Indian Financial sector – Rakesh Mohan and Partha Ray

 Indian Financial Sector: 1950–1990—From Laissez Faire to Government

Control
1. NATIONALIZATION - At the time of independence in 1947, India had 97
scheduled4 private banks, 557 “non-scheduled” (small) private banks organized as
joint stock companies, and 395 cooperative banks. Thus, at the time of India’s
independence, the organized banking sector comprised three major types of players,
viz., the Imperial Bank of India, joint-stock banks (which included both joint stock
English and Indian banks) and the foreign owned exchange banks. The decade of
1950s and 1960s was characterized by limited access to finance of the productive
sector and a large number of banking failures. Such dissatisfaction led the government
of left-leaning Prime Minister (and then Finance Minister) Mrs Indira Gandhi to
nationalize fourteen private sector banks on 20 July 1969: and later six more
commercial banks in 1980. Thus, by the early 1980's the Indian banking sector was
substantially nationalized. Even today, approximately 60% of all loans are in PSBs
and around 70% of all deposits are in PSBs.
2. RRBs - Regional Rural Banks (RRBs) were established in 1975 as local level banks in
different states of India. They are co-owned by the Central and State Governments,
and by sponsoring public sector banks. Capital ratio of RRBs = Centre 50%, State
15%, Sponsor banks 35%. Unlike the cooperative banks, RRBs are structured as
commercial banks and were established with a view to developing the rural economy.
They were envisaged to create a supplementary channel to the 'Cooperative Credit
Structure' for enlarging institutional credit extended to the rural and agriculture
sectors.
3. INSURANCE - The life insurance business was nationalized in 1956 giving birth to
the Life Insurance Corporation of India (LIC), which then had had a monopoly in the
insurance business till the late 1990s when the Insurance sector was opened to the
private sector. The general insurance business was nationalized later in 1972 when
107 insurers were amalgamated and grouped into just four government owned
companies. 64% of market share in life insurance is with LIC. However, life
insurance penetration in India is extremely low at 3.76%.
4. CONCLUSION - Thus, by the end of the 1980s, the financial sector in India was
virtually owned by the government with nationalized banks and insurance companies
and a single public sector mutual fund. Consequently, reforming the financial sector
was a very important part of Indian economic reforms initiated in the early 1990s.
 Banking in India since the 1990s: Towards Modern Competitive Banking
1. REPORTS CHAIRED BY M. NARASIMHAN (EX RBI GOVERNOR) –
Reduction in SLR, Reduction in CRR, Increase in loanable funds, elimination
of administered interest rate structure. Currently, CRR = 4% and SLR = 18%,
Loanable funds = 78%.
2. WEIGHTED AVERAGE CALL RATE - Once the repo rate is announced, the
operating framework envisages liquidity management on a day-to-day basis
through appropriate actions, which aim at anchoring the operating target – the
weighted average call rate (WACR)—around the repo rate. Over the years,
depending on the demand management imperatives, the RBI has used repo rate
 as an instrument of effective control of overnight liquidity. LAF = difference
between repo and reverse repo rates.

3. SARFAESI ACT - The Securitization and Reconstruction of Financial Assets

and Enforcement of Securities Interest (SARFAESI) Act was passed in 2002,
enabling the setting up of debt-recovery tribunals and asset-reconstruction
companies. Most recently, the Bankruptcy Act was passed by the Indian
parliament in May 2016.
4. ROLE OF IT- Information technology has played a key role in this
transformative journey of Indian banking. Technology has enabled more
effective, lower cost and real-time delivery of financial services, through the
establishment of a modern payments system. Setting up of the Indian Financial
Network (INFINET) as the communication backbone for the financial sector,
introduction of a Real Time Gross Settlement System (RTGS) are some of the
major technological initiatives implemented.
 Outcomes of liberalizing banking sector
1. Increase in deposits and credit: Over the years there has been a huge increase
in the extent of financialization of the Indian economy. This is reflected in
upward trend in aggregate deposit and credit as a percentage of GDP.
 2. Capital adequacy and asset quality improved, NPAs came down - The
financial health of banks also improved significantly, in terms of both capital
adequacy and asset quality. Illustratively, gross non-performing loans as a
percentage of gross advances came down steadily from 15.7 percent in 1996 to
2.4 percent in 2009. Notwithstanding recent stress, the capital to risk-weighted
assets ratio of scheduled commercial banks in India was 12.7 percent while
Tier-I leverage ratio stood at 6.5 percent in September 2015.

3. Private sector banks - Along with divestiture in the public sector banks, and
their subsequent listing in stock exchanges, a significant number of private
sector banks were allowed entry; consequently, the share of public sector banks
continued to decline gradually in banking business and a private sector bank
emerged as the second largest bank in India over the last ten years or so.
 Changes in money market
1. Repo rate, LAF - With the initiation of financial sector reforms and the need
to make monetary policy operational the call money market had to be
developed gradually into an inter-bank market through which monetary policy
transmission takes place. RBI’s policy rate is effectively the repo rate now,
which acts as the anchor of the money market through operation of its liquidity
adjustment facility (LAF).
2. Establishment of CCIL - An important institutional reform was the
establishment of the Clearing Corporation of India Limited (CCIL) as a central
counterparty to provide guaranteed clearing and settlement functions for
transactions in money, G-Secs, foreign exchange, and derivative markets. This
led to significant improvement in the market efficiency, transparency, liquidity,
and risk management/measurement practices in these markets along with added
benefits like reduced settlement and operational risk, savings on settlement
costs.
 3. CBLO - Further, new innovative instruments, such as collateralized borrowing
and lending obligations (CBLO; a tripartite repo between any two financial
entities along with CCIL) and market repo were introduced for widening and
deepening the money market.
 Emerging issues
1. Public nature of banking sector - Notwithstanding such trends, the Indian banking
sector continued to remain predominantly public in nature, with the public sector
banks still accounting for more than 70 percent of total banking sector assets. A recent
official report argued for reduction in government shareholding to below 50 percent to
allow more autonomy to banks as well as to create distance between the government
and governance of banks (RBI, 2014). However, during 2014–15, despite their
substantive share in total assets, public sector banks accounted for only 42 percent in
total profits (RBI, 2015), down from 74 percent in 2003–04. The fact that the
performance of public sector banks had converged to that of the new private sector
banks by 2008–09, before deteriorating subsequently poses a further puzzle, raises
further questions about the determinants of their performance.
2. Rise in GNPAs and stressed assets - Earlier, gross non-performing assets
(GNPAs) of the Indian banking sector, as a percentage of gross advances, had
come down from 15 percent in 1998 to 3.3 percent in 2009: since then GNPAs
have increased steadily to 5.1 percent by the end of 2015 (Figure 6). Taking a
wider definition, the stressed assets (i.e., gross NPA plus restructured standard
assets plus written off accounts) for the banking system as a whole increased
from 9.8 percent in 2012 to 14.5 percent in 2015; stressed assets in public
sector banks increased from 11.0 percent to 17.7 percent during the same
period.
3. Priority sector lending - India’s approach to financial inclusion has been multi-
pronged. One of its major corner-stones is the presence of stipulations on
“priority sector lending” by the commercial banks. For this purpose, priority
sector includes the following categories, viz., agriculture; micro, small and
medium enterprises; export credit; education; housing; social infrastructure;
renewable energy; and others (like weaker section of the community). Indian
commercial banks are required to lend 40 percent of their credit to the priority
sector. Now Foreign banks with 20 branches and above also have to achieve
the 40 percent total within a maximum period of five years over April 2013—
March 2018 as per the action plans submitted by them and approved by RBI.
Besides, there are sub-targets within this overall 40 percent target;
illustratively, 18 percent has to be disbursed to agriculture while 7.5 percent
has to be disbursed to the small and medium enterprises.
 Insurance sector since the 1990s: opening up the doors
1. IRDA 1999 - With the enactment of the IRDA Act, 1999, the monopoly
conferred to the Life Insurance Corporation in 1956 and to the General
Insurance Corporation in 1972 was repealed, allowing private sector players to
enter the insurance sector. A recent development in the insurance sector has
been enhancement of the limit of foreign investment in insurance sector from
26 to 49 percent under the automatic route.
2. Low life insurance penetration - Rate of life insurance penetration has
increased but is only 3.7% while LIC’s market share is 64%.
 3. LIC premium - Illustratively, in 2014–15 the share of LIC in total premium
was around 73 percent, in case of non-life insurance business, the private and
public sector companies have approximately equal share.
 Capital market – Bond (debt) and equity market
1. DEBT MARKET - Two types of bonds exist – government and corporate.
Government bond market in India is deep and developed but corporate
market bond is far less developed. Government bonds – Government
borrows via bonds. It gives a fixed interest rate on them. Price (p) of bonds
is inversely proportional to rate of interest (r). If rate of interest offered by
banks goes up, people would not demand government bonds and hence
their price will decrease. Price is inversely proportional to yields. Yield is
the effective rate of return. Debt market = 15% of GDP while equity
market is 80% of GDP.
2. EQUITY MARKET – This basically refers to stocks and shares.
Companies can raise money via IPOs and FPOs by selling their shares to
shareholders. The reforms in the equity market were aimed at (i) boosting
competitive conditions in the equity market through improved price
discovery mechanism; (ii) putting in place an appropriate regulatory
framework; (iii) reducing the transaction costs; and (iv) reducing
information asymmetry. Repealing of the Capital Issues (Control) Act in
1992 liberalized the process of raising capital from the market. The success
story of the Indian equity market has been driven by two major institutions,
both established under government auspicious, viz., Securities and
Exchange Board of India (SEBI) and the National Stock Exchange (NSE).
While SEBI, the securities market regulator, was established in 1988, it
was given statutory powers in April 1992 through the SEBI Act, 1992,
which set out its basic functions as, "...to protect the interests of investors
in securities and to promote the development of, and to regulate the
securities market and for matters connected therewith or incidental
thereto." Thus, SEBI is the overall capital market regulator charged with
the orderly functioning of the securities market.

Market cap = Price of share * Number of shares

3. Stock market is disjoint from real economy
The literature presents multiple reasons for this disconnect: abundant liquidity
supported by unprecedented government stimulus, low-interest rates,  leveraged
buybacks and high volatility. Interest rates, to take one example, have steadily
declined in the past few years. In reaction to the Covid-19 pandemic, India’s
apex bank – Reserve Bank of India (RBI) – further reduced interest rates to 4%.
In general, this indicates that investments in low-risk goods (such as bonds) pay
meagre returns and are therefore not in high demand by investors. Even
traditionally risk-averse investors have no choice, then, but to invest their
capital in riskier shares right now, thereby diverting their funds to equity
markets. This is one reason why India’s crucial stock market index – Bombay
Stock Exchange’s Sensex – has surpassed the high point of 60,000 even as the
aggregate demand in the economy is low. At the corporate level, the policy of
stock buybacks amid a lack of investment opportunities also favours equity
markets. Trends in foreign investments also support this rally.
 External account and India’s financial opening
1. Free floating exchange rate - The exchange rate regime moved from a basket-
based pegged exchange rate to a market determined, but managed, exchange rate in
1993, paving the way for current account convertibility in 1994. In line with the
substantial liberalization of capital account transactions over time, India's exchange
rate arrangement has been classified as "floating" but with significant degree of
capital account management (IMF, 2014).
2. India favours equity flows over debt flows and FDI over FPI.
3. FDI -

I
n UPA we saw a growth of 900% (from 3 to 30). In NDA we saw a growth of 110%
(from 30 to 63). In UPA 1 years, FDI as percentage of GDP (which is what must be
measured instead of looking at absolute FDI numbers) went from 0.9% to 2.7%.
UPA even had a record 3.6%. In UPA 2 it was 1.7%. In NDA years, it was 2%.
4. FOREX reserves – Development of the forex market has been a key ingredient of
India’s external sector. Market participants have been provided with greater
flexibility to undertake foreign exchange operations through simplification of
procedures and availability of several new instruments. In 1991, we had FOREX
reserves to cover only 2 weeks of import. In 2021, our FOREX reserves covered 18
months of imports. This is extremely impressive. Foreign exchange reserves
increased from $32.4 billion in 1998-99 to $113 billion in 2003-04. So, it is true
that India’s foreign exchange reserves quadrupled during the tenure of the NDA
Government. But do note that foreign exchange reserves also hit their highest mark
in the year 2007-08 - so they tripled since 2004 on a higher base! Today, our
FOREX reserves stand at more than 600 billion dollars. It must be noted however
that there has been a sudden surge in FOREX reserves during the COVID crisis.
This is not necessarily a good sign. This has mainly happened due to massive fall in
imports (remember that demand for FOREX is for buying imports) . Low import
demand is a sign of shrinking economy.
5. Exports – Exports as percentage of GDP have grown considerably after 1991.
Exports in UPA 2 grew 126% and under NDA 1 they grew at 10%
  NBFCs (Non-banking finance companies)
1. What are NBFCs? - The fundamental difference between banks and NBFCs in India are
three: (a) NBFCs cannot accept demand deposits; (b) NBFCs do not form part of the payment
and settlement system and cannot issue checks drawn on itself; and (c) deposit insurance
facility is not available to depositors of NBFCs, unlike in case of banks. NBFCs borrow from
banks and mostly lend to MSMEs.
2. Rise in deposits of NBFCs - While, on an average basis, deposits of NBFCs as a
proportion of bank deposits were 0.8 percent during 1985–86 to 1989–90, they shot up to as
much as 9.5 percent by 1996–97.
3. Rise in NBFC assets as % of GDP - The ratio of NBFCs’ assets in GDP increased
steadily from just 8.4 percent as on March 31, 2006, to 12.9 percent as on March 31, 2015.
4. NBFC crisis – The business model itself is flawed. It raises short term funds from banks
which are lent out for long term goals. This causes a liquidity crunch. Example IL&FS crisis.

No
money to
lend

Reduces
Default credit
on loans flow

Hits
economic
growth