India’s financial sector is generally sound, resilient and fairly liquid. The financial infrastructure is also assessed to be robust. But there are some concerns, according to the report of the Committee on Financial Sector Assessment (CFSA). These concerns include corporate governance in the co-operative sector, funding constraints of Non-Banking Finance Companies and the lack of up-to-date data to gauge household indebtedness. The report also finds serious gaps in the timely implementation of bankruptcy proceedings.

This self assessment of India’s financial sector—a comprehensive health check-up of the country’s financial sector--was carried out by the Committee on Financial Sector Assessment (CFSA) set up by the Government of India and the Reserve Bank in September 2006.   The self assessment is motivated by the desire to ensure compatibility of the Indian financial sector with international standards and assess its overall stability. It also built upon past experience of the IMF/World Bank Financial Sector Assessment Program (FSAP) for India and other self-assessments and was enabled by the publication of the Handbook on Financial Sector Assessment, published jointly by the IMF and World Bank in September 2005.

Dr. Rakesh Mohan, Deputy Governor, Reserve Bank of India was the Chairman and Shri Ashok Chawla, Shri Ashok Jha and Dr. D Subbarao as Secretary, Economic Affairs, Government of India, the Co-Chairmen of the CFSA. The Committee submitted its six-volume Report, India’s Financial Sector – An Assessment, to the Hon’ble Finance Minister, Shri Pranab Mukherjee on March 25, 2009 at New Delhi.

Framework

The financial assessment process is based on three, mutually reinforcing pillars: Pillar I (Financial stability assessment and stress testing), Pillar II (issues relating to the institutional and legal infrastructure) and Pillar III (assessment of financial standards and codes).

What tests are performed as part of this financial sector assessment? One such test assesses how the country’s financial institutions would handle shocks. This is done through “stress tests” that show whether the individual institutions and the banking system would remain solvent in the face of interest rate risks or changes in credit quality. The assessment also looks at indicators—called “financial soundness indicators” –such as capital adequacy, asset quality and profitability ratios, that signal the risks and vulnerabilities in the system.

The second pillar looks at the development issues of financial sector in particular focusing upon the legal, liquidity, governance and payment infrastructure to assess the strength and adequacy of financial infrastructure.

To conduct the independent and impartial assessment, four independent Advisory Panels were appointed. The reports put forward by these Advisory Panels, inter alia identified gaps in adherence to international standards and codes and suggested possible policy actions. These advisory panel reports were also peer reviewed by reputed international experts in the field. These independent reviews have further ensured an objective and impartial assessment.

The Report’s Findings

Sustainability of Macro Economic Growth

India’s growth in the recent period is contributed by several factors. These are high domestic demand, productivity, credit growth and high levels of savings and investment. The current global financial crisis, however, has resulted in the outlook being uncertain in the short term. Though India may face deceleration in its macro economic growth in the short term, 8 per cent plus growth for India is sustainable in the medium-term. For growth sustainability, however, India needs to focus on revival of growth in agriculture, address quick restoration of the fiscal reform path, continue financial sector consolidation and development and address the infrastructure deficit. While fuller capital account convertibility (FCAC) is desirable, it should be concomitant with macroeconomic and market developments.

Financial Institutions

Commercial Banks

Based on the stability assessment and stress testing of the financial institutions, the CFSA has found that commercial banking system in India is broadly sound. While the banks were generally in a position to absorb significant shocks due to credit, liquidity and market risks, there were some concerns relating to liquidity risk due to increasing illiquidity in banks’ balance sheets. There is, therefore, a need to strengthen liquidity management. Looking forward, the stress tests need to be conducted on a more systemic basis, to capture second round and contagion risks. For this purpose, CFSA has recommended setting up of an inter-disciplinary Financial Stability Unit.

The Government ownership of commercial banks poses dilemmas as it has been argued that this could lead to a conflict of roles and regulatory forbearance. The possibility of conflicts of interest could be minimised through even-handed regulation which has been the case in India. Also, the cost of recapitalisation of Indian public sector banks has also been relatively low.

The Government has, in the past, consistently shown willingness to contribute capital and the growth of public sector banks has so far not been constrained because of lack of capital. But, capital augmentation of these banks in future could be a challenge. This could be managed through a variety of ways, such as, amalgamation where commercial synergies exist, raising capital through newer instruments (like issuance of perpetual preference shares in foreign currency). If no other alternative is available, there could be case for selective dilution of government equity which would require amendment of existing legislation.

There is a need for capacity building in the commercial banking sector with accent on training, succession planning, lateral recruitment and improved remuneration (particularly for public sector banks) while at the same time discouraging excessive risk-taking through an appropriate and balanced incentives structure. A well considered approach for entry of foreign banks in India needs to be followed, while adhering to the WTO commitment and norms. Recommending that competition must be encouraged, CFSA has advised encouraging market-based consolidation of banks.

The CFSA notes that the power of the Competition Commission regarding combination could result in delay of amalgamation of banks. Also, certain provisions in the Competition (Amendment) Act 2007 may result in regulatory overlaps and conflicts between the Commission and the statutory regulatory authorities. In the view of CFSA, Central Government could give necessary exemption under Section 54 of the Competition (Amendment) Act 2007 in respect of banks to avoid regulatory conflicts.

The CFSA highlights risk management as a priority area and notes that the counter-cyclical prudential norms imposed by the Reserve Bank have paid dividends in the recent times. It highlights the growing requirement of appropriate accounting and disclosure norms, particularly with regard to derivatives transactions as well as better management of liquidity risk. In this context, the report recommends earmarking a specific capital charge if dependence on purchased liquidity by a commercial bank goes beyond a threshold.

Co-operative Sector

While the financials of urban co-operative banks have improved, these entities still remain vulnerable to credit risk as observed in the stress tests conducted for this sector. The financial indicators of the rural co-operatives throw up some cause for concern. Noting that co-operative and rural banks have dual control, the CFSA has stressed the need for better governance in these institutions.

Non-banking Financial Companies

The CFSA notes that while Non-banking Financial Companies (NBFCs) are important players in financial markets and their financials were broadly satisfactory, funding of this sector is constrained. Development of the corporate bond market would ease funding constraints of this sector. Further strengthening of prudential regulations of NBFCs has also been suggested.

Housing Finance Companies

For the growing and important segment of housing finance companies, the CFSA has noted that having a National Housing Price Index and a Housing Starts Index is a priority.

Insurance Sector

The CFSA noted that the insurance sector has significantly grown in size, penetration and diversified products, has comfortable solvency and capital adequacy. According to the CFSA the following measures need to be taken for further development of the sector:

• Supervisory powers of Insurance Regulatory and Development Authority (IRDA) need to be improved;
• An effective policy for group-wide supervision needs to be put in place;
• Risk management processes require to be improved;
• There is a further requirement of skilled professionals – actuaries and treasury managers.

Financial Markets

The equity, government securities, foreign exchange and money markets along with their corresponding derivatives segments have developed into reasonably deep and liquid markets and there has been significant increase in domestic market integration over the years. However, the credit derivatives market is yet to take off in any significant manner. Though the primary market in corporate bonds has seen an increase in issuance, the secondary market has not yet developed commensurately.

Equity Market

The equity market has witnessed wide-spread development in infrastructure and its functioning is comparable to that in advanced markets. It has seen significant increase in growth and diversity in composition in the past two decades. Certain areas, however, could be further developed. Among the major steps to be considered are:

• According Self-regulatory Organisation (SRO) status to certain trade and industry associations to enhance regulatory efficiency, subject to appropriate safeguards;
• Further improvements in infrastructure and risk management systems;
• More focussed monitoring of market intermediaries; and
• Streamlining of issuance procedures by setting up of a central integrated platform.

Foreign Exchange Market

With the economy moving towards fuller capital account convertibility in a calibrated manner, focussed regulation and monitoring of the foreign exchange market assumes added importance. There is though a need to strengthen infrastructure, transparency and disclosure, and product range in the forex derivatives segment. Strengthening the trading infrastructure, market conduct, transparency of Over-the-counter (OTC) derivatives in the forex market, accounting and disclosures in line with international practices, including disclosures by non-bank corporates, needs to be done on a priority basis. The recent introduction of currency futures is a step in this direction.

Government Securities Market

The government securities market has witnessed significant transformation in its various facets: market-based price discovery, widening of the investor base, introduction of new instruments, establishment of primary dealers and electronic trading and settlement infrastructure. This is the outcome of persistent and high-quality reforms in developing the government securities market. Increased transparency and disclosures, gradual scaling down of mandated investments and development of newer instruments are some major areas which could be considered for further development. Regulatory incentives to increase the size of trading book could also be considered as a measure to further develop the government securities market.

Money Market

The money market is an important channel for monetary policy transmission and India has generally conformed to being a liquid market. In the ongoing global financial crisis, the Indian money market has continued to function normally. The gradual shift towards a collateralised inter-bank market, phasing out of non-bank participants from the call and notice money market, policy direction towards reductions in cash reserve requirements, the introduction of new instruments, such as, Collateralised Borrowing and Lending Obligation (CBLO), implementation of Real Time Gross Settlement (RTGS), significant transformation of monetary operations framework towards market-based arrangements and facilitating trading through Negotiated Dealing System – Call Money (NDS-CALL) are some of the reform measures that have contributed to the development of a relatively vibrant and liquid money market. However, the limitations of market participants in taking a medium- term perspective on interest rates and liquidity, coupled with the absence of a credible long-term benchmark, constraining further market development that  needs to be addressed.

Corporate Bond Market

The development of the corporate bond market could be a source of long-term finance for corporates. The development of this market currently suffers from lack of buying interest, absence of pricing of spreads against the benchmark and a flat yield curve. It requires further regulatory and legislative reforms for its development and reforms in the pension and insurance sectors to aid in the emergence of large institutional investors.

Credit Derivatives

The unbridled proliferation of complex credit derivatives and excessive risk transfer by adoption of the originate-to-distribute model is recognised as one of the root causes of the current financial crisis. The recent credit turmoil has also underscored the importance of liquidity risk arising from off-balance sheet commitments, implicit or explicit, of the credit intermediaries. The Reserve Bank had put in place regulatory guidelines that were aligned with global best practices while tailoring them to meet country-specific requirements. While the development of markets for credit derivatives and asset securitisation products could play a critical role in furthering economic growth, this requires to be pursued in a gradual manner by sequencing reforms and putting in place appropriate safeguards before introduction of such products.

Financial Infrastructure

Regulatory Structure

The assessment of the regulatory and supervisory environment of financial institutions has been done with reference to the Basel Core Principles (BCPs). The coverage of the assessment has been made broader to include the non-banking sector as well because of the inherent linkages that such institutions have and their consequent impact on the stability of the financial system. The assessment of regulation and supervision in the insurance sector has been done with reference to International Association of Insurance Supervisors (IAIS) Core Principles. The assessments found the regulatory environment to be generally satisfactory, the major gaps being in risk management and cross-border supervisory co-operation.

Similarly, the International Organisation of Securities Commission (IOSCO) Principles for Securities Regulation are generally applicable to the equity and corporate bond markets. However, taking into account their importance for systemic stability, the Advisory Panel on Financial Regulation and Supervision has also assessed the foreign exchange, money and government securities markets against IOSCO principles as relevant and applicable. The overall assessment shows that the regulatory and supervisory infrastructure is generally robust as evidenced by the fact that the recent market volatility has not resulted in any settlement failure though home-host co-operation remained a major gap across market segments.

The CFSA feels that the existence of multiple regulators is perhaps consistent with the current stage of financial development in India, but stressed the need for further improvement of effective regulatory coordination.

Alluding to principles-based versus rules-based regulation, the CFSA observes that both needed to play a complementary role. Ideally it is desirable to identify a set of principles and then group the existing rules under them and consider validating the rules under these broad principles. This would also obviate the rules/regulations degenerating into ad-hocism.

There is no legislation specifically permitting regulation of financial conglomerates and holding companies in India. The Reserve Bank could, in the interests of financial stability, be armed with sufficient supervisory powers and monitoring functions in respect of financial conglomerates. Legislation of a new Act is required to empower the Reserve Bank to have regulatory jurisdiction of the holding company. Allowing ‘intermediate’ holding companies, however, may not be feasible till an appropriate regulatory structure for such an entity is in place. In the interest of financial stability, there is a need for strengthening inter-regulatory co-operation and information-sharing arrangements, both within and across borders among the regulators.

There is a view that SROs could potentially enhance regulatory efficiency and optimise regulatory costs. As SROs are essentially trade bodies, issues relating to conflict of interest could arise. Hence, it is necessary that issues like arm’s length relationship of SROs with the associated trade bodies and their corporate governance policies be looked into by the regulator before according SRO status to any entity.

Liquidity Infrastructure

Systems and procedures need to be developed for smoothing out volatility in liquidity and call money rates arising out of quarterly tax payments. Hence, there is a need to strengthen management of government cash balances. The introduction of auction of Central Government surplus balances with the Reserve Bank in a non-collateralised manner could be considered, though with appropriate caution, which would also make available the government securities in the Reserve Bank’s investment accounts for its own market operations.

There is a need for strengthening the asset-liability management of banks, including the development of the term money market as also the development of liquidity forecasting techniques.

In the context of the management of the capital account, the key issue for the monetary authority is to determine whether the capital inflows are of a permanent and sustainable nature or temporary and subject to sudden stops and reversals. There is a need to examine the likely implications of excessive inflows and outflows on monetary operations. Strategic management of the capital account would warrant preparedness for all situations.

Since the currency risk has the potential to transform into credit risk, banks should strengthen monitoring of unhedged positions of corporates.  

Accounting and Auditing Standards

The ongoing global financial crisis and subsequent problems relating to derivatives transactions in India have brought to the fore the necessity for early adoption of accounting standards AS 30 and 31 relating to financial instruments.

The autonomy of the Accounting Standards Board (ASB) would be greatly enhanced if it is given the authority to issue the standards and the Council of Institute of Chartered Accountants of India (ICAI) confines itself to the administrative, but not the functional, control of the ASB. There is a need for the ASB to consider the development of standards on various subjects as also to provide sector-specific guidance. Similarly, there is a need to give functional independence to the Auditing and Accounts Standards Board (AASB) vis-à-vis the Council of the Institute by making it the final authority for drafting and issuance of the standards, with the Council confining itself to administrative, but not functional, control of AASB.

Business Continuity Management

The increased dependence on information technology systems by financial institutions for transactions as well as record maintenance gives rise to a need for proactively managing business continuity. The assessment of compliance to business continuity principles, as applied to select banks, and the payment and settlements systems has indicated that, overall, the systems available in these institutions were in consonance with the requirements. However, certain issues like outsourcing applications, system maintenance and change control and incident response simulation are required to be monitored more closely from the Business Continuity Management (BCM) angle. Continuous upgrading of BCM processes as also capacity building of regulators remain areas that should be under constant focus. In addition to IT related issues, human resource management with proper succession planning also merits attention.

Payment and Settlement Infrastructure

A smooth and efficient payment and settlement infrastructure plays an important role in maintaining stability in the financial sector. The CFSA acknowledges that significant progress has been made in improving the payment systems infrastructure in India with the introduction of RTGS, High Value Cheque Clearing System, setting up of Clearing Corporation of India Ltd. (CCIL) as the central counterparty in the government securities, foreign exchange and CBLO segments as also system improvements in the settlement of equities transactions. The legal framework for payment and settlement has also been strengthened by the recent notification of the Payment and Settlement Systems Act and Rules. This has made India largely compliant with international standards and codes in this area. The assessments have, however, highlighted some gaps in the system, particularly with regard to the adequacy of financial resources with CCIL and improving its risk management measures.

The current low utilisation of the electronic payments infrastructure can be increased with the use of technology to make the facilities more accessible to customers, thus optimising the use of this infrastructure and achieving greater financial inclusion.

Legal Infrastructure

The CFSA notes that there have been improvements in legal infrastructure in the financial sector like setting up of Debt Recovery Tribunals (DRTs) and the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act.

Insolvency Regime

The major concern is that, despite the robust insolvency laws, the time taken for completion of liquidation proceedings is one of the highest in the world and the recovery rate one of the lowest. The operationalisation of the Companies Act (Second Amendment), 2002 will address the current problems relating to delays in completion of liquidation proceedings. The CFSA considers that a separate insolvency regime for banks and other categories of financial institutions is vital in the context of financial stability, as any inefficient handling of insolvency of such institutions could have a serious contagion effect and repercussions across the economic system that will destabilise economic activity.

Corporate Governance

In India, there is a comprehensive corporate governance framework in place for listed companies and the listing agreement forms an important pillar of corporate governance framework. There is a need to strengthen the corporate governance framework with regard to risk management in listed companies. Listed companies need to disclose the reasons for non-compliance with non-mandatory requirements. Steps need to be taken to protect the interests of shareholders, such as equitable treatment of all shareholders including minority shareholders and alternate methods of voting, which are convenient for shareholders and in which investor associations can play a constructive role. There is a need for strengthening the disclosure mechanism to bring about greater transparency in ownership structures and stringent penal action needs to be taken where such practices are unearthed. Penal provisions for fraudsters may be strengthened in corporate law by providing for disgorgement of gains and confiscation of assets. The corporate governance framework needs to evolve with the changing times and there is a parallel need to strengthen the corporate governance framework for unlisted companies.

Safety Net – Deposit Insurance

The coverage limit of deposit insurance offered by the Deposit Insurance and Credit Guarantee Corporation (DICGC) is comparable to international levels. Stress tests to ascertain the adequacy of the Deposit Insurance Fund shows that the DICGC would be in a position to meet the claims even under a worst-case scenario. While there is an element of cross-subsidisation of the flat premium charged by the  DICGC, a risk-adjusted premium could prove to be expensive for weak financial entities. An increase in ceiling of flat rate premia could, therefore, be considered to strengthen the deposit insurance fund, if required. The delay in the failure resolution process and the non-involvement of the DICGC in the failure resolution process remain major concerns. In order to enhance the efficacy of the deposit insurance system in India, it is felt that the pros and cons of DICGC’s involvement in the bankruptcy process need to be deliberated upon. Alternatively, delinking of DICGC claims from liquidation proceedings by amendments to the DICGC Act and Banking Regulation Act could be considered. There is a case for providing exemption from income tax to the DICGC.

Review of AML/CFT

Major areas where action needs to be taken to further strengthen Anti-money Laundering and Combating the Financing of Terrorism (AML/CFT) practices and align them with international standards are the effective implementation of recordkeeping requirements and a robust regime for submission of Suspicious Transactions Reports (STRs) and inclusion of money transfer agencies in Prevention of Money-Laundering Act (PMLA).

Transparency and Data Dissemination

India has made significant progress in enhancing transparency in monetary and financial policies, fiscal arena and data dissemination. There are some areas where further transparency and disclosure can be achieved.

Transparency in Monetary Policy

India is largely compliant with the IMF’s Code of Good Practices on Transparency in Monetary Policy. The roles, responsibilities and objectives of the Reserve Bank are well-defined. The Reserve Bank has explicit multiple objectives of monetary policy with changing relative emphasis. It also follows a multiple indicator approach, which has been reasonably effective. The present legislative framework provides enough room and manoeuvrability for the Reserve Bank to operate monetary policy in consonance with evolving needs and circumstances. The key element of the framework at present is the flexibility enjoyed by the Reserve Bank while going about its assigned task of maintaining the monetary stability of India. The main issues that have come out of the assessment of transparency in monetary policy pertain to the review of legislations with regard to the objectives of monetary policy, the issue of operational independence and accountability of the Reserve Bank and the separation of debt management from monetary management.

As far as the issue of operational independence of the central bank is concerned, the Reserve Bank enjoys independence vis-à-vis the executive arm of the state through conventions, agreements and MoUs in specific areas. The specification of procedures and reasons for the removal of the Governor/Deputy Governor as also for supersession of the Board could potentially lead to the loss of well-established de facto independence. Any modifications that might be required to strengthen monetary policy as also the regulatory framework might be carried out by necessary amendments to existing legislations as needed, which would not call for a fundamental review of legislations or an overhaul of the existing legal framework. The CFSA feels that an overhaul of legislation may not be appropriate at the current juncture.

Following the announcement in the Union Budget 2007-08, the Central Government is proceeding with the establishment of a Middle Office, as a prelude to setting up of a full-fledged Debt Management Office (DMO). While most members of the CFSA concurred with the proposal to set up a DMO, one member felt that the DMO should be an independent body. The Chairman, however, was personally of the view that the time is not ripe for the complete separation of debt management from the Reserve Bank at the current juncture.

Transparency in Financial Policies

The Reserve Bank, SEBI and IRDA are compliant with the relevant standards in transparency in financial policies. Any move to institutionalise the High Level Coordination Committee for Financial Markets (HLCCFM) could prove to be counter-productive as it could reduce flexibility in the formulation of financial policies; however, the present information-sharing mechanism could be improved.

Fiscal Transparency

The major area of concern arising out of the assessment of fiscal transparency is in the reporting of off-budget items, like oil bonds, and the need to have an additional augmented fiscal deficit measure to capture these items. Likewise, any move towards accrual-based accounting should also be attempted in a gradual manner.

Data Dissemination Standards

There has been significant improvement in the data dissemination practices of various agencies, namely, the Central Statistical Organisation, the Office of the Economic Adviser in the Ministry of Commerce and Industry and the Reserve Bank. There is an urgent need to strengthen the functioning and data dissemination practices of the CSO, which had weakened after data submission became a voluntary process. There is also a need to consolidate the process of compiling labour data and this should be done by a professional statistical organisation. As far as price indices are concerned, updating the weights and inclusion of new products in the basket of goods needs to be expedited.

Development Issues in the Socio-economic Context

A stability assessment of the financial sector should also address broader development aspects in the socio-economic context, which affect social stability and have an indirect bearing on financial stability.

Financial inclusion is one of the major determinants of economic growth. Higher economic growth and infrastructure, in turn, play a crucial role in promoting financial inclusion. In order to achieve the objective of growth with equity, it is imperative that infrastructure is developed in tandem with financial inclusion, as this would facilitate and enhance credit absorptive capacity.

Ajit Prasad