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IMPACT OF FINANCIAL SECTOR REFORMS ON ECONOMIC GROWTH IN INDIA

THESIS SUBMITTED TO THE UNIVERSITY OF DELHI FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY

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IMPACT OF FINANCIAL SECTOR
REFORMS ON ECONOMIC
GROWTH IN INDIA

THESIS SUBMITTED TO THE UNIVERSITY OF DELHI

FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY

BY

ANJALI BANSAL

DEPARTMENT OF COMMERCE
DELHI SCHOOL OF ECONOMICS
UNIVERSITY OF DELHI
DELHI
INDIA - 110007

[2009]
 DECLARATION

The present thesis entitled “IMPACT OF FINANCIAL SECTOR REFORMS ON

ECONOMIC GROWTH IN INDIA” is based on my original research work and
has not been submitted in part or full for any other diploma or degree of any
university.

My indebtedness to other works at has been duly acknowledged.

(Anjali Bansal) (Professor Y.P. Singh)

Research Scholar Research Supervisor
Department of commerce Department of commerce
Delhi School of Economics Delhi School of Economics
University Of Delhi University Of Delhi
Delhi Delhi
India-110007 India-110007

(Professor S.K. Jain)

Head
Department of commerce
Delhi School of Economics
University Of Delhi
Delhi
India-110007

I
II
 ACKNOWLEDGEMENTS

I would like to express my sincere gratitude to my research supervisor

Professor Y.P.Singh for his help and guidance. I thank him for helping me at

every stage of my work and offering valuable comments from time to time.

I am also thankful to Professor I.M.Pandey for his suggestions and guidance

especially in the context of econometric techniques used in the study. In

context of research methodology I also got great help from my friends Sonia

Mittal and Neha Gupta. My thanks are due to them.

I would also like to take this opportunity to thank the office and library staff

for their ready assistance whenever required.

I must also thank my husband for his patient help with the formatting of the

thesis and otherwise. Finally I thank my parents for their blessings and

encouragement throughout the process.

ANJALI BANSAL

III
IV
 CONTENTS

1. Introduction............................................................................................... 1-1

1.1 The Financial System.................................................................... 1-1

1.2 Role Of Finance In Economic Growth......................................... 1-5

1.3 Evolution Of The Indian Financial System ................................. 1-9

1.4 A Brief Outline Of The Proposed Study ....................................1-12

2. Financial Sector Reforms ........................................................................ 2-1

2.1 Need For Reforms ......................................................................... 2-1

2.2 The Reforms Of 1991 (NCR-I) ....................................................... 2-2

2.3 The Second Generation Reforms 1998 (NCR-II)......................... 2-6

3. Review Of Literature................................................................................. 3-1

3.1 Different Views In Literature......................................................... 3-1

3.2 Financial Development And Growth: Cross Section Vs. Time

Series Evidence ...........................................................................3-11

3.3 The Role Of Stock Market...........................................................3-14

3.4 The Studies For Indian Economy ..............................................3-18

4. Financial Development In India: Pre And Post Liberalization ............. 4-1

V
 4.1 Financial Development: Qualitative Aspects And Quantitative
Dimensions .................................................................................... 4-1

4.2 Indicators Of Financial Development.......................................... 4-3

4.2.1 Gross Domestic Savings And Investment......................... 4-4

4.2.2 Deposits ................................................................................ 4-6

4.2.3 Credit ...................................................................................4-10

4.2.4 Structure Of The Financial System ..................................4-17

4.3 Data And Methodology ...............................................................4-20

4.4 Trends In Financial Development..............................................4-22

5. Performance Of The Indian Financial Sector ........................................ 5-1

5.1 The Progress Pre-Liberalization .................................................. 5-1

5.2 Financial Sector Reforms: The Focus......................................... 5-2

5.3 Performance Parameters.............................................................. 5-4

5.3.1 Profitability............................................................................ 5-7

5.3.2 Non-Performing Assets/ Advances (NPAs).....................5-11

5.3.3 Capital Adequacy ...............................................................5-16

5.3.4 Productivity.........................................................................5-18

5.3.5 Competition.........................................................................5-31

6. Indian Financial Markets.......................................................................... 6-1

6.1 Importance ..................................................................................... 6-1

6.2 The Capital Market In India: Organization And Structure ......... 6-4

VI
 6.3 The Reform Measures................................................................... 6-7

6.4 Impact Of Reforms ........................................................................ 6-9

6.4.1 Size Of The Market .............................................................6-10

6.4.2 Liquidity...............................................................................6-14

6.4.3 Volatility...............................................................................6-18

7. Financial Development And Economic Growth .................................... 7-1

7.1 Empirical Literature: An Overview .............................................. 7-1

7.2 The Model ....................................................................................... 7-4

7.3 The Determinants Of Growth ....................................................... 7-9

7.4 Variables In The Model ...............................................................7-11

7.5 Data And Methodology ...............................................................7-17

7.6 Results..........................................................................................7-26

8. Summary And Conclusions .................................................................... 8-1

8.1 An Overview................................................................................... 8-1

8.2 The Development Of The Financial System ............................... 8-2

8.3 Financial System And Economic Growth Linkages .................. 8-4

8.4 Limtations And Outline For Further Research........................... 8-5

Appendix.................................................................................................................. 1

Bibliography............................................................................................................ 1

VII
 List Of Tables

Table 4.1: Gross Domestic Savings And Capital Formation ........................4-23

Table 4.2: Households’ Savings Behavior ......................................................4-30

Table 4.3: Deposits Of Scheduled Commercial Banks..................................4-32

Table 4.4: Deposits Of The Banking System ..................................................4-33

Table 4.5: Deposits Of Non-Banking Companies...........................................4-36

Table 4.6: Institutional Finance to the Private Sector....................................4-39

Table 4.7: Rate of Institutional Finance to the Private Sector ......................4-40

Table 4.8: Ratio Of Financial Assets To GDP .................................................4-43

Table 4.9: Density Of The Financial System ...................................................4-45

Table 4.10: Composition of Institutional Finance ..........................................4-47

Table 4.11: Percentage Of Bank Assets In The Total Financial Assets.......4-48

Table 4.12: Composition Of Financial Assets Of The Household Sector....4-50

Table 4.13: Composition Of Financial Liabilities Of The Household Sector4-53

Table 4.14: Select Financial Ratios for India ..................................................4-54

Table 5.1: Operating Profits Of Scheduled Commercial Banks ..................... 5-7

Table 5.2: Non-Performing Assets Of Scheduled Commercial Banks ........5-13

Table 5.3: Capital Adequacy Ratio I................................................................5-17

Table 5.4: Capital Adequacy Ratio II................................................................5-18

VIII
Table 5.5: Ratio of Intermediation Cost To Total Assets Of SCBs...............5-22

Table 5.6: Operating Profit Per Employee.......................................................5-25

Table 5.7: Business Per Employee ..................................................................5-28

Table 5.8: Net Interest Margin/ Total Assets...................................................5-34

Table 6.1: Number Of Listed Companies ........................................................6-10

Table 6.2: Market Capitalization Ratio .............................................................6-12

Table 6.3: Liquidity Ratios ................................................................................6-14

Table 6.4: Volatility Index..................................................................................6-18

Table 7.1: Results Of Co-integration Tests.....................................................7-28

Table 7.2: Results of Co-integration Tests II ..................................................7-29

IX
 List Of Charts

Chart 4.1: Savings As Percentage Of GDP .....................................................4-25

Chart 4.2: Investment As Percentage Of GDP................................................4-27

Chart 4.3: Institutionalization And Financialization Of Savings...................4-31

Chart 4.4: Bank Deposits/GDPmp....................................................................4-34

Chart 4.5: Aggregate Deposits Of Non-Bank Companies .............................4-37

Chart 4.6: Rate of Institutional Finance...........................................................4-41

Chart 4.7: Financial Development Ratios........................................................4-44

Chart 5.1: Operating Profits................................................................................ 5-8

Chart 5.2: Non Performing Assets ...................................................................5-15

Chart 5.3: Intermediation Cost Ratio ...............................................................5-23

Chart 5.4: Profit Per Employee.........................................................................5-26

Chart 5.5: Business Per Employee ..................................................................5-29

Chart 6.1: Number Of Listed Companies ........................................................6-11

Chart 6.2: Market Capitalization Ratio .............................................................6-13

Chart 6.3: SMC at end 2005 (International comparison)................................6-13

Chart 6.4: Liquidity Ratios ................................................................................6-15

Chart 6.5: Turnover Ratio 2005 Select Countries...........................................6-16

Chart 6.6: Volatility Of The Indian Stock Market ............................................6-19

Chart 6.7: Volatility of International Stock Indices.........................................6-19

X
 Chapter 1

INTRODUCTION

This chapter starts with an outline of the meaning, functions and importance of a
financial system. Then it gives a brief description of the Indian Financial System.
Subsequently, it provides an overview of the proposed research work.

1.1 THE FINANCIAL SYSTEM

The term ‘Finance’ in our simple understanding is perceived as equivalent to

money. It is, however, not exactly money, rather a source of providing funds for
any particular activity. The word ‘system’ implies a set of closely inter-connected
yet separate institutions, agents, practices, markets, transactions and so on
working together to achieve some purpose.

Financial System thus imply a set of complex and closely connected institutions,
agents, practices, markets, transactions, claims and liabilities that work together to
provide funds for different economic activities. Conceptually, financial system
includes complex institutional arrangements for mobilizing financial surpluses from
surplus units and transferring these to deficit spenders. These institutional
arrangements includes all conditions and mechanisms governing the production,
distribution, exchange and holding of financial assets of various types and the
organization as well as manner of operation of financial markets and institutions.

A financial system helps to promote savings and appropriately allocate the

available funds. It is concerned about money, credit, and finance: closely related,
yet different from each other. Money refers to the current medium of exchange or
means of payment. It also serves as a store of wealth and unit of account. It

1-1
consists of coins, notes and deposits with banks withdraw able on demand. It is a
liability of the banking system. Credit or loan is a sum of money lent by one party
to another to be returned normally with interest. It is a liability of the holding public
and asset for the lender/lending institution. Finance is monetary resources for
funding any activity. It consists of debt and ownership funds of an economic entity.

The financial system of any country typically comprises of financial institutions,

financial markets, and financial instruments and services.

I Financial Institutions are like business organizations involved in the sale-

purchase of financial assets and providing various financial services to the
community. These can be classified on the basis of functions, geographical
coverage, sector, scope of activity or type of ownership. An important classification
is that between intermediaries and non-intermediaries.

Intermediaries are the ones that mediate between those with budget surpluses and
those who wish to run deficits. They buy primary securities and sell secondary
securities that are in general far more acceptable to the surplus units. By
transforming primary into secondary securities they embody innovations in
financial technology whereby separate asset-debt preferences of lenders and
borrowers are reconciled to the satisfaction of both parties. Lenders get access to
a wide variety of secondary securities with lower risk, greater liquidity, lower
associated transaction and information costs and a host of other services.
Borrowers are benefited by availability of large pool of funds with greater certainty
and relatively low rates of interest.

An important question that comes to mind is how these intermediaries are able to
offer the low risk secondary securities when they buy primary securities that are
more risky. The answer lies in the law of large numbers, portfolio diversification,

1-2
and services of professional management – all these become realizable only when
operating on a large scale.

Intermediaries themselves can be further classified as bank (RBI, commercial

banks, co-operative banks) and non-bank financial intermediaries (NBFIs). The
distinguishing character of the banking mechanism lies in that –

1. They participate in economy’s payment mechanism i.e. provide transaction

services.
2. Their deposit liabilities constitute a major part of economy’s money supply.
3. They can create deposits or credit, which is money.

Many non-banking institutions like LIC, UTI also act as intermediaries and are
known as NBFIs. An important distinction between banks and NBFIs is that banks
are subject to legal reserve requirements. They can advance credit by creating
claims against themselves, while NBFIs can only lend out of resources put at their
disposal by savers.

The non-intermediary institutions like IDBI, NABARD do the loan business but their
funds are not directly obtained from the savers. These have come into existence
because of governmental efforts to provide assistance for specific purposes,
sectors and regions. They are therefore also called non-banking statutory financial
organizations (NBSFOs).

II Financial Markets are a significant component of any financial system. These

refer to the institutions or arrangements that facilitate the transactions in financial
assets and credit instruments of different types as currency, cheques, bonds etc.
The market may not have a precise physical location. The participants on the
demand and supply sides of these markets are financial institutions, agents,

1-3
brokers, dealers, borrowers, lenders, savers etc. These markets can be classified
in a variety of ways.

A. Based on maturity structure, we can talk of money market and capital-

market. Money market is a source of short-term funds (one year or less). It
facilitates adjustment of liquidity amongst its participants. Examples: bill
market, inter-bank call money market, working capital advances from
commercial banks etc. Capital Markets deal in long-term and medium term
claims. Examples: Stock market, government bonds market, financial
institution credit. For long and medium term claims the maturity is more
than a year but in a well-developed financial system secondary markets
exist for most of such claims thus making them fairly liquid.

B. Based on type of securities traded: primary and secondary market. Primary

market or new issues markets deal in new financial claims. Secondary
markets deal in securities already issued. Although secondary markets do
not contribute directly to the supply of additional capital, they do so
indirectly by increasing the liquidity of primary securities.

C. According to the nature of instruments traded, these markets can be

classified as debt, equity, or financial service markets. Debt market is where
lenders provide funds to borrowers for some specified period at fixed
interest rate. In equity market, ownership of tangible assets (such as
houses or share of stock) is brought and sold. Financial services markets
deal in services that enhance the working of debt and equity markets.
Examples: safety deposit boxes, ATM transactions, brokerage services etc.
No secondary market exists for financial services.

D. Organized and Unorganized markets – When financial transactions take

place outside well-established exchanges or without systematic and orderly

1-4
 structure, in an informal way - it constitutes the unorganized markets. It is
largely made up of indigenous banks, moneylenders, and activities not
coordinated by RBI or any other authority. The formal sector constitutes the
organized segment. It is subject to different types of regulations from the
authorities from time to time.

III Financial Instruments and Services: The financial claims or instruments and
services are many and varied in character because of diversity of motives behind
borrowing and lending. Indeed the maturity and sophistication of a financial system
is often gauged by the prevalence of a wide variety of assets and services to suit
varied investment requirements of heterogeneous investors. This enables them to
mobilize savings from as wide section of investing public as possible. Financial
securities can be classified as primary (direct) and secondary (indirect) securities.
Primary securities are financial claims against real sector units e.g. bonds,
equities, bills etc. – i.e. backed by real investments. Secondary securities are
claims issued by financial institutions against themselves to raise funds from public
e.g. currency, bank deposits, insurance policies, post office deposits etc.

1.2 ROLE OF FINANCE IN ECONOMIC GROWTH

The relationship between finance and economic development is a long debated

issue. There is a long list of economists who stress the importance of a sound
financial system for economic growth. Schumpeter1, the first modern economist to
study the relationship regarded banking system as one of the two ingredients in
the process of development. Gerschenkron2 considers that banking sector plays a

1
Schumpeter,J.A.(1911). The Theory of Economic Development. Cambridge,MA: Harverd
University Press.

2
Gerschenkron,A.(1962). Economic Backwardness in Historical Perspective. A Book of
Essays, Cambridge,MA Harverd University Press.

1-5
key role at certain stages of industrialization process. Goldsmith finds a positive
relation between economic development and financial development. McKinnon,
Shaw, Greenwood, Jovanovic, Levine, Allen, Gale all reiterate this view3. These
economists thus suggest a ‘supply-leading’ financial development i.e. financial
development precedes economic development; brought about through a
conscious, deliberate policy by the authorities. The basic idea behind such
promoted financial development is that it will help to accelerate the real rate of
growth. The available literature points to a number of channels through which
finance promotes growth:

Increasing savings rate and therefore investment.

Investment allocation

Technical innovations

Easing external financing constraints

Improving corporate governance

Reducing credit rationing
…and so on.

These lead to higher investment and/or increased investment efficiency that

ultimately speed up the growth process. Thus, one of the views on linkages
between financial development and economic growth is that the financial system
plays an important role in promoting economic development. It helps in production,
capital accumulation, and growth by encouraging more savings, mobilizing them to
productive uses and allocating them amongst alternative uses and users.

3
Refer chapter 3 for a detailed literature survey

1-6
In every economy, there are surplus sectors and deficit sectors. Household as a
sector is the surplus sector which has more funds than it wishes to spend.
Production firms on the other hand are deficit units that need much more than their
internal finances. The financial system encourages the surplus sectors to save
more and put the savings in financial assets. These savings can then be made
available to enhance production activities.

The financial system promotes savings by providing a wide range of financial

assets and services to suit the diversified needs of numerous savers. More
developed the financial system more options will be available to suit the needs of
different savers. Surplus funds will then flow more and more to the financial
system rather than in tangible physical assets. These funds can then be made
available to those who need them for productive investment. An efficient financial
system is in a position to improve the allocation of available funds by favoring more
productive and socially desirable activities. When increased funds are available,
more research activities and hence innovations become possible. Also the need
for external funds is greatly reduced or even eliminated. These specialized
financial institutions even provide suggestions and advice to improve the
functioning and efficiency of production units. All these above services are
instrumental for enhancing production, capital formation, and growth.

Parallel with the above view on the importance of the financial system, there also
exist an extremely contrasting view. There are a number of economists, notably,
Robinson, Gurley, Lucas, Nicholas Stern, Meier, and Seers, who feel otherwise.
Well-developed financial systems according to them are not essential for economic
progress. Rather it is economic growth that induces an expansion of the financial
system. Where enterprises leads, finance follows4. Thus they believe in “demand-

4
Robinson,J.(1952). 'The Generalization of the General Theory'. The Rate of Interest and other
Essays, McMillan,London.

1-7
following’ or passive financial development. Increased incomes with economic
betterment create a demand for diversified financial assets and services.

Thus we have above, a supply leading financial development where a sound

financial system assists in economic growth and secondly, a demand following
passive financial development that comes about with economic growth. A third
possible relationship pattern between the two is that the direction of causality
between economic growth and financial development does not remain the same in
all stages of development. In the beginning of growth process, financial
development may be promoted by authorities. It would induce capital formation,
innovations, and growth. As growth proceeds, this supply leading financial
development may be reinforced by the demand following development. The
relationship between economic growth and financial development is thus
symbiotic, mutually re-enforcing, and complex. While finance is an important
ingredient in growth; it is in no way sufficient to the growth process. Also, for
financial system to be effective in the growth process, the government must assure
minimum conditions of both financial and political order and refrain from random
adhoc interference that increases uncertainty for long range investment planning5.

It is usually presumed that financial system will always work for the benefit of
society. This is, however, not always true. Too much of regulations keeping
deposit rates low, can go against savings. Also, government regulations may
favor more credit and on favorable terms in areas and activities which may not
necessarily be highly productive. Often it is seen in the working of financial system
that weak borrowers are left behind even though they may have more promising
project in hand. Thus, financial system in itself may not necessarily be conducive
to economic growth. It must work in an efficient and unbiased way to promote
growth and development.

5
Cameron, R.(1972). 'Banking and Economic Development. New York.' Oxford University Press.

1-8
1.3 EVOLUTION OF THE INDIAN FINANCIAL SYSTEM

Pre-Independence: The Indian financial system, on the eve of planning, was

immature and partially rudimentary reflecting the underdeveloped state of the
economy. Some sort of banking business had begun during the early part of the
19th century, but it experienced little growth that too in the early part of 20th
century. It was concentrated in the hands of a few large banks, though
qualitatively, the services of small banks were of great importance. Most popular
form of bank credit was cash credit and overdrafts. Bill finance was not much
prevalent. The indigenous bankers dominated the financial scene. They financed
trade, acted as government bankers, mint-managers, and moneychangers, and
managed transfer of funds. Although co-operative banking began during 1920s, it
made little progress, particularly in relation to demand for funds in the agricultural
sector. Post offices saving bank deposits and small saving certificates have been
one of the oldest mediums for community savings. Life insurance business on
sound lines began in the second decade of the 20th Century.

The first stock exchange was established in 1887. The increased pace of
industrialization due to two world wars, protection to domestic industries in fiscal
measures, resulted in active new issue markets and stock exchanges. The
practice of companies accepting deposits directly from the public was well
developed even before 1950. The market for government securities and treasury
bills had also expanded phenomenally before 1950. The price of government
securities showed significant fluctuations before 1935. The setting up of the
Reserve Bank of India (RBI) in 1935 facilitated the pursuit of policy of stable
government security prices after that year. There were wide inter-bank and inter-
regional differences in the rates of interest. Compared to the position after 1950,
the level of interest rate even in the organized sector during major part of the
period before 1950 was quite high. They declined only after 1933 and then were
maintained at relatively low levels.

1-9
Post Independence: With the initiation of planned economic development in
1951, the Indian financial System entered a new phase of development.
Organization: The heavy industrialization strategy with a major role to the public
sector greatly conditioned the evolution of the financial system in the independent
India. It had a significant bearing on the institutional structure and regulatory
framework. Public control was extended over financial institutions partly through
nationalization of existing institutions but mainly through establishment of new
institutions in the public sector – the development financial institutions and unit
trusts that dominated the Indian financial system for quite some time. To ensure
that private industry operated on the desired path laid down by the five-year plans;
restrictions were imposed on investment institutions governing their investments in
the private sector. Public sector financial institutions participated in the
management and control of enterprises to which finance was provided.

After Liberalization: With liberalization in the nineties the organization of Indian

Financial System is undergoing a major transformation in terms of its ownership,
management, and control of financial institutions, their operations, institutional
pattern, regulatory framework etc. One important aspect relates to the entry of
new private sector (including foreign) banks and other financial institutions, public
sector financial institutions getting privatized, application of prudential norms in
accounting of income, asset classification, provisioning, and capital adequacy.

Growth and innovations: On the whole, the Indian Financial System has grown
enormously since 1950 in terms of its size, innovations, diversity, complexity, and
sophistication. Although banking system still remains the largest and most
important part of the Indian Financial System, other financial institutions have also
grown and now occupy an important place in the financial structure. The securities
market has emerged as an important mechanism for allocating resources in the
economy. Stock Exchange Board of India (SEBI) an autonomous body – provides
an integrated and focused regulation and helps development of the capital market.

1-10
There has also been a transformation in the role of various financial institutions.
The distinction between banks and other financial institutions has become blurred
and the Indian Financial System is moving in the direction of Universal banking
and financial conglomeration. It has become much more integrated than ever
before. The earlier divisions such as organized and un-organized markets, or
busy and slack seasons have become very blurred now.

The past fifteen years have witnessed the coming into being and growth of market
for security repurchase agreements (repos) that is serving the goal of liquidity
management in the system. There has been an increase in the synchronization of
the interest rates and the volume of turnover in various segments of money
markets. The variety of the financial instruments available is now much more. The
authorities have taken a number of steps to develop the supervisory, regulatory,
legal framework to ensure health, soundness, and stability of the Indian Financial
System6.

At present, India is experiencing a big rise of the service economy and the culture
of consumer personnel, installments, and hire-purchase credit. The current and
potential size of consumer finance market in India is quite vast. The secondary
market in different financial assets is largely underdeveloped. Markets for many
financial instruments are narrow and confined to a few financial institutions.

The volatility and instability of financial markets in India and all over the world has
increased with increasing liberalization and globalization. The stock markets in
particular are experiencing wild swings in prices, trading volumes and market
capitalization. At present, there is a great scope for improving the operational and
allocation efficiency of the Indian financial system. A cautious approach in
however required.

6
Refer chapter 4 for more details and statistical data.

1-11
1.4 A BRIEF OUTLINE OF THE PROPOSED STUDY

The study analyses the reforms relating to the financial sector undertaken in 1991
with a view to assess their impact on the economic growth of India. The study has
first examined the extent of financial development that has taken place subsequent
to the reforms. It has compared the pre and post–reform period on the basis of a
number of indicators so as to give a comprehensive impact of these reforms. It
has then examined the extent to which the resulting financial development has
influenced the economic growth in India.

Thus, the study is organized in two parts:

Impact of financial sector reforms on the development of Indian Financial
System, and

The FD-EG nexus for India.

Objectives
The work is a comparative study of pre and post liberalization period. It aims to
achieve the following objectives:

To study the reforms taken place in the financial sector.

To find the impact of these reforms on financial development in terms of
different indicators for density, deposits and credit making functions.

To assess the impact of reforms on the financial performance of financial
institutions.

To assess the impact on size, liquidity, and volatility of the stock market.

To examine the relationship between financial development and economic
growth in India.

In the light of above objectives the study has examined the following:

1-12
1. In the post-liberalization period (as compared to the pre-liberalization period).
a. Financial deepening has taken place.
b. Deposits and institutional credit have significantly increased.
c. Savings and investment have increased at much higher rates.
d. Competition in the financial sector has substantially increased.
e. Performance in terms of profits and productivity of the financial
sector has improved.
f. Size and liquidity of the stock market has shown improvement.
2. There exist a significant positive relation between institutional credit to the
private sector and rate of growth of the Indian economy.
3. There exist a significant positive relation between stock market indicators and
economic growth in India.
4. The contribution of financial development to economic growth in India through
increased investment is substantial.

The time period used in above analyses is 1950-51 to 2006-07. In cases where
data is not available for the entire time period, different sub-periods are used for
which the relevant data is available.

Rest of the work is organized as follows. Chapter two will outline the major reforms
undertaken in the financial sector. Chapter three presents a review of the existing
theoretical and empirical literature on the subject. Chapter four is devoted to the
empirical results on the trends in the financial sector in pre and post–liberalization
periods. It analyses if there exists an improvement in terms of the pre-defined
indicators. Chapter five deals with the productivity and performance of the Indian
financial sector, and six with the size, liquidity, and volatility of the stock market.
Chapter seven presents the empirical results on the relationship between financial
development and economic growth. Lastly chapter eight gives the summary and
conclusions and an outline for further research.

1-13
1-14
 Chapter 2

FINANCIAL SECTOR REFORMS

When India became independent in 1947, it was a backward, primarily agrarian,

stagnant, and low-income economy. Institutional set up and infrastructure was
terribly weak. We started with a centrally planned process of economic
development but the progress for a period of over four decades had been far from
satisfactory. Whether looked at from an economic angle or a social view point
there were problems of various kinds. On the whole, slow and uneven progress
had taken place. In the beginning of 1990s India was faced with serious fiscal and
financial problems. It had to approach the World Bank and other international
financial institutions for financial assistance. It was against this backdrop, that
wide-ranging reforms, encompassing all sectors of the economy were initiated.
This chapter outlines the need for reforms in the financial sector and presents a
summary of these reforms.

2.1 NEED FOR REFORMS

The Indian financial system of the pre-reform period essentially catered to the
needs of planned development in a mixed economy framework, where the
government had a pre-dominant role in economic activity. In order to facilitate the
large borrowing requirements of government, SLR was frequently revised upwards
and maintained at high levels. Interest rates on government securities were
artificially too low, unrelated to the market conditions. The government securities
market could not develop. The provision of fiscal accommodation through adhoc
treasury bills (at 4.6%) led to high levels of monetization of fiscal deficit. To check
the monetary effects, CRR was frequently revised upwards. The CRR and SLR on

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the eve of the reforms were quite high and the associated interest rates low.7 The
environment in the financial sector in those years was characterized by segmented
and under developed financial markets with paucity of instruments.

The existence of a complex structure of interest rates arising from economic and
social concerns of providing concessional credit to certain sectors had resulted in
cross subsidization which implied that higher rates were charged to non-
concessional borrowers. The regulation of lending rates led to the regulation of
deposit rates to keep the cost of funds to banks at reasonable levels. The system
of administered rates had led to multiplicity and complexity of interest rates. On
the whole the directed and concessional availability of bank credit with respect to
certain sectors resulted in distorting the interest rate mechanism and adversely
affected the viability and profitability of the banks. Lack of recognition of the
importance of transparency, accountability, and prudential norms in the operations
of banking system led to a rising burden of non-performing assets.

The policies pursued did have many benefits. The post nationalization phase
witnessed significant branch expansion to mobilize savings. There was visible
increase in the flow of bank credit to important sectors like agriculture, small-scale
industries, and exports. These achievements however, have to be viewed against
gross inefficiencies at the micro level.

2.2 THE REFORMS OF 1991 (NCR-I)

On the whole, banks, other financial institutions, and financial markets were all
operating in a highly controlled and regulated environment. Some steps towards
liberalization were taken during 1980s. In 1991, wide ranging economy wide
reforms were undertaken. In August 1991 the government of India appointed a

7
The CRR in 1991 was 15% with an additional incremental requirement of 10%. The SLR in 1991
was 38.5%. The government therefore mopped up 63.5% of the banking deposits in 1991.

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committee on the financial system under the chairmanship of Shri M.Narasimham,
a former governor of the RBI. The Committee was to examine the existing
structure of the financial system and its various components and to make
recommendations for improving the efficiency and effectiveness of the system with
particular reference to the economy of operations, accountability and profitability of
the commercial banks and financial institutions8.

The committee’s approach to the issue of the financial sector reform was to ensure
that the financial services industry operates on the basis of the operational
flexibility and functional autonomy with a view to enhancing efficiency, productivity,
and profitability. A vibrant and competitive financial system was seen as
necessary to sustain the ongoing reform in the structural aspects of real economy.
The committee was of the view that Indian banking and financial system had made
commendable progress in extending its geographical spread and functional reach
and that there had been considerable diversification of money and capital markets.
Despite this progress, however certain serious problems had emerged reflected in
a decline in productivity and efficiency and erosion of the profitability of the banking
sector. The two major factors identified were directed investments and directed
credit programmes, both earning a much lower rate of interest than the market
rate. Among the other important factors noted were the deterioration in the quality
of loan portfolio, increasing expenses due to massive branch expansion many of
which were unremunerative, specially in rural areas, over manning, inadequate
technical progress, weaknesses in internal organization structure, excessive
political interference etc.

Following were the major re-commendations:

SLR to be brought down is a phased manner to 25% over a period of 5 years. It
should not be viewed as a major instrument for financing the public sector.

8
Report of the Committee on the Financial System – A Summary, RBI Bulletin, Feb, 1992.

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CRR should be progressively reduced. RBI should have the flexibility to operate
this instrument to serve its monetary policy objectives rather than to control the
secondary expansion of credit.
Interest rate paid to banks on their SLR investments and CRR above the basic
minimum should be increased.
Directed credit programmes should be phased out. The priority sector should be
redefined to comprise the small and marginal farmers, the tiny sector of industry,
small business and transport operators, village and cottage industries, rural
artisans and other weaker sections. The credit target for this re-defined priority
sector should be fixed at 10% of aggregate credit.
Interest rates to be further de-regulated to reflect the emerging market conditions
and concessional rates be phased out. The structure of interest rates should bear
a broad relationship to the Bank rate, which should be used as an anchor to signal
the RBI’s policy stance.
Bank and financial institutions should achieve a minimum 4% capital adequacy
ratio in relation to risk-weighted assets by March 1993, of which Tier I capital
should not be less than 2%. The BIS standards of 8% should be achieved by
March 1996. In respect of those banks whose operations have been profitable
and which enjoy a good reputation in the markets could straight away approach
the capital market for enhancing capital. In respect of other banks, the
government could meet the shortfall by direct subscription to capital or by providing
a loan that could be treated as sub-ordinate debt.
Banks and other financial institutions should adopt uniform accounting practices
particularly in regard to income recognition and provisioning against doubtful debts
and sound practices in regard to valuation of investments on lines suggested by
the Ghosh Committee on final accounts.
Balance sheets of banks and financial institutions should be made transparent and
full disclosures be made as recommended by the International Accounting
Standards Committee.

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Special tribunals on the pattern recommended by Tiwari Committee should be set
up to speed up the process of recovery. It suggested the establishment of an
Asset Reconstruction Fund (ARF) that could take over a portion of bad and
doubtful debts of banks and financial institutions at a discount.
In regard to the structure of banking system, the committee suggested a broad
pattern consisting of:
3 or 4 large banks which could become international in character.
8 to 10 national banks with a network of branches throughout the country engaged
in universal banking.
Local banks whose operations would be generally confined to a specific region
and
Rural banks (including RRBS) whose operations would be confined to the rural
areas and whose business would be pre-dominantly engaged in financing of
agriculture and allied activities.
All this was to be market driven and based on considerations of profitability and
brought about through a process of mergers and acquisitions.
There should not be any difference in treatment between public sector and private
sector (including foreign) banks and an indication of no further nationalization.
Increased computerization.
Banks should be free to make their own recruitment.
Duality of control over banking system between RBI and Ministry of Finance
should end and RBI should be primary agency for regulations.
In the appointment of chief executive, the recommendations of a group of eminent
people invited by the RBI governor should be considered.

As regards development financial institutions (DFIs) also, the approach of the

committee was to ensure operational flexibility, a measure of competition and
adequate internal autonomy in matters of loan sanctioning and internal
administration. It was of the view that commercial banks should be encouraged to

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provide term finance to the industry, while at the same time, DFIs should
increasingly engage in providing core working capital. This would help to enhance
healthy competition between banks and DFIs.

The committee was in strong favor of substantial and speedy liberalization of the
capital market. It recommended that SEBI formulate a set of prudential guidelines
designed to protect the interest of the investor, to replace the restrictive guidelines
issued by the controller of capital issues (CCI). It was of the view that SEBI should
not become a controlling authority like CCI, but should function more as a market
regulator to see that market is operated on the basis of well laid down principles
and conventions. The capital market should gradually be opened up to foreign
portfolio investment and simultaneously efforts should be initiated to improve the
depth of the market by facilitating issue of new types of equities and innovative
debt instruments.

As regards various new institutions like merchant bank, mutual funds, leasing
companies that had appeared on the financial scene, the committee
recommended that the supervision of these should come within the purview of the
new agency to be set up for this purpose under the aegis of RBI. Prudential norms
and guidelines governing the functioning of these institutions should be laid down.

The committee emphasized the need for a proper sequencing of the reforms and
the need for the government to undertake certain amendments in the existing laws
that would be required to carry out its recommendations.

2.3 THE SECOND GENERATION REFORMS 1998 (NCR-II)

In the first phase of reforms as discussed above the focus had been on arresting
the qualitative deterioration in the functioning of the system. Most of the
recommendations were promptly implemented and a measure of success

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achieved. In the meanwhile, major changes had been taking place in the domestic
economic and institutional scene, coinciding with the movement towards global
integration of financial services. These developments re-enforced the importance
of building a strong and efficient financial system. In 1998, therefore, the situation
was reviewed and there were the second-generation reforms. These could be
looked at in terms of 3 broad inter related issues:

Actions that need to be taken to strengthen the foundations of the banking

system

Streamlining procedures, upgrading technology and human resource
development, and

Structural changes in the system.

The major recommendations included increase in CRAR to 10% by 2002, new

guidelines for asset classification, reduction in net NPAs to below 3% (0% for
those banks with international presence), elimination of subsidy element in priority
sector (redefined) lending, full disclosure of information, revised and regularly
updated operational manual by banks and consolidation and convergence of the
financial system, a system for recruiting skilled manpower from the open market,
re-deployment of surplus staff, flexibility to determine managerial remuneration,
achieving rapid induction of information technology, allowing foreign banks to set
up subsidiaries or joint ventures in India, evolution of a risk management system,
greater internal controls, transparency and market discipline, legislative steps etc.

The government’s responsibility as per the committee would then be to create and
nurture a diversified and functionally efficient financial system through an
appropriate incentive framework and a legal system rather than through direct
interventionalist policies.

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2-8
 Chapter 3

REVIEW OF LITERATURE

The earlier two chapters had been devoted to an introduction to the financial
system and an outline of the major reforms undertaken in the financial sector.
Before analyzing the impact of these reforms on financial development in India and
the growth of Indian economy, it is important to review the existing literature from
the viewpoint of the techniques and indicators used and the existing results in this
area. This chapter presents a review of the existing theoretical and empirical
literature on the subject.

3.1 DIFFERENT VIEWS IN LITERATURE

The reforms of the financial sector affect economic growth through the finance
growth linkages. The relationship between financial development and economic
growth is a long debated issue. Schumpeter (1911), the first modern economist
to study the relationship regarded the banking system as one of the two key
ingredients in the process of development. He argued that the services provided
by financial intermediaries - mobilizing savings, evaluating projects, managing risk,
monitoring managers and facilitating transactions – are essential for technological
innovation and economic development. Gerschenkron (1962) considered that the
banking system does play a key role at certain stages of the industrialization
process. He viewed industrialization as a process that spread from its birthplace in
England to ‘more backward’ countries.

Goldsmith’s (1969) pioneering study to assess whether finance exerts a causal

influence on growth found a positive relation between economic growth and
financial development. Economic growth according to him is a complex

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phenomenon determined by a number of factors – physical, technical, economic,
and mass psychological in nature. He identified the following measures of
financial structure:

- Financial inter-relationship ratio: This is the ratio of total value of all

financial assets at a date by total value of tangible assets plus net
foreign balance i.e. by national wealth. Thus, this gives a relation
between a country’s financial superstructure and its real infrastructure.
- Composition of financial super structure reflected in distribution of total
financial liabilities and assets among their main types, and distribution of
financial assets among main sectors and sub-sectors.
- Relative importance of different types of financial institutions.
- Degree of institutionalization of financial structure reflected by share of
financial institutions in the total stock of financial assets.

He used the financial inter-relationship ratio (FIR) as the single main characteristic
of level of a country’s financial development. Based on data from 35 countries, he
found that developed countries had higher FIR than less developed ones - the
association being loose and irregular. R2 obtained was 0.19 i.e. approximately
one-fifth of inter-country variations in FIR being explained by the differences in real
per capita GNP. He attributed this co-relation to the positive effect that financial
development has in encouraging more efficient allocation of capital expenditures
among and within sectors, types of tangible assets and regions. He contended that
both economic theory and economic history assure that the existence and
development of financial superstructure is a necessary though not sufficient
condition for economic growth and both point out that relationship between
economic growth and financial development is complicated and not easily
amenable to generalizations. He argued that the process of economic growth has
feedback effects on financial markets by creating incentives for further financial

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development. Thus both growth and financial intermediation are thought of as
endogenous.

Like Goldsmith works by McKinnon (1973) and Shaw (1973) also illustrate close
ties between financial and economic development. While the main focus of
Goldsmith was on the relationship between financial development and the
efficiency of investment, McKinnon and Shaw, influenced to a large extent by the
success stories of South East Asia, emphasized the role played by financial
liberalization in increasing savings, and hence, investment. The theoretical
framework of both presumed that the direction (positive) of causation runs from
financial to economic development and not vice-versa. Their focus was on the
effects of public policy regarding financial markets on savings and investments.
They argued that the policies that lead to financial repression e.g. controls that
result in negative real interest rates reduce the incentives to save. Lower savings
in turn, result in lower investment and growth. Thus, they concluded that higher
interest rates resulting from financial liberalization induce households to increase
savings and therefore stimulate growth. While the main channel of transmission
emphasized by the McKinnon-Shaw hypothesis is the effect of real interest rates
on the volume of savings, it is also recognized that positive real interest rates
make the allocation of investible funds more efficient, thus providing an additional
positive effect on economic growth.

A rather more vigorous and formal framework is that provided by Galbis (1977)
whose pre-occupation was an analysis of the possible effects of financial
liberalization on economic growth. Not withstanding the efforts of these and
numerous other theorists, the fact still remains that their frameworks are not
amenable to empirical testing. In fact, most of them were pre-occupied with the
role of interest rate liberalization, as opposed to the size of financial sector on
economic growth.

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At an empirical level, one of the earliest attempts at evaluating the relationship
between financial and economic development, as shown in the survey by Balassa9
(1989), is that of Patrick (1966). Based on his study, Patrick reached the
conclusion that causation runs from financial to economic development (i.e. a
supply leading relation) in the early stages of development while the direction of
causation is reversed (i.e. a demand following relationship prevails) in later stages.
By employing the causality-testing framework proposed by Granger10 (1969) the
same conclusion was arrived at by Fritz (1984) on the basis of data for Philippines.
Jung (1986) explored this issue further by confronting the Granger’s causality
testing framework with data for 19 developed and 37 developing countries. The
preponderance of his evidence was in support of supply-leading relationship
between financial and economic development, irrespective of the stage
development. This was in direct contrast with the earlier position maintained by
Goldsmith that the direction of causation is from economic to financial
development irrespective of the stage of development.

Most of the remaining empirical studies, for instance, Jao (1976), Wai (1980),
Lanyi and Saracoglu (1983), Gelb (1989), do not get involved in the controversy of
supply-leading versus demand following relationships. Instead, based on a supply
leading relationship, they proceed directly at evaluating the extent of the impact of
financial development on economic growth. In virtually all cases, the testing frame
works employed are adhoc, without standard theoretical under pinning. In addition
most of the studies employ only the financial development variable (plus,
sometimes, a single additional variable) as the determinant of economic growth in
the regression equations that are empirically estimated. By neglecting the other
growth determining variables like the share of investment in GDP, labor force

9
Balassa,B., (1989) Financial Liberalization In Developing Countries, PPR Working Papers, WPS
55. World Bank, Washington.
10
Granger, C.W.J. (1969) Investigating Causal Relations By Econometric Methods And Cross
Spectral Methods, Econometrica, 37,pp 424-38.

3-4
growth, etc., their estimates of the impact of financial development variable could
hardly be free of the bias caused by omitted variables and hence, little reliance can
be placed on their findings.

The World Bank’s 1989 issue of World Development Report reiterated the view
that development of the financial sector should have positive repercussions on the
development of the real sector. In the 1990s research on relationship between
financial development and growth has received a new source of inspiration from
the rapidly expanding “endogenous growth” literature. By focusing on the cases
where the marginal product of capital always remains positive, this literature
provides a natural frame work in which financial markets affect long run, and not
just transitional growth. The role of financial factors is incorporated in endogenous
growth models in an attempt to analyze formally the interactions between financial
markets and long run economic growth. Most of these studies tend to emphasize
the role of financial intermediation in improving the efficiency of investment rather
than its volume. That is, financial intermediaries play a central role in allocating
capital to its best use.

Greenwood and Jovanovic (1990) presented a model in which both financial

intermediation and growth were treated as endogenous. In their framework, the
role of financial institutions is to collect and analyze information and to channel
investible funds to the investment activities that yield the highest return. They show
that there is a positive two-way causal relationship between economic growth and
financial development. On one hand, the process of growth stimulates higher
participation in financial markets thereby facilitating the creation and expansion of
financial institutions. On the other, financial institutions by collecting and analyzing
information from many potential investors, allow investment projects to be
undertaken more efficiently and hence, stimulate investment and growth.

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Bencivenga and Smith (1991) developed an endogenous growth model with
multiple assets. Agents who face random future liquidity needs can accumulate
capital that is risky but has high productivity or invest in a liquid (safe but less
productive) asset. The effects of introducing financial intermediation into this
environment are considered. Conditions are provided under which the introduction
of financial intermediaries (FIs) shift the composition of saving towards capital,
causing intermediation to be growth promoting. Thus, the presence of financial
intermediation increases growth by channeling savings into the activity with high
productivity, while allowing individuals to reduce the risk associated with their
liquidity needs. Although individuals face uncertain liquidity needs, banks, by the
law of large numbers, face a predictable demand for liquidity and can, therefore
allocate funds more efficiently. In the absence of financial intermediaries,
individuals may be forced to liquidate their investments when needs arise. Thus
the presence of FIs generally reduces socially unnecessary capital liquidations,
which again promote growth. Bencivenga and Smith show in their model that
growth increases even when aggregate savings are reduced as a result of
financial development, the reason being the dominant effect on the efficiency of
investment.

Along similar lines, Levine (1992) analyzed the effects of alternative financial
structure on economic growth. In his model, financial institutions raise the fraction
of total savings devoted to investment and avoid premature liquidations of capital.
Banks, stock markets, mutual funds etc. enhance growth by promoting the efficient
allocation of investment through various channels. In a somewhat different
approach, Roubini and Sala-i-Martin (1992) have analyzed the relationship
between financial intermediation and growth by emphasizing the role of
government policy.

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Using data on 80 countries over the 1960-1989 period, king and Levine (1993)
found that higher levels of financial development are significantly and robustly co-
related with faster current and future rates of economic growth, physical capital
accumulation, and economic efficiency improvements. From these results they
conclude that the relationship between growth and financial development is not
just a contemporaneous correlation and that finance seems importantly to lead
economic growth. They point out both the merits and limitations associated with
the cross-country regressions approach.

Gregorio and Guidotti (1995) have examined the empirical relationship between
long run growth and financial development proxied by the ratio of bank credit to the
private sector to GDP. They found that this proxy is positively co-related with
growth in a large cross country sample, but its impact changes across countries,
and is negative in a panel data for Latin America. They argued that this latter
finding is the result of financial Liberalization in a poor regulatory environment.
They also show that the main channel of transmission from financial development
to growth is the efficiency rather than the volume of investment.

A number of other influential economists Boyd and Prescott (1986) Greenwood

and Jovanovic (1989), Fry (1988, 1993) Demirgiic-Kunt and Maksimovic (1996)
Allen and Gale (1997), Levine and Zervos (1998), Levine Ross (1997, 2003) - and
the list is unending – stress the importance of sound financial system for economic
growth and point out alternate channels via which the influence is carried on.

On the other hand, there is a long list of economists who feel otherwise. They
believe that finance is a relatively unimportant factor in economic growth. As early
as in 1952, Robinson wrote – where enterprise leads, finance follows. Gurley
(1967) feels banking systems, as intermediaries are not highly essential to the
growth process. Lucas (1988) contended that economists badly overstress the

3-7
role of financial factors in economic growth. Nicholas Stern’s (1989) survey of
development economics does not even mention finance – not even in a section
that lists omitted topics. Meier and Sears (1984) also reiterate this view.

Cameron (1967, 1972) takes a balancing position. According to him the true
importance of finance lies between the two extreme views. Historically the process
of development involves interactions among four major categories of factors
population, resources, technology, and social institution. The banking system,
therefore, is by no means the only or necessarily the most important element in
economic development and other things do not remain equal. At the same time,
banking systems are not ‘neutral’ to economic growth. Where they exist, they do
so because there is a demand for their services and such a demand is usually
evidence of a growing, developing economy. It is frequently said that the banking
systems are passive or permissive agents, merely responding to the demand for
their services. But on the basis of evidence assembled, Cameron argues, that it
becomes increasingly difficult to sustain this notion. The potential role of financial
system is greater in cases of derivative industrialization because of relative ease
with which financial innovations can be introduced and the relative amenability of
the banking system to sensible policy measures. This is not to say that banking
system invariably makes a positive, growth inducing contribution. Clearly, they do
not. Their effectiveness in the growth process depends upon a number of
structural and behavioral characteristics. Although the fundamental dynamics of
economic development lie outside the banking system, the way the system is
structured can either significantly hasten or retard development. It is thus a matter
of some importance for the policy makers to know what structural characteristics
are specially favorable or unfavorable.

The way in which banks perform their functions, especially in under developed or
developing economics may well determine the degree of success of the

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development effort. As intermediaries between savers and investors they may
vigorously seek out and attract reservoirs of idle funds that will be allocated to
entrepreneurs for investment in projects with a high rate of social return; or they
may listlessly exploit their quasi-monopoly position and fritter away investment
possibilities with unproductive loans. As creators and providers of means of
payment, they may redirect real resources into more productive activities, or as a
result of government pressure or private corruption, they may swamp the economy
with a flood of inflationary paper issues. Finally as potential entrepreneurs they
may set their country on the road to continuing growth, or they may waste its
resources in uneconomic or fraudulent activities. His conclusions, based on
studies of various countries is that if a banking system is to be effective in
contributing to industrial capital formation, the government must assure minimal
conditions of both financial and political order and refrain from random adhoc
interferences that increases uncertainty for long-range investment planning.

In context of contribution of banks to growth, according to Cameron, best results

have been achieved when competition was freest and most unfettered. Where
banking was left most free to develop in response to demand for its services it
produced best results. Restrictions on freedom of entry almost always reduce the
quantity and quality of financial services available to the economy and thus hinder
or distort economic growth. Competition on the other hand acts as a spur to
mobilization of idle financial resources and to their efficient utilization in commerce
and industry. It is also favorable to financial innovations. Another difficult question
according to him is that of best financial system and optimal growth path. His
study showed a wide range of variability of successful financial systems – the
system that is best at one place and time might not work successfully in other. In
every case, the financial system is related to and must grow out of distinctive legal,
social, and political traditions and the objective economic conditions of its specific
environment.

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For measuring the quantitative aspect of financial structure, Cameron used the
following:

1. Density = Number of bank offices x 10000

Total Population
Density greater than one was considered high, in between half and one, moderate
and less than half, low.

2. Relative Size of the banking sector = Bank Assets .

National Income
The ideal measure considered was Bank Assets. Being difficult to calculate, it was not used.
Total Assets
3. Size and concentration of bank Power.

On the question of an optimal path he found too rapid expansion might lead to
inflation and balance of payments problems. Optimal rate would seem to be that
which is consistent with full employment of resources, reasonable price stability
and the ability of the economy to absorb and utilize technological innovation.
Unfortunately such criteria cannot be specified in advance or generalized to cover
all situations. Nevertheless one can conceive of a theoretically optimal long-term
path of bank expansion. It would probably resemble a logistic curve – rising rapidly
at first owing to monetization of subsistence sectors of the economy, the
substitution of bank liabilities for commodity money and the existence of banks as
the sole or only significant institutions capable of supplying external finance for
industry and commerce. Subsequently the rate of expansion would drop off as
business firms become able to supply more of their own financial needs by
retained earnings and as other financial institutions rise to compete with the banks
for investible funds of the surplus spending units. The growth of NBFIs might
eventually reduce the relative share of banks in total assets. Both Goldsmith

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(1969) and Gurley and Shaw (1973) have noted this fact in highly developed
economics, especially in US.

3.2 FINANCIAL DEVELOPMENT AND GROWTH: CROSS SECTION VS.

TIME SERIES EVIDENCE

The empirical work on this issue has mainly utilized two different econometric
methodologies: Cross country regressions and time series regressions. The former
approach involves averaging out variables over long time periods and then using
them in cross section regressions aiming at explaining cross-country variations in
growth rates. Due to presence of significant cross-country heterogeneity in the
dynamics of financial structure and economic growth, such analyses suffer from
serious limitations. Further, it can capture only the average effects of a variable
across countries – thus ignoring the patterns of causality across countries. Many
investigators share a great deal of skepticism in relation to cross-country
regressions. The users of techniques themselves e.g. Levine and Zervos (1996),
Levine & Renelt (1992) acknowledge the sensitivity of the results to the set of
conditioning variables.

Quah (1993) pointed out that the technique is predicated on the existence of
stable growth paths and showed, using data from 18 countries, that long run
growth patterns are unstable. Evans (1995)11 discussed econometric problems
that stem from the heterogeneity of slope co-efficients across countries. Lee et al
(1996) showed that convergence tests obtained from cross country regressions
are likely to be misleading because the estimated co-efficient on the convergence
term contains asymptotic bias. Thus, under these circumstances the cross-
country variations in the results are difficult to interpret.

11
Evans, P. (1995) How To Estimate Growth Equations Consistently, Mimeo, Ohio State University;
th
presented at the 7 World Congress Of The Econometric Society (Tokyo).

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In relation to king and Levine (1993)12, Arestis and Demetriades (1996) argued
that their causal interpretation is based on a fragile statistical basis. Using their
data they showed that the contemporaneous correlation between the main
financial indicator and economic growth is much stronger than the co-relation
between lagged financial development and economic growth. In fact, conditioning
on contemporaneous financial development destroys the association between
lagged financial development and economic growth completely. While they did
agree with king and Levine that financial development and growth are robustly co-
related, they felt that the question of causality cannot be satisfactorily addressed in
a cross-section framework.

Demetriades and Hussain (1996) found causality patterns to vary across

countries in their sample and considerable evidence of a bi-directional causality.
Ram (1999) noted that in cross country data and models of the kind that have
been used in most studies, when the regression structure is permitted to vary
across three sub-groups, a huge parametric heterogeneity is observed and the
overall indication is that of a negligible or negative association between financial
development and growth. He suggested that future research on this topic should
include a greater focus on individual country studies.

The differences in causality patterns across countries can be detected by time–

series studies. Most of the earlier studies used the cross–country regressions and
were in the context of developed countries, Goldsmith (1969) being a notable
exception. Lately, a number of time-series analyses13 have come up. Arestis and
Demetriades (1996) which utilize data for 12 countries, provides evidence which
suggest that the casual link between finance and growth is crucially determined by
the nature and operation of the financial institutions and policies pursued in each

12
See pg. 27 above.
13
many of them for developing economies.

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country. The related study by Demetriades and Hussain (1996), where causality
tests were carried out for 16 developing countries, suggests that the causality
between financial development and growth varies across countries. In about half
the countries examined, they detect a feedback relationship but in several
countries the relationship runs from growth to finance, suggesting that it is by no
means universal that financial development can contribute to economic growth.

Odedokun (1996) determines and analyses the effects of financial intermediation

on growth of real GDP in LDCs14 by employing annual data for 71 countries over
varying periods that generally span the 1960s and the 1980s. He used a modified
version of the orthodox neoclassical one sector aggregate production function in
which financial development constitutes one of the inputs. In addition he used an
entirely new model framework that recognize the external effects of the financial
sector on the real sector, as well as effects of the financial sector on the
productivities of factor inputs engaged therein. Based on time series regression for
each country he obtained the following results: (a) financial intermediation
promotes economic results in about 85% countries (b) as compared with factors
that have often been emphasized in literature15 as important growth promoters,
financial intermediation is practically at par with export expansion and capital
formation ratio, and superior to labor force growth as partners in promoting
economic growth; (c) the growth promoting effects of financial intermediation are
more pre-dominant in low-income than in high income LDCs; and (d) the growth
promoting effects of financial intermediation are practically invariant across the
various regions of the globe.

Arestis, Luintal and Luintal (2004) utilizing time series data and methods with
dynamic heterogeneous panel approach on developing countries (including India)

14
Less developed countries (or economies).
15
export expansion, capital formation ratio and labor force growth

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found significant effects of financial structure on real per capita output. Some
other notable time-series studies include Gupta (1984), Murinde and Eng (1994),
Ford (1997) among others.

3.3 THE ROLE OF STOCK MARKET

Much of the early empirical evidence on relationship between finance and growth
(whether cross-section or time series) has utilized measures of financial
development reflecting the role of banks or at the most some other financial
institutions e.g. bank deposits, credit, credit by financial institutions, M3 etc. The
nineties saw the emphasis shifting to stock market indicators. Demirgiic-Kunt and
Levine (1996)16 noted that World Stock Market Capitalization grew from $4.7 to
$15.2 trillion between the mid-1980s and mid-1990s. The total value of shares
traded on developing countries stock markets rose over twenty five fold between
1983 and 1992 (Singh 1997)17 and that on emerging markets jumped from less
than 3% of the $1.6% Trillion in world total in 1985 to 17% of $9.6 trillion world
total in 1994 (Demirgiic-Kunt & Levine, 1996). These figures clearly suggest that
role of stock markets could be potentially substantial.

Levine and Zervos in their 1996 paper argued that well-developed stock markets
may be able to offer different kinds of financial services than banking system and
may therefore provide different kinds of impetus to investment and growth than the
development of banking system. Specifically, increased stock market capitalization
may improve an economy’s ability to mobilize capital and diversify risk. Increased
liquidity reduces transaction costs that could otherwise impede the efficient
functioning of the stock markets. They demonstrated that various measures of
equity market activity are positively co-related with measures of real activity. This

16
Demirguc-Kunt, A. And Levine, R. (1996). ‘Stock Markets Corporate Finance And Economic
Growth: An Overview.’ World Bank Economic Review, Vol. 10, No. 2, pp. 223-39
17
Singh, A. (1997). ‘ Stock Markets, Financial Liberalisation And Economic Development .’
Economic Journal, Vol. 107 (May), pp. 771-82

3-14
association is particularly strong for developing countries. Using cross-country
regressions and data for 41 countries covering the period 1976-93, they showed
that after controlling for initial conditions and various economic and political factors,
the measures of banking and stock market development are robustly co-related
with current and future rates of economic growth, capital accumulation and
productivity improvements. By including both stock market and bank-based
indicators in the same regressions, they showed that stock markets provide
different financial services than banks.

Atje and Jovanovic (1993) using a similar approach also found a significant co-
relation between economic growth and the value of stock market trading relative to
GDP for 40 countries over the period 1980-88. Levine (1996) argued that stock
markets may affect growth through liquidity that makes investment less risky.
Companies enjoy permanent access to capital through liquid equity issues. This
argument based on statistical work reported in Levine & Zervos above leads to the
conclusion that stock market development explains future growth. However as the
result is based on a cross-country analysis it can be analyzed using time series
approach whether the result of this type exhibits variation across countries.

Arestis and Demetriades (1997) provide such an analyses. Including indicators

for both the financial institutions and the stock markets, they showed that results
exhibit substantial variation across countries, even when the same variables and
estimation methods are used. Thus, the average country for which cross-country
regressions must, presumably relate to may well not exist.

Saint Paul (1992) developed a model where financial markets affect technological
choice. These markets allow individuals to hold a diversified portfolio to insure
themselves against negative demand shocks, and at the same time, to choose
more productive technology.

3-15
De Gregorio (1993) and Jappelli and Pagano (1994) have analyzed the effects
of financial market developments on savings rate. They concentrate their effects
on the borrowing constraints on economic growth. Full or partial inability of
individuals to borrow against future incomes induces them to increase savings.
These studies suggest that, in general financial deepening on the side of
consumer credit is unlikely to increase savings. The implication that the relaxation
of borrowing constraints is unlikely to stimulate savings does not necessarily imply
that such a form of financial deepening will result in lower growth. Gregorio
(1993), in fact showed that a relaxation of borrowing constraints increases the
incentives for human capital accumulation. This effect is likely to increase the
marginal product of capital and hence may lead to higher growth despite the
reduction in savings.

In contrast, in relation to stock markets, Singh 1997 noted that rapid growth of
stock markets, might possibly lead to speculative pressures. These pressures
may emanate from transactions induced by the euphoria created by financial
liberalization that rewards speculators with short-term horizons and punishes those
with a long-term view (Keynes 1936)18. They may also emanate from non-financial
corporations which enter financial markets in view of the higher returns induced by
financial liberalization, by borrowing to finance short term financial speculation.
Lenders in turn may feel compelled to provide this type of finance, essentially
because of fear of loss of market share (Minsky, 1986). An undesirable implication
of these types of pressures is that economies may be forced to bear a greater
degree of risk with financial liberalization than without it (Garbel, 1995). They may
actually reduce the total volume of real-sector investment while exerting upward
pressures on the interest rates in view of the higher risk (Federer 1993).

18
Keynes, J.M.,(1936) The general theory of employment, interest and money. London, Macmillam.

3-16
On the whole, one can say that from a financial stability perspective, it is
necessary to have a financial system whereby both financial institutions and
financial markets play an important role. Levine (2004) reviews, appraises and
critiques theoretical and empirical research on connections between the operation
of financial system and economic growth ‘While subject to ample qualifications and
countervailing views, the preponderance of evidence suggests that both financial
institutions and market matter for growth and that reverse causality alone is not
driving this relationship. Theory and evidence imply that better developed financial
systems ease external financing constraints facing firms, which illuminates one
mechanism through which financial development influences economic growth’.

The available literature points to a number of other channels:

Increasing savings rate and therefore investment

Investment allocation

Technical innovations

Easing external financing constraints that impede firm and industrial
expansion

Producing information and allocate capital

Improving corporate governance

Mitigating risks associated with individual projects, firms, industries and
regions

Reducing credit rationing

In words of Felix, Rioja and Nevenvalev (2004) finance has a strong positive
influence on productivity growth primarily in more developed countries. In LDCs,
the effect of finance on output growth occurs primarily though capital accumulation.

3-17
3.4 THE STUDIES FOR INDIAN ECONOMY

In case of Indian Economy, data on extensive set of measures of economic

performance and financial indicators is available for a much longer time span than
commonly used in studies of sets of countries. Another salient advantage of
focusing exclusively on one country is that the econometric finding can be related
to the prevailing institutional structure. There exist a number of studies that have
tried to analyze the impact of financial liberalization on economic growth of India.
Some studies focus on the impact of the liberalization on the productivity
performance of the financial sector.

Demetriades and Luintal (1996, 97) have examined the effects of various
banking sector controls prior to liberalization on financial deepening using RBI
data. They found that all controls except lending rate ceiling are negatively
associated with financial development. Financial repression has substantial
(adverse) direct effects on financial deepening, independent of its influence
through rate of interest. Exogeneity tests suggest that financial development and
economic growth are jointly determined. Thus polices which affect financial
development may also affect economic growth.

Bhattacharya, et al (1997) studied the impact of increased competition due to

limited liberalization initiated before the deregulation of nineties on performance of
different categories of banks, using Data Envelopment Analyses for the period
1986 to 1991 for 70 banks. They found that public sector banks had highest
efficiency. However, after 1987 efficiency of public sector banks (PSBs) declined,
that of private banks showed no change and that of foreign banks increased. In a
review of competition of banking sector in the deregulation period RBI (1999a)
noted that development after 1996 indicate that a majority of PSBs have been able
to progress considerably towards the direction of passing the acid test of achieving
competitive efficiency.

3-18
Bell, C and Rousseau, P.L (2000) have analyzed the Indian case in the post
independence period using multiple measures of financial development. They
have examined whether financial intermediaries have played a leading role in
influencing India’s economic performance. By constructing a set of vector auto-
regressive and vector error correction models, they evaluate the strength and
direction of the links between measures of financial intermediation and various
economic aggregates. They found that the activities of the financial sector had an
important impact on India’s post independence economic performance. The
expansion of the financial sector played an enabling role in promoting capital
accumulation. Consistent with this enabling role, increases in key financial
aggregates preceded increases in both investment and aggregate output. They
found no evidence that the expansion of financial sector had any influence on total
factor productivity in organized manufacturing. In this respect they found their
evidence consistent with Gurley and Shaw’s (1955) ‘debt accumulation
hypothesis’19. Their econometric results also decisively reject the hypothesis that
movements in the level of government spending preceded those in investment and
output, in contrast to movements in financial aggregates thus suggesting finance–
enabling development. On the whole their results suggest:

- The financial sector was instrumental not only in promoting aggregate

investment and output, but also in the steady shift towards industry that
has characterized India’s development.
- The operative channel was that of debt accumulation rather than
improvements in total factor productivity, and
- Its contributions went beyond the passive support of fiscal policy.

19
Gurley, J.G. Shaw ES, (1955) Financial aspects of economic developed, AER 45 pp 515 –
538.

3-19
RN Agarwal (2000) has analyzed the impact of financial sector reforms in India
during 1990s on the development of its financial system and tried to assess the
possible vulnerability of the Indian economy to financial crises as it integrates into
the world economy. The Indian financial system is found to have integrated itself,
though mildly, with the rest of the world in terms of trade flows, capital flows, and
interactions on the stock markets. They found evidence of financial development
in India with financial liberalization and integration. The financial development
indicators include the growth of broad money as compared to narrow money and
national income, growth of credit to private sector in total loans and growth of
assets of banking and non-banking financial institutions. Capital market is also
found to have developed fast as assessed by the growth of size (number of listed
companies and market capitalization of listed companies as a percentage of GDP)
and liquidity (turnover ratio). It has however become more volatile especially on
account of trading by foreign institutional investors and that has discouraged small
domestic investors to invest their savings in this market.

Bharti (2001) as part of her doctoral dissertation has analyzed the developments
in financial markets for the period 1989-90 to 1998-99. The study covers both
money markets and capital markets, although the emphasis is on capital markets.
Using secondary data from RBI reports and journals, she found that the market
had grown and transformed after reforms, but is not in a good shape since 1996. A
regression was run to find empirical evidence of relationship between stock market
and economic growth. Index of industrial production was taken as indicator of
economic growth. The independent variable was the resources raised from the
primary market by non-government (private) corporate sector and non-food bank
credit. Her major findings were that the GDP and per capita NNP were much
higher during 90s, gross domestic savings as percentage of GDP increased
substantially, and financial development ratio exhibited the growing importance of
financial intermediation and the growth of financial flows in relation to economic
activity. In money market, a base has been created with introduction of variety of

3-20
products and existing instruments have become more active. The primary equity
market boomed in the initial years of reform. Technology has changed the face of
secondary equity market; number of stock exchanges, listed companies, and
market capitalization has increased. On relation between stock markets and
economic growth, the regression model showed that the coefficients are positive, t-
values significant and both R2 and adjusted R2 are conducive at around 85%
suggesting that the primary market is an important market as it is significantly
related to IIP.

Bisht, Mishra and Belwal (2002) have analyzed the effect of liberalization on
Indian banking. The banking structure as at present, according to them, is the
outcome of a process of expansion, re-organization, and consolidation that has
been going on for many years. They perceive the banking development in four
important phases:
- Pre-nationalization (primarily economic considerations were important)
- Post-nationalization (infusion of social obligations, egalitarian society
objectives. Many ups and down in profitability of nationalized banks)
- Post-liberalization (with emphasis on competitive efficiency,
transparency, prudential norms etc.), and
- With the arrival of Internet the beginning of a fourth phase that they
perceive will lead to a mass structural change in banking.
They show that subsequent to liberalization, intense competition has come from
new private and foreign banks. The spread between lending and deposit rates has
substantially declined. Upto 1996, there has been a steady increase in profits.
With the industrial recession in end 1990s, there has been fall in the volumes and
profits.

Rai (2002) as part of his doctoral thesis showed that sanctions and disbursements
of financial institutions have increased considerably – sanctions only during 1999-
2000 being 41.8% more than total sanctions during the pre-reform period. The

3-21
disbursements of funds by the financial institutions to backward areas of the
country have suffered a set back during 1991-2000. Most of the funds, according
to him, have been flowing to the private sector; mutual funds in India have not
been successful to record steady growth in their business despite increasing
contribution from private players, and the financial institutions have started a
variety of new activities during the post reform period.

Das (2002) using Malmquist productivity index, showed that during 1996-2001,
higher capital led to rise in productivity in medium sized banks. They found higher
loan growth translated into lower productivity and increased government
ownership tended to increase productivity especially in small sized public sector
banks.

Bhattacharya and Sivasubramanian (2003) examined the causal relationship

between financial development and economic growth in India for the period 1970-
1971 to 1998-1999, using the techniques of unit root and co-integration analyses.
Their results show that for the period under consideration, it is M3 representing
financial sector development, which led GDP growth and not the other way round.

A Amarender Reddy (2004, 2005) examined the competitiveness of Indian

commercial banks in the deregulated period. Overall efficiency, scale efficiency,
and pure technical efficiency change over the period 1996 to 2002 was estimated
using DEA and window analyses. Overall total factor productivity was found to be
almost stagnant. The contribution of technical progress towards TFP was
decreasing, however that of technical efficiency and scale efficiency had
increased. Bank profitability increased and interest margins decreased in the
deregulation period. The results indicate an increase in technical and scale
efficiency of most banks, highest growth noted in public sector, followed by old
private sector banks. New private and foreign banks witnessed decline in

3-22
efficiency. The year-to-year variation in technical efficiency was explained by
variation in scale efficiency and general economic environment rather than
variation in pure technical efficiency. Increasing asset quality and priority sector
lending can improve scale efficiency. Tobit analyses revealed that both pure
technical efficiency and scale efficiency are influenced negatively by number of
branches per bank whereas positively by total assets.

Meena Sharma (2005) has analyzed the problem of non-performing assets

(NPAs) and its impact on strategic banking variables using a multiple regression
model. She found that NPAs adversely affect profitability, productivity, and
achievement of capital adequacy level, funds mobilization, and deployment policy.
A few other studies too show adverse effects of NPAs. Murthy (1988) showed that
NPAs bring down return accruing to them, decreases effective rate of interest,
funds re-circulation and increases the dependence on external sources, thereby
increasing costs. Gupta (1997) found that NPAs affect profitability of banks and
lead to liquidity crunch and slowdown in GDP growth. According to Toor (1994)
poor recovery management lead to reduction in yield on advances, reduced
productivity and loss in credibility, and put detrimental impact on the policies of
banks.

On the whole, mass of studies (cross sectional, panel, and time series) suggests
that better functioning financial systems support faster economic growth. The
country case studies document critical interactions among financial sector reforms,
financial intermediaries, financial markets, government policy, and economic
growth. Disagreement exists over some individual cases. Nonetheless, the body
of available country studies suggests that while the financial system responds to
the demands of the non-financial sector, well functioning financial system have, in
some cases during some time periods, importantly spurred economic growth.

3-23
The available studies on India suggest:

Financial repression prior to reforms had negative effect on the
development of financial system and therefore on economic growth
(through finance-growth nexus)

Subsequent to reforms, growth of both financial institutions and
financial markets is noted (based on some selected indicators).

Financial development has positively contributed to economic growth.

None of the studies cited above is comprehensive enough in terms of indicators

and techniques used to give a complete picture of financial development in India
subsequent to the reforms, and its association with economic growth. Moreover
there is no study (one exception being only efficiency analyses up to 2002) that
analyze the period beyond 1999. Also there has been no systematic attempt to
compare the pre and post-reform period.

In the subsequent chapters, I have tried to fill up these gaps.

3-24
 Chapter 4

FINANCIAL DEVELOPMENT IN INDIA: PRE AND POST

LIBERALIZATION

In the previous chapter, it was noted that subsequent to the financial sector
reforms, a substantial advancement of the financial sector had occurred during the
1990s. This chapter presents the empirical results of the developments in the
financial sector that have taken place till date and compares them to the position
prior to liberalization.

4.1 FINANCIAL DEVELOPMENT: QUALITATIVE ASPECTS AND

QUANTITATIVE DIMENSIONS

A financial system operates through financial institutions and markets. These deal
in financial assets and instruments of various kinds as currency, deposits, bills,
bonds etc. Any development of the financial system therefore involves significant
changes of quantitative and qualitative nature in financial institutions, markets and
securities; changes of the kind that would help the financial system serve its basic
functions of increasing savings and investment in the economy and allocating
available funds in the best possible manner.

Financial development thus is a broad concept incorporating a number of

quantitative and qualitative changes in the financial system20. As financial system
develops, various kinds of financial institutions, markets and instruments increase

20
For a succinct discussion of the concept see Bhole, L.M. (2004) : Financial Institutions and
Markets : Structure, Growth and Innovations, Tata, Mc Graw Hill.

4-1
substantially in the economy. This is to say, the depth of the financial system
increases. The institutions become geographically widespread. More and more
areas and therefore population is able to have access to their services. There is
emergence and development of a strong, active large sized non-bank financial
sector comprising of stock market, debt market, insurance companies, pension
funds, mutual funds etc. With coming up of a wide variety of new financial
institutions and markets, the range of assets available for mopping the surplus
funds in the economy substantially increase. This greatly encourages more and
more of surplus funds to move to productive uses via the financial sector.
Secondary market is well developed in all securities. This greatly increases the
liquidity of these securities and makes them more attractive for the investor.

Financial development usually involves upcoming of a number of private sector

(including foreign) banks and other financial institutions. Public sector becomes
less important. With the private sector coming in, there is enough competition and
inefficiency is penalized. New improved practices and methods develop; improved
ways of functioning e.g. computerization become prominent. With all this, time,
energy and money costs of transactions and the information costs are greatly
reduced. The institutions and markets become more and more efficient in their
functioning and rate of interest becomes market determined. The financial
institutions have specialized staff to look into profitability and productivity aspects
of different business proposals and accordingly disburse credit. These also often
provide them guidance and specialized services. There is strong and effective
system of supervision, inspection, auditing and regulation with financial
organization conforming to international standards with respect to capital
adequacy, non-performing assets etc. With all these, the financial system is greatly
able to increase savings and investment in the economy and allocate the available
funds to most productive uses.

4-2
4.2 INDICATORS OF FINANCIAL DEVELOPMENT

The study now examines what has been the nature and extent of financial
development in India and in what ways has it been affected by the liberalization
process. In this chapter, the focus is on financial institutions. Financial markets
are studied in a separate chapter later.

The financial development in independent India has been determined by the

nature of our mixed economic system. On the whole over a period of more than
half a century, the Indian financial system has shown remarkable progress, both in
quantitative and qualitative terms. The number and density of banks and other
financial institutions has greatly increased; new and new markets have
continuously come up. The number and types of financial securities now available
is huge as compared to 60 years ago. The entry of a number of private and foreign
banks have made for strong competitive pressures in the financial sector so that is
has become more efficient in its functioning. Non-performing assets now are
substantially lower than before and capital adequacy ratio much higher.
Computerization and e-transactions has become widespread, savings and
investment in the economy, bank deposits, and credit, primary and secondary
issues, have all increased tremendously, only a part of the increase being
explained by inflation. This quantitative growth has been accompanied by
significant diversification and innovations in respect of an array of financial
institutions, instruments and services. Also significant reorganization,
globalization, privatization, deregulation, automation, consolidation, and merger of
financial institutions have been affected.

In order to see the impact of financial sector reforms on the development of the
financial system it is required to make a comparative study of the development
prior to reforms and after the reforms. This is done based on a number of
indicators; time period for each of them has been indicated along with.

4-3
4.2.1 Gross Domestic Savings and Investment

The extent of development of the financial system best manifests itself in the
success of its basic functions i.e. to what extent the financial system has been able
to tap the surplus funds available in the economy and channel them into
productive investments.

Savings

Savings in India are done by the households, the businesses (i.e. the private
corporate sector), and the government. Of these sectors, the dominant saver in
India is the household sector followed by the private corporate sector. The
contribution of public sector to total domestic savings is small, lately negative21.
Both public sector and private corporate sector are net deficit spenders who draw
upon the savings of the household sector. The household sector also borrows from
other sectors (banks, term lending institutions etc.) but its savings far exceed the
borrowings22. So effectively, household is the only surplus sector in the economy.
It is a major task of the financial system to increase this surplus and make more
and more of it available for productive investment in the economy.

Savers (households) require stores of value to hold their savings. The financial
system promotes savings by providing a wide variety of financial assets, together
with numerous services of financial markets and financial intermediaries. With
financial progress and innovations in technology, scope of portfolio choice has
greatly improved. Lots of combinations of risk and return have become available
so that people in general tend to save more.

21
See table 4.1.
22
table 4.2 below.

4-4
Financial progress generally induces larger savings out of the same level of
income. More and more of these savings are in the form of financial assets as
currency, deposits, insurance policies, bonds etc. rather than physical assets like
gold or real estate. These assets are easy to store and manage, less risky and
more liquid than most tangible assets. Thus, out of given savings, the proportion
of financial assets (excluding currency) increase. This is financialization of
household savings.

Financial assets separate the act of savings from the act of real investment.
Mobilization of savings takes place when people move into financial assets. They
buy assets like bank deposits, insurance policies etc. from financial institutions23
thereby entrusting their savings to them who allocate it further among competing
borrowers. This represents financial intermediation or institutionalization of
savings i.e. going to borrowers through institutions rather than directly via primary
securities.

So the savings in India are done majorly by the households and in small amounts
by the private corporate sector and the government. Of these it is only the savings
of the household sector whose magnitude is affected by the changes in the
financial system. In order to assess the extent of financial development, it is
therefore more informative to look at savings of the household sector, their
financialization and institutionalization. As financial sector develops, much more
facilities and opportunities are available for deployment of surplus funds. So
people tend to save more, more of such savings are in financial rather than
physical assets and more and more of financial assets are held with institutions
rather than privately or as currency with individuals themselves or in primary
securities.

23
These are secondary securities as against primary securities issued by ultimate borrowers like
bonds, company deposits etc.

4-5
Investment
The terms refers to the act of purchasing tangible (real) assets for the purpose of
utilizing them in productive activity. Besides this fixed investment change in
stocks24 is also a part of investment. Investment can be either gross investment or
net investment, the difference between the two being consumption of fixed capital.
Although the net values give a true measure of the addition to the productive
capacity of an economy, it is common to use gross values for various analytical
purposes due to arbitrariness in calculation of depreciation. Investment too like
savings, is done both by the private and the public sectors, only private sector
investment being responsive to development, or otherwise of the financial system.

Aggregate savings (i.e. domestic availability of funds) and investment determine

the need for foreign funds and also success or otherwise of the financial system to
effectively mobilize the available funds to productive channels.

4.2.2 Deposits

An important task of the financial system is to collect the funds available with the
surplus sector. Success of any financial system depends on how much of the
surplus it is able to mop up in the first place. Deposits are moneys accepted by
various agencies from others to be held under stipulated terms and conditions. In
India, banks, post offices25, and non-bank companies accept deposits.

Bank deposits

Deposits constitute a major source of funds for banks. Bank deposits can be
further classified on the basis of whether they are made in commercial banks, co-
operative banks, and scheduled or non-scheduled banks. For a proper

24
stocks may be of finished goods, semi-finished goods, or raw materials.
25
For post office deposits see Gupta, S.B.(1999), Monetary Economics: Institutions Theory And
Policy, S.Chand, India.

4-6
classification, we therefore need to bring in the structure of the Indian Banking
System.
Indian Banking System

Reserve Bank Of India

Scheduled Banks Non-scheduled

Banks

State Commercial Central Coop. Commercial

Coop. Banks Banks and Banks
Banks Primary
Credit
Societies

As an apex institution of the Indian banking system is the Reserve Bank of India
(RBI). It is a regulatory body and does not directly accept deposits from public.
Deposits are accepted by commercial and co-operative banks, scheduled and
non-scheduled.

Deposits of Commercial Banks

Commercial banks deal in other people’s money. They receive various types of
deposits that serve as means of payment and medium of saving. Two main types
of deposits are demand deposits and term deposits. Demand deposits can further
be sub-divided into current and savings deposits. Deposits in current account are
payable on demand. Withdrawals can be made by cheque without any restrictions.
No interest is paid on these deposits, but, in return, the banks offer various kinds of
services at a modest charge. Business firms mostly hold such deposits. Savings
account deposits are also payable on demand and withdraw able by cheque. But
there are restrictions on frequency of use of cheque facility. These are therefore

4-7
suitable for households. Interest is paid on them at a fixed rate that does not vary
across banks. Term/time deposits (or fixed deposits) are deposits made for a
stipulated period of time in days, weeks, months, or years. Interest rate depends
on the time period of deposits but is higher than saving deposits for all time
periods. Cheques cannot be issued against such deposits. Moneys become
payable on maturity i.e. after expiry of the time period for which the deposit was
made. In practice, however, most banks allow pre-mature liquidation, with or
without penalty. It is these term deposits that represent a genuine saving medium.

Apart from commercial banks, the Indian banking system consists of co-operative
banks. In terms of volume of deposits and credit the co-operative banking is much
smaller than commercial banks. Their importance is not in the size of their
operations, but the sector of the economy they serve i.e. agriculture in particular
and rural in general.

Post offices serve as the vehicle for mobilizing small savings of the public for
government. Their large number and wide geographical distribution throughout
the country help in mobilizing available surpluses at very low additional cost.
Small savings are mobilized under different schemes launched by the central
government. Interest offered is often higher than comparable schemes of banks.
Also investments in small savings carry many fiscal incentives like tax concessions
which further raise their effective yield. Consequently post offices are able to mop
up sizeable surplus from the economy in form of ‘deposits’ and ‘certificates’. These
funds, however, are not available to the business for investment. Rather these are
a source of budgetary resource to the government.

Deposits of Non-Banking companies

A wide variety of non-bank companies accept deposits from the public. These are
large in number, privately owned, decentralized and relatively small sized financial

4-8
intermediaries that make a more or less competitive market. Some of these
companies raise funds from the public and also lend to it while others are engaged
in manufacturing or trade and accept deposits from the public merely for their own
use. The former are called financial companies and the latter, non-financial
companies. Only financial companies can be called non-banking financial
intermediaries (NBFIs) because only in this case the principal business is to accept
deposits in one arrangement or other and lend in any manner. The NBFIs
themselves from a heterogeneous group of different types of companies
performing diversified range of functions and offering various kinds of financial
services to their client.

The categories of NBFCs and the nature of their main activities currently being
followed by the RBI26 are:

1. Equipment leasing company (ELC) where the principal activity is leasing of

equipment or financing of such activity.

2. Hire Purchase finance company (HPFC) principal activity being hire-purchase

transactions or financing of such transactions.

3. Housing finance company (HFC) principal activity is the financing of

acquisition or construction of houses or acquisition or development of plots of
lands.

4. Investment company (IC) involved majorly in acquisition of securities.

5. Loan Company (LC) majorly engaged in providing finance excluding ELC,

HPFC, or HFC.

26
RBI Report On Trend And Progress Of Banking In India 1995-96, Bulletin, March 1997, Pg.78-79.

4-9
 6. Mutual benefit financial company (MBFC) as notified by the central
government.

7. Miscellaneous Non-Banking Company (MNBC)

a) Managing, conducting or supervising as a promoter, foreman or agent of any
transactions or arrangement by which the company enters into an agreement
with a specified number of subscribers that every one of them shall subscribe a
certain sum in installments over a definite period and that every one of such
subscribers shall in his turn be entitled to the prize amount.
b) Conducting any other form of chit that is different from the type of business
as in (a) above.

8. Residuary Non-Banking Company (RNBC): A company that receives any

deposit under any scheme or arrangement and is not insurance company or
belongs to any of the seven above.

4.2.3 Credit

The surplus funds that have been collected by the financial system in form of
deposits need to be channeled back to the economy in a way that is most
productive. This is done via credit to the deficit spenders in various forms.

Broadly speaking, credit27 is finance made available by one party to another. The
former may be a pure lender i.e. a financial institution or private money lender, a
seller supplying goods against buyer’s promise of future payment or a shareholder
or owner making funds available to the firm viewed as separate entity. The chief
function of credit is to relax the constraint of balanced budget that would greatly

27
For different types of classification of credit see Gupta, S.B.(1999), Monetary Economics:
Institutions Theory And Policy, S.Chand, India.

4-10
hinder the expansion of business units and consequently progress of the
economy. In this chapter, the attention has been confined to institutional finance or
credit. Finance through shares/bonds is a subject of later chapter on financial
markets.

In modern economy, there exist several sources of institutional credit. Commercial

banks by and large are major source of institutional credit although with time their
importance is declining. A number of other financial institutions (development
banks, NBFIs etc.) have come up and grown in importance. Besides, there are
financial non-banking companies involved in provision of finance to deficit
spenders i.e. the business units.

Bank Credit

This covers credit from commercial banks – scheduled and non-scheduled and co-
operative banks.

Commercial Banks provide finance to commerce and industry by investment in

their securities and directly as loans and advances in various forms. Finance is
made available partly to the government sector but a major proportion to private
commercial sector. Finance to the government28 is through investment in
government and other approved securities and bank credit to the government for
procurement of food. What goes to the private sector is then the non-food bank
credit. Additionally after mid 80’s these banks have been allowed to invest up to
five percent of their incremental deposits in corporate shares and convertible
debentures. This has enabled them to be active players in the financial market.
They are now also allowed to invest in commercial paper (CP), units of mutual
funds, shares and debentures of PSU and shares and debentures of private

28
Including local bodies

4-11
corporate sector (non-SLR investments) to the extent of 5% of their outstanding
advances.

Commercial banks have been a major source of finance to industry and

commerce. Time and again innovative schemes have been introduced for the
disbursement of credit. These include village adoption, agricultural development
branches, attractive education loans etc. Although commercial banks have
traditionally been providing short-term credit for financing working capital needs,
their term loans have been increasing over the years.

Co-operative Banks: In the beginning of 20th century the supply of credit,

particularly institutional credit to rural areas was woefully inadequate29.
Unorganized money market agencies were providing credit often at exploitatively
high rates of interest. The co-operative banks were conceived to substitute such
agencies, provide adequate short term and long term institutional credit at
reasonable rates of interest. The relative importance of co-operative banks in
financing agriculture and rural development has undergone a substantial change
over the years. Till 1969, they increasingly substituted the informal sector lenders.
After nationalization of banks and creation of regional rural banks (RRBs) and
NABARD, their relative share has somewhat declined.

The Indian Banking system on the whole has a very wide reach and deep
presence in metropolitan areas, cities, semi urban areas, and the remotest corners
of rural areas with its vast number of branches. The diversification and
development of the Indian economy are in great part due to the active role played
by the banks in financing economic activities. They have been playing an
important role in developing mutual funds, merchant banks, primary dealers, asset

29
Gupta, S.B.(1999), Monetary Economics: Institutions Theory And Policy, S.Chand, India.

4-12
management companies, and debt markets. They operate as issuers, investors,
underwriters, and guarantors in financial markets. Thereby, banks influence the
liquidity and growth of debt market that help in securitization30.

Development Banks/ Financial Institutions

These are specialized financial institutions that provide medium and long-term
finance to private industry and commerce. Unlike ordinary commercial banks, they
do not accept deposits from public. They are not intermediaries, as they do not
generally mobilize savings from the ultimate surplus units. Their resources are
mainly obtained from the government or RBI, although some of these have now
begun mobilizing public savings directly or indirectly. Mostly, the government has
set them up statutorily for specialized purposes, but some private sector
participation in ownership and functioning of some of them also exist.

As development banks, their chief distinguishing role is promotion of economic

development by promoting investment and enterprise in their allotted sphere,
whether agriculture, or industry, or exports, or any other. Their promotional/
developmental role may take a variety of forms including provision of risk capital,
underwriting of new issues, arranging of foreign loans, identification of investment
project, preparation and evaluation of project reports, provision of technical advice,
market information and management services. The Indian development banks
have as yet not developed so much as to provide the entire range of services. But
their contribution in channeling of finance has been sizeable and large-scale
industry in the private sector has been the main beneficiary.

Development banks in India are post independence phenomenon. All of them

were set up during the planning era to assist growth in specific desired directions.

30
For details see Bhole, L.M. (2004) : Financial Institutions and Markets : Structure, Growth and
Innovations, Tata, Mc Graw Hill.

4-13
They are like federal agencies in the US. Although similar institutions exist in other
countries also, in none other free enterprise or mixed economy they dominate the
financial system as they do in India.

The major forms in which these financial institutions provide assistance are:

Direct loans and advances in domestic and foreign currencies

Direct subscription to industrial securities and those of other finance
institutions.

Underwriting of new issues.

Guarantees for loans and deferred payments.

Refinancing loans and rediscounting bills.

Providing machinery to small units on a hire-purchase basis.

Provision of merchant banking services, lease finance, and venture capital.

Providing technical and managerial assistance, guidance and consultancy
services.

The financial assistance is mostly of medium or long term in nature although they
have now begun supplying short-term finance for working capital also. The
resource base of these institutions has also changed significantly over the years.
Initially it was built up mainly through share capital and borrowings from
government, RBI and World Bank. Their bonds31 used to be subscribed mainly by
banks, insurance companies, UTI, Provident Funds (PFs) etc. under SLR
requirements and little by individual savers as they were long-term and carried low
rates of interest as compared to the market. The importance of these sources
drastically declined with passage of time. The authorities have increasingly
reduced their access to these concessional sources as part of new economic
policy. They are now increasingly raising resources through equity and bond
issues on public and private placement basis in domestic market and also

31
which form a part of the “approved securities” for SLR

4-14
accessing the international financial markets for mobilizing foreign currency
resources. Some of them have also started accepting deposits from public.

Non-Bank Finance Companies

Besides banks and specialized (non-bank) financial institutions, there exist a large
number of non-banking finance companies32 across the country that provide
finance for various purposes. They have been helping to bridge the credit gaps in
several sectors that the traditional institutions are unable to fulfill. These
companies are highly heterogeneous group of intermediaries that offer wide range
of financial services. They provide credit to the unorganized and small borrowers
at local level till date. They are flexible in their organization and policies, and have
been able to build up a clientele of small borrowers to big corporates despite high
interest rates charged on loans.

Some of the important types of NBFCs providing credit are:

1. Loan companies: These provide loans to wholesale and retail traders,
small-scale industries, and self employed persons. The loans are mainly
short-term but easily and frequently renewed. Loans are generally
unsecured, made on knowledge of local conditions and personal credit
standing of the borrowers. Loans are often made to borrowers who have
been turned down by banks, even to hoarders of scarce commodities. Rate of
interest charged is high, comparable to those of moneylenders.

2. Investments companies: Their functional coverage is narrow and

specialized. Their loans to the industry are negligible; they finance other
important needs as house building; education and medicine and priority
sectors as small transport operator. Due to their close local links, they are in
a better position for decentralizing the financial structure of the economy.

32
For finer details refer - Scope e-knowledge Center Ltd. (2001) The Indian NBFs (Non-banking
Financial Companies) Industry, Market Research.com.

4-15
 Just like loan companies interest rates charged are much higher than rest of
the organized sector. Yet they do attractive loan business because the loans
are often unsecured and procedures and simpler.

3. Hire purchase finance: A system under which advances are made for
purchases of goods and services to be paid back in installments. The
ownership of the good may be transferred to the buyer either immediately on
purchase or after discharge of all financial obligations.

4. Lease finance: A financing device that developed rapidly during 1960 and
1970s in the US, and in India just before the middle of 1980s. It involves
finance employed to acquire the use of assets without owning it.

5. Mutual benefit finance companies: These advance consumption loans to

their members for house construction or repairs, marriage, medical expenses
etc. Loans are usually secured against either physical or financial assets.

6. Merchant Banks: They offer more of financial services than actual finance.
They offer financial advice and service for a fee. Their basic function is
marketing corporate and other securities. They handle all aspects of
organization, underwriting, and distribution. Besides, they also offer a host of
other services like project promotion and finance, leasing, advisory services,
venture services, investment services for NRIs and so on.

7. Venture Capital33 funds: This new type of financial intermediary emerged in

the US during the 1970s, in UK in early 80s, Japan and Canada in mid-80s,
and in India around 1987. It refers to the provision of equity finance or risk

33
For more on venture capital refer to Bartlett, J.W. (1999), Fundamentals Of Venture Capital,
Madison Book, UK.

4-16
 capital to little known, unregistered, highly risky, but potentially high profitable
small private business or to young, first generation small entrepreneurs. This
is prevalent particularly in technology oriented and knowledge intensive
business or industries which have long development cycles and which usually
do not have access to conventional sources of capital because of absence of
suitable collateral and presence of high risk. Besides funds, they are also
instrumental in supplying management and marketing expertise to such units.
Venture capital business in India is of relatively recent origin, but it has
expanded quite fast.

Besides the financial agencies discussed above, there exist a number of private
unregulated credit markets in India. Their forms of organization and methods of
working are not standardized. There is great diversity in their operations,
organization, methods, sources of funds, rate of interest charged etc. Such
agencies are neither integrated with each other nor with the organized sector of
the credit market. Reliable and complete information is not available about their
operations as there is no official or unofficial central agency to which such
financers report their operations. This represents a big gap in the knowledge of
finance industry and also hampers formulation and effectiveness of credit policy.

4.2.4 Structure Of The Financial System

As financial development takes place in an economy, the structure of financial

system undergoes a number of changes, quantitatively and qualitatively. Banking
sector declines in importance and other financial institutions become more
prominent. There is emergence and growth of strong, active, large sized, all
encompassing non-bank financial sector comprising of stock market, debt market,
insurance companies, pension funds, specialized financial institutions, mutual
funds etc. Private banking (domestic and foreign) too becomes prominent. With

4-17
coming up of such agencies and institutions also come up new types of financial
securities and practices and methods. Universal banking gains ground.

From time to time different economists have examined varying measures of

financial structure as indicators of financial development. Goldsmith, one of the
pioneering economists in the study of financial structure vis-à-vis development
discussed a number of measures of financial structure. He has used the financial
inter-relationship ratio (FIR)34 as the single main characteristic of a country’s
financial development. He defined FIR as the relation between total value of all
financial assets at a date by total value of tangible assets plus net foreign balance
i.e. ratio of financial assets to national wealth. This therefore gives relation
between a country’s financial super-structure and its real infrastructure. For
changes within the financial structure itself, according to him, one needs to look at:

Relative importance of different types of financial institutions,

Degree of institutionalization of financial structure reflected by the share of
financial institutions in the stock of financial assets, and

Composition of financial superstructure reflected in distribution of total
financial assets and liabilities among their main types and distribution of
financial assets among main sectors and sub-sectors.

Cameron’s study on “Banking in the early stages of industrialiszation (1967)”

shows wide range of variability of successful financial systems. The system that is
best at one place and time may not work successfully in other. In every case, the
structure of financial system is related to and must grow out of distinctive legal,
social, and political traditions and the objective economic conditions of its specific
environment. The structure and behavioral characteristics of a financial system

34
Refer to chapter 3 above.

4-18
greatly determines the effectiveness with which it plays its role in economic growth.
He gives three important quantitative aspects of a financial structure, namely

Density, given by the ratio of number of bank offices to total population

(multiply 10,000). A value of more than one office per 10000 inhabitants
give high density and less than half gives low density.

Relative size of banking sector given by ratio of bank assets to national
income. The ideal measure considered was ratio of bank assets to total
assets which becomes close to Goldsmith’s FIR35. Cameron talks only of
bank assets while Goldsmith’s coverage was comprehensive and would
therefore reflect a better relationship between financial and real economy.

Size and concentration of bank power i.e. size of individual bank unit and
degree of concentration of assets within the banking sector.

In addition to these measures, in order to judge the financial development of an

economy changes in one or more of the following financial ratios are often
examined:

Finance Ratio (FR): This measures the ratio of Primary issues (i.e. issues
by sectors other than banks and other financial institutions) to national
income.

Financial Inter-relations Ratio (FIR): This measures the ratio of total issues
(i.e. primary plus secondary) to net domestic capital formation. This is thus
the ratio of financial assets to physical assets and indicates the relationship
between financial structure and physical asset structure of the economy.

New issues ratio (NIR) i.e. the ratio of New (Primary) issues to net domestic
capital formation. This indicates how far direct issues to the savers have
financed the investment.

35
due to data problems national income was used.

4-19

Intermediation Ration (IR) is the ratio of secondary issues (i.e. issues by
banks and other financial institutions) to primary issues. This therefore
indicates the importance of the banks and other financial institutions as
mobilizers of funds relative to real sectors as direct mobilizers. Thus, this
represents institutionalization of financing in the economy.

4.3 DATA AND METHODOLOGY

The indicators just discussed have been examined with respect to any structural
breaks corresponding to the reforms. Time period and methodology differs in each
case depending on the availability of data and nature of analyses.

Testable Hypotheses

In relation to the period prior to liberalization 

i. Gross Domestic Savings (total and households’) have increased at same
rates
ii. Gross Domestic Capital Formation (total and private sector) have grown at
same annual rates
iii. Rate of growth of deposits (as ratio to GDP) has remained the same, and
iv. Rate of growth of institutional credit (as ratio to GDP) has remained the
same in the period after the reforms.
For other indicators simple data analyses assisted by appropriate graphs has been
used.

Time period for (i) and (ii) above is 1950-51 to 2006-07,

(iii) is 1970-71 to 2006-07,
(iv) is 1979-80 to 2006-07, and
for the rest the time period varies from case to case conditioned by data availability
and is indicated along.

4-20
Data Sources

The analysis is based on secondary data obtained from the following sources:

• Handbook of statistics on Indian Economy (Oct, 2008), RBI

• Statistical Tables Relating To Banks In India (1979-2007), RBI
• Economic Survey (2007-08) issued by the GOI, Ministry of Finance
• Report On Trend And Progress Of Banking In India (Different issues), RBI
• Flow Of Funds Accounts Of The Indian Economy (2000), RBI

Research Methodology

To start with time series of all stated indicators have been plotted against time.
This gives a fairly good indication of the presence (or absence) and direction of the
trends. If a jump and/or a change of slope occur at any particular time period it will
indicate a structural change with respect to the concerned variable.

A more rigorous approach is to obtain the rate of growth using the regression
analyses and then examine for a structural break corresponding to the reforms
using standard tests available. This is however possible only if adequate data is
available and it does not show wild fluctuations. So, wherever substantial and
consistent data is available for both pre and the post reform periods, in respect to
those indicators regression analyses has been used. In cases where substantial
pre-reform data is not available or the magnitudes in entirety have been sharply
fluctuating, simple data analysis as explained above has been done. Regression
analyses in such cases will not be able to give meaningful results. Where possible
the average annual rate of growth for each indicator has been obtained using
regression equation of the form y = a + bT+ e. a and b are the parameters to be
estimated and e is the error term. The variable is represented by y; T denotes the
time period, and ‘b’ i.e. the coefficient of T represents the average annual rate of

4-21
growth of the variable Y. The rate has been obtained for the two sub-periods36 and
for the entire time period for which data is available. Subsequently Chow test37 for
structural break has been performed to test for the impact of reforms.
Test Statistic:

(RSS – (RSS1+RSS2)/k)
F=
(RSS1+RSS2/ N1+N2- 2k)
RSS – Residual sum of squares for combined regression
RSS1 – Residual sum of squares for pre-reform period
RSS2 – Residual sum of squares for post-reform period
k – number of parameters to be estimated (= 2)
N1 – observations in pre-reform period
N2 – observations in post-reform period
Decision rule: If the value of F calculated using the above statistic is greater than
the value of F obtained from the tables i.e. Fcal> Fcritical , it implies the rejection of
null hypotheses of various growth rates being same in the pre and the post reform
periods. In other words a value of calculated F greater than the critical F implies
that the growth rates in the post reform sub-periods have been higher.
.
4.4 TRENDS IN FINANCIAL DEVELOPMENT

This section gives the empirical results of the comparative study of pre and post
liberalization period with respect to the indicators of financial development
discussed in section 4.2 above.

Gross Domestic Savings and Investment

Data on savings and investment is presented in table 4.1

36
break taken in the year 1992-93.
37
for further explanation and applications of the Chow test refer Gujarati, D (1988), Basic
Econometrics 2nd ed. Mc-Graw Hill

4-22
 Table 4.1: Gross Domestic Savings And Capital Formation
As Percent Of GDP At Current Market Prices
Gross Domestic Capital
Gross Domestic Saving
Formation
Household Private corporate
Year Public sector Total Public sector Private sector Total
sector sector
1950-51 5.73 0.92 1.95 8.6 2.9 7.37 8.4
1951-52 5.09 1.27 2.64 9 3.2 7.43 10.7
1952-53 5.69 0.61 1.7 8 2.8 5.84 7.7
1953-54 5.38 0.79 1.43 7.6 2.9 4.28 7.5
1954-55 6.19 1.09 1.82 9.1 4.7 5.08 9.3
1955-56 8.98 1.21 2.11 12.3 5.1 7.2 12.6
1956-57 8.43 1.18 2.29 11.9 5.6 8.66 14.6
1957-58 6.8 0.89 2.31 10 6.7 7.77 13.5
1958-59 6.19 0.93 1.98 9.1 6 5.54 11.6
1959-60 7.58 1.16 2.06 10.8 6.3 6.9 12.3
1960-61 6.53 1.61 3.06 11.2 7.2 7.19 14
1961-62 6.2 1.73 3.27 11.2 6.9 7.85 13.1
1962-63 7.03 1.74 3.53 12.3 8 7.43 14.5
1963-64 6.32 1.73 3.85 11.9 8.1 7.15 13.8
1964-65 6.34 1.46 3.8 11.6 8.1 7.28 13.8
1965-66 8.6 1.45 3.65 13.7 8.7 7.43 15.8
1966-67 9.52 1.34 2.74 13.6 7.5 8.91 16.6
1968-69 7.94 1.12 2.74 11.8 6.2 8.01 12.9
1969-70 9.73 1.27 3 14 5.8 9.27 14.5
1970-71 9.45 1.45 3.3 14.2 6.7 8.88 15.1
1971-72 9.93 1.55 3.22 14.7 7.3 9.38 15.7
1972-73 9.64 1.48 3.18 14.3 7.6 8.37 14.8
1973-74 11.43 1.63 3.34 16.4 7.8 8.63 17
1974-75 9.78 1.87 4.05 15.7 7.8 10.38 16.5
1975-76 10.88 1.29 4.73 16.9 9.8 9.01 16.7
1976-77 12.37 1.3 5.43 19.1 10.3 8.6 17.6
1977-78 13.25 1.37 4.88 19.5 8.5 10.02 18
1978-79 14.64 1.48 5.08 21.2 9.7 10.82 21.3
1979-80 12.96 1.96 4.88 19.8 10.6 10.65 20.3
1980-81 12.88 1.61 4.01 18.5 8.9 9.61 19.9
1981-82 11.51 1.5 5.09 18.1 10.6 11.6 19.6
1982-83 11.11 1.56 5.03 17.7 11.3 10.15 19
1983-84 11.74 1.46 3.9 17.1 10.3 9.24 18.3
1984-85 13.11 1.62 3.47 18.2 11 10.37 19.6
1985-86 13.13 1.93 3.94 19 11.4 12.07 21.2
1986-87 13.23 1.69 3.48 18.4 11.8 11.19 20.5

4-23
Contd …
Gross Domestic Capital
Gross Domestic Saving
Formation

Household Private corporate

Year Public sector Total Public sector Private sector Total*
sector sector
1987-88 15.62 1.66 2.92 20.2 10.2 11.84 22.1
1988-89 15.76 2 2.74 20.5 10.2 13.48 23.4
1989-90 16.97 2.43 2.4 21.8 10.2 13.53 24.3
1990-91 18.4 2.66 1.74 22.8 10 14.17 26
1991-92 15.81 3.1 2.59 21.5 9.5 12.5 22.1
1992-93 16.39 2.65 2.16 21.2 9.1 14.67 23.1
1993-94 17.27 3.45 1.18 21.9 8.8 12.45 22.5
1994-95 18.59 3.47 2.34 24.4 9.3 14.2 25.5
1995-96 16.87 4.96 2.57 24.4 8.2 18.39 26.2
1996-97 16.03 4.51 2.16 22.7 7.5 14.64 24
1997-98 17.7 4.31 1.79 23.8 7.1 16.84 25.3
1998-99 18.83 3.93 -0.46 22.3 7 15.62 23.3
1999-00 21.13 4.47 -0.8 24.8 7.4 17.9 25.9
2000-01 21.6 3.9 -1.8 23.7 6.9 16.6 24.3
2001-02 22.1 3.4 -2 23.5 6.9 16.7 22.9
2002-03 23.2 3.9 -0.7 26.4 6.1 18.6 25.2
2003-04 24.4 4.4 0.9 29.7 6.3 19.5 28.2
2004-05 23 6.6 2.2 31.8 6.9 23.4 32.2
2005-06 24.2 7.5 2.6 34.3 7.6 25.8 35.5
2006-07 23.8 7.8 3.2 34.8 7.8 27 35.9
* Total capital formation includes valuables and errors and omissions apart from capital formation
by the public and the private sector

It shows Gross Domestic savings and Gross Domestic Capital Formation from
1950-1951 to 2006-07. The magnitudes are shown as percentage to GDP at
current market prices. The data has been obtained from the latest Economic
Survey and the Handbook of statistics on The Indian Economy. The table
separately gives the contribution of the household sector, the private corporate
sector, and the public sector to the total savings in India. It can be seen from the
table that the dominant saver in India is the household sector followed by the
private corporate sector. The contribution of public sector to total domestic savings
is small, lately negative. Chart 4.1 below illustrates the trends in household sector

4-24
savings and gross domestic savings as percentage of GDP at current market
prices.

Chart 4.1: Savings As Percentage Of GDP

40

35

30

25
percent

20

15

10

0
19 51

19 54

19 57

19 60

19 63

19 66

19 69

19 72

19 75

19 78

19 81

19 84

19 87

19 90

19 93

19 96

20 99

20 02

5
-0
-

-
50

53

56

59

62

65

68

71

74

77

80

83

86

89

92

95

98

01

04
19

HH savings as% of GDPmp GDS savings as% of GDPmp

From the chart 4.1, it can be seen that in the case of savings of the household
sector, there is a noticeable up trend in the years after mid 1990s. For total
savings the noticeable increase in the rate occurs somewhat later but is more
marked than in case of household savings.

The results of regression analyses for structural break38 corresponding to the

reforms suggest that the rate of growth of both household and total savings have
significantly increased after the reforms. The relevant regression equations are:

38
Dummy variables provide an alternative approach to test for structural breaks. See Gujarati,
D (1988), Basic Econometrics 2nd ed. Mc-Graw Hill.

4-25
GDS = 15.03 + 0.335T; r2 = 0.91;df = 41; tcal = 20.21; t41 = 2.7 (1)
GDS = 25.68 + 0.796T; r2 = 0.64; df = 12; tcal = 4.43; t12 = 3.05 (2)

Fcal = 13.36 > F2,53 = 5.05 (level of significance 1%)

(1) above represents the best fit for the period prior to the reforms, and
(2) represents the position after the reforms.

For household savings, the regression equations are:

HH Sav = 10.29 + 0.27T; r2 = 0.87;df = 41; tcal = 16.78; t41 = 2.7 (1)
HH Sav = 19.98 + 0.57T; r2 = 0.76; df = 12; tcal = 5.99; t12 = 3.05 (2)

Fcal = 17.35 > F2,53 = 5.05 (level of significance 1%)

(1) above represents the best fit for the period prior to the reforms, and
(2) represents the position after the reforms.

These equations clearly show that the average annual rate of growth, given by the
estimated value of the parameter b, has more than doubled in the post-reform
period both for aggregate domestic savings and the household savings. The
associated t-values are greater than the critical values obtained from the tables in
all cases (at 1% level of significance)39. This implies that the estimated growth
rates are statistically significant in all cases. The F test is rejected in both cases
thus indicating a structural break corresponding to the reforms. This implies that in
the period after 1992-93 the average annual rates of growth of both aggregate
domestic savings and the household savings have substantially increased and that
this increase is statistically significant. One qualification needs to be considered

39
and all significance levels more than 1%. In fact the obtained t-values are high enough to reject
the null hypotheses even at 0%.

4-26
here. The observed increases in growth rates in the period after 1992-93 would
also contain the effect of a number of other changes going on in the economy after
the economic reforms of 1991. However one can reasonably expect that in case of
financial variables the predominant effects would be those of changes taking place
due to reforms of the financial sector. In any case the magnitude of change is
substantial in both cases so that even after allowing for some impact of other
factors a huge margin remains that can be attributed to the financial sector
reforms.

As for capital formation the table 4.1 above gives the contribution of the public
and the private sector separately. It is apparent that the contribution of the private
sector was more than that of the public sector even in the years before the
reforms. After the reforms the differential has substantially increased. Private
capital formation has increased much faster than the total. Chart 4.2 below
illustrates these investment trends.

Chart 4.2: Investment As Percentage Of GDP

40

35

30

25
percent

20

15

10

0
19 1

19 4

19 7

19 0

19 3

19 6

19 9

19 2

19 5

19 8

19 1

19 4

19 7

19 0

19 3

19 6

20 9

20 2

5
-5

-5

-5

-6

-6

-6

-6

-7

-7

-7

-8

-8

-8

-9

-9

-9

-9

-0

-0
50

53

56

59

62

65

68

71

74

77

80

83

86

89

92

95

98

01

04
19

GDCF(pvt) as% of GDPmp GDCF as% of GDPmp

4-27
Both the curves in chart 4.2 are steeper after the early 1990s than before that.
This indicates an increase in the rate of growth after the reforms. The gap between
the two curves representing capital formation by the public sector can be seen to
have declined consistently since the early nineties.

The regression equations for the trends in investment are as follows:

GDCF = 16.35 + 0.34T; r2 = 0.89; df = 41; tcal = 18.65; t41 = 2.4 … (1)
GDCF = 26.23+ 0.65T; r2 = 0.46; df = 12; tcal = 3.05; t12 = 2.7 … (2)

Fcal = 5.64 > F2,53 = 5.05 (level of significance 1%)

As before (1) above represents the best fit for the period prior to the reforms, and
(2) represents the position after the reforms.

The equations in case of private capital formation are:

GDCF(pvt) = 9.15 + 0.174T; r2 = 0.816; df = 41; tcal = 13.52; t41 = 2.4 (1)
GDCF(pvt) = 17.34+ 0.64T; r2 = 0.7; df = 12; tcal = 5.12; t12 = 2.7 (2)

Fcal = 41.86 > F2,53 = 5.05 (level of significance 1%)

The above analyses brings out that for GDCF the rate of growth is nearly double in
the post reform period while for GDCF (private) it has more than trebled. The
associated t-values are greater than the critical values obtained from the tables in
all cases (level of significance is 2%)40. This implies that the estimated growth
rates are statistically significant in all cases. The F test is rejected in both cases
thus indicating a structural break corresponding to the reforms. This implies that in

40
In case of GDCF the t-test is marginally rejected at 1% level of significance.

4-28
the period after 1992-93 the average annual rates of growth of both aggregate
domestic capital formation and private GDCF have substantially increased and
that this increase is statistically significant. In this case also it needs to be taken
into account that the observed increases in growth rates in the period after 1992-
93 would also contain the effect of a number of other changes going on in the
economy after the economic reforms of 1991. The effects of other changes could
be more important than in case of savings but in any case the magnitude of
change is substantial here too so that even after allowing for some impact of other
factors a huge margin remains that can be attributed to the financial sector
reforms.

From the above analyses on the savings and the investment rates one can safely
infer that on the whole a substantial increase in rate of growth of both savings and
investment has occurred after the reforms. Of all the cases analyzed above the
maximum change has been noted in case of investment by the private sector. As
earlier noted the savings and investment by the public sector are not directly
related to the changes in the financial sector and are determined by a number of
other factors41 and fiscal priorities of the government. The variables of greater
relevance in the context of developments in the financial sector are the household
savings and the capital formation by the private sector. For this reason separate
analyses has been presented with respect to these. The results obtained thereon
are encouraging.

When financial development takes place in an economy, apart from the increase in
aggregate savings there is a move towards the institutionalization and
financialization of savings.

41
Refer Kapila, U. (ed) India’s Economic Development Since 1947 article by Rakshit, M. on
Correcting Fiscal Imbalances In The Indian Economy: Some Perspectives

4-29
Table 4.2 below throws light on the
Table 4.2: Households’ Savings
trends in the savings behavior of the Behavior
household sector in India with Institutionali Financializat
Year zation of ion of HH
respect to their institutionalization savings savings
and financialization. The magnitudes 1970-71 69.43 26.63
1971-72 75.94 24.79
shown in the table have been
1972-73 69.18 32.87
calculated from the data available in 1973-74 69.7 26.8
1974-75 82.53 33.69
the Handbook of statistics on The
1975-76 74.66 39.9
Indian Economy, 2008. Institutionali- 1976-77 84.74 36.13
1977-78 76.36 34.8
zation of savings has been obtained
1978-79 73.74 32.61
as the ratio of households’ financial 1979-80 70.46 33.9
1980-81 71.12 37.31
assets with institutions (the sum of
1981-82 64.79 43.86
bank deposits, LIC fund, provident 1982-83 67.61 49.65
and pension funds, and their 1983-84 67.21 41.25
1984-85 66.84 45.51
holdings of the units of UTI) to the 1985-86 67.12 44.28
incremental financial assets for each 1986-87 71.17 48.61
1987-88 69.15 39.36
year. The ratio has been fluctuating 1988-89 67.94 34.19
throughout without a clear trend. 1989-90 62.38 36.72
1990-91 66.15 41.41
Financialization of savings has been 1991-92 68.25 52.07
obtained as the ratio of net financial 1992-93 71.01 47.63
1993-94 62.77 54.43
savings of the households minus 1994-95 63.59 55.52
currency to their total financial 1995-96 61.48 44.37
1996-97 63.83 57.93
savings. Fluctuations can be seen in 1997-98 73.58 49.59
this case also but a clear up trend 1998-99 72.99 48.07
1999-00 70.81 43.47
can be noted too. One can safely 2000-01 70.66 45.46
say that a trend towards moving into 2001-02 67.07 43.61
2002-03 68.91 41.79
financial assets is taking shape in 2003-04 62.16 40.27
the economy. These trends are 2004-05 64.39 41.01
2005-06 70.64 45.39
illustrated in the chart 4.3. 2006-07 79.76

4-30
 Chart 4.3: Institutionalization And Financialization Of Savings

90
80
70
60
percent

50
40
30
20
10
0
19 71

19 73

19 75

19 77

19 79

19 81

19 83

19 85

19 87

19 89

19 91

19 93

19 95

19 97

20 99

20 01

20 03

20 05

7
-0
-

-
70

72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04

06
19

Institutionalisation of savings Financialisation of hh savings

Deposits: This part of the section provides information on the deposits accepted
by the organized sector of the financial system i.e. bank deposits and deposits
accepted by the non-banking companies. Tables 4.3 and 4.4 provide the relevant
data on bank deposits. Table 4.3 below gives data on demand deposits and time
deposits of the scheduled commercial banks and their relative magnitudes. The
data has been obtained from the Handbook of statistics on The Indian Economy.
The ratio of time deposits to demand deposits and to the total deposits shows a
distinct jump in the year 1977-78. This corresponds to a change in classification of
total deposits as between demand and time deposits42. After accounting for the
change in classification one can say that the proportion of time deposits has shown
a steady overall up trend. The trend has been somewhat more marked for around
a decade starting mid 1990s. It may be noted here that while the proportion of
time deposits in particular did not show a sharp up trend, individually both demand
and time deposits have shown substantial increase after the reforms.

42
For the details of old and new classification refer Gupta, S.B.(1999), Monetary Economics:
Institutions Theory And Policy, S.Chand, India.

4-31
 Table 4.3: Deposits Of Scheduled Commercial Banks
Rupees Crores
Demand Time
Year TD/DD TD/D
Deposits Deposits
1970-71 2626 3280 1.25 55.396
1971-72 3127 3979 1.27 55.908
1972-73 3794 4849 1.28 56.022
1973-74 4336 5803 1.34 57.147
1974-75 4963 6865 1.38 57.95
1975-76 5817 8338 1.43 58.799
1976-77 6943 10623 1.53 60.401
1977-78 4872 17340 3.56 78.022
1978-79 5826 21190 3.64 78.405
1979-80 6643 25116 3.78 79.05
1980-81 7798 30190 3.87 79.455
1981-82 8383 35350 4.22 80.813
1982-83 9984 41374 4.14 80.541
1983-84 11312 49284 4.36 81.312
1984-85 14132 58113 4.11 80.42
1985-86 15612 69792 4.47 81.699
1986-87 19227 83496 4.34 81.259
1987-88 20247 97798 4.83 82.823
1988-89 23342 116808 5 83.315
1989-90 28856 138103 4.79 82.687
1990-91 33192 159349 4.8 82.729
1991-92 45088 185670 4.12 80.434
1992-93 46461 222111 4.78 82.674
1993-94 56572 258560 4.57 82.025
1994-95 76903 309956 4.03 80.107
1995-96 80614 353205 4.38 81.417
1996-97 90610 414989 4.58 82.079
1997-98 102513 495972 4.84 82.871
1998-99 117423 596602 5.08 83.555
1999-00 127366 685978 5.39 84.34
2000-01 142552 820066 5.75 85.191
2001-02 153048 950312 6.21 86.129
2002-03 170289 1110564 6.52 86.705
2003-04 225022 1279394 5.69 85.043
2004-05 248028 1452171 5.85 85.412
2005-06 364640 1744409 4.78 82.711
2006-07 429731 2182203 5.08 83.547
2007-08 524310 2672630 5.1 83.6

4-32
 Table 4.4: Deposits Of The Banking System
Rupees Crores
Deposits of
Aggregate Total
Deposit state co-ops Total
deposits of deposits of Bank Dep/
Year s of Non maintaining bank
SCBs (inc. commercial GDPmp
SCBs acc with deposits
RRBs) banks
RBI
1970-71 5906 15 5921 138 6059.0 13.101
1971-72 7106 11.1 7117.1 163 7280.1 14.7
1972-73 8643 12.6 8655.6 188 8843.6 16.2
1973-74 10139 15.5 10154.5 225 10379.5 15.625
1974-75 11827 19.4 11846.4 242 12088.4 15.414
1975-76 14155 25.5 14180.5 270 14450.5 17.158
1976-77 17566 21.6 17587.6 352 17939.6 19.768
1977-78 22211 13.4 22224.4 427 22651.4 22.035
1978-79 27016 10.4 27026.4 494 27520.4 24.711
1979-80 31759 13.1 31772.1 570 32342.1 26.476
1980-81 37988 8.2 37996.2 623 38619.2 26.566
1981-82 43733 9.9 43742.9 667 44409.9 26
1982-83 51358 12.2 51370.2 733 52103.2 27.271
1983-84 60596 14.8 60610.8 798 61408.8 27.601
1984-85 72244 17.5 72261.5 923 73184.5 29.36
1985-86 85404 22.2 85426.2 1029 86455.2 30.731
1986-87 102724 28.4 102752.4 1194 103946.4 33.018
1987-88 118045 35.6 118080.6 1381 119461.6 33.382
1988-89 140150 50 140200 1697 141897.0 33.424
1989-90 166959 59.5 167018.5 2017 169035.5 34.661
1990-91 192541 74.8 192615.8 2152 194767.8 34.192
1991-92 230758 77.4 230835.4 2576 233411.4 35.65
1992-93 268572 86.1 268658.1 2831 271489.1 36.074
1993-94 315132 90.5 315222.5 3415 318637.5 36.802
1994-95 386859 66.3 386925.3 3850 390775.3 38.471
1995-96 433819 1.7 433820.7 4286 438106.7 36.76
1996-97 505599 0.9 505599.9 5377 510976.9 37.064
1997-98 598485 0.0 598485 5628 604113.0 39.558
1998-99 714025 0.0 714025 7511 721536.0 41.202
1999-00 813345 0.0 813345 8870 822215.0 42.121
2000-01 962618 0.0 962618 9682 972300.0 46.249
2001-02 1103360 0.0 1103360 12119 1115479.0 48.947
2002-03 1280853 0.0 1280853 12226 1293079.0 52.681
2003-04 1504416 0.0 1504416 13782 1518198.0 55.115
2004-05 1700198 0.0 1700198 14581 1714779.0 54.448
2005-06 2109049 0.0 2109049 15665 2124714.0 59.344
2006-07 2611933 0.0 2611933 17118 2629051.0 63.415

4-33
Table 4.4 above gives data on the aggregate deposits of the banking system. The
data again has been obtained from the Handbook Of Statistics On The Indian
Economy. It can be seen from the table above that the deposits of both
commercial and co-operative banks have increased at rapid rates. In relative
terms, the deposits of non-scheduled commercial banks and co-operative banks
are of insignificant magnitudes in comparison to those of scheduled commercial
banks. With effect from 1997-98 the distinction between scheduled and non-
scheduled commercial banks has been done away with. The total deposits and
the deposits as percentage to GDP have substantially increased. Chart 4.4 shows
the deposit to GDP ratio.

Chart 4.4: Bank Deposits/GDPmp

70
60
50
percent

40
30
20
10
0
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20
71- 73- 75- 77- 79- 81- 83- 85- 87- 89- 91- 93- 95- 97- 99- 01- 03- 05-
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Although the curve is steadily moving upwards from the beginning of the time
period itself; the up trend is more marked after the early 1990s. Same result has
been obtained on the basis of regression analysis also.

The two equations for the pre-reform and the post-reform period respectively are:

4-34
DEP = 28.3 + 1.24T; r2 = 0.96; df = 21; tcal = 24.33; t21 = 2.8 (1)
DEP = 49.45+ 2.15T; r2 = 0.92; df = 12; tcal = 11.54; t12 = 3.05 (2)

Fcal = 23.63 > F2,33 = 5.29 (level of significance 1%)

It is apparent from the above equations that the rate of growth has nearly doubled
in the post reform period.. The t-test (level of significance is 1%) for the
significance of the slope co-efficients is rejected thereby implying that the
estimated growth rates are statistically significant. The F test is rejected indicating
a structural break corresponding to the reforms. This implies that in the period after
1992-93 the average annual rates of growth of bank deposits have substantially
increased and that this increase is statistically significant. It can be seen from the
coefficient of T in equation (1) that the growth rate was high even before the
reforms. In the case of deposits the influences other than those relating to the
financial sector would be minimal so that almost entire increase can be attributed
to the aforesaid reforms.

Deposits of Non-banking Companies (NBCs): Any statistical study on NBCs is

faced with difficulties for several reasons. Firstly, only a small proportion of these
file return with RBI and with time this proportion has been increasing so that at
least a part of increase in deposits could actually be due to greater proportion of
such deposits getting accounted. Secondly, with effect from 1997, the NBCs are
being more comprehensively defined, their coverage being more extensive, so that
more and more companies would fall under NBCs. Moreover the reporting format
pre and post 1997 is also different. Therefore, the data before and after 1997
becomes non-comparable. Data before 1997 is available in terms of regulated
deposits43 and exempted deposits/borrowings44 It must be noted that deposits

43
those deposits which are subject to ceilings and other restrictions imposed by the regulatory
measures.
44
those which are outside the scope of regulatory measures.

4-35
here mean any money received by an NBC by way of deposit or a loan or any
other form. Since April-May, 1993 apart from usual deposits they mean inter-
corporate loans, and borrowings by private limited NBCs from their shareholders.
Table 4.5 below gives the available data on the deposits of NBCs.

Table 4.5: Deposits Of Non-Banking Companies

Rupees Crore
Non-bank
Non-bank Total Year Total
non-
Year financial Aggregate (end- NBFCs RNBCs Public
financial
companies Deposits March) Deposits
companies
1970-71 149.7 419 568.7 1998 13571.7 10248.7 23820.5
1971-72 211 480.8 691.8 1999 9784.7 10644.3 20428.9
1972-73 230.4 517.4 747.8 2000 8338 11003.8 19341.8
1973-74 304 724.6 1028.6 2001 6459.4 11625.2 18084.6
1974-75 442.4 754.3 1196.7 2002 5933 12888.8 18821.8
1975-76 461.5 803.7 1265.2 2003 5034.6 15065 20099.7
1976-77 696.3 1038.6 1734.9 2004 4317 15327 19644
1977-78 749.5 1313 2062.5 2005 3926 16600 20526
1978-79 1038.5 1597.6 2636.1 2006 2447 20175 22622
1979-80 1612.6 1841 3453.6 2007 2075 22622 24697
1980-81 1475.7 2712.3 4188 NBFC : Non-banking financial company.
1981-82 1745.6 3746.2 5491.8 RNBC : Residuary non-banking company.
1982-83 2430.2 6764.1 9194.3 Notes:
1983-84 3161.3 7962.8 11124.1 1. Data format has changed after 1996-97
2. NBFCs include Deposit taking NBFCs ,
1984-85 4356 11784.4 16140.4
Mutual Benefit Financial Companies
Mutual Benefit Companies (MBCs) (Potential
1985-86 4959.6 13112.5 18072.1 Nidhis) etc., till 2005 and only NBFCs-D
thereafter.
1986-87 5941.6 15458.6 21400.2
1987-88 7499.7 16704.6 24204.3
1988-89 10484.9 18120 28604.9
1989-90 14643 21439 36082
1990-91 17236.2 26837.3 44073.5
1991-92 20438.5 30746.3 51184.8
1992-93 44956.4 103141 148097.4
1993-94 56437.4 129343.3 185780.7
1994-95 85495.1 158511.2 244006.3
1995-96 101672 186909.2 288581.6
1996-97 124370 223873.1 348242.8

4-36
The data for the above table has been obtained from the Handbook Of Statistics
On The Indian Economy. Left hand partition of the table gives data on aggregate
deposits. After 1997, continuous time series data is available only on public
deposits in NBCs. It is reproduced on the right hand side of the table. Data is
given separately for the non-bank financial companies and non-bank non-financial
companies (known as residuary non banking company after 1997). It may be
noted here that the non-financial companies have done much greater amount of
business of accepting deposits; both aggregate deposits and public deposits.
Another point to note here is the sharp increase in the deposits of both these types
of companies after the reforms. Even after allowing for increases due to wider
coverage, a big magnitude of increase would still remain. It is also evident in the
chart 4.5 below. All the three curves rise steeply after the reforms.

Chart 4.5: Aggregate Deposits Of Non-Bank Companies

400000
350000

300000
rupees crores

250000

200000

150000
100000

50000
0
1

7
-7

-7

-7

-7

-7

-8

-8

-8

-8

-8

-9

-9

-9

-9
70

72

74

76

78

80

82

84

86

88

90

92

94

96
19

19

19

19

19

19

19

19

19

19

19

19

19

19

Non-bank financial companies Non-bank non-financial companies Total

Credit
Credit to the deficit spenders is made available by the banking system, the
(specialized) financial institutions at all-India and state levels, non-bank finance

4-37
companies, and large number of unorganized operators providing credit. Of these,
commercial bank finance45 is still the dominant source although its relative
importance has declined in the recent years. Consistent data on credit from
NBFCs in totality is not available. In context of private unregulated credit markets
too, reliable and complete information is not available about their operations as
there is no official or unofficial agency to which such financers report their
operations. So the study has used bank finance together with financial assistance
provided by the non-bank financial institutions in the analyses.

Table 4.6 below gives the available data on institutional finance to the private
sector. Financial assistance from the banking system to the private sector
includes bank credit and the investments made by the banking sector in other than
government and approved securities. Total bank credit that goes to the banking
sector has been obtained as the sum of non-food credit advanced by the
scheduled commercial banks and the credit provided by the non-scheduled
commercial banks and co-operative banks. Data on bank credit exclude the
impact of mergers on May 3, 200246 and the impact of conversion of a non-
banking entity into banking entity on 11th October 2004. For financial assistance
provided by the financial institutions, state level institutions (SFCs and SIDCs) are
not included because in respect of these data is available only upto 2004. From
All India Financial Institutions (AIFIs) six FIs are included for which data is
available till 200747. The others have not been included in the analyses to maintain
the comparability of data. The data on bank investments shown in col. 3 has been
obtained from the Statistical Tables Relating To Banks In India (1979-2007). Rest
of the data has been obtained from the Handbook Of Statistics On The Indian
Economy.

45
The term finance rather than credit has been used due to inclusion of bank investments that is
not strictly credit.
46
ICICI Ltd. was merged with ICICI bank
47
These are SIDBI, LIC, GIC, TFCI, IVCF and IFCI.

4-38
 Table 4.6: Institutional Finance to the Private Sector
Rupees Crores
Bank credit Bank Total bank Total
(commercial investments finance to FA by institutional
Year
+ co-op (in non-SLR the private AIFIs finance
banks) securities) sector (2+3) (4+5)
1 2 3 4 5 6
1978-79 16590.8 629 17220 105.4 17324.9
1979-80 20078.1 998 21076 214.4 21290.2
1980-81 24374.8 1200 25575 219 25794.0
1981-82 28507.8 1115 29623 339.8 29962.5
1982-83 33559.6 1076 34635 328.1 34963.5
1983-84 38346.9 1305 39652 450.5 40102.7
1984-85 44563.4 1910 46473 545.9 47019.0
1985-86 52087.2 1988 54076 774.8 54850.5
1986-87 59851.2 2527 62378 975.7 63354.2
1987-88 69999.4 3649 73648 1106.4 74754.6
1988-89 86015.7 5742 91758 1559.5 93317.2
1989-90 101833.4 11395 113229 1774.3 115003.1
1990-91 114396.9 7926 122323 3314.2 125636.8
1991-92 124339.3 11313 135653 4095.1 139747.7
1992-93 149577.2 18854 168431 4576.1 173007.0
1993-94 157472.3 24243 181716 5093.4 186809.0
1994-95 204642.7 23693 228336 7005 235341.1
1995-96 250542.8 33766 284309 11532.2 295840.9
1996-97 278012.8 52301 330314 12581.1 342894.9
1997-98 319443.0 76693 396136 14748.8 410884.8
1998-99 361194.0 94596 455790 15847.9 471638.0
1999-00 420509.0 107094 527603 16400.3 544003.8
2000-01 484265.0 124064 608329 16572.3 624901.7
2001-02 549557.0 126552 676109 17327.8 693437.1
2002-03 694444.0 135511 829955 15485.1 845440.4
2003-04 819942.0 143031 962973 21716 984689.0
2004-05 1041083.0 145460 1186543 15322.5 1201865.5
2005-06 1481975.0 165352 1647327 21145.5 1668472.1
2006-07 1901073.0 183768 2084841 38652.6 2123493.6

The magnitudes in each column show a distinct break in the early nineties and
much faster increase thereafter. The above data will be more informative and
meaningful when expressed in terms of percentages to GDP. This is done in table
4.7 below.

4-39
The second column of the
Table 4.7: Rate of Institutional Finance to
table gives total bank the Private Sector
finance as percentage to Total
Total bank
GDPmp and the third FA by AIFIs institutional
finance as
Year as % of finance as
provides information on % of
GDPmp % of
GDPmp
GDPmp
financial assistance that has
1 2 3 4
been provided by the all-
1978-79 15.46 0.09 15.56
India financial institutions48. 1979-80 17.25 0.18 17.43
1980-81 17.59 0.15 17.74
The bank finance increased
1981-82 17.34 0.2 17.54
from a little above 17% of 1982-83 18.13 0.17 18.3
1983-84 17.82 0.2 18.02
the gross domestic product
1984-85 18.64 0.22 18.86
in the opening years of 1985-86 19.22 0.28 19.5
1986-87 19.81 0.31 20.12
eighties to nearly 24% by
1987-88 20.58 0.31 20.89
mid-nineties, registering a 1988-89 21.61 0.37 21.98
growth of little less than 40% 1989-90 23.22 0.36 23.58
1990-91 21.47 0.58 22.06
in one and a half decade. 1991-92 20.72 0.63 21.34
After mid nineties it 1992-93 22.38 0.61 22.99
1993-94 20.99 0.59 21.58
registered a sharp increase 1994-95 22.48 0.69 23.17
to reach more than 50% by 1995-96 23.86 0.97 24.82
1996-97 23.96 0.91 24.87
2006-07. Most of this 1997-98 25.94 0.97 26.91
increase has taken place in 1998-99 26.03 0.9 26.93
1999-00 27.03 0.84 27.87
the recent years as can be 2000-01 28.94 0.79 29.72
seen in the chart 4.6 below. 2001-02 29.67 0.76 30.43
2002-03 33.81 0.63 34.44
As for the finance provided 2003-04 34.96 0.79 35.75
by the all-India financial 2004-05 37.68 0.49 38.16
2005-06 46.01 0.59 46.6
institutions, it has grown 2006-07 50.29 0.93 51.22
rapidly during the nineties although it has always been less than 1% of GDP. Chart
4.6 below illustrates these trends. The curves representing the bank finance and

48
Here too the six AIFIs have been included as in table 4.6.

4-40
total institutional finance as percentage to GDP are both gradually rising at first
and then rapidly after the mid-nineties. The curves are almost overlapping due to
the small magnitude of the finance provided by the AIFIs.

Chart 4.6: Rate of Institutional Finance

60

50

40
percent

30

20

10

0
9

7
-7

-8

-8

-8

-8

-8

-9

-9

-9

-9

-9

-0

-0

-0

-0
78

80

82

84

86

88

90

92

94

96

98

00

02

04

06
19

19

19

19

19

19

19

19

19

19

19

20

20

20

20
Total bank finance as % of GDPmp Total institutional finance as % of GDPmp

The sharp change in the growth rate of finance after the reforms is also brought
out by the regression analysis. The two equations for the pre-reform and the post-
reform period respectively are:

CR = 23.32 + 0.656T; r2 = 0.92; df = 13; tcal = 12.4; t13 = 3.01 (1)

CR = 34.91+ 1.65T; r2 = 0.855; df = 12; tcal = 8.07; t12 = 3.05 (2)

Fcal = 20.61 > F2,25 = 5.31 (level of significance 1%)

It can be seen from the above equations that the rate of growth has increased by
more than two and half times in the post reform period.. The t-test for the

4-41
significance of slope co-efficients (level of significance is 1%) is rejected which
implies that the estimated growth rates are statistically significant. The F test for
the equality of slope co-efficients is rejected too thereby indicating a structural
break corresponding to the reforms. This implies that in the period after 1992-93
the average annual rate of growth of institutional finance has substantially
increased and that this increase is statistically significant. It can be seen from the
coefficient of T in equation (1) that the growth rate was high even before the
reforms. In the case of credit as in deposits the influences other than those relating
to the financial sector would be minimal so that almost entire increase can be
attributed to the aforesaid reforms.

On comparing the equations for credit and deposits it may be noted that prior to
the reforms the growth rate of credit was around half the growth rate of deposits.
Subsequent to the reforms it increased to around two-thirds of the average annual
rate of growth for deposits. This also brings out the increase in the proportion of
deposits that have been channeled to the private sector via the financial system.
This has been made possible only by the substantial reductions in the cash
reserve ratio, the statutory liquidity ratio, and the priority sector lending. The banks
and financial institutions now have much greater freedom to deploy the available
funds.

Structure Of The Financial System

Over the years the structure of the financial system has undergone a number of
changes, quantitatively and qualitatively. The quantitative analysis starts by
examining the indicators of financial development as emphasized by different
economists from time to time. The changes with respect to various measures
provided by Goldsmith and Cameron have been examined49.

49
refer chapter 3 and section 4.2.4 above for the detailed discussion on the suggested measures.

4-42
Table 4.8 provides the data for Table 4.8: Ratio Of Financial
Assets To GDP
Goldsmith’s FIR i.e the ratio of financial
assets to national wealth. This measure Bank assets/ FAs/GDP
Year
has been used with certain modifications. GDPfc fc (FIR)
Since long term data on total financial
1971-72 0.15 ...
assets and national wealth is not easily 1972-73 0.16 ...
available, the ratio of financial assets of 1973-74 0.16 ...
1974-75 0.16 ...
financial institutions to national income is 1975-76 0.18 ...
often used. The same has been used in 1976-77 0.2 ...
1977-78 0.22 ...
this study. Even for this ratio consistent
1978-79 0.25 ...
data has been available only since the 1979-80 0.28 ...
mid nineties. The data has been obtained 1980-81 0.28 0.48
1981-82 0.29 ...
from different issues of the Report On 1982-83 0.3 ...
Trends And Progress Of Banking In India, 1983-84 0.3 ...
1984-85 0.32 ...
RBI. The table also shows Cameron’s 1985-86 0.35 ...
‘ratio of bank assets to national income’. 1986-87 0.37 0.64
1987-88 0.38 0.67
The ideal measure considered by
1988-89 0.37 0.68
Cameron in his study was the ratio of 1989-90 0.38 0.7
bank assets to total assets. However due 1990-91 0.38 0.69
1991-92 0.37 0.72
to data problems, national income was 1992-93 0.38 0.73
used in place of total assets. The same 1993-94 0.38 0.74
1994-95 0.39 0.76
measure has been used in this study.
1995-96 0.4 0.73
Data for bank assets has been obtained 1996-97 0.39 0.71
from the Statistical Tables Relating To 1997-98 0.39 0.74
1998-99 0.39 0.75
Banks In India (1979-2007), RBI. The 1999-00 0.41 0.79
table shows that both the ratios have 2000-01 0.44 0.85
2001-02 0.48 0.88
increased overtime at nearly the same 2002-03 0.51 0.9
rates as can be seen from the two nearly 2003-04 0.55 0.94
2004-05 0.58 1.04
parallel curves of the chart 4.7 below. It
2005-06 0.74

4-43
can also be seen that increase in both the ratios has been markedly faster since the
late nineties. These trends imply an increase in the financial depth of the economy
over the years. In the last 7-8 years the progress in this direction has been the
fastest.

Chart 4.7: Financial Development Ratios

1.2

0.8
ratio

0.6

0.4

0.2

0
2

19 0

19 0

20 2

4
-7

-7

-7

-7

-8

-8

-8

-8

-8

-9

-9

-9

-9

-9

-0

-0

-0
71

73

75

77

79

81

83

85

87

89

91

93

95

97

99

01

03
19

19

19

19

19

19

19

19

19

19

19

19

19

20
BAs/GDPfc FAs/GDPfc (FIR)

The use of ratios in the form as has been done in the table and chart above brings
to the fore the problems of data availability. Such problems often constrains the
analyses and the best that one can do is to use some other measure to proxy a
variable which is more relevant to the analyses but in respect of which data is not
available. This is what has been done with respect to the above ratios.

In addition to the financial development ratios as discussed above that these

economists considered as a key reflection of the financial development in an
economy they used certain other indicators of financial development in their
analyses. While some of the indicators as above give the relation between the
financial structure and the real sector of the economy some others deal with the

4-44
 Table 4.9: Density Of The
changes that take place within the Financial System
financial structure itself with No. of SCB
Population/
offices/
development of the financial system. Year bank office
million
(1000s)
The indicators as provided in the table population
1971-72 41 24.588
4.9 help judge the density of the 1972-73 37 27.093
financial system. The ratio of 1973-74 35 29.2
1974-75 32 31.585
population per bank office gives 1975-76 29 34.959
Cameron’s measure for density. The 1976-77 25 40.003
1977-78 23 44.189
other measure – number of SCB
1978-79 22 46.608
offices per million populations is in fact 1979-80 21 48.824
just a mirror reflection. These 1980-81 19 52.588
1981-82 18 56.614
measures show a rapid increase in 1982-83 17 59.434
density during the seventies, followed 1983-84 16 62.7
1984-85 15 69.533
by a gradual increase till mid to late
1985-86 14 70.579
eighties and thereafter stagnation. By 1986-87 15 69.856
1987-88 14 70.317
the mid 1980s the density of the Indian
1988-89 14 71.676
banking system had already reached 1989-90 14 72.691
appreciable levels. As per the 1990-91 14 71.776
1991-92 14 70.759
standards prescribed by Cameron 1992-93 14 70.148
these magnitudes belong to moderate 1993-94 15 69.286
1994-95 15 68.535
to high levels. Thus, ever since the
1995-96 15 67.916
late 1980s, India has been holding on 1996-97 15 67.178
to nearly same density levels that are 1997-98 15 66.616
1998-99 15 66.062
quite satisfactory by all standards.. 1999-00 15 65.347
The improvements had all taken place 2000-01 15 64.69
2001-02 15 63.828
by late 1980s and reasonably 2002-03 16 63.066
satisfactory levels of density had been 2003-04 16 62.617
2004-05 16 62.654
achieved. This has been largely made
2005-06 16 62.437
possible as a result of deliberate policy 2006-07 15 66.26
2007-08 15 68.34

4-45
of the government of extending the geographical spread and functional reach of
the Indian banking system.

Apart from the above measures, decline in importance of the banking system is
one of the important manifestations of financial development as emphasized in
literature. In case of India it has been noted on the basis of available data that the
banking sector has experienced a small decline in importance and other financial
institutions have become somewhat more prominent. As seen earlier in this
section, new agencies, different from commercial banks have appeared on the
financial scene and have become important. Some of the segments that existed
earlier have become more prominent than before both in collecting the available
funds in terms of deposits and disbursing credit to the non-governmental sector.

However an important limitation in appropriately discerning the changes in the

relative importance of each of these arises due to non-availability of data on some
of the segments. Consistent data on NBFCs is not available with respect to either
deposits or credit or assets held. The data even in case of finance provided by the
non-bank financial institutions is far from complete. As mentioned earlier, in the
context of financial assistance provided by these institutions, data in respect of
state level institutions (SFCs and SIDCs)50 is available only up to 2004. Amongst
the all India financial institutions also complete data is available only for six
institutions. Apart from these there are the unregulated credit markets too for which
no data is available. So it needs to be remembered that the available statistics
have be interpreted with due caution.

Available data on changes in the composition of institutional finance has been

presented in the table 4.10 below. Bank investments are those in non-SLR

50
State finance corporations and state industrial development corporations.

4-46
securities. FI finance covers
financial assistance Table 4.10: Composition of Institutional
Finance
disbursed by six AIFIs51.
% of bank % of FI
% of bank
The term total institutional investme finance to
credit to total
Year nts total total
finance is used to represent institutional
bank institutional
finance
the sum of bank finance and finance finance
1978-79 3.65 0.61 95.76
FI finance. Bank finance
1979-80 4.73 1.01 94.31
includes bank credit to the 1980-81 4.69 0.85 94.5
private sector and bank 1981-82 3.76 1.13 95.15
1982-83 3.11 0.94 95.98
investments. The finance 1983-84 3.29 1.12 95.62
advanced by the AIFIs, 1984-85 4.11 1.16 94.78
1985-86 3.68 1.41 94.96
which was nearly one and 1986-87 4.05 1.54 94.47
half percent in the closing 1987-88 4.95 1.48 93.64
1988-89 6.26 1.67 92.18
years of the eighties 1989-90 10.06 1.54 88.55
increased to around 4% by 1990-91 6.48 2.64 91.05
1991-92 8.34 2.93 88.97
the mid nineties i.e.
1992-93 11.19 2.65 86.46
increase by around one and 1993-94 13.34 2.73 84.3
1994-95 10.38 2.98 86.96
half times. After mid-
1995-96 11.88 3.9 84.69
nineties however it started 1996-97 15.83 3.67 81.08
to decline and by 2006-07 1997-98 19.36 3.59 77.75
1998-99 20.75 3.36 76.58
had reached below 2%. 1999-00 20.3 3.01 77.3
Recent years have 2000-01 20.39 2.65 77.49
2001-02 18.72 2.5 79.25
witnessed major declines. 2002-03 16.33 1.83 82.14
Parallel changes have taken 2003-04 14.85 2.21 83.27
2004-05 12.26 1.27 86.62
place in the proportion of 2005-06 10.04 1.27 88.82
bank finance. Within bank 2006-07 8.81 1.82 89.53
finance the proportion of credit and investments has undergone substantial
changes. The investments by the commercial banks in the non-SLR securities

51
These include SIDBI, LIC, GIC, TFCI, IVCF and IFCI.

4-47
have increased during the nineties. Starting from nearly 6.5% in the opening years
of the nineties, they increased to more than 20%of the total bank finance. In the
subsequent years a downward trend has been noted.

The relative importance of the banking system

Table 4.11: Percentage
can also be judged from its share in the total Of Bank Assets In The
Total Financial Assets
stock of financial assets. Available data in this
% of bank
regard is presented in table 4.11. The assets in the
percentages have been calculated from the data Year total
financial
obtained from different issues of Report on trend assets
and progress Of Banking In India, RBI. Total 1980-81 58
1986-87 57
financial assets are taken to include the financial 1987-88 57
assets of the banking system and the financial 1988-89 54
1989-90 55
assets of NBFIs (both all-India and state level). 1990-91 55
For all those years when data is available, the 1991-92 52
1992-93 53
magnitude fluctuates in between 50 to 60%.
1993-94 51
This implies a residual 40 to 50% for the NBFIs. 1994-95 51
This shows the importance of the NBFIs in the 1995-96 56
1996-97 55
financial system. Information on assts of NBFCs 1997-98 52
is not available. Since the deposits made by 1998-99 52
1999-00 51
NBFCs have phenomenally grown overtime one
2000-01 52
has reasons to expect that even the assets must 2001-02 55
have shown an up trend in the least. It being so, 2002-03 57
2003-04 58
the proportion of commercial banks’ financial 2004-05 55
assets would then show a declining trend.

Apart from the changes in the relative importance of the banking system, some
changes have taken place within the banking system also. These include entry of
a number of private (domestic and foreign) banks after the removal of restrictions

4-48
on entry. With this the share of the public sector banks in total bank assets and
business was bound to decline. The public sector banks themselves have started
accessing the capital market for funds. It has been shown in the next chapter that
the new banks that appeared on the financial scene had high levels of profitability,
efficiency, and productivity right from inception. Under competitive pressure from
these the productivity and efficiency levels of the public sector banks also
increased as has been documented in various studies on banking efficiency52.

Thus while the relative importance of the banking sector declined there was
greater diffusion of ownership, assets and business within the banking sector itself.
The banking sector has also started providing medium to long-term finance apart
from meeting the working capital requirements. Moreover apart from traditional
lending practices banks have now developed innovative approaches such as
consortium, single window, syndicate, and participatory lending. They have
introduced new instruments such as stockinvest, PCs, IBPs53. In the recent past
they have diversified into many related areas as merchant banking, mutual funds,
venture capital, equipment leasing, housing finance, hire-purchase credit, credit
cards, securities trading, equity participation on their own or through the setting up
of specialized subsidiaries54.

As for the institutionalization of the financial structure and composition of financial

superstructure reflected in distribution of total financial assets and liabilities among
their main types, the data is provided in the table 4.12 and 4.13 below.

52
Refer chapter 3 on literature review.
53
Participation certificates, inter-bank participations
54
For details see Bhole, L.M. (2004) : Financial Institutions and Markets : Structure, Growth and
Innovations, Tata, Mc Graw Hill.

4-49
 Table 4.12: Composition Of Financial Assets Of The Household Sector
Percentage
Provident Claims Shares
Bank Non- Life Trade FA with
Curren and on & Units
Year deposit banking insuranc Debt institutions
cy pension Govern- debent- of UTI
s deposits e fund (Net) (3+5+6+9)
fund ment ures
1 2 3 4 5 6 7 8 9 10 11
1970-71 16.82 35.73 3.18 9.81 23.22 4.98 3.22 0.66 2.37 69.43
1971-72 17.42 44.16 4.48 10.82 20.44 -0.09 0.86 0.52 1.38 75.94
1972-73 21.36 40.71 3.62 10.3 17.54 2.68 0.91 0.64 2.25 69.18
1973-74 21.49 42.23 1.26 9.95 16.85 2.43 -0.45 0.67 5.56 69.7
1974-75 0.53 49.07 2.73 10.2 23.35 2.14 1.84 -0.09 10.23 82.53
1975-76 6.75 41.84 2.57 8.35 24.16 17.74 0.81 0.32 -2.53 74.66
1976-77 17.14 58.94 1.71 7.88 17.62 0.29 -0.08 0.3 -3.8 84.74
1977-78 9.83 49.22 3.17 8.28 18.4 4.54 2.81 0.48 3.28 76.36
1978-79 15.08 48.78 2.45 7.2 16.93 2.39 2.15 0.83 4.19 73.74
1979-80 13 45.46 4.65 7.54 17.06 5.18 2.47 0.4 4.24 70.46
1980-81 13.41 45.8 3.12 7.55 17.51 5.88 3.4 0.26 3.08 71.12
1981-82 7.08 38.13 6.56 7.61 18.21 13.1 3.74 0.84 4.72 64.79
1982-83 12.59 41.38 5.4 7.67 17.8 7.72 4.01 0.76 2.67 67.61
1983-84 14.77 42.46 5.42 7.32 16.24 10.52 2.95 1.18 -0.87 67.21
1984-85 12.48 41.87 4.08 6.61 15.96 13.19 3.24 2.41 0.17 66.84
1985-86 8.68 41.48 5.57 6.96 16.38 13.35 5.45 2.29 -0.17 67.12
1986-87 9.7 45.56 4.75 6.78 15.87 9.71 5.55 2.96 -0.88 71.17
1987-88 13.34 40.64 3.67 7.17 18.03 10.19 2.25 3.31 1.4 69.15
1988-89 10.65 36.91 3.95 8.57 18.9 13.71 2.84 3.57 0.9 67.94
1989-90 15.87 29 3.81 9.15 19.71 14.01 5.5 4.52 -1.58 62.38
1990-91 10.61 31.88 2.18 9.5 18.94 13.38 8.44 5.84 -0.77 66.15
1991-92 11.99 26.23 3.26 10.29 18.37 7.12 9.99 13.35 -0.61 68.25
1992-93 8.17 36.73 7.51 8.85 18.44 4.83 10.22 6.98 -1.74 71.01
1993-94 12.19 33.06 10.63 8.71 16.72 6.3 9.18 4.29 -1.09 62.77
1994-95 10.94 38.37 7.94 7.81 14.72 9.06 9.26 2.69 -0.79 63.59
1995-96 13.29 32.12 10.61 11.17 17.97 7.71 7.11 0.21 -0.2 61.48
1996-97 8.61 32.11 16.39 10.17 19.17 7.43 4.18 2.38 -0.45 63.83
1997-98 7.44 43.15 3.92 11.3 18.79 12.9 2.6 0.35 -0.45 73.58
1998-99 10.54 38.35 3.7 11.31 22.41 13.63 2.46 0.91 -3.32 72.99
1999-00 8.82 35.09 1.63 12.13 22.82 12.27 6.9 0.77 -0.43 70.81
2000-01 6.29 38.13 2.78 13.63 19.28 15.7 4.49 -0.38 0.07 70.66
2001-02 9.49 38.08 2.67 13.9 15.72 17.51 3.32 -0.63 -0.06 67.07
2002-03 8.88 38.27 2.72 16.12 15.02 17.39 2.21 -0.5 -0.11 68.91
2003-04 11.31 37.62 1.01 13.84 12.97 23.15 2.41 -2.28 -0.03 62.16
2004-05 8.51 36.44 0.78 15.65 13.02 24.5 1.87 -0.72 -0.05 64.39
2005-06 8.73 46.15 1.03 14.03 10.53 14.64 4.99 -0.07 -0.04 70.64
2006-07 8.62 55.62 0.12 15.01 9.17 5.17 6.36 -0.04 -0.02 79.76

4-50
These tables show the composition of financial assets and liabilities of the
household sector, thereby implying the relative importance of different instruments.

As can be seen from table 4.12, the major part of the households’ financial assets
has been going to bank deposits all through the period. Currency that had been
fluctuating in between 10 to 20% of the household financial savings has shown a
slight fall after the mid-nineties. This can partly be due to the increase in the
interest rates after deregulation and partly due to easy availability of other options.
Bank deposits that had substantially declined by the early nineties regained the
high levels attained towards the end of seventies. They have shown a clear
upward movement after the reforms. As for the non-bank deposits the data prior
to 1997-98 are not comparable with the data afterwards due to changes in the
regulatory framework. Till 1996-97, these deposits had shown an appreciable
increase. From less than 5% in most of the years prior to the reforms, these had
increased to above 16% by 1997-98. The data after that is not comparable.

The proportion going to the life insurance fund has also substantially increased
after the reforms. The provident and pension funds have experienced wide
fluctuations; after some increase during the nineties, they have shown a steep
decline. The overall trend is downwards in relation to the pre-reform years. The
reasons for the initial increase after the reforms can be seen in their high, safe,
and tax-free returns, and as provisioning for old age. The decline in later years is
associated with a corresponding increase of the life insurance fund reflecting the
changing preferences of the people. The proportion of funds going to shares and
debentures experienced a sharp growth in the immediate post reform period, but
subsequently declined. Amidst substantial ups and downs, the overall trend after
the early nineties has been downwards. The units of UTI have been very small in
proportion (less than 1%) till the early eighties and after mid nineties. In the
intervening period it increased gradually till the end of eighties. In the early years

4-51
of the nineties it witnessed a sharp fall to reach the pre-early eighties’ levels. It has
been a small negative magnitude in the recent years. Trade debt has been a very
small negative magnitude for most of the years after the early eighties.

Col.11 gives the sum of bank deposits, life insurance fund, provident and pension
funds, and units of UTI. It represents the proportion of the surplus household
funds going to the financial institutions i.e. degree of institutionalization of the
financial structure. As can be seen in the table, this measure has been sharply
fluctuating. Only in the recent years it shows a clear sharp up trend.

In case of financial liabilities too, the major, in fact a substantial part have been the
bank advances during the entire period. Though there have been ups and downs
throughout the period; for most years the percentage has fluctuated between 80 to
90%. In the recent years it has sharply increased to reach more than 96% by
2006-07. Loans and advances from the non-bank financial institutions increased
sharply in the immediate post-reform period but gradually declined thereafter. In
the recent years they have shown a steep decline associated with a sharp rise in
the corresponding magnitudes of advances from the banks.

Loans and advances from the government have been small in the post reform
years and lately negative. Loans and advances from the co-operative non-credit
societies too have been a small percentage throughout the period under
consideration; their magnitude being less than 1% for most years after the reforms.
On the whole there is no clear trend in the composition of financial assets and
liabilities of the household. All the components experienced large fluctuations in
the pre and the post reform period. One thing that comes out clearly is the
continuing and somewhat increasing importance of the banks both in context of
deposits and advances. Overall, institutionalization has increased only in the
recent years.

4-52
Table 4.13: Composition Of Financial Liabilities Of The Household
Sector
Percentage
Loans & Loans & advances
Loans &
Bank advances from from co-operative
Year advances from
advances other financial non-credit
Government
institutions societies
1 2 3 4 5
1970-71 86.13 6.43 11.68 -4.23
1971-72 70.69 7.61 18.97 2.73
1972-73 80.16 7.32 10.73 1.79
1973-74 86.97 5.68 2.71 4.65
1974-75 78.57 10.26 7.79 3.38
1975-76 84.1 7.3 6.27 2.34
1976-77 84.62 5.98 8.1 1.3
1977-78 86.56 7.31 5.55 0.58
1978-79 77.61 12.86 6.61 2.92
1979-80 80.77 11.07 5.55 2.62
1980-81 88.17 5.19 4.3 2.34
1981-82 86.96 6.05 3.67 3.32
1982-83 83.43 9.88 3.77 2.92
1983-84 85.32 8.78 3.88 2.02
1984-85 87.25 7.33 3.44 1.99
1985-86 86.54 9.25 2.94 1.27
1986-87 86.31 6.13 5.11 2.44
1987-88 87.85 5.98 3.74 2.43
1988-89 89.16 5.56 3.7 1.58
1989-90 81.5 10.34 7.33 0.83
1990-91 80.17 12.45 6.59 0.79
1991-92 61.51 25.86 7.82 4.8
1992-93 75.86 19.24 2.94 1.96
1993-94 80.57 12.56 4.78 2.09
1994-95 87.27 9.73 1.68 1.32
1995-96 83.81 12.88 1.48 1.84
1996-97 81.12 15.38 1.36 2.14
1997-98 79.8 16.87 1.96 1.38
1998-99 77.66 17.51 3.53 1.3
1999-00 82.79 12.84 3.4 0.97
2000-01 80.05 14.92 4.15 0.88
2001-02 83.81 13.3 2.15 0.74
2002-03 89.74 8.7 0.86 0.7
2003-04 82.71 17.52 -0.38 0.15
2004-05 92.62 6.9 0.23 0.25
2005-06 96.43 3.57 -0.15 0.15
2006-07 96.81 3.21 -0.1 0.08

4-53
Finally table 4.14 Table 4.14: Select Financial Ratios for India
provides data on the Financial New
Finance Intermediation
Year interrelation Issue
four financial ratios: ratio ratio
s ratio ratio
1951-52 0.015 0.109 0.179 15
Finance Ratio (FR) i.e.
1952-53 0.016 0.379 0.442 -0.144
ratio of primary issues to 1953-54 0.026 0.831 0.565 0.47
1954-55 0.039 1.127 0.635 0.775
national income, 1955-56 0.074 1.218 0.738 0.651
Financial Inter-relations 1956-57 0.049 0.675 0.398 128
1957-58 0.064 0.998 0.61 0.638
Ratio (FIR) or the ratio of 1958-59 0.067 1.325 0.82 0.615
1959-60 0.085 1.475 0.955 0.544
total issues (i.e. primary 1960-61 0.084 0.92 0.746 0.234
plus secondary) to net 1961-62 0.077 1.261 0.835 0.511
1962-63 0.089 1.164 0.809 0.439
domestic capital 1963-64 0.095 1.292 0.88 0.468
formation, New issues 1964-65 0.078 1.125 0.736 0.529
1965-66 0.107 1.276 0.87 0.467
ratio (NIR) i.e. the ratio 1966-67 0.101 1.08 0.73 0.48
1967-68 0.089 1.212 0.841 0.442
of New (Primary) issues 1968-69 0.073 1.376 0.84 0.638
to net domestic capital 1969-70 0.076 1.139 0.722 0.578
1970-71 0.097 1.381 0.832 0.66
formation, and 1971-72 0.095 1.323 0.772 0.713
Intermediation Ration 1972-73 0.1 1.742 0.955 0.824
1973-74 0.076 1.074 0.525 1.045
(IR) i.e. the ratio of 1974-75 0.11 1.373 0.855 0.606
1975-76 0.139 1.853 1.06 0.748
secondary issues to 1976-77 0.14 1.745 0.981 0.779
primary issues. Data on 1977-78 0.173 2.215 1.209 0.832
1978-79 0.136 1.242 0.73 0.703
all four of these ratios is 1979-80 0.2 2.033 1.228 0.655
1980-81 0.194 1.925 1.141 0.687
available in Flow Of
1981-82 0.197 2.037 1.284 0.587
Funds Accounts Of The 1982-83 0.241 3.055 1.76 0.736
1983-84 0.17 2.153 1.257 0.713
Indian Economy: 1951- 1984-85 0.215 2.937 1.703 0.725
1952 to 1995 –96 1985-86 0.204 2.273 1.316 0.727
1986-87 0.244 2.943 1.78 0.654
published by RBI in 1987-88 0.194 2.097 1.167 0.797
1988-89 0.251 2.324 1.335 0.741
August 2000. Data after
1989-90 0.272 2.374 1.409 0.685
1995-96 is however, not 1990-91 0.231 1.745 1.005 0.736
1991-92 0.275 2.922 1.618 0.806
yet available. For this 1992-93 0.209 2.183 1.186 0.84
1993-94 0.249 2.825 1.489 0.898
1994-95 0.25 2.433 1.161 1.096
1995-96 0.29 2.26 1.328 0.702

4-54
reason one cannot judge the impact of reforms on these financial ratios as 3-4
years is a very short time period for such an analyses.

During the time period for which data is available, the finance ratio exhibits a
steady upward trend. This shows the increasing importance of direct finance in the
economy. All the other three ratios show marked fluctuations with an overall up
trend. Of the three, the intermediation ratio is relatively stable. This together with
the increase in the finance ratio implies that overtime both primary and secondary
issues have increased in relation to national income. In case of other two ratios
although the fluctuations exist throughout the time period, they are much more
pronounced since the beginning of the eighties with the initiation of somewhat freer
economic environment in the country. A freer market environment in general can
be expected to cause various finance ratios to fluctuate more as they become
more vulnerable to the changes and fluctuations in other sectors of the economy
and in other economies.

The above analysis shows that the Indian financial system has developed
substantially in terms of the quantum of deposits and credit, contribution to
increased savings and investment in the economy and with regard to numerous
changes in the structure of the financial system. In terms of most of the indicators
discussed the developments subsequent to the reforms have been of much higher
magnitudes in relation to the period prior to the reforms. The changes discussed
above relate to general developments of the financial institutions. The performance
of these institutions in particular is the subject matter of the next chapter while the
developments relating to the capital market have been deferred to the sixth
chapter.

4-55
4-56
 Chapter 5

PERFORMANCE OF THE INDIAN FINANCIAL SECTOR

It has been noted in the previous chapter that substantial development of the
financial sector has taken place subsequent to the reforms. It now remains to
examine the financial health of the constituents of this sector. The performance of
the sector in terms of levels of profitability, non-performing assets, capital
adequacy ratio, and various indicators of efficiency and productivity has been
examined in the sections that follow. Before evaluating the performance the
chapter gives a brief overview of the progress in the financial sector prior to
liberalization and the major focus of the reforms.

5.1 THE PROGRESS PRE-LIBERALIZATION

Ever since nationalization, the Indian banking and financial system had made
commendable progress in extending its geographical spread and functional reach.
The spread of the banking system had been a major factor in promoting financial
intermediation in the economy and in the growth of financial savings from all parts
of the country. Besides mobilizing savings on a large scale, nationalized banks
were able to pay attention to the credit needs of weaker sections, artisans and self-
employed.

Bank nationalization55 however created its share of problems too: excessive

bureaucratization, red tapism, disruptive tactics of trade unions of bank employees
etc. Nationalization resulted in RBI enforcing uniform interest rates and service
charges among banks. This caused a lack of competition and gradually eroded the

55
For pros and cons associated with nationalization refer Patel, I.G., (2003) Glimpses Of Indian
Economic Policy, Oxford University Press, Oxford.

5-1
spirit of competition from the banking sector. This combined with the labor policies
where employees’ salaries and promotions were not linked to their performance
led to a steady decline in efficiency, quality of customer service, and work culture
in banks. Moreover, due to directed lending at concessional rates and other
statutory requirements like CRR, SLR etc. only around one-fourths of total
loanable funds with banks were available for meeting the financial needs of rest of
the economy.

With time the development financial institutions had established themselves as

major institutional support for investment in the private sector. Over the last two
and half decades, more so since the early nineties there has been considerable
diversification of the money and capital markets. New financial services and
instruments have appeared on the scene.

5.2 FINANCIAL SECTOR REFORMS: THE FOCUS

The (Narasimham) Committee on financial sector reforms took due note of the
progress in terms of quantitative parameters as increased savings (especially
financial savings) and investment, higher deposit mobilization and greater credit
reach and disbursement etc. as also of quantitative and qualitative changes in the
structure of the financial system. It did, however, stress on the fact that ‘despite
this commendable progress serious problems had emerged reflected in a decline
in productivity and efficiency and erosion of the profitability of the banking
sector56… the accounting and disclosure practices also do not always reflect the
true state of affairs of banks and financial institutions...’ Both banks and DFIs57
have suffered from excessive administrative and political interference in individual
credit decision-making and internal management. The committee’s focus
therefore was to ‘ensure that the financial services industry operates on the basis

56
Report of the Committee on the Financial System – A Summary, RBI Bulletin, Feb, 1992
57
developmental financial institutions.

5-2
of operational flexibility and functional autonomy with a view to enhancing
efficiency, productivity and profitability’. A vibrant and competitive financial system
was also seen necessary to sustain the ongoing reforms in structural aspects of
the real economy.

It is clear here that the prime focus of the financial sector reforms has been on
performance of the financial sector in terms of productivity and profitability.
Various other quantitative parameters had shown impressive growth even before
the reforms. An acid test of the impact of reforms would therefore be to look at the
performance of the financial sector. The banking system forms the core of the
financial sector in any economy. The role of commercial banks is particularly
important in upcoming countries like India. Moreover, as we have just seen in
chapter 4, the commercial banking sector even now forms a major segment of the
financial sector. Even though other financial institutions and NBFCs have grown in
importance, the commercial banks still dominate the financial scene in terms of
deposits, credit and therefore, their contribution to savings and investment. Also
consistent time-series data on financial institutions and NBFCs as a group is not
available for various performance parameters. Therefore the financial performance
only of the commercial banking sector has been evaluated.

Post liberalization, the banking sector has largely transformed itself into one
characterized by openness, competition and prudence conforming to the
liberalization and globalization needs of the Indian economy. Credit allocation is
now largely market determined. The overall performance of the scheduled
commercial banks showed a distinct turn around during late 1990s. All major
financial indictors i.e. operating profit, net profit, income, expenditure,
intermediation expenses, spread etc. have shown a noticeable improvement.
There has also been a gain in the health of banking sector in terms of reduction in
gross and net non-performing assets/advances (NPAs) as percentage of total

5-3
assets and an improvement in capital to risk weighted assets ratio (CRAR). Public
sector banks still continue to hold a major proportion of SCBs’ assets though the
proportion has declined substantially with the entry and expansion of private sector
(both domestics and foreign) banks. The government hold in the control and
management has also substantially got diluted with banks (including those in
public sector) opening up to the capital market. Competition in the banking sector
has greatly increased with deregulation of interest rates and removal of restrictions
on entry of private including foreign banks58.

5.3 PERFORMANCE PARAMETERS

The commercial banks themselves form a heterogeneous collection of different

categories of banks. These differ substantially in terms of ownership and
consequently in their performance levels. So59 the performance has been
evaluated in aggregate terms for all SCBs as a group and separately for different
categories60. The following parameters have been examined:

Operating profit/Total Assets – To examine the profitability of commercial

banks operating profit rather than net profit is used because it is not
affected by exogenous factors as tax rules, etc. Operating profit = net profit
+ provisions and contingencies.

Net Non-performing assets / net advances.

Capital Adequacy Ratio and proportion of banks above 10%.

58 Kapila, U. (ed) (2007) : India’s Economic Development since 1947, Academic Foundation. Article by Rakesh Mohan,

Financial Sector Reforms And Monetary Policy: The Indian Experience.

59
subject to the limitations imposed by the availability of data
60
The categorizing is different in case of different parameters and is indicated along.

5-4

Productivity as measured by - ratio of intermediation costs to total assets,
operating profit to wage bill ratio, and business per employee.

Competition - In addition to the above parameters inferences about the

increase (or decrease) in competitiveness of the banking sector have also
been made.

Most of the data has been obtained from the ‘Statistical Tables Relating To Banks
In India – 1979-2007’.61 This gives annual time series data relating to both balance
sheet and profit and loss variables. Data is available in terms of individual banks
and in terms of bank groups and aggregate for all scheduled commercial banks.

The categories of banks groups made are:

i. State Bank and its associates
ii. Nationalized banks
iii. Other scheduled commercial banks
iv. Foreign banks
v. Regional rural banks.

The first two categories comprise the public sector banks. The banks in private
sector (both old and new) are covered in other scheduled banks. The aggregate
data for scheduled commercial banks is given both including and excluding the
regional rural banks (RRBs). Data on public sector banks is available from 1979 to
2006-2007. For the rest, data up to 1988-89 is not available. This however does
not seriously constrain the analyses in view of the fact that public sector banks
constituted more than 90% of the total banking assets in the pre-reform period. So
the trends of the public sector banks can be taken as representative of the entire
banking system.

61
Wherever a source other than the one stated is used it has been specifically mentioned.

5-5
It also needs to be noted that the data up to 1987 is available for calendar years
i.e. January to December. The data for 1988-1989 covers 15 months i.e. Jan-Dec
1988 and Jan-March, 1989. So wherever a flow variable is involved it has been
deflated by a factor 12/15 = 0.8 so that it reflects the magnitude appropriate to 12
months duration on an average basis. 1989-90 onwards, data is available on the
basis of conventional financial years as followed in India i.e. 1st April to 31st March.
Data on NPAs has been obtained from different issues of the ‘Report On Trend
And Progress Of Banking In India (RTPBI)’ published annually by the RBI and for
CRAR from ‘RTPBI’ and ‘Handbook Of Statistics On Indian Economy, 2008’. Data
for all other parameters has been obtained from ‘Statistical Tables Relating to
banks in India – 1979-2007’.

While analyzing the pre and post liberalization data, certain factors need to be kept
in mind. First of all reform is an ongoing process, so one should not expect a
sudden jump on a particular date but a gradual change, possibly with a lag, and
spread over a certain time period. So if one finds an improvement even in mid or
late 90s it can be attributed to the reforms undertaken in early 1990s. Secondly,
subsequent to the reforms all banks have adopted new accounting standards62
prescribed by RBI. Therefore the comparison of pre and post reforms data cannot
be made without qualifications. With the adoption of new norms, the banks’
balance sheet and profit and loss position was bound to deteriorate. So, any
deterioration in observed values can substantially be due to the changes in the
norms rather than other factors. For such an analyses the appropriate technique
would be one that clearly expresses each data value rather than some average
changes over a given time period. The best way of analyses in this case is to look
at year-to-year data assisted by a visual representation of data by means of
appropriate graph(s).

62
With effect from 1992-1993

5-6
 5.3.1 Profitability

Profits represent the difference between income and expenditure. The difference
between total income and expenditure of any concern gives its net profit. Net profit
plus provisions and contingencies give operating profit. Table 5.1 gives data on
operating profits (as ratio to total assets) for different categories of banks.

Table 5.1: Operating Profits Of Scheduled Commercial Banks

As percent of total assets
State Bank All Scheduled All Scheduled
Private Regional
Of India Nationalized Foreign Commercial Commercial
Year Sector Rural
And Its Banks Banks Banks (Excl. Banks (Incl.
SCBs Banks
Associates RRBs) RRBs)
1980 0.08 0.09 NA NA NA NA NA
1981 0.08 0.08 NA NA NA NA NA
1982 0.08 0.08 NA NA NA NA NA
1983 0.08 0.07 NA NA NA NA NA
1984 0.07 0.06 NA NA NA NA NA
1985 0.08 0.06 NA NA NA NA NA
1986 0.09 0.12 NA NA NA NA NA
1987 0.09 0.13 NA NA NA NA NA
1988-89 0.12 0.13 NA NA NA NA NA
1989-90 0.13 0.17 0.25 1.37 0.22 0.22 0.22
1990-91 0.14 0.18 0.35 1.18 0.29 0.23 0.24
1991-92 2.81 1.27 2.25 5.47 -2.36 2.12 2.01
1992-93 1.89 0.40 1.50 2.04 -2.60 1.07 0.98
1993-94 1.53 0.74 2.08 3.88 -2.54 1.31 1.21
1994-95 1.75 1.13 2.43 4.24 -2.07 1.64 1.54
1995-96 2.29 1.21 2.52 3.68 -1.65 1.83 1.73
1996-97 2.28 1.32 2.53 3.86 -0.60 1.92 1.84
1997-98 2.17 1.44 2.57 4.20 0.53 1.99 1.94
1998-99 1.79 1.31 1.60 2.73 0.98 1.60 1.58
1999-00 1.88 1.39 2.23 3.45 1.34 1.79 1.78
2000-01 1.55 1.36 1.90 3.36 1.59 1.64 1.64
2001-02 2.05 1.94 2.15 3.28 1.45 2.11 2.08
2002-03 2.38 2.47 2.54 3.26 1.20 2.51 2.46
2003-04 2.75 2.93 2.48 3.95 1.57 2.87 2.82
2004-05 2.60 2.27 1.93 3.16 1.02 2.36 2.31
2005-06 2.28 1.86 1.95 3.77 0.91 2.12 2.08
2006-07 1.91 1.89 2.13 4.02 1.22 2.11 2.08

5-7
The time period considered is 1980 to 2006-2007. For the years 1980 to 1988-
1989, data is available only for public sector banks i.e. SBI and its associates and
nationalized banks. Since operating profit is considered the magnitudes will not
get affected by changes in the provisioning norms. However adoption of new
income recognition norms will show deterioration in the profitability as measured
by operating profits. Due to changes in classification related to non-performing
assets (NPAs), the total assets of banks will also be affected.

Chart 5.1: Operating Profits

6.00

5.00

4.00
ratio to total assets

3.00

2.00

1.00

0.00
89

91

93

95

97

99

01

03

05

07
80

82

84

86

-1.00
-

-
19

19

19

19

88

90

92

94

96

98

00

02

04

06
19

19

19

19

19

19

20

20

20

20
-2.00

-3.00

-4.00

STATE BANK OF INDIA and its ASSOCIATES NATIONALISED BANKS

PRIVATE SECTOR SCBS FOREIGN BANKS
REGIONAL RURAL BANKS ALL SCHEDULED COMMERCIAL BANKS (EXCL.
ALL SCHEDULED COMMERCIAL BANKS (INCL. RRBS)

From the chart 5.1 above is evident that after the financial sector reforms; the profit
position of all categories of banks has substantially improved. All the curves in the
chart show a sharp jump in the immediate post-reform period. They however slide

5-8
downwards in the year 1992-93 and once again in 1998-99. As explained earlier
this is largely attributable to the adoption of prudential income recognition norms.
Despite this however all bank groups (except RRBs) are able to show positive
operating profits.

All public sector banks as a group (SBI & associates and nationalized banks) show
a distinct jump in the post reform period. The operating profits, which were nearly
0.1% of total assets during 1980s were more than 1% in all post reform years and
in most years more than 2% i.e. increase by 10-20 times. For nationalized banks, it
was less than 1% in 1992-1993 and 1993-94 possibly due to adoption of prudential
norms. The number of PSBs63 paying dividend increased from 7 in 1995-96 to 14
(out of 19) in 2000-2001.

For all other categories substantial pre-reform data is not available. The data that it
is available for the other groups (as given in table 5.1) show distinct improvement
in mid to late 1990s. For the private sector banks, the profits rose from one-fourths
of a percent of total assets in 1988-89 to more than 2% (i.e. increase by 8 fold) in
mid 1990s and throughout sustained itself to close to 2% with some fluctuations.
These profits were higher in most years in relation to bank groups in the public
sector. The foreign banks show profits much higher than both the public and the
private sector banks for all years. This is largely because of their presence
predominantly in metropolitan areas serving high-end customers, providing a host
of services, and charging for them. As is evident from the data the post reform
profits for foreign banks are also in multiples to pre-reform profits but the multiple is
substantially low in comparison to the other bank groups i.e. public sector and
other than foreign banks in the private sector. This is due to high level of profits for
the foreign banks right from inception. From a little above 1% of total assets in the

63
public sector banks

5-9
years preceding liberalization, it rose to more than 3% in most years after the
reforms and in few years more than 4% i.e. increase by four folds in 15 years.

As for the RRBs the profit in the first half of 1990s was throughout negative. The
poor profitability position can be attributed to the operation in areas where risk is
substantially high, defaults are high, and a large proportion of advances go
towards concessional lending. The profits that were negative even before the
introduction of prudential accounting norms took time to recover from the jolt of
prudential accounting. The losses (negative profits) steadily fell after the reforms
and by the closing of decade the profits had risen to more than 1% of total assets.
During the first half of 2000’s the profit position further improved.

Thus data shows substantial improvements in profitability of all bank groups

after the reforms. All groups (except RRBs) could stand the prudential income
recognition norms without their operating profits becoming negative even for one
year. After announcement of the reforms in 1991, giving much autonomy to the
banks in their operation and freedom in fixing the interest rates, the profits for all
groups show an immediate jump as is evident in chart 5.1. Next year i.e. 1992-93,
when new accounting norms were adopted, the profits for all the groups
substantially came down, but remained substantially higher as compared to the
profits in years preceding the reforms. One more jolt to profitability came when in
1998 NCRII made the prudential norms more stringent. However within two years,
the profit percentages higher than those in 1998 were achieved.

Since all banks groups (except RRBs with a small share in the total) show similar
trends in profit, the average for all SCBs as a group is bound to move on the same
pattern. Even when RRBs are included in the total, it does not make any
noticeable difference as can be seen from two almost overlapping curves in chart
5.1 and last two columns of table 5.1. The operating profits for all SCBs in the

5-10
aggregate (whether including or excluding RRBs) increased from 0.22% of total
assets prior to liberalization to more than 2% after the reform package in
1991.Despite the new prudential norms of NCR-I and NCR-II the profits remained
around or more than 1% all through the 1990s and more than 2% of total assets
after 2000-2001.

5.3.2 Non-performing Assets/ Advances (NPAs)

Once a loan is overdue and ceases to yield income it becomes a non-performing

asset (NPA). In India, the concept of NPAs in its present form came into existence
with the recommendations of the Narasimham Committee implemented by RBI in
1992. In NCR-I i.e. the report of the Narasimham Committee presented in 1991, an
asset was considered non-performing if interest on such asset was due for a
period exceeding 180 days at the balance sheet date. This norm of 180 days was
tightened to 90 days in NCR-II (recommendations of the second-generation
reforms of 1998) to bring it at par with the international practice.

Ever since liberalization, the level of NPAs is constantly being referred to for
indicating the performance and the state of health of all types of financial
institutions. NPAs derive importance from the fact that high levels of NPAs has
effect not only on profitability and other performance indicators of the concerned
financial institutions but has far reaching implications for the economy as a whole.
Default brings down the return accruing to them, reduces the effective rate of
interest and the funds re-circulation, and increases their dependence on external
sources thereby increasing costs64. High level of NPAs affects the productivity of
banks by increasing the cost of funds and by reducing the efficiency of bank

64
Murty, J.V. and A.B. Reddy (1998), “Defaults Of Financial Institutions At What Cost, The
Chartered Accountant, Vol.37, No.6, Dec.1988.

5-11
employees65. Cost of funds is increased partly because due to non-availability of
sufficient internal resources they have to rely on external sources to fulfill their
future financial requirements. Efficiency of employees is reduced because it keeps
staff busy with the task of recovery of over dues. Instead of devoting time to plan
for development through more credit and mobilization of resources the bank staff
would primarily be engaged in preparing a large volume of returns and statements
relating to sub-standard, doubtful and loss assets, proposals for filing suits,
compromise, waivement of legal action etc. High level of problem loans cause
banks to increase spending on monitoring, working out and or selling of these
loans and possibly become more diligent in administering the portion of their
existing loan portfolio that is currently performing (Berger and Young - 1997).

For sustainability of any bank, in order that it is able to meet its repayment liabilities
towards depositors, it is essential that the bank is also able to mobilize funds at low
cost and deploy them in high earning assets that continue to yield income. In case
funds got deployed in such assets, which do not yield income, the return on funds
on an average would come down without a corresponding decline in the average
cost of funds mobilized. The loan amount that is not received back by the bank is
rendered unavailable for further lending. Due to high level of NPAs and fear of
default, banks prefer to invest in zero risk government securities, even if they
obtain a lower rate of interest on them. Also, credit to industry suffers. Moreover,
with the presence of NPAs beyond a reasonable level, banks find it difficult to
adhere to capital adequacy requirements. More weights are required to be
assigned to these risky assets and hence more capital requirement.

Besides these quantitative repercussions of high NPAs, there are important

qualitative aspects to it too which cannot be ignored. High incidence of loan default

65
Berger, Allen N. and Robert De Young (1997), “Problem Loans and cost efficiency in commercial
Banks”, Journal of Banking and Finance, Vol 2.1 No.6, June.

5-12
shakes the confidence of general public in the soundness of banking set up and
indirectly affects the capacity of the banking system to mop up deposits.
Inadequate recovery also inhibits the banks to draw refinance from higher-level
agencies. Deterioration in the quality of loan assets makes banks uncompetitive
globally.

High levels of NPAs affect not only the banks, but also the economy as a whole.
Banks do not put enough resources in lending due to fear of default. Once credit to
different sectors slows down, it leads to slow down in the growth of industrial
output and GDP as a whole. Profit margins of the corporates fall and depression
like situation take grip in the economy.

In India, the present concept of NPAs came up after the reforms of 1991. The
default rate in general, however, had always been quite high. Table 5.2 below
gives the available data on Net NPAs/ Net advances from 1996-97 to 2006-2007.

Table 5.2: Non-Performing Assets Of Scheduled Commercial Banks

As percent of net advances
Old
Public Sector New Private All Scheduled
Year Private Foreign Banks
Banks Banks Commercial Banks
Banks
1996-97 9.2 6.6 2 1.9 8.1
1997-98 8.15 6.46 2.63 2.25 7.3
1998-99 8.13 8.96 4.46 2.94 7.6
1999-00 7.42 7.06 2.88 2.41 6.8
2000-01 6.74 7.3 3.09 1.86 6.2
2001-02 5.82 7.13 4.94 1.89 5.5
2002-03 4.5 5.2 4.5 1.76 4.4
2003-04 2.99 3.85 2.36 1.48 2.9
2004-05 2.06 2.74 1.85 0.86 2
2005-06 1.32 1.65 0.78 0.83 1.2
2006-07 1.05 0.91 0.97 0.97 1.01
Source: Report On Trend And Progress Of Banking In India (different issues)

5-13
In 1996-97, the ratio was at reasonably high levels for public sector banks and old
private sector banks – higher in case of public sector banks i.e. 9.2% of net
advances. Ever since mid 1990s, it has shown a sharp decline as is evident from
the data in table 5.2. By 2006-2007, it reached a level of just a little above 1%
(1.05%). For the old private banks, the ratio initially increased in late 90’s but 2000
onwards it registered a sharp decline to reach 0.91% of net advances in 2006-
2007.

The trend for foreign banks and banks established in the private sector after
liberalization i.e. new private sector banks is somewhat different. In 1996-97 the
ratio for both groups was appreciably low (2% for new private sector banks and
1.9% for foreign banks). Right from inception these banks followed the prudential
norms and their recovery processes were relatively more effective. The new
private sector banks recorded an increase for a couple of years but never went
above 5%. After 2001-02, the ratio showed a steep decline and reached to a little
less than 1% in 2006-2007. The trend for foreign banks was on similar lines, some
increase in the closing years of 1990s followed by a steep decline after 2001-2002
to reach less than 1% in 2006-2007. The ratio itself was never 3% or more in any
of these 10 years for which data is available.

The data of table 5.2 is illustrated in chart 5.2 below. It clearly shows all the bank
groups converging to a low level of nearly 1%. Except for foreign banks all the
other curves take a sharp plunge after 2001-02. It is evident that magnitudes for
all years were lowest in case of foreign banks among all the groups. The new
private sector banks in this regard occupied the next best position. Public sector
banks fared the worst with the NPAs being highest in relation to net advances for
most of these years across all bank groups. Overall trend is common to all groups
of banks. All the bank groups have registered a sharp decline in their net NPAs
relative to net advances over the 10 years period. In the year 1998-99, the position

5-14
of all bank groups in this regard worsened66. Reason for this worsening of the
situation is to be found in NCR-II, wherein the norms for NPAs were made more
stringent.

Chart 5.2: Non Performing Assets

10
9
percent to net advances

8
7
6
5
4
3
2
1
0
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 2006-
97 98 99 00 01 02 03 04 05 06 07

PUBLIC SECTOR BANKS OLD PRIVATE BANKS

NEW PRIVATE BANKS FOREIGN BANKS
ALL SCHEDULED COMMERCIAL BANKS

All the bank groups however quickly recovered and showed a sharp decline in the
opening years of 2000. By 2006-07 all the bank groups could attain net NPA to net
advances ratio close to 1%. The foreign banks and banks in the private sector
could touch levels below 1%. Thus in aggregate, all schedule commercial banks
show a similar pattern. Starting from 8.1% of net advances in 1996-97 the net
NPAs reached 1.01% of net advances by 2006-2007 (col.6). Thus, it can be seen
that with regard to non-performing assets, a significant improvement has
been made after the reforms. In mid 90s all bank groups on an average were
operating with high level of NPAs. The position at the beginning of 1990 can be
expected to be much worse. By 2006-2007 all the bank groups had reached a

66
For the public sector banks it did not worsen but no remarkable improvement was shown either in
this particular year.

5-15
position where they stand very comfortable even in comparison to the
international benchmark of 2%. All this has been made possible by improvement
in credit appraisal processes, upturn of the business cycle, new initiatives for
resolution of NPAs (including promulgation of securitization and reconstruction of
financial assets and enforcement of security interest Act), and greater provisioning
and write offs enabled by enhanced profitability.

5.3.3 Capital Adequacy

The capital base of commercial banks has become a subject of great attention
since past 2 decades. In India, it had progressively become very weak by the
closing of 1980s. The ratio of paid-up capital and reserves to deposits of
scheduled commercial banks in India declined from 6.7% in 1956 to 4.1% in 1961,
2.4% in 1969, and 1.2% in 198467. In 1988 the Basle Committee on Banking
Supervision appointed by the Bank for International Settlement (BIS) established a
system in which capital requirements based on the risk of bank assets were set up
for the banks. It specified the capital to Risk (weighted) Assets Ratio (CRAR) of
8% as the capital adequacy norm. This risk based capital Standard has been
adopted by many countries including India where it came into force in 1992-93.
Initially, while it was deemed to attain a CRAR of 8% in a phased manner, NCR-II
recommended it to be raised to 9% by 2000 and 10% by 2002. The CRAR was
subsequently raised to 9% with effect from 1999-2000.

In order to achieve improved capitalization a multipronged strategy has been

implemented. Initially substantial infusion of funds was made by the government to
recapitalize the public sector banks. Subsequently in order to mitigate the
budgetary impact and induce market discipline, public sector banks were allowed

67
Bhole, L.M. (2004) : Financial Institutions and Markets : Structure, Growth and Innovations, Tata,
Mc Graw Hill.

5-16
to raise funds from the market through equity issuance subject to maintenance of
51% public ownership. Ownership in public sector banks is now well diffused. At
end March 2005 holding by general public in six banks ranged between 40-49%
and in 12 banks between 30 and 49%. In only 4 banks, the Government was
holding more than 90%. The overall capital position of commercial banks has
witnessed marked improvement during the post-reform period. Tables 5.3 and 5.4
give data on capital base of the banks in relation to risk (weighted) assets.

Table 5.3: Capital Adequacy Ratio I

Percentage
Public
Old Private New Private All Scheduled
Year Sector Foreign Banks
Banks Banks Commercial Banks
Banks
1 2 3 4 5 6
1997-98 11.6 12.3 13.2 10.3 11 .5
1998-99 11.3 12.1 11.8 10.8 11 .3
1999-00 10.7 12.4 13.4 11.9 11.1
2000-01 11.2 11.9 11.5 12.6 11 .4
2001-02 11.8 12.5 12.3 12.9 12.0
2002-03 12.6 12.8 11.3 15.2 12.7
2003-04 13.2 13.7 10.2 15 12.9
2004-05 12.9 12.5 12.1 14 12.8
2005-06 12.2 11.7 12.6 13 12.3
2006-07 12.36 12.08 11.99 12.39 12.28

Source: Report On Trend And Progress Of Banking In India (different issues)

Data on CRAR on a regular basis is available starting 1997-98. From the available
data, one thing is clearly evident. All groups of banks (public Sector, old private
sector, new private sector and foreign banks) on an average had CRAR of more
than 10% for all years after 1997-98. All banks average was in the range of 11-
13% for all years considered (Table 5.3). For individual banks, of course, not all
banks had the CRAR of more than 10%.

5-17
 Table 5.4: Capital Adequacy Ratio II

Number Of SCBs %Age Of Banks

Total Number Of
Year With CRAR Above With CRAR Above
Reporting SCBs
10% 10%
1995-96 42 92 45.65
1996-97 64 100 64
1997-98 71 103 68.93
1998-99 76 105 72.38
1999-00 84 101 83.17
2000-01 84 100 84
2001-02 81 91 89.01
2002-03 88 93 94.62
2003-04 87 90 96.67
2004-05 78 88 88.64
2005-06 78 85 91.76
2006-07 79 82 96.34

Source: Handbook of Statistics on Indian Economy, RBI.

Table 5.4 gives data on the number of banks, with CRAR of more than 10%. In
1995-96, less than half of the total scheduled commercial banks had CRAR above
10%. In the years to follow the percentage of such banks in the total sharply
increased. After 2002-2003 more than 90% banks had CRAR above 10% for
all years. Only in 2004-2005, the percentage was 88.6. But, of the remaining 10
banks that had CRAR less than 10%, 8 banks had CRAR above 9%. So 86 out of
88 i.e. close to 98% banks had CRAR above 9%. By 2006-07 the percentage of
banks with CRAR above 10% had reached more than 95%.

5.3.4 Productivity

Broadly speaking productivity implies output per unit of input. Conventional

productivity analyses for any productive unit is concerned with finding out the
productivity of any particular factor input and/or total factor productivity. Typically

5-18
one finds labor productivity, capital productivity, and overall productivity i.e., total
factor productivity68. Various approaches to measurement of productivity include:

Parametric approach i.e. econometric estimation of production or cost

function.

Non-parametric approach based on linear programming models of relative
efficiency. No explicit functional form or assumptions relating to technology
need to be incorporated.

Index number approach involving calculation of various productivity indices.
It is the most commonly used approach to measure total and various partial
productivities.

The parametric and the index number approach share a common set of minimal
assumptions. Both assume perfect competition in the product market so that the
individual firms do not have price setting power, firms engage in cost
minimization69 and a well-behaved production function exists. In measuring total
productivity, a choice needs to be made between specifying the output as gross
production or as value added in production. The former option leads to the notion
of total productivity (TP) and latter give rise to the widely deployed measure of total
factor productivity (TFP). In addition to TP/TFP, specific input productivities i.e.
labor and capital productivities are often calculated.

In context of banking firms the outputs and inputs are distinctly different as
compared to any ordinary production unit. A bank accepts deposits and gives
away credit in various forms. But here neither the deposits are inputs for the entity
nor is the credit output in the conventional sense of the term. The inputs will be

68
For different concepts on productivity refer Ahluwalia, I. J. (1991), Productivity And Growth In
Indian Manufacturing, Oxford University Press and Farell,M.J.,(1957), The Measurement Of
Productive Efficiency, Journal Of Royal Statistical Society, Series A,120,pp.253-290.
69
only a subset of profit maximization

5-19
 fixed assets, stationary etc., expenses paid as interest on deposits, and other
operational expenses. As for output, banks generate no physical output. They
provide some specialized services for which they charge fees, commission etc.
Majorly they act as intermediary between savers and investors; in the process
earning interest incomes for themselves. The banking business therefore consists
primarily of making deposits and extending credit to different segments of the
economy. In case of banks there is no capital input in the conventional sense.
Capital and reserves is of entirely different nature and no economic meaning can
be attached to productivity of capital. Most studies on productivity of banks70 have
measured productivity by the ratio of an output (such as deposits, loans, revenues)
to an input (labor and capital). One single ratio however fails to capture the multi-
product nature of banking activity. So, this study uses multiple indicators of
productivity and efficiency to see if they all suggest a common trend.

i. Ratio of Intermediation cost to total assets i.e. the intermediation cost ratio
(ICR) – Basic function of commercial banks is to act as intermediary between
surplus and deficit units of the economy. This ratio gives how efficiently banks
are carrying the function of intermediation of funds in the economy71. The data
for 1988-89 has been deflated by a factor 12/15 = 0.8.72

ii. Operating Profit to wage Bill (in terms of Rs.1000 spent on employees). The
ratio of operating profit to wage bill gives what is similar to labor productivity in
conventional accounting. It tells per thousand rupees spent on employees
what is the extent of profit for each bank group and all SCBs in the aggregate.

70
for concepts, measurement and other issues in the productivity of banking sector refer Berger,
A.N. And D.B. Humpherey (1992) Measurement And Efficiency Issues In Commercial Banking,
The University Of Chicago Press, Chicago.
71
Intermediation costs are identical to operating expenses i.e. all expenses minus interest that is
paid on deposits etc. by the banks.
72
See introduction to section 5.3 above.

5-20
iii. Business per employee/labor input (in monetary terms) - Banks’ basic
function is accepting deposits and making credit. So the sum of deposits and
loans and advances has been taken to represent business. Employee measure
is taken in monetary units [i.e. per rupee spent on payment (& provision) to
employees] for two reasons. First, consistent data is not available on the
number of employees. Second, wage rate increases may not always be
accompanied by an increase in productivity. So it will be the amount spent on
hiring of labor force rather than the number of employees that will reflect a truer
measure of productivity.

Magnitudes for (ii) and (iii) above are respectively calculated as follows:

ii. Operating profit x 1000

Payment to and provision for employees

iii. Deposits + loans & advances

Payment to and provision for employees

Data on these indicators is presented in tables 5.5 to 5.7. Charts 5.3 to 5.5
illustrate the trends. Different indicators have been calculated from the data
available in the Statistical Tables Relating to banks in India – 1979-2007’. All the
three indicators suggest an improvement in efficiency and productivity in
the post reform years.

Efficiency gains are reflected in containment of operating expenditure i.e.

intermediation costs as a proportion of total assets (table 5.5). Data for only public
sector banks is available for the years 1980 to 1988-1989; for all other groups data
is available starting 1989-90. As is evident from the table, the intermediation costs
in relation to total assets have gradually declined for all bank groups (except
foreign banks), noticeably after 2000.

5-21
 Table 5.5: Ratio of Intermediation Cost To Total Assets Of SCBs
Percentage
All All
State Bank
Private Regional Scheduled Scheduled
Of India Nationalize Foreign
Year Sector Rural Commercial Commercial
And Its d Banks Banks
SCBs Banks Banks (Excl. Banks (Incl.
Associates
RRBs) RRBs)
1980 2.78 2.72 NA NA NA NA NA
1981 2.68 2.57 NA NA NA NA NA
1982 2.43 2.53 NA NA NA NA NA
1983 2.43 2.56 NA NA NA NA NA
1984 2.75 2.75 NA NA NA NA NA
1985 2.82 2.69 NA NA NA NA NA
1986 2.76 2.62 NA NA NA NA NA
1987 2.71 2.56 NA NA NA NA NA
1988-89 2.55 2.46 NA NA NA NA NA
1989-90 2.36 2.53 3.55 3.52 4.62 2.55 2.60
1990-91 2.46 2.46 3.35 3.70 4.65 2.57 2.61
1991-92 2.54 2.70 3.24 2.50 5.43 2.65 2.72
1992-93 2.74 2.82 3.01 3.02 5.29 2.82 2.88
1993-94 2.83 2.79 2.80 2.72 5.16 2.80 2.86
1994-95 3.10 3.00 2.55 2.90 4.89 3.00 3.05
1995-96 3.36 3.11 2.68 3.11 4.29 3.16 3.19
1996-97 3.07 2.99 2.68 3.25 3.71 3.01 3.03
1997-98 2.85 2.87 2.44 3.19 3.14 2.85 2.86
1998-99 2.98 2.83 2.32 3.64 3.01 2.88 2.89
1999-00 2.66 2.73 2.11 3.25 2.71 2.68 2.68
2000-01 2.90 2.93 2.04 3.37 2.54 2.84 2.83
2001-02 2.23 2.54 1.80 3.17 2.74 2.38 2.39
2002-03 2.21 2.47 2.08 2.85 2.79 2.35 2.37
2003-04 2.32 2.36 2.24 2.97 2.75 2.37 2.38
2004-05 2.28 2.28 2.18 3.05 2.65 2.32 2.33
2005-06 2.39 2.07 2.41 3.32 2.39 2.30 2.31
2006-07 2.13 1.84 2.33 3.24 2.69 2.12 2.14

For private sector banks and RRBs, these costs have consistently and significantly
declined ever since 1990-1991, barring a slight increase in case of private sector
banks in the recent years. For private sector banks, these costs declined from
around 3½% in opening 1990 to a little below 2½% in 2006-2007, a decrease of
nearly 30% in 1½ decade. The decline is more marked in case of RRBs, from
more than 4½% to a little above 2½% during the same period i.e. nearly a 45%

5-22
fall. Till late 1990’s the ratio for RRBs was much higher than all other bank groups,
but subsequently it came to comparable levels as can be seen from the chart 5.3.

Chart 5.3: Intermediation Cost Ratio

6.00

5.00

4.00
percent

3.00

2.00

1.00

0.00
80

82

84

86

7
-8

-9

-9

-9

-9

-9

-0

-0

-0

-0
19

19

19

19

88

90

92

94

96

98

00

02

04

06
19

19

19

19

19

19

20

20

20

20
STATE BANK OF INDIA and its ASSOCIATES NATIONALISED BANKS

PRIVATE SECTOR SCBS FOREIGN BANKS

REGIONAL RURAL BANKS ALL SCHEDULED COMMERCIAL BANKS (EXCL. RRBS)

ALL SCHEDULED COMMERCIAL BANKS (INCL. RRBS)

The high costs in case of RRBs can be expected due to the nature of operating
environment and client in rural areas, a high proportion of priority sector lending
and associated high default rate, greater efforts, and therefore high costs involved
in recovery. From the changes after reforms, these banks have however greatly
benefited. For all groups, other than RRBs and private sector banks the ratio
increased somewhat before it started to decline after mid 90s. In case of foreign
banks, the decline came much later towards the end of 1990s, only for 4-5 years
and was marginal.

5-23
All through mid 1990s to 2006-07, the foreign banks had highest intermediation
cost ratio among all banks groups. It fluctuated between 2½ to 3% during the
period. This high level, rather than inefficiency in operations, is related to high
quantum and quality of services provided by foreign banks. These banks, located
largely in metropolitan areas provide a host of additional services and facilities in
relation to other SCBs. For better services, they do appropriately charge the
customers and consequently, together with intermediation costs, their incomes are
also high in relation to other bank groups. This is documented in highest level of
profits earned by foreign banks among all bank groups. Inefficiency and high
profits do not go together in an environment of free price competition. So, better
quality of intermediation makes for high costs that do not go down with the reform
measures.

For all other groups and for all SCBs as a whole, the overall trend after the reforms
is for the intermediation cost ratio to go downwards. The maximum and consistent
decline is seen in case of public sector banks including RRBs. All through 1980s,
the ICR was almost stagnant; fluctuating in the range from 2.4 to 2.8 percent for
public sector banks. Thereafter till mid 1990’s it increased and reached above 3%.
This was largely because of large expenses under voluntary pre-mature retirement
of more than 10% of their total staff strength and other expenses on up gradation
of technology etc. Nevertheless, after mid 1990s, it declined and by 2006-2007
reached nearly 2%73, a fall of 1/3rd in a decade. Thus, despite initially increased
expenses necessitated in various ways in the process of implementation of the
reform measures, the intermediation cost had an overall falling trend. For SCBs as
a whole it fell from 2.6% in 1989-90 to 2.14% in 2006-2007 (a fall of nearly 16%) in
over one and half decade74.

73
2.13% for SBI & associates and 1.84% for nationalized banks
74
Even after the declines, the intermediation costs continue to be high in relation to the developed
countries

5-24
What is more encouraging is the improvement in productivity in terms of various
productivity indicators. Table 5.6 gives data on operating profit per employee and
5.7 on business per employee.

Table 5.6: Operating Profit Per Employee

In 1000s,Rs unit
All All
State Bank
Private Regional Scheduled Scheduled
Of India Nationaliz Foreign
Year Sector Rural Commercial Commercial
And Its ed Banks Banks
SCBs Banks Banks (Excl. Banks (Incl.
Associates
RRBs) RRBs)
1 2 3 4 5 6 7 8
1979 39 45 NA NA NA NA NA
1980 38 48 NA NA NA NA NA
1981 40 42 NA NA NA NA NA
1982 45 47 NA NA NA NA NA
1983 45 42 NA NA NA NA NA
1984 37 31 NA NA NA NA NA
1985 41 33 NA NA NA NA NA
1986 45 65 NA NA NA NA NA
1987 47 78 NA NA NA NA NA
1988-89 68 76 NA NA NA NA NA
1989-90 80 96 96 1505 65 130 128
1990-91 86 106 148 1525 86 141 139
1991-92 1577 684 976 6725 -548 1189 1093
1992-93 958 205 710 2751 -614 570 505
1993-94 808 388 1117 4474 -642 722 647
1994-95 777 561 1515 4459 -542 828 757
1995-96 911 534 1620 3370 -463 832 771
1996-97 1024 610 1840 3379 -191 945 889
1997-98 1012 695 2138 4115 195 1037 996
1998-99 846 633 1433 2519 373 840 817
1999-00 985 692 2149 3193 574 1001 981
2000-01 733 613 2215 3136 725 849 844
2001-02 1290 1052 2869 3129 613 1367 1326
2002-03 1514 1415 3397 3590 496 1719 1648
2003-04 1720 1785 3189 4157 695 2011 1939
2004-05 1690 1455 2611 3354 495 1730 1670
2005-06 1409 1373 2396 3321 491 1626 1575
2006-07 1365 1614 2663 3116 601 1823 1759

5-25
Col. 2 and 3 in the table above show a sharp jump in the operating profits (per
1000 rupees spent on employees) of the public sector banks immediately after
reforms. Post liberalization years are marked by ups and downs, going above and
below 1000 levels. After 2001, the ratio though fluctuating is sustained above 1000
i.e. Rs.1000 operating profit per Rs.1000 spent on employees. Some of the
downturns i.e. in 1992-93, 1998-99, 2000-01 are partly due to dips in operating
profits, as explained earlier, caused by new prudential accounting norms and
changes therein at times. Some part of the downturns can also be explained by
the increases in wage bill. In 1998-99 wage bill would have substantially gone up
with the implementation of fifth pay commission report.

Chart 5.4: Profit Per Employee

8000
7000
6000
(per '000 wage bill)

5000
4000
3000
2000
1000
0
-1000
79

81

83

85

87

6
-9

-9

-9

-9

-9

-0

-0

-0

-0
19

19

19

19

19

89

91

93

95

97

99

01

03

05

-2000
19

19

19

19

19

19

20

20

20

year

STATE BANK OF INDIA and its ASSOCIATES NATIONALISED BANKS

PRIVATE SECTOR SCBS FOREIGN BANKS
REGIONAL RURAL BANKS ALL SCHEDULED COMMERCIAL BANKS (EXCL. RRBS)
ALL SCHEDULED COMMERCIAL BANKS (INCL. RRBS)

The chart above shows that the trend for RRBs and private sector banks is almost
steady in upward direction with somewhat constancy in recent years. For the

5-26
private sector banks, partly the new banks set up after liberalization is causing the
up trend. As in case of foreign banks, they have high profit per employee and
when old and new private banks are taken together as a single group, the overall
ratio is increasing75. The ratio for foreign banks is distinctively higher than all other
bank groups for all years. Over the years, the differential falls with the ratio slightly
falling for foreign banks and increasing for other groups. The average for all SCBs
(both including and excluding RRBs) is almost steadily increasing. On the whole,
the overall picture on operating profits per employee is that of an up trend in
the post liberalization years (expect foreign banks where relative values
were substantially high in early 1990s).

In case of business per employee (table 5.7 and chart 5.5), the overall picture is
similar in that an up trend is noted over the entire period of around one and half
decade after liberalization. The important difference lie in the years after 2000
where operating profit (relative to wage bill) is almost stagnant or slightly falling for
all banks groups but business per employee registered a sharp increase for all
groups except foreign banks. Fluctuations are also less for all bank groups. The
trend for RRBs and private sector banks is almost continuously upwards, the up
trend being very sharp in case of private banks majorly due to entry of new private
banks and greater relative increase in their business. Foreign banks that had
highest business per employee in the initial years registered a downtrend and by
2006-2007, they had gone below the other groups (except RRBs). The overall
trend for public sector bank groups (SBI and associates, and nationalized banks)
all through 1980s is that of almost constancy and till mid 1990s, somewhat decline.
The trend thereafter is upward, being moderate in second half of 1990s and a
sharp up trend thereafter till 2006-2007. The average for all SCBs as a group
(whether including or excluding RRBs) falls gradually till the first half of 1990s,
recovers gradually in the second half and thereafter increase sharply.

75
with new banks increasing in importance in relation to old banks

5-27
 Table 5.7: Business Per Employee
State All
All
Bank Of Scheduled
Nationali Private Regional Scheduled
India And Foreign Commercial
Year zed Sector Rural Commercial
Its Banks Banks
Banks SCSs Banks Banks (Incl.
Associate (Excl.
RRBs)
s RRBs)
1 2 3 4 5 6 7 8
1979 61 74 NA NA NA NA NA
1980 59 75 NA NA NA NA NA
1981 64 76 NA NA NA NA NA
1982 67 78 NA NA NA NA NA
1983 68 79 NA NA NA NA NA
1984 61 71 NA NA NA NA NA
1985 58 72 NA NA NA NA NA
1986 60 75 NA NA NA NA NA
1987 61 78 NA NA NA NA NA
1988-89 49 64 NA NA NA NA NA
1989-90 68 77 52 115 40 74 72
1990-91 66 77 55 132 37 74 72
1991-92 65 72 62 143 28 71 69
1992-93 61 71 69 151 29 70 67
1993-94 61 69 79 133 32 69 67
1994-95 53 67 92 128 33 65 64
1995-96 48 57 90 114 35 58 57
1996-97 53 60 109 108 38 63 62
1997-98 58 65 124 117 42 69 67
1998-99 60 65 126 100 44 69 67
1999-00 65 67 136 98 49 73 72
2000-01 59 62 159 103 53 68 67
2001-02 76 76 177 101 49 85 83
2002-03 78 80 164 117 49 89 86
2003-04 78 86 171 117 54 93 91
2004-05 87 93 182 118 62 101 99
2005-06 86 109 182 105 71 110 108
2006-07 107 134 183 90 66 129 126

5-28
 Chart 5.5: Business Per Employee

200000
180000
160000
(per'000 wage bill)

140000
120000
100000
80000
60000
40000
20000
0
79

81

83

85

87

6
-9

-9

-9

-9

-9

-0

-0

-0

-0
19

19

19

19

19

89

91

93

95

97

99

01

03

05
19

19

19

19

19

19

20

20

20
year
STATE BANK OF INDIA and its ASSOCIATES NATIONALISED BANKS
PRIVATE SECTOR SCBS FOREIGN BANKS
REGIONAL RURAL BANKS ALL SCHEDULED COMMERCIAL BANKS (EXCL. RRBS)
ALL SCHEDULED COMMERCIAL BANKS (INCL. RRBS)

Overall, both measures of productivity discussed above have shown a positive

trend. These improvements in general could be driven by two factors. Technology
improvement, which expands the range of production possibilities and a catching
up effect, as peer pressure amongst banks compels them to raise productivity
levels. The role of new business practices, new approaches and expansion of
business that has been introduced by new private and foreign banks has been of
utmost importance.

From the above analyses of various banking statistics it is clear that after
liberalization, the banks (in all groups) have substantially improved their
position in terms of efficiency, productivity and profitability. The maximum
gain in performance has been in case of RRBs in terms of all indicators
examined. From high level of losses, they have turned into profitable entity as a

5-29
group and the profit levels do not compare badly with other bank groups and all
bank average. The indicators for efficiency and productivity have also shown
dramatic improvement. Next in line are the banks in private sector as a group.
This is majorly because of addition of newly set up private banks to the group with
higher profitability and productivity right from inception. Public sector banks (SBI
and associates and nationalized banks) have also shown remarkable improvement
in the post liberalization period.

It is only in case of foreign banks that one does not find any improvement in
productivity indicators and lesser gains in profitability as compared to other bank
groups. Major reason lies in the fact that these banks had high levels of both
profitability and productivity right from inception. In the environment that had
become competitive consequent upon deregulation of interest rates and free entry
for new units, it is not possible to maintain the high differential in profit rates that
existed in early 1990s. Nevertheless, profits did increase in relation to total assets,
but only at rates lower than other groups so that there was convergence among
profit rates of different bank groups. Reasons for high intermediation costs also
were in the better quality of services provided. As for productivity, they had much
better technology and efficient working methods, so that their productivity levels
were very high in relation to other bank groups. The salaries paid by these banks
were also high. Despite this, productivity indicators are at higher levels to other
groups. One other reason for falling values of productivity indicators can be higher
increases in salaries given by foreign banks.

The all bank average increased significantly during the post reform years for
profitability indicators and moderately for the productivity indicators. The poor
performance of RRBs on both aspects in initial years did not pull down the average
performance because they were in very small proportion in relation to the entire
banking industry. In terms of profitability the Indian SCBs stand at a competitive

5-30
international position. Internationally, a return of 1% on assets is considered as
outstanding. India’s banking system in 2002 was the second most profitable in
world after US76.

5.3.5 Competition

Theoretically one defines competition as a market structure where there exist a

large (infinite) number of market players selling an identical product so that no one
is influential enough to affect the price that is itself determined by the market
forces. All firms are price takers, there is free entry, free exit, absence of any
regulation, no transportation costs or location differences, no communication gaps
on relevant information and so on. In such a scenario, efficiency prevails and
supernormal profits are absent.

In context of the Indian banking system, data clearly shows existence of a large
number of bank branches located throughout the country even prior to the reforms.
There were no hindrances to flow of relevant information. The Indian banking
system was, however, one of complete absence of competition. The reason lies in
administered rates of interest (both borrowing and lending) that prevailed in the
pre-liberalization period and restrictions on entry of new banks. The banks that
existed, though numerous, were operating in a highly controlled and regulated
environment. Most of them were in fact in the public sector. Throughout 1980’s
and in the initial years of 1990s, the public sector banks in aggregate accounted
for nearly 90% of total assets of the banking system. Other financial institutions
were also either in the public sector itself or even otherwise operating in highly
controlled and regulated environment. The situation in the Indian financial system
was therefore that of government monopoly. The governmental policies were such

76
Mohan, R.T.T. (2005) “Bank consolidation: Issues and Evidence,” EPW, Vol.40, 19th March
2005, pp 1151-1159.

5-31
that rather than any monopoly profits, a number of banks were making negligible
or negative profit. If one looks at net profits rather than operating profits, the
situation will be worse. So despite lack of competition, there was no exploitation of
consumers on account of high rates of interest. The rates were rather kept low and
in fact many segments of the economy were getting concessional credit.

After liberalization, the situation has dramatically changed. With deregulation of

rates of interest, there now exists active price competition among different
financial players. With removal of restrictions on entry and exit, a number of
new private and foreign banks have come on the scene. The public sector
banks’ share in total assets has declined dramatically although they still dominate
the financial scene. From around 90% of total bank assets in the beginning of
1990s, their share has come down to nearly two thirds of the total by 2006-200777.

Moreover even public sector banks are now free to access the capital market.
They have significantly more freedom in internal decision-making and operational
flexibility in management. Apart from high level of competition within the banking
system, there also now exist competition between banks and other financial
institutions. Now SCBs are also increasingly providing term finance and a number
of development banks have started meeting the working capital requirements of
business concerns. In addition a number of non-bank financial companies have
also come up on the scene. Thus post liberalization period is that of active
competition78, all conditions of competition being fulfilled. There exist a number of
players in the financial market providing (not identical but) similar services. The
price i.e. rate of interest is largely determined by market conditions. Although RBI
can substantially affect the interest rates in an indirect way via changes in bank
rate, CRR, repo rate, or other tools at its disposal, its actions are also largely

77
This is based on statistics available in the Statistical Tables Relating To Banks In India – 1979-
2007’
78
closely resembling monopolistic competition

5-32
dictated by market conditions. Of course, there does not prevail one single rate of
interest charged by different banks on loan (or given on deposits) but the rate
always moves in a narrow range. Private and foreign banks often are able to
charge somewhat higher rates, but it is because of the additional facilities and/or
services provided by them to their customers or due to location advantage enjoyed
by them. Free entry and exit prevails. In fact, after liberalization, a number of
unremunerative branches have been closed, amalgamated, or taken over by
profitable ones. Ownership is now relatively much more diversified and
interference is minimum. There are no communication gaps in the system and
bank branches are spread across the entire country. All this is not to say that the
banking industry has been entirely left to itself. It is under close supervision of the
relevant authorities and when the situation so requires appropriate corrective
measures are also taken.

With active price competition being prevalent, one would expect profit and net
interest margin (spread) to fall and efficiency to increase. However, as discussed
earlier, there were no monopoly profits to be wiped out. In fact, banks had poor
profitability and due to impact of reforms profitability levels have substantially
improved. Efficiency levels have gone up too as discussed earlier in this chapter.
As for net interest margin, data is presented in table 5.8 below. Net interest margin
or spread is the difference between interest earned and interest spent expressed
as percentage to total assets. Prior to liberation, both lending and deposit rates
were administered. There was no single lending / deposit rate. The rate structure
was highly complex; a number of concessional rates prevailed. In fact around
three-fourths of total available finance was to be compulsorily put on concessional
terms under CRR, SLR and priority sector lending. So, on the whole, interest
margin was low and there was no scope for a further fall after liberalization
despite competition.

5-33
 Table 5.8: Net Interest Margin/ Total Assets
Percentage
All
State All
Scheduled
Bank Of Private Regional Scheduled
Nationalised Foreign Commercial
Year India & Sector Rural Commercial
Banks Banks Banks
Its SCBs Banks Banks (Incl.
(Excl.
Associates RRBs)
RRBs)
1 2 3 4 5 6 7 8
1980 1.64 2.09 NA NA NA NA NA
1981 1.60 2.00 NA NA NA NA NA
1982 1.46 2.02 NA NA NA NA NA
1983 1.58 2.07 NA NA NA NA NA
1984 1.82 2.29 NA NA NA NA NA
1985 1.95 2.20 NA NA NA NA NA
1986 1.83 2.10 NA NA NA NA NA
1987 1.82 2.03 NA NA NA NA NA
1988-89 1.76 1.95 NA NA NA NA NA
1989-90 1.65 1.96 2.85 2.94 2.79 1.93 1.95
1990-91 1.70 1.83 2.73 3.07 3.23 1.89 1.92
1991-92 3.88 2.88 4.36 4.28 2.73 3.37 3.35
1992-93 3.13 2.13 3.25 3.97 2.31 2.65 2.64
1993-94 2.85 2.30 3.38 4.31 2.22 2.69 2.68
1994-95 3.44 2.97 3.40 4.53 2.29 3.26 3.23
1995-96 3.64 3.13 3.37 4.18 2.11 3.39 3.35
1996-97 3.63 3.12 3.36 4.41 2.63 3.40 3.38
1997-98 3.34 3.02 2.79 4.23 3.16 3.19 3.19
1998-99 3.14 2.99 2.34 3.74 3.52 3.03 3.05
1999-00 2.99 2.85 2.43 4.00 3.52 2.93 2.95
2000-01 3.01 3.08 2.54 4.01 3.60 3.06 3.08
2001-02 2.86 2.91 1.97 3.41 3.50 2.79 2.81
2002-03 2.90 3.16 2.05 3.42 3.27 2.91 2.92
2003-04 2.98 3.29 2.42 3.73 3.27 3.08 3.08
2004-05 3.27 3.13 2.51 3.54 3.40 3.08 3.09
2005-06 3.22 2.92 2.74 4.05 2.86 3.04 3.04
2006-07 3.00 2.85 2.77 4.36 3.37 2.99 3.00

All through 1980s till the starting of 1990s, the spread for public sector banks was
round about 2%. In case of SBI and associates it was in the range of 1.5% to 2%
while for nationalized banks it was around 2%. Average for all SCBs as a group

5-34
was also around 2%79. The rate for RRBs, private sector banks and foreign banks
was lot better - only slightly below 3%. The spread was highest in case of foreign
banks in the years proceeding liberalization. After liberalization it increased
maximum, all through remaining above all other bank groups. The other bank
groups with noticeable increase were the public sector banks where the spread
increased from less than 2% to nearly 3%80. In case of private sector banks, the
spread fluctuated above and below 3% and ended little below 3%. For the RRBs,
the spread fluctuated and ended at 3.37%. The average for all SCBs moved to
above 3% by mid 90’s but then declined to around 3%.

Thus, in case of spread there is no marked upward or downward trend. There are
both up and down movements for most bank groups. Overall trend is
predominantly upward, though not marked. One thing worth noting is that by
2006-2007 the spread for all bank groups had reached around 3% (ranging from
2.77 to 3.37%). This convergence indicates competition. The only exception was
foreign banks where it was substantially higher. The high interest rate differential
that these banks could maintain was because of quality and quantity of services
provided by them. It was not lack of competition but other facilities provided by
these banks that they could get deposits at relatively lower rates and lend at
relatively high rates. Moreover, they were not concerned with maximizing business
as is evident is their falling business per employee ratio.

The above analyses of the banking sector shows that the commercial banks in
India have experienced strong balance sheet growth and have substantially
improved their profit position in the post reform period. The profitability is at
distinctly higher levels for all post-reform years in comparison to years prior to
liberalization. Improvement in the financial health of banks, as reflected in

79
1.93% excluding RRBs and 1.95% including RRBs
80
from 1.65% to 3% in case of SBI and associates and 1.96 to 2.85% for nationalized banks

5-35
significant improvement in capital adequacy and improved asset quality, is
distinctly visible. All indicators of productivity that have been examined stand at a
much higher level today in comparison to the years prior to the reforms. It is
noteworthy that this progress has been achieved along with adoption of
international best practices in prudential norms. Technology deepening and flexible
human resource management has largely enabled competitiveness and
productivity gains.

5-36
 Chapter 6

INDIAN FINANCIAL MARKETS

In the preceding chapters, the focus of attention had been the financial institutions.
This chapter is devoted to a detailed study of the financial markets. Starting with
the importance of financial markets in an economy, it then brings out the
organization and the structure of these markets in India and in what way they have
been affected by the reforms undertaken in the financial sector.

6.1 IMPORTANCE

From a financial stability perspective it is necessary to have a financial system

whereby both financial institutions and financial markets play an important role.
Stock market is an important and growing ingredient of the financial market, more
so in developing countries. Well-developed stock markets may be able to offer
different kinds of financial services from financial institutions and a different kind of
impetus to investment and growth81. Increasing stock market capitalization (SMC)
may improve an economy’s ability to mobilize capital and diversify risk. On one
hand, there are models that emphasize the tensions between bank based and
market based systems82, on the other there exist a number of studies on financial
development and economic growth focusing on complementarity hypothesis83.

81
Levine, R. and Zervos, S. (1998) Stock Markets Development And Long Run Growth, World
Bank Economic Review, 10, pp 323-339.
82
Levine, R., (2002), Bank-Based Or Market-Based Financial Systems: Which Is Better? Journal Of
Financial Intermediation, 11(4), 398-428
83
Demirguc-Kunt,A. And Levine,R.(2001), Financial Structures And Economic Growth: A Cross-
Country Comparison Of Markets, Banks, And Development, Cambridge, MA: MIT Press

6-1
One such study suggests that stock markets and financial intermediaries have
grown hand in hand in the emerging market economies. Some other studies also
find that the levels of banking development and stock market liquidity exert a
positive influence on economic growth. Levine and Zervos (1998) show that initial
level of stock market liquidity and banking development are positively and
significantly co-related with future rates of economic growth, capital accumulation,
and productivity growth.

The capital market fosters economic growth in various ways such as by

augmenting the quantum of savings and capital formation and through efficient
allocation of capital that in turn raises the productivity of investment. It also
enhances the efficiency of a financial system as diverse competitors vie with each
other for financial resources. It adds to the financial deepening of the economy by
enlarging the financial sector and promoting the use of innovative, sophisticated,
and cost effective financial instruments, which ultimately reduce the cost of capital.
Well-functioning capital markets also impose discipline on firms to perform84.

Equity and debt markets can also diffuse stress on the banking sector by
diversifying credit risk across the economy. While capital markets provide both
equity and debt finance, banks and other FIs as intermediaries specialize in
providing debt finance only. Industry level studies have also found a positive
relationship between financial development and growth (Rajan and Zingales,
1998), but an increase in financial development disproportionately boosts the
growth of those companies that are naturally heavy users of external finance.
Using firm level data, Demirguc-Kunt and Maksimovic (1998) show that the

84
Beck, T. and Levine, R. (2002) Stock Markets, Banks, and Growth: Panel Evidence NBER
Working Paper Series No.9082 Cambridge, Mass: NBER.

6-2
proportion of firms that grow at rates exceeding the rate at which each firm can
grow with only retained earnings and short term borrowing is positively associated
with stock market liquidity (and banking system size). Thus, there is ample
literature supporting the role of stock market in economic growth by easing
external financing constraints.

While considering the role of financial markets, specifically the stock market, in
economic development, the associated problems and limitations cannot be
ignored. Quite often, the benefits of stock market are more from the point of view
of maximizing (speculative) returns for the individual investors and market
operator. The efficient market hypothesis mostly does not hold. Actually the stock
market valuations are often incorrect because they are less related to
fundamentals and more to speculative activity/trading. The corporate financing
system based on equity finance displays a tendency to discourage long-term
riskier investment in productive physical capital as companies become pre-
occupied with short-term financial return considerations to please shareholders,
and to avoid possible takeovers. The stock market induced liquidity may
encourage investor myopia and weaken investor commitment. It may reduce
investor incentive to exert corporate control and monitor company’s performance,
which can hurt economic growth. In today’s liberalized and globalized economics,
stock markets can easily act as conduit for spreading speculative pressures all
over the world85.

Singh (1997) argues that stock market expansion is not a necessary natural
progression of a country’s financial development and stock market development
may not help in achieving quicker industrialization and faster long-term economic
growth in most developing countries for several reasons. First because of inherent

85
For a detailed discussion of these weaknesses, see Bhole, L. M., The Indian Capital Market At
Crossroads, Vikalpa, April-June 1995 and Bhole, L. M., The State Of Indian Stock Market Under
Liberalization, Finace India, March 2002.

6-3
volatility and arbitrariness of the stock market, the resulting pricing process is a
poor guide to efficient investment allocation. Second, in the wake of unfavorable
economic shocks, the interactions between stock and currency markets may
exacerbate macro economic instability and reduce long-term economic growth.
Third, stock market development is likely to undermine the role of existing banking
systems in developing countries.

6.2 THE CAPITAL MARKET IN INDIA: ORGANIZATION AND STRUCTURE

The stock market in India consists of 19 stock exchanges spread all over the
country. The number increased from nine in 1979-80 to 22 in 1993-94 and
remained almost constant thereafter. In the year 2007-08 it declined to 19. Of
these exchanges, two of them opened up to derivative trading i.e. futures and
options contract in 1999-2000.

Infrastructure86 of stock market: The number of brokers (including corporate

brokers and sub-brokers) operating in these exchanges adds up to more than
55,000. Besides these there are over 1300 foreign institutional investors, hundreds
of depository participants, portfolio managers and merchant bankers and so on.
Numerous underwriters, debenture trustee, venture capital funds, registrars to
issue, and mutual funds support these. India has now the largest number of
organized ad recognized stock exchanges in the world. All of them are regulated
by SEBI. They are organized either as voluntary non-profit making associations or
public limited companies or companies limited by guarantee. All stock exchanges
have two parts:

The new Issues market (NIM) or the primary market (PM).

The Secondary market (SM).

86
The data on infrastructure has been obtained from The Handbook Of Statistics On The Indian
Securities Market, 2008

6-4
While the NIM supplies additional capital to companies, the SM does not directly
supply fresh capital, but encourages investors to invest more in industrial securities
by making them more liquid. It provides facilities for continuous and regular trading
in these securities.

The Bombay Stock Exchange (BSE) is the apex stock exchange in India. It is the
oldest market and has been recognized permanently, while recognition for other
exchanges is renewed every five years. It is biggest in size in terms of amount of
fresh capital raised, secondary market turnover and capitalization and the total
listed companies. Its business is no larger confined to Mumbai alone; at the end of
1997, there were 100 other cities in which it had set up its business.

Apart form BSE, there are two other stock exchanges in Mumbai, viz, the National
Stock Exchange of India Ltd. (NSE) and Over-the-Counter Exchange of India Ltd.
(OTCE). The NSE has a fully automated electronic screen based trading system.
It has two separate segments. The Wholesale Debt Market Segment (WDMS) that
caters to banks, financial institutions and other institutional participants and deals
in PSU bonds, units, treasury bills, government securities, call money, commercial
paper, certificate of deposits etc. (b) the Capital Market Segment (CMS) which
deals in equities, convertible debentures etc. The NSE allows its members to trade
from their offices through a communication network. By the end of 1997, it had
spread its business in 200 cities with more than 1000 terminals.

Over The Counter Exchange Of India (OTCE) was set up in 1992. It is the first
stock exchange in India to introduce screen based automated ring less trading
system. The securities that are traded on OTCE cannot be traded on other stock
exchanges. However, they can be bought and sold at any of the OTCE counters
all over India. It has an online trading-cum-depository, quote driven and

6-5
transparent system of trading. It follows T + 3 settlement system which is the
fastest in the country. It provides a liquid cash market for retail investors. The
existence of market makers and the modern trading and settlement system on it
ensures deliveries vs. payment on time. There are no problems of bad deliveries
or short deliveries because the system allows the execution of trades only on the
basis of electronic inventory of scripts. It encourages domestic and foreign
institutional investors also to trade on it by offering them netting facilities for both
intra-custodian and inter-custodian transactions. The trading on OTCE is based on
the roll over concept that means all trading done on any day is settled on the same
day itself. Netting with previous day or subsequent day transactions is not
permitted. Thus OTCE is a cash and retail market for small investors and small
companies. With time however, the focus of its activity is shifting to bigger
permitted scripts.

Apart from these three stock exchanges in Mumbai, there are 16 other national
and regional exchanges located in metropolitan centers and other cities in India.
After mid 1990s, the turnover on these exchanges has gone down drastically. The
relative position of BSE has also gone down over the years although it still is the
premier institution. It is the NSE that has gained in importance. Together BSE and
NSE account for more than 95% of the total turnover. Thus, at present, stock
market in India is mostly co-existent with only NSE and BSE.

In addition to the official stock exchanges, there are about 40 unofficial exchanges
operating as brokers’ associations. They are not recognized by SEBI, but some of
them transact considerable amount of business. In addition there are kerb and
illegal badla markets doing the securities trading business.

6-6
6.3 THE REFORM MEASURES

Although the capital market in India has a long history, during most part, it
remained on the periphery of the financial system. Various reforms undertaken
since the early 1990s by the SEBI and the GOI87 have brought about a significant
structural transformation in the Indian Capital market. The reforms have been
implemented in a gradual and sequential manner, based on international best
practices, modified to suit the country’s needs. The reform measures were aimed
at

Creating growth enabling institutions

Boosting competitive conditions in the equity market through improved price
discovery mechanism

Putting in place an appropriate regulatory framework

Reducing the transaction costs

Reducing information asymmetry, thereby boosting the investor confidence.

Institutional development was at the core of the reform process. SEBI that was
initially set up (in 1988) as a non-statutory body was given statutory powers in
1992 for regulating the securities markets. It was given the twin mandate of
protecting investors’ interests and ensuring the orderly development of the capital
market.

The most significant reform in respect of the primary capital market was the
introduction of free pricing. All companies are now able to price issues based on
market conditions. The norms for public issues were made stringent in April 1996
to prevent fraudulent companies from accessing the market. Greater disclosure
now required has enhanced transparency, thereby improving the level of investor
protection. Trading infrastructure in stock exchanges has been modernized and

87
government of India

6-7
trading and settlement cycles successively shortened. This greatly reduces the
risk associated with unsettled trades due to market fluctuations.

The setting up of National Stock Exchange of India Ltd.(NSE) as an electronic

trading platform set a benchmark of operating efficiency for other stock exchanges
in the country. The establishment of National Securities Depository Ltd.(NSDL) in
1996 and Central Depositing Services (India) Ltd.(CSDL) in 1999 has enabled
paperless trading in exchanges. This has also facilitated electronic transfer of
securities and eliminated the risks to the investors arising from bad deliveries in
the market, delays in share transfer, fake and forged shares, and loss of scripts.
The electronic fund transfer (EFT) facility combined with dematerialization of
shares has created a conducive environment for reducing the settlement cycle in
stock markets.

The improvement in clearing and settlement system has brought about a

substantial reduction in transaction costs. Several measures were also undertaken
to enhance the safety and integrity of the market. These include capital
requirements, trading and exposure limits, daily margins, and setting up of
trade/settlement guarantee fund to ensure smooth settlement of transactions in
case of default by any member.

Some of the other important reforms include introduction of trading in derivates,

move towards corporatization and demutualization of stock exchanges, system of
redressal of investor grievances, opening up of mutual funds industry to the private
sector, allowing foreign institutional investors (FIIs) to invest in all types of
securities, allowing Indian corporate sector to access the international capital
markets etc.

6-8
As a result of various measures undertaken, the Indian equity market has become
modern and transparent. However, its role in capital formation continues to be
limited. The private corporate debt market is active mainly in the form of private
placements, while the public issues market for corporate debt is yet to pick up. It is
the primary equity and debt markets that link the issuers of securities and investors
and provide resources for capital formation. In some advanced countries,
especially the US, the new issues market has been quite successful in financing
new companies and spurring the development of new technology companies. A
growing economy requires risk capital and long term resources in the form of debt
for enabling the corporate firms to choose an appropriate mix of debt and equity.
Long-term resources are also important for financing infrastructure projects.
Therefore in order to sustain India’s high growth path, the capital market needs to
play a major role. The significance of a well functioning domestic capital market
has also increased as the banks need to raise necessary capital from the market
to sustain their growing operations.

6.4 IMPACT OF REFORMS

Ever since the reform process began in early 1990s, the Indian Capital Market has
witnessed significant qualitative and quantitative changes. Substantial
improvement in terms of various parameters as size of the market, liquidity,
transparency, and efficiency has taken place. The changes in regulatory and
governance framework have brought about an improvement in investor
confidence. Together with these developments on the positive front it also needs
to be noted that with opening up to the foreign sector the stock market has
become much more volatile and vulnerable to foreign disturbances.

6-9
The studies relating to the stock markets often evaluate the developments with
regard to size, liquidity, and volatility. This study has examined the trends in these
indicators on the basis of whatever data is available. The data has been obtained
from ‘The Handbook Of Statistics On The Indian Securities Market, 2008.’ Where
any other data source is used it has specifically been mentioned. In most cases
the pre-liberalization data is not available. Therefore, rather than comparing the
pre and the post liberalization trends, the study has examined the trends after
liberalization. This gives a picture of the stock market after the reforms.

6.4.1 Size of the Market

Table 6.1: Number Of
Stock market development is most Listed Companies
commonly expressed in terms of its size and YEAR BSE NSE
liquidity. The indicators for size commonly 1 2 3
used are (i) number of listed companies and 1992-93 2861
1993-94 3585
(ii) market capitalization ratio (MCR) i.e. the
1994-95 4702 135
ratio of stock market capitalization88 to GDP. 1995-96 5603 422
1996-97 5832 550
1997-98 5853 612
Table 6.1 presents data on the number of
1998-99 5849 648
listed companies on India’s two premier 1999-00 5815 720
stock exchanges. On BSE, in the first half of 2000-01 5869 785
2001-02 5782 793
1990s the number of listed companies more
2002-03 5650 818
than doubled and then remained constant for 2003-04 5528 909
nearly a decade. In 2004-05 the number 2004-05 4731 970
took a sharp downturn and has increased 2005-06 4781 1069
2006-07 4821 1228
only slightly after that. The blue line in chart
2007-08 4887 1381
6.1 below shows these movements. The

88
value of listed shares on country’s exchanges

6-10
NSE started its functioning in the financial year 1994-95 with 135 companies on its
list. In little more than a decade the number of listed companies has increased by
more than a multiple of 10. The curve corresponding to NSE in chart 6.1 below
shows a steady increase in the number of listed companies. In case of BSE
however, some decline is observed in the recent years.

Chart 6.1: Number Of Listed Companies

7000

6000

5000

4000

3000 BSE
NSE
2000

1000

0
19 3

19 4

19 5

19 6

19 7

19 8

19 9

20 0

20 1

20 2

20 3

20 4

20 5

20 6

20 7

8
-9

-9

-9

-9

-9

-9

-9

-0

-0

-0

-0

-0

-0

-0

-0

-0
92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07
19

Data on MCR (All India and BSE) is presented in table 6.2. Ideally MCR at all
India level will give a true picture of the change in the size of the Indian stock
market but complete data is not available. So together with the data at All-India
level the data for the Bombay stock exchange has also been used in this study. It
is evident from the data and chart 6.2 below that the basic trend is similar in both
the cases. In the years before liberalization, the MCR, though low, was steadily
increasing. Post liberalization values show ups and downs, at times sharply. Of
course the magnitudes are much above the pre-liberalization levels. Amid lots of
fluctuations, the ratio has significantly increased in the recent years. Apart from
new listings the ratio in early years of 21st century has gone up due to substantial
increases in stock prices. In view of the sharp upturns and downturns noted in the

6-11
data any attempt to obtain an average rate of growth over the time period using
regression analyses would give grossly misleading results.

The size of the market is Table 6.2: Market Capitalization Ratio

influenced by several factors Percent
including improvement in macro- Year All India BSE
economic fundamentals, changes 1 2 3
1979-80 6.09 4.89
in financial technology and 1980-81 NA NA
increase in institutional efficiency. 1981-82 NA NA
1982-83 6.71 5.64
A cross-country study in this
1983-84 6.6 5.04
context has identified that in case 1984-85 10.67 8.95
of India, the equity market size 1985-86 10.84 8.5
1986-87 12.52 9.14
has expanded mostly because of 1987-88 15.98 14.15
change in financial technology 1988-89 NA 14.22
1989-90 15.95 14.75
followed by change in market 1990-91 21.41 17.64
fundamentals while change in 1991-92 59.6 54.42
1992-93 33.57 27.61
institutional efficiency has had no 1993-94 50.51 46.46
impact on the market size (Li, 1994-95 51.16 47.07
1995-96 52.83 48.6
2007).
1996-97 38.73 36.8
1997-98 42.07 39.97
1998-99 35.52 33.75
1999-00 66.76 51.1
2000-01 39.94 29.69
2001-02 35.72 29.19
2002-03 27.94 25.3
2003-04 51.96 47.33
2004-05 59.15 59.02
2005-06 NA 92.26
2006-07 NA 93.54
2007-08 NA 119.39

6-12
 Chart 6.2: Market Capitalization Ratio

140
120
100
80
%

60
40
20
0
0

8
-8

-8

-8

-8

-8

-9

-9

-9

-9

-9

-0

-0

-0

-0

-0
79

81

83

85

87

89

91

93

95

97

99

01

03

05

07
19

19

19

19

19

19

19

19

19

19

19

20

20

20

20
All India BSE

Another important finding is that while the size of Indian equity market still remains
much smaller than many advanced economies (e.g. US, UK, Japan,) it is
significantly higher than many other emerging market economics including Brazil
and Mexico (Chart-6.3).

Chart 6.3: SMC at end 2005 (International comparison)

700
600
500
(per cent)

400
300
200
100
0
O
G

D
E

EA

IA

IL

A
N

ES
R

LI

N
N

IC
PA
N

AZ
D
R

N
O

TI
LA
KO

IN

EX
KO
JA

BR

PI
AP

ST

EN
AI

IP

M
G

AU
G

TH

G
IL
N

AR
O

PH
SI
H

6-13
6.4.2 Liquidity

This measures the frequency of trading and frictionless ness in trading proxied by
low transaction cost. Two commonly used measures of liquidity are (i) the turnover
ratio and (ii) the value-traded ratio. The turnover ratio (TR) equals the total value
of shares traded on a country’s stock exchanges divided by stock market
capitalization (SMC) while the value traded ratio (VTR) equals the total value of
domestic stocks traded on a country’s exchanges relative to GDP. This ratio
measures the trading activity relative to the size of the economy.

Liquidity measures are presented in table

6.3 and illustrated in chart 6.4. Both Table 6.3: Liquidity Ratios
turnover ratio and value-traded ratio Percent
fluctuated with small variations in the first Turnover Value
Year
ratio traded ratio
half of 1990s. In the second half, however,
1 2 3
they registered a sharp increase. This
1990-91 32.7 6.3
increase was primarily driven by sharp rise 1991-92 20.3 11
in stock prices due to the IT boom. It must 1992-93 20 6.1
1993-94 21.1 9.8
however be remembered here that an
1994-95 14.7 6.9
increase in stock prices may lead to an 1995-96 20.5 9.9
increase in liquidity ratio even without an 1996-97 85.8 30.6
1997-98 98 38
increase in actual number of transactions
1998-99 126.5 41.7
or a fall in transactions costs. Further, 1999-00 167 78.1
liquidity may be concentrated among 2000-01 409.3 111.3
2001-02 134 36
larger stocks.
2002-03 162.9 37.9
2003-04 133.4 57.9
It may be noted here, that of the two 2004-05 97.7 53.1
2005-06 78.9 66.9
liquidity measures, the turnover ratio, 2006-07 81.8 70.7
being the ratio of value traded to value Source: Report On Currency And
listed, will be less affected by the increase Finance, (RBI) 31st May,2008.

6-14
in stock prices. This is so because both values are a function of stock prices. To
the extent higher priced shares are more frequently traded, the turnover ratio will
show an upward bias. In the light of this observation, the two liquidity ratios can be
more closely examined.

Chart 6.4: Liquidity Ratios

450
400
350
300
percent

250
200
150
100
50
0
19 91

19 92

19 93

19 94

19 95

19 96

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

7
-0
0-

-
91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06
9
19

turnover ratio value traded ratio

In 1991-92, TOR falls by around 40% to 20.3% and fluctuates around the same
level till 1995-96. During the same time period stock market capitalization also
fluctuates in a narrow range after increasing more than two folds in 1991-92. This
indicates that after announcement of the reforms, SMC greatly increased in hope
of higher rates of economic growth and improved institutional and infrastructure
facilities. A large number of companies got listed on stock exchanges. So value of
listed shares i.e.SMC showed substantial increase. Trading in new stocks and
earlier listed stocks however, lagged behind. This makes for a lower turnover ratio.
As for the TVR, it fluctuated sharply during these years. A sudden jump of over
70% in 1991-92 can at least in part be explained by the very low rate of growth of

6-15
GDP during the year. For the years that followed, GDP growth rates steadily
increased. This indicates fluctuations in trading volumes. During rest of the
decade both liquidity ratios steeply increased. Opening of the next century saw fall
in both liquidity measures although at varying rates. On the whole liquidity
measures show higher magnitudes and higher rates of growth after reforms as
compared to the pre-liberalization period. This basic trend is same as in case of
stock market capitalization.

As for international companions, it is evident from chart 6.5 that the turnover ratio
exhibits substantial cross-country variation. The TOR of NSE in 2005 was lower
than that in NASDAQ, Korea, Japan, China, and Thailand and higher than that of
Singapore, Hong Kong, and Mexico.

Chart 6.5: Turnover Ratio 2005 Select Countries

300
250
(per cent)

200
150
100
50
0
O
q)

G
A

D
EA

E
N

SE
IN

R
N

IC
PA

N
da

O
LA

KO
H

(N

EX
as

KO

JA

AP
C

AI

IA
N

M
NG
G
TH

D
S(

N
IN

O
U

SI

The spread of trading terminals across the country has also aided in giving access
to investors in the stock market. The opening up of Indian equity market to FIIs and
growth in assets of mutual funds has also contributed to increased liquidity in the
Indian Stock Market.

6-16
Now turning to the other aspect of the liquidity i.e. frictionless trading or low
transaction cost it is found that India is among one of the lowest transaction cost
countries. Automation of trading in stock exchanges has increased the number of
trades and number of shares traded per day. This has greatly helped reducing
transaction costs. Direct transaction costs such as fee to broker and exchange;
securities transaction tax, etc. are directly observable in the market. These direct
charges in India are among the lowest in the world (GOI, 2005-2006).

In addition to the direct transactions cost, there are indirect transaction costs, not
directly observable but can be derived from the speed and efficiency of execution
of trades. These can be captured by estimating the impact cost89 which varies with
the size of transaction. The impact cost has fallen in case of both Nifty and Nifty
Junior. As per the SEBI-NCAER Survey of Indian Investors, 2003, there has been
a substantial reduction in transaction cost in the Indian Securities Market. It
declined from a level of nearly 5% in 1994 to 0.6% in 1999, close to the global best
level of 0.45%. The Indian equity market had the lowest transaction cost after the
US and Hong Kong. As compared with some of the developed and emerging
markets, transaction costs for institutional investors on Indian stock exchanges are
also one of the lowest.

In all developed economies, stock markets provide mechanism for hedging.

Derivatives have increasingly become popular as an instrument of risk
management. By locking in asset prices, derivative products enable the
participants in the market to transfer, at least in part, the risks associated with price
fluctuations. In India, equity derivatives were introduced in 2000. Transactions in
derivatives are carried out in both the important stock exchanges i.e. BSE and
NSE. In a short span of time, the derivates market has flourished and sharply
expanded. Major activity is concentrated in single stock futures in contrast to
several other countries where index futures and options are more popular
89
the cost of executing a transaction on a stock exchange,

6-17
derivative products. The number of stocks on which individual stock derivatives are
permitted has gone up steadily from 31 in 2001 to 117 in 2007. This has helped in
percolating liquidity and market efficiency to a wide range of stocks. The turnover
in the derivatives market has also risen sharply. In less than a decade, India has
been able to build a modern and transparent derivates market. As per world
federation of stock exchanges, NSE was the leader in trading of single stock
futures in 2006 and at fourth position in trading of index futures.

6.4.3 Volatility90

Volatility of stock market is measured by the

Table 6.4: Volatility Index
standard deviation of daily returns. Table 6.4
Percentage
gives the volatility index of the Indian security 1 2 3
market for NSE and BSE. Data pertains to YEAR BSE NSE
calendar years. NSE started its operations 1992 3.3
during the year 1994; so the starting year for 1993 1.8
1994 1.4
which data is available is 1995. As seen in
1995 1.3 1.3
the table the magnitudes for NSE and BSE 1996 1.5 1.5
are very close to each other for all the years. 1997 1.6 1.7
1998 1.9 1.8
No pre-reform data on volatility is available. In 1999 1.8 1.8
the year 1992, the first year for which data is 2000 2.2 2
2001 1.7 1.6
available, the volatility index was very high at 2002 1.1 1.1
3.3%. The possible reason for this high 2003 1.2 1.3
2004 1.6 1.8
volatility can be found in the drastically
2005 1.1 1.1
changing and therefore uncertain economic 2006 1.6 1.7
environment in the immediate post reform 2007 1.5 1.8

period. Subsequently it declined to 1.8% in 1993 and further to 1.4 in 1994 and
fluctuated around that level. It was near about 2% in the closing years of 1990s.
For the rest it has fluctuated largely between 1% and 1.5%.

90
Kaur, H., (2002) Stock Market Volatility In India, Deep and Deep Publications, New Delhi

6-18
Internationally, the index is at a relatively high level. As is evident from the chart
6.7, it is quite high in comparison to countries like US, UK, France, Australia, South
Africa, and Japan and low only in caparison to Hong Kong and Brazil. One big
achievement of the strengthening of market design and of risk management
practices followed after liberalization was manifested when in 2004 and again in
2006 the exchanges were able to contain the impact of volatile movement in stock
prices without any disruption in financial markets.

Chart 6.6: Volatility Of The Indian Stock Market

3.5
3
2.5
percent

2
1.5
1
0.5
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

BSE NSE

Chart 6.7: Volatility of International Stock Indices

1.8 1.7 1.7

1.6 1.5
1.4 1.4
1.4 1.2 1.2
1.2 1.1 1.1
percent

1
1 0.9
0.8
0.6
0.4
0.2
0

ES
) 00) C) 30) SI) TI) ) )
OV XBOL ALSH
) Y) X)
J ON SE1 E (CA (AS NG (H RE (S IL (IB E (J N (NK ENSE
T C I A O M A S
OW UK (F AN AL KO AP AZ O ( FRICA JAP (BSE
A (D FR STR HONG SING BR XIC
US AU ME UT H A IND
IA
SO

6-19
After the reforms the Indian capital market has become modern in terms of market
infrastructure and trading and settlement practices and has also become a much
safer place than it was before the reform process began. The operational risk
benchmark that takes into consideration the settlement and safekeeping
benchmarks and other operational factors such as the level of compliance with
G30 recommendations, the complexity and effectiveness of the regulatory and
legal structure of the market, and counter party risk, improved from 28 out of 100 in
1994 to 67.2 in 2004 (NSE 2005). The secondary market has become deep and
liquid; there have been reductions in transaction costs, and substantial
improvements in efficiency and transparency.

Despite significant improvements in trading and settlement infrastructure, risk

management system, liquidity, and containment of volatility, the role of Indian
Capital Market (debt and equity) has remained less significant in terms of
resources raised by corporate sector. Its role in capital formation, both directly and
indirectly through mutual funds has remained less significant. The public issues
segment of the market in particular has shrunk over the past 15 years. The size of
primary market in India remains much small internationally, both in comparison to
the developed economies and the emerging market economies. Resource
mobilization from the primary capital market by way of public issues that touched
the peak during 1994-95 declined in the subsequent years. Although it picked up
again after 2003-04, the resource mobilization as percent of GDP and GDCF in
2005-06 was lower than that in 1990-91.

On the whole, after liberalization, the Indian Stock market has for sure become
modern and transparent. All companies are now able to price the issues based on
market conditions. With automation and improvement in clearing and settlement
cycles, the transaction cost and risks of trading have greatly declined. Trading
volumes and liquidity has sharply increased. A large number of new companies

6-20
and new players (investors) have come on the scene. While all this seems good
but one must not forget the potential dangers involved. With opening up to the
world, the domestic markets’ ups and downs will move along with other countries.
It becomes more vulnerable to problems going on in other countries. Also, when
stock market activity is high, speculative trading takes huge volumes with all its
associates risks and dangers. So a cautious approach is required.

6-21
6-22
 Chapter 7

FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

The basis objective of this study is to establish whether the reforms undertaken in
the financial sector of the economy have had any influences on the country’s
economic growth. In the previous chapters, it has been shown that after the
reforms, substantial development has taken place in the financial sector in terms of
a number of selected indicators. Both institutions and markets have witnessed
remarkable progress in the post reform period. Savings and investment during the
post reform period have also increased at much higher rates in comparison to the
pre-reform period. What now remains to analyze is that how far these
developments of the financial system have led the high rates of capital formation
and more importantly economic growth. This will depend on the extent to which
financial development in India is related to country’s economic growth. This
precisely is the subject of this chapter.

7.1 EMPIRICAL LITERATURE: AN OVERVIEW

It is usually expected that financial development should have positive

repercussions on the advancement of the real sector. This proposition however
cannot be taken for granted. Its validity needs to be empirically tested and
theoretically examined. In economic literature, ever since the pioneering works of
Goldsmith (1969), McKinnon (1973) and Shaw (1973), the relationship between
financial development and economic growth has remained an important topic of
debate91. Numerous studies have dealt with different aspects of this relationship
at both theoretical and empirical levels.

91
Some of the debates have been highlighted in chapter 3 on literature survey.

7-1
Most of the original contributions to this literature coincide in suggesting a strong
positive co-relation between the two. Research on the relationship between
financial development and economic growth has received a new direction from
development of the endogenous growth literature92. By focusing on cases where
marginal productivity of capital always remain positive, this literature provides a
natural framework in which financial markets affect long run and not just
transitional growth. Financial development has a dual effect on economic growth.
On one hand, the development of domestic financial markets may enhance the
efficiency of capital accumulation. On the other financial intermediation can
contribute to raising savings, and therefore, investment rates.

A number of studies document a positive two-way causal relationship between

economic growth and financial development. On one hand, the process of growth
stimulates higher participation in financial markets thereby facilitating the creation
and expansion of financial institutions. On the other, financial institutions, by
collecting and analyzing information from many potential investors, allow
investment projects to be undertaken more efficiently and hence stimulate
investment and growth. Well-developed stock markets may improve an economy’s
ability to mobilize capital and diversify risk.

The empirical work in this area has utilized two different econometric
methodologies - cross country regressions and time-series regressions93. Most of
the earlier studies on the topic with the notable exception of Goldsmith (1969) are
cross-sectional analyses based on the experience of developed countries.
Majority of these studies conclude that higher levels of financial development are
robustly co-related with faster rates of economic growth. Cross-country studies

92
Bencivenga,V.R. And Smith , B.D(1991). 'Financial Intermediation And Endogenous Growth'.
Review Of Economic Studies, Vol.58, PP.195-209

7-2
however suffer from a number of shortcomings. Firstly due to presence of
significant cross-country heterogeneity in the dynamics of financial structure and
economic growth, there is the econometric problem of heterogeneity of slope co-
efficient across countries. Such approach is only able to capture the average effect
of variable across countries – thus ignoring the dynamics of causality patterns
across countries. Estimates derived from cross sectional data can only be valid if
the institutional and other features that determine economic growth are invariant
across countries and the marginal response of economic growth to each measure
of financial development is also invariant. Lately, a number of time series analyses
for developing as well as developed countries and country specific studies have
come up.

On the whole, mass of studies (cross-sectional, panel, time-series) suggests that

better functioning financial systems support faster economic growth. The country
case studies document critical interactions among financial sector reforms,
financial intermediaries, financial markets, government policies, and economic
growth. Disagreement exists over some individual cases. Nonetheless the body of
available country studies suggests that while the financial system responds to the
demands of the non-financial sector, well functioning financial system have, in
same cases, during some time periods importantly spurred economic growth.

The available studies on India suggest

Financial repression prior to reforms had negative effect on the

development of the financial system and therefore on economic growth
(through finance-growth nexus).

93
For pros and cons of the two methodologies refer Ram, R., (1986) Government Size And
Economic Growth: A New Framework And Some Evidence From Time Series And Cross Section
Data, American Economic Review,76,March, pp 191-208.

7-3

Subsequent to the reforms, growth of both financial institutions and markets
is noted (based on some selected indicators).

Financial development has positively contributed to economic growth.

7.2 THE MODEL

A model is a simplified description of reality developed for studying various aspects

and relationships in a given context. For any model to obtain meaningful
relationships it is important to appropriately pin down the relevant variables and
clearly define all the variables to be used. The variables can be selected based on
theory or available empirical analyses on similar topics. The underlying
assumptions need to be clearly stated right at the outset. It needs to be
remembered here that different factors may be important in explaining a same
variable (say economic growth) at different geographical places and different
times. So past results on similar topics cannot be blindly relied upon.

In this study the aim is to examine whether causal relationship exists between
economic growth and financial development; specifically does financial
development promote economic growth. At first thought one may simply think of
examining the relationship of the form: y = f(F) where Y is some indicator of
economic growth and F is an indicator for financial development. Simple
regression techniques may be used to run the regression: Yt = a + bFt. The
significance of estimated b would indicate the presence or absence of a
relationship and estimated sign of b will indicate the direction of relationship for a
given time period. This simple procedure is inappropriate, however, due to various
reasons. First of all the economic growth of any nation depends on numerous
factors. Running a regression as mentioned above would amount to omission
/exclusion of a number of variables which may otherwise be important. The
purpose of this study is not to develop a model of economic growth; so it may at
one level not matter whether or not other important variables are included. But the

7-4
problem is that in the absence of variables that are otherwise relevant, the
parameter estimates of included variable(s) will be biased. This is to say that the
estimated value of b will be biased due to omitted variables and t-test will also not
give a true picture of the significance of relationship. Secondly, it is quite possible,
in fact highly probable that the relationship between economic growth and financial
development is either way or in the reverse direction i.e. growth affecting financial
development (or for that matter any other possible determinant of growth). In order
to take care of possible endogeniety of the determinants of growth, any single
equation model is clearly inappropriate. Simultaneous equations modeling
techniques are called for. Then, one also needs to remember that the influences
(either way) may not only be contemporaneous but often one variable may depend
on lagged values of the other variables. All these reasons necessitate a number
of modifications in the above regression model: including other key variables
together with appropriate lags and using econometric methodology which would
take care of the possible two-way relationship.

First thing required is to determine the variables to be included i.e. model

specification94. This in itself is important because a mis-specified model may
lead to incorrect conclusions. Specification errors could be on either side i.e.
excluding relevant variables or including irrelevant variables. Both have own costs.
The variables actually included in any model may also often be constrained by
data availability and some other factors.

No model can ever be a completely accurate description of reality. To describe

reality involving behavioral relationships one may need to develop such a complex
model that it will be of little practical use. Some amount of abstraction or

94
For properties of a good model and problems of mis-specification refer Gujarati, D (1988),
Basic Econometrics 2nd ed. Mc-Graw Hill.

7-5
simplification is inevitable in any model building. The principal of parsimony states
that a model is kept as simple as possible. In the words of Milton Friedman, ‘a
model (hypothesis) is important if it explains much by little’. This is to say that one
should introduce a few key variables in the model that capture the essence of
phenomenon under study and relegate all minor and random influences to the
error term. The variables introduced must be identifiable i.e. the model results in
unique estimate for each parameter. Since the basic thrust of econometric
modeling is to explain the maximum possible variation in a hypothysed dependent
variable by explanatory variables included in the model, a model is judged good, if
this explanation, as measured by R2 (or rather adjusted R2 i.e. R2) is as high as
possible. Sometimes, however, despite a high R2, a model may not be good. This
will happen if one or more of the estimated coefficients have wrong signs. So
together with a high R2, the signs and magnitudes of the estimated co-efficients
should be theoretically consistent. Lastly, a model should have a good predictive
power even beyond the sample period. A model satisfying the above criteria will
be a close approximation to reality and relationships obtained from such a model
may be relied upon.

In the presence of specification errors, this will not be the case. If a relevant
variable is omitted, the co-efficient estimates of all variables co-related with the
omitted variables will be biased as well inconsistent. More importantly, the
confidence intervals and hypothesis testing procedures are likely to give
misleading conclusions about statistical significance of the estimated parameters.
The inclusion of unnecessary variables on the other hand makes the variances of
the estimated parameters unnecessarily large i.e. the estimated values will be
generally inefficient. Although conventional hypothesis testing methods are valid,
the probability inferences about the parameters are less precise. Moreover, each
additional variable entails a loss of degrees of freedom and increases chances of
multi-collinearity. The degrees of freedom problem will be more binding if sample

7-6
size is small. In general best approach is to include only explanatory variables that
on theoretical grounds, directly influence the dependant variable and are not
accounted for by any other included variable.

Once the variables to be included are finalized it needs to be ensured that all the
variables are measured without any errors. The magnitudes used in the analyses
should not be guess estimates, extrapolated or interpolated or rounded off in any
systematic manner. This ideal however is often not met in practice due to a variety
of reasons e.g. non-response, reporting errors, a high degree of reliance on
secondary data, missing values, etc. The consequences depend on whether the
measurement error is a part of the dependent or the explanatory variable. The
errors of measurement in the dependent variable do not destroy the unbiasedness
property of the simple regression i.e. the OLS estimates but the associated
variances are larger. Errors of measurement in the explanatory variable(s) render
them co-related with the error term so that OLS estimates are not only biased but
also inconsistent. Thus, measurement errors when present in any of the
explanatory variable(s) pose a serious problem because they make consistent
estimates of parameters impossible. One possible remedy here is to make use of
instrumental or proxy variable(s) that are highly co-related with the original
explanatory variable(s). In literature there are other suggestions to solve the
problem, but most of them are specific to a given situation and are based on
restrictive assumptions. There is really no satisfactory answer to the measurement
error problem.

Another source of specification error is the use of incorrect functional form. For
instance, if the relationship were quadratic or cubic, use of a linear relationship
would not give accurate results. Often it happens that one knows what variables to
include in the model but does not know the exact functional form in which the
variables appear in the model. The underlying theory in most cases does not tell

7-7
us whether the model is linear or log linear or some combination. Since
specification errors (of all kinds) can be a serious problem there are several
techniques to detect their presence in a given situation. Once it is found that
specification errors have been made, the remedies often suggest themselves.

Very often specification biases arise inadvertently, perhaps from our inability to
formulate the model precisely because the underlying theory is weak or the right
kind of data required to test the model is not available. In practice, one is never
sure how much truth lies in the model adopted for empirical testing. Based on
theory and/or introspection and prior empirical work, one develops a model that is
believed to capture the essence of the subject under study. The model is then
subjected to empirical testing. It is only after obtaining the results that one comes
to know if the chosen model is adequate. For determining adequacy one looks at
some broad features as R2, estimated t-ratios, signs of estimated co-efficients in
relation to prior expectations, the Durbin-Watson statistic to look for serial co-
relation etc. If these diagnostics are reasonably good, one can contend that the
chosen model is a fair representation of reality. Else one has to detect the problem
and look for remedies.

In order to establish whether or not a relationship exists between the real sector
growth and developments in the financial sector, the key determinants of economic
growth must be included in the model. As earlier explained examining a simple
relationship between economic growth and financial development variables would
be inappropriate. So what is now required is an appropriate indicator(s) for
economic growth and financial development together with the additional variables
to be included in the regression analyses95. Once the variables of the model are
finalized, econometric techniques appropriate to capture the possible endogeneity
of the variables need to be looked for.

95
i.e. the important determinants of economic growth

7-8
7.3 THE DETERMINANTS OF GROWTH

Just as there is no consensus on the role of financial development in economic

growth, there also is lack of unanimity on the key determinants of growth. Here
too, as in case of finance–growth relationship, differences would exist between
different countries and at different times. A particular variable say government
expenditure can be a drag on growth in one country and a key stimulating factor in
another. In a same country it may vary across time periods.

Traditionally, growth models have focused on capital accumulation as the prime

determinant of growth. The concept of (incremental) capital output ratio was very
important. Traditional models96 single out investment as the only factor affecting
growth and contend that output grows in a fixed proportion in relation to the
incremental capital stock. Then, financial intermediation or any other variable for
that matter would have no place in determining growth. Such rigid relationships
between capital and output growth have been proven to be far from true.
Economic growth depends for sure on factors more than just capital. But what
these factors are? The answer has varied from time to time and place to place. At
different times and in view of different economists, various determinants of growth
are changing in importance.

The differences in rates of growth of various economies were in the past attributed
to differences in rates of physical capital accumulation. At one time government
expenditure and governance in the economy were considered of prime importance
in explaining differing rates of growth across economies. Finance or availability of
funds for production activities and overall development of the financial system has
also been considered as explaining differences in growth. Then lately, it has been
argued that it is not only physical capital formation but also human capital

96
e.g. Harrod-Domar model and the like.

7-9
formation that is crucial to the growth process. Going into a literature survey for
empirical results on all these factors would be diverging away from the main point.
The above discussion however is important as it points to various determinants of
economic growth being discussed in literature from time to time. In today’s
globalized world some international factors may also become important.
In totality, thus, economic growth depends on a number of qualitative and
quantitative factors. The important ones are physical capital accumulation, quality
and quantity of labor force and / or work force, development of human resources,
foreign capital, finance availability, government expenditures of productive
nature97, governance, and so on. Some demand factors may also be important in
stimulating growth.

Physical Capital Accumulation: Traditionally capital has occupied a dominant

place in growth literature. Accumulation of physical capital is often considered as
synonymous with growth. Capital formation takes place in the private sector and in
the government sector. In principle the trends in public and private capital
formation can often be different. The two can influence economic growth in a
substantially different manner. In such a case they need to be separately
accounted for.

Labor - In economies with low density of population, labor is a scarce input and
shortage of labor at times can hinder the growth process. In such a situation the
supply of labor in an economy (which would be nearly equal to work force) would
be strongly associated with the growth process. In economies like India, where
density of population is very high, labor is available in abundance and marginal
productivity of labor is low, often negative. So labor is not a constraining factor on
growth. Rather, more than required supply of labor leads to unemployment and
other problems that can act as a drag on growth.

97
Else they would be a drag on growth

7-10
Human Resource Development (HRD): HRD or formation of human capital can
be at times as important as physical capital accumulation as has been
documented in literature. It provides skilled labor to the production process and
greatly enhances the efficiency in the use of available capital. It leads to changes
in attitudes, institutions etc. which is conducive to accelerating growth. Returns to
primary education specifically have been found to be positive significant in most
studies.

Foreign Investment - In an open economy foreign investment can play a crucial

role in stimulating economic growth. Together with funds such investment often
brings in managerial expertise, technical know-how, an expanded market, crucial
inputs, foreign currency, etc- all ingredients crucial to a country’s growth process.
In one way it can act as an indicator to assess the role of liberalization in the
growth process.

Besides the above conventional factors98 there exist several other factors on which
there is less unanimity. These include factors like exports, government expenditure
in the economy, growth of the financial sector, etc. The influence of these factors
on economic growth is highly variable. They may have a growth stimulating effect
at one place and negative effect or no effect at some other place or time. So the
influence of such factors cannot be taken for granted but needs to be empirically
tested.

7.4 VARIABLES IN THE MODEL

This section pins down the variables relevant to the model. It consists of an
indicator for economic growth and the key determines of growth including
appropriate indicator(s) for financial development.

98
These are the factors that are by and large universally accepted as significantly affecting growth.

7-11
Economic growth indicator: Economic growth is a measure of growth in
aggregate output of a nation during a specified time period, usually one year. It
can be measured by annual growth rate of GDPfc (NDPfc) at constant prices.
When the growth rates are to be used to judge the improvement in the economic
well being of people, or any other similar purpose, the rates expressed in per
capital terms would be more meaningful. In this analyses, however, the aim is to
see the impact of financial development on economic growth in terms of an overall
output expansion. This is to say when financial constraints are relaxed, whether or
not it aids to expand the output via increased capital formation or increase in
productivity. So, using the rates in per capita terms will not be meaningful. The rate
of growth, per capita, will be affected by the growth rate of population, which as
such has no bearing in context of role of finance. Moreover, the rates of actual
increases in aggregate output will not be reflected in per capital growth rates. So,
as an indicator of economic growth, the study has used the average annual rate of
growth of Gross Domestic product at factor cost at constant prices (EG).

Financial Development Indicator(s): Ideally, financial development indicator(s)

should relate to the variety of institutions and markets available, how well they
mobilize resources, manage risk, facilitate transactions and so on. In practice, it
will not be possible to find a variable that could truly reflect the whole gamut of
services provided by the financial sector. In empirical studies, financial
intermediation has largely been proxied by the level of real interest rates and by
various monetary aggregates, all of which pose significant interpretation
problems99. Some recent studies have used some other measures of

99
Bhattacharya, P.C. And Sivasubramaniyan, M.N. (2003). 'Financial Development and
Economic Growth In India: 1970-71 To 1998-91'. Applied Financial Economics, Vol.13, PP.905-
909.

7-12
intermediation like deposits and/or credit in some form or the size of the financial
sector. This study has used two indicators, one each for financial institutions and
markets, which best relate their role to economic growth.

The first indicator is the institutional credit to the private sector (CR) as a ratio of
GDP. In studies where credit has been used as an indicator of financial
development, it is only bank credit that is considered. However, significant financial
development takes place outside the banking system. Moreover as the financial
system develops, the portion of bank credit to the total credit advanced usually
falls. For this reason the credit advanced by non-banking financial institutions has
also been included in the study. CR thus consists of non-food credit advanced by
scheduled commercial banks, credit advanced by non-scheduled commercial
banks, co-operative banks, and financial assistance disbursed by non-banking
financial institutions. It excludes credit to the public sector in the form food credit
and therefore is able to represent more accurately the role of financial
intermediaries in channeling funds to the private market participants. This measure
will therefore be more directly linked to investment and growth than various other
measures often used in such studies.

A number of studies on the topic have used the real rate of interest as an indicator
of financial intermediation. The McKinnon-Shaw hypothesis suggests that the level
of financial intermediation should be closely related to the prevailing level of the
real interest rate. The view is that a positive real interest rate stimulates financial
savings and financial intermediation, thereby increasing the supply of credit to the
private sector. This is turn stimulates investment and growth. In this context, it
seems reasonable to argue that savings do not increase only in response to real
interest rates. With financial development, the depth of financial sector increases;
this provides easy access of people in all regions to institutional credit. The
number and variety of financial assets available is substantially more. Thus,

7-13
transaction costs are much lower and diversified assets are available to suit the
needs and preferences of different types of surplus units. The real rate of interest
therefore would rather be a poor indicator of financial intermediation. Thus it
seemed far more sensible to directly use the amount of credit channeled to the
private sector rather than indirectly obtaining it via real rate of interest.

Monetary aggregates are an alternative set of financial development indicators

often used in empirical literature. It is argued that a monetised economy reflects a
highly developed capital market; hence the degree of monetization should be
closely related to the growth performance. The aspect of intermediation that is
related to investment and growth is the ability of the financial system to allocate
credit. A liquid aggregate such M1 (or M2) is mainly related to the ability of the
financial system to provide liquidity or a medium of exchange and not to the
allocation credit. It is in fact possible that a high level of monetization, measured by
say, ratio of M1 to GDP is the result of financial underdevelopment, while a low
level of monetization is the result of a high degree of sophistication of financial
markets which allows individuals to economize on their money holdings. To take
care of such a situation, a less liquid monetary aggregate M3 has sometimes been
used as a proxy for degree of financial intermediation. Although it may be more
related to the degree of credit market development, there may still be influences
other than that of financial depth. In particular because M3 still includes liquid
assets (M1), some studies have used M3 - M1. This ultimately comes to term
deposits in the system.

Deposits as an indicator do serve better than the real rate of interest or any of the
monetary aggregates as the influence of financial development on increase in
financial savings is directly captured. Yet it is not necessary that all deposits
translate into credit. In fact a large proportion often goes to the public sector. The
proportion of credit going to public sector keeps changing with policies and

7-14
priorities of the government. Moreover the total amount of credit that results from
a given amount of deposits will depend on the efficiency of financial sector and
various monetary policies of the government from time to time. Considering all this
it was found most appropriate to use the ratio of institutional credit to the private
sector to GDP to measure the growth of financial institutions in the economy. This
is what is most directly associated with investment and growth.

The institutional credit does well as an indicator for the development of institutions.
But it leaves out a very important segment of the financial system i.e. the securities
markets. In fact the role and nature of financial institutions and the financial
markets are substantially different. In order to fully account for the development of
the financial system, it is important to include an indicator to account for financial
markets too, specifically the securities market.

For the markets, the indicator used in various studies relate to size and/or liquidity
of the (secondary) market. Although it would have been more appropriate to
include an indicator for size i.e. MCR (Market Capitalization ratio) and one for
liquidity (turnover ratio or the traded value ratio), only MCR has been finally
included. For the liquidity indicator(s) the data is available only since the beginning
of 1990s. In fact in the context of contribution to economic growth the ideal
measure to be used would have been the resources raised from the primary
market, but in this regard too pre-liberalization data is not available. In fact pre-
liberalization data in case of Indian capital market is available only for stock market
capitalization. So this was the only possible capital market variable that could be
included in the analyses. On the whole, the study uses two indicators for
financial development: institutional credit to the private sector/GDP and
market capitalization ratio i.e. the ratio of stock market capitalization to
GDP.

7-15
Other variables of the model

Capital Accumulation - Capital formation takes place in the private sector and in
the government sector. The trends and composition in public and private sector
and their influences on growth therefore can often be different. In such a case
they need to be separately accounted for. In case of India however, during the
time period under consideration, the two tend to move parallel to each other. Both
seem equally related to economic growth. Initially three time series were
examined: capital formation by the private sector, public sector, and total capital
formation. All the three series follow a more or less similar pattern. Moreover, the
co-relation co-efficient of each series with rate of growth of real GDPfc is nearly the
same (both contemporaneous and with lags). Therefore rather than taking the
rates as separate variables and adding to the number of variables, the study has
used the real GDCF (public +private sector) as a single variable. The fourth
variable of the model is therefore rate of gross domestic Capital formation
(GDCF) i.e. ratio of nominal GDCF at current market prices to nominal GDPmp,
expressed as a percentage.

Labor - Satisfactory data is not available either on total supply of labor or on

workforce i.e. those employed. The employment data is available only for public
sector and organized private sector. These in no way represent the true magnitude
of, or the trend in workforce. This is because of the decreasing but still dominant
presence of the unorganized sector manifested in self-employment, retail trade,
agriculture etc. So considering workforce was out of question. As for labor force
too, data is not available. But there are numerous studies (on various topics) that
have taken population growth rates as proxy for rates of growth of labor force. The
study has used the lagged (by 14 years)100 population data as a proxy for labor
force to find the rate of growth of labor. Its co-relation co-efficient with EG is

100
The lag of 14 years has been taken because this is the entry age of population in the work force.

7-16
very small (negative). So, finally no variable representing labor force is
included in the regression model.

Foreign Investment - In case of India, although since liberalization, foreign

investment has substantially increased, it still remains very small in relation to
country’s GDP to have any noticeable affect on the growth process. Also, data for
first half of 1980s is not available for foreign investment and interpolation may lead
to other errors. The data format for foreign direct investment has been revised
since 2000-2001, so that the data pre and post 2000 is not comparable. For the
years where data is available, it is found highly co-related to GDCF. So
including GDCF as one of the variables will also take care of foreign
investment.

Human resource Development (HRD): Continuous time series data is not

available for any variable that can act as a proxy for HRD. Therefore there was no
option but to leave out this variable.

Government investment expenditure has already been included under capital

formation.

7.5 DATA AND METHODOLOGY

As just discussed four time-series variables form a part of the final regression
analyses to be undertaken. Some other variables were considered but finally
dropped for different reasons. The included variables are the average annual rate
of growth of real gross Domestic product at factor cost (EG), Institutional credit to
the private sector (CR)/GDP, market capitalization ratio (MCR)101 and rate of
gross domestic capital formation. Most of the data has been obtained from
‘Handbook of Statistics on Indian Economy, Oct 2008 published by RBI. Table 233

101
relating to Bombay stock Exchange

7-17
gives annual growth rate of real GDPFC (1999-2000 series) from 1950-51 to 2007-
08 in percentage terms. This series is used for the variable EG.

Data for CR is calculated from magnitudes from table 47 (non-food credit of

SCBs), table 66 (credit advanced by non-scheduled commercial banks (non
SCBs), 68 (Credit advanced by State Co-operative banks maintaining accounts
with RBI) and 85 (Financial assistance disbursed by all financial institutions).
Here, some clarifications are required. Data on bank credit exclude the impact of
mergers on May 3, 2002 and the impact of conversion of a non-banking entity into
banking entity on 11th October 2004. In context of financial assistance provided by
the development financial institutions the state level institutions (SFCs and SIDCs)
are not included because in respect of these data is available only up to 2004.
From All India Financial Institutions (AIFIs) six FIs are included for which data is
available till 2007. These are SIDBI, LIC, GIC, TFCI, IVCF and IFCI. SIDBI
commenced its operations in April 1990, TFCI in Feb. 1989 and GIC102 in 1973.
SCICI Ltd. was merged with ICICI Ltd. with effect from April 1996 and ICICI Ltd.
was merged with ICICI bank in 2002-03, ceasing to be an AIFI. UTI has been
organized into two separate institutions, ceasing to be an AIFI. For this reason
SCICI Ltd., ICICI Ltd. and UTI have not been included in the analyses to maintain
the comparability of data.

Data on SMC (BSE) has been taken from the Handbook of Statistics on Indian
Securities Market, 2008 published by SEBI. This data is available starting 1978-
79. In between data for 3 years (1979, 1981 and 1982) is missing. This has been
interpolated on the basis of BSE sensex trend. The two series were found to be
moving on the same pattern for the 30 years period 1978-2007. Although it may
lead to slight inaccuracy, the other alternatives were either to drop the variable

102
For GIC data include General Insurance Corporation of India, New India Assurance Company
Limited and United India Insurance Company Limited.

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altogether or take 1982-83 as the starting year for the entire analyses. Both
alternatives are unattractive. When the motive of study is to analyze the role of
financial sector development in economic growth the only available variable on
stock markets cannot be dropped. The number of observations is also pitiably less
considering the nature of analyses. So further reducing the span by five years
would not be advisable.

Data on GDCF (1999-2000 series) at current prices has been obtained from table
1 of the same reference as also the new series on GDP at market prices that is
used to obtain the ratios in respect of CR, SMC and CF. Different tables from
same RBI publication - Handbook of statistics on Indian Economy were used to
obtain data on variables which were initially taken for analyses but dropped after
some preliminary diagnosis.

Econometric Methodology

As far as the empirical studies103 (time-series) on the role of finance in economic

growth are concerned, most of them generally estimate the regression equation of
the form:
Economic growth = f (financial development).
In some cases, where other determinants are considered, simple OLS techniques
or at most, GLS have been used in the past to obtain the parameter estimates.
This is inappropriate in such models where explanatory variables may themselves
be endogenous. Single equation methods like OLS or GLS will not be able to
establish whether the estimated relationship indicates the effect of financial
development on economic growth or vice-versa. Most of the recent studies in this
area have used the Vector auto-regression (VAR) and Vector error correction

103
Odedokun,M.O.(1996). 'Alternative Econometric Approaches For Analyzing The Role Of The
Financial Sector In Economic Growth: Time Series Evidence From LDCs'. Journal Of
Development Economics, Vol.50,PP.119-146

7-19
(VECM) models104. But all such studies have used only growth variable(s) and
one or more financial development variables to the total neglect of other
determinants of growth105. Moreover, there are only a few studies that have
proper theoretical underpinnings of the production function involved.

The starting point of this analysis is the neo-classical production function in three
inputs and trend variable:

yt = f (X1t, X2t, X3t, T) (7.1)

y = Total output (real Gross domestic Product at factor cost)

X1 = Total Institutional credit to the private sector - CR
X2 = Stock market Capitalization (for BSE) - SMC
X3 = Stock of Capital – K
T = Trend
The subscript ‘t’ stands for time period t.
Trend variable is included to capture the possibility of time trend.

The function given by (7.1) specifies the aggregate output being determined by
various inputs. The exact functional form is not specified, it merely denotes the
output being a function of various inputs. On taking total differential and dividing
throughout by yt-1 this yields:

104
Luintel, K. B. And Khan, M. (1999), “A Quantitative Reassessment of Finance- Growth Nexus:
Evidence from Multivariate VAR,” Journal of Development Economics, 60(2), 381-405.

105
Bell,C. And Rousseau,P.L.(2000). ‘Post Independent India: A Case of Finance Lead
Industrialization?' Working Papers 0019, Department Of Economics, Vanderbilt University

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 dyt d (CR) d ( SMC ) dK
= aCR + aSMC + aK +C (7.2)
yt −1 yt −1 yt −1 yt −1

The term dyt gives the total variation in output in the year t as the sum of all
dyt
individual variations. therefore gives the annual rate of change in output i.e.
yt −1
rate of growth of real Gross Domestic Product at factor cost in time period t. The
terms aCR , aSMC, and aK are respectively the partial derivates of the function with
respect to the variable concerned, the interpretation being that of marginal change
in y consequent upon a small change in i. Thus each partial tells the change in the
function i.e. total output in response to a change in the concerned factor only .The
terms d(i) are the differential terms corresponding to each individual factor. Here
‘d’ is the operator differential, which in this analyses is taken as the annual
difference i.e. difference between 2 consecutive observations. So each of these
denote the annual change in corresponding variable (i = CR, SMC, and K) in time t
(relative to time period t-1). The constant C is obtained as the co-efficient of the
dyt
trend variable i.e. [dT=1] divided by yt-1. This denotes the change in output
dT
per time period.

The form in which the variables have been used in the regression analyses are
thus obtained as:
dyt
= average annual rate of growth (in percent) as obtained from the data.
yt −1

yt − yt −1
Implicit formula used is . This gives the first variable of the regression
yt −1
model.

d(CR) is the difference in credit outstanding at the end of each year. So it gives
the credit made to the private sector every year. For bank credit (BC) the data is

7-21
given as outstanding credit at the end of each year. So the difference (dBC) is
obtained as BCt - Bt-1. For the financial institutions the data gives financial
assistance sanctioned during the given year. So these value are added as such to
dBC of the corresponding year to obtain d(CR). This is then divided by one year
lagged value of GDP at current market prices and expressed as percentage. This
gives the second variable of the model.

d(SMC) is obtained as SMCt – SMCt-1. This is then divided by one year lagged
values of GDP at current market prices and expressed as a percentage. This gives
the third variable of the model.

In case of capital, dk refers to addition to capital every year. This is given by

gross capital formation106. So dk is the Gross domestic Capital formation (at
current prices). This as the previous two variables is divided by one year lagged
value of GDPmp at current prices and expressed as a percentage.

This gives four variables of the model: rate of growth of real GDP (EG), ratio of
incremental institutional finance to GDP (ICR), incremental market capitalization
ratio (IMCR), and ratio of GDCF to GDP (CF) all expressed as percentage

With these four variables a straightforward way would be to put EG as a function of

other three. However, in view of possible endogeniety of each of these variables,
such a model would not be appropriate. When we are not confident that a variable
is exogenous, the best way is to treat each variable symmetrically. This is exactly
what is done in a vector autoregressive (VAR)107 model. Each variable is

106
Although net figures would more accurately reflect the true addition to physical capital, Gross
values are taken due to arbitrariness in depreciation estimates
107
Enders, Walter (2004): Applied Econometric Time Series – 2nd Edition, Brijbasi Art Press Ltd.,
India.

7-22
considered to be affected by current and past realizations of all variables including
self. A multivariate VAR in standard form is written as

Xt = A0 + A1Xt-1 + A2X t-2 + … + ApX t-p + et (7.3)

Where Xt = (n.1) vector of variables

A0 = (n.1) vector of intercept terms
Ai = (n.n) matrix of co-efficients for all i=1…p; p being the order of VAR.
et = (n.1) vector of error terms.

The variables to be included in VAR are selected according to the relevant

economic model. The order of VAR (i.e. the lag length) can be determined using
standard tests available. The matrix A0 contains n parameters and each of Ai
matrixes contains n2 parameters. Hence the number of co-efficients to be
estimated is n + pn2. Unquestionably, a VAR will be over parameterized in that
many variables will be insignificant. However, if goal is to find important
relationships among variables and not to make short-term forecasts, improperly
imposing zero restrictions may waste important information. Moreover the
regressors themselves are likely to be co-linear so that t-tests on individual co-
efficients are not reliable guides for paring down the model.

In (7.3) above, the right hand side contains only pre-determined variables and the
error terms are required to be serially uncorrelated with constant variance. Hence
each equation of the system can be estimated using OLS. These estimates will be
consistent and asymptotically efficient. Even though the errors are correlated
across equations, seemingly unrelated regressions (SUR) do not add to the
efficiency of the estimation procedure since all equations have identical right hand
side variables.

7-23
There is an issue whether the variables in VAR need to be stationary. Sims (1980)
and Sims, stock and Watson (1990) recommend against differencing even if the
variables contain a unit root (and / or drift). They argue that the goal of VAR
analyses is to determine the inter relationships among variables and not the
parameter estimates. The main argument against differencing is that it throws
away information regarding co-movements in data (i.e. possibility of co-integrating
relationships). Similarly the data need not be de-trended. In VAR, a trending
variable is well approximated by a unit root plus drift. However, if the aim is to
estimate a structural model, then stationarity should be achieved so that the VAR
variables mimic the true data generating process. It is possible to perform
hypothesis tests on an individual equation when some regressors are stationary
and others non-stationary. If the co-efficient of a particular variable can be written
as a co-efficient of stationary variable, then a t-test is appropriate. F tests and t-
tests can be performed with regard to stationary variables. Where non-stationary
variables are involved in analyses one needs to test for the possibility of co-
integration.

Co-integration refers to linear combination of non-stationary variables integrated of

same order. If the variables are integrated of order one (written as I(1)) then such
a linear combination will be stationary. If xt has n non-stationary components there
can be maximum n -1 linearly independent co-integrating vectors. As a practical
matter, if multiple co-integrating vectors are found, it may not be possible to
identify behavioral relationships from reduced from relationships. Co-integration
among a given set of variables imply presence of a long run (or equilibrium)
relationship among the variables in question. In short run, of course, there may be
disequilibria. If the system is to return to long run equilibrium, then at least some of
the variables must respond to the magnitude of disequilibria. Thus, a principal
feature of co-integrated variables is that their time paths are influenced by the

7-24
extent of any deviation from long run equilibrium108. The dynamic model implied
here is that of error correction. In an error correction model the short-term
dynamics of variables in the system are influenced by the deviation from long run
equilibrium. Whenever a set of variables is co-integrated, then in short run
disequilibria, at least one of the variables must adjust. Else there is no error
correction nor does any long-run equilibrium exist. The model is not one of error
correction or co-integration.

Causality in a co-integrated system also needs to be re-interpreted. In a co-

integrated system {Yt} does not Granger cause {Zt} if lagged values of ∆Yt-1 do not
enter the ∆Zt equation and if {Zt} does not respond to the deviation from long run
equilibrium. Hence {Zt} must be weakly exogenous.

In order to ascertain whether or not a causal relationship exists between financial

development and economic growth; as a first step all four variables are examined
for stationarity. Since the tests for stationarity have low power, multiple tests are
used i.e. Augmented Dickey–Fuller (ADF), Phillips-Perron109 (PP) and KPSS110.
These tests show the presence of unit root in all four cases. After taking first
difference, all series became stationary. This means all variables are integrated of
order one i.e. I(1). This suggests the possibility of co-integration among variables.
The Johansen tests (λmax and λtrace) indicate the presence of a single co-integrating
vector. This means all variables are mutually co-integrated. In the presence of co-

108
Engle, R. F. And Granger, C. (1987), "Cointegration And Error Correction: Representation,
Estimation And Testing," Econometrica, 55, 251-276.

109
Philips,P.C.B. And Perron,P.(1988). 'Testing For a Unit Root in Time Series Regression'.
Biometrica, Vol.75, PP.335-346.

110
Kwiatkowski, D., Phillips, P., Schmidt, P. And Shin, Y. (1992), “Testing the Null Hypothesis of
Stationarity against the Alternative of a Unit Root,” Journal of Econometrics, 54, 159-178. 20

7-25
integration simply first differencing leads to misspecification error. The actual data
generating process is given by vector error correction model (VECM) of the form
p −1
∆xt = Πxt-1 + ∑
i =1
Πi∆ xt-i + et , (7.4)

 p
  p 
where Π = -  Ι − ∑ ai  and Πi = -  ∑ A j  and x and A are as in (7.3) above.
 
 i −1   j =i+1 
If the VAR is estimated in first differences i.e.
p −1
∆xt = ∑
i =1
Πi∆ xt-i + et , (7.5)

the system is mis-specified since it excludes the long-run equilibrium relationship

among variables contained in Πxt-1. Given this mis-specification error, all co-
efficient estimates, t-tests and F-tests will not be indicative of the true process. So
the error correction model (7.4) has been used in this study. Since the error
correction term and all values of Πxt-1 are stationary, inference on all variables
(except those appearing within the co-integrating vector) has been carried out
using usual test statistics.

7.6 RESULTS

The variables, EG, ICR, IMCR, and CF, were as first step examined for
stationarity. In addition to the usual ADF test, the PP test for stationarity was also
used to test the null hypothesis of unit root against stationarity and also unit root
with drift against trend stationarity. The appropriate lag lengths for these tests were
determined using Akaike (AC), Hannan-Quinn (HQ) and Schwarz (SC) information
criteria. Where different lags were suggested, the tests were conducted for all
lags. In case of variables ICR and CF, null hypothesis of unit root as well as unit
root with drift were both accepted using ADF and PP tests. So the intercept term
was retained in the model. In case of other two variables i.e. EG and IMCR, the
results of the two tests were conflicting. So KPSS test was used to test the null of
stationarity against the alternative of unit root. It was found on majority rule that

7-26
both variables posses a unit root. This implies that all variables of the VAR model
are non-stationary.

The first difference was then taken in all 4 cases and examined for stationarity. In
all the cases ADF did not reject the null of unit root but the PP test rejected at both
5% and 10% significance levels. So KPSS was again used for decision-making
and all variables were found to be stationary in the first difference. This implies
that all variables of the VAR model are integrated of order one. Since all the
variables are I(1), the obvious next step was to test for the presence of co-
integration.

The set of vectors are found to be co-integrated of order one. This implies that all
4 variables are mutually co-integrated. Due to trending nature of the series, the
co-integration test was carried including an intercept and with co-integrating
restrictions imposed. The co-integrating restrictions are found to hold. Since the
variables are co-integrated, the vector error correction model was applied to the
variables to obtain the results on relationship. The complete estimated model is
given in the appendix.

The order p of VAR (p) is chosen with the help of Hannan-Quinn (HQ) and
Schwarz information criteria (SIC). As per HQ and SIC optimal p i.e. p*= 1. This
was closely followed by p = 4 with only a marginal increase in both HQ and SIC.
Theoretically, it seems that where the impact of finance and capital is involved lag
of 1 year is too small a time span to obtain meaningful results. Moreover with p =1
the model did not yield theoretically expected signs of co-efficients. So p = 4 was
chosen.

In the co-integration analyses there are 4 variables (EG, ICR, IMCR and CF). The
chosen time period is 1978-79 to 2006-2007 because for one of the variable

7-27
(SMC) consistent time series data is available starting 1978-1979; and 2006-2007
is the last year for which data on another variable (intuitional finance) is available.
This makes 28 observations and the chosen level of VAR is p = 4. With these
specifications, that LR test for co-integration was carried out111. Both the LR tests
i.e. λmax (Lambda-max test) and λtrace (lambda trace test) suggest the presence of
a single co-integrating vector. LR test for co-integrating restrictions was also
carried out which suggested the restrictions to be valid.

Table 7.1: Results Of Co-integration Tests

LR test (Lambda-max test) of the null hypothesis that there are r co-integrated vectors
against the alternative that there are r + 1 co-integrated vectors
Table 3: Restrictions on intercept imposed. C.f. Johansen & Juselius (1990), Table A3
Critical values Conclusions
r test statistic 20% 10% 5% 20% 10% 5%
0 37 22.9 25.6 28.2 reject reject reject
1 18.6 17.5 19.8 21.9 reject accept accept
2 10 11.6 13.8 15.8 accept accept accept
3 1.7 5.9 7.6 9.1 accept accept accept

LR test (trace test) of the null hypothesis that there are at most r co-integrated vectors
against the alternative that there are 4 co-integrated vectors
Table 3: Restrictions on intercept imposed. C.f. Johansen & Juselius (1990), Table A3
Critical values Conclusions
r test statistic 20% 10% 5% 20% 10% 5%
3 1.7 5.9 7.6 9.1 accept accept accept
2 11.8 15.4 18 20.2 accept accept accept
1 30.4 28.8 32.1 35.1 reject accept accept
0 67.3 45.6 49.9 53.4 reject reject reject

Conclusion: r =1

111
See Johansen, S. (1991), “Estimation And Hypothesis Testing Of Cointegrating Vectors In
Gausian Vector Autoregression Models”, Econometrica, 59, 551-580

7-28
Table 7.2 presents the results for LR test of the null hypothesis that the imposed
restrictions on the intercept parameters hold

Table 7.2: Results of Co-integration Tests II

Test statistic = 2.82
Asymptotic null distribution: Chi-square (3)
p-value = 0.42033
Significance levels Critical values Conclusions
10% 6.25 accept
5% 7.81 accept

Warning:
Rejection of the null hypothesis involved implies that the test results regarding the
number of co-integrating vectors are invalid!

The parameter restriction of the two ‘speed of adjustment’ parameters being

proportional (with same proportionate change in absolute terms) was imposed on
the co-integrating vector. This restriction was found valid and the model was re-
estimated with the restricted co-integrated vector. The parameter estimates and
the associated t-values and R2 showed marginal changes. Various tests for joint
significance were then carried out to examine the impact of financial development
variables on EG and CF and impact of EG on the two financial variables. These
tests indicate that in the long run institutional credit significantly (at 1% significance
level) affects both capital formation and economic growth positively.

This result implies that financial sector reforms have been instrumental in
accelerating economic growth in India. In the post liberalization period, the
credit to the private sector has grown at a much rapid pace in comparison to the
pre-reforms years112. This has been the result of positive real interest rates tuned

112
as shown in chapter 4

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to the market and a wide range of financial assets to meet the diversified needs of
individual savers. Thus, financial savings have substantially increased. Then with
increased competition and autonomy of operations, efficiency of financial
institutions has also greatly improved. Moreover with substantial reductions in
CRR, SLR and credit to the priority sector, much greater proportion of available
funds can be lent out to the private sector for productive investment. This in turn
leads to speedy growth process.

As for the reverse causality, tests of joint significance show a negative effect from
economic growth to increase in credit advanced to the private sector. Possible
reason could be tight monetary policy often pursued during inflationary conditions
that often accompany high rates of growth. Moreover when growth is good
households’ earnings increase. These increases are often diverted to real estate,
precious metals, consumer durables (which are available in much more variety
and improved quality with economic growth), and host of other items of
conspicuous consumption. Huge amounts are spent partying, on ceremonies,
luxurious accessories, high-up clothing, consumer durables and the like.
Maximum savings in India come from the household sector. They save for their
future needs. When growth is good people are optimistic about their future
incomes also and may be less inclined to save. Moreover, once a certain high
level of savings (for future) is reached, they may often indulge into conspicuous
consumption rather than more savings, as the marginal utility from saving at that
point may drop too low. This explains the negative impact of economic growth on
increase in institutional finance in the long run.

In case of stock market, however, the results are substantially different in context
of markets explaining capital accumulation and the growth process. IMCR does
not affect economic growth at 5% and 10% levels of significance. However, as
seen from the p-valve of test of joint significance of all (lagged) IMCR variables, it

7-30
is permissible to say that at 15% level of significance IMCR does affect economic
growth. The effect is much small in magnitude (as can be seen from the co-
efficient values) and negative in direction. Thus, stock markets do (weakly)
influence economic growth (at 15% and above levels of significance) but the
impact is small and negative. The impact of IMCR on capital formation is
significantly negative (even at 1%).

The possible reasons for this negative impact are many and varied. Quite often,
the benefits of stock market are more from the point of view of maximizing
(speculative) returns for the individual investors and market operator. The efficient
market hypothesis mostly does not hold. Actually the stock market valuations are
often incorrect because they are less related to fundamentals and more to
speculative activity / trading. The corporate financing system based on equity
finance displays a tendency to discourage long-term riskier investment in
productive physical capital as companies become pre-occupied with short-term
financial return considerations to please shareholders, and to avoid possible
takeovers.

The stock market induced liquidity may encourage investor myopia and weaken
investor commitment. It may reduce investor incentive to exert corporate control
and monitor company’s performance, which can hurt economic growth. In today’s
liberalized and globalized economics, stock markets can easily act as conduit for
spreading speculative pressures all over the world. An undesirable implication of
these types of pressures is that economies may be forced to bear a greater degree
of risk with financial liberalization than without it. They may actually reduce the total
volume of real-sector investment while exerting upward pressures on the interest
rates in view of the higher risk. Moreover, in the wake of unfavorable economic
shocks, the interactions between stock and currency markets may exacerbate
macro economic instability and reduce long-term economic growth.

7-31
Growth of stock markets often leads to speculative pressures. These pressures
may emanate from transactions induced by the euphoria created by financial
liberalization that rewards speculators with short-term horizons and punishes those
with a long-term view (Keynes 1936). They may also emanate from non-financial
corporations which enter financial markets in view of the higher returns induced by
financial liberalization, by borrowing to finance short term financial speculation. In
fact as seen later in this section, in the short run when the rate of growth of
economy goes above the long run equilibrium levels, the stock markets respond
positively.

In light of above, it can be said that the possible reasons for the negative impact of
IMCR on CF and EG could be found in the nature of the Indian stock market that is
predominantly speculative in nature. This makes it highly volatile. Often stock
prices experience substantial speculative increases. When such a momentum is
built-up, lot of money goes into stock markets and gets diverted away from the
institutions and from other productive investments. Moreover when stock prices
start to fall, speculative shares drop most in prices and people often suffer losses.
At times such a situation continues for long and may create a serious liquidity
crunch in the economy as illustrated by the current scenario in stock markets.
Then, stock market, by its very nature is predominantly a secondary market. This
does not normally provide fresh funds directly to the productive units. It increases
the liquidity of primary securities so that they become more attractive to a surplus
unit.

When the stock market is going good it is often noted that IPOs (initial public
offerings of bonds) are oversubscribed and the corporate firms are easily able to
raise fresh capital. It seems, in case of India, such a role is limited and
overshadowed by speculative trading so that funds are diverted away from

7-32
productive to unproductive channels, thereby having a negative influence on
growth. Within the stock market trading activity, it is also noted that the shares
trading in high volumes are majorly momentum shares and rarely those of
companies with a promising future. Thus, stock market in Indian Economy has had
negative impulses on capital formation and to some extent on economic growth.

The effect in reverse direction i.e. of economic growth on stock market is also
negative. A large proportion of funds in the Indian Securities market come from
foreign institutional investors. When growth momentum is build into an economy
more of such funds often go to long term productive rather than speculative
activity. A point to note here is that market capitalization is directly influenced by
both volumes and price of shares traded. With high growth rates, within securities
market, more money flows into long term investment in shares of companies with
sound credentials rather than speculative investment. With long term investment
funds are siphoned out of circulation. Moreover, it is speculative trading that
pushes up stock prices too high (or too low). With investment trading the price
increases are moderate and so are the trading volumes. One other factor may be
important here. With economic growth doing well some of the corporate firms with
promising project in hand may liquidate large part of their stock holdings to pump
in fresh money into their business. Such block sales may have dampening effect
on the stock prices and therefore on market capitalization.

Thus it is noted that in context of long run equilibrium the institutional finance to the
private sector significantly affects capital formation and economic growth. The
effect is strong and positive. Now it remains to find out the behavioral relationships
in context of the short-term deviations from the long run equilibrium. As already
discussed co-integration among the variables imply the presence of error
correction mechanism. While co-integration implies existence of long run

7-33
equilibrium relationship among variables, the ECM corrects for short run dis-
equilibrium.

In the estimated model for India, the error correction term for all equations is non-
zero (p value being close to zero in all cases). Model shows that roughly 3% of
disequilibria in rate of growth of real GDPfc is corrected every year. From the co-
integrated vector it is inferred that whenever rate of economic growth shows 1%
positive deviation from equilibrium, incremental credit falls by same percentage.
IMCR in short run increases by around one-tenth of the increase in economic
growth rates. In short run or the disequilibria phase, economic growth and increase
in institutional credit share an inverse equi-proportional relationship. It is this
negative relation that takes the economy out of the momentary dis-equilibrium
phase.

This short run negative association can greatly be attributed to counter cyclical
policies of the government. For instance, if economic growth moves up above its
long-term equilibrium value, it leads to inflationary conditions in the economy.
Government may then undertake different combinations of restrictive monetary
and credit policies such as increase in bank rate and/or repo rate. Such policies
will make credit taking unattractive for production units. Or else the CRR or SLR
may be revised upwards thus making lesser funds available for lending to the
private sector. On the whole less of institutional credit will flow to the private sector
in short run. This reduced flow of credit will affect the production activity adversely
and via the positive long run equilibrium impact of institutional credit on economic
growth rate, the rate of growth of the economy will dampen, thus taking the
economy back towards the long run equilibrium. Conversely, if the economic
growth rate was to fall below the equilibrium level, the expansionary monetary
policies of the government will increase the flow of credit to the private sector in
short run. This will stimulate the production activity and put the economy back on

7-34
the long run equilibrium path. As shown by the error correction co-efficient of the
first equation whenever there are deviations from long run equilibrium in economic
growth, roughly 3% of these get corrected every year.

On the whole it is found that higher levels of financial development are significantly
and robustly co-related with faster current and future rates of economic growth and
physical capital accumulation. From the results it may be concluded that a strong
positive relationship exists between development of the financial sector and
economic growth and that this relationship is not just a contemporaneous
relationship. The existence of such a relationship has important policy implications.

7-35
7-36
 Chapter 8

SUMMARY AND CONCLUSIONS

8.1 AN OVERVIEW

This study has analyzed the impact of the reforms undertaken in the financial
sector on economic growth in India. Starting with an introduction of the financial
system and its development it then gives a brief overview of the Indian Financial
system since independence. This is followed by an outline of the major reforms
recommended in the financial sector as part of Narasimham Committee Report 1
and 2. Next, a comprehensive survey of literature has been presented. These give
theoretical and empirical overview of the relationship between financial
development and economic growth for developed as well as developing
economies. A host of cross-section and time series studies have examined the
finance growth nexus. Different methodologies varying from ordinary least squares
to vector error correction models have been used in cross country as well as
country specific regressions. There exist only a few studies for India that examine
the finance growth relationship. Some studies have examined the productivity
growth and performance of the banking sector in India and also growth of credit in
the economy. However, there is no study on the subject covering the period after
late 1990s

The survey of theoretical and empirical literature is followed by the results of

empirical analyses. Available data shows that substantial financial development
has taken place during the post liberalization period based on various quantitative
indicators. The performance of the commercial banking sector has shown
noticeable improvement during the post liberalization years. The Indian capital

8-1
market has also undergone major changes and improvements. Finally it has been
found that the financial sector has strong positive effects on the real sector
variables in India.

8.2 THE DEVELOPMENT OF THE FINANCIAL SYSTEM

The impact of financial sector reforms on the Indian financial system has been
examined in terms of the changes in the growth rates of savings, investment,
deposits, and credit; various changes in the structure of the financial system,
performance of the commercial banking sector, and size, liquidity and volatility of
the stock market. Time period and methodology differs in each case depending on
the availability of data and nature of analyses.

To start with time series of all stated indicators have been plotted against time.
This gives a fairly good indication of the presence (or absence) and direction of the
trends. Wherever substantial and consistent data is available for both pre and the
post reform periods, in respect to those indicators regression analyses has been
used to find whether there exists a significant difference in the growth rates in the
pre and the post liberalization periods. In cases where substantial pre-reform data
is not available or the magnitudes in entirety have been sharply fluctuating, simple
data analysis as explained above has been done.

It has been found that a substantial increase in rate of growth of both savings and
investment has occurred after the reforms. Of all the cases analyzed the maximum
change has been noted in case of investment by the private sector. Both deposits
and credit in relation to GDP has grown at rates substantially higher than in the
pre-liberalization period. On comparing the equations for credit and deposits it
was noted that prior to the reforms the growth rate of credit was around half the
growth rate of deposits. Subsequent to the reforms it increased to around two-
thirds of the average annual rate of growth for deposits. This also brings out the

8-2
increase in the proportion of deposits that have been channeled to the private
sector via the financial system. This has been made possible only by the
substantial reductions in the cash reserve ratio, the statutory liquidity ratio, and the
priority sector lending. The banks and financial institutions now have much greater
freedom to deploy the available funds. A number of changes in the structure of the
financial system have also been noted.

The performance of the banking sector has been examined on the basis of
profitability, levels of non-performing assets, capital adequacy ratio, and different
indicators for productivity and efficiency. The available data shows substantial
improvements in profitability of all bank groups after the reforms. With regard to
non-performing assets too, a significant improvement has been made after the
reforms. In mid 90s all bank groups on an average were operating with high level
of NPAs. The position at the beginning of 1990 can be expected to be much
worse. By 2006-2007 all the bank groups had reached a position where they
stand very comfortable even in comparison to the international benchmark of 2%.
For productivity and efficiency three indicators were examined. The intermediation
cost ratio had an overall falling trend. The picture on operating profits per
employee and business per employee is that of an up trend in the post
liberalization years (expect foreign banks where relative values were substantially
high in early 1990s).

After liberalization, the banks (in all groups) have substantially improved their
position in terms of efficiency, productivity and profitability. The maximum gain in
performance has been in case of RRBs in terms of all indicators examined. With
deregulation of rates of interest, there now exist active price competition among
different financial players. With removal of restrictions on entry and exit, a number
of new private and foreign banks have come on the scene.

8-3
The analyses of the banking sector shows that the commercial banks in India have
experienced strong balance sheet growth and have substantially improved their
profit position in the post reform period. The profitability is at distinctly higher levels
for all post-reform years in comparison to years prior to liberalization. Improvement
in the financial health of banks, as reflected in significant improvement in capital
adequacy and improved asset quality, is distinctly visible. All indicators of
productivity that have been examined stand at a much higher level today in
comparison to the years prior to the reforms. It is noteworthy that this progress has
been achieved along with adoption of international best practices in prudential
norms. Technology deepening and flexible human resource management has
largely enabled competitiveness and productivity gains.

Ever since the reform process began in early 1990s, the Indian Capital Market has
witnessed significant qualitative and quantitative changes. Substantial
improvement in terms of various parameters as size of the market, liquidity,
transparency, and efficiency has taken place. The changes in regulatory and
governance framework have brought about an improvement in investor
confidence. Together with these developments on the positive front it also needs
to be noted that with opening up to the foreign sector the stock market has
become much more volatile and vulnerable to foreign disturbances.

8.3 FINANCIAL SYSTEM AND ECONOMIC GROWTH LINKAGES

In order to ascertain whether or not a causal relationship exists between financial

development and economic growth; as a first step all the variables were examined
for stationarity. Since the tests for stationarity have low power, multiple tests were
used i.e. Augmented Dickey–Fuller (ADF), Phillips-Perron (PP) and KPSS. These
tests show the presence of unit root in all four cases. After taking first difference,
all series became stationary. This means all variables are integrated of order one
i.e. I(1). This suggests the possibility of co-integration among variables. The

8-4
Johansen tests (λmax and λtrace) indicate the presence of a single co-integrating
vector. This means all variables are mutually co-integrated. Due to trending nature
of the series, the co-integration test was carried including an intercept and with co-
integrating restrictions imposed. Since the variables are co-integrated, the vector
error correction model was applied to the variables to obtain the results on
relationship. The order p of VAR (p) was chosen with the help of Hannan-Quinn
(HQ) and Schwarz information criteria (SIC). As per HQ and SIC optimal p i.e.
p*= 1. This was closely followed by p = 4 with only a marginal increase in both HQ
and SIC. Theoretically, it seems that where the impact of finance and capital is
involved lag of 1 year is too small a time span to obtain meaningful results.
Moreover with p =1 the model did not yield theoretically expected signs of co-
efficients. So p = 4 was chosen.

Various tests for joint significance were then carried out to examine the impact of
financial development variables on EG and CF and impact of EG on the two
financial variables. These tests indicate that in the long run institutional credit
significantly (at 1% significance level) affects both capital formation and economic
growth positively. This result implies that financial sector reforms have been
instrumental in accelerating economic growth in India. Stock markets do
(weakly) influence economic growth (at 15% and above levels of significance) but
the impact is small and negative. The impact of IMCR on capital formation is
significantly negative (even at 1%).

8.4 LIMTATIONS AND OUTLINE FOR FURTHER RESEARCH

Any statistical study is often constrained by the non-availability of the data relevant
to the analyses. The present study also faced such constrains. Its major limitations
lie in the non-availability of some of the relevant data.

8-5
Ideally institutional finance in an economy should consist of funds obtained from
the banking sector, the non-bank financial institutions, and finance companies. In
addition to these the unregulated credit markets also need to be incorporated. In
case of India, consistent data on credit from NBFCs in totality is not available.
Even in case of financial institutions only partial data is available. In context of
private unregulated credit markets too, reliable and complete information is not
available about their operations as there is no official or unofficial agency to which
such financers report their operations. This represents a big gap in the knowledge
of finance industry and also hampers formulation and effectiveness of credit policy.

In context of the Indian capital markets too, the non- availability of substantial pre
reform data on various indicators has been a constraining factor. Moreover no data
is available on any variable that can act as a proxy for human resource
development as one of the explanatory variable in economic growth.

Another limitation relates to the inferences that can be drawn from different
econometric methodologies. The VAR model used in the analyses, although
capable of incorporating the endogeniety of the variables and the lags, does not
indicate the exact magnitudes of various relationships. Simple OLS or GLS
techniques that may give such magnitudes will not be able to give otherwise
satisfactory results due to enogeniety of the explanatory variables. One of the two
things has to be sacrificed. Moreover most of the test results are valid
asymptotically. Their reliability in small samples is open to question.

The limitations pointed above are not peculiar to this study but are true for any
statistical study. The only way to take care of these limitations is to interpret the
results with due care keeping in mind these limitations.

8-6
Subject to various limitations of data and otherwise the present study has been
able to obtain important insights into the impact of reforms of one of the important
segment of the economy. The financial sector has been found to be a crucial
element in the country’s growth process. One can carry on similar analysis further
into many related areas. One can for instance assess the impact of these reforms
on the growth of industrial sector, on the performance of priority sector after the
curtailment of financial assistance to them under the reforms. Inter-regional or
international comparisons can be made. In fact it is even possible to build a
suitable growth model proceeding on similar lines.

8-7
8-8
 APPENDIX

VECTOR ERROR CORRECTION MODEL

Dependent variables:
X(1) = EG
X(2) = ICR
X(3) = IMCR
X(4) = CF

Information criteria:

p Hannan-Quinn Schwarz

1 8.96847E+00 9.64292E+00
2 1.01662E+01 1.14066E+01
3 1.05833E+01 1.24154E+01
4 9.15985E+00 1.16121E+01
5 Not available due to singularity!
6 Not available due to singularity!
7 Not available due to singularity!
8 Not available due to singularity!
9 Not available due to singularity!

p = 1 1

Remark: These estimates of p are only asymptotically correct.

Chosen VAR (p) order: p = 4

VECM (4):
(Co-integrating restrictions on the intercept parameters imposed)

X(t)-X(t-1) = A(1)(X(t-1)-X(t-2)) + .... + A(3)(X(t-3)-X(t-4) + a.b'(X(t-4)',1)' + U(t),

where:

1: X(t) is a 4-vector with components:

X(1,t) = EG(t)
X(2,t) = ICR(t)
X(3,t) = IMCR(t)
X(4,t) = CF(t)

A1
2: b'(X(t-4)',1)' = e(t-4), say, is the 1-vector of error correction
terms, with b the 5x1 matrix of co-integrating vectors: b =
-0.2832984834
0.3007602624
-0.0027729695
-0.0200845925
1

3: U(t) is the 4-vector of error terms.

4: a and the A(.)'s are conformable parameter matrices,

5: t = 34(=1984),...,57(=2007).

LR test of the null hypothesis that the imposed restrictions on the intercept
parameters hold:

Test statistic = 2.82

Asymptotic null distribution: Chi-square (3)
p-value = 0.42033
Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: accept accept

WARNING:
Rejection of the null hypothesis involved implies that the test results regarding the number of
co-integrating vectors are invalid!

The co-integrating vectors are calculated without imposing

restrictions on the intercept parameters.

Standardized co-integrating vector:

-0.9732212 EG
1 ICR
-0.0112285 IMCR
-0.0568572 CF

Remark: This result will be used to test restrictions on the co-integrating vector.

VECM(4):

A2
(No co-integrating restrictions on the intercept parameters imposed)

X(t)-X(t-1) = A(1)(X(t-1)-X(t-2)) + .... + A(3)(X(t-3)-X(t-4) + a.b'X(t-4) + c + U(t),

where:

1: X(t) is a 4-vector with components:

X(1,t) = EG(t)
X(2,t) = ICR(t)
X(3,t) = IMCR(t)
X(4,t) = CF(t)

2: b'X(t-4) = e(t-4), say, is the 1-vector of error correction

terms, with b the 4x1 matrix of co-integrating vectors: b =
-0.9732212041
1
-0.0112284847
-0.056857211

3: c is a 4-vector of constants,

4: U(t) is the 4-vector of error terms.

5: a and the A(.)'s are conformable parameter matrices,

6: t = 34(=1984),...,57(=2007).

ML estimation results for the VECM:

Parameter names:
Elements of the matrix A(k): A(i,j,k), k=1,..,3
Components of the vector a: a(i)
Components of the vector c: c(i)

Equation 1: DIF1 [EG]

Parameter ML estimate t-value [p-value]
A(1,1,1) -1.104672 -6.43 [0.00000]
A(1,2,1) 0.331199 1.26 [0.20849]
A(1,3,1) -0.019267 -0.76 [0.44697]
A(1,4,1) 0.092875 0.54 [0.59148]
A(1,1,2) -1.392917 -4.93 [0.00000]
A(1,2,2) 0.791142 1.86 [0.06286]
A(1,3,2) -0.071800 -1.84 [0.06644]
A(1,4,2) 0.058004 0.28 [0.77707]

A3
A(1,1,3) -2.298392 -5.84 [0.00000]
A(1,2,3) 2.614375 5.69 [0.00000]
A(1,3,3) -0.051423 -1.31 [0.19184]
A(1,4,3) -0.229117 -0.99 [0.32435]
a(1) 2.875424 5.06 [0.00000]
c(1) 9.141778 5.10 [0.00000]

s.e.: 1.84410E+00
R-Square: 0.7974
n: 24

Equation 2: DIF1 [ICR]

Parameter ML estimate t-value [p-value]
A(2,1,1) 0.139108 1.01 [0.31205]
A(2,2,1) -0.312954 -1.48 [0.13765]
A(2,3,1) 0.001343 0.07 [0.94721]
A(2,4,1) 0.130643 0.94 [0.34566]
A(2,1,2) -0.115962 -0.51 [0.60830]
A(2,2,2) -0.508544 -1.49 [0.13526]
A(2,3,2) -0.032033 -1.02 [0.30635]
A(2,4,2) 0.419666 2.56 [0.01050]
A(2,1,3) -0.671351 -2.13 [0.03321]
A(2,2,3) 1.406204 3.82 [0.00013]
A(2,3,3) 0.017245 0.55 [0.58456]
A(2,4,3) -0.360137 -1.94 [0.05297]
a(2) 1.020619 2.25 [0.02473]
c(2) 3.510254 2.45 [0.01441]

s.e.: 1.47626E+00
R-Square: 0.7777
n: 24

Equation 3: DIF1 [IMCR]

Parameter ML estimate t-value [p-value]
A(3,1,1) -3.065838 -2.61 [0.00901]
A(3,2,1) -3.545070 -1.97 [0.04869]
A(3,3,1) -1.494928 -8.64 [0.00000]
A(3,4,1) 6.435975 5.45 [0.00000]
A(3,1,2) -7.439766 -3.85 [0.00012]
A(3,2,2) 5.773524 1.99 [0.04684]
A(3,3,2) -1.273772 -4.77 [0.00000]
A(3,4,2) 2.391558 1.71 [0.08738]
A(3,1,3) -11.634301 -4.33 [0.00002]
A(3,2,3) 7.885069 2.51 [0.01201]
A(3,3,3) -1.061577 -3.95 [0.00008]

A4
A(3,4,3) 0.512855 0.32 [0.74668]
a(3) 14.346596 3.70 [0.00022]
c(3) 45.806650 3.74 [0.00018]

s.e.: 1.25941E+01
R-Square: 0.8707
n: 24

Equation 4: DIF1 [CF]

Parameter ML estimate t-value [p-value]
A(4,1,1) -0.039676 -0.25 [0.80319]
A(4,2,1) -0.184711 -0.76 [0.44882]
A(4,3,1) -0.002032 -0.09 [0.93100]
A(4,4,1) 0.050489 0.32 [0.75274]
A(4,1,2) -0.452354 -1.73 [0.08398]
A(4,2,2) 1.506966 3.83 [0.00013]
A(4,3,2) -0.075164 -2.07 [0.03802]
A(4,4,2) 0.078623 0.41 [0.67859]
A(4,1,3) -1.279414 -3.51 [0.00045]
A(4,2,3) 1.552648 3.65 [0.00027]
A(4,3,3) -0.155316 -4.26 [0.00002]
A(4,4,3) 0.221607 1.03 [0.30336]
a(4) 2.646299 5.03 [0.00000]
c(4) 8.909417 5.37 [0.00000]

s.e.: 1.70791E+00
R-Square: 0.7948
n: 24

[The p-values are two-sided and based on the normal approximation]

ML estimate of the variance matrix of U(t):

1.416965723 -0.1309069751 -2.5254914557 -0.3030783608
-0.1309069751 0.9080572362 2.9999401248 0.6968596189
-2.5254914557 2.9999401248 66.0877568123 3.5395285526
-0.3030783608 0.6968596189 3.5395285526 1.2154045113

Error correction term = ICR(-4)

-0.973221*EG(-4)
-0.011228*IMCR(-4)
-0.056857*CF(-4)

Null hypothesis: The vector H is a co-integrating vector, where H is a

nonzero 4 x 1 vector.

A5
H:
-1
1
-0.0112284847
-0.056857211
Null hypothesis: H is also a co-integrating vector.

LR test: Test statistic = 0.05. Null distr.: Chi-square(3)

Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: accept accept
p-value = 0.99677

Re-estimation of the VECM under the null hypothesis

VECM(4):
(No co-integrating restrictions on the intercept parameters imposed)

X(t)-X(t-1) = A(1)(X(t-1)-X(t-2)) + .... + A(3)(X(t-3)-X(t-4) + a.b'X(t-4) + c + U(t),

where:

1: X(t) is a 4-vector with components:

X(1,t) = EG(t)
X(2,t) = ICR(t)
X(3,t) = IMCR(t)
X(4,t) = CF(t)

2: b'X(t-4) = e(t-4), say, is the 1-vector of error correction

terms, with b the 4x1 matrix of co-integrating vectors: b =
-1
1
-0.0112284847
-0.056857211

3: c is a 4-vector of constants,

4: U(t) is the 4-vector of error terms.

5: a and the A(.)'s are conformable parameter matrices,

6: t = 34(=1984),...,57(=2007).

ML estimation results for the VECM:

Parameter names:
Elements of the matrix A(k): A(i,j,k), k=1,..,3

A6
Components of the vector a: a(i)
Components of the vector c: c(i)

Equation 1: DIF1 [EG]

Parameter ML estimate t-value [p-value]
A(1,1,1) -1.118160 -6.56 [0.00000]
A(1,2,1) 0.343896 1.33 [0.18432]
A(1,3,1) -0.019229 -0.77 [0.44069]
A(1,4,1) 0.097660 0.57 [0.56741]
A(1,1,2) -1.421818 -5.06 [0.00000]
A(1,2,2) 0.797447 1.90 [0.05709]
A(1,3,2) -0.072506 -1.88 [0.06004]
A(1,4,2) 0.069396 0.34 [0.73186]
A(1,1,3) -2.340765 -5.97 [0.00000]
A(1,2,3) 2.600181 5.77 [0.00000]
A(1,3,3) -0.051925 -1.34 [0.18014]
A(1,4,3) -0.217579 -0.95 [0.34367]
a(1) 2.852029 5.20 [0.00000]
c(1) 9.488777 5.23 [0.00000]

s.e.: 1.81928E+00
R-Square: 0.8028
n: 24

Equation 2: DIF1 [ICR]

Parameter ML estimate t-value [p-value]
A(2,1,1) 0.142290 1.02 [0.30592]
A(2,2,1) -0.304437 -1.44 [0.14964]
A(2,3,1) 0.002057 0.10 [0.91944]
A(2,4,1) 0.128003 0.92 [0.35814]
A(2,1,2) -0.110588 -0.48 [0.62959]
A(2,2,2) -0.518786 -1.52 [0.12915]
A(2,3,2) -0.031089 -0.99 [0.32290]
A(2,4,2) 0.419743 2.54 [0.01106]
A(2,1,3) -0.661331 -2.07 [0.03859]
A(2,2,3) 1.386707 3.77 [0.00016]
A(2,3,3) 0.018734 0.59 [0.55329]
A(2,4,3) -0.361226 -1.93 [0.05394]
a(2) 0.974689 2.18 [0.02944]
c(2) 3.510428 2.37 [0.01759]

s.e.: 1.48395E+00
R-Square: 0.7753
n: 24

A7
Equation 3: DIF1 [IMCR]
Parameter ML estimate t-value [p-value]
A(3,1,1) -3.018790 -2.52 [0.01164]
A(3,2,1) -3.424185 -1.88 [0.05981]
A(3,3,1) -1.484684 -8.48 [0.00000]
A(3,4,1) 6.397603 5.33 [0.00000]
A(3,1,2) -7.359675 -3.73 [0.00019]
A(3,2,2) 5.625917 1.91 [0.05597]
A(3,3,2) -1.260149 -4.65 [0.00000]
A(3,4,2) 2.391486 1.68 [0.09270]
A(3,1,3) -11.486169 -4.17 [0.00003]
A(3,2,3) 7.606792 2.40 [0.01631]
A(3,3,3) -1.040158 -3.82 [0.00013]
A(3,4,3) 0.496042 0.31 [0.75854]
a(3) 13.690020 3.55 [0.00038]
c(3) 45.773314 3.60 [0.00032]

s.e.: 1.27769E+01
R-Square: 0.8669
n: 24

Equation 4: DIF1 [CF]

Parameter ML estimate t-value [p-value]
A(4,1,1) -0.040488 -0.25 [0.80194]
A(4,2,1) -0.167188 -0.68 [0.49568]
A(4,3,1) -0.000977 -0.04 [0.96703]
A(4,4,1) 0.048578 0.30 [0.76397]
A(4,1,2) -0.456196 -1.71 [0.08669]
A(4,2,2) 1.494601 3.76 [0.00017]
A(4,3,2) -0.074074 -2.03 [0.04256]
A(4,4,2) 0.083333 0.43 [0.66404]
A(4,1,3) -1.281932 -3.45 [0.00056]
A(4,2,3) 1.518537 3.55 [0.00038]
A(4,3,3) -0.153351 -4.18 [0.00003]
A(4,4,3) 0.224679 1.03 [0.30198]
a(4) 2.569997 4.94 [0.00000]
c(4) 9.049730 5.27 [0.00000]

s.e.: 1.72344E+00
R-Square: 0.7910
n: 24

[The p-values are two-sided and based on the normal approximation]

A8
ML estimate of the variance matrix of U(t):
1.3790761789 -0.1238779953 -2.4207270359 -0.3081396486
-0.1238779953 0.9175504514 3.1354207665 0.7135158378
-2.4207270359 3.1354207665 68.020783547 3.7790314691
-0.3081396486 0.7135158378 3.7790314691 1.2376078394

Error correction term = ICR(-4)

- EG(-4)
-0.011228*IMCR(-4)
-0.056857*CF(-4)

TESTS OF JOINT SIGNIFICANCE

Test of significance of the impact of institutional credit on economic growth

A(1,2,1) 0.343896 1.33 [0.18432](*)

A(1,2,2) 0.797447 1.90 [0.05709](*)
A(1,2,3) 2.600181 5.77 [0.00000](*)

Null hypothesis that the parameters indicated by (*) are jointly zero:
Wald test: 39.10
Asymptotic null distribution: Chi-square(3)
p-value = 0.00000
Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: reject reject

Test of significance of the impact of institutional credit on capital formation

A(4,2,1) -0.167188 -0.68 [0.49568](*)

A(4,2,2) 1.494601 3.76 [0.00017](*)
A(4,2,3) 1.518537 3.55 [0.00038](*)

Null hypothesis that the parameters indicated by (*) are jointly zero:
Wald test: 22.88
Asymptotic null distribution: Chi-square(3)
p-value = 0.00004
Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: reject reject

Test of significance of the impact of economic growth on institutional credit

A(2,1,1) 0.142290 1.02 [0.30592](*)

A9
A(2,1,2) -0.110588 -0.48 [0.62959](*)
A(2,1,3) -0.661331 -2.07 [0.03859](*)

Null hypothesis that the parameters indicated by (*) are jointly zero:
Wald test: 16.33
Asymptotic null distribution: Chi-square(3)
p-value = 0.00097
Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: reject reject

Test of significance of the impact of market capitalization ratio on economic

growth

A(1,3,1) -0.019229 -0.77 [0.44069](*)

A(1,3,2) -0.072506 -1.88 [0.06004](*)
(1,3,3) -0.051925 -1.34 [0.18014](*)

Null hypothesis that the parameters indicated by (*) are jointly zero:
Wald test: 5.55
Asymptotic null distribution: Chi-square(3)
p-value = 0.13542
Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: accept accept

Test of significance of the impact of market capitalization ratio on capital

formation

A(4,3,1) -0.000977 -0.04 [0.96703](*)

A(4,3,2) -0.074074 -2.03 [0.04256](*)
A(4,3,3) -0.153351 -4.18 [0.00003](*)

Null hypothesis that the parameters indicated by (*) are jointly zero:
Wald test: 20.89
Asymptotic null distribution: Chi-square(3)
p-value = 0.00011
Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: reject reject

Test of significance of the impact of on economic growth on market

capitalization ratio

A10
A(3,1,1) -3.018790 -2.52 [0.01164](*)
A(3,1,2) -7.359675 -3.73 [0.00019](*)
A(3,1,3) -11.486169 -4.17 [0.00003](*)

Null hypothesis that the parameters indicated by (*) are jointly zero:
Wald test: 17.65
Asymptotic null distribution: Chi-square(3)
p-value = 0.00052
Significance levels: 10% 5%
Critical values: 6.25 7.81
Conclusions: reject reject

A11
A12
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