1.

A Project Report on RefoRms in indian financial

systemTOWARDS FULFILLMENT OF THE PROJECT
REQUIREMENTS OF POST GRADUATE DIPLOMA OF
MANAGEMENT STUDIES SUBMITTED BY: RAHUL JAIN ROLL
NO: 38 PGDM-EBIZ-1 BATCH-2011-13 UNDER THE
GUIDANCE OF Dr. ANIL RAO PAILA DEAN, WELINGKAR
INSTITUTE OF MANAGEMENT And Dr. MADHAVI LOKHANDE
Core Faculty, WELINGKAR INSTITUTE OF MANAGEMENT
WELINGKAR INSTITUTE OF MANAGEMENT DEVELOPMENT
AND RESEARCH, ELECTRONIC CITY, BANGALORE
2. 2. STUDENT DECLARATION I, Mr. Rahul Jain, studying in the
First Year of Master ofManagement Studies at Welingkar Institute
of Management Studies,Electronic City, Bangalore, hereby
declare that I have completed theproject titled Reforms in
INDIAN FINANCIAL SYSTEM as a part ofthe course
requirements for PGDM Programme.I further declare that the
information presented in this project is trueand original to the
best of my knowledge.Date:Place: (Signature of the student)
3. 3. CERTIFICATE FROM THE INTERNAL GUIDEI, Prof. Anil Rao
Paila hereby certify that Mr. Rahul Jain, a studentfor the Master
of Management Studies course at Welingkar Instituteof
Management Studies, Electronic City, Bangalore, has competed
aproject on Reforms in INDIAN FINANCIAL SYSTEM under
myguidance during this year.His work and output has been found
to be satisfactory.Date:Place: (Signature of the Guide)
4. 4. AcknowledgementThis project was done in partial fulfilment of
the requirements forthe Post Graduate Diploma of Management
Studies. I would like tothank and extend my warm regards to Mr.
Vikas Jain, Vice President(Factoring), HSBC Bank for his
support and Dr. Anil Rao Paila, Dean,Welingkar Institute of

Management, Bangalore and also Dr. MadhaviLokhande, Core

Faculty, Welingkar Institute of Management,Bangalore for their
guidance and support throughout the project. Itake this
opportunity to thank all the people without whose help,guidance
and inputs it would not have been possible to make theproject
report a success. Finally, I would like to thank all those whowere
directly or indirectly related to my project.The timely guidance of
my mentors not only helped in making theeffort fruitful, but also
transformed the whole process of learninginto an enjoyable and
memorable experience. This project proved asan excellent
opportunity for me to apply the concepts learnt in thecourse of
my program at the institute. The three things which go onto make
a successful endeavour are dedication, hard work andcorrect
guidance.I express heartfelt gratitude to Welingkar Institute
Management forgiving me this opportunity which helped me in
gaining knowledgeabout Indian Financial Systems.- Rahul Jain
5. 5. EXECUTIVE SUMMARYFinancial sector reforms are at the
centre stage of the economic liberalization thatwas initiated in
India in mid 1991. This is partly because the economic
reformprocess itself took place amidst two serious crisis involving
the financial sector thebalance of payments crisis that threatened
the international credibility of thecountry and pushed it to the
brink of default; and the grave threat of insolvencyconfronting the
banking system which had for years concealed its problems
withthe help of defective accounting policies.Moreover, many of
the deeper rooted problems of the Indian economy in the
earlynineties were also strongly related to the financial sector:
Large scale pre-emption of resources from the banking system
by the government to finance its fiscal deficit; Excessive
structural and micro regulation that inhibited financial innovation

and increased transaction costs; Relatively inadequate level of

prudential regulation in the financial sector; Poorly developed
debt and money markets; and Outdated (often primitive)
technological and institutional structures that made the capital
markets and the rest of the financial system highly
inefficient.Over the last six years, much has been achieved in
addressing many of theseproblems, but a lot remains to be done.
6. 6. Table of content1) Acknowledgement2) Objective3) Executive
summary4) Introduction5) Current Structure of Financial
System6) What changed in Recent Decades?7) Need and
Importance of Financial Sector8) Banking and Credit Policy9)
Financial Innovations10) Conclusion
7. 7. 1. IntroductionStrengthening financial systems has been one
of the central issues facing emergingmarkets and developing
economies. This is because sound financial systems serveas an
important channel for achieving economic growth through the
mobilization offinancial savings, putting them to productive use
and transforming various risks.Many countries adopted a series
of financial sector liberalization measures in thelate 1980s and
early 1990s that included interest rate liberalization,
entryderegulations, reduction of reserve requirements and
removal of credit allocation.In many cases, the timing of financial
sector liberalization coincided with that ofcapital account
liberalization. Domestic banks were given access to cheap
loansfrom abroad and allocated those resources to domestic
production sectorsA financial system is a network of financial
institutions, financial markets, financialinstruments and financial
services to facilitate the transfer of funds. The systemconsists of
savers, intermediaries, instruments and the ultimate user of
funds. Thelevel of economic growth largely depends upon and is

facilitated by the state offinancial system prevailing in the

economy. Efficient financial system andsustainable economic
growth are corollary. The financial system mobilises thesavings
and channelizes them into the productive activity and thus
influences thepace of economic development. Economic growth
is hampered for want of effectivefinancial system. Broadly
speaking, financial system deals with three inter-relatedand
interdependent variables, i.e., money, credit and finance.
8. 8. 2. Current Structure of the Financial System 2.1 Finance and
the EconomyIn recent years, the Indian economy has grown
sharply and has enjoyed high ratesof savings and investment.
This has inevitably involved a substantial role forfinance as the
intermediary between households and firms (Shah, Thomas,
andGorham, 2008). Table 1 compares components of GDP at
current prices for 2008-2009 against the picture as seen one
decade ago. The nominal rupee-dollarexchange rate exhibited a
depreciation of roughly 9% over this period. Hence, thebulk of
the change across this decade can be interpreted as a change
expressed innominal dollars.Over this decade, India went from
being a medium sized developing country (withan aggregate
GDP of $379 billion in 1998-99) to being a member of the G-20
(withan aggregate GDP of $1.13 trillion in 2008-09), with a rough
tripling of aggregateGDP. Alongside this, the savings rate went
up dramatically from 24.13% to 34.65%.This combination gave a
4.64 times rise in gross domestic savings: the financialsystem
which used to handle a flow of $91 billion of savings in 1998-99
washandling $390 billion of savings in 2008-09.
9. 9. In addition, the private corporate sector, which is the focus of
the formal financialsystem, came to play a bigger role in
investment. Gross capital formation by theprivate corporate

sector grew from 7.67% of GDP to 13.53% of GDP over

thisdecade. There was a rise of 5.71 times: private corporate
investment went from $29billion in 1998-99 to $153 billion in
2008-09.Through this combination of high GDP growth, rise in
household savings, and abigger role for private corporate
investment, the financial system has come to play amore
prominent role in the economy, and has achieved a significant
size by worldstandards.Through these changes, the materiality of
financial reform has risen. With $390billion of household savings
being produced a year, and $153 billion of privatecorporate
investment taking place a year, modest improvements in the
capability ofthe financial system would help accelerate
growth.Table 2 shifts focus to the financing structure of large
companies. For each of thetwo years (1998-99 and 2008-09), the
aggregate balance sheet of all large non-financial firms in the
CMIE database is computed and shown. The overall
balancesheet grew much faster than GDP, with a rise of 4.52
times over the decade.A pronounced deleveraging is visible.
Equity, which used to be 33.94% of thebalance sheet in 1998-99,
made up for 39.22% of the balance sheet in 2008-09.
10.
10. Alongside this, the corporate debt market faded into
insignificance: it grew by only1.58 times, and went from 5.69% of
the balance sheet in 1998-99 to 2.06% of thebalance sheet in
2008-09.The evidence in Table 2 pertains only to large
companies. In addition, banks dolend to smaller, unlisted
companies. In order to assess the role of banks versus theequity
market, Figure 1 juxtaposes the market capitalisation of the
CMIE Cospiindex against the aggregate non-food credit of all
banks. This shows that in thecomprehensive picture, bank credit
is small in the Indian economy, whencompared with the market

value of equities (Thomas, 2006a). This broadrelationship has

held up even though there has been an unprecedented boom
inbank credit in the period under examination. 2.2 Financial
RepressionIn most areas, the interaction between the Indian
State and the economy is ruledby sound procurement principles.
As an example, purchases of steel or cement bythe government
are done through auctions, where these commodities
arepurchased from the lowest voluntary bidder. However, in the
area of government
11.
11. borrowing, the Indian State does not borrow from
voluntary lenders. The bulk ofgovernment bond issuance is
forcibly placed with financial norms. These includebanks,
insurance companies and pension funds. As an example, banks
are forcedto hold atleast 24% of their assets in government
bonds. The pension systemoperated by the Employee Provident
Fund Organisation (EPFO) is almost entirelyinvested in domestic
government bonds. Of the Rs.7.43 trillion invested by
lifeinsurance companies on 31 March 2009, 42.5% was in
central government bondsand another 14.4% was in state
government bonds.Indian financial policy thus ensures that the
government gets roughly all EPFOassets, roughly half of the
assets of life insurance companies and roughly a quarterof the
assets of banks. Data for 2007-08 shows that of the total stock of
Rs.11.47trillion of government bonds, only Rs.1.7 trillion or 15
per cent were heldvoluntarily. 2.3 ProtectionismIn most aspects
of the merchandise trade, the Indian State has shifted away
fromprotectionism. The Indian buyer of steel or benzene or
mobile phones is able tochoose between local and global
producers without either quantitative restrictionsor tariffs imposed
by the State. Once the Goods and Services Tax (GST) is

properlyimplemented, imported goods will face a GST-onimports, and apart from that,customs tariffs would go to nearzero levels. With financial products and services,in most areas,
the local buyer is inhibited from purchase of products or
servicesfrom offshore providers. This is done either through
outright prohibition orquantitative restrictions (typically through
capital controls), or constraints uponestablishment of distribution
channels for foreign producers (typically throughfinancial
regulation).
12.
12. One example of such protectionism lies in the treatment
of banks, where all foreignbanks (put together) are permitted to
open no more than 18 branches in India. Thisdisables the extent
to which foreign banks are able to build branches in India
andoffer competition to Indian banks. For another example, the
Indian buyer of futureson the NSE-50 index has a choice of three
venues where orders can be placed:Indias NSE, the Singapore
Exchange (SGX) and the Chicago Mercantile Exchange(CME).
However, the prevailing capital controls are structured in a way
whichprevents an Indian resident from paying initial margin on
overseas futuresexchanges. Through this, offshore competition
against the NSE-traded Nifty futuresand options is undermined.
2.4 Public ownershipThe third defining feature of Indian finance
lies in the extent of public ownership.Roughly 80% of banking,
95% of insurance and 100% of pensions is held in publicsector
financial norms. With insurance, it is possible to establish a
privateinsurance company with no more than 26% of foreign
ownership. With bankingand pensions, entry is infeasible either
for private or for foreign financial norms.The combination of
public ownership and protectionism hampers
competitivedynamism in large parts of Indian finance. At the

same time, competitivedynamism is found in certain areas. The

barriers are the weakest with securitiesnorms that seek to
become members of exchanges such as NSE and BSE, and
withmutual funds. In these two areas, India is de facto open to
private or foreign normsthat seek to establish business.
Unsurprisingly, these are also areas where creativedestruction is
visible, with both entry and exit taking place every year.
13.
13. 2.5 Central PlanningThe fourth defining feature of
Indian finances lies in the extent to which thegovernment controls
minute details of financial products and processes. Thestructure
of legislation and regulation is one where everything is prohibited
unlessexplicitly permitted. Hence, every time a firm wishes to
make a modification to asmall detail about a product or a
process, it has to go to a government agency inorder to request
permission.As a recent example, until recently, SEBI specified
that securities trading muststart at 9:55 AM and stop at 3:30 PM.
In an element of liberalisation, SEBI hasannounced that
exchanges can start and stop at any time of day, as long as
thestart of trading is after 9 AM and the end of day is before 5
PM. In most OECDcountries, governments do not get involved in
specifying the time at which tradingstarts and ends. On a related
note, on the equity derivatives market, optionstrading on the
index involve cash-settled European-style options and
optionstrading on individual securities involve cash-settled
American-style options. Noneof these parameters can be
changed without explicit approval from SEBI. In mostOECD
countries, decisions about whether options should be cashsettled orphysically-settled, and decisions about whether options
should be European-style or American-style, are not the purview
of government. 2.6 Regulatory and Legal ArrangementsThe fifth

and final defining feature of Indian finance is the financial

regulatoryarchitecture. Table 3 shows the role and function of
major government agencies inIndian finance. In addition to these
external agencies, finance policy work isundertaken by the
Department of Economic Affairs (DEA), Department of Financial
14.
14. Services (DFS), Department of Consumer Affairs
(DCA) and the Department ofCompany Affairs (DCA). There are
also other government bodies which performquasi-regulatory
functions, including NABARD, NHB and DICGC.This assignment
of functions into agencies is embedded in the texts of laws
before1956, and thus reflects a vision of economic policy, and a
state of development ofthe financial system, rooted in mid-20th
century India.An associated set of issues concerns the legal
process. From the 1990s onwards,regulators in India have been
placed in a legal setting where there is a clearseparation
between a regulator performing regulation while a private
industryperforms service provision, where the regulator is
charged with creation ofsubordinated legislation through a
transparent and consultative process, where theinvestigative and
enforcement process is performed in a quasi-judicial fashion
withfull transparency of reasoned orders, and there is a fast-track
specialised courtwhich hears appeals. None of these principles
were part of the ethos of governancein India in 1956. As a
consequence, a large part of the financial regulatorylandscape
lacks these features. 3. What changed in recent decades ?Much
has been written about the changes in Indian finance in recent
decades.Following are the eight areas where major changes
took place in Indian financialpolicy in the last 20 years. 3.1 The
revolution of equity marketThe equity and fixed income scandal
of 1992, and the desire of policy makers toencourage foreign

investors in the Indian equity market, in the early 1990s, helpedin

reopening long-standing policy questions about the equity
market. From 1993 to
15.
15. 2001, the Ministry of Finance and SEBI led a strong
reforms effort aiming at afundamental transformation of the
equity market. The changes on the equitymarket from December
1993 to June 2001 were quite dramatic: A new governance
model was invented for critical financial infrastructure such as
exchanges, depositories and clearing corporations. This involved
a three-way separation between shareholders, the management
team and member financial norms. These three groups were
held distinct in order to avoid conflicts of interest. The
shareholders were configured to have an interest in liquid
markets, and not maximise dividends. Floor trading was replaced
by electronic order books. Counterparty credit risk was
eliminated through netting by novation at the clearing
corporation. This has supported a competitive environment
where entry barriers have been set to very low levels and a
steady stream of norm goes out of business every year.
Exchange membership for foreign securities norms was enabled,
thus making it possible for foreign investors to transact through
their familiar securities norms. Physical share certificates were
eliminated through dematerialised settlement at multiple
competing depositories. Exchange-traded derivatives trading
commenced on individual stocks and indexes. The NSE-50
(Nifty) index became the underlying for one of the worlds biggest
index derivatives contracts, with onshore trading at NSE,
offshore trading at SGX in Singapore and CME in Chicago, and
an entirely offshore OTC market. A diverse order flow was
accessed from all across India and abroad, through hundreds of

thousands of trading screens. This gave heterogeneous views,

and a large mass of investable capital.
16.
16. Asymmetric information was diminished through
improvements in accounting standards and disclosure. The
eligibility rules for FIIs were enlarged through time, so that
thousands of FIIs were operating on the market, bringing both
foreign capital and heterogeneous views.Through these events,
the Indian equity market has come to have a dominant rolein
Indian finance. The financing of norms has shifted away from
debt towardsequity. Nifty-related products (ETFs, futures,
options, OTC derivatives) make up thebiggest single traded
product. NSE and BSE are at rank 3 and 5 in the worlds
topexchanges by the number of transactions, and this is the only
global ranking infinance where India is found.In the larger setting
of Indian finance, the equity market is the first place in
Indiawhere modern finance and financial regulation have taken
root. This is a majorchange when compared with the India of old,
where none of the financial marketsworked well. Looking
forward, the institutional capabilities and experience of
thesereforms will help in transforming other components of the
financial system. As anexample, in 2008, the institutional
capabilities of the equity market were used withgreat success in
establishing a currency futures market. 3.2 Entry of Private
BanksIndias starting condition, in the early 1990s, was one with
an almost entirelygovernment-owned banking system, where
entry by foreign or private banks wasblocked. In this
environment, an important experiment in easing entry barriers
17.
17. took place from 1994 to 2004, where a total of 12 `new
private banks werepermitted to come into being.In terms of
barriers to entry, this remains an environment with onerous

barriers toentry, given that only 12 new private banks were

permitted, and that over 80% ofassets remain in the public
hands. In addition, strong entry barriers have goneback up, for
after 24 May 2004, no new private banks have come about.At the
same time, this limited opening has had significant
consequences. Whilesome of these new private banks fared
badly, others have done well. They haveexperienced sharp
growth in assets. They dominate certain newer marketsegments,
such as cards and POS terminals. They have exerted a certain
limitedcompetitive pressure upon public sector banks. As an
example, public sector banksnow accept computers and ATMs
on a scale that was not seen in 1993, and it islikely that
competitive pressure from private banks has helped.In summary,
the limited economic reform, of bringing in 12 new private banks
from1994 to 2004, was one of the important milestones of
change in Indian finance,even though it was highly limited in
scope and onerous entry barriers remain inplace. 3.3 The RBI
Amendment Act of 2006In 2006, an amendment to the RBI Act
was passed, which established RBI as aregulator of the bond
market and the currency market. This was a step in thewrong
direction, given Indias direction for reform on the regulation and
supervisionof securities markets. In all OECD countries but one,
only one government agency(the securities regulator or the
unified financial regulator) deals with all aspects oforganised
financial trading. In India itself, shortly after 2006, expert
committeereports were produced advocating the merger of all
regulation of organised financial
18.
18. trading into a single regulator. The RBI Amendment Act
of 2006 stands out as astep in the wrong direction; the policy
agenda now involves reversing this.

19.
19. 3.4 Fiscal transfers to public sector financial firmsIn
recent decades, the exchequer has brought money into public
sector financialfirms under three scenarios: Explicit obligations of
the exchequer: Some public sector financial firms encountered
bankruptcy, and were always rescued using public money. This
covers experiences such as Indian Bank, IFCI, etc. Implicit
obligations of the exchequer: One scenario { the difficulties of
UTI in 2001 { concerned implicit promises which were made by
UTI, where upholding those promises required money from the
Ministry of Finance. Failure of banks to generate equity capital
through retained earnings: In a well run bank, the growth of
equity capital through earnings retention should enable growth of
the balance sheet. In India, on many occasions, public sector
banks which failed to produce retained earnings and thus
adequate equity capital were given additional equity capital by
the government so as to obtain balance sheet expansion.The
Indian experience has been a healthy one, when compared with
that of someother countries such as Indonesia, in that these
payments have been relativelysmall. At the same time, a threepronged modification of strategy is appropriate:1. Problems
should be solved before they are crystallised. Just as the UTI
problemshould have been detected and blocked ahead of time,
today there are loomingproblems which will yield difficulties in the
exchequer in the future. One example ofthese is the Employee
Pension Scheme (EPS).2. The discomfort associated with
accessing public resources needs to be increased.Firms like
IDBI and IFCI experienced rescues which were too comfortable
from the
20.
20. viewpoint of the (civil servant) managers. This
generates poor incentives for othermanagers of public sector

financial firms.3. Finally, government needs to deny additional

resources to banks which havefailed to build up adequate
capital, for these are precisely the banks which are notefficient.
3.5 Critical financial infrastructure of the bond marketIn the equity
market, the strategy for critical financial infrastructure
(exchanges,learning corporations and depositories) was based
on three principles. First, therewas a three-way separation
between shareholders, the management team and themember
financial firms. Second, there was a competitive framework.
Third, theregulator (SEBI) did not own critical financial
infrastructure.None of these three principles was used on the
bond market. The critical bondmarket infrastructure involved a
depository (the SGL) owned and operated by RBIand an
exchange (NDS) owned and operated by RBI.This was a
problematic arrangement because RBI had conflicts of interest
by virtueof being an owner and service provider, and at the same
time being the regulator(after the enactment of the RBI
Amendment Act of 2006). There was a loss ofcompetitive
dynamism when RBIs policy decisions leaned in favour of
blockingcompetition against NDS and SGL. The implementation
capability in SGL and NDSwas limited, by virtue of being run by
civil servants.Entry barriers into membership of this critical
financial infrastructure were enactedby RBI. A small club of
financial firms (banks and primary dealers) was allowed
toconnect into this infrastructure. This policy framework gave
dismal failure inachieving bond market liquidity. On paper, India
has an impressive bond marketwith trading screens, clearing
corporation, etc. But the essence of a market is
21.
21. liquidity, speculative views, and resilience of liquidity.
None of these are found onthe Indian bond market. 3.6 Institution

building of IRDA and PFRDAIndian financial policy showed an

impressive ability to throw up new institutionswhich rapidly made
a difference in the form of SEBI (founded in 1988), NSE(founded
in 1992) and NSDL (founded in 1995). In other areas, institution
buildingran into greater problems.IRDA was established with the
intent of becoming a regulator of the insurancebusiness. In an
unusual decision, IRDA was placed in Hyderabad, which led to
anincreased distance from the knowledge and staff quality of
Bombay. While IRDAwas relatively cutoff from the main Indian
discourse on financial policy andregulation which takes place in
Bombay and Delhi, insurance companies had astrong incentive
to engage with IRDA. With focused lobbying by
insurancecompanies acting upon relatively weak staff quality,
and the lack of the context ofthe financial discourse of Bombay,
IRDA came to increasingly share the world viewof insurance
companies.Through this, IRDA came to increasingly support
questionable sales practices andtax subsidies for fund
management by insurance companies. The establishment
ofIRDA, thus, must be chalked up as a failure of institution
building.In similar fashion, PFRDA was intended to start out as a
regulator and projectmanager for the New Pension System
(NPS), and perhaps to grow into a full edgedregulator of Indian
pensions in the future. PFRDA faced a difficulty akin to
SEBIsearly years in that its legislation has been delayed.At the
same time, SEBI started chalking up important achievements in
the 1988-1992 period. In addition, PFRDA has a strong
contractual role in the NPS, which
22.
22. gives it regulatory powers through enforcement of
contracts. Yet, in its first sevenyears, PFRDA has failed to
emerge as a strong organisation.The Indian discussion on the

role and function of government agencies in financialregulation

needs to be accompanied by a treatment of the difficulties of high
qualityagencies. While Indian policy makers have one important
success in SEBI, whichhas emerged as a relatively high quality
agency, Indian policy makers need todiagnose and the sources
of problems at the other four agencies in finance (RBI,FMC,
IRDA and PFRDA). The difficulties of IRDA and PFRDA serve as
a reminderthat even when an agency starts with a clean slate,
without institutional baggagefrom a pre-reforms India, without
conflicts of interest and archiac legalfoundations, there is still a
substantial risk of failure in institution building. 3.7 Payments
systemA critical element of the plumbing which underlies the
financial system is thepayments system. Significant changes
have taken place in this field, with theestablishment of the Real
time Gross Settlement (RTGS) system. However,
therequirements for the Indian payments system involve five
dimensions:1. Support for very high volumes by world standards,
given the large number ofeconomic agents in India2. 24 x 7
operation, given the need to function in Indian time, and to
eliminateHerstatt risk in cross-border transactions around the
globe3. Private management, so as to achieve efficiency and
technological dynamism4. A competitive framework, with multiple
competing providers5. A governance framework which induces a
focus on efficiencies for the economyrather than maximisation of
dividends.At present, these features are largely absent in the
Indian payments system.
23.
23. Existing systems support low transaction intensities,
limited hours of operation,have an excessive role for government
and lack competition. While critical financialinfrastructure in
payments has fared better than the critical financialinfrastructure

in the bond market, the outcomes are substantially below

therequirements of the economy.The governance problems in the
payments system are akin to those seen with othercritical
financial infrastructure. Hence, there is an applicability of many of
the keyideas seen in ownership and governance of critical
financial infrastructure such asexchanges, depositories and
clearing corporations. 4. Need and importance of financial
sector:The New Economic Policy (NEP) of structural adjustments
and stabilizationprogramme was given a big thrust in India in
June 1991. The financial systemreforms have received special
attention as a part of this policy because of theperceived
interdependent relationship between the real and financial
sectors of themodern economy.The need for financial reforms
had arisen because the financial institution andmarkets were in a
bad shape. The banking sector suffered from lack ofcompetition,
low capital base, low productivity, and high intermediation costs.
Therole of technology was minimal, and the quality of service did
not receive adequateattention. Proper risk management system
was not followed, and prudential normswere weak. All these
resulted in poor assets quality. Development financialinstitutions
operated in an over protected environment with most of the
fundingcoming from assured sources. There was little
competition in insurance andmutual funds industries. Financial
markets were characterized by control over
24.
24. pricing of financial assets, barriers to entry, and high
transactions costs. Thebanks were running either at a loss or on
very low profits, and, consequently wereunable to provide
adequately for loan defaults, and build their capital.There had
been organizational inadequacies, the weakening of
management andcontrol functions, the growth of restrictive

practices, the erosion of work culture,and flaws in credit

management. The strain on the performance of the banks
hademanated partly from the imposition of high Cash Reserve
Ratio (CRR), StatutoryLiquidity Ratio (SLR) and directed credit
programmes for the priority sectors all atbelow market or
concessional or subsidized interest rates. This, apart
fromaffecting bank profitability adversely, had resulted in the low
or repressed ordepressed interest rates on deposits and in
higher interest rates on loans to thelarger borrowers from
business and industry.Further, the functioning of the financial
system, and the credit delivery as well asrecovery process had
become politicized, which damaged the quality of lending andthe
culture of repaying loans. The widespread write-offs of the loans
had seriouslyjeopardized the viability of banks. As the closure of
sick industrial units wasdiscouraged by the government, banks
had to continue to finance non-viable sickunits, which further
compromised their own viability. The legal system was not
ofmuch help in recovering loans. There was a lack of
transparency in preparingstatements of accounts by banks.In
other words, the reforms had become imperative on account of
the facts thatdespite its impressive quantitative growth and
achievements, the financial health,integrity, autonomy, flexibility,
and vibrancy in the financial sector had deterioratedover the past
many years. The allocation of resources had become
severelydistorted, the portfolio quality had deteriorated, and
productivity, efficiency andprofitability had been eroded in the
system. Customer service was poor, work
25.
25. technology remained outdated, and transaction costs
were high. The capital baseof the system remained low, the
accounting and disclosure practices were faulty,and the

administrative expenses had greatly soared. The system suffered

also froma lack of delegation of authority, inadequate internal
controls and poorhousekeeping. 5. Banking and credit policy:At
the beginning of the reform process, the banking system
probably had a negativenet worth when all financial assets and
liabilities were restated at fair marketvalues (Varma 1992). This
unhappy state of affairs had been brought about partlyby
imprudent lending and partly by adverse interest rate
movements. At the peakof this crisis, the balance sheets of the
banks, however, painted a very differentrosy picture. Accounting
policies not only allowed the banks to avoid makingprovisions for
bad loans, but also permitted them to recognize as income
theoverdue interest on these loans. The severity of the problem
was thus hidden fromthe general public.The threat of insolvency
that loomed large in the early 1990s was, by and large,corrected
by the government extending financial support of over Rs 100
billion tothe public sector banks. The banks have also used a
large part of their operatingprofits in recent years to make
provisions for non performing assets (NPAs). Capitaladequacy
has been further shored up by revaluation of real estate and by
raisingmoney from the capital markets in the form of equity and
subordinated debt. Withthe possible exception of two or three
weak banks, the public sector banks havenow put the threat of
insolvency behind them. The major reforms relating to
thebanking system were:
26.
26. Capital base of the banks were strengthened by
recapitalization, public equityissues and subordinated debt.
Prudential norms were introduced and progressively tightened
for incomerecognition, classification of assets, provisioning of
bad debts, marking to market ofinvestments. Pre-emption of

bank resources by the government was reduced sharply. New

private sector banks were licensed and branch licensing
restrictions wererelaxed.At the same time, several operational
reforms were introduced in the realm of creditpolicy: Detailed
regulations relating to Maximum Permissible Bank Finance
wereabolished Consortium regulations were relaxed
substantially Credit delivery was shifted away from cash credit to
loan methodThe government support to the banking system of
Rs 100 billion amounts to onlyabout 1.5% of GDP. By
comparison, governments in developed countries like theUnited
States have expended 3-4% of GDP to pull their banking
systems out ofcrisis (International Monetary Fund, 1993) and
governments in developingcountries like Chile and Philippines
have expended far more (Sunderarajan andBalino,
1991).However, it would be incorrect to jump to the conclusion
that the banking systemhas been nursed back to health
painlessly and at low cost. The working results ofthe banks for
1995-96 which showed a marked deterioration in the profitability
ofthe banking system was a stark reminder that banks still have
to make largeprovisions to clean up their balance sheets
completely. Though bank profitabilityimproved substantially in
1996-97, it will be several more years before theunhealthy legacy
of the past (when directed credit forced banks to lend to
27.
27. uncreditworthy borrowers) is wiped out completely by
tighter provisioning. It ispertinent to note that independent
estimates of the percentage of bank loans whichcould be
problematic are far higher than the reported figures on non
performingassets worked out on the basis of the central banks
accounting standards. Forexample, a recent report estimates
potential (worst case) problem loans in theIndian banking sector

at 35-60% of total bank credit (Standard and Poor, 1997).The

higher end of this range probably reflects excessive pessimism,
but the lowerend of the range is perhaps a realistic assessment
of the potential problem loans inthe Indian banking system.The
even more daunting question is whether the banks lending
practices haveimproved sufficiently to ensure that fresh lending
(in the deregulated era) does notgenerate excessive
nonperforming assets (NPAs). That should be the true test of
thesuccess of the banking reforms. There are really two
questions here. First, whetherthe banks now possess sufficient
managerial autonomy to resist the kind ofpolitical pressure that
led to excessive NPAs in the past through lending toborrowers
known to be poor credit risks. Second, whether the banks ability
toappraise credit risk and take prompt corrective action in the
case of problemaccounts has improved sufficiently. It is difficult to
give an affirmative answer toeither of these questions (Varma
1996b). Turning to financial institutions,economic reforms
deprived them of their access to cheap funding via the
statutorypre-emptions from the banking system. They have been
forced to raise resources atmarket rates of interest.
Concomitantly, the subsidized rates at which they used tolend to
industry have given to market driven rates that reflect the
institutions costof funds as well as an appropriate credit spread.
In the process, institutions havebeen exposed to competition
from the banks who are able to mobilize deposits atlower cost
because of their large retail branch network. Responding to
thesechanges, financial institutions have attempted to restructure
their businesses and
28.
28. move towards the universal banking model prevalent in
continental Europe. It istoo early to judge the success of these

attempts. 6. Financial Innovations:From the early 1970s there

has been an explosive growth in financial innovations.Here is a
partial list of important novelties: Eurodollar accounts Forward
rate agreements Zero coupon bonds Commodity bonds
Negotiable certificates of Deposits Puttable and callable bonds
NOW accounts Indexed linked gilts Variable life insurance
Interest rate swaps Money market mutual funds Currency
swaps Index funds Shelf registration process Options
Electronic funds transfer system Financial futures Screen
based trading Options on futures Leveraged buyouts Options
on indexes
29.
29. This appendix explores various aspects of financial
innovations. It is divided intofour sections: What and why of
financial innovations Type of financial innovations Financial
innovations in India Excesses1. WHAT AND WHY OF
FINANCIAL INNOVATIONSMiller, Silber, and Van Horne
characterise and analyse financial innovationssomewhat
differently. Miller describes financial innovations as
unanticipatedimprovements in the array of financial products and
instruments that arestimulated by unexpected tax or regulatory
impulses. The Eurobond market emerged in response to a 30
percent withholding taximposed by the US Government on
interest payments on bonds sold in the US tooverseas investors.
Zero coupon bonds were offered to exploit a mistake of the
Internal RevenueService in the US which permitted deduction of
the same amount each year for taxpurposes.( Put differently, the
Internal Revenue Service employed simple interest,not
compound interest.) Financial futures came into being when the
Bretton Woods system of fixedexchange rates was abandoned in
the early 1970s. Paper currency, in a sense the most

fundamental financial instrument, wasinvented when the British

Government prohibited the minting of coins by thecolonial North
America. The Eurodollar market developed in response to
Regulation Q in the US thatimposed a ceiling on the interest rate
payable on time deposits with commercialbanks
30.
30. Financial swaps emerged initially in response to a
restriction imposed by theBritish Government on dollar financing
by British firms and sterling financing bynon-British firms.Since
taxes and regulation have triggered a number of major financial
innovations,Miller likens them to the grains of sand that irritate
the oyster to produce thepearls of financial innovation.Silber2
looks at financial innovations differently from Miller. He
considersinnovative financial instruments and processes as
devices used by companies toreduce the financial constraints
faced by them. Firms, he argues, maximise utilityunder certain
constraints, some dictated by governmental regulation, some
definedby the market place, and some self-imposed.Financial
innovations seek to reduce the cost of complying with these
constraints.Here are two examples. A lot of effort has gone into
the designing of capital notes, which are essentiallydebt
instruments but are treated as capital for the purposes of bank
regulation. Highly volatile interest rates enhanced the cost of
following a policy of investing infixed dividend rate preferred
stock. This stimulated the development of variousforms of
adjustable rate preferred stock.Silbers constraint-induced model
of innovation explains well a large proportion ofcommercial bank
products. Yet it offers only a partial view of financial innovationas
its focus is almost wholly on the issuers of securities, not the
investors insecurities.Van Horne3 views a new financial
instrument or process as innovative, if it makesthe financial

markets more efficient and/or complete. A financial innovation

makesthe market more efficient if it reduces transaction costs or
lowers differential taxesor diminishes deadweight losses. A
financial innovation makes the market morecomplete if its aftertax market is one where every contingency in the world is
31.
31. matched by a distinct marketable security. The sheer
number of securities requiredto span every possible contingency
suggests that the market is bound to beincomplete in some way
or the other. In such a market, there are unfulfilledinvestor needs.
Hence, there is scope for designing securities to satisfy
investordesires with respect to maturity, interest rate, protection,
cash flow characteristics,put feature, or some other
attribute.According to Van Horne the following factors prompt
financial innovation: volatileinflation and interest rates, regulatory
changes, tax changes, technologicaladvances, the level of
economic activity, and academic work on market efficiencyand
inefficiency.Collectively, the Miller, Silber, and Van Horne papers
suggest that the followingfactors drive financial innovations:1
M.H.Miller, Financial Innovation: The Last Twenty Years and
the Next, Journalof Financial and Quantitative Analysis,
December 1986.2 W.L. Silber, The Process of Financial
Innovation, American Economic Review,May 1983.3 J.C. Van
Horne, Of Financial Innovations and Excesses, Journal of
Finance,July 1985. Tax asymmetry Regulatory or legislative
changes Volatility of financial prices Transaction costs Agency
costs Opportunities to reduce some form of risk or reallocate
risk Opportunities to increase an assets liquidity Academic
work Accounting benefit
32.
32. Technological advances Level of economic activity2.
TYPES OF FINANCIAL INNOVATIONSFinancial innovations

may be divided into the following categories:Category ExampleA.

Consumer-type instruments Variable life insurance policy
Money market mutual fundB. Securities Zero coupon bond
Indexed linked giltsC. Derivative securities Options
FuturesD. Process Shelf registration process Screen based
tradingE. Creative solutions to a financial Project financing
problem Leveraged buyoutSince categories A, B and C
represent financial products, we may broadly define afinancial
innovation as a new product or a new process or a creative
solution to afinancial problem.3. FINANCIAL INNOVATIONS IN
INDIATill the mid 1980s, the Indian financial system did not
see much innovation. Inthe last two decades, financial innovation
in India has picked up and it is expected
33.
33. to grow in the years to come, as a more liberalised
environment affords greaterscope for financial innovation.The
important financial innovations that have taken place in India are
listed belowalong with the principal factor which motivated it or
fuelled its growth.Innovation Principal Motivating Factor Debtoriented schemes of mutual funds Tax benefit Partially
convertible debentures and fully convertible debentures Pricing
and interest rate regulation obtaining under the Capital
IssuesControl Act Deep discount / Zero coupon bonds Tax
benefit Puttable and callable bonds Perceived volatility of
interest rates Stock index futures Volatility of equity prices
Badla transactions Restriction on forward trading Ready
forwards Restrictions under the portfolio management scheme
Havala transactions RBI restrictions Interest rate
caps/floors/collars Volatility of interest rates Interest rate swaps
Volatility of interest rates Currency swaps

34.
34. Volatility of foreign exchange rates Forward rate
agreements Volatility of interest rates Automated teller
machines Technology Screen-based trading Technology
Floating rate bonds Volatility of interest rates Electronic funds
transfer Technology Money market mutual funds Volatility of
interest rates Specialised mutual funds Investor preferences
Exchange-traded options Volatility of stock prices Project
finance Risk sharing 7. ConclusionOne of the most important
areas of economic reform lies in the financial system.On one
hand, finance is the `brain of the economy, and the skills of the
financialsystem shape the efficiency of translation of gross
capital formation into GDPgrowth. In addition, a sophisticated
financial system gives resilience to shocks,particularly in an
increasingly internationalised India. As an example, the extent
towhich monetary policy can stabilise the economy critically
relies on a competitive
35.
35. banking system and a well functioning Bond-CurrencyDerivatives Nexus: untilfinancial policy puts these in order,
monetary policy will remain relativelyineffectual.In some
respects, Indian finance has made major progress. Policy
makers over thelast 20 years made important progress with
revolutionary reforms of the equitymarket (including sophisticated
thinking on institution building for SEBI, NSE andNSDL), the
limited entry of private banks, and the limited liberalisation of
thecapital account. But these three areas of greater success
have not been adequate inobtaining a financial system that is
commensurate with Indias needs, forintermediating $390 billion
of savings and investment a year for an increasinglycomplex and
internationalised economy.Key elements of the ancien regime
that remain intact are financial repression,Protectionism, public

sector ownership of financial norms, central planning, anarchaic

financial regulatory architecture and weaknesses of the rule of
law. Thereforms program now needs to frontally confront these
elements. Some of the ideasemphasised in this paper have been
accepted by policy makers and are undervarious stages of
implementation. These five areas are: Establishment of the
National Treasury Management Agency (NTMA) Establishment
of the New Pension System (NPS) and the Pension Fund
Regulatory and Development Authority (PFRDA) Establishment
of the Financial Stability and Development Council (FSDC)
Drafting rules for ownership and governance of critical financial
infrastructure (presently underway with SEBIs Bimal Jalan
committee) Drafting effort for financial law at the Financial Sector
Law Reforms Commission (FSLRC).In these areas, the
challenge is one of implementation. Thirteen issues remain
theagenda for policy for the future:
36.
36. Roadmap for removal of financial repression.Unification
of regulation of organised financial trading.Separation of banking
regulation and supervision from RBI.Establishment of a
meaningful deposit insurance corporation.Establishment of the
Financial Services Appellate Tribunal (FSAT).Modifying FEMA to
emphasise the rule of law, which would also remove thegap
between de facto and de jure openness.Modifying capital
controls so as to scale down protectionism.A fresh effort at
building IRDA.A fresh effort at building a payments system.A
reduced willingness to inject equity capital into public sector
financialnorms.Removal of entry barriers against banks and
banking.Removal of transaction taxes, i.e. the stamp duty and
the securitiestransaction tax.Shift towards residence-based
taxation of global financial income.