A decade of financial sector reforms

The last ten years have witnessed a maturing of the country's financial markets. While many major commercial banking and specialised investment institutions continue to be in the public sector, private sector institutions are growing rapidly in commercial banking and asset management business, says Abhijit Roy.

A DECADE is not a long time in the life of a nation. However, the last ten years mark a watershed in India's economic and political development. This article attempts to take stock, albeit briefly, of the important achievements of the financial sector reforms undertaken since 1991 by various governments.

Financial markets

The last ten years have witnessed a maturing of the country's financial markets. While many major commercial banking and specialised investment institutions continue to be in the public sector. Private sector institutions are growing rapidly in commercial banking and asset management business. With the recent opening up of the insurance sector, the private sector will start making a dent in the market.

Deregulation of the financial system and competition among financial intermediaries have led to a gradual decline in interest rates. The task is to keep the real interest rate, that is the difference between the nominal rate of interest and the expected rate of inflation, at a realistic level, so that borrowers do not pay a high price, while depositors have an incentive to save. In India structural rigidities in the form of high intermediation costs and non-performing assets have been responsible for high real interest rates.

It may be added that deregulation has not always been successful, witness the problems faced by a number of non-banking finance companies (NBFCs) and the poor performance of primary markets in recent years.

Regulators

The Government has accepted the important role of regulators. The Finance Ministry continues to formulate major policies relating to the financial sector. However, the Reserve Bank of India has become more independent, while the Securities and Exchange Board of India and the Insurance Regulatory and Development Authority (IRDA) have become important institutions. A Pensions Regulatory Authority is to be set up under the IRDA. There is an opinion that a multiplicity of regulators should be avoided and there is need for a super-regulator for the financial services sector.

The banking system

Public sector banks (PSBs) continue to dominate the commercial banking system, controlling 80 per cent of the business. Shares of leading PSBs are already listed on the stock exchanges. The Government proposes to reduce its equity stake in PSBs to 33 per cent. This can ultimately lead to privatisation of PSBs.

As part of the liberalisation process, the RBI gave licences to new private sector banks. Already restructuring of private sector banking has started with a few banks merging in order to form stronger entities. Only a few of the existing private sector banks have the managerial capability and financial strength to expand rapidly. The RBI has also been wary of granting banking licences to industrial houses. Further, a number of private sector banks have been successful in the retail and consumer segments, but are yet to deliver in important areas such as industrial finance, retail trade, small business and agricultural finance. With foreign banks facing the constraint of limited number of branches, the PSBs will continue to be the critical element in this industry for some time. Hence, in order to achieve an efficient banking system, the onus is on the Government to encourage the PSBs to be run on professional lines.

Development finance institutions

FIs's access to SLR funds reduced. Now they have to approach the capital market for debt and equity funds.

Convertibility clause no longer obligatory for assistance to corporates sanctioned by term-lending institutions.

Capital adequacy norms extended to financial institutions.

DFIs such as IDBI and ICICI have entered other segments of financial services such as commercial banking, asset management and insurance through separate ventures. The move to universal banking has started.

Non-banking finance companies

In the case of new NBFCs seeking registration with the RBI, the requirement of minimum net owned funds, has been raised to Rs.2 crores.

Until recently, the money market in India was narrow and circumscribed by tight regulations over interest rates and participants. The secondary market was underdeveloped and lacked liquidity. Several measures have been initiated and include new money market instruments, strengthening of existing instruments and setting up of the Discount and Finance House of India (DFHI).

The RBI conducts its sales of dated securities and treasury bills through its open market operations (OMO) window. Primary dealers bid for these securities and also trade in them. The DFHI is the principal agency for developing a secondary market for money market instruments and Government of India treasury bills. The RBI has introduced a liquidity adjustment facility (LAF) in which liquidity is injected through reverse repo auctions and liquidity is sucked out through repo auctions.

On account of the substantial issue of government debt, the gilt- edged market occupies an important position in the financial set- up. The Securities Trading Corporation of India (STCI), which started operations in June 1994 has a mandate to develop the secondary market in government securities.

Long-term debt market: The development of a long-term debt market is crucial to the financing of infrastructure. After bringing some order to the equity market, the SEBI has now decided to concentrate on the development of the debt market. Stamp duty is being withdrawn at the time of dematerialisation of debt instruments in order to encourage paperless trading.

The capital market

The number of shareholders in India is estimated at 25 million. However, only an estimated two lakh persons actively trade in stocks. There has been a dramatic improvement in the country's stock market trading infrastructure during the last few years. Expectations are that India will be an attractive emerging market with tremendous potential. Unfortunately, during recent times the stock markets have been constrained by some unsavoury developments, which has led to retail investors deserting the stock markets.

Mutual funds

The mutual funds industry is now regulated under the SEBI (Mutual Funds) Regulations, 1996 and amendments thereto. With the issuance of SEBI guidelines, the industry had a framework for the establishment of many more players, both Indian and foreign players.

The Unit Trust of India remains easily the biggest mutual fund controlling a corpus of nearly Rs.70,000 crores, but its share is going down. The biggest shock to the mutual fund industry during recent times was the insecurity generated in the minds of investors regarding the US 64 scheme. With the growth in the securities markets and tax advantages granted for investment in mutual fund units, mutual funds started becoming popular.

The foreign owned AMCs are the ones which are now setting the pace for the industry. They are introducing new products, setting new standards of customer service, improving disclosure standards and experimenting with new types of distribution.

The insurance industry is the latest to be thrown open to competition from the private sector including foreign players. Foreign companies can only enter joint ventures with Indian companies, with participation restricted to 26 per cent of equity. It is too early to conclude whether the erstwhile public sector monopolies will successfully be able to face up to the competition posed by the new players, but it can be expected that the customer will gain from improved service.

The new players will need to bring in innovative products as well as fresh ideas on marketing and distribution, in order to improve the low per capita insurance coverage. Good regulation will, of course, be essential.

Overall approach to reforms

The last ten years have seen major improvements in the working of various financial market participants. The government and the regulatory authorities have followed a step-by-step approach, not a big bang one. The entry of foreign players has assisted in the introduction of international practices and systems. Technology developments have improved customer service. Some gaps however remain (for example: lack of an inter-bank interest rate benchmark, an active corporate debt market and a developed derivatives market). On the whole, the cumulative effect of the developments since 1991 has been quite encouraging. An indication of the strength of the reformed Indian financial system can be seen from the way India was not affected by the Southeast Asian crisis.

However, financial liberalisation alone will not ensure stable economic growth. Some tough decisions still need to be taken. Without fiscal control, financial stability cannot be ensured. The fate of the Fiscal Responsibility Bill remains unknown and high fiscal deficits continue. In the case of financial institutions, the political and legal structures hve to ensure that borrowers repay on time the loans they have taken. The phenomenon of rich industrialists and bankrupt companies continues. Further, frauds cannot be totally prevented, even with the best of regulation. However, punishment has to follow crime, which is often not the case in India.

Where do we go from here?

The Indian financial system is fragmented and small by international standards. The global trend is towards convergence and consolidation. The M&A activity in the Indian financial system till now has been mainly restricted to private players. The role of foreign capital in the financial services sector has been somewhat limited in the past decade, but is expected to increase in the coming decade, with the World Trade Organisation probably facilitating the process. Foreign companies are already allowed to hold a majority stake in asset management companies and NBFCs, up to 49 per cent in banks and a maximum of 26 per cent in insurance companies.

The Government has to decide what it wants to do with its ownership of public sector financial institutions. Lack of funds will force its to divest its stake over a period, but this may mean only a slow death for the institutions involved. The political and bureaucratic establishment has to be convinced that they are doing more harm than good by interfering in the management of these institutions. Otherwise even after reduction of its equity stake to 33 per cent, the public sector character of banks will remain unchanged! Offices such as Department of Banking need to be wound up, with regulators taking control. Senior level appointments have to be made by the respective boards of directors by accessing the market place, and offering market related salaries and incentives. The board of directors, based on performance, should renew senior level appointments. The institutions should have the right to forcibly retire existing non-performing employees, and new staff should be recruited without guaranteeing life-time employment. Even the threat of action will improve performance and productivity.

A few steps will dramatically change the outlook of these institutions and Government will get much higher prices for the shares divested. Government shares should be offered either to the ordinary public, or domestic and international financial institutions like mutual funds, FIIs, insurance companies, pension funds and banks, and not to business houses. Today international capital movements have ensured that there is no dearth of funds for good proposals. It has to be realised that there is a difference between ownership and professional management. This is applicable to Government and private sector entities.

Consolidation imperative

Another aspect of the financial sector reforms is the consolidation of existing institutions. This is especially applicable to the commercial banks. There are just too many banks in India. First, there is no need for 27 PSBs with branches all over India. A number of them can be merged. The merger of Punjab National Bank and New Bank of India was a difficult one, but the situation is different now. No one expected so many employees to take voluntary retirement from PSBs, which at one time were much sought after jobs. Private sector banks will consolidate on their own, while co-operative banks and rural banks need to be encouraged to do so, and anyway play only a niche role.

In the case of insurance, the Life Insurance Corporation of India is a behemoth, while the four public sector general insurance companies will probably move towards consolidation with a bit of nudging. The UTI is again a large institution, even though facing difficult times, and most other public sector players are already exiting the mutual fund business. There are a number of small mutual fund players in the private sector, but the business being comparatively new for the private players, it will take some time before consolidation takes place.

We finally come to convergence in the financial sector, the new buzzword internationally. Modern technology and the need to meet heightened consumer expectations is encouraging convergence, even though it has not always been successful. In India organisations such as ICICI, IDBI, HDFC and SBI are already trying to offer various services to the customer under one umbrella. This phenomenon is expected to grow rapidly in the coming years. Where mergers may not be possible, alliances between organisations may be effective. Various forms of bancassurance are being introduced, with the RBI having already come out with detailed guidelines for entry of banks into insurance. The LIC has bought into Corporation Bank in order to spread its insurance distribution network. Both banks and insurance companies have started entering the asset management business, as there is a great deal of synergy among these businesses. The pensions market is expected to open up fresh opportunities for insurance companies and mutual funds.

It is not possible to play the role of the Oracle of Delphi when a vast nation like India is involved. However, a few trends are evident, and the coming decade should be as interesting as the last one.

* * *

Deregulation of banking system

Prudential norms introduced for income recognition, asset classification, provisioning for delinquent loans and capital kadequacy. In order to reach the stipulated capital adequacy norms, substantial capital has been provided by the Government to PSBs.

Government pre-emption of banks' resources through statutory liquidity ratio (SLR) and cash reserve ratio (CRR) brought down in stages.

Interest rates on deposit and lending sides almost entirely deregulated.

New private sector banks allowed to promote competition.

PSBs encouraged to approach the public to raise resources.

Recovery of debts due to banks and the Financial Institutions Act, 1993 passed, and special recovery tribunals set up to facilitate quicker recovery of loan arrears.

Bank lending norms liberalised and a loan system to ensure better control over credit introduced.

Banks asked to set up asset liability management (ALM) systems. RBI guidelines issued for risk management systems in banks encompassing credit, market and operational risks.

A credit information bureau being established to identify bad risks.

Derivative products such as forward rate agreements (FRAs) and interest rate swaps (IRSs) introduced.

* * *

Capital market developments

The Capital Issues (Control) Act, 1947, repealed, office of the Controller of Capital Issues abolished and initial share pricing decontrolled.

The SEBI, the capital market regulator, established in 1992.

Foreign institutional investors (FIIs) allowed to invest in Indian capital markets after registration with the SEBI.

Indian companies permitted to access international capital markets through euro issues.

The National Stock Exchange (NSE), with nationwide stock trading and electronic display, clearing and settlement facilities, established. Several regional stock exchanges change over from floor based trading to screen based trading.

SEBI regulations governing substantial acquisition of shares and takeovers, including conditions under which disclosures and mandatory public offers are to be made to shareholders.

Private mutual funds permitted.

The Depositories Act provides a legal framework for the establishment of depositories to record ownership deals in book entry form. Dematerialisation of stocks encourages paperless trading.

Companies required to disclose all material facts and specific risk factors associated with their projects while making public issues.

To reduce the cost of issue, underwriting by the issuer made optional, subject to conditions.

The practice of making preferential allotment of shares at prices unrelated to the prevailing market prices stopped and fresh guidelines issued by SEBI.

SEBI reconstitutes governing boards of the stock exchanges, introduces capital adequacy norms for brokers, and makes rules for making client/broker relationship more transparent, including separation of client and broker accounts.

One time permission to stock brokers extended to corporatise their business, without attracting capital gains tax.

Buy back of shares allowed.

The SEBI starts insisting on greater corporate disclosures. Steps being taken to improve corporate governance based on the report of a committee.

SEBI issues detailed employee stock option scheme and employee stock purchase scheme for listed companies.

Standard denomination for equity shares of Rs. 10 and Rs. 100 abolished. Companies given the freedom to issue dematerialised shares in any denomination.

Derivatives trading starts with index options and futures.

A system of rolling settlements introduced.

SEBI empowered to register and regulate venture capital funds.

The SEBI (Credit Rating Agencies) Regulations, 1999 issued for regulating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India.

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