Even as banks move closer to international standards, they cannot lose touch with the realities of the Indian economy.

Soumendra K. Dash

THE Indian financial sector is undergoing rapid change. Structural reforms aimed at improving the productivity and efficiency of the economy are apace. The $28-billion sector, growing at roughly 15 per cent, has displayed remarkable stability over the years even when other markets in the Asian region were facing a crisis. The Indian financial sector has kept pace with the growing needs of its borrowers.

Changing environment

The most important factor shaping today's world is globalisation. Companies are constantly in search of low-cost markets. Technology is driving growth in production and productivity and competition is stiff. Secondly, rapid development in communication technology has lead to greater integration of global financial markets, in turn boosting private capital flows and foreign direct investment.

A third factor is the increasing share of emerging market economies in world trade. Another fallout of globalisation is the increase in volatility and vulnerability of markets. This calls for the adoption of international standards and global benchmarks.

Aligning with global standards To strengthen India's banking system in an increasingly competitive environment and guard against financial fragility, financial sector reforms were initiated as part of the economic reforms launched in the country since 1991-92. Significant progress has been made in the past few years to bring the Indian Banking system closer to international standards.

India has adopted international prudential norms and practices with regard to capital adequacy, income recognition, provisioning requirement and supervision and these norms have been progressively tightened over the years. There has been a steady decline in the level of resource pre-emption from the banking system in the form of CRR (cash reserve ratio) and SLR (statutory liquidity ratio). Interest rates in various segments of financial markets have been deregulated in a phased manner.

The mark-to-market practice for valuation of government securities has been gradually enhanced and further refinement, in line with international best practices, carried out in valuation and classification of investment by banks.

Risk management in banks has been strengthened and measures put in place to mitigate credit and market risks and efforts are on to measure and control operational risk. Banks have been given greater freedom in investing as also raising funds abroad and managing their external liability, subject to prudential guidelines.

In the area of supervision, the Basel core principles for effective banking supervision are being followed. Along with off-site surveillance there is periodic on-site monitoring of the risk profile of banks and their compliance with prudential guidelines and a "CAMELS"-based rating system is being followed.

The Reserve Bank of India's regulatory and supervisory responsibility has been widened to include banking institutions and non-banking financial companies.

The end result, is that the Indian banking sector has been considerably strengthened; there is greater transparency and closer convergence of Indian financial system with practices prevailing in international financial markets.

There is special focus on corporate governance and the setting up of specialised board-level panels such as the executive, risk management, audit, compensation, asset-liability management committees, and so on.

The RBI's Standing Committee on International Financial Standards and Codes under the Chairmanship of Dr Y. V. Reddy has identified global standards and codes as part of the efforts to create a sound financial architecture aligned with global practices.

Moving forward

But there are some areas that need greater attention.

  • Need to check NPAs: The biggest challenge is the problem of NPAs (non-performing assets). Around 12 per cent of bank credit is locked in NPAs, which means that banks do not earn any interest on NPA accounts. This is a drain on the financial health of banks. If banks have to cut their costs and improve performance, they must reduce their NPAs.

    The Government has re-promulgated the ordinance to help banks expedite recovery. This calls for strengthening credit appraisal and risk management and developing review and control systems in tune with the changing requirements.

  • Strengthening internal controls: While the information technology explosion has been beneficial, it has also brought with it some unsavoury side-effects.The increase in frauds and scams in the financial sector is a cause for concern and calls for the strengthening of internal controls of banks and financial institutions.

  • Focus on Indian economy: Even as banks move closer to international standards, they cannot lose touch with the realities of the Indian economy. In this context, agriculture, small industries/businesses and the services sectors, must be given special consideration and credit flow to the rural sector increased. In an age where the world has become smaller and money moves as quickly as information, achieving global benchmarks is important for global players.

  • But underlying this is the need to have sound fundamentals. There is no doubt that only banks and financial institutions that are focussed on efficiency, productivity and profitability have a chance to survive in a highly competitive environment and therefore need to equip themselves thoroughly to face the future competition.

    (The author is a professor at the Institute of Finance and International Management Bangalore.)

    (This article was published in the Business Line print edition dated May 17, 2005)
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