Income Recognition/Asset Classification

Provisioning Norms

Investments by Banks

Guidelines on Infrastructure Financing

Norms for Foreign Banks

One-Time Settlement/Compromise Schemes

Lok Adalats

Debt Recovery Tribunals

Credit Information on Defaulters and Role of Credit Information Bureau

Bank Financing of Equities and Investment in Shares

Guidelines on Country Risk Management (CRM)

Guidance Notes on Management of Credit and Market Risk

Off-site Monitoring and Surveillance

Consolidated Supervision

10.26 All banks under the purview of consolidated supervision of the Reserve Bank, whether listed or unlisted, were advised to prepare and disclose consolidated financial statements (CFSs) from the financial year commencing from April 1, 2002 in addition to their single financial statements. The CFSs are required to be prepared in accordance with the Accounting Standards 21, 23 and 27 prescribed by the Institute of Chartered Accountants of India (ICAI). Banks coming under the purview of consolidated supervision would also need to prepare consolidated prudential reports (CPRs) in addition to CFSs. CPRs were initially introduced on half-yearly basis from March 31, 2003 as part of the off-site reporting system on the lines of the existing DSB returns for banks. The banks should prepare the CPR adopting the same principles as laid down in Accounting Standards 21, 23 and 27. The CPR should contain information and accounts of related entities which carry on activities of banking or financial nature and should not include group companies engaged in insurance or non-financial activities. Prudential norms/limits similar to those as applicable to banks are prescribed for compliance by the consolidated bank.

10.27 The scheme of prompt corrective action (PCA) was developed for pre-emptive adjustments by troubled banks to early signs of financial vulnerability (Table 10.3). The scheme is in operation, initially for a period of one year from December 2002. Continuation or otherwise of the PCA framework as well as modification in the trigger levels or actions to be taken will be reviewed in December 2003.

10.28 To ensure a smooth transition to Risk Based Supervision (RBS) and to facilitate the requisite preparation, commercial banks were involved in a consultative process to identify the support required by them in this regard. The Risk Profile Template (RPT) has been tried by banks for undertaking self-assessment of risks and found suitable. Training of commercial bank officers as well as the Reserve Bank supervisory staff at the training colleges of the Reserve Bank has made considerable progress. On-location and dedicated programmes on risk based supervision and risk management have also been conducted for banks. The RBS Manual has been prepared for use by the Reserve Bank supervisory staff. The pilot run of risk-based supervision of select banks was initiated during the quarter April-June 2003.

10.29 The financial turmoil during the second half of the 1990s in Asia and subsequently in several emerging economies provoked much reflection on ways to strengthen the global financial system. As part of its surveillance work, the International Monetary Fund (IMF) assesses financial system soundness in its member countries through the preparation of Financial System Stability Assessments (FSSA). Several national and international institutions have also initiated or intensified monitoring work. Towards this objective, several countries, including India, have undertaken efforts towards developing macro-prudential indicators (MPIs) for monitoring the health of the financial system (Box X.6).

10.30 Some changes were made to the system of rating banks under CAMELS/CALCS models keeping in view the importance of frauds monitoring and prevention. Compliance in the area of fraud monitoring and prevention would carry more weight while rating banks.

10.31 Guidelines in regard to Fair Practices Code for Lenders were framed and the banks/all-India Fis have been advised to adopt these guidelines (Box X.7). The Fair Practices Code, duly approved by their Board of Directors, should be put in place in respect of all lending prospectively not later than August 1, 2003. Banks and FIs have the freedom of enhancing the scope of the guidelines without sacrificing the spirit underlying them. The Board of Directors should also lay down the appropriate grievance redressal mechanisms within the organisation to resolve disputes arising in this regard. A periodical review of the compliance of the Fair Practices Code and the functioning of the grievances redressal mechanism may be submitted to the Board at regular intervals.

10.32 M/s. Kotak Mahindra Finance Ltd., a non-banking finance company, which was granted a licence for banking business in February 2003, commenced operations with effect from March 22, 2003 (Table 10.4).

10.33 The Government of India introduced Special Economic Zones (SEZs) with a view to providing an internationally competitive and a hassle-free environment for export production. For the first time, Offshore Banking Units (OBUs) were permitted to be set up in SEZs. These units would be virtually foreign branches of Indian banks but located in India. These OBUs, inter alia, would be exempted from cash reserve requirements and would be able to provide finance to SEZ units and SEZ developers at international rates of interest (Box X.8).

10.34 The exposure of banks by way of non-funded credit limits was hitherto capped at 50 per cent of such limits or outstandings, whichever is higher. The exposure to derivative products such as Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRS) was captured by applying the conversion factors to notional principal amounts as per the original exposure method. Effective April 1, 2003 in addition to reckoning non-fund based limits at 100 per cent, banks have to include forward contracts in foreign exchange and other derivative products at their replacement cost value in determining individual/group borrower exposure. Following the Basel Committee on Banking Supervision's paper on International Convergence of Capital Measurement and Capital Standards, 1988, banks have been encouraged to follow the Current Exposure Method which is an accurate method of measuring credit exposure in a derivative product.

10.35 The Reserve Bank has been continuously making efforts to ensure convergence of its supervisory norms and practices with the international best practices. In regard to accounting standards issued by the Institute of Chartered Accountants of India (ICAI), banks in India are generally complying with most of these standards (Box X.9).

10.36 Banks/subsidiaries were, hitherto, required to ensure that the funded and non-funded commitments (including investments and devolvement on account of underwriting and other commitments like standby facilities) relating to a single legal person or entity did not exceed 25 per cent of the net owned funds of the bank/subsidiary which was subsequently reduced to 15 per cent. Banks were also required to ensure that the commitments under a single underwriting obligation did not exceed 15 per cent of an issue. With a view to providing a level-playing field to the merchant banking subsidiaries of banks, it was decided that the existing ceiling on underwriting commitments would not be applicable to merchant banking subsidiaries of banks. These subsidiaries, regulated by the SEBI, would consequently be governed by the norms on the various aspects of the underwriting exercise taken up by them. The prudential exposure ceiling on underwriting and similar commitments of banks would, however, remain unchanged and continue to be reckoned within the norms prescribed by the Reserve Bank on overall borrower/issue size limits.

10.37 Unsecured advances given by banks to SHGs against group guarantees would be excluded for the purpose of computation of the prudential norms on unsecured guarantees and advances (i.e., 20 per cent of banks' outstanding unsecured guarantees together with total of outstanding unsecured advances should not exceed 15 per cent of total outstanding advances).

10.38 According to the existing guidelines for entry of banks into insurance business, banks were not allowed to undertake referral business through their network of branches. Under the referral arrangement, banks provide physical infrastructure within their select branch premises to insurance companies for selling their insurance products to the banks' customers with adequate disclosure and transparency and, in turn, earn referral fees on the basis of premia collected. Banks have now been permitted to enter into referral arrangements with insurance companies, subject to certain conditions to protect the interests of their customers.

10.39 After considering the recommendations of the Working Group on Discounting of Bills by Banks (Chairman: Shri K.R. Ramamoorthy), revised guidelines were issued to banks (Box X.10).

10.40 Banks were advised in August 2002 that if the shares of the disinvested PSU, against which bank finance is proposed to be extended, are illiquid due to lock-in period/restrictive clauses, the successful bidder to whom the bank proposes to extend finance, should obtain necessary approval from the Government of India and other regulatory agencies exempting such equity holdings from these restrictions. On a review, banks have been allowed to extend finance to the successful bidders - even though the shares of the disinvested company acquired/to be acquired by the successful bidder are subjected to a lock-in period/other such restrictions which affect their liquidity - subject to fulfilment of the specified conditions. The concerned bank must make a proper appraisal and exercise due caution about credit worthiness of the borrower and the financial viability of the proposal.

10.41 Banks are precluded from financing investments of NBFCs in other companies and inter-corporate loans/deposits to/ in other companies. On review, banks were advised that special purpose vehicles (SPVs) satisfying the following conditions would not be treated as investment companies and, therefore, would not be considered as NBFCs, and hence would be eligible for bank finance for PSU disinvestments of Government provided they: (a) function as SPVs with not less than 90 per cent of their total assets as investment in securities held for the purpose of holding the ownership stake; (b) do not trade in these securities except for block sale; and, (c) do not undertake any other financial activities.

10.42 With a view to encouraging wider participation of all classes of investors, including retail investors in Government securities, trading of the dated Government of India securities was allowed through a nation wide anonymous, order-driven, screen-based trading system in the stock exchanges in the same manner in which trading takes place in equities. This facility would be available in addition to the present Negotiated Dealing System (NDS) of the Reserve Bank. Accordingly, effective January 16, 2003, trading of dated Government of India securities in dematerialised form is being allowed on automated order driven system of the National Stock Exchange (NSE), The Stock Exchange, Mumbai (BSE) and Over the Counter Exchange of India (OTCEI). The scheme will subsequently be extended to the Government of India Treasury Bills and State Government securities.

10.43 In view of familiarity with the systems, processes and procedures, it was decided to adopt the equity trading model for trading of Government securities on the exchanges. As in the case of equities, banks as institutional investors can undertake transactions only on the basis of giving and taking delivery of securities. Besides, they were directed to obtain specific approval from their Board to enable them to trade in the Stock Exchanges and frame and implement a suitable policy to ensure that operations in securities on the above stock exchanges are conducted in accordance with the norms laid down by the Reserve Bank/SEBI and the respective stock exchanges.

10.44 Banks had been advised to switchover to a system of charging interest on advances at monthly rests, effective April 1, 2002, to facilitate adoption of 90 days norms for recognition of loan impairment from the year ending March 31, 2004. They were given the option to compound interest at monthly rests effective either from April 1, 2002 or July 1, 2002 or April 1, 2003. With effect from July 1, 2002, banks were supposed to ensure that the effective rate does not go up merely on account of the switchover to the system of charging/ compounding interest at monthly rests and increase the burden on the borrowers. Interest at monthly rests shall be applied to all running accounts (e.g. Cash Credit, Overdraft, Export Packing Credit Accounts), all new and existing term loans and other loans of longer/fixed tenor but not to agricultural advances.

10.45 In order to review the norms for empanelment of audit firms for their appointment as statutory auditors as well as the number of audit firms that were allotted to each PSB, a Working Group consisting of representatives from select PSBs, IBA, ICAI, Government of India, Comptroller and Auditor General of India and the Reserve Bank was constituted in December 2001. The Working Group's recommendations have been accepted by the SubCommittee (Audit) of the BFS and will be made applicable from 2004-05 (Box X.11).

10.46 A review of the accounting practices for repo/ reverse repo transactions revealed divergences among market players. Accordingly, uniform accounting guidelines for repo/reverse repo transactions were finalised, in consultation with Fixed Income Money Market and Derivatives Association (FIMMDA), and were applicable from the financial year 2003-04. On implementation of the guidelines, market participants may undertake repos from any of the three categories of investments, viz., Available for Sale (AFS), Held for Trading (HFT) and Held to Maturity (HTM). The legal character of repo under the current law as outright purchase and outright sale transactions is kept intact. The buyer of the securities under the reverse repo transactions can reckon the approved securities acquired for the purpose of SLR during the period and mark to market the securities as per the investment classification of the security. In case of entities not following any investment valuation norms, the valuation of securities acquired under reverse repo transactions will be in accordance with the valuation norms followed by them in respect of securities of similar nature. Securities sold under repo and purchased under reverse repo are to be disclosed by banks in the 'Notes on Accounts' to the balance sheet. The guidelines would not, for the present, apply to repo/reverse repo transactions under the Liquidity Adjustment Facility (LAF) with the Reserve Bank.

10.47 'Know Your Customer' (KYC) guidelines relating to identification of depositors were issued on August 16, 2002. Banks have to put in place systems and procedures to control financial frauds, identify money laundering and suspicious activities, and for scrutiny/monitoring of large value cash transactions. They have also been advised to be vigilant while opening accounts for new customers to prevent misuse of the banking system for perpetration of frauds. Taking into account recent developments, both domestic and international, the extant instructions on KYC norms and cash transactions were reinforced with a view to safeguarding banks from being unwittingly used for the transfer or deposit of funds derived from criminal activity (both in respect of deposit and borrowal accounts), or for financing of terrorism.

10.48 In view of the erosion of the net worth of the Nedungadi Bank Ltd., the Reserve Bank notified the draft scheme of its amalgamation with Punjab National Bank on November 13, 2002. The Scheme of Amalgamation came into force on February 1, 2003.

10.49 Under the Scheme of Amalgamation and in terms of Section 44A of the Banking Regulation Act, 1949, the Indian branches of Standard Chartered Grindlays Bank Ltd. (SCGB) were merged with the Indian branches of Standard Chartered Bank (SCB). Accordingly, SCGB was descheduled in August 2002 in terms of Clause (b) of sub-Section (6) of section 42 of the Reserve Bank of India Act, 1934.

10.50 During 2002-03 (July-June), the number of Indian banks with overseas operations remained at nine; of these, eight banks are in the public sector and one bank is in the private sector. With the closure of one branch of the State Bank of India in the USA, the total number of overseas branches of the nine Indian banks was reduced to 93. The number of Representative Offices of Indian banks abroad increased to 17 with the opening of Representative Offices in London and New York by ICICI Bank Ltd., in Dubai by HDFC Bank Ltd. and in Shenzen (China) and Ho Chi Minh City (Vietnam) by Bank of India. On the other hand, the State Bank of India closed down its Representative offices in Ho Chi Minh City (Vietnam), Sao Paulo (Brazil) and Jakarta (Indonesia).

10.51 At present, there are 36 foreign banks operating in India with 206 branches. Approval for opening 17 additional branches in India was given to existing foreign banks under the branch expansion programme for 2002-03. Out of this, eight branches have been opened up to June 2003. The foreign banks also have 26 Representative Offices in India. Four banks, viz., Commerzbank, Dresdner Bank AG, KBC Bank and The Siam Commercial Bank P.C.L. have wound up their banking operations in India. The Overseas-Chinese Banking Corporation Ltd. and the Toronto Dominion Bank are also in the process of closing down their Indian operations.

10.52 Scheduled commercial banks (SCBs) improved their profitability in 2002-03. Net profits (as a ratio of total assets) increased from 0.8 per cent during 2001-02 to 1.0 per cent during 2002-03, largely due to higher non-interest income and lower interest expenses. Non-interest income increased from 1.6 per cent of total assets in 2001-02 to 1.9 per cent in 2002-03 on account of treasury operations. Reflecting the soft interest rate environment, interest income as well as interest expenses (both as a ratio to total assets) moderated during the year to 8.4 per cent and 5.6 per cent, respectively. The reduction in the interest expenses ratio (around 22 basis points) was relatively sharper than that on the income side (around four basis points) suggesting that decline in lending rates was not commensurate with that in deposit rates. Banks were able to contain their operating expenses at 2.3 per cent of their total assets (Table 10.5).

10.53 The improvement in performance indicators was widespread across banks, with 70 banks (out of a total of 93) registering an increase in their net profits ratio. None of the public sector banks recorded an increase in their interest expenses ratio (Table 10.6).

10.54 At the end of March 2003, almost all SCBs (92 out of a total of 93) complied with the regulatory requirement of CRAR of nine per cent. The number of banks with CRAR in excess of 15 per cent increased to 36 at end-March 2003 from 30 at end-March 2002, mainly on account of foreign banks (Table 10.7).

10.55 There was a further improvement in the NPAs position of banks, both in relation to assets and advances (Table 10.8). This reflected, inter alia, recent initiatives at improving recovery. Group-wise, foreign banks had the lowest NPA ratios, followed by the State Bank group.

10.56 The number of banks with net NPAs (as a proportion of net advances) above 10 per cent fell from 23 during 2001-02 to 12 during 2002-03 (Table 10.9).

10.57 Co-operative credit institutions occupy an important position in the financial system in terms of reach, volume of operations and objectives. The co-operative credit system can be broadly classified into urban co-operative and rural co-operative banks. The rural co-operatives play a pivotal role in the rural credit delivery system, whereas the urban co-operative banks aim at mobilising savings from the middle-and low-income groups and purvey credit towards the weaker sections. UCBs and rural co-operative credit banks are supervised by the Reserve Bank and the NABARD, respectively. Both are regulated by State Governments in regard to certain types of functions; in addition, multi-state UCBs are regulated by the Union Government.

10.58 Since 2001-02, the Reserve Bank has undertaken a series of measures directed towards strengthening the financial position of the UCBs, such as applying capital adequacy standards, prescribing an asset-liability management framework, enhancing the proportion of holding of Government and other approved securities for the purpose of SLR, restriction on bank finance against the security of corporate shares and debentures. During 2002-03, these efforts were reinforced.

10.59 UCBs were advised in June 2002 that all purchase/sale transactions in Government securities should necessarily be through their SGL account with the Reserve Bank or through a Constituent SGL account with the designated agencies or in a dematerialised account with the depositories. UCBs were warned against dealing with brokers as counter-parties and advised to have their transactions in Government securities subjected to concurrent audit every quarter by chartered accountants and to confirm that the investments as reported by the bank were, in fact, owned and held by the bank. In line with the international best practice, it was decided to reduce the period of default for reckoning an advance as 'non-performing' from the existing 180 days to 90 days with effect from March 31, 2004.

10.60 With a view to strengthening the management system of UCBs, new urban banks are required to have at least two Directors with requisite professional qualifications or adequate experience in banking. This requirement was extended to existing UCBs as well. UCBs were earlier advised that all types of loans and advances granted by them to their Directors and their specified relatives and to concerns in which the directors or their relatives are interested should not, in the aggregate, exceed 10 per cent of the demand and time liabilities (DTL) of the bank. This limit was initially reduced to five per cent effective December 2002. A complete ban is to be imposed on such advances effective October 1, 2003.

10.61 Fully/partially computerised UCBs were advised to introduce an electronic data processing (EDP) audit system. All UCBs are required to have an audit committee of the Board for overseeing and providing directions to internal audit/inspection machinery of the UCB. The Audit Committees are also required to examine and follow up the observations and suggestions made in the inspection reports of the Reserve Bank and Statutory Audit reports.

10.62 Based on the recommendations of the Joint Parliamentary Committee (JPC) which enquired into the irregularities in capital market transactions, UCBs were advised that

• they have to take action for removing the deficiencies pointed out in the Reserve Bank inspection reports within a maximum period of four months from the date of the inspection report, and provide a certificate to that effect, failing which penalty will be imposed for non-compliance;
• the Audit Committee of the Board of Directors of UCBs should review the internal audit/statutory audit reports and the Reserve Bank's inspection reports and monitor action taken; and
• UCBs should appoint concurrent auditors.

10.63 To strengthen the system of supervision on UCBs, the Reserve Bank introduced a system of Off-Site surveillance on scheduled UCBs on March 31, 2001. Furthermore, the system of classifying UCBs as 'weak' was also modified with effect from March 31, 2002. A new system of grading based on their level of CRAR, level of net NPAs, record of losses and compliance with liquidity requirements was introduced. A system of supervisory rating for UCBs under the CAMELS model has been instituted. This rating system will initially be introduced for the scheduled UCBs commencing from the year ending March 31, 2003. A simplified rating system is also being introduced for non-scheduled UCBs with effect from March 31, 2004.

10.64 In order to impart greater transparency in the balance sheet and profit and loss accounts, UCBs with deposits of Rs.100 crore or more were advised to disclose the following information as 'Notes on Accounts' to their balance sheet, effective from the year ending March 31, 2003: (a) CRAR, (b) movement of CRAR, (c) investment (book value, face value and market value), (d) advances against real estate, construction business and housing, (e) advances against shares and debentures, (f) advances (both fund-based and non-fund based) to directors, their relatives, companies/firms in which they are interested in, (g) average cost of deposits, (h) NPAs (gross and net), (i) movement in NPAs, (j) profitability (interest income to working funds, non-interest income to working funds, operating profit to working funds, return on assets, business per employee and profit per employee), (k) provisions made towards NPAs and depreciation in investments, (l) movement in provisions towards NPAs, depreciation in investments and standard assets, and (m) foreign currency assets and liabilities.

10.65 As on March 31, 2003, there were 2,104 UCBs, inclusive of 89 salary earners' banks. Around 79 per cent of these UCBs are located in five States, viz., Andhra Pradesh, Gujarat, Karnataka, Maharashtra and Tamil Nadu. During the period 2002-03 (April-March), four UCBs, viz., Solapur Janata Sahakari Bank Ltd., Solapur, Bharati Sahakari Bank Ltd., Pune, Thane Bharat Sahakari Bank Ltd., Thane and Zoroastrian Co-operative Bank Ltd., Mumbai were included in the Second Schedule to the Reserve Bank of India Act, 1934. At end-March 2003, the total number of scheduled UCBs was 56, spread over the six states, i.e., Andhra Pradesh, Goa, Gujarat, Karnataka, Maharashtra and Uttar Pradesh.

10.66 Deposits and advances of scheduled UCBs increased marginally during the year, and their growth was significantly lower than that of the commercial banking system. This could be attributed to risk aversion of depositors in view of problems faced by a few large UCBs in the recent past. A positive aspect of the performance of the UCBs was a reduction in net NPAs, both in absolute terms as well as a proportion to net advances, reflecting the recent supervisory initiatives (Table 10.10).

10.67 During 2002-03, the main focus of policy initiatives of the Reserve Bank for select all-India financial institutions¹ (FIs) was on imparting operational flexibility, strengthening the prudential regulatory and supervisory framework, and improving accounting and auditing standards. The Government undertook restructuring packages for some of the FIs, taking into account their financial performance, rising NPAs, adverse market conditions for raising resources, and challenges posed by commercial banks under a competitive environment.

10.68 In line with the international practice and the norms applied for banks, the risk weight assigned to housing loans extended by FIs to individuals against the mortgage of residential housing properties was reduced from 100 per cent to 50 per cent. Investments by the FIs in the Mortgage Backed Securities (MBS) carry a risk weight of 50 per cent (in addition to the 2.5 per cent risk weight for market risk) provided that the assets underlying the MBS are the residential loan assets of the housing finance companies which are recognised and supervised by the National Housing Bank and satisfy the terms and conditions listed separately by the Reserve Bank. The loans granted by FIs against the security of commercial real estate would continue to attract 100 per cent risk weight. If the assets underlying the MBS also include commercial properties, then investment by FIs in such MBS would attract 100 per cent risk weight. The risk weights for the housing loans granted by the FIs to their own employees would, however, remain unchanged at 20 per cent for loans fully covered by superannuation benefits and mortgages of flats/ houses. Loans extended by FIs against the guarantee of a bank attract a risk weight of 20 per cent in computation of CRAR of the lending FI. The remaining amount of loan, if any, would normally attract 100 per cent risk weight.

10.69 For the purpose of exposure norms, the entire loan transaction of an FI should be reckoned as an exposure on the borrowing entity and not on the bank guaranteeing the loan so as to correctly reflect the degree of credit concentration. Before commencement of disbursement, the exposure would be either the sanctioned limit or the extent up to which the FI has entered into commitment with the borrowing entity in terms of the agreement. After commencement of disbursement, the exposure would be the aggregate of the outstanding amount plus the undisbursed or undrawn commitment.

10.70 The norms relating to credit exposures were modified and, as in the case of banks, the FIs are required to (i) reckon non-fund based exposures at 100 per cent value and (ii) include forward contracts in foreign exchange and other foreign exchange derivative products at their replacement cost in determining the individual/group borrower exposures. FIs were encouraged to switch to the Current Exposure Method for determining individual/group borrower exposures.

10.71 As per the existing norms, the asset classification of the projects under implementation falling under Category II (time overrun for projects with original project cost of Rs.100 crore or more) is required to be decided with reference to the 'deemed date of completion'. Provisions held by FIs in respect of such accounts should not be reversed even in cases where certain accounts might become eligible for upgradation to the 'standard' category as per the deemed date of completion of the Category II projects.

10.72 Occurrences of 'connected lending' by FIs has been engaging the attention of the Reserve Bank. Guidelines were, therefore, issued to FIs in this regard, relating to credit facilities to the Directors; non-fund facilities on behalf of the Directors; loans and advances to relatives of the FIs' Directors or to the Directors of other FIs/banks and their relatives; loans and advances to officers of FIs or to their relatives; time-frame for recovery of loans; effect of non-recovery within the stipulated time; remission of the liabilities of the borrowers; interpretation of the transactions; non-participation of the interested Directors in the proceedings; and award of contracts by the FIs.

10.73 Clarifications in regard to equity investments issued as a part of project finance proposal were provided. The preference shares acquired by conversion of loans/debentures in the nature of advance could be viewed as loan equivalent. In cases where there was no loan outstanding against a borrower company which had issued the shares, the record of dividend receipt on the preference shares should be examined to determine the asset classification of the preference shares, as per record of recovery. If the dividend on preference shares is not received within 180 days from the date of closing of annual accounts of the issuing company, the shares should be treated as NPA and provided for accordingly. As regards non-project related and redeemable preference shares which are eligible to be kept in the HTM category within the 25 per cent ceiling, these could be valued at acquisition cost/amortised cost, subject to provisioning for permanent diminution, if any, in value for which payment of dividend would also be a relevant factor. The investments in the units of closed-ended schemes of mutual funds could be included in the HTM category only if such units are not listed on the Stock Exchange. Units of closed-ended schemes of mutual funds, if listed on the Stock Exchange, should be placed in the AFS or HFT category.

10.74 As regards valuation of equity in the nature of advance in AFS category, the equity shares should be considered to be in the nature of advances if these equity shares were issued as part of a proposal for project finance. In cases where no loan against the company issuing the shares is outstanding, the equity shares in the nature of advance, should be valued at market price, if listed and quoted, provided the latest market quotation was not more than 30 days old as on the date of valuation. The market price in such cases should not be based on a solitary or small value transaction but on price observed in a reasonable volume transaction, between two independent parties in an arms-length relationship. 'Thinly traded shares' should be valued as per the extant norms. The unquoted equity shares or where current quotations are not available, should be valued at 'break up' value (without considering revaluation reserves, if any) derived from the company’s latest balance sheet. In case, the latest balance sheet is not available, the shares should be valued at Re. 1 per company. For the purpose of deriving break up value, the balance sheet used should not be older than one year (21 months in respect of companies, which close their accounts on dates other than 31 March) from the date of valuation.

10.75 Drawing from the recommendations of the Working Group on Consolidated Accounting (Chairman: Shri Vipin Malik), final guidelines were issued to FIs, which prescribed the group-wide prudential norms for capital adequacy, large exposures and liquidity gaps for the FIs to be implemented effective April 1, 2003 (July 1, 2003 in the case of NHB). FIs were also advised to build up requisite MIS to enable development of the database. Accordingly, FIs with subsidiaries have initiated steps towards consolidated accounting. Listed FIs have already commenced preparation/publishing Consolidated Annual Accounts as a part of their Annual Report, as mandated by the Accounting Standard 21 of ICAI, effective from the financial year 2001-02. The Reserve Bank’s guidelines seek to make such publication mandatory even by non-listed FIs from April 1, 2003 onwards.

10.76 A supervisory rating model was introduced with effect from the annual financial inspections conducted with reference to the position as on March 31, 2002 (June 30, 2002 in the case of the National Housing Bank). The Model is based on CAMELS components. The basic purpose of assigning supervisory ratings is to provide a summary measure of the performance and health of the financial institution concerned for requisite supervisory intervention.

10.77 In view of instances of appointment of auditors for long periods, FIs were advised to ensure rotation of the partner of the audit firm conducting audit, if the firm continues for more than four years.

10.78 Pursuant to the directions of the Audit SubCommittee of the BFS, a 'Committee on Computer Audit' was constituted in October 2001 with members from the Reserve Bank, ICAI and select commercial banks. The mandate of the Committee was to draw up a standardised checklist for conducting computer audit to enable the banks to ensure that requisite controls are applied by their computerised branches and the auditors verify them and report thereon. The Committee's recommendations, which have been accepted by the BFS, classified the possible areas of audit interest in the Information System (IS) environment into 15 broad categories and has prepared 'standardised checklists' under each category to facilitate the conduct of computer audit. The issues elaborated in the checklists would give a fair idea about areas that need to be controlled. These checklists would be in the nature of guidelines and FIs would be free to develop more elaborate checklists to conduct IS Audit suitable to the IT environment in which they operate.

10.79 FIs were required to fully comply with the Reserve Bank's instructions to necessarily hold their investments in Government securities portfolio in either SGL (with the Reserve Bank) or Constituents’ Subsidiary General Ledger (CSGL) or in a dematerialised account with depositories. Only one CSGL or dematerialised account can be opened by any such entity. In case the CSGL accounts are opened with a scheduled commercial bank or state co-operative bank, the account holder has to open a designated funds account (for all CSGL related transactions) with the same bank. In case a CSGL account is opened with any of the non-banking institutions, the particulars of the designated funds account (with a bank) should be intimated to that institution. The entities maintaining the CSGL/ designated funds accounts will be required to ensure availability of clear funds in the designated funds accounts for purchases and sufficient securities in the CSGL account for sales before putting through the transactions. No further transactions by a regulated entity should be undertaken in physical form with any broker with immediate effect. A specific timeframe has been separately indicated for each category of regulated entities to comply with these guidelines.

10.80 The Reserve Bank continued to undertake annual on-site inspection of nine FIs. During 2002-03, the supervisory process for all nine FIs with reference to their position as on March 31, 2002 and June 30, 2002 in the case of NHB was initiated and completed, including submission of reviews to the BFS.

10.81 A Prudential Supervisory Reporting System (PSRS) for ongoing off-site supervision, introduced in July 1999 as part of the integrated supervisory strategy, has been rechristened as FID-OSMOS. The FIs are required to submit off-site returns using the software input module provided to them for this purpose. A review of the performance of the FIs based on the off-site returns submitted by them is presented to the BFS on a quarterly basis.

10.82 All FIs, except IFCI Ltd. and IIBI Ltd., had a CRAR much above the norm of nine per cent as at end-March 2003. The IFCI's erosion of capital reflects asset liability mismatches arising out of bunching of repayments as also the requirement for meeting heavy provisioning due to high NPAs and consecutive financial losses. Furthermore, raising of resources in a cost-effective manner had become difficult due to downgrading of IFCI by the rating agencies. In order to mitigate this problem and augment its capital, a capital restructuring package was initiated by the Government. In the case of IIBI, accumulation of high NPAs and provisioning thereof, coupled with the problem of declining profitability explains its low CRAR (Table 10.11).

10.83 The net NPAs of all-India FIs increased during 2002-03 due to slow economic recovery, sectoral bottlenecks and adverse domestic/ international market conditions (Table 10.11). IDFC Ltd., NHB and NABARD continued to maintain nil or negligible NPAs.

10.84 The Union Government has initiated restructuring of two FIs, viz., IDBI and IFCI Ltd. As part of the restructuring exercise, PSBs and FIs who had exposures to the IDBI were assured about the payment of contracted interest rates up to original maturity by the Government. The IDBI, in turn, was given an assurance by the Government that it will meet the difference between the originally contracted interest rate and the agreed interest rate of eight per cent by the banks and FIs till the original maturity period. Besides, all PSU banks and FIs agreed to rollover their investments in IDBI bonds for a further similar period of maturity at the prevailing interest rate during the time of rollover. The characteristics of bonds, viz., SLR/ Non-SLR will remain unchanged. As part of the corporatising exercise, the Industrial Development Bank (Transfer of Undertaking and Repeal) Bill, 2002 was introduced in the Lok Sabha on December 4, 2002 which seeks to convert IDBI into a banking company. The Bill also seeks SLR exemption for a period of five years from the appointed day. The Bill was referred to the Standing Committee on Finance, which recommended exemptions from banking regulations such as SLR and CRR for five years and certain tax exemptions for the newly converted banking company. The Cabinet approved the amendments to the Bill on August 11, 2003 to incorporate provisions in the Bill to ensure that the new banking company also continues to be a development bank which will provide term lending to large, medium and small industries.

10.85 As part of the restructuring package in respect of liabilities of IFCI Ltd., the Government decided to take over all Government-guaranteed SLR bonds and retail borrowings of investors below Rs.1 lakh. Furthermore, the Government decided to service the loans from Asian Development Bank (ADB) and KfW. The package includes conversion of 20 year zero-coupon operationally convertible debentures/bonds worth Rs.1,811 crore into quasi-equity instruments, and conversion of preference capital into 20 year maturity at a coupon rate of 0.10 per cent per annum. Besides, the Life Insurance Corporation of India and the State Bank of India - the major institutional shareholders in IFCI Ltd. - have agreed to reinvest Rs.200 crore each for 20 years at the coupon rate of six per cent per annum. Similarly, the IDBI has also agreed to reinvest Rs.100 crore on similar terms and conditions.

10.86 The Corporate Debt Restructuring (CDR) mechanism became operational from March 2002 with the execution of the Inter-Creditor Agreement (ICA) on February 25, 2002 by 47 institutions/banks. Sixty-one institutions comprising all-India FIs (12), PSBs (27) and private sector banks (22) have signed the ICA. The UTI (among FIs), seven private sector banks (small in operation) and 41 foreign banks are yet to sign. During 2002-03, the CDR Standing Forum met two times, the Core Group five times and the Empowered Group 16 times. Of the 71 applications received (four from 2001-02), the CDR Cell referred all the cases to the Empowered Group within the stipulated time of 30 days. The Empowered Group approved final schemes in respect of 41 cases in which aggregate assistance by financial system amounted to Rs.38,638 crore; 18 cases were rejected and the remaining 12 cases are being processed (Box X.12).

10.87 At end-June 2003, a total of 37,859 applications were received by the Reserve Bank for grant of Certificate of Registration (CoR). Of these, approval was granted to 13,863 applications, including 725 applications of companies authorised to accept/hold public deposits.

10.88 Keeping in view the soft interest rate regime, the maximum rate of interest that NBFCs (including Nidhi companies and Chit Fund companies) can pay on their public deposits was reduced from 12.5 per cent to 11.0 per cent per annum with effect from March 4, 2003. The minimum rate of return payable by the residuary non-banking companies (RNBCs) to their depositors was also revised downwards (Table 10.12).

10.89 The ALM guidelines, issued in June 2001, are applicable to NBFCs (engaged in and classified as equipment leasing, hire purchase finance, loan, investment and residuary non-banking companies) meeting the criteria of asset base of Rs.100 crore (whether accepting/holding public deposits or not) or holding public deposits of Rs.20 crore or more (irrespective of their asset size) as per their audited balance sheet as of March 31, 2001. The Chit Fund and Nidhi Companies have been kept out of the purview of these guidelines. The guidelines became fully operational on March 31, 2002. A system of half-yearly reporting was put in place beginning with the position as on September 30, 2002 for only those NBFCs which hold public deposits.

10.90 The facility of holding Government securities in physical form was withdrawn. As in the case of FIs, all NBFCs were advised to invariably hold their investments in Government securities either in Constituents' Subsidiary General Ledger Account (CSGL) or in a dematerialised account with depositories. The NBFCs were prohibited from undertaking Government securities transaction/s in physical form with any broker.

10.91 NBFCs holding public deposits of Rs.50 crore and above and RNBCs with aggregate liabilities to depositors of Rs.50 crore and above as on March 31, 2002 or thereafter were directed to furnish information relating to their exposure to the capital market, at quarterly intervals, within one month of the close of the quarter.

10.92 Venture capital fund companies holding Certificate of Registration (CoR) from the SEBI have been exempted from the provisions of Sections 45-IA (obtaining CoR), 45-IB (maintenance of liquid assets) and 45-IC (creation of reserve fund) of the Reserve Bank of India Act, 1934 as also from the directions of the Reserve Bank on acceptance of public deposit and prudential norms for NBFCs, provided they are not accepting/holding public deposits. The stock broking companies, which are not holding public deposits as defined under the Reserve Bank regulations and registered with the SEBI, have also been similarly exempted.

10.93 Keeping in view the bifurcation of UTI as a result of which the mutual fund activities of UTI have come under the purview of SEBI (Mutual Funds) Regulations, 1996 the facility provided to RNBCs to invest in UTI units up to the entire sub-limit of 10 per cent of the aggregate liabilities to the depositors was withdrawn. Investment by RNBCs in the mutual funds including UTI will continue to be within the ceiling of 10 per cent of the aggregate liability and subject to the sub-ceiling of two per cent of such liabilities for any one mutual fund.

10.94 Consequent upon issue of final guidelines for entry of NBFCs into insurance business in June 2000, the Reserve Bank permitted five NBFCs to participate in insurance business on risk-sharing basis. Two NBFCs were granted permission to undertake both life and general insurance business while the other three NBFCs were permitted to undertake only life insurance business with risk participation. One company was permitted to engage both in insurance agency business as well as to make strategic investment in equity of an insurance company up to 10 per cent of its owned fund. Four companies were granted permission to conduct only insurance agency business, while two others were permitted to make only strategic investment in the equity of an insurance company.

10.95 The Reserve Bank undertook several measures for the benefit of depositors:

• Pursuing with State Governments for enactment of legislation for protection of interest of depositors in financial establishments.
• Undertaking extensive publicity campaign using the print and electronic media to educate the depositors.
• Conducting training programmes for personnel/ executives of NBFCs in order to familiarise them with the objectives, genesis and focus of the Reserve Bank regulations.
• Conducting seminars for the civil and police personnel of the State Governments.
• Conducting training programmes/seminars for the auditors, in association with the ICAI, to familiarise them with the directions and regulations of the Reserve Bank as applicable to the NBFCs as also the directions applicable to statutory auditors of the NBFCs.
• Holding meetings with the top Civil and Police officials of the State Governments and also other regulators like the Registrar of Companies and Department of Company Affairs of the Central Government wherein issues of common concern are discussed.

10.96 During the period 2002-03 (April-March), a total of 934 (292 deposit taking companies and 642 non-deposit taking companies) registered NBFCs were inspected. In addition to the inspections, the Reserve Bank also conducted 1,722 snap scrutiny exercises.

10.97 The norms relating to capital adequacy have been made applicable to NBFCs accepting or holding public deposits with effect from March 31, 1998. At the end of September 2002, almost 94 per cent of the NBFCs reported a CRAR equal to or in excess of the stipulated minimum of 12 per cent with as many as 74 per cent reporting a CRAR above 30 per cent (Table 10.13).

10.98 The gross and net NPAs of reporting companies have been showing a declining trend. The gross NPAs, which formed 12.0 per cent of the credit exposure in September 2001, came down to 9.7 per cent in September 2002. Over the same period, the net NPAs came down from 5.8 per cent to 4.3 per cent of credit exposure (Chart X.1).

10.99 Over the medium-term, the conduct of financial regulation and surveillance in India would progress from micro-regulation to macro-management, supported by a tightening of prudential norms and improvements in the functioning of the financial markets. A clearer definition of the regulatory role of the Reserve Bank is emerging within the broader debate on the conflict of interest between ownership and regulation. Co-operative banking is being sensitised to the changing context of financial regulation through enhanced standards of disclosure and governance, and a disentangling of the existing regulatory overlap.

10.100 The supervisory strategy of the Board for Financial Supervision would increasingly blend on-site inspection, off-site surveillance, enhanced role of external auditors and strengthening of corporate governance. Banks need to prepare for switching fully to risk-based supervision by 2003 by identifying information gaps in the compilation of risk profiles and training of personnel. The supervisory follow-up process will then involve a monitorable action plan including remedial actions and timely corrective steps.

10.101 Banks are being encouraged to improve the reliability and robustness of their risk management, management information and supervisory reporting systems. A scheme of prompt corrective action based on early warning triggers is evolving as a supervisory tool and would increasingly be adapted to country-specific circumstances. In addition to macro-prudential indicators of financial vulnerability being reviewed in India, financial soundness indicators have been proposed as early warning signals. The Reserve Bank and the Government have initiated a wide range of legal reforms to enable the regulatory and supervisory regime to keep pace with advancements in information and communication technology.