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Banking Regulatory Powers Should Be Ownership Neutral (Urjit R. Patel, Governor, Reserve Bank of India – March 14, 2018 – Inaugural Lecture : Centre for Law & Economics, Centre for Banking & Financial Laws Gujarat National Law University, Gandhinagar)

Banking Regulatory Powers Should Be Ownership Neutral (Urjit R. Patel, Governor, Reserve Bank of India – March 14, 2018 – Inaugural Lecture : Centre for Law & Economics, Centre for Banking & Financial Laws Gujarat National Law University, Gandhinagar) - News and Press Release - Dated:- 15-3-2018 - I speak today to highlight some fundamental fissures that exist in the regulation of banks, in particular, public sector banks (PSBs). It has been slightly over a month since the latest fraud in the In .....

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t with what has been at the heart of some of the immediate reactions - the Reserve Bank s supervision of banks. IMF/World Bank FSAP Assessment In its 2017 Financial Sector Assessment Programme (FSAP) of India, conducted, completed and released prior to this episode, the International Monetary Fund (IMF) and the World Bank (WB), made the following observations: 1. In the publicly released FSSA (Financial System Stability Assessment) report, Para 35, page 17: The RBI has made substantial progress .....

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regulations in 2015 have improved distressed asset recognition. In April 2017, the RBI established a new Enforcement Department and revised its prompt corrective action framework to incorporate more prudent risk-tolerance thresholds. 2. Further, in its specific comments on Other Regulation, Accounting, and Disclosure (Core Principles or CPs 20, 26-29: Para 60, page 21): The internal control regulations issued by the RBI are adequate and are supported by the requirements of the SPARC risk-based s .....

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satisfactory. However, the FSAP for India laments at several points the fact that the Reserve Bank s regulatory powers over banks are not neutral to bank ownership: 1. In the Detailed Assessment Report (DAR) on the Basel Core Principles (BCP) on the Effective Banking Supervision, Para 6, Page 7:Some previously observed weaknesses concerning the independence of the RBI and the inherent conflict of interest when supervising public sector banks (PSBs) remain. The RBI enjoys a large degree of opera .....

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k profiles, assessment of management, and compensation. Legal reforms are thus highly desirable to empower the RBI to fully exercise the same responsibilities for PSBs as now apply to private banks, and to ensure a level playing field in supervisory enforcement. 2. Specifically, on Corporate Governance (CP 14, Para 50, page 18): The appropriate rules on fitness and propriety, and banks internal governance structures, are in place with respect to private and foreign banks. Nevertheless, the influ .....

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Regulatory Powers in India are NOT Ownership Neutral All commercial banks in India are regulated by the RBI under the Banking Regulation (BR) Act of 1949. Additionally, all public sector banks are regulated by the Government of India (GoI) under the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970; the Bank Nationalisation Act, 1980; and the State Bank of India Act, 1955. Section 51 of the amended BR Act explicitly states which portions of the BR Act apply to the PSBs, most .....

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des for removal of the Chairman and Managing Director (MD) of a banking company is also not applicable in the case of PSBs.2 RBI cannot force a merger in the case of PSBs as per Section 45 of the BR Act. PSB s banking activity does not require license from RBI under Section 21 of the BR Act; hence, RBI cannot revoke a license under Section 22(4) of the BR Act as it can in the case of private sector banks. RBI cannot trigger liquidation of PSBs as per Section 39 of the BR Act. Furthermore, in a r .....

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fraud. Temptation to engage in fraud at the level of employee or employees is always present, in banks (or in corporations), be it in public sector or private sector. The question then is whether there is adequate deterrence faced by employees from undertaking frauds and enough incentives for management to put in place preventive measures to preempt frauds. In case of banks, three potentially powerful mechanisms could induce discipline against frauds: 1. Investigative/vigilance/legal deterrence: .....

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al and inducing solvency questions. In anticipation of such disruptive outcomes that might cause loss of control, management and board members may put in place governance mechanisms to prevent or reduce the incidence of fraud and/or hold larger buffers in the capital structure to bear losses when fraud materialises. 3. Regulatory discipline: Banks in most parts of the world, however, have a significant portion of deposit funding that is insured, and since banks serve critical payments and settle .....

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r the right reasons, a fair bit of time. Indeed, RBI data on banking frauds suggests that only a handful of cases over the past five years have had closure, and cases of substantive economic significance remain open. As a result, the overall enforcement mechanism - at least until now - is not perceived to be a major deterrent to frauds relative to economic gains from fraud. It is fair to say that in case of private sector banks, the real deterrence arises from market and regulatory discipline, a .....

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ld need to put the house in order at swift notice so it can raise funding from markets and get back to growth path. In turn, there are incentives to invest in governance, so as to limit frauds and regulatory violations, and to respond with alacrity when incidents do arise. In contrast, the market discipline mechanism for public sector banks is appreciably weakercompared to that at private banks. There is implicitly a stronger perceived sovereign guarantee for all creditors of PSBs, and the princ .....

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everse: RBI s regulatory powers over PSBs are weaker than those over the private sector banks. The BR Act exemptions for PSBs mean that the one agency - the regulatory - that can respond relatively quickly against banking frauds or irregularities cannot take effective action. Hence, for example, MDs at PSBs find it comfortable to tell media that business will be as usual for them under RBI s Prompt Corrective Action framework as even if they do not meet the stipulated restrictions of the framewo .....

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another opportunity to catalyse fundamental reform at PSBs pass by? It is fully transparent what needs to be done. From the RBI s standpoint, legislative changes to the BR Act that make our banking regulatory powers fully ownership neutral - not piecemeal, but fully - is a minimum requirement. It might also be the most readily feasible of these options.4 No Banking Regulator Can Catch or Prevent All Frauds Another point is in order before I move to the broader issue of bank stressed assets and t .....

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orm the entire banking intermediation activity itself. What is needed is that various mechanisms to deter frauds and other irregularities are in place and have bite so that fraud incidence is low and magnitudes contained. Indeed, frauds have happened at banks in regimes with varied levels of banking regulatory quality and in both public and private banks. In the specific case at hand, the Reserve Bank had identified, based on cyber risk considerations, the exact source of operational hazard -thr .....

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e at our second largest public sector bank. The RBI will undertake actions against the bank that it is empowered to but this set is limited under its BR Act powers over PSBs. Indeed, in a recent interview to the Press Trust of India, March 11 2018, the IMF Deputy Managing Director Tao Zhang has reinforced this point along with others I alluded to above: [W]e think the PSB recapitalisation should be part of a broader package of financial reforms to speed up the resolution of NPAs, improve PSB gov .....

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ically play a central role in preventing fraud. Need to Refocus on the Bigger Issue of Stressed Assets Resolution Let me now turn to an issue of greater magnitude and more significance than the most recent banking fraud. Its magnitude is larger than 8 1/2 lakh crores of stressed assets on bank balance-sheets and its significance stems from several practices in promoter-bank credit relationship that need immediate attention. The RBI s Financial Stability Report of June 2017 (Section VII. Frauds, .....

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billion (Rs. 9,750 crores) to ₹ 167.7 billion (Rs. 16,770 crores). Share of frauds in [loan] advances portfolio continued to be high at 86 per cent of the frauds reported during 2016-17 (in terms of amount involved)…In a number of large value frauds, serious gaps in credit underwriting standards were evident. Some of the often seen gaps are liberal cash flow projection at the proposal stage, lack of continuous monitoring of cash flows and cash profits (EBITDA), lack of security perf .....

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ing stressed credit problems swiftly, banks-either through loan-level fudges or refusal to recognise the true asset quality of the credits - have allowed promoters in charge of enterprises to have a soft landing. This soft landing has comprised of even more bank lending so as to keep the accounts artificially in full repayment on past dues, protracted control for promoters over failed assets, and effectively granting them the ability to divert cash and assets, often outside of our jurisdictional .....

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s the discretion of banks to delay the recognition of stress, ever-green zombie or living-dead borrowers, and poorly allocate credit. To this end, I wish to present and clarify the rationale behind RBI s revised framework for prompt recognition and resolution of stressed assets. The framework that was released last month remains somewhat under-appreciated in terms of its importance. So let me lay it out. Prompt Recognition and Resolution of Stressed Assets - Revised Framework 1. The Banking Regu .....

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e stressed assets. 2. The revised framework for resolution of stressed assets released by the Reserve Bank on February 12, 2018 is a step towards taking these initial steps to their natural conclusion and laying down a steady-state approach. The steady-state approach is aimed at ensuring early resolution of stressed assets in a transparent and time-bound manner so that maximum value could be realised by the lenders while also recognising the potential ongoing concern value of stressed assets. As .....

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deployment of the schemes. 4. The revised framework substitutes for these pre-IBC schemes and does away with forbearance since it delayed resolution. The framework relies instead on the biggest structural reform in the credit system in the country in several decades, viz., the IBC, as an important part of resolution. By employing the IBC as its lynchpin, the framework is intended rightly to ensure that the resolution plan for stressed assets is dictated also, and in fact, primarily, by asset via .....

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within 180 days from the date of default, failing which these would be referred under the IBC. This threshold would be brought down only gradually over a period of two years to enable the IBC infrastructure to install in parallel the required capacity to handle more cases. It must be emphasised that IBC itself is a resolution framework, whereby such accounts will have sufficient time (180 days from the date of default plus up to 270 days under the IBC) for effective resolution. 7. It must also b .....

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for lenders to implement an efficient turnaround plan to get a quicker upgrade in case of restructuring. Further since there is no forbearance for assets classified as NPAs, the revised framework will encourage banks to reduce slippages to NPAs through early recognition of stress and timely action, possibly even before a borrower gets into financial difficulty. In other words, the IBC along with RBI s revised framework will help break the promoter-bank nexus which has led to crony capitalism an .....

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amental reform needed in order to strengthen the credit culture at origination, default, asset quality recognition and resolution stages. By so doing, it should weaken in the first place opportunities for engaging in frauds relating to loan advances. Let me now make some Concluding Remarks. I have chosen to speak today to convey that we at the Reserve Bank of India also feel the anger, hurt and pain at the banking sector frauds and irregularities. In plain simple English, these practices amount .....

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cular, the comprehensive regulatory overhaul announced by the Reserve Bank on February 12th for prompt recognition and resolution of NPAs at banks - as the Mandara mount or the churning rod in the Amrit Manthan or the Samudra Manthan of the modern day Indian economy. Until the churn is complete and the nectar of stability safely secured for the country s future, someone must consume the poison that emanates along the way. If we need to face the brickbats and be the Neelakantha consuming this poi .....

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ing further, equally important contributions by: Making banking regulatory powers neutral to bank ownership and leveling the playing field between public sector and private sector banks; and, Informing itself about what do with the public sector banking system going forward as part of optimising over the best use of scarce national fiscal resources. It is an open issue whether centralised government control alone can be effective enough at designing and implementing governance of banking franchi .....

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