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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Microfinance Through Self Help Groups (SHG)

Microfinance

In India, the Task Force on Supportive Policy and Regulatory Framework for Microfinance has defined MF (Microfinance) as the “Provision of thrift, credit and other financial services and products of very small amounts to the poor in rural, semi-urban or urban areas for enabling them to raise their income levels and improve living standards”.

Major characteristics of Microfinance are:

  • Small amounts of saving and credit
  • Collateral free credit through collateral substitute like peer pressure
  • Group formation to create peer pressure and bring discipline
  • Easy access
  • Less and simplified procedures and documentations
  • Credit for both investment and consumption needs
  • Poor are bankable
  • Affordable interest rates
  • Sustainability

There are different methodologies for delivering microfinance like Grameen bank model of Prof. Yunus, SHG-Bank linkage model, Micro finance institutions (for profit and non profit),NBFC model, NGO model etc. In India SHG-Bank linkage model is the most popular model.

Self Help Groups (SHG) Model

Linking SHGs directly to banks is the basic model in which an SHG, promoted by an NGO or other institution, can access a multiple of its savings in the form of loan funds or a cash credit limit from the local rural bank.

Characteristics:

  • Self Help Groups are small groups of 10- 20  people staying in the same area(village),coming from the same economic background and  facing the same type of problems.
  • The members of the group decide to come together for  helping each other.
  • They also decide to save a small amount regularly and use the same as common kitty for helping the more needy members of the group by giving loans of very small amount on the terms and conditions mutually agreed upon by the group.
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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

Gilt-Edged (Government) Securities Market

Government securities refer to the marketable debt issued by the government of semi-government bodies. A government security is a claim on the government. It is a totally securer financial instrument ensuring safety of both capital and income. That is why it is called gilt-edged security or stock. Central Government securities are the safest among all securities. Government securities are issues by:

  • Central Government
  • State Government
  • Semi-Government authorities like local government authorities, e.g., city corporations and municipalities
  • Autonomous institutions, such as metropolitan authorities, port trusts, development trusts, state electricity boards.
  • Public Sector Corporations
  • Other governmental agencies, such as SFCs, NABARD, LDBs, SIDCs, housing boards etc.
Characteristics of Gilt-edged Securities Market

Gilt-edged securities market is one of the oldest market in India. The market in these securities is a significant part of Indian stock market. Main characteristics of government securities market are as follows:

  • Supply of government securities in the market arises due to their issue by the Central, State of Local governments and other semi-government and autonomous institutions explained above.
  • Government securities are also held by Reserve Bank of India (RBI) for purpose and sale of these securities and using as an important instrument of monetary control.
  • The securities issued by government organisations are government guaranteed securities and are completely safe as regards payment of interest and repayment of principal.
  • Gilt-edged securities bear a fixed rate of interest which is generally lower than interest rate on other securities.
  • These securities have a fixed maturity period.
  • Interest on government securities is payable half-yearly.
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Role of NBFCs in the Indian Financial Sector

The financial institutions are usually classified as banking institutions and non-banking financial institutions (NBFCs). The banks subject to legal reserve requirements can advance credit by creating claims against themselves, while the non-banking financial institutions can lend only out of resources put at their disposal by the ultimate savers. The distinction between the two has been highlighted by savers while characterizing the former as “creators” of credit, and the letter as mere “purveyors” of credit.

NBFCs and Monetary Policy

The proliferation of NBFCs in India has coincided with a major structural transformation in the Indian financial system, which has an important bearing on the conduct of monetary policy.

  • NBFCs started functioning in the sphere of mobilization of dormant assets and tapping of new users of credit. In the process, they channelized savings in the economy by collecting funds from savings surplus units and allocating them to savings deficit units for investment in real assets, for consumption, for portfolio adjustment of existing wealth, or for all such purposes for which access to bank credit was either denied or restricted. This mechanism is called “transmutation effect” which refers to the catalytic role of financial intermediaries in converting financial liability with a set of characteristics into financial assets with a different set of characteristics, so as to tailor the asset preference of the economic agents.
  • Non-banks provide credit to those sectors which are denied credit by banking sector, thereby defecting to some extent the very purpose of quantitative credit controls. Further, it is often argued that financial innovations place an upward pressure on the money multiplier.
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History of Derivatives Market in India

Interestingly, derivatives have been existed in India since long time in one form or the other. But, they were not liberalised nor efforts were put to enlighten the public. The area of existence of derivatives was in commodities, it was association by traders in Bombay which was named as Bombay Cotton Trade Association (BCTA) in 1875 and started dealing with the futures contracts. By the starting of 19th century derivatives in India crawled to top making India one of the worlds largest in futures industry. But, in the early 1952 Government banned trade in cash-settlements and option contracts. As a result derivatives’ trading was shifted to informal forward contracts which were a normal practice. Trading at that time was restricted to only few brokers, and their trading practice was typical located under the banyan tree in front of the town hall in Bombay. This practise was followed for long time unofficially and finally The Bombay Stock Exchange (BSE) was formed in May 1927 under the supervision of Bombay Securities Control Act (BSCA, 1925).

Indian markets took so long to get accustomed with the financial instruments innovations, it was due to the financial markets were not organised well as it was under the British rule where they showed no interest in the growth of the Indian Economy. After the Independence, government took initiatives and started liberating people about the stock market and always kept a close eye on the market making several changes when necessary, like banned the trading of forward contracts called “Badla” in 1993.

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