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May 24, 2007
Financial Sector in India - Efficiency Gains in the midst of Financial Stability
The reform in the Indian financial sector is about one and a half decades old. Prior to that, the Indian financial system essentially catered to the needs of planned development in a mixed-economy framework where the Government sector had a predominant role in economic activity. The financial sector prior to the 1990s was characterised by, (a) segmented and underdeveloped financial markets coupled with paucity of instruments. (b) complex structure of interest rates arising from economic and social concerns , (c) regulation of both deposit and lending rates, (d) a rising burden of non-performing assets. Thus, the government played a large role in deciding who gave and received credit and at what price. The phase was, nevertheless, characterised by significant branch expansion and increased flow of bank credit to important sectors like agriculture, small-scale industries, and exports.
Salient Features of the Financial Sector Reforms in India
The first phase of current reform of the Indian financial sector was initiated in 1992, based on the recommendations of Committee on Financial System (Narasimham Committee). The process has been marked by ‘gradualism’ within a consultative framework.
The main objectives of financial sector reform process in India initiated in the early 1990s have been to: (a) getting rid of the complexities created by excessive regulation with a view to create an atmosphere conducive to the emergence of an efficient, productive and profitable financial sector ; (b) enabling the growth of financial markets that would enable price discovery, in particular, determination of interest rates by the market; (c) providing operational and functional autonomy to the financial system; (d) promoting measures of financial stability, which emerged as an additional objective of monetary policy along with price stability and economic growth; and (e) opening up the external sector in a calibrated fashion so that the domestic sector could withstand the challenges posed by the global financial system.
To the attainment of these objectives, the approach of the Reserve Bank of India towards financial sector reform in India could be summarised by five key aspects :
(a) cautious and proper sequencing of various measures ,
(b) introduction of mutually reinforcing measures, enabling but non-disruptive to the system,
(c) ensuring synergies between reforms in banking sector and changes in fiscal, external and monetary policies,
(d) developing financial infrastructure in terms of supervisory body, audit standards, technology and legal framework; and
(e) taking initiatives to nurture, develop and integrate money, debt and forex markets .
Aspects of Financial Sector Liberalisation in India
Unshackling the financial system from excessive controls constituted an important element of financial liberalisation in India. Removal of these constraints meant a planned reduction in statutory pre-emption and a gradual deregulation of interest rate prescriptions. Accordingly, the complex Structure of administered interest rates has been almost totally dismantled. Prescriptions of rates on all term deposits, including conditions of premature withdrawal, and offering uniform rate irrespective of size of deposits have been dispensed with. Lending rates have been gradually abolished but transparency is insisted upon.
Secondly, reflecting the development of financial markets and the opening up of the economy, the use of broad money as an intermediate target has been de-emphasised, and a multiple indicator approach was adopted in 1998-99, wherein interest rates or rates of return in different markets (money, capital and government securities markets) along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange available on high frequency basis were juxtaposed with output data for drawing policy perspectives.
Thirdly, there has been a sea change in the functioning of financial markets in India since the onset of financial liberalization. Since the onset of reforms, architectural policy efforts has been initiated in organized financial market spectrum cover the money market, the credit market, the capital market, the Government securities market and the foreign exchange market.
Fourthly, along with the steps taken to improve the functioning of these markets, there has been a concomitant strengthening of the regulatory framework. Regulatory initiatives include consolidation of domestic banking sector; restructuring of Development Finance Institutions; and appropriate timing for the significant entry of foreign banks so as to be co-terminus with the transition to greater capital account convertibility while being consistent with our continuing obligation under the WTO commitments.
Fifthly, the financial sector in India is increasingly being integrated to the rest of the world.
Finally, several efforts at improving the payment system in India has been considerably strengthened with the introduction of Real time Gross Settlement System (RTGS), the Special Electronics Funds Transfer System and the Online Tax Accounting System. Liquidity in the Government Securities Market was enhanced by the introduction of Delivery versus Payment mode.
Performance
Adducing to the success of banking sector reforms, the profitability of banks has shown significant improvement, especially, during the last five years. This may be attributed to improvement in asset quality, better loan recovery, rising non-interest income, and containment of expenditure. Banks have made substantial progress in cleaning off non-performing assets (NPAs) from their balance sheet adducing to various institutional measures pertaining to one-time settlement, debt recovery, asset reconstruction and securitisation, lok adalats, and corporate debt restructuring.
A comparison of India’s financial sector with financial sector performance in other countries reveal that since the initiation of reforms, the Indian financial sector has improved considerably in terms of global benchmarks.
First, due to phased deregulation of interest rates, India has migrated from a country with high interest rates to a country with moderate interest rate.
Second, with the sharp decline in reserve requirements, India has transformed into a country with moderate reserve requirement.
Third, there has also been substantial deepening of financial markets under the economic reform process. Since the early 1980s, globally the number of listed companies in India remained second only to the US.
Fourth, in the 1990s, market capitalisation in India as a proportion of GDP , though lower than the global average, improved significantly.
The Road ahead
In the immediate future, certain issues are going to be important for the financial sector reforms in India. In the Banking Sector, there is felt need for further consolidation to remain globally competitive. At the same time, efforts should be directed towards cost containment is a key to sustainability of bank profits as well as their long-term viability. Diversification into fee-based activities coupled with prudent risk management hold the key to future profitability. International convergence in risk management practices under the aegis of Basel II is likely to lead to an even closer focus on risk measurement and risk management at the institutional level. Over the past few years, the Reserve Bank of India has initiated several steps to promote adequate risk management systems across market participants.
Another crucial issue relates to improving the credit delivery system. The persistence of divergence between the informal and formal sector interest rates in effect has meant that, with deregulation, the formal credit mechanisms have not been able to pierce the informal system. Recent policies have placed explicit emphasis on streamlining credit delivery through a gamut of measures, including, among others, widening the scope of infrastructure lending, revamping the rural credit delivery system by envisaged restructuring of the rural banking segment and widening the scope of priority sector lending.
Finally, the quality of corporate governance becomes critical as competition intensifies, ownership is diversified and banks strive to retain their client base. The RBI has, on its part, made significant efforts to improve governance practices in banks, drawing upon international best practices.
In retrospect, the financial sector reforms in India represent a cautious approach towards increasing efficiency within the framework of overall financial stability.
Posted by sunandoroy at May 24, 2007 06:21 AM
That is a well written and clear article on the banking sector in India, it did bring insight and summation of the years of change.
Posted by: Martin Davies at May 27, 2007 04:09 AM
Someone like me who worked in the Indian Financial sector few years back knows the hard fact that a very huge percentage of the Indian Financial Services Industry (even the Big guns) has grown over the past decades essentially through highly coterie based , non transparent and also highly corrupt environments. It is easy to be impressed by the the statistics on paper, but do we really believe that the essentialy corruption based mindset in Indian Financial sector can be changed so easily, just by showing good growth numbers or new technology based systems etc..
Posted by: indian at October 3, 2007 07:51 AM
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