Money and Banking - Part II, Indian Economy PDF

Money and Banking – Part I Mains Questions:  How would the recent phenomena of protectionism and currency manipulations in world trade affect macroeconomic stability of India?  Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good...

Money and Banking – Part I Mains Questions:  How would the recent phenomena of protectionism and currency manipulations in world trade affect macroeconomic stability of India?  Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments. 124  Money and Banking – Part II 3 Money and Banking - Part II 3.1 History of Indian Banking and Reforms Modern banking in India began in the 18th Century, with the founding of the English Agency Houses in Calcutta and Bombay. Then in the first half of the 19th Century three presidency banks viz. Bank of Bengal (1806), Bank of Bombay (1840) and Bank of Madras (1843) were established. After the introduction of limited liability in 1860, private and foreign banks entered into the market. The beginning of 20th century saw the introduction of Joint stock banks. In 1921, the three presidency banks were merged to create Imperial Bank of India. Imperial Bank of India performed all the normal functions which a commercial bank was expected to perform. In the absence of any Central Bank in India till 1935, the Imperial Bank of India also performed a number of functions which are normally carried out by a Central Bank. At the time of Independence in 1947, the banking system in India was fairly well developed with over 600 commercial banks operating in the country. However soon after independence, the view that the banks from the colonial heritage were biased in favour of working capital loans for trade and large firms and against extending credit to small scale enterprises, agriculture and commoners, gained prominence. To ensure better coverage of banking needs of larger parts of economy and the rural constituencies, the Government of India nationalized the Imperial bank which was established in 1921 and transformed it into the State Bank of India (SBI) with effect from 1955. Despite the progress in 1950s and 1960s, it was felt that the creation of SBI was not far reaching enough since the banking needs of small-scale industries and the agricultural structure was still not covered sufficiently. This was partially due to the existing close ties commercial and industry houses maintained with the established commercial banks, which give them an advantage in obtaining credit. Additionally, there was a perception that banks should play a more prominent role in India’s development strategy by mobilizing resources for sectors that were seen as crucial for economic expansion. As a result, the policy of social control over banks was announced. Its aim was to cause changes in the management and distribution of credit by commercial banks. The post war development strategy was in many ways a socialist one and Indian Government felt that banks in private hands didn’t lend enough to those who needed it most. In July 1969, the Government nationalized all 14 banks whose nation wise deposits were greater than Rs. 50 crores. The bank nationalization in July 1969 with its objective to ‘Control the commanding heights of the economy and to meet progressively the needs of development of the economy in conformity with the national policy and objectives’ served to intensify the social objective of ensuring that financial intermediaries fully met the credit demands for the productive purposes. Two significant purposes of nationalization were rapid branch expansion and channelling of credit according to the plan priorities. The Indian banking system progressed by leaps and bounds after Nationalization and bank branches expanded rapidly both in rural and urban areas. There was a rapid growth in deposits mobilized by the banks, besides credit expansions, especially in the areas 125  Money and Banking – Part II designated as priority sector. After nationalization, the breadth and scope of Indian banking sector expanded at a rate perhaps unmatched by any other country. In April 1980, the government undertook a second round of nationalization, placing under government control the six private banks whose nationwide deposits were above Rs. 200 crores, which increased the public sector bank’s share of deposits to 92%. The second wave of nationalizations occurred because control over the banking system became increasingly more important as a means to ensure priority sector lending reach the poor through a widening branch network and to fund rising government deficits. In addition to the nationalization of banks, the priority sector lending targets raised to 40% from 33.3%. Besides the establishment of priority sector credits and nationalization of banks, the government took further control over banks funds by raising the statutory liquidity ratio (SLR) and the cash reserve ratio (CRR). From a level of 2% for the CRR and 25% for the SLR in 1960, both witnessed a steep increase until 1991 to 15% and 38.5% respectively. In the period of 1969 to 1991, bank branches increased a lot but banks remained unprofitable, inefficient, and unsound owing to their poor lending strategy and lack of internal risk management under government ownership. The major factors that contributed to deteriorating bank performance included:  Too stringent regulatory requirements of CRR and SLR that required banks to hold a certain amount in government and eligible securities  Low interest rates charged on government bonds as compared to commercial advances  Directed and concessional lending  Administrated interest rates and  Lack of competition These factors not only reduced incentives to operate properly, but also undermined regulators incentives to prevent banks from taking risks. While government involvement in the financial sector can be justified at the initial stage of economic development, the prolonged presence of excessively large public sector banks often results in inefficient resource allocation and concentration of power in a few banks. The policies that were supposed to promote a more equal distribution of funds, also lead to inefficiencies in the Indian banking system. India’s banking system until 1991 was an integral part of the government’s spending policy. Through the directed credit rules and the statutory pre-emptions, it was a captive source of funds for the fiscal deficit and the key industries. Through the CRR and the SLR, more than 50% of the savings had either to be deposited with the RBI or used to buy government security. Of the remaining savings, 40% had to be directed to priority sectors that were defined by the government. Besides these restrictions on the use of funds, the government had also control over the prices of the funds, that is, the interest rates on saving and loans. Like the overall economy, the Indian banking sector had severe structural problems by the end of 1980s. The major of those problems were unprofitability, inefficiency and financial unsoundness. By international standards, the Indian banks were, even despite a rapid growth of deposits, extremely unprofitable. Despite the impressive progress made by the banks in the two decades following nationalization, the excessive controls enforced on them by the government fostered certain rigidities and inefficiencies in the commercial banking system. This not only hindered their development but also eroded their profitability. 126  Money and Banking – Part II The need to correct the defects of financial sector was felt during the 1991 crisis. Hence, a high-level committee was constituted under the chairmanship of Shri. M. Narasimhan (Committee on Financial System or Narasimhan Committee - I) to review the progress and working of the Indian financial sector and to suggest measures to reform it. The following were some of the recommendations of the committee:  Statutory Liquidity Ratio (SLR) should be based on prudential requirement for banks and not viewed as a major instrument for financing government budget. SLR should be brought down to 25%  Interest rates should be deregulated gradually and with the deregulation of interest rates, the RBI should resort more to open market operations (buying and selling securities) than changing Cash Reserve Ratio (CRR) to control the secondary expansion of credit  Interest rates on SLR investments should be market related while that on CRR should be broadly related to banks’ cost of deposits  The directed credit programme (requirements to lend certain minimum amount to specific sectors at specified/concessional rates of interest) should be phased out/redefined.  Create a level playing field between the public sector, private sector and foreign sector banks.  An Asset Reconstruction Company (ARC) should be established which could take over from banks and financial institutions a portion of the bad and doubtful debts at an appropriate discount and the ARC should be provided with special powers of recovery.  Select few large banks which could become international in character and eight to ten national level banks with a network of branches throughout the country.  The duality of control over the banking system between the RBI and the Ministry of Finance should end, and RBI should be the primary agency for the regulation of the banking system. The Government of India felt towards the end of 1997 that the time was ripe to look ahead and chart the reforms necessary in the years ahead so that India’s banking system can become stronger and better equipped to compete effectively in a fast-changing international economic environment. Another committee specifically called Committee on banking Sector Reforms was accordingly constituted in 1997 under the chairmanship of the same M. Narasimhan (Narasimhan Committee - II). Following were the major recommendations of Narasimhan Committee - II:  Autonomy in Banking: Greater autonomy was proposed for the public sector banks in order for them to function with equivalent professionalism as their international counterparts. For this the panel recommended that recruitment procedures, training and remuneration policies of public sector banks be brought in line with the best- market-practices. Secondly, the committee recommended GOI equity in nationalized banks be reduced to 33% for increased autonomy.  Stronger Banking System: The committee recommended for merger of large Indian banks to make them strong enough for supporting international trade. 127  Money and Banking – Part II  Capital Adequacy Norms: In order to improve the inherent strength of the Indian banking system the committee recommended that the Government should raise the prescribed capital adequacy norms. This would also improve their risk-taking ability.  Reform in the role of RBI: The committee recommended that the Reserve Bank as a regulator of the monetary system should not be the owner of a bank in view of a possible conflict of interest. Pursuant to the recommendations, RBI has transferred its shareholdings of public banks like SBI, NHB and NABARD to government of India. Most of the reforms as recommended by the two committees have now been implemented. The “Committee on Comprehensive Financial Services for Small Businesses and Low- Income Households” was set up by the RBI in Sep 2013 under the chairman Nachiket Mor. The committee gave its report in January 2014, of which some of the recommendations are listed below:  Each Indian resident, above the age of 18 years, would have an individual, full service, safe and secure bank account.  Aadhaar should be the prime driver towards rapid expansion in the number of bank accounts  Every resident in India should be within a fifteen-minute walking distance of a payment access point.  Each low-income household and small business would have access to providers that can offer them suitable investment and deposit products. Such services must be available to them at reasonable charges. P J NAYAK Committee Public Sector Banks (PSBs) has been established through the “State Bank of India Act 1955” and “The banking companies (acquisition and transfer of undertakings) act, 1970” also referred as Bank Nationalization Act. These Acts require Govt. of India to have majority shareholding and voting power in the PSBs and this empowers the Govt. to appoint Board of Directors and involve in the decision making of the PSBs. It leads to governance issues as the people appointed on the board of these PSBs are not that qualified for their job but are close to Govt. Through this, Govt. starts manipulating the decisions which lead to various kinds of frauds and corruption. In January 2014, P J Nayak committee was constituted, for review of governance of boards of banks in India (which submitted its report in May 2014) to examine the working of banks’ boards, review RBI guidelines on bank ownership and representation in the board, and investigate possible conflicts of interest in the board representation. The following were the main recommendations:  Government should setup a Bank Investment Company (BIC), under Companies act, 2013. Govt. should transfer its present ownership in PSBs to BIC and all the PSBs will be incorporated as subsidiaries of BIC and will be registered under the Companies Act 2013. And the PSBs will become limited companies for example “State Bank of India” will become “State Bank of India Limited”. (This limited means now if the State Bank of India Limited will become bankrupt then Govt. of India/BIC will not be liable and may 128  Money and Banking – Part II not have to put funds from their own resources to protect SBI limited). Government should reduce its stake in PSBs (through BIC) to less than 50%.  The BIC will become a holding company which will be owned by Govt. of India. BIC will have the voting powers to appoint Board of directors and other policy decisions of the banks. Government will sign shareholding agreement with BIC, promising its autonomy. This means that even if the Govt. will be majority shareholders in BIC, but it will not intervene in its working and BIC will select banks directors and top management. (And if required to preserve the autonomy of BIC, Govt. may reduce its ownership to less than 50% in BIC).  But since repealing of the Acts (1955, 1970) and establishment of BIC will take time, so for the time being Govt. can establish Banks Board Bureau (BBB) through an executive order and BBB will select and appoint directors/top management in public sector banks and other public sector financial institutions like NABARD/SIDBI/LIC etc. And once BIC is set up, BBB will be dissolved. In line with the recommendations of the P J Nayak committee and with a view to improve the Governance of Public Sector Banks (PSBs), the GoI appointed an autonomous Banks Board Bureau (BBB) but it was later on replaced by Financial Services Institutions Bureau (FSIB) from 1st July 2022. The following are the functions of the FSIB:  To recommend persons for appointment as whole-time directors (WTDs) and non- executive chairpersons (NECs) on the Boards of Directors in Public Sector Banks, financial institutions and Public Sector Insurers (hereinafter referred to as “PSBs”, “FIs” and “PSIs” respectively.  To advise the Government on matters relating to appointments, transfer or extension of term of office and termination of services of the said directors.  To advise the Government on the desired management structure at the Board level for PSBs, FIs and PSIs  To advise the Government on a suitable performance appraisal system for WTDs and NECs in PSBs, FIs and PSIs  To build a databank containing data related to the performance of PSBs, FIs and PSIs  To advise the Government on formulation and enforcement of a code of conduct and ethics for whole-time directors in PSBs, FIs and PSIs  To advise the Government on evolving suitable training and development programmes for management personnel in PSBs, FIs and PSIs  To help PSBs, FIs and PSIs in terms of developing business strategies and capital raising plan etc.  To carry out such process and draw up a panel for consideration of competent authority for any other bank, financial institution or insurer for which the Government makes a reference (FIs are basically public sector financial institutions like NABARD, NHB, SIDBI, EXIM, MUDRA etc.) 129  Money and Banking – Part II 3.2 Relationship between RBI and Government of India Reserve Bank of India [As per the RBI Act, the Central Board is made up of the following members (21): Governor, four Deputy Governors, Four Directors (one each from the four regional boards of the RBI), 10 directors to be nominated by the Centre, and two government officials, also to be nominated by the Centre]. The relationship between the Board and the Governor is not comparable to a corporate set- up where the managing director (the corporate equivalent of the Governor) reports to the board and draws his powers from it. While a managing director is an agent of the board in a company, in the RBI, the Governor is not. He draws his powers from the RBI Act and not from the Central Board. He is appointed by the Prime Minister in consultation with the Finance Minister. The RBI Board has no say whatsoever in his appointment. In a company, the board of directors chooses one of its own to be appointed as the managing director. In the RBI, the Governor secures board membership only after he is appointed to the post. It is, thus, wrong to compare a corporate board to the RBI’s and suggest that the Governor is subservient to it. In RBI, policy decisions are taken by the Governor with its 4 deputy governors and the (Central) Board is just engaged in providing a broader vision to the RBI. RBI Board has always functioned in an advisory role with the understanding that the Governor would consider its advice while making policy decisions. In other words, there is mutual respect between the Board and the Governor, with both operating in a spirit of accommodation. Relationship between Centre (GoI) and RBI Centre (GoI) and RBI both has their task cut out but they work in close coordination. But in case of a fundamental disagreement between the Centre and the Governor (RBI management), where they are unable to arrive at a common ground, then Centre has the upper hand and can use Section 7 of the RBI Act to give written direction to RBI and in that case RBI decision making will pass on to the RBI (Central) Board and then RBI Governor will have no say. Section 7 has never been unleashed in the 85 -year existence of RBI. It is not as if there have not been any disagreements between RBI Governors and governments before this but, things did not reach the brink and were sorted out quietly behind the scenes. Centre also understands that using Sections 7 will necessarily come with a price and will set a bad precedent. RBI has been kept at arm’s length from the Centre and bestowed with acertain independence. That is because the Centre is the spender and the RBI is the creator of money, and there has to be a natural separation between the two. The Centre arming itself with powers to run the RBI runs afoul of this precept. But there is also a clear reason why, even while it is conceded that control of the nation’s currency should be with an independent authority removed from the sway of elected representatives, the RBI Act has the veto option to the Government in the form of Section 7. And that’s because it is not the technocrats and economists sitting in Mumbai’s Mint Street who carry the can for the policies they frame; it is the rulers in Delhi who do. Ultimately, it is the elected representative ruling the country who is answerable to the citizen every five 130  Money and Banking – Part II years. The representative cannot split hairs before the voter while explaining the economy’s performance — he has to own up for everything, including the RBI’s actions, as his own. In a democracy, it is unthinkable that we will have an institution that is so autonomous that it is not answerable to the people. The risk of such an institution is that it will impose its preferences on society against the latter’s will, which is undemocratic. Seen from this perspective, the limits to the RBI’s autonomy will be clear. It is autonomous and accountable to the people ultimately, through the government. The onus is thus on responsible behaviour by both sides. There is enough creative tension between the two built into the system. The Governor has to be conscious of the limits to his autonomy at all times, and the government has to consider the advice coming from Mint Street in all seriousness. Interpretation of RBI Act regarding its autonomy by previous Governors  Dr. Manmohan Singh: The dynamic between the RBI and the government is one of give and take but if the finance minister insists on a certain course of action, his view need to prevail and the governor may not refuse, unless he is willing to quit his job. The governor of the Reserve Bank is not superior to the finance minister.  Bimal Jalan: RBI is accountable to the government and should make policies within the framework set by the government.  D. Subbarao: RBI does not have the absolute autonomy but it is autonomous within the framework of RBI Act 1934. The existence of Section 7 in the RBI Act, even if it has never been used till now, proves that the RBI is not fully autonomous. The fact that it has never been used is testimony to the sense of responsibility that the government and the central bank have displayed. The Central Bank is autonomous within the limits set by the government and its extent depends on the subject and the context.  Y. V. Reddy: RBI is independent, but within the limits set by the government. I believe that, in operational issues, RBI has total freedom. But, in case of policy related matters, RBI should prior consult with the mandarins in the Finance ministry. Coming to the issues that were thrown up in the recent past, these are mostly operational and it would have been unwise for government to use Section 7 to issue instructions. It would have sent out the wrong signals both at home and abroad. It is good that the government has desisted from using Section 7. Nevertheless, one must say that Section 7 hangs like the sword of Damocles. It is important to have continuous and sustained dialogue, and an atmosphere of give and take is much needed. 3.3 Should large corporate be allowed to open their own banks? Background: Even after three decades of liberalization and rapid growth, “the total balance sheet of banks in India still constitutes less than 70% of the GDP, which is much less compared to global peers” such as China, where this ratio is closer to 175%. Further, domestic bank credit to the private sector is just 50% of GDP when in economies such as China, Japan, the US and Korea it is upwards of 150%. 131  Money and Banking – Part II The Indian economy, especially the private sector, needs money (credit) to grow. Far from being able to extend credit, the government-owned banks are struggling to contain their NPAs. Government finances were already strained before the Covid crisis. With growth faltering, revenues have plummeted and the government has limited ability to push for growth through the public sector banks. Large corporates, with deep pockets, are the ones with the financial resources to fund India’s future growth. But choosing this option is not without serious risks, of which some are mentioned below: 1. Conflict of Interest (technically it is inter-connected lending): Inter-connected lending refers to a situation where the promoter/owner of the bank is also a borrower and, as such, it is possible for a promoter to channel the depositors’ money into their own group companies. So corporate houses can easily turn banks into a source of funds for their own businesses and ensure that funds are directed to their cronies (and at more relaxed terms and conditions which will increase the cost for other borrowers). They can use banks to provide finance to customers and suppliers of their businesses. Adding a bank to a corporate house thus means an increase in concentration of economic power. 2. Even if we equip RBI with legal framework to deal with inter-connected lending, RBI can only react to interconnected lending ex-post, that is, after substantial exposure to the entities of the corporate house has happened. It is unlikely to be able to prevent such exposure. Corporate houses are adept at routing funds through a maze of entities/subsidiaries in India and abroad. Tracing interconnected lending will be a challenge. Monitoring of transactions of corporate houses will require the cooperation of various law enforcement agencies. Corporate houses can use their political clout to thwart such cooperation. 3. Even if RBI gets hold on to interconnected lending, how is the RBI to react? Any action that the RBI may take in response could cause a flight of deposits from the bank concerned and precipitate its failure. The challenges posed by interconnected lending are truly formidable. 4. The recent episodes in ICICI Bank, Yes Bank, DHFL etc. were all examples of inter- connected lending. The so-called ever-greening of loans (where one loan after another is extended to enable the borrower to pay back the previous one) is often the starting point of such lending. 5. Banks owned by corporate houses will be exposed to the risks of the non-bank entities of the group. If the non-bank entities get into trouble, sentiment about the bank owned by the corporate house is bound to be impacted and the depositors will have to be protected through the use of public safety net. 6. Unlike an NBFC (many of which are backed by large corporates), a bank accepts deposits from common public and that is what makes this riskier. Hence, it is prudent to keep the class of borrowers (big corporates) separate from the class of lenders (banks). But if in case large corporates and industrial houses has to be allowed as promoters of banks then this should be done only after the strengthening the supervisory mechanism for large conglomerates. 132  Money and Banking – Part II 3.4 Financial Stability and Development Council (FSDC) With a view to strengthening and institutionalizing the mechanism for maintaining financial stability, enhancing inter-regulatory coordination and promoting financial sector development, the Financial Stability and Development Council (FSDC) was set up by the Government of India as the apex level forum in December 2010. FSDC is not a statutory body and was set up through a gazette notification. The Chairman of the Council is the finance minister and its members include the heads of financial sector Regulators (RBI, SEBI, PFRDA, IRDA), Chairperson of Insolvency and Bankruptcy Board of India (IBBI), Chief Economic Advisor and secretaries from ministry of finance, ministry of Information Technology and ministry of Corporate Affairs. The Council can also invite experts to its meeting if required. Without prejudice to the autonomy of regulators, FSDC shall deal with issues relating to:  Financial stability  Financial sector development  Inter-regulatory coordination  Financial literacy  Financial Inclusion  Macro prudential supervision of the economy including the functioning of large financial conglomerates  Coordinating India’s international interface with financial sector bodies like Financial Action Task Force (FATF), Financial Stability Board (FSB), and any such body as may be decided by the finance minister from time to time  Any other matter relating to the financial sector stability and development referred to by a member/Chairperson and considered prudent by the Council/Chairperson 3.5 Development Financial Institutions (DFIs) An efficient and robust financial system acts as a powerful engine of economic development by mobilizing resources and allocating the same to their productive uses. In a developing country, however, financial sectors are usually incomplete in as much as they lack a full range of markets and institutions that meet all the financing needs of the economy. For example, there is generally a lack of availability of long-term finance for infrastructure and industry, finance for agriculture and small and medium enterprises (SME) development and financial products for certain sections of the people. The role of development finance is to identify the gaps in institutions and markets in a country’s financial sector and act as a ‘gap-filler’. The principal motivation for developmental finance is, therefore, to make up for the failure of financial markets and institutions to provide certain kinds of finance to certain kinds of economic agents and sectors. The failure may arise because the expected return to the provider of finance is lower than the market-related return (notwithstanding the higher social return) or the credit risk involved cannot be covered by high-risk premium as economic activity to be financed becomes unviable at such risk-based price. The vehicle for extending development finance is called development financial institution (DFI) or development bank. The following are the important features of DFIs: 133  Money and Banking – Part II  A DFI is defined as "an institution promoted or assisted by Government mainly to provide development finance to one or more sectors or sub-sectors of the economy.  The institution distinguishes itself by a judicious balance between commercial norms of operation, as adopted by any private financial institution, and developmental obligations;  It emphasizes the "project approach" - meaning the viability of the project to be financed – against the "collateral approach";  Apart from provision of long-term loans, equity capital, guarantees and underwriting functions, a development bank normally is also expected to upgrade the managerial and the other operational pre-requisites of the assisted projects.  Its insurance against default is the integrity, competence and resourcefulness of the management, the commercial and technical viability of the project and above all the speed of implementation and efficiency of operations of the assisted projects.  Its relationship with its clients is of a continuing nature and of being a "partner" in the project than that of a mere "financier". Thus, the basic emphasis of a DFI is on long-term finance and on assistance for activities or sectors of the economy where the risks may be higher than that the ordinary financial system is willing to bear. DFIs may also play a large role in stimulating equity and debt markets by (i) selling their own stocks and bonds; (ii) helping the assisted enterprises float or place their securities and (iii) selling from their own portfolio of investments. The success of various DFIs across the world provided strong impetus for creation of DFIs in India after independence, in the context of the felt need for raising the investment rate. RBI was entrusted with the task of developing an appropriate financial architecture through institution building so as to mobilize and direct resources to preferred sectors as per the (Five Year) Plan priorities. While the reach of the banking system was expanded to mobilize resources and extend working capital finance on an ever-increasing scale, to different sectors of the economy, the DFIs were established mainly to cater to the demand for long- term finance by the industrial sector. The first DFI established in India in 1948 was Industrial Finance Corporation of India (IFCI) followed by setting up of State Financial Corporations (SFCs) at the State level after passing of the SFCs Act, 1951. Besides IFCI and SFCs, in the early phase of planned economic development in India, a number of other financial institutions were set up, which included the following. ICICI Ltd. was set up in 1955, LIC in 1956, Refinance Corporation for Industries Ltd. in 1958 (later taken over by IDBI), Agriculture Refinance Corporation (precursor of ARDC and NABARD) in 1963, UTI and IDBI in 1964, Rural Electrification Corporation Ltd. and HUDCO Ltd. in 1969-70, Industrial Reconstruction Corporation of India Ltd. (precursor of IIBI Ltd.) in 1971 and GIC in 1972. NABARD, NHB, SIDBI, EXIM bank are also treated as development financial institutions. As such, the term “DFI” is not standardized in any statute. 3.6 Categorization of Loans (No need to go in detail on this topic, just have a look on the terms which will help you in understanding other topics) Loans and advances given by banks are ‘assets’ for them (the "loan document" signed by the borrower and kept with banks is an asset for the bank as based on this loan document the 134  Money and Banking – Part II bank receives principal and interest back). Depending on the performance of such loans (i.e. whether banks are receiving interest & principal or not) they are classified as per the norms provided by RBI. The RBI's classification of assets is aimed to bring transparency and consistency in the accounts. There are different criteria for different types of loans (assets) for standard and non performing classification, and there is no need to go into detail. But generally non- performing assets (NPA) are those assets for which interest and/or principal have remained overdue for a period of more than 90 days. Restructured asset or loan are that assets which got an extended repayment period, reduced interest rate, converting a part of the loan into equity, providing additional financing, or some combination of these measures. Hence, under restructuring a bad loan is modified as a new loan (standard). A restructured loan also indicates bad asset quality of banks. This is because a restructured loan was a past NPA and it has been modified into a new loan. Write-off: It is an accounting term. It means that the lender doesn't count the money you owe them as an asset of the company anymore and it removes it from the balance sheet. The banks write-off loan when they are sure that they won't be able to recover the money and they reduce the value of the loan/asset to zero. They're required to write off certain bad loans so as not to mislead investors. But you still owe the money. Default means non-payment of debt when whole or any part or instalment of the amount of debt has become due and payable and is not repaid by the debtor. Stressed assets = NPAs + Restructured loans + Written off assets Secured debt means a debt which is secured by any security interest. Security interest means right, title or interest of any kind, upon property (physical/financial) created in favour of any secured creditor. Secured Creditor means any bank or financial institution holding any right, title or interest upon any physical or financial (tangible or intangible) asset. Security agreement means an agreement, instrument or any other document or arrangement under which security interest is created in favour of the secured creditor including the creation of mortgage by deposit of title deeds with the secured creditor. 135  Money and Banking – Part II Secured asset means the property (physical like house or financial like shares) on which security interest is created. Asset Reconstruction Company (ARC): A company registered with RBI (and regulated by RBI) for the purpose of carrying on the business of asset reconstruction or securitization. Asset reconstruction means acquisition by an ARC of any right or interest of any bank or financial institution in any debt/loan/advance for the purpose of realisation/recovery of such debt. Securitization: Acquisition of financial assets (debt or security interest) by an ARC from any financial institution for the purpose of converting such assets into marketable securities. It refers to conversion of illiquid assets into liquid assets. ARCs can purchase both the rights/interest (asset reconstruction) in a debt or the debt itself (for the purpose of securitization). 3.7 SARFAESI Act 2002 The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act 2002 (SARFAESI Act 2002) Earlier, the banks and financial institutions in India did not have power to take possession of securities and sell them in case of a loan default (rather they had to enforce their security interests through the court process, which was extremely time consuming). This had resulted in slow pace of recovery of defaulting loans and mounting levels of nonperforming assets of banks and financial institutions. Narasimham Committee I and II constituted by the Central Government for the purpose of examining banking sector reforms had considered the need for changes in the legal system in respect of these areas. These Committees, inter alia, suggested enactment of a new legislation for securitisation and empowering banks and financial institutions to take possession of the securities and to sell them without the intervention of the court. Acting on these suggestions, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 was enacted to regulate securitisation and reconstruction of financial assets and enforcement of security interest. The SARFAESI Act sanctions three processes to recover Non-Performing Assets as follows: 1. Security Enforcement without court’s intervention: As per the Act, the financial institutions are entitled to issue notice to the defaulting loan takers as well as guarantors, asking them to clear the sum in arrears within 60 days from the date of issuing the notice. If the defaulter fails to act in accordance with the notice, the bank is entitled to enforce security interest (i.e., the act allows banks and financial institutions to sell the “security interest” in case the debt/ loan is secured and it has become non performing). 2. Asset reconstruction: It means acquisition by an ARC of any right or interest of any bank or financial institution in any debt/loan/advance for the purpose of realisation/recovery of such debt. 136  Money and Banking – Part II 3. Securitization: Acquisition of financial assets (loans) by an ARC from any financial institution for the purpose of converting such assets into marketable securities. The provisions have enabled banks and financial institutions to improve recovery by exercising powers to take possession of securities, sell them and reduce nonperforming assets by adopting measures for recovery and reconstruction. 3.8 NPA Crisis and Bad Bank Credit led boom of the 2000 decade followed by the Global Financial Crisis of 2008 and then domestic issues in the UPA-II regime (2009-2014) resulted in huge NPAs in the economy. When the NPA’s started surfacing in the post 2013 period because of the RBI’s strict supervision then various measures/schemes were announced by RBI to resolve the NPA mess and IBC 2016 was also enacted. But every default cannot go to NCLT under IBC, so the Economic Survey in 2017 suggested for a different approach to set up a centralized public sector asset reconstruction company to resolve the NPA mess. And due to Covid-19, which is once in a century crisis, the problem of NPA is expected to aggravate, and the establishment of a bad bank is now more pertinent to handle the stressed asset crisis. Accordingly, Govt. of India created a ‘Bad Bank’ named ‘National Asset Reconstruction Company Ltd.’ (NARCL) in 2021 which is basically an ‘Asset Reconstruction Company’ (ARC). NARCL will be 51% owned by Public Sector Banks and financial institutions, and the remaining 49% stake will be held by private sector lenders. NARCL is "Government Company", "Public Company" and "Unlisted Company". Another entity, India Debt Resolution Company (IDRCL), has also been set up which is a ‘Non-Govt.’ Company. NARCL and IDRCL will together act as bad bank. NARCL will first purchase the bad loans from commercial banks and then IDRCL will try to sell out the bad loans and recover money. A two-entity structure has been created for operational and governance purpose. Let us understand with an example. Suppose SBI had earlier given loan worth Rs. 1000 crore and it turned into NPA. So, SBI would sell this NPA to the bad bank for recovery and would rather focus on its banking business. So, Bad bank will purchase this NPA from SBI but not in Rs. 1000 crore. The bad bank will try to estimate how much money it would actually be able to recover from the NPA and accordingly it would quote a price for it. If SBI also agrees then, SBI will sell this NPA/bad loan (paper) to bad bank, let us say in Rs. 300 crores. But the bad bank will not immediately pay in cash Rs. 300 crores to SBI. Rather, the bad bank will pay just 15% of the agreed amount (of the Rs. 300 crore) i,e. Rs. 45 crores in cash and the rest 85% i.e., Rs. 255 crores in securities (a kind of debt paper), which will be paid once the bad bank recovers the money by resolution or liquidation of the bad asset. But what if the bad bank in future is unable to sell the bad loan or sells the bad loan at a loss (i.e., at less than Rs. 300 crore) and is not able to pay Rs. 255 crores to SBI. So, Govt. of India has agreed to provide "Government Guarantee" on the securities that will be issued by the bad bank. 137  Money and Banking – Part II A bad bank conveys the impression that it will function as a bank but has bad assets (NPAs) to start with. Technically, a bad bank is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time. The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans. The bad bank concept is in some ways similar to an Asset Reconstruction Companies (ARC) but is funded by the government initially, with banks and other investors co-investing in due course. The presence of the government is seen as a means to speed up the clean-up process. Bad bank will lead to freeing of the commercial bank’s capital which will lead to further lending and will promote investment and growth in the economy. And Bad Banks will have experts which will try to recover/resolve the NPAs (bad loans) that it has acquired from all the banks. This will clean up the bank’s balance sheet but mere transferring the NPAs to bad bank will not reduce the overall NPA in the economy which will have to be taken care of by the bad bank. 3.9 RBI Circular (June 2019) on Resolution of NPAs Once a borrower is reported to be in default, lenders should start a review of the borrower account within 30 days of the default. “During this review period of thirty days, lenders may decide on the resolution strategy, including the nature of the resolution plan (RP), the approach for implementation of the RP. If the RP is to be implemented, lenders have been asked to enter into an inter-creditor agreement (ICA), within the review period, to provide for ground rules for finalization and implementation of the RP. The ICA shall provide that any decision agreed by lenders representing 75% by value of total outstanding credit facilities and 60% of lenders by number shall be binding upon all the lenders. The RP will have to be implemented within 180 days from the end of review period. There is a disincentive for banks if they delay implementing a viable resolution plan. In case the plan is not implemented within 180 days from the end of review period, banks have to make additional provision of 20% and another 15% if the plan is not implemented within 365 days from the start of the review period. The additional provisions would be reversed if resolution is pursued under IBC Code. Half of the additional provisions could be reversed on filing of insolvency application and the remaining additional provisions may be reversed once case is admitted for insolvency proceedings. This has been done so that more lenders move to IBC Code. The new guidelines are applicable to Scheduled Commercial Banks (excluding RRBs), Small Finance Banks, Non-Banking Financial Companies (NBFCs) and Development Financial Institutions like NABARD, SIDBI, EXIM Bank and NHB. Amendments done in 2017 in Banking Regulation Act 1949 (regarding resolution of NPAs):  The Central Government may, by order, authorize RBI to issue directions to any banking company to initiate insolvency resolution process in respect of a default, under the provisions of Insolvency and Bankruptcy Code 2016 138  Money and Banking – Part II  RBI may from time-to-time issue directions to any banking company for resolution of stressed assets As per Supreme Court judgement dated 2nd April 2019, “RBI can only direct banking institutions to move under the IBC Code 2016 if there is a central government authorization and it should be in respect of specific defaults. Thus, any directions which are in respect of debtors in general, would-be ultra vires Section 35AA of Banking Regulation Act 1949”. 3.10 Insolvency and Bankruptcy Code 2016 Insolvency is a situation when an individual or a company is unable to pay its debt while bankruptcy is a legal procedure for liquidating (winding up) a business (or property owned by an individual) which cannot fully pay its debts out of its current assets. Before the IBC code, there were multiple overlapping laws and adjudicating forums in India like Company Law Boards, Debt Recovery Tribunal, SARFAESI Act 2002, Sick Industrial Companies (Special Provisions) Act, 1985 and the winding up provisions of the Companies Act, 1956 etc. dealing with financial failure of companies and individuals leading to significant delays in winding up a company. The legal and institutional framework did not help lenders in effective and timely recovery or restructuring of defaulted assets and caused undue strain on the Indian credit system. Recognizing that reforms in the bankruptcy and insolvency regime were critical for improving the business environment and alleviating distressed credit markets, the Government enacted the Insolvency and Bankruptcy Code in May 2016, making it easier to wind up a failing business and recover debts. The Code makes a significant departure from the earlier resolution regime by shifting the responsibility on the creditor to initiate the insolvency resolution process against the corporate debtor. Under the previous legal framework, the primary onus to initiate a resolution process lied with the debtor, and creditor may pursue separate actions for recovery, security enforcement and debt restructuring. Procedure: Under the IBC code, a creditor (financial or operational) or the corporate debtor may initiate corporate insolvency resolution process in case a default is committed by corporate debtor worth more than Rs. 1 crore. An application can be made before the National Company Law Tribunal (NCLT) for initiating the resolution process. The creditor needs to give demand notice of 10 days to corporate debtor before approaching the NCLT. If corporate debtor fails to repay dues to the creditor or fails to show any existing dispute or arbitration, then the creditor can approach NCLT. Upon admission of application by NCLT, Corporate insolvency process shall be completed within 180 days (in complex cases it can be extended to 90 days) during which time NCLT hears the proposals for revival and decide on the future course of action. [The corporate insolvency resolution process should be completed within 330 days if there are any legal proceedings involved but in case of exceptional cases (tardy legal proceedings) it can be extended even beyond 330 days]. NCLT appoints the Insolvency Professionals (IP) upon confirmation by the Insolvency and Bankruptcy Board (IBB). NCLT causes public announcement to be made of the initiation of corporate insolvency process and calls for submission of claims by any other creditors. After receiving claims pursuant to public announcement, IP constitutes the creditors’ committee called Committee of Creditors (CoC) constituting all creditors (first interim IPs are 139  Money and Banking – Part II appointed and when the CoC approves, then the IPs are confirmed as Resolution Professionals). Resolution Professionals shall submit the insolvency resolution plan before the creditors’ committee for its approval. The CoC has to then take decisions regarding insolvency resolution by a 66% majority voting (by value). The resolution plan could either be a revised repayment plan (which is essentially a reorganization plan through debt restructuring, sale of assets, merger, takeover of the company etc.) for the company, or liquidation of the assets of the company. The resolution plan will be sent to NCLT for final approval, and implemented once approved. If no decision is made during the resolution process or CoC fails to approve the resolution plan then the debtor’s assets will be liquidated to repay the debt. The IBC process flowchart [The Resolution Plan is submitted by interested resolution applicants who can participate in the resolution process and submit ‘resolution plans’, which are basically instruments for taking over the corporate debtor, paying the dues of its creditors and undertaking its revival and turn-around. The Resolution plan is placed for consideration before the Committee of Creditors (“CoC”) by the Resolution professionals. If Resolution happens that means the company will exist and continue its business and Liquidation means company’s assets will be sold and the company will cease to exist]. [Committee of Creditors (CoC) consists of only financial creditors (like banks, NBFCs etc.). But the proceeds/money from the resolution process is shared by the financial and operational creditors both. Only CoC will decide how the resolution proceeds will be shared among financial and operational creditors and NCLT will not have any say. NCLT cannot interfere in the merits of the commercial decision taken by the CoC but a “limited judicial review” is possible to see that the CoC had taken into account, inter alia, the fact that the interest of all stakeholders, including operational creditors had been taken care of. A Financial creditor, operational creditor, or a corporate debtor (who has borrowed money) anyone can initiate insolvency proceedings upon any default made by the corporate debtor.] The objective of the new law is to promote entrepreneurship, availability of credit, and balance the interests of all stakeholders by consolidating and amending the laws relating to reorganization and insolvency resolution of companies and individuals in a time bound manner and for maximization of value of assets. Some business ventures will always fail, 140  Money and Banking – Part II but they will be handled rapidly and swiftly. Entrepreneurs and lenders will be able to move on, instead of being bogged down with decisions taken in the past. The Code has four pillars of institutional infrastructure which is its most innovative feature and are as following: - 1. The first pillar of institutional infrastructure is a class of regulated persons, the ‘Insolvency Professionals’. They would play a key role in the efficient working of the bankruptcy process. They would be regulated by ‘Insolvency Professional Agencies’. 2. The second pillar is a new industry of `Information Utilities'. These would store facts about lenders and terms of lending in electronic databases. This would eliminate delays and disputes about facts when default does take place. 3. The third pillar is adjudication. The National Company Law Tribunal (NCLT) will adjudicate cases related to insolvency of companies and Debt Recovery Tribunal (DRTs) will do the same for individual insolvencies. These institutions, along with their Appellate bodies, viz. National Company Law Appellate Tribunal (NCLAT) and Debt Recovery Appellate Tribunal (DRAT) will help in better functioning of the bankruptcy process. 4. The fourth pillar is a regulator viz., ‘The Insolvency and Bankruptcy Board (IBB) of India’. This body will have regulatory over-sight over the Insolvency Professional, Insolvency Professional agencies and information utilities. The code also protects workers (paying their salaries for up to 24 months will get first priority in case of liquidation of assets) in case of insolvency and disqualifies anyone declared bankrupt from holding any public office. The Insolvency and Bankruptcy Code (IBC) 2016 was not applicable for Financial Service Providers (FSP) like Commercial, Co-operative and Regional Rural Banks, NBFCs, Insurance Companies, Pension Funds, Securities Market Players etc. But, as there were a lot NBFCs like IL&FS, DHFL etc. facing crisis, Ministry of Corporate Affairs, Govt. of India, on 15th Nov. 2019, notified section 227 of IBC 2016 (only temporary arrangement) to enable the resolution of NBFCs (Financial Service Providers) regulated by RBI, through NCLT under IBC. As per Section 227 of IBC 2016: "Notwithstanding anything to the contrary examined in this Code or any other law for the time being in force, the Central Government may, if it considers necessary, in consultation with the appropriate financial sector regulators, notify financial service providers or categories of financial service providers for the purpose of their insolvency and liquidation proceedings, which may be conducted under this Code…..” Ministry of Corporate Affairs, using the powers under section 227, consulted the regulator i.e., RBI and notified that those NBFCs with asset size of more than Rs. 500 crores can be brought under IBC code for resolution. The insolvency for Financial Service Provider (NBFCs) can be initiated only on an application by the regulator (RBI). This is not applicable in other company cases where in case of default, either the creditor or the debtor (company), anyone can move for resolution under IBC 2016. DHFL was the first NBFC to be referred to NCLT under section 227 of IBC 2016. 141  Money and Banking – Part II Government is working on a new framework/law to handle insolvencies of Financial Service Providers (FSP) like Commercial, Co-operative and Regional Rural Banks, NBFCs, Insurance Companies, Pension Funds, Securities Market Players etc. This new framework/law will be on the lines of Financial Resolution and Deposit Insurance (FRDI) Bill, which Govt. had planned to introduce in 2018 but did not do so because of the protests regarding the controversial "Bail-in" clause. Important features of the Code:  Time bound and market linked resolution of stressed assets.  During the resolution process, management of the company passes on to resolution professionals who will prevent any siphoning off funds or manipulation by debtors.  IBC tries for maximization of value of assets by prioritizing resolution (where the company will continue to function) rather than liquidation (company cease to exist and assets are sold in the market). Some business ventures will always fail, but they will be handled rapidly and swiftly which will promote entrepreneurship, availability of credit, and balance the interests of all stakeholders.  The code makes it easier to exit or attempt revival of a business, thereby improving the NPA scenario for the financial services sector. Entrepreneurs and lenders will be able to move on, instead of being bogged down with decisions taken in the past.  The IBC has provided a major stimulus to ease of doing business, enhanced investor confidence and has given a boost to both foreign and domestic investors as they now look at India as an attractive investment destination.  The implementation of IBC has helped in pushing economic growth higher by a few percentage points by saving various companies from premature death.  The success of the IBC is not just in numbers, rather its performance lies in the behavioural change of the companies (debtors). Credible threat of the IBC process that a company may change hands has changed the behaviour of the debtors. Thousands of debtors are settling defaults in early stages of the life cycle of a distressed asset. Challenges:  Out of all the cases admitted to NCLT under IBC, only 15% ended in Resolution and rest went for Liquidation  Very few benches of NCLT to admit the insolvency cases, resulting in delay in resolution  Cross border insolvency has not yet been implemented Comment: The code aims at early identification of financial failure and maximizing the asset value of insolvent firms. The Code is thus a comprehensive and systemic reform, which will give a quantum leap to the functioning of the credit/bond market. It would take India from among relatively weak insolvency regimes to becoming one of the world's best insolvency regimes giving a big boost to ease of doing business in India. IBC 2016 was amended in 2021 to introduce a "Pre-Pack" scheme for MSMEs.  If an MSME has defaulted and the default is of less than Rs. 1 crore then "Pre-Pack" scheme can be used. Under this scheme the previous promoters and the creditors will take up a resolution plan to NCLT for approval rather than resolution plan suggested by outsiders through open bidding process in which case the company may go to new owners. And during this resolution process, the management of the firm (MSME) will 142  Money and Banking – Part II remain with the original promoters. [Under normal IBC proceedings, the management control of the firm passes on to Resolution Professionals]  If the resolution plan does not offer full recovery for operational creditors, then an open bidding process for submission of resolution plan can be conducted in which there will be chances that the company (MSME) may go to some other new owners and this will force the original promoters to compensate the operational creditors. This is called "Swiss Challenge". Following are differences between Pre-Pack and Corporate Insolvency Resolution Process. Pre-Packaged Insolvency Resolution Corporate Insolvency Resolution Process Process (PIRP) (CIRP) Only corporate debtors can initiate PIRP Corporate debtors or creditors anyone can initiate CIRP The owner of the distressed company Public bidding process happens wherein (debtor) submits the resolution plan anyone can submit the resolution plan Existing management retains control of the Management of the distressed firm is passed distressed firm under PIRP on to ‘Resolution Professionals’ in CIRP Applicable for defaults of less than Rs. 1 Applicable for defaults of more than Rs. 1 crore crore. Should be completed in 120 days Should be completed in 180 days 3.11 Advance Pricing Agreement (APA) XYZ and PQR companies are owned by ABC. XYZ, PQR and ABC will be called related parties. And the directors/owners of these companies are also called related parties. Any transaction happening between related parties are called related/connected parties’ transaction and this transaction should happen at market price which is referred as ‘Arm’s Length Principle’. The pricing of goods and services between related parties is called ‘Transfer Pricing’ and it should follow ‘arms-length principle’. One of the disputed issues in taxation related to MNCs is the area of intra (group) company transactions or related party transactions. Here, a parent company say in Japan may charge a convenient price from its subsidiary in India to minimise its tax payment in India. For example, suppose that Maruti Suzuki India 143  Money and Banking – Part II has higher profit and has to pay higher tax to the Government of India. In this case, if Suzuki Japan charges a high price for a component it sold to Maruti, then profit of Maruti in India will come down and the tax payment of the company to GoI will also come down. On the other hand, the revenue/profit of Suzuki Japan will go up. Altogether, the Suzuki Motor Corporation (SMC) group improves its position; but GoI’s tax revenue gets affected. This is a strategy/manipulation to shift the profit from Maruti India to Suzuki Japan because the tax is favourable in Zapan. This would be called “Base Erosion and Profit Shifting” (BEPS). In recent times, MNCs are developing sophisticated and refined tax planning practices to avoid tax by shifting their incomes/profits to other countries, especially to tax havens. Such practices eroded the tax base. To avoid such a manipulation, tax department of India pre-sets the price charged for different components between Maruti Suzuki India and Suzuki Japan. But this price should follow “arm’s length principle” i.e., market based. An arm's length transaction refers to a business deal in which buyers and sellers act independently without one party influencing the other. These types of sales assert that both parties act in their own self-interest and are not subject to pressure from the other party; furthermore, it assures others that there is no collusion between the buyer and seller. At the beginning of the year, the price charged for intra company transactions will be determined in advance and will be kept for the coming five years or so. This price arrangement between Maruti and India’s tax department is called advance pricing agreement (APA). An APA is a contract, usually for multiple years, between a taxpayer and at least one tax authority specifying the pricing method that the taxpayer will apply to its related-company transactions. These programmes are designed to help taxpayers voluntarily resolve actual or potential transfer pricing disputes in a proactive, cooperative manner, as an alternative to the traditional examination process. APAs gives certainty to taxpayers reduces disputes, enhance tax revenues and make the country an attractive destination for foreign investments. These agreements would be binding both on the taxpayer as well as the government. Similarly, they lower complaints and litigation costs. In June 2019, India ratified the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (multilateral instruments (MLI)), which was signed by the finance minister in Paris in June 2017 on behalf of India, along with representatives of more than 65 countries. The MLI is a result of concerted work by the G20 countries to tackle the issue of base erosion and profit shifting, something that affects them all. The MLI will modify India’s tax treaties to curb revenue loss through treaty abuse and base erosion and profit shifting strategies by ensuring that profits are taxed where substantive economic activities generating the profits are carried out. The MLI will be applied alongside existing tax treaties (such as Double Taxation Avoidance Agreement), modifying their application in order to implement the BEPS measures. The MLI came into force for India from October 1, 2019. Bilateral Investment Treaties (BIT): BITs are agreements between two Countries (States) for the reciprocal promotion and protection of investments in each other's territories by individuals and companies situated 144  Money and Banking – Part II in either State. When countries enter into a BIT, both countries agree to provide protections for the other country’s foreign investments that they would not otherwise have. A BIT provides major benefits for investors in another country, including national treatment, fair and equitable treatment, protection from expropriation and performance requirements for investments, and access to neutral dispute settlement (international arbitration) etc. The first BIT was signed by India on March 14, 1994. Since then, the Government of India has signed BITs with more than 80 countries. Recently, India has terminated its bilateral investment treaties (BIT) with 57 countries. In Dec 2015, The Union Cabinet gave its approval for the revised Model Text for the Indian Bilateral Investment Treaty. The revised model BIT will be used for re-negotiation of existing BITs and negotiation of future BITs. The new model clarifies that it only covers investments that have a physical presence and substantial business activities in the territory of the host state. Foreign investors also claim that the new model BIT is protectionist in nature. 145