A USER'S GUIDE TO THE RESERVE BANK OF INDIA AND THE INDIAN

UNCLAS SECTION 01 OF 08 MUMBAI 000373

SENSITIVE
SIPDIS

DEPT PLEASE PASS TO USTR
TREAS PLEASE PASS TO FED

E.O. 12958: N/A
TAGS: ECON EFIN EINV IN
SUBJECT: A USER'S GUIDE TO THE RESERVE BANK OF INDIA AND THE INDIAN
BANKING SYSTEM

MUMBAI 00000373 001.2 OF 008



1. (SBU) Summary: Over the last decade, the Indian banking
sector has deepened, matured, and grown, and many of its banks
have become leaders in the new Indian economy. Moreover,
foreign banks have also succeeded in expanding in the Indian
market, and have become a significant part of the banking
landscape, though their expansion has been limited by
restrictions. Nevertheless, with a few notable exceptions, the
Indian banking sector is dominated by major state-run banks
which were nationalized almost 40 years ago in order to ensure
that credit and banking policies served social and development
goals. The central bank and banking regulator, the Reserve Bank
of India, remains conscious of this mission, and continues to
prize price stability over growth in its monetary and banking
policies. The RBI has also proved extremely cautious in
liberalizing the banking sector, firmly restricting the
participation of foreign banks and the introduction of more
complicated financial products. While there are differences
between the RBI and the Finance Ministry over the pace of
banking sector reforms, the RBI is likely to continue a slow,
gradualist reform agenda, giving prominence to minor tinkering
instead of major policy changes. Given that the RBI's
reluctance to liberalize is now widely seen as a prescient step
that enabled India to avert some of the most dire effects of the
global financial crisis, the ideological arguments for more
financial liberalization have less currency than they once did,
making it more difficult for governments and the private sector
to press for additional reforms. End Summary.



Indian Banks: The Legacy of Nationalization

--------------




2. (U) After Indian independence, the Indian banking industry
was largely controlled by a number of business houses who used
banks to apportion credit to select industrial enterprises. The
banking sector grew slowly, and according to then-Prime Minister
Indira Gandhi, was insufficiently responsive to the development
needs of India, especially for India's rural masses. Mixing
socialist rhetoric and shrewd politics, Prime Minister Gandhi
ordered the nationalization of 14 major private commercial banks
in 1969, and six more in 1980. Arguing that banks were not
fulfilling social and developmental goals, Gandhi directed banks
to extend credit and provide banking services to the rural and
urban poor, farmers, and small industries to promote economic
development. By the 1990s, the government controlled around 91
percent of the assets of the total banking sector.




3. (SBU) Up to the 1990s, the nationalized, or public sector,
banks (PSBs) grew at around four percent, mirroring the growth
rate of the Indian economy. The banks opened up thousands of
branches and operations in rural areas; regional banks, now
under a national mandate, expanded into other parts of India.
Under government direction, these banks continued to follow
largely social and industrial policies, rather than economic
ones, lent to rural borrowers and favored industrial projects,
and offered high interest rate savings accounts to attract
savers. The number of bank branches increased from about 7,000
in 1969 to more than 60,000 in 1994. The deposit base rose from
USD 1.04 billion in 1969 to around USD 71.6 billion in 1994.
However, by 1991, with non-performing loans, bloated labor
pools, a lack competition and allergic to technology, the Indian
banking system was saddled with inefficient and financially
unsound banks.




4. (SBU) Beginning in 1992, the Indian government carried out a
wide range of economic and financial reforms, including
gradualist measures to make the banking system stronger, more
efficient, and competitive. Some state-run banks, such as ICICI
and HDFC, were effectively privatized, and began to grow
quickly. Some new private banks were licensed. The Indian
government sold equity in PSBs, and divested its ownership to
raise capital (though current law requires that the Indian

MUMBAI 00000373 002.2 OF 008


government own at least 51 percent). India now has 27 public
sector banks (where the government owns a majority stake),22
private Indian-origin banks, and 32 foreign banks. (Note:
There are also several hundred smaller, regional commercial
banks and rural and urban credit cooperatives. End Note.)
Currently, the Indian banking system has a deposit base of
around USD 837 billion with more than 77,700 bank offices.
(Note: The U.S. has a deposit base of about USD 10 trillion.
End Note.)





State-Run Banks Dominate the Financial Landscape

-------------- ---




5. (SBU) The banking sector in India continues to be dominated
by PSBs. In March 2009, PSBs accounted for 74 percent of total
deposits, of which 24 percent came from just the State Bank of
India (SBI) and its associate banks. PSBs also account for
about 74 percent of all bank credit, with SBI holding 23
percent. Nevertheless, the Indian banking sectors, and its
major banks, are small compared internationally. According to
"The Banker," a Financial Times publication that rates the
world's top 1,000 banks, SBI is the world's 64th largest bank
based on tier I capital and ranks 76th in terms of assets.
ICICI Bank, India's second largest lender by assets, is the
world's 81st largest bank based on tier I capital and ranks
127th based on assets. Among the top 25 Asian banks (excluding
Japan) on the basis of tier I capital, SBI ranks 11th and ICICI
Bank ranks 15th.




6. (SBU) Over the last decade, the health of most Indian banks
has improved significantly. For instance, banks have introduced
new technologies and made significant progress in lowering the
rates of non-performing loans from a high of 14.78 percent in
1998, to 2.42 percent in 2009 (sometimes through advantageous
reclassifications). Nevertheless, PSBs are still often accused
of being inefficient, slower and less technologically savvy than
their private sector rivals, and, sometimes, politically
pliable, all of which is largely true. However, there is a wide
range of health among the PSBs. Some banks, such as SBI, Punjab
National Bank, and the Bank of Baroda, are at the forefront of
modernization efforts. They now offer more sophisticated
products to clients, and have a reach into the country side and
into different income classes that cannot be matched by private
sector banks. Moreover, with explicit government ownership and
patronage, most Indians have grown up believing that PSBs are
safe and secure places to bank, a feeling confirmed when savers
returned to PSBs during the first shocks of the financial
crisis. Even the most dynamic private sector banks are still
small compared to the PSBs.




7. (SBU) Despite this growth, however, only 40 percent of
Indians have a bank account. Only 5.2 percent of villages have
a bank branch. India's economic policymakers, including the
central bank and banking regulator, the Reserve Bank of India
(RBI),have recognized the importance of microfinance and
microcredit initiatives, and these sectors have grown
dramatically in the last decade, largely through the efforts of
dynamic social entrepreneurs. This large, unbanked population
makes it difficult to establish identity, target payments,
reduce corruption, build up credit history, and marshal India's
high savings rates into productive investments.



Requirements for Banks in India

--------------



MUMBAI 00000373 003.2 OF 008






8. (U) The continued dominance of state-owned banks ensures
that the GoI can carry out its social, industrial, and fiscal
agenda, and the operating environment for banks in India reflect
this objective. Under law, all banks operating in India are
required to hold a certain proportion of their liabilities in
government securities. These mandated ratios, apart from acting
as a safety net for banking capital, ensure a captive market for
government securities, and aid government borrowing programs.
This requirement, known as the statutory liquidity ratio, or
SLR, is currently set at 24 percent. The government has at
times raised the SLR to ensure the government borrowing program
is conducted smoothly, and has in times of crisis lowered this
ratio to ensure liquidity in the system. (A one per cent
increase in the SLR yields additional demand for government
bonds of roughly USD 8.5 billion.) As government securities
offer an attractive yield - a five-year government bond yields
around 7 percent - banks often prefer the safety of these
investments to more risky credit operations. For much of the
last decade, banks significantly exceeded the SLR, prompting
charges of "lazy banking." RBI guidelines also require that
banks set aside a certain percentage of their deposits with the
RBI, known as the Cash Reserve Ratio (CRR). In addition,
current RBI guidelines require that Indian banks - both public
and private -- allocate at least 40 percent of the bank credit
to certain priority sectors, including exports, housing, and the
rural and agriculture sectors. Of this 40 percent, 18 percent
of credit is exclusively allocated to agriculture and 10 percent
to "weaker sections" of the economy, including small and
marginal farmers, landless laborers, and urban and rural
microfinance.




9. (SBU) As with the RBI, the Union Ministry of Finance (MoF)
plays an important role in guiding the banking sector. The MoF
appoints the heads of the PSBs and board members, determines the
amount of government equity, and guides some lending policies.
A common concern is that the MoF strives to influence credit
policy in general, especially lending rates. Banking sector
observers presume that the Finance Ministry consistently
pressures state banks to lower interest rates to encourage
greater borrowing, especially for high-end consumer goods,
homes, and industrial purposes, though both bank leaders and MoF
officials deny this. In practice, despite clear government
interest in reducing lending rates and reductions in the policy
lending rates, bank lending rates have stayed in the 11-16
percent range.


The Reserve Bank of India

--------------






10. (SBU) The Reserve Bank of India (RBI) is the central bank
of India, and is the regulator and supervisor of the financial
system. Led by a Governor appointed by the Prime Minister, the
RBI is responsible for formulating and implementing monetary and
credit policy, overseeing foreign exchange, issuing currency,
and lending to the government. The RBI has a dual mandate to
promote economic development - rather than growth - and ensure
price stability. In practice, therefore, the RBI privileges
stability and low inflation over growth. The RBI believes that
while economic growth benefits many sectors of the economy,
inflation hits everyone, and the poorest the hardest. For this,
the RBI has a number of "levers" at its disposal, including two
policy rates - the repo rate and the reverse repo rate - at
which the RBI lends or absorbs money in the system, and sends
signals about inflationary or monetary policy trends. The RBI
can also use the aforementioned CRR and SLR to absorb or release
liquidity into the system when credit expands or contracts too
quickly. In addition, the RBI can conduct foreign exchange
operations to mitigate the impact of capital flows on liquidity
in the banking system or the value of the rupee, both of which

MUMBAI 00000373 004.2 OF 008


can affect inflationary trends, credit policy, interest rates,
and market operations. In the last several years, the RBI has
actively used all these tools to control, limit, or encourage
various market trends, depending on the policy goal. With so
many tools, however, the RBI remains in constant "policy
motion," like the wizard behind the curtain, for the use of each
lever provokes the need for adjustment elsewhere in the system.




11. (SBU) On banking, the RBI's philosophy strives for holistic
growth and development. The RBI takes seriously its mandate to
protect banking consumers and the safety of the banking system
as a whole, and believes that India's financial system should
serve the overall needs of India's economic development first.
The RBI displays caution - and sometimes distrust - toward
entrepreneurial banking and complicated financial products,
especially those products originating from abroad, and is
concerned that smart financiers will, if given the opportunity,
take advantage of the system and of less financially literate
investors for short-term gains. To that end, banking guidelines
require the RBI's approval for all new bank branches to ensure
that development needs are being met, especially the creation of
larger rural banking networks, and the RBI scrutinizes the
introduction of all new financial products.



12. (SBU) The previous RBI Governor, Y.V. Reddy (2002-2008) was
noted -- and often criticized -- for his caution, conservatism,
and perceived lack of transparency. Nevertheless, Reddy left a
lasting legacy as a strong, and independent, central banker who
presciently helped the Indian banking sector avoid much of the
tumult of the global financial crisis. In 2005, Reddy, fearing
a real estate asset bubble, required banks to raise their risk
weight ratios for real estate loans, which curtailed some real
estate lending and limited banks' exposure to a potential asset
bubble. In addition, against the advice of the Finance Ministry
which supported the creation of more innovative financial
products, Reddy restricted the participation of banks in the
derivative and asset securitization markets, arguing that the
Indian financial system was not yet ready for many complicated
financial products. In 2003, the RBI imposed tight restrictions
on banks' ability to trade in interest derivatives which was
then an exchange-traded product regulated by the capital market
regulator, the Securities and Exchange Board of India (SEBI).
The RBI stipulated that trading in interest futures would be
allowed only for hedging interest risk of their underlying
government securities portfolio. He also refused to make other
pro-cyclical moves, such as lowering interest rates, to
forestall a borrowing boom and he placed restrictions on India's
exposure to external commercial borrowings, which, while
limiting short term growth, reduced Indian corporate exposure to
foreign loans. Indeed, many of his most ardent critics have
grudging praised him for ensuring India's relative isolation
from the extremes of the financial crisis.




THE RBI in Action: Management of the financial crisis

--------------




13. (U) The current RBI Governor, Duvvuri Subbarao, took over in
September 2008, as the global financial crisis hit. The impact
of the global financial crisis on India was initially
disorienting, but its overall effect was ultimately much more
moderate than other major economies. Through much of 2008, the
RBI was concerned about rising commodity and oil costs and
raised interest rates in order to stave off inflation. The
Lehman collapse in September, however, caused an immediate
tightening in global credit markets. Indian corporate borrowers
- now unable to borrow in international markets - turned to
local banks, most of whom were scaling back their lending due to
concerns over the risks and viability of borrowers. This
emergency borrowing - much of it for working capital - forced
short-term rates to jump and squeezed out lending for many
smaller companies, who were considered more risky. For some

MUMBAI 00000373 005.2 OF 008


time, trade finance became difficult to secure, which coincided
with a decrease in demand for India's exports. And finally,
foreign portfolio investors began to pull out of India's equity
markets, withdrawing USD 12.8 billion in a few months, and
forcing the depreciation of the rupee to new lows.




14. (U) Recognizing India's vulnerability to the global credit
crunch, the RBI took a number of measures to inject liquidity
into the system, restore confidence in credit markets, and spur
banks to lend. Over a number of weeks, the RBI significantly
reduced its two policy interest rates, reduced the CRR, and
lowered the SLR by one percent. These actions put together
released nearly USD 50 billion in the economy. Simultaneously,
the RBI sold dollars in the forex market to reduce pressure on a
depreciating rupee. Due to a shortage of dollars in the forex
market, RBI created a forex swap facility for banks having
overseas branches. The RBI also created special facilities for
mutual funds facing major redemptions, non-banking finance
companies, and housing finance companies. All in all, these
measures gradually restored confidence in Indian credit markets
and helping India ride out the crisis, and demonstrated that the
RBI had the ability to intervene quickly to protect the banking
sector and credit markets.



Foreign Banks

--------------




15. (SBU) The presence of foreign banks dates back to the
pre-independence period, but foreign participation in the Indian
banking system has expanded dramatically only in the last
decade. From just a few foreign banks in 1999, there are
currently 32 foreign banks operating in India, with over 293
branches, largely in urban areas, performing a wide range of
services, from investment banking and asset management to retail
and corporate banking. (Note: The RBI issues a single class of
commercial banking license, so all banks, domestic or foreign,
are able to offer the full scope of banking operations. End
Note.) Foreign investment in a domestic private bank is capped
at 74 percent of the bank's capital; no foreign institutional
investor can hold more than 10 percent, and no bank can hold
more than 5 percent, with voting rights capped at 10 per cent.
Foreign direct investment in PSBs is subject to a statutory
limit of 20 percent per bank. Some publicly traded Indian
private banks, such as ICICI, HDFC Bank, Development Credit Bank
and ING Vysya, are now technically majority foreign-owned.
(Note: Currently, the foreign holding in ICICI Bank is 65.6
percent and in HDFC is 73.85 percent. End Note.) The
prudential norms applicable to foreign banks for capital
adequacy, income recognition and asset classification are, by
and large, the same as for the Indian banks, and deposit
insurance is provided by the Indian government to all savers.






16. (U) Foreign banks had a 5.9 percent share in total bank
credit, while foreign banks accounted for 5.2 percent of total
deposits. Foreign banks account for 7.5 percent of banking
assets in India (unlike China, where foreign banks hold only
about 2 percent of assets). However, foreign banks are more
dominant in the off-balance sheet business - such as investment
banking -- with a market share of as high as 77 percent. All
private banks - both foreign and domestic -- have a combined
market share in the deposits, advances and off-balance-sheet
business of 23.4, 24.1 and 77 percent, respectively. Foreign
banks are considerably more profitable than domestic state-owned
banks as indicated by a higher return of assets. In 2008,
foreign banks had a return of assets ratio of 2.57 as against
1.01 for nationalized banks and 0.86 for SBI and its associates.
In line with these figures, we have been told repeatedly by
American bank representatives that their operations in India are
some of their most profitable globally.

MUMBAI 00000373 006.2 OF 008






17. (U) The RBI has the authority to review and approve the
addition of any new bank branches, domestic or foreign, and
foreign banks have long claimed that this policy is
discriminatory and impedes India's economic development. In the
WTO, India committed to permit 12 new bank branch licenses per
year to foreign banks. Between 2004-2008, the RBI approved 59
new foreign bank branches. During the same period, however, the
RBI approved the addition of 8525 new branches for domestic
banks. However, foreign banks are exempt from some of the RBI's
lending requirements. For instance, foreign banks must only
allocate 32 percent of net credit to meet priority sector
lending requirements, as compared to 40 percent for domestic
banks, and are exempt from agriculture and "weaker section"
lending mandates. In addition, foreign banks can classify
export credit as priority sector lending, which is not permitted
for domestic banks. Unlike their Indian competitors, there is
also no regulatory compulsion for foreign banks to open branches
in rural and semi-urban areas. In contrast, private banks in
India must open one out of four branches in rural and semi-urban
areas after their first five years of operation.



The RBI's Philosophy: Liberal, Just, and Prudent

-------------- ---




18. (SBU) Traditionally, RBI officials have argued that their
policy on foreign bank branches is liberal, just, and prudent.
First, liberal because the RBI has historically granted a few
more branches than their WTO pledge required. Second, "just"
because the RBI is motivated by principles of reciprocity, and
is more inclined to approve branches for banks whose home
markets are open to Indian banks. Third, prudent because as the
final crisis shows, foreign banks engaged in highly risky
practices that could have endangered the Indian financial
system. More recently, the RBI has further justified this
caution by pointing to the role of foreign banks in the global
economic crisis, and the subsequent wave of government bailouts,
collapses, or mergers. The RBI considers the risk appetites of
many foreign banks to be unhealthy, and not in synch with the
wider social mandates necessary in a developing country like
India, such as rural lending and soft credit terms to avoid
NPAs. (Note: So far, only one American bank - Citibank - has
expressed interest in significantly expanding their branch
network in India. End Note.)



Reciprocity: The Key to More Branches?

--------------




19. (SBU) According to the RBI, it reviews the holistic
strategy for bank branch openings on a yearly basis, and
approves branches based on overall needs and the perceived
sincerity of the bank's goals. Before the crisis changed the
focus of many international banks, their leaders insisted that
most foreign banks are keen to assist the RBI in its vision of
financial inclusion, and offered to open rural branches, along
with more lucrative urban ones. During the period when U.S.
regulatory authorities were evaluating the applications of
several India banks to open new branches in the U.S., the Indian
government promised that further bank branches would be granted
according to the principals of reciprocity. For instance, after
signing the 2005 Comprehensive Economic Cooperation Agreement
(CECA) with Singapore, the RBI allowed Singapore-based DBS bank
to open 8 branches in India between July 2008 and June 2009.
Simultaneously, Singapore's central bank allowed SBI to
establish 4 branches, with more to follow. However, as U.K.
government colleagues are quick to point out, the number of
branches granted to English banks in India has not kept pace
with Indian branches in the UK, much to their chagrin.

MUMBAI 00000373 007.2 OF 008







The Indian Banking Sector of the Future: The Roadmap

-------------- --------------






20. (SBU) In February 2005, the RBI released its banking
"Roadmap" which laid out the central bank's vision on the future
development, equity structure, ownership, and governance of the
banking sector. In the first phase, between 2005 and 2009, the
RBI provided that foreign banks could operate in India through
one of three channels: branches, wholly-owned subsidiaries, or
subsidiaries with foreign investment of up to 74 percent in a
private bank. During this phase, the RBI said that it would
also permit individual foreign banks to take greater equity --
more than the five percent already allowed -- in "unhealthy"
domestic banks, on a case by case basis. With the roadmap, the
RBI expressed its intention to encourage the consolidation of
the domestic banking industry - in other words, to promote the
mergers of lacklustre, smaller, unhealthy private and public
sector banks with bigger, healthier ones - as a precursor to
gradually allowing more foreign participation in the Indian
banking sector. The RBI pledged to review the implementation of
these more liberal banking guidelines in 2009, and many foreign
bankers expected that the RBI would implement new reforms and
liberalization measures which would expand opportunities for
foreign banks.




21. (SBU) However, in its update to the roadmap released in
April 2009, the RBI decided against any additional reform
measures, citing concerns over the benefits of greater
participation of foreign banks in India and current global
conditions, referring to the current financial crises. In the
intervening five years, the RBI did not allow any foreign banks
to takeover unhealthy local banks - never an appetizing offer to
begin with, since foreign banks would prefer to invest in
healthy banks as a matter of course - and the RBI was not able
to engineer the consolidation of some of the most duplicative
banks during this time period, largely due to opposition from
bank employee unions, among other reasons - all problems that
continue today.




22. (SBU) The RBI's vision of the Indian banking sector
continues to be far more conservative than the Finance Ministry
or Planning Commission would like. Two reports - the High
Powered Expert Committee on Mumbai as an International Financial
Center (2007 - known as the Mistry Report, after its Chairman,
Percy Mistry) sponsored by the Finance Ministry, and the
Raghuram Rajan Committee Report (2008) sponsored by the Planning
Commission - both urged broader financial sector reforms,
including further liberalization in the banking sector. The
Mistry report, focused on an international dimension, and the
Rajan report, focused on the domestic environment, both
recommended inflation targeting, a floating exchange rate, the
creation of liquid bond and derivative markets, and government
equity divesture from inefficient PSBs, and advocated for
`principles-based' regulation, rather than rules-based
regulation. The Mistry Report also called for full capital
account convertibility, while the Rajan Report made dozens of
other small suggestions which would "tweak" markets in the right
direction without shaking the system. The RBI, under Governor
Reddy, largely ignored the findings of these two reports, and
dismissed the idea of principles-based regulations. With
Governor Subbarao, a former Finance Ministry official, at the
helm, it is too soon to tell whether the RBI will take heed of
the ideas in these reports. Already, interlocutors have noted
that Subbarao has been considerably clearer and more transparent
in his public monetary policy statements than his predecessor.


MUMBAI 00000373 008.2 OF 008




Comment: Progress Will Be Slow, New Approaches Needed

-------------- --------------




23. (SBU) As the Indian banking system has liberalized, the
competition created by the expansion of Indian private sector
and foreign banks have spurred greater innovation and efficiency
among the dominant public sector banks. Nevertheless, large
numbers of unbanked citizens remain, with access to credit and
financial products restricted to a relatively small section of
India's population. The RBI has exerted prudent, but
conservative, oversight over the banking sector, favoring price
stability and gradualism over growth and rapid change. The RBI
- and many in the Indian financial sector - believes that the
central bank's caution in restricting the expansion of foreign
banks, overseas borrowing, and complicated financial products
was instrumental in India's avoidance of the worst excesses of
the financial crisis. Moreover, the RBI believes that foreign
banks, in particular, have little to offer India by way of
domestic credit, financial inclusion, and rural banking, three
of the central bank's biggest priorities. By allowing slow,
gradual reform over the course of many years, the RBI wants to
ensure that Indian banks - especially laggard state-run ones --
will be competitive with foreign banks when more access is
given. In doing so, the RBI believes it can influence the
practices of the Indian banks to ensure that they fulfill the
country's development priorities. Therefore, USG arguments that
greater financial sector liberalization will promote India's
overall development goals will continue to fall on deaf ears at
the RBI. Instead, moving forward, we should remain focused on
the needs of the wider U.S. financial services sector - and
other areas, such as infrastructure finance - where some
progress can be made. We should also tie our arguments to
clearly stated Government of India or RBI priorities where
possibly. End Comment.
FOLMSBEE