Key Note Address at the Panel Session on

“Setting new paradigm in regulation” 1

The global financial crisis was predominantly a first world phenomenon. The fall

out in the emerging market economies (EMEs) was mostly through contagion.

The level of financial sector development, complexity of financial markets,

extent of deregulation and global integration, the degree of leverage of

households and financial intermediaries, the nature of business model and

quality of supervision determined the impact of the crisis on any institution or

jurisdiction. The impact of the global financial crisis and consequently the

corrective actions required in the regulatory regime vary across different

countries. According to the International Monetary Fund, upfront government

support to the financial sector averaged 5.8 per cent of GDP in developed

countries and 0.3 per cent in developing countries. It is important to note that

many of the EMEs had their own crises in the past requiring varying degrees of

public intervention (Latin American crisis, Asian Crisis, Russian crisis etc.).

2. While the global fora are working out regulatory reforms to ensure that

similar crises do not recur, the members of such fora like BCBS and FSB

including India have supported such initiatives as it is realized that there is a

need for a consistent minimum regulatory framework across countries. For

example, we have realized that though all countries had a minimum capital

adequacy norm of 8 per cent - the components of such capital were so varying

as to result in capital adequacy ratio ranging from 2 to 8 per cent across

1Keynote address by Smt. Usha Thorat, Deputy Governor, Reserve Bank of India at the
Panel Session on ‘Setting New Paradigm in Regulation’ at the FICCI-IBA Conference on
‘Global Banking: Paradigm Shift’ on September 8, 2010
 2

countries if the new proposals are implemented!! India is at the top end of this

range. In his talk yesterday, the Governor has elaborated on the new regulatory

paradigm under the Basel III initiatives. I will, therefore, not revisit these

aspects, but instead focus on the challenges that the regulator in an emerging

market economy like India faces in ensuring development of the financial sector

for facilitating rapid and inclusive growth, while at the same time ensuring

soundness of financial institutions and financial stability.

Role of financial penetration

3. One of the drivers of growth in India has been the high level of savings.

Savings rate is 32.5 per cent of GDP today (2008-09) compared to 22.3 per

cent ten years ago (1998-99). The contribution of the household sector to

savings is 70.0 per cent. While the overall savings ratio has increased

significantly, financial savings has remained at around 50 per cent of household

savings. Within financial savings, share of bank deposits has increased from 33

per cent in 2000-01 to 55 per cent in 2008-09.. In March 2004, there were 59

savings and current accounts per 100 adult population – in March 2009, the

number has risen to 96. The number of borrowal accounts per 100 adult

population rose from 12 to 20 in the same period. State-wise coverage shows

improvement in all States (Annex). This reflects the impact of increasing

banking penetration although there is a long way to go in many regions.

Achieving higher rates of growth would call for higher financial savings and this

in turn implies much greater penetration of banks and other financial

intermediaries like insurance companies, mutual funds and pension funds.

Achieving higher level of financial savings also requires a benign inflationary

 3

environment. The freeing up of branch licensing in Tier 3 to 6 centres and the

liberalization of the Business Correspondent model are steps for achieving

greater penetration. The linking of branch licensing in Tier 1 and 2 centres to

performance of banks in opening branches/ banking presence in underbanked

areas is an element of banking policy intended to incentivize banks to establish

presence in such areas for facilitating greater financial inclusion and inclusive

growth. Distribution of NREGA payments through bank accounts with job cards

serving as document of identity provides an enormous window of opportunity to

achieve higher banking coverage. The speed with which UIDs are provided to

residents will further facilitate such penetration as these will serve to meet the

KYC norms for account holders with small value transactions.

Role of Payments System

4. I believe that an important task in our national efforts towards achieving

inclusive growth is to bring a significant portion of the payment transactions

across the length and breadth of the country into the formal channels.

Technology adoption by the financial sector offers a unique opportunity in

achieving this objective. The National Payments Corporation of India is

currently engaged in a project that will roll out in a few months. This project will

result in a beneficiary of a remittance being able to use any BC outlet

anywhere, even if he/she has no bank account, to receive in cash a remittance

up to Rs.5000 irrespective of the bank from where the remittance has

emanated. It will also allow seamless transfers across banks using the new

payment products driven by technology. Whenever the issue of technology led

financial inclusion is flagged, a debate often ensues as to whether the model

 4

for inclusive development should look beyond the formal banking channels

insofar as it relates to money transfers/payments. We have studied the

experience of Philippines and Kenya in this regard. We believe that providing

payments services alone is not financial inclusion as there is need for other

products as well. Given that India is still far from being a cash-less society, the

cash-in/cash-out arrangements in these models play an important part in

scaling up. It is important to note that the high level Inter-Ministerial Group

anchored by the Department of Information Technology, Government of India

that went into the issue, after extensive discussions on the various issues

involved , has reached more or less the same conclusion i.e. to proceed with a

bank led model. It is, therefore, essential that banks and mobile /card operators

work together as partners in achieving the objective of a ubiquitous and

efficient payments system.

Savings bank interest rate – case for deregulation?

5. Given the level of interest rates on bank deposits, common persons are lured

by higher interest provided by alternate channels especially in the informal

markets. The deregulation of savings bank interest that is currently set at 3.5

per cent by RBI is an issue which is on our radar. A Working Group is being set

up to debate the issues and draw conclusions. On one hand, the low cost

savings accounts provide banks with low cost funds of an enduring nature

which facilitate ALM and help lower lending rates. On the other hand, the costs

not currently recovered in handling such accounts have to be considered as

well. Totally freeing rates could, in situations where there is virtual monopoly of

banking, lead to lowering rates in some areas while leading to increase in other
 5

areas - it would need to be ensured that there is no discrimination between

different customers of the same bank. Transparency in cost recovery could

facilitate deregulation - this would also need to be non-discriminatory across

locations. An important consideration should be whether deregulation of

savings rates would draw more population into the fold of formal banking

system. All these issues will be gone into in detail by the Working Group..

Capital needs of banks to support inclusive growth

6. A major factor that will determine banks ability to facilitate high growth will be

their ability to garner capital. Over the last 5 years, banks have been able to

increase their Tier 1 capital by an annual average of nearly 30 per cent while

their risk weighted assets increased over this period by more than 26 per cent,

of which about one fourth has been from internal generation, small amount

from government and most of it from the capital markets. Assuming the same

growth in risk weight assets going forward, and given the average return on

capital for the Indian banks, raising capital from the markets may not be a

problem. Given the requirement of Basel III to have common equity as the

dominant part of Tier I capital, and Tier I to be the major part of regulatory

capital, and given that Indian banks are already well placed in this respect, it

would be advisable to retain the advantage even though the new norms will

kick in only in a phased manner.

Forward looking provisioning

7. In a growing economy facing global and domestic shocks, it is likely that

NPAs will increase and the NPA ratio could go up and down. The issue,
 6

however, is whether the margins on earning assets are sufficient to make

adequate provisions for expected losses, apart from generating internal

accruals to support growth in the risk weighted assets. In this context, making

forward looking provisions as is being considered at the Basel level is

extremely important for a country like India. While we have asked banks to

achieve at least a PCR of 70 per cent for NPAs, we are also working on a

scheme based on the Spanish dynamic provisioning model for evolving norms

for provisioning for standard assets in different sectors based on time series

and cross sectional data. Such provisions envisage setting aside profits in good

times which can be used in down turn and provide greater comfort from

financial stability perspective when the economy is pushing forward for higher

growth.

Lending to Infrastructure

8. Aspiration for higher growth implies much more investment in infrastructure.

Needless to say, the headroom available in government finances either at the

State or Central level for funding or for guarantees (explicit or implicit) is limited.

This calls for funding from both financial institutions and capital markets, both

domestic and external. The single borrower and group borrower exposure limits

of banks have already been relaxed to allow for more funding for infrastructure

by Indian banks. Taking into account the concentration risk and asset-liability

mismatches, any further relaxation would be imprudent. From regulatory point

of view, interest rate derivatives - both OTC and exchange traded – have been

allowed and these provide the opportunity to hedge the interest rate risk.

Liquidity requirements on a broad SLR basis as also on a more granular basis

 7

are in place and banks’ positions are constantly monitored to ensure that

mismatches are controlled. To provide liquidity to corporate bonds, repos have

been allowed. The final guidelines on single name Credit Default Swap, once

issued will facilitate dispersal of risk and help mitigate the exposure related

problem to a large extent. Securitization can contribute significantly to

redistribute the credit risk across a wide range of investors outside the banking

system thereby freeing the credit lines of larger borrowers with the banks.

However, securitization should develop in an orderly manner without creating

systemic risk. The revised securitization guidelines including introduction of

minimum retention requirement and minimum holding period with a view to

aligning the interest of the originator and the investor are almost ready as also

the guidelines on capital treatment in case of take-out facility. The overarching

principle that we follow in tweaking these regulations is to see that the needs of

the growing economy are met by the financial system, while taking care that

prudential principles are not compromised, nor is financial stability threatened..

We study the global practices and modify them to meet our unique

requirements and this has been the hallmark of the Indian regulatory approach.

I can assure you that no other sector has posed as much challenge for the

regulators as the infrastructure sector.

Given its unique position, India Infrastructure Finance Company Ltd. (IIFCL) as

a specialized government owned institution for infrastructure funding is well

placed to leverage its parentage and capital in offering more credit

enhancement products and risk mitigants which will help investors such as

banks, insurance and pension funds in managing their credit and market risks
 8

risk. The real issue remains of incentivising long term savers through

insurance and pension schemes with a view to increasing the pool of long term

savings in the system for funding infrastructure.

Para banking activities

9. Of late, banks are also getting involved in investing in or setting up

infrastructure funds or venture capital funds or even in private equity funds.

Where such investments (including the leverage) is below a threshold and do

not constitute a significant share (less than 20 per cent of the fund) or where

the bank has not lent its name or is not involved in the management, no

specific regulatory requirement is being envisaged other than such investment

remaining within the overall capital market exposure limit and maintenance of

appropriate capital.. However, where a bank lends it name directly or indirectly

or floats / manages large private pools of capital, there is a need to have

additional capital requirements to take care of reputation, concentration and

other risks not captured in the traditional framework. This is the reason why we

are looking at bringing out guidance on banks managing large private pools of

capital.

Derivatives – risks in leveraged and complex structures

10. One of the important needs of a growing and increasingly globalizing

economy is for businesses to be able to focus on their main business and have

efficient ways of hedging forex and interest rate risks. Over more than a

decade, new products in the derivatives market have been gradually

 9

introduced, to begin with mostly in OTC markets and more recently on the

exchanges. While many corporates and businesses have used these products

for hedging, the aggressive marketing of these, especially leveraged products,

and their use by businesses to ostensibly lower the cost of funding or cost of

hedging have led to grief to many – banks and businesses alike. The lessons

from this experience underline the need for both banks and customers to

understand such products and the associated risks especially in those with

leveraged and complex structures, having proper risk management policies,

accounting standards and disclosures with adequate guidance to users and

auditors alike for appropriate valuation and MTM practices.

Lending to the millions

11. A major challenge of the next decade is going to be financing the millions in

the unorganized sector, self-employed in the micro and small business sector,

the small and marginal farmers as also oral share-croppers in the agricultural

sector; other challenges include financing affordable housing and education

needs of low income households. These households and businesses do not

maintain proper books of account, have irregular cash flows and hardly any

documents of property or other collateral. Drawing these households into the

formal banking system through opening of bank accounts is only one and albeit

a very first step. The number of borrowers who had borrowed Rs.25,000 and

below from the banking system rose from 36.8 million 2004 to 39.2 million in

2009 - an increase of just 2.4 million over five years. The number of borrowers

who borrowed less than Rs.2,00,000 increased from 61.9 million in 2004 to

95.8 million in 2009 – although there is an increase of nearly 34 million, a vast

 10

majority of the population still remain unserved. If the coverage of those

borrowing less than Rs.2,00,000 has to increase to at least 50 per cent of the

adult population in the next three years, the number of borrowal accounts will

have to increase annually by at least 41.3 per cent. How are banks going to

deal with this scale? Standard products like GCC / ODs against savings

products at affordable rates will have to be offered based on the track record in

savings and recovery, as there is no likelihood of offer of any security. Risk

mitigant products will need to be offered by the development financial

institutions.. Already, SIDBI offers today a credit guarantee product for loans to

MSE where there is no collateral – the scheme has recently been made more

user-friendly. Similar credit risk mitigation products will need to be evolved by

NABARD for small farmers, who cannot offer any document of proof of

possession of land farmed by them, as also for the landless engaged in non

farm and allied activities. Suitable credit guarantees are also required for loans

affected by widespread distress in the event of successive and repeated

natural calamities. NHB will need to evolve similar products for minimizing

documentation risk, credit risk and other risks involved in financing low income

housing. Enhanced and well documented property rights would also improve

the collateral that households and small businesses can offer to lenders that

could lead to reduction in the pricing of such loans. Finally, banks will have to

partner with non-banking financial companies, microfinance institutions and

financial cooperatives to increase outreach as the latter have been quite

innovative addressing the last mile issue. In doing so, banks’ attention will have

to shift to oversight of such portfolios- assigned or securitized- to ensure asset

quality, reasonable rates of interest and fair treatment to ultimate borrowers.

 11

Risk measurement for SMEs

12. In applying a uniform set of regulatory norms across sectors, it is possible

that the nature of risk is not properly differentiated or there is a tendency for

regulating the mean. It is necessary that the specific nature of certain sectors

be kept in focus. First, in retail lending the activity specific cash flow patterns

and portfolio level risk profile will need to be recognized. The concept of retail

lending was brought into Basel II with a specific focus on SMEs. The

diversification benefit resulting in lowering of risk was recognized; under

advanced approaches, models that factor in default behavior over business

cycles provide a more realistic measure of risk. The challenge lies in enhancing

capabilities amongst banks and supervisors to move to advanced approaches

where the credit risk in development finance can be properly captured. Second,

the ratings based approach for risk weighting may need a relook. SMEs that do

not qualify as retail credit are subject to an external rating based risk weight

under the standardized approach. EMEs face significant challenges in this

regard. First, the rating agencies in these countries may not have adequate

credit history to model the default rate. Second, the volumes are huge and

difficult to cope with. Third, the ratings could increase the cost of credit. Fourth,

even with a good rating the availability and pricing of credit depends on other

factors. Finally, the SME borrowers may not able to present well audited

accounts and facts about markets and business dynamics that can be relied

upon by credit rating agencies. As already indicated above, credit guarantee

under the SIDBI scheme takes care of borrowers that have no collateral to
 12

offer. For other SME borrowers credit enhancement schemes would be useful

in enhancing flow of credit to this critical segment of the economy.

Role of credit information agencies

13. The role of credit information companies in this context is worth mentioning.

Ensuring a healthy credit culture requires building up comprehensive and

accurate credit records that can provide information to prospective lenders/

creditors. It can also help build up risk profile in different sectors and regions

and other granulated data that can assist lending institutions in meeting the

challenges of dealing with large numbers. This, however, needs the full

cooperation of credit providers in populating such data bases quickly and

accurately. It is hoped that the four credit information companies recently

licensed will fulfill the role expected of them.

Multiple borrowing and end use issues

14. While the needs of growing economies are manifold, currently, it is

observed that sources of funding of business from non-banks have been equal

to, if not more than, from banks. Multiple borrowing, competitive pressures and

so called balance sheet funding has further aggravated the problem of ensuring

end use. Excess borrowing beyond the needs of production and investment

can lead to potential bubbles and possible deterioration in credit quality. The

role of credit rating agencies in this regard is critical as they provide the link to

capital market funding as also play a role in the capital requirement under

standardized approach for non-retail borrowers. While banks should be moving

towards advanced approaches with less reliance on rating agencies, the rating
 13

agencies in turn have to take a holistic approach while awarding ratings having

regard to end use, asset bubbles and financial stability. The system of

exchange of information that has been put in place by RBI should be made use

of effectively by banks. Also when borrowers with multiple banking

arrangements start showing signs of stress, banks should come together and

look at the holistic viability of the entity rather than adopt ad hoc ‘go it alone’

solutions – this will avert larger sacrifices at later stage.

Conclusion

15. The magnitude of the global financial crisis and consequent corrective

actions have necessitated changes in the regulatory regime. The changes

however, may vary across different countries depending upon the nature and

level of sophistication of the respective financial markets. The new global

standards are expected to enhance the resilience of the banking sector as a

whole, while promoting financial stability in both developed and EMEs.

However, in EMEs such as India, the challenges of rapid and inclusive growth

require the regulator to focus on facilitating financial sector development that is

conducive to such growth while not compromising on prudential principles and

financial stability. This has also implied evolving the regulatory framework to

meet the needs of the productive sectors and in particular, paying specific

attention to key areas such as infrastructure financing, agriculture , MSE,

education and low income housing.

Thank you
 14

Annex
Number of current and savings accounts vis-a-vis population– March 2004 & March 2009

Region/State/Union Total No. of accounts Total Adult Pop. No. of acc. No. of acc. Per
Territory (savings + current) Population (2001 Per 100 of 100 of adult
(2001 Cens.) population pop.
Mar-04 Mar-09 census) Mar- Mar- Mar- Mar-09
04 09 04
NORTHERN REGION 56631826 85513359 132676462 67822312 43 64 84 126
Haryana 8604132 14125096 21082989 11308025 41 67 76 125
Himachal Pradesh 2567880 3894901 6077248 3566886 42 64 72 109
Jammu & Kashmir 3372319 5293074 10069917 5379594 33 53 63 98
Punjab 14898338 20500939 24289296 14185190 61 84 105 145
Rajasthan 12828959 21989369 56473122 28473743 23 39 45 77
Chandigarh 1207303 1625586 900914 546171 134 180 221 298
Delhi 13152895 18084394 13782976 7929589 95 131 166 228
NORTH-EASTERN 7367684 13199596 38495089 19708982 19 34 37
REGION 67
Arunachal Pradesh 219611 430270 1091117 544582 20 39 40 79
Assam 5449787 9488869 26638407 14074393 20 36 39 67
Manipur 213107 451792 2388634 1222107 9 19 17 37
Meghalaya 483084 751812 2306069 1088165 21 33 44 69
Mizoram 121326 307161 891058 476205 14 34 25 65
Nagaland 209271 414093 1988636 995523 11 21 21 42
Tripura 671498 1355599 3191168 1784212 21 42 38 76
EASTERN REGION 49690359 79373634 227613073 122136133 22 35 41 65
Bihar 13689753 22368417 82878796 40934170 17 27 33 55
Jharkhand 6000348 9969955 26909428 13737485 22 37 44 73
Orissa 7258164 13427147 36706920 21065404 20 37 34 64
Sikkim 129462 236944 540493 288500 24 44 45 82
West Bengal 22487486 33147204 80221171 45896914 28 41 49 72
Andaman & Nicobar 125146 223967 356265 213660 35 63 59
Islands 105
CENTRAL REGION 66456406 110517420 255713495 129316677 26 43 51 85
Chhattisgarh 3538965 6542616 20795956 11209425 17 31 32 58
Madhya Pradesh 12285299 19815273 60385118 31404990 20 33 39 63
Uttar Pradesh 47128859 78817573 166052859 82229748 28 47 57 96
Uttaranchal 3503283 5341958 8479562 4472514 41 63 78 119
WESTERN REGION 52703203 79825097 149071747 86182206 35 54 61 93
Goa 1665728 2187748 1343998 891411 124 163 187 245
Gujarat 17176226 26049908 50596992 28863095 34 51 60 90
Maharashtra 33695424 51234546 96752247 56207604 35 53 60 91
Dadra & Nagar 75384 198829 220451 122765 34 90 61
Haveli 162
Daman & Diu 90441 154066 158059 97331 57 97 93 158
SOUTHERN REGION 88052912 148696075 223445381 135574225 39 67 65 110
Andhra Pradesh 25130985 48752136 75727541 44231918 33 64 57 110
Karnataka 20234481 34083877 52733958 30623289 38 65 66 111
Kerala 18269788 23262900 31838619 20560323 57 73 89 113
Tamil Nadu 23839326 41564546 62110839 39511038 38 67 60 105
Lakshadweep 23488 40166 60595 33686 39 66 70 119
Pondicherry 554844 992450 973829 613971 57 102 90 162
ALL-INDIA 32,09,02,390 51,71,25,181 102,70,15,247 54,10,31,553 31 50 59 96
 15

Number of Borrowal accounts vis-à-vis population – March 2004 & 2009

Region/State/Union Territory Total Adult No. of Borrowal No. of No. of acc.
Population Population Accounts acc. Per Per 100 of
(2001 census) (2001 100 of adult pop.
census) populatio
n
Mar-04 Mar-09 Mar Mar Mar- Ma
-04 -09 04 r-
09
NORTHERN REGION 132676462 67822312 6991741 11197675 5 8 10 17
HARYANA 21082989 11308025 1091198 1634121 5 8 10 14
HIMACHAL PRADESH 6077248 3566886 377089 556563 6 9 11 16
JAMMU & KASHMIR 10069917 5379594 376520 586533 4 6 7 11
PUNJAB 24289296 14185190 1524061 2092653 6 9 11 15
RAJASTHAN 56473122 28473743 2272974 3473840 4 6 8 12
CHANDIGARH 900914 546171 103559 190403 11 21 19 35
DELHI 13782976 7929589 1246340 2663562 9 19 16 34
NORTH-EASTERN REGION 38495089 19708982 1217328 2001487 3 5 6 10
ARUNACHAL PRADESH 1091117 544582 30,986 56829 3 5 6 10
ASSAM 26638407 14074393 745588 1300912 3 5 5 9
MANIPUR 2388634 1222107 38,637 73996 2 3 3 6
MEGHALAYA 2306069 1088165 78,113 115229 3 5 7 11
MIZORAM 891058 476205 35,918 60244 4 7 8 13
NAGALAND 1988636 995523 30,626 91328 2 5 3 9
TRIPURA 3191168 1784212 257460 302949 8 9 14 17
EASTERN REGION 227613073 122136133 9150268 12191968 4 5 7 10
BIHAR 82878796 40934170 2323496 3795805 3 5 6 9
JHARKHAND 26909428 13737485 977306 1326608 4 5 7 10
ORISSA 36706920 21065404 2340734 3076704 6 8 11 15
SIKKIM 540493 288500 24,696 36357 5 7 9 13
WEST BENGAL 80221171 45896914 3469985 3931929 4 5 8 9
ANDAMAN & NICOBAR 356265 213660 14,051 24565 4 7 7 11
CENTRAL REGION 255713495 129316677 10104468 14178147 4 6 8 11
CHHATTISGARH 20795956 11209425 607764 948331 3 5 5 8
MADHYA PRADESH 60385118 31404990 2223676 3507700 4 6 7 11
UTTAR PRADESH 166052859 82229748 6787589 9002270 4 5 8 11
Uttarakhand 8479562 4472514 485439 719846 6 8 11 16
WESTERN REGION 149071747 86182206 9118713 31286538 6 21 11 36
GOA 1343998 891411 122574 185453 9 14 14 21
GUJARAT 50596992 28863095 2036263 3224998 4 6 7 11
MAHARASHTRA 96752247 56207604 6948260 27866601 7 29 12 50
DADRA & NAGAR HAVELI 220451 122765 5,777 5072 3 2 5 4
DAMAN & DIU 158059 97331 5,839 4414 4 3 6 5
SOUTHERN REGION 223445381 135574225 29807772 39200362 13 18 22 29
ANDHRA PRADESH 75727541 44231918 7777824 12013970 10 16 18 27
KARNATAKA 52733958 30623289 5967108 8469354 11 16 19 28
KERALA 31838619 20560323 4068814 5702986 13 18 20 28
TAMIL NADU 62110839 39511038 11890839 12803893 19 21 30 32
LAKSHADWEEP 60595 33686 2,469 4641 4 8 7 14
Puducherry 973829 613971 100718 205518 10 21 16 33
 16

ALL-INDIA 1027015247 541031553 66390290 110056177 6 11 12 20

Source: BSR 1
Note: No. of Borrowal accounts is as per place of sanction as on 31st March 2004 & 2009