development financial institution

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ROLE OF STATE-OWNED FINANCIAL INSTITUTIONS IN INDIA:

SHOULD THE GOVERNMENT DO OR LEAD?

Urjit R. Patel*

Infrastructure Development Finance Company Limited

Mumbai, India

April 2004

World Bank, International Monetary Fund and Brookings Institution

Conference on Role of State-Owned Financial InstitutionsWashington, D.C., April 26-27, 2004

Abstract

The importance of a sound financial sector in efficient intermediation of resources

is generally accepted. A case for government intervention in the sector might also be made

in the initial stages of a countrys development, given systemic failures in achieving

certain economic goals. The paper argues that, in the case of India, this role is now

redundant; the public sector should no longer be directly intermediating resources. Thereremain, however, certain aspects of the financial sector (which have merit good

characteristics) where the government might be required to catalyse developments; these

are what may be termed its market completion role. These interventions should

essentially be for establishing enabling mechanisms that facilitate financial transactions.

*Correspondence: Urjit R. Patel, IDFC, Ramon House, 2nd

Floor,

169 Backbay Reclamation, Mumbai 400 020, India; e-mail: [email protected]. I would

like to thank Saugata Bhattacharya for collaborating on work that forms the basis of this

paper.

Disclaimer: The opinions presented in the paper are those of the author and not necessarily

of the institution to which he is affiliated.


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The Agricultural Infrastructure and Credit Fund, the Small and Medium Enterprise Fund, andthe Industrial Infrastructure Fund will be operational shortly. All the three funds will, without

compromising the norms of financial prudence, provide credit at highly competitive rates,which is expected to be 2 percentage points below the Prime Lending Rate (PLR).

Interim Budget, India, 2004-05.

1. INTRODUCTION

A deep and efficient financial sector is necessary for optimal allocation of

resources. Governments have been involved in the financial sectors in intermediation,

if not directly owning intermediaries of many countries, even currently developed

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

South Korean and Japanese process of industrialisation. In some developed countries,

such as Germany, especially in the post Second World War era, this (command) mode

of financial intermediation has been used in national reconstruction as well. In many

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

role for state-owned intermediaries.

Arguably, compelling arguments have been made for this involvement in the

initial stages of a countrys development. It is in the financial sector that market failures


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are particularly likely to occur.1

In addition, the significant asymmetries of information

characterising the sector, as well as the commercial unviability of lending to most

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,

governments had often established development oriented intermediaries to nurture

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

have a high level of direct government ownership of financial intermediaries, the

involvement of governments in intermediation has been significant.

Reflecting the erstwhile predominance of the public sector in most areas of

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

the relative simplicity of transactions then prevalent. As economic activity became

increasingly commercially oriented, however, the government dominated financial

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

as well as systemic moral hazard, manifest in repeated bailouts and recapitalisations.

1Events over the past half a decade have provided numerous examples of these failures spanning

geographical areas as well as various types of economic systems.


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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

opposed to rate of return calculations, are often important in determining resource

allocation. In many instances, as well as across a wide spectrum of countries, this

involvement has led to fragility of the financial sector, occasionally resulting in

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

explored in detail in Patel [1997b]. A conflict of interest arises between development

goals of the government directed credit flows and the absence of commercial discipline

that gradually percolates the lending process.

The issue of incentives is especially relevant in Indias financial reforms,

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

2Hawkins and Mihaljek [2001] outline the characteristics of financial systems that are dominated by

government ownership of intermediaries.


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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

high degree of government involvement gives rise to a belief of depositors and

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

becomes insolvent. While selective regulatory forbearance might be justified as a

measure designed to balance the likely panic following news of runs on troubled

institutions, a blanket guarantee by government makes forbearance difficult to calibrate

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

and purposes, all deposits are covered by an umbrella of implicit government

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

associated with their projects.

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

3We 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 anaggravated 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.

4In this regard, Indias decision not to provide deposit insurance, ex post, to non-bank financial

intermediaries was commendable.


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comparable to international peer group standards. This sector is also complemented by

relatively well developed capital markets which are playing an increasingly important

role in the resource requirements of commercial entities.

The paper draws heavily on recent papers (Bhattacharya and Patel [2002],

Bhattacharya and Patel [2003b] and Patel and Bhattacharya [2003]). It argues that the

useful role of public sector financial institutions in resource intermediation in India is

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.

2. THE FINANCIAL SECTOR IN INDIA AND CURRENT INFIRMITIES

From independence to the end of the 1960s, Indias 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

entrepreneurial base, thereby stifling economic growth. Hence, it was decided to

nationalise 20 large private banks in two phases, once in 1969 and again in 1980, with

the objectives of promoting broader economic goals, better regional balance of

economic activity, extending the geographic reach of banking services and the diffusion

of economic power. Significant financial deepening has taken place over the three


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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

areas, which now account for 71% of total branches.

Table 1: Decadal indicators of financial deepening

1970-71 1980-81 1990-91 2000-01 2002-03

M3 / GDP 24% 39% 47% 63% 70%

Bank branches / 000 population 0.02 0.05 0.07 0.07 0.07

Source: RBI Report on Trend and Progress of Banking in India, various issues.

After a hiatus of two decades, private banks were allowed to be established in

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

for half of financial savings.

2.1 Public sector involvement in the Indian financial system

Banking intermediaries continue to dominate financial intermediation (see

Appendix 1 Table A1.1 and Patel [2000] for a detailed exposition). Much of this

segment is publicly owned and accounts for an overwhelming share of financial

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).


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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

known. There have also been efforts, predominantly through a regulation-centric

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

government-sponsored Systemically Important Financial Institutions (SIFIs).6

A very

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

is especially serious in the case of the latter.

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 LICs socially

oriented investments mainly comprising of government securities holdings and

social sector investments at end-March 2003 amounted to Rs. 1,882 bn, i.e., 71% of a

5In India, DFIs are a sub-group of intermediaries termed All India Financial Institutions (AIFIs).

6Our classification of SIFIs is somewhat different from the governments view, enunciated in the RBIs

Monetary and Credit Policy, April, 2003, which referred to large intermediaries, including banks likeSBI and ICICI Bank.


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total portfolio value of Rs. 2,650 bn (10.9% of GDP)8. A staggering 87% of this

portfolio comprises of exposure to the public sector.

Compared to the LIC, the EPFOs 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),

EPF Act (1952) and Indian Trusts Act (1882).

More importantly, the involvement of the government in intermediation is much

wider than mere ownership numbers indicate; its ambit stretches across mobilisation of

resources, direction of credit, appointments of management, regulation of

intermediaries, providing comfort and support to depositors and investors, as well as

influencing lending practices of all intermediaries and the investment stimuli of private

corporations. These practices include treating banks as quasi-fiscal instruments, the

consequent pre-emption of resources through statutory requirements, directed lending,

administered interest rates applicable for selected savings instruments, encouraging

imprudent practices like cross-holding of capital between intermediaries, continual bail-

outs of troubled intermediaries, control and manipulation of smaller intermediaries like

7The 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


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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

One of the arguments previously advanced to justify government ownership of

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 Indias10

(UTI) US-64 scheme are

for about a fifth of the socially oriented investments portfolio, with the balance accounted by governmentand government guaranteed securities.9

Appendix 2 provides a description of the Index construction methodology.10

Indias largest mutual fund.

80

90

100

110

120

130

140

1990-

91

1991-

92

1992-

93

1993-

94

1994-

95

1995-

96

1996-

97

1997-

98

1998-

99

1999-

00

2000-

01

2001-

02


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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

allowed to redeem up to 3000 units at an administratively determined price, with the

GoI making up the gap between this price and the NAV of a unit. Eight Public Sector

Banks offered liquidity support to UTI in the event of large-scale redemptions.

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,

these implicit safety nets create an insidious expectation of government support to

investors, weakening their commercial judgment.

2.2 Weaknesses characterising the Indian financial system

Certain structural characteristics and institutional rigidities evident in India

further weaken mechanisms for prudent de-risking of portfolios. The absence of

effective bankruptcy procedures leading to a lack of exit opportunities for both

intermediaries and the firms that they lend to, force intermediaries to roll-over existing


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sub-standard debt or convert them into equity, thereby continually building up the

riskiness of their asset portfolio. The use of intermediaries by the government in

diverting funds, for purposes that are not entirely commercially motivated, reinforces

the decline in the quality of assets. A prominent reason is an attempt by government to

boost investment, both by direct spending and indirectly via credit enhancements, like

guarantees, partially to counter low private investment. In combination with the

frequently observed tunnelled structure of many corporations (Johnson, et al.

[2000]), which facilitates connected lending and diversion of funds between group

companies, institutional rigidities (especially weak foreclosure laws) and regulatory

forbearance (including inadequate disclosure requirements of investments and other

lending practices), the outcome is a disproportionate build up of the riskiness of

intermediaries asset portfolios.

2.2.1 Incentive distortions arising from public ownership of intermediaries

In the process, the incentive structures that underlie the functioning of

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

recapitalisations of banks in the early and mid-nineties may be rationalised as being

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


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capital without large attached risk premia. The impact of this support, though, has been

considerably reduced, if not eliminated, by the series of ongoing bailouts, with

seemingly little by way of (binding) reciprocating requirements imposed on

intermediaries to prevent repeats of these episodes. It needs to be recognised that the

only sustainable method of ensuring capital adequacy in the long run is through

improvement in earnings profile, not government recapitalisation or even mobilisation

of private capital from the market.

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

outcome unless banks are restructured simultaneously; this includes introduction of

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

classification norms. A multiplicity of economic regulators, most of them not wholly


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independent, deters enforcement of directives (see Bhattacharya and Patel [2001] for an

analysis of the way regulators have looked at financial market failures).11

Other than structural changes in corporate resource raising patterns, commercial

lending is inhibited inter alia due to distortions in banks cost of borrowing and lending

structures arising from interest rate restrictions. Continuing floors on short-term

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

factors has made treasury operations an important activity in improving banks

profitability.12

Over and above the regulatory oversight of the RBI, the role of

government audit and enforcement agencies like the Comptroller and Auditor

General (CAG), Central Vigilance Commission (CVC), Central Bureau of Investigation

(CBI), etc. in audits of decisions taken by loan officers at banks undermines normal

risk taking associated with lending (see Banerjee et al. [2004]).13

The outcome of this environment is lazy banking14

; banks in India seem to

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

11For 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 anda 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 goodcredit 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.


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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

increase in demand for credit.

Figure 2: Cumulative (quarter-wise) SLR securities investment - deposit ratio of SCBs (in %)

Sources: RBI Handbook of Statistics, 2002-03 and Weekly Statistical SupplementsNote: Q4 2003-04 figures are as of March 5, 2004.

Note that this phenomenon is actually rational behaviour by banks given the

incentive structure described above. In deciding on a trade-off between increasing

credit flows and investing in government securities, the economic, regulatory and fiscal

environment is stacked against the former. An unintended consequence of the

increasingly tighter prudential norms that banks will be forced to adhere has been a

15It 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 LICs website).

40%

50%

60%

70%

80%

Q1 Q2 Q3 Q4

2001-02 2002-03 2003-04


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further shift in the deployment of deposits to government securities and other

investments that carry a comparatively lower risk weight16

.

3. RESIDUAL ROLES OF GOVERNMENT IN INTERMEDIATION IN A

MARKET ECONOMY: A CRITICAL LOOK

Given the scenario described in the previous section, primarily driven through

distorted incentives, of public sector involvement described above, there is a robust

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

are claimed to be the residual arenas of government involvement in a commercial

environment, it in no way provides a blanket endorsement of these actions in India.

The paper adapts an institution-specific framework explored in Rodrik [2002]

formulated in the context of general economic development as a touchstone for this

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

16Banks 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 relevantcategories). 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).


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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

orientation of economic activity.


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Table 3: Matrix of institutional processes in the reform of the financial sector

Institutionsrole

Objective Mapping to the Indian(financial) context

Addressing specific shortcomin

Market

stabilisation

Stable monetary and fiscal management. Profligate fiscal

environment.

Pre-emption of resources by gove

Efficacy of central bank functions.

Marketregulation

Mitigating the impact of scale economiesand informational incompleteness.

Regulatory forbearance.

Public ownership ofinstitutions.

Appropriate prudential regulation.

Imposition of market discipline.

Transparency and information disc

Market creation Enabling property rights and contractenforcement.


Enforcing creditor rights.

Effective dispute resolution mecha

Marketlegitimisation

Social protection; conflict management;market access.

Profligate fiscalenvironment.

Regulatory forbearance.


Mixing social and commercial obje(e.g., rural branch requirements fo

Appropriate insurance for deposito

Capital markets enforcement.

Effective redressal of investor grie

Marketcompletion

Spanning states of nature. Shallow or non-existentmarkets.

Lack of institutions and products tospecific (market-making) risks thatformation of markets.

Inadequate old-age income safety


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3.1 Facilitating transactions and deepening markets

Given the significant information asymmetries that normally characterise capital

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

the inability of institutions to catalyse certain specialised economic activities. Market

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

deficiencies and failures as well as facilitating transactions and increasing market

liquidity, as well as improving clearing and settlement systems.

Dealing with the commercial consequence of the new set of risks, however,

demands the presence of specialised institutions. Debt markets in developed countries now

serve both as a complement to intermediaries loans to corporations as well as for

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.

As a consequence, the market disciplining effect of capital markets on intermediaries

loans, especially to corporations, has tended to be mitigated.

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


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overtaken the BSE in terms of spot transactions and has spearheaded the introduction of

derivative instruments, where it now accounts for 95% of trades.

The NSCCL, a wholly owned subsidiary of NSE, was incorporated in August

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

sophisticated risk containment framework.

To promote dematerialisation of securities, the NSE, IDBI and UTI set up NSDL,

which commenced operations in November 1996, to gradually eradicate physical paper

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

constitutes 99.99% of total delivery-based settlements.

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

to mention the service taxes that directly accrue to it).

3.2 Catalysing niche economic activities

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


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appropriate financial structures, innovative products, resource syndication and project

facilitation. Without these institutions, the probability of private sector operations not

succeeding increases, leading to the political risk of re-nationalisation of at least some of

these activities. In addition, individual initiatives depend upon a critical mass being

attained in certain supporting areas, which we analyse in the sub-sections below.

3.2.1 Exim financing

Although commercial banks in developed markets have the capability of financing

(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

traditional role in building export competitiveness. In developing countries, in addition,

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

intermediary for coordinating institutions engaged in financing foreign trade transactions,

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,

financing export marketing, besides information and advisory services20. As Indian

corporations increasingly invest in foreign countries, there is also a need for political risk

insurance, the mantle of which might also be assumed by this institution.

19NSE Factbook 2002-03.

20The Exim Banks 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.


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23

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

various risk-guarantee instruments, as well as financing structures such as the annuity

method for road projects. These initiatives have had the effect of orchestrating a

significant quantum of private investment into infrastructure projects.

3.3 Channels and instruments for social objectives

The original rationale for nationalisation of banks in India, as well as the

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

understandable, and even recommended, in a specific context, the justification for a

continuation of these policies has been largely eroded. For some of these objectives, India

already has specialised intermediaries the National Bank for Rural Development

( NABARD), Small Industries Development Bank of India (SIDBI), State Finance

Corporations (SFCs), etc. These institutions have quite obviously failed to live up to their

mandates, given the periodic exhortations by the government and supplementary

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

achieve them is sub-optimal.

21There 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.


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25

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

refrain of the government to disburse funds to the agricultural sector at administratively

mandated rates of interest.23

Not only are lending decisions of individual banks distorted

(through the implicit cross-subsidies), financial sector reforms are systemically

undermined through these administrative directives. The success of operations of certain

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 governments social

objectives might be more cost-effective.

3.3.2 Lending to priority sectors

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 NABARDs administrative ambit) has

led to concerns about its relatively non-transparent procedures of disbursement and the

potential of future Non Performing Assets (NPAs).

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

22India Post Annual Report 2002-03.


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26

(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

to the perils of administrative mandates in advancing social goals as well as reliance on

state government-guaranteed lending.26

3.3.3 Social security nets

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

23For 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).


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27

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 EPFOs 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.

3.4 Deposit insurance to enhance systemic stability

Other than instituting a sound regulatory mechanism and facilitating efficient and

seamless transactions, a major aspect of the governments 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.

India has a relatively liberal deposit insurance structure, compared to international

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

banks to take on additional (and commercially non-viable) risks.

The Deposit Insurance and Credit Guarantee Corporation (DICGC) came into

existence in 1978 as a statutory body through an amalgamation of the erstwhile separate

Deposit Insurance Corporation (DIC) and Credit Guarantee Corporation (CGC). DICGC

27The rate of return on the EPF scheme has been set at 12% per annum from 1989-90 onwards, till July 2000


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28

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,

superceding the existing one, is supposedly required to be passed in order to implement

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

large to be justified solely on considerations of containing systemic risk.

There might have been justifiable reasons for government ownership of

intermediaries in the early years of Indias development, but these have now been

rendered redundant, and possibly even damaging. India now has a relatively well

developed intermediation network, with intermediaries that are becoming increasingly

commercially oriented. The raison detre of the Development Finance Institutions (DFIs)

from when they have been progressively reduced to the current 9%.


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30

safety of intermediaries is due more to the social contract between the government and

depositors than underlying robustness in the health of the sector.

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

ownership is an important aspect). To sharpen these incentives, outright privatisation may

not be sufficient, but it is necessary. It is the first step to a true relinquishing of

management control, which remains far beyond the scope envisaged in the Banking

Companies (Acquisition and Transfer of Undertakings) Bill tabled in Parliament in 2002

(and still languishing), designed to reduce government holding in nationalised banks to

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.

Attempts to shed commercial risks of investors, borrowers and depositors (through

implicit bailout and other means of accommodating fragility) will almost certainly lead to

economic ones during slowdowns, creating a new kind of instability.

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


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31

to confuse outcomes with mechanisms and processes. Both, after a brief period of

increasing emphasis on commercial viability, are again becoming target driven.

Given the increasing integration of financial markets, there is also a need to shift

reform focus from individual intermediaries to a system level. An important component in

this shift is enhancing intermediaries ability to de-risk their asset portfolios. Undoubtedly,

the Securitisation and Reconstruction of Financial Assets and Enforcement of Security

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

distortions in incentives that are intrinsic to large parts of the system.

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.


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References

Allen, F. and D. Gale, 2001, Comparative financial systems: A survey, Mimeo., New

York University.

Asher, M. G., 2003, Reforming Indias 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, 2001, New regulatory institutions in India: White

Knights or Trojan Horses?, forthcoming in volume of Conference Proceedings on PublicInstitutions in India: Performance and Design, Harvard University (revised version: May2003).

Bhattacharya, S. and U. R. Patel, 2002, Financial intermediation in India: A case of

aggravated moral hazard?, Working Paper No. 145, SCID, Stanford University, July;

(revised version forthcoming in volume on Proceedings of Third Annual Conference onthe Reform of Indian Economic Policies, Stanford University, (ed) T. N. Srinivasan).

Bhattacharya, S. and U. R. Patel, 2003a, Markets, regulatory institutions, competitiveness

and reforms, Working Paper No. 184, SCID, Stanford University, September.

Bhattacharya, S. and U. R. Patel, 2003b, Reform strategies in the Indian financial sector,

forthcoming in the Proceedings volume of IMF-NCAER Conference on Indias and

Chinas Experience with Reform and Growth, New Delhi, November.

Buiter, W. H. and U. R. Patel, 1997, Budgetary aspects of stabilisation and structural

adjustment in India, in Macroeconomic Dimensions of Public Finance, Essays in Honour

of Vito Tanzi, M. Blejer and T. Ter-Minassian (Eds.) (Routledge, London).

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 BankConference on Deposit Insurance, July.

Gerschenkron, A., 1962, Economic backwardness in historical perspective: A book ofessays, Harvard University Press.

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.

Kornai, J., 1979, Resource-constrained vs. demand-constrained systems, Econometrica,

vol. 47, pp. 801-819.


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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.

Lewis, W. A., 1955, The theory of economic growth, London.

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., 1997b, Emerging reforms in Indian banking: International perspectives,

Economic and Political Weekly, vol. XXXII (No. 42, October 18-24) pp. 2655-2660.

Patel, U. R., 2000, Outlook for the Indian financial sector, Economic and Political

Weekly, vol. XXXV (No. 45, November 4-10), pp. 3933-3938.

Patel, U. R. and Bhattacharya, S., 2003, The Financial Leverage Coefficient:

Macroeconomic implications of government involvement in intermediaries, Working

Paper No. 157, SCID, Stanford University.

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.

Shleifer, A. and R. Vishny, 1994, Politicians and Firms, Quarterly Journal of

Economics, vol. 109, pp. 995-1025.


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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)

Turnover of Government securities (excluding repos)through SGL (monthly average)

-- 310 2,287

(1.8) (9.0)

Annual turnover as % of stock market turnover -- 24% 276%

Volume of corporate debt traded at NSE (excludingCommercial Paper)

-- 9 58

Legends: *: denotes figures at end-March 1993. &: Pertains only to BSE. --: Not comparable.

Table A1.2: Current trends in banking in urban and non-urban areas (as on March 31, 2003)

No. ofbank

branches

Deposits(Rs. bn)

Credit(Rs. bn)

C-D Ratio(%)

Scheduled Commercial BanksUrban 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%

Regional Rural Banks (RRBs) 14,462(21%)

498(4%)

221(3%)

44%

Source: Culled from RBI Banking Statistics Quarterly Handout, March 2003.

Note: Percentages for RRBs in parentheses represent shares relative to those for all India ScheduledCommercial Banks.


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Figure A1.1: Country comparison of government ownership of banks

8679

68

5244

31 3025

18 15

1 0 0 0

12

13

23

32 49

62

21

55

82

7893

83

95

50

28 9

167 7

49

20

19 6

17

5

50

0%

25%

50%

75%

100%

China Ind

iaRu

ssia

Brazil

Indon

esia

Thaila

nd

Argen

tina

Mexic

o

Germ

any

Switz

erlan

dJap

an

Austr

alia USA

Singa

pore

Government banks Domestic private banks Foreign Banks

Source: BCG presentation, CII Banking Summit, 2003.


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36

APPENDIX 2

METHODOLOGY OF CONSTRUCTION OF THE INDEX OF DENSITY OF

GOVERNMENT INVOLVEMENT IN THE FINANCIAL SECTOR (IDGI-F).

This appendix is an enumeration of the constituent groupings of the Index of

Density of Government Involvement in the Financial Sector (IDGI-F) and an associated

weighting system. The weights are uniform, being simply +1 or 1 depending on the

appropriate definition of the respective series vis--vis the definition of impact on

involvement.

I. Constituents of IDGI-F

A. Share of public sector banks (PSBs) and financial institutions (FIs) in total financial

intermediation.

1. Share in resource mobilisation (as a sum of the following):

a. Net demand and time liabilities of public sector banks (as % of

financial savings).

b. Resources mobilised by DFIs through bond issues (as % of financial

savings).

c. Premia of LIC / Amounts mobilised by UTI (as % of financial savings).

B. Lending practices and use of funds.

2. Investments in government securities by banks and financial institutions (as %

of their incremental lendable resources).

3. Excess deposits deployed by PSBs in priority sectors (as % of Net Bank Credit,

in excess of minimum prescribed norms).

C. Trends in the governments pre-emption of financial resources.

4. Share of public investment in overall investment (e.g., 7.7 percent out of 26.8

percent in 1995-96 and 6.9 percent out of 23.7 percent in 2001-02).


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5. Public sector saving - investment gap (as % of GDP).

6. Public sector fiscal / resource gap (a proxy for Public Sector Borrowing

Requirement (PSBR), as % of GDP).

7. Outstanding explicit liabilities of the (central and state) governments (as % of

GDP).

8. Outstanding contingent liabilities (guarantees and other off-balance sheet

items) of the (central and state) governments (as % of GDP).

II. Methodology for construction of the IDGI-F

The IDGI-F is a simple weighted average of the rates of change of synthetic

(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

variables of the individual series each being normalised to 100 in 1990-91.

development financial institution

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