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Date: 30 Mar 2009

Overview - Volume II

INDIA’S FINANCIAL SECTOR
AN ASSESSMENT

Volume II
Overview Report

Contents
Chapter No.	Subject		Page No.
	Cover Page		ix
	Letter of Transmittal		ix
	Composition of the Committee		ix
	Preface		ix
	List of Acronyms		xix
I.	Introduction		1
	1.1	Approach and Framework for the Assessment	2
	1.2	Work Process	3
	1.3	Scheme of the Report	6
II.	Macroeconomic Environment		35
	2.1	Introduction	35
	2.2	Global Economy	38
	2.3	The Indian Context	40
	2.4	Potential Areas of Macroeconomic Vulnerability	46
	2.5	Linkages between Macroeconomic Performance and Financial Stability	55
	2.6	Financial Development Index 2008 Rankings – Strengths and Weaknesses of the Indian Financial System	56
	2.7	Concluding Observations	57
III.	Financial Institutions		63
	3.1	Introduction	63
	3.2	Commercial Banks	69
	3.3	Co-operative and Rural Banking Sector	149
	3.4	Non-banking Financial Companies	175
	3.5	Housing Finance Companies	191
	3.6	Development Finance Institutions	201
	3.7	Insurance Sector	204
	3.8	Concluding Remarks	226
IV.	Financial Markets		239
	4.1	Introduction	239
	4.2	Equity Market	244
	4.3	Foreign Exchange Market	257
	4.4	Government Securities Market	268
	4.5	Money Market	279
	4.6	Development of Other Market Segments	286
	4.7	Concluding Remarks	294
V.	Financial Infrastructure		297
	5.1	Introduction	297
	5.2	Regulatory Structure	297
	5.3	Liquidity Infrastructure	346
	5.4	Accounting Standards	360
	5.5	Auditing Standards	367
	5.6	Business Continuity Management	374
	5.7	Payment and Settlement Infrastructure	379
	5.8	Legal Infrastructure	408
	5.9	Corporate Governance	435
	5.10	Safety Net – Deposit Insurance	445
	5.11	Review of AML/CFT	452
	5.12	Concluding Remarks	463
VI.	Transparency Issues		469
	6.1	Introduction	469
	6.2	Transparency in Monetary Policy	469
	6.3	Transparency in Financial Policies	498
	6.4	Issues Relating to Fiscal Transparency	505
	6.5	Data Dissemination Standards	520
	6.6	Concluding Remarks	531
VII.	Development Issues in the Socio-Economic Context		533
	7.1	Introduction	533
	7.2	Financial Inclusion	533
	7.3	Access to Finance by Small-Scale Industries (SSIs)	551
	7.4	Customer Service	551
	7.5	Sustainability Issues	553
	7.6	Summary	553
	7.7	Concluding Observations	555
VIII.	Summary		557
	8.1	Macroeconomic Environment	557
	8.2	Institutions	562
	8.3	Financial Markets	585
	8.4	Financial Infrastructure	595
	8.5	Transparency Issues	628
	8.6	Development Issues in the Socio-Economic Context	643
Major Recommendations of Previous Committees			648

List of Boxes
Box 3.1	Basel Core Principles for Banking Regulation and Supervision	65
Box 3.2	The Pros and Cons of Public Sector Banks in India	106
Box 3.3	Risk Management - Key Lessons and Recommendations	120
Box 3.4	Principles for Sound Liquidity Risk Management and Supervision	129
Box 3.5	World Council of Credit Unions - Principles of Credit Union Governance...	156
Box 3.6	Insurance Core Principles	213
Box 4.1	IOSCO Principles for Securities Market Regulation	242
Box 5.1	How Countries Supervise Financial Conglomerates	305
Box 5.2	Cross-country Practices Regarding SROs in Securities Markets	315
Box 5.3	Perils of Lack of Independence - Some International Experiences	317
Box 5.4	Regulatory Co-ordination in a Crisis	323
Box 5.5	Recent Training Initiatives by Regulatory Institutions	339
Box 5.6	Major BCM Initiatives by Regulators	375
Box 5.7	Standards in Payment and Settlement Systems	383
Box 5.8	Competition Issues – Approaches in the UK and the US	413
Box 5.9	Principles for Effective Insolvency and Creditor Rights Systems (Revised) – 2005	415
Box 5.10	OECD Principles on Corporate Governance	436
Box 6.1	Transparency in Monetary Policy	471
Box 6.2	Monetary Policy Committees	477
Box 6.3	Transparency in Financial Policies	498
Box 6.4	IMFs Code of Good Practices on Fiscal Transparency	506
Box 6.5	IMFs Special Data Dissemination Standards	521
Box 6.6	Recent Developments in respect of Price Indices	529
Box 7.1	Financial Inclusion - Experience in Select Economies	538
List of Tables
Table 2.1	Output Growth, Inflation and Interest Rates in Select Economies	39
Table 2.2	Indias Ranking under Financial Development Index	57
Table 2.3	Indias Ranking under Individual Elements within the Major Pillars	58
Table 3.1	Scheduled Commercial Banks - Business Size as per cent of GDP (end-March)	70
Table 3.2	Herfindahl-Hirschman Index	76
Table 3.3	Bank Group-wise Productivity Indicators (2006-07)	77
Table 3.4	Capital Adequacy of Banks as at end-March and September 2008	84
Table 3.5	Asset Quality of Banks as at end-March and September 2008	84
Table 3.6	Earnings and Profitability of Banks as at end-March and September 2008	85
Table 3.7	Off-balance Sheet Exposure of Banks as at end-March and September 2008	86
Table 3.8	Stress Tests of Credit Risk – Scenarios and Results – Position with reference to March 31, 2008	87
Table 3.9	Stress Test on Balance Sheet (Economic Value Perspective) - March 2008	90
Table 3.10	Impact on Trading Book (Economic Value Perspective) - March 2008	90
Table 3.11	Impact on Banking Book (Economic Value Perspective) - March 2008	91
Table 3.12	Liquidity Ratios - Average Value	92
Table 3.13	Stress Test of Credit Risk - Scenarios and Results with Reference to September 30, 2008	95
Table 3.14	Liquidity Ratios	97
Table 3.15	Summary Assessment of Commercial Banks	98
Table 3.16	Financial Indicators of Banks	107
Table 3.17	State Co-operative Banks - Liabilities and Assets	166
Table 3.18	District Central Co-operative Banks - Liabilities and Assets	166
Table 3.19	Cost of Funds of Rural Financial Institutions - March 2007	167
Table 3.20	Profile of NBFC-D/RNBC Segment	177
Table 3.21	Cross-Country Experience of Regulating NBFCs	178
Table 3.22	Key Financial Indicators of NBFC-D	180
Table 3.23	Key Performance Indicators of NBFC-D	180
Table 3.24	Profile of Systemically Important Non-Deposit Taking NBFCs	181
Table 3.25	Key Financial Indicators of NBFC-ND-SI	182
Table 3.26	Key Balance Sheet Components of HFCs as Percentage to Total Assets	192
Table 3.27	Profile of DFIs	203
Table 3.28	Premia as a Per Cent of GDP	205
Table 3.29	Stress Test Results	211
Table 3.30	Summary Assessment of Insurance Core Principles	215
Table 3.31	Summary Assessment of Urban Co-operative Banks	231
Table 3.32	Summary Assessment of State Co-operative Banks/District Central Co-operative Banks	232
Table 3.33	Summary Assessment of Regional Rural Banks	234
Table 3.34	Summary Assessment of Non-Banking Financial Companies	235
Table 3.35	Summary Assessment of Housing Finance Companies	237
Table 4.1	Depth of Financial Markets in India - Average Daily Turnover	241
Table 4.2	Summary Assessment of Equity and Corporate Bond Market	248
Table 4.3	Geographical Distribution of Reported Foreign Exchange Market Turnover	259
Table 4.4	Indicators of Indian Foreign Exchange Market Activity	259
Table 4.5	Summary Assessment of Foreign Exchange Market	261
Table 4.6	Government Securities Market - A Profile	270
Table 4.7	Summary Assessment of Government Securities Market	274
Table 4.8	Summary Assessment of Money Market	283
Table 5.1	Existing Structure of Financial Markets Regulation in India	329
Table 5.2	Volatility in Money Market Rates	348
Table 5.3	Summary Assessment – Systemically Important Payment Systems	389
Table 5.4	Summary Assessment – Recommendations for Securities Settlement Systems	394
Table 5.5	Volume of Transactions in Foreign Exchange Market	399
Table 5.6	Summary Assessment – Recommendations for Central Counterparties – CCIL	400
Table 5.7	Summary Assessment – Recommendations for Central Counterparties – NSCCL & BOISL	406
Table 5.8	Summary Assessment of Effective Insolvency and Creditor Rights Systems	419
Table 5.9	Cross-country Comparison on Closing a Business	426
Table 5.10	Summary Assessment of OECD Principles	439
Table 5.11	Penal Action Taken Against Banks	461
Table 5.12	Inspection of Stock Brokers and Sub-brokers	461
Table 5.13	Inspection of Depository Participants	462
Table 5.14	Submission of CTRs as at end-March 2008	462
Table 6.1	Summary Assessment of Transparency in Monetary Policy	472
Table 6.2	Summary Assessment of Transparency in Financial Policies	500
Table 6.3	Summary Assessment of Fiscal Transparency	508
Table 6.4	Data Quality Assessment Framework – Summary of Results	524
Table 7.1	Savings Accounts with Scheduled Commercial Banks	536
Table 7.2	Credit Accounts with Scheduled Commercial Banks	537
Table 7.3	Cost of Credit from Various Agencies in India	541
Table 7.4	Sources of Loans by Income Groups	542
List of Charts
Chart 2.1	Gross Domestic Saving	41
Chart 2.2	Public and Private Investment Rates	41
Chart 2.3	Indias Share in World Exports of Goods and Services	43
Chart 2.4	Indias Current Account	43
Chart 2.5	Foreign Investment in India	44
Chart 3.1	Indian Financial Institutions - Share of Assets - March 2008	63
Chart 3.2	CRAR of Scheduled Commercial Banks	70
Chart 3.3	Asset Quality of Scheduled Commercial Banks	71
Chart 3.4	Profitability Indicators for Scheduled Commercial Banks	72
Chart 3.5	Cost Income Ratio for Scheduled Commercial Banks	72
Chart 3.6	Off-Balance Sheet Exposures to Total Assets of Scheduled Commercial Banks	73
Chart 3.7	Components of Off-Balance Sheet Items for Scheduled Commercial Banks	74
Chart 3.8	Bank Group-wise Business Size	75
Chart 3.9	Branches of Private Sector Banks	76
Chart 3.10	Bank Group-wise Business Per Employee	77
Chart 3.11	Bank Group-wise Cost Income Ratio	77
Chart 3.12	Bank Group-wise Capital Adequacy Ratio	78
Chart 3.13	Bank Group-wise Gross NPAs to Gross Advances	78
Chart 3.14	Bank Group-wise Net NPAs to Net Advances	79
Chart 3.15	Bank Group-wise Asset Slippage Ratio	79
Chart 3.16	Bank Group-wise Coverage Ratio	79
Chart 3.17	Bank Group-wise Provisioning to NPA	80
Chart 3.18	Bank Group-wise Return on Assets	80
Chart 3.19	Bank Group-wise Return on Equity	81
Chart 3.20	Bank Group-wise Net Interest Income to Total Income	81
Chart 3.21	Bank Group-wise Fee Income to Total Income	81
Chart 3.22	Bank Group-wise Treasury Income to Total Income	82
Chart 3.23	Bank Group-wise Operating Expenses to Total Assets	82
Chart 3.24	Bank Group-wise Net Interest Margin	83
Chart 3.25	Bank Group-wise Off-Balance Sheet Exposures	83
Chart 3.26	Grade-wise Position of UCBs	159
Chart 3.27	Key Financial Indicators of Scheduled UCBs	159
Chart 3.28	CRAR of Scheduled UCBs	160
Chart 3.29	Asset Quality of UCBs	160
Chart 3.30	Profitability Indicators - Scheduled UCBs	161
Chart 3.31	Distribution of UCBs by Deposit Base (as on March 31, 2008)	161
Chart 3.32	Stress Testing Results - Credit Risk - Scheduled UCBs	162
Chart 3.33	Non-Performing Loans to Total Loans – Rural Co-operatives	167
Chart 3.34	Net Profit to Total Assets – Rural Co-operatives	167
Chart 3.35	Assets and Liabilities of RRBs	169
Chart 3.36	Asset Quality of RRBs	169
Chart 3.37	Return on Assets - RRBs	170
Chart 3.38	CRAR of NBFCs-D	179
Chart 3.39	Asset Quality of NBFCs-D	179
Chart 3.40	CRAR of HFCs	193
Chart 3.41	Asset Quality of HFCs	193
Chart 3.42	Profitability Indicators of HFCs	194
Chart 3.43	Current Ratio – HFCs	194
Chart 3.44	Balance Sheet Indicators of DFIs	202
Chart 3.45	Herfindahl Index - Life Insurance Sector	205
Chart 3.46	Capital Adequacy of Life Insurance Sector	206
Chart 3.47	Asset Quality of Life Insurance Sector	207
Chart 3.48	Indicators of Life Insurance Sector - Reinsurance and Actuarial Issues	207
Chart 3.49	Profitability Indicators – Life Insurance Sector	208
Chart 3.50	Capital Adequacy Indicators of Non-life Insurance Sector>	209
Chart 3.51	Indicators of Non- Life Insurance Sector -Reinsurance and Actuarial Issues	209
Chart 3.52	Earning and Profitability Indicators of Non- life Insurance Sector	210
Chart 3.53	Liquidity Indicators of Non-life Insurance Sector	211
Chart 4.1	Index Returns in Per Cent	246
Chart 4.2	Trends in Market Capitalisation	246
Chart 4.3	Daily Average Inter-bank and Merchant Transactions in the Foreign Exchange Market	258
Chart 4.4	Comparison of 1- month Forward in NDF & Domestic Markets	264
Chart 4.5	10-Year G-Sec Yield	271
Chart 4.6	Net Market Borrowings to Gross Fiscal Deficit	271
Chart 4.7	Yield Curves	272
Chart 4.8	Commercial Paper Issued and Outstanding	281
Chart 5.1	Regulatory Structure of the Indian Financial System - Institutions and Markets	301
Chart 5.2	LAF Corridor and the Call Rate	347
Chart 5.3	BCM – Development Period for a New Problem	376
Chart 5.4	Payment System Indicators	381
Chart 5.5	Recovery Ratio and Time of Resolution of Insolvency	427
Chart 7.1	Progress in No-Frills Accounts	540
Chart 7.2	SHG-Bank Linkage Programme	541

INDIA’S FINANCIAL SECTOR
AN ASSESSMENT

Volume II
Overview Report

Committee on Financial Sector Assessment
March 2009

The findings, views and recommendations expressed in this Report are entirely those of the Committee on Financial Sector Assessment and should not be interpreted as the official views of the Reserve Bank of India or Government of India.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise, without the prior written permission of the publisher.

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Published by Dr. Mohua Roy, Director, Monetary Policy Department, Reserve Bank of India, Central Office, Mumbai - 400 001 and printed at Jayant Printery, 352/54, Girgaum Road, Murlidhar Temple Compound, Near Thakurdwar Post Office, Mumbai - 400 002.

LETTER OF TRANSMITTAL


Government of India Ministry of Finance Department of Economic Affairs New Delhi	Reserve Bank of India Central Office Shaheed Bhagat Singh Marg Mumbai

March 20, 2009

Dear Hon’ble Finance Minister

Report of the Committee on Financial Sector Assessment

We have great pleasure in submitting the Report of the Committee on Financial Sector Assessment (CFSA).

The Government of India, in consultation with the Reserve Bank of India, constituted the CFSA to undertake a comprehensive self-assessment of Indias financial sector. The assessment has drawn upon the experience gained from the earlier self-assessment of international financial standards and codes and the standards assessments carried out by the International Monetary Fund and the World Bank.

The CFSA has followed a constructive and transparent approach to self-assessment keeping in view that such a self-assessment must be a rigorous and impartial exercise, with appropriate checks and balances.

The Report of the CFSA is being released in six volumes. Apart from the overview report and its executive summary, the other volumes comprise the Advisory Panel Reports on Financial Stability Assessment and Stress Testing, Financial Regulation and Supervision, Institutions and Market Structure, and Transparency Standards. Each of the Advisory Panel Reports has been reviewed by expert international peer reviewers.

Even while the impact of the recent global financial turmoil is still unfolding, the CFSA hopes that this assessment would enhance the understanding of the Indian financial sector, both in India and abroad. We would earnestly urge the Government of India, the Reserve Bank, SEBI, IRDA and other concerned market participants to promote wide dissemination and debate and initiate policy actions for improving the structural aspects of the Indian financial architecture.

We would also like to acknowledge the generous help and time given by the Chairmen and members of the Advisory Panels, the external peer reviewers and all officials and colleagues from the Government, regulatory and other institutions associated with this exercise.

Yours sincerely,

With warm regards


(Ashok Chawla) Co-Chairman and Secretary, Department of Economic Affairs Ministry of Finance Government of India	(Rakesh Mohan) Chairman and Deputy Governor Reserve Bank of India

Shri Pranab Mukherjee
Minister of Finance
Government of India
New Delhi - 110 001.

Composition of the Committee on Financial Sector Assessment

Chairman Dr. Rakesh Mohan Deputy Governor Reserve Bank of India	Co-Chairman Shri Ashok Chawla Secretary Department of Economic Affairs Ministry of Finance Government of India (from September 6, 2008)

	Dr. D. Subbarao Former Finance Secretary Government of India (July 16, 2007 - September 5, 2008)
	Shri Ashok Jha Former Finance Secretary Government of India (September 13, 2006 - July 15, 2007)

Members

Shri Arun Ramanathan
Finance Secretary
Government of India
(from February 4, 2008)

Shri Vinod Rai
Former Secretary
Department of Financial Services
Ministry of Finance
Government of India
(January 11, 2007 - February 3, 2008)

Dr. Arvind Virmani
Chief Economic Adviser
Department of Economic Affairs
Ministry of Finance Government
of India

Dr. Alok Sheel
Joint Secretary (Fund-Bank)
Department of Economic Affairs
Ministry of Finance
Government of India
(from October 23, 2008)

Shri Madhusudan Prasad
Joint Secretary (Fund-Bank)
Department of Economic Affairs
Ministry of Finance
Government of India
(September 13, 2006 - October 22, 2008)

PREFACE

It is well-recognised, particularly after the East Asian crisis of 1997, that in an environment of large cross-border capital flows, which increased dramatically in the past two decades, the financial sector must be resilient and well-regulated. The fact that advanced financial markets, with well-tested monetary policy and regulatory frameworks, are also not free from such unexpected and extraordinary developments, has become very evident in the ongoing global financial crisis. In this context, the Financial Sector Assessment Programme (FSAP), a joint IMF/World Bank initiative introduced from May 1999 has aimed at identifying the strengths and vulnerabilities of a country’s financial system; to determine how key sources of risk are being managed; to ascertain the financial sectors’ developmental needs; and to help prioritise policy responses. These objectives are sought to be achieved through financial system stability assessment (FSSA) by undertaking macroeconomic surveillance and assessment of stability and soundness of the financial system in all its facets or the entire gamut of the financial system, viz., institutions, markets and infrastructure. A detailed assessment of observance of relevant financial standards and codes which gives rise to Reports on Observance of Standards and Codes (ROSCs) as a by-product is an integral part of FSAP – either undertaken as part of FSSA or independently. Overall, an FSAP enhances the scope for strengthening resilience and fostering financial stability within and helps promote smoother integration of economies with the global markets.

Member countries’ participation in both FSAPs/ROSCs and the publication of related reports is voluntary. Hence, the effectiveness of these assessments hinges upon the ownership of and commitment to the process from member country authorities. In the approximately ten years since the FSAP began, about three-quarters of IMF and World Bank member countries have completed or requested an initial assessment. The IMF/ World Bank has begun in recent times to focus upon updates of the FSAP. It is significant that among the countries that have not been comprehensively covered yet are some advanced countries among the G-7 and emerging markets among the G-20 Group – though some ROSCs have been completed by many of these countries in a sporadic manner.

India was one of the earliest member countries that participated voluntarily in the Financial Sector Assessment Programme (FSAP) exercise in 2000-01. Based on mutual consultations between the Government and the Reserve Bank, an elaborate self-assessment exercise on standards and codes was also conducted during 2000-02. In this exercise, India undertook a comprehensive self-assessment in all of 11 international financial standards and codes under the aegis of the Standing Committee on International Financial Standards and Codes, with Anti-Money Laundering (AML)-Combating the Financing of Terrorism (CFT) Recommendations assessed by a separate Working Group. These reports served as benchmarks for understanding the status as also for initiating several legal and institutional reforms in the financial sector. Thereafter, a review of the follow-up action taken on the recommendations of the 11 Groups mentioned above was completed in January 2005. India also completed assessments by the Bank-Fund of most of the financial standards by December 2004, except for those relating to insurance.

Building upon the experience thus far, the Government of India, in consultation with the Reserve Bank, decided to undertake a comprehensive self-assessment of the financial sector and for that purpose constituted the Committee on Financial Sector Assessment (CFSA) in September 2006. It needs to be mentioned that standards themselves are evolving and getting modified. Since the last FSAP in 2000-01, India has also undertaken a series of continuing reforms over this period. The financial sector reforms undertaken since the early 1990s have no doubt borne fruit: the country has reached a higher growth trajectory; savings have increased and investment into productive activities has expanded significantly; the financial markets have gained depth, vibrancy and more efficiency; and capacity-building overall is embedded in the system.

The CFSA, therefore, decided to undertake a full-scale and fresh assessment instead of updating earlier assessments. Also, instead of a selective approach, the CFSA decided to cover assessments of all financial standards and codes, so that a compact roadmap in a medium-term perspective for the entire financial sector could evolve in persevering with convergence towards international best practices. The current assessment, however, builds upon the earlier FSAP and ROSCs as needed and relevant. These reports were indeed educative. The current effort of the CFSA is, thus one more step in carrying forward the self-assessment approach, further enabling financial sector stability assessment and stress testing for the first time. The timely publication in September 2005 of the comprehensive Handbook on Financial Sector Assessment by the IMF and the World Bank enabled the initiation of this exercise. In addition, the assessors have also taken into account the Guidance notes, manuals and questionnaires that have been provided to the CFSA by the international standard-setting bodies. We take this opportunity to acknowledge and thank all of the institutions and standard-setters who have encouraged this effort.

The CFSA has followed a constructive and transparent approach to self-assessment, keeping particularly in view that such a self-assessment must be seen as a rigorous and impartial exercise. This unique experiment undertaken by India would, however, amply demonstrate that it is possible to achieve objectivity and credibility through self-assessments, if accompanied by appropriate checks and balances. In this regard, we would like to highlight the salient features of the broad approach and the work process designed by the CFSA.

Three Pillars of Assessment

The CFSA followed a forward-looking and holistic approach to self-assessment based on three mutually-reinforcing pillars:

Pillar I : Financial stability assessment and stress testing;
Pillar II : Legal, infrastructural and market development issues; and,
Pillar III : Assessment of the status and implementation of international financial standards and codes.

The first pillar (Pillar I) is essentially in the nature of stability assessment which utilises analytical tools for quantifying the risks and vulnerabilities in the financial sector. The attempt entails an assessment of the systemic risks at the macro and sectoral levels. This involves a comprehensive analysis and interpretation of financial data pertaining to various constituents of the financial sector. viz., banking, securities, insurance, non-banking financial institutions, and corporates as also the fiscal and external sectors. It also includes stress testing for the key risks identified.

The second pillar (Pillar II) focuses on the developmental issues of the financial sector, concentrating upon the legal and institutional infrastructure for prudential regulation and supervision, payment and settlement systems, liquidity management and the crisis-mitigating financial safety nets. It also addresses the extent of coverage of the financial sector and the strength and adequacy of financial intermediation, both in the urban and rural segments.

The third analytical component of financial sector assessment encompasses a comprehensive assessment of the status and implementation of international financial standards and codes (Pillar III).

The CFSA envisaged that in view of the updates to standards that have taken place since the earlier FSAP in 2001, there is a need to take a fresh view on the developments in this area and their current status, duly taking into account the specific features of the Indian financial system. Towards this end, apart from considering the earlier review of self-assessment on standards and codes, the assessments of respective standards made by the IMF and the World Bank have also been taken on board.

Framework

We now provide an overview of the framework evolved by the CFSA in its work process.

First, as the assessment involved comprehensive technical knowledge in respective areas, the CFSA constituted Technical Groups comprising mainly officials with first-hand experience in handling the respective subject areas from the concerned regulatory agencies and the Government. The Technical Groups, based on their functional domain knowledge, thus undertook the preliminary assessment, and prepared technical notes and background material in the concerned subject areas. The greatest advantage of this approach has been that the concerned operating officials who have great familiarity with their own systems, who know where weaknesses exist and can also identify best alternative choices for finding solutions, were involved in this work. Moreover, this experience also operated as a very useful capacity-building exercise for the agencies and officials participating in it.

Second, whereas the preliminary work was done by the Technical Groups, these assessments served as inputs that needed a thorough review and finalisation by impartial experts with domain knowledge in the concerned areas. On this basis, Advisory Panels were constituted by the CFSA comprising non-official experts drawn from within the country. These Advisory Panels, however, had for support some senior officials with requisite domain knowledge, but only as special invitees and not as members. The Advisory Panels made their assessments after a thorough debate and rigorous scrutiny of inputs provided by Technical Groups. This ensured an impartial assessment.

Third, for further strengthening the credibility of assessment, it was considered necessary that the Advisory Panels’ assessments be peer reviewed by eminent external experts before finalisation of the panel reports. The Advisory Panels considered the peer reviewers’ comments and modified their assessments as appropriate. If they differed from peer reviewers, the reasons have been recorded. For a better exchange of views between the peer reviewers and the Advisory Panels, extensive conferences and seminars were held involving the respective peer reviewer, Advisory Panels and officials of the regulatory agencies at the highest levels.

The Advisory Panel reports, along with peer reviewers’ comments, are being publicly disclosed on the Reserve Bank and Government websites. The CFSA drew up its own overview report at the final stage, drawing upon the assessments, findings, and the recommendations of the Advisory Panels.

Thirty-one experts from diverse fields were identified as members of the four Advisory Panels. In addition, senior officials from the Government, the Reserve Bank, Securities and Exchange Board of India (SEBI) and Insurance Regulatory and Development Authority (IRDA) were also inducted as ex officio special invitees to the panels.

The four Advisory Panels were supported by four Technical Groups with the involvement of more than 100 officials drawn from various agencies. The areas covered by the four Advisory Panels were:

Advisory Panel on Financial Stability Assessment and Stress Testing, covered macro-prudential analysis and stress testing of the financial sector (Chairman: Shri M.B.N. Rao, former Chairman and Managing Director, Canara Bank).
Advisory Panel on Financial Regulation and Supervision, covered banking regulation and supervision, securities market regulation and insurance regulation standards (Chairman: Shri M.S.Verma, former Chairman, State Bank of India).
Advisory Panel on Institutions and Market Structure, covered standards regarding bankruptcy laws, corporate governance, accounting and auditing and, payment and settlement systems (Chairman, Shri C.M. Vasudev, former Secretary, Department of Economic Affairs, Ministry of Finance, Government of India).
Advisory Panel on Transparency Standards, covered standards pertaining to monetary and financial policies, fiscal transparency and data dissemination issues (Chairman: Shri Nitin Desai, former Under-Secretary-General, United Nations).

Institutions/Agencies Involved

Yet another area of strength in the current process of self-assessment has been the spirit of inter-regulatory co-operation and association of several other agencies in the process of assessment. Taking into account the legal, regulatory and supervisory architecture in India, the CFSA felt the need for involving and associating closely all the major regulatory institutions, viz., the Reserve Bank, Securities and Exchange Board of India (SEBI) and Insurance Regulatory and Development Authority (IRDA). Depending upon the sectoral/functional distribution, several other regulatory and supervisory agencies in the financial system were also associated, besides involving concerned departments of the Central Government.

Involvement of Peer Reviewers

The CFSA identified 13 international experts and three Indian experts to peer review the relevant portions of the Panel reports in accordance with the reviewers’ areas of expertise. The draft Advisory Panel Reports were forwarded to the respective peer reviewers for their comments. To discuss the comments and suggestions of the peer reviewers, two brainstorming sessions interfacing the peer reviewers with the Panel and CFSA members were also held in Mumbai in the form of a two-day seminar on June 13-14, 2008 and a day’s conference on July 7, 2008. The views of the peer reviewers and the Advisory Panel’s stance have been incorporated in the Panel Reports. Depending upon the stance of the Panel, the texts of the Panel Reports were appropriately modified by the Panels.

We would like to acknowledge the significant contributions made by the experts of the four Advisory Panels chaired by Shri M.B.N. Rao, former Chairman and Managing Director, Canara Bank, Shri M.S. Verma, former Chairman, State Bank of India, Shri C.M. Vasudev, former Secretary, Department of Economic Affairs, Ministry of Finance, Government of India and Shri Nitin Desai, former Under-Secretary-General, United Nations. The CFSA expresses its sincere gratitude to Dr. Y.V. Reddy, then Governor, the Reserve Bank, Shri M. Damodaran, former Chairman, SEBI, Shri C.B. Bhave, Chairman, SEBI, Shri C.S. Rao, former Chairman, IRDA and Shri J. Harinarayan, Chairman, IRDA for extending wholehearted support to the Panels and the CFSA in undertaking their tasks. We are grateful to note that, despite the pressing demands on their time, the external peer reviewers have sent in their very insightful comments, in an honorary capacity. The Secretariat to the CFSA and the Technical Groups comprising officials drawn from the Reserve Bank, the SEBI, the IRDA, Government and other agencies have done outstanding background work for the Advisory Panels and the Committee. We also acknowledge the valuable contribution made by Shri T.C.A. Srinivasa Raghavan who edited and helped in producing these volumes for publication and Dr. Renu Gupta and Dr. Janak Raj for copy editing. A complete list of officials, non-officials, agencies associated and peer reviewers who contributed to this enormous task can be found as part of the Introductory Chapter to this Overview Report. The CFSA acknowledges their wholehearted and committed support. This whole exercise demonstrates the continuing commitment of Indian authorities to benefit from theory and practice, and the experiences of other countries, in our quest for global benchmarking of our financial sector standards.

The CFSA, while finalising its Overview Report, attempted to address issues arising out of the four Advisory Panel reports thematically into a set of key areas. As the Advisory Panels comprised independent non-official experts and their reports were peer reviewed by eminent external academics and policy-makers and are being transparently made public, their reports on a stand-alone basis deserve consideration for follow-up on their own merit. While the CFSA mostly endorsed the assessment, findings and recommendations of the Panels, it recognised at the same time that on certain aspects there were differing perspectives and stance taken by Panels on certain overlapping issues. Second, the CFSA also took into account the complexities of the current stage of economic and market development, including the Indian democratic polity, and has attempted to present a synthesised approach, whenever it viewed that issues were contestable. Third, while the membership of the CFSA along with the involvement of other regulators provides enormous comfort of ownership and commitment from authorities, the views of the Committee should for all practical purposes be treated nevertheless as independent and it is for the concerned authorities to chalk out an implementation plan for action.

The framework and work process, besides ensuring impartiality and credibility as brought out above, also carried with it certain other important benefits:

First, the direct official involvement at different levels brought with it enormous responsibility, ownership and commitment.
Second, it ensured constructive pragmatism while addressing, in particular, contestable issues. In the current context of several established conventions and practices being re-examined in the light of the ongoing global financial crisis, there is a need to approach reforms in the financial sector, particularly from the point of view of emerging markets that are more vulnerable than any other, with a sense of humility. The CFSA carried this burden throughout.
Third, the close involvement of officials and non-official experts in conjunction with external peer reviewers – an entirely new dimension added for the first time – meant that the process itself proved to be an investment in human resources producing an outcome that sensitised the financial sector agents and the internalised learning is expected to act as a stimulus for spearheading financial sector development and carrying the reform measures forward. No doubt, this has helped enhance the skill-sets within the financial sector, leading to significant capacity-building.

We would like to place on record our sincere and heartfelt appreciation of the valuable and painstaking contributions made by the Secretariat to the CFSA based in the Reserve Bank of India, headed by Shri K. Kanagasabapathy and supported by Dr. (Smt.) Mohua Roy, Shri Susobhan Sinha, Shri Sunil T. S. Nair, Dr. Saibal Ghosh, Shri D.Sathish Kumar, Shri Nishanth Gopinath, Shri Prabhat Gupta, Smt. P.K. Shahani, Shri A.B. Kulkarni, Shri R.J. Bhanse, Shri S.S. Jogale and Shri B.G. Koli. The Secretariat, besides organising the work of the CFSA, also co-ordinated the work relating to Technical Groups and Advisory Panels. The members of the Secretariat also actively associated themselves in preparing technical notes and background material at various stages and in organising conferences/ seminars and drafting the CFSA Report. Shri V.K. Sharma, Executive Director, Reserve Bank of India helped greatly in overseeing the Secretariat and making sure that all inputs were available from the different departments of the Reserve Bank. In addition, Shri Sharma made significant conceptual and technical contribution in areas like the assessment of Business Continuity Management, development of liquidity ratios to assess liquidity risks and related capital charge as also duration of equity as a measure of interest rate risk. Shri Anand Sinha, Executive Director, Reserve Bank of India also contributed in conceptualising the scenario analysis to assess the liquidity position of banks. The CFSA also places on record the coordination and help received from Shri Anuj Arora, Shri Vanlalramsanga and Smt. Aparna Sinha, Ministry of Finance, Government of India.

It is with pleasure and with a sense of utmost humility that the CFSA presents the results of assessment of the India’s financial sector and a set of recommendations meant for the medium-term of about five years. The accent in this assessment is on transparency. Thus, where conflicting views have emerged among the Panels, the peer reviewers, and even among the members of the CFSA, they have been reported transparently. Regulation and development of the financial sector is a complex affair and there is room for constant debate and discussion, as shown particularly by the debate that is now being conducted in the wake of the ongoing global financial crisis. The approach taken in this assessment is to provide general directions and excessive specificity has been eschewed.

The assesssment and recommendations comprise six volumes consisting of the Executive Summary, the Overview Report of the CFSA and the Reports of the four Advisory Panels on Financial Stability Assessment and Stress Testing, Financial Regulation and Supervision, Institutions and Market Structure and Transparency Standards. These volumes should be viewed as a package complementing one another.

The CFSA hopes that these volumes greatly enhance the understanding of the Indian financial sector among a wide readership, both in India and abroad. The CFSA would earnestly urge the Government of India, the Reserve Bank, SEBI, IRDA and other concerned market agents to promote wide dissemination and debate and initiate policy actions for improving the structural aspects of the Indian financial architecture.

Ashok Chawla
Co-Chairman and
Secretary, Department of Economic Affairs
Ministry of Finance Government of India

Rakesh Mohan
Chairman and
Deputy Governor
Reserve Bank of India

March 20, 2009

List of Acronyms

AACS	As Applicable to Co-operative Societies
AASs	Auditing and Assurance Standards
ADR	American Depository Receipt
ADs	Authorised Dealers
AFS	Available for Sale
AGL	Aggregate Gap Limit
AGM	Annual General Meeting
AIG	American International Group
ALM	Asset-liability Management
AMA	Advanced Measurement Approach
AMBI	Association of Merchant Bankers of India
AMFI	Association of Mutual Funds in India
AML	Anti-money Laundering
ANMI	Association of NSE Members of India
APC	Auditing Practices Committee
APG	Asia/Pacific Group
AS	Accounting Standards
ASB	Accounting Standards Board
ASSOCHAM	Associated Chambers of Commerce and Industry of India
ATM	Automated Teller Machine
BC	Business Correspondent
BCBS	Basel Committee on Banking Supervision
BCM	Business Continuity Management
BCP	Business Continuity Planning
BCPs	Basel Core Principles
BCSBI	Banking Codes and Standards Board of India
BIFR	Board for Industrial and Financial Reconstruction
BIS	Bank for International Settlements
BOISL	Bank of India Shareholding Limited
BPLR	Benchmark Prime Lending Rate
BPO	Business Process Outsourcing
BPSS	Board for Regulation and Supervision of Payment and Settlement Systems
BR Act	Banking Regulation Act
BSE	Bombay Stock Exchange
CAD	Current Account Deficit
CAG	Comptroller and Auditor General
CAGR	Compounded Annual Growth Rate
CAL	Capital Account Liberalisation
CASA	Current and Savings Account
CBLO	Collateralised Borrowing and Lending Obligation
CCIL	Clearing Corporation of India Ltd.
CCPs	Central Counterparties
CD	Certificate of Deposit
CDD	Customer Due Diligence
CDS	Credit Default Swap
CDSL	Central Depository Services (India) Ltd.
CEO	Chief Executive Officer
CFP	Contingency Funding Plan
CFSA	Committee on Financial Sector Assessment
CFT	Combating the Financing of Terrorism
CIBIL	Credit Information Bureau of India Ltd.
CII	Confederation of Indian Industry
CIP	Central Integrated Platform
CIS	Collective Investment Scheme
CLS	Continuous Linked Settlement
CME	Capital Market Exposure
CP	Commercial Paper
CPI	Consumer Price Index
CPI-AL	Consumer Price Index - Agricultural Labourers
CPI-IW	Consumer Price Index - Industrial Workers
CPI-RL	Consumer Price Index - Rural Labourers
CPI-UNME	Consumer Price Index - Urban Non-manual Employees
CPSS	Committee on Payment and Settlement Systems
CRA	Credit Rating Agencies
CRAR	Capital to Risk-weighted Assets Ratio
CRISIL	Credit Rating Information Services of India Ltd.
CRR	Cash Reserve Ratio
CRT	Credit Risk Transfer
CSC	Clients of Special Category
CSGL	Constitutents Subsidiary General Ledger
CSO	Central Statistical Organisation
CTR	Cash Transactions Report
CVC	Central Vigilance Commission
DBOD	Department of Banking Operations and Development
DCCBs	District Central Co-operative Banks
DEA	Data Envelopment Analysis
DFIs	Development Financial Institutions
DICGC	Deposit Insurance and Credit Guarantee Corporation
DIF	Deposit Insurance Fund
DIP	Disclosure and Investor Protection
DIPP	Department of Industrial Policy and Promotion
DMO	Debt Management Office
DoE	Duration of Equity
DP	Depository Participant
DQAF	Data Quality Assessment Framework
DR	Disaster Recovery
DRAT	Debt Recovery Appellate Tribunal
DRR	Designated Reserve Ratio
DRT	Debt Recovery Tribunal
DvP	Delivery versus Payment
EaR	Earnings at Risk
ECS	Electronic Clearing System
EFT	Electronic Funds Transfer
EGM	Extraordinary General Meeting
ELSS	Equity-linked Savings Scheme
EMEs	Emerging Market Economies
ESOP	Employee Stock Option Plan
EWS	Economically Weaker Sections
FATF	Financial Action Task Force
FBs	Foreign Banks
FCAC	Fuller Capital Account Convertibility
FCs	Financial Conglomerates
FDI	Foreign Direct Investment
FEDAI	Foreign Exchange Dealers’ Association of India
FEMA	Foreign Exchange Management Act
FERA	Foreign Exchange Regulation Act
FFMCs	Full-fledged Money Changers
FICCI	Federation of Indian Chamber of Commerce and Industry
FII	Foreign Institutional Investor
FIMMDA	Fixed Income Money Market and Derivatives Association of India
FIU	Financial Intelligence Unit
FOMC	Federal Open Market Committee
FPI	Foreign Portfolio Investment
FPSBI	Financial Planning Standards Board of India
FRB	Federal Reserve Bank
FRBM	Fiscal Responsibility and Budget Management
FRRB	Financial Reporting Review Board
FSA	Financial Services Authority
FSAP	Financial Sector Assessment Program
FSF	Financial Stability Forum
FSIs	Financial Soundness Indicators
FSRB	FATF-style Regional Body
GAAP	Generally Accepted Accounting Principles
GASAB	Government Accounting Standards Advisory Board
GB	Gramin Bank
GCC	General Credit Card
GDP	Gross Domestic Product
GDR	Global Depository Receipt
GFD	Gross Fiscal Deficit
GFS	Government Finance Statistics
GFSM	Government Finance Statistics Manual
GLB	Gramm-Leach-Bliley
GS	Government Securities
HFCs	Housing Finance Companies
HFT	Held for Trading
HHI	Herfindahl Index
HLCCFM	High Level Co-ordination Committee on Financial Markets
HR	Human Resources
HTM	Held to Maturity
IAASB	International Auditing and Assurance Standards Board
IADI	Insurance Association of Deposit Insurers
IAIS	International Association of Insurance Supervisors
IAPC	International Auditing Practices Committee
IAS	International Accounting Standards
IASB	International Accounting Standards Board
IBA	Indian Banks’ Association
ICAAP	International Capital Adequacy Assessment Process
ICAI	Institute of Chartered Accountants of India
ICICI	Industrial Credit and Investment Corporation of India Ltd.
ICOR	Incremental Capital-Output Ratio
ICPs	Insurance Core Principles
ICSI	Institute of Companies Secretaries of India
ICWAI	Institute of Cost and Works Accountants of India
IDL	Intra-day Liquidity
IFCI	Industrial Finance Corporation of India Ltd.
IFRIC	International Financial Reporting Interpretations Committee
IFRS	International Financial Reporting Standards
IGFRS	Indian Government Financial Reporting Standards
IMF	International Monetary Fund
IMSS	Integrated Market Surveillance System
IOSCO	International Organisation of Securities Commission
IPOs	Initial Public Offers
IR	Industrial Relations
IRB	Internal Ratings-based Approach
IRDA	Insurance Regulatory and Development Authority
IRS	Interest Rate Swaps
ISA	International Standards on Auditing
JLG	Joint Liability Group
KCC	Kisan Credit Card
KYC	Know Your Customer
LABs	Local Area Banks
LAF	Liquidity Adjustment Facility
LDC	Less Developed Countries
LIB OR	London Inter-bank Offer Rate
LIC	Life Insurance Corporation
LIG	Low-income Group
LoC	Line of Credit
LoLR	Lender of Last Resort
LtV	Loan to Value
MCA	Ministry of Corporate Affairs
MFI	Micro-finance Institutions
MoU	Memorandum of Understanding
MPC	Monetary Policy Committee
MRTP	Monopolies and Restrictive Trade Practices
MSS	Market Stabilisation Scheme
MTM	Mark-to-market
NABARD	National Bank for Agriculture and Rural Development
NACAS	National Advisory Committee on Accounting Standards
NASD	National Association of Securities Dealers
NASDAQ	National Association of Securities Dealers Automated Quotations
NBFC-D	Deposits taking Non-banking Financial Companies
NBFC-ND	Non-deposit taking Non-banking Financial Companies
NBFC-ND-SI	Non-deposit taking Systemically Important Non-banking Financial Companies

NBFCs	Non-banking Financial
	Companies
NBO	National Building Organisation
NCLT	National Company Law Tribunal
NDFs	Non-deliverable Forwards
NDS	Negotiated Dealing System
NDS-OM	Negotiated Dealing System -
	Order Matching
NEFT	National Electronic Fund
	Transfer
NGO	Non-governmental Organisation
NHB	National Housing Bank
NII	Net Interest Income
NPAs	Non-performing Assets
NPBs	New Private Sector Banks
NSC	National Statistical Commission
NSCCL	National Securities Clearing
	Corporation Ltd.
NSDL	National Securities Depository
	Ltd.
NSE	National Stock Exchange
NSSO	National Sample Survey
	Organisation
OBS	Off-balance Sheet
OECD	Organisation of Economic Co-
	operation and Development
OFIs	Other Financial Institutions
OIS	Overnight Index Swap
OMO	Open Market Operations
OPBs	Old Private Sector Banks
OTC	Over-the-Counter
OTD	Originate to Distribute
P/E	Price to Earnings
PACS	Primary Agricultural Credit
	Societies
PCA	Prompt Corrective Action
PCAOB	Public Company Accounting
	Oversight Board
PDAI	Primary Dealers Association of
	India
PDO	Public Debt Office
PDs	Primary Dealers
PEP	Politically-exposed Persons
PFRDA	Pension Fund Regulatory and
	Development Authority
PMLA	Prevention of Money-laundering
	Act
PMRY	Prime Minister’s Rozgar Yojana
PNs	Participatory Notes
PPP	Public-private Partnership
PSBR	Public Sector Borrowing
	Requirement
PSBs	Public Sector Banks
QIB	Qualified Institutional Buyers
QRB	Quality Review Board
RARoC	Risk-adjusted Return on Capital
RBC	Risk-based Capital
RBS	Risk-based Supervision
RCS	Registrar of Co-operative
	Societies
RDDBFI	Recovery of Debts Due to Banks
	and Financial Institutions
RNBCs	Residuary Non-banking
	Companies
RoA	Return on Assets
RoE	Return on Equity
ROSC	Report on Observance of
	Standards and Codes
RRBs	Regional Rural Banks
RSE	Recognised Stock Exchange
RTGS	Real Time Gross Settlement
SARFAESI	Securitisation and
	Reconstruction of Financial
	Assets and Enforcement of
	Security Interests Act
SBI	State Bank of India
SCODA	SEBI Committee on Disclosures
	and Accounting Standards
SCRA	Securities Contracts (Regulation)
	Act
SDDS	Special Data Dissemination
	Standard
SEBI	Securities and Exchange Board
	of India
SEC	Securities and Exchange
	Commission
SFCs	State Financial Corporations
SGL	Subsidiary General Ledger
SHG	Self-help Group
SICA	Sick Industrial Companies
	(Special Provisions) Act
SIDBI	Small Industries Development
	Bank of India
SIPS	Systemically Important Payment
	Systems
SIVs	Structured Investment Vehicles
SJSRY	Swarna Jayanti Shahari Rojgar
	Yojana
SLBC	State-level Bankers’ Committee
SLR	Statutory Liquidity Ratio
SMEs	Small and Medium Enterprises
SPV	Special Purpose Vehicle
SRA	Statutory-regulatory Authority
SRI	Socially Responsible Investing
SROs	Self-regulatory Organisations
SSI	Small Scale Industry
SSS	Securities Settlement Systems
StCBs	State Co-operative Banks
STP	Straight-through Processing
STR	Suspicious Transactions Report
STRIPS	Separate Trading of Registered
	Interest and Principal of
	Securities
STT	Securities Transaction Tax
SUCBs	Scheduled Urban Co-operative
	Banks
TACMP	Technical Advisory Committee
	on Monetary Policy
TAFCUB	Task Force for Urban Co-
	operative Banks
TAG	Technical Advisory Group
TDS	Tax Deducted at Source
UAPA	Unlawful Activities Prevention Act
UCBs	Urban Co-operative Banks
ULIPs	Unit-linked Insurance Plans
UNCITRAL	United Nations Commission on
	International Trade Law
URRBCH	Uniform Regulations and Rules
	for Bankers’ Clearing Houses
VaR	Value-at-Risk
WI	When issued
WOS	Wholly-owned Subsidiaries
WPI	Wholesale Price Index
WTO	World Trade Organisation

Chapter I

Introduction

The Government of India in consultation with the Reserve Bank of India constituted the Committee on Financial Sector Assessment (CFSA) in September 2006 with a mandate to undertake a comprehensive assessment of the India’s financial sector focusing upon stability and development, including therein detailed assessments of its status and compliance with various international financial standards and codes. The CFSA was chaired by Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India; the Co-Chairmen were Shri Ashok Jha, Dr. D. Subbarao and Shri Ashok Chawla. The Committee also had officials from the Government of India as its members (Annex I).

The CFSA had the following terms of reference:

• To identify appropriate areas, techniques and methodologies in the Handbook on Financial Sector Assessment brought out by the International Monetary Fund/World Bank, and in other pertinent documents for financial sector assessment relevant in the current and evolving context of the Indian financial sector;

• To apply relevant methodologies and techniques adapted to the Indian system and attempt a comprehensive and objective assessment of Indian financial sector, including its development, efficiency, competitiveness and prudential aspects;

• To analyse specific development and stability issues relevant to India; and

• To make available its report(s) through the Reserve Bank of India/ Government of India websites.

The approach, broad framework and work procedures were approved in the first meeting of the Committee. Following this, contact points were established with other major regulators as also external agencies like the International Monetary Fund (IMF) and the World Bank for co-ordination of the work. The IMF/World Bank also provided relevant templates for assessment of various standards and codes, which have been appropriately utilised in the Committee’s work. The CFSA held a series of meetings to review the progress, take stock and guide the work. The CFSA submitted an interim report to the then Hon’ble Finance Minister, Shri P Chidambaram and to the then Governor, Reserve Bank of India, Dr. Y V Reddy on August 2, 2007. The CFSA finalised its Overview report in its meeting held on December 20, 2008. The CFSA held 11 meetings between October 2006 and December 2008 before finalising its report.

1.1     Approach and Framework for the Assessment

The CFSA followed an approach to self-assessment based on three mutually-reinforcing pillars, viz., Pillar I: financial stability assessment and stress testing, essentially in the nature of stability assessment which utilises analytical tools for quantifying the risks and vulnerabilities in the financial sector; Pillar II: legal, infrastructural and market development issues; and Pillar III: comprehensive assessment of the status and implementation of international financial standards and codes, taking into account updates since the last FSAP/ ROSC and earlier self-assessments and the specific features of the Indian financial system. The second pillar draws inputs from the assessment in the first and third pillars focusing on developmental issues for further strengthening the financial sector.

In order to assist the CFSA in its process of assessment, four Technical Groups mainly comprising officials from relevant organisations who, based on their functional domain knowledge, provided technical notes and background material for assessments of their respective subject areas. The preliminary assessments of standards were also carried out by them. These Groups focused on (a) Financial Stability Assessment and Stress Testing, (b) Financial Regulation and Supervision, (c) Institutions and Market Structure and (d) Transparency Standards, respectively. The CFSA also constituted four Advisory Panels comprising non-official experts in the respective areas and, wherever necessary, was supported by senior officials in the form of Special Invitees, with requisite domain expertise. These Panels provided an impartial review of assessments made by the Technical Groups and prepared their draft reports.

With a view to further enhancing the credibility of the self-assessment, the CFSA arranged for the draft reports of the Advisory Panels to be peer reviewed by external experts. The Advisory Panel reports were finalised after taking into account the peer reviewers’ comments and their interactions with peer reviewers in conferences/seminars.

The CFSA finally drew up its Overview report based on the Advisory Panel reports.

A schematic diagram of the framework is provided in Annex II.

1.2     Work Process

1.2.1. Constitution of Advisory Panels and Technical Groups

Twenty six experts from diverse fields were identified as members of the four Advisory Panels. In addition, senior officials from the Government, the Reserve Bank, SEBI and IRDA were also inducted as ex officio special invitees to the panels. The complete list of all members and special invitees to the Advisory Panels is given in Annex III.

The four Advisory Panels were supported by four Technical Groups with the involvement of more than 100 officials drawn from various agencies. The details of membership and participation in various Technical Groups are provided in Annex IV.

1.2.2   Co-ordination with Multilateral Agencies

The IMF and the World Bank have been evincing keen interest in CFSA’s work and extending their support. At a very early stage, the Chairman held meetings with World Bank/IMF officials, who offered to help the Committee identify a list of experts, identify contact persons in the World Bank/IMF to liaise with the CFSA, share FSAP templates and identify FSAP documents for reference by the Committee. Also, the International Association of Insurance Supervisors (IAIS) assisted IRDA in suggesting the names of peer reviewers and the International Organisation of Securities Commission (IOSCO) provided SEBI with the necessary IOSCO templates for the assessments. The CFSA gratefully acknowledges the assistance of these institutions.

1.2.3 Institutions/Agencies Involved

Taking into account the legal, regulatory and supervisory architecture in India, the CFSA involved and associated closely with all three major regulatory institutions, viz., the Reserve Bank, SEBI and IRDA. Depending on the sectoral/ functional distribution, several other agencies in the financial system were associated, besides involving concerned departments of the Central Government. A complete list of the agencies involved in the assessment exercise is given in Annex V.

1.2.4   Involvement of Peer Reviewers

The CFSA identified 14 international experts and three Indian experts to peer review the relevant portions of the Panel reports in accordance with the reviewers’ areas of expertise. The list of peer reviewers is given in Annex VI.

1.2.5   The Secretariat

To further the technical work and for administrative co-ordination between all the involved institutions and the study of relevant documents to prepare background material for the Technical Groups and Advisory Panels, a Secretariat was constituted in the Reserve Bank, Monetary Policy Department (Please see Annex VII for the composition of the Secretariat).

1.2.6   Detailed Work Procedures under each of the Three Pillars

Pillar I: Financial Stability Assessment and Stress Testing

The Advisory Panel on Financial Stability Assessment and Stress Testing covered areas related to the macro-economy, financial markets, financial infrastructure and financial institutions. The Panel constituted three sub-groups: relating to financial stability, stress testing and business continuity management (BCM). The sub-group on financial stability deliberated and identified the soundness and vulnerabilities in the Indian financial system. In addition to the Reserve Bank, SEBI and IRDA, it has also taken on board the perspectives of agencies like the National Bank for Agriculture and Rural Development (NABARD), National Housing Bank (NHB), Indian Banks’ Association (IBA), Investment Information and Credit Rating Agency of India Limited (ICRA), Credit Rating Information Services India Ltd. (CRISIL), KPMG and Clearing Corporation of India Ltd. (CCIL), and incorporated the same as part of their report.

The sub-group on stress testing adopted a plausible ‘bottom-up’ approach to stress testing, using various scenarios. Single factor stress tests for the commercial banking sector covering credit risk, market/interest rate risk and liquidity risk were carried out. The Group also undertook quantitative stress tests and qualitative analysis in respect of certain financial variables and liquidity infrastructure.

The sub-group on business continuity management (BCM) assessed the status of business continuity planning (BCP) and disaster recovery management. A questionnaire suitably expanding on the High Level Principles for Business Continuity Management developed by the BIS Joint Forum in August 2006 was circulated among identified banks as also CCIL. In addition, the Reserve Bank also undertook an assessment of its own BCM systems.

IRDA prepared a separate stability analysis for institutions within their regulatory purview including financial stability and stress testing issues relating to the insurance sector.

Pillar III: Assessment of Implementation of International Financial Standards and Codes

The implementation of/compliance with 14 international financial standards was evaluated under the comprehensive assessment exercise. The CFSA decided that in respect of AML-CFT standards a review of assessment undertaken by the Asia Pacific Group (APG) in 2005 would be incorporated in the Overview Report. For operational convenience, these standards were divided into three compact groups, viz., Regulation and Supervision, Institutions and Market Structure, and Transparency Standards.

In addition to the assessment of adherence to Basel Core Principles regarding supervision of commercial banks, the Advisory Panel on Financial Regulation and Supervision also conducted assessment of the adherence to Core Principles as relevant in other closely-related segments such as the urban cooperative banking sector, rural credit institutions and non-banking and housing finance companies. Likewise, an assessment of the observance of International Organisation of Securities Commissions (IOSCO) Core Principles in the securities market was undertaken by SEBI. In addition, an assessment of the implementation of IOSCO Principles as relevant to government securities market and in respect of foreign exchange and money markets was also undertaken for the first time, involving the concerned departments in the Reserve Bank. The adherence to Core Principles of the International Association of Insurance Supervisors (IAIS) was assessed by IRDA.

The Advisory Panel on Institutions and Market Structure undertook a detailed assessment of market infrastructure focusing on liquidity management, accounting and auditing, corporate governance, payment and settlement systems and legal infrastructure.

In respect of payment and settlement systems, the coverage was extended to an assessment of their adherence to the Core Principles for Systemically Important Payment Systems in respect of Real Time Gross Settlement System (RTGS) and High Value Clearing System; Recommendations for Securities Settlement Systems in respect of settlement of government securities and equities markets; Recommendations for Central Counterparties applicable to government securities, foreign exchange market and Collateralised Borrowing and Lending Obligation (CBLO) and corporate bonds and equities. The assessment of adherence to the Organisation for Economic Co-operation and Development (OECD) Principles of Corporate Governance in respect of listed and unlisted companies was carried out jointly by SEBI and the Ministry of Corporate Affairs, Government of India. The assessment of convergence of Indian accounting and auditing standards put out by ICAI to the international accounting and auditing standards was assessed by ICAI, AASB and the Reserve Bank. The adherence to the World Banks Principles for Effective Insolvency and Creditor Rights Systems was assessed by the Reserve Bank and the Ministry of Corporate Affairs.

The Advisory Panel on Transparency Standards assessed the adherence to relevant IMF standards, viz., Code of Good Practices on Transparency in Monetary and Financial Policies, Code of Good Practices on Fiscal Transparency, Special Data Dissemination Standards and Data Quality Assessment Framework. While the assessment of transparency in monetary policy pertained to the Reserve Bank, transparency in financial policies included the three agencies, viz., the Reserve Bank, SEBI and IRDA. Fiscal transparency assessment involved a response to a detailed questionnaire to relevant government departments, State Governments and the Reserve Bank to identify the gaps in fiscal transparency. For the first time, the Advisory Panel attempted a separate assessment of fiscal transparency pertaining to State Governments. Data dissemination was assessed with emphasis on dimensions of quality of the data.

Pillar II: Development Issues

The assessments and findings under Pillar I and III led to identification of several areas for convergence with international best practices as also certain issues and concerns in regard to further strengthening and developing the financial sector. The Advisory Panels have made appropriate recommendations as part of their assessments of financial institutions, financial markets and financial infrastructure.

1.3     Scheme of the Report

Drawing on inputs from the four Advisory Panel Reports, the CFSA first addresses the issues relating to the macro-economic environment and identifies certain potential areas of vulnerability at the current juncture. The financial sector assessment part is covered in three major parts, viz., financial institutions, financial markets and financial infrastructure. All standards assessments, excepting transparency issues, have also been integrated appropriately into these assessments. The CFSA addresses these areas broadly encompassing their performance and resilience to certain shocks, and identifying areas for further strengthening and development. Transparency issues are covered in a separate chapter by the CFSA. The CFSA considered the views of the Panels as also those of peer reviewers and recorded their own stance in the respective chapters.

Based on the above approach, the Committee’s Overview Report is divided into eight chapters. Following this chapter, Chapter 2 covers aspects relating to the macro-economic environment including an assessment of potential areas of vulnerability; Chapter 3, after providing an overview of the financial structure, covers in detail the stability aspects of financial institutions including structure and performance, resilience, relevant observance of standards and issues and recommendations for further development; Chapter 4 covers assessment of financial markets which includes structure and performance, observance of relevant standards and issues and recommendations for further market development; Chapter 5 covers financial infrastructure which encompasses a host of dimensions, viz., regulatory structure, liquidity management, accounting and auditing, payment and settlement systems, legal infrastructure including bankruptcy laws, business continuity management, corporate governance issues and safety net issues focusing on deposit insurance. The concerned sections also address issues and recommendations for strengthening the financial infrastructure. Chapter 6 covers transparency issues relating to monetary policy, financial policies, fiscal policy and data dissemination, and Chapter 7 covers broader development issues in the socio-economic context, mainly relating to customer service and financial inclusion.

The concluding Chapter provides a summary of observations and recommendations with appropriate cross-references to earlier chapters.

Annex I

Composition of the Committee on Financial Sector Assessment
Chairman Dr. Rakesh Mohan Deputy Governor Reserve Bank of India	Co-Chairman Shri Ashok Chawla Secretary Department of Economic Affairs Ministry of Finance Government of India (from September 6, 2008)
	Dr. D. Subbarao Former Finance Secretary Government of India (July 16, 2007 - September 5, 2008)
	Shri Ashok Jha Former Finance Secretary Government of India (September 13, 2006 - July 15, 2007)
Members
Shri Arun Ramanathan Finance Secretary Government of India (from February 4, 2008)
Shri Vinod Rai Former Secretary Department of Financial Services Ministry of Finance Government of India (January 11, 2007 - February 3, 2008)
Dr. Arvind Virmani Chief Economic Adviser Department of Economic Affairs Ministry of Finance Government of India
Dr. Alok Sheel Joint Secretary (Fund-Bank) Department of Economic Affairs Ministry of Finance Government of India (from October 23, 2008)
Shri Madhusudan Prasad Joint Secretary (Fund-Bank) Department of Economic Affairs Ministry of Finance Government of India (September 13, 2006 - October 22, 2008)

Governor

Reserve Bank of India
Central Office
Mumbai - 400 001

MEMORANDUM

Committee on Financial Sector Assessment

Building up resilient, well-regulated financial systems is essential for macroeconomic and financial stability. This is being increasingly recognised as an integral part of financial sector reforms in India. Following the initiation of the Financial Sector Assessment Programme (FSAP) in 1999 by the World Bank and the International Monetary Fund in the aftermath of the Asian financial crisis, and their experience in the conduct of assessment in member countries, the two institutions have jointly brought out in September 2005, a comprehensive Handbook on Financial Sector Assessment. The Handbook is designed for use in financial sector assessment, whether conducted by country authorities themselves or by World Bank and IMF teams. The Handbook, available to the public, is intended to serve as an authoritative source on the objectives, analytical framework, and methodologies of financial sector assessment as well as a comprehensive reference book on the techniques of such assessments.

2. It may be recalled that India, besides being one of the earliest member countries participating voluntarily in the FSAP assessment, has been a forerunner in comprehensive self-assessment of various international financial standards and codes. The Reserve Bank has also released a Synthesis Report in May 2002 and a Progress Report in January 2005. The experience has thus far been very encouraging and the financial sector reforms have progressed well in recent years, enhancing the soundness of the financial system and promoting financial stability.

3. Consistent with this approach, it would be appropriate and expedient for India to undertake a self-assessment of financial sector stability and development, using the new Handbook as the base as also any other pertinent documents for financial sector assessment. Accordingly, the Government of India has decided, in consultation with the Reserve Bank of India to constitute a Committee on Financial Sector Assessment, with the following terms of reference:

(i) To identify the appropriate areas, techniques and methodologies in the Handbook and also in any other pertinent documents for financial sector assessment relevant in the current and evolving context of the Indian financial sector;

(ii) To apply relevant methodologies and techniques adapted to Indian system and attempt a comprehensive and objective assessment of Indian financial sector, including its development, efficiency, competitiveness and prudential aspects;

(iii) To analyse specific development and stability issues as relevant to India; and

(iv) To make available its report(s) through RBI/GoI websites.

4. The Committee may co-opt members depending upon the subject area of assessment under consideration and may also constitute Technical/ Advisory groups to study and report on specific areas of assessment.

5. The Committee will be chaired by Dr.Rakesh Mohan, Deputy Governor, Reserve Bank of India, with Shri Ashok Jha, Secretary (Economic Affairs) as Co-Chairman. Dr.Ashok Lahiri, Chief Economic Adviser and Shri Madhusudan Prasad, Joint Secretary (Fund-Bank), Government of India will be its members. The Secretariat will be provided by the Reserve Bank of India.

6. The Committee will review its own status and report the progress to the Government of India/Reserve Bank of India in six months from commencement of its work.

(Y.V. Reddy)

Mumbai - 400 001.
September 13, 2006

Governor

Reserve Bank of India
Central Office
Mumbai - 400 001

MEMORANDUM

Committee on Financial Sector Assessment

In partial modification of the memorandum dated September 13, 2006 regarding constitution of the Committee on Financial Sector Assessment, it has been decided to include Shri Vinod Rai, Secretary (Financial Sector), Government of India and Dr. Arvind Virmani, Principal Adviser, Planning Commission, into the Committee. Accordingly, the composition of the reconstituted Committee on Financial Sector Assessment is as follows:

Dr. Rakesh Mohan Deputy Governor Reserve Bank of India	Chairman	Shri Ashok Jha Finance Secretary Government of India	Co-Chairman
Shri Vinod Rai Secretary (Financial Sector) Government of India	Member
Dr. Arvind Virmani Principal Adviser Planning Commission	Member
Shri Madhusudan Prasad Joint Secretary (Fund-Bank) Government of India	Member

(Y.V. Reddy)

Mumbai - 400 001.
January 11, 2007

Governor

Reserve Bank of India
Central Office
Mumbai - 400 001

MEMORANDUM

Committee on Financial Sector Assessment

In partial modification of the memorandum dated January 11, 2007 it has been decided to appoint Dr. D Subbarao, Finance Secretary, Government of India as the Co-chairman of the Committee on Financial Sector Assessment on retirement of Shri Ashok Jha, the earlier Finance Secretary and Co-chairman of the Committee. Accordingly, the composition of the reconstituted Committee on Financial Sector Assessment is as follows:

Dr. Rakesh Mohan Deputy Governor Reserve Bank of India	Chairman	Dr. D Subbarao Finance Secretary Government of India	Co-Chairman
Shri Vinod Rai Secretary (Financial Sector) Government of India	Member
Dr. Arvind Virmani Principal Adviser Planning Commission	Member
Shri Madhusudan Prasad Joint Secretary (Fund-Bank) Government of India	Member

(Y.V. Reddy)

Mumbai - 400 001.
July 16, 2007

Governor

Reserve Bank of India
Central Office
Mumbai - 400 001

MEMORANDUM

Committee on Financial Sector Assessment

In partial modification of the memorandum dated July 16, 2007 it has been decided to co-opt Shri Arun Ramanathan, Secretary (Financial Sector), Government of India as a member of the Committee on Financial Sector Assessment in place of Shri Vinod Rai, former Secretary (Financial Sector), Government of India, consequent to Shri Rais appointment as the Comptroller and Auditor General of India. Accordingly, the composition of the reconstituted Committee on Financial Sector Assessment is as follows:

Dr. Rakesh Mohan Deputy Governor Reserve Bank of India	Chairman	Dr. D Subbarao Finance Secretary Government of India	Co-Chairman
Shri Arun Ramanathan Secretary (Financial Sector) Government of India	Member
Dr. Arvind Virmani Chief Economic Adviser Government of India	Member
Shri Madhusudan Prasad Joint Secretary (Fund-Bank) Government of India	Member

(Y.V. Reddy)

Mumbai - 400 001.
February 4, 2008

Governor

Reserve Bank of India
Central Office
Mumbai - 400 001

MEMORANDUM

Committee on Financial Sector Assessment

In partial modification of the memorandum dated February 4, 2008 it has been decided to co-opt Shri Ashok Chawla, Secretary (Economic Affairs), Department of Economic Affairs, Government of India as Co-chair of the Committee on Financial Sector Assessment in place of Dr. D. Subbarao, former Finance Secretary, Government of India, consequent to Dr.D.Subbaraos appointment as the Governor, Reserve Bank of India. Accordingly, the composition of the reconstituted Committee on Financial Sector Assessment is as follows:

Dr. Rakesh Mohan Deputy Governor Reserve Bank of India	Chairman	Shri Ashok Chawla Secretary (Economic Affairs) Government of India	Co-Chairman
Shri Arun Ramanathan Secretary (Financial Sector) Government of India	Member
Dr. Arvind Virmani Chief Economic Adviser Government of India	Member
Shri Madhusudan Prasad Joint Secretary (Fund-Bank) Government of India	Member

(D.Subbarao)

Mumbai - 400 001.
October 1, 2008

Governor

Reserve Bank of India
Central Office
Mumbai - 400 001

MEMORANDUM

Committee on Financial Sector Assessment

In partial modification of the memorandum dated October 1, 2008 it has been decided to appoint Shri Alok Sheel, Joint Secretary (Fund-Bank), Government of India as a member of the Committee on Financial Sector Assessment in place of Shri Madhusudan Prasad who has been transferred from the post of Joint Secretary (Fund-Bank). Accordingly, the composition of the reconstituted Committee on Financial Sector Assessment is as follows:

Dr. Rakesh Mohan Deputy Governor Reserve Bank of India	Chairman	Shri Ashok Chawla Secretary (Economic Affairs) Government of India	Co-Chairman
Shri Arun Ramanathan Finance Secretary Government of India	Member
Dr. Arvind Virmani Chief Economic Adviser Government of India	Member
Shri Alok Sheel Joint Secretary (Fund-Bank) Government of India	Member

(D.Subbarao)

Mumbai - 400 001.
November 26, 2008

Annex III

Advisory Panel Members and Special Invitees

Name	Designation/Institution
1. Financial Stability Assessment and Stress Testing
Shri M.B.N.Rao	Chairman and Managing Director, Canara Bank	Chairman
Dr. Rajiv B. Lall	Managing Director and Chief Executive Officer, Infrastructure Development Finance Company Ltd.	Member
Dr. T.T.Ram Mohan	Professor, Indian Institute of Management, Ahmedabad	Member
Shri Ravi Mohan	Managing Director and Region Head, Standard & Poor’s, South Asia	Member
Shri Ashok Soota	Chairman and Managing Director, MindTree Consulting Ltd.	Member
Shri Pavan Sukhdev	Head of Global Markets, Deutsche Bank	Member
Special Invitees
Shri V.K.Sharma	Executive Director, Reserve Bank of India
Dr. R. Kannan	Member (Actuary), Insurance Regulatory and Development Authority
Shri G. C. Chaturvedi	Joint Secretary (Banking and Insurance),
Dr. K. P. Krishnan	Joint Secretary (Capital Markets), Government of India
Shri Amitabh Verma	Joint Secretary (Banking Operations), Government of India
Dr. Sanjeevan Kapshe	Officer on Special Duty, Securities and Exchange Board of India

2. Financial Regulation and Supervision

Shri M. S. Verma	Former Chairman, State Bank of India	Chairman
Shri Nimesh Kampani	Chairman, JM Financial Consultants Pvt. Ltd.	Member
Shri Uday Kotak	Executive Vice-Chairman and Managing Director, Kotak Mahindra Bank Ltd.	Member
Shri Aman Mehta	Former Chief Executive Officer, Hong Kong and Shanghai Banking Corporation	Member
Dr. M. T. Raju	Professor and In-charge, Indian Institute of Capital Markets	Member
Smt. Shikha Sharma	Managing Director, ICICI Prudential Life Insurance Company	Member
Shri U. K. Sinha	Chairman and Managing Director, UTI Asset Management Co. Pvt. Ltd.	Member
Special Invitees
Shri Anand Sinha	Executive Director, Reserve Bank of India
Shri C.R. Muralidharan	Member, Insurance Regulatory and Development Authority
Shri G. C. Chaturvedi	Joint Secretary (Banking and Insurance),
Dr. K. P. Krishnan	Joint Secretary (Capital Markets), Government of India
Shri Amitabh Verma	Joint Secretary (Banking Operations), Government of India
Smt. Usha Narayanan	Executive Director, Securities and Exchange Board of India
Shri Arun Goyal	Director, Financial Intelligence Unit, Government of India

3. Institutions & Market Structure

Shri C M. Vasudev	Former Secretary, Department of Economic Affairs Ministry of Finance Government of India	Chairman
Shri C. B. Bhave	Chairman and Managing Director, National Securities Depository Ltd. (upto Febuary 15, 2008)	Member
Dr. K. C. Chakraborty	Chairman and Managing Director, Punjab National Bank	Member
Dr. R. Chandrasekhar	Dean, Academic Affairs, Institute for Financial Management and Research	Member
Dr. Ashok Ganguly	Chairman, Firstsource Solutions Ltd.	Member
Dr. Omkar Goswami	Chairman, CERG Advisory Pvt. Ltd.	Member
Shri Y. H. Malegam	Managing Partner, S. B. Billimoria & Co. Chartered Accountants	Member
Dr. Nachiket Mor	President, ICICI Foundation for Inclusive Growth	Member
Shri T.V.Mohandas Pai	Member of the Board, Infosys Ltd.	Member
Shri Gagan Rai	Chairman and Managing Director, National Securities Depository Ltd. (from Febuary 25, 2008)	Member
Dr. Janmejaya Sinha	Managing Director, Boston Consulting Group	Member
Special Invitees
Dr. R. B. Barman	Executive Director, Reserve Bank of India
Shri Anand Sinha	Executive Director, Reserve Bank of India
Shri C.R. Muralidharan	Member, Insurance Regulatory and Development Authority
Shri Jitesh Khosla	Joint Secretary (Corporate Affairs), Government of India
Dr. K. P. Krishnan	Joint Secretary (Capital Markets), Government of India
Shri Sandeep Parekh	Adviser (Legal), Securities and Exchange Board of India

4. Transparency Standards

Shri Nitin Desai	Under-Secretary-General, United Nations	Chairman
Dr. Jaimini Bhagwati	Additional Secretary, Ministry of External Affairs, Government of India	Member
Dr. Shubhashis Gangopadhyay	Director, India Development Foundation	Member
Dr. Rajiv Kumar	Director and Chief Executive, Indian Council for Research on International Economic Relations	Member
Dr. Rajas Parchure	Faculty, Gokhale Institute of Politics and Economics, Pune	Member
Dr. Indira Rajaraman	Reserve Bank Chair Professor, National Institute of Public Finance and Policy	Member
Shri Mahesh Vyas	Managing Director & CEO, Centre for Monitoring Indian Economy	Member
Special Invitees
Dr. R. B. Barman	Executive Director, Reserve Bank of India
Shri Jitesh Khosla	Joint Secretary (Corporate Affairs), Ministry of Corporate Affairs Government of India
Dr. M. C. Singhi	Economic Advisor, Department of Economic Affairs, Ministry of Finance Government of India
Shri P. K. Nagpal	Executive Director, Securities and Exchange Board of India

Annex IV

Technical Group on Financial Stability Assessment and Stress Testing
No.	Name	Designation/Organisation
1.	Shri C.S. Murthy	Chief General Manager-in-charge, RBI	Member
2.	Shri P.Krishnamurthy	Chief General Manager-in-charge, RBI	Member
3.	Shri Prashant Saran	Chief General Manager-in-charge, RBI	Member
4.	Shri N.S. Vishwanathan	Chief General Manager, RBI	Member
5.	Shri Chandan Sinha	Chief General Manager, RBI	Member
6.	Dr. A.S Ramasastri	Adviser, RBI	Member
7.	Shri Sudarshan Sen	Chief General Manager, RBI	Member
8.	Dr. Charan Singh	Director, RBI	Member
9.	Shri S. Ramann	Chief General Manager, SEBI	Member
10.	Shri K. Kanagasabapathy	Secretary to CFSA	Convener

Technical Group for Aspects of Stability and Performance of Insurance Sector

No.	Name	Designation
1.	Shri S.V. Mony	Secretary General, Life Insurance Council
2.	Shri S. P. Subhedar	Senior Advisor, Prudential Corporation, Asia
3.	Shri N. S. Kannan	Executive Director, ICICI Prudential Life Insurance Company Ltd
4.	Prof R. Vaidyanathan	Professor (Finance), IIM Bangalore
5.	Dr. K. Sriram	Consulting Actuary, Genpact

List of Officials also Associated with the Technical Group’s/Panel’s Deliberations on Financial Stability Assessment and Stress Testing

No.	Name	Designation/Organisation
1.	Shri T.V.Mohandas Pai	Member of the Board and Director-Human Resources, Infosys
2.	Shri Anand Sinha	Executive Director, RBI
3.	Shri S.K. Mitra	Executive Director, NABARD
4.	Dr. Nachiket Mor	President, ICICI Foundation for Inclusive Growth
5.	Shri H. N. Sinor	Former Chairman, IBA
6.	Shri Akhilesh Tuteja	Executive Director, KPMG
7.	Shri G. Padmanabhan	Chief General Manager, RBI
8.	Shri A. P. Hota	Chief General Manager, RBI
9.	Shri A. K. Khound	Chief General Manager-in-charge, RBI
10.	Shri M. P. Kothari	Chief General Manager, DICGC
11.	Shri K.D. Zacharias	Legal Adviser-in-Charge, RBI
12.	Dr. Janak Raj	Adviser, RBI
13.	Dr. A. M. Pedgaonkar	Chief General Manager, RBI
14.	Shri R. Ravi Chandran	Chief General Manager, SEBI
15.	Shri B. B. Mohanty	Chief General Manager, NABARD
16.	Shri S. Ramann	Chief General Manager, SEBI
17.	Shri R. Nagarajan	Chief General Manager, SBI
18.	Ms. Ritu Anand	Principal Adviser& Chief Economist, IDFC
19.	Shri R. Bhalla	General Manager, NHB
20.	Shri P.R. Ravimohan	General Manager, RBI
21.	Shri E. T. Rajendran	General Manager, RBI
22.	Shri Somnath Chatterjee	Director, RBI
23.	Shri S. Ganesh Kumar	General Manager, RBI
24.	Shri A. S. Meena	General Manager, RBI
25.	Dr. Ashok Hegde	Vice President, MindTree Consulting Ltd
26.	Smt. Asha P. Kannan	Director, RBI
27.	Shri R. K. Jain	Director, RBI
28.	Shri Anujit Mitra	Director, RBI
29.	Shri Rajan Goyal	Director, RBI
30.	Smt. R. Kausaliya	Director, RBI
31.	Shri Neeraj Gambhir	Former General Manager, ICICI
32.	Shri B. P. Tikekar	Senior Vice President, HDFC
33.	Shri S. Ray	Senior Vice President, CCIL
34.	Shri Ashok Narain	Deputy General Manager, RBI
35.	Shri T. Rabi Shankar	Deputy General Manager, RBI
36.	Shri K. Babuji	Deputy General Manager, RBI
37.	Shri K.R. Krishna Kumar	Deputy General Manager, RBI
38.	Shri Susobhan Sinha	Deputy General Manager, RBI
39.	Shri Aloke Chatterjee	Deputy General Manager, RBI
40.	Shri Sunil T. S. Nair	Deputy General Manager, RBI
41.	Shri Shayama Chakraborty	Deputy Director, IRDA
42.	Shri R. Chaudhuri	Deputy General Manager, ICICI Bank
43.	Shri V. Konda	Deputy General Manager, ICICI Bank
44.	Shri Rakesh Bansal	Deputy General Manager, ICICI Bank
45.	Shri N. Muthuraman	Director, CRISIL
46.	Shri Somasekhar Vemuri	Senior Manager, CRISIL
47.	Shri G. Sankaranarayanan	Former Senior Vice President, Indian Banks Association
48.	Shri Puneet Pancholy,	Assistant General Manager, RBI
49.	Shri D. Sathish Kumar	Assistant General Manager, RBI
50.	Shri Divyaman Srivastava	Assistant General Manager, RBI
51.	Shri Y. Jayakumar	Assistant General Manager, RBI
52.	Shri K. Vijay Kumar	Assistant General Manager, RBI
53.	Shri Navin Nambiar	Assistant General Manager, RBI
54.	Shri N. Suganandh	Assistant General Manager, RBI
55.	Shri Ashok Kumar	Assistant General Manager, RBI
56.	Shri Ashish Kumar Verma	Assistant General Manager, RBI
57.	Shri Prabhat Gupta	Assistant General Manager, RBI
58	Shri Brij Raj	Assistant General Manager, RBI
59.	Shri D.P. Singh	Assistant Adviser, RBI
60.	Shri Indranil Bhattacharya	Assistant Adviser, RBI
61.	Dr. Pradip Bhuyan	Assistant Adviser, RBI
62.	Shri Unnikrishnan N. K.	Assistant Adviser, RBI
63.	Dr. Saibal Ghosh	Assistant Adviser, RBI
64.	Smt. Anupam Prakash	Assistant Adviser, RBI
65.	Shri Jai Chancier	Assistant Adviser, RBI
66.	Shri S. Madhusudhanan	Assistant General Manager, SEBI
67.	Shri Vineet Gupta	Former General Manager, ICRA
68.	Shri Ranjul Goswami	Director, Deutsche Bank
69.	Shri Abhilash A.	Legal Officer, RBI
70.	Shri M. Unnikrishnan	Legal Officer, RBI
71.	Shri Piyush Gupta	Manager, RBI
72.	Shri Aloke Kumar Ghosh	Research Officer, RBI
73.	Ms. Sangita Misra	Research Officer, RBI
74.	Ms. P.B. Rakhi	Research Officer, RBI
75.	Shri Dipankar Mitra	Research Officer, RBI
76.	Shri S.K. Chattopadhyay	Research Officer, RBI
77.	Shri Samir Ranjan Behera	Research Officer, RBI

Technical Group on Financial Regulation and Supervision

No.	Name	Designation/Organisation
1.	Shri G. Gopalakrishna*	Chief General Manager-in-charge, RBI	Member
2.	Shri P. Krishnamurthy	Chief General Manager-in-charge, RBI	Member
3.	Shri A. K. Khound	Chief General Manager-in-charge, RBI	Member
4.	Shri G. Srinivasan	Chief General Manager-in-charge, RBI	Member
5.	Shri G. Mahalingam	Chief General Manager, RBI	Member
6.	Dr. K.V. Rajan	Chief General Manager, RBI	Member
7.	Dr. Janak Raj	Adviser, RBI	Member
8.	Shri Shekhar Bhatnagar	General Manager, RBI	Member
9.	Shri K. Damodaran	General Manager, RBI	Member
10.	Shri Ananta Barua	Legal Adviser, SEBI	Member
11.	Shri P K Goel	Additional Director, Financial Intelligence Unit	Member
12.	Shri K. Kanagasabapathy	Secretary to CFSA	Convenor
* Now Executive Director, RBI.

List of Members who were a part of the Technical Group for Assessment of IAIS Core Principles

No.	Name	Designation
1.	Shri C.N.S. Shastri	Adviser, IRDA
2.	Shri N.M. Goverdhan	Former Chairman, LIC of India
3.	Shri K.N. Bhandari	Secretary General, General Insurance Council
4.	Shri Thomas Mathew	Managing Director, Life Insurance Corporation of India
5.	Shri Deepak M. Satwalekar	Chief Executive Officer, HDFC Standard Life Insurance Company Ltd.

List of Officials also Associated with the Technical Group/Panel Deliberations on Financial Regulation and Supervision

No.	Name	Designation/Organisation
1.	Shri V. K. Sharma	Executive Director, RBI
2.	Shri V. S. Das	Executive Director, RBI
3.	Shri S. K. Mitra	Executive Director, NABARD
4.	Shri A. V. Sardesai	Former Executive Director, RBI
5.	Smt. Vani Sharma	Former Regional Director, RBI
6.	Shri S.R. Kamath	Former General Manager, Securities Trading Corporation of India
7.	Shri Prashant Saran	Chief General Manager-in-charge, RBI
8	Shri P. Krishnamurthy	Chief General Manager-in-charge, RBI
9.	Shri Salim Gangadharan	Chief General Manager, RBI
10.	Shri Chandan Sinha	Chief General Manager, RBI
11.	Smt. Surekha Marandi	Chief General Manager, RBI
12.	Shri Vinay Baijal	Chief General Manager, RBI
13.	Shri P.K.Panda	Chief General Manager, RBI
14.	Shri B. B. Mohanty	Chief General Manager, NABARD
15.	Shri Rakesh Bhalla	General Manager, NHB
16.	Shri P. R. Ravimohan	General Manager, RBI
17.	Shri K. Bhattacharya	General Manager, RBI
18.	Shri R. C. Sarangi	General Manager, RBI
19.	Shri R. Subramanian	Deputy General Manager, RBI
20.	Shri Navin Bhatia	Deputy General Manager, RBI
21.	Smt. Molina Chaudhury	Deputy General Manager, RBI
22.	Shri Himanshu Mohanty	Deputy General Manager, RBI
23.	Shri Susobhan Sinha	Deputy General Manager, RBI
24.	Shri Aditya Gaiha	Deputy General Manager, RBI
25.	Smt. Anupam Sonal	Deputy General Manager, RBI
26.	Shri P.K. Das	Deputy General Manager, RBI
27.	Shri V. I. Ganesan	Deputy General Manager, NABARD
28.	Shri Sunil T. S. Nair	Deputy General Manager, RBI
29.	Ms. Mamta Suri	Deputy Director, IRDA
30.	Shri Anup Kumar	Assistant General Manager, RBI
31.	Shri S. Subbaiah	Assistant General Manager, RBI
32.	Shri Puneet Pancholy	Assistant General Manager, RBI
33.	Shri Prabhat Gupta	Assistant General Manager, RBI

Technical Group on Institutions and Market Structure

No.	Name	Designation/Organisation
1.	Shri K.D. Zacharias	Legal Adviser-in-Charge, RBI	Member
2.	Shri Chandan Sinha	Chief General Manager, RBI	Member
3.	Shri A. P. Hota	Chief General Manager, RBI	Member
4.	Dr. Janak Raj	Advisor, RBI	Member
5.	Shri PR. Ravimohan	General Manager, RBI	Member
6.	Shri D. Rajagopala Rao	General Manager, RBI	Member
7.	Shri Amarjeet Singh	Regional Manager, SEBI	Member
8.	Shri Pawan Kumar	Director, Ministry of Corporate Affairs	Member
9.	Ms. Mamta Suri	Deputy Director, IRDA	Member
10.	Shri K. Kanagasabapathy	Secretary to CFSA	Convenor

List of Officials also Associated with the Technical Group/Panel Deliberations on Institutions and Market Structure

No.	Name	Designation/Organisation
1.	Shri G. Padmanabhan	Chief General Manager, RBI
2.	Shri T. B. Satyanarayana	General Manager, RBI
3.	Shri R. N. Kar	General Manager, RBI
4.	Shri Arun Pasricha	General Manager, RBI
5.	Smt. Sudha Damodar	General Manager, RBI
6.	Dr. (Smt.) Mohua Roy	Director, RBI
7.	Shri Jaikant Singh	Director – Ministry of Corporate Affairs
8.	Shri O. N. Ravi	Senior Vice President, CCIL
9.	Ms. Bhavna Doshi	Senior Adviser, KPMG
10.	Shri Vijay Kapur	Director, AASB
11.	Shri P. Rama Rao	Official Liquidator, Ministry of Corporate Affairs
12.	Shri Himanshu Mohanty	Deputy General Manager, RBI
13.	Ms. Jyoti Jindgar	Deputy General Manager, SEBI
14	Shri Sunil T. S. Nair	Deputy General Manager, RBI
15.	Ms. Mamta Suri	Deputy Director, IRDA
16.	Ms. Nilima Ramteke	Assistant General Manager, RBI
17.	Shri Puneet Pancholy	Assistant General Manager, RBI
18.	Shri K. Vijay Kumar	Assistant General Manager, RBI
19.	Shri D. Sathish Kumar	Assistant General Manager, RBI
20.	Shri N. Gopinath	Assistant General Manager, RBI
21.	Shri A. Abhilash	Legal Officer, RBI
22.	Shri B. Bohra	Legal Officer, RBI
23.	Ms. Vandana Jindal	Assistant General Manager, SEBI
24.	Shri S. Dhamodaran	Senior General Manager, ICICI Bank
25.	Shri L.M. Devare	Official Liquidator, Bank of Karad Ltd. (in liquidation), Mumbai
26.	Shri V.S. Rao	Regional Director (West), Ministry of Corporate Affairs

Technical Group on Transparency Standards

No.	Name	Designation/Organisation
1.	Dr. M.D. Patra	Adviser-in-Charge, RBI	Member
2.	Dr. R.K. Pattnaik	Adviser, RBI	Member
3.	Dr. K.S. Ramachandra Rao	Principal Adviser, RBI	Member
4.	Shri P. Vijaya Bhaskar	Chief General Manager, RBI	Member
5.	Shri S.V. Raghavan	Chief General Manager, RBI	Member
6.	Shri R.N. Kar	General Manager, RBI	Member
7.	Shri R.N. Dubey	Additional Economic Adviser, MoF	Member
8.	Shri P.K. Bindlish	Chief General Manager, SEBI	Member
9.	Shri R.S. Jagpal	Deputy Director, IRDA	Member
10.	Shri K. Kanagasabapathy	Secretary to CFSA	Convenor

List of Officials also Associated with the Technical Group/Panel Discussions on Transparency Standards

No.	Name	Designation/Organisation
1.	Dr. B.K. Bhoi	Adviser, RBI
2.	Shri B.M. Misra	Adviser, RBI
3.	Shri M.R. Anand	Additional Economic Adviser, Government of India
4.	Shri R.N. Kar	General Manager, RBI
5.	Ms. Saraswathy Shyamaprasad	General Manager, RBI
6.	Shri V.P. Arya	General Manager, RBI
7.	Shri A.B. Balwatkar	General Manager, DICGC
8.	Dr. (Smt.) Mohua Roy	Director, RBI
9.	Smt. R. Kausaliya	Director, DICGC
10.	Shri Aditya Gaiha	Deputy General Manager, RBI
11.	Shri Rajiv Ranjan	Director, RBI
12.	Smt. Rekha Misra	Director, RBI
13.	Shri J.K. Khundrakpam	Director, RBI
14.	Smt. Kumudini Hajra	Director, RBI
15.	Shri M. Ramaiah	Assistant Adviser, RBI
16.	Shri D. Sathish Kumar	Assistant General Manager, RBI
17.	Shri N. Gopinath	Assistant General Manager, RBI
18.	Shri S.Venkateswaran	Assistant General Manager, SEBI
19.	Shri H.K. Behera	Research Officer, RBI

Annex V

List of Agencies Involved in the Assessment Exercise

Regulatory Authorities/Government

Reserve Bank of India
Securities and Exchange Board of India
Insurance Regulatory and Development Authority
Government of India
State Governments

Others

Auditing and Assurance Standards Board
Clearing Corporation of India Limited
Credit Rating Information Services of India Limited
Deutsche Bank
Foreign Exchange Dealers’ Association of India
ICICI Bank Limited
ICICI Prudential Life Insurance Company
ICRA Ltd.
Indian Banks’ Association
Infrastructure Development Finance Company
Institute of Chartered Accountants of India
KPMG India
National Bank for Agriculture and Rural Development
National Housing Bank
State Bank of India

Annex VI

List of Peer Reviewers

No	. Subject	Peer Reviewer
1.	Financial Stability and Stress Testing:	V Sundararajan Consultant and former Deputy Director IMF
		Andrew Sheng Former Chairman Hong Kong Securities and Futures Commission
	Financial Regulation and Supervision
2.	Assessment of Basel Core Principles	Eric S. Rosengren President and Chief Executive Officer Federal Reserve Bank of Boston
3.	IOSCO Principles for Securities Market Regulation	Ranjit Ajit Singh Managing Director Securities Commission, Malaysia
		Shane Tregillis Deputy Managing Director Monetary Authority of Singapore
4.	IAIS Principles for Insurance Regulation	Carl Hiralal Inspector of Financial Institutions Central Bank of Trinidad and Tobago
		Michael Hafeman Independent Consultant Canada
	Institutions & Market Structure :
5.	Accounting Standards	Ian Mackintosh Chairman Accounting Standards Board, UK
		Kamal Gupta FCA, India
6.	Auditing Standards	Ian Mackintosh Chairman Accounting Standards Board, UK
		N. P. Sarda Partner Deloitte, Haskins & Sells, India
7.	Payments and Settlement Systems	Greg Johnston Head of Banking Reserve Bank of Australia
8.	Corporate Governance	Sir Andrew Large Former Deputy Governor Bank of England
9.	Bankruptcy Laws	Thomas Baxter Jr. General Counsel and Executive Vice-President Federal Reserve Bank of New York
		T.R.Sridharan Former Chairman Canara Bank, India
	Transparency Standards:
10.	Transparency in Monetary Policy	Sir Andrew Large Former Deputy Governor Bank of England
11.	Assessment of Fiscal Transparency	Vito Tanzi Former Director Fiscal Affairs Department, IMF
12.	Data Dissemination Standards	Neil Patterson Former Director Statistics Department, IMF

Annex VII

Secretariat to CFSA*

Sr. No.	Name	Designation
1.	Shri K. Kanagasabapathy	Consultant, Secretary
2.	Dr.(Smt.) Mohua Roy	Director
3.	Shri Susobhan Sinha	Deputy General Manager
4.	Shri Sunil T. S. Nair	Deputy General Manager
5.	Shri Saibal Ghosh	Assistant Adviser
6.	Shri D.Sathish Kumar	Assistant General Manager
7.	Shri Nishanth Gopinath	Assistant General Manager
8.	Shri Prabhat Gupta	Assistant General Manager
9.	Smt. P.K. Shahani	Manager
10.	Shri A.B. Kulkarni	Assistant Manager
11.	Shri R.J. Bhanse	Assistant Manager
12.	Shri S.S. Jogale	PS to Consultant
13.	Shri B. G. Koli	Stenographer
* Functioned as part of the Monetary Policy Department, RBI.

Chapter II

Macroeconomic Environment

2.1 Introduction

An assessment of the financial sector needs to recognise the linkages between macroeconomic performance and financial stability. It has been well established that a well-functioning financial system promotes economic growth. Financial development has two mutually reinforcing effects. From the demand side, it promotes efficiency of investments through better allocation of resources and from the supply side it increases savings and, hence, the scale of investments.

There is evidence that financially developed economies seem to allocate their resources more efficiently. Financial intermediation enhances economic growth by channelling savings into productive areas of investment, while allowing individuals to reduce the risks associated with their liquidity needs. The Indian financial sector in terms of institutions, markets and infrastructure has expanded and acquired greater depth and vibrancy particularly after the reforms initiated in the early 1990s. In different phases, financial sector development in India has broadly been supply-led, inasmuch as the central bank and the government took an active role in promoting and nurturing institutions and markets.

As macroeconomic developments and shocks have an impact on the financial sector, the role of macro-prudential or financial stability analysis has gained importance in recent years among central banks, regulatory authorities and international agencies. Various macroeconomic developments such as an increase in inflation due to a spurt in crude oil/commodity prices, sudden inflow/outflow of capital, sharp increases in fiscal deficit, or sudden and sharp increases in interest rates/asset prices may have an adverse effect on financial institutions’ balance sheets and financial markets and thereby have implications for financial stability. Macro stress testing has, therefore, assumed significance in recent years.

Keeping this in view, the CFSA, drawing mainly on the assessment made by the Panel on Financial Stability Assessment and Stress Testing, has briefly reviewed global economic developments and, against that backdrop, assessed the Indian economic scenario with the objective of identifying potential and key macroeconomic vulnerabilities of the Indian economy at the present juncture that could have a bearing on the stability of the financial sector.

After a relatively long period of robust growth with moderate inflation and benign market conditions, the global economic environment recently entered a turbulent phase following significant volatility in the prices of oil, commodities and food, and the emergence of the sub-prime crisis in the US around mid-2007. The financial crisis has deepened further during the past six months and entered a new turbulent phase in September 2008 which has severely affected confidence in global financial institutions and markets. The dislocation in financial markets has been particularly severe and the situation remains in flux. Given that the dimensions of this turmoil and its impact both on the real economy and on the world of finance are still uncertain, this period represents a turnaround inasmuch as it has generated a wide range of discussions on both policy and operational matters akin to the aftermath of the depression of the 1930s. The overall assessment of global economic trends as also related issues in the Indian context had to undergo a shift from a benign and optimistic outlook to a relatively more cautious and guarded one. This was because of the many downside risks. Therefore, even while the CFSA was progressing with its work, unfolding events made the Advisory Panels, as also the CFSA, approach the whole assessment of the financial sector, including that of the macroeconomic environment impinging on the performance of the financial sector, with the utmost humility.

Non-performing housing loans, declining global equity prices and the rising cost of default protection on corporate bonds has forced some major national and international banks to face significant losses. Alongside, tightening of bank credit standards in major industrial economies has reinforced worries of an impending credit crunch. The impact has been compounded by persistent volatility in international oil prices. Coinciding with the rise in global commodity and food prices, global inflation was at elevated levels in the early part of 2008-09, though inflation has started showing a decline consequent to softening of commodity and food prices very recently due to the deceleration in global demand.

The adjustment process in advanced economies is incomplete and the extent of de-leveraging and its spasmodic unfolding has implications for global capital flows, exchange rates and the adjustment of domestic economies to these shocks. With the growing integration of the Indian economy with the global markets, the weight of global factors, along with domestic considerations, has also become important in dictating macroeconomic policies and outcomes. While there are several positives pointing to a sustainable higher growth rate in the medium term, some of the global and domestic developments show heightened downside risks to the short-term outlook of both the global and Indian economies.

The flagging confidence in the global financial system and markets has gained utmost priority and the G-7 in October 2008 agreed on a five-point plan of action:

• Take decisive action and use all available tools to systemically support important financial institutions and prevent their failure.

• Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.

• Ensure that banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and business.

• Ensure that the respective national deposit insurance and guarantee programmes are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.

• Take action, where appropriate, to restart the secondary markets for mortgages and other securitised assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high-quality accounting standards are necessary.

This plan of action has been strongly endorsed by the IMF’s International Monetary and Financial Committee.

The G-20 in its November 2008 summit agreed on five common principles to guide financial market reform: (i) strengthening transparency and accountability; (ii) enhancing sound regulation; (iii) promoting integrity in financial markets; (iv) reinforcing international co-operation; and (v) reforming international financial institutions (IFIs). The leaders also approved a detailed Action Plan that sets forth a comprehensive work plan to implement these principles so as to ensure that the action plan is fully and vigorously implemented.

The turmoil in financial markets, the freezing of the money markets and spreading market failures and contagion are compelling central banks to evolve co-ordinated policy action to mitigate the impact of the current crisis. In this turbulent environment, many of the mainstream ideas about central bank independence, single objective, Lender of Last Resort (LoLR), and separation of regulation and supervision are coming under renewed discussion. The CFSA is aware that there is considerable thinking going on internationally on the issue of financial regulatory architecture, and on the changes that are needed to make the global financial system more resilient. The CFSA has followed these trends and approached related issues with considerable nuance and with a sense of utmost humility in the institutional and country context.

2.2 Global Economy

After stronger than expected growth up to the third quarter of 2007, most of the advanced economies have recorded a sharp deceleration in their growth towards the end of 2008, driven mainly by the financial crisis, which spread beyond the US sub-prime mortgage market to other jurisdictions. The world economy has entered a major downturn in the face of the most dangerous financial shock in the advanced economies since the 1930s. As per IMF estimates, global growth decelerated to 3.4 per cent in 2008 from 5.2 per cent in 2007. Slowdown has been witnessed in both advanced as well as emerging market economies like Argentina, China, India, Malaysia and Thailand during 2008. Global growth is now projected by the IMF to drop further to 0.5 per cent in 2009, along with recession in North America and Europe. It is however expected to improve to 3.0 per cent by 2010 (Table 2.1).

The overall balance of risks to the short-term global growth outlook thus remains heavily tilted to the downside. Financial risks remain high, as rising losses in the context of a global slowdown could add to the strains on capital and exacerbate the squeeze on credit availability. The pattern of exchange rate adjustments has borne little relationship to the pattern of current account balances. Rising international oil prices had raised the projected current account surpluses of oil exporting countries, international oil prices though, have declined rapidly of late.

Headline inflation firmed up in major economies up to August 2008, reflecting the combined impact of elevated food and fuel prices, as well as strong demand conditions, especially in emerging markets. The rising inflation, which was a concern for a major part of the year, has however eased since September 2008, and is now a declining concern on account of marked decline in food and fuel prices as well as augmentation of downward risks to growth from the intensification of the global financial market crisis. Globally, inflation has softened in several countries in recent months. According to the IMF, the combination of stabilising commodity prices and slowdown of the economy would help contain inflationary pressures in 2009, which is expected to fall to 0.25 per cent, before edging up to 0.75 per cent in 2010.

Table 2.1: Output Growth, Inflation and Interest Rates in Select Economies

(per cent)
Region/ Country	Real GDP*				Consumer price Inflation		Short-term interest rate
Region/ Country	2007	2008	2009	2010	2007	2008	Current
1	2	3	4	5	6	7	8
World	5.2	3.4	0.5	3.0	-	-
Advanced economies	2.7	1.0	(-2.0)	1.1	2.1	3.5
Of which
United States	2.0	1.2	(-2.0)	1.6	4.3	3.8	0.51
Euro Area	2.6	0.8	(-2.1)	0.2	3.2	3.1	1.85
Japan	2.4	(-0.2)	(-3.2)	0.6	0.7	1.4	0.60
Emerging economies	8.3	6.3	3.3	5.0	6.4	9.2
Developing Asia	10.6	7.8	5.5	6.9	5.4	7.8
China	13.0	9.0	6.0	8.0	7.1	5.9	1.28
India**	9.3	5.3	5.0	6.5	5.5	8.2	4.74
South Korea	5.0	2.6	(-5.9)	-	3.9	4.7	2.52
Singapore	7.7	1.2	(-7.2)	-	6.6	6.5	0.58
Thailand	4.8	3.0	(-1.8)	-	4.3	5.5	2.05
Argentina	8.7	6.0	(-2.7)	-	8.2	8.6	14.56
Brazil	5.7	5.3	1.6	3.5	4.6	5.7	12.66
Mexico	3.2	1.5	(-1.8)	2.1	3.7	5.1	7.24
Central and Eastern Europe	5.4	3.2	(-0.4)	2.5	-	-
Russia	8.1	6.0	1.0	1.3	12.6	14.1	13.00
Turkey	4.6	1.5	(-1.5)	-	8.2	10.5	12.90
Updated from World Economic Outlook – January 28, 2009 and ‘The Economist’ – February 28, 2009 * : Average annual change, in per cent; : for India, wholesale prices; Note: Interest rate per cent per annum. Source:** IMF World Economic Outlook and The Economist.

Global financial markets witnessed heightened uncertain conditions during the first half of 2008. The financial market witnessed a cautious return of investor risk tolerance in the credit markets between mid-March 2008 and end-May 2008. As a result, spreads narrowed in credit markets and investor interest revived temporarily in equity markets. In sharp contrast, inter-bank money markets failed to recover as liquidity demand remained elevated. Spreads between LIBOR rates and overnight index swap rates increased in all three major markets, viz., the US, the UK and the Euro area. Central banks continued to work together as well as individually to improve liquidity conditions in financial markets. Financial markets, however, came under stress again in June 2008 and early July 2008 as concerns mounted about the losses and longer-term profitability of two US mortgage companies, viz., Fannie Mae and Freddie Mac. In mid-September 2008, failures of certain major firms in the US further deepened the crisis across world markets. The IMF has recently revised its estimate of loss due to the sub-prime crisis to US $ 1.3 trillion. Overall, the markets have been volatile since mid-2007. While some recovery takes place whenever there is some central bank action, the markets tend to turn volatile again due to fresh developments.

During the last quarter of 2008, short-term interest rates in advanced economies witnessed a mixed trend, moving broadly in tandem with policy rates and liquidity conditions. Improved liquidity conditions resulted in decline in short-term interest rates generally in major economies in January 2009.

2.3 The Indian Context

The impressive performance of the Indian economy is testimony to the benefits of the economic reforms undertaken since the early 1990s. Real GDP growth averaged 5.7 per cent from 1991-92 to 1996-97, 5.2 per cent during 1997-98 to 2002-03 and 8.8 per cent from 2003-04 to 2007-08, making it one of the world’s fastest growing economies in the latter period. Since 2003-04, there has been a distinct strengthening of the growth momentum. Restructuring measures by domestic industry, overall reduction in domestic interest rates, both nominal and real, improved corporate profitability, a benign investment climate amidst strong global demand and commitment to rule-based fiscal policy have led to the shift to a higher trajectory of real GDP growth over the 5-year period ended 2007-08; growth in the past three years has averaged 9.2 per cent per annum, the highest average during any three-year period in the history of independent India.

As the sustained growth was accompanied by a decline in population growth, the growth of real per capita income improved from 3.4 per cent during 1997-2002 to 6.1 per cent during 2002-2008. While there may be debate on the exact timing of the growth acceleration, the various alternative approaches do suggest a move to the higher growth trajectory from the 1980s onwards and further acceleration in recent years. The growth is clearly associated with the consistent trends of increasing domestic savings and investment over the decades (Chart 2.1 & Chart 2.2). Since 2003-04, there has also been significant bank credit growth.

Besides a consistent upward trend in India’s investment rate, there is evidence that capital has been employed productively. There are some signs of improvement in domestic productivity in the post-reforms period. A cross-country comparison indicates that Incremental Capital Output Ratio (ICOR) in India has been amongst the lowest in the world. This is especially true of the period from the 1980s onwards. Various reform measures aimed at increasing competitiveness appear to be having the desired impact on the productivity of the Indian economy. According to estimates by Bosworth and Collins, productivity gains accounted for almost 70 per cent of the growth in output per worker of the services sector during the period 1993-2004.

Unlike many of the East Asian economies, in India domestic demand has been the main driver of economic activity. The consumption GDP ratio – at nearly two-thirds – is one of the highest in Asia. The corporate sector has responded to increased global competition by improving productivity as manifest in an improvement in the ICOR from 6.6 in the 1970s to 3.6 during 2003-04 to 2006-07. This, in turn, has improved corporate profitability and, along with the improvement in public sector savings, enabled a pick-up in investment rates, from 22.8 per cent of GDP in 2001-02 to 35.9 per cent in 2006-07.

Inflation rates were benign for most of the current decade. Thus, the annual average increase in the Wholesale Price Index between 2000-01 and 2007-08 was 5.1 per cent and the annual average increase in CPI between the same periods was 4.6 per cent. After a brief period of significant increase in inflation during 2008-09, as has also happened globally, of late there has been moderation in inflation rates due to cooling down of energy and commodity prices in particular. Inflation stood at 3.0 per cent as on February 21, 2009, considerably down from the high of 12.9 per cent in August 2008.

In response to increased perceptions of inflationary pressures, the Reserve Bank had gradually raised policy rates from 2004. The Cash Reserve Ratio was also raised during this period to 9.00 per cent. The repo rate was increased in stages from 4.75 per cent in October 2004 to 9 per cent in July 2008 before a gradual decline to 5.0 per cent in March 2009. The reverse repo rate was increased from 4.75 per cent in October 2004 to 6 per cent in November 2008. However, the reversal of capital flows which has led to liquidity concerns in the economy has induced the Reserve Bank to reduce in stages the Cash Reserve Ratio to 5.0 per cent.The repo and reverse repo rates have been reduced in stages to 5.0 per cent and 3.5 per cent, respectively. There has been a reduction in the Statutory Liquidity Ratio from 25 per cent to 24 per cent. It also tightened prudential norms, including increasing provisioning requirements and raising risk-weights in select sectors, with some relaxations in November-December 2008 as a contra-cyclical measure. Indicators on financial soundness, including stress tests of credit and interest rate risks, nevertheless suggest that banks’ balance sheets remain healthy and robust. The liquidity ratio analysis of the banking system has however, shown a few concerns, that need to be addressed.

Since 2003-04, there has been a significant jump in bank credit growth, which could be partly attributed to the step-up in real GDP growth, decline in interest rates, intensive policy initiatives to improve flow of credit to sectors like agriculture and, finally, strong demand for retail credit, particularly housing. The ratio of outstanding bank credit to GDP initially declined from 30.2 per cent at end-March 1991 to 27.3 per cent at end-March 1997; over the next decade, the ratio of bank credit to GDP more than doubled to reach about 60 per cent by end-March 2008.

Merchandise exports have been growing and becoming increasingly broad-based in terms of destinations and composition, reflecting India’s growing integration into the global economy (Chart 2.3). Based on Balance of Payments (BoP) data, merchandise exports to GDP increased from 5.8 per cent in 1990-91 to 9.9 per cent in 2000-01 and to 14.2 per cent in 2007-08. A striking feature of export growth has been the rapid growth in services exports. The growth in imports has also been rapid, with the imports to GDP rising from 8.8 per cent in 1990-91 to 12.6 per cent in 2000-01 and to 22.0 per cent in 2007-08. Despite the widening trade deficit, the current account deficit has remained modest, due largely to high levels of private transfers and increasing service sector exports (Chart 2.4). India is the leading remittance-receiving country in the world with relative stability of such inflows. Thus, while the merchandise trade deficit has increased from 2.7 per cent in 2000-01 to 7.8 per cent in 2007-08, the current account balance has been in the range of (-) 0.4 per cent and 2.3 per cent during this period. Strong capital inflows have been instrumental in financing the current account deficit. A positive investment climate and progressive liberalisation of the FDI policy regime, along with the rising pace of mergers and acquisitions across diverse sectors, contributed to a significant rise in both portfolio and FDI flows in recent years (Chart 2.5). The global financial turmoil has, however, led to a reversal in trend in respect of both trade and capital flows in 2008-09 which has impacted the capital market and foreign exchange markets significantly. The foreign exchange reserves which reached a peak of USD 309.7 billion at end-March 2008 have declined and stood at USD 249.3 billion as on February 27, 2009.

The rupee, exhibiting two-way movements against the US dollar during 2002-03 to 2007-08, remained in the broad range of Rs.39.25 and Rs.46.96 per US dollar during this period. The rupee has witnessed highly volatile conditions since mid-September and early October 2008, driven by global market uncertainties. During 2008-09, till end January 2009, the rupee has depreciated and moved in the range of Rs.39.89-50.53 per US dollar (RBI Reference Rate). On an annual average basis, however, the real effective exchange rate of the Indian rupee based on trade-weight measures reflected an appreciation of 6.7 per cent in 2007-08. Net market purchases by the Reserve Bank amounted to US $ 78.2 billion during 2007-08 as against US $ 26.8 billion in 2006-07.

Financial markets in India in general have gained in depth, liquidity and resilience on account of various policy measures initiated over a period of five years. Interest rates in various segments of the financial market moved in tandem with the policy stance of the Reserve Bank. Initiatives have also been concurrently undertaken to strengthen the financial infrastructure necessary to support increased financial market activity. As per the BIS Triennial Central Bank Survey 2007, the foreign exchange market and derivative transaction volumes in India exhibited the fastest growth among the countries surveyed and currently compare well with some advanced countries.

The fiscal position of the government since 2004-05 has been influenced by the rule-based fiscal correction process that is based on the Fiscal Responsibility and Budget Management (FRBM) Act implemented by the Government of India in July 2004. Similar legislations have been enacted by most of the States. The combined fiscal deficit of the Centre and States was budgeted to decline to 4.6 per cent of GDP in 2008-09 from 5.3 per cent as per the revised estimates (RE) for the previous year and 9.6 per cent in 2002-03. The continued increase in revenue receipts at a higher rate in relation to increases in expenditure led to improvement in all the deficit indicators during 2007-08 compared to the previous year. However as per the Interim Budget for 2009-10, the revised estimates in 2008-09 show a sharp increase in both revenue and fiscal deficit. Emerging fiscal pressures from the implementation of the Sixth Pay Commission recommendations, debt waivers and oil and fertilizer subsidies point, however, to the need for continued focus on fiscal balance. The Government and the Reserve Bank of India have also introduced a host of fiscal stimulus measures. However, given the current pressures on the economy in terms of global slowdown, oil price volatility, declared farm loan waivers coupled with various fiscal concessions that have been offered to keep the country on a high growth trajectory, it was not possible to contain fiscal deficit at the budgetary levels for the year 2008-09. The Government has in fact, deviated from its fiscal reform path and the FRBM targets have been relaxed to allow for higher spending as well as to absorb the impact of lower revenue growth expected in 2008-09 and 2009-10. The government has announced that it will return to FRBM targets, once the economy is restored to its recent trend growth path.

The strengthening of the market infrastructure and improvements in trading and settlement systems have made the Indian stock market one of the best in the world. The market has acquired greater depth over the years and is increasingly integrated with world markets. The insurance sector is also gradually moving away from the erstwhile state-owned regulated regime to one characterised by liberalisation and increased competition. The life insurance segment has been experiencing robust growth with increasing product diversification and customer orientation by both public and private players. The non-life segment has also been graduating towards risk-based pricing and health insurance products are being introduced.

Mr. Andrew Sheng, peer reviewer for Financial Stability and Stress Testing, by way of his general comment stated: “I want to commend the Indian authorities on the tremendous achievements in reforming the Indian financial system through their pragmatic and gradualist approach. The fact that India has not gone through any financial crisis as a result of financial deregulation is not only remarkable, but a testimony to the correctness of the judgment that reforms to global standards need to be adjusted to local conditions. The results have been impressive by any standards and the quality of the analysis and policies adopted are professional and objective.”

2.4 Potential Areas of Macroeconomic Vulnerability

Macroeconomic conditions in India have, in general, improved significantly in recent years with the economy witnessing robust growth and moderate inflation, except for temporary spikes in 2008-09 as has happened globally, coupled with a resilient banking system, improved depth and width of financial markets, and robust payment and settlement systems consequent to the implementation of RTGS. However, the Advisory Panel has identified several downside risks to macroeconomic prospects, which are summarised below.

2.4.1 Sustaining the Current Growth

Given India’s past record, when its economic growth has never grown at double-digit rates except in 1988-89 and the above 8 per cent growth has been achieved only in recent years, views have been expressed about the sustainability of India’s current growth momentum. The IMF has projected India’s growth would be 7.3 per cent in 2008 and 5.1 per cent in 2009. Drawing on the experience of other countries, several instances have been found in recent history when economies have grown at 8-9 per cent or higher annual rates for continuous periods. Therefore, 9 per cent growth in India during 2007-08 as well as the previous year cannot be viewed as an unusual phenomenon. In view of the positive features of the Indian economy, the Panel concluded that despite some marginal moderation in the immediate future due to uncertain global market conditions, India could return to an 8 per cent growth rate over the medium term as economic normalcy returns in the global economy.

The growth process was sustained in view of various growth enabling factors: (a) growth is led by demand – both of investment and consumption; (b) an upbeat investment climate for the medium and long term; (c) continued general upturn in capital goods production; and (d) record rise in sales and profits in the corporate sector. Though there will be a moderation in Indias growth rate in the immediate future. As economic normalcy returns in the global economy, India has the potential to grow at 8-10 per cent in the medium term. Therefore, any growth rate of more than 8 per cent is assessed to be a sustainable rate for India.

Indian economic growth has been largely enabled by a sustained increase in the level of domestic savings. The efficiency of resource use has also been high with a long term ICOR of around four, which is comparable to the record of the best countries in the world. Hence, for 10 per cent plus growth to be achieved, the continuation of growth in savings in each of the sectors – households, private corporate sector, public corporate sector and the government – would be essential, along with a prudent and sustainable absorption of external savings.

The recent acceleration in growth has been enabled by a surge in private sector investment and corporate growth. With regard to corporates, data available for the manufacturing sector reveals that the debt to equity ratio for public limited companies showed a general declining trend from 63 per cent in 2003-04 to about 50 per cent in 2006-07. In the case of private companies, though the ratio showed an increasing trend from about 15 per cent to 20 per cent between 2003-04 and 2005-06, the ratio was significantly lower than in the public sector. The profitability of Indian companies, measured by return on equity, was healthy and increased during the period under review. The current ratio for Indian companies was also above one, indicating comfortable liquidity.

The low debt to equity ratio points to higher internal accrual and buoyancy in the capital market. The question that arises is the sustainability of the low debt to equity ratio. There has been some moderation in sales and profits growth in 2007-08 that has begun to impact profitability, which could result in lower generation of internal funds going forward. Recently, there has also been a sharp correction in the valuations of listed firms, and thus there could be some reversal in the declining debt to equity ratio. Mr. Sundararajan, peer reviewer, has commented that sizeable reductions in debt to equity ratios of non-financial corporate sectors is one of the structural and conjectural factors which have contributed to financial stability, along with dominance of public sector banks and strategic management of capital account.

Going forward, there is a need to achieve an improved balance between financial development and financial stability. The improved performance of corporates has become possible with the improvement in fiscal performance reducing the public sector’s draft on private savings, thereby releasing resources to be utilised by the private sector. For the growth momentum to be sustained, it is therefore necessary to continue the drive for fiscal prudence at both the central and state government levels.

The Panel has therefore noted that the public debt of the country is to be further brought down and fiscal discipline is to be ensured to sustain growth. At the same time, fiscal allocation to social and infrastructure sectors needs to be scaled up to sustain ongoing economic growth. The capital market is to be further developed and portfolio flows need to be prudently managed. Encouragement should be given for direct investment flows rather than portfolio flows. Above all, institutional reforms are to be strengthened in addition to reforms in the administrative machinery. Sustainability of corporate investment will crucially be conditioned by low and stable inflation enabling low and stable nominal and real interest rates.

The key to maintaining high growth with reasonable price stability lies in rapid capacity additions through investments, productivity improvements, removal of infrastructure bottlenecks and amelioration of skill shortages. While monetary policy should continue to play a critical role in maintaining price stability, the sustainability of high growth with moderate inflation will depend critically on bolstering the twin pillars of growth, namely, fiscal prudence and high investment, and improving the effectiveness of government intervention in critical areas such as agriculture, education and health to achieve more inclusive growth.

2.4.2 Reversing Slowdown in Agriculture

The performance of the agricultural sector is critical to sustain economic growth and maintain food security. Although the share of agriculture declined from over half of GDP in the 1950s to less than a fifth by 2006-07, there has not been a concomitant decline in the share of population dependent on agriculture; over half of the workforce is still dependent on this sector. The co-relation between agricultural growth and overall GDP growth has been observed to have strengthened over the reforms period.

In the present phase of growth momentum as witnessed in the service and industrial sectors, the agriculture sector has to grow faster than its long-term average growth rate of 2.5 per cent. If the agriculture sector remains in distress, growth can be neither inclusive nor sustainable. The most critical problems in the agricultural sector are low yields and the inability of farmers to exploit the advantages of the market. Clearly, the need of the hour is to modernise and diversify the agriculture sector by improving both the forward and backward linkages. These will include better credit delivery, investment in irrigation and rural infrastructure, improved cropping patterns and farming techniques, and development of the food processing industry and cold storage chains across the entire distribution system.

2.4.3 Fiscal Consolidation

Among the other critical challenges is the way forward on fiscal consolidation, which is a necessary pre-requisite for sustained growth. High fiscal deficits would crowd out private investments. Depending on how they are financed, fiscal deficits can have an adverse impact on the economy through adverse movements in inflation, interest rates and the exchange rate. While the FRBM Act brought about a rule-based regime for consolidation both at the Central and State levels, the challenge lies in maintaining fiscal prudence so as to augment the levels of public sector savings. However, given the current pressures on the economy in terms of global slowdown, oil price increases (which have moderated considerably of late), and the consequent impact on subsidies, the increase in revenue deficits, coupled with the declared farm loans waivers, and the implementation of Sixth Pay Commission recommendations, the CFSA recognised that it would be a challenging task to resume the fiscal correction after the current financial turmoil. Whereas there is a clear need and justification for fiscal expansion to counter the current global and domestic economic downturn, it is of the utmost importance that India return to its path of fiscal correction once the current crisis is over.

Some of the fiscal correction has been achieved by reduction in public investment. A desirable shift has taken place from public to private investment in sectors that essentially produce private goods and services, and there is a move towards public-private partnerships (PPP) in those which have aspects of both public good and private good. But it is necessary to recognise that public investment is essential in sectors providing public services. Continued fiscal correction through restructuring and reduction in subsidies, and continued attention to the mobilisation of tax revenues is necessary to enhance public sector savings that can then finance increases in levels of public investment. If this is not done, private corporate sector investment would be hampered, and the leads and lags in the availability of necessary public infrastructure would also lead to inflationary pressures, and lack of competitiveness.

2.4.4 Meeting the Infrastructure Deficit

Among the key concerns that businesses in India, as also foreign investors, face are those related to infrastructure, where there are significant gaps. In fact, the critical constraint to economic growth in India in recent years has been the infrastructure deficit. The Eleventh Plan document has estimated that to accelerate GDP growth at 9 per cent per annum during the Plan period, there is a need to accelerate the current level of investment in infrastructure at 5.0 per cent of GDP during 2006-07 to 9.0 per cent during the Plan period. Given the governance structure, policy uncertainty and lack of stricter entry and exit norms prevalent in the country, achieving this infrastructure target will be a challenge.

An investment requirement of roughly Rs.22,50,000 crore has been projected as financing requirements for physical infrastructure (comprising roads, power, telecom, railways, airports and ports). Out of this, an amount of roughly Rs.6,75,000 crore is to be funded by the private sector. With budgetary resources limited, the government has sought to foster a policy and procedural environment that actively encourages public-private partnerships (PPP). Additional efforts would bolster the PPP framework: strong and independent sector regulators would reduce regulatory uncertainties for investors, while developing domestic bond markets would facilitate infrastructure finance.

Sustained growth in private sector infrastructure investment can take place in only those sectors which are financially viable and exhibit adequate returns. The robust performance of the telecom sector has reflected this. A renewed focus on the levy of adequate user charges will therefore be necessary, along with policy measures that provide stability to the flow of infrastructure revenues.

There has been a paradigm shift in infrastructure funding from the government to the private sector mainly due to budgetary constraints in making funds available to meet the burgeoning financing requirements and the expected higher efficiency of the private sector. In addition, the emphasis on allocating budgetary resources to social sectors has also engendered this shift. As a result, the emphasis has shifted towards public-private partnerships (PPPs) and, increasingly, it is perceived that commercial entities such as banks could play an important role in this respect. Although the argument is not without its merits, there are significant challenges for the banking sector in funding the growing infrastructure need. It is estimated that debt finance for infrastructure would have to increase by more than 2.5 times a year on average during the next five years.

There are issues of asset-liability mismatch as the maturity of banks’ assets has become longer term while their liabilities have become shorter. Banks will also reach exposure limits to large developers. Lending by Non-Banking Finance Companies (NBFCs) will be constrained, as they rely to a large extent on unsecured borrowings and to a certain extent on commercial banks for their funding – and the cost would be higher due to prudential requirements for bank lending to NBFCs. External Commercial Borrowing has to be managed prudently, in keeping with resulting macroeconomic vulnerabilities and desirable levels of capital flows. The investment by insurance companies in infrastructure companies is constrained by their investment guidelines.

All this points to the urgency in getting additional sources of debt financing for infrastructure investment – and increasing private participation/ financing – towards the goal of 9 per cent of GDP investment in infrastructure. This requires some shift from the bank-dominated financing system to a market-based one for financing infrastructure and housing projects, which would depend upon the development of an active corporate bond market. This requires the active development of domestic institutional investors. Reforms in the pension and insurance sectors will help in such institutional development so that pension funds and insurance companies can progressively acquire adequate size to become substantial investors in the domestic corporate market. Development of the municipal bond market, mortgage backed securities and the like would also be needed.

2.4.5 Challenges in Reaping the Demographic Dividend

It has been argued that as increasing numbers of people join the workforce in India, this will entail greater savings, as it did in other countries in East Asia that developed rapidly, where the greater bulge within the labour force created additional growth. While this is a favourable factor in sustaining productivity-led growth, there is need for rapid job creation, particularly in the hinterland states and the coastal areas. The employment growth rate (based on current daily status) accelerated from 1.25 per cent per annum during the period 1993-94 to 1999-2000 to 2.62 per cent during the period 1999-2000 to 2004-05. Because of the growing labour force, the unemployment rate (based on current daily status) rose from 7.31 per cent to 8.28 per cent during the same period. The overwhelming majority of the labour force continues to work in agriculture. The challenge going forward will be to create jobs on a scale needed to successfully absorb excess agricultural labour and the rapid increase in the labour force over the next decade. Investments in social sectors like education and health should receive particular attention.

2.4.6 International Oil Prices

As India is primarily an oil-importing country, oil prices constitute a critical element in the sustainability of the Indian growth process and maintenance of financial stability. An analysis by BIS in 2007 estimates that a supply-induced doubling of prices would raise the inflation rate in emerging Asia by as much as 1.4 percentage points above the baseline. International crude oil prices have risen sharply since June 2007, reflecting a tight supply-demand balance, geo-political tensions, the weakening of the US dollar against major currencies and increased interest from investors and financial market participants. Oil prices have of late moderated significantly due to expected deceleration in global economic activity.

The pass-through of international oil prices to domestic inflation is somewhat constrained because of the government’s policy of price controls and cross-subsidies. But, this builds up pressures in the future. Apart from the inflationary pressure, any rise in international oil prices will have potential implications for the current account deficit and the exchange rate. If domestic prices are not raised commensurately, the rise in international crude prices will adversely affect the financial performance of domestic oil companies. This may necessitate further financial support to the oil companies from the Government, which would cause a strain on government finances.

The CFSA recognises, however, that adjustments in domestic oil prices to changes in international prices need to consider the volatility aspects, distinguishing between temporary spikes as happened recently and an enduring trend of rising prices. In the absence of any stabilisation funds, such adjustment mechanisms including special market operations by the Reserve Bank help tide over external shocks that impact the stability of local markets. With high exposure to oil imports that is combined with a widespread impact on the domestic economy, a more efficient use of oil products is warranted, such as thoroughly improved public transportation systems. New investments in upgrading public transport systems would not only contain the high dependency on oil, but also have positive externalities in terms of curbing climate change emissions.

2.4.7 Food Prices

Besides the oil price volatility, another major concern both domestically and globally has been the rise in food prices. However, the recent increase in food prices in India has been a fraction of that observed in many other countries. For example, the global prices of wheat and rice almost doubled between January and April 2008, while in India the increase has been less than one-tenth of that. Yet, the prices of food articles increased in India in 2006 and 2007, though moderated somewhat in 2008.

As regards prospects for the near future, public policies in regard to food, especially diversion to bio-fuel, cross-border trading, subsidies, and replenishment or use of buffer stocks would impact the evolution of prices globally. As regards India, on the supply side some abatement of global prices, the indication of better domestic supplies and addition to our buffer stocks, along with the series of measures already taken by the government are expected to yield results in the months to come.

2.4.8 Managing the Impact of Capital Inflows

Foreign investment flows into India, comprising foreign direct investment (FDI) and foreign portfolio investment (FPI), rose sharply during the 1990s reflecting the policies to attract non-debt creating flows. Net capital flows to India increased sharply to US $ 108.0 billion (or 9.2 per cent of GDP) during 2007-08, which was 2.4 times higher than the level in 2006-07. Both direct and portfolio investment flows by and large have maintained this pace in recent periods. Foreign direct investment flows into India were 50.5 per cent higher during 2007-08 on the back of a positive investment climate, improved growth prospects and initiatives aimed at liberalising the FDI policy and simplifying the procedures. Updated information on capital flows shows that net FDI flows and capital issues under American Depository Receipts (ADRs)/Global Depository Receipts (GDRs) continued to support capital inflows. Gross FDI inflows increased to US $ 34.4 billion in 2007-08 from US $ 22.8 billion in the previous year. In 2008-09, however, there has been a reversal in capital flows as net FII outflows were to the tune of US$ 11.9 bn. (till January 9, 2009). Based on the duration of the crisis, India may continue to face further outflows. There has also been a depreciation in the USD/Rupee exchange rate and a decline in stock market indices.

A success story in the Indian reforms process has been the gradual opening of the economy. On the one hand, trade liberalisation and tariff reforms have provided Indian companies with increased access to the best inputs available globally at almost world prices. On the other hand, the gradual opening has enabled Indian companies to adjust adequately to be able to compete both in world markets and with imports in the domestic economy. The performance of the corporate sector in both output growth and profit growth in recent years is testimony to this. It is therefore necessary to continue with the tariff reforms until India reaches world levels, beyond the current stated aim of reaching the levels of the Association of South East Asian Nations (ASEAN).

While the capital inflows eased the external financial constraint, they posed dilemmas for the conduct of monetary policy. Under the circumstances, the objectives of containing exchange rate volatility and the maintenance of orderly conditions in the foreign exchange market become difficult to achieve. More particularly, if capital inflows outstrip the demand for foreign exchange, the appreciation of the domestic currency often necessitates interventions by the central bank to drain off the excess supply of foreign currency. In doing so, the accretion to official reserves implies an immediate expansion in primary money supply with attendant consequences for maintaining price stability. In this context, judgements have to be made whether capital flows are of an enduring nature or temporary, which are difficult to make ex-ante. The judgement about excess volatility will depend not merely on the quantity of the flow, but to some extent on the quality in terms of components of the capital flow. Although the immediate focus could be on managing capital inflows, far in excess of the financing needs of the current account, and some volatility in regard to the excess, it would be prudent not to exclude the possibility of some change in course due to any abrupt changes in sentiments or global liquidity conditions as happened in mid-September 2008. Strategic management of the capital account would warrant preparedness for all situations. The significant changes experienced in capital flows in 2007-08 and in 2008-09 illustrate the volatile nature of such flows and the need for judicious capital account management consistent with the extant stance on monetary policy.

India’s approach to the capital account has consistently made a distinction between debt and equity, with greater preference for liberalisation of equity markets vis-à-vis debt markets. Equity markets provide risk capital, which can be beneficial for growth. On the other hand, opening the domestic debt markets to foreign investors in the face of inflation and interest differentials, as is the case in India at present, can lead to large movements of arbitrage capital. In view of higher domestic nominal interest rates, open debt markets can attract a large amount of capital flows and further add to the existing volume of capital flows, which are in any case well above the current account financing needs of the country. If the debt markets were open, such excess capital flows would have to be necessarily sterilised by the Reserve Bank in order to maintain domestic macroeconomic and financial stability. This would further add to the sterilisation costs already being borne by the country’s financial sector and the Government. Thus, debt flows into India are subject to ceilings; such ceilings would be appropriate until wedges on account of higher inflation and interest rates narrow significantly over time. When reversal of sentiment takes place, as has happened in 2008, such flows also reverse rapidly; thus caution in operating foreign debt flows needs to be exercised.

Mr. V. Sundararajan, the peer reviewer for Financial Stability and Stress Testing, has commented that greater emphasis could and should be placed on the role further capital account liberalisation (CAL) can play in strengthening domestic financial markets. He has added that the sequencing and prioritisation of capital account policies and the associated prudential measures can be driven by the priorities for the development of domestic financial markets and need not be phased in over time mainly on the grounds of caution. He has mentioned that assuming that the measures to liberalise external capital flows and the associated prudential safeguards are implemented in tandem, a well-sequenced move towards fuller capital account can be a powerful financial sector development tool. Mr. Andrew Sheng has commented that the development of the capital market would play a major role when the rupee becomes more internationalised, which is a matter of time. It is therefore important to build this on a solid foundation while macroeconomic conditions remain favourable due to the young demographics and growing savings.

The CFSA recognises the role of capital account liberalisation in promoting growth among resource-constrained developing countries which need external capital to sustain an excess of investment over domestic saving. Financial openness fosters market efficiency by enabling residents to base investment and consumption decisions on world interest rates and prices. CAL also offers the opportunity of using the world market to diversify the portfolios of savers and investors. While the CFSA concurs with the broad thrust, there now appears to be a broad consensus that CAL is desirable, but should be gradual, well-sequenced and undertaken in conjunction with several other measures at the micro and macro level. Several policy areas have been identified as being critical to the future health of global monetary and financial systems. There is certainly an implicit recognition that the net benefits from liberalisation of capital account in respect of any developing country would be enhanced if complementary policies are followed. While the Panel supported a general policy stance that encourages the liberalisation of CAL, this should be done strategically to help the evolution of the Indian financial markets in alignment with concomitant improvements in macro-economic management. Among the more important of these are: fiscal consolidation, sustained reduction in inflation to international levels, strengthening the banking system, diversifying financial intermediation through both banks and non-banks, and strengthening the regulation of financial markets.

2.5 Linkages between Macroeconomic Performance and Financial Stability

The macroeconomic shocks through vulnerability factors as listed above can be real or financial in nature. Shocks to the system influence financial institutions’ balance sheets through the conventional channels of credit and market risk. They also affect the balance sheets of institutions through financial markets and asset prices. Both effects may amplify the first-round balance sheet impact, in particular liquidity and network effects. Taken together, all these channels can then translate into a final impact on balance sheets, causing risks to financial stability.

The resilience of the financial system can be tested by subjecting the system to stress scenarios. Stress tests at the level of individual institutions have been widely applied by internationally active banks since the early 1990s. In addition to applying stress tests to the portfolios of individual institutions at the micro level, stress testing is also assuming an increasingly important role in macro-prudential analysis. The main objective of an aggregate stress test is to help public authorities identify those structural vulnerabilities and overall risk exposures in a financial system that could lead to systemic problems.

In the above context, Mr. V. Sundararajan has commented that from a stability assessment perspective, the analysis of macroeconomic and external environment and sectoral developments should be systematically and explicitly linked to an assessment of the likelihood of shocks from the economy that are likely to impact the financial system. Ideally, stress scenarios need to be linked to a macroeconomic framework. Sometimes, macro-econometric or simulation models can be used to formulate forward-looking and internally consistent sets of values for key variables that define a stress scenario.

While the Advisory Panel was broadly in agreement with the above approach and recognises the importance of stress tests that reflect system resilience to one-time shocks, an important issue in stress testing is determining the yardsticks when setting the ranges of shock variables. In India, stress-testing scenarios tend to be hypothetical due to the lack of past data on benchmarks. To get a more realistic view, there is a need to construct scenarios which are combinations of shock variables; however, the correlations among such variables need to be considered when constructing the scenarios. Hence, as in many other countries, macro stress testing in India is constrained by data availability and lack of a comprehensive macroeconomic model. In view of its importance for monetary and financial stability, there is a need to put in place a macroeconomic stress testing framework for assessment and surveillance on a regular basis.

While the Panel on Financial Stability Assessment and Stress Testing has addressed several areas of potential vulnerability by highlighting downside risks to stability at the current juncture, due to logistical and data constraint factors it has not attempted a quantitative stress test that builds upon the linkages between financial institutions’ performance to macroeconomic shocks. In the next chapter the results of stress tests to certain shocks have been presented on the basis of single factor analysis. The Panel has however recommended that future assessment should incorporate more comprehensive stress tests that link institutional balance sheets to identified macroeconomic shocks. The CFSA concurs with this proposal.

2.6 Financial Development Index 2008 Rankings – Strengths and Weaknesses of the Indian Financial System

The World Economic Forum, a think-tank, undertook a research initiative aimed at providing business leaders and policymakers with a common framework to identify and discuss the key factors in the development of global financial systems and markets. This inaugural Financial Development Report provides an Index and ranking of 52 of the world’s leading financial systems. As a prelude to the financial sector assessment that follows, the CFSA felt that it would be useful to summarise aspects of the strengths and weaknesses as revealed from India’s rankings under each pillar.

The analysis, covering over 120 different data sets, has been grouped into seven major pillars which form the foundation of the index, viz., institutional environment, business environment, financial stability, banks, non-banks, financial markets, and size, depth and access.

2.6.1 Overall Ranking

India is placed 31^st in terms of its overall ranking. As per the Report, while India delivered solid results in terms of its financial markets (particularly foreign exchange and derivatives) and its non-bank institutions, its banks appeared hamstrung by their small size, low efficiency and poor information disclosure. Despite this, the banking system has been considered very stable (ranked 5^th) likely owing in part to sizeable capital buffers that help it weather credit cycles. As per the Report, the business environment shows significant room for development, characterised by an inhospitable tax regime and relatively poor contract enforcement. India has received low marks and rankings in relation to the liberalisation of its domestic financial sector and capital account. The quality of India’s higher education institutions is apparent as seen in the high score for the quality of management schools (ranked 8^th).

Among comparable countries, countries that were ranked higher than India include Malaysia (20), China (24) and Thailand (29), while countries that were ranked lower than India covered Pakistan (34), Indonesia (38) and the Philippines (48). Almost all Latin American countries, despite their financial openness, were ranked at the lower end of the spectrum ranging from 40 (Brazil) to 47 (Argentina).

India ranked above average in four out of seven pillars (Table 2.2). Below-average areas included institutional and business environment, and banks. The individual elements within the major pillars on which India is ranked relatively strong in the range of 1 to 10 are summarised in Table 2.3.

2.7 Concluding Observations

In spite of the current blips, the evidence indicates that the economy has moved firmly to a higher growth trajectory. Macroeconomic fundamentals continue to inspire confidence and the investment climate provides reasons for optimism. The change in growth trend also means that the economy needs to adequately prepare itself to meet incipient and ongoing challenges.

Going forward, it is essential to continue with focussed attention on achieving balance between financial development and financial stability. The key to maintaining high growth with reasonable price stability lies in rapid capacity additions through investments, productivity improvements, removal of infrastructure bottlenecks and amelioration of skill shortages. While monetary policy will continue to play a critical role in maintaining price stability, the sustainability of high growth with moderate inflation will depend critically on bolstering the twin pillars of growth, namely, fiscal prudence and high investment; and improving the effectiveness of government intervention in critical areas such as agriculture, education and health in the quest for more inclusive growth. The oil and food price shocks could result in an increase in inflationary pressures and this, along with management of capital flows, could emerge as a major challenge for policymakers. Though the inflation has started showing a decline consequent to softening of energy, commodity and food prices very recently, the increased volatility in prices, along with manifestations in the financial sector will have the effect of causing a slowdown in global economic activity in major economies during 2008-09.

Table 2.2: India’s Ranking Under Financial Development Index
Pillar		Ranking
Pillar		Above Average (11-31)	Below Average (32-52)
1.	Institutional Environment	-	43
2.	Business Environment	-	45
3.	Financial Stability	28	-
4.	Banks	-	50
5.	Non-banks	16	-
6.	Financial Markets	22	-
7.	Size, depth and access	28	-
Source: Financial Development Report, 2008, World Economic Forum.

Table 2.3: India’s Ranking under Individual Elements within the Major Pillars
Element	Rank	Element	Rank
Risk of systemic banking crisis	5	Share of World IPOs	6
Shareholder rights index	1	Share of total number of M&A deals	9
Quality of management schools	8	Real growth of direct insurance premiums	1
Quality of math and science education	9	Share of total securitisation deals	9
External debt to GDP	3	Public debt to GDP	7
Activity restriction for banks	8	Ease of access to credit	10
Capital restriction for banks	4	Ease of access to local equity market	10
Stability index	1	Ease of access to local equity market	10
Source: World Economic Forum - Financial Development Report-2008. Detailed ranking of India under all the elements is provided in Annex I.

While financial sector reforms and development have considerably improved the system’s resilience in India and the country has weathered both domestic and external shocks without any major adjustment thus far, the CFSA believes that reforms in the financial sector are a continuous process of responding to evolving circumstances and they should move in tandem and at times ahead of real sector responses. In a transition economy like India’s, the leading role of supply in the development of the financial sector will continue to be relevant and government and regulators would thus continue to play a proactive role in that process. The findings and recommendations that follow should be viewed in that context.

Annex I
Financial Development Index: India’s Ranking (Figures in parentheses indicate rank amongst 52 countries)
FACTORS, POLICIES, AND INSTITUTIONS
1st pillar: Institutional environment Overall Rank – 43
Capital Account Liberalisation (Overall Rank – 46)
1.01	Capital Account liberalisation	Below Average (46)
Corporate Governance (Overall Rank – 20)
1.02	Extent of incentive-based compensation	Below Average (32)
1.03	Efficacy of corporate boards	Above Average (25)
1.04	Reliance on professional management	Above Average (21)
1.05	Willingness to delegate	Above Average (23)
1.06	Strength of auditing and accounting standards	Above Average (21)
1.07	Shareholder rights index	Strong area (1)
1.08	Ethical behaviour of firms	Below Average (34)
1.09	Protection of minority shareholder’s interests	Above Average (21)
Legal and Regulatory Issues (Overall Rank – 28)
1.10	Burden of government regulation	Below Average (32)
1.11	Centralisation of economic policy-making	Above Average (18)
1.12	Regulation of security exchanges	Above Average (23)
1.13	Property rights	Above Average (27)
1.14	Intellectual property protection	Above Average (29)
1.15	Diversion of public funds	Below Average (34)
1.16	Public trust of politicians	Below Average (38)
Contract Enforcement (Overall Rank – 49)
1.17	Effectiveness of law-making bodies	Above Average (15)
1.18	Judicial independence	Above Average (18)
1.19	Irregular payments of judicial decisions	Above Average (30)
1.20	Number of procedures to enforce a contract	Below Average (48)
1.21	Time to enforce a contract	Below Average (51)
1.22	Cost of enforcing contracts	Below Average (46)
1.23	Strength of investor protection	Above Average (17)
1.24	Time to close a business	Below Average (51)
Domestic Financial Sector Liberalisation (Overall Rank – 38)
1.25	Domestic financial sector liberalisation	Below Average (38)
2nd pillar: Business environment		Overall Rank – 45
Human Capital (Overall Rank – 33)
2.01	Quality of management schools	Strong area (8)
2.02	Quality of math and science education	Strong area (9)
2.03	Extent of staff training	Above Average (23)
2.04	Local availability of research and training services	Above Average (24)
2.05	Brain drain and use of hiring foreign labour	Below Average (37)
2.06	Tertiary enrollment	Below Average (49)
Taxes (Overall Rank – 45)
2.07	Irregular payments in tax collection	Below Average (45)
2.08	Distortive effect on competition of taxes and subsidies	Below Average (39)
2.09	Corporate tax rate	Below Average (39)
Infrastructure (Overall Rank – 49)
2.10	Quality of overall infrastructure	Below Average (41)
2.11	Quality of telephone/fax infrastructure	Above Average (23)
2.12	Internet users	Below Average (44)
2.13	Broadband internet subscribers	Below Average (47)
2.14	Telephone lines	Below Average (50)
2.15	Mobile telephone subscribers	Below Average (52)
Cost of Doing Business (Overall Rank – 47)
2.16	Cost of starting a business	Below Average (50)
2.17	Cost of dealing with licenses	Below Average (44)
2.18	Cost of registering property	Below Average (45)
2.19	Cost to export	Above Average (22)
2.20	Cost to import	Below Average (46)
2.21	Cost of enforcing contracts	Below Average (46)
2.22	Cost of closing a business	Above Average (18)
3rd pillar: Financial Stability Overall Rank – 28
Risk of a Currency Crisis (Overall Rank – 13)
3.01	Change in real effective exchange rate	Above Average (15)
3.02	External vulnerability indicator	Above Average (26)
3.03	Current account balance to GDP	Below Average (40)
3.04	Dollarisation vulnerability indicator	Above Average (24)
3.05A	External Debt to GDP (developing economies)	Strong area (3)
3.05B	Net international investment position to GDP (advanced economies)	n/a
Risk of Systemic Banking Crisis (Overall Rank – 5)
3.06	Activity restrictions for banks	Strong area (8)
3.07	Entry restrictions for banks	Below Average (33)
3.08	Capital restrictions for banks	Strong area (4)
3.09	Official supervisory power	Above Average (24)
3.10	Private monitoring of the banking industry	n/a
3.11	Frequency of banking crises	Above Average (12)
3.12	Stability Index	Strong area (1)
3.13	Cumulative real estate appreciation	n/a
Risk of Sovereign Debt Crisis (Overall Rank – 39)
3.14	Local currency sovereign rating	Below Average (41)
3.15	Foreign currency sovereign rating	Below Average (38)
FINANCIAL INTERMEDIATION
4th pillar: Banks Overall Rank – 50
Size index (Overall Rank – 48)
4.01	Size index	Below Average (48)
Efficiency index (Overall Rank – 41)
4.02	Efficiency index	Below Average (36)
4.03	Public ownership of banks	Below Average (33)
Financial Information Disclosure (Overall Rank – 45)
4.04	Public credit registry coverage	Above Average (21)
4.05	Private credit bureau coverage	Below Average (34)
4.06	Credit Information Index	Below Average (31)
5th pillar: Non-banks Overall Rank – 16
IPO Activity (Overall Rank – 12)
5.01	IPO market share	Above Average (13)
5.02	IPO proceeds amount	Above Average (21)
5.03	Share of world IPOs	Strong area (6)
M&A Activity (Overall Rank – 16)
5.04	M & A market share	Above Average (13)
5.05	M & A transaction value to GDP	Above Average (25)
5.06	Share of total number of M & A deals	Strong area (9)
Insurance (Overall Rank – 21)
5.07	Insurance premiums, direct	Above Average (14)
5.08	Insurance density (43)	Below Average (43)
5.09	Real growth of direct insurance premiums	Strong area (1)
5.10	Insurance penetration	Above Average (23)
5.11	Relative value-added of insurance	Above Average (25)
Securitisation (Overall Rank – 13)
5.12	Securitisation to GDP	Above Average (24)
5.13	Share of total number of securitisation deals	Strong area (9)
6th pillar: Financial Markets Overall Rank – 22
Foreign Exchange Markets (Overall Rank – 13)
6.01	Spot foreign exchange turnover	Above Average (13)
6.02	Outright forward foreign exchange turnover	Above Average (11)
6.03	Foreign exchange swap turnover	Above Average (17)
Derivatives Market (Overall Rank – 14)
6.04	Interest rate derivatives turnover: Forward rate agreements	n/a
6.05	Interest rate derivatives turnover: Swaps	Above Average (18)
6.06	Interest rate derivatives turnover: Options	n/a
6.07	Foreign exchange derivatives turnover: Currency Swaps	Above Average (11)
6.08	Foreign exchange derivatives turnover: Options	Strong area (9)
Equity Market Development (Overall Rank – 25)
6.09	Equity market turnover	Above Average (17)
Bond Market (Overall Rank – 37)
6.10	Private-sector bonds to GDP	Below Average (32)
6.11	Public-sector bonds to GDP	Above Average (19)
6.12	International bonds to GDP	Below Average (48)
CAPITAL AVAILABILITY AND ACCESS
7th pillar: Size, Depth, and Access Overall Rank – 28
Size and Depth (Overall Rank – 29)
7.01	M2 to GDP	Above Average (19)
7.02	Private debt to GDP	Below Average (40)
7.03	Public debt to GDP	Strong area (7)
7.04	Bank deposits to GDP	Above Average (28)
7.05	Stock market capitalisation to GDP	Above Average (25)
7.06	Relative value-added of financial institutions to GDP	Above Average (14)
7.07	Private credit to GDP	Below Average (32)
7.08	Stock market value traded to GDP	Above Average (19)
Access (Overall Rank – 26)
7.09	Financial market sophistication	Above Average (26)
7.10	Venture capital availability	Above Average (21)
7.11	Ease of access to credit	Strong area (10)
7.12	Ease of access to local equity market	Strong area (10)
7.13	Bank branches	Below Average (38)
7.14	Ease of access to loans	Ab4ove Average (25)

Chapter III

Financial Institutions

3.1 Introduction

The Indian financial sector is still dominated by bank intermediation. Though the size of the capital market has expanded significantly with financial liberalisation in the early 1990s, bank intermediation remains the dominant feature. This chapter which addresses performance and stability aspects of financial institutions is divided into seven sections covering commercial banks, urban co-operative banks (UCBs), rural financial institutions, non-banking financial companies (NBFCs), housing finance companies (HFCs), Development Financial Institutions (DFIs) and the insurance sector. In addition to the various Panel Reports, the chapter draws on significantly from the Reserve Bank’s Report on Currency and Finance 2006-08, which delineates the various existing and emerging challenges faced by the banking sector and suggests measures to address them as also benchmarks, wherever possible, the performance/practices of the Indian banking sector against international best practices.

Commercial banks are the dominant institutions in the Indian financial landscape accounting for around 60 per cent of its total assets (Chart 3.1).

Though public sector banks (PSBs) account for around 70 per cent of commercial banking assets, competition in the banking sector has increased in recent years with the emergence of private players as also with greater private shareholding of PSBs. Listing of PSBs on stock exchanges and increased private shareholding have also added to competition. The new private banks which accounted for 2.6 per cent of the commercial banking sector in March 1997 have developed rapidly and accounted for nearly 17 per cent of the commercial banking assets by end-March 2008. Together with cooperative banks, the banking sector accounts for nearly 70 per cent of the total assets of Indian financial institutions.

The insurance sector, the second largest group of institutions, has also been opened up to private competition in recent years. The life insurance industry has reported compounded annual growth rate (CAGR) of 25.2 per cent during the period 2000-01 to 2007-08. A significant portion of the growth in the life insurance industry has been savings linked insurance products in the last few years. The non-life insurance segment has reported CAGR of 45.3 per cent during the period 2000-01 to 2007-08.

Non-banking financial companies (NBFCs) are witnessing robust growth mainly on the back of the high growth registered in its non-deposit taking segment. The assets under management of mutual funds has also increased significantly.

Over the past decade, financial institutions in India have benefited from a stable macroeconomic environment, with sustained growth especially from 2003 onwards when India recorded one of the highest GDP growth rates (CAGR of 8.8 per cent between 2003-08) in the world. This strong growth in the economy was accompanied generally by an acceptable level of inflation except for the temporary spike in inflation in 2008. Financial sector reform, which has been gradual and calibrated, has helped financial institutions to weather various global financial turmoils during the past ten years. This resilience is also currently evident, as the Indian financial sector has so far not been severely affected by the financial turbulence in advanced economies. There is, however, no room for complacency and the increasing global uncertainties need to be watched and guarded against appropriately. However, India has been affected by the crisis inasmuch as there has been drying up of capital flows with its resultant effect on the equity market and the rupee has depreciated against the US dollar. This, in turn, had an impact on overall liquidity in the system.

Financial institutions have transited since the mid-1990s from an environment of an administered regime to a system dominated by market-determined interest and exchange rates, and migration of the central bank from direct and quantitative to price-based instruments of monetary policy and operations. However, increased globalisation has resulted in further expansion and sophistication of the financial sector, which has posed new challenges to regulation and supervision, particularly of the banking system. In this context, the capabilities of the existing regulatory and supervisory structures also need to be assessed by benchmarking them against the best international practices.

The assessment of financial institutions has been undertaken by the Advisory Panels from two different perspectives. First, an analysis of the performance and resilience of the institutions has been carried out by the Advisory Panel on Financial Stability Assessment and Stress Testing. This has been supplemented with an assessment of the observance of Basel Core Principles (BCPs) in regulating and supervising these institutions by the Advisory Panel on Financial Regulation and Supervision (Box 3.1). The focus of the entire exercise has been on identifying issues and vulnerabilities which need to be addressed in the interest of bringing about continuous improvement in the sector and enabling it to adapt to emerging challenges.

Box 3.1: Basel Core Principles for Banking Regulation and Supervision

The Basel Committee on Banking Supervision had developed the core principles methodology in October 1999 which was subsequently revised in October 2006. It set international standards for benchmarking sound prudential regulation and supervision of banks. The 25 Core Principles are broadly classified into seven categories. Each BCP contains essential criteria for the system to be considered effective. The extent of fulfillment on essential criteria decides the observance status of each principle – compliant, largely compliant, materially non-compliant and non-compliant. The 25 BCPs are enumerated below:

Category I: Objectives, autonomy and resources

Principle 1: Objectives, independence, powers, transparency and co-operation.
This principle deals with (i) responsibilities and objectives of supervisor; (ii) independence, accountability and transparency of supervisor; (iii) legal framework; (iv) enforcement powers; (v) adequate legal protection for supervisors; and (vi) information sharing.

Category II: Licensing powers

Principle 2: Deals with permissible activities of banks.
Principle 3: Deals with licensing criteria and licensing process.
Principle 4: Requires supervisors to review and have the power to reject significant transfer of ownership of banks.
Principle 5: Requires supervisors to review major acquisitions and investments by banks.

Category III: Prudential requirements and risk management

Principle 6: Deals with minimum capital adequacy requirements.
Principle 7: Deals with identification, evaluation, monitoring and control of all risks.
Principle 8: Deals with identification, evaluation and monitoring of credit risk.
Principle 9: Sets out requirements for evaluating asset quality and adequacy of loan loss provisions and reserves.
Principle 10: Sets forth rules for identifying and limiting concentrations of exposures to single borrowers or groups of related borrowers.
Principle 11: Sets out rules for lending to related parties.
Principle 12: Deals with identification, evaluation and monitoring country and transfer risk.
Principle 13: Deals with identification, evaluation and monitoring market risk.
Principle 14: Deals with identification, evaluation and monitoring liquidity risk.
Principle 15: Deals with identification, evaluation and monitoring operational risk.
Principle 16: Deals with identification, evaluation and monitoring interest rate risk in banking book.
Principle 17: Calls for banks to have adequate internal control systems.
Principle 18: Sets out rules for prevention of abuse of financial services.

Category IV: Methods of ongoing supervision

Principle 19: Deals with developing and maintaining thorough understanding of operations of individual banks and banking groups.
Principle 20: Defines overall framework for on-site and off-site supervision.
Principle 21: Sets out requirements of off-site supervision.

Category V: Accounting and disclosure

Principle 22: Accounting policies and practices to be followed for preparation of accounts.

Category VI: Corrective and remedial measures

Principle 23: Requires supervisor to have and promptly apply adequate remedial measures for banks when they do not meet prudential requirements.

Category VII: Consolidated supervision

Principle 24: Requires supervisor to apply global consolidated supervision over internationally active banks.
Principle 25: Requires supervisors to establish contact and exchange information with other supervisors/host country authorities.

Source: Basel Committee on Banking Supervision, October 2006.

The Advisory Panel on Financial Stability Assessment and Stress Testing conducted a comprehensive assessment of the financial institutions through a macroprudential analysis to assess the soundness and stability of the financial institutions. Subject to availability of data, this was supplemented by system-level single factor stress tests to assess the resilience of the financial institutions. Stress tests have been conducted for commercial banks, scheduled urban co-operative banks and the insurance sector. Based on this assessment, the Advisory Panel suggested various measures to strengthen the institutions from a medium-term perspective. The Report of the Panel was peer reviewed by Mr. V. Sundararajan, former Deputy Director, IMF and Mr. Andrew Sheng, former Chairman of Hong Kong Securities and Futures Commission.

Mr. Sundararajan broadly concurred with the conclusions in the Report and found the scope and comprehensiveness of the assessments, and their technical quality to be impressive. His comments pertained mainly to the methodology and partly to the substance and structuring of the report. He observed that while the methodology for stress testing is broadly in line with that in the IMF’s FSAP Handbook, the plausible shocks and vulnerabilities arising from domestic macroeconomic and external sectors should be systematically linked to the formulation of a set of stress scenarios. Moreover, the macroeconomic and institutional determinants of financial soundness indicators have not been clearly spelt out in some instances, and the likely evolution of Financial Soundness Indicators (FSIs) in response to various shocks needs further analysis. He was of the view that due to the growing use of purchased funds to support asset expansion, the analysis of second-round contagion effects – by stress testing the data on a matrix of bilateral inter-bank exposures – should be further developed. He mentioned that the identified sources of risks and vulnerabilities in the financial system should be systematically linked to assessments of supervision and regulation.

Mr. Andrew Sheng commended the Indian authorities on their achievements in reforming the Indian financial system and the fact that India has not gone through any financial crisis as a result of financial deregulation. He agreed with the analysis that there are challenges for the banking system to fund infrastructure needs, as is the need to develop the corporate bond market. He was of the view that the real issue is how to engineer a stable shift in the financial sector from a bank-dominated system to a capital market-oriented system, so that long-term funding is available to finance the long-term needs of the economy, such as housing and infrastructure. This would call for greater development of the pension and social security systems in preparation for an ageing population, as well as the creation of a secondary mortgage market for India. He observed that the development of the capital market would play a major role when the rupee becomes more internationalised. He supported the encouragement of consolidation through mergers and acquisitions of private banks and public sector banks (PSBs). He suggested that macroprudential regulation should start using more quantity-based instruments than hitherto to protect banks against asset bubbles. With regard to the performance of financial institutions, he was of the view that risk management is inextricably linked with governance and that as long as pay is constrained, PSBs may lose valuable staff with entrepreneurial skills to the higher-paying private financial institutions. On the issue of 51 per cent state ownership constraint he opined that as a ‘transition’ to a more market-oriented PSB environment, as long as the state plus public pension funds owns more than 51 per cent, public pension funds could be counted as ‘state’. On liquidity, he mentioned that as long as banks held more than 25 per cent government paper, they have more than enough liquidity since Indian banks are not yet at the ‘originate to distribute’ model, which requires almost total reliance on central bank’s lender of last resort facilities to anchor individual bank liquidity. To avoid a repeat of the sub-prime type of problem, he recommended that bank supervisors should use more stress tests by individual institutions, supplemented by system-wide modelling of liquidity using different levels of margins and risk spreads. Also, the on-site examination process should be supplemented by a forensic ‘follow the evolution of the product’ approach.

While BCPs, in a strict sense, are applicable only to commercial banks, the Advisory Panel on Financial Regulation and Supervision had made an attempt to extend the principles, as relevant and applicable, to other categories of financial institutions, viz., co-operative banks and NBFCs, including housing finance companies (HFCs). In the case of NBFCs, the Advisory Panel felt that the assessment was useful because NBFCs provide services similar to banks, are potential conduits in spreading systemic risk, and there is scope for regulatory arbitrage between NBFCs and banks. The assessment could also throw up developmental issues which, if implemented, could strengthen the regulation and supervision of NBFCs. As regards housing finance companies, the Panel felt the need to assess BCP compliance in HFCs in view of the contagion of HFCs to banks through borrowings. Also, risk-based capital requirements for HFCs are similar to the Basel-stipulated norms. Further, there is scope for regulatory arbitrage between HFCs and banks.

Mr. Eric Rosengren, President, of the Federal Reserve Bank of Boston and the peer reviewer of the Report on Basel Core Principles prepared by the Advisory Panel on Financial Regulation and Supervision, noted that the assessment provides many useful insights into the Indian financial and banking systems. He was particularly happy to note that the report has recognised the critical need to attract and retain top-quality staff to serve in the supervisory and regulatory community. He felt that another key contribution of the report was that it pointed out the urgent need to improve co-operation among the regulatory agencies and suggested streamlining theoverall regulatory infrastructure in the long run. He also appreciated the report’s recognition of the need to tailor the regulatory programme to fit the Indian financial system. He laid stress among other things on careful management of liquidity risk, issues relating to operational risk arising from usage of complex instruments and monitoring of conglomerates. The Panel incorporated the comments of Mr. Rosengren appropriately in its report.

The CFSA notes that though BCPs are not strictly applicable to financial institutions other than commercial banks, the Advisory Panel’s efforts to extend the scope of BCP assessment to other sectors are commendable in the current context of the potential linkages of such institutions and their impact on the stability of the financial system. The Reserve Bank has already been extending such principles to non-bank entities, subject to certain thresholds and the nature of their operations. As regards the recommendations made by the Panel for convergence of status to BCP, the CFSA feels that the Reserve Bank should closely examine the rationale provided by the Panel and evaluate the necessity to move into tighter or fresh guidelines particularly taking into account their relevance from the perspective of systemic stability.

The CFSA also feels that the present global financial crisis has highlighted the limitations of the present Basel Core Principles inasmuch as the assessment does not specifically cover areas like SIVs/NBFCs or aspects like dynamic provisioning and countercyclical norms. Hence, the CFSA feels that the Basel Committee on Banking Supervision should revisit the Basel Core Principles to cover the new areas.

The regulation and supervision of the insurance sector has been benchmarked against IAIS core principles. Based on the gaps and vulnerabilities emanating from the assessments, the Panel on Financial Regulation and Supervision has made recommendations addressing development issues from the medium-term perspective. The portion of the Panel Report pertaining to the assessment of IAIS core principles was peer reviewed by Mr. Carl Hiralal, Inspector of Financial Institutions, Central Bank of Trinidad and Tobago and Mr. Michael Hafeman who is an independent consultant.

The CFSA believes that improvements in the strength and resilience of financial institutions must be viewed as a continuous process and the assessment and recommendations of the Panels should be viewed in this context.

3.2 Commercial Banks

3.2.1 Performance

3.2.11 Business Size and Key Financial Soundness Indicators (FSIs)

Exhibiting healthy growth, the assets of commercial banks grew at a CAGR of 22.9 per cent between 2002 and 2008. Credit growth during this period (CAGR of 25.1 per cent) has far outstripped growth in investment by banks (CAGR of 10.1 per cent). With growing corporate dependence on internal accrual and external commercial borrowings to fund their operations, credit growth in the period after 2002 has been largely due to rapid expansion in the retail credit portfolio of banks. Deposits have been the primary funding source, accounting for 76 per cent of the asset base in 2008. The large increase in deposits and credit, as seen from the increase in their respective ratios to GDP between 1992 and 2007, has led to significant financial deepening (Table 3.1).

Table 3.1: Scheduled Commercial Banks – Business Size as per cent of GDP (end-March)
	1992	1997	2002	2005	2006	2007	2008
Assets	52	49	67	75	78	84	92
Deposits	41	39	53	58	60	65	70
Borrowings	3	2	5	5	6	6	6
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