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Financial Sector Development : Indian Experience Rakesh Mohan Deputy Governor Reserve Bank of India Financial Sector Development : Indian Experience Rakesh Mohan Deputy Governor Reserve Bank of India

Structure of Presentation Ø I Financial Development II. Banking III. Financial Markets • Money Structure of Presentation Ø I Financial Development II. Banking III. Financial Markets • Money Market • Government Securities Market • Forex Market IV. Overall Issues

Financial Development (1) Importance • Influences economic growth § Intermediating between savers and investors Financial Development (1) Importance • Influences economic growth § Intermediating between savers and investors § Allocation of scarce resources to activities with higher productivity § Intertemporal allocation of savings with appropriate returns § Enhancing saving rate (reduction in risks and reducing financial repression) § Allows investors to access resources at lower interest § Lowering intermediation costs § Motivation for liberalization § Price discovery of interest rates § Efficient allocation of resources

Financial Development (2) Efficient Financial System : Features • Provides least arbitrage opportunities based Financial Development (2) Efficient Financial System : Features • Provides least arbitrage opportunities based on common public information • Accurate pricing of assets and liabilities • Provision of hedging opportunities • Cost effectiveness of provision of services

Financial Development (3) Efficient Financial System : Recent Focus • Renewed focus after Asian Financial Development (3) Efficient Financial System : Recent Focus • Renewed focus after Asian Crisis – – – – – Efficiency Stability Institutional Development Regulation/Supervision Competition Transparency Corporate Governance Price Discovery Removal of External Constraints on Funds Strong Payments System

Financial Development (4) Financial Sector : Structure • Credit Market – Institutional (organized) • Financial Development (4) Financial Sector : Structure • Credit Market – Institutional (organized) • Banks • Non-banking Financial Companies (not focused here) • Development Finance Institutions (Not focused here) • Financial Markets – Money market – Debt Market – Forex Market – Equity Market (not focused here) – Insurance (not focused here)

Structure of Presentation I Financial Development Ø II. Banking III. Financial Markets • Money Structure of Presentation I Financial Development Ø II. Banking III. Financial Markets • Money Market • Government Securities Market • Forex Market IV. Overall Issues

Banking (1) Banking in the 1980 s • • • Ø Ø High level Banking (1) Banking in the 1980 s • • • Ø Ø High level of statutory preemptions (SLR/CRR) Norms for priority sector advances (quantity targets and fixed subsidized price) Cross subsidization (high price of credit to corporate sector) Financial repression Potential for adverse selection in deployment of free resources of banks Branch licensing Severe Constraint in operational independence and financial autonomy Profitability of banking system was compromised Lack of transparency Heavy market segmentation (Banks in short-end and DFIs in the long-end) Administered interest rates – no price discovery Inefficient allocation of resources

Banking (2) Reform Process in Banking • • 1985 : Chakravarty Committee (Monetary Committee) Banking (2) Reform Process in Banking • • 1985 : Chakravarty Committee (Monetary Committee) 1987 : Vaghul Committee (Money Market Reforms) 1991 : Narasimham Committee I 1998 : Narasimham II

Banking (3) Narasimham I - Lowering of preemptions - Deregulation of interest rate - Banking (3) Narasimham I - Lowering of preemptions - Deregulation of interest rate - Initiation of prudential norms - Infusion of competition in banking system - Greater disclosure norms - Strengthening and rationalisation of regulatory/supervisory system - Progressive development of financial markets

Banking (4) Narasimham II • Building on the foundations of prudential norms to reach Banking (4) Narasimham II • Building on the foundations of prudential norms to reach international best practice • Structural Changes - Ownership - Universal Banking - Mergers and Acquisition - Weak Banks

Banking (5) Impact of Reforms (1) • Institutional • Presence of diversified banking structure Banking (5) Impact of Reforms (1) • Institutional • Presence of diversified banking structure with subsidiaries (MFs/PDs/AMCs/Merchant Bankings, etc. ) • Ownership of PSBs widened – private shareholding in PSBs has gone up ranging from 23 % to 44 %. • Competition • New private sector banks • Universal banks

Banking (5) Impact of Reforms (2) • Stability • PSBs strengthened through increasing autonomy/recapitalisation, Banking (5) Impact of Reforms (2) • Stability • PSBs strengthened through increasing autonomy/recapitalisation, • Imposition of prudential norms (capital adequacy, exposure norms, provisioning norms, risk-weights for interest rate risk on G-Secs, investment fluctuation reserves, etc. ) • Greater awareness of the risks and risk management • On-site and off-site supervision

Banking (6) Impact of Reforms (3) • Removal of external constraints on funds – Banking (6) Impact of Reforms (3) • Removal of external constraints on funds – Lowering of statutory preemptions down from 63. 5 % to 30. 5% – Dilution of priority sector advances norms – More funds available to banks to lend for commercial purposes • Price Discovery – Deregulation of deposit rates (except saving bank) – Deregulation of lending rates (except less than Rs. 2 lakh) • Transparency – Greater level of transparency and standards of disclosure achieved (Tier I and II, NPAs, marked-to-market, etc. )

Banking (7) Impact of Reforms (4) • Efficiency (1) • Considerable improvement in profitability Banking (7) Impact of Reforms (4) • Efficiency (1) • Considerable improvement in profitability of PSBs Operating profits increased : 1992 -93 (-) Rs. 31 bn 2001 -02 Net profits increased Rs. 217 bn 1992 -93 (-) Rs. 33 bn. 2001 -02 Rs. 83 bn. • Improvements in intermediation process Net interest income / Assets declined : 1990 -91 2001 -02 3. 22 2. 70

Banking (8) Impact of Reforms (5) • Efficiency (2) • Improvements in NPAs position Banking (8) Impact of Reforms (5) • Efficiency (2) • Improvements in NPAs position in gross/net terms Gross NPAs/Total Loans 1992 -93 23 % 2000 -01 12. 4% Net NPAs/Total Loans March 1995 11% March 2001 6. 7 % • Robust Payments System - Improvements in Technology – EFT / ATMs/Shared Payment Network/ RTGS in progress • Greater Acquisition of Skills

Banking (9) Weakness in Banking • Interest Rate Deregulation not complete • NPAs • Banking (9) Weakness in Banking • Interest Rate Deregulation not complete • NPAs • • act as a drag on efficient pricing – weak debt recovery processes non-realisability of collateral – Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance 2002 promulgated • Directed Lending – • credit to priority sector and small and medium enterprises coming down • Ownership structure • Government still majority owner – RBI owns SBI – structure has constrained autonomy and accountability • Corporate Governance • Government ownership creates potential for regulatory forbearance

Banking (10) Challenges in Banking (1) • Reduction in Government ownership • Maintaining Capital Banking (10) Challenges in Banking (1) • Reduction in Government ownership • Maintaining Capital Adequacy while increasing lending • Lasting Solution for Non-Performing Assets (both overhang and flow) – Role of AMCs • Sound regulation and supervision • Deposit Insurance modernization

Banking (11) Challenges in Banking (2) • Complete the process of legal reform in Banking (11) Challenges in Banking (2) • Complete the process of legal reform in deposit insurance, ownership, bankruptcy procedures, lenders liability, etc. • Enhance efficiency through improvements in credit evaluation, risk assessment and management, quality of human resources, quality of internal controls and corporate governance. • Payments System Regulation Ø Greater innovation Ø Encouragement of entrepreneurship Ø Appropriate risk management

Structure of Presentation I Financial Development II. Banking Ø III. Financial Markets • Money Structure of Presentation I Financial Development II. Banking Ø III. Financial Markets • Money Market • Government Securities Market • Forex Market IV. Overall Issues

Financial Markets (1) Why Develop ? (1) • Multi-institutional financial structure diversifies risks in Financial Markets (1) Why Develop ? (1) • Multi-institutional financial structure diversifies risks in financial system • Criticality in acting as transmission channel of monetary policy especially while moving towards reliance on indirect instruments

Financial Markets (2) Why Develop ? (2) • Money Market – Focal point for Financial Markets (2) Why Develop ? (2) • Money Market – Focal point for payments and settlements – Acting as equilibrating mechanism for s-t liquidity flows – Greater linkages with forex markets • Government Securities Market – Focal point for entire debt market – Serves as benchmark for pricing other debt securities – Serves as efficient transmission channel • Forex Market – Serves to integrate domestic markets with global markets

Financial Markets (3) Financial Markets in the 1980 s • • • Market segmented Financial Markets (3) Financial Markets in the 1980 s • • • Market segmented Lack of transparency Administered pricing in financial markets Antiquated accounting Lack of disclosure Non-level playing field among participants Incrementalism in reforms Lack of inadequate institutional structure Lack of clarity in regulatory jurisdiction Lack of technological infrastructure Absence of hedging products

Financial Markets (4) Development of Financial Markets • RBI responsible for ►Government Securities Market, Financial Markets (4) Development of Financial Markets • RBI responsible for ►Government Securities Market, ►Money Market ►Forex Market • Process : • Institutional development • Instrument development • Improving market microstructure

Financial Markets (5) Development : First Phase • • Easing Structural Rigidities (Price and Financial Markets (5) Development : First Phase • • Easing Structural Rigidities (Price and Quantity) Price Discovery (Auction) Introduction of Sophisticated Instruments Promoting Institutions Fostering Competition Transparency in Market Practices & Efficient Settlement Mechanism Ensuring Adequate Liquidity in Market Segments

Financial Markets (6) Development : Second Phase • Stability of Financial Markets (priority in Financial Markets (6) Development : Second Phase • Stability of Financial Markets (priority in agenda) • Fostering Market Discipline and Fine-tuning Market Microstructure to reflect evolving sophistication and technological advancements • Developing regulatory / institutional / legal / technological infrastructure

Structure of Presentation Financial Development II. Banking III. Financial Markets Ø Money Market • Structure of Presentation Financial Development II. Banking III. Financial Markets Ø Money Market • Government Securities Market • Forex Market IV. Overall Issues

Money Market (1) Money Market Reform • Initially diversified participation in call money market Money Market (1) Money Market Reform • Initially diversified participation in call money market & subsequently restrict to interbank and later even to banks and PDs • Inter-bank Repo market - CCIL • Efforts to develop Term Money Market • Instrument Development Fine-Tuning in CP/CD Markets (Demat) • Treasury Bills Market - Rationalization • RBI Repo/Reverse Repo through LAF (Phasing out of Refinance)

Money Market (2) Money Market : Current Issues • Restrict call access to banks Money Market (2) Money Market : Current Issues • Restrict call access to banks / PDs to reduce systemic risks from non-collateralized market • Shift bulk of overnight transactions to repo market through CCIL with novation • Reduce CRR to 3 % • Phase out refinance completely • RBI operations in the short-end of the market entirely through LAF • Bank Rate to become true signaling rate

Structure of Presentation I. Financial Development II. Banking III. Financial Markets • Money Market Structure of Presentation I. Financial Development II. Banking III. Financial Markets • Money Market Ø Government Securities Market • Forex Market IV. Overall Issues

Government Securities Market (1) • Auction system for sale of Government Stock • Stoppage Government Securities Market (1) • Auction system for sale of Government Stock • Stoppage of automatic monetisation and establishment of WMA framework • Introduction of notified amounts for market borrowing • Establishment of Primary Dealers (PDs) (Facilities / Responsibilities / Strengthening) • Introduction of T-Bills of varying maturities & Later Rationalization

Government Securities Market (2) • New products /Players - ZCBs, index linked, floating rate Government Securities Market (2) • New products /Players - ZCBs, index linked, floating rate bonds, callput option, Gilt Funds / Permitting FIIs in Gilts Market • Re-opening and price based auctions / Consolidation and Liquidity • Constituent SGL (Retailing) • Transparency and data dissemination • Initially Focus on near maturities and later on Elongation • Delivery vs Payment (Dv. P) System in scripless settlement • Move towards Mark-to-Market Norms for Valuation

Government Securities Market (3) • Regulation of Government securities markets - jurisdiction clarity (Securities Government Securities Market (3) • Regulation of Government securities markets - jurisdiction clarity (Securities Contract Regulation Act) • Legal reforms (Government Securities Bill in the offing) • Focus on State level debt management

Government Securities Market (4) Current Issues • Access of retail investors to G-Sec – Government Securities Market (4) Current Issues • Access of retail investors to G-Sec – More widespread availability of G-Secs to retail investors will gradually reduce importance of providing small savings instruments with administered interest rates. • Proposed Order-driven trading in Government Securities through Stock Exchanges - Greater Retail Base for G-Sec • Proposed RTGS • When-Issued Market / Short Selling • Separation of Debt and Monetary Management Functions (conditional on passage on Fiscal Responsibility and Budget Management Bill)

Structure of Presentation I. Financial Development II. Banking III. Financial Markets • Money Market Structure of Presentation I. Financial Development II. Banking III. Financial Markets • Money Market • Government Securities Market Ø Forex Market IV. Overall Issues

Forex Market (1) Framework for External Sector Management • Rangarajan Committee provided the Basic Forex Market (1) Framework for External Sector Management • Rangarajan Committee provided the Basic Framework for current account, capital account & exchange rate management • Keep CAD at sustainable level • Flexible Exchange Rate Management • Discourage Debt • Cap External Commercial Borrowings • Cap Short-term Debt • Encourage Non-Debt Creating Flows • Build Reserves

Forex Market (2) Forex Market Reform • Market determined exchange rate since March 1993 Forex Market (2) Forex Market Reform • Market determined exchange rate since March 1993 • Permission to banks to invest in and borrow from overseas money markets upto 25 % of Tier-I capital • Deregulation of deposit rates on NRE/FCNRB • Permission for banks to lend out of FCNRB to residents forex as well as Rupee needs • Freedom to banks to fix aggregate gap and position limits since April 1996. • Pre-shipment credit encouraged in foreign currency • Exporters permitted to keep part of earnings in EEFC accounts

Structure of Presentation I. Financial Development II. Banking III. Financial Markets • Money Market Structure of Presentation I. Financial Development II. Banking III. Financial Markets • Money Market • Government Securities Market • Forex Market Ø IV. Overall Issues

Overall Issues (1) Regulation • Blurring of boundaries between different segments and attendant systemic Overall Issues (1) Regulation • Blurring of boundaries between different segments and attendant systemic implications • Current trends point towards emergence of financial conglomerates in banking, insurance, investment banking, broking entities, etc. • Expansion of financial markets/number of institutions • How to supervise without intrusion • Careful about where we have to go and how to reach the destination • Need to learn from the experiences of East Asia and the recent accounting irregularities in USA on the need for good corporate governance

Overall Issues (2) Credit Access of SMEs and Agriculture • Interest rates deregulated • Overall Issues (2) Credit Access of SMEs and Agriculture • Interest rates deregulated • Reduction/eventual elimination of directed lending (? ) • Reduced Government ownership of banks Ø Reduction in Transaction Costs / Risk Assessment • Credit Information Bureau • Group Lending • Reinvigoration of Cooperatives

Overall Issues (3) Funding of Industrial /Infrastructure Projects • Equity – Fall in debt/equity Overall Issues (3) Funding of Industrial /Infrastructure Projects • Equity – Fall in debt/equity ratios – UTI problems – Flat stock market • Debt – Decline of DFIs Ø Equity market expansion Debt market expansion Equity Funds Venture capital Angel investors Pension Funds Insurance Funds Provident Funds

Overall issues (4) Diversification of Financial Sector • As pension / insurance sector opens Overall issues (4) Diversification of Financial Sector • As pension / insurance sector opens more diversification in financial sector would occur • Current debate on privatization/strategic sale has roots in the ownership issue of financial institutions – I. e. lack of adequate number of institutional investors • Current challenge is one of greater diversification of banks/FIs/MFs/pension funds/insurance companies so that there is greater competition in financial system which is then reflected in real sector.

Overall Issues (5) Competition in Financial Sector • Progress being made in real sector Overall Issues (5) Competition in Financial Sector • Progress being made in real sector through deregulation and privatization • Financial sector still predominantly Government owned • Introduction of greater competition needs greater progress