Reforming India's Financial Sector: An Overview

MONTEK S. A!"#A!IA$
(July 6, 2000)
Financial sector reforms have long been regarded as an important part of the agenda for
policy reform in developing countries. Traditionally, this as because they ere e!pected to
increase the efficiency of resource mobili"ation and allocation in the real economy hich in
turn as e!pected to generate higher rates of groth. #ore recently, they are also seen to
be critical for macroeconomic stability. This is especially so in the aftermath of the $ast %sian
crisis, since ea&nesses in the financial sector are idely regarded as one of the principal
causes of collapse in that region. Folloing $ast %sia, soundness of the financial system has
been elevated to a position similar to that of fiscal deficit as one of the 'fundamentals' for
(udging the health of an economy.
)
*eveloping countries can e!pect increasing scrutiny on
this front by international financial institutions, and rating agencies and countries hich fail to
come up to the ne standards are li&ely to suffer through loer credit ratings and poorer
investor perceptions. +n this bac&ground it is both relevant and timely to e!amine ho far
+ndia's financial sector measures up to hat is no e!pected.
,eform of the financial sector as identified, from the very beginning, as an integral part of
the economic reforms initiated in )--). %s early as %ugust )--), the government appointed
a high level .ommittee on the Financial /ystem (the 0arasimham .ommittee) to loo& into all
aspects of the financial system and ma&e comprehensive recommendations for reforms. The
.ommittee submitted its report in 0ovember )--), ma&ing a number of recommendations
for reforms in the ban&ing sector and also in the capital mar&et. /hortly thereafter, the
government announced broad acceptance of the approach of the 0arasimham .ommittee
and a process of gradualist reform in the ban&ing sector and in the capital mar&et as set in
motion, a process that has no been under ay for more than si! years. +n this overvie, +
propose to highlight only some of the more important achievements of financial sector
reforms thus far and to focus on the critical issues hich need to be addressed if e are to
ma&e further progress.
%. !I&ERA!I'ATION AN( RE)"!ATION: *ARA!!E! NOT +ONTRA(I+TOR,
TR"STS
1efore e!amining the specific achievements of financial sector reforms in +ndia, it is useful to
reflect on the principles underlying these reforms and their congruence ith international
practice. Financial sector reforms all over the orld have been driven by to apparently
contradictory forces. The first is a thrust toards liberali"ation, hich see&s to reduce, if not
eliminate a number of direct controls over ban&s and other financial mar&et participants. The
second is a thrust in favour of stronger regulation of the financial sector. This dual approach
is also evident in the reforms attempted in +ndia and the bac&ground and rationale for it need
to be ell understood.
2 The views expressed in this chapter are those of the author and do not necessarily
reflect the views of the Commission. Acknowledgements are due to Surjit Bhalla, .
!amodaran, "ames #anson, $ajiv %umar, S.S. Tarapore and C. &asudev for helpful
comments.
The case for liberali"ation of financial mar&ets is based on efficiency considerations similar
to those used to (ustify liberali"ation in the real sector. The efficiency losses generated by
various types of direct controls over ban&s have been e!tensively discussed by economists
1
% ea& ban&ing system is vieed ith some (ustification as a fiscal time bomb aiting to go
off because ban&ing crises typically force government to recapitali"e the ban&s in order to
avoid a larger systemic crisis, involving a fiscal burden hich can be 3uite large as a
percentage of 4*5 (see for e!ample .aprio and 6lingebiel, )--6).
)
concerned ith the problems of 'financial repression' in developing countries.
2
*irect controls
on interest rates, high cash reserve re3uirements, mandatory investments in government
securities, and other forms of directed credit policies all amount to a ta! on financial
intermediation hich has the effect of suppressing the level of intermediation belo hat
ould otherise prevail and also of reducing the allocative efficiency of such intermediation.
1oth effects lead to a loss of efficiency and loer real groth in the economy. These
arguments against financial repression ere a reaction to the idespread practice of
intrusive and direct intervention by the government in ban&ing systems in most developing
countries and played an important role in promoting financial liberali"ation in 7atin %merica in
the late )-80s and early )-90s.
The case for stronger regulation on the other hand derives from the perception that financial
mar&ets are different from goods mar&ets in important respects and liberali"ation of such
mar&ets aimed at alloing mar&et forces free play can lead to inferior outcomes
:
. Financial
mar&ets are characteri"ed by significant asymmetries of information, moral ha"ard problems,
and principal;agent problems and because of these features a free mar&et e3uilibrium may
not have the efficiency characteristics normally associated ith mar&et e3uilibrium in the
goods mar&et. For e!ample, asymmetries of information in credit mar&ets lead to mar&et
e3uilibrium here interest rates are typically belo mar&et clearing levels resulting in e!cess
demand for credit ith ban&s resorting to credit rationing. <oever, this does not necessarily
entail inefficiency as implied in the financial repression literature, to be eliminated by letting
interest rates rise to mar&et clearing levels
=
. /imilarly moral ha"ard v> problems can lead
ban&s under financial stress to engage in high cost mobili"ation of deposits ith ris&y lending
at high interest rates to shore up profitability. %symmetry of information generates principal;
agent problems in capital mar&ets because corporate managements have incentives to
behave in a manner hich is not consistent ith ma!imi"ation of shareholder value, thus
calling into 3uestion the efficiency of e3uilibrium capital mar&ets. /ome of these problems,
especially those related to information asymmetry and moral ha"ard, can be mitig by
ensuring that ban&s and capital mar&ets are sub(ected to strong prudential norms ith
transparent accounting and disclosure re3uirements and strong e!ternal supervision, all of
hich ould encourage ban&s toards more prudent conduct of ban&ing. /imilar
considerations apply to the functioning of capital mar&ets. ?ithout such regulation,
liberali"ation leading to free play of unregulated and unsupervised financial mar&ets can lead
to suboptimal outcomes.
Financial mar&ets are also special because of possible systemic effects and this provides
another (ustification for regulation. The failure of an individual participant such as a large
ban& cannot be vieed in the same ay as the failure of an individual supplier in the goods
mar&et .losure of a large ban& can lead to panic and irrational behaviour by depositors ith
other ban&s in the system, regardless of the actual financial health of these ban&s, because
depositors typically do not have full information on these issues. /uch panic could precipitate
serious li3uidity problems hich could force otherise solvent ban&s to fail, ith highly
destabili"ing systemic effects in terms of a brea& don in the payments system and a
contraction of credit. To avoid such shoc&s the central ban& has to be ready to act as a
lender of last resort, illing to provide li3uidity to otherise solvent ban&s threatened by
irrational panic. <oever, a lender of last resort facility has to be predicated on continuing
supervision of the ban&ing system. /uch supervision helps identify possible problems at any
2
/ee especially /ha ()-8:) and #c6innon ()-8:) and a more recent revie by Fry ()--8).
3
/ee /tiglit" and ?eiss ()-9)) and /tiglit" ()--=). For a s&eptical vie of the efficiency of
stoc& mar&ets in allocating capital and their role in developing countries, see /ingh ()--8).
4
+t should be noted hoever that the particular e!planation for a 'repressed' interest rate
does not (ustify repression through government control. +t only implies that prudential
behaviour by the ban&s ould lead them to restrain interest rates belo mar&et levels on
their on. +f government does fi! interest rates, the e!tent of the distortion is measured by
the e!tent to hich this forces ban&s to repress interest rates belo the level they should
themselves choose.
2
early stage, hen they can be tac&led before they reach unmanageable proportions. +t also
reduces the moral ha"ard that ould otherise e!ist if ban& managements felt they ere
free to act in hatever manner they li&ed hile counting on access to last resort financing in
the event of difficulty.
The need for regulation in financial mar&ets began to be emphasi"ed in part as a reaction
against the problems e!perienced in the /outhern .one countries of 7atin %merica as a
result of e!cessively enthusiastic financial liberali"ation in the late )-80s (see *ia";
%le(andro, )-9@). To this e!tent the liberali"ing, and regulatory thrusts described above are
somehat contradictory, but the apparent contradiction is easily reconciled. 5roponents of
greater regulation do not necessarily endorse all the direct controls critici"ed by adherents of
the financial repression school.A Their main point is that financial liberali"ation by itself ill
not achieve the desired results in the financial sector. +t may be necessary to remove direct
controls in many areas to achieve greater efficiency in financial intermediation but this must
be accompanied by stronger regulation aimed at strengthening prudential norms,
transparency, and supervision. This is broadly the approach to financial reforms adopted in
+ndia and progress can therefore be evaluated in terms of progress achieved on each of
these fronts.
- *RO)RESS IN !I&ERA!I'ATION OF TE &ANKIN) SE+TOR
Bn the liberali"ation side of ban&ing sector reforms significant progress has been achieved
in several areas, especially interest rate liberali"ation and reduction in reserve re3uirements,
but not in the matter of directed credit.
-.% INTEREST RATE !I&ERA!I'ATION
+nterest rates in the ban&ing system have been liberali"ed very substantially compared to the
situation prevailing before )--.), hen the ,eserve 1an& of +ndia (,1+) controlled the rates
payable on deposits of different maturities and also the rates hich could be charged for
ban& loans hich varied according to the sector of use and the si"e of the loan. +nterest
rates on time deposits ere decontrolled in a se3uence of steps beginning ith longer term
deposits and the liberali"ation as progressively e!tended to deposits of shorter maturity.
?ith effect from Bctober )--8 interest rates on all time deposits, including fifteen day
deposits, have been freed. Bnly the rate on savings deposits remains controlled by the ,1+.
7ending rates ere similarly freed in a series of steps. The ,eserve 1an& no directly
controls only the interest rate charged for e!port credit, hich accounts for about )0 per cent
of commercial advances.
@
+nterest rates on loans upto ,s.200,000, hich account for 2@ per
cent of total advances, are sub(ect to hybrid controlCthe rate is not fi!ed at a level set by the
,1+, but is constrained to be no higher than the prime lending rate (57,) hich is
determined by the boards of individual ban&s. The ne arrangement implies a considerable
reduction in the range of loans ith subsidi"ed rates compared to the position earlier.
The rationale for liberali"ing interest rates in the ban&ing system as to allo ban&s greater
fle!ibility and encourage competition. 1an&s ere able to vary rates charged to borroers
according to their cost of funds and also to reflect the creditorthiness of different borroers.
They could also vary nominal rates offered on deposits in line ith changes in inflation to
maintain real returns. Fle!ibility to discriminate among borroers has helped create a more
competitive situation. Fle!ibility on deposit rates has proved to be asymmetrical. 1an&s are
able to raise rates hen inflation increases but they are not able to loer deposit rates hen
inflation de clines. This became evident in )--@ and )--6 hen inflation varied beteen =
and @ per cent but ban& deposit rates remained high. /ome observers have attributed this to
the fact that e!pectations of inflation had not fallen even though inflation declined, but a
more plausible e!planation is that the rates of interest available on postal savings
instruments, hich are fi!ed by the central government, have been maintained at high levels
%s postal savings are close substitutes for ban& deposits, ban&s find it difficult to loer rates
on deposits as long as postal savings rates are not ad(usted donards. +nterest rate
5
$!port credit benefits from availability of refinancing from the ,1+ at a concessional rate
hich mitigates the burden of this particular control on the ban&ing system.
:
deregulation re3uires that interest rates on postal savings be made more fle!ible, perhaps by
lin&ing them to interest rates in the ban&ing system in some ay.
6
7oo&ing ahead, the remaining hybrid control on lending rates for small loans can also be
phased out at an early date. The desire to control interest rates for small loans reflects an
understandable desire to help small borroers, but e must recogni"e that these controls
may actually discourage ban&s from lending to these sectors or alternatively they may
encourage corruption in determining access to such loans. There is overhelming evidence
that hat matters for lo income borroers is timely availability of credit rather than lo
interest rates and a policy hich &eeps rates lo but impedes the flo of credit does not help
the target group. 1an&s forced to charge unprofitably lo interest rates may also see& to
protect their profitability by improving credit 3uality by insisting on higher levels of collateral
than ould otherise be the case, thus effectively e!cluding precisely the groups hich
interest rate controls are meant to favour. /ome segments of the ban&ing system have
already been freed from restrictions on lending rates. .ooperative ban&s ere freed from all
controls on lending rates in )--6 and this freedom as e!tended to regional rural ban&s and
private local area ban&s in )--8. %s the system gets used to higher rates being charged on
smaller si"ed loans by these institutions, it should be possible to ta&e the ne!t step and
remove e!isting controls on lending rates in other commercial ban&s.
-. - RESER.E RE/"IREMENTS
%nother important area here some liberali"ation has ta&en place relates to the cash
reserve re3uirement (.,,) and the separate re3uirement for mandatory investment in
government securities through the statutory li3uidity ratio (/7,). %t one stage, the .,,
applicable to incremental deposits as as high as 2@ per cent and the /7, as =0 per cent,
thus pre;empting 6@ per cent of incremental deposits. These ratios ere reduced in a series
of steps after )--2. The /7, is no 2@ per cent, hich appears high, but its distortionary
effect has been, greatly reduced by the fact that the interest rate on government securities is
increasingly mar&et determined. +n fact, most ban&s currently hold a higher volume of
government securities than re3uired under the /7, reflecting the fact that the attractive
interest rate on these securities, combined ith the "ero ris&;eight, ma&es it commercially
attractive for ban&s to lend to the government. The .,, has varied beteen )0 and )) per
cent. This is definitely high by international standards and constitutes a ta! on financial
intermediation in the terminology of the financial repression literature.
The &ey constraint on reducing the .,, is the continuing high level of the fiscal deficit,
hich cannot be financed entirely from the mar&et and therefore re3uires substantial support
from the ,1+
8
. ,educing the .,, is not a viable option in this situation because the
e!pansionary impact on money supply via the money multiplier (hich is a function of the
.,,), ould need to be offset by a monetary contraction elsehere. +n effect the ,1+ ould
have to refrain from moneti"ing the deficit to the e!tent that it does at present hich means
interest rates on government securities ould have to be alloed to rise. The high .,, is
therefore the cost imposed on the ban&ing system to allo the fiscal .deficit to be financed at
a loer cost to the government than ould otherise prevail. 7oering the .,, ould of
course reduce the implicit ta! on the ban&ing system, enabling ban&s to reduce rates on (
commercial advances but it ould be at the cost of either accepting higher rates for
government borroing or tolerating greater monetary e!pansion and possible inflation.
6
1ecause the net accretions to postal savings are shared ith the states, state governments
are li&ely to resist reduction in these interest rates for fear that it ill impede mobili"ation of
resources. This resistance has to be overcome since otherise the system ill not be able to
transit to a sustainable lo inflation regime.
7
The earlier practice of automatic moneti"ation of the deficit through issue of ad hoc
Treasury 1ills has been abandoned but as long as fiscal deficits not controlled, this only
forces the ,1+ to resort to mar&et borroing to finance the deficit. The ,1+ is therefore
presented ith a <obson's choiceCit must either accept the high interest rates generated by
government borroing or moderate interest rates by moneti"ing the deficit.
=
-.0 (IRE+TE( +RE(IT
%n area here there has been no liberali"ation thus far relates to directed credit. *irected
credit policies have been an important part of +ndia's financial strategy under hich
commercial ban&s are re3uired to direct =0 per cent of their commercial advances to the
priority sector hich consists of agriculture, small;scale industry, small;scale transport
operators, artisans, etc. ?ithin this aggregate ceiling there are sub;ceilings for agriculture
and also for loans to poverty;related target groups. The 0arasimham .ommittee had
recommended reducing the =0 per cent directed credit target to )0 per cent, hile
simultaneously narroing the definition of the priority sector to focus on small fanners and
other lo;income target groups. This recommendation as not accepted by the government
and the directed credit re3uirement continues unchanged.
/hould directed credit re3uirements be phased outD This is an important and potentially
controversial 3uestion. *irected credit in support of e!port industries as a part of $ast
%sia's financial policy during the miracle groth period and these policies ere generally
regarded as successful. <oever, this is not so for all cases of directed credit. 5revailing
international perceptions of best practice in ban&ing are generally against directed credit.
9
The shortcomings of directed credit policies in +ndia are ell &non and are reflected in the
fact that the proportion of non;performing assets (05%s) in the priority sector portfolio of the
ban&s is significantly higher than in the non;priority sector. <oever, abandoning of directed
credit is unli&ely to be a practical option in +ndia in the near E future, especially because
directed credit in +ndia relates mainly to lending to agriculture, small;scale industry, and
poverty groups. +f the present level of directed credit has to continue for some more time, e
should at;least consider ays of ameliorating the adverse conse3uences of this policy as
much as possible.
% step in the right direction ould be to eliminate the present concessional interest rates
applicable to loans belo ,s.200,000, most of hich fall in the priority sector. +f priority
sector credit does involve higher cost to the ban&s e should reflect this in the interest rate
alloed to be charged. This ould increase the illingness of ban&s to lend to .the priority
sector and ma&e the directed credit target less onerous. %nother desirable step ould be to
e!pand the list of activities eligible under the priority sector as this ould increase the range
of economically viable activities for the deployment of priority sector credit and A.thus help
improve the 3uality of the portfolio.
-
?e should also consider redefining the priority sector
target as a percentage of the total assets of the ban&ing system and not as a percentage of
commercial advances as .at present. This is because the share of commercial advances in
total assets is li&ely to increase over time as reserve re3uirements are reduced and fi!ing the
priority sector target as a percentage of commercial advances means a rising percentage of
total assets going to the priority sector hich may be too onerous.
The 3uality of directed credit could also be improved if the identification of beneficiaries as
left solely to the ban&s. This is perhaps the most important reform hich should be
implemented. %t present, recipients of priority sector credit under various anti;poverty
schemes (hich also involve a government subsidy) are identified primarily by the district
administration hich administers these schemes, and the credit applications of these
beneficiaries are then processed by ban&s. $ven here ban& officials are involved in the
pre;selection, their involvement is perfunctory and the attitude is one of having to meet
targets of lending rather than underta&ing serious credit appraisal. #any (though not all) of
the priority sector schemes oriented toards micro;enterprises have dubious economic
8
/tiglit" ()--=) has argued that directed credit may actually promote economic efficiency if it
is used to push credit into areas here there are technological spin;off and other
e!ternalities. <oever, this argument is based on the usual argument that government
intervention is helpful henever there is mar&et failure The problem, as pointed out by Fry
()--8) is that mar&et failure does not mean government success.
9
The .ommittee on 1an&ing ,eforms referred to in the third section of the chapter has
suggested including activities related to food processing, dairying, and poultry.
@
viability but ban&s find it difficult to re(ect loan applications. #any borroers tend to vie
credit e!tended as part of official anti;poverty programmes as a form of government largesse
here repayment is not .really intended, ma&ing it all the more difficult to fit these schemes
ithin normal ban&ing activity.
% somehat theoretical sounding possibility, but one hich should be e!amined, is that of
introducing 'trading' of priority sector performance among ban&s so that ban&s hich e!ceed
their targets of priority sector lending may be able to 'trade' the e!cess to the credit of other
ban&s hich are falling short. To the e!tent that some ban&s are relatively more efficient in
priority sector lending than others (e.g. because of broader spread of certain ban&s in
agriculturally prosperous areas), it ould enable the ban&ing system as a hole to achieve
the priority sector target at lesser cost. This ould especially be so if interest rate ceilings
are rela!ed.
0. RE)"!ATOR, REFORM OF TE &ANKIN) S,STEM
/ignificant progress has also been made in reform of the regulatory side of the ban&ing
sector. 5rior to )--) +ndian ban&s did not follo uniform accounting practices for income
recognition, classification of assets into performing and non;performing, provisioning for non;
performing assets and valuation of securities held in the ban&'s portfolio. 0or ere they
sub(ect to uniform capital ade3uacy re3uirements.
0.% ESTA&!ISMENT OF "NIFORM *R"(ENTIA! NORMS
The 0arasimham .ommittee recommended the establishment of uniform prudential norms
and standards broadly along the lines recommended by the 1asle .ommittee on 1an&ing
/upervision. These recommendations ere implemented in a phased manner over a period
of three years ith the ne norms becoming fully operational from :) #arch )--6.
+ndian ban&s have ad(usted ell to the ne standards and are in a stronger position today
than they ere Jul )--). Fery fe ban&s had a capital ade3uacy ratio up to the 9 per cent
level prior to )--). 1y #arch )--9 only one of the tenty;eight public sector ban&s fell short
of this standard and many ban&s ere significantly above that level. %dmittedly, the increase
in capital in many cases as achieved only through additional contribution of capital by the
government, and to that e!tent does not reflect an improvement in operational performance,
but there ere also substantial contributions from internal reserves resulting from improved
profitability.
)0
/ome ban&s ere also able to raise capitaG from the mar&et reflecting their
ability to attract private investors. The ne prudential norms and the greater transparency
they impart to ban& balance sheets have also increased consciousness of the need to
improve asset 3uality. $fforts to reduce 05%s sho encouraging results ith the ratio of net
05%s (i.e. net of provisions) to total advances declining from )6.: per cent at the end of
)--);2 to 9.2 per cent at the end of )--8;9
))
.
These are impressive improvements but it is also true that folloing the collapse in $ast
%sia, and subse3uent problems in ,ussia and elsehere, the standards being demanded for
regulating ban&ing systems in developing countries have risen significantly. +n anticipation of
this 'development the government, in *ecember )--8, appointed a .ommittee on 1an&ing
/ector ,eforms (.1/,) to revie the progress made in ;reform of the ban&ing sector and to
chart a course for the future. The (.ommittee has since submitted its report outlining a
comprehensive agenda for the second stage of ban&ing sector reforms.
0.- A!I)NIN) *R"(ENTIA! NORMS #IT INTERNATIONA! *RA+TI+E
10
5art of the profitability of ban&s reflects only the income earned from capitali "ation bonds
but there ere improvements in profitability even if their contribution is e!cluded.
11
Figures for gross 05%s are higher but the net figure is more relevant because ;+ndian
ban&s tend to delay riting off 05%s against provisions made. +t must also be recogni"ed
that 05%s as a proportion of total assets are significantly loer than as a proportion of
advances because a substantial proportion of the assets of +ndian bati&s is in the form of
government securities.
6
The obvious ne!t step is to align prudential norms as closely as possible ith international
practice. The .1/, has documented various deficiencies in this regard. For e!ample, loans
are classified as substandard hen ;payments become overdue for a period e!ceeding to
3uarters, hereas the international norm is one 3uarter. /imilarly substandard assets are
dongraded to doubtful if they remain substandard for to years instead of one year
internationally. 7oans ith government guarantees are treated as "ero;ris& assets and are
also not classified as non;performing even if there is a payment default. 4overnment
securities are treated as "ero;ris& assets hereas they are sub(ect to interest rate ris& and a
modest ris& eight is therefore appropriate. 0o provisions are re3uired to be made for
assets classified as standard hereas it ould be more prudent to ma&e a small provision
even in these cases. Finally the capital to ris&;eighted assets ratio is only 9 per cent
hereas internationally ban&s are no aiming at higher levels, especially in vie of the
greater .ris&s to hich ban&s in developing countries are sub(ect. ; The .1/, has made
specific recommendations to upgrade standards in these areas. The first step has been
ta&en ith the ,1+'s recent announcement that the capital ade3uacy ratio must be raised to
- per cent by :)st #arch 2000. The .1/, had recommended a )0 per cent level, hich ill
presumably be enforced over a longer time period. % ris& eight of 2.@ per cent has also
been attached to investments in government securitiesChalf the level recommended by the
.1/,. Bther recommendations of the .1/, to tighten prudential norms, especially
regarding criteria for classifying 05%s, also need to be implemented in a phased manner. +t
is sometimes argued that 05% recognition norms in +ndia cannot be e3uated ith
international norms because the slo pace of the legal system in enforcing ban& claims on
collateral security ma&es> it inevitable that assets ill remain non;performing for a longer
time. ?hile this may be true, it represents a real cost in the system and must be e!plicitly
recogni"ed as such. There may be a case for phasing the transition over time but it does not
(ustify accepting loer standards.
+mplementation of tighter norms ill have an impact on the ban&ing system. +t ill raise the
level of 05%s and force a higher level of provisioning. This ould erode the surplus over the
minimum capital re3uirement currently en(oyed by some ban&s and increase capital
deficiency in other cases. 1an&s are li&ely to complain that the shrin&age in the capital base
ill limit their ability to e!pand commercial credit forcing some of them to become 'narro
ban&s'. The credit restraining effect is indeed a genuine problem for affected ban&s, but
credit for the system as a hole may not be affected if enough ban&s have surplus capital,
as these ban&s ould e!pand at the e!pense of those constrained by capital deficiency. +f
the net result is a gain in mar&et share for better performing ban&s at the e!pense of the
others, it is clearly desirable from the efficiency point of vie. #ore generally, e need to
recogni"e that regulatory forbearance in the form of la! prudential norms is not in the interest
of the ban&ing system. The e!perience ith ban&ing crises m other countries shos that
understatement of 05% levels because of inade3uately stringent norms and ea&
supervision only lulls ban&s into complacency, ma&ing them more vulnerable to crises hen
they arise. The balance of advantage lies in early announcement of the internationally
acceptable norms to hich ban&s must finally adhere, hile alloing a reasonable period of
time to reach these norms in a phased manner.
0.0 STREN)TENIN) S"*ER.ISION
%long ith the introduction of prudential norms it is also necessary to strengthen the system
of ban& supervision. %n. important step forard as the establishment of a separate 1oard
for Financial /upervision ithin the ,1+ to underta&e supervision. The system of supervision
is also being moderni"ed to focus on both on;site and off;site surveillance. The role of
e!ternal auditors has been strengthened as also the role of internal controls and audit. The
cycle of inspection and follo;up ith ban& managements, hich earlier often e!tended over
a period of to years, is no completed ithin telve months after the close of the .fiscal
year of inspection. The focus of inspection needs to shift aay from a mechanical pre;
occupation ith the e!tent of compliance ith procedures toards forming an overall
assessment of the ban&'s financial condition and performance under the .%#$7 system.
These are elcome steps, but the process of improving supervision is a continuing process
especially since ban&ing is li&ely to become more comple! ith ban&s e!posed to more
8
comple! ris&s. % great deal ill 'depend upon the ability of the ,1+ to upgrade the 3uality of
supervisory s&ills. 1an& supervision is an e!tremely difficult and highly s&illed operation and
s&illed ban& supervisors are a rare commodity even in industriali"ed countries. The 1oard
has greater fle!ibility for lateral recruitment but a great deal of upgrading of e!isting
personnel s&ills ill be necessary.
1. OTER ISS"ES IN &ANKIN) REFORM
1ringing prudential norms up to international standards is only one part of the reform
agenda. The more difficult part is to change the ay ban&s function in practice so that their
performance comes up to the more demanding re3uirements of the ne regulatory
environment. This means ban&s must function in a manner hich brings 05%s don to
acceptable levels hile simultaneously shoing sufficient profit to ensure groth of reserves
to support additional lending. The challenge is all the greater because economic reforms and
liberali"ation in the economy mean that ban& borroers no face greater competition
(domestic and international) hich increases the ris& of commercial failure compared to the
situation hen ban&s ere lending to clients operating in a protected economy. 1an&s have
to upgrade their credit appraisal methods to ensure that the activities for hich they lend are
economically viable in the ne more competitive environment. % more open economy also
implies greater volatility in e!change rates and interest rates and ban&s must allo for the
direct impact of;these uncertainties on their balance sheets because of their on e!posure
and also the indirect effect via the impact on their clients. 1an&s ill have to ma&e changes
on several fronts to deal ith these challenges including the upgradation of human s&ills,
induction of information technology, an understanding ith labour unions to phase out
outdated or& practices, etc.
1.% TE RO!E OF +OM*ETITION
The role of competition in accelerating change is especially important. 1an&s are more li&ely
to change if they are faced ith competition hich forces them to become more efficient in
order to survive. The creation of a more competitive environment in ban&ing as one of the
e!plicit ob(ectives of the reform and the degree of competition has increased to some e!tent.
/ome of the competition has come from outside the system. 1ecause of the development of
capital mar&ets and access to international sources of funds, the most creditorthy
corporate clients are able to obtain funds from other sources and this puts pressure on
ban&s to improve the cost and 3uality of their service or ris& losing creditorthy clients.
.ompetition ithin the ban&ing system has also increased. /everal ne private ban&s have
started operations and foreign ban&s have also been alloed to e!pand their branches more
liberally than in the past. %s a result the share of business of private ban&s and foreign
ban&s together increased from )0.6 per cent in )--);2 to )8.6 per cent in )--6;8. 5ublic
sector ban&s still remain in a dominant position, but foreign ban&s and some of the ne
private sector ban&s are ahead of public sector ban&s in the use of information technology
and this ill enable them to compete effectively for a larger business share, especially in the
high income segment of the mar&et, ithout having a very ide branch netor&. .ompetition
among public sector ban&s is also increasing and this also generates pressures for greater
efficiency.
+f competition leads to general improvement in efficiency of all public sector ban&s,
strengthening them all e3ually, e ould have an ideal outcome ith all participants gaining
in the process. +n practice, it is more li&ely that individual ban&s ill respond differently,
reflecting long;standing differences in managerial culture and or& practices, and some
ban&s ill pull ahead at the e!pense of others. The ea&er ban&s are in any case li&ely to be
held bac& by enforcement of capital ade3uacy re3uirements hich ill automatically limit the
e!tent to hich they can e!pand credit. This is li&ely to produce a restructuring of the
ban&ing system, ith better ban&s gaining mar&et share at the e!pense;of others. This
should be accepted as a natural outcome of competition, even though it may intensify the
problem of ea& ban&s.
1.- *RO&!EM OF #EAK &ANKS
<o to deal ith ea& public sector ban&s is a ma(or problem for the ne!t stage of ban&ing
sector reforms. +t is particularly difficult because the poor financial position of many of these
9
ban&s is often blamed on the fact that the regulatory regime in earlier years did not place
sufficient emphasis on sound ban&ing, and the ea& ban&s are, therefore, not responsible
for their current predicament. This perception often leads to an e!pectation that all ea&
ban&s must be helped to restructure after hich they ould be able to survive in the ne
environment.
The usual recipe for revival of ea& ban&s is to ta&e care of the inherited burden of 05%s
through some mechanism, such as, for e!ample, an %sset ,econstruction .ompany as
recommended by the .1/,, and then let the 'restructured' ban&s, ith their cleaned up
balance sheet compete ith other ban&s. This approach may be orth trying in some cases
but it must be recogni"ed that it does not guarantee revival. $ven if the bac&log of 05%s is
ta&en care of, many of the ea& ban&s ill also need to cut costs by closing loss;ma&ing
branches and reducing e!cess staff if they are to have to any hope of surviving in
competition ith other ban&s in the more competitive environment of the future hen
margins ill be under pressure. +n short, revival may only be possible if it is preceded by a
illingness to slim don and cut overheads drastically. +t may also need a ma(or overhaul of
top and middle management hich is not easy to achieve in a public sector ban&.
$ven after donsi"ing some ea& ban&s may not be able to survive in competition against
stronger ban&s hich have better management cultures, stronger human s&ills, and better
labour relations. +n such a situation e must beare of repeated efforts at restructuring
aimed at &eeping such ban&s alive. The .1/, has recommended that such cases should be
handed over to a ,estructuring .ommission, hich can then decide on suitable solutions,
including merger ith other ban&s or even closure. #erger in this conte!t should not mean
mere arithmetical aggregation of the ea& ban& ith all its staff and branches into another
financially sound ban&. #ergers have the advantage that they protect depositor interests
hich is an important consideration, but they ma&e economic sense only if they are
preceded by sufficient effort to reduce cost by further donsi"ing before the merger. +n the
competitive environment e!pected in the future, strong ban&s are unli&ely to be illing to
accept merger ith a ea& ban& unless these issues are resolved and they should not be
forced to do so.
1.0 MA2ORIT, O#NERSI* OF &ANKS
5erhaps the most difficult issue for the future is hether government should retain ma(ority
control over public sector ban&s. The prevailing international consensus is against
government onership and many developing countries are actively engaged in privati"ing
government ban&s as part of financial sector reform. 5rivati"ation is obviously not a
guarantee against bad ban&ing, as is evident from the many ban&ing crises involving private
ban&s in both developed and developing countries. <oever this argument is usually
countered by conceding that hile privati"ation alone is definitely not sufficient, and must be
accompanied by improved regulation and supervision, it is nevertheless necessary because
government onership involves 'politici"ation' and 'bureaucrati"ation' of ban&ing
)2
.
The .1/, considered this issue and has recommended that the governmentH,1+ holding in
the public sector ban&sH/tate 1an& of +ndia be reduced to :: per cent. To reasons have
been given by the .ommittee. Bne is that the capital re3uirement of ban&s ill e!pand
substantially because of the combined effect of groth of lending and enhanced capital
ade3uacy re3uirements, and the additional capital needed is much larger than the li&ely
groth of reserves through plough bac& of profit. %dditional capital ill, therefore, have to be
contributed and maintaining a @) per cent share in e3uity for the government ill re3uire
12
The to phenomena are 3uite distinct. 5olitici"ation in the conte!t refers to politically
motivated credit decisions hich may range from 'cronyism' in the sense of favouring
individual, usually large, borroers or politically directed populist loan programmes hich are
not based on sound credit appraisal, or even populist programmes of loan aivers.
1ureaucrati"ation refers to the conversion of public sector ban&s into organi"ations
characteri"ed by a layer of decision ma&ing ith inade3uate delegation hich slos don
decision ma&ing arid produces an inability to respond 3uic&ly to commercial needs and an
insensitivity to customer needs.
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India: A Financial Sector f
large contributions from the budget hich, the .ommittee felt, cannot be (ustified given the
many other demands for budgetary funds. The .ommittee therefore recommended that the
additional capital needs of the ban&s should be met by bringing in ne private e3uity, hich
ould dilute the government's share belo @) per cent. The second reason given by the
.1/, is more fundamental and is based on the vie that the degree of functional autonomy
re3uired for the e!ercise of sound ban&ing may not be possible as long as government
retains a ma(ority share.
#a(ority government onership of public sector ban&s has been an article of faith in many
circles in +ndia and it is important to consider carefully hether it is in fact inconsistent ith
sound ban&ing. Faghul ()--9) has sought to finesse the problem by suggesting that
government could retain ma(ority onership but the management of the ban& must be
entrusted entirely to a board of eminent professionals, hich ould appoint (and presumably
also remove) the chief e!ecutive, and e!ercise all the functions of supervision over the
management. +n this arrangement the management ould be responsible to the board and
the government ould deal ith only the board hich ould not include any government
officials. The arrangement ill appeal to those ho retain a preference for public onership
on principle but are illing to delegate poer in practice. <oever, the degree of
independence envisaged may not be feasible in practice.
4overnment accountability to parliament ma&es it unli&ely that government ould be illing
to distance itself sufficiently from management by delegating all poers of supervision to an
entirely independent non;government 1oard of *irectors. +n any case, since the aboard must
reflect the interests and perception of shareholders, it is difficult to envisage a board acting
completely independently of the government as long as the government is a ma(ority
shareholder. +n fact, there is real danger that such an arrangement might degenerate into
one hich gives an appearance of independence but allos informal and unstructured
interference in practice. This ould only continue the relationship of dependence ithout the
transparency and formal procedures involved hen government is formally responsible.
):
#a(ority onership also imposes certain statutory constraints. For e!ample, it implies that
ma(ority oned ban&s ill be treated as the state under %rticle )2 of the .onstitution hich
implies that action can be ta&en against the ban& on grounds of 'natural (ustice', a feature
hich limits the freedom available to managements in dealing ith personnel matters
including promotion. +t also implies that the government's anti;corruption machinery has
(urisdiction over ban& officials in the same ay as for government officials. The .entral
1ureau of +nvestigation (.1+) can therefore initiate investigation of ban& officials for
suspected malafide actions ithout complaints from the management and indeed even if the
management or board of the ban& is satisfied that the impugned actions do not merit
investigation. The agencies can also prosecute in such cases even though management
may have a different vie of the culpability of the action. /ince investigations typically ta&e a
long time ban& officials involved suffer significant costs in the process, including possible
suspension and denial of promotion. Fulnerability on this score encourages multiple layers of
scrutiny and decision ma&ing in public sector ban&s because ban& officials find comfort in
concurrence from others. This creates cumbersome systems in hich negative vies
e!pressed at any stage are unli&ely to be countered, all of hich introduces rigidity and an
unillingness to ta&e reasonable commercial ris&s.
+t is difficult to imagine +ndian public sector ban&s engaging in innovative ban&ing under
these constraints. ,educing the government's e3uity belo @) per cent should therefore be
the ne!t step in ban&ing sector reform.
1.1 !E)A! REFORMS
% ma(or obstacle to the development of an efficient ban&ing system in +ndia is the state of the
legal frameor& governing recovery of ban& dues. ,eali"ation of dues from sale of collateral
is e!tremely difficult, especially in the case of immovable property. Further, under the /ic&
13
,eference is appropriate in this conte!t to the vie e!pressed by Jeffrey /achs to the
author that 'the only thing orse than public sector ban&s is autonomous public sector
ban&s'.
)0
India: A Financial Sector f
+ndustrial .ompanies %ct (/+.%) companies declared sic& immediately come under the
pervie of the 1oard for +ndustrial and Financial ,econstruction (1+F,) hereupon legal
action for recovery of dues is stayed until the 1+F, process is completed. This process is
e!tremely dilatory. %n amendment of /+.% to ma&e it appro!imate more closely to
internationally accepted standards for ban&ruptcy legislation is essential. $ffective
ban&ruptcy la ould provide an incentive to the borroers to meet their obligations to the
ban&s. The Finance #inistry has appointed an $!pert 4roup to go into these issues. 7egal
reforms in this area must have high priority.
3. +A*ITA! MARKET REFORM
,eform of the capital mar&et as an important part of the agenda of financial sector reforms
and action has been ta&en in this area parallel ith reforms in ban&ing. +ndia has a long
tradition of functioning capital mar&ets the 1ombay /toc& $!change (1/$) is over a hundred
years old C but until the )-90s the volume of activity in the capital mar&et as relatively
limited. .apital mar&et activity e!panded rapidly in the )-90s and the mar&et capitali"ation of
companies registered in the 1/$ rose from @ per cent of 4*5 in )-90 to ): per cent in
)--0. <oever the stoc& mar&et remained primitive and poorly regulated. .ompanies
ishing to access the capital mar&et needed prior permission of the government hich also
had to approve the price at hich ne e3uity could be raised.
)=
?hile ne issues ere
strictly controlled, there as inade3uate Iregulation of stoc& mar&et activity and also of
various mar&et participants including stoc& e!changes, bro&ers, mutual funds, etc. The
domestic;capital mar&et as also closed to portfolio investment from abroad e!cept through
a fe closed ended mutual funds floated abroad by the Jnit Trust of +ndia (JT+) hich ere
dedicated to +ndian investment.
The process of reform of the capital mar&et as initiated in )--2 along the lines
recommended by the 0arasimham .ommittee. +t aimed at removing direct government
control and replacing it by a regulatory frameor& based on transparency and disclosure
supervised by an independent regulator. The first step as ta&en in )--2 hen the
/ecurities and $!change 1oard of +ndia (/$1+), hich as originally established as a non;
statutory body in )-99, as elevated to a full fledged capital mar&et regulator ith statutory
poers in )--2. The re3uirement of prior government permission for accessing capital
mar&ets and for prior approval of issue pricing as abolished and companies ere alloed
to access mar&ets and price issues freely, sub(ect only to ;disclosure norms laid don by
/$1+.
3.% TE RE)"!ATOR, FRAME#ORK
Bver the years /$1+ has put in place a modern regulatory frameor& ith rules and
regulations governing the behaviour of ma(or mar&et participants such as stoc& e!changes,
bro&ers, merchant ban&ers, ;and mutual funds. +t has also sought to regulate activities such
as ta&eovers and insider trading hich have implications for investor protection. The
governing structure of stoc& e!changes has been modified to ma&e the boards, of the
e!changes more broad based and less dominated by bro&ers. The ne regulatory
frameor& see&s to strengthen investor protection by ensuring disclosure and transparency
rather than through direct control. /$1+ acts as a supervisor of the system underta&ing
supervision of the activities of various participants including stoc& e!changes and mutual
funds and violations of the rules are punishable by /$1+.
The regulatory frameor& is as yet ne and ill need to be refined in the light of e!perience
gained and also as gaps and inade3uacies are identified. /$1+ needs to be further
strengthened in some areas and its punitive poers enhanced. <oever there is no doubt
that a good start has been made.
3.- O*ENIN) TE +A*ITA! MARKET TO FOREI)N IN.ESTORS
14
The system forced companies to price ne e3uity issues at levels substantially loer than mar&et
prices, ostensibly as a measure of protection for the small investor. <oever this implicitly'penali"ed
firms raising capital from the public and the volume of e3uity raised in the capital mar&et as relatively
small.
))
India: A Financial Sector f
%n important policy initiative in )--: as the opening of the capital> mar&et to foreign
institutional investors (F++s) and alloing +ndian companies to raise capital abroad by issue of
e3uity in the form of global depository receipts (4*,s). Bver @00 F++s are no registered
ith /$1+, of hom about )@0 are active investors, and there has been a cumulative inflo
of around K- billion into the capital mar&et through this route upto the end of )--8;9. The
4*, route has also seen an inflo of about K 6 billion.
The cumulative investment of around K)@ billion in +ndian stoc&s through F++s and 4*,s has
effectively lin&ed +ndia's domestic capital mar&et ith orld mar&ets and has important
implications for macroeconomic management. *omestic li3uidity conditions and asset prices
are no affected by international mar&et perceptions and this must be ta&en into account in
formulating monetary policy. % large inflo of portfolio investment can lead to a sharp
increase in domestic li3uidity and asset prices as happened in )--= to )--6, and a reversal
can loer asset prices as in )--9. $!change rate behaviour is no as much determined by
developments in the capital account as on current account. /ince capital flos are affected
by international perceptions, and these perceptions can be triggered not (ust by
developments in +ndia but also by contagion effects from developments abroad,
management of the e!change rate has to ta&e these lin&ages into account. The economy is
not as vulnerable to volatile flos as it ould be ith full capital account convertibility, and
this is one reason hy +ndia's currency mar&ets ere not seriously disrupted in the %sian
crisis, but it is certainly more so because of FT+ and 4*, flos. The potential volatility of
these flos must be accepted and strategies for e!change mar&et management should ta&e
this into account.
3.0 MO(ERNI'ATION OF TRA(IN) AN( SETT!EMENT S,STEMS
#a(or improvements have ta&en place in trading methods hich ere highly anti3uated
earlier. The 0ational /toc& $!change (0/$) as set up in )--= as an automated electronic
e!change. +t enabled bro&ers in 220 cities all over the country to lin& up ith the 0/$
computers via F/%Ts and trade in a unified e!change ith automatic matching of buy and
sell orders ith price time priority, thus ensuring ma!imum transparency for investors. The
introduction of electronic trading by the 0/$ generated competitive pressure hich forced
the 1/$ to also introduce electronic trading in )--@.
The settlement system as anti3uated, involving physical delivery of share certificates to the
buyer ho then had to deliver them to a company registrar to record change of onership
after hich the certificates had to be returned to the buyer. This process as very time
consuming and also created significant ris&s for investors.
)@
The first step toards paperless
trading as put in place by enacting legislation hich alloed demateriali"ation of share
certificates ith settlement by electronic transfer of onership from one account to another
ithin a depository. The 0ational /ecurities *epository 7td (0/*7) opened for business in
)--6 +n June )--8 only forty;eight companies, ith a mar&et capitali "ation of ,s.-=,000
crore, had signed up enabling demateriali"ation of their securities. 1y June )--9 this had
increased to )-9 companies ith a mar&et capital of ,s.299,000 crore. The value of
securities actually held in the depository has increased from ,s.2@)9 crore in June )--8 to
,s.:@,000 crore in June )--9. +t is e!pected that the volume of settlements ta&ing place
through the depository ill e!pand rapidly.
3 1 F"T"RES TRA(IN)
%n important lacuna in +ndia's capital mar&et at present is futures mar&ets. % ell;functioning
mar&et in inde! futures ould help in ris& management and provide greater li3uidity to the
mar&et. % decision to introduce futures trading has been ta&en and the legislative changes
needed to implement this decision have been submitted to parliament. Futures trading is
15
The ris&s included loss of certificates in transition, fear of fa&e or forged certificates being
involved in stoc& e!change transactions hich ould be discovered only much later, and
also disputes at the time of registration of ne oners on the grounds that signatures of the
seller on the certificates did not match Lsignatures in the records of the registry.
)2
India: A Financial Sector f
e!pected to commence in )--- and ith this a ma(or deficiency in the capital mar&et ill
have been corrected.
3.3 SOME *RO&!EMS IN TE +A*ITA! MARKET
*espite these important improvements in the regulatory frameor& and trading and
settlement systems, the functioning of the capital mar&et in J the post;reform period has
been the sub(ect of much criticism. +nvestors, especially small investors ho entered the
mar&et in the early M stages of liberali"ation, have not found their investments to be good
value. There is a idespread perception that many unscrupulous companies too& advantage
of the removal of government control over issue prices to raise capital at inflated prices, at
the e!pense of ine!perienced investors. #erchant ban&ers and underriters involved in t
these issues, some of hich ere among the better &non names in the business, are seen
to have misled investors. 0or is disappointment confined to ill;informed small investors
greedily venturing into ris&y investments hich they should never have underta&en m any
case. +nvestors ho invested in a ide range of blue chip stoc&s or in mutual funds,
including funds managed by some of the best &non international names, have also fared
poorly because the /ense! has fluctuated idely since )--: ith a dominantly bearish trend
in )--8 and )--9. 5art of the problem is the change in sentiment among F++s in this period
reflecting a contagion effect from $ast %sia. 5art of it may also reflect the sloing of
industrial groth after )--6.
+nvestor disappointment has led to a ithdraal of ordinary investors from e3uity mar&ets.
The volume of capital (both debt and e3uity) mobili"ed from the primary mar&et increased
substantially in the initial years of the reforms and reached a pea& in )--@;6. The ne!t to
years sa a sharp decline in the volume of e3uity raised in the primary mar&et ith offsetting
increase in resources raised through debt. This sitch aay from e3uity, folloing the poor
e!perience of investors ith e3uity investment, can be e!plained as a corrective process but
it has created problems for financing of ne pro(ects hich ere begun in the e!pectation of
easier availability of e3uity.
These problems have dran attention to the need to restore confidence among small
investors and this is indeed an important issue. <oever the solution does not lie, as is
sometimes supposed, in e!tending a variety of ta! incentives to lure small investors bac&
into the mar&et. To some e!tent it ill happen automatically hen the industrial cycle shos
an upturn. <oever it also re3uires deeper rooted institutional changes. /tudies conducted
by the /ociety for .apital #ar&et ,esearch and *evelopment sho that part of the reason
for the reluctance of small investors to enter the mar&et is the lo level of confidence about
corporate governance in many listed companies. % pre;condition for healthy capital mar&ets
hich is ell recogni"ed in industriali"ed countries is the e!istence of institutions hich
ensure high levels of corporate governance. These include high standards of accountancy to
ensure transparency in financial performance, active involvement of institutional investors in
monitoring performance based on good 3uality e3uity research inputs and also codes of
corporate governance hich are designed to ensure that managements are sub(ected to
effective oversight by boards and that shareholder interests are protected. +ndia's capital
mar&et is as yet far from this ideal. /ome corrective processes are hoever at or&.
.ompanies ishing to access capital mar&ets in future ill have to price +5Bs more
reasonably. They ill also have to sho improvements in corporate governance in line ith
groing consciousness of our deficiencies on this score.
+ssuers of capital must also reali"e that the capital mar&et should not be vieed, as a
passive source of e3uity capital hich can be tapped by companies at ill to raise e3uity on
favourable terms. .ross;country studies have shon that stoc& mar&ets in developing
countries have been a more important source for financing of ne investments through +5Bs
than in developed countries here financing of ne investment has relied mainly on internal
generation of surpluses. 0e companies raising funds have typically relied on venture
capital or private placement rather than public issues. To some e!tent this is made possible
by the e!istence of institutional investors such as insurance and pension funds illing to
invest in the capital of ne companies based on their on due diligence.
):
India: A Financial Sector f
*oes the emergence of these problems indicate that the broad thrust of reforms in the
capital mar&et has been inade3uateD The vie 'is sometimes e!pressed that perhaps the
removal of direct control on issue prices in the primary mar&et as premature and should
have been implemented only after greater e!perience had been gained ith regulation of the
secondary mar&et. +t is difficult to be certain on this issue, but it can be argued that a more
dran out process ould not have made much difference. +t ould certainly not ma&e sense
to retain price controls on domestic issuers of capital hile also opening up the mar&ets to
foreign investors. The solution for protecting the interest of small investors lies less in price
control and more in investor education. +nevitably, some of education comes through actual
e!perience hich is not alays pleasant.
4. REFORM OF TE INS"RAN+E SE+TOR
0o revie of financial sector reforms in +ndia can be complete ithout reference to the need
for reforms in the insurance sector. +ndia is one of only four countries C the other three
being .uba, 0orth 6orea, and #yanmar C here insurance is a public sector monopolyN
The rationale' of liberali"ing the ban&ing system and encouraging competition among the
three ma(or participants vi". public sector ban&s, +ndian private sector ban&s, and foreign
ban&s, applies e3ually to insurance. There is a strong case for ending the public sector
monopoly in insurance and opening it up
A
to private sector participants sub(ect to suitable
prudential regulation.
.ross;country evidence suggests that contractual savings institutions are an e!tremely
important determinant of the aggregate rate of savings and insurance and pension schemes
are the most important form of contractual savings in this conte!t. Their importance ill
increase in the years ahead as household savings capacity increases ith rising per capita
incomes, life e!pectancy increases, and as traditional family support systems, hich are a
substitute for insurance and pensions, are eroded. % competitive insurance industry
providing a diversified set of insurance products to meet differing customer needs, can help
increase savings in this situation and allocate them efficiently. The insurance andD pensions
industry typically has long;term liabilities hich it see&s to> match by investing in long;term
secure assets. % healthy insurance is therefore an important source of long;term capital in
domestic currency hich is especially for infrastructure financing. ,eforms in insurance ill
therefore strengthen the capital mar&et at the long;term end by adding ne players in this
segment of the mar&et, giving it greater depth or li3uidity.
+t is relevant to as& hy these developments are less li&ely if insurance remains a public
sector monopoly. Bne reason is that the industry suffers from a relatively high re3uirement
for mandatory investment in government securities. <oever this implies that it is the
mandatory re3uirement
>
and not the public sector monopoly hich is the real constraint. The
fact is that the insurance industry does not fully utili"e even the fle!ibility> available at present
for investment in corporate securities. This is principally because lac& of competition in the
insurance sector means there is no pressure to improve the return offered to the investor.
.ompetition ill increase the pressure to improve returns and push insurance companies to
move out of government securities to see& higher returns in high 3uality corporate debt.
0eedless to say, the process ould be greatly e!pedited if fiscal deficit is also reduced
resulting in a fall in the interest rate on government securities. ,eforms in insurance are
therefore more li&ely to create a flo of finance for the corporate sector if e can
simultaneously ma&e progress in reducing fiscal deficit.
The #alhotra .ommittee had recommended opening up the insurance sector to ne private
companies as early as )--=. +t too& five years to build a consensus on this issue and
legislation to open up insurance, alloing foreign e3uity up to 26 per cent as finally
submitted to. 5arliament in )---. +t could not be passed before the dissolution of 5arliament
and the earliest it can no be passed is by 2000. +f approved, i t ill re3uire legislation to
remove the e!isting government monopoly and the earliest that this can be done is some
time in )---. This means ne licences to competing insurers can only be issued by the end
of 2000 and since the ne entrants ill have to build up their business from scratch, i t i ll
ta&e another @ to )0 years before private insurance companies, even ith foreign partners,
can reach significant levels. The sooner e start the sooner e ill derive the benefit of
)=
India: A Financial Sector f
providing better service for the consumer, and the sooner it ill be possible to finance
infrastructure from the capital mar&et.
+ON+!"SION
The reforms currently under ay in the ban&ing sector and in the capital mar&et, combined
ith the agenda for reform identified for the insurance sector, represent a ma(or structural
overhaul of the financial system. +t ill certainly bring +ndia's financial system much closer to
hat is e!pected of developing countries as they integrate ith the orld economy. %s in so
many other areas, reforms in the financial sector have been of the gradualist variety, ith
changes being made only after much discussion and over a somehat longer period than
attempted in most other countries. <oever the direction of change has been steady and in
retrospect a great deal has been accomplished in the past seven years. +t is essential to
continue these reforms along the directions already indicated and to accelerate the pace of
change as much as possible.
Finally, it is important to recogni"e that financial sector reforms by themselves cannot
guarantee good economic performance. That depends upon a number of other factors,
including especially the maintenance of as a favourable rnacro;economic environment and
the pursuit of much needed economic reforms in other parts of the real economy. The impact
of financial sector reforms in accelerating groth ill be ma!imi"ed if combined ith
progress in economic reforms in other areas.
References
). .aprio,4erard, and *aniela 6lingebiel. )--6. I1an& +nsolvenciesA .ross;.ountry
$!perience.I 5olicy ,esearch ?or&ing 5aper )620. ?orld 1an&, ?ashington. *...
2. *ia";%le"andro, .. ()-9@). '4ood;vye financial repression, hello financial crash.' Journal
of *evelopment $conomics, vol. )- (/eptember;Bctober), pp.);2=.
:. #c6innon, ,.+.()-8:). #oney and .apital in $conomic *evelopment. ?ashington, *...A
1roo&ings +nstitution.
=. /ha, $. /. ()-8:). Financial *eepening in $conomic *evelopment. 0e Oor&A B!ford
Jniversity 5ress
@. /ingh, %. ()--8), 'Financial liberalisation and economic development.' $.B0B#+.
JBJ,0%7, vol. )08(#ay), pp.88);92.
6. /tiglit", J. $. ()--=). 'The role of the state in financial mar&ets.' +n 5roceedings of the
?orld 1an& %nnual 1an& .onference on *evelopment $conomics )--: (ed. #. 1runo and
1.5les&ovic), pp. )-;@2. ?ashington, *...A ?orld 1an&
8. /tiglit", J.$. and ?eiss, %. ()-9)). '.redit rationing in mar&ets ith imperfect information.'
%merican $conomic ,evie, vol. 8)(June), pp.:-:;=)0.
9. #a!ell, J. Fry ()--8). '+n favour of Financial 7iberalisation.' $conomic Journal, vol.
)08(#ay) pp. 8@=;880
P2G The author is currently serving as #ember, 5lanning .ommission in the 4overnment of
+ndia. The vies e!pressed in this paper are those of the author and do not necessarily
reflect the vies of the .ommission. %c&noledgements are due to /ur(it 1halla, #.
*amodaran, James <ansen and ..#. Fasudev for helpful comments.
P)G % ea& ban&ing system is vieed ith some (ustification as a fiscal time bomb aiting to
go off because ban&ing crises typically force government to recapitalise the ban&s in order to
avoid a larger systemic crisis, involving a fiscal burden hich can be 3uite large as a
percentage of 4*5 Psee for e!ample .aprio and 6lingebiel ()--6)G.
P2G /ee especially /ha ()-8:) and #c6innon ()-8:) and a more recent revie by Fry
()--8)
P:G /ee /tiglit" and ?eiss ()-9)) and /tiglit" ()--=). For a s&eptical vie of the efficiency of
stoc& mar&ets in allocating capital and their role in developing countries see /ingh ()--8).
)@
India: A Financial Sector f
P=G +t should be noted hoever that the particular e!planation for a IrepressedI interest rate
does not (ustify repression through government control. +t only implies that prudential
behaviour by the ban&s ould lead them to restrain interest rates belo mar&et levels on
their on. +f government does fi! interest rates, the e!tent of the distortion is measured by
the e!tent to hich this forces ban&s to repress interest rates belo the level they should
themselves choose.
P@G /ee *ia";%le(andro ()-9@)
P6G $!port credit benefits from availability of refinancing from the ,eserve 1an& of +ndia at a
concessional rate hich mitigates the burden of this particular control on the ban&ing
system.
P8G 1ecause the net accretions to postal savings are shared ith the states, /tate
governments are li&ely to resist reduction in these interest rates for fear that it ill impede
mobilisation of resources. This resistance has to be overcome since otherise the system
ill not be able to transit to a sustainable lo inflation regime.
P9G /tiglit" ()--=) has argued that directed credit may actually promote economic efficiency if
it is used to push credit into areas here there are technological spin;off and other
e!ternalities. <oever, this argument is based on the usual argument that the government
intervention is helpful henever there is a mar&et failure. The problem, as pointed out by Fry
()--8) is that mar&et failure does not mean government success.
P-G The .ommittee on 1an&ing ,eforms referred to in /ection : of the paper has suggested
including activities related to food processing, dairying and poultry.
P)0G 5art of the profitability of the ban&s reflects only the income earned from capitalisation
bonds but there ere improvements in profitability even if their contribution is e!cluded.
P))G Figures for gross non;performing assets are higher but the net figure is more relevant
because +ndian ban&s tend to delay riting off 05%s against provisions made. +t must also
be recognised that 05%s as a proportion of total assets are significantly loer than as a
proportion of advances because a substantial proportion of the assets of +ndian ban&s are in
the form of government securities.
P)2G The to phenomena are 3uite distinct. 5oliticisation in the conte!t refers to politically
motivated credit decisions hich may range from Icronyism in the sense of favouring
individual, usually large, borroers or politically directed populist loan programmes hich are
not based on sound credit appraisal, or even populist programmes of loan aivers.
1ureaucratisation refers to the conversion of public sector ban&s into organisations
characterised by layer of decision ma&ing ith inade3uate delegation hich slos don
decision ma&ing and produces an inability to respond 3uic&ly to commercial needs and an
insensitivity to customer needs.
P):G ,eference is appropriate in this conte!t to the vie e!pressed by Jeffrey /achs to the
author that Ithe only thing orse than public sector ban&s is autonomous public sector
ban&sI.
P)=G The system forced companies to price ne e3uity issues at levels substantially loer
than mar&et prices, ostensibly as a measure of protection for the small investor. <oever
this implicitly penalised firms raising capital from the public and the volume of e3uity raised
in the capital mar&et as relatively small.
P)@G The ris&s included loss of certificates in transition, fear of fa&e or forged certificates
being involved in stoc& e!change transactions hich ould be discovered only much later,
and also disputes at the time of registration of ne oners on the grounds that signatures of
the seller on the certificates do not match signatures in the records of the registry.
)6