ANALYSIS ON RBI STUNNING GROWTH AFTER 1991

1. Post-Reform
Period: A State Level Analysis

Biswa Swarup Misra

This paper examines whether allocative efficiency of the Indian Banking system
has improved after the introduction of financial sector reforms in the early 1990s.
Allocative efficiency has been studied for twenty three States of India. To get a
comparative perspective, allocative efficiency has been estimated for two periods
1981-1992 and 1993- 2001; broadly corresponding to the pre financial sector
reforms and the post reforms periods, respectively. The analysis carried under
panel cointegration framework reveals that overall allocative efficiency of the
banking system has almost doubled in the post reform period. This goes to suggest
the success of reforms in improving allocative efficiency of the banking system in
India. Allocative efficiency at the State and sectoral level has
also been estimated to get a deeper insight. While allocative efficiency of Banks'
funds deployed in the services sector has improved that in the agriculture and
industry has deteriorated in the post reform period for the majority of the States.
The study finds improvement in the overall allocative efficiency in the post reform
period for the majority of the States. Further, the improved allocative efficiency is
more marked for the services sector than for industry across the States.

1.1

Introduction

Enduring growth, in the context of a developing economy like India invariably

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ANALYSIS ON RBI STUNNING GROWTH AFTER 1991

requires that the economy be put to a trajectory of higher savings and ensuring,
further, that the realised savings are chanelised into productive investment. In this
scheme of growth, the banking system has a dual role to play. The banking system
acts both as a mobiliser of savings as well as an allocator of credit for production
and investment. Effectiveness of the banking sector s contribution to the economic
growth and development is broadly determined by its efficiency in the allocation of
the mobilised savings amongst competing projects. Financial sector reforms were
initiated in India in 1992-93 to promote a diversified, efficient and competitive
financial system with the prime objective of improving the allocative efficiency of
available resources. Banking sector being the dominant segment in India's
financial system, a number of measures specific to the banking system were
initiated to improve its allocative efficiency. Freedom to price their products along
commercial considerations, relaxation in various balance sheet restrictions in the
form of statutory pre-emptions, exposing the banking sector to an increased
competition by allowing entry of new private sector banks and the introduction of
prudential norms relating to income recognition, asset classification and capital
adequacy were some of the ingredients of the banking sector reforms. Improved
allocative efficiency was sought to be achieved through operational flexibility,
improved financial viability and institutional strengthening. The early initiatives in
the banking reforms were geared towards removing the functional and operational
constraints impinging upon bank operations, and subsequently, providing them
with greater operational autonomy to take decision based on commercial
considerations. With gradual relaxation of administered controls, banks and
financial institutions were expected to evolve as truly commercial entities. More
importantly, the operation of banks under free interplay of market forces in a
deregulated atmosphere was expected to lead to increased allocative efficiency of
scarce resources among competing sources of demand. Banking sector reforms
have been in vogue for more than a decade in India. In this context, it would be
appropriate to study whether the various reform measures have helped in
improving the allocative efficiency of the banking system.This study seeks to
enquire whether the financial sector reforms in general, and banking sector
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ANALYSIS ON RBI STUNNING GROWTH AFTER 1991

reforms in particular had any beneficial impact on the allocative efficiency of the
banking system. To get a comparative perspective, the allocative efficiency of the
banking system in the post banking sector reforms period has been compared and
contrasted with that of the pre-reform period. Allocative efficiency is measured for
the twenty-three States of India, individually and as well for all the States taken
together. In addition to the scenario at the aggregate level, the allocative efficiency
in the sectoral context has also been studied to get a deeper insight. Therest of the
study is schematised as follows. Section I discusses the manner in which allocative
efficiency has been construed in this study. Section II reviews the literature on
allocative efficiency. Some of the stylized facts regarding the credit deployment
pattern are discussed in Section III. The data and the empirical framework have
been discussed in Section IV. The econometric findings are discussed in Section V.
Finally, Section VI presents some concluding observations.
Section I
Interpreting Allocative Efficiency
Efficiency of a financial system is generally described through four broad
nomenclatures i.e., information arbitrage efficiency, fundamental valuation
efficiency, full insurance efficiency and functional efficiency. The ensuing
discussion in this paper would centre around the concepts of functional or
allocative efficiency. Allocative efficiency can be judged either directly by
monitoring some proxy of allocative efficiency or indirectly by estimating the
contribution of a financial variable to economic growth. As far as direct measures
are concerned, the interest rate structure, cost of intermediation and net interest
margin (RBI, 2002a) as measures of bank efficiency are the oftenly-used criterions
to evaluate the allocative efficiency of the banking system. Allocative efficiency,
however, can also be inferred indirectly by studying whether a bank's resources are
allocated to most productive uses or not. Most productive use, in turn, can be
defined in terms of the economic rate of return (ERR) of a project financed by the
banking system. Allocative efficiency would mean that projects with very high ERR
are being financed by the banks. It would imply that the funds of the banking
system are so deployed as to maximise the rate of return (ERR) of the projects
financed by them. The ERR o f individual bank financed projects, however, is
difficult to quantify in practice. Akin to the interpretation of allocative efficiency of
a bank's resources in terms of the ERR for individual projects, one can
conceptualise the allocative efficiency of the entire banking system. In an
aggregated sense, allocative efficiency would imply that maximum output is
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ANALYSIS ON RBI STUNNING GROWTH AFTER 1991

obtained from the deployment of banking system's resources. The concept of
'maximum output', however, is rather vague. As such, studying changes in
allocative efficiency reflected in changes in output from a given pool of financial
resources under two different time periods or circumstances is more
comprehendible than the concept of allocative efficiency per se. Allocative efficiency
of an individual bank involves some sort of constrained optimisation. When studied
in the cross section dimension, efficiency measurement generally involves use of
nonparametric frontier methodology (English, Grosskopfet al., 1993). In the panel
context, however, the frontier approach does not capture the panel nature of the
data and treats each observation as a separate unit. So it is like a pooled
regression, unlike random/ fixed effects models. There are recent developments to
overcomethis problem, but it is still in a nascent stage. Consequently in a panel
context, following RBI (2002a) allocative efficiency has been approximated by the
elasticity of output with respect to credit in this study
Section II
Review of Literature
There has been a revival of finance and economic development linkage by the
endogenous growth theory over the past decade. In the endogenous growth theory
framework, bank finance has a scope to influence economic growth by either
increasing the productivity of capital, lowering the intermediation cost, or
augmenting the savings rate. The role of financial institutions is to collect and
analyse information so as to channel investible funds into investment activities
that yield the highest returns [Greenwood and Jovanovic (1990)]. Though in a pure
neo-classical framework, the financial system is irrelevant to economic growth, in
practice, an efficient financial system can simultaneously lower the cost of external
borrowing, raise the return to savers, and ensure that savings are allocated in
priority to projects that promise the highest returns ; all of which have the
potential for improving growth rates (RBI, 2001a). Commercial banks are the main
conduit for resource allocation in a bank dominated financial system like India.
Commercial banks generally provide the working capital needs of business. There
is no strict boundary of division, however, in the us age of the funds;once
disbursed by financial institutions. Once allocated, a part ofthe bank funds may
very well be put towards building up fixedcapital. This is because, a business
enterprise would be encouraged to undertake fixed capital formation, once it is
assured of working capital needs. Though in India there have been institutions
created specifically to meet the long term investment needs of business enterprise,
the pervasive character of the scheduled commercialbanks had a greater role to
play in reaching to a wider mass of people through its vast branch-banking
network. Pattrick (1966) provides a reference framework to study financial
development by enunciating the 'demand-following approach' and the 'supplyleading approach' to financial development. Demand following is defined as a
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ANALYSIS ON RBI STUNNING GROWTH AFTER 1991

situation where financial development is an offshoot of the developments in the
real sector. In the case of supply leading, financial development precedes and
stimulates the process of economic growth; the supply of financial services and
instruments create the demand for them. Patrick suggested that in the early stages
of economic development, a supply-leading relation is more likely since a direct
stimulus is needed to mobilise savings to finance investment for growth. At a later
stage, when the financial sector is more developed, the demand-following relation
will be more prevalent. Empirical studies such as Gupta (1984), Jung (1986) and
St. Hill (1992) are broadly suggestive of the pattern of financial development
envisaged by Patrick (1966). However, such a theoretical dichotomy between
'demand following' and 'supply leading' is difficult to defend in the context of
continuous interaction between the real and the financial sectors in practice.
Regarding the impact of bank finance on growth, a number of empirical studies
drive home the positive impact of bank credit on output. Employing GMM panel
estimators on a panel data set of 74 countries and a cross sectional instrumental
variable estimator for 71 countries, Levine et al (2000) find that the exogenous
component of financial intermediary development is positively associated with
economic growth. Further, empirical studies by King and Levine (1993), Gregorio
and Guidotti (1995) strongly borne out the positive effect of financial development
on the long run growth of real per capita GDP. In the tradition of disentangling the
impact of bank credit on growth, Reserve Bank of India (2002a) explored the
relative impact of finance in inducing output growth using panel regression
techniques. Estimates of elasticity of output with respect to credit improved from
0.30 during the period 1981-1991 to 0.35 during 1992- 2001 indicating as
improvement in the allocative efficiency of the banking system at the all India level
(RBI 2002a). Sector-wise credit elasticities of output also indicate as improvement
in the allocative efficiency for most of the sectors in the post reform period
compared to the 1980s. However, no attempt has been made to study allocative
efficiency at the State level and across the sectors. The present study seeks to fill
this gap.

Section III
Credit and Output in the Spatial Dimension: Some Stylised Facts
The relative growth rates in credit and output in the pre and post- reforms periods
can act as pointers to allocative efficiency. Aggregate credit has grown at a similar
pace both in the pre reform and the post
Table 1: Growth of Output and Credit
(Per cent)
VARIABLE

TY.B.F.M

1981-1992

1993-2001

1981-2001

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ANALYSIS ON RBI STUNNING GROWTH AFTER 1991

NSDP*

Output
2.7

Agriculture
Industries
Services

1.6
3.6
4.0

Credit

Output

Credit

Output

Credit

12.9

4.1

12.9

3.1

13.2

11.1
15.1
11.2

0.7
5.6
6.0

9.6
11.5
15.3

1.5
4.2
4.6

9.1
14.2
13.3

* Net State Domestic Product

Source : Central Statistical Organisation and Reserve Bank of India

reform period, aggregate output, however, grew at a distinctly higher rate in the
post reform phase. This indicates that at the aggregate level, there could be some
improvement in the allocative efficiency. However, one finds a mixed picture at the
sectoral level. While both output and credit growth has decelerated for the
agricultural sector, that for services sector has accelerated in the post reform
phase as compared to the pre reform phase. For industry, however, higher
growth in output is witnessed in spite of deceleration in credit growth in the reform
period. Focusing only on growth rates of output and credit to comment on the
allocative efficiency may be quite misleading, if the share of different sectors in
aggregate credit and output has not remained the same. In fact, the share in credit
and output has increased for both industry and services sector and has declined
for the agriculture sector in the post reform period (Table 2). Thus, a much deeper
Table 2: Share in Output and Credit
(Per cent)

Sector

Average Share in the prebanking sector reform

period

Average Share in the post

banking sector reform
period

Output

Credit

Output

Credit

Agriculture

37

15.7

29

10

Industry

23

43.5

25.5

48

Services

40

40.8

45.5

42

Source : Central Statistical Organisation and Reserve Bank of India.

analysis is required to comment on the allocative efficiency in different sectors in

the post reform phase. At the State level, all the States under study can be broadly
classified into four categories based on their shares in aggregatecredit and output.
States with increased share in output and credit in the post reform phase as
compared to the pre reform period are the 'Group A' States. States with increased
share in output but reduced share in credit are the 'Group B' States. States ith
increased share in credit and reduced share in output are 'Group C' status, and
States with decline in their share in output and credit belong to the 'Group D'
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ANALYSIS ON RBI STUNNING GROWTH AFTER 1991

with 3, the States
with
decline (Thirteen) belong
category. As canStates
be with
seen fromStates
Table
majority
ofStates
thewithStates
increased share in
increased share in
increased share in
in their share in
to Group D, which
suffered
decline
inandtheir
output and
outputhave
and credit
output butareduced
credit
reducedshare
outputin
and aggregate
credit
share in credit
share in output
credit. In total, share
of credit
in the aggregate
credit has
gone down for 16 States
(Group A)
(Group B)
(Group C)
(Group D)
and has improvedAndhra
for Pradesh,
7 States
in the
postKerala
reform phase.
inequality is
Arunachal
Pradesh,
Assam,Considerable
Bihar,
Delhi, Tamil Nadu, Rajasthan and
Pradesh,
thus , seen among
the States in terms of their share Himachal
in overall
credit. In such a
Maharastra,
West Bengal
Jammu & Kashmir,
scenario, it becomes
interesting to enquire, whether, Pondicherry,
States receiving an increasing
Karnataka
and Gujarat
Manipur,
share of the credit
resource have been able to make the
most of it. In other words,
MadhyaPradesh,
whether, rising credit shares are also accompanied with
allocative
Punjab,improved
Orissa,
Uttar
Pradesh,
efficiency. Further, if allocative efficiency of credit has improved even
Tripura, Meghalaya

Table 3 : Changing Share of Different States in Output and

and Haryana
Credit: A Comparison of Pre-Reform and Post-Reform Period
Source : Central Statistical Organisation and Reserve Bank of India.

TY.B.F.M

Page 7

for States that have undergone a decline in their share of credit, it would have well
served the purpose of reforms in the banking sector. Hence, it would be useful to
decipher,if any pattern is emerging at the State level, when allocative efficiency of
the banking system is seen in conjunction with their credit shares. Apart from
differences in their shares in output and credit, States have also exhibited a varied
pattern in their growth of output and credit in the post reform period. Based on
their growth in aggregate credit and output, there can be four categories of States.
States with increased share in output and credit in the post reform phase as
compared to the pre reform period are the 'Group E' States. States with higher
growth in output but lower growth in credit belong to 'Group F'. 'Group G' States
are those with higher growth in credit and lower growth in output and States with
reduced growth both in output and credit belong to the 'Group H' category. The
differential growth pattern in credit and output can act as a guide to comment on allocative efficiency
across States. Group F States that have shown an increased growth in output along with low credit
growth in the post reform period are likely to exhibit higher allocative efficiency. On the other hand,
Group G States with lower output and higher credit growth are clear candidates where allocative
efficiency would be deteriorating. However, it is tricky to judge about the allocative efficiency for
States belonging to the Group E and group H, that have experienced either increased or

Table 4: Growth in Output and Credit of Different States:

A Comparison of Pre Reform and Post - Reform Period
States with higher
growth in output
and credit
(Group E)

States with
higher growth
output but lower
growth in credit
(Group F)

States with higher

growth in credit and
lower growth in
output
(Group G)

States with
lower growth in
output and credit

Delhi, Karnataka,

Andhra Pradesh,

Punjab and Haryana

Arunachal Pradesh,

Kerala Maharastra,
and Rajasthan

Gujarat,
Himachal Pradesh,

Assam, Bihar, Orissa

(Group H)

and Uttar Pradesh

Jammu & Kashmir,

MadhyaPradesh,
Manipur,Meghalaya
Pondicherry,
Tamil Nadu, Tripura
and West Bengal
Source : Central Statistical Organisation and Reserve Bank of India.

reduced growth both in credit and output. For Group E States, that have witnessed
higher growth both in credit and output, allocative efficiency would be guided by
the relative growth of output vis-a-visthat of credit. Similarly, for Group H States

that have experienced a lower growth of both credit and output in the post reform
phase, allocative efficiency would depend on the relative decline in onevis-a-visthe
other. The indications for allocative efficiency obtained from the above informal
analysis, however, need to be corroborated with more rigorous analysis to arrive at
robust inferences. The empirical framework to estimate the allocative efficiency is
discussed in the next section.
Section IV
Data and Empirical Methodology
The study examines the allocative efficiency of the banking system for 23 States of
India. Allocative efficiency has been estimated separately for the two periods 19811992 (first period) and 1993-2001(second period). The periods have been so
chosen as torepresent the pre banking sector reforms and the post banking sector
reforms scenario s, respectively. The credit output dynamics has been studied for
three broad sectors of each State viz, agriculture, industry and services. While
measuring output; the following classification has been used. Agriculture includes
agriculture, forestry and fishing and logging. Industry includes mining, quarrying
and manufacturing (registered and non-registered) and services include electricity,
gas and water supply, transport, storage and communication, trade, hotels and
restaurants, banking and insurance, real estate, ownership of dwellings and
business services, public administration and other services. Income originating
from the States rather than income accruing to State concept has been used to
measure output. The data on output has been taken from the information supplied
by the various States to the Central Statistical Organisation. SDP data at the 199394 base has been used in the study. The data on credit refers to the outstanding
credit to different sectors from all scheduled commercial banks in a region. The
data for credit has been taken from the 'Basic Statistical Returns' published by the
Reserve Bank of India. The output variable is represented by log of per capita net
State Domestic Product (LPNSDP) and the credit variable by the log of per capita
credit for the State (LPTCAS). Though certain new regions have been carved out
from the existing ones in the year 2000, for analytical purposes, necessary
adjustments have been made to make the output and credit figures for the year
2001 comparable to that for the previous years. The choice of the regions and the
time period have been completely motivated by the availability and consistency of
the data. However, with inclusion of regions having share of less than one percent

and as well having more than ten percent in the combined NSDP for all the 25
regions, heterogeneity that prevails across the regions in India has been captured
considerably.
Empirical Methodology
To estimate the credit elasticities of output, we have twelve data points for the pre
reform and nine data points in the post reform period. Use of time series
estimation techniques, however, isprecluded given the small number of
observations for estimation.However, taking advantage of the panel nature of the
data, one canuse panel data techniques. With panel data techniques, information
from the time-series dimension is combined with that obtained from the crosssectional dimension, in the hope that inference about the existence of unit roots
and cointegration can be made more straightforward and precise. To ascertain the
appropriate estimation technique , the variables have been first examined for
stationarity in a panel context. If the variables are found to contain a unit root, the
variables are then examined for possible cointegration. In the event cointegration
between the variables, Fully Modified OLS (FMOLS) estimation technique is used
to obtain coefficient estimates. Specifically, the panel unit root tests developed by
Levin, Lin and Chu and Im, Pesaran and Shin have been employed. Pedroni's
method is used to test for panel cointegration. Fully modified OLS estimation
technique given by Pedroni is used to derive the elasticities. The details of the
empirical methodology are given in the Annex 6.
Section V
Empirical Results
The results of the panel unit root tests for each of our variables are shown in
Annex 3. In no case, can we reject the null hypothesis that every country has a
unit root for the series in log levels. Once ascertained that both the variables are I
(1), we turn to the question of possible cointegration between log of per capita SDP
and log of per capita credit. In the absence of cointegration, we can first
Differentiate the data and then work with these transformed variables.However, in
the presence of cointegration, the first differences do not capture the long run
relationships in the data and the cointegration relationship must be taken into
account. Annex 4 depicts the evidence on the cointegration property between percapita SDP

and per-capita credit for the Indian States. The panel cointegration tests suggested
by Pedroni (1999) have been applied. In general, the Pedroni (1999) tests turn out
to be in favour of a cointegrating relation between the variables that are non
stationary. The agriculture sector has not been studied for cointegration as the
output variable for agriculture is stationary and the credit variable is non
stationary. 2 Efficient FMOLS estimation technique is used to obtain the estimate
of elasticity of output with respect to credit for each sub-period. The results are
given in Annex 5. The changing allocative efficiency over time and across States
can be seen from Chart 1. The results broadly indicate an improvement in the
allocative efficiency for the majority of the States.3 For instance, for fifteen States,
there was an improvement in allocative efficiency with respect to the State
Domestic Product. It may be noted that eight out of these fifteen States had
undergone a decline in their share in aggregate credit in the post reform period. As
indicated by the analysis of growth in terms of credit and output, the allocative
efficiency of banks' funds has improved for all States that had higher output and
lower credit growth in the post reform phase.For all States taken together,
allocative efficiency has improved from 0.18 to 0.34 as indicated by the pooled
estimates. An overview of the results in terms of States and sectors that have
witnessed an improvement in allocative efficiency of bank funds is given in Table 5.
At the sectoral level, an improvement in allocative efficiency of bank funds in the
services sector is witnessed for 18 States and in the industrial sector for 12
States (Table 5).

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OCCASIONAL PAPERS

Table 5: Allocative Efficiency Across Sectors and States

in the Post reform period
Sectors
State

ANDHRAPRADESH

Industry

Services

Overall5

ARUNACHAL PRADESH
ASSAM

GUJARAT

HARYANA

BIHAR
DELHI

HIMACHAL PRADESH

JAMMU & KASHMIR

KARNATAKA

KERALA

MADHYAPRADESH

MAHARASHTRA

MEGHALAYA

ORISSA

MANIPUR

PONDICHERRY

PUNJAB

RAJASTHAN

TAMIL NADU

TRIPURA

UTTARPRADESH

WEST BENGAL

Note : indicates improvement in allocative efficiency in the post reform phase as compared
to the pre reform period. Blank cells indicate deterioration in allocative efficiency in

the post reform period.

Section VI
Conclusion
One of the main aims of financial sector reforms in the post 1990s was to improve
the allocative efficiency of the financial system. The efficiency improvement of the
banking system has a bearing on the overall efficiency of the Indian financial
system as the banking sector has a dominant role to play in the entire financial
edifice. This study attempted to enquire into the allocative efficiency of the Indian
banking system on a wider canvass encompassing twenty three States and across
the agriculture, industry and services sectors. Th e finding of the study broadly
corroborates that there hasbeen an improvement in allocative efficiency for all
States taketogether as far as elasticity of total output to total credit is concerned.
At the sectoral level, however, the picture is mixed. For the services sector there
has been a distinct improvement in allocative efficiency of credit in the post reform
period. The agriculture and industry sector, however, have witnessed a decline in
the allocative efficiency of credit in the same period. At theState level, majority of
the States witnessed an improvement in the overall allocative efficiency in the post
reform period. The improved allocative efficiency is more marked for the services
sector than for industry across the States.
Notes
1 Given that credit output relations involve relatively short time
series dimensions, and the well known low power of conventional unit root tests
when applied
to a single time series, there may be considerable potential for tests
that can be
employed in an environment where the time series may be of limited
length, but
very similar data may be available across a crosssection of
countries, regions,
firms, or industries.
2 Both fixed and random effects estimation of elasticity of output
with respect to
credit shows deterioration in allocative efficiency in the post reform

period for
the agriculture sector.
3 Allocative efficiency as defined by elasticity of SDP with respect to
total credit.
The individual and pooled FMOLS estimates are given in Annex-5.
4 Manipur is an exception
5 Overall refers to the State Domestic Product

State

Agriculture

Industry

Services

NSDP

1981 1993 1981 1981 1993 1981 1981 1993 1981 1981 1993 1981
-1992 -2001 -2001 -1992 -2001 -2001 -1992 -2001 -2001 -1992 -2001 -2001
ANDHRA
PRADESH

0.1

1.5

0.7

6.1

6.2

6.3

6.0

5.8

5.4

3.6

4.5

3.8

ARUNACHAL

5.1

-3.5

2.4

5.1

0.9

5.3

6.0

6.8

6.6

5.4

1.0

4.4

ASSAM

0.1

-0.3

-0.1

1.4

2.0

0.5

2.4

1.4

2.3

1.2

0.8

1.0

BIHAR

0.2

-0.4

-1.3

4.3

3.8

2.1

3.2

3.6

2.7

2.2

2.1

0.9

DELHI

-0.3 -10.8

-6.8

4.1

-0.3

2.7

3.4

5.9

4.5

3.5

4.1

3.8

GUJARAT

-2.8

-3.1

-0.2

4.8

4.3

5.9

5.0

6.8

5.5

2.4

3.7

4.0

HARYANA

2.1

-0.3

1.3

6.4

4.1

4.3

5.4

7.2

5.1

4.0

3.5

3.3

HIMACHAL

0.3

-1.8

-0.2

5.4

7.2

6.5

5.0

5.1

4.1

3.0

3.6

3.1

-2.6

1.2

-0.8

2.4

-2.9

0.2

1.1

3.7

2.2

-0.3

1.8

0.7

KARNATAKA

0.7

3.0

1.9

4.9

5.8

4.8

5.5

9.0

6.4

3.4

6.1

4.3

KERALA

1.2

0.4

1.8

1.9

4.1

4.3

2.8

6.8

4.8

2.0

4.3

3.7

MADHYA

-0.4

-1.8

0.3

2.7

7.4

6.8

4.1

4.0

3.5

1.6

2.1

2.1

0.7

-0.9

1.7

3.9

4.4

4.3

5.0

5.9

6.2

3.6

4.2

4.6

MANIPUR

-0.4

1.9

0.2

4.0

8.1

3.0

4.1

5.3

4.2

2.2

4.9

2.7

MEGHALAYA

-1.6

2.7

-1.1

2.6

6.7

4.0

4.9

2.8

3.6

2.3

3.4

2.2

ORISSA

-0.8

-0.9

-1.4

5.1

-1.9

4.1

4.3

5.9

4.4

2.0

1.6

1.4

PONDICHERRY

-1.8

-2.7

-2.6

1.0

21.6

3.2

2.2

10.0

5.2

0.9 12.3

2.8

PUNJAB

3.1

0.2

1.9

5.1

4.9

5.0

2.5

4.9

2.8

3.3

2.8

2.9

RAJASTHAN

1.9

0.0

1.7

4.3

7.0

5.6

6.2

5.8

5.4

3.7

4.1

3.8

TAMILNADU

2.6

0.8

2.7

3.2

4.4

4.1

5.1

8.2

6.2

3.9

5.3

4.7

TRIPURA

-0.1

0.4

-0.6

-1.2

12.3

4.2

6.2

5.0

5.9

2.6

4.4

3.1

UTTAR
PRADESH

0.5

0.0

0.3

5.2

2.5

3.3

3.9

2.9

3.0

2.5

1.7

1.9

WEST

3.2

2.1

2.9

1.3

4.4

2.6

2.7

8.3

4.6

2.4

5.5

3.5

PRADESH

PRADESH
JAMMU &

KASHMIR

PRADESH
MAHARA-

SHTRA

BENGAL
1

Compound annual growth rates.

Annex 2: Growth of Sector-wise Credit2

(Per cent)
State

Agriculture

Industry

Services

TotalCredit

1981 1993 1981 1981 1993 1981 1981 1993 1981 1981 1993 1981
-1992 -2001 -2001 -1992 -2001 -2001 -1992 -2001 -2001 -1992 -2001 -2001
ANDHRA
PRADESH

14.0

11.1

11.0 17.1 12.3 14.9 19.7 17.2

17.4 17.0 14.1 14.8

ARUNACHAL

37.3

7.7

19.6 36.4

-7.2

11.1 23.8 20.3

18.5 32.3

5.7 15.2

ASSAM
BIHAR
DELHI

15.3
14.8

-1.9
0.3

7.2 19.4
10.0 11.0

1.7
1.6

8.9 17.8 13.7

8.7 20.2 8.4

13.2 18.0
14.8 15.1

6.8 10.6
4.9 11.5

GUJARAT

-5.9

19.4

14.3

6.7

HARYANA

11.4

8.5

7.6

12.8

15.8

12.4

13.2

13.3

12.1

12.4 13.5 11.0

HIMACHAL

13.4

7.1

7.6

18.0

12.2

12.4

16.8

12.2

13.3

16.5 11.6 12.1

PRADESH

9.1

14.1

10.3

16.2

4.3

15.1

11.1 15.1 15.4 14.0 15.3 16.0

11.0

7.9

12.3 13.2

15.6 15.0 14.5 14.0

PRADESH
JAMMU &

KASHMIR

13.0

8.6

7.3

16.6

4.8

8.9

16.1

17.9

14.8

15.9 14.2 12.6

KARNATAKA

16.1

12.2

12.1

14.8

15.1

14.0

17.2

19.5

16.0

15.9 16.3 14.3

13.6
17.1

12.3
10.2

11.1 11.8 11.1 11.0 14.9 17.6

12.1 18.7 14.6 14.6 19.2 10.7

15.3 13.5 14.9 13.2

15.0 18.5 12.1 14.1

12.0

12.8

10.6

15.4

23.3
27.2
14.0

7.9
-3.7
8.1

13.0 38.8
10.1 36.0
9.2 19.8

7.8

7.5

KERALA
MADHYA

PRADESH
MAHARA

-SHTRA
MANIPUR
MEGHALAYA

ORISSA
PONDI
-CHERRY
PUNJAB

7.9

11.0

RAJASTHAN

14.2

12.3

TAMILNADU

16.1

TRIPURA

20.4

UTTAR
PRADESH
WEST

16.6

15.5

13.1

17.6

13.4 16.9 15.1

1.3 19.9 21.2 12.8

5.7 16.0 17.1 9.5
7.9 12.2 20.1 14.1

14.1 25.3 8.6 15.3

14.3 23.3 6.3 13.7
14.9 18.5 11.0 12.7

6.9

15.4

7.1

12.2

16.2

15.1

15.8

14.0 10.6 12.5

7.0

15.9

14.2

13.4

10.1

14.7

12.7

11.3

13.8 11.3

11.1 12.9 12.7 13.0 14.6 16.1

14.1 13.8 13.9 12.9

8.4

12.2

16.0

16.1

15.5

17.9

17.6

17.8

16.6 15.8 15.9

1.7

10.1

26.9

-2.3

10.9

21.8

4.6

12.5

22.5

13.6

9.0

10.8 13.8

8.5

14.4

3.9

BENGAL
2

14.1

Compound annual growth rates.

8.1

11.8

11.3 16.7 11.3

8.7 10.9 16.7 13.1

13.2 14.8

2.8 11.6

9.8 11.9

14.4 13.4 10.0 11.8

Annex 3 : Panel Unit Root Tests 1981-1992

Variable

LPAGRI
LPINDS
LPSERV
LPNSDP
LPACS
LPICS
LPSCS
LPTCAS

LevinLevinLevinLin rho Lin t-rho

Lin
-stat
-stat ADF-stat
-7.80
1.15
2.45
1.75
0.82
2.09
1.08
1.64

-4.52
2.27
3.36
2.91
0.68
2.40
1.20
1.73

-2.58
2.37
3.53
3.58
1.33
1.98
2.81
2.58

1993-2001

IPS LevinLevinLevinADF Lin rho Lin t-rho

Lin
-stat
-stat
-stat ADF-stat

IPS
ADF
-stat

-6.13
2.45
4.54
3.99
1.46
0.74
5.31
2.20

-6.31
-0.42
2.85
2.29
2.36
0.17
3.88
2.54

-6.67
0.47
2.49
1.58
1.67
1.49
2.36
2.47

-4.56
0.73
3.46
2.18
2.82
2.57
3.49
3.53

-3.73
0.73
3.25
2.51
2.63
1.87
3.22
3.33

Notes : a. The critical values are from Levin and Lin (1992).
b. IPS indicates the Im et al. (1997) test. The critical values are taken from Table 4.
c. Unit root tests include a constant and heterogeneous time trend in the data.

Annex 4 : Panel Cointegration Tests

1981-1992
Statistics

Panel v-statistics

1993-2001

LPINDS LPSERV LPNSDP

and
and
and
LPICS LPSCS LPTCAS

LPINDS
and
LPICS

LPSERV LPNSDP
and
and
LPSCS LPTCAS

4.52

2.49

2.97

1.02

2.80

1.79

Panel rho-statistics

-1.96

-1.71

-1.51

-0.39

-0.84

-0.80

Panel pp-statistics

-3.57

-2.96

-2.96

-3.83

-2.89

-3.65

Panel adf-statistics

-4.45

-3.47

-1.99

-2.03

-3.32

-2.48

Group rho-statistics

-0.34

0.21

0.0006

1.01

1.35

0.47

Group pp-statistics

-4.31

-3.02

-3.20

-6.66

-3.56

-6.44

Group adf-statistics

-5.75

-5.09

-3.75

-23.83

-15.36

-22.65

Notes : The critical values for the panel cointegration tests are base on Pedroni (2001a).
LPAGRI =
Log of per capita agricultural output
LPINDS = Log of per capita industrial output
LPSERV = Log of per capita services sector output
LPNSDP = Log of per capita net State domestic product
LPACS
= Log of per capita agricultural credit
LPICS
= Log of per capita industrial credit
LPSCS
= Log of per capita services sector credit
LPTCAS = Log of per capita total credit outstanding for all sectors of the State

Annex 5 : Individual and Pooled FMOLS Results

States

1981-1992 1993-2001
LPNSDP

ANDHRAPRADESH
ARUNACHAL PRADESH

ASSAM

BIHAR
DELHI
GUJARAT
HARYANA
HIMACHAL PRADESH
JAMMU & KASHMIR
KARNATAKA

KERALA
MAHARASHTRA
MANIPUR
MEGHALAYA
MADHYAPRADESH

ORISSA
PONDICHERRY

PUNJAB
RAJASTHAN
TAMILNADU
TRIPURA
UTTARPRADESH

WESTBENGAL
POOLED

LPNSDP

1981-1992 1993-2001
LPINDS

1993-2001

LPSERV

LPSERV

0.22
(-12.95)
0.17
(-42.90)
0.05
(-78.06)
0.14
(-26.38)
0.42
(-10.74)
0.15
(-29.75)
0.37
(-11.96)
0.22
(-12.84)
-0.02
(-38.75)
0.21
(-25.53)
0.15
(-15.67)
0.08
(-33.23)
0.31
(-14.19)
0.09
(-97.31)
0.08
(-22.14)
0.14
(-55.82)
0.06
(-57.65)
0.29
(-11.00)
0.32
(-12.24)
0.25

0.31
(-33.96)

(52.30)

(-63.08)

(-23.21)

(-28.70)

(-65.09)

0.11
(-22.23)
0.19
(-63.23)
0.21
(-30.22)
0.18

1.46
-1.91
0.17
(-38.75)
0.5
(-29.80)
0.34

0
(-39.83)
0.05
(-51.47)
0.21
(-16.57)
0.03

-2.31
(-3.05)
0.29
(-11.36)
0.49
(-29.83)
0.18

0.3
(-19.08)

(-156.24)

(-124.94)

(-194.26)

(-162.03)

0.06

(-26.11)
0.11
(-48.25)
0.19
(-8.86)
0.33
(-11.09)
0.21
(-13.17)
0.26
(-85.73)
0.29
(-41.42)
0.1

(-61.07)
0.39
(-13.58)
0.28

(-49.23)
0.15
(-36.83)
0.24

(-74.81)
0.48
(-2.92)
0.2
(-6.10)
0.11
(-58.34)
1.09
-0.48

0.22
(-86.15)
0.27

(-11.18)
0.33

(-166.41)

0.41
(-10.60)
0.15
(-31.56)
-0.03
(-86.56)
0.34
(-12.21)
0.32
(-32.89)
0.28
(-15.23)
0.52
(-9.53)
0.03
(-14.24)
-0.19
(-13.13)
0.02
(-43.88)
0.09
(-13.33)
-0.05
(-47.65)
0.03
(-9.61)
-0.01
(-129.84)
-0.06

LPINDS

1981-1992

(-75.61)

0
(-16.08)
-0.12
(-13.49)
0.16
(-7.50)
0.14
(-6.93)
0.16

0.44
0.32
(-27.86) (-13.61)
0.1
0.34
(-6.07)
(-19.96)
0.25
0.14
(-11.31)
(-37.71)
0.05
0.17
(-6.08) (-153.24)
-0.09
0.55
(-16.46)
(-2.82)
0.27
0.34
(-24.29) (-27.64)
0.25
0.43
(-235.33)
(-8.25)
0.47
0.34
(-7.34)
(-11.42)
-0.24
0.08
(-13.86) (-67.00)
0.4
0.34
(-12.76) (-24.92)
0.3
0.2
(-36.07) (-31.35)
0.29
0.23
(-27.18) (-47.62)
0.25
0.4
(-55.47)
(-5.83)
0.02
0.2
(-1.38)
(-47.02)
0.14
0.29
(-5.11)

(-10.05)

-0.59
0.25
(-9.70)
(-76.56)
2.19
0.14
-1.18 (-133.73)
0.34
0.27
(-17.70) (-18.51)
0.53
0.46
(-13.45)
(-8.75)
0.24
0.32

0.27

(-30.85)
0.17
(-70.59)
0.28

0.35
(-45.14)
0.38
(-8.08)
0.09
(-52.65)
0.37
(-8.82)
0.36
(-9.69)
0.47
(-14.50)
0.52
(-31.67)
0.46
(-18.74)
0.2

(-51.85)
0.47
(-15.15)
0.4

(-25.86)
0.38
(-18.57)
0.35
(-24.06)
0.44
(-7.77)
0.24
(-9.58)
0.43
(-60.82)
0.66
(-8.45)
0.37
(-16.08)
0.37
(-16.27)
0.5
(-15.10)

0.97
(-0.64)
0.28
(-64.79)
0.63
(-9.82)
0.42
(-111.37)

Note : Figures are estimated elasticities of output with respect to credit of the respective sectors.

Figuresinparenthesisindicatet-value

Annex 6
Panel Unit Root, Panel Cointegration and Fully Modified OLS Estimation

Panel unit root Tests

There are several techniques, which can be used to test for a unit root in
panel data. Specifically, we are interested to test for non- stationarity against the
alternative that the variable is trend stationary. Levin, Lin and Chu (LLC) Test
One of the first unit root tests to be developed for panel data is that of Levin and
Lin, as originally circulated in working paper form in 1992 and 1993. Their work
was finally published, with Chu as a coauthor, in 2002. Their test is based on
analysis of the equation:yt tyi tiii i t,, 1i 1,2,.. ,N t 1,2,... ., ,This model
allows for two-way fixed effects (a
and q) and unit- specific time trends. The
unit-specific fixed effects are an important source of heterogeneity, since the
coefficient of the lagged dependent variable is restricted to be homogeneous across
all units of the panel. The test involves the null hypothesis H0: ri= 0 for all I
against the alternative
HA: ri =r< 0 for all I with auxiliary assumptions under the null also being required
about the coefficients relating to the deterministic components. Like most of the
unit root tests in the literature, LLC assume that the individual processes are
cross- sectionally independent. Given this assumption, they derive conditions and
correction factors under which the pooled OLS estimate will have a standard
normal distribution under the null hypothesis. Their work focuses on the
asymptotic distributions of this pooled panel estimate of r under different
assumptions on the existence of fixed effects and homogeneous time trends. The
LLC test may be viewed as a pooled Dickey-Fuller (or ADF) test, potentially with
differing lag lengths across the units of the panel.
The Im-Pesaran-Shin Test
The Im-Pesaran-Shin (IPS, 1997) test extends the LLC framework to allow for
heterogeneity in the value of riunder the alternative hypothesis. Given the same
equation:yi tiittyi 1,2,.. ,N t 1,2,... ., ,The null and alternative hypotheses
are defined as:H0: i0 I and H A:iN0,i 1,2,...,1;i0,i N11, N12,...N Thus under
the null hypothesis, all series in the panel are nonstationary processes; under the
alternative, a fraction of the series in the panel are assumed to be stationary. This
is in contrast to the LLC test, which presumes that all series are stationary under
the alternative hypothesis. The errors are assumed to be serially autocorrelated,
with different serial correlation properties and differing variances across units. IPS
propose the use of a group- mean Lagrange multiplier statistic to test the null
hypothesis. The ADF regressions are computed for each unit, and a standardized
statistic computed as the average of the LM tests for each equation. Adjustment

factors (available in their paper) are used to derive a test statistic that is distributed
standard Normal under the null hypothesis. IPS also propose the use of a groupmean t-bar statistic, where the t statistics from each ADF test are averaged across
the panel; again, adjustment factors are needed to translate the distribution of tbar into a standard Normal variate under the null hypothesis. IPS demonstrates
that their test has better finite sample performance than that of LLC. The test is
based on the average of the augmented Dickey-Fuller (ADF) test statistics
calculated independently for each member of the panel, with appropriate lags to
adjust for auto- correlation. The adjusted test statistics, [adjusted using the tables
in Im, Pesaran, and Shin (1995)] are distributed as N(0,1) under the null of a unit
root and large negative values lead to the rejection of a unit root in favor of
stationarity.
Panel Cointegration Tests and Efficient Estimation
Cointegration analysis is carried out using a panel econometric approach.
Since the time series dimension is enhanced by the cross section, the analysis
relies on a broader information set. Hence, panel tests have greater power than
individual tests, and more reliable findings can be obtained. We use Pedroni's
(1995, 1997) panel cointegration technique, which allows for heterogeneous
cointegrating vectors. The panel cointegration tests suggested by Pedroni (1999)
extend the residual based Engle and Granger (1987) cointegration strategy. First,
the cointegration equation is estimated separately for each panel member. Second,
the residuals are examined with respect to the unit root feature. If the null of nocointegration is rejected, the long run equilibrium exists, but the cointegration
vector may be different for each cross section. Also, deterministic components are
allowed to be individual specific. To test for cointegration, the residuals are pooled
either along the within or the between dimension of the panel, giving rise to the
panel and group mean statistics (Pedroni, 1999). In the former, the statistics are
constructed by summing both numerator and denominator terms over the
individuals separately; while in the latter, the numerator is divided by the
denominator prior to the summation. Consequently, in the case of the panel
statistics the autoregressive parameter is restricted to be the same for all cross
sections. If the null is rejected, the variables in question are cointegrated for all
panel members. In the group statistics, the autoregressive parameter is allowed to
vary over the cross section,as the statistics amounts to the average of individual

statistics. If the null is rejected, cointegration holds at least for one individual.
Therefore, group tests offer an additional source of heterogeneity among the panel
members. Both panel and group statistics are based on augmented Dickey Fuller
(ADF) and Phillips- Perron (PP) method. Pedroni (1999) suggests 4 panel and 3
group s tatistics. Under appropriate standardization, each statistic is distributed
as standard normal, when both the cross section and the time series dimension
become large. The asymptotic distributions can be stated in the form Z Z* N(1)v
where Z* is the panel or group statistic, respectively, N the cross
section dimension m and n and arise from of the moments of the underlying
Brownian motion functionals. They depend on the number of regressors and
whether or not constants or trends are included in the co-integration regressions.
Estimates for m and n are based on stochastic simulations and are reported in
Pedroni (1999). Thus, to test the null of no co-integration, one simply computes the
value of the statistic so that it is in the form of (1) above and compares these to the
appropriate tails of the normal distribution. Under the alternative hypothesis, the
panel variance statistic diverges to positive infinity, and consequently the right tail
of the normal distribution is used to reject the null hypothesis. Consequently, for
the panel variance statistic, large positive values imply that the null of no cointegration is rejected. For each of the other six test statistics, these diverge to
negative infinity under the alternative hypothesis, and consequently the left tail of
the normal distribution is used to reject the null hypothesis. Thus, for any of these
latter tests, large negative values imply that the null of no co- integration is
rejected. The intuition behind the test is that using the average of the overall test
statistic allows more ease in interpretation: rejection of the null hypothesis means
that enough of the individual cross sections have statistics 'far away' from the
means predicted by theory were they to be generated under the null.
Panel FMOLS
In the event the variables are co-integrated, to get appropriate estimates of the cointegration relationship, efficient estimation techniques are employed. The
appropriate estimation method is so designed that the problems arising from the
endogeneity of the regressors and serial correlation in the error term are avoided.
Due to the corrections, the estimators are asymptotically unbiased. Especially, fully
modified OLS (FMOLS) is applied. In the model
yitxiiitxuitx,(u)(2) (2)itit 1ititit,itthe asymptotic distribution of the OLS
estimator depends on the long run covariance matrix of the residual process w.

This matrix is given by lim1TE T,u,(3)(3)iTTt1itt1itiiu

i,ifor the i-th panel member, where1T2u iilimTEitit,2,T t1u
i,i(4)1 T 1T,u iiiTTkt1E wwitit kui,,i(4)denote the matrices of
contemporaneous correlation coefficients and theauto-covariance, respectively,
where the latter are weighted according to the Newey and West (1994) proposal.
For convenience, the matrix ,ui,iiE ww'(5)(5)i,,ij 0ii 0 is defined.
The endogeneity correction is achieved by the transformation
*uiyityit,,1ixit(6) and the fully modified estimator is * 1**i'iiX yiiTu)
('(7) (7)where,*u u i1,provides the autocorelation correction, The
estimates needed for the
transformations are based on OLS residuals obtained in a preliminary step. The
panel FMOLS estimator is just the average of the individuals parameters.

Narasimham Committee Report - Some Further Ramifications and

Suggestions
Jayanth R. Varma, V. Raghunathan, A.Korwar and M.C. Bhatt
Working Paper No. 1009

February 1992
Indian Institute of Management, Ahmedabad

2. Narasimham Committee Report

Some Further Ramifications and Suggestions
Abstract

This paper while agreeing with the general thrust of the Narasimham Committee
Report, calls attention to some logical corollaries of the Report and analyses some
possible fallout from implementing the Report. We agree with the view that control
of banking system should be under an autonomous body supervised by the RBI.
However at the level of individual banks, closer scrutiny of lending procedures may
be called for than is envisaged in the Report. In a freely functioning capital market
the potential of government bonds is enormous, but this necessitates restructuring
of the government bond market. The government bonds may then also be used as
suitable hedging mechanisms by introducing options and futures trading. We
recommend freeing up the operation of pension and provident fund to enable at
least partial investment of such funds in risky securities. In the corporate sector,
we believe that the current 2:1 debt equity norm is too high and not sustainable in
the long term. We envisage that high debt levels and higher interest rates,
combined with higher business risk may result in greater incidence of corporate
sickness. This may call for various schemes for retrenched workers and
amendment to land laws for easy exit of companies. On account of
interdependencies across different policies, any sequencing of their implementation
may be highly problematic. We therefore suggest a near simultaneity in the
implementation of various reforms in order to build up a momentum which would
be irreversible if people are to have confidence that the reforms will endure, and if
we are to retain our credibility with international financial institutions.

Narasimham Committee Report

Some Further Ramifications and Suggestions

The Narasimham Committee Report is without doubt a major path- breaking piece
of work and deserves the support of all who yearn for a more rational and effective
banking system in this country. We strongly agree with the general thrust of the
report and enthusiastically endorse its major recommendations. In particular, we
welcome its proposals to delink the entire issue of concessional credit from the
issue of banking operations, to reduce the SLR limits, to strengthen the capital
base of banks, and to bring about a general freeing of interest rates. We also
strongly endorse the call for greater transparency in banking reports as well as the
proposal to strengthen the regulatory role of SEBI while abolishing the office of the
CCI. The concept of ARF for bad debts and the idea of having special tribunals to
expedite recovery of dues are also very practical and eminently implementable. The
intent of this note is not to comment paragraph by paragraph on the Committee

Report or to attempt to pick holes in what is a welcome as well as a comprehensive

set of recommendations to reform the banking system. Instead, what we shall
attempt to do here is to call attention to some natural corollaries of the Report, and
to speculate about some possible fall-out from implementing the Report which the
Government and the financial system in general may want to look out for. The note
is structured in five parts: in the first, we shall examine the implications of the
Report for the government bond markets. This will be followed by a look at the
implications for the corporate sector. After this section, a brief look at the
implications for the rural sector will be followed by some speculations regarding the
financial auditing and consulting sector. Finally, a look at the interlinkages
between the financial sector and the real economy, and we conclude with a word
about the pace of reform.

I. Restructuring the Government Bond Market

Today, the government bond market is exclusively the province of banks and
banking institutions. From the point of view of the banks, the chief function of
government bonds is to satisfy the SLR requirements. One likely consequence of
the proposed reduction in SLR limits from 38.5% to 25% is that government bonds
will increasingly be subject to some of the market pressures other bonds
experience in financial markets. The government bond market is likely to be
increasingly integrated into the mainstream capital market with investors
comparing the yields on government bonds with yields available on comparable
financial instruments elsewhere. A considerable widening and deepening of the
government bond market will be necessary to handle these changes. Currently,
while government bonds are listed on the stock exchanges, they are not actively
traded. Trading is essentially restricted to the interbank market. The potential role
of government bonds in a freely functioning capital market is enormous - one has
only to observe that the U.S. treasury bill and bond market is the largest in the
world, to recognize this fact. Because of the virtual absence of default risk on
government debts, government bonds have the potential to offer investors a
riskless investment with which to manage overall portfolio risk. Private corporate
funds, both large and small, would be attracted to such an investment as a place to
park cash without undue risk. Mutual funds could use the government bond
markets to manage the risk of their overall portfolios on a day to day basis switching in and out of government bonds depending on their perception of the
likely course of the stock markets. Government bonds are also an excellent vehicle
to manage inflation risk - in a freely functioning bond market, yields on
government bonds would have high correlations with expected inflation rates.
Forecasting of inflation rates would also become possible as the government bond
market develops and matures. Various organizations including corporations, trade
associations and trade unions could use such forecasts in pricing and bargaining.
Individuals would be able to use government bonds as part of their investment
strategy, especially for trusts and legacies for their children. To cater to such
demands, a number of bond trading firms would probably arise, specializing in

dealing in government bonds. Operating on thin, almost invisible margins, such

firms would help keep the government bond markets efficient in the informational
efficiency sense, rather like Salomon Brothers, for instance, in the U.S. Public
sector enterprises and government agencies may well find that an active, efficient
bond market which attracts private capital could be a major source of muchneeded funds.
SLR

It is clear that the SLR limits are intended mainly to ensure that banks maintain
adequate liquidity to discharge their obligations. It is difficult to see how long-term
bonds - government or otherwise - could qualify as liquid assets. At the same time,
there are a number of other financial assets which could qualify - short-term
corporate debt instruments like commercial paper of the highest quality, for
instance. There is a need to rethink the meaning of liquidity, keeping foremost the
basic intent of the SLR. This would be in line with the spirit of the Narasimham
Committee Report - to return to sound banking practices. It would, in any case, be
necessitated by the expected integration of the government bond market with the
rest of the financial markets.
Trust Securities

Bringing government bonds into the mainstream of financial markets would also
mean that they should compete openly with other high-grade securities for
inclusion in the portfolios of provident funds and pension funds. These, and
similar bodies, are currently required to invest only in approved Trust securities
which are essentially government bonds. We believe that non-government
securities of comparable risk should be permitted as investment vehicles. In a
further move to free up the operation of pension and provident funds, employees the ultimate investors - should be permitted the option of choosing to have their
funds deployed at least partly in equity securities. We believe such liberalisation of
the investment activities of pension and provident funds will fuel an unprecedented
boom in such funds. Strong funds of this kind can help mobilize savings just as
mutual funds have in the past few years. Strong pension funds can serve two
purposes - they can act as major sources of funding, both loans and equity, for
companies in both the private and public sector. This would help alleviate some of
the financing crunch so many companies are facing today. Secondly, well-managed
pension funds can provide the banking system some healthy competition, which
would force them to strive for greater efficiency and productivity.
Interest Rate Hedging

With interest rates deregulated, there will be a need to develop suitable hedging
mechanisms in the form of futures and options. In the long run, these mechanisms
may well be needed for all securities. However, since government bonds would be
influenced by a relatively small number of factors such as inflation and the term
structure of interest rates, they would provide an ideal vehicle to experiment and
learn how to operate options and futures markets in the Indian context. We believe

government bonds should be the first choice of securities exchange boards

contemplating introducing options and futures trading.

II. The Corporate Sector

If we compare corporate debt levels in India with those elsewhere, we would find
that Indian companies operate with an astoundingly high degree of borrowing.
Debt levels of 2:1 and 3:1 are commonplace in India - whereas they would be
unthinkable in most other financial markets of the world. There are many aspects
to this issue - a high debt level permits control of the company with a very small
equity investment. The results of such 'control without commitment' are not always
healthy for the company, to say the least. When major shareholders strip a
company of its productive earning power and leave a shell behind, at least part of
the blame must be ascribed to a system which allows such extraordinary levels of
debt financing. In economic downturns and recessions - inevitable in any economy
- high levels of debt will often cause a company to fall when it should only stumble.
Why have such high debt levels been permitted? There are probably mean reasons,
rooted in the history of the growth pains of a developing economy. One such reason
would be that government controlled financial institutions have often seen it as
their duty to provide funds to an 'approved' company - namely, any company which
has been able to secure a license. Even companies implementing the riskiest of
projects have been able to find debt financing, often at concessional rates, once
they have been able to get a license for the project. With the reform of the financial
system proposed by the Narasimham Committee, financial institutions will begin to
move away from such concerns with developmental or societal objectives. One
result will be that corporations will be forced to reduce their reliance on debt
financing. There are at least three other reasons why the historical high debt levels
of corporations cannot be sustained in the future. One is that, as the interest rates
are deregulated, they are likely to rise, at least in the short term. This is especially
the case because so much of corporate debt has been obtained in the past at
concessional rates from financial institutions. The increase in interest rates will
increase the debt service burden sharply at current levels of borrowings. As the
equity markets grow, equity financing will appear more and more attractive in
comparison. Further, with the greater reliance upon borrowing from the capital
markets rather than from Development Finance Institutions, there will be less
flexibility in terms of rescheduling of payments, since it is hardly practicable to
convene a meeting of
debenture-holders at every turn. Finally, since high debt levels increase the overall
risk of the corporation, companies will have to seek ways to control their financial
risk as they struggle to cope with the increased business risks they will face in
openly competitive product markets. With the risk of mistakes and stumbles
greatly increased, companies will find their equity values depressed if they burden
themselves with debt and thereby invite financial disasters. This is one of the likely
but thus far unheralded consequences of the liberalization of industrial policy by
the present government, which has left few protected markets for companies to
keep harvesting as they have in the past.

Corporate Sickness

Until such time as the corporate debt levels are brought down to more manageable
levels, the corporate sector will probably see a greater incidence of sickness on
account of its inability to absorb the higher debt service charges. This is especially
true of the older, more established companies which will, at the same time, find
their hitherto profitable
and protected markets invaded by new and more aggressive competitors. The
erosion of profitability and the increase in debt service burden will be a vise many
such companies will find themselves inexorably squeezed in. Needless to say, this
brings up issues such as exit policy, which we address in the section on
Interlinkages. At this stage, however, we suggest that the debt equity norm should
be reduced in a time-bound manner, say over a period of two years, from 2:1 to 1:1,
in order to give the corporate sector some time to adjust their long-term financing
mix. Eventually, of course, the debt equity norm will have to be determined purely
on business considerations, and will vary in a complex manner from industry to
industry if not from company to company. However, a phased move in this direction
must be implemented as soon as the Narasimham Committee report itself is
implemented in its final form.

III. Rural Sector Banks

With the implementation of the Narasimham Committee Report, commercial banks

will no longer be cross-subsidizing loans to the rural sector with earnings from the
urban sector. While this will certainly put an end to the strategic schizophrenia
banks have been afflicted with in the past, it does mean that commercial banks,
including their rural subsidiaries, will find it increasingly difficult to compete with
specialized rural banks. We anticipate that the need and the demand for credit in
the rural sector will only grow as the economy grows. To meet this demand, a
number of such specialized banks are likely to arise, probably floated by
entrepreneurs with strong rural roots. Because such entrepreneurs are likely to
perform much better than the rural subsidiaries of the existing commercial banks
at the critical tasks of credit appraisal and understanding the real needs of rural
people, we expect these new financial institutions to serve rural markets better.
However, they will always suffer from two major problems: they will always be
localized and therefore not adequately diversified, which will make them prone to
failure with every local disaster; secondly, they will be short of capital in the short
run. We expect that government will have to find ways to provide capital to such
new banks, preferably in the form of venture capital in the form of equity. It is hard
to see what can be done to solve the problem of inadequate geographical
diversification without jeopardizing the strong local expertise which will be the
main competitive advantage for these new banks.

IV. Financial Auditing and Consulting

We believe that the scheme proposed by the Committee for supervision of banks
will be found to be inadequate, in as much as it relies strongly on self-regulation by

banks with a small supervisory board. The main aim of bank supervision should
be to protect the interests of depositors and to prevent any run on the banking
system which may be follow any significant bank failures. We propose that the best
way to ensure this would be a strong system of bank examiners, coupled with a
system of insurance of bank deposits. Bank examiners would be charged with the
task of auditing the portfolios of individual banks, at a detailed level, and to assess
the overall portfolio of the individual bank. Examiners should be able to provide an
early warning system to the bank itself as well as to the RBI if the bank has
excessive exposure to particular risks, for instance. Such examiners would need to
be independent of the both the bank and the RBI. Ideally, they would be
professionals, trained in financial and investment management. We suggest that
such the RBI hire such professional services on a contract basis. A number of
other financial services would need to be developed. For instance, we have
proposed in the section on government bonds that pension and provident funds be
allowed to invest in 'high grade' debt securities other than government bonds.
Naturally, then, there will need to be a number of independent agencies
specializing in the appraisal of debt securities.

V. Interlinkages with the Real Economy

Strong interrelationships obviously exist between the banking system and the rest
of the economy.
Exit Policy

Opening up the entries but keeping the exit clogged is clearly not a viable
procedure. The need for a workable exit policy to go along with the liberal entry
policies introduced by the current government, is a rather obvious one. The point
to be made here is that this need for a workable exit policy will be greatly increased
by some of the fallouts from the proposed reform of the banking sector. Quite apart
from the fact that some banks themselves will become unviable and will have to
start downsizing or adopting a more regional focus, we expect that the incidence of
corporate failures will also increase as the debt burden increases. We have dealt
with this issue at length in a previous section.
Labour Laws

The retrenchment of workers arising from the sickness of firms could be taken care
of by the following options:
a) Rather than force sick units to continue retaining the labour force, which is not
feasible in the long run in any case and results in a downward spiraling of morale
and productivity in the short run, employers could be forced to find alternative
employment for workers elsewhere. In practice, an employer who wishes to lay off
workers may have to pay a new employer to take them on. Some form of insurance
could be obtained by the old employer to help defray such costs in the event of
sickness. We expect an active market in this area if this option is resorted to.
b) An employment retrenchment insurance scheme wherein the employer pays an
insurance premium to an insurance company to cover retrenchment payments to

employees (not covering retrenchment on disciplinary grounds etc.) The insurance

company could pay the retrenched worker directly to provide him or her some
cushion or to pay finance any retraining which would be needed for him or her to
find a new job. Various combinations of the above schemes could also be worked
out. In any case, as sickness and layoffs become more common, workers also need
to have a variety of insurance and pension schemes which would not be dependent
on any one employer. We anticipate a growing demand for independent insurance
and pension fund companies as the proposed reforms are implemented.
Land Laws

Certain restrictions on the sale of certain kinds of land properties have acted as
major impediments in the way of sick companies which could otherwise have sold
the land to raise funds to finance rehabilitation efforts. With the increased
incidence of corporate sickness we predict as a consequence of both the liberalized
industrial policy and the reforms proposed in the Narasimhan Committee report,
some major amendments to land laws appear to be urgently called for.

VI. Pace of Reform

Major economic reforms are being contemplated today. One issue which naturally
arises is that of sequencing these reforms. At first blush, it may appear that it
would be logical to implement reforms in some logical order of priority, based
perhaps on some sense of relative urgency. However, a closer examination reveals
that there is some sort of circular sequencing requirement here, where each reform
appears to be a precondition for another. For example, it would make little sense to
reform the banking system first, since the real urgency driving this set of reforms
comes from the need to rationalize the entire economic system. On the other hand,
how feasible would it be to implement the reform of the industrial system first, if
there is not a strong banking system to finance the new entrants into newly
deregulated industries? Again, how feasible would it be to implement an easy entry
policy without an easy exit policy and how would an exit policy work without a
system of insurance for retrenched workers, which would require a reformed
financial system as a precondition? Indeed, reforms in industrial policy are hardly
likely to win the enthusiastic support of industry if industry leaders did not have
reason to believe that reforms in the financial system are imminent if not
concurrent. We believe the simplest way out of such a dilemma is to aim for a near
simultaneity in these reforms. This will necessarily mean a rapid pace of reform in
which time is measured in days, not years. Days as units connote a sense of
urgency not communicated by months and years. At the same time, there is a need
to build up a momentum which would be irreversible if the people are to have
confidence that the reforms will endure. A slow pace of reform will breed a 'wait
and see' attitude, which would neither bring the benefits of reform nor permit
continued economic growth under the old rules of the game. The greatest danger is
uncertainty - he who hesitates is indeed lost. As we look around us, we see even
more momentous reforms being introduced in the world today, especially in
Europe and the erstwhile Soviet Union. India cannot afford to be slower than these

countries, especially if we are to retain our credibility with international financial

institutions.

Capital Adequacy Ratio

INTRODUCTION

The instructions regarding the components of capital and capital charge required
to be provided for by the banks for credit and market risks. It deals with providing
explicit capital charge for credit and market risk and addresses the issues involved
in computing capital charges for interest rate related instruments in the trading
book, equities in the trading book and foreign exchange risk (including gold and
other precious metals) in both trading and banking books. Trading book for the
purpose of these guidelines includes securities included under the Held for
Trading category, securities included under the Available For Sale category, open
gold position limits, open foreign exchange position limits, trading positions in
derivatives, and derivatives entered into for hedging trading book exposures.
Measurement of capital charge for foreign exchange and gold open positions
Foreign exchange open positions and gold open positions are at present risk
weighted at 100%. Thus, capital charge for foreign exchange and gold open position
is 9% at present. These open positions, limits or actual whichever is higher,
would continue to attract capital charge at 9%. This is in line with the Basel
Committee requirement.
Capital Adequacy for Subsidiaries
1.The Basel Committee on Banking Supervision has proposed that the New Capital
Adequacy Framework should be extended to include, on a consolidated basis,
holding companies that are parents of banking groups. On rudential
considerations, it is necessary to adopt best practices in line with international
standards, while duly reflecting local conditions.
2.Accordingly, banks may voluntarily build-in the risk weighted components of
their subsidiaries into their own balance sheet on notional basis, at par with the
risk weights applicable to the bank's own assets. Banks should earmark additional
capital in their books over a period of time so as to obviate the possibility of
impairment to their net worth when switchover to unified balance sheet for the
group as a whole is adopted after sometime. Thus banks were asked to provide

additional capital in their books in phases, beginning from the year ended March
2001.
3.A consolidated bank defined as a group of entities which include a licensed bank
should maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR)as
applicable to the parent bank on an ongoing basis. While computing capital funds,
parent bank may consider the following points :i.Banks are required to maintain a
inimum capital to risk weighted assets ratio of 9%. Non-bank subsidiaries are
required to maintain the capital adequacy ratio prescribed by their respective
regulators. In case of any shortfall in the capital adequacy ratio of any of the
subsidiaries, the parent should maintain capital in addition to its own
regulatory requirements to cover the shortfall. ii.Risks inherent in deconsolidated
entities (i.e., entities which are not consolidated in the Consolidated Prudential
Reports) in the group need to be assessed and any shortfall in the regulatory
capital in the econsolidated entities should be deducted (in equal proportion from
Tier I and Tier II capital) from the consolidated bank's capital in the proportion
of its equity stake in the entity.
Procedure for computation of CRAR
1. While calculating the aggregate of funded and non-funded exposure of a
borrower for the purpose of assignment of risk weight, banks may net-off against
the total outstanding exposure of the borrower -(a) advances collateralised by cash
margins or deposits,(b) credit balances in current or other accounts which are not
earmarked for specific purposes and free from any lien,(c) in respect of any assets
where provisions for depreciation or for bad debts have been made (d) claims
received from DICGC/ ECGC and kept in a separate account pending adjustment,
and (e) subsidies received against dvances in respect of Government sponsored
schemes and kept in a separate account.
2.After applying the conversion factor as indicated in Annex 10, the adjusted off
Balance Sheet value shall again be multiplied by the risk weight attributable to the
relevant counter-party as specified.
3. Computation of CRAR for Foreign Exchange Contracts and Gold: Foreign
exchange contracts include- Cross currency interest rate swaps, Forward foreign
exchange contracts, Currency futures, Currency options purchased, and other
contracts of a similar nature Foreign exchange contracts with an original maturity
of 14 calendar days or less, irrespective of the counterparty, may be assigned "zero"
risk weight as perinternational practice. As in the case of other off-Balance Sheet

items, a two stage calculation prescribed below shall be applied:

(a) Step 1- The notional principal amount of each instrument is multiplied by the
conversion factor given below:
Residual Maturity

Conversion Factor

One year or less

Over one year to five years

Over five years

2%

10%
15%

(b) Step 2 - The adjusted value thus obtained shall be multiplied by the risk weight
age allotted to the relevant counter-party as given in Step 2 in section D of Annex
10.
4. Computation of CRAR for Interest Rate related Contracts::
Interest rate contracts include the Single currency interest rate swaps, Basis
swaps, Forward rate agreements, Interest rate futures, Interest rate options
purchased and other contracts of a similar nature. As in the case of other offBalance Sheet items, a two stage calculation prescribed below shall be applied:
(a)Step 1 - The notional principal amount of each instrument is multiplied by the
percentages given below :
Residual Maturity

Conversion Factor

One year or less

0.5%
1.0%

Over one year to five years

Over five years

3.0%

(b) Step 2 -The adjusted value thus obtained shall be multiplied by the risk
weightage allotted to the relevant counter-party as given in Step 2 in Section I.D.
of Annex
The Committee on Banking Regulations and Supervisory Practices (Basel
Committee) had released the guidelines on capital measures and capital
standards in July 1988 which were been accepted by Central Banks in various
countries including RBI. In India it has been implemented by RBI w.e.f. 1.4.92
Objectives of CAR : The fundamental objective behind the norms is to
strengthen the soundness and stability of the banking system.
Capital Adequacy Ratio or CAR or CRAR : It is ratio of capital fund to risk

weighted assets expressed in percentage terms i.e.

Minimum requirements of capital fund in India:
* Existing Banks 09 %
* New Private Sector Banks 10 %
* Banks undertaking Insurance business 10 %
* Local Area Banks 15%
Tier I Capital should at no point of time be less than 50% of the total capital.
This implies that Tier II cannot be more than 50% of the total capital.
Capital fund
Capital Fund has two tiers - Tier I capital include
*paid-up capital
*statutory reserves
*other disclosed free reserves
*capital reserves representing surplus arising out of sale proceeds of assets.
Minus
*equity investments in subsidiaries,
*intangible assets, and
*losses in the current period and those brought forward from previous periods
to work out the Tier I capital.
Tier II capital consists of:
*Un-disclosed reserves and cumulative perpetual preference shares:
*Revaluation Reserves (at a discount of 55 percent while determining their value
for inclusion in Tier II capital)
*General Provisions and Loss Reserves upto a maximum of 1.25% of weighted
risk assets:
*Investment fluctuation reserve not subject to 1.25% restriction
*Hybrid debt capital Instruments (say bonds):
*Subordinated debt (long term unsecured loans:
Risk weighted assets - Fund Based : Risk weighted assets mean fund based
assets such as cash, loans, investments and other assets. Degrees of credit risk
expressed as percentage weights have been assigned by RBI to each such assets.

Non-funded (Off-Balance sheet) Items : The credit risk exposure attached to

off-balance sheet items has to be first calculated by multiplying the face amount
of each of the off-balance sheet items by the credit conversion factor. This will
then have to be again multiplied by the relevant weightage.
Reporting requirements :
Banks are also required to disclose in their balance sheet the quantum of Tier I
and Tier II capital fund, under disclosure norms.
An annual return has to be submitted by each bank indicating capital funds,
conversion of off-balance sheet/non-funded exposures, calculation of risk
-weighted assets, and calculations of capital to risk assets ratio,

Asset - Liability Management System in banks - Guidelines

Over the last few years the Indian financial markets have witnessed wide ranging
changes at fast pace. Intense competition for business involving both the assets
and liabilities, together with increasing volatility in the domestic interest rates as
well as foreign exchange rates, has brought pressure on the management of banks
to maintain a good balance among spreads, profitability and long-term viability.
These pressures call for structured and comprehensive measures and not just ad
hoc action. The Management of banks has to base their business decisions on a
dynamic and
integrated risk management system and process, driven by corporate strategy.
Banks are exposed to several major risks in the course of their business - credit
risk, interest rate risk, foreign exchange risk, equity / commodity price risk,
liquidity risk and operational risks.
2.
This note lays down broad guidelines in respect of interest rate and liquidity
risks management systems in banks which form part of the Asset-Liability
Management (ALM) function. The initial focus of the ALM function would be to
enforce the risk management discipline viz. managing business after assessing the
risks involved. The objective of good risk management programmes should be that
these programmes will evolve into a strategic tool for
bank management.
3.
The ALM process rests on three pillars:
ALM information systems
=> Management Information System
=> Information availability, accuracy, adequacy and expediency
ALM organisation
=> Structure and responsibilities
=> Level of top management involvement
ALM process
=> Risk parameters
=> Risk identification
=> Risk measurement

=> Risk management

=> Risk policies and tolerance levels.
TRENDS IN DOMESTIC RATES AND YILED CURVE
The major focus of prudential regulation in developing countries has traditionally
been on credit risk. While banks and their supervisors have grappled with nonperforming loans for several decades, interest rate risk is a relatively new problem.
Administrative restrictions on interest rates in India have been steadily eased since
1993. This has led to increased interest rate volatility. Table I shows the trends in
domestic interest rates in India during the study period. It is clear that the rates
are increasing.

Table I - Trends in Domestic Interest Rates in India (in %)

Effective since
reverse repo rate
Mar 31, 2004
4.50
Sep 18, 2004
4.50
Oct 2, 2004
4.50
Oct 27, 2004
4.75
Apr 29, 2005
5.00
Oct 26, 2005
5.25
Jan 24, 2006
5.50
Jun 9, 2006
5.75
Jul 25, 2006
6.00
Oct 31, 2006
6.00
Dec 23, 2006
6.00
Jan 6, 2007
6.00
Source: RBI Bulletin

repo rate

CRR
6.00
6.00

4.50
4.75

6.00

5.00

6.00
6.00
6.00
6.25
6.50
6.75
7.00
7.25

5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.25

7.25

5.50

The yield curve has shifted upward since March 04, with the 10-year yields
moving from 5% to 7% (Fig.I). However,the longer end of the curve has flattened.
The significant drop in turnover in 2004-05 and 2005-06 could be due to a buy
and hold tendency of the participants other than commercial
banks (like insurance companies) and also due to the asymmetric response of
investors to the interest rate cycle. Inthe absence of a facility of short selling in
government securities, participants generally refrained from taking positions which
resulted in volumes drying up in a falling market. The Reserve Bank's efforts to
elongate the maturity profile resulted in a smooth and reliable yield curve to act as

a benchmark for the other markets for pricing and valuation

purposes. The weighted average maturity of securitiesincreased from 5.5 years in
1995-96 to 14.6 years during2006-07. The weighted average yield of securities
alsodeclined to 5.7 per cent in 2003-04 and since then, it has increased to 7.3 per
cent in 2005-06 and further to 7.9 percent in 2006-07.The Indian yield curve today
compares with not only emerging market economies but also the developed world.

Cash Reserve Ratio*

Rate Effective Date

1

3.5

5/7/1935

Rate
Effective Date
1

(a)5% of DL 5/7/1935

Rate
Effective Date
1

20 16-03-1949

(b)2% of TL
3

28-11-1935

(a)5% of DL 6/3/1960
(b)2% of TL @

25 16-09-1964

(a)5% of DL 6/5/1960
(b)2% of TL @
3.5

15-11-1951

(a)5% of DL11/11/1960

26

(b)2% of TL

27 24-04-1970

316-09-1962

5/2/1970

28 28-08-1970

529-06-1973
4

16-05-1957

6 8/9/1973
722-09-1973

29

4/8/1972

5 1/7/1974

30 17-11-1972

4.514-12-1974
4.5

3/1/1963

428-12-1974
5 4/9/1976

32 8/12/1973

613-11-1976
6 @14-01-1977
5

26-09-1964

6 @ 1/7/1978

33

1/7/1974

6 @ 5/6/1979
6.531-07-1981
721-08-1981
6

17-02-1965

7.2527-11-1981

34 1/12/1978

RBI repo rate - Indian central banks interest rate

Charts - historic RBI interest rates
Graph Indian interest rate RBI - interest Graph Indian interest rate RBI - longrates last year
term graph

The current Indian interest rate RBI (base rate) is 8.500 %

RBI - Reserve Bank of India

The Reserve Bank of India (RBI) is the Indian central bank. The RBIs most
important goal is to maintain monetary stability - moderate and stable inflation in India.. The RBI uses monetary policy to maintain price stability and an adequate
flow of credit. Rates which the Indian central bank uses for this are the bank rate,
repo rate, reverse repo rate and the cash reserve ratio. Reducing inflation has been
one of the most important goals for some time.
Other important tasks of the Reserve Bank of India are:

to maintain the populations confidence in the system, to safeguard the

interests of those who have entrusted their money and to supply cost-effective
banking systems to the population;
to manage foreign currency controls: facilitating exports, imports and
international payment traffic and developing and maintaining the trade in
foreign currencies in India;

issuing money (the rupee) and adequately ensuring a high quality money
supply;

providing loans to commercial banks in order to maintain or grow the Gross

National Product (GNP);

acting as the governments banker;

acting as the banks banker.

RBI Repo rate or key short term lending rate

When reference is made to the Indian interest rate this often refers to the repo rate,
also called the key short term lending rate. If banks are short of funds they can
borrow rupees from the Reserve Bank of India (RBI) at the repo rate, the interest
rate with a 1 day maturity. If the central bank of India wants to put more money
into circulation, then the RBI will lower the repo rate. The reverse repo rate is the
interest rate that banks receive if they deposit money with the central bank. This
reverse repo rate is always lower than the repo rate. Increases or decreases in the
repo and reverse repo rate have an effect on the interest rate on banking products
such as loans, mortgages and savings.
This page shows the current and historic values of Indian central bank's Repo rate
Base Rate
i.The Base Rate system will replace the BPLR system with effect from July 1, 2010.
Base Rate shall include all those elements of the lending rates that arecommon
across all categories of borrowers. Banks may choose any benchmark to arrive at
the Base Rate for a specific tenor that may be disclosed transparently. An il
ustration for computing the ase Rate is set out in theAnnex. Banks are free to use
any other methodology, as considered appropriate, provided it is consistent and is
made available for supervisory review/scrutiny, as and when required.
ii. Banks may determine their actual lending rates on loans and advances with
reference to the Base Rate and by including such other customer specific charges

as considered appropriate.
iii.In order to give banks some time to stabilize the system of Base Rate calculation,
banks are permitted to change the benchmark and methodology any time during
the initial six month period i.e. end-December 2010.
iv.The actual lending rates charged may be transparent and consistent and be
made available for supervisory review/scrutiny, as and when required.
Applicability of Base Rate
v.All categories of loans should henceforth be priced only with reference to the
Base Rate. However, the fol owing categories of loans could be priced without
reference to the Base Rate: (a) DRI advances (b) loans to banks own
employees (c) loans to banks depositors against their own deposits.
vi.The Base Rate could also serve as the reference benchmark rate for floating rate
loan products, apart from external market benchmark rates. The floating interest
rate based on external benchmarks should, however, be equal to or above the Base
Rate at the time of sanction or renewal.
vii.Changes in the Base Rate shall be applicable in respect of all existing loans
linked to the Base Rate, in a transparent and non-discriminatory manner.
viii.Since the Base Rate wil be the minimum rate for all loans, banks are not
permitted to resort to any lending below the Base Rate. Accordingly, the current
stipulation of BPLR as the ceiling rate for loans up to Rs. 2 lakh stands withdrawn.
It is expected that the above deregulation of lending rate will increase the credit
flow to small borrowers at reasonable rate and direct bank finance will provide
effective competition to other forms of high cost credit.
ix.Reserve Bank of India will separately announce the stipulation for export
credit.
Review of Base Rate
x.Banks are required to review the Base Rate at least once in a quarter with
theapproval of the Board or the Asset Liability Management Committees (ALCOs)
as per the banks practice. Since transparency in the pricing of lending products
has been a key objective, banks are required to exhibit the information on their
Base Rate at all branches and also on their websites. Changes in the Base Rate
should also be conveyed to the general public from time to time through
appropriate channels. Banks are required to provide information on the actual
minimum and maximum lending rates to the Reserve Bank on a quarterly basis, as
hitherto.
Transitional issues
xi.The Base Rate system would be applicable for all new loans and for those old
loans that come up for renewal. Existing loans based on the BPLR system may run
till their maturity. In case existing borrowers want to switch to the new system,
before expiry of the existing contracts, an option may be given to them,on mutually
agreed terms. Banks, however, should not charge any fee for such switch-over.
xii.In line with the above Guidelines, banks may announce their Base Rates after
seeking approval from their respective ALCOs/ Boards.
Effective date

xiii.The above guidelines on the Base Rate system will become effective on July 1,
2010.
Illustrative Methodology for the Computation of the
Base Rate
Base Rate
a Cost of Deposits/funds
(benchmark)
b Negative Carry on CRR and SLR

100

c Unallocatable Overhead Cost 100

d Average Return on Net Worth
Where:
Cost of Deposits/funds
Total Deposits
Time Deposits
Deposits
Saving Deposits
Deployable Deposits
1Total deposits less
share of deposits
locked as CRR and
SLR balances, . .

100

Current

Annex

CRR : Cash Reserve Ratio

SLR : Statutory Liquidity Ratio
364 TBill Rate
Unallocatable Overhead Cost
NP : Net Profit
NW : Net Worth Capital Free Reserves
Negative Carry on CRR and SLR
Negative Carry on CRR and SLR 100 Negative carry on CRR and SLR balances
arises because the return on CRR balances is nil, while the return on SLR
balances (proxied using the 364-day Treasury Bill rate) is lower than the cost of
deposits. Negative carry on CRR and SLR is arrived at in three steps. In the first
step, return on SLR investment was calculated using 364-day Treasury Bills. In the
second step, effective cost was calculated by taking the ratio (expressed as a
percentage) of cost of deposits(adjusted for return on SLR investment) and
deployable deposits (total deposits less the deposits locked as CRR and SLR
balances). In the third step, negative carry cost on SLR and CRR was arrived at by
taking the difference between the effective cost and the cost of deposits
Unallocatable Overhead Cost

100

Unallocatable Overhead Cost

5
Unallocatable Overhead Cost is calculated by taking the ratio (expressed as a
percentage) of unallocated overhead cost and deployable deposits.
Average Return on Net Worth
Average Return on Net Worth Average Return on Net Worth is computed as the
product of net profit to net worth ratio and networth to deployable deposits ratio
expressed as a percentage.
Guidelines on Benchmark Prime Lending Rate (BPLR) applicable to loans
sanctioned upto June 30, 2010 ( Paragraph 2.2.1)
With effect from October 18, 1994, RBI has deregulated the interest rates on
advancesabove Rs.2 lakh and the rates of interest on such advances are
determined by the banks themselves subject to BPLR and Spread guidelines. For

credit limits up to Rs.2 lakh, banks should charge interest not exceeding their
BPLR. Keeping in view the international practice and to provide operational
flexibility to commercial banks in deciding their lending rates,banks can offer loans
at below BPLR to exporters or other creditworthy borrowers, including public
enterprises, on the basis of a transparent and objective policy approved by their
respective Boards. Banks will continue to declare the maximum spread of interest
rates over BPLR. Given the prevailing credit market in India and the need to
continue with concessionality for small borrowers, the practice of treating BPLR as
the ceiling for loans up to Rs. 2 lakh will continue.Banks are free to determine the
rates of interest without reference to BPLR and regardless of the size in respect of
loans for purchase of consumer durables, loans to individuals against shares and
debentures / bonds, other non-priority sector personal loans, etc. as per details
given below.BPLR will be made uniformly applicable at all branches of a bank.
Determination of Benchmark Prime Lending Rate (BPLR)
In order to enhance transparency in banks pricing of their loan products as also to
ensure that the BPLR truly reflects the actual costs, banks should be guided by
the following considerations while determining their Benchmark PLR: Banks
should take into account their (i) actual cost of funds, (ii) operating expenses and
(iii) a minimum margin to cover regulatory requirement of provisioning / capital
charge and profit margin, while arriving at the benchmark PLR. Banks should
announce a Benchmark PLR with the approval of their Boards The Benchmark PLR
will be the ceiling rate for credit limit up to Rs.2 lakh. All other lending rates can be
determined with reference to the Benchmark PLR arrived at as above by taking into
account term premia and / or risk premia. Detailed guidelines on operational
aspects of Benchmark PLR have been issued by IBA on November 25, 2003.In the
interest of customer protection and to have greater degree of transparency in regard
to actual interest rates charged to borrowers, banks should continue to provide
information on maximum and minimum interest rates charged together with the
Benchmark PLR.

Freedom to fix Lending Rates

Banks are free to determine the rates of interest without reference to BPLR and
regardless of the size in respect of the following loans:
I.

iii.
iv.
v.

Loans for purchase of consumer durables;

Loans to individuals against shares and debentures / bonds;
Other non-priority sector personal loans including credit card dues;
Advances / overdrafts against domestic / NRE / FCNR (B) deposits
with the bank,provided that the deposit/s stands / stand either in
the name(s) of the borrower himself / borrowers themselves, or in the
names of the borrower jointly with another person;
Finance granted to intermediary agencies including housing finance
intermediary agencies (list as given below) for on-lending to ultimate

beneficiaries and agencies providing input support.;

Discounting of Bills;
Loans / Advances / Cash Credit / Overdrafts against commodities
subject to Selective Credit Control;
viii. To a co-operative bank or to any other banking institution;
ix. To its own employees;
vi.
vii.

State sponsored organisations for on-lending to weaker sections. Weaker sections

include
i)

Small and marginal farmers with landholdings of 5 acres and less, and
landless labourers, tenant farmers and share-croppers;
ii)
Artisans, village and cottage industries where individual credit
requirements do not exceed Rs. 50,000/-;
iii) Beneficiaries of Swarnjayanti Gram Swarozgar Yojana (SGSY);
iv) Scheduled Castes and Scheduled Tribes;
v)
Beneficiaries of Differential Rate of Interest (DRI) scheme;
vi) Beneficiaries under Swarna Jayanti Shahari Rozgar Yojana (SJSRY);
vii) Beneficiaries under scheme of Liberation and Rehabilitation of
Scavengers(SLRS);
viii) Advances to Self-Help Groups (SHGs);
ix) Loans to distressed poor to repay their debt to informal sector, against
appropriate collateral or group security;Loans granted under (i) to (viii)
above to persons from minority communities as may be notified by
Government of India from time to time.In states, where one of the
minority communities notified is, in fact, in majority, item
x)
will cover only the other notified minorities. These States/Union
Territories are Jammu and Kashmir, Punjab, Sikkim, Mizoram,
Nagaland and Lakshadweep.

An Illustrative list of Intermediary Agencies

1.
Loans covered by refinance schemes of term lending institutions.
2.
Distributors of agricultural inputs / implements.
3.
State Financial Corporations (SFCs) / State Industrial Development
Corporations (SIDCs) to the extent they provide credit to weaker sections.
4.
National Small Industries Corporation (NSIC).
5.
Khadi and Village Industries Commission (KVIC).
6.
Agencies involved in assisting the decentralised sector.
7.
State sponsored organisations for on-lending to the weaker sections.
8.
Housing and Urban Development Corporation Ltd. (HUDCO).
9.
Housing Finance Companies approved by National Housing Bank
(NHB) for refinance.
10.
State sponsored organisations for SCs / STs (for purchase and supply
of inputs to and / or marketing of output of the beneficiaries of these

organisations).
11.
Micro Finance Institutions / Non-Government Organisations (NGOs)
on-lending to SHGs.
Interest Rate Risk (IRR)
The phased deregulation of interest rates and the operational flexibility given to
banks inpricing most of the assets and liabilities have exposed the banking system
to Interest Rate Risk. Interest rate risk is the risk where changes in market interest
rates might adversely affect a bank's financial condition. Changes in interest rates
affect both the current earnings (earnings perspective) as also the net worth of the
bank (economic value perspective). The risk from the earnings' perspective can be
measured as changes in the Net Interest Income (Nil) or Net Interest Margin (NIM).
In the context of poor MIS, slow pace of computerisation in banks and the absence
of total deregulation, the traditional Gap analysis is considered as a suitable
method to measure the Interest Rate Risk. It is the intention of RBI to move over to
modern techniques of Interest Rate Risk measurement like Duration Gap Analysis,
Simulation and Value at Risk at a later date when banks acquire sufficient
expertise and sophistication in MIS. The Gap or Mismatch risk can be measured by
calculating Gaps over different time intervals as at a given date. Gap analysis
measures mismatches between rate sensitive liabilities and rate sensitive assets
(including off-balance sheet positions). An asset or liability is normally classified as
rate sensitive if:
i) within the time interval under consideration, there is a cash flow;
ii) the interest rate resets/reprices contractually during the interval;
iii) RBI changes the interest rates (i.e. interest rates on Savings Bank
Deposits, advances upto
Rs.2 lakhs, DRI advances, Export credit, Refinance, CRR balance, etc.) in
cases where
interest rates are administered ; and
iv) it is contractually pre-payable or withdrawable before the stated
maturities.
The Gap Report should be generated by grouping rate sensitive liabilities, assets
and off- balance sheet positions into time buckets according to residual maturity or
next repricing period, whichever is earlier. The difficult task in Gap analysis is
determining rate sensitivity. All investments, advances, deposits, borrowings,
purchased funds etc. that mature/reprice within a specified timeframe are interest
rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the
bank expects to receive it within the time horizon. This includes final principal
payment and interim instalments. Certain assets and liabilities receive/pay rates
that vary with a reference rate. These assets and liabilities are repriced at pre-

determined intervals and are rate sensitive at the time of repricing. While the
interest rates on term deposits are fixed during their currency, the advances
portfolio of the banking system is basically floating. The interest rates on advances
could be repriced any number of occasions, corresponding to the changes in PLR.
The Gaps may be identified in the following time buckets:
i) upto 1 month
ii) Over one month and upto 3 months
iii) Over 3 months and upto 6 months
iv) Over 6 months and upto 12 months
v) Over 1 year and upto 3 years
vi) Over 3 years and upto 5 years
vii) Over 5 years
viii) Non-sensitive

The various items of rate sensitive assets and liabilities in the Balance Sheet may
be classified as explained in Appendix - II and the Reporting Format for interest
rate sensitive assets and liabilities is given in Annexure II.
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more
RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. The
Gap reports indicate whether the institution is in a position to benefit from rising
interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to
benefit from declining interest rates by a negative
Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate
sensitivity.Each bank should set prudential limits on individual Gaps with the
approval of the Board/Management Committee. The prudential limits should have
a bearing on the total assets, earning assets or equity. The banks may work out
earnings at risk, based on their views on interest rate movements and fix a prudent
level with the approval of the Board/Management Committee.
RBI will also introduce capital adequacy for market risks in due course. The classifica
components of assets and liabilities into different time buckets for preparation of Gap
and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. Ban
equipped to reasonably estimate the behavioural pattern, embedded options, rolls-in
various components of assets and liabilities on the basis of past data / empirical stud
them in the appropriate time buckets, subject to approval from the ALCO / Board. A
approved by the ALCO / Board may be sent to the Department of Banking Supervisio
Background
INTRODUCTION
The importance of extending speedy, efficient, fair and courteous customer service
in banking industry is being regularly emphasised by the Government of India
(GOI) and Reserve Bank of India (RBI). They have set up various high level Working
Groups and Committees which led to considerable improvement in customer

service in Banks

1.2In 1975, the Government of India had appointed the Talwar Committeeon
customer service in banks. In 1990, RBI appointed the Goiporia Committee on
customer service in banks. In 2004, the Tarapore Committee recommendations led
to formation of Board level committees for monitoring customer service in banks.
In 2006, Reserve Bank of India appointed a Working Group to formulate a scheme
to ensure reasonableness of bank service charges under the chairmanship of Shri.
N. Sadasivan. The recommendations of the various Committees / Working Groups
reflected the need of the time in which the Committees / Working Groups were setup. For instance, the Goiporia Committee broadly covered the following aspects:
Causes of the persistence of below par customer service in banks.
Areas of deficiencies in customer service in banks.
Measures for improvement in work culture.
Steps for inculcation of greater customer orientation among bank employees.
Identification of structural and operational rigidities and inadequacies which
adversely affect the working of banks.
Upgradation of technology to ensure prompt and efficient customer
service.
In addition to the guidelines framed based on the recommendations of the
Committees, RBI had been giving instructions to banks as and when required.
Over the years, the customer service in banks has improved considerably with the
introduction of technology based products:
ATM (this has facilitated customer to access cash withdrawal/deposits/
account querying/transfer of funds/payment of utilities/purchase of air/train
tickets 24 X 7).
Internet Banking.
Debit Cards (dispensed the need for carrying cash for making purchases).
Mobile Banking (stage wise implementation) and the youngsters accessing
banking services.
Further, the banking sector has undergone a sea-change from the time when the
previous Customer Service Committees were appointed. There has been a huge
proliferation of bank branches. Further, de-regulation has brought in its wake
numerous banking services, niche products etc. Widespread use of technology also
enhanced the customer expectations, specifically on the aspects of speed and

quality of service delivery. In addition, technology implementation has made

branch banking redundant on many aspects, redefined several of the existing
services and raised customer expectations regarding reasonableness of service
charges. While the bankers hold a view that the introduction of core banking
solution entailed huge cost and the passing of benefit will take some more time till
substantial portion of customers start using technology based products. The
economy is also experiencing demographic dividend, thereby the number of
youngsters accessing banking service is on the increase with the resultant
pressure on providing technology based services.
1.4 Citizens Charter
On the occasion of completing fifty years of independence, the Government of India
introduced the concept of Citizens Charter in the form of a promise to the
consumers from a public authority regarding its performance. The Government of
India directed all Government Departments, public sector undertakings (including
public sector banks) to display a Citizens Charter in each of their offices. The
public sector banks were required
INTRODUCTION to specif
ically indicate the products /
services available and the normal time taken/tariffs to put through customer
transactions. The introduction of the Citizens Charter was an exercise in setting
benchmarks for prompt delivery of banking services (including the pricing thereof)
and any customer not getting the service in the promised time could access the
grievances redressal machinery of the bank.

netrf Banking
s to the remote
s of the country
en

attempted both by the use of technology and change in regulations with the
introduction of Business Facilitators and Business Correspondents of banks.
However, the challenge of the un-banked and under-banked areas is being
addressed by coordinated efforts from banks, Regulator, IBA and
Government.Setting up of the Damodaran Committee on Customer Service
(2010)In the above circumstances, RBI constituted a Committee (through a Board
Memorandum dated May 26, 2010) under the chairmanship of Shri M.
Damodaran, former Chairman, SEBI (Securities and Exchange Board of India) to
look into the customer service aspects. The following persons were the members of
the Committee:
Smt. M. Rajyalakshmi Rao, former member, National Consumer Disputes
Redressal Commission, New Delhi.
Shri Ashok Ravat, Hon. Secretary, All India Bank Depositors Association,
Mumbai.
Shri M.V. Nair, Chairman, Indian Banks Association and CMD, Union Bank
of India, Mumbai.
Shri B.M. Mittal, Chief Executive Officer, BCSBI, Mumbai.
Shri M.S. Sundara Rajan, former CMD, Indian Bank, Chennai.
Shri S. Gopalakrishnan, former Banking Ombudsman, Chennai and former
CMD, Vijaya Bank, Bangalore.
Shri Kaza Sudhakar, Chief General Manager, Customer Service
Department, RBI, CO, Mumbai and Member Secretary to the Committee.
The terms of reference of the Committee was broadly classified into:
a) Review the existing system of attending to customer service in banks approach, attitude and fair treatment to customers from retail, small and
pensioners segment.
b) Evaluate the existing system of grievance redressal mechanism prevalent in
banks, its structure and efficacy and recommend measures for expeditious
resolution of complaints. The Committee may also lay down a suitable time
frame for disposal of complaints including last escalation point within that
time frame.
c) Examine the functioning of Banking Ombudsman Scheme - its structure,
legal framework and recommend steps to make it more effective and
responsive.

d) Examine the possible methods of leveraging technology for better

customer service with proper safeguards including legal aspects in the light
of increasing use of Internet and IT for bank products and services and
recommend measures to enhance consumer protection.
e) Review the role of the Board of Directors of banks and the role of Regulators in
customer service matter
Banking Codes and Standards Board of India (BCSBI)
-A profile
The expectations of customers of banks are generally confined to prompt
delivery of services relating to their deposit accounts, assistance in handling
the ancillary services, transparency in dealings and a helpful attitude to
solve their difficulties. Towards this end, and as a part of the regulatory
process, RBI has been taking various steps over the years to ensure that services
rendered by the banks to customers and common persons meet their
genuine requirements.
However, while the customer expectations have kept rising, the services to
common person have not improved to expected levels. Therefore, RBI in 2003
constituted a Committee on Procedures and Performance Audit in Public Services
(CPPAPS) under Chairmanship of Shri S.S. Tarapore, former Deputy Governor of
the Reserve Bank.
The CPPAPS examined the areas of interaction of customers and common
person with the banks and the quality of service rendered. The Committee in its
various reports covered all facets of banking services like Government
business, foreign exchange business, exchange of currency, etc. to customers of
commercial banks. The Committee recommended that a Banking Codes and
Standards Board of India (BCSBI) should be set up in India as an organization to
evaluate and oversee observance of a code of conduct by banks so that there is
healthy and virtuous pressure on the banks to provide good customer service
on par with best practices.
To fill in the institutional gap and to calibrate the banks against codes and
standards based on best practices, Dr. Y.V. Reddy, Governor, Reserve Bank
in his Monetary Policy Statement on September 2005, announced the RBI
intention to set up a Banking Codes and Standards Board of India as an

independent organization. This Board is expected to function as a watchdog of the

banking industry.
The Governing Council of the Board consists of seven members drawn from
different disciplines such as banking, accountancy, consumer forum, service
industry, etc.
The Board is intended to be a lean organization with minimum overheads.
Relationship between RBI and BCSBI
The Board has been set up as an independent and autonomous
organisation. But it is strongly supported by RBI as RBI would bear the financial
cost of this institution in the initial period of five years in the best interests of the
entire banking system and more particularly the interests of the common person
as customer.
Although the membership of BCSBI is optional, RBI is expected to have more
intensive oversight on banks that do not become members of BCSBI.
Functions of BCSBI
The initiative to establish the Board is driven by the banks themselves as
this would lead to the empowerment of their customers for a higher level of
satisfaction with regard to the services offered, through a significant and
enduring improvement in customer services. Internationally, such codes are
developed by associations of bankers as self-regulatory exercises. The IBA and the
BCSBI have drawn up the voluntary codes in general terms and the codes will be
followed by detailed Guidance Notes on each of the code.
The adherence to the codes by banks will be monitored by BCSBI. The central
task of the Board would, therefore, be to ensure that the subscriber banks file
detailed compliance reports to the Board on observance of voluntary codes
and that they are followed rigorously.
If, after a thorough assessment the Board is still not satisfied with the
compliance, the Board could contemplate sanctions which may include the
following: Follow Name & Shame policy. That is publication by the Board
of the banks name and details of the breach; Inclusion of details of the breach
in the Boards Annual Report; Issue of instructions to banks on remedial action;
Warning or reprimand; Public censure; andCancellation of registration with the
Board. While provisions for penal action exist, the basic approach of BCSBI is

to take collaborative remedial action rather than through penal measures.Of the 79
scheduled commercial banks, 70 banks have enrolledas members of the BCSBI
and have voluntarily adopted the Code of Banks Commitment to Customers.
Chapter 2

Analytics of Monetary (Policy

in India since Independence
Chapter-II
ANALYTICS OF MONETARY POLICY IN INDIA
SINCE INDEPENDENCE

Introduction
Very useful insights on the causes and events that shaped the direction and
pace of an event can be gained by studying its evolutionary process. It is also
useful in guiding the current actions and future plans. This logic tempts to
undertake a purposeful analytical review of policy trends in the sphere of monetary
policy in India, since Independence. Over the last five decades, the conduct of
monetary policy in India has undergone sharp transformation and the present
mode of monetary policy has evolved over time with numerous modifications. In
this chapter, we shall trace the evolution of institutional arrangements, changes in
the policy framework, objectives, targets and instruments of monetary policy in
India in the light of shifts in theoretical underpinnings and empirical realities. This
will serve as a useful guide for the empirical analysis in the following chapters.
The discussion on the historical developments of monetary policy in India can
be carried out with different ways of periodisation. Our method of periodisation is
primarily based on the policy environment. Based on the policy framework, broadly
two distinct regimes can be delineated in the monetary policy history of India,
since
Independence. The first regime refers to the credit-planning era followed since the
beginning upto the mid-1980s. The second is the regime started with adoption of
'money-multiplier' framework, implemented as per recommendations of
Chakravarty Committee (RBI 1985). However, both the regimes command
appropriateness under the circumstances and institutional structure existed
during the respective periods. In the first regime, there was a shift towards a
tightly regulated regime for bank credit and interest rates since the mid-1960s with
emergence of a differential and regulated interest rate regime since 1964, adoption
of the philosophy of social control in 14 December 1967, the event 'bank
nationalisation' in 1969, increasing deficit financing by the government, etc.
Similarly, The post-Chakravarty Committee regime also can be separated into two

sub-periods distinguished by the event of economic reforms of 1991-92. There was

a radical shift from direct to indirect instruments and emergence of a broad, deep
and diversified financial market, with prevalence of greater autonomy, in the postreform period. Thus, the whole period since Independence can be divided into four
subperiodsin our discussion on the historical development of monetary policy in
India.They are
(i) Initial Formative Period, which extends since Independence upto 1963,
(ii) Period of High Intervention (Regulation) and Banking Expansion with social
control since 1964 to 1984, (iii) New Regime of Monetary Targeting with Partial
Reforms, from 1985 to 1991, and (iv) Post-Reform Period with Financial
Deepening,since 1992.
Initial Formative Period (1947-1963)
Prior to the Independence, the broad objectives of monetary policy in India
could be classified as (a) issue of notes, acting in national interest by curtailing
excessive money supply and to overcome stringency where it mitigated production
activities, (b) public debt management, and (c) maintaining exchange value of the
Rupee. In the initial days of Independence, there were some challenges for
monetary operations due to the event of partition and consequent division of assets
of RBI, and its responsibility of currency and banking management in the
transitory phase in the two new Dominions. In Independent India, the advent of
planning era with establishment of Planning Commission in 1950 brought a
directional change in all parameters in the economic management. As bulk of the
actions and responsibilities pertaining to the economic policy rested with the
Planning Commission, other entities of policymaking including the monetary
authority had a supplementary role. However, setting the tone of monetary policy,
the First Five Year Plan envisaged, "judicious credit creation somewhat in
anticipation of the increase in production and availability of genuine savings"
(GOI, 1951). During the First Five Year Plan, monetary management witnessed a
distinguished order with effective coordination between the then Finance Minister
Chintaman Deshmukh, a former Governor of RBI and the then Governor of RBI
Benegal Rama Rau. The RBI decided to withdraw support to the gilt-edged market
signifying the proof of an independent monetary policy (da Costa, 1985). The
initiatives of the Finance Minister to control government expenditure with
emphasis to enhance revenue and capital receipts facilitated such a move. A mere
10.3 percent growth of money supply in the whole First Plan reflects restrictive

monetary policy during this period. In the next two five year plans, conduct of
monetary policy faced unprecedented challenges due to the new initiatives in the
planning regime and the degree of independence enjoyed by the RBI was heavily
curtailed. At the beginning of the Second Five Year Plan, both foreign exchange
reserves and India's external credit were very high for easy availability of required
investments. In this backdrop, under the able leadership of Prof. P. C. Mahalanobis
the plan exercise emphasised on heavy industries. Although, there were notable
success in the front of output expansion mainly lead by industrialisation during
the Second Five Year Plan, there were some setbacks for monetary policy
operations. Firstly, finance minister T. T.Krishnamachari emphasised on
transforming sterling balances into investment goods since 1956-57. The foreign
exchange assets depleted to the extent of Rs. 664 crores during a decade since
then. There was increasing pressure on the RBI to provide credit to the
government. Thus, when the real income (NNP) increased by 21.5 per cent in
Second Five Year Plan, money supply (Ml) increased by 29.4 per cent (da Costa,
1985). During this period, the prices increased by 35.0 per cent contrary to the
magnificent control on it in the First Five Year Plan. 'Selective Credit Control' was
followed during this period as a remedy to overcome the dilemma of controlling
inflationary pressure and need for financing developmental expenditure (Iengar,
1958). Much needed expenditure on infrastructure projects, which was not
immediately productive exerted upward pressure on the prices of consumer goods.
On the other hand, the private sector was to be provided credit for complementary
expansion of investment. Hence, monetary policy did not adopt general tightening
or relaxation of credit but some sectors were provided preferential credit and for
some others the credit was made expensive. In the Third Five Year Plan, the 1962
hostilities with China further added pressure on monetary policy operations. This
was mainly due to the credit requirement of the government for the increasing
defence and developmental expenditure. Thus, money supply (Ml) during this
period increased by as high as 57.9 percent. With only 11.8 percent growth of NNP
in the Third Plan, prices rose by close to 32 percent. Thus, the conduct of
monetary policy became a process of passive accommodation of budget deficits, by
early 1960s. The decade of 1960s witnessed a gradual shift of priority from price
stability to greater concerns for economic growth and accompanying credit control.
A new differential interest rates regime emerged with a view to influence the
demand for credit and imparting an element of discipline in the use of credit.
Under the 'quota-cum-slab' introduced in October 1960, minimum lending rates

were stipulated. This was the beginning of a move towards regulated regime of
interest rates.
Period of High Regulation and Bank Expansion (1964 - 1984)
This period witnessed radical changes in the conduct of monetary policy
predominantly caused by interventionist character of credit policy and external
developments. The process of monetary planning was severely constrained by
heavily regulated regime consisting of priority sector lending, administered interest
rates, refinance to the banks at concessional rates to enable them to lend at
cheaper rates to priority sectors, high level of deficit financing, external oil price
shocks, etc. Inflation was thought to be primarily caused by supply factors and not
emanating from monetary causes. Hence, output expansion was thought to be
anti-inflationary and emphasis was attributed on the credit expansion to step up
output. In the process, the ANALYTICS OF MONETARY POLICY IN INDIA
17 government occupied the pivotal role in monetary management and the RBI was
pushed down to the secondary position. Since the mid-1960s, regulation of the
domestic interest rates became ubiquitous in India. In September 1964 a more
stringent system for bank credit based on net liquidity position was introduced and
both deposit and credit rates were regulated. The introduction of Credit
Authorisation Scheme (CAS) in 1965 initiated rationing of bank credit (RBI, 1999).
With implementation of CAS, prior permission of RBI was required for sanctioning
of large credit or its augmentation. It served the twin objectives of mobilising
financial resources for the Plans and imparting better credit discipline. The degree
of constraints on the monetary authority started mounting up with the measures
of 'social control' introduced by the Government of India in December 1967, which
envisaged a purposive distribution of credit with a view to enhance the flow of
credit to priority sectors like agriculture, small sector industries and exports
coupled with mobilisation of savings. Accordingly, National Credit Council was set
up to provide a forum for discussing and assessing the credit priorities. Credit to
certain economic activities like exports was provided with concessional rates since
1968. The transfer of financing of public procurement and distribution and fertliser
operations from government to banks in 1975-76 further constrained the banking
operations. The rationalisation of CAS guided by recommendations of Tandon
Committee (1975), Chore Committee (1979) and Marathe Committee (1983)
subsequently refined the process of credit rationing. The event of nationalisation of
major commercial banks in July 1969 constitutes an important landmark in the
monetary history of India, which had significant bearings on the banking

expansion and social control of bank credit. The nationalisation of banks led to use
of bank credit as an instrument to meet socioeconomic needs for development. The
RBI began to implement credit planning with the basic objective of regulating the
quantum and distribution of credit to ensure credit flow to various sectors of the
economy in consonance with national priorities and targets. There was massive
branch expansion in the aftermath of bank ANAL YTICS OF MONETARY POLICY IN
INDIA nationalisation with the spread of banking facilities reaching to every nook
and corner of the country. The number of bank branches rapidly increased from
8,262 in 1969 to 13,622 in 1972, which subsequently increased to 45,332 by
1984.These developments had significant implications for financial deepening of
the economy. During this period the growth of financial assets was faster as
compared to the growth of output. The volume of aggregate deposit of scheduled
commercial banks increased from Rs 4,338 crore in March 1969 to Rs 60,596 crore
in March 1984 and the volume of bank credit increased from Rs 3,396 crore to Rs
41,294 crore in between the same period (Table II. 1). Particularly, non-food credit
increased from Rs 3,915 crore in March 1970 to Rs 37,272 crore in March 1984.
The average annual growth rate of aggregate deposits markedly increased from 9.5
per cent for the perio1951-52 to 1968-69 to 19.3 per cent for the period 1969-70 to
1983-84. In between the same period, bank credit increased from annual average
of 10.9 per cent to 18.2 per cent. This period also witnessed growing volume of
priority sector lending, which had not received sufficient attention by the
commercial banks prior to nationalisation. The share of priority sector advances in
the total bank credit of scheduled commercial banks rose from 14 per cent in 1969
to 36 per cent in 1982. The share of medium and large industries in the bank
credit had come down from 60.6 per cent in 1968 to 37.6
per cent in 1982. During this period, monetary policy of the RBI mainly focused on
bank credit, particularly non-food credit, as the policy indicator. Basically, the
attention was limited to the scheduled commercial banks, as they had high
proportion of bankdeposits and timely available data. Emphasis on demand
management through control of money supply was not in much evidence upto mid1980s. Reserve money was not considered for operational purposes as the major
source of reserve money creation -RBI's credit to the government - was beyond its
control. Due to lack of control on the reserve money and establishment of direct
link between bank credit and output, credit aggregates were accorded greater
importance as indicators of the stance of monetary policy and also as intermediate
targets. ANALYTICS OF MONETARY POUCY IN INDIA Among the policy instruments,

SLR was mainly used to serve the purpose of raising resources for the government
plan expenditure from the banks. The level of SLR had progressively increased
from the statutory minimum of 25 per cent in February 1970 to 36 per cent in
September 1984 (Table II.2). Banks were provided funds through standing facilities
such as 'general refinance' and 'export refinance' to facilitate developmental
financing as per credit plans. The instrument of CRR was mainly used to
neutralise the inflationary impact of deficit financing. The CRR was raised from its
statutory minimum of 3 per cent since September 1962 to 5 per cent in June 1973
(Table 11.2). Gradually it was hiked to 9 per cent by February 1984. During this
period, the Bank Rate had a limited role in monetary policy operations. The year
1976 constitutes one of the most eventful period in the monetary thinking in India,
when a heated debate surfaced on the issue of validity of the then
prevailing monetary policy procedure. The first dissenting note came from S.B.
Gupta with his seminal article advocating in favour of 'money-multiplier' approach.
Gupta (1976a) argued that, the then practice of RBI's money supply analysis
simply sums up its various components, and hence merely an accounting or ex
post analysis. It was accused of being tautological in nature. He suggested, money
supply analysis based on some theory of money supply like money multiplier
approach could provide better understanding of the determinants of money supply.
He also highlighted the difference in monetary impact of financing government
expenditure through credit from RBI versus investment of the banks in government
securities. However, RBI economists rejected Gupta's analysis as mechanistic and
unsatisfactory in theory and useless in practice (Mujumdar, 1976) and claimed
that, RBI's analysis provides an economic explanation of money supply in India.
Mujumdar (1976) questioned the basic ingredients of 'money-multiplier approach'
such as stability of the relationship between money supply and reserve
money,controllability of reserve money and endogeneity of money-multiplier, and
stated that, "... in certain years if the expansion in M does not confirm to the
postulated relationship, one has to explain away the situation by saying that the
multiplier itself has changed". He also claimed that, RBI analysis takes into
account both primary money supply through the RBI and secondary expansion
through commercial banks and provides a total explanation of variations in money
supply. As against this, multiplier approach explains only the secondary expansion
through the moneymultiplier. Shetty, Avadhani and Menon (1976) supplemented
Mujumdar in defending RBFs money supply analysis. They argued that, money
supply is both an economicand a policy controlled variable. As an economic
variable it may be determined by the behaviour of the public to hold currency and

bank deposits, but as a policy controlled variable it depends on the monetary

authority's perception about the appropriate level of primary and secondary
money. Thus, they refuted any simple and mechanical relationship between reserve
money and money supply. They completely rejected the appropriateness of
projecting monetary aggregates based on money-multiplier in the short-term due to
erratical behaviour of related coefficients, but they do not rule out usefulness of
long-term projections. On the issue of the relationship between reserve money and
money supply, Shetty et al (1976) asserted that, "it is incorrect of Gupta to
state that the RBI is ignorant of the significance of reserve money in monetary
analysis. The RBI, however, does not consider it as the single element for
explanation of the sources of changes in money supply." At this point a
reconciliatory note came from Khatkhate (1976). He emphasised the usefulness of
'money-multiplier framework' as suggested by Gupta (1976a), but was critical of
him for accusing the RBI being not aware of it. According to Khatkhate (1976),
"Gupta is quite right in suggesting this line, but the difficulty is that it has no
connection with the RBI presentation of monetary data. And what is even worse is
that Gupta does no better than the RBI in proposing his alternative.Towards end of
1970s, there were resentments regarding the way monetary management is
operated in the policy circle. With large part of the monetary reserve outside the
control of monetary authority, the channel of credit allocation to few pockets of the
commercial sector could transmit very limited influence to the real ANALYTICS OF
MONETARY POLICY IN INDIA economic variables. The neglect of issues related to
monetary targeting viewed as an unnecessary byproduct of the preoccupation with
credit targeting. The period 1979-82 witnessed a turbulent phase for Indian
economy. During 1979-80 adverse weather conditions caused record downfall in
foodgrains production. It was accompanied by a setback in industrial production.
The budget nonetheless continued to be expansionary. The budgetary deficit as
percentage of GDP was 2.13 per cent in 1979-80 and 1.82 per cent in 1980-81.
The external sector added to further deterioration of the situation with hike in
prices of petroleum products and fertilisers.All these contributed together towards
prevalence of a widespread general inflation Reserve money growth was explosive
and financial crowding out threatened long run prospects of stable growth. These
macroeconomic developments made the conduct of monetary policy extremely
difficult and progressively brought a sharp shift in monetary policy.
New Regime of Monetary Targeting (1985 - 1991)

In the backdrop of intellectual debate as discussed above and prevailing economic

conditions, it was imperative to comprehensively review the functioning of
the monetary system and carry out necessary changes in the institutional set up
and policy framework of the monetary policy. This was materialised by setting up a
high level committee in 1982, under the chairmanship of Prof. Sukhamoy
Chakravarty. The major recommendations of the Chakravarty Committee include,
inter alia, shifting to 'monetary targeting' as the basic framework of monetary
policy, emphasis on the objectives of price stability and economic growth,
coordination between monetary and fiscal policy to reduce the fiscal burden on the
former and suggestion of a scheme of interest rates in accordance with some valid
economic criteria. Clarifying the stand on monetary targeting with feedback,
Rangarajan (2002) asserts that, c*the scheme of fixing monetary targets based on
expected increase in output and the tolerable level of inflation is far removed from
the Friedmanite or any other version of monetarism." The Committee endorsed the
use of bank reserves as the main operating target of monetary policy and laid down
guidelines relating to the optimal order of the growth of money supply in view of
stability in demand for money. The recommendations of Chakravarty Committee
guided far-reaching transformation in the conduct of monetary policy in India.
There was a shift to a new policy framework in the conduct of monetary policy by
introducing monetary targeting. In addition, recommendations of the Report of the
Working Group on Money Market, 1987 (Chairman: Vaghul) and subsequent move
to activate the money market by introducing new financial instruments such as
182-day Treasury Bills (TBs), Certificates of Deposit (CDs), Commercial Paper (CP)
and Participation Certificates, and, establishment of Discount and Finance House
of India (DFHI) in April 1988 created new institutional arrangements to support
the process of monetarytargeting. It was felt that, the complex structure of
administered interest rate and crosssubsidisation resulted in higher lending rates
for the non-concessional commercial sector. The concessional rates charged to the
priority sector necessitated maintaining the cost of funds i.e. deposit rates at a low
level. Nevertheless, there was a move to activate money market with new
instruments to serve as a transmission channel of monetary policy, within this
administered regime. Gradually, the complex lending rate structure in the banking
sector was simplified in 1990. By linking the interest rate charged to the size of
loan, the revised structure prescribed only six slabs (Rangarajan, 2002). However,
credit rationing continued with its due importance in the new framework to
support the growth process. The share of priority sectors in total non-food credit
rose from 36.9 per cent in 1980-81 to the peak of 43.6 per cent in 1986-87. But,

inadequacy of this system slowly emerged due to problems in the monitoring of

credit thereby causing delays in the sanctioning of bank credit. With the
strengthening of the credit appraisal systems in banks, the CAS lost its relevance
through the 1980s, eventually leading to its abolition in 1988.During this period,
the primitive structure of the financial markets impeded their effective functioning.
The money market lacked depth, with only the overnight interbank call money
market in place. The interest rates in the government securities market and credit
market were tightly regulated. The dispensation of credit to the government took
place via SLR stipulations, where commercial banks were made to set aside a
substantial portion of their liabilities for investments in government securities at
below market rates, known in the literature as 'financial repression'. The
SLR had touched the peak of 38.5 by September 1990 (Table 11.2). As increasing
SLR was not adequate, the RBI was forced to be a residual subscriber. The process
of financing the government deficit involved 'automatic monetisation', in terms of
providing short-term credit to the government that slipped into the practice of
rolling over the facility. The situation was aggravated as the government's fiscal
balance rapidly deteriorated. The process of creating 91-day ad hoc TBs and
subsequently funding them into non-marketable special securities at a very low
interest rate emerged as the principal source of monetary expansion. In addition,
RBI had to subscribe dated securities those not taken up by the market. As a
result, the net RBI credit to the Central Government which constituted about 77
per cent of the monetary base during the 1970s, accentuated to over 92 per cent
during the 1980s (Table II. 1). In such an environment, monetary policy had to
address itself to the task of neutralising the inflationary impact of the growing
deficit by raising CRR from time to time. CRR was mainly being used to neutralise
the financial impact of the government's budgetary operations rather than an
independent monetary instrument. 2.5- Post-Reform Period with Financial
Deepening (1992 Onwards) Indian economy experienced severe economic crisis in
mid-1991, mainly triggered by a balance of payment difficulty. This crisis was
converted to an opportunity by introducing far-reaching reforms in terms of twin
programs of stabilisation and structural adjustment. The financial sector received
its due share of attention in the reform process mainly guided by the influential
recommendations of Narasimham Committee - I (1991) and - II (1998). To curtail
the excessive fiscal dominance on the monetary policy in the spirit of the
recommendations of the Chakravarty Committee (RBI, 1985) and Narasimham
Committee (RBI, 1991), the memorandum of understanding (MoU) was signed
between the Government of India and the RBI in 1994. Consequently, the issuance

of ad hoc TBs was eliminated with effect from April 1, 1997. Instead, Ways and
Means Advances (WMA) was introduced to cope with temporary mismatches. This
was a momentous step and necessary condition towards greater autonomy in the
conduct of monetary policy. As a result, the proportion of net RBI credit to
government to reserve money has substantially come down to close to 50 per cent
in recent years (Table II. 1). Interestingly, this period witnessed the new problem of
coping with increasing inflow of foreign capital due to opening up of the economy
for foreign investment. Foreign exchange reserves increased from mere US $ 5.83
billion in March 1991 to US $ 25.18 billion in March 1995. Presently, foreign
exchange reserves with RBI stand at close to US $ 82 billion. Hence, increase in
foreign exchange assets had a sizeable contribution to raise reserve money in this
period. As a proportion of reserve money, the share of net foreign assets is
increased from 9.1 per cent in 1990-91 to 38.1 per cent in 1995-96 and
subsequently reached 78.1 per cent in 2001-02 (Table II. 1). To negate the effect of
large and persistent capital inflows, RBI absorbed excess liquidity through outright
OMO and repos under liquidity adjustment facility (RBI,2003a). In the post reforms
era, emphasis was placed to develop and deepen various components of the
financial market such as money market, government securities market, forex
market, which has significant implication for the monetary policy to shift from
direct to indirect instruments of monetary control. To widen the money market in
terms of improving short term liquidity and its efficient management, new
instruments such as inter-bank Participation Certificates, CDs and CP were
further activated and new instruments in the form of TBs of varying maturities
(14-, 91- and 364-day) were introduced. The DFHI was instrumental to activate the
secondarymarket in a range of money market instruments, and the interest rates
in money market instruments left to be market determined. The government
securities market witnessed radical transformation towards broadening its base
and making the yields market determined. Major initiatives in this direction
include introducing the system of auctions to impart greater transparency in the
operations, setting up a system of Primary Dealers (PDs) and Satellite Dealers
(SDs) to trade in Gilts, introducing a delivery versus payment (DvP) system for
settlement, adopting new techniques of flotation, introducing new instruments with
special features like zero coupon bonds, partly paid stock and capital-indexed
bonds, etc. All these measures have helped in creating a new treasury culture in
the country, and today, the demand for the government securities is not governed
by solely SLR. requirements but by considerations of treasury management. Now,
the SLR is at the statutory minimum of 25 per cent since October 1997, far below

than its peak of 38.5 per cent in February 1992 (Table II.2). Also, the CRR has
been gradually brought down to the current level of 4.5 per cent (effective from
June 2003) from 10 per cent in January 1997 and 15 per cent in October 1992.
Certain initiatives to reform the foreign exchange market include, inter alia, moving
to full convertibility of Rupee in the current account since August 1994, greater
freedom to Authorised Dealers (ADs) to manage their foreign exchanges, activation
of the forward market and setting up a High Level Committee (Chairman: S.S.
Tarapore) to provide a roadmap for capital account convertibility. All these
measures acted towards making the foreign exchange rate market-determined and
linking it to the domestic interest rates. In the process of reforms, the interest rate
structure was rationalised in the banking sector and there is greater emphasis on
prudential norms. Banks are given freedom to determine their domestic term
deposit rates and prime lending rates (PLRs), except certain categories of export
credit and small loans below 2 lakh Rupees. All money market rates were set free.
The 'Bank Rate' was reactivated in
1997 by linking it to various refinance rates. Because of all these reforms, we find
today, interest rates in various segments of the financial market are determined by
the market and there is close association in their movement, as discussed in detail
in Chapter 5. The developments in all the segments have led to gradual broadening
and deepening of the financial market. This has created the enabling conditions for
a smooth move towards use of indirect instruments of monetary policy such as
open market operations (OMO) including repos and reverse repos. The operation of
LAF has been used as an effective mechanism to withdraw or inject liquidity on
day-to-day basis and providing a corridor for call money rate. In June 2002, RBI
has come out with its Short Term Liquidity Forecasting Model to evaluate the short
term interaction between the monetary policy measures and the financial markets,
which will be immensely helpful for imparting discipline once started operation.
Because of reforms in the financial market, new interest rate based transmission
channels have opened up. Importantly, this period has witnessed emergence of
monetary policy as an independent instrument of economic policy (Rangarajan,
2002).To sum up, this chapter undertakes an analytical survey of evolution of
monetary policy in India. We observed that, the existing policy regime an
institutional arrangements constrained monetary management in the pre-reform
period. Monetary policy during this period was limited to credit rationing. The key
segments of the financial market in India are developed only in the post-reform
period and the interest rates were deregulated. Recently, there has been greater
emphasis in short-term liquidity management in monetary policy operation with

emergence of a broad-based and developed financial market. In the new

environment, the operating procedure and monetary transmission mechanism are
completely transformed. These observations will guide our econometric analysis of
monetary policy in India in the following chapters.

Conclusion

Factory output in June grew 8.8 per cent over the corresponding period last year,
outstripping the consensus growth rate of 5.5 per cent forecast by 23 economists
polled by Bloomberg. This sets the stage for another round of interest increase by
Reserve Bank of India (RBI) in September.
The factory output data comes on the heels of a week of largely negative global
developments that threaten to eventually affect the Indian economy. Despite the
adverse implications of global factors on India, RBI is likely to continue with its
policy of increasing rates in the near future as the domestic inflation rate will
increase for a while longer. The second round impact of end-June's increase in the
price of diesel is expected by economists to show up over the next couple of
months, pushing inflation higher.
The deterioration in the global scenario primarily on account of fears that the
sovereign debt crisis in Europe may spread and the US economy may slip into
recession may, however, begin to exert more influence on RBI's actions after
September. By the last quarter of 2011, a more comprehensive picture of the way in
which the US Federal Reserve plans to respond to the country's economic situation
may be apparent. If the US Fed chooses to go through the third round of expanding
its balance sheet to revive the economy (QE 3), RBI's task of managing the
"impossible trinity" - an independent monetary policy, partly managed exchange
rate and a liberalized capital account - would become more challenging on account
of a part of the newly created liquidity finding its way into India. At that point,
global developments may have a greater influence on monetary policy as compared
to domestic factors.
Home buyers in for trouble as RBI hikes key rates yet again
For the moment, RBI's 26 July monetary policy statement is likely to be the
dominant influence. It emphatically stated that RBI's foremost priority today is to
rein in inflation, and the thrust of monetary policy would be in the direction of
meeting this objective. On Friday, Subir Gokarn, RBI's deputy governor, who was in
Delhi for a meeting, repeated the message of the July policy on the central bank's
determination to combat inflation.June factory output data, as measured by the
Index of Industrial Production (IIP), was driven primarily by a 10 per cent growth in
manufacturing. IIP has been a volatile indicator of economic performance. Since
the beginning of the last financial year, IIP has ranged between 13 per cent and 4

per cent. According to Gokarn, RBI typically juxtaposes IIP with other indicators
before it reaches a conclusion on the state of economy.More than the growth in IIP,
the strength of consumer demand in India appears to be driving monetary policy.
As the 26 July policy and the subsequent interaction of RBI governor, D Subbarao,
had with the media indicated, the central bank feels consumer spending will
remain robust. Consequently, it has used interest rate as the primary tool to pull
back demand and, thereby, lower the price level in the economy
Inflation can be brought down: RBI
The next policy announcement is scheduled for September 16, when the central
bank is likely to announce its 12th interest rate increase since March 2010. The
primary policy rate, that is, the repo rate stands at 8 per cent. Repo rate is the rate
which RBI lends money to banks.The deterioration in the global scenario, which
includes last week's unprecedented lowering of US's long-term rating by a notch to
AA+ by Standard & Poor's, has led to mixed conclusions about the direction of
monetary policy.For instance, two research reports released after Friday's factory
output data reached different conclusions. Deepali Bhargava, economist at ING
Vysya Bank, wrote she expected RBI to hike repo rate by 25 basis points (one basis
point is one-hundredth of a percentage point) in its September policy
announcement