Financial sector reforms

• Refers to the reforms in the banking system and financial markets.

• Financial sector reforms involve instituting policies which will increase the
allocative efficiency of available saving, promote growth of real sector,
and enhance the health, stability, profitability and viability of financial
institutions.
• The reforms refers to the policy of reducing or removing completely the
legal restrictions, physical or administrative or direct controls, ceilings on
interest rates, restrictions on flow of funds, official directives regarding
sectoral and other allocations of funds, restrictions on the scope of
activities of banks and other financial institutions and so on..
• An efficient banking system and a well functioning of financial markets
are essential to mobilize savings and to channel them to productive uses.
• The main objectives of the financial sector reforms are to allocate the
resources efficiently, increasing the return on investment and
accelerated growth of the real sectors in the economy.
Financial sector before reforms
• Until the beginning of the 1990s, the state of the financial sector in India could be
described as a classic example of ‘financial repression’. The sector was characterized by
1. Administered interest rates:the interest rate was regulated and controlled by the
central bank and government of the country.
2. Opaque accounting norms and limited disclosure: There were general concerns
about their viability. Insurance companies both life and non-life were all publicly
owned and offered very little product choice
3. Complex regulations and extensive restrictions:: In the securities market, new equity
issues were governed by a plethora of complex regulations and extensive restrictions.
Less transperancy. Interest rates on government securities, the pre-dominant segment
of fixed-income securities, were decided through administered fiat. There was little
depth in the foreign exchange market as most such transactions were governed by
inflexible and low limits and also prior approval requirements.
4. Capitalization levels were low: The lack of commercial
considerations in credit planning and weak recovery culture
resulted in large accumulation of non-performing loans. This had no
impact on the confidence of depositors, however, because of
government ownership of banks and financial intermediaries
5. Predominance of government securities:
6. Limited external capital flows: Such a closed-economy set-up kept
debt markets underdeveloped and devoid of any competitive
forces. In addition, there was hardly any secondary market for
government securities, and such transactions were highly opaque
and operated through over-the-telephone deals
7. Phase of nationalization and ‘social control’ of financial
intermediaries:
• The initiation of financial reforms in the country during the early
1990s was to a large extent conditioned by the analysis and
recommendations of various committees and working group’s setup
to address specific issues
• The financial sector reforms have received special attention as part of
NEP of 1991.
• Immediately after the announcement of NEP, the government has
appointed a high level committee under the chairmanship of M
Narasimham, on financial system, to examine all aspects relating to
the structure, organisation, functions and procedures of the financial
system.
• The committee has submitted its report in November 1991.
Recommendations of Narasimham committee
• Reductions in the CRR and SLR: Narasimham committee recommended reducing both these requirements as
it was very high and created an undue burden on financial institutions. It advocated reducing SLR from
38.5% to 25% and CRR from 15% to 3-5%.
• Priority sector lending: The main reason for the reduced profitability of the commercial banks in India was
the priority sector lending.
• Set up tribunals for recovering loans of NPA: The proportion of bad loans and non-performing assets was
very high in the financial sector. In light of these, the committee recommended the creation of an asset
reconstruction fund (ARF) tribunal. The ARF would assume a percentage of these bad debts and help clean
the balance sheets of banks and other financial institutions
• Deregulations of interest rates: In the Indian financial system, interest rates were controlled by the
government. However, the committee recommended phasing out government controls to achieve better
efficiency and productivity. Instead, interest rates should be organically determined by demand and supply
market forces.
• Removal of dual control: Regulation of banks was under the dual control of the Ministry of Finance banking
department and the Reserve Bank of India. It created avoidable problems in the bank’s functioning and
hampered the efficiency of the overall financial system. The Narasimham committee recommended
entrusting the Reserve Bank of India with the sole responsibility of regulating banks and financial services
• More freedom to banks: The Narasimham committee was selected to usher
in banking sector reforms. It did so by advocating more freedom for banks
and other financial institutions. Managing directors and boards of governors
of respective banks should be given adequate leverage to undertake certain
actions necessary to improve banks' financial health and enhance efficiency.
• Reorganisation of banking sector: Entry of new private banks and foreign
banks in the banking system. Under this, it said that public sector banks
should be rationalized by carrying out mergers and acquisitions. Apart from
this, RBI should license private banks if they meet regulatory criteria and
conditions. It also recommended allowing foreign banks to join with Indian
partners in the investment banking segment.
Objectives
• To develop a market oriented, competition, world integrated, diversified,
autonomous and transparent financial system
• To increase the allocative efficiency of available savings and to promote accelerated
growth in the real sector
• To increase effectiveness, accountability, profitability, viability, vibrancy, balanced
growth, operational economy and flexibility, professionalism in the financial sector.
• To increase rate of return on investment
• To promote competion and facilitating free entry and exit for the participants
• To ensure that the interest rates are flexible
• To build a financial structure relating to supervision, audit, technology and legal
matters
• To modernise the instruments of monetary control
• The financial sector reforms includes the following:
1. Liberalisation: Liberalisation was introduced to put an end to the restrictions and open
various sectors of the economy. All banks and other financial institutions in India are
regulated through various norms and regulations of the RBI. financial sector may be
allowed to take decisions on many matters without consulting the RBI. The reform
policies led to the establishment of private sector banks, Indian as well as foreign.
Foreign investment limit in banks was raised to around 74 per cent. Foreign Institutional
Investors (FII), such as merchant bankers, mutual funds and pension funds, are now
allowed to invest in Indian financial markets.
2. Privatisation: Private sector allowed to set up banks, MFs, Money market MFs, ,
insurance companies and so on. Public sector banks permitted to diversify their
ownership
3. Prudential regulation: Prudential regulations refers to a set of laws and rules designed
to minimize the risks banks assume and to ensure the safety and soundness of both
individual institutions and the system as a whole. These reforms were launched as part
of the banking sector reforms of the 1990s. Examples of prudential regulation include
lending limits, minimum capital adequacy guidelines, liquidity ratios, NPA norms etc
4. Integration: Among globalisation, deregulation and advances in information technology
national stock markets have arisen as the major network. It is basically for financial
integration of emerging market economies.
5. Internationalisation and globalisation: capital inflows and outflows and international
financial relations
6. Securitisation
7. Reduction in Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR): SLR reduced
from 38.5% to 20.75% and CRR reduced from 15% to 4 %
8. End of Administered Interest Rate Regime: Most of the interest rate in the economy are
deregulated and moved towards market rates
9. Prudential Norms: High Capital Adequacy Ratio: Capital Adequacy Ratio (CAR) is the ratio of
a bank’s capital in relation to its risk weighted assets and current liabilities. It is decided by
central banks and bank regulators to prevent commercial banks from taking excess leverage
and becoming insolvent in the process. However, as per RBI norms, Indian scheduled
commercial banks are required to maintain a CAR of 9% while Indian public sector banks are
emphasized to maintain a CAR of 12%.

10. Competitive Financial System: entry of private sector financial institutions led to the
competition
11. A foreign bank may operate in India
• as foreign bank branches
• as a subsidiary of a foreign bank which is wholly owned by the Indian bank
• As a subsidiary of a foreign bank within which maximum foreign investment by 74%
12. Non-Performing Assets (NPA) and Income Recognition Norm: recovery of bad debts due to Banks and
Financial Institutions Act 1993, passed to set up special recovery tribunals to facilitate quicker recovery. Lok
adalats. Measures taken to reduce non-performing assets include restructuring at the bank level, recovery of
bad debt through Lok Adalats, Civil Courts, setting up of Recovery Tribunals and compromise settlements.
Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest’ (SARFAESI). Under
this Act, Debt Recovery Tribunals have been set up which will facilitate the recovery of bad debts by the
banks. As a result of the above measures gross NPA declined

13. Elimination of Direct Credit Controls: Under selective credit controls RBI used to control through the
system of changes in margin for provision of bank credit to traders against stocks of sensitive commodities
and to stock brokers against shares. As a result, there is now greater freedom to both the banks and
borrowers in respect of credit.
14. Promoting Micro-Finance to Increase Financial Inclusion: To promote financial inclusion the
government has started the scheme of micro finance. Though there are different models for
pursuing micro-finance, the Self-Help Group (SHG)-Bank Linkage Programme has emerged as the
major micro-finance programme in the country. It is being implemented by commercial banks,
regional rural banks (RRBs), and cooperative banks.
16. Reforms in government debt market: t a functioning G-Sec debt market was really
initiated in the 1990s. The system had to essentially move from a strategy of pre-emption of
resources from banks at administered interest rates and through monetization to a more
market oriented system. ver the past few years numerous steps have been taken to broaden
and deepen the government securities market and to raise the levels the transparency.
Automatic monetization of the government’s deficit has been phased out and the market
borrowings of the central government are presently undertaken through a system of
auctions at market-related rates. Legislative provisions, technology development, market
infrastructure such as settlement systems, trading systems and the like have all to be
developed. Various treasury bills were introduced
17. Reforms in foreign exchange market: The move towards a market-based exchange rate
regime in 1993 and the subsequent adoption of current account convertibility were the key
measures in reforming the Indian foreign exchange market. Authorized dealers of foreign
exchange have been allowed to carry on a large range of activities. Banks have been given
large autonomy to undertake foreign exchange operations. In order to deepen the foreign
exchange market, a large number of products have been introduced and entry of newer
players has been allowed in the market.
18. Reforms in banking sector: interest rates on deposits and advances has been
deregulated. Nationalised banks were enabled to access capital market.
Prudential norms. Greter freedom to banks with respect to its operations.
Privatisation. Banking ombudsman scheme, lok adakats, civil courts etc
19. Reforms in derivatives market: various types of derivative contracts have
been introduced. Technical advisory committee. Standardisation of various
contracts etc.
20. Reforms in primary and secondary markets: underwriting of public issues.
Depositories act of 1996 to provide legal framework. Stock lending scheme was
implemented. Modification of listing agreements. SEBI framed guidelines. PAN
requirement for all demat accounts. International financial reporting standards
adoption, introduction of various types of stocks etc.
Impacts
• The operational profits of the commercial banks were increased
• The assest quality of Indian banking system has improved
• The financial performance of SCBs had also improved
• Improvements in the efficiency of the banking system
• Encouraged productivity of banking sector
• It increased competition
• Reforms in derivatives market helped the participants to manage risk
• Efficiently managed inflation rate in the economy
• Reflected strong growth prospects in Indian economy.
• Risk management practices of banks were improved
• The BoP composition has undergine significant changes
• Current account surplus
• Allowed for flexibility in the determination of exchange rate
• It has increased competition among the banks
• It has quickened the pace of structural transformation of IFS