The global regulators have finalised the regulatory ecosystem with the adoption of post crisis reform package. On the domestic front, the regulatory stance is trying to inculcate a better credit culture even as the Insolvency and Bankruptcy Code is leading to a market-based time-bound resolution of corporate insolvencies. Given the escalation of operational risk, a more proactive approach addressing embedded operational risk especially in PSBs as also calibrating risk-taking limits in vulnerable banks will help in reducing systemic risk. RBI has put in place a framework for taking enforcement action in an objective, consistent and non-partisan manner and has initiated enforcement actions on a wide range of contraventions.

On the non-banking front, the increasing trend of financial savings in mutual funds continues. Furthering its thrust on reforms, SEBI has permitted liquidity enhancement schemes (LES) in commodity derivative contracts. The recent regulatory initiatives in insurance sector are aimed at broad-basing the investor base in insurance companies as also easing the process of their registration in International Financial Services Centre (IFSC). Initiatives in pension sector are targeted at rationalising requirements for appointment of Retirement Advisors as also easing partial withdrawal requests from pension investors. The overriding shadow of cyber risk in the wake of adoption of innovative technologies like Fintech and data-analytics based financial intermediation have created new frontiers in regulatory and supervisory challenges.

Section A

International and domestic developments

I. Banks

a. International regulatory developments

Post-crisis reforms

3.1 The final pieces of the regulatory ecosystem culminated in the form of a post-crisis reforms package to Basel III, also frequently referred to as Basel IV, which was endorsed by the Basel Committee on Banking Supervision (BCBS) in December 2017. These reforms streamline the ways in which banks calculate their capital requirements so as to make outcomes comparable across the globe.

3.2 The progress report¹ on Basel implementation has noted that at the end of March 2018 all 27 member jurisdictions had risk-based capital rules, liquidity coverage ratio (LCR) regulations and capital conservation buffers in place. Most of the member jurisdictions also had in force the final rules for counter-cyclical capital buffers, domestic systemically important banks (D-SIBs)² and global systemically important banks (G-SIBs). According to the last updated list published in November 2017, 30 banking groups had been identified as G-SIBs.

Accounting standards

3.3 International Financial Reporting Standard 9 (IFRS 9) came into force in January 2018 for European Banks, replacing International Accounting Standard (IAS 39). IFRS 9 introduces a forward looking approach for recognising credit losses in financial accounts viz., the ‘expected credit loss’ (ECL) approach. A survey by Risk Quantum consisting of 36 large banks from 11 European countries found an average decline of Common Equity Tier 1 (CET1) capital (between December 2017 when old accounting system IAS 39 was still in effect and March 2018, the first reporting date of IFRS 9 adoption) by 34 basis points (bps). This decline is computed by excluding banks who have adopted the transitional measures.

Early supervisory intervention framework³

3.4 A BCBS report discusses a range-of-practice study on how supervisors have adopted frameworks, processes and various tools to support early supervisory interventions globally. Early supervisory intervention involves supervisors taking action to correct an identified weakness before rules or buffers are materially breached. The report found that early supervisory action taken by the supervisors depends not only on the expert judgement of the supervisors but also to a large extent on organisational infrastructure that sets in place:

(i) supervisory reinforcement through both vertical and horizontal risk assessments to maximise the early detection of risks;

(ii) a clear framework for when actions should be taken; and

(iii) internal governance processes and programmes to support supervisory development and capacity building.

Understanding NPAs

3.5 A cross-country survey for identifying and measuring non-performing assets (NPAs) has thrown up interesting nuances across regions (Box 3.1).

Shadow banking⁵

3.6 FSB in its annual Shadow Banking⁶ Report (2017) observed that other financial intermediaries (OFIs),⁷ under a broad definition of shadow banking, grew by 8 per cent to USD 99 trillion in 21 jurisdictions and the Euro area; this was faster than the growth rates of banks, insurance corporations and pension funds. OFI assets now represent 30 per cent of total global financial assets, the highest level since 2002. The activity based narrow measure⁸ of shadow banking grew by 7.6 per cent in 2016 to USD 45.2 trillion for the 29 jurisdictions. Data also shows that pension and insurance funds in countries like Belgium, India, Brazil and Netherlands are investing in shadow banks in search of yields.

b. Domestic developments

Banks’ supervisory actions and portfolio choices

3.7 The recent capitalisation of domestic public sector banks (PSBs) and the consequent debate on an appropriate governance and control environment in the banking sector in general and for PSBs in particular has re-focussed attention on the evaluation of the overall business strategies and governance frameworks in banks. Clearly, the efficacy of annual supervisory assessments and the consequent risk mitigation plans or more intrusive supervisory interventions like prompt corrective action (PCA) to correct the underlying risk issues is predicated on the underlying control environment prevailing in these institutions. It is possible that inasmuch as the control environment plays a major role in removing information asymmetry between the supervisors and the regulated institutions such mechanisms are also instrumental in the efficient discharge of the monitoring and information processing function of the banks through internalising of the information embedded in borrower/client transactions. In other words, factors beyond an economic downturn can be responsible for the asset quality deterioration in the banking sector (Box 3.2). Conversely, banks’ portfolio choices also determine their susceptibility to the robustness of internal controls.

Box 3.2: Issues in lending decisions The financial crisis of 2008-09 is largely blamed for excessive risk taking by banks. Hence, it is worth exploring what prompts banks to start riskier credit allocations. Increased credit availability is a major factor that may induce risky credit allocations by banks. Theory posits that during a credit expansion, loan officers’ screening abilities become low because of a loss of institutional memory about bad credit risks (Berger and Udell, 2004). In addition, during credit booms, financial intermediaries find it less profitable to properly screen borrowers or maintain lending standards (Dell Ariccia and Marquez, 2006). Three indicators of riskiness of firms receiving credit9 based on 3 vulnerability measures – (i) debt to total assets (ii) debt to profit before depreciation, interest and taxes (PBDIT) and (iii) interest coverage ratio (ICR) are constructed taking a sample of Indian listed public limited firms10 for the period 1995-2017. Starting from information on a firm level vulnerability measure, the indicators are built as follows - first, for each year, a firm is assigned the value (from 1 to 10) of its decile in the distribution of the measure. A higher decile represents larger value of vulnerability. Second, firms are similarly sorted by the changes in net debt to lagged total assets in five equal sized bins. Firms in the bin with the largest increase in debt are “top issuers” and with the largest decrease are called “bottom issuers”. Finally, the indicators are computed as the difference between the average vulnerability decile for top issuers and the corresponding average for the bottom issuers (Ref: Global Financial Stability Report, April 2018). A higher value of the indicator implies riskier firms getting more credit as compared to less riskier ones. All three indicators display cyclical patterns in the riskiness of credit allocations (Chart 1). To explore credit cyclicality of the indicators further, Chart 2 plots the debt to total assets based indicator11 with the credit-to-GDP gap12; the relationship appears quite strong. Periods of positive (negative) credit to GDP gap are associated with a higher (lower) riskiness of credit allocations. Theory also points to an increase in the riskiness of credit allocation following a positive macroeconomic shock or when interest rates fall. In the event of a positive macroeconomic shock or a fall in interest rates, there is an improvement in a firm’s short-term prospects and net worth. This allows firms with high leverage easier access to credit markets (Bernanke and Gertler, 1989; Kiyotaki and Moore, 1997). The relationship between the riskiness indicator and real interest rates13 shows an expected inverse relationship (Chart 3). However, in the Indian case, PSBs in particular have been struggling with increased NPAs. Does that mean that PSBs went in for riskier lending whereas private sector banks (PvBs) were risk averse? Chart 4 plots the riskiness of credit allocation with stressed advances ratio for these two bank groups. While the stressed advances ratio of PSBs correlates well with the indicator, that of PvBs appears to be impervious to such allocations. This implies that the riskiness of credit allocation is not only influenced by macroeconomic factors but also by idiosyncratic factors. It also underlines the possible role of governance in limiting the risk appetite as also oversight of the credit portfolio, particularly of PSBs. In literature, it is seen that banks with more effective boards are less likely to lend to risky commercial borrowers (Faleye and Krishnan, 2010). References: 1. Berger, Allen N. and Gregory F. Udell (2004). “The Institutional Memory Hypothesis and the Pro-cyclicality of Bank Lending Behaviour,” Journal of Financial Intermediation, 13 (4): 458–95. 2. Bernanke, Ben S. and Mark Gertler (1989). “Agency Costs, Net Worth and Business Fluctuations,” American Economic Review, 79 (1): 14–31. 3. Dell’Ariccia, Giovanni and Robert Marquez (2006). “Lending Booms and Lending Standards,” Journal of Finance, 61 (5): 2511–46. 4. Faleye, O. and K. Krishnan (2010). Risky lending: does bank corporate governance matter? Available at: http://ssrn.com/abstract=1661837. 5. Kiyotaki, Nobuhiro and John Moore (1997), “Credit Cycles,” Journal of Political Economy, 105 (2): 211–48.

3.8 Asset quality issues in PSBs and the interplay between internal controls / regulatory regime and realised credit risks are assessed by broadly looking into legacy asset allocation inter-se between select PCA and non-PCA PSBs (benchmark banks). In addition, incremental asset allocation in wholesale banking/ SLR assets (Box 3.3) has been examined to look at the composite impact of supervisory actions / risk aversion on asset yields.

Box 3.3 : PSBs’ legacy asset choices and realised credit risks – A comparison between PSBs under PCA and benchmark PSBs Differences in realised credit risk between a sample of PSBs14 placed under PCA and the benchmark PSBs15 is examined here. Charts 1 a & b show the dominance of multiple banking/consortium (M/C) originated assets in stressed assets among PSBs, implying general screening issues with respect to such assets. Such screening issues are pervasive for PCA-PSBs in general, that is, PCA- PSBs with a relatively lower share of M/C assets in aggregate loan portfolios also have impairment issues with regard to M/C assets. However, the superior asset screening ability of benchmark PSBs can be seen from the relative slippage ratios of ‘self originated assets’ to stressed assets in Chart 2. While in general, PCA banks have a higher share of stressed assets to begin with (Chart 3) one favoured hypothesis is that ‘operational risk led credit risk’ for self-originated asset classes particularly affected the aggregate stressed asset load for this chosen cohort of PCA-PSBs (see paragraphs 3.9-3.13). It may however be appropriate in this context to appreciate that M/C arrangements by their construct carry the benefit of risk sharing and that participating banks having agreed to be part of M/C arrangements must be passive. But in the Indian context, in the absence of appropriate institutional mechanisms to deal with information flow across the participating banks inhibit fruitful co-ordination of efforts towards recovery or rehabilitation with other consortium partners. The implementation of Insolvency and Bankruptcy Code (IBC, 2016) has given the cohort of banks under PCA a significant opportunity to unload legacy assets. A comparison of the relative size of IBC intermediated resolution referrals to gross GNPA for the PCA cohort shows that on aggregate, cohort of PCA banks discussed earlier had referred an amount equivalent to 64 per cent of outstanding gross NPAs (as on March 31, 2018) to the resolution process. The provisions held against such referrals are, on aggregate, about 52 per cent of the referred amount. Three specific advantages of an aggressive asset cleansing strategy can be seen: first, it brings in a lot of transparency to the quality of the asset portfolio thus possibly crowding in potential investors; second, marginal pricing without provisions of legacy assets can be more competitive going forward; and third, to put an end to frittering away opportunity costs in the eternal hope of a miraculous turnaround of stressed assets’ quality when a significant part of the assets owe their current status to operational risks contributing to or amplifying credit risks. In this regard, the current capital adequacy regime is in alignment with global norms while the lingering impact of past forbearance on asset provisioning implies that there are unrecognised credit losses in the books. In the absence of a legally binding resolution framework, there probably was a justification for a forbearing regulatory approach. However with the benefit of hindsight it is clear now that “a regulation susceptible to forbearing instincts carries the concomitant chance of risk inducing behaviour by stakeholders”16. Given that close to 50 per cent of multiple banking assets of the cohort of PCA-PSBs are stressed clearly points towards such behavioural tendencies whereby regulated entities depend on regulatory dispensations and the entire regime of forbearance had been getting institutionalised – blurring the distinction between good and bad forbearance.17 These concerns led to RBI issuing the revised framework for resolution of stressed assets announced on February 12, 2018. While the previous paragraphs outline the impact of legacy choices on asset impairment, whether asset screening in PCA-PSBs have undergone a significant reorientation in the recent past, specifically following the imposition of PCA is an issue of importance. To this end, a broad review of asset choices of PCA PSBs and non-PCA banks (PSBs + PvBs) based on their relative participation in top 210 ‘wholesale banking18’ performing accounts (as on Q3, 2017-18, forming about 30 per cent of the wholesale banking) since March 2016 was undertaken. For the analysis relating to Charts 4 to 6, the entire cohort of PSBs placed under PCA, as on date and having exposure to the top 210 wholesale banking accounts is being considered. For the previous analysis, an additional criteria of 3 clear quarters following imposition of PCA was put as an additional restriction, so as to analyse the performance of PCA-PSBs after the PCA restrictions have been internalised in their operations. They show an unchanged/increased share of both PCA PSBs and PvBs therein, largely at the expense of non PCA-PSBs in respect of advances to lower rungs of the credit spectrum (Chart 4). As regards exposure to sovereign assets, SLR maintained by PSBs in general exceed that of PvBs (Chart 5) and there was no systematic difference between SLR holdings of PSBs between PCA and non PCA banks. Incidentally, the foreign banks given their lack of credit appetite maintain the highest proportion of SLR assets. Given the portfolio choices of different categories of banks, the aggregate impact of such choices on asset yields is outlined in Chart 6. Clearly, a significant proportion of yield enhancement through diversification into lower rungs of credit has been offset by sizeable surplus investments. Given the fact that PCA banks have a significant burden of provision requirement from legacy assets, the trade-off to optimise yield returns with obvious capital constraints requires attention. Investments in relatively poorer rated assets, as observed above for the PCA PSBs require robust internal controls/governance mechanisms for prudential oversight. In this context, it is important to evaluate the relative efficacy of internal controls across different bank groups (please see paragraphs 3.9-3.13).

Operational risks in banks

3.9 Operational risks in banks have implications across the entire spectrum of risks and hence materialisation of operational risk may be symptomatic of the weakness in the underlying risk management framework, internal controls, internal audits and governance mechanism. In recent years, frauds reported( for amount ≥ ₹1 lakh) in the Indian banking sector show an increasing trend both in terms of number and quantum (Chart 3.1 a). In terms of the relative share of frauds, PSBs have a disproportionate share (>85 per cent) (Chart 3.1b) significantly exceeding their relative business share (credit and deposit ≈ 65-75 per cent). A sharper rate of growth observed in total number of frauds in 2017-18, which is driven by a significant jump in card/internet banking related frauds (Chart 3.1a). Banks are increasingly leveraging technology to deliver retail services and the significant buy-in from customers by their adoption of these delivery channels are anecdotally validated. The sharper increase in number of frauds owing to card/internet banking related issues are pointers to the underlying vulnerability of this delivery channel.

3.10 The composition of fraud amount reported is largely dominated by frauds in loans and advances both in PSBs and PvBs (Charts 3.2a and b) although the relative potency of frauds relative to income is sharply different between the two categories of banks (Chart 3.2c). Fraud amount reported in PCA-PSBs is well in excess of their relative share in credit. It could be that somewhat lax internal controls in these bank cohorts have magnified their stressed asset positions relative to non-PCA PSBs.

3.11 The dominance of loans, particularly working capital loans in PSB frauds (Chart 3.2d) points to co-ordination issues in implementing the ‘three lines of defence architecture’.¹⁹ Structurally, the operational risk oversight frameworks of PSBs and PvBs is not different. Yet, significant differences realised in operational risk calls for a deeper introspection as to the effectiveness of the oversight of ‘processes’ at the exclusion of ‘outcomes’ in PSBs. A significant deterioration in such assets in the PSB segment possibly owes a lot to poor credit screening, deficiency in oversight of the account by the lead bank and information asymmetry between participating banks in M/C arrangements. In addition, integration of information technology in audit oversight is well thought out in PvBs allowing them to optimise on human resources as compared to PSBs.

3.12 A critical evaluation of the outcomes of risk management practices also indicates significant scope for understanding and improvements. The issue of incentives for the operating staff is particularly relevant as such incentives are internalised at the PvBs through the performance assessment and rewards framework of the operating staff while they are clearly missing in the PSB space. In addition, for PSBs co-ordination issues between the three pillars of defence imply that verification/ validation of the underlying oversight processes in general and the audit framework in particular is not effectively done.

3.13 Finally, there is significant information asymmetry between external auditors and internal stakeholders and the consequences of this for the quality of internal oversight are important. Recent global reforms aim to put in place institutional structures that incentivise auditors to learn more and internal stakeholders to divulge more about the functioning of the institutions. A previous issue of FSR (December 2017) outlined the role of disclosures of ‘critical audit matters’ in the US (analogous to ‘Key Audit Matters’ in the EU) in the audit report to reduce information asymmetry between internal stakeholders and external auditors. One additional advantage of such disclosures is that they can be validated post-facto with realised risks. Moreover, unlike some jurisdictions, reasons for any omission/ commission on the part of external auditors can be assigned and hence auditor performance can be back-tested. Similarly, the internal audit has undergone a significant evolution globally as banks reorganise themselves from branch-centric delivery of financial services to web-centric delivery. The introduction of IFRS globally has also put governance of internal models in the limelight. This has necessitated internal audits extending to areas involving the overall model governance framework encompassing validation of rating models, applicability of datasets, and an analysis of deviations. A ringside reassessment of efficacy of audit framework (both internal and external), the internal governance framework, specifically with regard to accountability and credit screening / oversight is required to address the issues arising out of “operational risk” embedded in credit risk. Also in this context, the ‘Fugitive Economic Offenders Bill, 2018’ could act as a major deterrence for wilful defaulters.

II. The securities market

The International Organisation of Securities Commissions (IOSCO) has taken a number of initiatives with regard to emerging issues in securities markets.

(A) Framework for supervisory stress testing of central counterparties (CCPs)²⁰

3.14 Post-crisis reforms focussed on ensuring that all standardised OTC derivative contracts were cleared through CCPs to reduce systemic risks. Continued growth in central clearing and the resulting network concentration have further heightened the need for CCPs to have better risk controls.

3.15 The Committee on Payments and Market Infrastructures (CPMI) and IOSCO have released the framework for supervisory stress testing of CCPs. This explains that the supervisory stress-testing framework ‘is intended to serve as a guide for one or more authorities to design and run multi-CCP supervisory stress tests (SSTs) with a macro-prudential orientation.’ The framework sets out six components detailing underlying elements that describe the steps that the authorities will follow while designing and running a multi-CCP SST. The framework is flexible enough to accommodate SSTs that are conducted by a single authority or several authorities from the same jurisdiction or multiple jurisdictions.

(B) Mechanism used by trading venues to manage extreme volatility and preserving orderly trading

3.16 Following the recent extreme volatility events, regulatory authorities and trading venues have been reviewing their approaches to managing extreme volatility. In the European Union, for example, the MiFID II²¹ regime contains detailed provisions and guidelines, while other jurisdictions provide more flexibility to trading venues in determining appropriate volatility control mechanisms.

3.17 In an effort to help trading venues and regulators address extreme volatility and help maintain orderly markets, IOSCO in a recent consultation paper outlined a set of recommendations which stress that differences in liquidity or product types necessitate a tailored approach when it comes to the design and functionality of mechanisms to protect the price discovery process and to avoid significant disruptions to orderly trading.

(C) Domestic initiatives

3.18 On the domestic front, the Securities and Exchange Board of India (SEBI) has taken steps to develop the securities market by introducing new products, redesigning existing products, taking up investor awareness initiatives, revising the margin trading facility, permitting stocks as collateral for availing funding from stock brokers and revising the securities lending and borrowing (SLB) mechanism, among others

3.19 With a view to improving market integrity and providing better alignment between the cash and derivatives segments, several measures have also been taken up in connection with eligibility criteria, exit criteria and settlement of stock derivatives. These include mandatory physical settlement of stock derivatives in a calibrated manner. Derivatives on all existing and new stocks which meet the enhanced eligibility criteria are required to be cash settled until further notification. However, if such stocks fail to satisfy any of the enhanced eligibility criteria for a continuous period of three months, they will move from cash settlement to physical settlement. After moving to physical settlement, if such stocks do not meet any of the eligibility criteria for a continuous period of three months then they will exit from the derivatives segment. Stocks currently in the derivatives segment which meet the eligibility criteria but do not meet the enhanced criteria will be physically settled.

III. Insurance

3.20 The International Monetary Fund’s (IMF) recent assessment of the insurance sector (IMF-FSAP) observed that public sector insurers continue to command a majority of the market and life insurance predominates with about 75 per cent of the total premia. Non-life insurance is dominated by motor insurance. Risks in life insurance are relatively well spread while in non-life categories they are mainly short-term in nature. The sector is profitable and solvency exceeds minimum requirements but with some exceptions. The report suggests modernisation of the solvency framework, implementing a standardised approach to risk-based capital, insurers developing their own risk and solvency assessment (ORSA) mechanisms and a move to a more risk-based framework for supervision.

IV. Pension funds

3.21 A joint report by PFRDA and CRISIL on security for seniors (Opportunities and challenges in creating an inclusive and sustainable pension system in India) was released in February 2018. It brings out key issues and concerns in areas of demographic transition of different states, fiscal space, pension penetration, different pillars of pension provision, creating awareness about pension planning, an information repository and a pay-out design for further discussion.

3.22 The National Pension System (NPS) continued to grow in terms of the number of subscribers and assets under management (AUM). Total Subscribers to NPS increased from 15.44 million in March 2017 to 21.18 million in March 2018. AUM increased from ₹1,746 billion to ₹2,346 billion (Charts 3.3a and b).

V. The insolvency and bankruptcy regime

3.23 The Insolvency and Bankruptcy Code 2016 provides for a reorganisation and insolvency resolution of corporate persons, among others, in a time-bound manner for maximising the value of assets of such persons to promote entrepreneurship, credit availability and balancing the interests of all stakeholders. It segregates commercial aspects of insolvency resolution from its judicial aspects and empowers the stakeholders of the corporate debtor (CD) and the Adjudicating Authority (AA) to decide matters expeditiously within their respective domains. It provides an incentive-compliant, market-driven and time-bound process for insolvency resolution of a CD. The code critically depends on choices made by financial creditors for its success. As of March 2018, 525 corporates were undergoing the resolution process (Chart 3.4).

3.24 The number of processes triggered by operational creditors (OCs) is relatively more, though the number of processes initiated by financial creditors (FCs) have started to show an uptrend prompted primarily by the Banking Regulation (Amendment) Act 2017 (Chart 3.5). About 38 per cent of the admitted petitions were filed by FCs, a vast majority of which were banks, indicating their usage of the Corporate Insolvency Resolution Process (CIRP) to clean up their balance sheets.

3.25 Of the 701 corporates admitted to the resolution process during January 2017 to March 2018, 67 were closed on appeal or review, 22 resulted in a resolution and 87 yielded liquidations; this is broadly consistent with the expectation under the code in its initial days of implementation. The distribution of 87 corporate debtors ending with liquidation is given in Chart 3.6.

VI. Recent regulatory initiatives and their rationale

3.26 Some of the recent regulatory initiatives, including prudential and consumer protection measures with the rationale thereof, are given in Table 3.1

Section B

Other developments, market practices and supervisory concerns

I. The Financial Stability and Development Council

3.27 Since the publication of the last FSR in December 2017, the Financial Stability and Development Council (FSDC) held its 18th meeting on December 29, 2017 under the chairmanship of the Finance Minister where pre-budget consultations were held with financial sector regulators. The regulators presented their proposals for Union Budget 2018-19 related to the development of their respective sectors. The council deliberated on these proposals and concerned ministries/departments were advised to examine the respective proposals in detail for further appropriate decisions. FSDC was reconstituted by the Government to include the ‘Minister of State responsible for the Department of Economic Affairs (DEA)’, ‘Secretary, Department of Revenue’ and ‘Secretary, Ministry of Electronics and Information Technology’ as new members.

II. Fund flows: FPIs and mutual funds

Trends in mutual fund (MF) investments

3.28 Resources mobilised by MFs have been on an upswing for the past few years. During 2017-18, MFs’ assets under management (AUM) increased from ₹17.55 trillion in March 2017 to ₹21.36 trillion in March 2018 (Chart 3.7a). AUM from B-15 cities has grown 223 per cent during the 5-year period from 2013-14 (Chart 3.7b). The number of systematic investment plans (SIPs) grew by 53.4 per cent during 2017-18 over the previous financial year while premature termination of SIP accounts was at 9.48 per cent (Chart 3.7c). Investments through SIPs in mutual funds and wider geographical diversity of mutual fund holdings is conducive for both growth and stability of the MF industry.

3.29 Share of individual holdings which includes holdings of retail and High Net-worth Individuals (HNIs) grew from 50 per cent in March 2017 to 55 per cent March 2018 (Chart 3.7d). Increasing individual holdings in mutual funds could potentially provide more diversity to the holding pattern and consequent stability to mutual funds from the point of view of redemption pressures.

A. Cash versus derivatives turnover

3.30 Both the equity and derivative markets are important for a well-functioning securities market. Over a period of time the ratio of turnover in equity cash to equity derivatives market has been increasing -- from 14.24 per cent in 2013-14 to 15.59 per cent in 2016-17 and to 19.84 per cent in 2017-18 (Chart 3.8).

B. Fund raising activity in the capital market

3.31 Over the years, the aggregate funds raised by the primary market has been on an upswing. There was an increase of more than 10 per cent in the total capital raised during 2017-18 over 2016-17, excluding Alternative Investment Funds (AIFs). However, despite the stable grading of corporate bonds, bond issuance (both public and private) saw a decline during 2017-18 compared to the previous year (Chart 3.9). Capital raised through initial public offerings (IPOs) increased substantially during 2017-18 over the previous year. For the last few years, the share of offer for sale (OFS) has been dominating fresh issuances in IPOs and the trend continued in 2017-18

3.32 SEBI recently initiated several measures to improve the corporate governance of listed firms; Keeping in view the recommendations of the Kotak Committee, along with the public comments thereon, SEBI has taken decisions on several measures to further improve corporate governance in India, including reduction in the maximum number of listed entity directorships from 10 to 8, at least one woman independent director in the top 500 listed entities, separation of CEO/MD and Chairperson, enhanced role of the audit committee, nomination and remuneration committee and risk management committee, enhanced disclosure of related party transactions (RPTs) etc. It also developed a standard operating procedure for dealing with non-compliance by listed entities and fine-tuned guidelines for co-location and algorithmic (Algo) trades (Box 3.4).

III. The commodity derivatives market

(a) Market developments

3.33 The commodity derivatives market witnessed promising trends during October 2017 – March 2018 with all the categories of energy, metals and agriculture indices²² showing positive returns (Chart 3.10). The total turnover at all the commodity derivative exchanges (futures and options combined) increased by 7.9 per cent during the second half of 2017-18 over the previous half year. The total share of the non-agri derivatives in the turnover was 87.2 per cent during the period while the agri-derivatives contributed the remaining 12.8 per cent (Chart 3.11).

3.34 SEBI permitted liquidity enhancement schemes (LES) in commodity derivative contracts, except for sensitive commodities vide revised guidelines for LES. SEBI also issued a circular aligning norms related to the base minimum capital (BMC) and liquid net worth for members of clearing corporations in commodity derivatives with those applicable for clearing members in equity and currency derivatives. SEBI’s circular on ‘Margin provisions for intra-day crystallised losses’ issued to recognised clearing corporations has also been made applicable to commodity derivatives exchanges. Norms for providing margin benefits on spread positions in commodity derivative contracts were revised based on proposals from exchanges and the recommendations of the risk management review committee.

(b) Price discovery and hedging in agri commodities – time for transition from MSP to derivatives

3.35 Procurement agencies/government agencies have led the trend in many countries like the US and Mexico in using commodity derivative markets for smoothening volatility in commodity prices benefitting farmers. The role of farmer producer organisations (FPOs)/producer companies in the Indian agri-derivatives market may be worth evaluating considering that Indian agriculture is primarily characterised by fragmented landholdings. Creation of more FPOs (along with village producer organisations (VPOs) and cooperative societies) is considered one of the enablers of agricultural marketing under a new market architecture in the draft committee report on ‘Strategy for Doubling Farmers’ Income by 2022.’ State Involvement (through procurement agencies), institutional participation and improved market infrastructure will further add to the success of futures as effective price floors. The role of integrated spot markets will also be crucial in determining the success of the futures market for hedging by farmers. e-NAM (the electronic national agricultural market) is seen to effectively achieve that objective in the future. A developed futures market has the potential to effectively replace the current Minimum Support Price regime. The resultant de-stressing of the state procurement infrastructure will make way for investments in other segments of the agricultural value chain.

IV. Fintech

3.36 In a recently published research paper²³ BCBS has assessed the impact of Fintech on the banking industry and the activities of supervisors in the near to medium term. The paper argues that banks will have difficulty in maintaining their current operating models under the changing technological scenario and customer expectations. The report identifies ‘customer relationship’ as a key battleground between incumbents and new entrants and argues that this will vary depending on each scenario.

3.37 On the domestic front, a group in the Ministry of Finance is examining the policy and institutional development measures needed for creating right environment for Fintech companies to grow.

V. Cyber security and data protection

3.38 Cyber risks have emerged as a major risk in recent times. The increasing sophistication and complexity amongst financial intermediaries have made them particularly vulnerable to cyber risks. The Reserve Bank has been taking proactive steps to mitigate the risks in adopting technology. The Cyber Security and IT Examination (termed as the CSITE Cell) reviews cyber security developments and threats on an on-going basis and necessary measures are taken to strengthen banks’ cyber resilience.

3.39 Pursuant to the 2017-18 budget announcement on Computer Emergency Response Team in Financial Sector (CERT-Fin) and submission of the Working Group report on the same, CERT-Fin is proposed to work towards preventing and responding to cyber security incidents in the financial sector in close coordination with all financial sector regulators/ agencies and The Indian Computer Emergency Response Team (CERT-In).

3.40 Recognising the need for coordinated efforts at the global level to combat cyber risks, the Reserve Bank has been collaborating with other jurisdictions in the area of cyber security. It is a member of the Cyber Lexicon Group constituted by the Financial Stability Board (FSB) for developing a lexicon of cyber resilience terms for use by authorities and international bodies to facilitate consistent use of the terminology.

3.41 In 2017, the Financial Stability Board (FSB) did an assessment of existing relevant cyber security regulations and supervisory practices across select countries including India based on publicly available material. In India, the banking sector was found to be compliant with most of the points in the survey. The salient features of the emerging data protection framework as outlined in the recently promulgated General Data Protection Regulation (GDPR) in the European Union is outlined in Box 3.5.

VI. Supervision, enforcement and market surveillance

A. Measures taken to address asset quality related challenges

3.42 Pursuant to the efforts undertaken since 2015 for improving the asset quality of banks, the Reserve Bank of India issued a harmonised and simplified generic framework for resolution of stressed assets through its circular no. RBI/2017-18/131 DBR. No.BP.BC.101/21.04.048/2017-18 dated February 12, 2018. As per the revised framework, lenders have to identify incipient stress in loan accounts immediately on default by classifying stressed assets as special mention accounts (SMAs). Lenders have to report credit information, including classification of an account as SMA to the Central Repository of Information on Large Credits (CRILC) on all borrower entities having aggregate exposure of 50 million and above with them. The CRILC-Main Report will now be required to be submitted on a monthly basis effective April 01, 2018. In addition, lenders have to report to CRILC, all borrower entities in default (with aggregate exposure of 50 million and above) on a weekly basis. Further, all lenders must put in place board-approved policies for resolution of stressed assets under this framework, including timelines for resolution. Conditions and timelines regarding implementation of the Resolution Plan have also been provided under the framework.

B. Enforcement actions

3.43 The Enforcement Department has put in place an Enforcement Policy and Framework for taking enforcement action in an objective, consistent and non-partisan manner. It has also put in place a protocol for sharing information within the bank and initiated enforcement action. During the period July 01, 2017 to May 31, 2018, the department undertook enforcement action against 13 banks (including a payment bank and a small finance bank) and imposed an aggregate penalty of Rs. 964 million, for non-compliance with/contravention of regulatory restrictions on loans and advances, licensing conditions and operating guidelines for payments banks, and for violations of directions/ guidelines issued by the Reserve Bank on know your customer (KYC) norms, Income Recognition & Asset Classification (IRAC) norms, reporting of information security incidents, cheque purchase/ discounting, extending bill discounting and non-fund based facilities, detection and impounding of counterfeit notes, for deficiencies in the compliance and treasury functions, and for not adhering with specific directions issued on direct sale of securities from the HTM portfolio and specified disclosure in this regard. Going forward, enforcement of regulations pertaining to urban cooperative banks and non-banking financial companies will also be brought under the Enforcement Department in a phased manner.

VII. Consumer protection

3.44 Sustaining the confidence of consumers in banks through prompt and effective grievance redressal, together with empowering customers through education is pivotal for maintaining trust in the banking system. The fast growing volumes of financial transactions through the digital channel reflect the increasing interconnectedness of consumers and financial entities on mobile telephony/internet service providers. This has enhanced risks in the security of digital transactions arising due to increasing incidents of cloning, hacking, phishing, vishing, SMiShing, pharming and malware observed of late. The fact that the digital mode of transacting rests on banks’ and telecom service providers’ infrastructure, calls for close coordination between the two. As a corollary, there is also an increasing requirement of tight coordination between banking and telecom regulators so that wrongdoers cannot misuse any regulatory gaps.

VIII. Evolving business correspondent (BC) architecture - potential risks

3.45 The Global Findex Database 2017 report of the World Bank²⁵ has reported that during 2014 - 17, the bank account ownership in India rose by more than 30 percentage points among women and by the same percentage points among adults in the poorest 40 percent of households. As this segment of newly included bank customers are served mostly by Business Correspondents (BCs), banks need to pay close attention to the services rendered by such BCs to avoid illiterate customers getting attracted to inappropriate products. In this context, the interaction of newly included customers with BCs and frontline staff of banks who can at times be driven by tough target-based incentives needs to be closely monitored by the banks.

IX. Non-Banking Financial Companies (NBFCs)

A. Regulatory developments

3.46 Illegal deposit taking activities continue to be a cause for concern, especially in view of the possibility of erroneous public perception about the entities engaged in such activities being under regulation. Such entities have managed to flourish by exploiting regulatory gaps and inadequate law enforcement to lure gullible investors. The problem becomes more acute when such illegal activities affect the financially excluded, illiterate and lower-income sections of the population, especially in the economically backward areas of the country. Further, the regulatory framework for deposit taking activities continues to be fragmented with different sectoral regulators. While, the Banning of Unregulated Deposit Schemes Bill 2018 when enacted will no doubt provide a comprehensive framework to deal with illegal deposit taking activities in the country, the challenges lie in plugging the regulatory gaps and overlaps, strict enforcement of laws and creating financial awareness. In this regard, initiatives such as State Level Co-ordination Committee (SLCC) and ‘Sachet Website’ as part of financial awareness play an important role.

3.47 In an effort towards implementing ownership-neutral regulation, NBFC regulations were extended to government NBFCs as per a laid down timeline²⁶. Government NBFCs that are already complying with the prudential regulation as per the road map submitted by them shall continue to follow the same.

B. Implementation of Indian Accounting Standards (IndAS)-NBFC

3.48 3.48 Non-banking financial companies (NBFCs)²⁷ will implement IFRS-converged Indian Accounting Standards (Ind AS) with effect from accounting periods beginning April 01, 2018. The implementation of Ind AS will mark a major transition from the current accounting framework followed by NBFCs which is based on a blend of accounting standards and regulatory guidelines, especially in certain key areas such as classification, measurement and impairment of financial assets. The focus of accounting is hence intended to shift from a rule-based approach to a principle-based approach. The overall impact of Ind AS on the regulatory capital of NBFCs is uncertain at this stage.

¹ Available at : https://www.bis.org.bcbs/publications

² Framework for Dealing with Domestic Systemically Important Banks” was issued by RBI in 2014. Three banks, State Bank of India, HDFC Bank and ICICI Bank have been designated as D-SIBs. RBI reviews D-SIBs list every year and based on Systemic importance score of D-SIB entity, additional CET1 requirements are imposed on the entity.

³ Available at : https://www.bis.org.bcbs/publications

⁴ Available at : https://www.bis.org/fsi/fsiinsights

⁵ Available at : http://www.fsb.org/2018/03/global-shadow-banking-monitoring-report-2017/

⁶ Shadow Banking is considered to be credit intermediation involving entities outside the regular banking system.

⁷ OFI comprise all financial institutions that are not central banks, banks, insurance corporations, pension funds, public financial institutions, or financial auxiliaries.

⁸ Narrow Measure of shadow banking includes non- bank financial entity involved in credit intermediation that may pose financial stability risk, based on FSB methodology and classification guidelines.

⁹ The measures are based on the methodology mentioned in Global Financial Stability Report, April 2018.

¹⁰ Sample included non-financial firms only. The size of the sample varied from 1500 to 2500 for different years.

¹¹ Similar relationship was found for other indicators also.

¹² Credit-to-GDP gap is the difference between total bank credit-to-GDP ratio and its long term statistical trend.

¹³ Proxied by Repo rate minus CPI-IW Inflation.

¹⁴ Five PSBs on which Prompt Corrective Actions have been imposed on or prior to June 30, 2017 has been selected as the PCA cohort

¹⁵ Two PSBs not under PCA, one from Southern and one from Western region have been considered as benchmark banks.

¹⁶ Urjit R. Patel - Financial regulation and economic policies for avoiding the next crisis - October 15, 2017 - 32nd Annual G30 International Banking Seminar, Inter-American Development Bank, Washington, D.C.

¹⁷ Financial Stability Report – June 2017 – Paragraph 3.2

¹⁸ Any account wherein aggregate exposure is in excess of Rs.50 million is considered as wholesale banking.

¹⁹ Common industry practice for sound operational risk governance often relies on three lines of defence – (i) business line management, (ii) an independent corporate operational risk management function and (iii) an independent review.

²⁰ Available at : https://www.iosco.org/publications

²¹ The Markets in Financial Instruments Directive (MiFID) II is EU legislation that regulated firms who provide services to clients linked to ‘financial instruments’ (shares, bonds, units in collective investment schemes and derivatives) and the venues where those instruments are traded. MiFID II, which took effect in January 2018, aims to improve the functioning of financial markets in the light of financial crisis and to strengthen investor protection.

²² MCX India Commodity Index is a composite Index based on the traded futures prices at MCX comprising a basket of contracts of bullion, base metal, energy and agri commodities.
NCDEX Dhaanya is a value weighted index, based on the prices of the 10 most liquid commodity futures traded on the NCDEX platform.
S&P World Commodity Index is an investable commodity index of futures contracts traded on exchanges outside the U.S comprising Energy, Agricultural products, Industrial and precious metals.
Thomson Reuters/Core Commodity CRB Index is based on Exchange Traded Futures representing 19 commodities, grouped by liquidity into 4 group’s viz. Energy, Agriculture, Livestock and Metals.

²³ Available at : https://www.bis.org.bcbs/publications

²⁴ Available at : https://eugdpr.org

²⁵ Demirgüç-Kunt, Asli, Leora Klapper, Dorothe Singer, Saniya Ansar, and Jake Hess. 2018. The Global Findex Database 2017: Measuring Financial Inclusion and the Fintech Revolution. Washington, DC: World Bank. Doi: 10.1596/978-1-4648-1259-0. License: Creative Commons Attribution CC BY 3.0 IGO

²⁶ As per RBI circular vide RBI/2017-18/181/DNBR (PD) CC.No.092/03.10.001/2017-18/ Withdrawal of Exemptions Granted to Government Owned NBFCs

²⁷ As per instructions issued by Ministry of Corporate Affairs (MCA) outlining the roadmap for implementation of Ind AS for NBFCs, they are required to prepare Ind AS financial statements in two phases as under:
a) In Phase I, NBFCs with net worth of Rs.5 billion or more and holding, subsidiary, joint venture or associate companies of such companies are required to prepare Ind AS based financial statement for accounting period beginning from April 1, 2018 onwards with comparatives for the period ending March 31, 2018.
b) In Phase II, NBFCs whose equity and/or debt securities are listed or in process of listing in stock exchange having net worth less than Rs.5 billion and unlisted companies, other than above, having net worth of Rs. 2.5 billion to Rs.5 billion and holding subsidiary, joint venture or associate companies of such companies are required to prepare Ind AS based financial statement for accounting period beginning from April 1, 2019 onwards with comparatives for the period ending March 31, 2019.