Dynamic Provisioning in Indian Banking

Dynamic Provisioning: The Basel II Framework is approaching dynamic provisioning by clearly requiring banks to separately measure EL(Expected Loss) and UL(Unexpected Loss). EL-based provisioning has forward-looking element as it is capable of incorporating through the cycle view of probability of default. The recent financial crisis has provided a still further fillip to the search for a forward-looking provisioning approach due to pro-cyclical considerations.

Inadequacy of the Current Provisioning Policy in India: In normal provisioning policies, specific provisions are made ex-post based on some estimation of the level of impairment. The general provisions are normally made ex-ante as determined by regulatory authorities or bank management based on their subjective judgment. While such a policy for making specific provisions is pro-cyclical, that for general provisions does not lay down objective rules for utilization thereof. Indian banks make the following types of loan loss provisions at present:

  • General provisions for standard assets,
  • Specific provisions for NPAs,
  • Floating provisions,
  • Provisions against the diminution in the fair value of a restructured asset.

The present provisioning policy has the following drawbacks: 

  • The rate of standard asset provisions has not been determined based on any scientific analysis or credit loss history of Indian banks.
  • Banks make floating provisions at their own will without any pre-determined rules and not all banks make floating provisions. It makes inter-bank comparison difficult.
  • This provisioning framework does not have countercyclical or cycle smoothening elements. Though RBI has been following a policy of countercyclical variation of standard asset provisioning rates, the methodology has been largely based on current available data and judgment, rather than on an analysis of credit cycles and loss history.
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Reasons for Liquidity Fluctuations in Indian Banking System

Liquidity risk is inherent in bank’s core business because banking organizations employ a significant amount of leverage in their business activities and need to meet contractual obligations in order to maintain the confidence of customers and fund providers. The first step in measuring and managing liquidity risk is the identification of the most important sources of risk.

In the Indian context of banking, unexpected liquidity fluctuations are driven mainly by the following items:

  • Behavior of non-maturity deposits: A large fraction of deposits, in an Indian bank, consists of low-cost current and savings deposits which do not have any contractual maturity. Moreover, the depositor has the option to introduce or withdraw funds at any point of time. This makes the analysis of future cash inflows and outflows quite difficult. However, it is extremely crucial because the main reason for the closure of banks has been the inability to pay depositors on sudden demand. Therefore, the bank needs to know how much of these deposits is volatile, i.e. likely to flow out at short notice and how much is core or stable, i.e. unlikely to leave the bank. In the absence of contractual maturity, the bank needs to analyze the behavioral maturity of these deposits.
  •  Renewal patterns of term deposits: If the actual proportion of renewal is more than what the bank expects, it is left with surplus funds which might have to be reinvested at lower rates. If the actual fraction is less than anticipated, the bank faces a liquidity deficit, which might entail higher financing costs.
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Securitization in India – SARFAESI Act, 2002

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 or SARFAESI Act, 2002 allows banks and financial institutions to auction properties (residential and commercial) when borrowers fail to repay their loans. The Act aims at speedy recovery of defaulting loans and to reduce the mounting levels of Non-performing Assets of banks and financial institutions.

As stated in the Act, it has “enabled banks and FIs to realise long-term assets, manage problems of liquidity, asset-liability mismatches and improve recovery by taking possession of securities, sell them and reduce non performing assets (NPAs) by adopting measures for recovery or reconstruction.”

The SARFAESI Act, 2002 has been largely perceived as facilitating asset recovery and reconstruction. The Act has been passed based on the recommendations of Narasimham Committee I and II and Andhyarujina Committee constituted by the Central Government for the purpose of examining banking sector reforms and to consider the need for changes in the legal system in respect of these areas. The provisions of the Act would enable the banks and financial institutions to realize long-term assets, manage problems of liquidity and asset liability mismatches and to improve recovery by exercising powers to take possession of securities, sell them and reduce non-performing assets by adopting measures for recovery or reconstruction.

Provisions of the SARFAESI Act, 2002

The Act has made provisions for registration and regulation of securitization companies or reconstruction companies by the RBI, facilitate securitization of financial assets of banks, empower SCs/ARCs (Securitisation Companies and Asset Restructuring Companies) to raise funds by issuing security receipts to qualified institutional buyers (QIBs), empowering banks and FIs to take possession of securities given for financial assistance and sell or lease the same to take over management in the event of default.… Read the rest

Lead Bank Scheme

A milestone in the history of banking in India is the nationalization of the 14 major commercial banks in 1969. This process was undertaken with the main objective of involving the banking sector in a big way in the nation building and economic development. To help to achieve this commendable objective, two committees were set up viz., National Credit Council Study Group with D.R. Gadgil as the Chairman and the Committee of Bankers under the chairmanship of Nariman. These   committees   independently   went into   their   terms   of reference  and recommended an ‘area approach’ for involving the banks in   economic development. This paved the way for giving a concrete shape to the Lead Bank Scheme. As nationalization of banks took place to extend and expand the banking services to all the non-banked areas especially the rural areas, the RBI decided to implement its Lead Bank Scheme through the nationalized banks. But this did not discourage the private sector banks from playing their role in economic development. Infact the Lead bank Scheme involved all the nationalized banks, State bank of India and its associates and three private sector banks. Hence, the era of bank-propelled economic development started.

Features of Lead Bank Scheme

The Lead bank scheme has the following features :

  1. All the districts in the country except the Metropolitan area were allotted among the banks selected for this purpose.
  2. Each bank was expected to take all the initiative to develop the district allotted to it. The initiative includes conducting a detailed survey to identify the resources and the potential of the district concerned and then to devise suitable schemes for utilizing these resources.
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Different Modes of Granting Loans by Commercial Banks

The basic function of a commercial bank is to make loans and advances out of the money which is received from the public by way of deposits.The loans are particularly granted to businessmen and members of the public against personal security, gold and silver and other movable and immovable assets. Such loans and advances are given to members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances varies depending upon the purpose, period and the mode of repayment. The difference between the rates of interest allowed on deposits and the rate charged on the loans is the main source of a commercial banks income. A loan is granted for a specific time period. Generally, commercial banks grant short-term loans. But term loans, that is, loan for more than a year, may also be granted. The borrower may withdraw the entire amount in lump sum or in installments. However, interest is charged on the full amount of loan. A loan may be repaid either in lump sum or in installments. An advance is a credit facility provided by the bank to its customers. It differs from loan in the sense that loans may be granted for longer period, but advances are normally granted for a short period of time. Further the purpose of granting advances is to meet the day to day requirements of business. The rate of interest charged on advances varies from bank to bank.… Read the rest

Different Modes of Acceptance of Deposits by Commercial Banks

The most important activity of a commercial bank is to mobilize deposits from the public. People who have surplus income and savings find it convenient to deposit the amounts with banks. Depending upon the nature of deposits, funds deposited with bank also earn interest. Thus, deposits with the bank grow along with the interest earned. If the rate of interest is higher, public are motivated to deposit more funds with the bank. There is also safety of funds deposited with the bank. The following types of deposits are usually received by banks:

  1. Current Deposit: Also called ‘demand deposit’, current deposit can be withdrawn by the depositor at any time by cheques. Businessmen generally open current accounts with banks. Current accounts do not carry any interest as the amount deposited in these accounts is repayable on demand without any restriction. The Reserve bank of India prohibits payment of interest on current accounts or on deposits up to 14 Days or less except where prior sanction has been obtained. Banks usually charge a small amount known as incidental charges on current deposit accounts depending on the number of transaction.
  2. Savings Deposit/Savings Bank Accounts: Savings deposit account is meant for individuals who wish to deposit small amounts out of their current income. It helps in safe guarding their future and also earning interest on the savings. A saving account can be opened with or without cheque book facility. There are restrictions on the withdrawals from this account. Savings account holders are also allowed to deposit cheques, drafts, dividend warrants, etc.drawn in their favor for collection by the bank.
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