Economic Analysis of Public Policy

 

 
REFORMS IN 
FINANCIAL SECTOR  
1991, 2008 AND BEYOND 
 

ADITYA KULKARNI  2015B3A40359P 

MRIGANKSHI KAPOOR 2015B3A70616P 

SRISHTI BANZAL  2015B3A70456P 

 
 1  

RATIONALE FOR THE STUDY 

 
It has now been know for a few decades that financial sector & economic 
growth are intimately connected. While there has been varying opinions on the 
direction and extent of the relation, the most widely accepted model given by 
Levine concludes that for economies to thrive, they need deep and broad 
financial systems.   
An underdeveloped financial sector can serve as a bottleneck to economic 
growth of a nation as observed in the case of Russia. Since this correlation is 
found to be more important for emerging and developing economies, it is vital 
that we explore the past financial reforms in India, the changing in scenario of 
the economy and hence derive possible future policy action. 
 

INTRODUCTION 
 
Institutions like BSE (1899) and RBI (1935) were established well before 
independence. Since then, the major reforms in Indian financial and banking 
sector can be studied by dividing the events in 3 time periods.  

 
 2  

THE PRE 1991 ERA 

Before 1990’s the financial system served government’s plan priorities rather 
than the public.  
The pre 1991 banking regulations were characterized as "financial repression". 
This includes: 
● Statutory pre-emptions   
● Interest rate regulation  
● Directed credit program  
THE 1991 REFORMS 
The protectionist policies resulted in the problem of ‘​Twin Deficit​’ - trade balance 
that followed the Gulf war along with a Fiscal deficit. As a result, India’s forex 
reserves were nearly depleted. To remedy the situation the govt. had to take a 
loan from IMF and devalue the currency. 
The Narsimham committee was set up to suggest changes in the financial 
system: 
 
MAJOR CHANGES: 
1. CRR and SLR Reductions 
● The practice of financing deficit through ad hoc issue of treasury 
bills was terminated and market-related rates of interest on 
government securities were implemented inevitably reducing 
CRR/SLR. 
 
● The reduction in CRR and SLR made more lendable resources 
available for growth sectors and gave RBI the choice to use indirect 
instruments like OMOs and bank rates. 

 
 3  

 
CRR SLR 

2. Termination of monetization through treasury bills: 

● Govt budget deficit used to be financed by borrowing from RBI 
through issuing of ad hoc treasury bills. Deficits increased year after 
year and these bills were never retired.  
● This resulted in the increase in reserve money causing inflationary 
tendencies through a manifold increase in money supply which was 
curbed by increasing CRR/SLR. 

3. Competitive Financial System: 

● To encourage competition, private sector banks were allowed to 
be set up and liberalized entry of branches of foreign banks was 
also allowed. 
● In 2004, the limit of FDI was raised from 49 % to 74 % and govt. is 
mulling over changing it to 100% for private sector banks.   

 
 4  

4. High Capital Adequacy Ratio: 

● CAR is a measure of a bank’s capital. A high CAR ensures that 
banks have enough cushion to absorb a some loss without 
becoming insolvent. 
● Before 1991, the accounting practices of banks had no 
transparency. The international norms (like CAR) were not applied.  
● Thus there was the risk of rising NPAs- which lead to insolvency & 
bank panic- without it being public knowledge until late.  
● Considering these risks, the international CAR norm of 8 per cent 
was introduced.   
 

 
 5  

5. NPAs & Income Recognition Norm: 

● Under the income recognition norm, income on assets of a bank is 
not recognized if it is not received within two quarters after the due 
date. 
 

6. Others: 
● RBI did away with administered interest rates for banks.  
● Direct or selective credit controls were also removed.  
● Since there was no provision for credit control, to ensure lending to 
priority sectors, microfinance practices were promoted. 

2008 & BEYOND 

TRENDS IN BANKING SECTOR (2008 - 2017) 
● Slowdown in credit growth : Due to increasing problem of NPAs 
banks have run short of loanable funds and are more cautious with 
their funds. 
● Increase in share of corporate lending by public sector banks : PSBs 
funded a significant share of infrastructure and other funding during 
2004 - 11. 
● Increasing NPAs in public sector banks  
● Increasing share of foreign holdings in private sector banks : Due to 
more relaxed FDI norms 
 

THE TWIN BALANCE SHEET PROBLEM 

 
● The PSBs had funded several corporate projects post 2004 to lead 
to an economic boom. The companies had also overleveraged 

 
 6  

themselves to fund new projects. When the slump came after 

2008, the projects they had undertaken become unprofitable and 
companies couldn’t even repay interest payments. The banks’ 
assets turned into NPAs and the banks didn’t write them off due to 
lack of adequate level of banking capital. 
 
● The banks were not lending any money due to bank capital issues. 
The debtors didn’t have money to pay for old loans. The new credit 
seekers were unable to secure loans at reasonable interest rates. All 
this led to investment bottlenecks. 

REFORMS 
 

1. Insolvency and Bankruptcy Code, 2016 

○ The Insolvency and Bankruptcy Code will make it easier to exit or 
attempt revival of a business. 
○ This will help improve the health of bank balance sheets as well as 
help them in recognizing NPAs in a time bound manner. 
○ Process:  

 
 7  

2. The Banking Regulation Act (amended 2017) 

○ The Ordinance amends the Banking Regulation Act, 1949 to insert 
provisions for recovery of outstanding loans.   
○ RBI can direct banks to initiate recovery proceedings against loan 
defaulters.  
○ Provision for a time-bound process to resolve defaults by either (i) 
restructuring a loan or (ii) liquidating the defaulter’s assets. 
○ RBI may issue directions to banks for resolving stressed assets.   
 

 
 8  

3. Mission Indradhanush 
○ Mission Indradhanush is a 7 pronged strategy of the govt to better 
PSBs situation. The scheme covers: 
i. Appointments : to posts of CEO and MD 
ii. Bank Board Bureau : will replace the appointments board of 
PSBs and advise on NPA resolution 
iii. De-stressing PSB : Solve issues in the infrastructure sector to 
check the problem of stressed assets in banks 
iv. Capitalization : Capitalisation of the banks by inducing Rs 
70,000 crore into the banks in the next 4 years 
v. Empowerment  
vi. Framework Of Accountability 
vii. Governance reforms in PSBs 
4. Bank Recapitalization 
○ To help banks take a haircut and easen the flow of capital, a 
recapitalization package was crafted for PSBs. 
○ Through budgetary allocations, the govt. will buy Rs.18,000 crore 
worth shares of public sector banks with Rs. 58,000 crore to be raised 
from the market 
○ The govt. will issue Bank Recapitalization Bonds for Rs. 1,35,000 crore 
to buy more shares in public sector banks over 2 years timespan 
○ There’s a 75-25 government-private infusion of new money into 
banks. 
  

PUSH TOWARDS FINANCIAL INCLUSION 

Policy measures which have been taken towards this aim: 

 
 9  

1. Payment banks :  

○ RBI has allowed 11 companies to open their payment banks 
(They cannot accept deposits > 1Lakh, cannot lend) to 
expand the reach of formal banking sector 
2. Differentiation of bank licenses : 
○ There are licenses for Payment banks, small finance banks 
etc. to diversify the formal banking options available to the 
poor  
3. Ease of Application: 
○ It’s easier than ever to obtain a banking license to encourage 
more companies to enter the industry 
4. Financial Inclusion: 
○ PMJDY, JAM trinity, UPI, BHIM etc. have been launched in the 
recent years to promote financial inclusion through digital 
means as well. 

 
 10  

POLICY RECOMMENDATIONS: 

 
Broad Classifucation of Capital Markets 

CAPITAL ACCOUNT CONVERTIBILITY i​ s a monetary policy which gives the 

power to Indian nationals to conduct transactions of local financial assets into 
foreign financial assets freely and at market determined exchange rates. The 
term CAC was first coined by the ​SS Tarapore Committee​ of ’97.  
The report indicated few parameters for the implementation of the full CAC. 
They are summarised in the infograph below. The committee gave 
recommendations on fiscal deficit, inflation rates, NPAs, Cash Reserve Ratio 
(CRR). 

 
 11  

 
 
The benefits of full CAC mostly benefit the medium and upper class population 
who find foreign capital more attractive in terms of returns. 
 
Also, there are benefits to FCAC for financial institutions, including increased 
diversification, greater access to capital, and a broader range of risk 
management tools.  
At about $ 106 billion, total foreign bank claims on India are comparable to 
those on China and Russia. In contrast, Indian banks’ claims on other countries 
are almost four times less than this total. With fuller capital account convertibility, 
new risks will arise as cross-border transactions increase.  
Such activities will involve different currencies, include on-balance sheet lending 
& funding, and off-balance sheet derivatives. 
 

 
 12  

RISKS 
 
The current situation on a macro-level seems to be conducive for the 
implementation of the FCAC. But implementation comes with certain risks as 
named in ​Fig 1 b
​ elow. 
 

 
Fig 1. Various Possible Risks that may arise post FCAC implementation 
 
As shown in Tarapore Committee Report, the ability of financial institutions to 
identify & manage risk will also depend on the availability of instruments to 
manage risk, the liquidity of financial markets & the quality of infrastructure, 
and level of market discipline; key segments of the Indian capital markets 
remain underdeveloped. The term money market is limited and the 
corporate bond market is relatively small and illiquid. The market for 
securitised assets has fallen short of expectations whereas the OTC 

 
 13  

derivatives market is growing rapidly but its prudential and regulatory 

framework has just been laid out. 
 
So over a horizon of 10 years India needs improve its macro-fundamentals, and 
with a strong banking system it can go ahead with the next big reform of 
implementation of Capital Account Convertibility.  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 14  

REFERENCES 
● http://www.prsindia.org/billtrack/the-banking-regulation-amendment-bill-2017-4771/ 
● https://en.wikipedia.org/wiki/Banking_Regulation_Act,_1949 
● https://thewire.in/190554/explained-great-indian-bank-recapitalisation-push/ 
● https://economictimes.indiatimes.com/news/economy/policy/govt-plans-indradhanush
-2-0-for-recapitalisation-of-public-sector-banks/articleshow/57108572.cms 
● https://www.chanakyaiasacademy.com/blog/item/94-mission-indradhanush-for-banks 

● https://www.pwc.in/assets/pdfs/publications-2010/india-captial-market.pdf