Financial Sector Assessment

Rakesh Mohan Deputy Governor Reserve Bank of India and Chairman, CFSA

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

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


Part I The FSAP and Self-Assessment 4 .

Background and Timing 5 .A.

emphasis by the G-20 6 . 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.Background and Timing (1) The Story So Far IMF-WB FSAP in 2001. self-assessment of international standards and codes in 2002.

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 .

RBI. IRDA. SEBI. 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 .Background and Timing (3) The Process  Benefits  Composition of CFSA: ownership and commitment  Regulatory cooperation: GoI.

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 .

Broad improvement in the postreform period 2000 11.7 12.5 48.0 2.0 12.1 13.9 14 Financial Soundness Indicators CRAR Gross NPAs to Gross Advances Net NPAs to Net Advances Return on Total Assets Return on Equity Efficiency (Cost Income) Ratio .4 1.Stability Assessment and Stress Testing (2) Financial Soundness Indicators  Commercial Banks .7 61.1 7.1 1.2 2008 13.1 0.

1 12.2 24.5 0.2 1.2 8.9 1.4 0.Stability Assessment and Stress Testing (3) Financial Soundness Indicators  Other Institutions .0 18.0 1.7 1.3 0.9 18.9 2.9* 19.5* 5.4 15.---16.7 11.5 3.2 2.5 2.3 14.Broad improvement in the postreform period ± Rural Co-operative Sector ± some concerns NBFCs D 2004 2008 Scheduled HFCs 2004 2008 UCBs 2005 2008 RRBs 2005 2008 StCBs/ DCCBs 2005 2007 CRAR Gross NPAs Ratio RoA* 26.8 14.1 * Ratio to Total Assets .2 0.02 15 ---- 2.3 0.6 ---.8 22.7 0.9 ---8.

 identifies how portfolios respond to changes in key economic variables: e. 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 .g. interest rates.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..

6 17 Note: CRAR = credit to risk assets ratio .1 150 per cent CRAR (%) 11.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 Scenario .6 11.increase in NPA by: Without Stress CRAR (%) Mar-08 Sept±08 13.0 10.5 100 per cent CRAR (%) 11.0 12.

0 Sep-08 8. greater the sensitivity of banks capital to interest rate shocks Calculates the erosion in accounting capital due to unit increase in interest rate Period DoE (yrs) Mar-06 14.1 Mar-07 12.0 Mar-08 8.Stability Assessment and Stress Testing (6) Interest rate risk Higher the DoE (duration of equity).1 years.1 The annualised yield volatility is estimated at 244 bps Given a DoE of 8. => Better management of interest rate risk by 18 commercial banks over time . a 244 bps shock implies an erosion of 20 per cent of capital and reserves.

3 (Volatile Liabilities ±Temporary Assets) / 34.8 (Extent to which assets are funded through stable deposit base) (Loans + Mandatory CRR + Mandatory 75.) (Core Deposits) / Total Assets (per cent) .8 1.9 Sep-08 49.7 (Earning Assets ±Temporary Assets) (per cent) (High and positive number implies some risk of funding liquidity.8 19 .7 86.3 86.4 SLR + Fixed Assets) / Core Deposits ± (Dependence on purchased liquidity) 49.3 47.53.Stability Assessment and Stress Testing (7) An Overview of Liquidity Ratios Ratio Mar-05 Mar-08 43.5 1.0 SLR + Fixed Assets) / Total Assets (per cent) ± (Embedded illiquidity in the balance sheet) (Loans + Mandatory CRR + Mandatory 1.

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 .

Assessment done for health check Results: Generally satisfactory 24 . Regional Rural Banks. NBFCs. HFCs But.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.

Financial Institutions (2) Basel Core Principles: A Compliance Summary Assessment CB UCB StCB/ DCCB RRB NBFC HFC Compliant Largely Compliant Materially Non-compliant Non-compliant Not applicable 7 11 6 1 - 4 11 4 2 4 3 10 6 2 4 4 8 6 2 5 1 13 2 8 1 2 10 5 8 - 25 .

corporate governance NBFCs: Major acquisitions. internal control . 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. homehost country regulation Commercial Banks: Exposure to related parties. transfer of significant ownership. internal control 26 HFCs: Permissible activities.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).

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 well-considered 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 .

Housing Starts Index a priority Regulation of HFCs should be entrusted to RBI ± 31 Government¶s stance ± status quo .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.

Financial Institutions (9) An Assessment of Insurance The level of compliance of the Insurance Sector to IAIS Core Principles Assessment Observed Largely Observed Partly Observed Not Observed Number of Principles 5 13 10 32 .

Financial Institutions (10) An Assessment of Insurance Significant growth in size. treasury managers 33 . 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.

Financial Markets 34 .E.

Forex Markets.Financial Markets (1) Regulation and Supervision Systemic stability Importance of markets other than equity market IOSCO Principles extended to: G-Sec 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 2007-08 Derivatives:  High growth in forward market  Forex futures introduced in 2008  Need for monitoring and regulation  Customer appropriateness and product suitability 36 .3 trillion during 1997-98 to USD 12.

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/ Assessment Fully Implemented Broadly Implemented Partly Implemented Not applicable Equities Foreign exchange Govt. securities Money market 20 8 2 - 16 5 9 19 2 5 4 19 4 5 2 41 .

disclosure of financial results  Money markets: Operational independence. regulatory cooperation with foreign regulator 42 . inspection and surveillance powers. co-operation and detection of manipulation and unfair trading practices  G-Sec markets: Operational independence and accountability of regulator. capital and prudential requirements for market intermediaries  Foreign Exchange Market: Operational independence and accountability of regulator.Financial Markets (8) Compliance With IOSCO  Despite high compliance. some gaps remain  Equities Market: Responsibilities and operational independence of regulator. home-host co-operation.

F. Financial Infrastructure 43 .

a new Act? Develop Self -Regulatory Organisations? Regulatory independence Panels have raised some issues But CFSA considered adequate 44 . Rules-based: complementary Develop supervision of financial conglomerates Legislation.Financial Infrastructure (1) Regulatory Infrastructure Multiple roles of regulators Consistent with financial development Needs effective coordination Principles vs.

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 integrity² 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 .

2007 49 Lack of a Central Registry for recording security interests .World Bank Amendment to the Companies Act still pending ± Setting up of NCLT Issues relating to Competition Amendment Act.Financial Infrastructure (6) Assessment of Bankruptcy Law Principles Assessment Observed Broadly Observed Partly Observed Total Major Gaps: Number 38 24 12 74 Implementation of bankruptcy laws ± poor.average 10 years to complete liquidation proceedings ± µDoing Business Report¶.

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 processdelink settlement of DICGC claims from liquidation process 50 .

G. Transparency and Development Issues 51 .

overhaul of legislations not required Operational independence of RBI Strengthening TACMP ± requires ongoing review Separation of debt management from monetary management ± Chairman¶s dissent Price index for measuring inflation ± WPI/CPI debate 52 .Transparency and Development Issues (1) Assessment of Transparency in Monetary and Financial Policies Assessment Transparency in Monetary Policy 40 1 3 2 Transparency in Financial Policies RBI Observed Broadly Observed Partly Observed Not Observed Not Applicable 32 4 SEBI 33 3 IRDA 29 1 6 Major Gaps/Issues: Need for review of legislations.

Transparency and Development Issues (2) Assessment of Fiscal Transparency Assessment Observed Broadly Observed Partly Observed Not Observed Significant Centre 36 4 5 - States 22 6 15 2 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 Need for accrual-based accounting ± guarded approach 53 .

Transparency and Development Issues (3) Assessment of Data Dissemination Standards
Assessment National Accounts WPI CPI-IW Government Finance Statistics Monetary Statistics Balance of Payments

Observed Largely Observed Largely Not Observed Not Observed

6 13 3 -

15 6 1 -

18 3 1 -

9 10 3 -

22 -

19 3 -

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 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


Part III Transparent Reporting


Peer Reviewers¶ Comments 57 .H.

58 .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 ³follow the evolution of the product´ approach.

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 .

Sarda Determining the role of the Quality Review Board to review and improve the quality of audit service is required 61 .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.

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. Medium-term .high growth sustainable Banks ± Healthy and Robust Financial Markets ± Resilient and fairly liquid Financial Infrastructure ± Robust Transparency ± Significant improvements 65 . acquired greater depth and vibrancy Macro economy ± Short-term .Uncertainty.

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 66 sectoral interlinkages as also contagion risk .

Need to strengthen data collection agencies 67 .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.

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 .

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