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Students Corner - A Decade of Economic
Reforms in India - A Review
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Module No: 4
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A Decade of Economic Reforms - Review by RBI Module: 4 - Financial Sector Reforms - Finance provides an important link between reforms and growth. Perhaps no area of the Indian economy has been as much influenced by impulses of reforms as the financial sector. Module 4 provides an account of these changes with special focus on what these reforms portend for stability and efficiency of the financial system. Several stability and efficiency parameters are analysed for different classes of financial intermediaries, such as commercial banks, cooperative banks, development finance institutions and mutual funds. The module analyses legal and institutional constraints that have weighed down the progress. The module also appraises the impact of reforms in terms of the functioning of various financial markets, specially the money market, the government securities market, the capital market and the foreign exchange market. Evidence regarding growing integration of money, debt, equity and foreign exchange markets is also analysed. In spite of increased integration that could bring volatility spillovers, the volatility in the Indian financial markets has been kept low through a modicum of regulatory interventions and the general policy design for the financial sector put in place during the 1990s. In line with the deregulation and liberalisation policies of the 1990s, financial sector reforms were undertaken in the early phase of reforms. The basic objectives of the reforms were to enhance stability and efficiency of the financial system. It was felt that directed allocation of resources during the pre-reform period, although in accordance with the Plan priorities, was not conducive to allocative efficiency, and the higher rate of growth of financial saving was not matched by a proportionate increase in the rate of growth. The recurrence of domestic banking crises in developed and developing economies alike during the 1980s, and the financial crises in a host of countries in the 1990s underscored the necessity of financial stability for sustained growth. It was recognised that a vibrant, resilient and competitive financial sector is vital for sustaining the reform process in the real sectors of the economy. The most significant achievement of the financial sector reforms has been the marked improvement in the financial health of the commercial banking sector, in terms of asset quality, capital adequacy and profitability. Despite these improvements, the commercial banking sector continues to face several challenges. First, a major concern for the banking system has been the high cost and low productivity as reflected in relatively high spreads and cost of intermediation. An important challenge for the banking sector, therefore, remains in transforming itself to a more efficient, productive and competitive set up. Second, although the capitalisation level of almost all banks operating in India is above the prescribed minimum levels, banks may face difficulties to maintain their capital levels in coming years. The capital requirement of banks is likely to increase with pick up in credit demand and the implementation of the New Capital Accord sometime in 2006, which has accorded greater emphasis on risk-sensitivity in credit allocation. Banks would need to consider these factors while estimating their capital requirements. Given depressed capital market conditions and banks’ limited ability to generate sufficient funds internally, maintaining the capital position in line with the prescribed norms would be a major challenge. Third, commercial banks continue to face the problem of overhang of NPAs, attributable, inter alia, to systemic factors such as weak debt recovery mechanism, non-realisability of collateral and poor credit appraisal techniques. Policy measures have yielded mixed results. The recent enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 has increased the momentum for the recovery of NPAs. However, banks need to intensify their efforts to recover their overdues and prevent generation of fresh NPAs. Fourth, in a regulated regime, risks were essentially compartmentalised with various categories of market and credit risks being managed separately. Increasingly, risk is viewed as multi-dimensional. To enable banks to cope with risks, the Reserve Bank has been engaged in preparing banks for pro-active risk management. Banks would need to establish technical systems and management processes necessary not only to identify risks associated with their activities, but also to effectively measure, monitor and control them. Fifth, it is important that financial institutions possess means and measures of corporate governance. The quality of corporate governance would become critical as competition intensifies, ownership is diversified and banks strive to retain their client base. Banks would be required to further improve their internal management systems in terms of housekeeping, audit practices, asset-liability management and systems management to attain international best practice levels. Sixth, a sound and well-diversified banking system envisages development of a banking sector with a diverse array of well-capitalised and healthy banks. As the dynamics of reforms gathers momentum, the coming years are likely to witness consolidation in the banking sector. Such consolidation will be driven by market forces in an enabling environment, which brings together willing institutions. A related issue is that of ownership of banks. Public sector banks (PSBs) continue to dominate the Indian banking sector and progressively the ownership needs to be diversified to make them more amenable to market discipline and reduce the possibility of regulatory forbearance. Finally, bank lending tends to be pro-cyclical, while the level of NPAs tends to behave in a counter-cyclical fashion. Consequently, in a downturn, as the condition of borrowers deteriorates, they tend to be downgraded by banks with the consequence that extra provisioning has to be set aside, potentially exacerbating the capital shortage. Such behaviour on the part of banks tends to accentuate cyclical fluctuations. In these circumstances, dynamic or forward-looking provisioning by banks may be useful for circumventing such outcome. With the phased withdrawal of Government from direct intervention in the financial sector and gradual divestment of Government ownership in major financial institutions, the importance of deposit insurance arrangements has increased in the context of attainment of financial stability. Introduction of risk-based deposit insurance premium, separation of deposit insurance arrangements for co-operative and commercial banks and introduction of co-insurance, among others, would help foster greater systemic stability as also provide a safety net for depositors. In co-operative banks, the impact of reforms appears to be limited, if assessed in terms of stability and efficiency parameters. One of the reasons for this appears to be delay in the initiation of reforms and the slow paced reform in the sector. Duality of control has also posed concern over the sharing of responsibilities among the regulatory and supervisory authorities. The current duality of control over co-operative banks by the Reserve Bank and the respective State Governments is impeding effective supervision of such entities, which needs to be resolved. In the changed operating environment, development finance institutions (DFIs), which have traditionally been among the main sources of long-term finance for the corporate sector in India, are finding it increasingly difficult to maintain their viability. In view of this, the future role of these DFIs needs to be addressed urgently as the alternative source of long-term funds has not developed. As some DFIs convert themselves into banks or NBFCs, an important source of long-term funds would dry up. Thus, there is a concern regarding the vacuum which would be created by the withdrawal of DFIs from the scene. Although banks have entered the domain of term-lending, there are limits on the extent to which commercial banks may be able to fill this vacuum. The shift from fixed to flexible interest rate regime, development of instruments for hedging interest rate risk, and effectiveness of timely resolution of NPA-related problems would influence the flow of funds from banks for meeting long-term financing requirements. Banks alone, however, may not be able to compensate the decline in long-term funds by DFIs to the corporate sector. To fill the gap, the development of a private corporate debt market is of crucial importance. The development of a benchmark in the fixed securities market and development of secondary market for corporate debt would also stimulate banks’ investment in corporate securities. In the case of mutual funds, while reforms have been successful in creating a competitive environment, the growth of mutual funds slowed down sharply partly due to depressed market conditions and partly due to the problems faced by the Unit Trust of India. Reforms in the insurance sector, which are of recent origin, have also been successful in enhancing competition even as the impact of increased competition on the insurance penetration is yet to be felt. Financial sector reforms have been successful in bringing significant improvements in various market segments by effecting regulatory and legal changes, building up of institutional infrastructure, constant fine-tuning in market microstructure and substantial upgradation of technological infrastructure. Efficient, stable and healthy financial markets constitute the bedrock for successful conduct of monetary policy; hence, improving the effectiveness of the transmission channel of monetary policy necessitated significant reforms in the money and government securities markets. Facilitating integration of domestic financial markets was the other major objective of financial market reforms. Financial market reforms have helped in improving the price discovery in the primary market, while the secondary markets have attained greater depth and liquidity. The number of instruments and participants has also increased. The capital market has become a safer place for investors as various risks involved at various stages of trading and settlement have been either completely eliminated or reduced considerably. Liquidity in the stock market has improved considerably. The government securities market has witnessed a transformation from a captive bank-dominated market to an active debt market operating at market related/determined interest rates. Among the financial market segments, the linkages among the money, government securities and foreign exchange markets have been established and are growing. The presence of foreign institutional investors has strengthened the integration between the domestic and international capital markets. The Reserve Bank’s short-term liquidity management is centred around the LAF operations through repo/reverse repo transactions. However, certain impediments need to be overcome for the smooth operation of LAF. These include the presence of non-bank players in the call market and skewed distribution of liquidity among market players. Further development of the term money market would help in removing the segmentation in the yield curve. This is crucial for effectiveness of monetary policy transmission. Placing limits on banks’ exposure to call money market, making call money market a purely inter-bank market, encouraging development of the collateralised repo market, adherence to prudential asset-liability and risk management guidelines, and on-line connectivity between major bank branches are expected to preserve the integrity of financial markets and facilitate emergence of term money/repo markets in the near future. Significant achievements have been made through the operationalisation of the Clearing Corporation of India Ltd. (CCIL) and the Negotiated Dealing System (NDS). The wider accessibility of NDS to facilitate the development of a repo market in a risk free environment for settlement would need to be expedited. Future developments in the Government securities market hinge on legislative changes consistent with modern technology and market practices. Other measures include the introduction of an RTGS system, integration of the payment and settlement systems for government securities, standardisation of practices with regard to manner of quotes, conclusion of deals and code of best practices for repo transactions and retailing of government securities. The recently proposed introduction of trading in government securities through a nation-wide, anonymous, order-driven, screen-based trading system of the stock exchanges, in the same manner in which trading takes place in equities, would further enhance the operational and informational efficiency of the market as well as its transparency, depth and liquidity, thereby providing for a country-wide retail investor base. Derivatives can play an important role in risk mitigation. There has been a substantial increase in Interest Rate Swaps (IRS)/Forward Rate Agreements (FRA) transactions in 2002. With the increased popularity of the derivatives, a range of possibilities for efficient pricing, hedging and managing of interest rate risks will open up. These would raise new issues like counterparty risks and liquidity risks. For optimising the capital charges, the clearing and settlement of contracts could increasingly be through a centralised counterparty. It may, however, be noted that derivatives market is in an evolving stage in India. A cautious, gradual and sequenced approach to introduction of derivatives instruments to avoid pitfalls is in order. Like derivatives, introduction of floating rate bonds can promote effective management of balance sheet risks when interest rate outlook is uncertain. Depth and liquidity in the spot as well as forward segments in the foreign exchange markets need to be enhanced further. A way to address these concerns lies in the further development of the money market as well as in assumption of the role of ‘market makers’ by large public sector banks who handle the major portion of the export-import transactions. The pre-conditions for the pick-up of activity in forex derivatives include sequentially, the development of-
Expeditious development of these market segments would remove the irritants in the healthy development of the foreign exchange market. In the light of the experience of the East Asian crisis, the movement would need to be ‘gradual’ as the ‘big-bang’ approach could have adverse repercussions for the exchange rate regime, foreign exchange reserves, BoP situation and the overall growth prospects of the economy. Although the capital market has made significant strides in information acquisition, processing and dissemination, there is little evidence that it is now processing the information more efficiently than before reforms. Both, the primary market for private debt (with preponderance of privately placed debt issues) and the secondary market are lagging behind the equity markets in terms of transparency, thus adversely affecting the process of price discovery. Preponderance of the private placement market can potentially strip the market of its ability to discipline issuers and thereby enhance systemic risk. Not all privately placed issues are listed. As a result, investors cannot signal their changing evaluation of the business prospects of the issuers. Some recent regulatory initiatives have been taken to contain risks. In addition, norms for corporate disclosure would also require to be strengthened that would enable investors to take informed decisions as well as to promote transparency. Measures to revive the public issues segment of the primary market could also be contemplated. |
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