banking system, yet there was some growth
in the private sector banks.
• There was a credit boom in the newly liberalised, privatised and deregulated economy.
• Investment increased in the economy: Investment boom
• Foreign competition also increased
• Domestic firms tried to expand, but survival of fittest happened. Some firms went out of market.

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 • Rise and fall of DFIs: Before 1991, Development Finance Institutions (DFIs), such as the
Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of
India (ICICI) Bank, and Industrial Finance Corporation of India (IFCI) were critical players in
providing commercial long term credit, mainly for development purposes, to the industrial
sector. However, during 1991 reforms, they faced stiff competition from commercial banks, and
hence it became difficult for them to operate in the market. Their NPAs got accumulated, and
eventually, by late 1990s, they were no longer economically viable.
• Other events:
o India conducting nuclear blasts in 1998, after which international sanctions were
imposed on India
o Collapse of the internet bubble in the United States (US) in 2000–01
o These events led to general slowdown in the economic growth of the country.
• In some sense, the banking crisis of 1997–2002 was an outcome of post-liberalisation structural
changes in the economy and was accentuated by a few events, both internal and external,
which resulted in a cyclical slowdown of the real economy.
• However, some positive signs were there:
o India was a major beneficiary of information technology (IT) and subsequent
outsourcing boom. Export of IT services increased by a huge amount, contributing to
economic recovery.
o This economic recovery, coupled with the low inflation and low interest rate was a
blessing for the banking sector. Credit boom started during this period and the economy
recovered. NPAs also slowed down.
o In other words, the banking sector got bailed out of the crisis through rapid and
dramatic improvements in the macroeconomic environment, which itself were an
outcome of very specific domestic and global conditions.

2007-08 Global Financial Crises

Financial crises of 2008 started with the collapse of Lehman Brothers. The effects of the crises are still
prevalent and continue to affect global growth and welfare of countries.

Causes of the Crisis

• East Asian Crisis of 1997: Financial crisis of 2007-08 was a result of global imbalances occurred
after the East Asian crises of 1997-98, when it was recognized that there is a need to maintain
good amount of foreign exchange reserves to meet any kind of forex crises. As a results, many
Asian countries, especially China promoted export-led growth, which led to countries like USA
and Europe to become net importers.
• Introduction of complex innovative financial instruments: In search of good returns, market
players indulged in financial innovation and engineering. They developed structured financial
products like securitization and re-securitization based on sub-prime mortgage backed securities
(MBS), collateralized debt obligations (CDOs) and CDO squared etc., which increased their

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 illiquidity and complexity. It increased the sub-prime lending, leading to disastrous
consequences.
• Let them eat credit argument: Another cause of the crisis was attributed to the socio-economic
and political factors in the USA. The income of average American was stagnant for quite some
time and poverty and inequality were increasing. The politicians could not improve the income
of the people but devised policies to encourage them to fulfill the dream of owning a house by
taking loans from banks and financial institutions at the prevailing low interest rates. Thus, the
birth of the toxic product “sub-prime mortgage” took place. It was said if the poor people
cannot have income for consumption, “let them eat credit”.
• Flawed business models of banks and financial institutions: Banks have no incentive to monitor
their loans. Short term funds were used for creating long term assets. The availability of plenty
and cheap funds encouraged banks to be highly leveraged in lending, leading to an increase in
NPAs.
• Inadequate and inappropriate corporate governance: Corporate governance arrangements
failed to curb excessive risk taking in banks and financial institutions. The Board and even senior
management, in some cases, failed to establish an informative and responsive risk measurement
and management reporting framework. NO strategy for monitoring was there.
• Huge compensation of employees: It s argued that executive pay and compensation practices in
the financial sector have perhaps invoked the maximum public outrage. There has been wide
spread criticism that incentives and pay packages were set inappropriately, encouraged
irresponsible risk taking, were inconsistent with the firm’s capital bases and focused on short-
term profit maximization. Compensation for senior executives has been perceived to be
excessive with little correlation to the long term performance of the institutions concerned.
Particularly glaring was the multi-million dollar payments and bonuses to the executives of
failed firms which had received public funding. It is now widely acknowledged that the flawed
incentives framework underlying banks’ compensation structures in the advanced countries
fuelled the crisis.
• Improper accounting records by banks: Banks entered the crisis with inadequate capital. They
did not even calculate the capital requirements properly. They invested in such financial
products which require less capital. They artificially increased their rating in accounting books,
thus lowering their needs to maintain adequate capital requirements. This was done in
accounting books, when actually they were short of capital.
• Shadow Banking System: The growth of “shadow banking” system added to the crisis situation.
One estimate suggests that the size of shadow banking system was almost three times the
formal banking system. This coupled with their dependence on the wholesale funding market
compounded the crisis.
• Junked financial system: Supported by unprecedented innovation and engineering, the financial
sector became too big in relation to the real economy, but the regulatory and supervisory
system was found wanting. The regulators and supervisors did not look at system-wide build up
of risk. They reposed faith in free markets and believed in self-correction of market excesses.

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 But that did not happen. “Leaning against the wind” was considered inappropriate. The credit
rating agencies also did not perform their role as envisaged and junked themselves.
• Breakdown of Trust: Trust in banks, in financial system, in rating agencies, in investment
advisers and in politicians broke down. Trust, which takes time to build up is an important
element in the functioning of financial markets as the very nature of financial contracts requires
a high level of trust.
• Leadership issues: Leaders at that time were lulled by the phenomenal success of modern
financial engineering and the “great moderation” and got carried away by “irrational
exuberance” and could not see the “black swan”, leading to financial crisis.
o Partly the slowdown was also triggered by widespread corruption scandals specifically in
the coal, and telecommunication sectors that shook the entire economy. Public
exposure of the corruption scandals led to policy paralysis with the government backing
away from any major structural reform.
o New projects failed to take off due to the lack of government approvals and projects
that had received credit during the credit boom period got stalled owing to the general
slowing down of the economy. The problem was especially acute in the infrastructure
sector.
o This led to a fresh wave of NPAs, especially in sectors such as infrastructure, steel,
metals, textiles, etc.
• Change in composition of bank credit: With the death of DFIs and ever growing NPAs, project
financing became a part of commercial bank lending. This was especially the case for the PSU
banks that were more susceptible to political pressures. There was a huge demand of credit
from the industries like aviation, telecom, mobile telephony, etc, but commercial banks had
little expertise or experience in assessing these businesses. This resulted in potential mismatch
of the skills required to do project lending and the capabilities at the PSU banks.
• Maturity Mismatches: There is a fundamental asset-liability mismatch problem with the change
in the composition of bank’s credit. Deposits are the main source of funding for commercial
banks which tend to be more short-term in their maturity. Hence banks doing long-term project
lending on the back of short-term assets are bound to result in maturity mismatches in the
balance sheets.
• Risk increased: With infrastructure lending, banks got exposed to the risk they were not
exposed to earlier.
o These risks emanated from delays and roadblocks due to policy issues, environmental
approvals, and the ability of the promoters to bring in large amount of equity needed to
complete the projects.
o It also complicated the government’s role. On the one hand, the government was the
owner and provider of capital to banks, and hence would be concerned about the credit
risks that the PSU banks were undertaking.
o On the other hand, as a key participant in the economy’s infrastructure development,
the government bore crucial responsibility for the viability and creditworthiness of such
projects.

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 • Banks doing infrastructure lending is structurally problematic, leading to crisis situation. WHY???
o Infrastructure financing contracts are susceptible to political problems.
o It is harder to predict long-term demand while doing these project assessments.
o Recovery of debt and resolution when the project fails is also much harder.
o For example, recovering a cement factory is typically easier than recovering a bridge or a
road.
• Basel II could be one of the reasons for crisis: Basel II introduced risk sensitive capital
regulation.
o In good times, when banks are doing well, and the market is willing to invest capital in
them, Basel II does not impose significant additional capital requirement on banks. On
the other hand, in stressed times, when banks require additional capital and markets
are wary of supplying that capital, Basel II requires banks to bring in more of it. Basically,
doing what is not required, making the entire system to fail.
o There was no model for accurate measurement of risk in Basel II norms and hence no
measure to mitigate that risk.
o Basel II focused on individual financial institutions and ignored the interconnectedness
between them, through which crises was spreading across the entire financial markets.
o Basel II has actually helped the crises to grow.
Thus, the roots of 2007-08 Global Financial Crises can be traced to excessive lending done by the banks
during the credit and investment boom of 2003-08.

Consequences of Global Financial Crisis of 2007-08

• India experienced a dramatic slowdown in growth
• A massive depreciation of the exchange rate
• High inflation
• A sustained period of monetary contraction during which RBI raised interest rates to deal with
rising inflation.
• Banks were undercapitalized
• NPAs were very high. Not only in terms of the level of NPAs, the growth of NPAs was also very
high.
• PSU banks were having higher NPAs than private sector banks.
• Bank credit was falling from year to year
• Illiquidity increased
• Lending decreased
• Increase in Moral Hazard Problem: Since banks are essential to an economy and their failure
affects the real sector, particularly when they are too big, the public authorities had no
alternative but to rescue the banks by injecting capital, guaranteeing their liabilities and
purchasing their toxic assets. This created the moral hazard issue of “privatization of profits but
socialization of losses”.
• All of these wreaked havoc for the corporate sector and in turn for the banking sector.

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 Solution to Financial Crises or Policy Responses

• Introduction to Basel II.5: Immediately after the crisis, Basel II.5 norms were introduced so
that banks could maintain adequate capital. But they were not of much help.
• Introduction to Basel III Norms: The Basel Committee published its Basel III rules in
December 2010. The objectives of these norms were:
o To minimize the probability of recurrence of a crisis of such magnitude
o To improve the shock absorbing capacity of each and every individual bank as the
first order of defence and in the worst case scenario, if it is inevitable that one or a
few banks have to fail, Basel III has measures to ensure that the banking system as a
whole does not crumble and its spill-over impact on the real economy is minimized.
• Basel III had some micro-prudential elements so that risk is contained in each individual
institution; and a macro-prudential overlay that will “lean against the wind” to take care of
issues relating to the systemic risk. Lets understand them.

Micro-prudential Norms of Basel III

Micro-prudential regulation or micro-prudential supervision is firm-level financial regulation by
regulators of financial institutions that ensure the balance sheets of individual institutions are robust to
shocks.The micro-prudential elements of Basel III are:
• Correct definition of capital
• Enhancing risk coverage of capital
• Strengthen Leverage ratio
• Proper International liquidity framework.

1. Correct definition of capital

• The existing definition of capital is flawed.
• Quality of capital is deficient in both equity and in terms of debt.
• Under Basel III norms, all the capital details have to be disclosed.
• As a result, the definition of capital in terms of its quality, quantity, consistency and
transparency will improve under Basel III.

2. Enhancing risk coverage of capital

• Banks have excessive exposures derivative products whose risks were not captured
comprehensively under Basel I or Basel II framework.
• Thus, the Basel III framework will have enhanced risk coverage.
• Management and capitalization of counterparty credit was improved.
• Counterparty credit means the credits where two parties are involved, like futures or other
derivative instruments.
• Standards for collateral management and initial margining have been strengthened.
• Additional standards have been adopted to strengthen collateral risk management practices.

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 3. Strengthen Leverage Ratio
• A leverage ratio looks at how much capital comes in the form of debt (loans) or assesses the
ability of a company to meet its financial obligations.
• The risk of leverage, particularly when built up with short term borrowings, and the
consequential impact of deleveraging during periods of stress by withdrawing credit to the real
sector, accentuated the crisis.
• The Basel Committee has, therefore, introduced a simple, transparent, non-risk-based leverage
ratio as a supplementary “backstop” measure to the risk-based capital requirements.
• If this ratio is good, then the bank is in sound position.

4. International Liquidity Framework

• Until before 2007-08 crises, there were no internationally recognized standards for liquidity.
• The financial crisis has highlighted the importance of robust liquidity risk management by banks.
• The crisis demonstrated that liquidity and solvency are quite deeply interrelated. Illiquid banks
can become insolvent in no time and similarly an insolvent bank can become illiquid rapidly.
• Basel III has introduced two new liquidity standards to improve the resilience of banks to
liquidity shocks.
o Liquidity Coverage Ratio: In the short term, banks will be required to maintain a buffer
of highly liquid securities measured by the Liquidity Coverage Ratio (LCR). This liquidity
buffer is intended to promote resilience to potential liquidity disruptions over a 30-day
horizon.
o Net Stable Funding Ratio (NSFR): This measure requires a minimum amount of stable
sources of funding at a bank relative to the liquidity profiles of the assets, as well as the
potential for contingent liquidity needs arising from off-balance sheet commitments,
over a one-year horizon. The objective of the NSFR is to promote resilience over a
longer time horizon by creating additional incentives for banks to fund their activities
with more stable sources of funding on an ongoing basis.

Macro-prudential Norms of Basel III

Macro-prudential regulation is the approach to financial regulation that aims to mitigate risk to the
financial system as a whole (or "systemic risk"). To bring financial stability in the economy, Basel III
norms introduced the need for certain macro-prudential norms. These are:
• Leverage ratio
• Capital conservation buffer
• Countercyclical capital buffer
• Addressing procyclicality of provisioning requirements
• Addressing interconnectedness
• Addressing the too-big-to-fail problem
• Addressing reliance on external credit rating agencies.

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 1. Leverage Ratio
Basel III protects against any systematic accumulation or reduction of leverage. It also protects against
perverse incentive to pile on “low risk” assets.
2. Capital Conservation Buffer
Banks have to maintain a buffer of capital, which can be drawn down during periods of stress. When
buffers have been drawn down, banks can build them up either through a reduction in distribution of
dividend, share buyback and staff bonus payments or raising capital from the private sector.

3. Countercyclical Capital Buffer

Apart from capital conservation buffer, banks will maintain a countercyclical capital buffer which will
take into account the capital requirements of banks during difficult times, arising from macro-financial
environment in which banks operate.

4. Addressing Procyclicality of provisioning requirements

Financial institutions are prone to business cycles. In good times, banks’ borrowers do well and service
the loans in time; and hence are incentivized to give more loans. In bad times, borrowers tend to default
in servicing interest and principal payment. Banks’ profits go down but at the same time they are
required to make higher loan loss provisions for the non-performing loans. In order to address the
procyclical issues, the Basel Committee started the formulation of calculating losses from loans through
an expected loss approach, rather than incurred loss approach.

5. Addressing too-big-to-fail problem

• The Basel Committee identifies some banks which are global systemically important banks (G-
SIBs).
• These are the banks, which if are on the verge of failure, will be rescued by the govt as they are
too big too fail, to create a panic situation in the economy.
• The G-SIBs will also be subject to tighter supervision.
• Currently, no Indian bank appears in the list of G-SIBs.
• Separately, the Basel Committee is working on establishing a minimum set of principles for
domestic systemically important banks (D-SIBs).
• Larger banks offer certain benefits such as economies of scale in operation and capacity to
finance large infrastructure projects which are typically considered more risky. Thus, need large
banks, and they should not fail.
• Thus, we have to balance the benefits that large banks extend with the moral hazard costs they
entail.

6. Addressing Interconnectedness
Interconnectedness among banks, especially the large ones, is sought to be addressed through various
measures such as enhanced regulatory framework for global systemic important banks (G-SIBs),
prescription of higher asset value correlation.

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 7. Addressing reliance on External Credit Ratings
Measures have been proposed in Basel III that includes requirements for banks to perform their own
internal assessments of externally rated securitization exposures.

Critical Analysis of Basel III Norms

Positive Impact of Basel III Norms
• Recovery from financial crisis: Effective implementation of Basel III will demonstrate to
regulators, customers, and shareholders that the banking system is recovering well from the
global financial crisis of 2008 and has been developing the resilience to future shocks.
• Increased Banks’ competitiveness: A smooth implementation will also contribute to a bank’s
competitiveness by delivering better management insight into the business, allowing it to take
advantage of future opportunities
• Higher and better quality of capital: As per Basel III norms, banks have to keep more capital and
better quality capital, so that they can meet any losses, without breaching any of the contracts,
or going for borrowings. It is like banks have to maintain a buffer of capital to meet any kind of
unforeseen contingencies and to maintain both short-term and long-term liquidity stress.
• Changes in provisioning norms: The approach of calculating losses was changed from “incurred
loss” approach to “expected loss” approach, which make financial reporting more useful for
stakeholders.
• Disclosure requirements: Basel III requires banks to disclose all relevant details, including any
regulatory adjustments, as regards the composition of the regulatory capital of the bank. The
disclosures made by banks are important for market participants to make informed decisions.
• Basel III would deliver a much safer financial system with reduced probability of banking crises
at affordable costs.
• Basel III would strengthen the financial system of both developing and developed countries. In
the present-day globalised world it is difficult for any local financial and economic system to
completely insulate itself from the global economic shocks. The indirect effects of events
happening in any part of the world can very well be transmitted throughout the world through
various channels. Thus, it is appropriate for the countries which neither contributed to the crisis
nor have exposure to the toxic assets need to implement Basel III.

Negative Impact of Basel III Norms

• Curtail economic growth: Under Basel III norms, banks have to maintain higher levels of capital,
which means less amount is available for further lending, and hence lowers the economic
activity.
• Reduce bank’s profitability: Since banks have to maintain higher and better quality of capital,
there are costs attached to it, which will reduce banks’ profitability.
• Impact on Liquidity: To maintain higher levels of capital and liquidity, banks will either not lend
or lend to govt securities only, reducing the funds available for private investment and hence,
reducing growth. Thus, trade-off between liquidity and growth.

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 • Impact on capital: Banks have to maintain a buffer of capital under Basel III norms. However, in
comparison to other countries, India already has substantial amount of surplus capital (which
has actually helped it to stand through the financial crisis). However, it is required that India
should actually increase its capital base, as it will be needing this capital for manufacturing led
growth model (which India is following now).
• Short term versus long term impacts: Whatever negative impacts of Basel III norms are, they
are only for short time period. Over a longer horizon, India will be needing more capital for
infrastructure projects, bringing low income HHs into formal banking system, and hence will
lead to more growth.

Certain Policy Recommendations

• Capital needs to be raised for growth purposes, and not just to maintain Basel III requirements.
• Capital can be raised from the primary market, but it will take time and reforms are needed in
that market as well.
• Govt has to reduce its ownership on the PSU banks so that the burden of capitalizing (or
recapitalizing) banks gets reduced. However, it should not give away its ownership rights over
banks.
• Even though India was protected against Global Financial crisis, and it stood strong during crises,
it does not mean that it should not adhere to Basel III norms.
o Given that Indian economy is now getting very much linked with the ROW, we cannot
afford to have a different regulatory framework as adopted in other countries.
o The “perception” of a lower standard regulatory regime will put Indian banks at a
disadvantage in global competition, especially because the implementation of Basel III is
subject to a “peer group” review whose findings will be in the public domain.
o Basel III provides for improved risk management systems in banks. It is important that
Indian banks have the cushion afforded by these risk management systems to withstand
shocks from external systems, especially as they deepen their links with the global
financial system going forward.

Concluding Remarks on Basel III Norms

• There could be some initial costs in the implementation of Basel III norms, but the long-term
benefits will be immense.
• Along with the implementation of Basel III norms, other important issues such as strengthening
the corporate governance, compensation practices, and resolution regimes; enhancing the
regulatory and supervisory framework for global and domestic Systemic Important Banks (SIBs);
improving the OTC derivatives markets; and regulation of shadow banking system have also
been addressed
• Effective implementation of Basel III is going to make Indian banks more strong, stable and
sound so that they can deliver value to the real sectors of the economy.

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Recent Economic Slowdown: An overview
• GDP growth is less
• Exports are less from India because developed countries are still struggling from the global
financial crisis of 2008 and hence, their demand is less, and hence, exports of India are less.
• Private investment is low, and has been declining since the year 2013.
• Moreover, in Nov, 2016, high denomination currency notes were demonetized, withdrawing
nearly 86% of currency in circulation, which may even add to the problem of NPAs.
• Troubles in the banks’ balance sheets started happening as early as 2011-12.
• RBI initiated many restructuring programmes (such as Corporate Debt Restructuring, Strategic
Debt Restructuring, 5/25 scheme, Joint Lenders Forum, etc) to enable the banks to resolve the
stressed asset problem.
• But rather than solving the problems, they just helped banks in hiding the problem in the their
balance sheets.
• The continuation of the stressed asset problem has worsened the availability of credit for the
real economy.
• The government initiated the Indradhanush programme in August 2015 to revamp the PSU
banks. It is a seven-pronged plan, which also includes recapitalisation or infusion of capital into
the banks.
• Another action taken by the government under the Indradhanush programme has been to set
up a Banks Board Bureau (BBB) to facilitate the appointment of top officials at the PSU banks.
However, the progress made by the BBB has been slow since it began functioning in April 2016.
• What matters a lot in resolving the crisis situation is how quickly steps taken by the govt. The
ongoing problem has to be solved by taking three pronged approach: Recognition,
Recapitalization, and Resolution.
• To make the banks to lend again, some amount of capital needs to be infused into the system.
But question is where to get this capital???
• Insolvency and Bankruptcy (IBC) norms have been implemented in the year 2016, which is
designed to facilitate quick resolution of stressed corporate assets in a time-bound manner. The
banks must now use the platform offered by IBC to recover their dues and resolve the
underlying stressed assets.
• There are specific roles to be played by the regulator, the government, and the banks
themselves, to ensure that the next time banks face NPA problem, it can be contained and the
damage can be minimized.
• RBI as the banking sector regulator can adopt pre-emptory measures such that if bank credit
goes beyond a specific range, countercyclical steps such as imposing capital requirements and
sectoral caps can be adopted if some sectors are overheated.
• Introduce alternative sources of financing like corporate bonds, which reduce the pressure from
the banks.
• Comprehensive reforms of banking regulation and supervision are required.

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 • Banking regulation needs to be more proactive and needs to create incentives for the banks to
recognise the losses as early as possible so that NPAs do not keep accumulating on the bank
balance sheets.
• In recent times, the government has initiated the process of merger of five subsidiaries of the
SBI (State Bank of Bikaner and Jaipur, State Bank of Travancore, State Bank of Patiala, State Bank
of Hyderabad and the new Bharatiya Mahila Bank) with the parent bank. This merger was
possibly motivated by the desire to increase operational efficiencies in the SBI group.
• More such mergers are encouraged, especially of weaker banks with stronger ones in order to
reduce fragmentation of the banking system, foster efficiency, and help the government as
majority stakeholder to improve the governance of these banks. Recently 10 PSU banks have
been merged into four mega state-owned banks.
• The banks themselves need to tighten their mechanisms for scrutinising loan applications,
especially when the NPAs start increasing and when there is overheating in the economy or a
credit boom.

Conclusion

• Financial crisis is a problem which arises mainly because of increased problem of asymmetric
information, leading to increased NPAs.
• Time is the key essence of resolution towards financial crisis.
• Early recognition and action on resolution mitigates the damaging impact of a crisis. In order for
banks to take such early action, strong governance and proactive banking regulation is critical.
This will ensure that the subsequent NPA resolution has minimal effect on bank’s capital.
• A big factor that aids quicker and more efficient resolution is a strong legal framework for
resolution. IBC have been introduced, but still weak in India. Feb, 2018 resolution has also been
introduced.
• Unless NPAs are dealt with quickly and efficiently, profitability and liquidity of banks can get
severely affected and resource allocation in the economy becomes inefficient.
• Given the predominance of government-owned banks in India, any banking crisis invariably ends
up affecting the public finances, which is far from desirable.
• RBI as the banking regulator, government as a major stakeholder, and the banks themselves
must step up to ensure that the current crisis is resolved rapidly, and the flow of the credit to
the real sector in the future is not disrupted so much so that public finances have to be involved
to rescue the banks.
• This calls for building adequate regulatory capacity, comprehensive reforms in bank regulation
and supervision, a strong legal framework for resolution, and policy thinking on the merits of
government ownership of banks.

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