Ensuring more transparency in banking

K. Srinivasa Rao | Updated on May 16, 2021

Tightening supervision   -  Bloomberg

The apex court has told the RBI to make public annual inspection reports of banks. RBI must revamp its assessment systems

The recent Supreme Court judgment affirmed its 2015 judgment directing Reserve Bank of India to release annual inspection reports, annual reports and list of loan defaulters of its regulated entities under the Right To Information Act - 2005. The apex court rejected the prayer of State Bank of India, HDFC Bank Ltd and a few others who had filed a “recall petition” against the judgment of 2015.

The apex court reiterated that it has a duty to uphold the interest of public at large, the depositors, country’s economy and the banking sector and that RBI does not place itself in a fiduciary relationship with the financial institutions because, the reports of the inspections, statements of the bank, information related to the business obtained by the RBI are not to be held back under the pretext of confidence or trust.

The judgment has far reaching ramifications on the RBI and its regulated entities where both have to work in coordination to bring about transparency to share annual inspection reports of banks with public at large. The RBI is empowered under Section 35 of the Banking Regulation Act, 1949 to conduct annual inspection of all commercial banks.

It conducts an on-site inspection of all banks once a year or at a periodicity decided by the central bank where its officials visit the head offices and branches of banks to inspect the books. A copy of the report of the scrutiny is shared with the bank to initiate rectification of deficiencies if any.

The RBI began to inspect the banks using CAMELS (Capital adequacy, asset quality, Management, Earnings, Liquidity and Systems & Control) model from 1994 that involved compliance based transaction testing approach. The CAMELS system of banking supervision worked until the global financial crisis in 2008.

Risk based supervision

Based on the recommendation 2012 high-level steering committee, set up to upgrade inspection systems of banks, RBI began to migrate to Risk Based Supervision (RBS) model to cover the supervisory rating mechanism and adopted a risk focused supervisory rating framework for measuring riskiness of the banks.

The RBS model then shifted the focus from selective transaction scrutiny to measuring the risks inherent in the business increasing the risk sensitivity in banks. It is largely meant to ensure that banks do not take undue risks to maximise profits and boost performance. Under the new framework, RBI links business risks with capital adequacy while staying focused on quality of capital. Thereby it assesses the inherent credit, market and operational risk and how bank is geared to manage its risks and ensures that capital levels are in conformity with the risks.

The RBI’s concern has always been to ensure that the observations in its annual inspection should not work to the advantage/disadvantage of the underlying financial institutions. Its final view is kept confidential to provide an opportunity for a corrective mechanism to work its way. If the reports are made public, the investors and customers may be swayed by the RBI’s observations. The purpose of a regulator is to regulate for the long-term sustainability and orderliness in the functioning of financial entities.

Time for revamp

Keeping in view the apex court direction, it is now necessary to revamp RBI’s internal inspection system to make it into a commentary on governance and implementation of policy framework providing better assessment of riskiness and capital adequacy of the organisation. The compliance towards micro procedures, processes and client specific decision support may be left to the banks to maintain the fiduciary relations between banks and its customers.

Banks should also enhance the rigour of its internal inspection systems and develop score card models of risk assessment and base its working on sector specific risk heat maps so as to facilitate the RBI to make RBS more effective. RBI will then be able to keep its internal inspection tool as a searchlight to spot weakness in governance and policy implementation rather than intermingling it with operational aspects of business.

RBI having already shifted from transaction scrutiny to gross risk assessment under RBS to test the adequacy of capital to absorb the degree of risk of the entity, banks should also reform its internal audit system to pin point the deficiencies, if any in the procedures, processes and standard operating procedures. Banks have to be hitherto be mindful that their operational status is subject to reputation risk when RBI discloses the annual inspection reports. A great deal of collaborative preparedness is necessary among all stakeholders to meet the emerging needs. It may eventually create a systemic control to improve the operational efficiency of banks to stay competitive in the market.

The writer is former General Manager – Strategic Planning, Bank of Baroda. The views expressed are personal

Published on May 16, 2021

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