A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 4 - Financial Sector Reforms

Financial Markets - An Assessment of Reforms

Credit Risk, Capitalisation and Efficiency - Insurance & Mutual Funds

Insurance has been an important part of the Indian financial system. Until recently, insurance services were provided by the public sector, i.e., life insurance by the Life Insurance Corporation of India since the mid-1950s, and general insurance by the General Insurance Corporation (GIC) and its four subsidiaries since the 1970s. The insurance industry was opened up to the private sector in August 2000. The primary objective of liberalisation in the insurance sector was to deepen insurance penetration by enlarging consumer choices through product innovation. After opening up of the insurance sector, 12 new companies have entered the life segment and 9 companies in the non-life segment. The increased competition led to rapid product innovations for catering to the diverse requirements of the various segments of the population. Besides statutory commitments in respect of weaker sections of society, competitive pressures are pushing life insurers to adopt innovative marketing strategies to extend insurance penetration, especially targeting lower income groups.

The size of the insurance sector, which stagnated around 0.6 per cent of GDP during the 1980s and the 1990s, accelerated in recent years as the existing insurers endeavoured to retain their market share, while new players attempted to establish themselves.

The share of insurance sector in household financial savings moved up from 7.6 per cent during the 1980s to 10.1 per cent during the 1990s and further to about 12 per cent during 2000-01. However, the insurance penetration ( i.e., the share of premium as percentage of GDP) in India remained low at 2.3 per cent as at end-March 2000 in comparison with the world average of 7.8 per cent and the emerging market average of 3.2 per cent.

The opening up of the insurance sector is expected to lead to increased competition and innovations in financial products. Insurance products compete with other saving products such as bank term deposits and small savings. Many of the new insurance products, especially unit-linked insurance/pension schemes, now bear a close resemblance to mutual funds. While the yield on life insurance products, in the range of 7.15 per cent to 9.46 per cent during the 1990s, was normally much lower than other long-run investments, this was compensated by the insurance cover and tax benefits. As new players join the fray, the competition in respect of various financial products is expected to go up in the near future.

The expansion of the insurance industry has a special significance in that it creates a demand for long-term Government paper, especially as Government securities accounted for 52.2 per cent of the life investment as at end-March 2002. This could ease the fiscal constraint on monetary policy in two ways, i.e., by enlarging the pool of institutional investors in the Government securities market and by according the Reserve Bank the necessary flexibility to enlarge the maturity profile of public debt.

The key policy challenge, at this stage, is to ensure the financial stability of the new insurers, while at the same time encouraging entrepreneurship, product innovation and increasing insurance penetration especially in rural and semi-urban areas.

There is, therefore, a case for gradually replacing across-the-board capital requirements with capital stipulations linked to the risk and claims characteristics of a particular line of business as is the practice in some advanced countries as recommended by the Advisory Group on Insurance Regulation (2001). This would increase the number of players and product innovation. Also, while the present statutory stipulations are adequate, there is a need to explore the possibilities of linking prudential norms to the size of the balance sheet, especially in terms of capital adequacy norms (IRDA, 2002). Presently, insurers are mainly offering insurance schemes, which are based on assured returns. This is fraught with serious risks, especially when interest rate scenario/market condition changes. In order to stave off the risks associated with assured returns schemes, insurers need to shift to unit-linked insurance schemes based on the market rates of return. While the joint ventures formed by new insurers with entities, including banks and NBFCs, having a large branch/dealer network, minimise establishment costs, the contagion risks also get amplified in the process. This would require close coordination among the regulating agencies.

The Unit Trust of India (UTI), set up in 1964, was the only mutual fund in the country until 1987-88 when a public sector bank-sponsored mutual fund was established. The mutual fund industry expanded in the 1990s after it was opened to the private sector in 1993. A large number of mutual funds (37 as at end-March 2002) operating in the country has intensified competition and led to product innovation. Mutual funds presently offer a variety of options to investors such as income funds, balanced funds, liquid funds, gilt funds, index funds, exchange traded funds, sectoral funds, etc. In all, there were 417 schemes (as at end-March 2002) in operation to cater to diverse investor needs.

Despite increase in the number ofZZZ mutual funds and the schemes operated by them, net resource mobilisation by mutual funds decelerated sharply during 1990-2002 (with the average annual growth rate being 13.0 per cent) in comparison with the 1980s (71.1 per cent). Net resource mobilisation in relation to GDP also declined sharply from 1.7 per cent in 1991-92 to 0.4 per cent in 2001-02 (Table 6.24). Their share in household savings also declined to 1.3 per cent in 2000-01 from 5.5 per cent in 1993-94. Total assets under management of all mutual funds also witnessed a similar trend.

The sharp deceleration in the growth of mutual funds in the 1990s and early 2000s could be attributed partly to relatively poor performance of the stock market (the BSE Sensex during 1990-2002 on an average increased by 17.5 per cent per annum as compared with 22.4 per cent per annum during the 1980s) and partly to withdrawal of tax benefits under Section 80M of the Income Tax Act. Another major factor which appeared to have contributed to the deceleration was the problem with assured return schemes and US-64 of UTI.

Some of the mutual funds had offered assured return schemes. While these assured return schemes enabled them to mobilise large resources, a number of mutual funds faced difficulties in meeting their redemption obligations relating to such schemes. In several cases, the sponsors of mutual funds had to infuse additional funds to meet the shortfall. As a result, mutual funds, by and large, discontinued the floatation of assured return schemes, which had some dampening effect on the resource mobilisation by mutual funds. While most of the mutual funds were somehow able to meet their commitments on account of assured return schemes, UTI faced a somewhat different problem on two different occasions between October 1998 and July 2001. US-64, which was the flagship scheme of UTI and enjoyed the investors’ faith, first faced problem in December 1998 when the reserves under the scheme were reported negative. In July, the original corpus of US-64 scheme had been eroded to the extent of over Rs.1,000 crore. In order to restore investors’ confidence, several measures were initiated by the Government/UTI. While these helped the US-64 to make a turnaround, the problem resurfaced again in July 2001 when UTI slashed down the dividend rate for the year 2000-01 and suspended sales and repurchases of US-64 for a period of six months from July 2001 to December 2001. This created a crisis of confidence and to restore investors’ confidence various measures were initiated, which culminated in splitting the UTI into two parts, i.e., UTI-I and UTI-II.5 6.83 The problem with US-64 scheme of UTI adversely affected the resource mobilisation by mutual funds in general and UTI in particular (Table 6.25 and Chart VI.6). On both the occasions when UTI faced difficulties, while resource mobilisation by UTI declined sharply, private sector mutual funds were able to fill the gap created by UTI only partially as overall mobilisation by all mutual funds on both the occasions declined sharply after the occurrence of the problem. During 1998-99, resource mobilisation declined by 33.67 per cent in comparison with 1997-98 (UTI faced problem first in October 1998) and by 27.9 per cent in 2001-02 in comparison with 2000-01 (UTI faced problem again in July 2001). During 2002-03 (April-September), net outflow of resources from UTI was more or less offset by net inflows into private sector mutual funds and thus, private sector mutual funds were able to fill the gap created by UTI.

Mutual funds are an ideal vehicle for investment by retail investors in the stock market for several reasons. First, it pools the investments of small investors together increasing thereby the participation in the stock market. Secondly, mutual funds, being institutional investors, can invest in market analysis generally not available or accessible to individual investors, providing thereby informed decisions to the small investors. Thirdly, mutual funds can diversify the portfolio in a better way as compared with individual investors due to the expertise and availability of funds.

Mutual funds in India, because of their small size and slower growth in the recent past, have tended to play only a limited role in the stock market. The share of mutual funds in total turnover of the stock markets (BSE+NSE), which was 4.9 per cent in January 2000, declined to 3.6 per cent by January 2003. One of the reasons for the decline in the share of mutual funds in the turnover was that in the recent past, mutual funds shifted the portfolio composition from equity to debt due to subdued equity market conditions.

In view of small size of their operations, mutual funds in normal times hardly exert any influence on the stock market. This is evident from the correlation coefficient between net purchases of equities by mutual funds and the BSE Sensex during the period from February 4, 2000 to February 7, 2003, which worked out to an insignificant -0.02. Nonetheless, major developments concerning mutual funds do exert significant influence on the sentiment. It can be seen from Chart VI.9 that negative developments at UTI such as reporting of negative corpus for US-64 in October 1998, heavy redemption pressure on US-64 and ban on sale and repurchase of US-64 units in July 2001 resulted in decline in the BSE Sensex. On the other hand, positive developments like implementation of special unit scheme and announcement of positive corpus for US-64 were associated with general uptrend in the equity prices.

Mutual funds are very popular all over the world and they play an important role in many countries. As at end 2001, there were about 52,735 open-ended mutual fund schemes in operation in the world with a total asset base of US $ 1,094 billion. Despite a long history, assets of mutual funds in India constitute less than 5 per cent of GDP which is very low in comparison with about 25 per cent in Brazil and 33 per cent in Korea.

One of the major reasons for this is that the penetration of mutual funds, especially in the rural areas remains small. According to the survey carried out by SEBI-NCAER (2000), mutual funds have been found to be popular mainly with the middle and high-income groups and have not been found to be an attractive investment avenue for the low-income groups. Thus, if mutual funds have to grow fast, they would need to devise appropriate schemes to attract the saving of low-income groups, especially in rural areas. This is the only way to ensure participation of all categories of investors into the capital market, which is so crucial for its long-term development. Mutual funds with large funds at their disposal are also required to act as a counterweight to FIIs, which generally exerts a significant influence on the stock market.

To sum up, financial sector reforms introduced since the early 1990s have brought about a significant improvement in the financial system. The commercial banking sector, which constitutes the most important segment, has witnessed a remarkable improvement both in stability and efficiency parameters such as capital position, asset quality, spread and overall profitability. It is significant to note that the improvement was noticed in respect of all bank groups. However, the empirical evidence does suggest that public ownership impinged on the efficiency of the banking sector. This was evident from the fact that old private sector banks and those PSBs, which divested their equity recently, outperformed fully government-owned banks, although significant improvement was observed in the performance of fully Government-owned banks in the recent years. There is a feeling in some quarters that stability measures impinge on the efficiency of the banking sector. However, in the context of the Indian banking sector, various measures introduced to enhance the stability of the Indian banking system have not adversely affected their efficiency. In fact, stability and efficiency measures were found to be mutually reinforcing and complimentary.

In respect of other intermediaries, however, the impact of reforms was not so perceptible. In the case of co-operative banks, no significant improvement was observed either in the stability or efficiency parameters, except that state co-operative banks and District central co-operative banks, which were incurring losses, turned around and made some profits. The performance of scheduled urban co-operative banks in terms of asset quality and profitability deteriorated in the recent years. One reason for this appears to be that the reform process for co-operative banks started much later than the commercial banking sector and that too in a phased manner. It may, therefore, take some more time for the reforms to have their impact.

While there was some improvement in the stability parameters (capital and assets quality) of DFIs as a group, the asset quality of some of the DFIs was seriously impaired. Profitability of DFIs, in general, also declined. The decline in their profitability was due to increased competition on the asset side and increased cost of funds on the liability side after assured sources of funds were withdrawn. Thus, insofar as DFIs are concerned, overall there has been some deterioration in efficiency parameters. Reforms have been successful in increasing the competition in the insurance sector and mutual fund industry. In the case of mutual funds, while the 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 problem faced by UTI. 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 insurance penetration is yet to be felt. Thus, insofar as financial intermediaries are concerned, reforms have had a mixed impact. While reforms have brought about significant improvement in respect of commercial banks, the impact was not so perceptible in respect of co-operative banks and non-bank financial intermediaries.