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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
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Preface & Introduction
Until the early 1990s, the role of the financial system in India was primarily restricted to the function of channelling resources from the surplus to deficit sectors. Whereas the financial system performed this role reasonably well, its operations came to be marked by some serious deficiencies over the years. The banking sector suffered from lack of competition, low capital base, low productivity and high intermediation cost. After the nationalisation of large banks in 1969 and 1980, the Government-owned banks have dominated the banking sector. The role of technology was minimal and the quality of service was not given adequate importance. Banks also did not follow proper risk management systems and the prudential standards were weak. All these resulted in poor asset quality and low profitability. Among non-banking financial intermediaries, development finance institutions (DFIs) operated in an over-protected environment with most of the funding coming from assured sources at concessional terms. In the insurance sector, there was little competition. The mutual fund industry also suffered from lack of competition and was dominated for long by one institution, viz., the Unit Trust of India. Non-banking financial companies (NBFCs) grew rapidly, but there was no regulation of their asset side. Financial markets were characterised by control over pricing of financial assets, barriers to entry, high transaction costs and restrictions on movement of funds/participants between the market segments. This apart from inhibiting the development of the markets also affected their efficiency. It was in this backdrop that wide-ranging financial sector reforms in India were introduced as an integral part of the economic reforms initiated in the early 1990s.
Financial sector reforms in India are grounded in the belief that competitive efficiency in the real sectors of the economy will not be realised to its full potential unless the financial sector was reformed as well. Thus, the principal objective of financial sector reform was to improve the allocative efficiency of resources and accelerate the growth process of the real sector by removing structural deficiencies affecting the performance of financial institutions and financial markets.
The main thrust of reforms in the financial sector was on the creation of efficient and stable financial institutions and markets. Reforms in respect of the banking as well as non-banking financial institutions focused on creating a deregulated environment and enabling free play of market forces while at the same time strengthening the prudential norms and the supervisory system. In the banking sector, the particular focus was on imparting operational flexibility and functional autonomy with a view to enhancing efficiency, productivity and profitability, imparting strength to the system and ensuring financial soundness. The restrictions on activities undertaken by the existing institutions were gradually relaxed and barriers to entry in the banking sector were removed. In the case of non-banking financial intermediaries, reforms focussed on removing sector-specific deficiencies. Thus, while reforms in respect of DFIs focussed on imparting market orientation to their operations by withdrawing assured sources of funds, in the case of NBFCs, the reform measures brought their asset side also under the regulation of the Reserve Bank. In the case of the insurance sector and mutual funds, reforms attempted to create a competitive environment by allowing private sector participation.
Reforms in financial markets focused on removal of structural bottlenecks, introduction of new players/ instruments, free pricing of financial assets, relaxation of quantitative restrictions, improvement in trading, clearing and settlement practices, more transparency, etc. Reforms encompassed regulatory and legal changes, building of institutional infrastructure, refinement of market microstructure and technological upgradation. In the various financial market segments, reforms aimed at creating liquidity and depth and an efficient price discovery process.
In response to reforms, the Indian financial sector has undergone radical transformation over the 1990s. Reforms have altered the organisational structure, ownership pattern and domain of operations of institutions and infused competition in the financial sector. The competition has forced the institutions to reposition themselves in order to survive and grow. The extensive progress in technology has enabled markets to graduate from outdated systems to modern market design, thus, bringing about a significant reduction in the speed of execution of trades and the transaction costs. However, despite substantial improvements in the financial sector, some issues have to be addressed over time as the reform process is entrenched further. Whether the public sector character of the banking sector is affecting its performance adversely? Whether dilution of the government stake would have a positive impact on the efficiency of the banking sector? As a result of various reform measures aimed at enhancing stability of financial institutions, there is a possibility that such measures might have affected the efficiency of financial institutions. Whether DFIs have lost their relevance? The relevant issue, however, is how to fill the vacuum that would be created when DFIs withdraw from the scene. The role of mutual funds in promoting savings continues to be insignificant. There is also an issue of availability of adequate risk capital with the resource mobilisation from the primary capital market showing a sharp decline in the second half of 1990s and the early 2000s. It has also been argued by some that various markets are still segmented. With blurring of boundaries among providers of various financial services, the issue as to what should be the appropriate supervisory framework for regulating them has also arisen.
As wide-ranging reforms have been initiated in the financial sector with a view to making it more efficient and stable, the main focus of this chapter is to assess the impact of reforms on efficiency and stability of financial institutions and financial markets. Besides, this chapter attempts to seek answers to the following three questions:
whether ownership pattern (public or private) impinges on the efficiency of the banking sector whether various stability enhancing measures introduced in the Indian banking system have had any adverse impact on its efficiency; and whether the various market segments have become integrated.
The Module is structured as follows. Section I provides the theoretical underpinnings of the financial sector reforms and cross-country experiences with respect to reforms in the financial sector. Section II assesses the impact of reforms on the banking sector and other financial intermediaries in terms of various parameters relating to efficiency and stability. It also highlights some of the issues emerging out of the operations of various categories of non-banking financial institutions (NBFIs) such as DFIs, NBFCs, insurance companies and mutual funds. Section III presents an analysis of the impact of reforms on various segments of the financial market, viz., the money market, the Government securities market, the foreign exchange market and the capital market. The integration of various market segments is also tested empirically and analysed in this Section. The final Section sets out an overall assessment of reforms.
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Theoretical Rationale and International Experience
The financial system acts as an efficient conduit for allocating resources among competing uses. The role and importance of the financial sector in the process of economic growth has evolved over time along with the changing paradigms. Till the late 1960s, the role of financial intermediaries in general, and banks in particular, in the process of economic growth of a country was largely ignored. The views on neutrality of financial intermediaries to economic growth, however, came under attack during the late 1960s. It was pointed out that there exists a strong positive correlation between financial development and economic growth of a country (McKinnon, 1973; Shaw, 1973). The McKinnon–Shaw paradigm highlighted the negative impact of ‘financial repression’, under which the Government determined the quantum, allocation and price of credit, on the growth process. They argued that credit is not just another input and instead, credit is the engine of growth. Subsequently, the proponents of endogenous growth theories argued that with positive marginal productivity of capital, development of financial market induces economic growth in the short as well as long-run by improving efficiency of investment (Bencivenga and Smith, 1991). Under this approach, efficient financial intermediation is growth-inducing through its role in allocating financial resources in the best possible uses. This approach challenged the McKinnon–Shaw paradigm that efficient financial intermediation results in positive real interest rate and that this enhances both saving and investment and thereby economic growth.
Notwithstanding the debate over the relative significance of the channels of financial intermediation in promoting economic growth, an efficient financial system is regarded as a necessary pre-condition for higher growth. Several developing countries, therefore, undertook programmes for reforming their financial systems. In the initial stages of the development process, the financial sector in developing countries was characterised by directed credit allocation, interest rate restrictions and lending criteria based on social needs, etc. These policies retarded the nature of financial intermediation in developing countries and the recognition of the same paved the way for financial sector reforms. Since the late 1970s and the 1980s, financial sector reforms encompassing deregulation of interest rates, revamping of directed credit and the measures to promote competition in the financial services became an integral part of the overall structural adjustment programmes in many developing economies (Box VI.1).
Box VI.1
Financial Sector Reforms: Cross-Country Experiences
The guiding objectives of financial sector reforms in several countries were to improve financial sector efficiency while strengthening financial stability. It was believed that stable and efficient financial systems provided the foundation for implementing effective stabilisation policies, stepping up savings and improving the efficiency of investment, all of which help in achieving sustainable and higher rates of economic growth.
Cross-country experiences relating to financial sector reforms exhibited significant diversity, both over time and across countries. Despite the evolving consensus on the underlying rationale of a robust financial system, there was no unique approach that was uniformly applied across countries. Significant differences could be observed in respect of the content, pace and sequencing of reforms, which, to some extent, were due to the reason that some countries experienced financial crises after implementation of liberalisation measures.
There was significant liberalisation of the financial sector both in industrial and developing countries over the period 1973-2002. Interest rate controls were almost universally eliminated and barriers to entry for most non-bank financial institutions were lowered, and in certain instances, rationalised. Most Latin American economies eliminated directed credit programmes and interest rate controls (exceptions being Brazil and Venezuela). Competition in the commercial banking sector was permitted in Latin American economies in the late 1970s and more recently in several Asian countries. Privatisation of state-owned banks was less sweeping across developing countries. For instance, prior to reforms, in several developing countries, the state-owned banks accounted for at least 40 per cent of the total banking sector assets. In several Asian (Korea, Taiwan and Indonesia) and Latin American countries (Chile and Mexico), the share of state-owned banks was higher than 70 per cent. However, recent evidence suggests a significant scaling down of Government ownership in the banking sector.
As regards the pace of reforms, Asian countries like Japan, Korea, Malaysia and Indonesia followed a gradualist approach to financial liberalisation in contrast to transition economies of Eastern Europe and some of the Latin American countries which adopted the ‘big-bang’ approach. While the Asian countries could afford a gradualist approach and maintain a system of financial repression because it did not reduce their ability to mobilise savings for economic development, some of the Southern Cone countries needed to liberalise rapidly to encourage greater mobilisation of savings to finance development. The pace of liberalisation tended to be faster in the Latin American countries, although there were instances of reversal. For example, Chile first liberalised with a big-bang in the 1970s when it privatised nationalised banks and removed controls on interest rates. Argentina also eliminated directed credit and interest rate controls in the late 1970s. However, both Chile and Argentina re-imposed controls during the financial crisis of the early 1980s, although they were subsequently relaxed. Chile, for instance, removed most controls by 1984 and re-privatised the nationalised banks in the mid-1980s. Argentina, on the other hand, embarked on a course of bank regulatory reform in the early 1990s, albeit at a slower pace. The major elements of the reforms comprised privatisation, free entry, limited safety net support and a mix of regulatory and market discipline to ensure stable growth of the banking system during the liberalisation process (Calomiris and Powell, 2000). Mexico’s liberalisation in the late 1980s was punctuated by four turning points: 1982 (exchange rate crisis and bank nationalisation), 1988-89 (interest rate liberalisation), 1991-92 (bank privatisation) and 1994 (Tequila crisis). The financial liberalisation process culminated into transfer of ownership of state-owned banks to the private sector in 1991-92 and elimination of most of the entry barriers.
A number of countries in Asia, following the gradualist approach, progressively dismantled their directed credit programmes by introducing market-based rates on directed loans and increasing the number of categories eligible for special credit access. In Thailand, for instance, directed credit was eased in 1987 by widening the definition of agricultural credit to include wholesale and small-scale industrial activities. In Indonesia, Malaysia and South Korea, targeted lending programmes were reduced in scope, and subjected to market rates in the 1980s and the 1990s. In Philippines, however, the Government exerts influence over credit allocations through commercial banks’ dependence on central bank rediscount window. Indonesia, Malaysia and Philippines assumed the lead in interest rate deregulation, beginning the process in the early 1980s.
Following the macroeconomic crisis in the early 1980s in Argentina and Chile and subsequent to the initiation of financial sector reforms, a strand of literature evolved which sought to explain the failure of reforms in terms of incorrect sequencing of the reform programmes (McKinnon, 1993). According to the conventional wisdom, stable macroeconomic environment and a sound system of prudential supervision are prerequisites for domestic financial deregulation. In practice, however, several countries implemented macroeconomic reforms prior to, or in tandem with, financial liberalisation. Chile, Peru and Turkey began financial sector deregulation under conditions of macroeconomic instability, but implemented their reforms as part of a larger stabilisation effort. Argentina, Brazil and Mexico, however, deregulated their financial sectors during periods of high inflation ahead of stabilisation programmes.
The apprehension that financial liberalisation is destined to breed crises has been documented in an influential study (Diaz-Alejandro, 1985). Several developing and industrial countries experienced episodes of systemic or borderline banking crises of varying magnitude and frequency, although in several instances they were not associated with financial liberalisation. Most developing countries, in particular, witnessed some financial instability, following liberalisation, including those in Latin America (Argentina, Chile, Brazil and Mexico) and Asia (Indonesia, Malaysia, Philippines, Sri Lanka, Thailand and Turkey). Banks generally found their existing loan portfolios to be less sound in a liberalised environment, because borrowers were not able to service debts due to higher interest costs or simply because implicit guarantees from Government on these debts were no longer available.
Thus, the evidence suggests that there are no iron cast formulae for financial liberalisation. A strategy adopted by a country could largely depend on the initial conditions of its financial infrastructure and extent of repression, the response of monetary and credit aggregates to monetary reforms and the health of its banking sector. Recent studies indicate that banking crises tend to precipitate balance of payments crises, but not vice versa (Kaminsky and Reinhart, 1999). The analysis of the experience of over 50 countries during 1980-1995 reveals that banking crises are more likely to occur in liberalised financial systems, but not where the institutional environment is strong in terms of respect for the rule of law, low level of corruption and good contract enforcement (Demirgüc-Kunt and Detragiache, 2002).
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