Financial sector reforms and emerging issues

Excerpts from the speech delivered by Dr. C. Rangarajan, Governor of Andhra Pradesh, recently at the Asian Regional Seminar on `Financial sector reforms and stability: systemic issues,' co- sponsored by Administrative Staff College of India, Hyderabad, along with the International Monetary Fund.

IT IS well recognised now that the financial sector plays a critical role in the development process of a country. Financial institutions, instruments and markets that constitute the financial sector act as a conduit for the transfer of resources from net savers to net borrowers, that is, from those who spend less than they earn to those who spend more than they earn.

The financial sector performs this basic economic function of intermediation essentially through four transformation mechanisms:

(1) Liability-asset transformation (that is, accepting deposits as a liability and converting them into assets such as loans);

(2) Size transformation (that is, providing large loans on the basis of numerous small deposits);

(3) Maturity transformation (that is, offering savers alternative forms of deposits according to their liquidity preferences while providing borrowers with loans of desired maturities); and

(4) Risk transformation (that is, distributing risks through diversification which substantially reduces risks for savers that would prevail while lending directly in the absence of financial intermediation).

The process of financial intermediation supports increasing capital accumulation through the institutionalisation of savings and investment. The gains to the real sector of the economy, therefore, depend on how efficiently the financial sector performs this basic function of financial intermediation.

Emerging financial risks

While recognising the key role played by the financial system in augmenting savings and investment and thereby accelerating growth, developments in the financial system, particularly in the last three decades, have raised concerns relating to the safety and soundness' of the financial system. The financial system has become more sophisticated; the volume of transactions has multiplied and competitive pressures have grown.

As a result of rapid increases in telecommunications and computer-based technologies, a dramatic expansion in financial flows, both crossborder and within countries, has emerged. Along with these changes, consolidation and increased geographic spread of banks and financial institutions and the blurring of distinctions between various financial institutions have also occurred.

Developments in technology and in the pricing of assets have enabled innovations and financial instruments that allowed risks to be separated and allocated to parties most willing and able to bear them. Thus the menu of financial products has expanded enormously.

All these changes have undoubtedly created new opportunities, but they have also magnified risks. Close interdependencies among markets and market participants have increased the potential for adverse events to spread quickly. They have increased significantly the scope for and speed of contagion.

Banks, for example, are highly leveraged institutions. The systemic risk attached to banking has always been recognised and that is why banks have been subject to controls of various types. It is reported that since the late 1970s, more than two thirds of all IMF (International Monetary Fund) members - industrial, developing and transition economies - have experienced banking crises.

Protecting the banking system

The evolution of the concerns relating to financial stability can be understood by looking at the series of measures taken in relation to banking. In the aftermath of the failure of Bankhaus Herstatt of Germany, the Basle Committee on Banking Regulation and Supervisory Practices was set up in 1974 by the Bank for International Settlements.

In the early 1980s, the committee was concerned that the capital ratios of leading international banks were deteriorating just at the time that international risks were growing. To halt the erosion of capital standards of banks, capital adequacy ratio was prescribed in 1988. Since 1988, this framework has been modified. The capital adequacy ratio now incorporates market risks besides credit risks. Market risks arise from banks' open positions in foreign exchange, traded debt securities, equities, commodities and options.

More recently in 1997, the BIS developed a set of "Core principles for effective banking supervision.' This provides a comprehensive blue-print for an effective supervisory system. These core principles besides laying down procedures for effective supervision over banking also lay down prudential rules and requirements. After describing in some depth the various types of risks in banking, the core document deals with capital adequacy, credit risk management, market risk management, other risk management including interest risk and liquidity management and internal controls.

While these prescriptions are suggested in the context of the supervisory role of central banks or banking supervisory authorities, they essentially refer to practices to be adopted by commercial banks. The IMF and the World Bank have taken more interest in the analysis of the functioning of the banking system in their country assessments. In April 1999, the Financial Stability Forum was set up to promote international financial stability through information exchange and international cooperation in financial supervision and surveillance. In addition, in 1999 a new forum known as 'G-20' was established comprising not only industrially advanced countries but also more leading developing countries such as India. The ministers and governors of the G-20 meet to take stock of the global financial system.

In the wake of the East Asian financial crisis, more attention is being paid on assessing the vulnerabilities of financial systems. An effort is in progress to develop macro prudential indicators that will serve as indicators of the health and stability of financial systems. These indicators comprise both aggregated micro prudential indicators of the health of individual financial institutions and macro economic variables associated with financial system soundness.

Prudential norms

A stable domestic financial system is characterised by financial soundness, efficient markets and integrity of financial operations. In creating a stable financial system, there are two sets of separate but inter dependent concerns. The first set relates to the functioning of individual institutions and markets. It is here the standard setting bodies in the banking, insurance and security sectors are playing a major role. Prudential regulations and supervision are assuming importance. In this context, considerable emphasis is being placed on transparency and disclosure by regulators, supervisors and financial intermediators. Market discipline is also considered an important complement, even though there is no general agreement on how far this can be relied on to promote prudent behaviour.

The second set of concerns relate to vulnerability of the economy as a whole to disruptions. As mentioned earlier, an effort is on to develop macro prudential indicators. In identifying appropriate indicators, we only learn by experience. In the case of at least some of the East Asian economies, the strong economic growth hid several weaknesses in the macro economic management. In fact they were not even recognised as weaknesses. Current account deficit going as high as eight per cent of the GDP, a high proportion of external debt in short maturity and a more or less pegged exchange rate despite deterioration in real terms are factors that were totally ignored.

Thus, maintaining the stability of the financial system requires careful specification of prudential indicators at macro and micro levels. Volatility is an inherent feature of financial markets. Despite capital adequacy ratios and risk management principles being put in place, it is not possible to eliminate volatility. What can, however, be achieved is to keep volatility under control and contain the contagion effect and systemic risk. Both crisis prevention and crisis management need attention.

Reforms in India

The financial sector reforms in India were an integral part of the economic reforms introduced in 1991. The motivations for reforms in India were somewhat different from other countries. Since the nationalisation of banks in 1969, there had been a considerable expansion in banking facilities. The geographical and functional coverage of the Indian banking system was impressive. However, serious concerns had been expressed on the quality and efficiency of the services rendered and more particularly on the viability and profitability of the public sector banks. Profits after provisioning were at a level providing cause for serious concern. This was in a situation when the norms adopted for provisioning themselves were not very strict.

The various measures that were introduced since 1991, as part of banking sector reforms, can be classified into three broad categories: (a) modifying the policy framework, (2) improving the financial health through prescription of prudential norms, and (3) institutional strengthening.

Policy framework

The external factors having a bearing on the functioning of the banking system related to the administered structure of interest rates, high levels of pre-emptions in the form of reserve requirements and mandatory credit allocation to certain sectors. Easing of these external constraints constituted an important part of the reform agenda. The administered structure of interest rates was progressively dismantled. Banks are free to determine the interest rates on all domestic bank deposits as well as on loans except for small loans and credit for export.

The deregulation of the interest rate structure also meant that the Government had to borrow at more or less market determined interest rates. This facilitated the introduction of treasury bills of various maturities and paved the way for the use of open market operations as an instrument of monetary and credit control. The "repos" market also emerged as a consequence. A significant aspect of the reform process was to reduce primary and secondary reserve requirements leading to an expansion in the lendable resources of banks.

Prudential norms relating to income recognition, asset classification, provisioning for bad and doubtful debts and capital adequacy were introduced to ensure proper assessment of the health of banks. The prudential norms were steadily tightened over a period of time. In fact, the process is still continuing so that ultimately Indian standards would be exactly the same as the international standards.

Institutional strengthening included a variety of measures such as licensing of new banks in the private sector, enabling the public sector banks to go to the market and augment their capital base, creation of debt recovery tribunals to deal with loans owned to the commercial banks and the creation of an institutional agency such as ombudsmen to settle the grievances of bank customers. The licensing policy relating to opening of branches by foreign banks was also eased during this period. The public sector banks were recapitalised by the Government to the tune of Rs. 20,000 crores.

To enhance the system of bank supervision, a separate Board for Financial Supervision was created within the Reserve Bank of India. On-site inspection was supplemented by off-site surveillance, which required information to be supplied by commercial banks quarterly in certain formats. A greater emphasis was laid on internal control systems in banks.

Cautious sequencing

A cautious sequencing of measures has been the strength and hallmark of banking sector reforms in India. While banking sector reforms have been proceeding in the right direction, there are a number of unresolved questions. The level of non-performing assets remains high in a number of banks. While there are alternative proposals to deal with accumulated non-performing assets, what is more important is to ensure that non-performing assets out of new loans are kept at a minimum through better assessment and monitoring of loas.

The prescription of prudential norms in the West started with the introduction of the capital to risk assets ratio. India too started with the prescription of the ratio at 8 per cent. Recently it has been increased to 9 per cent. The Narasimham Committee has recommended that it should be raised to 10 per cent by 2002. Capital serves an important purpose. It acts as a buffer to absorb losses. However, the answer to banking stability does not lie in the prescription of higher and higher levels of capital adequacy ratio.

Given the conditions in India, the prescription of 10 per cent as recommended by the Narasimham Committee may be acceptable. However, beyond that, a higher ratio can be counter productive and can, in fact, create a "moral hazard". The need to maintain a higher ratio may push banks into acquiring assets that have a higher earning potential but also carry with them higher risk. Therefore, along with the increase in the capital adequacy ratio, banks must ensure that they have a proper system to manage risks.

Accent on risk management

The old saying was `liquidity and profitability are opposing considerations'. But what is emerging as important now is the management of risk associated with the portfolio. This is what prudential norms taken together stress. Management of risk is much more important than providing for risk. The major focus of banks in India in the coming years will have to be on how to evaluate and manage risks.

The Indian financial system is somewhat isolated from the rest of the world because Indian banks have limited branches outside. However, external forces do impinge through the foreign exchange market. External sector related indicators such as current account deficit and proportion of short-term debt to total external debt are much under control. Domestic factors are the major influence on the functioning of the financial system in India. Strengthening of the regulatory framework keeping in view the special features of the Indian situation is the key to the maintenance of financial stability. The country must create a dynamic financial system that can on its own respond to the changing environment and also correct its mistakes.

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