India - Financial Sector Development Project

Document of The World Bank Report No. 13740-IN STAFF APPRAISAL REPORT INDIA FINANCIAL SECTOR DEVELOPMENT PROJECT FEBRUARY 24, 1995 Country Operations, Industry & Finance Division South Asia Country Department II  CURRENCY EQUIVALENTS (As of January 15, 1995) Currency Unit = Rupee (Re/Rs) US$1.00 = Rs 31.37 Re 1.00 = US$0.032 MEASURE I crore = 10 million DEFINITION Basis Point: one hundredth of one percent GOVERNMENT FISCAL YEAR April 1 to March 31  ABBREVIATIONS AND ACRONYMS ALM - Asset-Liability Management BF - Backstop Facility CAR - Capital Adequacy Ratio CAS - Country Assistance Strategy CRISIL - Credit Rating Information Services of India CRR - Cash Reserve Ratio DBOD - Department of Banking Operations and Development (RBI) EB - Eligible Bank or Financial Institution participating in the Backstop Facility DFI - Development Finance Institutions DOS - Department of Supervision (RBI) GDP - Gross Domestic Product GDR - Global Depository Receipt GOI - Government of India HRD - Human Resource Development ICB - International Competitive Bidding ICICI - Industrial Credit & Investment Corporation of India IDBI - Industrial Development Bank of India IFC - International Finance Corporation IFCI - Industrial Finance Corporation of India IMF - International Monetary Fund LCB - Local Competitive Bidding LIBOR - London Inter-Bank Borrowing Rate MIS - Management Information System MTR - Mid-term Review OD - Operational Directive PB - Participating Bank POS - Point of Sales RBI - Reserve Bank of India SBI - State Bank of India SCL - Single Currency Loan SEBI - Security Exchange Board of India SFA - Subsidiary Finance Agreements SLR - Statutory Liquidity Ratio TM - Treasury Management UTI - Unit Trust of India   INDIA FINANCIAL SECTOR DEVELOPMENT PROJECT Table of Contents LOAN AND PROJECT SUMMARY ........................... i I. BACKGROUND ....................................... 1 II. ECONOMIC DEVELOPMENTS AND PROSPECTS 1................ III. THE FINANCIAL SECTOR REFORM PROGRAM 3 Description of Financial Institutions 3 Historical Perspective and Key Problems. 5 GOI's Financial Reform Program. 6 Medium-term Strategy for Bank Restructuring .10 Broadening the Ownership Base of Public Sector Banks .12 Developing Government Securities Markets .13 Development Capital Markets .13 Reforming the Rural Credit System .14 Summary .15 IV. BANK GROUP ASSISTANCE AND STRATEGY ................. 15 V. THE PROJECT ....................................... 16 Project Objectives and Description ......... .................... 16 Capital Restructuring ..................................... 18 Modernization and Institutional Development ...................... 24 Backstop Facility ....................................... 26 Project Costs and Financing . ................................ 30 Proposed Financing Plan . .................................. 31 Procurement ....................................... 32 Disbursement ....................................... 36 Accounts and Audits ..................................... 36 VI. PROJECT IMPLEMENTATION ........ .................... 37 This report is based on findings of a World Bank appraisal mission that visited India in August/September 1994. The mission consisted of Messrs./Mmes. Mansoor Dailami (Mission Leader and Task Manager), Paul Beckerman (SA2RS): Diana McNaughton (FSD); Ramasastry Ambarish (FODD3); Vikas Sahasrabudhe (PMDTR); Patchamuthu Illangovan (ASTEN); Donald Carlson, King Lowe, and Stanley Silverberg (consultants). A subsequent post-appraisal mission, consisting of Luis Emesto Derbez (mission leader), Mansoor Dailami (SA2RS). Paul Beckerman (SA2RS); William Nickel (SA2AG); Mohan Gopal (LEGSA); Odo Habeck (FSD); and Rohil Hafeez (SASVP), visited India in January 1995. The Division Chief is Luis Emesto Derbez and Director, Heinz Vergin.  VII. PROJECT BENEFITS AND JUSTIFICATION ................ 40 VIII. AGREEMENTS TO BE REACHED AND RECOMMENDATION .... 44 Capital Restructuring Loan . ............................... 44 Modernization and Institutional Development Loan ................ 45 Backstop Facility Loan . ................................ 46 All Three Loans ..................................... 48 Recommendation ..................................... 48 ANNEXES Annex I: Financial Markets and Institutions .................... 49 Annex II: List of Bank's Previous Financial Investment Projects in India . . . 53 Annex III: Review of Participating Banks ...................... 54 Annex IV: Institutional Development of Nationalized Banks ........... 57 Annex V: Rating Agencies in Banking ....................... 74 Annex VI: The Industrial Development Bank of India .............. 78 Annex VII: Project Details and Summary Costs .................. 84 Annex VIII: Schedule of Estimated Disbursements ................ 105 Annex IX: Supervision Plan ............................. 106 Annex X: Environmental Aspects ......................... 108 Annex XI: Procurement ................................ 112 Annex XII: Documents in Project File ....................... 134  INDIA FINANCIAL SECTOR DEVELOPMENT PROJECT LOAN AND PROJECT SUMMARY Borrowers: India and the Industrial Development Bank of India (IDBI). Guarantor: India (for the loans to IDBI). Beneficiaries: Borrowers and depositors at participating banks; companies and exporters requiring term credit in foreign exchange. Amount and Terms: US$700 million equivalent consisting of: (a) a US$350 million currency pool loan to India for capital restructuring at the Bank's standard variable rate, repayable over 20 years with five years of grace; (b) a US$150 million currency pool loan to IDBI for bank modernization and institutional development at the Bank's standard variable rate, repayable over ten years with three years of grace; and (c) a US$200 million single currency loan (SCL) lent in US dollars to IDBI for a Backstop Facility at the Bank's LIBOR-based variable lending rate, repayable over 14 years with eight years of grace. Project Objectives: The project aims to foster greater market orientation, allocative efficiency, technical competence and competition in India's financial system and contribute to meeting the long-term financing needs of its investors as a means of stimulating economic growth. It would assist the Government of India (GOI) to sustain financial liberalization, institutional development of public sector commercial banks and integration into the global capital markets. It would facilitate expansion of private equity ownership in public sector commercial banks and development of term foreign currency lending. Project Description: The project would consist of the following three components: (a) Capital restructuring under the project would support selected nationalized commercial banks which commit to plans for increasing private equity through public offerings and modernization initiatives. Such support would be through subordinated loans from GOI to strengthen their capital base as required by capital adequacy norms. (b) The project would support a modernization and institutional development program focused on building financial strength and long- term competitiveness in a more liberalized business and banking environment. It would foster actions in the following areas: (i) strategic  - 11 - planning, (ii) automation and computerization of payment and accounting functions, (iii) human resource development, (iv) organizational improvements, and (v) enhanced capability in the areas of asset-liability, credit and treasury management. (c) The Backstop Facility (BF) would assist eligible Indian banks and financial institutions in India (EBs) to source private funds to meet rapidly expanding demand for foreign currency term loans. It would assist in meeting such demand from small- and medium-sized companies with foreign exchange earnings and exporters whose direct access to offshore markets is hampered by high issue costs. The BF would provide a medium-term liquidity assurance at a market-related price to EBs by offering them the option to borrow funds from the BF at a market-related price representing a market perception of systemic disruption. Onlending Arrangements: (a) Recapitalization Loan. A US$350 million equivalent loan to GOI would be onlent to participating conmmercial banks for their recapitalization as subordinated loans. These loans would be repayable over 12 years with a grace period of up to five years, would be denominated in rupees, and would carry a floating interest rate linked to GOI's 364-day treasury bill plus a margin of 50 basis points. GOI would bear the currency and interest rate risk. Up to one-half of subordinated loan funds designated for recapitalization would be provided after the relevant commercial banks adopt and start implementation of satisfactory business plans, and the remaining funds would be made available following issuance of equity to private shareholders. Participating banks (PBs) would in turn onlend the proceeds of Bank loan to eligible sub-borrowers at prevailing market rates. (b) Modernization Loan. A World Bank US$150 million equivalent loan to IDBI guaranteed by India would be onlent to participating commercial banks for implementing their modernization and institutional development plans. Subloans would be repayable over ten years with grace periods of up to three years and would be charged variable market lending rates. (c) Backstop Facility Loan. A World Bank US$200 million SCL to IDBI, guaranteed by India, would support the establishment of the BF. In the event that a benchmark interest rate spread widens beyond a stipulated amount, EBs would be entitled to drawdown loans from the BF at a floating rate of interest equal to US dollar six-month LIBOR plus a spread set at the time each backstop commitment is made, and would have maturities of up to seven years. Subloans extended by eligible  - 111 - banks to eligible firms would be priced with a market-determined margin. Rate of Return: Not applicable. Poverty Category: Not applicable. Benefits: The proposed project would: (a) help bring about a greater degree of market orientation, allocative efficiency, technical competence and competition in the financial system as a whole, (b) facilitate sourcing of private funds and access to foreign currency finance to meet long-term investment financing needs; and (c) foster modern banking practices and services. The expansion of private sector ownership of public sector banks and the associated change in the composition of their boards of directors would enhance management autonomy within the existing regulatory framework and would reorient banks' business goals and strategies towards achievement of profitability, improved customer services, and higher efficiency. The reinvigoration of competition in financial markets brought about by deregulation of interest rates and entry of new private banks would reinforce such tendencies, with tangible economic benefits in terms of narrower interest rate spreads and lower cost of capital. In addition, enhanced access to foreign currency term finance through the BF would reinforce the prospect for sustainable export expansion and private capital flows. Efficiency and profitability in banking operations would be encouraged by system-wide adoption of automation and modern banking practices. The SCL terms for the BF would also help to reduce currency and interest rate risk for IDBI, eligible banks and sub-borrowers. Risks: Main project risks relate to: (a) the ability of PBs to restore profitability and health sufficiently within the project period to be able to maintain the required capital adequacy ratio, (b) their ability to adjust successfully to the new environment of intensified competition, (c) adverse macroeconomic developments that would erode the quality of banks' portfolios; and (d) adverse external developments that would negatively affect the supply of external funds to domestic financial institutions. The first risk is mitigated by the facts that PBs have intensified their loan recovery efforts over the past year and that GOI has taken meaningful actions to strengthen the loan recovery legal framework, and increase the banks' ability to operate under greater autonomy rules and with more commercially oriented credit criteria. The second risk would be reduced by GOI's commitment to expand private sector ownership in public sector banks and subject the banks to more stringent supervision and exposure to market forces. The third and fourth risks are considered small at present because of sustained improvements in macroeconomic conditions, particularly in India's external accounts.  - iv - Estimated Project Costs: Project Component Local Foreign Total -----(USS million)----- Capital Restructuring 1,157.2 0.0 1,157.2 Bank Modernization 84.6 113.1 197.7 Backstop Facility 0.0 200.0 200.0 Total Baseline Costs 1,241.8 313.1 1,554.9 Physical Contingencies 8.3 11.3 19.6 Price & Foreign Exchange Contingencies -47.8 7.4 40.4 TOTAL PROJECT COSTS' 1,202.3 331.8 1,534.1 Financing Plan: Local Foreign Total --(US$ million)----- IBRD 384.4 315.6 700.0 GOI 618.4 0.0 618.4 Participating Banks 199.7 16.0 215.7 TOTALS 1,202.5 331.6 1,534.1 Estimated Loan Disbursements:2 FY95 FY96 FY97 FY9 FY99 FY00 FY01 ------------------(US$million)------------- Annual 75.0 128.8 99.7 84.5 54.7 40.6 16.7 Cumulative 75.0 203.8 303.5 388.0 442.7 483.3 500.0 Including taxes and duties of US$24.5 million equivalent. 2 Excludes projections for BF-related disbursements.  INDIA FINANCIAL SECTOR DEVELOPMENT PROJECT I. BACKGROUND 1.1 India's financial system is undergoing significant change as a result of the overall liberalization measures carried out since July 1991. Initiatives aimed at developing a healthy, efficient and market-oriented financial system have already resulted in interest rate deregulation, development of market instruments for pricing public debt and bank loans, upgrading of India's regulatory and accounting standards to international norms, greater freedom to banking institutions to allocate credit in accordance with market signals, and adjustment of monetary policies and exchange rate management for an increasingly liberalized and open economic environment. 1.2 The key elements of the financial reform agenda have been articulated in several official statements, and have been debated in the press and Parliament for securing approval for necessary legislative changes, gaining the consent of bank employee unions to extend modern technology and automation in banks, and pacing judiciously the sequencing of financial policy reform with broader macroeconomic stabilization efforts. The Government of India's (GOI) strategy emphasizes permitting private ownership in public sector banks up to a 49% ceiling, market discipline through reinvigorating competition and opening international capital markets to Indian corporate borrowers either directly or indirectly through intermediation of India's financial institutions, and market-based incentive methods of credit delivery to small farmers, village artisans, small-scale industries, and women entrepreneurs. This strategy also fosters greater efficiency and bank responsiveness to client needs through the adoption of technological and operational innovations and institutional development. 1.3 A Financial Sector Development Project is proposed to support the initial phase of India's financial liberalization program. The project would consist of three components: capital restructuring of eligible banks; bank modernization and institutional development; and promoting the expansion of foreign currency term lending. The project would be the Bank's first for India's financial sector. It would also be the first for India that seeks, through the proposed Backstop Facility, to catalyze and improve the ability of the financial institutions and banks to raise foreign currency funds through market-based instruments in the domestic foreign exchange market. The project is consistent with the Bank's assistance strategy to India presented to the Board in May 1994 which recognizes the increasing role of private market financing flows and the need for supporting a broad-based private sector-led growth. II. ECONOMIC DEVELOPMENTS AND PROSPECTS 2.1 In the four decades after its independence, India pursued a dirigiste approach to economic development, which involved tight control of industrial investment, a highly protective trade regime with a multiplicity of discretionary import licenses, high tariffs and numerous quantitative restrictions, and establishment of a large number of public enterprises by the central and state governments, often with monopolistic positions in many core sectors. Faced with a balance of payments crisis of unprecedented proportions and severe macroeconomic imbalances, the government that came into power in June 1991 initiated a program of bold stabilization and structural reforms  - 2 - aimed at promoting rapid and sustainable growth in income and employment, coupled with more effective and efficient public interventions to reduce poverty and raise human capital performance. These initiatives have stimulated a reassessment of the nature of public and private interaction to ensure social equity while at the same time reaping the benefits of broad-based private-led growth and closer integration into the world economy. 2.2 Structural reforms concentrated on trade and payments regimes, the tax system, and investment regime. Trade and payments regimes have been liberalized significantly. The rupee has been made convertible at the market rate on the current account, and India acquired Article VIII status in the IMF with effect from August 20, 1994. Quantitative controls and licensing of both imports and exports have been reduced substantially. Most intermediate and capital goods are now imported freely and the average tariff rate has been reduced gradually from 87% in 1991 to 33 % in 1994. Progress has also been made to simplify and rationalize the tax system. New measures include: reduction of corporate tax rates from 45 and 50% to a unified 40%; simplification of the central excise tax system by a shift from specific to ad valorem taxes, a reduction in the number of rates and exemptions, and the extension of the scope of the modified VAT; and broadening the tax base. The environment for private sector development has improved significantly since 1991: The number of sectors reserved for public enterprises has been sharply reduced; prior government approval for investment, largely abolished; foreign investment, significantly liberalized; and control on prices and distribution of some key commodities, eliminated. As a result, key sectors of the economy such as mining and infrastructure (including power, telecommunications, air transport, and banking) are now open to private investors. 2.3 The fiscal deficit has been reduced, although not to the extent expected. After a reduction from 8.4% of GDP in 1990/91 to 5.7% in 1992/93, the central governmnent deficit increased again to 7.3% of GDP in 1993/94. Tax revenue shortfalls due to weak growth of industry and imports were partly responsible for the fiscal slippage, but expenditure overruns had also a strong impact on increased deficit. A target deficit of 6% of GDP for FY95, predicated on the basis of buoyant tax revenues resulting from a strong industrial recovery and GOI's efforts to contain expenditures, may be slightly missed. With interest payments claiming over one-half of central government fiscal revenues, major efforts are needed to consolidate fiscal adjustment because the sourcing of financing the fiscal deficit is shifting from low-cost forced financing through the Reserve Bank of India (RBI) and the banking sector towards market borrowing. Recent estimates indicate that to keep the central government's debt at the current level relative to GDP, the fiscal deficit will have to decline further beyond the 6% target set for 1994/95--a difficult task under current conditions in the country. 2.4 Despite the uneven performance in the public sector deficit, progress on the structural front has bolstered foreign investors' confidence in the Indian economy and has resulted in a large increase in capital inflows from US$150 million in 1991/92 to about US$5 billion in 1993/94, contributing to a large accumulation of foreign exchange reserves which reached US$19 billion as of end-November 1994 (equivalent to nine months of imports). Managing such large capital inflows requires maintaining a delicate balance of macroeconomic policy mixes in the short-run while putting in place a stable financial framework to channel resources to productive investment and export expansion for the long-run. In the face of GOI's policy of keeping the nominal exchange rate stable, accommnodating such capital inflows has contributed to an excessive domestic monetary expansion and to a real appreciation of the rupee, which if left unattended may have adverse implications for  - 3 - export growth in the future. Fully aware of this problem, GOI has incorporated into its macroeconomic program measures to slow down capital inflows and control their negative impact in the economy. As a result, the pace of capital inflows has fallen in recent months. As production and demand for foreign exchange recover and financial sector reforms help reduce interest rate differentials between India and the rest of the world, pressure on the competitiveness of the rupee from capital inflows is expected to decline. 2.5 India's economy has reacted favorably to the reform program. Inflation fell to 10% as of December 1994 from 17% in August 1991. External accounts benefited substantially from reforms: Export growth reached 20% in 1993/94 in current dollars. Import growth being stagnant, the current account deficit declined from 3.5% of GDP at the beginning of the reform program to 0.3% in 1993/94. For 1994/95, export growth is expected to be 18% and the current account deficit, under 1 %. After growing relatively modestly over the last three years, GDP is expected to grow by over 5 % in the current year based on strong recovery in industrial output and continued good agricultural production. III. THE FINANCIAL SECTOR REFORM PROGRAM Description of Financial Institutions3 3.1 India's financial system is one of the largest in the world with a broad variety of banking, financial and capital market institutions and instruments. The combination of a high domestic savings rate (averaging 24% of GDP in the 1990-94 period) and the country's success in lowering inflation led to a high rate of resource mobilization. Financial assets in the form of bank deposits and corporate securities held by Indian residents now amount to 108% of GDP, up from 19% in the early 1970s (Table 3.1). 3 A detailed description of key institutional and infrastructural features of India's financial system is provided in Annex 1.  - 4 - Table 3.1: Composition of India's Financial Assets: End-July 1994 Rs billion % of GDP Money (M3): 4620 57.6 Currency 962 12.0 Current and Saving Deposits 680 8.5 Term Deposits 2978 37.1 Short-term Debt 251 3.1 Treasury bills 209 2.6 Commercial Paper 42 0.5 Long-term Debt a/ 2679 33.4 GOI debt 2160 26.9 Corporate Debt 220 2.7 State Government's debt 299 3.7 Equity 4862 60.6 held by: mutual Funds, 1070 13.3 directly by Investors 3792 47.2 a/ As of end March 1994. Sources: Reserve Bank of India and CMIE. 3.2 Established in 1934, RBI is the central bank of the country. It performs the traditional central banking roles of note issue and banker to the government and commercial banks. It formulates and implements monetary and credit policy, manages the foreign exchange market, and regulates and supervises all commercial banks, financial institutions and non-bank finance companies. Its prudential regulations include: minimum capital requirements, qualifications for directors, limits on loan concentration and insider borrowing, and guidelines for asset classification and income recognition. RBI has powers to levy fines and penalties for non-compliance and also intervene in the management of a bank if serious problems arise. It also provides deposit insurance to small depositors through a subsidiary, the Deposit Insurance and Credit Guarantee Corporation. 3.3 The banking system consists of a network of 81 commercial banks, 169 regional rural banks and 180 central and state cooperative banks. Since nationalization in 1969 and 1980, the commercial banking sector has been dominated by public sector banks (currently 27) which account for nearly 83% of deposits and 92% of bank branches. Their widespread network of 45,000 branches enables them to raise deposits countrywide to service an asset base of Rs 3,520 billion (US$112.2 billion), or 50% of GDP as of March 1993, including an investment portfolio of Rs 1,009 billion, or 14.3% of GDP. With the recent entry of four new private domestic and two foreign banks, private commercial banks currently in operation consist of 28 Indian and 26 foreign banks, each accounting for about 6% of total assets. 3.4 Other financial institutions include: (a) three term-lending institutions (Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), and Industrial Financial Corporation of India (IFCI)) at the national level; (b) 18 state finance corporations; (c) specialized institutions providing financial assistance to exporters, agriculture,  housing, tourism, small-scale industry and venture capital; and (d) non-bank finance companies, comprising leasing, housing-finance, and hire-purchase finance companies. The three important all- India term-lending institutions (ICICI, IDBI and IFCI), with total assets of US$19 billion as of end- March 1994, dominate India's term lending market. They provide medium- and long-term financial assistance to the private corporate sector for new projects, as well as the expansion and modernization of ongoing operations either directly or through consortium arrangements with commercial banks. These institutions had traditionally funded themselves through issuance of government-guaranteed domestic bonds and foreign lines of credit from multilateral and bilateral sources. However, compelled by the recent adjustment program, they have started tapping local and foreign financial markets. ICICI and IFCI have private shareholdings of 48% and 30%, respectively, and the IDBI Act was amended in October 1994 to authorize it to raise private equity capital from the market. Table 3.2: Indicators of banking sector size and employment Assets Assets Branches Employees (Rs billion) (X of total) (000's) Scheduled Commercial Banks * 4037 100.0 46281 930 A. State Bank of India Group 1285 31.8 12586 304 B. Nationalized Banks 2235 55.4 30315 576 C. Private Banks 516 12.8 3380 50 a. Domestic 190 4.7 3240 37 b. Foreign 326 8.1 140 13 Term Lending Institutions ** 594 100.0 37 5 D. Industrial Credit and 151 25.4 8 1 Investment Corporation of India E. Industrial Development Bank of 346 58.2 36 3 India F. Industrial Finance Corporation 97 16.4 17 1 of India Regional Rural Banks * 99 100.0 14543 70 * As of March 31, 1993. ** As of March 31, 1994. Source: Balance Sheets of respective institutions. Historical Perspective and Key Problems 3.5 Until the recent reforms begun in 1991, financial services were among the most controlled and regulated of all economic activities in India. In the capital markets, pricing of corporate capital issues was controlled by GOI, and the insurance and mutual fund industries were the exclusive purview of the public sector. Commercial banks were subject to a complex set of interest rate restrictions, high cash reserve requirements, high mandatory holding of government securities, directed lending, and detailed and restrictive norms governing credit operations. Social and fiscal objectives evolved to dominate interest rate determination and credit allocation. In the face of persistent fiscal deficits, interest rates on government debt were deliberately kept low to alleviate the debt service burden. Under these circumstances, marketing of government debt involved imposition of mandatory investment in government securities through the stipulation of the Statutory Liquidity Ratio (SLR) on commercial banks and other captive financial institutions. With interest rates serving primarily as a fiscal tool, monetary management depended on quantitative credit  controls, sector-specific rediscount facilities, and a high Cash Reserve Ratio (CRR) requirement. The combination of SLR and CRR imposed a marginal pre-emption of 28 % of bank deposits in the early 1950s, increasing to 63.5% by 1991. In addition, banks were required to allocate a large proportion of their lending to designated priority sectors, comprising agriculture, small-scale industries, and weaker sectors of society, with a large proportion at concessional rates (para 3.12). 3.6 GOI nationalized the largest Indian commercial banks in two rounds--14 in 1969 and six in 1980. Nationalization achieved many of GOI's initial goals, including extending banking services to all parts of the country and channelling resources to the public and socially designated sectors. However, it proved costly to the banking industry: First, the potential to impart subsidies through credit allocation to sectors such as agriculture and small-scale industries without explicit budgetary support had a strong populist appeal in India's democratic system, and over time became an important source of bureaucratic interference as well as micro-management. Second, the emphasis on meeting social objectives tended to divert supervisory attention away from asset quality and provided a rationalization for bad lending by bank management. Third, nationalization prompted a strong bank employee union movement that resisted introduction of modern communication and computer technologies with the result that Indian banks have lagged behind in the adoption of the technological innovations which have swept the financial service industry worldwide. These shortcomings have had an adverse impact on the quality of customer services of banks, their efficiency and financial health. The transition to a broad-based, private sector-led path begun in July 1991 has exposed the financial system's overall weaknesses as regards providing resources at internationally competitive rates, contributing to industrial restructuring, and financing the massive infrastructural investment needs of India. GOI's Financial Reform Program 3.7 The liberalization of India's financial system has been one of the main components of GOI's economic reform policy launched in July 1991. GOI established a high-level committee (the Narasimham Committee) in August 1991 to consider all relevant aspects of the structure, organization, functions and procedures of the financial system. This committee's report was presented in Parliament in December 1991 and was followed by several other specialized committee reports which dealt with more specialized aspects of financial sector reform. These have provided the basis for GOI's program of financial sector reform, which over the past three years has been debated in the press, deliberated in Parliament and articulated in several official statements. The adopted strategy has the following key components: (a) liberalization of financial policies in pace with GOI's program of fiscal and balance of payments adjustment; (b) restoration of health to banking institutions through introduction of international standards of prudential regulations for asset classification, income recognition, provisioning requirements and adoption of Basle Accord capital adequacy norms for commercial banks and term lending institutions, establishing an improved legal mechanism for the recovery of non-performing loans, and recapitalization of public sector banks;  (c) reinvigoration of competition in financial service industries through entry of the private sector in the banking and mutual fund industries, opening India's capital markets (with the exception of government securities market) to foreign investment, allowing large and reputable Indian corporations to tap Euro-issues markets and lowering/removing various administrative barriers to competition in the term lending market; (d) broadening the ownership of public sector banks by permitting them to issue equity (up to 49% of their paid-up capital) in the capital market, enhancing managerial autonomy in line with increased private shareholder representation on boards of banks, and transforming these banks into competitive and commercially-oriented business enterprises; (e) development of an active government securities market involving regular auctioning of treasury bills and long-dated securities, and secondary trading in the newly established National Stock Exchange as a basis for better management of monetary policy and development of a deep and liquid debt market; and (f) initiating reform of the rural credit system as an important part of India's overall strategy of moving to a market-oriented financial system. Considerable progress has been achieved in all the above areas, as summarized below. 3.8 Deregulating Interest Rates. Over the past three years RBI has simplified administrative controls on the interest rate structure. It has reduced the multiplicity of bank lending rates, removed most restrictions on banks' issuance of certificates of deposit (a minimum denomination remains), and freed interest rates on debentures and most public sector bonds (other than tax-free bonds). With its Credit Policy Statement of October 1994, RBI has also removed the minimum lending rate applicable to commercial bank advances exceeding Rs 200,000 (US$6,400). This is a major step in interest rate liberalization that will enhance competition in the banking sector and foster new risk-hedging instruments such as floating rate notes, note issuance facilities and revolving underwriting facilities in Indian financial markets. The key remaining administrative interest rate restriction is the ceiling on term deposits for maturities of 46 days and beyond. In pacing the timing for the lifting of this ceiling, GOI is conscious of the need to first improve banks' financial soundness, internal controls, asset-liability management capabilities and communication systems to ensure that complete deregulation of deposit rates does not endanger the stability of the banking system. 3.9 Liberalizing Credit Norms. Along with the measures adopted to deregulate interest rates, steps have been taken to liberalize credit norms governing major areas of bank operations. Indian banks were subject to cumbersome sector-specific credit norms and obligatory consortium arrangements for loans exceeding a certain magnitude. In its successive credit policy statements over the past two years, RBI has announced several important measures, including raising the loan size above which consortium lending is mandatory, liberalizing selective credit controls applicable to sensitive agricultural commodities, allowing banks more leeway to decide levels of collateral and other requirements for particular loans, and removing the limit on banks' purchases of bonds of  - 8 - public sector undertakings. These reforms have removed many impediments to competition in the commercial banking industry and should serve to increase lending efficiency. 3.10 Reducing the Statutory Liquidity Ratio (SLR). Envisaged initially as a prudential measure, commercial banks in India are required to invest a proportion of their demand and time liabilities in approved central and state government guaranteed debt securities. The yields on such investments were until recently below those available on comparable market instruments. The management of the central government fiscal deficit since 1991, in conjunction with GOI's increasing reliance on market borrowing, has provided the scope for a reduction in the SLR from 38.5% in 1991 to the current level of 31.5%. GOI has announced publicly that the SLR would be reduced to 25% by March 1996, but due to unforeseeable monetary policy exigencies, it considers it inadvisable to commit publicly to precise intermediate targets. However, as yields on government bonds have improved and have been brought to market levels, the burden on banks' profitability from the imposition of the SLR has been totally eased, with the consequence that commercial banks in 1993/94 increased sharply their investments in government and other securities as part of their overall efforts to meet capital adequacy norms. 3.11 Reducing the Cash Reserves Ratio (CRR). GOI intends to increase the flexibility and effectiveness of the CRR as a tool of monetary policy. To that end it has reduced the CRR on incremental deposits from 25% in 1991 to 15% at present and intends to phase out its remuneration. The medium-term goal is to enhance the efficacy, independence, and operation of monetary policy by: (a) phasing out monetization of the fiscal deficit by RBI via ad-hoc treasury bills over a period of three years; and (b) reducing the CRR significantly to a level consistent with reliance on open market operations as the basic day-to-day instrument of monetary control. In implementing this policy, the Finance Minister proposed in the 1994-95 Union Budget to limit GOI's recourse to RBI financing through ad-hoc treasury bills over 1994/95 to Rs 60 billion, representing two-thirds of 1 % of GDP. To ensure strict adherence to this limit, RBI has been empowered to sell the ad-hoc treasury bills issued by GOI, should these exceed Rs 90 billion (1 % of GDP) for more than ten consecutive working days any time during the year. This arrangement has recently been codified in a signed agreement between the Ministry of Finance and RBI. This agreement would increase the scope for reducing the CRR, improving the conduct of monetary policy and enhancing the autonomy of RBI. 3.12 Rationalizing Priority Sector Lending Schemes. A policy of priority sector lending requirements emerged in the late-1960s as part of efforts to meet the credit needs of agriculture, small-scale industries, and the weaker sections of the population such as the scheduled caste/tribes, women and minorities. Over the years the lending target to the priority sectors has been raised from 33% to the current statutory level of 40% of net bank credit, with guidelines set for sectoral and group allocations. Priority sector lending expanded further in 1980 with the Integrated Rural Development Programme (IRDP), a nationwide program of poverty alleviation and promotion of self- employment for the poor. With considerable progress already achieved in reducing concessionality through narrowing of interest rate differentials between priority sector borrowers and others, GOI's strategy for rationalizing priority sector lending is now geared to enhance banks' discretion in selecting more creditworthy borrowers and application of tightened prudential norms to all loans, including priority sector loans. In addition, GOI is developing more cost-effective mechanisms of credit delivery, possibly including informal self-help groups, to reach weaker sections of society, particularly in the rural areas. Developing a workable approach to meet the credit needs of India's  - 9 - rural economy on a financially sustainable basis hinges on reforming India's massive rural credit system (paras 3.29-3.30). 3.13 Introducing New Regulatory Norms. While the health of India's public sector commercial banks deteriorated over time, such decline had until recently been masked by lax regulatory and accounting norms. The previous asset classification norms under which loans were classified into eight health codes ranging from 1 (best) to 8 (worst) involved a significant degree of subjectivity and suffered from two major shortcomings: (a) income was recognized on an accrual basis rather than on actual recovery of cash; and (b) banks were not required to make sufficient provision for non-performing loans. To address such shortcomings and bring India's bank regulatory framework closer to international standards, RBI issued new guidelines in April 1992 for income recognition, asset classification and provisioning requirements and adopted the Basle Accord capital adequacy standards. Banks are now required to classify assets into four categories (standard, substandard, doubtful and lost), cease accruing interest income on non-performing loans and make prudential provisions against probable future losses. These norms have been tightened progressively over the past two years. Before these changes, a loan could be overdue for as long as four quarters (as of March 1993) and three quarters (as of March 1994) before being classified as substandard. For the current fiscal year ending March 1995, a loan can be overdue for only 180 days before being so classified, which is consistent with international practice. In terms of provisioning, banks must provide 10% against substandard loans, 20-50% against the unsecured portions of doubtful loans, and 100% against loss loans. The application of these norms brought to light the financial weakness of many public sector banks in India. For the public sector banks as a whole, non-performing loans amounted to 23.4% of the total loan portfolio, or 11.7% of total assets as of end-March 1993. The banks' March 1993 financial statements showed capital adequacy averaging 2.5% (ranging from -9.6 to 7%), and gross profits in relation to total assets ranging from -2.4 to 1.8%. 3.14 Complementing the tightening of regulatory norms, RBI is taking steps to improve its capacity to monitor the new standards by adding off-site inspection activities to its current mix of techniques. Until now, RBI had emphasized on-site inspection as the means to carry on banking supervision and although its inspection procedures and methodologies were well developed, on-site inspection activities tended to be wide-ranging, requiring banks to submit many complex "returns" for analysis by RBI's experts. Since actual data submission was largely manual and actual processing within the RBI not fully rationalized, access to basic information about the banks' portfolio remained limited with the result that it reduced the quality of the supervision performed by banking authorities, inspectors and other interested persons. To resolve this problem, RBI has defined a three-year program to improve its banking supervision capacity. Priorities within this program are: (a) to develop a highly automated off-site monitoring capability, not only for commercial banks but also for non-bank financial intermediaries and All-India (Development) Financial Institutions; (b) to improve substantially the efficiency and effectiveness of on-site inspection, largely through effective use of off-site supervision. As part of planned activities, RBI has defined: (i) procedures by which commercial banks communicate the data to the Department of Bank Supervision (DOS); (ii) improvements in DOS's capacity to process, store and evaluate the data received; and (iii) training of supervision staff to enable them to make effective use of computer technology and better portfolio evaluation. These activities will be supported an ODA-funded program to improve RBI's supervisory function (para 5.2).  - 1( - Medium-Term Strategy for Bank Restructuring 3.15 The recognition of the poor finanicial situation of India's public banks, as revealed in 1992/93, provided the impetus for GOI's re-examinationi of the role of public sector banks in India's financial system and highlighted the need to adopt a medium-termii strategy to restore health and soundness to the banking system. Acknowledging that the losses revealed in public sector banks' accounts stemmed from a combination of past restrictive policies, organizational and management shortcomings, and inadequate supervision, GOI's reform program has included actions to reduce and eventually eliminate such problems. For a long time both bank managers and regulatory authorities focused excessively on quantitative indicators, such as growth of total lending and sectoral deployment of credit, rather than on credit quality and the capacity of borrowers to service loans. As regards smaller borrowers, repayment discipline suffered because of politically motivated loan waivers. The recovery of large loans was imlpeded by court delays in debt recovery suits, the cumbersome process of corporate restructuring and closure, and willful defaults. Incorporating lessons learned from a large number of hank rescue efforts carried out in both developed and developing countries since the mid-1980s. India's emerging strategy containis the following key elements: 3.16 Rehabilitating Weak Banks. Five of the 20 nationalized banks were classified as "weak" banks, requiring special attention and having the greatest need of restructuring. RBI entered into specific agreements with these banks to curb their expenses and improve their operating efficiency. The banks were asked to: rationalize their organizational structure by reducing unnecessary layers of management, cease acquiring buildings and incurring new capital expenditures; stop recruiting new personnel except for specialists in computerization and other key areas; and, apart from certain existing commitments, stop opening new offices and cleanse their asset portfolios by fully provisioning against lost portfolio accounts. Tlhese banks vary significantly in size, location, and nature of underlying problems. Therefore, a turn-around program has to be tailor-made to each specific case. One small bank, the New Bank of India, was mlerged with the Punjab National Bank in 1993, a bank with an established track-record of success. To deal with the other four banks, RBI appointed a group of consultants in November 1994 to review their operations and suggest turn- around strategies within tllree months. This study will determine whether the banks can be turned around effectively and allowed to retain their independent identities, or should be merged or made subsidiaries of other banks. 3.17 Improving Recovery of Non-Performing Loans. Recognizing that weakness in the legal framework has been a major cause of delay in recovery of bank loans, GOI has adopted a number of measures to enhance the effectiveness of the law to improve debt recovery, including speedy resolution of the large number of pending suits against defaulters. A major step was Parliament's adoption of the Recovery of Debts Due to Banks and Financial Institutions Act (1993) establishing special tribunals for expeditious adjudication and recovery of debts. Such tribunals have already been established in Bombay, Calcutta, and Delhi and are expected to begin operations during calendar year 1995. In addition, GOI is planning further steps, including monitoring of recovery actions against top defaulters, establishing a credit information system, and streamlining laws governing the creation and enforcement of mortgages. In reinforcing actions taken to strengthen the legal apparatus, GOI is urging banks to intensify their own recovery efforts by advising their line managers that their recovery performance will heniceforth take on a far heavier weight in their performance evaluations. To reinforce this message, GOI has indicated to all public commercial  - 11 - banks that the current infusion of capital (paras 5.8-5. 11), will be the last one obtained from budget sources, and that a fundamental element in the capacity of banks to expand their business will lie in their ability to increase their profitability ratio, which will, at least in the initial two years of the program, strongly depend on their ability to increase their non-performing asset recovery levels. 3.18 Raising Profitability. International experience indicates that improvements in managerial autonomy and the cleaning up of bank balance sheets and restoring them to health has proved more successful and enduring when it is combined with banks' own efforts to improve profitability through increasing operational efficiency. Analysis of banks' profitability in India demonstrates the importance of loan portfolio quality, operating efficiency and management quality. To improve earnings sufficiently so that banks can provide most of their future capital needs, loan quality will have to improve dramatically. The percentage of future loans that becomes non- performing will have to decline to less than 5 %, which will require important behavioral changes by bank management and bank supervisors, which is expected to come in part from the increase in equity participation from non-government sources and the representation of private sector investors in the banks' boards of directors (para 5.12). With respect to operating efficiency, future control of expenses, better use of personnel, and strengthening of internal controls through computerization and automation will be essential. 3.19 Infusing Government Capital. To improve the banks' capital/asset situation, GOI has provided considerable budgetary support over the past year to nationalized banks for which it has been the sole shareholder. GOI injected Rs 57 billion (US$1.82 billion) in January 1994 in the form of 12-year bonds yielding 10% annual interest. As a condition of release of funds, GOI reached agreement with the banks' managements on performance criteria for the year ending March 1994. The proposed budget for 1994/95 provides an additional Rs 56 billion in assistance for nationalized banks, of which a total of Rs 38.8 billion was allocated to 13 banks in December 1994. In view of the fact that banks' financial performance improved in 1994, the remaining part of the budgetary appropriation has not been allocated. 3.20 The program has started to yield results. As of March 1994, overall financial statements indicated a considerable improvement in the banks' financial health. Gross profits (i.e., before provisions) improved due to a combination of factors: (a) the banks' cost of funds fell faster than lending rates over the year; (b) portfolio investment yields rose as the banks increased the proportion of newer, higher-yielding term securities in their portfolios; and (c) recovery and upgrading of non-performing assets were successful. Some of the better performing banks--notably Canara Bank and Oriental Bank of Commerce--ended March 1994 with capital adequacy in excess of 8%. 3.21 Promoting Competition. Reinvigorating competition among banks constitutes a key element of GOI policy to raise efficiency and improve bank performance. In January 1993 RBI announced guidelines for entry of new commercial banks. These were intended to ensure that new entrants are well-capitalized, technically competent and technologically advanced, and that there would be no adverse consequences from practices such as concentrations of credit or cross-holding with industrial groups. RBI has so far issued 11 licenses for setting up banks, and four have already started operations (one with equity investment of 9.87% from IFC). Two others are in an advanced stage of operations start-up. These new banks are expected to have widely-held private sector equity ownership and to meet the capital adequacy norm of 8% from their inception. Approval has also  - 12 - been given to four new foreign banks to set up operations in India, and existing foreign banks have been allowed to expand their branch networks. In addition, foreign banks have recently been allowed to have equity participation of up to 20% in the equity of new private banks. 3.22 GOI also opened the mutual fund industry to domestic and foreign participation, and in 1992 allowed domestic companies in good standing to tap international capital markets. Private mutual funds began operations in 1993/94 and managed to mobilize about 13% of total funds mobilized by all mutual funds in the same year. More than 30 large Indian corporations have raised over US$3 billion through issuance of Global Depository Receipts (GDRs) and foreign currency convertible bonds in offshore markets since September 1992. Broadening the Ownership Base of Public Sector Banks 3.23 Expanding Private Equity. Considerable progress has been achieved over the past three years in expanding private sector ownership and management participation in public sector banks. The Banking Regulation Act (1949) and the Banking Companies (Acquisition) Acts (1970 and 1980) were amended in May 1994 to allow private equity participation in the capital of nationalized commercial banks up to 49% of their paid-up capital as part of their recapitalization and restructuring efforts. Amendments to the State Bank of India (SBI) Act and the SBI General Regulation Act to facilitate public issue of shares by SBI were promulgated in October 1993. The IFCI Act (1948) was repealed and IFCI converted into a public limited company in July 1993. Following this conversion, IFCI successfully made an initial public offering in December 1993 that introduced 38% private ownership in its equity. The IDBI Act (1964) was amended authorizing it to raise capital in the market. The Banking Regulation Act (1949) was amended in January 1994 to raise the ceiling on the exercise of voting rights of individual shareholders in private commercial banks from 1 to 10% of total voting rights of all shareholders. 3.24 Enhancing Managerial Autonomy and Governance of Banks. To reinforce measures giving banks greater freedom in credit allocation and pricing decisions, GOI recognizes the need to enhance managerial autonomy and improve bank governance. To that end it established a high-level committee to review the governance of public sector banks, including the procedures for selecting of directors of banks' boards and statutory auditors as well as developing human resources. Based on this committee's recommendations and consistent with the constitutional mandate to ensure equality of employment opportunity and special reservations, GOI has taken action to provide increased autonomy in: (a) day-to-day business operations, (b) recruitment of bank officers (including specialists in such areas as technology, treasury, and forex operations), and (c) staff promotion. Bank staff salaries will also be determined in negotiations with bank employee unions within the framework of public sector guidelines and practices. Management autonomy in public sector banks has also increased through reconstitution of their boards of directors to give them more professional orientation and provisions for representation by private shareholders. A schedule for increasing private sector representation has been announced whereby from the total number of Board members (15), private shareholders will elect two board members once their equity ownership reaches 20% of total equity, which will increase to four and six board members as private ownership increases over 20% up to 40% and over 40% up to 49%, respectively.  - 13 - Developing Government Securities Markets 3.25 The move toward a more liberal interest rate policy and adoption of a risk-based, capital-adequacy framework have reinforced the need to develop a broad and active market for government securities to facilitate secondary trading and orderly absorption of new issues. Outstanding government debt consists of instruments issued by the central and state governments, as well as government-guaranteed securities issued by financial institutions and other public sector agencies. About 60% of this debt is held by commercial banks and another 30% by insurance companies to meet stipulated reserve requirements. RBI acts as the agent for GOI, and holds and manages government securities on its own account for open market operations. In April 1992 RBI introduced fortnightly auctions of 364-day treasury bills. The auction procedure was extended subsequently to include five- and ten-year dated securities. As part of the overall effort to phase out automatic monetization of the fiscal deficit, in January 1993 RBI began auctioning 91-day treasury bills, which had previously been eligible for refinancing at RBI at a flat 4.6% rate. 3.26 GOI is conscious of the need to develop markets in government securities as part of its overall program of promoting long-term debt markets. In view of India's large and well-developed financial system (including a robust equity market and individual investor base of over ten million), the current environment of moderate inflation, declining interest rates, and portfolio restructuring by commercial banks, the stage is set to move rapidly to improve auction procedures and create a network of well-capitalized government securities dealers for reaching a larger pool of potential investors. With technical assistance from the IMF, RBI has recently developed an action plan to introduce a system of primary dealers in government debt to provide adequate underwriting capacity to act as market-makers in secondary markets, thereby providing needed liquidity. This plan is expected to be announced in the near future. Trading in the secondary market would foster the establishment of a market yield curve for rupee funds in Indian financial markets--a prerequisite for developing India's long-term debt market. Developing Capital Markets 3.27 With the relaxation of restrictions on foreign investment in the past two years, India's equity market has attracted significant non-debt financial resources from foreign institutional investors such as mutual funds, pension funds, and insurance companies seeking international asset diversification. At the same time, the opening of the equity market to foreign investors has highlighted the need for continued reform of capital markets, including: (a) developing a deep and liquid corporate bond market; (b) creating the necessary policy and regulatory framework for modernization of securities depository and clearing systems; (c) strengthening the regulatory framework for investor protection; and (d) reforming the insurance industry. To that end, GOI has introduced important measures over the past two years: The Capital Issues (Control) Act has been repealed, and consequently governmental control over the issuance and pricing of capital by corporations via the Controller of Capital Issues has been removed. Statutory power has been given to the Securities Exchange Board of India (SEBI) to regulate the functioning of securities markets and securities industry intermediaries and oversee corporate acquisitions and takeovers. GOI has directed the Stock Holding Corporation of India Ltd to establish a National Clearing and Settlement System and a Central Depository Trust for Securities. In addition, in an effort to enhance investor protection, SEBI has issued detailed  - 14 - guidelines governing the various stages of public capital issues, in particular, the obligations of underwriters. SEBI has also made several important changes, including registering secondary market intermediaries, establishing a customer protection fund and an Investor's Grievances Cell in each stock exchange, broadbasing the governing bodies of the stock exchanges, and increasing the number of members of stock exchanges. 3.28 As regards insurance reform, the GOI-appointed Malhotra Committee has submitted its report with a strong recommendation to introduce competition in the industry by eliminating the monopoly power of the two government-owned insurance corporations--the Life Insurance Corporation and General Insurance Corporation. The proposed reforms cover: (a) conditions for entry of private sector firms and uniform treatment for all market participants by eliminating special dispensations for public sector firms, (b) changes in the structure of mandated investments and rates to permit greater operating efficiency, (c) establishment of a regulatory agency to ensure protection of consumer interests and compliance with norms, and (d) restructuring the two large public sector companies with a view to reducing GOI's equity holding through phased disinvestment. These proposals are now under consideration by GOI. Reforming the Rural Credit System 3.29 India's rural financial system comprises 28 state-level cooperative banks, several state land development banks, about 26,000 rural commercial bank branches and 196 Regional Rural Banks (RRBs), which are jointly owned by GOI, state governments and sponsoring commercial banks (comprising 15,000 branches). In addition, the National Bank for Agriculture and Rural Development (NABARD) provides term loans for agricultural projects, funding itself in turn from a combination of foreign credit and bonds (which are eligible for SLR). Credit growth in these institutions in total has stagnated in real terms since 1980, and the rural credit system as a whole faces a number of institutional and policy problems. GOI recognizes that many of the existing difficulties are attributable to government interventions and the inherent misalignment of incentives, both on the part of the borrower and the lender. Servicing loans to a large number of borrowers and mobilizing resources through small deposits are inherently expensive, and this has depressed profitability. In addition, deep-seated operational problems have developed since the early 1980s. The performance of the RRBs has been particularly poor. The service area approach, which restricted the lending operation of the RRBs, implied considerable loan concentration and low loan recovery. About 75 % of RRBs have suffered losses, and 117 out of a total of 196 have accumulated losses in excess of their share capital. Also, failure to mobilize adequate deposits, mounting overdues and lack of trained staff have implied that cooperative banks have small borrowing membership, low business turnover and large accumulation of losses. 3.30 Since the recommendations of the Agricultural Credit Review Committee (Khusro Committee) in 1989, consensus has emerged on the need to move toward a more market-driven and incentive system of promoting credit delivery, restructure the RRBs, and improve the capabilities of cooperative banks to function as intermediaries. Several important measures already taken include: (a) increased discretionary RRB lending through reduced directed lending from 100 to 40% and greater freedom in their branch rationalization; (b) increasing the share capital of NABARD, enlarging the scope of its activities, and requiring it to enter into  - 15 - memoranda of understanding with state governments and District Cooperative Banks to revamp the cooperative system; and (c) providing tax incentives to commercial banks for advances to the rural sector. In October 1994, interest rates of rural/agricultural cooperative banks were deregulated (subject to a minimum lending rate of 12%). Summary 3.31 Over the past three years, GOI has formulated a comprehensive program of financial liberalization, which it has implemented in pace with its program of fiscal adjustment and macroeconomic stabilization. The success achieved in stabilizing the economy has provided a favorable macroeconomic context within which important reforms have been implemented including reduction in reserve requirements on commercial banks, deregulation of lending rates, stimulated competition in financial markets, increased bank freedom to allocate credit according to market signals, and improved management of public debt through regular auctioning of government paper. As banks' accounts have been disclosed, bank performance and managerial competence have become objects of market scrutiny and public debate. These reforms have helped to establish a sound framework for strengthening banking institutions, broadening financial markets, and strengthening regulatory and supervisory frameworks to ensure the soundness of the system. IV. BANK GROUP ASSISTANCE AND STRATEGY 4.1 The Bank's strategy for India, presented in the Country Assistance Strategy of May 1994, emphasizes support for the economic reform program started in 1991. It recognizes the need to encourage broad-based private sector-led growth and the increasing role of private market financing flows to fuel this growth. The strategy also recognizes that accommodating foreign private capital inflows on the scale that has recently been experienced in India will require a more stable long-term financial sector framework to channel these flows toward productive investment, which would expand India's export base and enhance its international competitiveness. 4.2 To date, the Bank had funded numerous operations through financial institutions for India's industrial, agricultural, and housing sectors, and recently has agreed to finance an industrial pollution control project.4 In the past, the dialogue on financial sector issues focused on onlending interest rates, exchange rate risk, credit line performance and overall institutional performance. The broader issues of the reform of the overall financial system, the health of banking institutions and the adequacy of the regulatory and supervisory framework were introduced more explicitly in the dialogue when GOI requested the Bank's assistance for its program of financial sector reforms in November 1991. Discussions with GOI continued in that context until March 1994 when the case for supporting GOI's financial reforms through an investment operation was justified. In response to GOI's request for Bank assistance, the 4Annex 11 presents a list of financial intermediary projects in India financed by the Bank.  - 16 - proposed operation was conceived as a sector investment project to support India's financial liberalization and modernization efforts. 4.3 The proposed project would be the first in which the Bank would assist India to implement fundamental reforms and modernization of its banking sector. It would also be the first in catalyzing and improving the ability of the financial institutions and banks to source directly private foreign currency markets in order to fund their foreign currency term loans. The focus envisaged for the project would reflect fully the Operational Directive on Financial Sector Operations (OD 8.30) which requires that Bank operations related to the financial sector have a sound financial sector policy framework, with particular emphasis on minimizing credit distortions, ensuring effective accounting and supervision, and supporting financially sound autonomous financial institutions. The project would also be consistent with OD 8.30 in moving away from the traditional Bank credit lines through a few selected intermediaries towards multiple intermediaries with built-in incentives for improvement of participating financial intermediaries and competition in the financial system as a whole. In addition, the reforms envisaged under the project would help establish a sound sectoral policy framework within which the scope of the Bank's future support for India's financial sector would be expected to extend to include the modernization of the payment system and capital markets as well as reform of the rural credit system. 4.4 The project would also improve the environment for future IFC activities in India, which have increased significantly as trade and financial sector reforms have begun opening the economy and liberalizing financial markets. India is now the largest client of IFC. As of end- December 1994, IFC's India portfolio included 83 operations, supported by a variety of instruments including loans, syndications, equity and quasi-equity participation, swaps, and underwritings with a cumulative commitment of US$1.6 billion in a number of subsectors, including financial services. Its operations in financial services have gathered momentum in recent years as the impact of financial sector reforms and opening of international capital markets to domestic companies have begun to be felt. IFC assists the development of the domestic capital market by directly financing private sector financial service firms, venture capital and mutual fund companies, and joint ventures in private commercial banks and by providing technical assistance for capital market development. Continuation of financial reforms and particularly development of foreign currency term lending supported by the proposed project would open up possibilities for non-funded lending by IFC, such as loan option facilities and stand-by loan arrangements. V. THE PROJECT Project Objectives and Description 5.1 The project aims to foster greater market orientation, allocative efficiency, technical competence and competition in India's financial system and contribute to meeting the long-term financing needs of its investors as a means of stimulating economic growth. It would assist GOI to sustain financial liberalization, institutional development of public sector commercial banks  - 17 - and integration into the global capital markets. It would facilitate expansion of private equity ownership in public sector commercial banks and development of term foreign currency lending. (a) Capital Restructuring. The project would facilitate private equity ownership in public sector commercial banks by making their shares more attractive to potential private sector investors in India's capital markets. Expansion of private equity in public sector banks would: (i) improve the governance of banks by subjecting the banks to the discipline of a private shareholder base; and (ii) reorient their business goals and strategies towards achieving profitability, improved customer services, and higher efficiency. Access to the private capital market would also offer such banks the opportunity to strengthen their capital base independent of GOI's budget. Replenishment of public banks' capital constitutes a key element of GOI's strategy of enhancing the banking system's stability and competitiveness. (b) Bank Modernization and Institutional Development. Initiatives supported under the project would enhance the efficiency and profitability of the six participating banks (PBs) by extending automation and computerization of banking operations and by encouraging modern banking practices. In addition to equipment requirements, the project would fund specialist services and training to facilitate this modernization effort. (c) Backstop Facility. The Backstop Facility (BF) would assist eligible financial institutions and banks in India to meet rapidly expanding demand for US dollar term loans sourced with private funds. It would assist in meeting such demand from small- and medium-sized companies with foreign exchange earnings and exporters whose direct access to offshore markets is hampered by high issue costs. The BF would provide a medium-term liquidity assurance at a market-related price to banks and financial institutions in India (EBs) by offering them the option to borrow funds from the BF under specified terms and conditions. Under the BF EBs would extend medium- to long-term foreign currency loans to eligible firms and would fund such loans through market borrowings such as certificates of deposit and notes. Conditions under which EBs would access the Facility for drawdown of funds would reflect the widening of a benchmark interest rate spread due to market disruptions. 5.2 ODA Assistance. The project would benefit from separate but complementary technical assistance being considered by the Overseas Development Administration (ODA) of the UK that would help in the transition from direct intervention in the financial intermediation process towards indirect intervention through regulation and supervision of the commercial banking operations. This grant assistance would build RBI's capacity to put in practice a modern and efficient bank supervision and surveillance system. RBI, the Bank and ODA collaborated in defining appropriate technical assistance to be funded under the ODA grant to ensure consistency between this and of the project's recapitalization component. ODA would finance activities supporting RBI's efforts to develop its off-site monitoring system. Technical assistance would operate over three years. It would assist RBI in implementing planning activities, acquisition of technical equipment for data processing and training of its staff to improve its overall monitoring capacity. Progress in the following areas would be monitored:  - 18 - (a) new data-gathering forms introduced in 1995, (b) physical site preparation for installation of new computer facilities in RBI's Department of Supervision (DOS) by late-1995; (c) training in basic computer skills to DOS personnel no later than December 1996; (d) rationalization of data inputs with a view to reduce the regulatory burden on commercial banks during 1996; (e) development of RBI's communication systems for data input both at its Bombay headquarters and its regional offices during 1996/97; and (f) development of a training curriculum for RBI officials involved in inspection activities during 1996. Detailed Features of the Project Capital Restructuring (US$1,157.2 million)5 5.3 The project would foster expansion of private equity ownership through a program of recapitalization that would strengthen participating commercial banks' balance sheets. Recent legislative and policy changes have removed statutory obstacles to private equity partnership in India's public sector banks and have provided for increased managerial autonomy and private sector representation on their boards (para 3.24). Public commercial banks that commit to plans to increase private equity through public offerings within 1-4 years would be entitled to subordinated loans from GOI to strengthen their capital base to the extent required to fulfill newly-established RBI capital adequacy norms. They would also be entitled to financial and technical assistance for modernization and institutional development in priority areas of strategic planning, automation, human resource development, and asset-liability, credit and treasury management (para 5.14(e)). Offer documents for public equity offerings by commercial banks are reviewed by the Securities Exchange Board of India as well as GOI, and are required to meet disclosure and regulatory requirements as well as market performance standards. The market for bank shares in India has expanded recently and gained depth with initial public offerings by several public sector banks as well as by new private banks that have entered the market over the past year, giving assurance that the PBs will succeed in placing their equity offerings. 5.4 The use of subordinated debt would be employed in the proposed recapitalization process for three reasons: First, capitalization through subordinated debt with an associated fixed maturity of repayment profile would provide the banks with the necessary transitional capital infusion to strengthen their capital base, which could be retired once banks are able to issue equity in the private market. Second, capitalization through subordinated debt would allow banks to move to a more optimal capital mix and therefore to a lower cost of capital by taking advantage of the more favorable tax treatment of interest payments on debt (i.e., interest 5 Base costs.  - 19 - payments are deductible against profit whereas dividend payments are not).6 Third, while subordinated debt from GOI does not have the force of market discipline as expected from private market sources, it would nevertheless provide GOI with a vehicle for monitoring banks' performance and progress.7 5.5 Participating Banks (PBs). Out of the 19 nationalized commercial banks, six have been selected for participation in the project8: Allahabad Bank, Bank of India, Dena Bank, Indian Bank, Indian Overseas Bank, and Syndicate Bank. These banks were selected by the Government for the project because their needs for recapitalization required external assistance in the short-term, and accepted by the Bank because of its profit prospects which would allow them to satisfy capital requirement over the span of the project. The selected banks have wide geographical representation, with headquarters in four metropolitan centers: Bangalore, Bombay, Calcutta, and Madras. At end-March 1993 they accounted for 32% of the nationalized banks' assets and 20% of all commercial banks' assets. Banks were excluded from the project because either they were under stringent supervision by RBI or it was concluded that they could not implement within a reasonable time period institutional reforms sufficient to attract private sector investors. As part of the process of meeting eligibility criteria, the selected banks prepared and provided to the Bank detailed business plans outlining their institutional development needs and strategies, recent financial performance and projections, and plans for public offerings of equity shares to reach up to 49% equity participation currently allowed. 5.6 The key financial and institutional indicators for the PBs are summarized in Table 5.1 below. All PBs are large institutions with staff numbers ranging from 16,000 to 53,000 and branches from 1,121 to 2,389. Total assets as of end-March 1994 ranged from Rs 60 billion (US$2 billion) to Rs 255 billion (US$8 billion). Each bank has a lengthy performance record, starting as a private bank and operating since 1969 or 1980 as a nationalized bank with, until recently, considerable government control and interference. The six PBs all accumulated losses in 1992/93 and 1993/94, and are now in a turnaround process of restoring profitability. Despite much-improved performance in 1993/94, by March 1994 these banks still had large volumes of non-performing loans ranging from 9.8 to 17.4% of total assets, as well as low profitability and 6 Once the banks eliminate their accumulated net losses they will be subject to a corporate income tax rate of 46% including a surcharge of 15%; the dividends they would pay on Tier I equity issues would be after-tax (see Annex I for taxation of financial institutions). Also, it is important to note that to the extent that subordinated debt increases a bank's leverage and leads to an increase in volatility of profit, it has an adverse impact on the market value of the bank's shares. This effect, however, is likely to be more than offset in the Indian context for two reasons: First, the market incorporates in its pricing of a bank's shares the positive impact of higher capital on bank's ability to expand assets in the future. Second, through subordinated debt GOI can monitor the bank's performance better than through an equity infusion. 7 Except in the US bond market where investors are particularly sensitive to banks' strengths and weaknesses, in other countries where commercial banks have issued subordinated debt, the market has generated a flat cost curve due to deposit insurance schemes and government bail-out of failing banks. 8 These banks are described in Annex 111.  - 20 - inadequate capital positions.9 To reach the stage at which these banks can issue shares successfully in India's capital markets, they must: (a) replenish capital lost in recent years; (b) establish solid profitability track records to provide assurance that they can pay adequate dividends while leaving sufficient retained earnings to sustain their capital adequacy against growing risk-weighted assets; and (c) implement institutional development programs successfully to assure potential investors that they can withstand vigorous future competition. As provided under a Presidential Ordinance (January 21, 1995): (i) GOI has been empowered to reduce its paid-up capital in nationalized commercial banks up to 75 %, against accumulated loan losses, and (ii) banks have beein authorized, with GOI and RBI approvals, to reduce excess capital. Banks which hold private equity after public offerings, have the authority to reduce their capital in any manner approved by a special majority of shareholders. This will facilitate the process of tapping the capital market. 9Two of the participating banks that had posted negative net profits in 1992/93 and 1993/94 (Bank of India and Indian Overseas Bank) attributed a large share of their problems to losses in overseas branches. Unsuccessful projects, sovereign lending and adverse exchange rate movements all contributed to these losses.  - 21 - Table 5.1: Financial and Institutional Indicators of Participating Commercial Banks (as of March 31, 1994) Allahabad Bank of Dena Indian Indian Syndicate Bank India Bank Bank Overseas Bank Bank A. Assets (Rs billion) 96.81 254.85 61.25 136.46 131.32 121.00 of which: a. Advances 37.22 109.22 21.58 67.81 53.40 39.81 b. Investments 38.25 72.95 23.46 38.87 47.70 49.64 B. Costs and Profits (X of total assets) 1. Gross Income 9.9 8.9 9.8 10.7 9.3 9.3 Interest Income 9.1 7.8 8.9 9.5 7.4 8.5 Other Income 0.8 1.1 1.0 1.2 1.9 0.8 2. Gross Expenses 13.7 13.1 11.0 13.6 12.0 11.8 Interest Expenses 7.2 5.7 6.3 7.7 6.4 6.1 Operating Expenses 2.5 2.3 2.9 2.6 2.6 3.2 Provisions & Contingencies 4.0 5.1 1.8 3.2 3.0 2.5 3. Interest Spread 1.9 2.1 2.5 1.8 1.0 2.4 4. Net Profit -3.8 -4.3 -1.1 -2.9 -2.7 -2.5 5. Return on Assets a/ 0.2 0.8 0.6 0.4 0.3 0.0 C. Loan Quality, Provisioning and Capital Adequacy (percentage or as indicated) 6. NPAs as % of Loan PortfoLio 25.3 30.0 23.9 26.8 33.1 29.4 7. NPAs as % of TotaL Assets 10.8 14.8 9.8 15.0 17.4 11.6 8. Provisions as % NPAs 38.6 39.9 29.5 28.1 53.5 48.8 9. Capital Adequacy Ratio -0.6 0.7 6.0 3.5 0.3 0.3 D. Branch, Employment and Productivity 10. Branches 1845 2389 1121 1409 1407 1558 Domestic 1845 2367 1121 1407 1401 1557 International N.A. 22 N.A. 2 6 1 11. Employees (in thousands) 22.89 53.75 16.55 25.81 25.97 36.54 12. Productivity (Rs million per employee) 5.32 6.02 4.28 7.20 6.22 3.86 /a Return on Assets is defined as the ratio of Gross Profit to Total Assets. /b Productivity per employee is defined as the ratio of Deposits plus Advances to Total number of employees. N.A. : Not Applicable. Source: Published balance sheets and financial statements as of March 31, 1994. 5.7 Recapitalization. RBI has accepted the Basle Accord as the guiding framework for commercial banks and term lending institutions and has required all Indian commercial banks to achieve capital adequacy ratios (CAR) of at least 8% of risk-weighted assets by March 31, 1996 (March 31, 1995 for banks with foreign operations). At least one-half of the capital must be in the form of Tier I, or core capital, consisting of paid-up capital and reserves less any accumulated net losses and any equity holdings in banking subsidiaries that are themselves subject to capitalization requirements. The remainder of capital takes the form of "Tier II" capital comprising subordinated debt, designated special reserves, hidden reserves, and revaluation reserve for fixed assets (discounted at 55%). 5.8 The capitalization of PBs is being carried out according to the new regulatory guidelines for asset classification, income recognition and provisioning requirements issued by RBI in April 1992 and subsequent amendments thereof. Balance sheets and profit and loss accounts for the financial years ending in March 1993 and 1994 were prepared under the new guidelines for the PBs. This financial information, supplemented by related additional information on asset classification, formed the basis for estimating the additional capital requirements to meet the RBI-stipulated  - 22 - performance criteria. The banks' accounts were audited by qualified statutory auditors, as required under the Banking Regulation Act of 1949 (Section 29), but have not yet been examined by RBI inspectors. In view of the Bank's concern that the new asset classification as well as income recognition and provisioning norms (while marking a substantial improvement over the past health code norms) do not yet meet international standards, it was recommended that an independent loan portfolio review of PBs be carried out under terms-of-reference acceptable to the Bank by June 30, 1995. GOI has agreed to such a review, and should it be necessary, the findings of these reviews would be used to revise the estimated capital requirements for PBs. Assurances were obtained that RBI shall provide to the Bank by June 30 of each year starting in 1995 an independent review of the loan portfolio of each PB through independent auditors acceptable to the Bank and with scope satisfactory to the Bank. 5.9 Table 5.2 presents the March 1996 forecasts of capital requirements of the six PBs, the date by which all Indian commercial banks must satisfy the Basle standards. The estimated capital requirements are based on the banks' financial statements of end-March 1994 and their projected risk-weighted assets. For each bank, the difference between the estimated March 1996 requirement and the March 1994 position represents additional capital needed during 1994/95 and 1995/96. Estimates indicate that the six banks will need additional capital of about Rs 37 billion (about US$1.18 billion) to achieve a minimum capital adequacy of 8%. Table 5.2: Additional Capital Requirements of Participating Banks (Rs Million) Atlahabad Bank of Dena Indian Indian Over- Syndicate Six Bank India Bank Bank seas Bank Bank Banks 1. Actual position, March 1994 Risk-weighted Assets 40599 133810 28200 67980 54940 38050 363579 Unimpaired Capitat -263 950 2030 2363 940 110 6130 Tier 1 -1508 -1500 1390 1455 90 -1010 -1083 Tier 11 1245 2450 640 908 850 1120 7213 2. Projected capital adequacy, March 1996 Risk-weighted Assets 41980 180000 42370 88500 70000 53300 476150 Capital required: 3367 15768 5195 9558 5621 4296 43804 Tier 1 1683 7884 2597 4460 2811 2148 19046 Tier 11 1683 7884 2597 4460 2811 2148 19046 3. Additional capital required, 1994/5-95/6 3630 14818 3165 6558 4681 4186 37038 5.10 Table 5.3 gives projections of how these capital requirements would be met. GOI's 1994/95 Budget includes an appropriation of Rs 56 billion (about US$1.8 billion) of which Rs. 19.7 billion (US$ 630 million) has been allocated to these six banks. In addition, about Rs 10.9 billion (about US$350 million) has been earmarked by GOI to these six banks in the form of purchases of bank subordinated debt issues. The project would finance these purchases, which as indicated in Table 5.3 would represent 2.5-4.2% of the March 1994 bank advances. The banks would lend the proceeds of their capitalization as new subloans to the private sector at prevailing market rates. Since the subordinated debt would be relatively long-term, PBs would be encouraged to provide long- term subloans. The combined Tier I and Tier II capital infusions would therefore be about Rs 30.6 billion, with the balance coming from banks' retained profits and other Tier II capital sources, such as revaluation of assets. Since the banks have provisioned substantially for loan losses in 1993/94 and 1994/95, they are expected to post improved net profits in 1994/95 and 1995/96.  - 23 - TabLe 5.3: CapitaL Sources of Participating Banks (Rs Mi[lion) Attahabad Bank of Dena Indian Indian Over- Syndicate Six Bank India Bank Bank seas Bank Bank Banks Tier 1: 3192 9384 1207 3005 2721 3158 22667 Tier I Capital Provided by the Govt. 3562 8484 61 2310 2586 2786 19788 Retained Profit -370 900 1146 696 135 372 2879 Tier II: 438 5434 1957 3552 1961 1028 14371 Subordinated Debt * 1594 4060 723 1809 1327 1466 10979 Memorandum: Totat Advances (excl. provisions), March 1994 37722 109220 24220 67810 53400 39812 332184 Subordinated Debt/Total Advances 4.2% 3.7% 3.0% 2.7/ 2.5% 3.7% 3.3% * After adjusted for projected changes in revaluation of reserves and others. 5.11 Recapitalization of the banks has already resulted in new rules of the game regarding credit and portfolio management. In order to continue the progress already attained in the redefinition of these rules in such a way that GOI will reinforce a level playing field between nationalized and private commercial banks, has agreed not to provide any further capital infusions to PBs, in effect forcing them to either raise their future capital requirements by tapping India's capital markets or by reinvesting retained profits. The projections upon which the project's recapitalization was defined include this scenario. Assurances were given at negotiations that GOI will ensure that the number of equity shares owned by GOI in each PB is not increased from the level prevailing as of March 31, 1995, except: (a) as may be required to comply with applicable laws, and (b) for two PBs in order to allow them to comply by March 31, 1996 with capital adequacy norms prescribed by RBI. 5.12 In addition to the commitment not to increase GOI's equity participation, business plans (referred as MOUs) have been agreed on and signed by the PBs with RBI. These MOUs contain measures geared to increase the banks' efficiency in terms of numbers of staff, credit allocation procedures, profitability targets, and managerial autonomy in conducting day-to-day business. Assurances were obtained that RBI shall enter into a Performance Agreement (also referred to as a Nlemorandum of Understanding) with each PB annually, with terms and conditions satisfactory to the Bank, including, inter alia: (a) that the concerned PB shall carry out its Business Plan each year; and (b) maintain, at levels satisfactory to the Bank, (i) gross and retained profits; (ii) operational costs over assets; (iii) capital adequacy ratios; and (iv) non- performing assets. Assurances were given by RBI at negotiations that each PB shall adopt and carry out an annual Business Plan each year in respect of the forthcoming financial year, with scope and content satisfactory to the Bank, including, inter alia: (A) changes to capital structure; (B) institutional development programs; (C) profitability improvements; (D) actions for debt recovery; (E) schedules for issuing equity to private shareholders; (F) programs for improvement of computers/communications; and (G) programs for human resource development. Assurances were obtained that RBI shall take prompt action satisfactory to the Bank to ensure the continued safety and soundness of each PB in the event that the Tier I risk- adjusted capital adequacy ratio of each PB falls below 4%, and that RBI shall take prompt remedial action satisfactory to the Bank in the even the net worth of any PB becomes negative. Assurances were obtained that GOI will not be entitled to withdraw from the Bank loan more than 50% of each subordinated loan unless the respective PB has issued equity consistent with  - 24 - the PB's Business Plan. In addition to providing for bank autonomy to conduct day-to-day and long-term planning activities, current GOI policy fosters stronger independent representation in the boards of directors of the banks. In this regard, discussions of measures geared to provide substantial, albeit not yet complete, management autonomy to PBs' boards of directors were held with GOI, RBI and PBs. Building on the actions that have already increased managerial autonomy in all public commercial banks (para 3.24), assurances were given at negotiations that GOI will ensure that each PB shall issue equity shares to shareholders other than the Government, pursuant to a public offering, at levels and in accordance with a schedule satisfactory to the Bank and that GOI will ensure that the boards of directors of each PB shall include the maximum number of directors representing private shareholders permissible under applicable laws. 5.13 Assurances were obtained at negotiations that GOI shall onlend proceeds of the Capital Restructuring Loan to PBs as subordinated loans. GOI shall enter into a Subordinated Loan Agreement with each PB on terms and conditions satisfactory to the Bank which would specify that: (a) GOI subordinated loans to PBs shall be provided through promissory notes to be issued by each PB to GOI which shall: (i) be denominated in rupees; (ii) be required to be paid at par at the expiry of twelve years from the date of issue; (iii) not be redeemable at the instance of holders for five years, and thereafter be redeemable only with the consent of RBI; (iv) carry an interest rate which shall be 0.5% over the average rate on GOI 364-day treasury bills for the previous two quarters, with interest being paid at half-yearly intervals; (v) constitute direct, unsecured and subordinated obligations of the concerned PB, subordinated to the claims of all other creditors and depositors of the PB regarding repayment of principal and payment of interest by the PB out of its own resources to such creditors and depositors; (vi) not provide holders any rights or privileges of shareholders; (vii) not be converted into shares; (viii) be transferable by endorsement and delivery; and (ix) not limit the right of the PB to borrow or change its capital structure without the consent of, or intimation to the holder of any such note. A condition of disbursement for each PB would be that GOI shall provide to the Bank a legal opinion that it has entered into a satisfactory Subordinated Loan Agreement with the respective PB. Assurances were also given that the proceeds of subordinated loans would be relent by PBs as subloans to sub-borrowers under terms and conditions satisfactory to the Bank, including that subprojects shall comply with subproject criteria, including environmental standards, acceptable to the Bank. Modernization and Institutional Development (US$197.7 million) 5.14 The project would support a modernization program focused on building financial strength and long-term competitiveness in a more liberalized business and banking environment. It would support actions in the identified key areas of: (a) strategic planning (b) automation and computerization of payment and accounting mechanisms, (c) human resource development (HRD), (d) organizational improvements, and (e) improved asset-liability, treasury and credit management. In implementing such actions, PBs would be required to prepare and implement annual business plans containing agreed changes in their capital structures, institutional and strategic development, profitability improvements, and schedules for issuing equity to private shareholders. PBs would update these plans annually for review by RBI and the Bank. Modernization activities proposed are summarized below:  - 25 - (a) Strategic Planning. Formulation and implementation of sound strategic plans are at the core of the project's institutional development program. To operate in a competitive business environment, banks will need to develop the capacity to articulate their goals for the future and build their operations accordingly. Once defined, such strategic plans will allow comparisons of the profitability of different financial products and markets and of costs of operations, including branch profitability. Marketing plans, allowing banks to bring marketing practices to bear on depositor and client relationships, would spell out actions required to meet revenue and funding targets, and develop market research and product development plans. (b) Automation and Computerization. PBs' objectives for automation and computerization are to improve: (i) customer service, (ii) internal controls, (iii) decision-making, and (iv) productivity and profitability. Until recently, opposition of bank employee unions kept banks from installing modern computer and connmunication technologies. As a consequence, "fully computerized" status has been reached only on average by about ten branches (out of 1,000-2,000 branches) in each bank. An agreement recently reached between the Indian Banks Association and employee unions has provided banks the opportunity to reap the full benefits of automation and computerization. Under the project, support would be provided to PBs to carry out programs that would include systems architecture compatible with RBI's computerization plan and would include the following activities: (A) fully automating/computerizing selected branches, (B) computerizing functions such as credit management, treasury and asset/liability management and management information systems (MISs), (C) implementing electronic communication capabilities within each bank and with external agencies, (D) installing Point of Sales debit card facilities (POS) and automatic teller machines (ATMs) where markets warrant, and (E) providing computer training to PB staff. (c) Human Resource Development (HRD). PBs have large staffs of about 50% clerical, 30% officers, and the balance, support. About 90% of the work force is employed in the branches. Each bank now conducts a full range of human resource functions, including an extensive training program through which about 25-50% of staff is trained for periods of 1-15 days each year. Newly emerging training needs include automation/computerization, merchant banking, credit analysis and management, marketing, product pricing, lending in new sectors, treasury management, asset-liability management, foreign exchange, MISs, strategic planning, and auditing of computerized processes. The project would support HRD efforts in each bank by providing specialist services to: (i) help design initial strategic HRD plans, including reviews of changes required in banks' human resource departments and facilities, (ii) design improved internal training programs where the expertise is currently unavailable within each bank, and (iii) identify extramural training needs in new functional and business areas, which could take place within or outside India. (d) Organizational Improvements. As part of their business plans, PBs would review their organizational structures to rationalize zone-region-branch configurations as well as head office functions to eliminate excess costs, improve customer services and deal with chronic loss-making branches. Some banks have already reorganized to a limited  - 26 - extent, combining certain head-office functions and reducing the number of zonal and regional offices. Many banks have also opened new branches for certain specialized functions (such as export credit and leasing) and in particularly fast-growing locales. Specialist services would be provided under the project to develop banks' organizational systems in light of emerging business priorities and their strategic plans. (e) Asset-Liability and Treasury Management (ALM and TM). Interest rate liberalization is making ALM crucial for profitability, particularly as competition places interest rate spreads under pressure. In most banks ALM amounts now to managing cash balances in response to changing patterns of cash flows as well as some management of deposit liabilities, rather than to analyzing and managing the different risks involved. Thus far, the banks have rarely used treasury operations to manage risk, but this is becoming increasingly important as the financial system is liberalized. Foreign exchange management will also become more important in response to changing client needs. To respond to these emerging needs, banks must improve their ALM and TM to control their overall balance sheet risk and liquidity volatility. They also need to establish automated MISs for ALM that would gather all relevant data on loans, deposits, liquidity positions, margins, maturity gaps, and interest rate gaps. Banks must evaluate the scope for using CDs, inter-bank funds and other instruments to manage their liability positions and improve their foreign exchange management capabilities. The project would provide specialist services to help: (i) introduce modern ALM and TM techniques in PBs, and (ii) improve their MISs in ALM and TM. (f) Credit Management. In response to the tightening asset classification and income recognition standards established in April 1992, banks have begun to implement actions leading to improved credit appraisal and monitoring capabilities. They have also begun to monitor existing portfolios more closely to provide clearer pictures of non-performing assets. Further improvements are now required in evaluating credit risk, particularly to incorporate environmental impact into loan appraisals and in pricing credit in relationship to risk. Improvements are also needed in streamlining loan documentation and approval procedures to allow faster decision-making. Greater attention is needed to identify both risk concentrations and opportunities at the sector level. The project would provide specialist services to assist banks to design the credit aspects of their strategic plans, formulate credit policy and develop financial products. Backstop Facility (US$200.0 million) 5.15 Rationale. The project aims to promote an orderly development of the foreign currency term lending market through the establishment of a Backstop Facility (BF) that would encourage eligible banks and financial institutions in India to offer medium- to long-term foreign currency loans to companies with foreign exchange revenues. Demand for such loans has strengthened over the past three years due to the liberalization of India's foreign trade and payment system. It has gained further momentum over the past year as a result of the strong revival of economic activity. This demand is not limited to short-term export credits but also includes longer-term loans to finance a wide range of expenditures such as imports of equipment and new technology, expansion of production facilities, market research, and overseas activities including setting up offices or subsidiaries, purchasing patents, and entering into joint ventures. Based on loan proposals and active  - 27 - inquiries received by financial institutions, the demand for such loans is estimated to be about US$1 billion over the next three years. A significant proportion of this demand is for loans of US$1-4 million each from exporters with well-established records and proven capacities to service foreign currency debt. 5.16 To meet this rapidly expanding demand for foreign currency financing by Indian enterprises and exporters, GOI has adopted a two-fold strategy: First, GOI has permitted large Indian corporations to raise funds directly in international capital markets through issuance of GDRs and debt instruments. Over the period of May 1992 to December 1994, 46 corporations raised the equivalent of US$3.7 billion through issuance of GDRs and 11 corporations issued about US$1.0 billion in equity-linked debt instruments. Second, GOI authorized selected Indian financial institutions to intermediate foreign resources for creditworthy small- and medium-sized companies. This strategy is framed within GOI's broader approach for moving towards capital account convertibility of the rupee and external debt management, and it builds upon progress already achieved in macroeconomic stabilization and financial sector reforms. Such reforms are expected to continue to strengthen foreign investors' demand for Indian private sector and quasi-sovereign securities including those issued by Indian financial institutions. Yet, the ability of Indian financial institutions to establish themselves in offshore markets and raise funds in the most cost-efficient manner is currently hampered by regulatory restrictions designed to control capital flows and the market perception of systemic risk, which results in high term premiums and lack of readily available financing sources beyond the medium-term. 5.17 Indian financial institutions need to make the transition from the regulated past in which financial institutions intermediated sovereign-backed long-term funds with minimal risk to an environment in which they have to rely on market sources to fund lending operations. These institutions have traditionally funded foreign currency term loans through government-backed lines of credit obtained from multilateral institutions (primarily the Bank), official bilateral sources (including export credits), and commercial borrowing. Prior to recent reforms, such financial institutions were required to match their foreign currency assets and liabilities and to obtain clearance from RBI/GOI for advancing foreign currency loans on a transaction-by-transaction basis. By relaxing restrictions on funding and lending rates (para 5.21), GOI plans to enable them to tap the domestic foreign exchange market directly and diversify their funding base in order to provide medium- to long-term foreign currency loans. However, financial institutions face the risk that due to political, economic and international factors beyond their control, they may not be able to roll-over borrowings from the market on reasonable terms. This risk is systemic and affects all financial institutions in transition. The relatively high term premium attached to longer maturity foreign currency funds available to Indian financial institutions also results in unavailability or unattractive terms associated with longer maturities for entrepreneurs. This term premium, which incorporates an important element of country risk as well as institution-specific commercial risk, is expected to decline as India's credit rating improves and participating financial institutions gain greater market recognition. 5.18 Objective. The BF would assist in an orderly development of the foreign currency lending market by addressing systemic risks that affect financial institutions' funding costs as a whole. The BF would provide a transitional mechanism to enable participating institutions to increase their reliance on private sources of funds for meeting rapidly expanding demand for foreign currency term loans. As participating institutions gain experience in accessing the markets on a  - 28 - routine basis and the market is able to provide ongoing liquidity, the need for BF support would diminish. 5.19 Structure. The BF would have a term of seven years and would be structured as a stand-by arrangement. It would provide liquidity assurance at a market-related price to EBs by offering the option to borrow funds from the BF under specified terms and conditions. Under the BF, EBs would extend medium- to long-term foreign currency subloans to qualified sub-borrowers and would fund such loans through: (a) domestic market foreign currency instruments, such as CDs and notes;'