Beruflich Dokumente
Kultur Dokumente
Urjit R. Patel*
April 2004
Abstract
1. INTRODUCTION
ones, during various stages of their growth. In many countries, Development Financial
Institutions (DFIs) have been major conduits for channeling funds to particular firms,
industries and sectors during their development. Many studies (more recently, Allen
and Gale [2001] and Levine [1997]) have identified the importance of DFIs in the
such as Germany, especially in the post Second World War era, this (command) mode
developing countries, there has traditionally been a strong presence of the government
in the sector, usually through a combination of either owning these entities or indirectly
by mandating credit allocation rules. This followed a line of thinking emanating from
the works of Gerschenkron [1962] and Lewis [1955] that advocated a “development”
Arguably, compelling arguments have been made for this involvement in the
initial stages of a country’s development. It is in the financial sector that market failures
1
are particularly likely to occur.1 In addition, the significant asymmetries of information
pioneering or small scale projects, generate a bias in bank loan portfolios away from
areas deemed vulnerable but are identified as thrust areas for development. As a result,
infant industries and have also occasionally resorted to bank expropriations and
nationalisations if the need was felt to advance social goals like expanding the reach of
banking; in other words, addressing “market failures”. Even in countries that did not
economic activity, the government involvement in the financial sector had been devised
to implicitly assume counter-party risks. This cover had been adequate in the past given
systems of most developing countries became ill-equipped to tackle the changed profile
of risks arising from the increased complexity of transactions. Nor did there exist the
robust clearing systems needed to support new financial products, or the accounting
and hedging mechanisms to deal with the significant counter-party risks that now
permeated the system. The consequence was a large increase in both institution-specific
1
Events over the past half a decade have provided numerous examples of these failures spanning
geographical areas as well as various types of economic systems.
2
Worldwide experience suggests that in the case of public sector institutions, the
owner – the government – typically lacks both the incentive and the means to ensure an
adequate return on its investment (La Porta, et al. [2000]). Political decisions, as
macroeconomic turbulence as well. One thread of explanations for this stems from the
“political” theories advanced, for instance, by Kornai [1979], Shleifer and Vishny
[1994] and others. Directed lending to projects that might be socially desirable but not
privately profitable is not likely to be sustainable in the long run. These weaknesses go
beyond the normal crises that have characterised the financial sector and have been
goals of the government directed credit flows and the absence of commercial discipline
particularly given the current importance of government owned financial entities that
cover almost all segments. India is one of a number of countries whose intermediaries
have been used by the government to allocate and direct financial resources to both the
public and the private sector. Government ownership of banks in India is, barring
China, the highest among large economies.2 Beside the standard problems of the
financial sector that result from information asymmetry and “agency” issues, moral
2
Hawkins and Mihaljek [2001] outline the characteristics of financial systems that are dominated by
government ownership of intermediaries.
3
hazard might be aggravated3 in countries like India with high government involvement
because both depositors and lenders count on explicit and implicit guarantees.4 The
investors that the system is insulated from systemic risk and crises by engendering a
sense of confidence, making deposit runs somehow unlikely, even when the system
measure designed to balance the likely panic following news of runs on troubled
and has the effect of sharply increasing system-wide moral hazard. Depositors,
borrowers and lenders all know that the government is guarantor. Since, for all intents
guarantees, there is little incentive for “due diligence” by depositors, which further
erodes any semblance of market discipline for lenders in deploying funds, as witnessed
most recently in the case of cooperative banks in India. The regularity of “sector
restructuring packages” (for steel and textiles and proposed most recently for telecom),
on the other hand, diminishes incentives for borrowers for mitigating the credit risk
Just as importantly, India now has a banking sector whose indicators (in terms
of standard norms like profitability, spreads, etc.) are prima facie more or less
3
We distinguish the term “aggravated” from “enhanced”, considering the former as a parametric shift of
the underlying variables as opposed to a functional dependence in the case of the latter. More explicitly,
increasing moral hazard enhances the incentives of banks to accumulate riskier portfolios, whereas an
aggravated moral hazard results in a failure to initiate corrective steps to mitigate the enhanced hazard,
for example, increasing requirements of capital, proper risk weighting, project monitoring, etc.
4
In this regard, India’s decision not to provide deposit insurance, ex post, to non-bank financial
intermediaries was commendable.
4
comparable to international peer group standards. This sector is also complemented by
relatively well developed capital markets which are playing an increasingly important
The paper draws heavily on recent papers (Bhattacharya and Patel [2002],
Bhattacharya and Patel [2003b] and Patel and Bhattacharya [2003]). It argues that the
now very limited. After a brief sketch of the status of the sector, Section 2 highlights
the infirmities and weaknesses of the system engendered by the high degree of
involvement of the government in the sector. Section 3 is a critical look at the areas
which are often claimed to be the residual (but legitimate) domain of intervention by
the government, and examines the merits of the arguments advanced. Section 4
concludes.
From independence to the end of the 1960s, India’s banking system consisted of
a mix of banks, some of which were government owned (the State Bank of India and its
associate banks), some private and a few foreign. The political class felt that private
banks, which concentrated mainly on high-income groups and whose lending was
security rather than purpose oriented, were not sufficiently encouraging widening of the
nationalise 20 large private banks in two phases, once in 1969 and again in 1980, with
economic activity, extending the geographic reach of banking services and the diffusion
of economic power. Significant financial deepening has taken place over the three
5
decades since the seventies (see Table 1 below). The M3/GDP ratio has increased from
24% in 1970-71 to 70% at present, and the number of bank branches have increased
eight fold over the same period, with much of the expansion in rural and semi-urban
1993, but their share in intermediation, albeit increasing, continues to be low. The
largest growth in savings since 1997-98 has been in bank deposits, which now account
Appendix 1 Table A1.1 and Patel [2000] for a detailed exposition). Much of this
transactions (see Table 2 below for a thumbnail view). Appendix 1 Figure A1.1 also
shows that the extent of government ownership of banks in India is quite high
compared to international levels. The Reserve Bank of India (RBI), moreover, has a
majority ownership in the State Bank of India (SBI), the largest Public Sector Bank
(PSB).
6
Table 2: Share of public sector institutions in specific segments of the financial sector
Public sector (%) Private (%) Total (Rs. bn)
Scheduled Commercial Banks (SCBs) 75.6 24.4 16,989
Mutual Funds (MFs) 48.2 51.8 1,093
Life Insurance 99.9 -- 2,296
Source: RBI Report on Trend and Progress in Banking 2002-03; Annual Reports of SEBI
(2002-03) and IRDA (2001-02).
Banking and mutual fund data are at end-March 2003. Insurance data is end-March 2002.
Definition of shares:
SCBs: Total assets. Private banks include foreign banks.
MFs: Total Net Assets of domestic schemes of MFs (public sector includes UTI).
Insurance: Life insurance Policy Liabilities. Public sector insurance includes LIC and SBI Life.
The shortcomings of the banking system in India are now relatively well
approach, to tackle these issues. There is also a move to transform the major DFIs5 into
entities approximating commercial banks. But there remains another large section of
intermediaries that has not attracted requisite attention: specifically, the large
serious lacuna in the oversight framework is the inadequate attention that has been
devoted to the role of market discipline for SIFIs like Life Insurance Corporation of
India (LIC) and Employees’ Provident Fund Organisation (EPFO). A particular cause
of concern is the opacity of the asset portfolios of LIC and EPFO, a shortcoming which
LIC, as of March 2003, had investible funds of Rs. 2,899 bn (which, to provide
perspective, was 11.9% of GDP in 2002-03)7. The book value of LIC’s “socially
social sector investments – at end-March 2003 amounted to Rs. 1,882 bn, i.e., 71% of a
5
In India, DFIs are a sub-group of intermediaries termed All India Financial Institutions (AIFIs).
6
Our classification of SIFIs is somewhat different from the government’s view, enunciated in the RBI’s
Monetary and Credit Policy, April, 2003, which referred to “large” intermediaries, including banks like
SBI and ICICI Bank.
7
total portfolio value of Rs. 2,650 bn (10.9% of GDP)8. A staggering 87% of this
Compared to the LIC, the EPFO’s accounts are, simply, opaque. Cumulative
contributions to the three schemes of the EPFO, i.e., Employees’ Provident Fund
(EPF), Employee Pension Scheme (EPS) and Employees’ Deposit Linked Insurance
(EDLI), up to the end-March 2002, amounted to Rs. 1,271 bn (5.1% of GDP). Total
cumulative investments of these three schemes were Rs. 1,390 bn (5.6% of GDP), with
the EPF being the largest scheme. The EPFO does not come under the purview of an
independent regulator, with oversight resting on three sources: Income Tax Act (1961),
wider than mere ownership numbers indicate; its ambit stretches across mobilisation of
influencing lending practices of all intermediaries and the investment stimuli of private
7
The Industrial Development Bank of India (IDBI) Report on Development Banking in India, 2002-03,
Appendix Tables 117-119.
8
Social sector investments include loans to State Electricity Boards, housing, municipalities, water and
sewerage boards, state Road Transport Corporations, roadways and railways. These, however, account
8
cooperative banks, weak regulatory and enforcement institutions, unwarranted levels of
government controlled deposit insurance, etc (Buiter and Patel [1997]). A set of indices
to quantify the extent of this involvement was developed in Bhattacharya and Patel
[2002]9. Figure 1 below (here updated from the paper) shows that after having declined
almost secularly till 1995-96, the degree of involvement has risen – fairly sharply after
1997-98.
Figure 1: Index of Density of Government Involvement in the Financial Sector (IDGI-F) in India
140
130
120
110
100
90
80
1990- 1991- 1992- 1993- 1994- 1995- 1996- 1997- 1998- 1999- 2000- 2001-
91 92 93 94 95 96 97 98 99 00 01 02
many intermediaries was related to concerns about systemic stability. The argument
went that an implicit government net of “comfort and support” to both depositors and
lenders deterred the prospect of financial runs. Till 2001-02, the explicit component of
this support had translated into a cumulative infusion into banks of Rs. 225 bn.
The government has also engineered many other indirect forms of bailouts.
Financial interventions in the Unit Trust of India’s10 (UTI) US-64 scheme are
for about a fifth of the socially oriented investments portfolio, with the balance accounted by government
and government guaranteed securities.
9
Appendix 2 provides a description of the Index construction methodology.
10
India’s largest mutual fund.
9
examples. Following the recommendations of an Expert Committee constituted after an
earlier payments crisis in 1998, the government decided to exempt for three years the
US-64 from a 10% dividend tax (deducted at source) that other equity mutual funds
were required to pay. Data on dividend income distribution and the dividend tax for
US-64 for 1999-2000 indicate foregone tax revenue of around Rs. 2 bn. Under the
Special Unit Scheme of 1999, the Government of India (GoI) did a buyback of PSU
shares at book value, higher than the then prevailing market value, effectively
transferring Rs. 15 bn to investors. After the second US-64 payments crisis in 2001,
under a Repurchase Facility covering 40% of the assets of US-64, investors were
GoI making up the gap between this price and the NAV of a unit. Eight Public Sector
Recognising the unviability of this support and a high probability of an ultimate default
on these loans, however, these banks have sought comfort through government
guarantees to help in easy provisioning against the loans and avoiding violation of
norms of lending without collateral. Even more than the actual losses to the exchequer,
intermediaries and the firms that they lend to, force intermediaries to roll-over existing
10
sub-standard debt or convert them into equity, thereby continually building up the
“diverting” funds, for purposes that are not entirely commercially motivated, reinforces
boost investment, both by direct spending and indirectly via credit enhancements, like
[2000]), which facilitates connected lending and diversion of funds between group
intermediaries are blunted and distorted to the extent that they over-ride the safety
systems that have nominally been put in place. The large fiscally-funded
designed to prevent a system-wide collapse at a time when the sector had been buffeted
by the onset of reforms and it had not had time to develop risk mitigation systems.
Moreover, the overall reforms were designed to enhance domestic and external
competition, as a result of which past loans to industry were bound to get adversely
affected, impacting these banks’ balance sheets. The nascent state of capital markets at
that time might also have been seen as a hindrance in accessing capital, especially
11
capital without large attached risk premia. The impact of this support, though, has been
only sustainable method of ensuring capital adequacy in the long run is through
A singular aspect of financial sector reforms in India has been that, while the
“look and feel” of organisations associated with intermediation has altered, the focus of
the changes has revolved around the introduction of stricter sector regulatory standards.
Caprio [1996] argues that regulation-oriented reforms cannot deliver the desired
measures that empower banks to work the new incentives into a viable and efficient
business model and encourage prudent risk-taking. These mechanisms are also meant to
inter alia mitigate the “legacy costs” that continue to burden intermediaries even after
restructuring. Some of these costs, in the Indian context, apart from the consequences
of public ownership discussed above, are well known: weak foreclosure systems and
legal recourse for recovering bad debts, ineffective exit procedures for both banks and
corporations, etc. In addition, during difficult times, fiscal stress is sought to be relieved
through regulatory forbearance; there are demands for (and occasionally actual
instances of) lax enforcement (or dilution) of income recognition and asset
12
independent, deters enforcement of directives (see Bhattacharya and Patel [2001] for an
lending is inhibited inter alia due to distortions in banks’ cost of borrowing and lending
deposits and high administered rates on bank deposit-like small savings instruments
(National Savings Certificates, post office deposits, etc.) artificially raise the cost of
funds for intermediaries. Lending constraints relate to various PLR related guidelines
for Small Scale Industries (SSIs) and other priority sector lending. This constellation of
profitability.12 Over and above the regulatory oversight of the RBI, the role of
government audit and enforcement agencies – like the Comptroller and Auditor
(CBI), etc. – in audits of decisions taken by loan officers at banks undermines “normal”
have curtailed their credit creation role. Outstanding assets of commercial banks in
government securities are, as of March 5, 2004, much higher (just over 46%) than the
11
For instance, cooperative banks have been lax in implementing RBI notifications on lending to
brokers.
12
Declining interest rates increased trading profits (in securities) of PSBs in 2001-02 more than two and
a half times that of the previous year and accounted for 28% of operating profits (RBI Report on Trend
and Progress of Banking in India, 2001-02, Table II.14).
13
Loan officers have complained about being harassed, if not penalised, for having taken on “good”
credit risks, whereas risks not warranted by sound commercial practices have often been foisted on by
the political owners of these institutions.
14
A term coined by one of the current Deputy Governors of the RBI.
13
mandated SLR (25%).15 As Figure 2 below shows, a large fraction of bank deposits are
being deployed for holding government securities. This ratio, as is evident, has been
increasing steadily over the last seven quarters and, more pertinently, has persisted over
the last two quarters despite a strong economic rebound and, presumably, a consequent
Figure 2: Cumulative (quarter-wise) SLR securities investment - deposit ratio of SCBs (in %)
80%
70%
60%
50%
40%
Q1 Q2 Q3 Q4
2001-02 2002-03 2003-04
Note that this phenomenon is actually rational behaviour by banks given the
credit flows and investing in government securities, the economic, regulatory and fiscal
increasingly tighter prudential norms that banks will be forced to adhere has been a
15
It is also noteworthy that 51% of the outstanding stock of central government securities at end-March
2002 was held by just two public sector institutions: the State Bank of India and the Life Insurance
Corporation of India (sourced from Government of India Receipts Budget, RBI Report on Trend and
Progress and investment information on LIC’s website).
14
further shift in the deployment of deposits to government securities and other
Given the scenario described in the previous section, primarily driven through
case for the government to exit from actual intermediation. This section is a critical
look at the functions which are often claimed to be the residual (but legitimate) domain
of intervention by the government, and examines the merits of the arguments advanced.
We need to emphasise that even though the paper analyses the specific activities that
analysis. Rodrik groups the shortcomings and required actions related to market driven
reforms into four components, viz., (i) market stabilisation; (ii) market regulation; (iii)
market creation; and (iv) market legitimisation. This paper relates to the last two
aspects, but primarily through the lens of a fifth component that we add and explore in
this paper, namely, “market completion”. Table 3 below provides a schematic layout as
an organising scaffold for drawing together the threads of various aspects of the role of
16
Banks were advised in April 2002 to build up an investment fluctuation reserve (IFR) of a minimum
5% of their investments in the categories “Held for Trading” and “Available for Sale” within 5 years. As
at end-June 2003, total IFR amounted to only about Rs. 100 bn (i.e., 1.7% of investments under relevant
categories). While 12 banks are yet to make any provisions for IFR, 20 have built IFR up to 1% but only
65 have IFR exceeding 1% (RBI Mid-term Credit and Monetary Policy, 2003). 17 PSBs have IFRs of
2% or more (RBI Report on Trend and Progress, 2002-03).
15
the government in creating new markets that are necessary for facilitating transactions
as well as deal with issues that are a corollary of a move towards commercial
16
Table 3: Matrix of institutional processes in the reform of the financial sector
Institutions’ Objective Mapping to the Indian Addressing specific shortcomings
role (financial) context
Market Stable monetary and fiscal management. Profligate fiscal Pre-emption of resources by government.
stabilisation environment.
Efficacy of central bank functions.
Market Mitigating the impact of scale economies Regulatory forbearance. Appropriate prudential regulation.
regulation and informational incompleteness.
Public ownership of Imposition of market discipline.
institutions.
Transparency and information disclosure.
Market creation Enabling property rights and contract Public ownership of Enforcing creditor rights.
enforcement. institutions.
Effective dispute resolution mechanisms.
Market Social protection; conflict management; Profligate fiscal Mixing social and commercial objectives
legitimisation market access. environment. (e.g., rural branch requirements for banks).
Regulatory forbearance. Appropriate insurance for depositors.
Public ownership of Capital markets enforcement.
institutions.
Effective redressal of investor grievances.
Market “Spanning states of nature”. Shallow or non-existent Lack of institutions and products to mitigate
completion markets. specific (market-making) risks that hamper
formation of markets.
Inadequate old-age income safety nets.
17
3.1 Facilitating transactions and deepening markets
markets and, consequently, the specific risks that individual intermediaries (or even
groups) might not be able to bear, there are often inefficiencies in market transactions or
institutions that minimise transactions cost, often in the nature of a quasi-public good, may
not necessarily emerge as a rational collective outcome of the individual players involved.
These activities usually share characteristics of public merit goods. The government has an
important role in developing institutions that serve as platforms for correcting market
Dealing with the commercial consequence of the new set of risks, however,
demands the presence of specialised institutions. Debt markets in developed countries now
innovating structured financial instruments. In India, on the other hand, the fragmented
nature of debt markets had entailed significant counter-party risk, thereby becoming a
barrier to market integration and further hindering the formation of benchmark yield
curves. This resulted in large and distorted spreads on rates of interest on debt instruments.
The RBI, recognising the need for a financial infrastructure for clearing and
settlement of government securities, forex, money and debt markets (thereby bringing in
efficiency in the transaction settlement process and insulate the financial system from
shocks emanating from operations related issues), initiated a move to establish the
18
Clearing Corporation of India (CCIL), with the SBI playing a lead role. CCIL was
incorporated in October 2001. CCIL takes over and mitigates counterparty risks by
“novation”17 and “multilateral netting”. The risk management system at CCIL includes a
liquidity support in the form of pre-arranged lines of credit from banks, and a procedure
for collecting initial and mark-to-market margins from the members to ensure that the risk
contributions to SGF.
The core activities of the Securities Trading Corporation of India (STCI) comprise
sponsored by the RBI (jointly with PSBs and AIFIs18) with the main objective of fostering
the development of an active secondary market for Government securities and bonds
programme in the 1990s consisted of creating three new institutions – the National Stock
Securities Depository Limited (NSDL) – to facilitate the three legs of trading, clearing and
settlement. The first of these has been the most successful, and was in fact the progenitor
of the other two. Promoted in 1993 by some AIFIs (at the behest of the government), as an
alternative to the incumbent Stock Exchange, Mumbai (BSE), the NSE has since become a
benchmark for operations characterised by innovation and transparency. The NSE has
17
Novation is the original contract between the two counterparties being replaced by a set of two contracts –
between CCIL and each of the two counterparties, respectively.
18
These comprise the DFIs, Investment Institutions like LIC and UTI, other Specialised Financial
Institutions and Refinance Institutions (NABARD and the National Housing Bank, NHB).
19
overtaken the BSE in terms of spot transactions and has spearheaded the introduction of
1995. It was constituted with the objectives of providing counter-party risk guarantees and
to promote and maintain, short and consistent settlement cycles. NSCC has had a trouble-
free record of reliable settlement schedules since early 1996, having evolved a
To promote dematerialisation of securities, the NSE, IDBI and UTI set up NSDL,
trading and settlement of securities. This got rid of risks associated with fake and bad
paper and made transfer of securities automatic and instantaneous. Demat delivery today
A point worth noting has been the inherent profitability of many of these
institutions. Volumes at the NSE, both in the spot and derivatives segments, have
increased significantly in recent times. The annual compound growth in turnover at NSE
over 1995-96 to 2002-03 was 73.1%19, and is likely to have significantly increased in the
current fiscal year. The government (indirectly, through the sponsoring financial
institutions) stands to increase its returns from the volumes evident in these markets (not
As the government begins to open up areas of economic activity that had hitherto
been the exclusive domain of government to the private sector, many processes and
institutions have to develop that can mitigate and allocate the attendant risks through
20
appropriate financial structures, innovative products, resource syndication and project
facilitation. Without these institutions, the probability of private sector operations not
these activities. In addition, individual initiatives depend upon a critical mass being
(and re-financing) most trade related transactions, there remains – even in developed
countries – a residual role for a state-sponsored Exim bank for underwriting sovereign-
related risks, as well as advancing matters that are strategic in nature, apart from the
there might not be commercial banks with sufficiently diversified portfolios of assets that
can adequately cover the forex risks that are necessarily an adjunct of trade financing.
The Export-Import Bank of India (Exim Bank) was established in 1982, for the
purpose of financing, facilitating, and promoting foreign trade of India. It is the principal
accepting credit and country risks that private intermediaries are unable or unwilling to
accept. The Exim Bank provides export financing products that fulfill gaps in trade
financing, especially for small businesses, in the areas of export product development,
corporations increasingly invest in foreign countries, there is also a need for political risk
19
NSE Factbook 2002-03.
20
The Exim Bank’s role in export promotion, besides extending lines of credit, consists of educating
exporters about market potential, banking facilities, payment formalities, etc., which has a bearing on the
country risk they might face.
21
Exim Bank’s loan assets have risen from Rs. 20.3 bn in 1993-94 to Rs. 87.7 bn in
2002-03 (an increase of 340%), and its guarantee portfolio from Rs. 7.5 bn to Rs. 16.1 bn
(113%) over this period. India’s manufacturing exports, over this period, has increased
Universally considered a pivot for economic growth, infrastructure has been one of
the two large segments that has traditionally been under the rubric of the state in India (the
other, as we have discussed, being the financial sector). The gradual recognition of the
inefficiencies inherent in public provision of utility services, as well as the inability of the
exchequer to cope with the large investments needed to upgrade, refurbish and build
assets, made the Indian government amenable to introducing private participation in the
sector (in the early 1990s). Bhattacharya and Patel [2003a] had previously detailed the
finance necessary for financial closure of private infrastructure projects had been
recognised early on, but, of itself, this was soon found to be insufficient. After years of
effort, and initial failure in most sectors in India, the importance of sound policy and
understood.
Company (IDFC) was established to “lead private capital into commercially viable
infrastructure to lower the cost of capital, IDFC was tasked with rationalising the existing
policy regimes in sectors as diverse as electricity, telecom, roads, ports, water &
22
sanitation, etc. Its policy advocacy initiatives in the telecom and civil aviation sectors are
good examples of the success in “developing sectors”, in contrast (and addition) to merely
financing individual projects. IDFC has also made an impact in bringing in funds into
projects through innovative financial products like “take-out” financing and the use of
method for road projects. These initiatives have had the effect of orchestrating a
establishment of DFIs, was the failure of existing private sector intermediaries to extend
the reach of banking to rural and remote areas, as well as perceived inadequacies in
channelling credit to what were then deemed as critical areas of industrialisation. Although
continuation of these policies has been largely eroded. For some of these objectives, India
already has specialised intermediaries – the National Bank for Rural Development
Corporations (SFCs), etc. These institutions have quite obviously failed to live up to their
mechanisms that are proposed to be instituted to advance their stated objectives.21 We look
at individual components of these objectives and argue that using bank intermediaries to
21
There is a proposal in the Interim Budget 2004-05 for a “Fund” for small scale enterprises, but the
objective and disbursement mechanisms of this fund are not clear.
23
3.3.1 Intermediating rural financial resources
Rural banking is rife with inefficiencies. Commercial banks, especially PSBs, have
an inordinately large presence in rural and semi-urban areas. While only 33% of their
deposits are sourced from (and 21% of credit is disbursed in) these areas, a full 71% of
their branches are located there (see Appendix 1 Table A1.2). RBI licensing conditions for
new private sector banks stipulate that, after a moratorium period of three years, one out of
four new branches has to be in rural areas, thereby adding significantly to operating costs
This is despite the prevalence of a large network of post offices that is the
predominant channel for small savings, as well as specialised Regional Rural Banks
(RRBs), cooperatives and other intermediaries working through NABARD. India had
around 155,000 post offices at end-March 2002, including about 139,000 in rural areas.22
The Post Office Savings Bank, operated as an agency for the Ministry of Finance, besides
being a conduit for National Small Savings (NSS) schemes, also offer money order and
limited life insurance schemes. The ambit of these outlets, many already operating in
partnership with commercial banks and insurance companies, can be further expanded in
rural areas to address credit delivery shortcomings (the problematic aspect of rural
a re-organised post office network in India as the main channel of delivery of rural credit
has not been done, an instructive report is that of the Performance and Innovation Unit of
the British government, whose post office organisational structure is similar to India’s
(PIU [2000]).
Rural banking needs might be “narrower” in nature and alternative credit delivery
mechanisms – which might be better suited and more cost effective – may be considered.
24
The other side of the coin is the reported shortcomings of credit delivery through
institutions like NABARD, which is validated through the casual empiricism of a periodic
mandated rates of interest.23 Not only are lending decisions of individual banks distorted
Self Help Groups (SHGs) and micro credit institutions (SEWA being a prime example)
has also demonstrated the viability and higher sustainability of these alternative channels.
The use of minimum subsidy bidding to achieve some of the government’s social
As seen above, the dilution of the credit creation role of banks have raised
concerns about under-lending. This worry is especially high for agriculture and small scale
industries. According to RBI guidelines, banks have to provide 40% of net bank credit to
priority sectors, which include agriculture, small industries, retail trade and the self-
employed. Within this overall target, 18% of the net bank credit has to be to the
agriculture sector and another 10% to the weaker sections. Commercial banks have been
consistently unable to attain these targets, and the expedient of channeling the shortfalls to
the Rural Infrastructure Development Fund (under NABARD’s administrative ambit) has
led to concerns about its relatively non-transparent procedures of disbursement and the
One of the arguments for mandating lending to the priority sectors at interest rates
lower than market rates is an administrative mitigation of the higher risk premiums for the
22
India Post Annual Report 2002-03.
25
(supposedly) inherently risky nature of this lending. An outcome of this risk is the level of
NPAs. While credit appraisals for small firms are definitely more difficult, the argument
of potentially high NPAs in priority sector advances may need to be nuanced (even if just
a little) in light of the numbers on the sector-wise origins of NPAs of PSBs, as of end-
March 2003. While the share of priority sector NPAs in the total is about 47%24 for PSBs,
their total loans outstanding to the priority sector (as a percentage of total loans) at end-
March 2003 was about 43%25. At the same time, the high NPAs of DFIs remain a pointer
The provident fund system is the most important component of the social security
net, but covers a meager 11 million persons, all of them in the organised sector. An
important component of the Employee Provident Fund (EPF) Scheme of the EPFO
(discussed earlier) is the administratively determined markup for the returns provided on
deposits into the EPF, justified on the basis of providing an adequate livelihood for
pensioners and others on limited fixed incomes. It is estimated that the average real annual
compound rate of return over the period 1986-2000 was 2.7% (Asher [2003]).
One of the worries, apart from concerns about investment efficiency, is the
sustainability of this method. The average markup between the returns provided by the
EPF and 10-year Government of India securities since 1995-96 has been 120 basis
23
For instance, the recent directive to banks in December 2003 to disburse farm credit at 2% below their
respective Prime Lending Rates (PLRs).
24
RBI Statistical Tables Relating to Banks in India, 2002-03, Table 7.2.
25
RBI Report on Trend and Progress in Banking, 2002-03, para. 3.93. This includes transfers to RIDF,
SIDBI, etc.
26
Net NPAs of DFIs were 18.8% of advances in 2002-03 (RBI Report op. cit).
26
points27. The various tax exemptions that are granted to these deposits – throughout the
life of these deposits – make the effective rate of return even higher. A back-of-the-
envelope calculation in Patel [1997a] indicated that the EPS was actuarially insolvent and
the EPFO’s reluctance to make public its actuarial calculations does little to assuage this
conclusion. Other than issues of sustainability, there remain concerns of these and other
National Small Savings (NSS) schemes regarding the distortive effects on the yield curve
(term structure of interest rates). As Table A1.1 shows, small savings outstanding
accounted for over 15% of GDP in 2002-03, dwarfing all other intermediaries but banks.
Other than instituting a sound regulatory mechanism and facilitating efficient and
seamless transactions, a major aspect of the government’s role in imparting stability to the
financial system is the constitution of an appropriate safety net for depositors. The current
system has a built-in bias which leans towards using taxpayer funds to finance bank losses,
thus undermining even limited market discipline and encouraging regulatory forbearance.
norms (Demirguc-Kunt and Kane [2001]). Depositors in India do not have to bear co-
insurance on the insured deposit amount and the ceiling insured amount (Rs. 100,000) is
five times the per capita GDP, high by international standards. This encourages some
depositors to become less concerned about the financial health of their banks and for
The Deposit Insurance and Credit Guarantee Corporation (DICGC) came into
Deposit Insurance Corporation (DIC) and Credit Guarantee Corporation (CGC). DICGC
27
The rate of return on the EPF scheme has been set at 12% per annum from 1989-90 onwards, till July 2000
27
extended its guarantee support to credit granted to small scale industries from 1981, and
from 1989, the guarantee cover was extended to priority sector advances. However, from
1995, housing loans have been excluded from the purview of guarantee cover. As of 2001-
02, about 74% of the total (accessible, i.e., excluding inter-bank and government) deposits
of commercial banks was insured28. Banks are required to bear the insurance premium of
Re 0.05 per Rs. 100 per annum (depositors are not charged for insurance protection).
The issues raised by an overly generous deposit insurance structure have been
recognised by the government. Some of the major recommendations of the 1999 Working
Group constituted by the RBI to examine the issue of deposit insurance are withdrawing
the function of credit guarantee on loans from DICGC and instituting a risk-based pricing
of the deposit insurance premium instead of the present flat rate system. A new law,
the recommendations.
4. CONCLUSION
Despite the institution of market reforms in India since the early nineties,
government “interests” in the financial sector have not diminished commensurate to its
withdrawal from most other aspects of economic activity. The continuing presence is too
intermediaries in the early years of India’s development, but these have now been
rendered redundant, and possibly even damaging. India now has a relatively well
commercially oriented. The raison d’etre of the Development Finance Institutions (DFIs)
from when they have been progressively reduced to the current 9%.
28
is also now obsolete, with the continuing development of project finance skills of banks
forbearance (arising out of an implicit overarching guarantee umbrella) has mitigated the
essential corrective effect of market discipline in both lending and deposit decisions.
support scaffold, this has resulted in an aggravation of the problems of moral hazard that
A cycling analogy is the most apt to describe the outcome of these deficiencies.
The set of actions that increasingly aggravate moral hazard, through visible and invisible
props to keep the edifice from falling, is like riding a bicycle without brakes down a hill –
attempting to stop or intensifying pedalling will lead inexorably to a wreck. The prudent
escape is to look for a soft spot to crash to minimise damage and then get the brakes
repaired.
contexts in various countries. Its financial sector inefficiencies are likely to simply
simmer, with occasional payments crises, like the one at the dominant mutual fund over
the last five years. However, the cumulative inefficiencies and grim fiscal outlook, with
the concomitant regulatory forbearance that public involvement inevitably entails, are
certain to retard India’s transition to a high growth trajectory. The persistent unease with
the state of the system, it can be speculated, arises from the recognition that the perceived
28
DICGC Annual Report 2001-02.
29
safety of intermediaries is due more to the “social contract” between the government and
The system of intermediation will not improve appreciably in the absence of any
serious steps towards changing incentives blunted by public sector involvement (of which
management control, which remains far beyond the scope envisaged in the Banking
33%, but allowing them to retain their “public sector character” by maintaining effective
control over their boards and restricting the voting right of non-government nominees.
implicit bailout and other means of accommodating fragility) will almost certainly lead to
Old habits, unfortunately, die hard. There has re-emerged in official thinking an
ambiguity about the perceived role of financial institutions as a tool of financial policy. On
the one hand, there is an extensive restructuring of the DFIs underway, through mergers
and redefinitions of their statutory status. Yet, on the other, various aspects of financial
sector reforms are either being rolled back (directives for lending to target groups) or are
not being addressed (artificially high rates of interest for small savings schemes). Various
decisions that strengthen the “DFI model” – including directed disbursements at lower
than market interest rates, use of public sector intermediaries for interventions in capital
markets, etc. – have recently been taken. More than anything else, the cardinal mistake is
30
to confuse outcomes with mechanisms and processes. Both, after a brief period of
Given the increasing integration of financial markets, there is also a need to shift
this shift is enhancing intermediaries’ ability to de-risk their asset portfolios. Undoubtedly,
Interest (SARFAESI) Act of 2002 is a crucial step forward in addressing bad loans, but, on
its own, it is limited in scope and even this is beset by various legal challenges.
Establishing asset reconstruction companies, even under private management, will serve
only to tackle the overhang of existing bad assets – they per se do little to correct the
There, however, remain some aspects of intermediation that are in the nature of
public goods. One is the establishment of specific “platforms” for facilitating transactions.
Another is to catalyse certain economic activities that are in the nature of testing waters or
else are pioneering financial services. The government has constituted diverse bodies to
fulfill these roles; it is worth noting that the most successful among these have been
institutions that have had no direct intermediation functions. The state might have other
legitimate social objectives like extending the reach of intermediation in rural and remote
areas and providing social security nets; these, though, would be better achieved through
the use of existing networks like post offices rather than commercial banks.
31
References
Allen, F. and D. Gale, 2001, “Comparative financial systems: A survey”, Mimeo., New
York University.
Asher, M. G., 2003, “Reforming India’s social security system”, Mimeo., National
University of Singapore, May.
Banerjee, A. V., S. Cole and E. Duflo, 2004, “Banking Reform in India”, paper presented
at the Inaugural Conference of the India Policy Forum, New Delhi, March.
Bhattacharya, S. and U. R. Patel, 2003b, “Reform strategies in the Indian financial sector”,
forthcoming in the Proceedings volume of IMF-NCAER Conference on India’s and
China’s Experience with Reform and Growth, New Delhi, November.
Calomiris, C. W. and A. Powell, 2000, “Can emerging market bank regulators establish
credible discipline?”, National Bureau of Economic Research Working Paper No. 7715,
May.
Caprio, G., 1996, “Bank regulation: the case of the missing model”, Paper presented at
Brookings - KPMG Conference on Sequencing of Financial Reform, Washington, D.C.
Demirguc-Kunt, A. and E. J. Kane, 2001, “Deposit insurance around the world: Where
does it work?”, Paper prepared for World Bank Conference on Deposit Insurance, July.
Hawkins, J. and D. Mihaljek, 2001, “The banking industry in the emerging market
economies: Competition, consolidation and systemic stability,” Overview Paper, BIS
Papers No. 4, August.
32
La Porta, R., F. L. de-Silanes and A. Shleifer, 2000, “Government ownership of banks”,
Mimeo., Harvard University.
Levine, R., 1997, “Financial development and economic growth: Views and agenda”,
Journal of Economic Literature, vol. XXXV, pp. 688-726.
Patel, U. R., 1997a, “Aspects of pension fund reform: Lessons for India”, Economic and
Political Weekly, vol. XXXII (No. 38, September 20-26) pp. 2395-2402.
Patel, U. R., 2000, “Outlook for the Indian financial sector”, Economic and Political
Weekly, vol. XXXV (No. 45, November 4-10), pp. 3933-3938.
Performance and Innovation Unit Report, 2000, “Counter revolution: Modernising the
post office network”, UK Government Cabinet Office, June.
Rodrik, D., 2002, “After neo-liberalism, what?”, Mimeo. Harvard University, June.
33
APPENDIX 1
Table A1.1: Comparative profile of financial intermediaries and markets in India
(Amounts in Rupees billion, and numbers in parentheses are percentage of GDP)
1990-91 1998-99 2002-03
Gross Domestic Savings 1,301 3,932 5,500
(24.3) (22.3) (24.0)
Bank deposits outstanding 2,078 7,140 13,043
(38.2) (40.5) (50.1)
Small Savings deposits, PPFs, outstanding etc 1,071 3,333 3,810
(20.0) (19.1) (15.4)
Mutual Funds (Assets under management) 253 858 1,093
(4.7) (4.9) (4.2)
Public / Regulated NBFC deposits 174* 204 178
(2.4) (1.2) (0.7)
Total borrowings by DFIs (outstanding) -- 2108 901
(12.0) (3.5)
&
Annual Stock market turnover (BSE & NSE) 360 15,241 9,321
(5.6) (79.0) (35.8)
Stock market capitalisation (BSE & NSE) 845& 18,732 11,093
(15.8) (97.1) (42.6)
Table A1.2: Current trends in banking in urban and non-urban areas (as on March 31, 2003)
No. of Deposits Credit C-D Ratio
bank (Rs. bn) (Rs. bn) (%)
branches
Scheduled Commercial Banks
Urban centres (including metros) 19,379 29% 8,619 67% 5,998 79% 70%
Metro centres 8,664 13% 5,719 45% 4,745 62% 83%
Top 100 centres 15,066 23% 7,603 61% 5,758 75% 74%
Non Urban centres 38%
Semi urban centres 14,813 22% 2,405 19% 847 11% 35%
Rural centres 32,244 49% 1,763 14% 748 10% 42%
All India 66,436 12,787 7,592 59%
34
Figure A1.1: Country comparison of government ownership of banks
100% 2 1 5
8 9 7 7 9 6
12 16 20 17
13
23
75% 49 50
32 49
62
82
55 78
50% 93 95
86 21 83
79
68
25% 52 50
44
31 30 25
18 15
0% 1 0 0 0
a ia ia il s ia d na o y nd n lia A e
h in In d ss Br
az e ai la n nti x ic an r la Ja
pa tr a US
ap
or
C Ru on Th ge Me r m
tz e Au
s g
In d Ar Ge i Sin
Sw
Government banks Domestic private banks Foreign Banks
35
APPENDIX 2
weighting system. The weights are uniform, being simply +1 or –1 depending on the
involvement.
I. Constituents of IDGI-F
A. Share of public sector banks (PSBs) and financial institutions (FIs) in total financial
intermediation.
financial savings).
savings).
3. Excess deposits deployed by PSBs in priority sectors (as % of Net Bank Credit,
4. Share of public investment in overall investment (e.g., 7.7 percent out of 26.8
36
5. Public sector saving - investment gap (as % of GDP).
6. Public sector fiscal / resource gap (a proxy for Public Sector Borrowing
GDP).
(sub-index) constituent series. These synthetic sub-index series are constructed using the
(observed) rates of change of the constituent variables (detailed above), with the values of
37