3 Major Financial Reforms Undertaken in India Since 1990s

The following points highlight the three major financial reforms undertaken in India since 1990s. The financial reforms are: 1. Banking Sector Reforms 2. Money Market Reforms 3. Capital Market Reforms.

Financial Reform # 1. Banking Sector Reforms:

The reforms of the banking sector started with the nationalisation of 14 private banks in 1969 and 6 more banks in 1980. The focus of bank nationalisation was on social banking. The emphasis was on branch expansion in rural, semi-urban and urban areas, to mobilise deposits on a massive scale and to lend funds for productive activities, with greater emphasis on the weaker sections of the society.

These public sector banks were successful in extending their geographical coverage and increasing their targets of deposit mobilisation and advancing loans. But they were afflicted with low profitability, inefficiency and a high proportion of non-performing assets (NPAs), i.e., bad loans.

One of the serious problems of the banking system was the massive pre-emption of banks’ resources to finance Government’s budgetary needs. At the beginning of the reforms process in 1991, the statutory pre­emptions under both CRR and SLR on an incremental basis were as high as 63.5%. Of the remaining 36.5%, there were 40% pre-emptions under the priority sector, export credit, food credit and other formal and informal pre-emptions. These pre-emptions along with administered interest rates were referred to as “financial repression”.

There were restrictions on the use of funds by banks which affected their profitability. Many of the public sector banks had become unprofitable and under-capitalized. To remedy the growing deficiencies of the Indian banking sector, the Government of India set up the Narasimham Committee on Financial System in 1991.

It recommended deregulation and liberalisation of the banking sector. This was followed by the recommendations of Narasimham Committee (II) of 1998. Besides, prior to the pre-reform era, there were administered interest rates on term deposits of varied maturities and various categories of loans by banks.

There was no transparency and disclosure in the working of accounting policies of banks. There were no prudential norms relating to banks and risk management techniques like capital adequacy ratio (CAR), capital to risk-weighted assets ratio (CRAR), non-performing assets (NPAs) norms, income ratios, asset-liability management, and risk management guidelines for banks, etc. Due to lack of these norms and guidelines in the Indian banking system, there were bank failures. Therefore, there was an urgent need for adequate regulation and supervision of banks.

Moreover, the banking sector did not have sufficient competition because there were restrictions on the entry and expansion of domestic and foreign private banks. The branch expansion of banks was rigidly controlled by the RBI. No bank was allowed to open a branch without its permission.

Despite reforms, there have been direct administrative controls on the direction of credit allocation and rates at which credit is given, Last but not the least, the customer service in the public sector banks was at its lowest level due to lack of competition from private and foreign banks. To remedy all the above noted defects of the Indian banking system, the following policy measures have been adopted.

1. Reduction of Pre-Emption:

The total effective pre-emption has been brought down from the pre-reform level of 65% to less than 35% now. This has been done by reducing the CRR from 15% to 4.5% and SLR from 38.5% to 25%.

2. De-regulation of Interest Rates:

Phase-wise de-regulation of interest rates on both deposits and advances has been done. At present, only saving deposits and those for less than 15 days and loans up to Rs. 2 lakh are under administered interest rate regime. Banks are free to fix their own Prime Lending Rate (PLR) for advances over Rs. 2 lakh. But foreign currency deposits and advances and export credit rates are being regulated.

3. Adoption of Prudential Norms and Risk Management:

Prudential norms relating to capital adequacy ratio (8% — 9%), asset classification, income recognition, classification and valuation of investment portfolio, etc. are being introduced gradually to meet international standards.

4. Promoting Competition:

Competition is being promoted in the banking sector by permitting new private sector banks and by allowing foreign banks to open more branches. Local Area Banks (LABs) are also being encouraged in rural and semi-urban areas to foster competition.

The transparency and disclosure standards of banks have been raised to meet international standards. They relate to disclosure of accounting policies, capital adequacy ratio, percentage of Government shareholding, percentage of non-performing assets (NPAs) to net advances, income ratios, business and profit per employee, etc.

As per the recommendations of Narasimham Committee (II), the banks are required, effective March 31,2000, to disclose maturity pattern of loans and advances, investment securities, deposits and borrowings, foreign currency assets and liabilities, movement in NPAs (non-performing assets), etc.

5. Allowing PSBs to Raise Capital:

To enable public sector banks to meet their additional needs of capital, the Government has allowed the banks to approach the capital market directly to raise funds. They can sell 49% of the share capital to the public. Few banks which have raised capital from the public are State Bank of India, Bank of India, Oriental Bank of Commerce, Bank of Baroda, Indian Overseas Bank, etc.

6. Supervision:

The RBI has set up an independent Board for Financial Supervision (BFS) which undertakes on-site and off-site supervision of banks and reports to the RBI. The on-site supervision relates to solvency, liquidity, operational soundness and prudent management. The off-site supervision consists of submission of returns by banks on capital adequacy, asset quality, large credit, lending earnings, and currency, liquidity and interest rate risks, etc.

7. Credit Delivery System:

Loan system for delivery of bank credit for working capital has been introduced to bring greater discipline in credit utilisation and control in credit flows.

8. Customer Service:

To strengthen customer service, a number of measures have been implemented as recommended by the Jaipuria Committee. To ensure efficient customer service, banks collect feed-back on a regular basis through visits of senior officials from controlling offices to their branches.

To elicit customer reactions about the quality of service rendered, the system of holding customer meets at regular intervals at branches has been evolved. Some banks have formed customer service committees and customer councils. Banks have put up ‘Complaints and Suggestions Boxes’ at all branches which are dealt with promptly. Some of the banks have also introduced courier system to expedite collections, remittances and transfer of accounts of customers.

For expeditious and inexpensive settlement of customer complaints against deficiency in banking services, including non-observance of the RBI directives on loans and advances, etc. the Banking Ombudsman has been appointed on a full time basis each at Mumbai, New Delhi, Bhopal, Chandigarh, Hyderabad, Patna, Jaipur, etc. The scheme covers all scheduled commercial banks, except RRBs and PCBs.

Financial Reform # 2. Money Market Reforms:

Prior to the beginning of reforms in early 1990s, the Indian money market was dual in character being divided into organised and unorganised sectors. It had a limited number of participants, limited number of instruments, small geographical areas, shortage of capital, highly skewed call money market, undeveloped bill market, etc.

Moreover, it was a highly regulated market lacking in depth. In particular, interest rates on money market instruments were tightly regulated by the Government.

To remove these defects of the Indian money market and to develop it on sound lines, the RBI appointed Chakravarty Committee in 1985 and the Vighul Working Group in 1987. It was on the basis of their recommendations that the following measures have been taken to develop and deepen the money market.

(i) Introduction of Inter-bank Participations, Certificates of Deposits (CDs), Commercial Paper (CP) Repos, Reverse Repos and Inter-bank Repos;

(ii) Setting up the Discount and Finance House of India (DFHI);

(iii) Allowing commercial banks and public financial institutions to set up Money Market Mutual Funds (MMMFs) to provide greater liquidity and depth to the money market;

(iv) Total freeing of interest rates on call and notice money, inter-bank term money, rediscounting of commercial bills and on Inter-bank participation; and

(v) Lowering the bill discount rate to encourage the bill market.

Government Securities Market:

Before the beginning of the reform era, the Government Securities and Treasury Bills market in India was under-developed and lacked in liquidity and depth. There were only 91-Day Treasury Bills in the Government securities market. They were a permanent source of Government funds. To keep the cost of Government borrowings low, the discount (or coupon) rates on them remained unchanged at 4.6% per annum, whereas the average lending rate had been much higher.

Thus the coupon rate on them remained negative in real terms for several years. As a result of low coupon rates offered on Government securities to investors, the securities market did not attract much investment. Further, the RBI had little control over the volume and maturity structure of Government securities and the term structure of interest rates.

To remedy these defects and develop the Government securities market, the following measures have been adopted by the RBI since the middle of 1991:

(1) The maximum coupon rate on Central Government loans is fixed at near market rates at the time of issuing.

(2) A variety of Treasury Bills have been introduced such as 14-Day Treasury Bills, 91-Day Treasury Bills, 182-Day Treasury Bills, and 364-Day Treasury Bills. They are auctioned by DFHI.

(3) Some new instruments like conversion of auction Treasury Bills into term securities, Zero Coupon and Capital Indexed Bonds, Tap Stocks and Partly Paid Stocks have been introduced in the Government securities market.

(4) A system of primary dealers and satellite dealers has been established to deal in Government securities.

(5) The practice of automatic monetisation of Central Government budget deficit through ad hoc Treasury Bills has been replaced by a new scheme of Ways and Means Advances.

(6) RBI has introduced a delivery versus payment (DVSP) system for transactions in Government securities in Mumbai. This system ensures settlement by simultaneously transferring securities with cash payments. This has reduced risk in settlement of securities transactions and prevention of diversion of funds.

(7) RBI has started providing liquidity support to those mutual funds which exclusively invest in Government securities.

(8) FIIs (foreign institutional investors) with 100% debt funds are allowed to invest in Government securities and Treasury Bills. Other FIIs are permitted to invest up to 30%.

(9) Banks are allowed to have minimum of 75% of their Government securities as current investments effective March 31, 2000 which can be traded on a day-to-day basis.

(10) The interest income from Government securities has been exempted from tax.

(11) The primary subscription of RBI in Government securities has been mainly for carrying out its open market operations.

(12) As a result of the various measures undertaken to build and strengthen the Government Securities and Treasury Bills market, its investor base has expanded on a large scale in favour of short-term and medium- term borrowings. The number of participants in the primary market for Government Securities now include banks, insurance corporations, finance companies, mutual funds, FIIs, financial institutions and corporates.

(13) There is also a secondary market for Government Securities in which transactions take place through Subsidiary General Ledger (SGL) Accounts of the Reserve Bank.

Financial Reform # 3. Capital Market Reforms:

The Indian capital market, both in its primary and secondary segments, suffered from some serious defects prior to the beginning of reforms in 1991. The principal deficiencies in the primary market were vague prospectus containing little and often wrong information about the proposed financial position of the company, unfair pricing and premium fixing, high cost of new issues, etc. There was no regulatory authority to supervise new issues.

The secondary market had more serious problems. There were limited number of stock exchanges in the country. Consequently, there were mushrooming of un-authorised and unregistered stock exchanges which indulged in speculative practices and duped the shareholders.

Recognised stock exchanges did not function satisfactorily. They were governed by their internal bye-laws framed by their governing bodies which operated under elected member-brokers. There was unusual delay in the delivery of shares and settlement (or payment) of transactions.

There was excessive speculation and price fluctuation due to insider trading which adversely affected ordinary shareholders. The stock broking system was defective. Brokers manipulated prices and cheated the buyers and sellers of shares. There was no transparency in trading operations.

Settlement cycles were often uncertain and long which led to frequent payment crisis and suspension of market activity. In post- made settlements, there were delayed settlements, bad deliveries, clubbing of settlements, loss of shares in transit, etc. There was inadequate protection to clients in case of default by sub-brokers and brokers.

Since 1992, the following policy measures have been undertaken to reform both the primary and secondary segments of the Indian capital market:

(1) SEBI was established as an autonomous and statutory body to regulate and oversee the new issues, protect the interests of investors, promote the orderly development of primary and secondary markets and regulate the working of stock exchanges. It has initiated a number of measures in these direction such as registration of intermediaries, strict disclosure norms, regulations on insider trading and inspection of the functioning of stock exchanges, etc.

(2) A company raising issue capital from the market is not required to have the consent of any authority, except following the guidelines of SEBI for disclosure and investor protection.

(3) Restrictions on rights and bonus issues have been removed.

(4) Interest rate on debentures has been freed.

(5) The primary market has been strengthened and diversified with mutual funds, merchants bankers, investment and consultancy agencies, registrar to the issue, etc.

(6) The primary capital market has been widened and deepened by permitting public sector banks, financial institutions and public sector enterprises to raise resources from the market through bonds and equity.

(7) On-line screen-based electronic trading has been started in all 23 stock exchanges of the country.

(8) Trading and settlement cycles have been reduced from 14 days to 7 days in all stock exchanges. All stock exchanges have established clearing houses.

(9) In order to reduce counter-party risk, major stock exchanges have set up Trade Settlement Guarantee Funds, while the NSE has a separate clearing corporation.

(10) Insider trading has been completely stopped and is a criminal offence.

(11) FIIs (foreign institutional investors) such as mutual funds, pension funds, etc. have been permitted to invest and operate in the Indian capital market. They now invest in equity shares, debentures, Government Securities and Treasury Bills.

(12) There has been globalisation of Indian equity by Indian companies through the issue of Global Depository Receipts (GDRs), American Depository Receipts (ADRs), Foreign Currency Convertible Bonds (FCCBs), etc. Shares of Indian companies are being traded at New York and London Stock Exchanges.

(13) To protect the investors and to encourage FIIs to participate in the Indian Capital Market, dematerialization of shares through depositories and their transfer through electronic book entry have been in progress.

(14) Companies have been permitted to buy back their own shares provided the buy-back does not exceed 25% of the paid-up capital.

(15) All institutions and agencies related to the Indian Capital market such as stock exchanges, stock brokers, sub-brokers, mutual funds, intermediaries, share transfer agents, merchant bankers, portfolio managers, underwriters, debenture trustees, bankers to an issue, custodians of securities, venture capital funds etc. have been brought under SEBI regulations.