Investment
in India - Banking System
Financial
And Banking Sector Reforms
The last decade witnessed the
maturity of India's financial markets. Since 1991, every governments of
India took major steps in reforming the financial sector of the country.
The important achievements in the following fields is discussed under
serparate heads:
- Financial markets
- Regulators
- The banking system
- Non-banking finance companies
- The capital market
- Mutual funds
- Overall approach to reforms
- Deregulation of banking system
- Capital market developments
- Consolidation imperative
Now let us discuss each segment
seperately.
Financial Markets
In the last decade, Private Sector Institutions played an important
role. They grew rapidly in commercial banking and asset management
business. With the openings in the insurance sector for these
institutions, they started making debt in the market.
Competition among financial intermediaries gradually helped the
interest rates to decline. Deregulation added to it. The real interest
rate was maintained. The borrowers did not pay high price while
depositors had incentives to save. It was something between the nominal
rate of interest and the expected rate of inflation.
Regulators
The Finance Ministry continuously formulated major policies in the
field of financial sector of the country. The Government accepted the
important role of regulators. The Reserve Bank of India (RBI) has become
more independant. Securities and Exchange Board of India (SEBI) and the
Insurance Regulatory and Development Authority (IRDA) became important
institutions. Opinions are also there that there should be a
super-regulator for the financial services sector instead of
multiplicity of regulators.
The banking system
Almost 80% of the business are still controlled by Public Sector Banks
(PSBs). PSBs are still dominating the commercial banking system. Shares
of the leading PSBs are already listed on the stock exchanges.
The RBI has given licences to new private sector banks as part of the
liberalisation process. The RBI has also been granting licences to
industrial houses. Many banks are successfully running in the retail and
consumer segments but are yet to deliver services to industrial finance,
retail trade, small business and agricultural finance.
The PSBs will play an important role in the industry due to its number
of branches and foreign banks facing the constrait of limited number of
branches. Hence, in order to achieve an efficient banking system, the
onus is on the Government to encourage the PSBs to be run on
professional lines.
Development finance institutions
FIs's access to SLR funds reduced. Now they have to approach the
capital market for debt and equity funds.
Convertibility clause no longer obligatory for assistance to corporates
sanctioned by term-lending institutions.
Capital adequacy norms extended to financial institutions.
DFIs such as IDBI and ICICI have entered other segments of financial
services such as commercial banking, asset management and insurance
through separate ventures. The move to universal banking has started.
Non-banking finance companies
In the case of new NBFCs seeking registration with the RBI, the
requirement of minimum net owned funds, has been raised to Rs.2 crores.
Until recently, the money market in India was narrow and circumscribed
by tight regulations over interest rates and participants. The secondary
market was underdeveloped and lacked liquidity. Several measures have
been initiated and include new money market instruments, strengthening
of existing instruments and setting up of the Discount and Finance House
of India (DFHI).
The RBI conducts its sales of dated securities and treasury bills
through its open market operations (OMO) window. Primary dealers bid for
these securities and also trade in them. The DFHI is the principal
agency for developing a secondary market for money market instruments
and Government of India treasury bills. The RBI has introduced a
liquidity adjustment facility (LAF) in which liquidity is injected
through reverse repo auctions and liquidity is sucked out through repo
auctions.
On account of the substantial issue of government debt, the gilt- edged
market occupies an important position in the financial set- up. The
Securities Trading Corporation of India (STCI), which started operations
in June 1994 has a mandate to develop the secondary market in government
securities.
Long-term debt market: The development of a long-term debt market is
crucial to the financing of infrastructure. After bringing some order to
the equity market, the SEBI has now decided to concentrate on the
development of the debt market. Stamp duty is being withdrawn at the
time of dematerialisation of debt instruments in order to encourage
paperless trading.
The capital market
The number of shareholders in India is estimated at 25 million.
However, only an estimated two lakh persons actively trade in stocks.
There has been a dramatic improvement in the country's stock market
trading infrastructure during the last few years. Expectations are that
India will be an attractive emerging market with tremendous potential.
Unfortunately, during recent times the stock markets have been
constrained by some unsavoury developments, which has led to retail
investors deserting the stock markets.
Mutual funds
The mutual funds industry is now regulated under the SEBI (Mutual
Funds) Regulations, 1996 and amendments thereto. With the issuance of
SEBI guidelines, the industry had a framework for the establishment of
many more players, both Indian and foreign players.
The Unit Trust of India remains easily the biggest mutual fund
controlling a corpus of nearly Rs.70,000 crores, but its share is going
down. The biggest shock to the mutual fund industry during recent times
was the insecurity generated in the minds of investors regarding the US
64 scheme. With the growth in the securities markets and tax advantages
granted for investment in mutual fund units, mutual funds started
becoming popular.
The foreign owned AMCs are the ones which are now setting the pace for
the industry. They are introducing new products, setting new standards
of customer service, improving disclosure standards and experimenting
with new types of distribution.
The insurance industry is the latest to be thrown open to competition
from the private sector including foreign players. Foreign companies can
only enter joint ventures with Indian companies, with participation
restricted to 26 per cent of equity. It is too early to conclude whether
the erstwhile public sector monopolies will successfully be able to face
up to the competition posed by the new players, but it can be expected
that the customer will gain from improved service.
The new players will need to bring in innovative products as well as
fresh ideas on marketing and distribution, in order to improve the low
per capita insurance coverage. Good regulation will, of course, be
essential.
Overall approach to reforms
The last ten years have seen major improvements in the working of
various financial market participants. The government and the regulatory
authorities have followed a step-by-step approach, not a big bang one.
The entry of foreign players has assisted in the introduction of
international practices and systems. Technology developments have
improved customer service. Some gaps however remain (for example: lack
of an inter-bank interest rate benchmark, an active corporate debt
market and a developed derivatives market). On the whole, the cumulative
effect of the developments since 1991 has been quite encouraging. An
indication of the strength of the reformed Indian financial system can
be seen from the way India was not affected by the Southeast Asian
crisis.
However, financial liberalisation alone will not ensure stable economic
growth. Some tough decisions still need to be taken. Without fiscal
control, financial stability cannot be ensured. The fate of the Fiscal
Responsibility Bill remains unknown and high fiscal deficits continue.
In the case of financial institutions, the political and legal
structures hve to ensure that borrowers repay on time the loans they
have taken. The phenomenon of rich industrialists and bankrupt companies
continues. Further, frauds cannot be totally prevented, even with the
best of regulation. However, punishment has to follow crime, which is
often not the case in India.
Deregulation of banking system
Prudential norms were introduced for income recognition, asset
classification, provisioning for delinquent loans and for capital
adequacy. In order to reach the stipulated capital adequacy norms,
substantial capital were provided by the Government to PSBs.
Government pre-emption of banks' resources through statutory liquidity
ratio (SLR) and cash reserve ratio (CRR) brought down in steps. Interest
rates on the deposits and lending sides almost entirely were
deregulated.
New private sector banks allowed to promote and encourage competition.
PSBs were encouraged to approach the public for raising resources.
Recovery of debts due to banks and the Financial Institutions Act, 1993
was passed, and special recovery tribunals set up to facilitate quicker
recovery of loan arrears.
Bank lending norms liberalised and a loan system to ensure better
control over credit introduced. Banks asked to set up asset liability
management (ALM) systems. RBI guidelines issued for risk management
systems in banks encompassing credit, market and operational risks.
A credit information bureau being established to identify bad risks.
Derivative products such as forward rate agreements (FRAs) and interest
rate swaps (IRSs) introduced.
Capital market developments
The Capital Issues (Control) Act, 1947, repealed, office of the
Controller of Capital Issues were abolished and the initial share
pricing were decontrolled. SEBI, the capital market regulator was
established in 1992.
Foreign institutional investors (FIIs) were allowed to invest in Indian
capital markets after registration with the SEBI. Indian companies were
permitted to access international capital markets through euro issues.
The National Stock Exchange (NSE), with nationwide stock trading and
electronic display, clearing and settlement facilities was established.
Several local stock exchanges changed over from floor based trading to
screen based trading.
Private mutual funds permitted
The Depositories Act had given a legal framework for the establishment
of depositories to record ownership deals in book entry form.
Dematerialisation of stocks encouraged paperless trading. Companies were
required to disclose all material facts and specific risk factors
associated with their projects while making public issues.
To reduce the cost of issue, underwriting by the issuer were made
optional, subject to conditions. The practice of making preferential
allotment of shares at prices unrelated to the prevailing market prices
stopped and fresh guidelines were issued by SEBI.
SEBI reconstituted governing boards of the stock exchanges, introduced
capital adequacy norms for brokers, and made rules for making client or
broker relationship more transparent which included separation of client
and broker accounts.
Buy back of shares allowed
The SEBI started insisting on greater corporate disclosures. Steps were
taken to improve corporate governance based on the report of a
committee.
SEBI issued detailed employee stock option scheme and employee stock
purchase scheme for listed companies.
Standard denomination for equity shares of Rs. 10 and Rs. 100 were
abolished. Companies given the freedom to issue dematerialised shares in
any denomination.
Derivatives trading starts with index options and futures. A system of
rolling settlements introduced. SEBI empowered to register and regulate
venture capital funds.
The SEBI (Credit Rating Agencies) Regulations, 1999 issued for
regulating new credit rating agencies as well as introducing a code of
conduct for all credit rating agencies operating in India.
Consolidation imperative
Another aspect of the financial sector reforms in India is the
consolidation of existing institutions which is especially applicable to
the commercial banks. In India the banks are in huge quantity. First,
there is no need for 27 PSBs with branches all over India. A number of
them can be merged. The merger of Punjab National Bank and New Bank of
India was a difficult one, but the situation is different now. No one
expected so many employees to take voluntary retirement from PSBs, which
at one time were much sought after jobs. Private sector banks will be
self consolidated while co-operative and rural banks will be encouraged
for consolidation, and anyway play only a niche role.
In the case of insurance, the Life Insurance Corporation of India is a
behemoth, while the four public sector general insurance companies will
probably move towards consolidation with a bit of nudging. The UTI is
yet again a big institution, even though facing difficult times, and
most other public sector players are already exiting the mutual fund
business. There are a number of small mutual fund players in the private
sector, but the business being comparatively new for the private
players, it will take some time.
We finally come to convergence in the financial sector, the new
buzzword internationally. Hi-tech and the need to meet increasing
consumer needs is encouraging convergence, even though it has not always
been a success till date. In India organisations such as IDBI, ICICI,
HDFC and SBI are already trying to offer various services to the
customer under one umbrella. This phenomenon is expected to grow rapidly
in the coming years. Where mergers may not be possible, alliances
between organisations may be effective. Various forms of bancassurance
are being introduced, with the RBI having already come out with detailed
guidelines for entry of banks into insurance. The LIC has bought into
Corporation Bank in order to spread its insurance distribution network.
Both banks and insurance companies have started entering the asset
management business, as there is a great deal of synergy among these
businesses. The pensions market is expected to open up fresh
opportunities for insurance companies and mutual funds.
It is not possible to play the role of the Oracle of Delphi when a vast
nation like India is involved. However, a few trends are evident, and
the coming decade should be as interesting as the last one.
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