Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: The Indian Approach
Regulatory and Supervisory Initiatives

As indicated above, in the pursuit of financial stability, monetary policies need to be supported by proactive regulatory and supervisory initiatives in regard to the financial sector. In what follows, a brief overview of the Indian financial system is presented followed by a discussion of the various initiatives and an assessment of the health of the financial sector. The financial sector in India is sufficiently deep. Financial savings have grown steadily in line with developments and liberalisation of the financial sector, reflecting high savings rate (24.2 per cent in 2002-03) and prudent management that has fostered macroeconomic stability.

The financial sector, which was closed and tightly regulated till the early 1990s, has become open and competitive. The approach towards financial sector reforms has been based on pancha sutra or five principles:

1. cautious and appropriate sequencing of reform measures;

2. introduction of norms that are mutually reinforcing;

3. introduction of complementary reforms across sectors (most importantly, monetary, fiscal and external sector);

4. development of financial institutions; and,

5. development of financial markets.

The reforms have aimed at enhancing productivity and efficiency of the financial sector, improving the transparency of operations and ensuring that it is capable of withstanding idiosyncratic shocks. Interest rates were gradually liberalised, directed credit allocations were expanded to encompass an extended range of activities, competition was increased in the banking sector and the insurance sector was opened up to private competition. At the same time, the regulatory and supervisory apparatus was strengthened. Salient features of the Indian financial system are briefly discussed below: l Commercial banks are the most important financial intermediaries, accounting for about 66 per cent of total assets and public sector banks (PSBs) dominate the sector, comprising nearly 47 per cent of the banking system assets. New private and foreign banks, whose activities were limited until the onset of reforms, represent a rising share of the sector, promoting new financial products with strong technological backup².

• A large network of regional rural banks (RRBs) and cooperative banks (rural and urban) serves borrowers in rural and urban areas. The RRBs were established under an Act of Parliament with the Central Government, State Governments and sponsor PSBs all taking holdings in them to improve credit delivery in rural areas. The cooperative banks cater to the credit needs of specific communities or groups of people in a region and comprise both rural and urban entities.

• The term-lending institutions are mostly government-owned and have been the traditional providers of long-term project loans. Accounting for approximately six per cent of total assets, these institutions raise funds in capital markets as well as through retail sales of savings instruments. Over the past few years, two such institutions have since transformed into a bank.

• Investment institutions are currently largely in public domain, although the sector has since been opened up to private participation. The Life Insurance Corporation of India has a dominant position in the public sector category.

• Non-life insurance providers - the General Insurance Corporation of India and its four erstwhile subsidiaries - account for two per cent of total financial sector assets.

• State-level institutions - the State Financial Corporations registered under the State Financial Corporations Act, 1951 and the State Industrial Development Corporations (SIDCs) - purvey credit to industries/sectors in different states and account for about 0.8 per cent of total assets³.

• There are also the Deposit Insurance and Credit Guarantee Corporation (DICGC), a wholly-owned subsidiary of the Reserve Bank providing insurance for deposits with commercial and cooperative banks and the Export Credit Guarantee Corporation (ECGC), providing guarantee cover to exports. Their share of total financial sector assets approximates 0.3 per cent.

• Non-bank financial companies provide a gamut of services and account for roughly two per cent of financial sector assets. This sector witnessed a rapid growth in the mid 1990s, but consequent upon the introduction of new norms for their registration and functioning, growth has since slowed down and the Reserve Bank has authorised 584 NBFCs to accept/hold public deposits.

• Primary dealers are active players in the Government securities market. Numbering 17, they account for 0.5 per cent of assets. The majority of them are promoted by banks, which largely continue to retain majority stakes in their sponsored primary dealers. In 2003-04, they accounted for 25 per cent of the outright market turnover.

• There are 23 stock exchanges in India, dominated by the two large exchanges: National Stock Exchange of India (NSE) and the Stock Exchange, Mumbai (BSE). The functioning of the stock exchanges has witnessed significant developments after the initiation of reforms in the 1990s. At end-March 2004, market capitalisation was Rs.1,201,207 crore, while turnover aggregated Rs.5,02,620 crore at the BSE; turnover in equity derivatives was also significant at Rs.2,130,610 crore at the NSE.

²In March 2004, the Government of India issued notification while raising foreign direct investment limit in private sector banks up to a maximum of 74 per cent under the automatic route, including the investments made by foreign institutional investors. According to the Government's notification, foreign banks are permitted to have either branches or subsidiaries only. They may operate in India through one of the three channels, viz., (i) branch/es; (ii) wholly-owned subsidiary; or (iii) a subsidiary with aggregate foreign investment up to a maximum of 74 per cent in a private bank.

³Other institutions established to meet specific financing needs include Power Finance Corporation (PFC) and Rural Electrification Corporation (REC) (financial assistance to the power sector) and Indian Railway Finance Corporation (IRFC), which is the capital market financing arm of Indian Railways. These institutions have been notified as Public Financial Institutions (PFIs) under the Companies Act, 1956. In addition, at the state-level, there exist the North Eastern Development Finance Corporation (extending credit to industry/agricultural concerns in the North Eastern region) and Technical Consultancy Organisations (providing technical inputs for feasibility studies on viability of projects).