UPSC

INDIAN
ECONOMY
CHAPTER 7

PREPARED BY
MR. M.JEEVA
 FINANCIAL SYSTEM IN INDIA
INTRODUCTION

Financial market is the market that facilitates transfer of funds between investors/
lenders and borrowers/ users. Financial market may be defined as ‘a transmission
mechanism between investors (or lenders) and the borrowers (or users) through which
transfer of funds is facilitated’.
MAIN FUNCTIONS OF FINANCIAL MARKET

a. It provides facilities for interaction between the investors and the borrowers.
b. It provides pricing information resulting from the interaction between buyers and
sellers in the market when they trade the financial assets.
c. It provides security to dealings in financial assets.
d. It ensures liquidity by providing a mechanism for an investor to sell the financial
assets.
e. It ensures low cost of transactions and information.
CLASSIFICATION OF FINANCIAL MARKET
A financial market consists of two major segments:
1. Money Market
2. Capital Market
BANKING
NATIONALISATION AND DEVELOPMENT OF BANKING IN INDIA
The development of banking industry in India has been intertwined with the story
of its nationalisation. Once the Reserve Bank of India (RBI) was nationalised in 1949
and a central banking was in place, the government considered the nationalising of
selected private banks in the country due to the following major reasons:

(i) As the banks were owned and managed by the private sector the services of the
banking were having a narrow reach the masses had no access to the banking
service;

(ii) The government needed to direct the resources in such a way that greater public
benefit could take place;

(iii) The planned development of the economy required a certain degree of

government control on the capital generated by the economy.
EVOLUTION OF BANK NATIONALISATION
Important Private Banks
Old Private sector Bank New Private Sector Banks
Catholic Syrian Bank Ltd. South Indian Bank Ltd.

City Union Bank Ltd. Tamilnad Mercantile Bank Ltd

Dhanalakshmi Bank Ltd. Axis Bank Ltd.

Federal Bank Ltd. Development Credit Bank Ltd.

ING Vysya Bank Ltd. HDFC Bank Ltd.

Jammu and Kashmir Bank Ltd. ICICI Bank Ltd.

Karnataka Bank Ltd. IndusInd Bank Ltd.

Karur Vysya Bank Ltd. Kotak Mahindra Bank Ltd.

Lakshmi Vilas Bank Ltd. Yes Bank Ltd.

Nainital Bank Ltd. IDFC Bank , Banthan Bank.

Ratnakar Bank Ltd.

SBI Commercial and International Bank Ltd.

RESERVE BANK OF INDIA:

In 1926, the Royal Commission on Indian Currency and Finance which is also
known as the Hilton-Young Commission recommended the creation of a central
bank. The idea was twofold:

1. To separate the control of currency and credit from the government

2. To augment banking facilities throughout the country.

The Reserve Bank of India Act of 1934 established the Reserve Bank as the
banker to the central government and set in motion a series of actions
culminating in the start of operations on April 1, 1935.
FUNCTIONS OF RBI
MONETARY POLICY OF RBI
➢ To speed up the economic development of the nation and raise the national income and
standard of living of the people.
➢ Control and reduce the "Inflationary" pressure on the economy.
The requirement was an adequate financing of the economic growth programmes, and at the
same time containing the inflationary pressure and maintenance of price stability. Thus this was
a period of "Controlled Expansion".

TYPES OF MONETARY POLICY

1. Expansionary Monetary Policy
2. Contractionary Monetary Policy
1. Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by decreasing interest
rates, purchasing government securities by central banks, and lowering the reserve requirements for
banks. An expansionary policy lowers unemployment and stimulates business activities and consumer
spending. The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can
also possibly lead to higher inflation

2. Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be
achieved by raising interest rates, selling government bonds, and increasing the reserve requirements for
banks. The contractionary policy is utilized when the government wants to control inflation levels.
MONETARY POLICY COMMITTEE (MPC)
• Monetary Policy Committee was constituted in 2016 as a statutory body under the RBI Act in
order to formulate monetary policy in India
• MPC is entrusted with the responsibility of fixing the benchmark policy rate (repo rate) required
to contain inflation as defined in the Monetary Policy Framework Agreement.
COMPOSITION
• Monetary Policy Committe is 6-member body including 3 members from RBI and 3 members to be
appointed by the Central Government.
• The members include
✓ RBI Governor - ex-officio chairperson
✓ RBI Deputy Governor
✓ One more member from RBI to be nominated by the Central Board of Directors.
✓ 3 other members are be appointed by the Central Government.
TERM
• Members of MPC hold office for a period of four years and are not eligible for re-appointment.
Central Government has the power to remove any of its nominated members from MPC.
FUNCTIONS

a. The MPC is required to meet at least four times in a year.

b. The quorum for the meeting of the MPC is 4 members.
c. The MPC determines the policy repo rate required to achieve the inflation target.
d. The MPC takes decision based on majority vote (by those who are present and
voting. In case of a tie, the RBI governor will have the second or casting vote. The
decision of the committee would be binding on the RBI.
INFLATION TARGETING
• The Monetary Policy Framework provides for inflation targeting to be set by GoI every 5 years.
• Government uses CPI for the purpose of inflation targeting in India.
• Flexible Inflation Targeting: In 2016, the RBI Act was amended to adopt flexible inflation targeting
in India.
• Accordingly the inflation target under Monetary Policy Framework is Consumer Price Index (CPI)
inflation of 4% (+/- 2%) for the period from August 5, 2016 to March 31, 2021.
MONETARY POLICY TRANSMISSION
Monetary policy transmission is said to have occurred when the changes in the policy rates
(repo, reverse repo) will lead to corresponding change in the interest rates in retail sector.
(Housing, auto loans etc.)
• MCLR refers to the minimum interest rate of a bank below which it cannot lend, except in some
cases allowed by the RBI.

• In 2016 RBI introduced the concept of MCLR in order to ensure monetary policy transmission.

• Under MCLR the banks use the marginal cost for obtaining funds to set their lending rates.

• Marginal cost includes cost that the banks incur to obtain fund like in case of deposit from
customers or at repo rate from RBI. MCLR has replaced base rate system of fixing interest rates.

The main reasons for implementing the MCLR system are

➢ To improve the transmission of monetary policy

➢ To bring transparency in the methodology of banks to fix interest rates
➢ To ensure that bank credit is available at interest rates which are fair to both borrowers and
lenders.
EXTERNAL BENCHMARKING OF INTEREST RATES

• Under the new system which will come into effect from April 1, 2019, banks will have to
link their lending rates with an external benchmark instead of MCLR.

• The RBI has given these options to banks: RBI repo rate, the 91-day T-bill yield; the 182-
day T-bill yield; or any other benchmark market interest rate produced by the Financial
Benchmarks India Pvt. Ltd.
NON-PERFORMING ASSETS (NPA)

PROCESS OF NPA
NON-PERFORMING ASSETS (NPA)

• A loan whose interest and/or instalment of principal has remained 'overdue ' for a period of 90
days is considered as NPA. Banks are required to classify NPAs further into the three categories
based on the period for which the asset has remained non-performing:

(a) Sub-standard asset: Remained NPA for a period less than or equal to 12 months.

(b) Doubtful asset: If it has remained in the substandard category for a period of 12 months.

(c) Loss assets: NPA identified by the bank or the RBI but the amount has not been written off.

Stressed assets = NPAs + restructured loans + written off assets

5/25 Refinancing: This scheme offered a larger window for revival of stressed assets in the infrastructure sectors and 8
core industries. Under this scheme lenders were allowed to extend the tenure of loans to 25 years with interest
rates adjusted every 5 years, so tenure of the loans matches the long gestation period in the sectors. The scheme
thus aimed to improve the credit profile and liquidity position of borrowers, while allowing banks to treat these
loans as standard in their balance sheets, reducing provisioning costs against NPAs.

SDR (Strategic Debt Restructuring): In June 2015, RBI came up with the SDR scheme provide an opportunity to
banks to convert debt of companies (whose stressed assets were restructured but which could not finally fulfil
the conditions attached to such restructuring) to 51 per cent equity and sell them to the highest bidders—
ownership change takes place in it. By end-December 2016, only 2 such sales had materialized, in part because
many firms remained financially unviable, since only a small portion of their debt had been converted to equity.

AQR (Asset Quality Review): Resolution of the problem of bad assets requires sound recognition of such assets.
Therefore, the RBI emphasized AQR, to verify that banks were assessing loans in line with RBI loan classification
rules. Any deviations from such rules were to be rectified by March 2016.
S4A (Scheme for Sustainable Structuring of Stressed Assets): Introduced in June 2016, in it, an independent agency is hired by the
banks which decides as how much of the stressed debt of a company is ‘sustainable’. The rest (‘unsustainable’)
is converted into equity and preference shares. Unlike the SDR arrangement, this involves no change in the
ownership of the company.

Joint Lenders Forum (2014)

It is done to avoid a situation where a loan is taken from one bank to repay the loans in other banks

Mission Indradhanush (2015)

It is the most comprehensive reforms undertaken to improve the functioning of the Public Sector
Banks, by using the ABCDEFG formula.
INSOLVENCY AND BANKRUPTCY CODE (IBC), 2016

➢ Set of laws for the resolution of failed t bankrupt entities/individuals.

➢ It provides clear, coherent and speedy process for early identification of financial distress and
resolution of entities if the underlying business is found to be viable.

➢ It suggests two options – a restructuring if the firm is viable and liquidation if it is not financially
viable.

FEATURES

• Deals with all aspects of insolvency and bankruptcy of all kinds of companies, LLPs, Partnerships and
Individuals; however it does not deal with insolvency of banks.

• Separation of commercial aspects from judicial aspects of insolvency and bankruptcy proceedings

• Moving away from the ‘debtor-in-possession’ regime to a ‘creditors-in-control’ regime

• Collective mechanism to resolve insolvency rather than recovery of loan by a creditor;

• Insolvency resolution in a time bound manner.

PILLARS OF IBC

1. Insolvency professionals - who assist the stakeholders in the insolvency

process;
2. Information utilities - who store and make valuable information
available required to carry out various transactions under the code;
3. Adjudicating authorities - National Company Law Tribunal and Debt
Recovery Tribunal; and
4. Insolvency and Bankruptcy Board of India (for regulatory oversight).
SPECIAL MENTION ACCOUNTS

• It is a tool for early stress discovery of bank loans.

• Introduced as a corrective action plan.

• Accordingly banks should identify potential stress in the account by creating a new
sub-asset category viz. ‘Special Mention Accounts’

In March 2016, RBI had notified a mechanism for resolving stressed MSME loans of up
to Rs 25 crore. According to the stress level such loans are categorised into three
categories

1. SMA 0 ( Delay up to 30 Days)

2. SMA 1 ( Delay up to 31-60 Days)
3. SMA 2 ( Delay up to 61-90 Days)
FINANCIAL SECTOR REFORMS

The process of economic reforms initiated in 1991 had redefined the role of government in
the economy—in coming times the economy will be dependent on the greater private
participation for its development.
A high level committee on Financial System (CFS) Announced by the government while
setting up under M. Narasimham Committee on Finacial System was set up on 14 August,
1991 to examine all aspects relating to structure, organisation, function and procedures of the
financial system—based on its recommendations, a comprehensive reform of the banking
system was introduced in the fiscal 1992–93.

The recommendations of the CFS (Narasimham Committee I) were aimed at:

➢ Ensuring a degree of operational flexibility.

➢ Internal autonomy for public sector banks (PSBs) in their decision-making process.
➢ Greater degree of professionalism in banking operation.
The key recommendations with respect to the banking sector were as follows:
1. Establishment of 4 tier hierarchy for banking structure with 3 to 4 large banks (including SBI)
at the top and at bottom rural banks engaged in agricultural activities.
2. The supervisory functions over banks and financial institutions can be assigned to a quasi-
autonomous body sponsored by RBI.
3. A phased reduction in statutory liquidity ratio.
4. Phased achievement of 8% capital adequacy ratio.
5. Abolition of branch licensing policy.
6. Proper classification of assets and full disclosure of accounts of banks and financial
institutions.
7. Deregulation of Interest rates.
8. Delegation of direct lending activity of IDBI to a separate corporate body.
9. Competition among financial institutions on participating approach.
10. Setting up Asset Reconstruction fund to take over a portion of the loan portfolio of banks
whose recovery has become difficult.
Narasimham Committee-II
In December 1997 the government did set up another committtee on the banking sector reform
under the chairmanship of M. Narasimham. The objective of the committee is objectively clear by
the terms of reference it was given while setting up:
“To review the progress of banking sector reforms to date and chart a programme of financial
sector reforms necessary to strengthen India’s financial system and make it internationally
competitive”

(i) Need for a stronger banking system for which mergers of the PSBs and the financial institutions
(AIFIs) were suggested—stronger banks and the DFIs (development financial institutions, i.e.,
AIFIs) to be merged while weaker and unviable ones to be closed.
(ii) A 3-tier banking structure was suggested after mergers:
(a) Tier-1 to have 2 to 3 banks of international orientation;
(b) Tier-2 to have 8 to 10 banks of national orientation; and
(c) Tier-3 to have large number of local banks.

The first and second tiers were to take care of the banking needs of the corporate sector in
the economy.
(iii) Higher norms of Capital-to-Risk Weighted Adequacy Ratio (CRAR) suggested—increased to 10 per
cent.

(iv) Budgetary recapitalisation of the PSBs is not viable and should be abandoned.

(v) Legal framework of loan recovery should be strengthened (the government passed the SARFAESI
(Act, 2002).

(vi) Net NPAs for all banks suggested to be cut down to below 5 per cent by 2000 and 3 per cent by 2002.

(vii) Rationalisation of branches and staffs of the PSBs suggested.

(viii) Licencing to new private banks (domestic as well as foreign) was suggested to continue with.

(ix) Banks’ boards should be depoliticised under RBI supervision.

(x) Board for financial Regulation and Supervisions (BFRS) should be set up for the whole banking,
financial and the NBFCs in India.
PUBLIC CREDIT REGISTRY (PCR)
An extensive database of credit information that will capture information pertaining to
borrowers (individuals and corporate) including data about wilful defaulters and pending
legal suits against them.

PROMPT CORRECTIVE ACTION (PCA)

Framework under which banks with weak financial metrics are put under watch by the RBI.
Under PCA RBI can place certain restrictions on banks such as a cap on lending limit, halting
branch expansion etc.
WHEN IS PCA INVOKED?
RBI invokes PCA on those banks when three risk thresholds are breached. These are based on:
1. Asset quality (NNPA – net non-performing assets to advances ratio),
2. Capital (CRAR – regulatory capital to risk weighted assets ratio and leverage ratio)
3. Profitability (ROA – return on assets).
NOTE: The PCA framework is applicable only to commercial banks
BASEL ACCORDS

Basel Committee on Banking Supervision is an international committee formed in 1974 to

develop standards for banking regulation. The Basel Accords (i.e., Basel I, II and now III) are a
set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides
recommendations on banking regulations in regards to capital risk, market risk and operational
risk. The purpose of the accords is to ensure that financial institutions have enough capital on
account to meet obligations and absorb unexpected losses.

The BIS Accords were the outcome of a long-drawn out initiative to strive for greater
international uniformity in prudential capital standards for banks’ credit risk. The objectives of
the accords could be summed up as:
(i) to strengthen the international banking system;
(ii) to promote convergence of national capital standards; and
(iii) to iron out competitive inequalities among banks across countries of the world.
THE FIRST BASEL ACCORD, known as Basel I focuses on the capital adequacy of financial
institutions. The capital adequacy risk (the risk a financial institution faces due to an
unexpected loss), categorises the assets of financial institution into five risk categories (0 per
cent, 10 per cent, 20 per cent, 50 per cent, 100 per cent). Banks that operate internationally
are required to have a risk weight of 8 per cent or less.

THE SECOND BASEL ACCORD, known as Basel II, is to be fully implemented by 2015. It
focuses on three main areas, including minimum capital requirements, supervisory review
and market discipline, which are known as the three pillars. The focus of this accord is to
strengthen international banking requirements as well as to supervise and enforce these
requirements.
THE THIRD BASEL ACCORD

It is known as Basel III is a comprehensive set of reform measures aimed to strengthen the
regulation, supervision and risk management of the banking sector. These measures aim to:

(i) improve the banking sector’s ability to absorb shocks arising from financial and economic
stress, whatever the source be;

(ii) improve risk management and governance; and

(iii) strengthen banks’ transparency an disclosures.

The capital of the banks has been classified into three tiers as given below:

1. Tier 1 capital: which can absorb losses without a bank being required to cease trading.
2. Tier 2 capital: absorb losses in the event of winding up, which provide lesser degree of
protection to depositors.
3. Tier 3 capital: tertiary capital of banks which are used to meet market risk, commodity risk and
foreign currency risk.
DOMESTIC-SYSTEMICALLY IMPORTANT BANKS (D-SIBS)

• SIBs are banks that are perceived as ‘Too Big To Fail’.

• The Basel Committee on Banking Supervision came out with a framework in
2011 for identifying the Global Systemically Important Banks (G-SIBs).
• Similarly, the RBI has been mandated to identify the Domestic systemically
Important banks (D-SIBs).
• This is primarily done in order to stronger regulatory requirements to
prevent their failure.
 Criteria:
• Banks whose size is equal to or more than 2% of GDP
• Lack of readily available substitutes
• Interconnectedness and Complexity
NOTE: RBI has classified SBI, ICICI Bank, and HDFC as D-SIBs

The Union Budget 2020-21 has increased the deposit insurance cover in scheduled
commercial banks to Rs 5 lakh per depositor from the current Rs 1 lakh.
PRIORITY SECTOR LENDING
Priority sector was first properly defined in 1972, after the National Credit Council emphasized
that there should be a larger involvement of the commercial banks in the priority sector. The
sector was then defined by Dr. K S Krishnaswamy Committee.
Objective of Priority Sector Lending
To ensure that adequate institutional credit flows into some of the vulnerable sectors of the
economy, which may not be attractive for the banks from the point of view of profitability.

Refer RBI Website

MERGER OF PUBLIC SECTOR BANKS
• The Government of India has proposed to merge 10 Public sector Banks into 4 large banks by April 1 2020.
CHRONOLOGY
• PJ Nayak Committee (2014) recommended for merger of PSBs
• 2017: Union Cabinet gave in-principle approval for amalgamation of Public Sector Banks
• 2017: State Bank of India merged with 5 of its associate banks and Bharatiya Mahila Bank -- State Bank of
Bikaner and Jaipur, State Bank of Mysore, State Bank of Travancore, State Bank of Hyderabad, and State Bank of
Patiala.
• 2018: Vijaya Bank, Dena Bank and Bank of Baroda (Anchor bank - BoB)
CURRENT DECISION
• This move would bring down the number of Public Sector Banks to 12.
a. Allahabad Bank and Indian Bank (anchor bank – Indian Bank)
b. PNB, OBC and United Bank (anchor bank - PNB)
c. Union Bank of India, Andhra Bank and Corporation Bank (anchor bank - Union Bank of India)
d. Canara Bank and Syndicate Bank (anchor bank – Canara Bank)
RATIONALE

➢ Consolidation of banking structure in India (recommended by Narasimhan

Committee of 1991)
➢ To meet credit demand, Better monitoring.
➢ Reduction in the net NPA ratio of the merged bank and kick start credit creation.
➢ The merger of weak banks (higher NPAs and low profits) with the strong Banks
would prevent the collapse of the weak banks and protect the customers and
financial system.
➢ Would reduce the financial burden on the Government on undertaking frequent
recapitalisation of the Public Sector Banks.
➢ Meeting the stringent capital requirements stipulated under the BASEL III Norms.
NON-BANKING FINANCIAL COMPANY (NBFC)
Financial institutions engaged in non-banking activities like leasing, microfinance, chit fund,
gold loan etc. Besides company whose principal business is receiving deposits also constitute
NBFC.

CATEGORIES OF NBFCS
1. Asset Finance Company - Principal business is financing physical assets such as
automobiles, tractors, housing etc.
2. Investment Company - Principal business is acquisition of securities.
3. Loan Company - Principal business of providing loans
4. Infrastructure Finance Company - NBFC that deploys at least 75% of its total assets in
infrastructure loans
5. Infrastructure Debt Fund - NBFC to facilitate the flow of long term debt into infrastructure
projects
REGULATION OF NBFCS

• Different categories of NBFCs are regulated by different regulators

• Most NBFCs are regulated by RBI, however not all.

• Venture Capital Fund/Merchant Banking companies/Stock broking companies are registered

with SEBI.

• The Insurance Companies are regulated by IRDA

• Chit Fund Companies are regulated by the respective State Governments

• Nidhi Companies are regulated by Ministry of Corporate Affairs, Government of India