As the dust settles around the post-Budget stock market collapse, attention is being increasingly directed at the role played by the banking system in the events that led up to the mini-crisis. The explicit role of a few cooperative banks and some smaller private sector banks is now well documented. There were some, like the Madhavpura Mercantile Cooperative Bank and Global Trust Bank, that where willing to accommodate brokers with funds to invest in shares to an extent where their exposure to particular brokers and to the stock market was far beyond what would be considered prudent. There were others, like the Bank of India, that were willing to discount instruments, however safe, representing more than unusually large sums of money, issued by organizations whose ability to back such instruments were obviously doubtful. Yet others have been characterized by a degree of exposure to investments in the affected banks, which could imply large losses that could affect their viability.
 
These acts of omission and commission (concentrated no doubt in a few cooperative banks in a few centers) which helped finance a speculative run that collapsed in the wake of a bear attack, has not merely triggered investigations of varying intensity against individual officials in the system, but threatened the existence of at least one bank, forced losses on others and left a large number of small savers with no access to their own money.
 
These developments have raised questions about the adequacy and efficacy of the regulatory framework designed and implemented by the Reserve Bank of India. The RBI has been quick to respond. Unfortunately, however, that response combines an effort to trivialise the fall-out of the crisis for banking system, to declare that the acts of omission and commission referred to earlier were more the exception than the rule and that minor tinkering with the regulatory mechanism would be adequate to deal with the problem.
 
This emerges from the following paragraph in the RBI’s Monetary and Credit Policy Statement for the year 2001-2002, portions of which have been highlighted to focus on the thrust of the central banks reading of the problem. "The recent experience in equity markets, and its aftermath, have thrown up new challenges for the regulatory system as well as for the conduct of monetary policy. It has become evident that certain banks in the cooperative sector did not adhere to their prudential norms nor to the well-defined regulatory guidelines for asset-liability management nor even to the requirement of meeting their inter-bank payment obligations. Even though such behaviour was confined to a few relatively small banks, by national standards, in two or three locations, it caused losses to some correspondent banks in addition to severe problems for depositors. In the interest of financial stability, it is important to take measures to strengthen the regulatory framework for the cooperative sector by removing "dual" controlby laying down clear-cut guidelines for their management structure and by enforcing further prudential standards in repect of access to uncollateralised funds and their lending against volatile assets."
 
Clearly, the RBI sees the problem as being largely restricted to the cooperative banking sector, where it arises not because the regulatory mechanism is not well defined, but because the structure of management and control has worked against the implementation of those guidelines. To cover itself against the criticism that it ignores the fact that the problem goes deeper and is systemic, the RBI has hastened to add that: "In the light of recent experience, some corrective steps to prevent commercial banks from taking undue risks in their portfolio management are also outlined."
 
A close look at the evidence suggests, however, that the RBI’s response is indeed inadequate. The exposure of banks to the stock market occurs in three forms. First, it takes the form of direct investment in shares, in which case, the impact of stock price fluctuations directly impinge on the value of the banks’ assets. Second, it takes the form of advances against shares, to both individuals and stock brokers. Any fall in stock market indices reduces, in the first instance, the value of the collateral. It could also undermine the ability of the borrower to clear his dues. To cover the risk involved in such activity banks stipulate a margin, between the value of the collaeral and the amounts advanced, set largely according tto their discretion.
 
Third, it takes the form of "non-fund based" facilities, particularly guarantees to brokers, which renders the bank liable in case the broking entity does not fulfill its obligation.
 
As at present, RBI guidelines regarding bank exposure to the stock market apply only to direct investment in shares. Even these have been substantially relaxed in recent times. According to guidelines issued in October 1996, when banks were being encouraged to investment in stocks as part of the process of financial liberalization, banks were permitted to invest up to 5 per cent of their incremental deposits in stock markets. Initially, investments in debentures/bonds and preference shares were included within this five per cent ceiling. However, as stock market performance was increasingly accepted as an indicator of the success of reform, and the government was under pressure in 1997 to revive flagging markets, it sought to encourage banks to invest more in the markets by taking debentures/bonds and preference shares out of the calculation of the limit in April 1997. This made the ceiling only relevant for investment in equities. Driven by these signals a group of 21 public sector banks increased their investments in equities from Rs. 1,488 crore in 1997 to Rs. 2,293 crore in 1998.
 
In September last year these guidelines were relaxed even further based on the recommendations of a committee comprising of senior executives of the RBI and the Securities and Exchange Board of India (SEBI). The committee held that instead of setting a ceiling on bank investments in equity relative to incremental deposits, banks' exposure to the capital market by way of investments in shares, convertible debentures and units of mutual funds should be linked with their total outstanding advances and may be limited to 5 per cent of such advances. This was subsequently accepted by the RBI and is the guideline that prevails now.