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Non Performing Assets

by admin

Non Performing Assets

This article deals with ‘Non Performing Assets .’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Scale of Problem

India is facing a serious NPA problem.
Indian Commercial Banks’ NPA reached ₹12 lakh crores in 2018; and 11.2% of total lending. Although NPAs are declining after achieving a peak in 2018.
RBI has placed a moratorium on Indian banks like Lakshmi Vilas Bank and Yes Bank capping deposit withdrawals due to a large amount of NPAs in these banks.
The majority of these NPAs is in Public Sector Banks (Rs 10 lakh crore in 2018) and are in the name of Big Business Houses, leading to the Twin Balance Sheet Problem.

What is NPA?

Generally speaking, NPA is any asset of a bank that is not producing any income.
On a bank’s balance sheet, loans made to customers are listed as assets. The biggest risk to a bank is when customers who take out loans stop making their payments, causing the value of the loan assets to decline.

Criteria of deciding NPA

Loans don’t go bad straightaway. Customers are allowed a certain grace period.
- Commercial Loans: More than 90 days overdue.
- Agriculture Loans: More than 2 harvest seasons or 2 years, whichever is lesser.

Categories

Net NPA

Above is Gross NPA. Net NPA is obtained by taking into account Provisioning.
Provisioning means banks are required to set aside some funds to cover the losses done by NPAs.

Net NPA = Gross NPA – Provisioning

Stressed Assets

Stressed Assets = NPA + Loans Written Off
Banks generally write-off loans to reduce their taxable income & corporate tax & also to clean up their balance sheet. But Write-off doesn’t mean Loan Waiver. They still have the right to recover their loans.

Causes of huge NPA

NPA has reached the level of ₹12 lakh crore. The main reasons that the situation has reached such a level are

Over-optimism of the Banking Sector: Many NPAs can be traced back to 2006-2008 when banks didn’t pay due diligence while giving loans to power and infrastructure projects, anticipating high economic growth.
Global and domestic macro-economic instabilities in the recent decade: Due to this, a slowdown was seen in the economy diluting the capability of the borrowers to service the loans.
Cost Overruns: Projects suffered from delays due to Policy Paralysis, Judicial Activism and Environmental activism, thus impacting the loan servicing capability of the borrowers was dented in a big way.
Projects were not able to recover their costs due to the Global Financial Crisis of 2008.
Poor Credit Appraisal System: The banks have not developed sufficient capacity to undertake credit appraisal before giving loans.
Wait & Watch Approach of Banks: Evergreening of loans (i.e. zombie lending or giving the loan to pay back the old loan) by banks before forming Bankruptcy code.
Regulatory and Policy Risks: The past few years in India saw a volatile regulatory framework that built stress in certain industries. Some examples include
- Mining ban in certain southern Indian states
- The decision to cancel and re-auction the telecom airwaves
Industry-Specific Risks: Industry-specific reasons caused a rise in NPA levels in India. Sectors that are seeing advanced stress are aviation, textile, and telecom. The higher NPAs in the aviation sector can be attributed to the high cost of aviation turbine fuel, which accounts for 45% of total operating costs.
Poor Credit Appraisal System: The banks have not developed sufficient capacity to undertake credit appraisal before giving loans.
Wilful Defaulters: There has been an increase in the number of wilful defaulters who have failed to repay their loans in spite of having the capability to do so.
Priority Sector Lending loans turned NPA because they cater to economically vulnerable sections.
Credit Culture: The announcement of farm loan waivers by the Central Government and various state governments has affected the credit culture in India.
Lack of Policy foresight: Delay in the formulation of insolvency and bankruptcy code for faster resolution of NPAs.
Lack of Integrated database on Credit Information: Presently, multiple agencies capture credit-related information without proper coordination. Further, the RBI’s proposal to create Public Credit Registry faces legal challenges.

Impact of higher NPAs

Reduced Profitability of Banks: Due to the provisioning, banks are forced to keep 25 to 30% of NPAs, impacting banks’ profitability.
Capital Adequacy: With the increase in the NPAs, the banks’ capital requirements become higher, thus putting additional pressure on the government to recapitalize the banks.
Lower confidence of shareholders: The increase in the levels of NPAs decreases shareholders’ confidence, making it difficult for the banks to raise capital from the market.
Public confidence: It lowers the confidence of the common public in weak banks, making it difficult for such banks to gather cash for their operations.
It has led to the scarcity of funds in the Indian market. Consequently, businesses can’t get loans to expand their businesses.
Fall in value of shares of Banks: Return on Assets (ROA) of Indian banks has become lower than international norm of 1.5%. Hence, Investors are not willing to invest in shares of Banks.
Total NPAs have touched figures close to the size of the UP budget. Imagine if all the NPA was recovered and how well it can augur for the Indian economy.

In a nutshell, the high incidence of NPA has a cascading impact on all important financial ratios of the banks, viz., Net Interest Margin, Return on Assets, Profitability, Dividend Payout, Provision coverage ratio, Credit contraction etc., which may likely erode the value of all stakeholders including shareholders, depositors, borrowers, employees and public at large.

But Indian Case is unique in some sense

When Japan (1990s) , East Asia (1998), US & UK (2008) faced an such NPA crisis, their economies collapsed. But it isn’t likely in India because the Indian NPA crisis is unique.

Reasons for this are

NPAs are concentrated in Public Sector Banks which enjoy Sovereign Backing. No bank run has happened due to this.
The majority of NPA is in infrastructure loans like Power Plants, Ports etc. Once the world economy starts to boom, these projects will begin to generate income (in contrast to US Subprime Crisis, NPAs were concentrated in Housing loans).
Most NPAs are concentrated in a few big corporate houses. Hence, banks have to deal with a few cases.

What RBI has done to tackle this menace?

1. Special Mention Account

Loans become NPA after 90 days. If we can classify assets that are approaching to become an NPA but haven’t yet become NPA, we can tackle them.
Hence, RBI came with a new category known as Special Mention Accounts (SMA) between Standard Asset and NPA.

SMA 0	If loan principal / interest unpaid for 1-30 days from its due date
SMA 1	31-60 days
SMA 2	61-90 days

2. Asset Quality Review

In 2015, RBI ordered the Banks to conduct Asset Quality Review (AQR) and start rectifying bad loans, i.e. Bank doesn’t change loan interest, tenure or terms but asks the client to rectify his irregularity in loan repayment.

3. Strategic Debt Restructuring

Under Strategic Debt Restructuring, Bank converts its debt to equity (shares with voting rights). Later, the bank sells this equity to the highest bidder.
But scheme remained unsuccessful as floating shares with voting rights require the approval of existing shareholders.

4. 5/25 for Infra loans

RBI allowed banks to extend the tenure of infrastructure loans o 25 years and even reduce loan interest rates for the client so that tenure of the loans matches the long gestation period in the sectors. But, such an interest rate was to be reviewed every 5 years.

6. Scheme for Sustainable Structuring of Stressed Assets (S4A)

Under S4A , the unsustainable portion of the debt is converted to equity (Preferential Shares without voting rights).
This scheme was more successful than the Strategic Debt Restructuring as no permission is required for floating such shares as it doesn’t affect the voting powers of existing shareholders.

7. SARFAESI

Earlier, banks couldn’t recover their loans because clients used to obtain stay orders from ordinary courts. Hence, Narsimham Committee recommended the formation of the Debt Recovery Tribunal (DRT). DRT was formed in 1993 so that ordinary courts couldn’t interfere in loan recovery cases.
To further empower Banks, the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act was enacted in 2002, under which
1. Banks and Housing Finance Companies (NBFCs) can attach the mortgaged assets when the loan is not repaid. They can also change the board of directors, auction such assets, and sell them to Asset Reconstruction Companies (ARC).
2. SARFAESI is not applicable on farm loans.
3. If the loan-defaulter wants to obtain a stay order against the decision of the Bank, he can’t go to ordinary courts. He will have to approach DRT. The decision of DRT can be challenged in the Debt Recovery Appellate Tribunal (DRAT) after depositing a minimum 50% of the loan dues.

8. Insolvency & Bankruptcy Code

Dealt in Separate Article (Click here)

Now, just the Insolvency and Bankruptcy Code will be used to settle all the cases involving NPAs. All other schemes have been scrapped.

9. Haircut / One Time Settlement (OTS) Scheme for Agriculture Loans

Agricultural Loans don’t come under SARFAESI Act. The Haircut / One Time Settlement (OTS) Scheme is used to settle such cases.

Under the scheme, some part of the loan is waived, and the rest is recovered from the farmer.
E.g., For Tractor Loans given before September 2011, there was a total of 6,000 crores worth of doubtful/loss cases. One Time Settlement with a Haircut of 40% (i.e. have to pay 60%) was announced in 2017.

10. Amendment to Banking Regulation Act

Earlier, Officers of the Banks were not able to take decisions to resolve NPAs in fear of persecution by CVC, CBI, CAG etc., as resolving such cases requires giving haircuts and restructuring loans.
To solve these problems, the government amended Banking Regulation Act. The amendment has the following provisions.
- Government can order RBI to initiate Insolvency & Bankruptcy proceedings against defaulters.
- It empowers Central Bank to identify specific stressed assets and initiate Insolvency and Bankruptcy proceedings against them.
- The decisions of bank officials will be ratified by Oversight Committees appointed by the RBI, which will ensure that due process was followed to reach a particular decision.

11. Prompt Corrective Action

Under Prompt Corrective Action (PCA), Banks are categorized in Category 1, 2 or 3 based on levels of NPA in that bank.

Then, accordingly, RBI will take corrective actions against weaker banks with high NPA like :
1. Restricting raise in salaries of bank directors.
2. Stopping banks to give a dividend to their investors.
3. Restricting branch expansion.
4. Restricting lending operations of weak banks.
5. Forcing merger and shutdown of the weak bank.
If a bank wants to come out of restrictions, it will have to reduce its NPA.
In 2022, RBI brought the NBFC (D) or Deposit Taking NBFCs into the ambit of PCA.

12. Wilful Defaulters

A Wilful Defaulter is one who
- is financially capable of repaying and yet does not do so OR
- diverts the funds for purposes other than what the fund was availed for OR
- has sold or disposed of the property used as a security to obtain the loan.
If an entity’s or individual’s name is figured in the list of wilful defaulters, it is barred from availing of any banking facility and accessing financial institutions for five years. The lenders can initiate the recovery process and can even initiate criminal proceedings if required.

13. Fugitive Economic Offenders Act, 2018

This act targets economic offenders accused of cheque dishonour, loan and investment scam, money laundering etc., worth ₹ 100crores or more & left India to avoid prosecution.
Special courts under the PMLA (Prevention of Money-Laundering Act, 2002) have the power to order a fugitive to appear within 6 weeks. If the person doesn’t comply, he is declared a “Fugitive Economic Offender”. Subsequently, Indian & Overseas & Benami properties of such fugitives can be attached.
No ordinary civil court or tribunal can issue a stay order. The person can appeal only in High Court and Supreme Court.

Economic Survey (2021): Regulatory Forbearance

Regulatory forbearance means emergency relief from the strict regulations provided by the RBI to banks to deal with the spillover effects of the Subprime crisis of 2008 in India. Under the provisions, RBI allowed the restricting bank loans and their reclassification from NPA to Standard loans. It proved helpful as Banks were not required to keep a large amount in the provisioning.

But what went wrong was the fact that such forbearance was allowed to continue till 2015, even when the crisis was over. Ideally, such relief should have been a temporary measure and should have stopped after 2011, when economic recovery happened.

Regulatory forbearance was an emergency medicine that started to show its side effects when it was allowed to continue forever. The side effects were in the form of detrimental impacts on the health of the banking sector and economy like

Unviable loans were restructured by the banks to dress up their accounts and further deepen the NPA crisis.
Encouraging banks to do zombie lending.
Banks indulged in the ever-greening of loans, i.e. gave new loans to non-creditworthy borrowers to pay back their previous loans.

As a result, NPAs were doubled compared to pre-forbearance levels.

Policy Lessons for the Post-Corona Recover

During the Covid pandemic, RBI has again announced regulatory forbearance measures such as loan moratoriums, loan restrictions etc. But, the government shouldn’t continue these measures once the situation normalises.
Bank auditors who fail to report the malpractices such as ever-greening and zombie lending should be penalized.
Economic Survey believes it can be counterproductive when emergency medicine becomes a staple diet. Moreover, Spanish philosopher George Santayana says, “those who don’t learn from the history are condemned to repeat it.”

The Wayout

1. Recover NPA

The simplest approach to cut down NPA is to recover the debt by

Making Bad Bank/ PARA (explained below).
Amending Bankruptcy Act to make it friendly for creditors to recover their money.

2. Using tools of Information Technology

Economic Survey (2020) has suggested to used AI and ML to fight the menace of NPAs. It can be used in the following ways

Using Artificial Intelligence (AI) and Machine Learning (ML): AI can be used to monitor transactions of Wilful defaulters so that they can be stopped from transferring assets of the company to other accounts before applying for insolvency.
Geo-tagging the assets of the company (using GPS technology) so that defaulters can’t pledge the same assets to take different loans and move assets from the property before undergoing bankruptcy.
Using Blockchain Technology to check the authenticity of data provided by the creditors.
Tracking Social Media accounts and travel history of the defaulters using AI and ML to know about the actual financial position of the defaulter.

3. Using PSBN

Economic Survey (2020) has recommended creating Public Sector Bank Network (PSBN).
PSBN will act as a Financial Technology Hub that will connect all the banks to a single server containing data from the past 50 years, Financial data from the Corporate Affairs Ministry, SEBI, Income Tax Department etc.

4. Employee Stock Option Plans (ESOPs)

ESOP is a type of benefit plan wherein employees are given some company shares apart from regular salary (companies like Facebook, Google and many other StartUps already use ESOPs).
The existing salary-based compensation mechanism encourages employees to prefer safety and conservatism over risk-taking and innovation. But giving them some shares via ESOP may encourage risk-taking and a possible change of mindset from that of an employee to that of an owner.

6. Conservatism

Banks need to be more conservative in granting loans to sectors that have traditionally been contributors to NPAs. The infrastructure sector is one such example.

7. Deregulate economy

Government should promote the Corporate Bond market so that Corporate houses and entrepreneurs can directly raise debt from the market instead of approaching the banks.

8. Merger and Privatization

Government should recapitalize only profit-making banks, while loss-making PSBs with high levels of NPAs should either be merged with some anchor bank or privatized.

Once the Twin Balance Sheet problem is resolved, there could be significant moral hazards. Newly cleaned-up balance sheets may encourage bank managers to lend freely, ignoring past lessons. Structural reform aimed at preventing this can take many forms, but serious consideration must also be given to the issue of government majority ownership in the public sector banks. It leads to Governance Reforms in the Banking sector.

Bad Bank / PARA

To solve the NPA problem, PARA/ Bad Bank buys bad loans from PSBs and tries to salvage the loan’s maximum value by either restructuring loan or liquidation, auctioning or changing ownership of the company and absorbing the losses.

July 2021: The government of India set up National Asset Reconstruction Company Ltd (NARCL) and Indian Debt Resolution Company Ltd. (IDRCL) (together NARCL and IDRCL will act as the Bad Bank) to clean up the NPAs.

Process

NARCL will acquire the NPAs up to the worth of Rs 2 lakh crore from commercial banks by paying 15% of the agreed price as upfront money and the rest of 85% in the Security Receipts. NARCL will be capitalised through equity and debt from various banks and has a limited life of 5 years.
These NPAs will then be transferred to Indian Debt Resolution Company Ltd. (IDRCL), which will sell the stressed assets to recover the money.

Why Bad Bank can be a good idea?

East Asian Economies have successfully used this approach to solve the mess created during the South Asian Currency Crisis of the mid-1990s. Similarly, other countries such as Malaysia, Finland, Belgium, Indonesia etc., have also set up Bad Banks to deal with NPAs.
Decentralised Decision making isn’t working because there are coordination problems since large debtors have many creditors. Bad Bank can solve this issue.
Stressed debt in India is heavily concentrated in large companies. Such big debts can be solved by a professional organisation like PARA or Bad Bank.
Before this arrangement was put in place, India has 28 ARCs (Asset Reconstruction Companies). But they haven’t proved any more successful than banks in resolving bigger NPAs due to limited capitalisation. But international experience shows that a professionally run central agency with government backing can provide the solution in this regard.
It will lead to the unlocking of capital locked up as provisioning requirements, thus increasing the credit creation.
Enable the bank to focus on its core areas of accepting deposits and lending loans when the recovery of bad loans gets transferred to the specialist Bad Bank.
Aggregating debt: Set up of NARCL will help address the problem of contradictory views (lack of consensus) among different lenders, allowing debt recasts.

Arguments against

Moral Hazard: Shifting of NPAs without accountability risks the moral hazard of reckless lending, further amplifying the problem.
It will not have a long term impact because it doesn’t solve the underlying problem of NPAs in the country and only leads to the transfer of NPAs.
Financing a Bad Bank in India is also very difficult.
Qualified Professionals: India lacks adequately trained manpower.
Mere shift of bad loans: According to ex-RBI Governor Raghuram Raman, the setting up of a Bad bank will merely transfer Assets from one entity to another.
RBI has raised issues over the structure of this mechanism. According to the SARFAESI Act, which deals with the ARCs, there needs to be one entity that deals with both the purchase of the bad loans and the resolution of those loans.

Side Topic: Deposit Insurance & Credit Guarantee Corporation of India (DICGCI)

The acts came to the scene due to the higher probabilities of bank failures due to large NPAs. There are some issues in DICGCI which needs to be corrected.

DICGCI

Deposit Insurance & Credit Guarantee Corporation of India.
It is a 100% RBI owned company.
This insurance cover is provided to Commercial banks, Regional Rural Banks, Local Area Banks, Payment Banks, Small Finance Banks and Cooperative Banks.
All Banks have to buy insurance from DICGCI on their deposit. A maximum of 5 lakh (changed in Budget 2021 – earlier it was Rs 1 lakh) of each depositor is insured in the case of a Bank shut down or if the bank is placed under moratorium.

Problem

If a customer had deposited more than ₹5 lakh in a single commercial bank, then he gets only ₹5 lakh from DICGCI. For the remaining amount, he must wait till RBI liquidates the bank.
DICGCI doesn’t cover NBFCs. E.g., UTI Mutual Fund Case of 2002.

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Digital Banking

by admin

Digital Banking

This article deals with ‘Digital Banking / Cashless Economy.’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Indian Case: More Cash in Circulation

India uses too much cash for transactions. The ratio of Cash to GDP in India is one of the highest in the world

India = 12.4% (2014)
Whereas in China = 9.4% or Brazil = 4%

Pros and Cons of Cashless Economy

Pros of Cashless Economy

It will be challenging to evade taxes as all transactions can be tracked in a cashless economy. Money laundering, black money and terrorist financing can be easily controlled.
No fear of physical theft: In Sweden, where 50% of transactions have gone, cashless robberies have fallen to 30 years because people don’t have any cash.
Cash transactions in small denominations can happen easily. One can pay even a single paisa (or cent).
No issue of counterfeit currency and wearing and tearing of currency notes.
The Cashless Currency is working fine in Sweden & Norway, where 50% of transactions have gone cashless.
Ratan Watal Committee (in December 2016) quoted that the dependency on cash costs the country about ₹1 Lakh crore on account of the cost of printing new currency, operating currency chests, maintaining supply to ATM networks etc.
If small vendors start to take payment via digital means in Bank Accounts, their credit history will develop, and they can use this to get credit from institutional lenders.

Cons of Cashless Economy

Extreme surveillance: Every payment is traceable. The power this hand over to banks & governments is enormous, and the potential scope for Orwellian levels of surveillance is terrifying.
It can lead to the exclusion of segments of the population who are slow to embrace new technologies, especially the elderly.
The problem of electronic frauds increases, and the whole system can be hacked.
Cashlessness may produce a peculiar human problem as people are sentimental about coins and notes.
For payment to happen cashlessly, infrastructure is required at point of sale destinations that small businesses can’t afford.
Ultimately, digital payment costs are borne by consumers even when they are charged from producers or vendors. Charges can range from 0.1 per cent to as much as 4 per cent of the value of the transaction.

International Case Study: mPesa

In Kenya, M-PESA in partnership with Vodafone’s local operator Safaricom has ushered Cashless Revolution.

Problems in the adoption of Digital Payment in India

As seen by Chandrababu Naidu Committee & Ratan Watal Committee, problems associated with Digital Payment in India are

1 . Lesser Points of Sale

India has 160 ATMs per million (UK = 1000 / million)
India has 1000 Point of Sale (PoS) per million (UK = 30,000 / million)

2. MDR Issue

MDR = Merchant Discount Rate
Banks charge around 2% from Merchant for providing Cashless Payment Services. Due to this, the profit margin of merchants decrease. It restricts the the adoption of digital payment by Merchants.

3. KYC norms for Point of Sale Devices

Vendors cant buy Point of Sale devices as they don’t have any permanent address.

4. Interoperability

There is no interoperability between different payment systems (Eg: PayTM to FreeCharge) and between different Financial Institutions (Eg: SBI to PayTM).

5. Regulatory Problems

The Banking Ombudsman doesn’t have the required powers to deal with Internet Banking Frauds.
IT Act is not comprehensive enough to deal with such financial frauds.

6. Government doesn’t act as Role Model

Although the government is promoting a Cashless economy, one cant pay taxes via mobile wallets like PayTM and bidding fees for various e-Tenders are to be paid in cash (only). Hence, the government doesn’t act as a role model.

7. Low Digital Financial Literacy

People aren’t aware enough to handle a cashless system of payment.

8. Behavioural Issue

Changing behaviour to use Cashless transactions is a complex process.

Issue: Interoperability

Interoperability is the ability of customers to transact across commercially and technically independent payment platforms.

Due to legal complications under the payment & settlement system act 2007, users don’t have full interoperability i.e.
- Users can’t transfer money from one wallet to another (can’t transfer money from Paytm to Phonepe).
- Users can’t use wallets to pay all types of taxes, fees, insurance premiums etc.
It acts as an obstacle to the ‘cashless economy’.

In 2018, RBI issued guidelines for interoperability with the Know Your Customer check, customer grievances redressal mechanism etc., so that transactions can be made between different platforms.

Issue Analysis: Regulation over Payment Settlement

1998: Banking Reforms / Narsimham-II Committee suggested a regulatory framework for e-banking, card payment etc.
2007: Payment & Settlement Systems Act enacted according to Narsimham II under which RBI supervises e-banking, card payment, and other digital money-related issues through Board for Regulation and Supervision of Payment & Settlement Systems (BPSS).
All Payment system providers have to register with RBI’s BPSS – whether a bank, non-bank, wallet-PPI etc.
2016: Ratan Watal Committee on digital payment suggested replacing BPSS with a Payments Regulatory Board (PRB) in RBI to regulate Interoperability, Consumer protection, Innovation, R&D in digital payments (as BPSS looks after only Payment and Settlement).
2018: RBI opposed the formation of the Payments Regulatory Board due to differences with the government over the issue of who should be Chairman, how many members should be from the Government side etc.

RBI made Ombudsman Scheme for Digital Transactions (OSDT) in 2019 with the following functions

To look into matters of Digital Payment like Consumer Protection.
The consumer can make a free complaint about matters up to Rs 20 lakh against Mobile Wallets, Payment Payment Instruments (PPI) and other digital transactions.
It can charge a penalty of up to Rs 1 lakh to the victim for his mental agony, loss of time etc.

Issue Analysis: Merchant Discount Rate

MDR is a merchant’s fee to pay to a bank for every credit/debit card transaction.
MDR hurts merchants’ profit margin and discourages them from adopting Point of Sale terminals, a digital payment system.
2017-18: RBI put ceilings on MDR fees to encourage the digital economy.
WEF 1/1/18: The Government of India started 100 % MDR-subsidy on payments made via Debit card, BHIM or Aadhar enabled payment system for bills up to Rs.2,000. The scheme was valid for 2 years. It will encourage digital payments ecosystem.
Budget 2019: No MDR will be charged from a firm whose annual turnover is less than Rs 50 crore. RBI and Bank will absorb this burden for not handling so much money.

Developments Related to Cashless/Less Cash Economy

1. Suggestion of various committees to promote the Cashless Economy

1.1 Ratan Watal Committee

Formed in December 2016.
To suggest Medium Term Recommendations to strengthen the digital payment ecosystem in India.

Recommendations of Ratan Watal Committee

Separate Regulator for Digital Payments under RBI known as Payments Regulatory Board.
The committee envisaged a prominent role for Aadhaar as the primary identification for (KYC) purposes.
Government departments should levy a cash-handling charge to discourage cash transactions.
Give incentives like discounts to consumers to make cashless payments.
It had also suggested interoperability between banks and non-bank digital payment gateways.
Rewards for government departments, state governments, districts, and Panchayats to promote digital payments.
Create a fund proposed as DIPAYAN from savings generated from cash-less transactions to expand digital payments.
Reduce or eliminate import duty on import of ATMs & Point of Sale machines.

1.2 Chandra Babu Naidu Committee

Formed in Nov 2016 & submitted a report in Jan 2017
Name of Committee: Chief Minister’s Committee to promote Digital Payment in India by NITI Aayog.

Recommendations

Tax incentives should be given for domestic production of Point of Sale machines & ATMs.
Banks should charge 0% MDR from Government Bodies like Railways, Electricity etc.
Develop a Common QR based payment system for Vendors (led to the formation of BHARAT QR).

1.3 Nandan Nilekani Committee

In Jan 2019, RBI appointed Nandan Nilekani Committee for suggesting ‘how to deepen the digital payments’.
Its main recommendations were
1. Government should extend the MDR subsidy for two more years.
2. Give tax incentives to companies using digital payments.
3. Reduce the taxes on devices required for digital payments.
4. Raise awareness about BHIM-UPI.
5. Setup Computer Emergency Response Team for Finance (CERT-Fin).
6. Prepare area-wise ‘Digital Financial Inclusion Index’ to monitor progress.

2. Schemes to promote Cashless System

2.1 Rupay Card

RuPay is the Payment Gateway started by the National Payment Corporation of India (NPCI).
It will help in financial inclusion indirectly by decreasing the operating cost of Banks to service their customers using debit & credit cards.

How Payment Gateway system work?

Case 1: If there is no payment gateway

Each bank has to tie up with merchants separately.
It leads to duplication of effort.

Case 2: In presence of payment gateways

Each bank can tie up with a payment gateway & the payment gateway will tie-up with the merchant.

Banks are paying ₹300 cr per year to payment gateways (Banks charge them from Merchants as Merchant Discount Rate (MDR) per transaction)

What Rupay will do?

Rupay will do the same work at 40% lower rates. Hence, the user will have to pay lower Credit/ Debit card charges, and Merchants will have to pay lower Merchant Discount Rates to the banks.

Rupay is the 7th payment gateway in the world.
3 channel payments can be made using this: ATM, PoS(point of sale) and Online.
They can tie up with any organization: prepaid cards by milk/ grain procurement agencies in Punjab.
Under Jan Dhan Scheme, Rupay Debit Card is given to the customers.

2.2. FastTag

FASTags are prepaid rechargeable tags for automatic toll collection at toll collection booths using RFID technology.
It helps in faster mobility by solving the issue of Jams at toll booths. It is also an issue in the direction of a cashless economy.
From 15th January 2020, it shall be mandatory for all vehicles passing through tolls to have FASTags.

2.3 Payment Infrastructure Development Scheme (PIDF)

PIDF aims to strengthen digital payment infrastructure across Tier-3 to Tier-6 cities, focusing on the North-Eastern States.
PIDF will subsidize banks and NBFCs for deploying digital payment systems like Point of Sale (PoS) terminals, a QR-based payment system, etc. The target is to create 30 lakh new touchpoints every year.
The scheme will be operational for 3 years, starting from 1st January 2021.

2.4 NEFT System

Using a bank, a person can settle the amount with another person even if they have a bank account in another bank. The NEFT (National Electronic Funds Transfer) system is used in the backend to settle these payments.
NEFT settles the net amount between banks at the interval of 30 minutes. After 30 minutes, it will check the lakhs of transactions made between particular two banks throughout the country and settle the remaining amount between two banks.
RBI operates this system.
Using this system, transactions of up to ₹10 lakhs can be made.
According to the 2021 update, even Prepaid Payment Instruments such as AmazonPay, Mobikwick etc. can also use the NEFT system.

2.5 White Label ATMs

White Label ATMs are operated by private non-banking companies that own & operate their brand of ATMs.
All the other Bank ATMs can use these White Label ATMs & get service but at a nominal charge.
It is a step towards financial inclusion. ATM penetration will increase because of this (present = 160/1million compared to US= 1400/1Million)
E.g., Tata’s Indicash, Muthoot Finance, Srei Infra, Vakrangee Software, Prizm Payments etc.

2.6 Schemes by NPCI

NPCI is a not for profit company made by 10 promoter banks in 2008 to provide cost-effective payment solutions for banks

NPCI is running various initiatives related to high-end technology in Banking & Payment Systems.

Initiatives of NPCI

1. UPI

UPI = Unified Payment Interface
It was started in 2016.
It is a technology for building digital payment apps (i.e. UPI is not an app but technology made by NPCI, which banks use to make their apps).
123Pay has been launched for using UPI on basic phones.
Features provided by UPI
- Scan QR Code and pay directly to merchant’s account.
- Link your bank account to directly transfer money from your bank account without storing it in an e-wallet first (unlike PayTM).
- The facility of ‘push transaction’ (e.g. Sending Remittances to family).
- The facility of ‘pull transaction’ (e.g. Cable operator sending a request for the monthly bill within the app).
- The facility of Bill sharing.
Examples of UPI based apps: SBI Pay, AxisPay and NPCi’s own BHIM.

2. UPI 2.0

The upgraded version of UPI was launched in Oct 2018 with the following additional features:

Overdraft facility
Cash on Delivery
User mandate for a future date, e.g. DTH
Invoice in the inbox.

3. BHIM

BHIM = Bharat Interface for Money
It is an app for iOS & Android-based on UPI (in simple terms, it is an app in which UPI technology).
BHIM has been developed by NPCI
Benefits
- No need to install multiple apps for each bank account (SBI Pay, AxisPay etc.). The single BHIM app can be used for using all bank accounts.
- App has a 3-factor authentication system.
- Your money stays in a bank account. It is not stored in an e-wallet outside a bank like PayTM. Hence, a person can earn interest on his money.
- No cards involved. Hence, no MDR or such hidden charges need to be paid.

4. Bharat QR Code

It was started in Feb 2017
Bharat QR code has been developed jointly by the National Payments Corporation of India (NPCI), Visa, MasterCard and American Express under instructions from the Reserve Bank of India (RBI).
Note – QR is a two-dimensional machine-readable matrix. QR Code can store up to 7089 digits compared to conventional bar codes that can store a max of 20 digits.

Advantages

It eliminates the need of using card swiping machines for digital payments. There is no need to have ‘Swiping Machines’ in shops. Just have QR printed & payments can be easily done via that.
Interoperability: Using the BharatQR code, the merchants will be required to display only one QR code instead of multiple ones.
For the buyer, there is no need to carry a card. Payment can be made via mobile.

5. Aadhar Enabled Payment System (AePS)

The customer has to tell the Aadhar number and name to the merchant or Bank Business Correspond, who authenticate it using the customer’s fingerprint. Following this simple step, his transaction is completed.

6. Cheque Truncation System (CTS)

If somebody from Delhi gives a Cheque from the Delhi Bank Branch to a person in say Chandigarh. Earlier, that cheque was physically sent to Delhi Branch for settlement.
Under CTS, a Scanned image of the cheque can be sent to Delhi Branch, and settlement can be done rapidly.

7. National Financial Switch

ATM Card of one Bank can be used in another Bank too. The system that is working in the backend to make this possible is NFS.
NFS helps re-route transactions to the Core Banking Solution Network of the Bank whose ATM card is being used.

8. NACH (National Automated Clearing House)

NACH help in Automated Payments, which are to be paid periodically like each month or year like salaries, bills, EMI etc.
NACH is finding great attraction among customers, companies and government departments to pay bills, EMIs, salaries, pensions etc.

9. IMPS

IMPS = Immediate Payment Settlement System
It is available 24X7.
It is used for real-time settlement of all online payments up to Rs. 5 lakh.
It is not free. A service fee is charged on the transactions.

10. e-RUPI

e-RUPI is a QR based purpose-specific digital voucher where it is not required for the customer to have a bank account and is operable on basic phones, even in areas that lack an internet connection.

11. Offline Retail Payments using Card and Mobile Devices

RBI has allowed offline payment using the card and mobile devices to deal with the issue of internet connectivity.
The maximum transaction allowed under the scheme
1. Rs. 200 per transaction
2. Subject to an overall limit of Rs 2000 (after that person will have to go online to settle the transactions)

Side Topic: ATM security features introduced to prevent frauds

1. ATM Card Technology changed to EMV Technology

Magnetic Technology

Magnetic Technology used in the ATMs has been used since the 1960s.
In this, data is stored on the magnetic strip. But it is insecure as the data can be duplicated, cloned, skimmed while swiping the card, which increases the chances of fraud.
So, RBI stopped such cards from 1/1/2019 using the Payment & Settlement Act powers.

EMV Technology

Full form: Europay + Mastercard+ Visa
It is based on chip infrastructure with encryption.
RBI had ordered migration in 2013. It has become operational on 1/1/2019.
Two sub-types
- EMV-Contact: cards must remain in the Point of Sale (PoS) Terminal during the transaction.
- EMV-contactless cards: Tap the card on the terminal using RFID technology.

2. Card Tokenisation

When we shop on sites like Amazon, Flipkart etc. or pay bills using PayTM, they allow us to store our Debit or Credit Card information like Card Number, Expiry date etc., for future convenience. But this thing has security implications in case the server of such a company is hacked, and user information is leaked.
To prevent such incidents, Card Tokenization was introduced by RBI in Jan 2019
- Tokenization = Token number is generated for a given credit/debit card.
- Card customer gives the token number during any type of online/physical shop transaction. His original card number, expiry date, etc., remains hidden from the third party seller.

Financial Inclusion

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Financial Inclusion

Last Updated: March 2023

This article deals with ‘Financial Inclusion.’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

What is Financial Inclusion?

As defined by Rangarajan Committee on Financial Inclusion in 2008, Financial inclusion means everyone is given access to financial services, i.e. Banking, Credit, Insurance & Investment, at affordable cost & in an appropriate time frame.

Importance of Financial Inclusion

It helps the family cope with unforeseen circumstances like the breadwinner’s death.
It helps in converting savings to investments, which helps in nation-building. Japan, the USA etc., have earlier followed the same path.
Protect common people from exploiting informal money lenders who charge exorbitant interest rates.
Providing good investment schemes can protect people from falling into traps like Ponzi Schemes like Saradha & Rose Valley Chit Fund Schemes.
E – Payment: Cashless subsidies & salaries can save the government ₹1 Lakh crore, according to McKinley’s study.

Challenges

In rural areas, there is the problem of accessibility. The number of branches in rural areas is low.
Geographically hilly and desert regions don’t have extensive bank penetration.
Gender: Access of women to banks is low. Women have a disproportionately lower number of accounts than men.
55% of rural Dalits borrow from money lenders at exorbitant rates.
MSMEs are given a low value of loans compared to big industrial houses.

New steps taken by Government for Financial Inclusion

Government is very much concerned to increase Financial Inclusion and taking various steps in this regard.

1 . Committees

Various committees have been formed like

Nachiket Mor Committee: Suggested various measures like Payment Banks, Small Banks etc.
Deepak Mohanty Committee for Mid Term Path to Financial Inclusion: Suggested various measures like (1) Use USSD on simple mobiles, (2) Scrap Interest Subvention Scheme for farmers and concentrate on Insurance instead, (3) promote Sukanya Samridhi Scheme to cultivate saving habit in girls etc.

2. New types of Differential Banks started

Payment Banks: 11 Licenses given.
Small Banks: 10 Licenses given.

3. Schemes

Jan Dhan Yojana is the main one (we are going to read it in detail below).

4. Digital Schemes

The government has taken various initiatives in this regard like

Introduction of Rupay Card
UPI, UPI 2.0 & BHIM
Bharat pay

5. Small Investment Schemes

The government has launched to promote the habit of savings among the poor and save them from Ponzi scams
Main schemes include
1. Kisan Vikas Patra (doubles money in 8 years 4 months)
2. Indira Vikas Patra
3. Public Provident Fund
4. Sukanya Samridhi Yojana (component of Beti Bachao, Beti Padhao): Scheme for small girl children in which the parents can deposit money (between Rs 250 to 1.5 lakh per annum) till girl reaches the age of 14 years and can be later withdrawn by the girl when she reaches the age of 18 years for her studies or marriage. Government offers higher interest than normal rates on such deposits.

Earlier Schemes for Financial Inclusion

Bank Nationalization was done in 1969 and 1980.
Regional Rural Banks & Cooperative Banks have been opened.
Micro Finance Institutions have been promoted by the government.
Various banks have started no-frills accounts (i.e. accounts with zero balance) schemes.
25% rural bank mandate: Banks have to open 25% of their branches in rural unbanked areas.
Post Office Schemes to deposit money.

Jan Dhan Yojana

Works on following pillars pillars

Free Bank Account for every family, Rupay Card, 1 lakh accident insurance, & 10,000 overdraft facility.
Banking outlet for each household within 5 km.
Imparting financial literacy.
Direct Benefit Transfer (DBT) of government schemes and subsidies through Jan Dhan Accounts.

As of March 2021,

42.2 crore PMJDY Accounts have been opened.
Rs. 1.45 lakh crore have been deposited in the PMJDY accounts.

Benefits

According to Global Findex Report, 80% of adults in India now have Bank accounts due to Jan Dhan Scheme. Bank accounts have increased from 14.72 crores in 2015 to 43.04 crores in 2021.
It has helped in Women empowerment as many women’s accounts have been opened. About two-thirds of the accounts opened under PMJDY are of women belonging to rural and semi-urban areas.
It has helped the government implement Direct Benefit Transfers and prevent leakage of subsidies.
It has helped in breaking the hold of local moneylenders.
It has helped in the formalization of the financial system in India and gave an avenue to the poor for bringing their savings into the formal financial system.

Issues

Account Dormancy (72% of accounts opened under the scheme are dormant, according to Microwave (think tank survey).
Account Duplication (33% duplicate accounts have been opened due to the attraction of insurance & overdraft facility).
Rupay cards are not given to 70% of Jan Dhan Account holders. Overdraft facility can’t be used without that.
Jan Dhan Account Holders are being used as money mules by Hawala Agents.
The operating cost of Banks is increasing because they have to keep on servicing the dormant account. It costs ₹100 to 150 / annum to banks to maintain each account.
In 2016, Indian Express reported that Bank Officials made one ₹ deposit to Jan Dhan accounts to hide their zero balance status. It shows that these can be used in money laundering too.

Priority Sector Lending

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Priority Sector Lending

Last Update: March 2023

This article deals with ‘Priority Sector Lending .’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Introduction

The basic principle in Economics states that ‘No Risk-No Reward’ & ’High Risk-High Reward’.
Hence, Banks will charge a high rate of interest from farmers, students, small entrepreneurs, etc. To tackle this, RBI in the 1980s came with PSL norms.

Who is covered under Priority Sector Lending (PSL)?

The following classes of Banks are required to give a certain percentage of their total loans to Priority Sector

Domestic Scheduled Commercial Bank (Public and Private) = 40%
Foreign Scheduled Commercial Bank (SCB) = 40%
RRB = 75 %
Small Finance Banks = 75%
Cooperative Banks = No Requirement

What includes PSL?

Category	% SCB
Weaker Sections	10%
Agriculture & Allied Activities	10%
Marginal & Small farmer	8%	– Added as a new category in April 2016. – Earlier Agriculture and Allied Activities were given 18% but due to broad categories, small & marginal farmers weren’t getting anything.
Micro-Enterprise – Khadi-Village industry	7.50%
All other PSL categories	4.5%	These include 1. Small & Medium Enterprises 2. Affordable housing loans to beneficiaries under PMAY 3. Food processing companies 4. Vermicompost, biofertilizer, seed production 5. Student-Education loans (up to Rs.10 lakh) 6. Social Infrastructure (schools, health care, drinking water, sanitation facilities) 7. Renewable Energy Projects (windmills, solar etc.)
Total PSL	40%

Note: For Foreign Banks with less than 20 branches, 40% PSL is there, but there is no internal classification. Their consolidated PSL should be 40%.

Benefits of Priority Sector Lending

It helps in channelizing credit to the vulnerable section.
PSL helps in Financial Inclusion.
PSL provides higher social returns on lending.
It helps in the diversification of the credit portfolio of the banks.
Credit Formalization: It helps break the hold of non-institutional lenders, especially in rural areas.

Issues with Priority Sector Lending

Rising NPA: Second Narsimham Committee (1998 ) observed that 47% of all NPA have come from PSL. It recommended ending the system of PSL for the betterment of the Banking Sector.
Lethargy in Lending: Most banks seem reluctant to lend to the priority sectors.
Not used for the intended purpose, especially in the Agriculture sector. The loan given to farmers under PSL is to increase productivity, but it is used for unproductive purposes like marriages and other social obligations.
Targeting issues: Suitcase farmers benefitted instead of poor farmers.
Deter banks from expanding their scale of lending as the more they lend, the more they will have to contribute to PSL.

What if the PSL quota is not met?

Most banks aren’t able to meet their PSL quotas. In this case, they have to invest the remainder in RIDF or SIDF as the case may be

Indian Banks + Foreign banks (with 20 or more branches)

1. RIDF =Rural infra. Development fund

Managed by NABARD
For funding rural infrastructure projects

2. UIDF = Urban Infrastructure Development Fund

New Fund announced in Budget 2023
Managed by National Housing Bank (NHB)
For funding urban infrastructure projects, especially in Tier-2 cities.

Foreign Banks with less than 20 branches

SEDF = Small Enterprises development fund

Managed by SIDBI

But the problem with both of the above is that money is given for the long term, i.e. around 20 years. Hence, banks’ money is gone for a long time which they cant use & as a result, they suffer in the meantime. To address this, RBI came with Priority Sector Lending Certificates.

Priority Sector Lending Certificates

In this arrangement, the overachieving Banks can sell their excess PSL in the form of ‘certificates’ to underachieving banks without transferring the loan assets or its risk.

Four kinds of PSLCs are traded through RBI’s e-Kuber Portal, viz
- Agriculture (PSLC-A)
- Small and Marginal Farmers (PSLCSM)
- Micro Enterprises (PSLC-ME)
- General (PSLC-G)

Rural Banking

by admin

Rural Banking

Last Update: March 2023

This article deals with ‘Rural Banking.’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Steps taken to promote Rural Banking

Various steps have been taken to penetrate Banking into Rural Areas.

1. Before Independence

During the British Raj & initial years of independence, Banks (& insurance companies) operated in Urban Areas only.
Result: Villagers used to rely on money lenders, who lend money at exorbitant rates & they remained in debt & poverty.

2. After Independence

1950s	Cooperative Banks/Societies
1955	Birth of SBI & ICICI
1960s	Bank Nationalisation (1960 & 1969)
1969	Lead Bank Scheme
1975	Regional Rural Banks (RRB) setup
1980s	NABARD setup + Bank Nationalisation(2nd Round)
Early 90s	Self Help Group & Bank linking
Late 90s	Kisan Credit Card
Mid 2000s	No Frills Account Banking Business Correspondent Interest Subvention Schemes on crop loans
Present	RRB Amendment + Payment Banks

Lead Bank Scheme

During the 1960s, Narsimham Committee recommended that the responsibility of development be given to banks. Hence, Lead Bank Scheme was launched.
In 1969, the State Bank of India and its subsidiaries, along with 14 national banks and 3 Private banks, were selected under this. Every district was given to a specific bank making it responsible for the development of Banking in that district called Lead Bank.
Later, in 1975, these banks were asked to set up subsidiary banks in their districts known as Regional Rural Banks.

Rural Infrastructure Development Fund (RIDF)

RIDF was started in the mid-1990s.
NABARD operates RIDF.
This fund provides cheap loans to state & state-owned corporations so that they can complete projects related to

Medium & minor irrigation	Community Irrigation Wells
Soil conservation	Village Knowledge centres
Watershed Management	Desalination plants in coastal areas
Flood Protection	Building schools & Anganwadi centres
Forest development	Building toilet blocks
Cold storage	Rural roads & bridges

Banks that don’t meet their Priority sector lending requirements provide money to RIDF.

Regional Rural Banks

Already studied in the previous article.

Cooperative Banks

Dealt below

Priority Sector Lending

In the next article.

Cooperative Banks

A cooperative bank is a financial entity that belongs to its members, who are, at the same time, the owners and the customers of their bank.
These banks work on the principle of NO PROFIT & NO LOSS and ONE MEMBER, ONE VOTE.
They are subjected to CRR & SLR requirements. However, the requirements are less than for commercial banks.
PSL requirements are not applicable to them.
They can be Scheduled or Non-Scheduled.
They were instrumental in dismantling the hegemony of money lenders in rural finance.
Before the nationalization drive took place in the 1960s, Cooperative banks constituted 80% of institutional credit. But after the nationalization of banks, their share decreased significantly due to stiff competition from commercial banks.
Due to the One Member, One Vote, they suffer from caste politics.
These banks don’t have an all-India presence & are present in selected regions like Gujarat, Maharashtra, Andhra Pradesh and Tamil Nadu, where the cooperative movement was strong.
In 2018, RBI allowed Urban Cooperatives to voluntarily transform into Small Finance Banks, with conditions.

Comparison

	Commercial	Cooperative
Banking Regulation Act	Yes	Yes (Since 1966)
CRR and SLR requirements	Yes	Yes ( but lesser than Commercial Banks)
PSL	Yes	No
Who can borrow?	Anyone	Only Members
Voting Power	Proportionate to Shareholding	One Member, One Vote
Profit Motive	Yes	No Profit, No Loss
Presence	All India	Present all over India but mainly concentrated in Gujarat, Maharashtra, Andhra & Tamil Nadu.

Who Regulates Cooperative Banks?

Earlier, Cooperative Banks were under the dual regulation of RBI and the Registrar of Cooperative Societies, as shown in the figure below. But this led to delays in the corrective actions, which culminated in corruption and the fall of banks (like Punjab and Maharashtra Cooperative Bank)

Hence, Banking Regulation Act has been amended, and the problem of dual regulation has been solved wrt Urban and Multi-State Cooperative Banks. Now, RBI has been made the sole regulator in the case of Urban and Multi-State Cooperative Banks.

Regulation of Cooperative Banks in India

Rural Co-Operative Banks

Structure and Funding of Rural Co-operative banks is as follows

Rural Cooperative Bank (Example) — Rural Cooperative Bank Structure (Example)

Challenges

Rural Cooperatives suffer from huge NPAs. The NPA level in these banks was around 25% in 2015.
Due to 1 person 1 vote, they suffer from Casteism during voting. After that, they serve people belonging to their caste only.
Although SARFAESI Act powers are given to these banks, these banks don’t take action on defaulters due to political backing.
Deposits are very low because rates are not competitive against Scheduled Commercial Banks & Post Office Deposits. Hence, they have to depend on NABARD funding.
Large-scale manipulation goes on in District Central Cooperative Banks (DCCBs) and PACS as their operations are not digitalized and aren’t connected to Core Banking Solution. During demonetization, District Cooperative Banks changed black money in the back-date.
They are under the dual supervision of RBI and the Registrar of Cooperative Societies (RCS) of the respective states. It has led to poor supervision and control.

Solution

Close down PACS & form LAMPS (LArge Sized Multipurpose Society) in their place. Their operations will not be restricted to giving loans. Apart from banking, LAMPS will also be involved in food processing, supplying fertilizers and seeds etc.

Urban Cooperative Banks (UCBs)

Traditionally, the area of operation of the UCBs was confined to metropolitan, urban or semi-urban centres and catered to the needs of small borrowers, including MSMEs, retail traders, small entrepreneurs, professionals and the salaried class. However, there is no formal restriction as such, and today UCBs can conduct business in the entire district in which they are registered, including rural areas.
UCBs are suffering from losses.

Reasons for losses

UCBs are dominated by builders and manipulators. They indulge in Zombie-lending. E.g., Punjab and Maharashtra Cooperative Bank kept on doing zombie-lending to a weak company called HDIL due to corrupt nexus between directors and HDIL owners. When HDIL failed, the NPA of the bank increased exponentially, and the depositor’s money was stuck in the bank.
Although they are given powers under the SARFAESI Act, bank officials don’t use them because debtors are their friends and relatives.

Steps taken

RBI’s 4-tiered Regulatory Framework for Urban Cooperative Banks: To ensure the safety of deposits in Urban Cooperative banks, a 4-tiered Regulatory Framework has been introduced. It will ensure that banks with more deposits are subjected to stricter regulations (explained in the diagram below).

RBI’s 4-tiered Regulatory Framework for Urban Cooperative Banks:

In 2020, the power of the Union and State Government’s Registrar for Cooperative Societies to regulate the Cooperative Banks had been scrapped. These Cooperative Banks have been brought under the direct regulation of RBI. It will ensure effective regulation and curtail scams such as PMC Bank (Punjab and Maharashtra Cooperative Bank).
Banking (Regulation) Act has been amended, and according to the new provisions, 51% of the Directors should have knowledge of accountancy, banking, economics or law. This will solve the problem of the nomination of directors based on political considerations.
RBI has offered all Urban Cooperative Banks to convert to Small Finance Banks so that RBI can have more regulation over these Banks. But most UCBs are least interested in converting because of the benefits accruing from present loopholes.
RBI is forcing shutdowns (reduced from 1900 (2004) to 1500 (2018)) and mergers (Maharashtra = 72 mergers between 2004 to 2018) due to frauds and scams.

This marks the end of ‘rural banking.’ For more articles, CLICK HERE.

Differential Banks

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Differential Banks

Last Updated: March 2023

This article deals with ‘Differential Banks (Payment Banks, Small Area Banks, Local Area Banks etc.).’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Differential Banks vs. Universal Banks

	Universal Banks	Differential Banks
Branches	Universal Banks can open Branches anywhere. For example SBI, ICICI etc.	Differential Banks have geographical restrictions on branch opening for Local Area Bank (LAB), Regional Rural Banks (RRB) etc.
Money acceptance	Universal Banks can accept both Time & Demand Deposits of any amount can be accepted.	Restrictions are there. Eg: Payment Bank: Can accept the maximum amount of Rs 1 lakh only in deposit.
Give Loans to	Anyone	Restrictions are present. Eg: 1. Small Finance Bank, Regional Rural Bank: must give 75% to Priority Sector. 2. Payment Bank can’t give loans.

1. Regional Rural Banks (RRB)

Need of RRBs

In 1975, the government appointed MM Narsimham Committee to look into rural banking.
Observations of the Narsimham Committee were as follows:-
- The staff of the Banks has expertise in banking & financial matters but is not aware of rural people’s problems.
- Primary Agriculture Credit Societies (PACS) have members from villages & are aware of the needs and problems of the villagers.
Recommendation: CREATE HYBRID OF BOTH, i.e. BANKS HAVING FINANCIAL STRENGTH OF COMMERCIAL BANKS & GRASSROOT PROBLEM AWARENESS OF COOPERATIVES. Hence, the concept of RRB came to being.
As a result, Regional Rural Banks (RRBs) were first set up on 2 October 1975 (only 5 in numbers) under RRB Act.

Client of RRBs

RRB provide loan & saving facilities to villagers & they include

Farmers	Rural Entrepreneurs
Agricultural Labourers	Cooperative societies
Rural Artisans	Primary Agricultural Credit Societies

Structure

RRBs are sponsored by Commercial Banks
- Sponsor Bank provides training to the staff of RRB.
- Sponsor Bank also provides initial capital to set up RRB.
RRB operates in selective districts & doesn’t have all India presence.
The provisions of Priority Sector Lending (PSL) are applicable to RRB (75% of loans should be PSL).
According to the original RRB Act, paid up capital ( ownership) of RRBs was Central Government: State Government: Sponsor Bank = 50: 35: 15

Failure of RRBs

Due to excessive lending towards social banking & catering to highly weaker sections, these banks started to incur huge losses by the early 1980s.
Private & Public banks too started to operate in rural areas, which resulted in low deposits in RRBs. As a result, RRBs had to depend on NABARD for credit.
Debt waivers to farmers & NPA also created a lot of problems.

Subsequently, following the suggestions of the Kelkar Committee, the government stopped opening new RRBs in 1987—by that time, their total number stood at 196.

Steps to revive

RRB Amendment Act, 2015

Earlier shareholding requirements – Central : State : Sponsor Bank = 50:15:35 .
After Amendment, Centre, State & Sponsor Bank’s cumulative shareholding can reduce up to 51%.

In 2005, the amalgamation process of RRBs with their’ Parent Banks’ was initiated so these banks could become more viable (As of April 2020, there are only 53 RRBs ).
Jan 2021: RBI enabled the RRBs to avail the benefits through the Liquidity Adjustment Facility (LAF).
June 2021: RBI has allowed the RRBs to issue the Certificate of Deposits.
The obligation of concessional loans has been abolished & RRBs have started to charge commercial interest rates on lending.
Target client restrictions have been ended & RRBs can now serve anybody.
Dr KC Chakrabarty Committee has recommended that CAR/CRAR for RRBs should also be 9% & to achieve this, the government should recapitalize RRBs.

Note – Recently launched Priority Sector Lending Certificates (PSLC) will help them because they do a lot of PSLs.

2. Local Area Banks (LAB)

In 1996, Manmohan Singh (as Finance Minister) mooted to start Local Area Bank (LAB).
They are licensed under Banking Regulation Act but not included in the 2nd Schedule of the RBI Act.
The vision was to increase financial inclusion.

Conditions

They can operate only in Rural & Semi-Urban Areas.
LAB can operate in a maximum of 3 geographically contiguous districts.
LAB can open only 1 branch in an Urban / District city.
PSL norms apply to LABs as well. 40% of loans should go to Priority Sector.
They are not Scheduled Commercial Banks because their names are not mentioned in RBI Act.

Problems with Local Area Banks

MSME loans given by LABs aren’t covered under the Credit Guarantee Scheme of the Government.
Farm loans aren’t covered under Interest Subvention Scheme.
State/Central PSUs/Institutes don’t open accounts in them.
Branch expansion is heavily restricted in rural & semi-urban areas.
They can’t get loans from RBI at Bank Rate /MSF.
They can’t get refinance from NABARD /SIDBI.

Operating Banks

10 Licenses were given at that time & only 4 are operating presently.
LABs were in the news in 2016 when applications for Small Financial Banks were called. Usha Thorat Committee allowed them to apply for Small Finance Banks & one out of them, i.e. Capital Local Area Bank based in Punjab got the license to open Small Finance Bank

3. Payment Banks

What are Payment Banks?

Payment Banks are a new stripped-down type of bank expected to reach customers mainly through mobiles rather than traditional bank branches.
Payment Banks were formed under the recommendations of the Nachiket Mor Committee. Consequently, in 2015, RBI granted ‘in-principle’ approval for payment banks to 11 entities. Later, 3 backed out of business. Hence, 8 in the market now.
1. Aditya Birla Nuvo Ltd.
2. Airtel M-Commerce Services Ltd.
3. Department of Posts
4. Fino PayTech Ltd.
5. National Securities Depository Ltd
6. Reliance Industries Ltd. (Jio)
7. Vijay Shekhar Sharma (Pay TM)
8. Vodafone m-Pesa Ltd.
9. ~~Cholamandalam Distribution Services Ltd (withdrew later)~~
10. ~~Dilip Shantilal Shanghvi (withdrew later)~~
11. ~~Tech Mahindra Ltd. (withdrew later)~~

Characteristics of Payment Banks

1. Target Audience

Small businessmen, poor (domestic) immigrant workers and the rural population

2. Potential candidate to run

Mobile companies, consumer goods companies, post office systems, Agri/dairy type cooperatives and Corporate Business correspondents.

3. CRR

Banks have to keep Cash Reserve Ratio (CRR) just as Scheduled Commercial Banks.

4. Entry Capital

Payment Banks require ₹ 100 crores as entry capital/

5. Features

Payment Banks can hold up to ₹ 1 Lakh in an account and pay interest on these balances like a savings bank account.
But they cant involve in any credit risk, i.e. can’t give loans to others. However, they can invest in SLR-approved securities.
They must maintain the Capital Adequacy Ratio (CAR) of 15% (compared to ordinary Banks which are required to maintain a CAR of 9%).
They can issue debit cards and ATM cards usable on ATM networks of all banks. But they can’t issue credit cards.
They can enable transactions, transfers and remittances through a mobile.
Since Payment Banks can become Banking Correspondents of Universal Banks, the customer can use the same account as that of Universal Bank and take services of Payment Bank from that account.
The Payment bank will enjoy all the rights and responsibilities of Scheduled commercial banks.
Payments Banks must use the word ‘Payments’ in their name to differentiate them from other banks.

Working of Payment Banks

Case Study of m-Pesa: Why India should get Payment Banks (case study)

M-Pesa is Kenya’s Payment bank.
M = mobile & Pesa = Money in Swahili .
It provides banking services through mobile and works in the same way as Payment Banks. Nachiket Mor Committee recommended starting Payment Banks based on the success story of m-Pesa in Kenya.

Benefits of Payment Banks

Help in financial inclusion: It is uneconomical for traditional banks to open branches in every village, but mobile coverage is a promising low-cost platform.
Remittances at Zero Cost: Their main target is migrant labourers. It will tap India’s domestic remittance market.
Increase in disposable income of poor migrant families: Since Remittances will happen at zero cost, it will increase disposable income in the hands of low-income migrant families.
These banks will help in the easy implementation of Direct Benefit Transfer.
They will help in moving India towards a less-cash society.
They will create job opportunities in the form of Payment Bank’s Agents.

Problems with Payment Banks

Low revenue: Payment Banks can’t undertake any lending businesses and can only invest in SLR-approved securities.
Banks are already offering most services that payments banks can offer. Hence, offering a new and differentiated proposition will not be easy for payments banks.
RBI has launched Unified Payment Interface (UPI), giving a blow to the business plans of Payment banks.

As a result, after initial enthusiasm in applying for payment banks, companies like Tech Mahindra, Sanghvi’s, and Cholamandalam Investment have opted out.

Started till now

Jan 2017	(1) Airtel (first to start)
May 2017	(2) PayTM
2018	(3) Reliance Jio, (4) Fino, NSDL and (5) Birla launched their Payment Banks
September 2018	(6) India Post Payment Bank

Side Topic: Indian Post

Post office as Financial Intermediary

In September 2018, India Post Payment Bank was launched.

All 1.55 Lakh Post Offices were linked to Payment Bank System.
3 lakh Postmen and Grameen Dak Sewaks now provide on-the-door banking facilities.
India Post Payment Bank has all the features & benefits of Payment Banks like 1. Up to 1 lakh deposit 2. 4% interest Rate 3. Debit Card facility 4. Free withdrawals from own ATMs and Punjab National Bank’s ATMs and 5. No minimum balance (with the added benefit that they already have post office infrastructure).
They have also partnered with Bajaj Alliance Life Insurance (BALIC) to sell insurance policies.

Post office as Financial Intermediary

Indian Post is the oldest & largest organization involved in resource mobilization in India.
It has a huge network of 1.55 lakh post offices, 3 lakh postmen & 5 lakh employees.
90% of the post offices are present in Rural areas.
Earlier, too, it provided a wide array of ‘financial services’ such as saving and other time deposit accounts, Public provident funds, Monthly Investment schemes, and National saving certificates.
It comes to rescue the government when the banking system cannot deliver cash benefits such as under MGNREGA, Old age/disability Pension Schemes, etc.
Post offices worldwide have gone through this transformation in many countries & experience was quite successful there. Most notable is Royal Post in the UK, which, apart from Banking services, also provides mobile and broadband services. The US is also considering such plans.
It can free bigger commercial banks to concentrate on competitive commercial operations leaving social security works to be handled by Postal Bank.

4. Small Finance Banks

The purpose of the small banks will be to provide a whole suite of basic banking products, such as deposits and supply of credit but in a limited area of operation (contiguous districts in a homogenous cluster of states or union territories).
These are modelled on Community Banks of USA.
In Community Banks, Employees of banks know almost every family and therefore are well aware of their assets, credit history, financial position and business. As a result, MSME Industry, Retail Businessmen and Farmers can take loans from them without any problem.

Indian Parallels of Community Banks

Old Private Banks like Catholic Syrian Bank of Kerala, Nainital Bank etc.
Local Area Banks
Regional Rural Banks
Microfinance Institutions

Unlike big PSBs (like SBI) and New Private Banks (like Axis, ICICI Bank), their employees know their customers very well.

Hence, Nachiket Mor recommended the creation of Small Financial Banks based on the Community Banks of the USA. They should focus on unserved, underserved, small and marginal farmers along with MSMEs. Even Indian parallels can get an SFB license. At last, 10 contenders got a license. e.g., Capital Area Bank (Punjab), Au Financiers (Jaipur) etc

Prelims related information regarding Small Finance Banks

They are licensed under Banking Regulation Act.
PSL requirement = 75% (40% category wise (as Universal Banks) + 35% into PSL with competitive edge).
They are Scheduled Banks under RBI Act.
CRR and SLR requirements are similar to existing Commercial Banks.
CRAR/CAR requirements – 15% (ordinary Banks – 9%).
FDI – up to 74% allowed.
They can open bank branches with the condition that 25% of branches should be in rural unbanked areas.
The maximum loan size and investment limit exposure to single/group borrowers/issuers would be restricted to 15% of capital funds.
Loans and advances of up to ₹25 lakhs, primarily to micro-enterprises, should constitute at least 50 per cent of the loan portfolio.
They can evolve into Universal Banks after 5 years, subject to RBI’s discretion.

5. Wholesale Bank

It has not formed yet. RBI proposed it in 2017.

Wholesale Bank will be regulated under the Banking Regulation Act.
They can only accept deposits larger than Rs.10 crore from big investors. Apart from that, they will raise money by issuing bonds.
It will not give a loan to a retail /common person. It will only lend in wholesale markets such as the infrastructure sector or corporates.
PSL norms are applicable but at the wholesale level. They will finance big projects in Priority Sector and can sell extra PSL certificates to Scheduled Banks to fulfil their targets.

Why do we need Wholesale Banks?

India needs huge investments in the Infrastructure Sector (₹40 trillion in the next decade). But there are issues.
- The government is the biggest spender in the infrastructure sector (45% of total infrastructure spending). But government can’t invest more because of Fiscal Deficit problems.
- The next biggest investor is banks. But they too cant invest more due to NPA Problem.

To get more investment in infrastructure, the government plans to come up with Wholesale Banks.

The tenor of the infrastructural loans is very long, and therefore it does not incentivize institutions like Banks. Thus there is a need for separate infrastructure banks. Wholesale Banks will perform that work.
Right now, NBFCs are not under the supervision of RBI (and act somewhat like Shadow Banks) and are not covered under SARFAESI to recover their Bad Loans. It is not in the government’s interest to let them continue because they don’t have protection cover of CRR & SLR. By making Wholesale Banks, bigger NBFCs can be made to come under RBI’s regulatory supervision.
Apart from that, they will help Banks to achieve their PSL Targets. They will invest huge amounts in PSL Projects and then issue their PSL Certificates which Banks can buy.

Merger and Consolidation of Public Sector Banks

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Merger and Consolidation of Public Sector Banks

Last Updated: March 2023

This article deals with ‘Merger and Consolidation of Public Sector Banks.’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Bank Mergers

In 2016, it was decided in Gyan Sangam II that since Public Sector Banks aren’t performing well, there is a need to consolidate banks by merging small banks with the State Bank of India, Punjab National Bank, Bank of Baroda, Canara Bank etc. as Anchor Banks.
The crux of the matter is the government is working on a consolidation of public sector banks to create 3-4 global-sized banks and reduce the number of state-owned banks to about 10-12.

Mergers happened till now

2017: SBI’s 5 Associated Banks & Bhartiya Mahila Bank merged with SBI.
2019: Vijaya & Dena Bank merged with Bank of Baroda.
2019: Oriental Bank of Commerce and United Bank of India merged into Punjab National Bank.
2019: Syndicate Bank merged with Canara Bank.
2019: Andhra Bank and Corporation Bank merged with Union Bank of India.
2019: Allahabad Bank merged with Indian Bank.

Merger and Consolidation of Public Sector Banks

Points in favour of Merger of Banks

(Economic Survey 2020) It will help in placing more Indian Banks in the top 100 banks of the world. It is sine quo non to have at least 6-8 top-100 banks of the world in India if we want to make India a financial hub of Asia and channelize global savings towards India to make India a $ 5 trillion economy. Currently, India has just one bank in the top 100 banks (SBI = 55 Rank), while China has 18.

India needs atleast 6-8 global
banks in Top-100 to make India
a $ 5 Trillion economy.
(Economic Survey 2020)

Earlier State Bank of Saurashtra (2008) & Indore (2010) merger into SBI was successful. Hence, previous experience is pleasant.
Larger banks provide financial stability and act as engines of growth in times of trouble. E.g. Chinese Banks in 2008.
It will lead to branch rationalization and reduce operating costs.
Larger Public Sector Banks can support the corporate sector better in overseas acquisitions as done by Chinese Banks.
To comply with BASEL III Norms, if big banks like Consolidated SBI issue shares, they can fetch a good response.
Enhanced geographical reach: For example, Vijaya Bank has strength in the South, while Bank of Baroda and Dena Bank had a stronger base in Western India. That would mean wider access for the proposed new entity and its customers.

Points against Merger of Banks

Mergers eat up a lot of top management time. At a time when Public Sector Banks need razor focus to deal with the NPA menace, mergers will be very distracting.
Large banks aren’t necessarily efficient banks: The quest to create an Indian banking giant is an old one when the world looked in awe at the Japanese banking giants. But their big size emboldened them to do excessive lending and ultimately they had to be bailed out by taxpayers’ money.
The merged State Bank of India is likely to be five times larger than its nearest competitor and can stifle the competition.
Setback to corporate governance: The merger sends out a poor signal of a dominant shareholder (the government) dictating decisions that impact the minority shareholders.
Banks will lose their regional identities.
Political Implications: Kerala Legislative Assembly has passed a resolution that the State Bank of Travancore’s merger with SBI will affect the state’s economic growth negatively.
Protests: Addressing the concerns of unions and shareholders will be challenging.
Harmonization of Technology: It is a big challenge as various banks are currently operating on different technology platforms.

Best way to Merge: Merge complementary banks. E.g., Bank of Baroda with Dena and Vijaya Bank so that layoffs aren’t large.

History of Banking System

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History of Banking System

Last Updated: March 2023

This article deals with the ‘History of Banking System.’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Financial Intermediaries

For the economy to function properly, savings must be channelled into investments. But there is a conflict here between savers and businesses/corporates.

Savers: Want instant access to their savings in case of unexpected expenditure.
Businesses/Corporates: Want promise that they will not be forced to repay loans prematurely.

Banks can solve this problem by acting as an intermediary between savers and businesses (Ben Bernanke et al. )

These include banks, insurance companies, pension funds, mutual funds etc.

Banking System

Scheduled Commercial Banks

When RBI is satisfied that a bank has (Paid Up Capital + Reserves) of at least 5 Lakhs & it is not conducting business in a manner harmful to its depositors, such bank is listed in the 2nd Schedule of RBI Act, and it is known as a Scheduled Bank.

It is different from the Non-Scheduled Banks in the following way

Scheduled Banks	Non-Scheduled Banks
– Scheduled Banks are bound to maintain Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) as mandated by the RBI.	They are not required to maintain SLR and CRR.
– They are eligible to borrow funds via Liquidity Adjustment Facility (Repo and Bank Rates).	It depends on RBI’s discretion to borrow via this mechanism.
It can be subdivided into various parts 1. Scheduled Commercial Banks, e.g. SBI, Axis, PNB, ICICI Bank etc. 2. Schedule Cooperative Banks like Haryana Rajya Sahakari Bank etc. 3. Schedule Payment Banks like PayTM Payment Bank, Fino Payments Bank etc.	Hundreds of cooperative banks are non-Schedule Banks.

Topic: History of the Banking System in India

History of the Banking System in India before Independence

The present Banking System was introduced in the western world and was later introduced in India during the British Raj.
During British times, there were two types of Banks

1. British Banks

East India Company established Banks in 3 Presidencies.

Bengal	1806
Bombay	1840
Madras	1843

In 1921, these three merged to form the Imperial Bank of India. Later, it was nationalized and became SBI.
It provided services to British Army officers, Civil Servants & Judges.

2. Swadeshi Banks

These were set up by the Indians parallel to the British Banks.
First Indian Bank to be opened was Allahabad Bank(1856). Later, other banks such as Bank of Baroda (backed by Gaekwads of Baroda), Punjab National Bank (the role was played by Lala Lajpat Rai in its formation), Punjab & Sind Bank (by Bhai Vir Singh).
These banks targeted big merchants, particularly raw-material exporters.

But neither helped in financial inclusion.

Birth of RBI

By the early 1930s, many banks were operating in India. They were registered under the Company Law, and regulations on this sector were not present. But the problem arose during The Great Depression (1929), which started in the USA. Due to this, the demand for Indian exports in the foreign market decreased, and Indian merchants began to default.
Consequently, a large number of Indian banks collapsed.
To deal with such a situation and bring the banking sector under regulation, the British Indian government set up the Reserve Bank of India in 1934 under the recommendations of the Hilton Young Royal Commission.

History after Independence

The Government of India took two important steps

Nationalisation of RBI
Banking Regulation Act,1949: It empowered RBI to control & regulate the Banking sector in India.

Nationalisation of Banks

Nationalisation of Banks: SBI Case (1st Round )

1955	Imperial Bank was nationalized & renamed SBI. (At the same time, the Nationalization of Insurance Companies was also done)
1960	8 Banks were nationalised & made subsidiaries of the State Bank of India.
1963	Two subsidiary Banks were merged (State Bank of Bikaner & State Bank of Jaipur), leading to the formation of the State Bank of Bikaner & Jaipur.
2008	State Bank of Saurashtra merged with Parent Bank.
2010	State Bank of Indore merged with Parent Bank.
Till recent times	There were 5 subsidiaries of SBI 1. State Bank of Bikaner & Jaipur 2. State Bank of Hyderabad 3. State Bank of Mysore 4. State Bank of Patiala 5. State Bank of Travancore
2017	All subsidiaries merged into Parent Bank

Nationalisation of Banks: Except SBI (2nd Round)

1969: 14 Banks having deposits of more than ₹ 50 Crore were nationalized.
1980: 6 more banks Nationalized, having deposits of more than ₹200 Crore.

Nationalised in 1969	Punjab National Bank, Canara Bank etc.
Nationalised in 1980	Punjab & Sind Bank, Vijaya Bank, Oriental Bank of Commerce etc.

Reasons of Nationalisation

To remove control & concentration of economic power in the hands of a few industrialists.
Due to misuse of funds by owners.
Due to the tendency of banks to ignore the needs of small-scale industrial sector & agriculture.
To remove the concentration of the banking sector mostly in Urban areas.

Objectives after Nationalisation

To open more banks in rural & semi-urban areas & to collect savings from these areas.
To provide credit facilities to areas defined as Priority Sector in the economy.

Has the nationalization of private banks benefitted India?

According to Economic Survey (2020), banking resources to rural areas, agriculture, and priority sectors have increased due to the nationalization of banks. For example, in the period between 1969-90
- The number of rural bank branches increased ten-fold.
- Credit to rural areas increased twenty-fold.
- Agriculture credit expanded forty-fold.
The US Banking System shows the inefficiencies of the Private Banking System during the successive financial scams, including the Subprime crisis of 2008, lending to subprime borrowers, bias against people of colour etc. These things have not happened in India as the banks were nationalized in India.
But at the same time, Economic Survey (2020) doubts whether these benefits were entirely caused by nationalization as the period also saw various other events like green revolution, anti-poverty programmes (like the Integrated Rural Development Programme) and policies of RBI (such as RBI’s 4:1 formula).

Issues faced by Public Sector Banks due to Bank Nationalisation

Since the government was the majority shareholder of the banks, it started to give loans at populistic ‘Government Administered Interest Rates’, which decreased the banks’ profitability.

Banks were forced to give loans to fund unviable projects based on political considerations, which increased the NPAs of Public Banks as the recovery of such loans was low.

Public Sector Banks account for 92.9% of bank fraud cases. A large majority (90%) were related to advances, suggesting the poor quality of screening and monitoring processes for corporate lending adopted by Public Sector Banks.

PSBs perform poorly on Return-on-Assets (RoA), Return-on-Equity (RoE) etc., when compared with Private Banks. Public Sector Banks are having negative RoA presently.

The politicization of Bank Boards happened with the government placing its favorites in the Board of Directors irrespective of their knowledge and talent. It reduced the professionalism in the banks.

Due to the above reasons, RBI feared that banks could collapse. Hence, it mandated a high Cash Reserve Ratio (CRR), reducing the funds at the disposal of banks for loan purposes.

A large staff was hired in banks, even more than required, to create government jobs. It led to the unionization of staff and inefficient customer services. Frequent hartals of bank employees were observed in the period after nationalization.

PSB officers are subjected to extra scrutiny by the Central Vigilance Commission and CAG. Officers are wary of taking risks in lending or in renegotiating bad debt due to fears of harassment under the veil of vigilance investigations.

Side Topic: Number of Public Sector Banks Today

Public Sector Banks = 13 ( on January 2022, including India Post Payment Bank)

Old Private Banks

All the Big Private Banks were nationalized. But there were Small Private Banks whose deposits were less than limits and weren’t nationalized. These Banks are now called Old Private Banks.
There are 12 such banks in India.
These are Scheduled Banks and have to maintain Cash Reserve Ratio & Statutory Liquidity Ratio.
Examples: Catholic Syrian Bank, Dhanlaxmi Bank, Federal Bank, Jammu and Kashmir Bank etc.

Narsimham Committee and (Rise of ) New Private Sector Banks

After the 1980 nationalization, Public Sector Banks had a 91% share in the national banking market which has reduced to 70%. The reduced stake has been absorbed by New Private Banks (NPBs), which came up in the early 1990s after liberalization. It brings us to the topic of New Private Banks.

Share of Private and Public Sector Banks

Private Sector Banks

The Balance of Payment crisis of 1991 finally forced the government to set up a Committee for Banking Sector Reforms under the former RBI Governor M Narsimham. He recommended following

Government should decrease its shareholding in Public Sector Banks.
The banks’ resources came from the general public and were held by the banks in trust that they were to be deployed for the maximum benefit of the depositors. Even the government had no business to endanger the solvency, health and efficiency of the nationalized banks under the pretext of using banks, resources for economic planning, social banking, poverty alleviation, etc.
RBI should decrease Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
Priority Sector Lending (PSL) given to agriculture and Small Scale Industries (SSIs) should be phased out gradually as they had already grown to a mature stage.
Government should not dictate interest rates to Banks.
Liberalize the branch expansion policy.
Allow entry of New Private Banks and New Foreign Banks.

This led to 3 Rounds of Banking Licences.

1st Round (1993-95)	10 licenses were given to open the following banks. 1. ICICI 2. HDFC 3. Indus 4. DCB 5. UTI (later became Axis bank) 6. IDBI (presently owned by LIC) 7. Global Trust Bank (later merged with Oriental Bank) 8-9-10: Bank of Punjab, Centurion Bank, and Times Bank were merged into HDFC
2nd Round (2001-04)	2 licenses were given in the 2nd Round 1. Kotak Mahindra 2. Yes Bank
3rd Round (2013)	Bimal Jalan Committee made selections 1. Bandhan Bank (Originally, a Microfinance company based in West Bengal) 2. IDFC (Originally, an infra finance NBFC based in Maharashtra).

Side Topic: Number of Private Banks in India

22 presently (after IDBI is privatised).

On Tap System of Banking License

Earlier System: Start & Stop System
- RBI issues notification and interested entities can apply at that time only..
- Till now, 3 such rounds have happened

The new system proposed in 2016: On Tap System
- In this system, there will be no deadline for application. Hence, there is no need to wait for notification.
- When an entity thinks it is fit to become a bank, it can approach RBI with the application.
- RBI has issued guidelines regarding this too.
In 2021, RBI gave Small Banking License to Unity Small Finance Bank through this route.

The following company can apply for Bank License via the ‘On-Tap’ System

The company must have a minimum of 500 crores paid-up capital.
The company must have 10 years of record in the banking/finance sector.
Initially, it must be controlled by Indians (100% shareholding should be with Indians).
Applicant must be willing to open a minimum of 25% branched in rural areas.
They have to maintain CRR, SLR, PSL etc.
But large industrial houses and NBFCs can’t open banks via this route.

Foreign Commercial Banks

In the Nehruvian Socialist Economy, there was disdain & apprehensions about Foreign Banks. Only a handful of them was allowed to open branches. But, Post-Narasimham-Reform, foreign banks approval policy was liberalized.
In 1991, M Narsimham Committee recommended allowing Foreign Banks on a reciprocal basis. The government accepted this proposal.

There are 44 Foreign Banks in India
1. AB Bank
2. Abu Dhabi Commercial Bank
3. American Express banking
4. ANZ Banking Group
5. Bank of America
6. Bank of Bahrain and Kuwait
7. Barclays Bank
8. BNP Paribas
9. Citibank
10. Commonwealth Bank of Australia
11. CCRB
12. Credit Agricole
13. Credit Suisse
14. DBS Bank
15. Deutsche Bank
16. Doha Bank
17. FirstRand Bank
18. Industrial and Commercial Bank of China
19. Industrial Bank of Korea
20. JP Morgan Chase Bank
21. JSC VTB Bank
22. KBC Bank
23. KEB Hana Bank
24. Krung Thai Bank
25. Mashreq Bank
26. Mizuho Bank
27. National Bank of Australia
28. National Bank of Abu Dhabi
29. PT Bank
30. Maybank Indonesia
31. Sberbank
32. SBM Bank
33. Shinhan Bank
34. Societe Generale
35. Sonali Bank
36. Standard Chartered Bank
37. Sumitomo Mitsui Banking Corporation
38. Bank of Nova Scotia
39. Bank of Tokyo
40. The Hongkong and Shanghai Bank
41. Royal Bank of Scotland
42. United Overseas Bank
43. Westpac Bank
44. Woori Bank
First, foreign banks have to open an Indian Subsidiary registered in India under the Companies Act.

Core Banking Solution

Core Banking Solution (CBS) is the networking of branches, enabling customers to operate their accounts and avail banking services from any branch of the Bank on the CBS network, regardless of where he maintains his account. The customer is no more the customer of a Branch. He becomes the Bank’s Customer.
It has helped in converting Branch Banking to Branchless Banking.

Entry of Business Houses in the Banking Sector

Procedure to open a new bank

Register the company with the Ministry of Corporate Affairs.
The company has to issue IPO in the share market after taking SEBI’s permission to arrange the capital.
Then, the company has to take permission from RBI through the ‘On Tap’ System.
After doing this, the company will initially get a Non-Scheduled Bank License. After some years, when RBI is confident that the bank has good health, RBI will upgrade the license of the Bank to Scheduled Commercial Bank.

Analysis: Should private houses be allowed to open banks

Arguments in favour

More competition will lead to better services, higher interest rates and better customer services.
Existing banks have stressed balance sheets due to high NPAs. Hence, they have become over cautious while giving new loans. The entry of fresh banks will re-invigorate the lending process.
It will help the ‘shadow banks’ such as IL&FS and DHFL to become banks and come under the proper supervision of RBI.

Based on the above arguments, PK Mohanty Committee, to review the corporate structure for Indian Private Sector Banks (2020), recommended allowing private houses’ entry into the banking sector.

Arguments against

Connected Lending: In Connected lending, promoters of the bank lends loan at favourable terms to the companies owned by that group. The issue of connected lending was rampant in India from 1947 to 1958, which led to the failure of 361 banks in India during that phase.
Circular Banking: It has the potential to lead to circular banking under which a bank controlled by Corporation A lends a loan at favourable terms to Corporation B and a bank controlled by Corporation B lends a loan at favourable terms to Corporation A. In the process, the interests of the depositors are jeopardized.
The higher competition will lead to excessive loan disbursement and misspelling of the banking products to gain new customers and retain the old customers. These types of practices led to Subprime Crisis in 2007-08. After the subprime crisis, most countries have become cautious to such ideas.
History: Corporate houses were active in the banking sector till five decades ago, when the banks promoted by them were nationalized in the late sixties amid allegations of connected lending and misuse of depositors’ money.
RBI cannot effectively regulate the existing banks as shown by various scams like Yes Bank-Rana Kapoor Scam, ICICI-Vodafone Loan Scam, Punjab National Bank-Nirav Modi Scam etc. Hence, it is not guaranteed that RBI will be able to regulate the new banks effectively.
Large industrial houses face severe corporate governance issues, as epitomized by Ratan Tata- Cyrus Mistry and Narayan Murthy-Vishal Sikka controversy. In such a situation, allowing them to open banks is not advisable.
Banks controlled by big business houses can be misused for nefarious activities such as money laundering.
It can create very powerful oligarchs with large economic power.
Even regulators in developed countries don’t encourage the entry of business houses in the banking sector.

Considering the above discussion, the risks outweighs the benefits. Government can take steps to strengthen the corporate structure and health of the present banking sector.

This marks the end of the article on “History of Banking System.’

Convertibility of Current Account & Capital Account

by admin

Last Updated: May 2023 (Convertibility of Current Account & Capital Account)

Convertibility of Current Account & Capital Account

This article deals with ‘Convertibility of Current Account & Capital Account .’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Why restrictions on Convertibility?

Central Bank can’t manage a floating exchange rate regime all the time. Otherwise, Forex reserve will get empty. Hence, quantitative restrictions are placed on the conversion of ₹ to foreign currency.
There can be two types of restrictions, i.e. on the Current Account & Capital Account.

Current Account Convertibility

Current account convertibility means the freedom to convert currency for current transactions in terms of outflows and inflows.
In the case of India, Current Account is fully convertible (since 1994) & there are no quantitative restrictions. It means ₹ is fully convertible into another currency for current account transactions & vice versa is also true.

Capital Account Convertibility

Full capital account convertibility means :
1. A foreign investor can convert any amount of foreign currency to Indian Rupees and invest in any asset in India without any restriction. This investor can also sell the investment without any restriction, convert the resulting Indian Rupee amount to a foreign currency and take it out of the country.
2. A Domestic Investor can convert Indian Rupee to foreign currency and invest in any asset abroad without any restriction.
3. A Domestic Investor can raise any amount from External Market and convert it into Indian Rupees to invest that amount in India.
₹ is not fully convertible on the capital account. But after the S.S. Tarapore Committee (1997) recommendations on Capital Account Convertibility, India has been moving toward allowing full Capital Account Convertibility.
There are the following limitations on Capital Account Convertibility
1. Indian corporates are allowed full Convertibility of up to $ 500 million annually for oversea ventures.
2. Individuals are allowed to invest in foreign assets, shares, etc., up to $ 2,50,000 per annum.

Liberalised Remittance Scheme (LRS)

LRS was started by Government in 2004.
Under the scheme, an Indian resident (including a minor) is allowed to take out up to $2,50,000 from India either for a current Account or capital account transaction. (e.g. paying for college fees abroad, buying shares, bonds, properties, and bank accounts abroad.)
Issue: Panama papers allege various Bollywood celebrities used the LRS window to shift money from India to tax havens for tax avoidance.

Debate : Should there be Full Capital Account Convertibility?

There is an ongoing debate that there should be full capital account convertibility.

Arguments in favour of full Capital Account Convertibility

If the capital account is fully convertible, India can attract more FDI, FPI and ECB to India, creating new jobs & pushing economic growth.
It will increase the choices for investments– Investors get the opportunity to base their investment and consumption decisions on world interest rates and world prices for tradeable.
Various committees like SS Tarapore Committee have also accepted this.

Arguments against Capital Account Convertibility

IMF study says there is no correlation between full Capital Account convertibility & business growth.
It could lead to the export of domestic savings.
Companies that would get money in $ via ECB would be returned in $s only. But this is not favourable in times of Exchange rate volatility.
If our currency falls, the whole system can collapse, as happened in the East Asian Crisis of 1997. India & China survived the crisis because both didn’t have full capital account convertibility.
Various committees, like HR Khan Committee, have rejected full Capital Account Convertibility.

Side Topic: East Asian Financial Crisis

Before 1997, All East Asian Economies deliberately kept their currencies undervalued to boost export. (like China is doing now)
All these countries had full capital account convertibility. Foreign investment was quite high, and GDP growth was in double digits.

But then came Asian Crisis
- Thailand’s steel & automaker companies filed for bankruptcy. Foreign investors panicked and started to pull out $s from similar companies from all South East Asian Nations. As a result, their currencies & economies collapsed. E.g.: Indonesian Rupiah collapsed from 1$ = 2,000 to 1$ = 18,000 Indonesian Rupiah.
- It led to high inflation culminating in rioting & political instability.

On the other hand, India and China survived this tumultuous period because their capital account wasn’t fully convertible. Hence, investors couldn’t pull off their investments overnight due to restrictions under Capital Account convertibility.

Convertibility of Current Account & Capital Account

SS Tarapore Committee (1997)

The recommendations of the committee were as follows

He was in favour of Full Capital Account convertibility, but he also feared that a crisis like East Asian Crisis could happen in India too. For this, he advised that there should be some conditions before doing that
Conditions

Conditions	India’s situation
Forex to sustain 6 months of imports	Yes, India has a forex of more than $550 billion (i.e. Can sustain 11 months of imports)
Fiscal Deficit of 3.5% of GDP	Target for 2020 is 3.5% (but will be breached due to Corona pandemic induced slowdown)
Inflation should be between 3-5% (for 3 years)	Under the new Monetary Policy Framework, it should be contained between 2-6%
Bank NPA should be less than 5%	They are above 10%

Forex Reserves of India

by admin

Last Updated: May 2023 (Forex Reserves of India)

Forex Reserves of India

This article deals with ‘Forex Reserves of India .’ This is part of our series on ‘Economics’, which is an important pillar of the GS-3 syllabus. For more articles, you can click here.

Current Status of Forex Reserves of India

Forex is the external assets that are readily available and controlled by the monetary authority for direct financing of external payment imbalances, for indirectly regulating the magnitude of such imbalances through exchange market intervention to affect the currency exchange rate and other purposes.
India’s forex reserves are about $562 billion (Dec 2022).
It is enough to finance about 9 months of imports. It has reduced from 13 months of imports in 2021. In March 1991, it was reduced to just 2.5 months of import coverage (which forced the country to seek International Monetary Fund assistance).

Ranking of Foreign Reserves with RBI

Foreign Currency and Foreign Currency Assets
Gold
IMF’s SDR
Reverse Tranche Position in the IMF

World Ranking of Forex Reserves ( India 6th and China topped with 3.2 Trillion Forex)

Rank	Country	Forex
1	China	$ 3.2 trillion
2	Japan	$1.2 trillion
3	Switzerland	$812 billion
—-	———	————-
6	India	$562.72 billion (Dec 2022) (Covering 9.3 months of imports)

Forex Reserves of India are under pressure and decreased in recent times. The reason include

Adverse global economic conditions and the fear of global recession led to a decrease in Indian exports.
Sharp rise in the price of oil in the international market
Fed Tapering led to an outflow of forex currency from India.

Reason for maintaining High Forex Reserves

It reduces the risk of external vulnerabilities such as high oil prices or Fed Tapering.
Exchange Rate Management: High Forex allows occasional RBI intervention to curb excessive volatility in the foreign exchange market.
It increases the investor’s confidence in the economy of the country.
It will help India to become a regional leader by signing currency swap agreements with other neighbours such as Sri Lanka, Bangladesh etc.

Issues with maintaining more than required Forex

While reserves are imperative in both preventing crisis situations and mitigating their impact, there are issues with maintaining more than required Forex Reserves. The problems with maintaining more than required Forex reserves include

Lost Opportunity Cost: Holding more than the required Forex Exchange reserve has opportunity cost because the stored money could be used for improving infrastructure and social services (like health and education)
Increase borrowing cost: Borrowing in foreign currency has high borrowing cost and is vulnerable to volatility in the exchange rate

Is India’s Forex Reserves enough?

As evident from the graph above, India’s Forex reserves have reduced. But it should not be a cause of worry as India has enough Forex Reserves based on the following yardsticks.

#1 IMF’s Guidotti–Greenspan Rule

According to Guidotti-Greenspan Rule, the country should have enough Forex Reserves to cover the short-term external debt.
Indian Forex Reserves comfortably meets this rule.

#2 RBI’s Tarapore Committee

According to Tarapore Committee, the country should have enough Forex Reserves to pay for 6 months’ imports.
Indian Forex Reserves comfortably meets this rule as well (Indian Forex Reserves can pay for more than 9 months’ imports).

Side Topic: How did China reach the top foreign exchange reserve position?

The term used for this phenomenon is ‘China’s Mercantile Policy’. Under this policy, China refrains from imports from other countries, and at the same time, exports are encouraged.

China restrains from imports in the following ways

IT	SOEs (State Owned Enterprises) opaquely control the domestic market
Pharma	Inordinate delay in clearance
Food	SPS agreements used to ban imports
Manufacturing	Domestic products are too cheap

At the same time, Exports are promoted by

Keeping Yuan undervalued
SOE get cheap loans
Subsidies are provided on a large scale
Tech-piracy is neglected

Side Topic: Manipulators of Currency

US Treasury Department makes a list of countries which manipulate their currency.
3 Conditions to include any country in this list
1. A trade surplus of over $20 billion with the US.
2. The current account surplus is 3% of the GDP with the rest of the world.
1. Persistent foreign exchange purchases of 2% plus of the GDP over 12 months.
In 2018, India was included in this list. But India was removed in 2019.
Countries which are included in this list include
- China
- Germany
- Japan
- South Korea
- Switzerland