110. The First Quarter Review of July 2007 intensified policy monitoring in the context of high volatility in equity and currency markets. Banks, financial institutions and corporates were advised to be vigilant and well prepared with appropriate risk mitigation strategies to deal with significantly higher volatilities than before. It was indicated that contextually, financial stability would assume greater importance in the months to come.

111. Going forward, the Reserve Bank would continue to balance the development of a sound, efficient and diversified financial system that facilitates smooth transmission of monetary policy with financial inclusion in which satisfactory customer services are rendered by financial institutions/ intermediaries. Credible communication, adequate availability of information and a broad-based, participative and consultative approach will shape the conduct of developmental and regulatory policies in respect of the financial system.

112. The Mid-term Review of the Annual Statement on Developmental and Regulatory Policies focuses on certain key areas: new financial instruments and prudential requirements; liberalisation of foreign exchange transactions; strengthening risk management in banks; migration to Basel II; fine-tuning of supervisory processes in response to financial innovations and consolidation in the banking sector and business processes; ongoing development and integration of various segments of financial markets; and improved credit delivery mechanisms with specific focus on the developmental needs of agriculture and small and medium enterprises and inclusive growth.

113. This Review is divided into four sections: I. Financial Markets; II. Credit Delivery Mechanism and Other Banking Services; III. Prudential Measures; and IV. Institutional Developments.

I. Financial Markets
114. The Reserve Bank has consistently emphasised the importance of developing financial markets as well as operational flexibility for market participants in various segments in an environment secured by effective regulation and oversight.

115. The Technical Advisory Committee (TAC) on Money, Foreign Exchange and Government Securities Markets has provided valuable guidance to the Reserve Bank in the context of its developmental and regulatory role vis-à-vis financial markets. The Committee has met three times since the announcement of the Annual Policy Statement in April 2007.

Government Securities Market
116. The Reserve Bank has endeavoured to broaden and deepen the Government securities market in terms of participants, instruments and processes. Consequent upon the implementation of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 and withdrawal of the Reserve Bank from the primary segment, development of the Government securities market has assumed vital importance.

(a) State Government Borrowings

(i)Market Borrowings of States: Information Dissemination
117. In consultation with State Governments, the information on gross allocation inclusive of net allocation, additional allocation and repayments during 2007-08 and the amount that could be raised during the remaining period of 2007-08 as market borrowings by State Governments was disseminated through a press release in September 2007.

(ii) Non-Competitive Bidding Scheme in the Auctions of State Development Loans: To be Operationalised
118. The Annual Policy Statement of April 2007 proposed to introduce a ‘Non-Competitive Bidding Scheme’ in the auctions of State Development Loans (SDLs) in the financial year 2007-08 following discussions with State Governments. Accordingly, a scheme for Non-Competitive Bidding Facility was incorporated in the Revised General Notification issued by all State Governments on July 20, 2007. The scheme would be operationalised by March 31, 2008.

(iii) Reissuance of State Government Securities
119. Reissuance of SDLs has been favoured with a view to building up a critical mass of stock in the gilt market thereby improving the secondary liquidity of such securities. The Reserve Bank, in consultation with State Governments, has proposed to introduce a system of reissuances. Responses received from State Governments in this regard are being examined and it is proposed to re-issue SDLs in the second half of 2007-08.

(iv) Power Bonds
120. Under the scheme for one-time settlement of outstanding dues of the State Electricity Boards (SEBs) to Central Public Sector Undertakings (CPSUs), power bonds for an aggregate amount of Rs.31,581 crore were issued by 27 State Governments. The repayment of these power bonds started from the year 2006-07. State Governments could exercise the call option for full or part prepayment of their outstanding power bonds on April 1, 2008 as per the terms and conditions of the respective Notifications.

(b) Central Government Securities

Floating Rate Bonds
121. With a view to simplifying the methodology for pricing of floating rate bonds (FRBs) in the secondary market, the Annual Policy Statement of April 2007 had proposed to examine the change in valuation methodology in consultation with Fixed Income Money Market and Derivatives Association (FIMMDA)/Primary Dealers’ Association of India (PDAI). Accordingly, a new issuance structure for FRBs has been approved by the TAC on Money, Foreign Exchange and Government Securities Markets and the facility to handle the new issuance structure is being built into the new Negotiated Dealing System (NDS) auction system being developed by the Clearing Corporation of India Limited (CCIL). This is expected to be completed by March 31, 2008.

(c) Development of Market Infrastructure

(i)Repos in the Corporate Bond Market
122. The High Level Expert Committee on Corporate Bonds and Securitisation (Chairman: Dr. R.H. Patil) had recommended, inter alia, the establishment of a trade reporting platform for better price discovery. The Securities and Exchange Board of India (SEBI) has since operationalised the reporting platforms managed by the two exchanges, namely, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), as well as the industry body, the FIMMDA. As the corporate debt markets develop and the Reserve Bank is assured of availability of fair prices, and an efficient and safe settlement system based on delivery versus payment (DvP) III and Straight Through Processing (STP) is in place, the Reserve Bank is committed to permitting market repos in corporate bonds.

(ii) Reporting Platform for Interest Rate Swaps
123. In the Annual Policy Statement of April 2007, it was announced that the CCIL would develop a trade reporting platform for Rupee Interest Rate Swaps (IRS). The platform has since been operationalised on August 30, 2007 and banks and Primary Dealers (PDs) have started reporting the IRS and Forward Rate Agreements (FRAs) trades on the platform on a daily basis.

(iii)Interest Rate Derivatives
124. Interest rate futures were introduced in India in June 2003. In the context of continued financial market developments, the Annual Policy Statement of April 2007 had proposed to set up a Working Group under the aegis of the TAC on Money, Foreign Exchange and Government Securities Markets to study and suggest measures to facilitate the development of the interest rate futures market. Accordingly, the Reserve Bank has constituted a Working Group on Interest Rate Futures (Chairman: Shri V.K. Sharma) which would review the experience gained so far with interest rate futures with particular reference to product design issues and make recommendations for activating the instrument. The Group would also revisit the recommendations of the earlier Committees in this area and examine regulatory requirements as well as the scope and extent of participation of non-residents while making its own recommendations. The report would be placed on the Reserve Bank’s website within three months (by December 31, 2007) after further discussions with the TAC on Money, Foreign Exchange and Government Securities Markets.

(iv) Market Stabilisation Scheme:Revision of Ceiling
125. A Memorandum of Understanding (MoU) was signed between the Government of India and the Reserve Bank on March 25, 2004 detailing the rationale and operational modalities of the MSS. The Government of India, in consultation with the Reserve Bank, has periodically raised the ceiling on the outstanding obligations of the Government of India by way of issuance of bills/securities under the MSS for the year 2007-08 to the level of Rs.2,00,000 crore as on October 4, 2007. The Reserve Bank announces the auctions under the MSS, if any, for the succeeding week every Friday.

(v) Guidelines on ‘Short Sales’ and ‘When Issued’ Transactions
126.Currently, ‘Short sale’ and ‘When Issued’ transactions are undertaken on the Negotiated Dealing System - Order Matching (NDS-OM) system only. In order to provide further flexibility to participants, it is proposed:

• to permit covering of ‘Short-sale’ and ‘When Issued’ transactions outside the NDS-OM system.

127. Guidelines in this regard would be issued in consultation with the FIMMDA and the PDAI.

(vi) CSGL Option on NDS-OM
128. The screen-based order driven anonymous NDS-OM module was operationalised in August 2005 for trading in Government securities. Access to the module was initially extended to banks and PDs and later to other NDS members including insurance companies, mutual funds and bigger provident funds for their proprietary deals. Constituent trading on the NDS-OM was enabled from May 2007 and access to the system was extended to certain ‘qualified entities’, including deposit taking non-banking financial companies (NBFCs) maintaining gilt accounts with NDS members. It is now proposed:

• to include systemically important non-deposit taking NBFCs (NBFC-ND-SI) as ‘qualified entities’ for accessing the NDS-OM using the CSGL route.

Foreign Exchange Market
129. The Reserve Bank has taken several initiatives to rationalise and simplify the procedures in the conduct of foreign exchange transactions with a view to facilitating prompt and efficient customer service. Keeping in view the recommendations of the Committee on Fuller Capital Account Convertibility (CFCAC), a number of measures were taken towards liberalisation of foreign exchange transactions.

130. The pace of implementation of the recommendations of CFCAC was accelerated with regard to foreign exchange outflows. These measures include: (i) permitting Indian companies as well as registered partnership firms to invest in overseas joint ventures (JV)/wholly owned subsidiaries (WOS) up to 400 per cent of the their net worth under the automatic route; (ii) increasing the existing limit of 35 per cent of the net worth for portfolio investments by listed companies to 50 per cent of the net worth and dispensing with the requirement of 10 per cent reciprocal share holding in the listed Indian companies by overseas companies; (iii) increasing the existing limit for prepayment of external commercial borrowings (ECBs) without the Reserve Bank’s approval from US $ 400 million to US $ 500 million, subject to compliance with the minimum average maturity period; (iv) increasing the aggregate ceiling for overseas investments by mutual funds registered with the SEBI from US $ 4 billion to US $ 5 billion while continuing with the existing facility of investing up to US $ 1 billion in overseas Exchange Traded Funds that may be permitted by the SEBI; and (v) enhancing the existing limit under the Liberalised Remittance Scheme (LRS) for resident individuals from US $ 100,000 to US $ 200,000 per financial year.

131. In the context of recent global and domestic developments and with a view to giving an opportunity to small and medium enterprises to manage the challenges in global markets, the Reserve Bank, in consultation with the Government of India, permitted all exporters as a temporary measure, to earn interest on their Exchange Earners’ Foreign Currency (EEFC) accounts to the extent of outstanding balances of US $ 1 million per exporter. This facility would be valid up to October 31, 2008 and banks are free to determine the rate of interest.

132. In addition, the coverage of the interest subvention scheme in respect of rupee export credit to specified categories of exporters was widened and the validity of the scheme was extended by three months from December 31, 2007 to March 31, 2008.

(a) Expansion of Hedging Facilities

133. The range of hedging tools available to the market participants has been further expanded keeping in view the evolution of foreign exchange market.

Forward Contracts

Hedging Facility for Exporters and Importers
134. Under extant guidelines, exporters and importers are permitted to hedge on the basis of declaration of an exposure and based on past performance criteria as specified. Market participants have represented to the Reserve Bank that the facility of hedging under the past performance route may be available on a continuous basis. In order to facilitate exporters and importers to hedge their exposures on a dynamic basis, it is now proposed:

• to permit reinstatement of the eligible limits under the past performance route to the extent that supporting underlying documents are produced during the term of the hedge undertaken; and

• the reinstatement facility would not, however, be available for contracts already cancelled under the scheme.

Oil Refining and Marketing Companies

135. With a view to facilitating hedging of foreign exchange exposure in respect of oil companies, it is proposed:

• to permit oil companies to hedge their foreign exchange exposures to the extent of 50 per cent of their inventory volume as at the end of the previous quarter by using overseas over-the-counter (OTC)/exchange traded derivatives up to a maximum of one year forward.

(b) Currency Futures
136. The Annual Policy Statement of April 2007 proposed to set up a Working Group on Currency Futures to study the international experience and suggest a suitable framework to operationalise the proposal within the existing legal and regulatory framework. Accordingly, an Internal Working Group on Currency Futures (Chairman: Shri Salim Gangadharan) was set up which studied, inter alia, the experiences of some emerging market economies where currency futures exchanges have been functioning within an environment of capital controls. The Group considered the views of a wide cross section of stakeholders, including banks, industry associations, domestic and international exchanges, and has had extensive and detailed consultations with market participants in the TAC on Money, Foreign Exchange and Government Securities Markets. The Group has explored various options for the proposed currency futures exchange, particularly on aspects like participation, clearing and settlement, market intermediaries, margins, contract design and surveillance mechanism. The draft report of the Group would be placed on the Reserve Bank’s website for comments by November 15, 2007.

(c) Derivatives
137. The Reserve Bank had constituted an Internal Group for preparing consolidated guidelines on derivatives. Based on the recommendations of the Group in respect of foreign exchange derivatives, the following measures are proposed with a view to providing greater flexibility to the residents:

(i) Writing of Options
138. Currently, corporates are allowed only to purchase options on a stand-alone basis. In certain cases, corporates are permitted to write options as part of a zero cost structure. It is now proposed:

• to allow importers and exporters having foreign currency exposures to write covered call and put options in both foreign currency/rupee and cross currency and receive premia.

(ii) Running Options Book
139. In terms of extant guidelines, authorised dealers (ADs) desirous of running options books in foreign currency rupee options are permitted to do so, subject to approval by the Reserve Bank. In order to enable the ADs to manage their risks efficiently, it is proposed:

• to permit ADs to run cross currency options books, subject to the Reserve Bank’s approval.

(iii) Types of Options
140. Under extant guidelines on foreign currency rupee options, ADs are permitted to offer only plain vanilla European options. In keeping with the gradual evolution of the foreign exchange market and based on market demand, it is now proposed:

• to permit ADs to offer American options as well.

II. Credit Delivery Mechanisms and Other Banking Services
141. It has been the endeavour of the Reserve Bank to address the developmental needs of sectors of the economy that are disadvantaged in the credit market, especially agriculture and SMEs, by improving credit delivery mechanisms and making available basic banking services to the widest sections of the society without procedural hassles. Initiatives taken in this regard include refocus on employment-intensive sectors under priority sector lending; simplification of the procedures for obtaining agricultural loans; reduction of risk weight on loans extended against gold and silver; augmenting credit flow to distressed farmers; revival of the cooperative structure and regional rural banks (RRBs); development of new avenues of credit dispensation such as micro-finance institutions; and legislation for regulating money lending, deepening financial inclusion and improving customer services.

(a) Delivery of Credit to Agriculture and Other Segments of Priority Sector
142. Domestic scheduled commercial banks, both public and private, are required to formulate special agricultural credit plans (SACP) in order to achieve a distinct improvement in flow of credit to agriculture. During 2006-07, disbursements to agriculture by public sector banks (PSBs) and private sector banks under SACP aggregated Rs.1,22,443 crore and Rs.25,360 crore (provisional), respectively, as against the target of Rs.1,80,160 crore and Rs.40,656 crore. Since the inception of the kisan credit card (KCC) scheme in 1998, PSBs have issued 27.27 million KCCs covering an amount of Rs.1,00,226 crore. During 2007-08 (up to June 30), PSBs have issued 0.66 million KCCs covering limits aggregating Rs.5,514 crore (provisional). The Union Budget, 2007-08 has announced establishment of the Rural Infrastructure Development Fund (RIDF) XIII with the National Bank for Agriculture and Rural Development (NABARD) with a corpus of Rs.12,000 crore and a separate window under the RIDF XIII for rural roads under the Bharat Nirman Programme with a corpus of Rs.4,000 crore. Since the inception of the RIDF, the total allocation under the RIDF (I to XII) was of the order of Rs.64,000 crore. While cumulative sanctions to State Governments and the National Rural Roads Development Agency (NRRDA) under various tranches of the RIDF (I to XII) stood at Rs.61,312 crore and Rs.4,000 crore, respectively, the cumulative disbursements stood at Rs.38,934 crore (as on July 31, 2007). The disbursements under various tranches of RIDF during 2007-08 (up to July 31) amounted to Rs.1,374 crore. During 2006-07, various State Governments were sanctioned loans aggregating Rs.10,555 crore, including Rs.1,023 crore sanctioned to the distressed districts of four States viz., Andhra Pradesh, Kerala, Karnataka and Maharashtra.

(b) Priority Sector Lending: Revised Guidelines
143. Guidelines on lending to the priority sector were revised with effect from April 30, 2007 based on the Technical Paper of the Internal Working Group (Chairman: Shri C. S. Murthy) and the feedback received thereon from the Government of India, banks, financial institutions, NBFCs, associations of industries, media, public and the Indian Banks’ Association (IBA). The revised guidelines focus on ensuring adequate flow of bank credit to weaker segments of the population and to employment-intensive sectors of the economy. The broad categories that are covered under the priority sector include agriculture, small enterprises, retail trade, micro credit, education and housing, subject to certain limits. The revised guidelines also take into account the revised definition of small and micro enterprises envisaged in the Micro, Small and Medium Enterprises Development Act, 2006.

(c) Simplification of the Procedures and Processes for Agricultural Loans
144. The Working Group (Chairman: Shri C.P. Swarnkar) constituted by the Reserve Bank to examine the documentation, procedures and other requirements prescribed by banks in providing agricultural loans, submitted its report in April 2007 which was placed on the Reserve Bank’s website. On the basis of its recommendations, all SCBs (including RRBs) were advised to dispense with the requirement of submitting ‘Nil Dues’ Certificate (NDC) for small loans up to Rs.50,000 to small and marginal farmers, share-croppers and the like and, instead, obtain self-declaration from the borrower. Furthermore, in order to overcome the problem of producing identification/status documents, banks were advised to accept certificates provided by local administration/panchayati raj institutions regarding the cultivation of crops in case of loans to landless labourers, share-croppers and oral lessees.

(d) Agricultural Indebtedness: Constitution of Internal Working Group
145. The Committee on Agricultural Indebtedness (Chairman: Dr. R. Radhakrishna) constituted by the Government of India has submitted its report, which, inter alia, addresses issues relating to creation of credit absorption capacities, need for risk mitigation practices, introduction of cyclical credit system, dispute resolution mechanisms and setting up of a debt redemption fund. It is proposed to constitute an Internal Working Group to examine the Committee’s recommendations that are relevant to the banking system in general and the Reserve Bank, in particular. The Group is expected to have consultations with stakeholders and submit its report before December 31, 2007. The Working Group’s report will be placed in the public domain for feedback and further processing.

(e) Revival of Rural Co-operative Credit Structure: Status
146. Based on the recommendations of the Task Force on Revival of Rural Co-operative Credit Institutions (Chairman: Prof.A.Vaidyanathan) and in consultation with State Governments, the Government of India had approved a package for revival of the short-term rural cooperative credit structure. Thirteen States have executed Memoranda of Understanding (MoUs) with the Government of India and the NABARD as envisaged under the package. Implementation and monitoring of the revival package are being overseen by the National Implementing and Monitoring Committee (NIMC) set up by the Government of India. Furthermore, a study on the long-term cooperative credit structure was entrusted to the Task Force by the Government of India which submitted its report in August 2006. The Government is in the process of formulating a package of measures in consultation with State Governments.

(f) Regional Rural Banks: Status and Further Action
147. The Government of India initiated the process of State-level sponsor bank-wise amalgamation of RRBs in September 2005 in order to strengthen them. Consequent upon amalgamation of 147 RRBs into 46 new RRBs sponsored by 18 banks in 17 States, the total number of RRBs was reduced from 196 to 95.

148.In order to prepare RRBs to adopt appropriate technology and migrate to core banking solutions for better customer services, it is proposed:

• to constitute a Working Group with representatives from the Reserve Bank, the NABARD, sponsor banks and RRBs for preparing a road-map for migration to core banking solutions by RRBs.

149. The Internal Working Group on RRBs (Chairman: Shri A.V.Sardesai) had recommended that RRBs may be advised to maintain a minimum level of capital to risk-weighted assets ratio (CRAR) which would be progressively raised to the current level of CRAR as per the Basel I norms. At present, capital adequacy norms are not prescribed for RRBs and state/central cooperative banks. In order to further strengthen the capital structure of RRBs and state/central cooperative banks as also in the context of financial stability of the whole system, it is proposed that:

• RRBs and state/central cooperative banks should disclose the level of CRAR as on March 31, 2008 in their balance sheets.
• a road-map may be evolved for achieving the desired level of CRAR by these banks.

(g) Relief Measures for Distressed Farmers
150. The Working Group (Chairman: Prof.S.S.Johl) constituted by the Reserve Bank to suggest measures for assisting distressed farmers, including provision of financial counselling services and introduction of a specific Credit Guarantee Scheme under the Deposit Insurance and Credit Guaranee Corporation (DICGC) Act for such farmers, submitted its final report in November 2006. Based on the recommendations of the Working Group, an Agricultural Loans (Distressed Farmers) Guarantee Scheme, 2007 has been drafted and forwarded to the Government of India. The Scheme is being revised based on the Government’s comments.

(h) Technical Group for Review of Legislations on Money Lending
151. The Technical Group (Chairman: Shri S.C.Gupta) set up to review the efficacy of the existing legislative framework governing money lending and its enforcement machinery in different States and make recommendations to State Governments for improving the legal and enforcement framework in the interest of rural households, submitted its report in July 2007. The report has been forwarded to State Governments for consideration.

(i) Credit Flow to Micro, Small and Medium Enterprises Sector
152. Consequent upon announcement made in the Annual Policy Statement of April 2007, all State Level Bankers’ Committee (SLBC) convenor banks were advised on May 8, 2007 to review their institutional arrangements for delivering credit to the small and medium enterprises (SME) sector, especially in 388 clusters identified by the United Nations Industrial Development Organisation (UNIDO) spread over 21 states in various parts of the country.

(j) Promotion of Livelihood in the Unorganised Sector: Role of Financial System
153. The National Commission for Enterprises in the Unorganised Sector, under the Chairmanship of Dr. Arjun K.Sengupta has submitted to the Central Government a comprehensive report on ‘Conditions of Work and Promotion of Livelihood in the Unorganised Sector’. The report has suggested a package of measures for addressing some critical issues relating to farm and non-farm sectors. Some of the recommendations contained in the report relate to the Indian financial system. In order to study these recommendations and suggest the way forward, it is proposed:

• to constitute a Working Group to study the various recommendations of the report of the Sengupta Committee which are relevant to the financial system and to suggest an appropriate action plan for implementation of acceptable recommendations. The Group would submit its report within a month.

(k) Rehabilitation/Nursing of Potentially Viable Sick SME Units
154. The Standing Advisory Committee on Flow of Institutional Credit to the SME Sector observed in its eighth meeting held on January 16, 2007 that there has been considerable delay in rehabilitation/nursing of the potentially viable sick SME units due to the inability of promoters to bring in additional contribution for rehabilitation/nursing of the units. As suggested in the meeting, a Working Group has been constituted (Chairman: Dr.K.C. Chakrabarty) with representatives from banks and the Small Industries Development Bank of India (SIDBI) to examine the feasibility of bringing in additional capital through alternative routes such as equity participation and venture financing and suggest remedial measures for those potentially viable sick units which can be rehabilitated at the earliest. The Group is expected to submit its report by December 2007.

(l) Financial Inclusion

(i) Pilot Project for SLBCs for 100 per cent Financial Inclusion: Status and Further Action
155. So far, 160 districts have been identified for financial inclusion and 100 per cent financial inclusion has been achieved in the Union Territory of Puducherry and in 28 districts in eight States (Andhra Pradesh, Gujarat, Haryana, Himachal Pradesh, Karnataka, Kerala, Punjab and West Bengal). Notably, all districts of Himachal Pradesh have achieved financial inclusion. An evaluation of the progress made in achieving financial inclusion in these districts is being undertaken to draw lessons for further action in this regard.

(ii) Working Group on Improvement of Banking Services in Lakshadweep: Status
156. A Working Group (Chairman: Regional Director for Kerala and the Union Territory of Lakshadweep) with members from the Government of the Union Territory, the zonal heads of the NABARD, the SIDBI and the SLBC convenor bank has been constituted to undertake a study of banking services provided in the Union Territory of Lakshadweep. The Group is currently examining the various issues relating to improvement in banking services in the Union Territory.

(iii) Working Group on Improvement of Banking Services in Himachal Pradesh
157. A Working Group (Chairman: Regional Director for Punjab and Himachal Pradesh and the Union Territory of Chandigarh) has been constituted to review the role of banks and financial institutions in supporting initiatives taken by the State Government of Himachal Pradesh for promoting economic development and recommending measures for enhancing greater outreach/penetration of the banking system in the State. The Group has representatives from the State Government of Himachal Pradesh, the NABARD, the SIDBI and the SLBC convenor bank. The Group submitted its report in September 2007 which is under examination.

(iv) Working Group on Improvement of Banking Services in Jharkhand
158. With a view to improving banking facilities in certain less developed States/regions, the Reserve Bank had earlier constituted State-specific working groups to suggest necessary developmental initiatives. In pursuance of this policy, a working group for the State of Jharkhand has since been constituted to recommend measures to enhance the outreach of banking services in the State.

(v) Services to Depositors and Small Borrowers in Rural and Semi-Urban Areas: Status
159. As indicated in the Annual Policy Statement of April 2005, the National Council of Applied Economic Research (NCAER) was entrusted to carry out a study on the quality of services rendered by branches of commercial banks to their customers (both depositors and small borrowers) in the rural and semi-urban areas. The NCAER has since submitted its report which is being placed in the public domain.

(vi) Lead Bank Scheme
160. The Lead Bank Scheme, introduced in 1969, aimed at coordinating the activities of banks and other development agencies for achieving the overall objectives of enhancing the flow of bank finance to the priority sector and promoting banks’ role in overall development of the rural sector. With a focus on financial inclusion and recent developments in the banking sector, and in order to improve the Scheme’s effectiveness, it is proposed:

• to constitute a High Level Committee to review the Lead Bank Scheme.

(vii) Credit Counselling: Setting up of Financial Literacy-cum-Counselling Centres
161. In the light of the recommendations of the Working Group (Chairman: Prof. S. S. Johl) constituted for suggesting measures for assisting distressed farmers as also the Working Group (Chairman: Shri C. P. Swarnkar) constituted to examine procedures and processes for agricultural loans, SLBC convenor banks were advised to set up a financial literacy-cum-counselling centre in any one district on a pilot basis and extend it to all other districts in due course, based on the experience gained. Several banks have since taken initiatives in opening credit counselling centres in the country. In order to take this initiative forward it is proposed:

• to prepare a concept paper on the subject detailing the future course of action and place it on the Reserve Bank’s website for feedback.

(viii) Information and Communication Technology to Enhance Financial Inclusion
162. Widespread use of Information and Communication Technology (ICT) is expected to make 100 per cent financial inclusion a feasible goal in terms of convenience, delivery, cost effectiveness, reliability and security for costumers as well as providers of financial services. The initial cost in rolling out such technology-based services could hinder the path of financial inclusion. Furthermore, in certain remote areas, the unavailability of electricity supply may also require investment in solar power generating devices for use of ICT. It is, therefore, proposed:

• to provide financial assistance to RRBs for defraying a part of their initial cost in implementing ICT-based solutions, including installation of solar power generating devices for powering ICT equipment in remote and under-served areas.

(m) Micro-finance
163. The self help group (SHG)-Bank Linkage Programme has emerged as the major micro-finance programme in the country and is being implemented by commercial banks, RRBs and co-operative banks. By 2006-07, 29,24,973 SHGs were credit-linked to banks, with cumulative bank loans of Rs.18,047 crore.

(n) Customer Service in the Reserve Bank
164. It has been the endeavour of the Reserve Bank to improve the quality of its public services to the common person and reduce transaction costs as well as time, both for the Reserve Bank and the citizens/organisations. A Committee on Procedures and Performance Audit on Public Services (CPPAPS) (Chairman: Shri S.S. Tarapore) was set up in 2003 to undertake procedures and performance audit on public services and regulatory clearances in the Reserve Bank and to coordinate with the Committees on Customer Services set up by banks. It has now been proposed to constitute a Committee (Chairman: Shri Prabhakar Rao) to evaluate customer services rendered by the Reserve Bank. The Committee would evaluate the efforts for improving public services to common persons undertaken by the Reserve Bank since the adoption of the recommendations of the CPPAPS, review the existing policies and procedures and suggest improvement in the quality of services.

III. Prudential Measures

165. The Reserve Bank has been adapting regulatory and supervisory tools to facilitate appropriate evolution of the financial system. The endeavour has been to anchor public confidence, to engage in financial development to support accelerated economic growth and to adopt international best practices with regard to prudential regulations, disclosure standards and supervisory processes.

(a) Discussion Paper on Holding Companies in Banking Groups
166. In many countries, deregulation and financial consolidation has led to the development of financial holding companies (commercial banking, insurance, investment banking and other financial activities are conducted under the same corporate umbrella). Different financial services within the same organisation are purveyed using different conglomerate models, viz., the universal bank, the bank subsidiary and the bank holding company. These conglomerate models can have one or more layers of intermediate holding companies. Accordingly, a discussion paper on holding companies in banking groups has been placed on the Reserve Bank’s website for feedback. Guidelines in this regard would be issued by end-November 2007.

(b) Guidelines on Asset-Liability Management System: Amendments
167. The Reserve Bank had issued guidelines on the Asset-Liability Management (ALM) system in February 1999, which covered, inter alia, interest rate risk and liquidity risk measurement/reporting framework and prudential limits. Having regard to the international practices, the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management, these guidelines have been reviewed and amended with reference to the approach to the measurement of liquidity risk, mismatches and the structural liquidity as also the frequency of supervisory reporting. Operational guidelines in this regard have since been issued.

(c) Introduction of Credit Default Swaps

168. The recent amendments to the Reserve Bank of India Act, 1934 has provided legality of OTC derivative instruments, including credit derivatives, and accordingly the Annual Policy Statement of April 2007 proposed to permit banks and PDs to begin transacting in single-entity credit default swaps (CDS). The draft guidelines on CDS were placed on the Reserve Bank’s website for wider dissemination and comments. On the basis of the feedback, revised draft guidelines have been placed on the Reserve Bank’s website for a second round of consultation and final guidelines would be issued by end-November 2007.

(d) Bank Finance to Factoring Companies: Review of Existing Guidelines

169. In view of difficulties expressed by some banks, a Working Group has been constituted with representatives from banks, factoring companies and the Reserve Bank to review the existing guidelines regarding financing of factoring companies. The Group would submit its report by November 15, 2007.

(e) Differentiated Bank Licences
170. The Annual Policy Statement of April 2007 proposed to prepare a technical paper on differentiated bank licences with a view to directing the resources of banks to their niche areas and to sustain efficiency in the banking system which can be equally applicable to both domestic and foreign banks. The technical paper has been placed on the Reserve Bank’s website on October 19, 2007.

171. The paper examined the statutory background of licensing of banks, the existing policies of licensing of private sector banks and foreign banks, international experiences and practices, and pros and cons of the introduction of a differentiated bank licensing regime. The paper recommended that in order to enable the banking system to operate at optimum efficiency and in the interest of financial inclusion, it would be necessary for all banks to offer certain minimum services to all customers, while allowing sufficient freedom to function according to their own business models. The paper also recommended continuation of the existing system for the time being.

(f) Recovery Agents Engaged by Banks
172. In view of the rise in the number of litigations against banks for engaging recovery agents in the recent past, it is felt that the adverse publicity could result in serious reputational risk for the banking sector as a whole. An urgent need has, therefore, arisen to review the policy, practice, procedure involved in the engagement of recovery agents by banks in India. Accordingly, banks are urged to follow prescribed specific considerations while engaging recovery agents.

173. Complaints received by the Reserve Bank regarding abusive practices followed by a bank’s recovery agents would invite serious supervisory disapproval. The Reserve Bank would consider imposing a temporary ban (or even a permanent ban in case of persistent abusive practices) for engaging recovery agents on those banks where strictures have been passed/penalties have been imposed by a High Court/Supreme Court or against its Directors/Officers with regard to the abusive practices followed by their recovery agents. An operational circular in this regard would be issued by November 15, 2007.

(g) Cross-border Supervision
174. Cross-border supervision has assumed importance in view of rapid integration of financial markets as also the heightened pace of merger and acquisition activities worldwide. In this context, the present system of informal exchange of information and supervisory cooperation amongst regulators need to be enhanced and well structured, particularly for internationally active banks. Accordingly, it is proposed:

• to constitute a working group to lay down the road-map for adoption of a suitable framework for cross-border supervision and supervisory cooperation with overseas regulators, consistent with the framework envisaged in the Basel Committee on Banking Supervision (BCBS).

(h) Consolidated Supervision and Financial Conglomerate Monitoring Mechanism: Integration
175. Guidelines for consolidated accounting and other quantitative methods to facilitate consolidated supervision were issued to banks in February 2003, based on recommendations of the report of a multi-disciplinary working group (Chairman: Shri Vipin Malik). Consolidated supervision is undertaken through consolidated financial statements (CFSs) which are intended for public disclosure, consolidated prudential reports (CPRs) for supervisory assessment of risks that could be transmitted to banks by other group members, and compliance with prudential norms on group basis.

176. The financial conglomerates (FC) monitoring framework was put in place on the basis of the recommendations of the report of the Inter-regulatory Working Group (Chairperson: Smt. Shyamala Gopinath) on monitoring of Systemically Important Financial Intermediaries (Financial Conglomerates). The focus of the FC return is mainly on intra-group transactions and exposures (both fund-based and non-fund based transactions). The dominant/major entity in the group, called a ‘designated entity’ (DE), collects and collates FC data/information and forwards them to the principal regulator for analysis.

177. The evaluation of overall risks and possible transfer thereof within the group structure, however, needs to be evolved under the consolidated supervision process for bank-led conglomerates. Accordingly, in order to enhance the effectiveness of the banking supervisory system for bank-led conglomerates, it is proposed to integrate the process of consolidated supervision with the financial conglomerate monitoring mechanism. Draft guidelines in this regard would be placed on the Reserve Bank’s website by end-January 2008.

(i) Monitoring Banks’ Exposure to Derivatives
178. At present, supervision of derivatives transactions by banks is carried out through on-site inspection during the annual financial inspection of banks and off-site monitoring of exposures through specified returns. In view of the potential of derivatives instruments to amplify systemic risks, there is a need to put in place a comprehensive oversight structure targeting the credit risk and operational risk in addition to the market risk, as at present. Furthermore, supervisory oversight needs to include stress testing of derivatives portfolios of banks for credit risk, particularly in view of banks resorting to multi-lateral netting for their counter party exposures. In view of majority of derivatives being over the counter (OTC) products, it is proposed:

• to cover, besides general market risk, specific risk, especially the credit risk arising out of deficient documentation or settlement risk, under the supervisory process.

(j) Implementation of Basel II - Pillar 2
179. The Reserve Bank issued final guidelines on implementation of Basel II framework in regard to Pillar 1 and Pillar 3 in April 2007. As regards Pillar 2, banks were advised to put in place internal capital adequacy assessment process (ICAAP) to capture all material risks, including those that are partly covered or not covered under the other two Pillars, with the approval of their boards. The ICAAP of banks are required to be subject to a supervisory review evaluation process (SREP) for which the structure and methodologies for identification and quantification of various risks (not covered under Pillar 1) and provision of additional capital or controls/management actions are being worked out.

(k) Supervisory Review Process
180. The Mid-term Review of October 2005 had indicated the initiation of a supervisory review process (SRP) for select banks having significant exposure to some sectors, namely, real estate, highly leveraged NBFCs, venture capital funds and capital markets, in order to ensure that effective risk mitigants and sound internal control systems are in place. In the first round of SRP, a framework was developed for monitoring the systemically important individual banks. The second round of SRP analysed the exposure to sensitive sectors, in particular, to the real estate and capital market sectors of select banks. Ten banks were identified as outliers based on the real estate and capital market exposures in excess of 200 per cent and 25 per cent, respectively, of their net worth. The initial analysis revealed that prima facie, all banks under review had put in place risk management policies and systems and controls to manage risks arising from exposures to sensitive sectors. In case of exposures to real estate, certain irregularities were observed with regard to the implementation of banks’ own approved policies. Accordingly, banks were advised to improve risk management processes at operating levels. Furthermore, banks were provided with an indicative list of deficiencies and irregularities and were advised to explicitly spell out the required norms for lending to the real estate sector in their policies.

IV. Institutional Developments

Payment and Settlement Systems

181. The Reserve Bank continued to strengthen the framework for payment and settlement systems by utilising the full potential of information technology (IT) to improve operational efficiency. The main focus has been on ensuring business continuity, prompt customer service and development of electronic payment products.

(a) Adequacy of Business Continuity Plans
182. The Annual Policy Statement of April 2007 emphasised adequate business continuity plans by banks as part of disaster recovery management, with a view to ensuring continuous and prompt customer services. With increasing reliance on the use of IT-based processing of day-to-day operations for extending banking and financial services, ensuring appropriate business continuity plans assumes critical importance. The Reserve Bank conducts regular and periodic drills in respect of critical inter-bank systems in order to facilitate banking services and ensure continuity. The level of preparedness by the participating banks in these exercises conducted by the Reserve Bank is, however, inadequate. Banks are urged to ensure that adequate disaster recovery systems are put in place so as to fully comply with the requirements of the next drill of the Reserve Bank.

(b) Implementation of Core Banking Systems
183. Implementation of core banking systems (CBS) for banking operations has increased and banks have been encouraged to install the CBS in a phased manner. In view of the advantages of these systems in promoting better costumer services, banks are urged to draw up time-bound action plans for implementation of CBS across all their branches.

(c) Electronic Payment Products: Status and Proposed Action
184. The coverage of the Real Time Gross Settlement (RTGS) system has increased significantly. By October 23, 2007 RTGS connectivity was available in more than 34,023 branches and the Reserve Bank continues to improve the quality of services through the RTGS.

185. The Committee (Chairman: Dr.R.B. Barman) constituted for introduction of the National Settlement System (NSS) examined various models and recommended the Centralised Funds Transfer System (CFTS) model for implementation. Under the CFTS model, banks would be able to transfer funds across all Deposit Accounts Departments (DADs) on real time basis. The CFTS interface would enable the member banks to transfer funds from surplus centre for meeting the clearing obligations smoothly. So far, 11 DADs - Mumbai, Chennai, New Delhi, Kolkata, Hyderabad, Bangalore, Nagpur, Ahmedabad, Chandigarh, Kanpur and Jaipur - have been connected to the CFTS. The remaining five centres would be connected after the system stabilises in these 11 centres.

186. The Electronic Clearing Service (ECS), which facilitates bulk payments, is currently available at 67 centres. The Reserve Bank proposes to operationalise the National Electronic Clearing Service (NECS) using the existing infrastructure of National Electronic Funds Transfer (NEFT) system with a view to widening the geographical coverage of the ECS. Under the NECS, the clearing and settlement would be centralised at Mumbai. Banks would receive their ECS centrally and transfer the transactions either on their core banking solution or arrange to distribute to their branches. Banks having their branches under the core banking solution can derive maximum benefits out of this system. It is proposed to draw up an action plan for its implementation in consultation with banks.

(d) Eligibility Criteria for Access to Payment Systems
187. An Internal Working Group, constituted to prepare comprehensive draft guidelines on minimum eligibility criteria for direct members of the clearing houses, submitted its report in September 2007 which has been placed on the Reserve Bank’s website for public comments. The Group has recommended a set of financial parameters as criteria for clearing house membership and has also suggested for periodical review of compliance by members with a view to ensuring continued safety and soundness of the system.

(e) Annual Review of Payment and Settlement Systems

188. The Annual Policy Statement of April 2007 proposed an annual review of payment and settlement systems and accordingly, its first review was undertaken for the year ended March 31, 2007. The comments/views of banks, chambers of commerce and industry/trade bodies were obtained on the review and a policy paper would be placed on the Reserve Bank’s website by November 15, 2007.

Urban Co-operative Banks

Information Technology Support to UCBs
189. Considerable progress has been made in the area of human resources development for facilitating the growth of the UCB sector, pursuant to the Reserve Bank entering into MoUs with State Governments and the Government of India. During 2006-08, 69 programmes have been held in which 675 Directors, 515 Executives, 163 Auditors have participated with a view to professionalising the management of UCBs. In furtherance of commitments under the MoUs and with a view to identifying the areas requiring IT support for UCBs, it is proposed:

• to constitute a working group comprising representatives of the Reserve Bank, State Governments and the UCB sector to examine the various areas where IT support could be provided by the Reserve Bank.

Committee on Financial Sector Assessment
190. The Annual Policy Statement of April 2007 outlined the approach and progress made by the Committee on Financial Sector Assessment (CFSA) (Chairman: Dr.Rakesh Mohan; Co-Chairman: Dr.D.Subbarao) to undertake a self-assessment of the Indian financial sector. As envisaged, the CFSA has constituted four Advisory Panels for the assessment of Financial Stability and Stress Testing, Financial Regulation and Supervision, Institutions and Market Structure and Transparency Standards. The Advisory Panels would prepare separate reports covering each of the above aspects. These Advisory Panels comprise of non-official experts with domain knowledge in respective areas and officials with similar expertise represented as Special Invitees.

191. The Advisory Panel on Financial Stability and Stress Testing (Chairman: Shri M.B.N. Rao) would conduct macro-prudential surveillance (including system-level stress testing) to assess the soundness and stability of financial system and suggest measures for strengthening the financial structure and system and its development in a medium-term perspective. The other three Advisory Panels would identify and consider the relevant standards and codes as currently prescribed and applicable to different areas, evaluate their implementation in the Indian context, identify gaps in adherence to respective standards and suggest possible roadmaps towards compliance in a medium-term perspective. The Advisory Panel on Financial Regulation and Supervision (Chairman: Shri M.S. Verma) would consider the relevant standards and codes applicable for financial regulation and supervision pertaining to the banking sector, financial markets and insurance; the Advisory Panel on Institutions and Market Structure (Chairman: Shri C.M. Vasudev) would consider the relevant standards and codes applicable to bankruptcy laws, accounting and auditing, payment and settlement systems and corporate governance policies; and the Advisory Panel on Transparency Standards (Chairman: Shri Nitin Desai) would consider the relevant standards and codes applicable for transparency in monetary, financial, fiscal and data dissemination policies.

192. The CFSA, before setting up of the Advisory Panels, had set up Technical Groups comprising of officials representing mainly regulatory agencies and the Government in all the above-mentioned subject areas which have progressed with technical work in their respective areas. These Groups also provide the Advisory Panels with technical notes and background material as necessary.

193. The CFSA submitted an interim report delineating its approach and reviewing the progress of work to the Finance Minister and Governor, Reserve Bank of India in July 2007. As mentioned in the Annual Policy Statement, the CFSA would publish Advisory Panel reports and also its own Synthesis Report. Based on an objective analysis of the present strengths and weaknesses of the financial sector and the status with regard to standards, the CFSA is also expected to lay out a road-map for further reforms in a medium-term perspective. The CFSA is expected to complete the assessment by March 2008.