INDIAN FINANCIAL SYSTEM - REFORMS

22,360 views

Published on

1 Comment
22 Likes
Statistics
Notes
No Downloads
Views
Total views
22,360
On SlideShare
0
From Embeds
0
Number of Embeds
7
Actions
Shares
0
Downloads
0
Comments
1
Likes
22
Embeds 0
No embeds

No notes for slide

INDIAN FINANCIAL SYSTEM - REFORMS

  1. 1. A Project Report on “RefoRms in indian financial system”TOWARDS FULFILLMENT OF THE PROJECT REQUIREMENTS OF POST GRADUATE DIPLOMA OF MANAGEMENT STUDIES SUBMITTED BY: RAHUL JAIN ROLL NO: 38 PGDM-EBIZ-1 BATCH-2011-13 UNDER THE GUIDANCE OF Dr. ANIL RAO PAILA DEAN, WELINGKAR INSTITUTE OF MANAGEMENT And Dr. MADHAVI LOKHANDE Core Faculty, WELINGKAR INSTITUTE OF MANAGEMENT WELINGKAR INSTITUTE OF MANAGEMENT DEVELOPMENT AND RESEARCH, ELECTRONIC CITY, BANGALORE
  2. 2. STUDENT DECLARATION I, Mr. Rahul Jain, studying in the First Year of Master ofManagement Studies at Welingkar Institute of Management Studies,Electronic City, Bangalore, hereby declare that I have completed theproject titled “Reforms in INDIAN FINANCIAL SYSTEM” as a part ofthe course requirements for PGDM Programme.I further declare that the information presented in this project is trueand original to the best of my knowledge.Date:Place: (Signature of the student)
  3. 3. CERTIFICATE FROM THE INTERNAL GUIDEI, Prof. Anil Rao Paila hereby certify that Mr. Rahul Jain, a studentfor the Master of Management Studies course at Welingkar Instituteof Management Studies, Electronic City, Bangalore, has competed aproject on “Reforms in INDIAN FINANCIAL SYSTEM” under myguidance during this year.His work and output has been found to be satisfactory.Date:Place: (Signature of the Guide)
  4. 4. AcknowledgementThis project was done in partial fulfilment of the requirements forthe Post Graduate Diploma of Management Studies. I would like tothank and extend my warm regards to Mr. Vikas Jain, Vice President(Factoring), HSBC Bank for his support and Dr. Anil Rao Paila, Dean,Welingkar Institute of Management, Bangalore and also Dr. MadhaviLokhande, Core Faculty, Welingkar Institute of Management,Bangalore for their guidance and support throughout the project. Itake this opportunity to thank all the people without whose help,guidance and inputs it would not have been possible to make theproject report a success. Finally, I would like to thank all those whowere directly or indirectly related to my project.The timely guidance of my mentors not only helped in making theeffort fruitful, but also transformed the whole process of learninginto an enjoyable and memorable experience. This project proved asan excellent opportunity for me to apply the concepts learnt in thecourse of my program at the institute. The three things which go onto make a successful endeavour are dedication, hard work andcorrect guidance.I express heartfelt gratitude to Welingkar Institute Management forgiving me this opportunity which helped me in gaining knowledgeabout Indian Financial Systems.- Rahul Jain
  5. 5. EXECUTIVE SUMMARYFinancial sector reforms are at the centre stage of the economic liberalization thatwas initiated in India in mid 1991. This is partly because the economic reformprocess itself took place amidst two serious crisis involving the financial sector thebalance of payments crisis that threatened the international credibility of thecountry and pushed it to the brink of default; and the grave threat of insolvencyconfronting the banking system which had for years concealed its problems withthe help of defective accounting policies.Moreover, many of the deeper rooted problems of the Indian economy in the earlynineties were also strongly related to the financial sector: Large scale pre-emption of resources from the banking system by the government to finance its fiscal deficit; Excessive structural and micro regulation that inhibited financial innovation and increased transaction costs; Relatively inadequate level of prudential regulation in the financial sector; Poorly developed debt and money markets; and Outdated (often primitive) technological and institutional structures that made the capital markets and the rest of the financial system highly inefficient.Over the last six years, much has been achieved in addressing many of theseproblems, but a lot remains to be done.
  6. 6. Table of content1) Acknowledgement2) Objective3) Executive summary4) Introduction5) Current Structure of Financial System6) What changed in Recent Decades?7) Need and Importance of Financial Sector8) Banking and Credit Policy9) Financial Innovations10) Conclusion
  7. 7. 1. IntroductionStrengthening financial systems has been one of the central issues facing emergingmarkets and developing economies. This is because sound financial systems serveas an important channel for achieving economic growth through the mobilization offinancial savings, putting them to productive use and transforming various risks.Many countries adopted a series of financial sector liberalization measures in thelate 1980s and early 1990s that included interest rate liberalization, entryderegulations, reduction of reserve requirements and removal of credit allocation.In many cases, the timing of financial sector liberalization coincided with that ofcapital account liberalization. Domestic banks were given access to cheap loansfrom abroad and allocated those resources to domestic production sectorsA financial system is a network of financial institutions, financial markets, financialinstruments and financial services to facilitate the transfer of funds. The systemconsists of savers, intermediaries, instruments and the ultimate user of funds. Thelevel of economic growth largely depends upon and is facilitated by the state offinancial system prevailing in the economy. Efficient financial system andsustainable economic growth are corollary. The financial system mobilises thesavings and channelizes them into the productive activity and thus influences thepace of economic development. Economic growth is hampered for want of effectivefinancial system. Broadly speaking, financial system deals with three inter-relatedand interdependent variables, i.e., money, credit and finance.
  8. 8. 2. Current Structure of the Financial System 2.1 Finance and the EconomyIn recent years, the Indian economy has grown sharply and has enjoyed high ratesof savings and investment. This has inevitably involved a substantial role forfinance as the intermediary between households and firms (Shah, Thomas, andGorham, 2008). Table 1 compares components of GDP at current prices for 2008-2009 against the picture as seen one decade ago. The nominal rupee-dollarexchange rate exhibited a depreciation of roughly 9% over this period. Hence, thebulk of the change across this decade can be interpreted as a change expressed innominal dollars.Over this decade, India went from being a medium sized developing country (withan aggregate GDP of $379 billion in 1998-99) to being a member of the G-20 (withan aggregate GDP of $1.13 trillion in 2008-09), with a rough tripling of aggregateGDP. Alongside this, the savings rate went up dramatically from 24.13% to 34.65%.This combination gave a 4.64 times rise in gross domestic savings: the financialsystem which used to handle a flow of $91 billion of savings in 1998-99 washandling $390 billion of savings in 2008-09.
  9. 9. In addition, the private corporate sector, which is the focus of the formal financialsystem, came to play a bigger role in investment. Gross capital formation by theprivate corporate sector grew from 7.67% of GDP to 13.53% of GDP over thisdecade. There was a rise of 5.71 times: private corporate investment went from $29billion in 1998-99 to $153 billion in 2008-09.Through this combination of high GDP growth, rise in household savings, and abigger role for private corporate investment, the financial system has come to play amore prominent role in the economy, and has achieved a significant size by worldstandards.Through these changes, the materiality of financial reform has risen. With $390billion of household savings being produced a year, and $153 billion of privatecorporate investment taking place a year, modest improvements in the capability ofthe financial system would help accelerate growth.Table 2 shifts focus to the financing structure of large companies. For each of thetwo years (1998-99 and 2008-09), the aggregate balance sheet of all large non-financial firms in the CMIE database is computed and shown. The overall balancesheet grew much faster than GDP, with a rise of 4.52 times over the decade.A pronounced deleveraging is visible. Equity, which used to be 33.94% of thebalance sheet in 1998-99, made up for 39.22% of the balance sheet in 2008-09.
  10. 10. Alongside this, the corporate debt market faded into insignificance: it grew by only1.58 times, and went from 5.69% of the balance sheet in 1998-99 to 2.06% of thebalance sheet in 2008-09.The evidence in Table 2 pertains only to large companies. In addition, banks dolend to smaller, unlisted companies. In order to assess the role of banks versus theequity market, Figure 1 juxtaposes the market capitalisation of the CMIE Cospiindex against the aggregate non-food credit of all banks. This shows that in thecomprehensive picture, bank credit is small in the Indian economy, whencompared with the market value of equities (Thomas, 2006a). This broadrelationship has held up even though there has been an unprecedented boom inbank credit in the period under examination. 2.2 Financial RepressionIn most areas, the interaction between the Indian State and the economy is ruledby sound procurement principles. As an example, purchases of steel or cement bythe government are done through auctions, where these commodities arepurchased from the lowest voluntary bidder. However, in the area of government
  11. 11. borrowing, the Indian State does not borrow from voluntary lenders. The bulk ofgovernment bond issuance is forcibly placed with financial norms. These includebanks, insurance companies and pension funds. As an example, banks are forcedto hold atleast 24% of their assets in government bonds. The pension systemoperated by the Employee Provident Fund Organisation (EPFO) is almost entirelyinvested in domestic government bonds. Of the Rs.7.43 trillion invested by lifeinsurance companies on 31 March 2009, 42.5% was in central government bondsand another 14.4% was in state government bonds.Indian financial policy thus ensures that the government gets roughly all EPFOassets, roughly half of the assets of life insurance companies and roughly a quarterof the assets of banks. Data for 2007-08 shows that of the total stock of Rs.11.47trillion of government bonds, only Rs.1.7 trillion or 15 per cent were heldvoluntarily. 2.3 ProtectionismIn most aspects of the merchandise trade, the Indian State has shifted away fromprotectionism. The Indian buyer of steel or benzene or mobile phones is able tochoose between local and global producers without either quantitative restrictionsor tariffs imposed by the State. Once the Goods and Services Tax (GST) is properlyimplemented, imported goods will face a GST-on-imports, and apart from that,customs tariffs would go to near-zero levels. With financial products and services,in most areas, the local buyer is inhibited from purchase of products or servicesfrom offshore providers. This is done either through outright prohibition orquantitative restrictions (typically through capital controls), or constraints uponestablishment of distribution channels for foreign producers (typically throughfinancial regulation).
  12. 12. One example of such protectionism lies in the treatment of banks, where all foreignbanks (put together) are permitted to open no more than 18 branches in India. Thisdisables the extent to which foreign banks are able to build branches in India andoffer competition to Indian banks. For another example, the Indian buyer of futureson the NSE-50 index has a choice of three venues where orders can be placed:Indias NSE, the Singapore Exchange (SGX) and the Chicago Mercantile Exchange(CME). However, the prevailing capital controls are structured in a way whichprevents an Indian resident from paying initial margin on overseas futuresexchanges. Through this, offshore competition against the NSE-traded Nifty futuresand options is undermined. 2.4 Public ownershipThe third defining feature of Indian finance lies in the extent of public ownership.Roughly 80% of banking, 95% of insurance and 100% of pensions is held in publicsector financial norms. With insurance, it is possible to establish a privateinsurance company with no more than 26% of foreign ownership. With bankingand pensions, entry is infeasible either for private or for foreign financial norms.The combination of public ownership and protectionism hampers competitivedynamism in large parts of Indian finance. At the same time, competitivedynamism is found in certain areas. The barriers are the weakest with securitiesnorms that seek to become members of exchanges such as NSE and BSE, and withmutual funds. In these two areas, India is de facto open to private or foreign normsthat seek to establish business. Unsurprisingly, these are also areas where creativedestruction is visible, with both entry and exit taking place every year.
  13. 13. 2.5 Central PlanningThe fourth defining feature of Indian finances lies in the extent to which thegovernment controls minute details of financial products and processes. Thestructure of legislation and regulation is one where everything is prohibited unlessexplicitly permitted. Hence, every time a firm wishes to make a modification to asmall detail about a product or a process, it has to go to a government agency inorder to request permission.As a recent example, until recently, SEBI specified that securities trading muststart at 9:55 AM and stop at 3:30 PM. In an element of liberalisation, SEBI hasannounced that exchanges can start and stop at any time of day, as long as thestart of trading is after 9 AM and the end of day is before 5 PM. In most OECDcountries, governments do not get involved in specifying the time at which tradingstarts and ends. On a related note, on the equity derivatives market, optionstrading on the index involve cash-settled European-style options and optionstrading on individual securities involve cash-settled American-style options. Noneof these parameters can be changed without explicit approval from SEBI. In mostOECD countries, decisions about whether options should be cash-settled orphysically-settled, and decisions about whether options should be European-style or American-style, are not the purview of government. 2.6 Regulatory and Legal ArrangementsThe fifth and final defining feature of Indian finance is the financial regulatoryarchitecture. Table 3 shows the role and function of major government agencies inIndian finance. In addition to these external agencies, finance policy work isundertaken by the Department of Economic Affairs (DEA), Department of Financial
  14. 14. Services (DFS), Department of Consumer Affairs (DCA) and the Department ofCompany Affairs (DCA). There are also other government bodies which performquasi-regulatory functions, including NABARD, NHB and DICGC.This assignment of functions into agencies is embedded in the texts of laws before1956, and thus reflects a vision of economic policy, and a state of development ofthe financial system, rooted in mid-20th century India.An associated set of issues concerns the legal process. From the 1990s onwards,regulators in India have been placed in a legal setting where there is a clearseparation between a regulator performing regulation while a private industryperforms service provision, where the regulator is charged with creation ofsubordinated legislation through a transparent and consultative process, where theinvestigative and enforcement process is performed in a quasi-judicial fashion withfull transparency of reasoned orders, and there is a fast-track specialised courtwhich hears appeals. None of these principles were part of the ethos of governancein India in 1956. As a consequence, a large part of the financial regulatorylandscape lacks these features. 3. What changed in recent decades ?Much has been written about the changes in Indian finance in recent decades.Following are the eight areas where major changes took place in Indian financialpolicy in the last 20 years. 3.1 The revolution of equity marketThe equity and fixed income scandal of 1992, and the desire of policy makers toencourage foreign investors in the Indian equity market, in the early 1990s, helpedin reopening long-standing policy questions about the equity market. From 1993 to
  15. 15. 2001, the Ministry of Finance and SEBI led a strong reforms effort aiming at afundamental transformation of the equity market. The changes on the equitymarket from December 1993 to June 2001 were quite dramatic: A new governance model was invented for critical financial infrastructure such as exchanges, depositories and clearing corporations. This involved a three-way separation between shareholders, the management team and member financial norms. These three groups were held distinct in order to avoid conflicts of interest. The shareholders were configured to have an interest in liquid markets, and not maximise dividends. Floor trading was replaced by electronic order books. Counterparty credit risk was eliminated through netting by novation at the clearing corporation. This has supported a competitive environment where entry barriers have been set to very low levels and a steady stream of norm goes out of business every year. Exchange membership for foreign securities norms was enabled, thus making it possible for foreign investors to transact through their familiar securities norms. Physical share certificates were eliminated through dematerialised settlement at multiple competing depositories. Exchange-traded derivatives trading commenced on individual stocks and indexes. The NSE-50 (Nifty) index became the underlying for one of the worlds biggest index derivatives contracts, with onshore trading at NSE, offshore trading at SGX in Singapore and CME in Chicago, and an entirely offshore OTC market. A diverse order flow was accessed from all across India and abroad, through hundreds of thousands of trading screens. This gave heterogeneous views, and a large mass of investable capital.
  16. 16. Asymmetric information was diminished through improvements in accounting standards and disclosure. The eligibility rules for FIIs were enlarged through time, so that thousands of FIIs were operating on the market, bringing both foreign capital and heterogeneous views.Through these events, the Indian equity market has come to have a dominant rolein Indian finance. The financing of norms has shifted away from debt towardsequity. Nifty-related products (ETFs, futures, options, OTC derivatives) make up thebiggest single traded product. NSE and BSE are at rank 3 and 5 in the worlds topexchanges by the number of transactions, and this is the only global ranking infinance where India is found.In the larger setting of Indian finance, the equity market is the first place in Indiawhere modern finance and financial regulation have taken root. This is a majorchange when compared with the India of old, where none of the financial marketsworked well. Looking forward, the institutional capabilities and experience of thesereforms will help in transforming other components of the financial system. As anexample, in 2008, the institutional capabilities of the equity market were used withgreat success in establishing a currency futures market. 3.2 Entry of Private BanksIndias starting condition, in the early 1990s, was one with an almost entirelygovernment-owned banking system, where entry by foreign or private banks wasblocked. In this environment, an important experiment in easing entry barriers
  17. 17. took place from 1994 to 2004, where a total of 12 `new private banks werepermitted to come into being.In terms of barriers to entry, this remains an environment with onerous barriers toentry, given that only 12 new private banks were permitted, and that over 80% ofassets remain in the public hands. In addition, strong entry barriers have goneback up, for after 24 May 2004, no new private banks have come about.At the same time, this limited opening has had significant consequences. Whilesome of these new private banks fared badly, others have done well. They haveexperienced sharp growth in assets. They dominate certain newer marketsegments, such as cards and POS terminals. They have exerted a certain limitedcompetitive pressure upon public sector banks. As an example, public sector banksnow accept computers and ATMs on a scale that was not seen in 1993, and it islikely that competitive pressure from private banks has helped.In summary, the limited economic reform, of bringing in 12 new private banks from1994 to 2004, was one of the important milestones of change in Indian finance,even though it was highly limited in scope and onerous entry barriers remain inplace. 3.3 The RBI Amendment Act of 2006In 2006, an amendment to the RBI Act was passed, which established RBI as aregulator of the bond market and the currency market. This was a step in thewrong direction, given Indias direction for reform on the regulation and supervisionof securities markets. In all OECD countries but one, only one government agency(the securities regulator or the unified financial regulator) deals with all aspects oforganised financial trading. In India itself, shortly after 2006, expert committeereports were produced advocating the merger of all regulation of organised financial
  18. 18. trading into a single regulator. The RBI Amendment Act of 2006 stands out as astep in the wrong direction; the policy agenda now involves reversing this.
  19. 19. 3.4 Fiscal transfers to public sector financial firmsIn recent decades, the exchequer has brought money into public sector financialfirms under three scenarios: Explicit obligations of the exchequer: Some public sector financial firms encountered bankruptcy, and were always rescued using public money. This covers experiences such as Indian Bank, IFCI, etc. Implicit obligations of the exchequer: One scenario { the difficulties of UTI in 2001 { concerned implicit promises which were made by UTI, where upholding those promises required money from the Ministry of Finance. Failure of banks to generate equity capital through retained earnings: In a well run bank, the growth of equity capital through earnings retention should enable growth of the balance sheet. In India, on many occasions, public sector banks which failed to produce retained earnings and thus adequate equity capital were given additional equity capital by the government so as to obtain balance sheet expansion.The Indian experience has been a healthy one, when compared with that of someother countries such as Indonesia, in that these payments have been relativelysmall. At the same time, a three-pronged modification of strategy is appropriate:1. Problems should be solved before they are crystallised. Just as the UTI problemshould have been detected and blocked ahead of time, today there are loomingproblems which will yield difficulties in the exchequer in the future. One example ofthese is the Employee Pension Scheme (EPS).2. The discomfort associated with accessing public resources needs to be increased.Firms like IDBI and IFCI experienced rescues which were too comfortable from the
  20. 20. viewpoint of the (civil servant) managers. This generates poor incentives for othermanagers of public sector financial firms.3. Finally, government needs to deny additional resources to banks which havefailed to build up adequate capital, for these are precisely the banks which are notefficient. 3.5 Critical financial infrastructure of the bond marketIn the equity market, the strategy for critical financial infrastructure (exchanges,learning corporations and depositories) was based on three principles. First, therewas a three-way separation between shareholders, the management team and themember financial firms. Second, there was a competitive framework. Third, theregulator (SEBI) did not own critical financial infrastructure.None of these three principles was used on the bond market. The critical bondmarket infrastructure involved a depository (the SGL) owned and operated by RBIand an exchange (NDS) owned and operated by RBI.This was a problematic arrangement because RBI had conflicts of interest by virtueof being an owner and service provider, and at the same time being the regulator(after the enactment of the RBI Amendment Act of 2006). There was a loss ofcompetitive dynamism when RBIs policy decisions leaned in favour of blockingcompetition against NDS and SGL. The implementation capability in SGL and NDSwas limited, by virtue of being run by civil servants.Entry barriers into membership of this critical financial infrastructure were enactedby RBI. A small club of financial firms (banks and primary dealers) was allowed toconnect into this infrastructure. This policy framework gave dismal failure inachieving bond market liquidity. On paper, India has an impressive bond marketwith trading screens, clearing corporation, etc. But the essence of a market is
  21. 21. liquidity, speculative views, and resilience of liquidity. None of these are found onthe Indian bond market. 3.6 Institution building of IRDA and PFRDAIndian financial policy showed an impressive ability to throw up new institutionswhich rapidly made a difference in the form of SEBI (founded in 1988), NSE(founded in 1992) and NSDL (founded in 1995). In other areas, institution buildingran into greater problems.IRDA was established with the intent of becoming a regulator of the insurancebusiness. In an unusual decision, IRDA was placed in Hyderabad, which led to anincreased distance from the knowledge and staff quality of Bombay. While IRDAwas relatively cutoff from the main Indian discourse on financial policy andregulation which takes place in Bombay and Delhi, insurance companies had astrong incentive to engage with IRDA. With focused lobbying by insurancecompanies acting upon relatively weak staff quality, and the lack of the context ofthe financial discourse of Bombay, IRDA came to increasingly share the world viewof insurance companies.Through this, IRDA came to increasingly support questionable sales practices andtax subsidies for fund management by insurance companies. The establishment ofIRDA, thus, must be chalked up as a failure of institution building.In similar fashion, PFRDA was intended to start out as a regulator and projectmanager for the New Pension System (NPS), and perhaps to grow into a full edgedregulator of Indian pensions in the future. PFRDA faced a difficulty akin to SEBIsearly years in that its legislation has been delayed.At the same time, SEBI started chalking up important achievements in the 1988-1992 period. In addition, PFRDA has a strong contractual role in the NPS, which
  22. 22. gives it regulatory powers through enforcement of contracts. Yet, in its first sevenyears, PFRDA has failed to emerge as a strong organisation.The Indian discussion on the role and function of government agencies in financialregulation needs to be accompanied by a treatment of the difficulties of high qualityagencies. While Indian policy makers have one important success in SEBI, whichhas emerged as a relatively high quality agency, Indian policy makers need todiagnose and the sources of problems at the other four agencies in finance (RBI,FMC, IRDA and PFRDA). The difficulties of IRDA and PFRDA serve as a reminderthat even when an agency starts with a clean slate, without institutional baggagefrom a pre-reforms India, without conflicts of interest and archiac legalfoundations, there is still a substantial risk of failure in institution building. 3.7 Payments systemA critical element of the plumbing which underlies the financial system is thepayments system. Significant changes have taken place in this field, with theestablishment of the Real time Gross Settlement (RTGS) system. However, therequirements for the Indian payments system involve five dimensions:1. Support for very high volumes by world standards, given the large number ofeconomic agents in India2. 24 x 7 operation, given the need to function in Indian time, and to eliminateHerstatt risk in cross-border transactions around the globe3. Private management, so as to achieve efficiency and technological dynamism4. A competitive framework, with multiple competing providers5. A governance framework which induces a focus on efficiencies for the economyrather than maximisation of dividends.At present, these features are largely absent in the Indian payments system.
  23. 23. Existing systems support low transaction intensities, limited hours of operation,have an excessive role for government and lack competition. While critical financialinfrastructure in payments has fared better than the critical financialinfrastructure in the bond market, the outcomes are substantially below therequirements of the economy.The governance problems in the payments system are akin to those seen with othercritical financial infrastructure. Hence, there is an applicability of many of the keyideas seen in ownership and governance of critical financial infrastructure such asexchanges, depositories and clearing corporations. 4. Need and importance of financial sector:The New Economic Policy (NEP) of structural adjustments and stabilizationprogramme was given a big thrust in India in June 1991. The financial systemreforms have received special attention as a part of this policy because of theperceived interdependent relationship between the real and financial sectors of themodern economy.The need for financial reforms had arisen because the financial institution andmarkets were in a bad shape. The banking sector suffered from lack ofcompetition, low capital base, low productivity, and high intermediation costs. Therole of technology was minimal, and the quality of service did not receive adequateattention. Proper risk management system was not followed, and prudential normswere weak. All these resulted in poor assets quality. Development financialinstitutions operated in an over – protected environment with most of the fundingcoming from assured sources. There was little competition in insurance andmutual funds industries. Financial markets were characterized by control over
  24. 24. pricing of financial assets, barriers to entry, and high transactions costs. Thebanks were running either at a loss or on very low profits, and, consequently wereunable to provide adequately for loan defaults, and build their capital.There had been organizational inadequacies, the weakening of management andcontrol functions, the growth of restrictive practices, the erosion of work culture,and flaws in credit management. The strain on the performance of the banks hademanated partly from the imposition of high Cash Reserve Ratio (CRR), StatutoryLiquidity Ratio (SLR) and directed credit programmes for the priority sectors – all atbelow market or concessional or subsidized interest rates. This, apart fromaffecting bank profitability adversely, had resulted in the low or repressed ordepressed interest rates on deposits and in higher interest rates on loans to thelarger borrowers from business and industry.Further, the functioning of the financial system, and the credit delivery as well asrecovery process had become politicized, which damaged the quality of lending andthe culture of repaying loans. The widespread write-offs of the loans had seriouslyjeopardized the viability of banks. As the closure of sick industrial units wasdiscouraged by the government, banks had to continue to finance non-viable sickunits, which further compromised their own viability. The legal system was not ofmuch help in recovering loans. There was a lack of transparency in preparingstatements of accounts by banks.In other words, the reforms had become imperative on account of the facts thatdespite its impressive quantitative growth and achievements, the financial health,integrity, autonomy, flexibility, and vibrancy in the financial sector had deterioratedover the past many years. The allocation of resources had become severelydistorted, the portfolio quality had deteriorated, and productivity, efficiency andprofitability had been eroded in the system. Customer service was poor, work
  25. 25. technology remained outdated, and transaction costs were high. The capital baseof the system remained low, the accounting and disclosure practices were faulty,and the administrative expenses had greatly soared. The system suffered also froma lack of delegation of authority, inadequate internal controls and poorhousekeeping. 5. Banking and credit policy:At the beginning of the reform process, the banking system probably had a negativenet worth when all financial assets and liabilities were restated at fair marketvalues (Varma 1992). This unhappy state of affairs had been brought about partlyby imprudent lending and partly by adverse interest rate movements. At the peakof this crisis, the balance sheets of the banks, however, painted a very differentrosy picture. Accounting policies not only allowed the banks to avoid makingprovisions for bad loans, but also permitted them to recognize as income theoverdue interest on these loans. The severity of the problem was thus hidden fromthe general public.The threat of insolvency that loomed large in the early 1990s was, by and large,corrected by the government extending financial support of over Rs 100 billion tothe public sector banks. The banks have also used a large part of their operatingprofits in recent years to make provisions for non performing assets (NPAs). Capitaladequacy has been further shored up by revaluation of real estate and by raisingmoney from the capital markets in the form of equity and subordinated debt. Withthe possible exception of two or three weak banks, the public sector banks havenow put the threat of insolvency behind them. The major reforms relating to thebanking system were:
  26. 26. · Capital base of the banks were strengthened by recapitalization, public equityissues and subordinated debt.· Prudential norms were introduced and progressively tightened for incomerecognition, classification of assets, provisioning of bad debts, marking to market ofinvestments.· Pre-emption of bank resources by the government was reduced sharply.· New private sector banks were licensed and branch licensing restrictions wererelaxed.At the same time, several operational reforms were introduced in the realm of creditpolicy:· Detailed regulations relating to Maximum Permissible Bank Finance wereabolished· Consortium regulations were relaxed substantially· Credit delivery was shifted away from cash credit to loan methodThe government support to the banking system of Rs 100 billion amounts to onlyabout 1.5% of GDP. By comparison, governments in developed countries like theUnited States have expended 3-4% of GDP to pull their banking systems out ofcrisis (International Monetary Fund, 1993) and governments in developingcountries like Chile and Philippines have expended far more (Sunderarajan andBalino, 1991).However, it would be incorrect to jump to the conclusion that the banking systemhas been nursed back to health painlessly and at low cost. The working results ofthe banks for 1995-96 which showed a marked deterioration in the profitability ofthe banking system was a stark reminder that banks still have to make largeprovisions to clean up their balance sheets completely. Though bank profitabilityimproved substantially in 1996-97, it will be several more years before theunhealthy legacy of the past (when directed credit forced banks to lend to
  27. 27. uncreditworthy borrowers) is wiped out completely by tighter provisioning. It ispertinent to note that independent estimates of the percentage of bank loans whichcould be problematic are far higher than the reported figures on non performingassets worked out on the basis of the central bank‘s accounting standards. Forexample, a recent report estimates potential (worst case) problem loans in theIndian banking sector at 35-60% of total bank credit (Standard and Poor, 1997).The higher end of this range probably reflects excessive pessimism, but the lowerend of the range is perhaps a realistic assessment of the potential problem loans inthe Indian banking system.The even more daunting question is whether the banks lending practices haveimproved sufficiently to ensure that fresh lending (in the deregulated era) does notgenerate excessive nonperforming assets (NPAs). That should be the true test of thesuccess of the banking reforms. There are really two questions here. First, whetherthe banks now possess sufficient managerial autonomy to resist the kind ofpolitical pressure that led to excessive NPAs in the past through lending toborrowers known to be poor credit risks. Second, whether the banks ability toappraise credit risk and take prompt corrective action in the case of problemaccounts has improved sufficiently. It is difficult to give an affirmative answer toeither of these questions (Varma 1996b). Turning to financial institutions,economic reforms deprived them of their access to cheap funding via the statutorypre-emptions from the banking system. They have been forced to raise resources atmarket rates of interest. Concomitantly, the subsidized rates at which they used tolend to industry have given to market driven rates that reflect the institutions‘ costof funds as well as an appropriate credit spread. In the process, institutions havebeen exposed to competition from the banks who are able to mobilize deposits atlower cost because of their large retail branch network. Responding to thesechanges, financial institutions have attempted to restructure their businesses and
  28. 28. move towards the universal banking model prevalent in continental Europe. It istoo early to judge the success of these attempts. 6. Financial Innovations:From the early 1970s there has been an explosive growth in financial innovations.Here is a partial list of important novelties:• Eurodollar accounts• Forward rate agreements• Zero coupon bonds• Commodity bonds• Negotiable certificates of Deposits• Puttable and callable bonds• NOW accounts• Indexed linked gilts• Variable life insurance• Interest rate swaps• Money market mutual funds• Currency swaps• Index funds• Shelf registration process• Options• Electronic funds transfer system• Financial futures• Screen based trading• Options on futures• Leveraged buyouts• Options on indexes
  29. 29. This appendix explores various aspects of financial innovations. It is divided intofour sections:• What and why of financial innovations• Type of financial innovations• Financial innovations in India• Excesses1. WHAT AND WHY OF FINANCIAL INNOVATIONSMiller, Silber, and Van Horne characterise and analyse financial innovationssomewhat differently. Miller describes financial innovations as unanticipatedimprovements in the array of financial products and instruments that arestimulated by unexpected tax or regulatory impulses.• The Eurobond market emerged in response to a 30 percent withholding taximposed by the US Government on interest payments on bonds sold in the US tooverseas investors.• Zero coupon bonds were offered to exploit a mistake of the Internal RevenueService in the US which permitted deduction of the same amount each year for taxpurposes.( Put differently, the Internal Revenue Service employed simple interest,not compound interest.)• Financial futures came into being when the Bretton Woods system of fixedexchange rates was abandoned in the early 1970s.• Paper currency, in a sense the most fundamental financial instrument, wasinvented when the British Government prohibited the minting of coins by thecolonial North America.• The Eurodollar market developed in response to Regulation Q in the US thatimposed a ceiling on the interest rate payable on time deposits with commercialbanks
  30. 30. • Financial swaps emerged initially in response to a restriction imposed by theBritish Government on dollar financing by British firms and sterling financing bynon-British firms.Since taxes and regulation have triggered a number of major financial innovations,Miller likens them to the grains of sand that irritate the oyster to produce thepearls of financial innovation.Silber2 looks at financial innovations differently from Miller. He considersinnovative financial instruments and processes as devices used by companies toreduce the financial constraints faced by them. Firms, he argues, maximise utilityunder certain constraints, some dictated by governmental regulation, some definedby the market place, and some self-imposed.Financial innovations seek to reduce the cost of complying with these constraints.Here are two examples.• A lot of effort has gone into the designing of capital notes, which are essentiallydebt instruments but are treated as ‗capital‘ for the purposes of bank regulation.• Highly volatile interest rates enhanced the cost of following a policy of investing infixed dividend rate preferred stock. This stimulated the development of variousforms of adjustable rate preferred stock.Silber‘s constraint-induced model of innovation explains well a large proportion ofcommercial bank products. Yet it offers only a partial view of financial innovationas its focus is almost wholly on the issuers of securities, not the investors insecurities.Van Horne3 views a new financial instrument or process as innovative, if it makesthe financial markets more efficient and/or complete. A financial innovation makesthe market more efficient if it reduces transaction costs or lowers differential taxesor diminishes ‗deadweight‘ losses. A financial innovation makes the market morecomplete if its after-tax market is one where every contingency in the world is
  31. 31. matched by a distinct marketable security. The sheer number of securities requiredto span every possible contingency suggests that the market is bound to beincomplete in some way or the other. In such a market, there are unfulfilledinvestor needs. Hence, there is scope for designing securities to satisfy investordesires with respect to maturity, interest rate, protection, cash flow characteristics,put feature, or some other attribute.According to Van Horne the following factors prompt financial innovation: volatileinflation and interest rates, regulatory changes, tax changes, technologicaladvances, the level of economic activity, and academic work on market efficiencyand inefficiency.Collectively, the Miller, Silber, and Van Horne papers suggest that the followingfactors drive financial innovations:1 M.H.Miller, ―Financial Innovation: The Last Twenty Years and the Next‖, Journalof Financial and Quantitative Analysis, December 1986.2 W.L. Silber, ―The Process of Financial Innovation‖, American Economic Review,May 1983.3 J.C. Van Horne, ―Of Financial Innovations and Excesses‖, Journal of Finance,July 1985.• Tax asymmetry• Regulatory or legislative changes• Volatility of financial prices• Transaction costs• Agency costs• Opportunities to reduce some form of risk or reallocate risk• Opportunities to increase an asset‘s liquidity• Academic work• Accounting benefit
  32. 32. • Technological advances• Level of economic activity2. TYPES OF FINANCIAL INNOVATIONSFinancial innovations may be divided into the following categories:Category ExampleA. Consumer-type instruments• Variable life insurance policy• Money market mutual fundB. Securities• Zero coupon bond• Indexed — linked giltsC. Derivative securities• Options• FuturesD. Process• Shelf registration process• Screen — based tradingE. Creative solutions to a financial• Project financing problem• Leveraged buyoutSince categories A, B and C represent financial products, we may broadly define afinancial innovation as a new product or a new process or a creative solution to afinancial problem.3. FINANCIAL INNOVATIONS IN INDIATill the mid — 1980s, the Indian financial system did not see much innovation. Inthe last two decades, financial innovation in India has picked up and it is expected
  33. 33. to grow in the years to come, as a more liberalised environment affords greaterscope for financial innovation.The important financial innovations that have taken place in India are listed belowalong with the principal factor which motivated it or fuelled its growth.Innovation Principal Motivating Factor• Debt-oriented schemes of mutual funds• Tax benefit• Partially convertible debentures and fully convertible debentures• Pricing and interest rate regulation obtaining under the Capital IssuesControl Act• Deep discount / Zero coupon bonds• Tax benefit• Puttable and callable bonds• Perceived volatility of interest rates• Stock index futures• Volatility of equity prices• Badla transactions• Restriction on forward trading• Ready forwards• Restrictions under the portfolio management scheme• Havala transactions• RBI restrictions• Interest rate caps/floors/collars• Volatility of interest rates• Interest rate swaps• Volatility of interest rates• Currency swaps
  34. 34. • Volatility of foreign exchange rates• Forward rate agreements• Volatility of interest rates• Automated teller machines• Technology• Screen-based trading• Technology• Floating rate bonds• Volatility of interest rates• Electronic funds transfer• Technology• Money market mutual funds• Volatility of interest rates• Specialised mutual funds• Investor preferences• Exchange-traded options• Volatility of stock prices• Project finance• Risk sharing 7. ConclusionOne of the most important areas of economic reform lies in the financial system.On one hand, finance is the `brain of the economy, and the skills of the financialsystem shape the efficiency of translation of gross capital formation into GDPgrowth. In addition, a sophisticated financial system gives resilience to shocks,particularly in an increasingly internationalised India. As an example, the extent towhich monetary policy can stabilise the economy critically relies on a competitive
  35. 35. banking system and a well functioning Bond-Currency-Derivatives Nexus: untilfinancial policy puts these in order, monetary policy will remain relativelyineffectual.In some respects, Indian finance has made major progress. Policy makers over thelast 20 years made important progress with revolutionary reforms of the equitymarket (including sophisticated thinking on institution building for SEBI, NSE andNSDL), the limited entry of private banks, and the limited liberalisation of thecapital account. But these three areas of greater success have not been adequate inobtaining a financial system that is commensurate with Indias needs, forintermediating $390 billion of savings and investment a year for an increasinglycomplex and internationalised economy.Key elements of the ancien regime that remain intact are financial repression,Protectionism, public sector ownership of financial norms, central planning, anarchaic financial regulatory architecture and weaknesses of the rule of law. Thereforms program now needs to frontally confront these elements. Some of the ideasemphasised in this paper have been accepted by policy makers and are undervarious stages of implementation. These five areas are: Establishment of the National Treasury Management Agency (NTMA) Establishment of the New Pension System (NPS) and the Pension Fund Regulatory and Development Authority (PFRDA) Establishment of the Financial Stability and Development Council (FSDC) Drafting rules for ownership and governance of critical financial infrastructure (presently underway with SEBIs Bimal Jalan committee) Drafting effort for financial law at the Financial Sector Law Reforms Commission (FSLRC).In these areas, the challenge is one of implementation. Thirteen issues remain theagenda for policy for the future:
  36. 36. Roadmap for removal of financial repression.Unification of regulation of organised financial trading.Separation of banking regulation and supervision from RBI.Establishment of a meaningful deposit insurance corporation.Establishment of the Financial Services Appellate Tribunal (FSAT).Modifying FEMA to emphasise the rule of law, which would also remove thegap between de facto and de jure openness.Modifying capital controls so as to scale down protectionism.A fresh effort at building IRDA.A fresh effort at building a payments system.A reduced willingness to inject equity capital into public sector financialnorms.Removal of entry barriers against banks and banking.Removal of transaction taxes, i.e. the stamp duty and the securitiestransaction tax.Shift towards residence-based taxation of global financial income.

×