FINANCIAL INSTITUTIONS & MARKETS

Executive MBA Program (2011 – 13)

Faculty: Prof. Shreedharan

Group #: 1

Topic: Financial Sector Reforms in India

Submission Date: 7th April 2012

Group Members:

80118110001 - Vaibhav Agarwal

80118110002 - Aakash Ahuja

80118110003 - Sudhanshu Arora

80118110017 - Bhavin Dalal

80118110018 - Amit Dalmia

80118110037 - Rajesh Gupta

80118110051 - Rajnish Kumar

80118110056 - Arnab Maiti

80118110062 - Prashant Mehta

80118110065 - Ravindra Mudugu

Financial Sector Reforms In India

Introduction

The economic reform process that began in 1991 took place amidst two acute crises involving the financial sector:

The balance of payments crisis that threatened the international credibility of the country and pushed it to the brink of default; and

The grave threat of insolvency confronting the banking system which had for years concealed its problems with the help of defective accounting policies.

Moreover, many of the chronic and deeper-rooted problems of the Indian economy in the early nineties were also strongly related to the financial sector:

The problem of financial repression in the sense of McKinnon-Shaw (McKinnon, 1973; Shaw, 1973) induced by administered interest rates pegged at unrealistically low levels;

Large scale pre-emption of resources from the banking system by the government to finance its fiscal deficit;

Excessive structural and micro regulation that inhibited financial innovation and increased transaction costs;

Relatively inadequate level of prudential regulation in the financial sector;

Poorly developed debt and money markets; and outdated (often primitive) technological and institutional structures that made the capital markets and the rest of the financial system highly inefficient.

Financial sector reforms have therefore been an important part of the overall reform process.

Thankfully the Indian financial system has changed considerably since the 1990s.

Interest rates have been deregulated and new entrants allowed in the banking and the securities business.

The Indian equity markets have become more efficient and are now regarded as one of the leading exchanges in the world.

New private banks have emerged that are more customer-oriented than the older state-owned banks.

Meanwhile, the scale of saving within the economy has expanded considerably, much as in East Asian economies during their high-growth period.

Yet, after a decade of reforms, many of the deep seated problems in the financial sector remain. The hopes that were raised by the impressive progress in the initial years of the reforms have not been fulfilled. The state has not relinquished its grip on the financial sector.Except in isolated pockets, competition has not been unleashed in the financial sector on a scale sufficient to produce visible benefits in terms of efficiency, innovation and customer service.Evolution of Financial sector

1. Economic planning ￫ allocation of resources to “preferred” sectors at low cost ￫ directed credit programs and interest rate controls

2. 1970s: disillusionment with the policies of “command and control” in many developing countries3. Liberal view: financial repression (a combination of heavy taxation, interest controls, and

government participation in the credit allocation process) would lead to both a decrease in the depth of the financial system and a loss of the efficiency with which savings are intermediated

4. Liberal view: complete liberalization of the financial sector is essential to economic development5. Far reaching financial liberalization in the 1970s and 1980s in many Latin American countries6. Efficiency gains did not materialize, wide spread bankruptcies, sustained periods of high interest

rates, high inflation etc.7. Lessons learned: (i) macroeconomic stability is an essential pre-condition for successful reforms (ii)

adequate bank supervision is an essential component of reform (setting up of an appropriate regulatory framework) (iii) financial sector reforms must be accompanied by real sector reforms (trade and industrial liberalization)

8. ‘Market failures’ are more pervasive in financial markets than in other markets 9. Assumption of the liberal view: all relevant information is freely available to all agents in the

market.10. Asymmetries of information between those provide and those seek capital is the reality - for e.g.,

insiders have more information than outsiders11. Asymmetric information explains the existence of financial intermediaries – it would be costly for

each individual investor to evaluate the borrowers 12. By avoiding duplication in verification, financial intermediaries exploit economies of scale in

information provision and thereby reduce the cost of finance13. Problem of asymmetric information may be more acute in developing countries because of

segmented markets, firms with a short history of operations, absence of information gathering institutions (such as credit rating agencies), significant presence of small firms

Indian Financial Sector: different phases

1. Three distinct periods: 1947-68, 1969-91, 1991 onward2. 1947-68: Relatively liberal environment - the role of RBI was to supervise and control the

banks3. 1969-91: Bank nationalization and Financial Repression – banking policies re-oriented to meet

social objectives such as the reduction in inequalities and the concentration of economic power – interest rate controls and directed credit programs

4. 1991 onward: Financial Sector liberalization

Pre-Nationalization

1. RBI Act: Scheduled commercial banks are required to maintain a minimum cash reserve of 7% of their demand and time liabilities - SLR was 20% (cash, gold, govt. securities)

2. LIC formed in 1959 by nationalizing the existing insurance companies3. 1962: RBI was empowered to vary the CRR between 3% and 15% - empowered to stipulate

minimum lending rates and ceilings rates on various types of advances4. Problem of bank failures and compulsory merger of weak banks with relatively stronger ones

(no. of banks fell from 566 in 1951 to 85 in 1969 due to mergers).5. 1962: Deposit insurance scheme with the establishment of the Deposit Insurance Corporation

6. 1964: RBI directly regulated the interest on deposits (prior to this, interest rates were governed by a voluntary agreement among the important banks)

7. Certain disquieting features: (i) banking business was largely confined to the urban areas (neglect of rural and semi-urban areas) (ii) agriculture sector got only a very small share of total bank credit (iii) within industry, the large borrowers got the greatest share of credit

8. The pattern of credit disbursement was inconsistent with the goal of achieving an equitable allocation of credit and the priorities set in the plans - bank nationalization in 1969

Bank nationalization

1. 1969: 14 largest scheduled commercial banks nationalized; 22 largest banks accounting for 86% of deposits had become public sector banks; 6 more banks nationalized in 1980 bringing the share of public sector banks’ deposits to 92%

2. Rural branch expansion to mobilize deposits and enhancement of agriculture credit3. Priority sector lending (agriculture, small scale industries, retail trade, transport operators etc);

requirement was 33%, raised to 40% in 1979.4. UTI and IDBI, IFCI and ICICI were set up with specific objectives in mind

Indian Financial Sector: 1980s

1. To neutralize the effects of deficit financing on monetary growth, CRR steadily increased from 7% (1973-4) to 15% (1989-90)

2. Larger portion of the bank funds locked into non interest bearing bank reserves3. Suppressed the govt. securities market to keep the cost of borrowing low for the govt.; open

market operations lost its effectiveness as a tool of monetary policy4. Problems:(i) heavy segmentation of markets, (ii) in-efficient use of credit, (iii) poor bank profitability

due to restrictions on the use funds, (iv) rigidity due to the imposition of branch licensing requirements (v) lack of competition and efficiency due to entry restrictions and public sector dominance

Indian Financial Sector: Reforms since 1991

1. Reforms in Banking Sector

Prudential Measures

1. Introduction and phased implementation of international best practices and norms on risk-weighted capital adequacy requirement, accounting, income recognition, provisioning and exposure.

2. Measures to strengthen risk management through recognition of different components of risk, assignment of risk-weights to various asset classes, norms on connected lending, risk concentration, application of marked-to-market principle for investment portfolio and limits on deployment of fund in sensitive activities.

Competition Enhancing Measures

1. Granting of operation autonomy to public sector banks, reduction of public ownership in public sector banks by allowing them to raise capital from equity market up to 49% of paid-up capital.

2. Transparent norms for entry of Indian private sector, foreign and joint-venture banks and insurance companies, permission for foreign investment in the financial sector in the form of Foreign Direct Investment (FDI) as well as portfolio investment, permission to banks to diversify product portfolio and business activities.

Measures Enhancing Role of Market Forces

1. Sharp reduction in pre-emption through reserve requirement, market determined pricing for government securities, disbanding of administered interest rates with few exceptions and enhanced transparency and disclosure norms to facilitate market discipline.

2. Introduction of pure inter-bank call money market, auction-based repos-reserve repos for short-term liquidity management, facilitation of improved payments and settlement mechanism.

Institutional and Legal Measures

1. Setting up of Lok Adalats, debt recovery tribunals, asset reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery/ restructuring. Promulgation of Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act and its subsequent amendment to ensure creditor rights.

2. Setting up of Credit Information Bureau for information sharing on defaulters as also other borrowers.

3. Setting up Credit Information Bureau for information sharing on defaulters as also other borrowers.4. Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter party for

facilitating payments and settlement system relating to fixed income securities and money market instruments.

Supervisory Measures

1. Establishment of the Board for Financial Supervision as the apex supervisory authority for commercial banks, financial institutions and non-banking financial companies.

2. Introduction of CAMELS supervisory rating system, move towards risk-based supervision, consolidated supervision of financial conglomerates, strengthening of off-site surveillance through control returns.

3. Recasting of the role of statutory auditors, increased internal control through strengthening of internal audit.

4. Strengthening corporate governance, enhanced due diligence on important shareholders, fit and proper tests for directors.

Technology Related Measures

1. Setting up of INFINET as the communication backbone for the financial sector, introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities and Real Time Gross Settlement (RTGS) system.

2. Reforms in Government Securities Market

Institutional Measures

1 Administered interest rates on government securities were replaced by an auction system for price discovery.

2. Automatic monetization of fiscal deficit through the issue of ad hoc Treasury Bills was phased out.3. Primary Dealers (PD) were introduced as market makers in the government securities market.4. For ensuring transparency in the trading of government securities. Delivery versus Pay (DvP)

settlement system was introduced.5. Repurchase agreements (repo) were introduced as a tool of short-term liquidity adjustment.

Subsequently, the Liquidity Adjustment Facility (LAF) was introduced. LAF operates through repo and reverse auctions to set up a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also signaling device for interest rates in the overnight market.

6. Market Stabilization Scheme (MSS) has been introduced, which has expanded the instruments available to the Reserve Bank for managing the surplus liquidity in the system.

Increase in Instruments in Government Securities Market

1. 91-day Treasury bill was introduced for managing liquidity and benchmarking. Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued and exchange traded interest rate futures were introduced. OTC interest rate derivatives like IRS/FRAs were introduced.

Enabling Measures

1 Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to certain limits.

2 Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and settlement system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement System (RTGS).

3 Introduction of trading of government securities on stock exchanges for promoting retailing in such securities, permitting non-banks to participate in repo market.

3. Reforms in the Forex market

Exchange Rate Regime

1 Evolution of exchange rate regime from a single currency fixed-exchange rate system to fixing the value of rupee against a basket of currencies and further to market-determined floating exchange rate regime.

2 Adoption of convertibility of rupee for current account transactions with acceptance of Article VIII of the Articles of Agreement of the IMF. Defacto full capital account convertibility for nonresidents and calibrated liberalization of transactions undertaken for capital account purposes in the case of residents. Institutional Framework

Replacement of the earlier Foreign Exchange

1 Regulation Act (FERA), 1973 by the market friendly Foreign Exchange Management Act, 1999. Delegation of considerable powers by RBI to Authorized Dealers to release foreign exchange for a variety of purposes.

Increase in Instruments in forex market

1 Development of rupee-foreign currency swaps market. Introduction of additional hedging instruments, such as, foreign currency-rupee options. Authorized dealers permitted to use innovative products like cross-currency options, interest rate and currency swaps, cap/collars and forward rate agreements (FRSs) in the international forex market.

Liberalization Measures

1. Authorized dealers permitted to initiate trading positions, borrow and invest in overseas market subject to certain specifications and ratification by respective Banks’ Boards. Banks are also permitted to fix interest rates on non-resident deposits, subject to certain specification, use derivative products for asset-liability management and fix overnight open position limits and gap limits in the foreign exchange market, subject to ratification by RBI.

2. Permission to various participants in the foreign exchange market, including exporters, Indian investing abroad, FIIs, to avail forward cover and enter into swap transactions without any limit subject to genuine underlying exposure.

3. FIIs and NRIs permitted to trade in exchange traded derivative contracts subject to certain conditions.

4. Foreign exchange earners permitted to maintain foreign currency accounts. Residents are permitted to open such accounts within the general limit of US$25,000 per year.

4. Reforms in the credit market

1. Interest rate deregulation in a phased manner: total freedom to the banks to set their own lending rates (from 1994)

2. Since 1991, term lending institutions can charge interest rates in accordance with perceived risks

3. Contraction of subsidized and captive source of funds to term lending institutions – forced to borrow at market rate of interest

4. Diversification of term lending institutions in to banking, MFs etc.

5. Some decline in the priority sector lending particularly agriculture credit

5. Reforms and changes in the capital market market

1. Upward revision of interest rates for govt. securities (T bills and dated securities) and significant growth in the primary market for T bills

2. Use of open market operations by the RBI (by selling and buying the govt. securities) to absorb a part of the excess liquidity in the banking system caused by the surge in foreign capital inflows

3. The proportion T bills outstanding with the RBI came down significantly from the earlier level of about 90%

4. Dated Securities: alignment of the interest rate with other interest rates in the financial sector – reduction in the maximum maturity from 20 to 10 years

5. Creation of the Securities and Trading Corporation of India (STCI) in 1993: the task is to develop an efficient secondary market in govt. securities and public sector bonds

6. Stock Market: prior to 1992, the primary issues market was very closely regulated, which discouraged corporations from using new issues to raise funds

7. Creation of SEBI (1992): regulatory authority for new issues of companies; companies are now free to approach the capital market after a clearance from SEBI

8. Free entry of FII (pension funds, mutual funds, investment trusts, asset management companies) – initial registration with SEBI

Narasimham Committee on Banking Sector Reforms (1998)

From the 1991 India economic crisis to its status of fourth largest economy in the world by 2010, India has grown significantly in terms of economic development. So has its banking sector. During this period, recognizing the evolving needs of the sector, the Finance Ministry of Government of India (GOI) set up various committees with the task of analyzing India's banking sector and recommending legislation and regulations to make it more effective, competitive and efficient. Two such expert Committees were set up under the chairmanship of M. Narasimham. They submitted their recommendations in the 1990s in reports widely known as the Narasimham Committee-I (1991) report and the Narasimham Committee-II (1998) Report. These recommendations not only helped unleash the potential of banking in India, they are also recognized as a factor towards minimizing the impact of global financial crisis starting in 2007.

Unlike the socialist-democratic era of the 1960s to 1980s, India is no longer insulated from the global economy and yet its banks survived the 2008 financial crisis relatively unscathed, a feat due in part to these Narasimham Committees.

Background :-

During the decades of the 60s and the 70s, India nationalized most of its banks. This culminated with the balance of payments crisis of the Indian economy where India had to airlift gold to International Monetary Fund (IMF) to loan money to meet its financial obligations. This event called into question the previous banking policies of India and triggered the era of economic liberalization in India in 1991.The banking sector, handling 80% of the flow of money in the economy, needed serious reforms to make it internationally reputable, vibrant and competitive economy. In the light of these requirements, two expert Committees were set up in 1990s under the chairmanship of M. Narasimham .The first Narasimham Committee (Committee on the Financial System - CFS) was appointed by Manmohan Singh as India's Finance Minister on 14 August 1991, and the second one (Committee on Banking Sector Reforms) was appointed by P. Chidambaram as Finance Minister in December 1997.The purpose of the Narasimham-I Committee was to study all aspects relating to the structure, organization, functions and procedures of the financial systems and to recommend improvements in their efficiency and productivity. The Narasimham-II Committee was tasked with the progress review of the implementation of the banking reforms since 1992 with the aim of further strengthening the financial institutions of India. It focused on issues like size of banks and capital adequacy ratio among other things.

Recommendations of the Committee (1998 report)

Autonomy in Banking:

1. Greater autonomy was proposed for the public sector banks so that they can perform their functions in more professional fashion like their international counterparts. For this the panel recommended that recruitment procedures, training and remuneration policies of public sector banks be brought in line with the best-market-practices of professional bank management.

2. The committee recommended GOI equity in nationalized banks be reduced to 33% for increased autonomy.

3. It also recommended the RBI relinquish its seats on the board of directors of these banks. As government nominees to the board of banks are often members of parliament, politicians, bureaucrats, etc., they often interfere in the day-to-day operations of the bank in the form of the behest-lending.

4. The committee recommended a review of functions of banks boards with a view to make them responsible for enhancing shareholder value through formulation of corporate strategy and reduction of government equity.

To implement this, criteria for autonomous status was identified by March 1999 (among other implementation measures) and 17 banks were considered eligible for autonomy.

But some recommendations like reduction in Government's equity to 33%, the issue of greater professionalism and independence of the board of directors of public sector banks is still awaiting Government follow-through and implementation.

Reform in the role of RBI

1. The committee recommended that the RBI withdraw from the 91-day treasury bills market and that interbank call money and term money markets be restricted to banks and primary dealers.

2. The Committee proposed a segregation of the roles of RBI as a regulator of banks and owner of bank.

Pursuant to the recommendations, the RBI introduced a Liquidity Adjustment Facility (LAF) operated through repo and reverse repos in order to set a corridor for money market interest rates. The RBI decided to transfer its respective shareholdings of public banks like State Bank of India (SBI), National Housing Bank (NHB) and National Bank for Agriculture and Rural Development (NABARD) to GOI.

Stronger banking system

1. Recommended for merger of large Indian banks to make them strong enough for supporting international trade.

2. Recommended a three tier banking structure in India through establishment of three large banks with international presence, eight to ten national banks and a large number of regional and local banks.

3. The Committee recommended the use of mergers to build the size and strength of operations for each bank. However, it cautioned that large banks should merge only with banks of equivalent size and not with weaker banks, which should be closed down if unable to revitalize themselves.

4. Given the large percentage of non-performing assets for weaker banks, some as high as 20% of their total assets, the concept of "narrow banking" was proposed to assist in their rehabilitation.

There were a string of mergers in banks of India during the late 90s and early 2000s, encouraged strongly by the Government of India in line with the Committee's recommendations.

Non-performing assets

1. The committee had highlighted that 'priority sector lending' was leading to the build up of non-performing assets of the banks and thus it recommended it to be phased out.

2. Recommended the need for 'zero' non-performing assets for all Indian banks with International presence.

3. The Committee recommended creation of Asset Reconstruction Funds or Asset Reconstruction Companies to take over the bad debts of banks, allowing them to start on a clean-slate.

Overall the committee wanted a proper system to identify and classify NPAs and for an independent loan review mechanism for improved management of loan portfolios.

The committee's recommendations let to introduction of a new legislation which was subsequently implemented as the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and came into force with effect from 21 June 2002.

Capital adequacy and tightening of provisioning norms

1. Recommended that the Government should raise the prescribed capital adequacy norms. This would also improve their risk taking ability.

2. The committee targeted raising the capital adequacy ratio to 9% by 2000 and 10% by 2002 and recommended penal provisions for banks that fail to meet these requirements.

3. For asset classification, the Committee recommended a mandatory 1% in case of standard assets and for the accrual of interest income to be done every 90 days instead of 180 days.

To implement these recommendations, the RBI in Oct 1998, initiated the second phase of financial sector reforms by raising the banks' capital adequacy ratio by 1% and tightening the prudential norms for provisioning and asset classification in a phased manner on the lines of the Narasimham Committee-II report. The RBI targeted to bring the capital adequacy ratio to 9% by March 2001. The mid-term Review of the Monetary and Credit Policy of RBI announced another series of reforms, in line with the recommendations with the Committee, in October 1999.

Entry of Foreign Banks

The committee suggested that the foreign banks seeking to set up business in India should have a minimum start-up capital of $25 million as against the existing requirement of $10 million. It said that foreign banks can be allowed to set up subsidiaries and joint ventures that should be treated on a par with private banks.

Implementation of recommendations

In 1998, RBI Governor informed the banks that the RBI had a three to four year perspective on the implementation of the Committee's recommendations.Based on the other recommendations of the committee, the concept of a universal bank was discussed by the RBI and finally ICICI bank became the first universal bank of India.The RBI published an "Actions Taken on the Recommendations" report on 31 October 2001 on its own website. Most of the recommendations of the Committee have been acted upon (as discussed above) although some major recommendations are still awaiting action from the Government of India.

Reception1. Initially, the recommendations were well received in all quarters, including the Planning

Commission of India leading to successful implementation of most of its recommendations.

2. Then it turned out that during the 2008 economic crisis of major economies worldwide, performance of Indian banking sector was far better than their international counterparts.

3. This is credited to the successful implementation of the recommendations of the Narasimham Committee-II with particular reference to the capital adequacy norms and the recapitalization of the public sector banks.

Chakravarty Committee on Monetary Policy (1985)

The S. Chakravarty Committee was formed in 1985 under the chairmanship of Prof.Sukhamoy Chakravarty to assess the functioning of the Indian Monetary system.Its goal was to improve monetary regulation; a feat that was hoped would enable price stability. The committee, which submitted its report in April 1985, believed that price stability was essential for promoting growth and achieving other social objectives.

Main recommendations:

1. Develop treasury bills as a monetary instrument so that open market operations could gradually become the dominant instrument of monetary policy

2. Revise upwards the yield structure of government securities so as to increase the demand for them and limit the degree of monetization

3. The committee linked the interest rates with the Rate of Inflation. i = r + pe, where i = money rate of interest and r = real rate of interest. The committee's recommendation focused on translating this equation into actual practice. It suggested from its own side what the target “r” the Reserve Bank of India should aim at for a particular administered “I”. It would also estimate the appropriate Pe ; short term or long term as required. Using these values will give the appropriate value of i.

Vaghul Committee on Money Market (1987)

The Vaghul Committee (1987), while recommending the introduction of a number of money Market instruments to broaden and deepen the money market, recommended that the call markets should be restricted to banks. The other participants could choose from the new money market instruments, for their

short -term requirements. One of the reasons the committee ascribed to keeping the call markets as pure inter-bank markets was the distortions that would arise in an environment where deposit rates were regulated, while call rates were market determined.

Main recommendations:

1. Study the money market; recommendation to achieve a phased decontrol and development of money markets

2. Introduction of the 182 days Treasury Bills; withdrawal of the ceilings on call money rates; new short term instruments (Commercial Paper and Certificates of deposits)

3. Discount and Finance House of India (DFHI) was instituted by RBI in 1987 – DFHI was allowed to participate as both lender and borrower; No. of lenders increased

4. Instability in the rates and RBI intervention to stabilize

5. Significant deregulation and development of money market by the late eighties– little progress in the deregulation of credit and capital markets

Constitution of a High Level Committee on Financial Sector Reforms

With a view to outlining a comprehensive agenda for the evolution of the financial sector indicating especially the priorities and sequencing decisions which the Govt. must keep in mind, it was decided to set up a High Level Committee on Financial Sector Reforms under the chairmanship of Shri. Raghuram Rajan. The terms of reference of the committee were as follows:

To identify the emerging challenges in meeting the financing needs of the Indian economy in the coming decade and to identify real sector reforms that would allow those needs to be more easily met by the financial sector.

To examine the performance of various segments of the financial sector and identify changes that will allow it to meet the needs of the real sector.

To identify changes in the regulatory and the supervisory infrastructure that can better allow the financial sector to play its role, while ensuring that risks are contained; and

To identify changes in other areas of the economy—including in the conduct of monetary and fiscal policy, and the operation of the legal system and the educational system—that could help the financial sector function more effectively.

The committee has put forward several proposals to bring about the second stage of financial sector reforms in the economy. These have been enumerated below.

1. The RBI should formally have a single objective, to stay close to a low inflation number, or within a range, in the medium term, and move steadily to a single instrument, the short-term interest rate (repo and reverse repo) to achieve it. The RBI should be as willing to cut rates when inflation is expected to fall below the objective, so that the policy revives growth, as it is to raise rates when inflation is expected to exceed the objective because growth exceeds the economy’s potential. It is in this way that the RBI can best support the objectives of growth and stability.

2. Steadily open up investment in the rupee corporate and government bond markets to foreign investors after a clear monetary policy framework is in place.

3. Allow more entry to private well-governed deposit-taking small finance banks offsetting their higher risk from being geographically focused by requiring higher capital adequacy norms, a strict prohibition on related party transactions, and lower allowable concentration norms (loans as a share of capital that can be made to one party). This proposal is similar to the Local Area Bank initiative by the RBI that was prematurely terminated.

4. Liberalize the banking correspondent regulation so that a wide range of local agents can serve to extend financial services. Use technology both to reduce costs and to limit fraud and misrepresentation.

5. Offer priority sector loan certificates (PSLC) to all entities that lend to eligible categories in the priority sector. Allow banks that undershoot their priority sector obligations to buy the PSLC and submit it towards fulfillment of their target.

6. Liberalize the interest rate that institutions can charge, ensuring credit reaches the poor, but require (i) full transparency on the actual effective annualized interest cost of a loan to the borrower, (ii) periodic public disclosure of maximum and average interest rates charged by the lender to the priority sector, (iii) only loans that stay within a margin of local estimated costs of lending to the poor be eligible for PSLCs.

7. Sell small underperforming public sector banks, possibly to another bank or to a strategic investor, to gain experience with the process and gauge outcomes.

8. For large and better performing public sector banks, focus should be on reforming the governance structure, while perhaps also acquiring strategic partners, with the eventual disposition determined based on experience with privatization, the public mood, and the political environment.

9. Create stronger boards for large public sector banks, with more power to outside shareholders (including possibly a private sector strategic investor), devolving the power to appoint and compensate top executives to the board.

10. After starting the process of strengthening boards, delink the banks from additional government oversight, including by the Central Vigilance Commission and Parliament, with the justification that with government-controlled boards governing the banks, a second layer of oversight is not needed.

11. Be more liberal in allowing takeovers and mergers, including by domestically incorporated subsidiaries of foreign banks.

12. Free banks to set up branches and ATMs anywhere.13. Allow holding company structures, with a parent holding company owning regulated subsidiaries.

Universal banking should thus be possible in India through holding company structures. Some legislative and tax change will however be required to make these structures viable.

14. Bring all regulation of trading under the Securities and Exchange Board of India (SEBI). This will allow scope economies to be realized, improve liquidity, and increase competition.

15. Creating more efficient and liquid markets. The corporate bond market is moribund and will have to be revived and a number of missing markets will have to be created. In the equity markets, the environment needs to be made more conducive to private equity, venture capital, and hedge funds. Mutual funds and pension funds (when they emerge) should play a more active role in governance. In other markets, participation needs to increase substantially to enhance liquidity,

and foreign players could play a key role, as could domestic financial institutions such as insurance companies and provident funds.

16. Access to markets for the poor need to be increased, as does access to international financial services for Indian firms and investors.

17. The production of international financial services by Indian financial firms needs to be enhanced.18. Stop creating investor uncertainty by banning markets. If market manipulation is the worry, take

direct action against those suspected of manipulation.19. Create the concept of one consolidated membership of an exchange for qualified investors (instead

of the current need to obtain memberships for each product traded).20. Encourage the setting up of ‘professional’ markets and exchanges with a higher order size, that are

restricted to sophisticated investors (based on net worth and financial knowledge), where more sophisticated products can be traded.

21. Create a more innovation friendly environment, speeding up the process by which products are approved by focusing primarily on concerns of systemic risk, fraud, contract enforcement, transparency and inappropriate sales practices.

22. Create growth friendly regulatory environment. Allow greater participation of foreign investors in domestic markets. Increase participation of domestic investors by reducing the extent to which regulators restrict an institutional investor’s choice of investments.

23. Changes to legislation - Rewrite financial sector regulation, with only clear objectives and regulatory principles outlined. For eg the requirement that banks obtain regulatory approval for a range of routine business matters, including opening branches, remuneration to board members and even payment of fees to investment bankers managing equity capital offerings, is enshrined in the Banking Regulation Act.

24. Regulatory actions should be subject to appeal to the Financial Sector Appellate Tribunal, which will be set up along the lines of, and subsume, the Securities Appellate Tribunal.

25. Supervision of all deposit taking institutions must come under the RBI. Situations where responsibility is shared, such as with the State Registrar of Cooperative Societies, should gradually cease.

26. The Ministry of Corporate Affairs (MCA) should review accounts of un- listed companies, while SEBI should review accounts of listed companies.

27. A Financial Sector Over- sight Agency (FSOA) should be set up by statute. The FSOA’s focus w ill be both macro-prudential as well as supervisory; the FSOA will develop periodic assessments of macroeconomic risks, risk concentrations, as well as risk exposures in the economy; it will monitor the functioning of large, systemically important, financial conglomerates; anticipating potential risks, it will initiate balanced supervisory action by the concerned regulators to address those risks; it will ad- dress and defuse inter-regulatory conflicts.

28. Strengthening the capacity of the Deposit Insurance and Credit Guarantee Corporation (DICGC) to both monitor risk and resolve a failing bank, instilling a more explicit system of prompt corrective action, and making deposit insurance premia more risk-based.

29. Creating a robust infrastructure for credit. This includes expediting the process of creating a unique national ID number with biometric identification. Also, ongoing efforts to improve land registration and titling—including full mapping of land, reconciling various registries, forcing compulsory registration of all land transactions, computerizing land records, and providing easy remote access to land records—should be expedited, with the Centre playing a role in facilitating pilots and sharing experience of best practices.

30. Restrictions on tenancy should be re-examined so that tenancy can be formalized in contracts, which can then serve as the basis for borrowing.

31. The powers of SRFAESI that are currently conferred only on banks, public financial institutions, and housing finance companies should be extended to all institutional lenders.

32. Asset Reconstruction Companies (ARCs) have additional powers such as step-in rights and the ability to change man- agement, and the right to sell or lease the business. Given these additional powers, it is important that a number of ARCs flourish so that no single ARC has excessive power. Also provision should be made to allow foreign direct investment i n ARCs.

Conclusion

India’s financial sector is at a turning point. There are many successes—the rapidity and reliability of settlement at the NSE or the mobile phone banking being implemented around the country indicate that much of our system is at the Internet age and beyond. There is justifiable reason to take pride in this. Yet much needs to be done. Some parts of our system have not yet reached the electronic age, and unfortunately, this is the part that our poor typically face. There is an opportunity here. In the process of gaining the productivity and innovativeness to serve the masses, the financial sector will get the unique edge and scale to be competitive internationally—indeed, the road to making Mumbai an international financial centre runs through every village and slum in India.The old system of attempting to mandate outcomes from the centre does not work any more, even if it might have when our private sector institutions were less well developed and the Indian economy was more closed. The proper role of the government today is to improve the financial sector’s infrastructure and its regulation even while removing the plethora of constraints and distortions that have built up over the years. It also requires the government to withdraw from financing and direct control of institutions so that the financial sector can get on with the job. The populism and the direct intervention, that unfortunately seems to be making a come back, should be relegated firmly to the past.

Financial inclusion, growth, and stability are the three objectives of the financial sector reform process. With the right reforms, the financial sector can be an enormous source of job creation both directly, and indirectly through the enterprise and consumption it can support with financing. Without reforms, however, the financial sector could become an increasing source of risk, as the mismatches between the capacity and needs of the real economy and the capabilities of the financial sector widen. Not only would the lost opportunities be large, but, the consequences for the economy could be devastating. The country’s leaders have a choice to make, and we hope they will make the right one.