Research paper - Introduction to financial liberalization, financial repression, benefits of financial liberalization, financial liberalization in India, MAJOR FINANCIAL SECTOR REFORMS CARRIED OUT IN INDIA SINCE 1991, OVERALL IMPACT OF THE REFORMS ON FINANCIAL SECTOR OF INDIA SINCE 1991.

1. FINANCIAL LIBERALIZATION, MAJOR FINANCIAL REFORMS
CARRIED OUT IN INDIA AND THEIR IMPACT ON FINANCIAL SECTOR
PRESENTED BY:
Simran Kaur
Muskan Khurana
INTRODUCTION
The post era of world war II witnessed the time of financial repression. Extensive control or
intervention in the finance sector of a country is characterized as financial repression. Many
critical decisions such as credit allocation, interest rate ceilings, control of the capital account of
the country, exchange rates, entry of new institutions in the banking sector were in the hands
of the government instead of markets. It had various limitations such as undervalued real
interest rates due to the administered interest rates, allocation of credit to big companies,
inefficient allocation of resources, and so on which in turn resulted in slow growth and forced
the emerging market countries to liberalize their economies.
This paper focuses on understanding financial liberalization and its advantages and
disadvantages in brief. It looks up to the factors which made the implementation of financial
liberalization necessary in India and the strategy adopted by India. Further, it studies the major
financial reforms carried out on external and internal fronts in India and their effect on the
financial sector.
FINANCIAL LIBERALIZATION
The meaning of financial liberalization is the withdrawal of intervention by the government on
the financial sector of its country. Financial Liberalization covers a whole set of measures and
includes eliminating restrictions on the financial sector, such as removal of bank interest rate
ceilings, fixed exchange rate, credit allocation decisions, compulsory reserve requirements, and
barriers to entry, providing free movement to finance in the country.
In the past three decades, all industrial and emerging market countries have taken steps
toward liberalizing its financial systems.
The transition to financial liberalization from the era of financial repression had various
benefits like:
➔ Mobilization of savings at both local and international level
➔ Being able to invest more than the level of domestic savings by allowing foreign direct
investment in the financial sector.
➔ Advanced technology associated with foreign investment.
➔ Increasing competition for banks and financial institutions.
➔ Strengthening of policies and supervisory framework.
➔ Reducing control over credit allocation.
➔ Promoting the growth of financial markets.
And hence, focusing on the growth of the economy which was the main objective.

2. But the other side of the coin, which was argued by the opponents of financial liberalization, is
that government alone is capable enough to handle economic activities efficiently and
liberalization can lower down the earnings of government which would affect the growth of the
economy contrary to the purpose of liberalization. Also, it may lead to financial crises as the
markets would be vulnerable, for example, it may favor excessive borrowings. Chile, in 1981
soon after the deregulation of its banking sector and Argentina, in 2001 after taking major
financial liberalization measures witnessed major financial crises.
FINANCIAL LIBERALIZATION IN INDIA
Both the pace and scope of implementation of financial liberalization varied from one country
to another, so we would be focusing majorly on India.
During the 1970s and 1980s in India, financial repression was a mix of nationalism, populism,
politics, and corruption.
Financial liberalization in India was initiated in the year 1991.
Following are the broad reasons which led India to liberalize its economy:
➔ After independence, India had adopted the planned economy model for rapid economic
development based on the ​Mahalanobis model which started showing its limitations in
the mid-1980s.
➔ The growth rate was around 3.5 before the 1980s and reached 5% in the mid-1980s
which was still inefficient to solve the financial problems of the country.
➔ The government had gone by the strategy of fiscal activism which resulted in heavy
expenditure and borrowings.
➔ The nationalization of banks had led to a lack of transparency and professionalism.
➔ Inefficient management of the financial sector and the technology used was also
outdated.
➔ Foreign exchange reserves had started reducing and India started facing problems
regarding its balance of payment in 1985 and by the end of 1990, India was in a serious
economic crisis.
During the year 1991, P.V. Narasimha Rao, then prime minister, and Dr. Manmohan Singh, then
finance minister were the architects of economic liberalization. When they introduced the idea
of liberalization, they had to face a lot of criticisms, but the oppositions were also aware of the
crises, so even with minimal support, the government started introducing reforms.
The strategy adopted by India to introduce reforms:
➔ Learned from the best practices adopted internationally and adjusted them as per the
need of the country.
➔ Instead of bringing drastic changes, reforms were introduced and implemented
gradually to avoid discontinuity and imbalance in the financial sector.
➔ The First generation reforms aimed to create an efficient and profitable financial sector.
➔ The second-generation reforms aimed to strengthen the financial sector by
implementing structural improvements.
➔ Consensus driven approach came into the picture for liberalization which was necessary
gradually to avoid discontinuity and imbalance in the financial sector for a democratic
country like India.

3. MAJOR FINANCIAL SECTOR REFORMS CARRIED OUT IN INDIA SINCE 1991
Financial sector reforms include all kind of reforms associated with the banking sector, capital
market, government debt market, and foreign exchange market and we will talk about each
one of these categories in detail:
THE NARASIMHAM COMMITTEE:
The Narasimham committee was established in August 1991 to give recommendations on the
financial sector in India which included capital market and banking sector reforms. The major
recommendations by the committee involved lowering down of CRR and SLR,
recommendations about priority sector lending, deregulation of the interest rate, setting up
tribunals for recovery of NPA, and entry of private banks in the country.
BANKING SECTOR REFORMS:
1. Reduction in CRR and SLR:​ ​Legal reserve ratios play a key role in determining a bank’s
lending capacity which in turn determines the growth of the economy. It was suggested
by Narasimha Committee and SLR was reduced from as high as 39% to present 18% and
CRR was reduced from 15% to present 3%.
2. Change in Regulated Interest Rates: ​Prior to these reforms, the power to decide the
interest was with RBI and the purpose of such concentration of power was to make sure
that loans to the priority sectors such as agriculture and government were provided at
concessional rates. But, now this system of regulated and selective credit lending has
been done away with. However, RBI still controls the interest rates on loans less than 2
lakhs.
3. Increasing Competitiveness in the Banking Sector: ​ All the entry barriers on the private
sector for entering into the banking system were removed and new establishments like
HDFC bank, ICICI Bank, IDBI Bank, Corporation bank, etc. came into the picture to
improve the efficiency of the banking system. Even foreign banks were allowed to
operate in India in the following ways :
➔ By opening their branch
➔ By owning a wholly-owned subsidiary
➔ By having a subsidiary with maximum capital investment up to 74%.
This paved the way for banks like CITI Bank, American Bank, American Express, etc.
opening up their branches in India.
4. Promotion of Microfinance for Financial Inclusion​: To promote the objective of
financial inclusion and to link the unorganized sector with the formal banking system,
the microfinance scheme was introduced .No specific model was prescribed in reforms
but banks were given autonomy to design their own model.
There has been the introduction of various models but one of the major models was
Self Help Group Linkage Programme under which all the members who were part of
some specific SHG (usually 15-20 members) could deposit their savings in the banks and
take loans multiple times of their deposits from commercial banks, regional rural banks,

4. cooperative banks, etc. Whatever loans are issued under this system, are considereds
priority sector advance.
5. Non -Performing Assets and Income Recognition Norms:​ Non-performing assets are
those assets whose due installment has not been paid up for 90 days. A large quantity
of non-performing assets lowers down the profitability of the bank, so RBI brought
income recognition norms into the picture as per which if the income on the asset is not
received within two quarters from the last date, it will not be recognized. Furthermore,
recovery of bad debts was taken care of by Lok adalats, Civil courts, setting up of
Recovery Tribunals, and compromise settlements. ​The recovery of bad debt got a great
boost with the enactment of ‘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.
6. ​Capital Adequacy Ratio:​ ​In order to ensure financial stability, prudential norms with
respect to capital adequacy ratio were introduced. The capital adequacy ratio is the
ratio between the paid-up capital and reserves to the deposits of the bank.​ ​The capital
base of Indian banks has been very much lower by international standards and in fact,
declined over time​.
As a part of financial sector reforms, a capital adequacy norm of 8 percent based on a
risk-weighted asset ratio system has been introduced in India. Indian banks that have
branches abroad were required to achieve this capital-adequacy norm by March 31,
1994. Foreign banks operating in India had to achieve this norm by March 31, 1993.
Other Indian banks had to achieve this capital adequacy norm of 8 percent at the latest
by March 31, 1996. Banks were advised by RBI to review their existing level of capital
funds as compared to the prescribed capital adequacy norm and take steps to increase
their capital base in a phased manner to achieve the prescribed norm by the stipulated
date.
It may be noted that Global Trust Bank (GTB), a private sector bank, whose operations
had to be stopped by RBI on July 24, 2004, had a capital adequacy ratio much below the
prescribed prudent capital adequacy ratio norm. In this regard, the link between capital
adequacy and provisioning is worth noting. Capital adequacy norms can be met by the
banks after ensuring that adequate capital provisions have been made.
FOREIGN EXCHANGE MARKET REFORMS:
1. One of the most important steps was the devaluation of the currency and it was
intended at correcting the balance of payment by increasing the inflow of foreign
exchange which in turn was achieved by export promotion.
2. The foreign exchange Regulation Act, 1973 was replaced by the foreign exchange
management act, 1999 for providing greater freedom to the exchange markets.
3. Foreign institutional investors and non-resident Indians were allowed to trade
exchange-traded derivatives.
4. The commercial banks were now allowed to undertake operations in foreign exchange.

5. GOVERNMENT DEBT/SECURITIES MARKET REFORMS :
The government debt market has undergone a huge transformation since 1991. Its
development since 1991 can be divided into two subphases i.e. 1991-1996 and post-1996.
During the first phase, the idea while introducing the reforms was to facilitate borrowing from
the market. The following major reforms were introduced during this period:
1. Commenced the auction of central government securities on the prices determined by
the market itself.
2. 91-day treasury bills were introduced to maintain liquidity and meet short term
financial needs.
3. Delivery versus payment method was introduced to reduce the settlement risk and
ensure transparency in the transactions.
4. The automatic monetization of debt was restricted by fixing caps on the issuance of the
Ad Hoc treasury bill.
During the second phase, the main focus of reforms introduced was to have a market
microstructure. The major reforms introduced since 1996 are as follows:
5. The technical advisory committee was formed to advise the central bank on developing
the government debt market.
6. The automatic monetization of debt was completely abolished by discontinuing the
issuance of Adhoc bills.
7. Allowing foreign institutional investors to invest in government securities, in both
primary and secondary markets.
8. The system of repo was introduced to be able to cater to short term liquidity
adjustments.
OTHER IMPORTANT FINANCIAL SECTOR REFORMS:
1. Some key steps were taken for non-banking financial companies to improve
their productivity, efficiency, and competitiveness, and they were brought under
the regulation of the Central Bank. Many of the other intermediaries were
brought under the supervision of the Board of Financial Supervision.
2. The monopoly of UTI was ended in 1992 and the private sector was opened up
for mutual funds. The mutual funds are now regulated by SEBI Mutual Fund
Regulations 1996 and its amendments.
3. The Indian capital markets were opened for foreign institutional investors in
1992.
4. In NSE in 1994 and BSE in 1995, electronic trading was introduced.

6. OVERALL IMPACT OF THE REFORMS ON FINANCIAL SECTOR OF
INDIA SINCE 1991
In the following charts, we would try to have a look at the impacts resulting from financial
liberalization and reforms introduced in India.
BSE SENSEX
A very small percentage of the Indian
population participates in financial markets
yet the ups and downs in Sensex reflect upon
the economic and political scenario. In 1991,
the index was around 1000 levels which
drastically increased to around the mark of
4000 after the implementation of reforms.
Apart from the FY years 1992-93 and 2007- 08
which witnessed a downturn due to the Harshad Mehta scam and global financial crisis
respectively the Sensex has been steadily increasing.
FOREIGN INSTITUTIONAL INVESTMENT
(IN $MILLION)
In FY 1992-93, FII inflows stood at just $4.2 million
which drastically raised to $2.43 billion in the next
year. The global financial crisis resulted in a major
outflow of $9.83 billion. Another dramatic rise in
inflow from $8.87 billion to $45.69 billion was
witnessed in the year 2014-15.
FOREIGN DIRECT INVESTMENTS (IN $MILLION)
Before 1991, the foreign direct investment in India
was negligible. As soon as the reforms were
implemented, India witnessed the FDI of $74
million. Since then India has witnessed a steady
increase except for a few blips due to the global
economic slowdown. In 2015, India replaced China
as the top FDI destination by receiving $63 billion.

7. FOREIGN EXCHANGE RESERVES (IN $BILLION,
CUMULATIVE)
One of the reasons for financial reforms was the
poor state of foreign exchange reserves. In 1991,
it stood at just $5.8 billion but since then, India
has witnessed a steady increase in the reserve.
INDIA’S EXTERNAL DEBT (IN $BILLION)
With the growth of the economy, the external
debt of our country is also increasing. In 1991,
the amount stood at $83.8 billion and since then
this number is only increasing. But as compared
to GDP, the external debt has declined since
1991.
BANKING SECTOR
India’s banking and insurance sectors have witnessed major growth since 1991 with the
much-needed entry of private and foreign banks bringing in the required competition.
But one of the major problems faced by India’s banking sector is Non-Performing assets.
India’s public sector collectively owed rs. 6.8 trillion at the end of the fiscal year 2020.
CONCLUSION
Financial reform is a continuing process and not just a one time action and the government is
maintaining the legacy by continuously introducing measures. The overall impact of financial
response has been positive. But continuous efforts are a must to sustain and improve the
financial sector of India.
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