Introduction of financial sector

Indias financial sector is diversified and expanding rapidly. It comprises commercial banks, insurance companies, non-banking financial companies, cooperatives, pensions funds, mutual funds and other smaller financial entities. Ours is a bank dominated financial sector and commercial banks account for over 60 per cent of the total assets of the financial system followed by the Insurance. Other bank intermediaries include regional rural banks and cooperative banks that target under serviced rural and urban populations. Many non banking finance companies (NBFC) operate in specialized segments (leasing, factoring, micro finance, infrastructure finance), though some can accept deposits. Pension provision covers 12 percent of the working population and consists of civil service arrangements, a compulsory scheme for formal private sector employees, and private scheme offered through insurance companies. REFORMS IN THE FINANCIAL SECTOR Financial sector reform affects everyone in the country and beyond given the growing interface of our economy with the rest of the world. We live in a globalizing world with strong and growing inter-connections between our financial systems. What happens anywhere in the world will have an impact everywhere, as indeed demonstrated by the experience of the last five years. As foreign banks come into our country, and our banks expand their global footprint, we cannot afford to be offline on global standards and international best practices. As the former Managing Director of the IMF has said just because this crisis originated in advanced economies, emerging economies cannot assume that they have

insulated themselves from all future crises. Such hubris can be dangerously costly. Along with financial globalization, complexities of financial regulation have also increased. This became more complex after the crisis and following the adoption of greater scrutiny of the concerns arising from terrorism-related financial activities. The new obligations under the Financial Action Task Force (FATF) and Combating the Financing of Terrorism (CFT) regimes have necessitated coordination between domestic financial regulators amongst all the jurisdictions and between the global coordinating institutions. Greater co-ordination has also become imperative in the context of an efficient financial system has been regarded as a necessary pre condition for higher growth. Propelled by this ruling paradigm, several developing countries undertook programs for reforming their financial system. Concerns on financial stability. All these factors necessitate the need to redraft our legislation and harmonize them with international standards.

Financial Sector Reforms In India

The role of the financial system in India, until the early 1990s, was primarily restricted to the function of channeling resources from the surplus to deficit sectors. Whereas the financial system performed this role reasonably well, its operations came to be marked by some serious deficiencies over the years. The banking sector suffered from lack of competition, low capital base, low productivity and high intermediation cost. After the nationalization of large banks in 1969 and 1980, public ownership dominated the banking sector. The role of technology was minimal and the quality of service was not given adequate importance. Banks also did not follow proper risk management system and the prudential standards were weak. All these resulted in poor asset quality and low profitability.

Among

non-banking

financial

intermediaries,

development

finance

institutions (DFIs) operated in an over-protected environment with most of the funding coming from assured sources at concessional terms. In the insurance sector, there was little competition. The mutual fund industry also suffered from lack of competition and was dominated for long by one institution, viz., the Unit Trust of India. Non-banking Financial Companies (NBFCs) grew rapidly, but there was no regulation of their asset side. Financial markets were characterized by control over pricing of financial assets, barriers to entry, high transaction costs and restrictions on movement of funds/participants between the market segments. Apart from inhibiting the development of the markets, this also affected their efficiency. Against this backdrop, wide-ranging financial sector reforms in India were introduced as an integral part of the economic reforms initiated in the early 1990s. Financial sector reforms in India were grounded in the belief that competitive efficiency in the real sectors of the economy will not be realized to its full potential unless the financial sector was reformed as well. Thus, the principal objective of financial sector reforms was to improve the locative efficiency of resources and accelerate the growth process of the real sector by removing structural deficiencies affecting the performance of financial institutions and financial markets. The main thrust of reforms in the financial sector was on the creation of efficient and stable financial institutions and markets. Reforms in respect of the banking as well as non-banking financial institutions focused on creating a deregulated environment and enabling free play of market forces while at the same time strengthening the prudential norms and the supervisory system. In the banking sector, the focus was on imparting operational flexibility and functional autonomy with a view to enhancing efficiency, productivity and profitability, imparting strength to the system and ensuring accountability and financial soundness. The

restrictions on activities undertaken by the existing institutions were gradually relaxed and barriers to entry in the banking sector were removed. In the case of non-banking financial intermediaries, reforms focused on removing sector-specific deficiencies. Thus, while reforms in respect of DFIs focused on imparting market orientation to their operations by withdrawing assured sources of funds, in the case of NBFCs, the reform measures brought their asset side also under the regulation of the Reserve Bank. In the case of the insurance sector and mutual funds, reforms attempted to create a competitive environment by allowing private sector participation. Reforms in financial markets focused on removal of structural bottlenecks, introduction of new players/instruments, free pricing of financial assets, relaxation of quantitative restrictions improvement in trading, clearing and settlement practices, more transparency, etc. Reforms encompassed regulatory and legal changes, building of institutional infrastructure, refinement of market

microstructure and technological up gradation. In the various financial market segments, reforms aimed at creating liquidity and depth and an efficient price discovery process. Reforms in the commercial banking sector had two distinct phases. The first phase of reforms, introduced subsequent to the release of the Report of the Committee on Financial System, 1992 (Chairman: Shri M. Narasimham), focused mainly on enabling and strengthening measures. The second phase of reforms, introduced subsequent to the recommendations of the Committee on Banking Sector Reforms, 1998 (Chairman: Shri M. Narasimham) placed greater emphasis on structural measures and improvement in standards of disclosure and levels of transparency in order to align the Indian standards with international best practices. During the last four decades, particularly after the first phase of nationalization of banks in 1969, there have been distinct improvements in the

banking activities which strengthened the financial intermediation process. The total number of offices of public sector banks which was merely at 8262 in June 1969 increased to 62,607 as of June 2011. Similarly, there have been many fold increases in aggregate deposits and credit indicating existence of a vibrant bankbased financial system.

Banking Sector
The main objective of banking sector reforms was to promote a diversified, efficient and competitive financial system with the ultimate goal of improving the a locative efficiency of resources through operational flexibility, improved financial viability and institutional strengthening. The reforms have focused on removing financial repression through reductions in statutory preemptions, while stepping up prudential regulations at the same time. Furthermore, interest rates on both deposits and lending of banks have been progressively deregulated (Box I). As the Indian banking system had become predominantly government owned by the early 1990s, banking sector reforms essentially took a two pronged approach. First, the level of competition was gradually increased within the banking system while simultaneously introducing international best practices in prudential regulation and supervision tailored to Indian requirements. In particular, special emphasis was placed on building up the risk management capabilities of Indian banks while measures were initiated to ensure flexibility, operational autonomy and competition in the banking sector. Second, active steps were taken to improve the institutional arrangements including the legal framework and technological system. The supervisory system was revamped in view of the crucial role of supervision in the creation of an efficient banking system. Measures to improve the health of the banking system have included (i) restoration of

public sector banks' net worth through recapitalisation where needed; (ii) streamlining of the supervision process with combination of on-site and off-site surveillance along with external auditing; (iii) introduction of risk based supervision; (iv) introduction of the process of structured and discretionary intervention for problem banks through a prompt corrective action (PCA) mechanism; (v) institutionalisation of a mechanism facilitating greater coordination for regulation and supervision of financial conglomerates; (vi) strengthening creditor rights (still in process); and (vii) increased emphasis on corporate governance. Consistent with the policy approach to benchmark the banking system to the best international standards with emphasis on gradual harmonisation, all commercial banks in India are expected to start implementing Basel II with effect from March 31, 2007 though a marginal stretching beyond this date should not be ruled out in view of the latest indications on the state of preparedness (Reddy, 2006a). Recognising the differences in degrees of sophistication and development of the banking system, it has been decided that the banks will initially adopt the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk. After adequate skills are developed, both by the banks and also by the supervisors, some of the banks may be allowed to migrate to the Internal Rating Based (IRB) Approach. Although implementation of Basel II will require more capital for banks in India, the cushion available in the system - at present, the Capital to Risk Assets Ratio (CRAR) is over 12 per cent - provides some comfort. In order to provide banks greater flexibility and avenues for meeting the capital requirements, the Reserve Bank has issued policy guidelines enabling issuance of several instruments by the banks viz., innovative perpetual debt instruments, perpetual non-cumulative preference shares, redeemable cumulative preference shares and hybrid debt instruments.

reforms in the Banking Sector A. Competition Enhancing Measures Granting of operational 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 percent of paid-up capital. 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. Roadmap for presence of foreign banks and guidelines for mergers and amalgamation of private sector banks and banks and NBFCs. Guidelines on ownership and governance in private sector banks. B. Measures Enhancing Role of Market Forces Sharp reduction in pre-emption through reserve requirement, market determined pricing for government securities, disbanding of administered interest rates with a few exceptions and enhanced transparency and disclosure norms to facilitate market discipline. Introduction of pure inter-bank call money market, auction-based repos-reverse repos for short-term liquidity management, facilitation of improved payments and settlement mechanism. Significant advancement in dematerialization and markets for securitized assets are being developed. C. Prudential Measures Introduction and phased implementation of international best practices and norms on risk-weighted capital adequacy requirement, accounting, income recognition, provisioning and exposure. 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.

Money Laundering' guidelines, roadmap for Basel II, introduction of capital charge for market risk, higher graded provisioning for NPAs, guidelines for ownership and governance, securitisation and debt restructuring mechanisms norms, etc. D. Institutional and Legal Measures reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery/ restructuring. ecuritisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002 and its subsequent amendment to ensure creditor rights. information sharing on defaulters as also other borrowers. counter party for facilitating payments and settlement system relating to fixed income securities and money market instruments. E. Supervisory Measures authority for commercial banks, financial institutions and non-banking financial companies. risk-based supervision, consolidated supervision of financial conglomerates, strengthening of offsite surveillance through control returns. strengthening of internal audit. shareholders, fit and proper tests for directors. F. Technology Related Measures sector, introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities and Real Time Gross Settlement (RTGS) System. 5 Reforms in the Monetary Policy Framework The basic emphasis of monetary policy since the initiation of reforms has been to reduce

market segmentation in the financial sector through increased interlinkages between various segments of the financial market including money, government security and forex market. The key policy development that has enabled a more independent monetary policy environment as well as the development of Government securities market was the discontinuation of automatic monetisation of the government's fiscal deficit since April 1997 through an agreement between the Government and the Reserve Bank of India in September 1994. In order to meet the challenges thrown by financial liberalisation and the growing complexities of monetary management, the Reserve Bank switched from a monetary targeting framework to a multiple indicator approach from 1998-99. Short-term interest rates have emerged as the key indicators of the monetary policy stance. A significant shift is the move towards market-based instruments away from direct instruments of monetary management. In line with international trends, the Reserve Bank has put in place a liquidity management framework in which market liquidity is managed through a mix of open market (including repo) operations (OMOs), changes in reserve requirements and standing facilities, reinforced by changes in the policy rates, including the Bank Rate and the short term (overnight) policy rate. In order to carry out these market operations effectively, the Reserve Bank has initiated several measures to strengthen the health of its balance sheet. Over the past few years, the process of monetary policy formulation has become relatively more articulate, consultative and participative with external orientation, while the internal work processes have also been re-engineered. A recent notable step in this direction is the constitution of a Technical Advisory Committee on Monetary Policy comprising external experts to advise the Reserve Bank on the stance of monetary policy (Box II).

Following the reforms, the financial markets have now grown in size, depth and activity paving the way for flexible use of indirect instruments by the Reserve Bank to pursue its objectives. It is recognised that stability in financial markets is critical for efficient price discovery. Excessive volatility in exchange rates and interest rates masks the underlying value of these variables and gives rise to confusing signals. Since both the exchange rate and interest rate are the key prices reflecting the cost of money, it is particularly important for the efficient functioning of the economy that they be market determined and be easily observed. The Reserve Bank has, therefore, put in place a liquidity management framework in the form of a liquidity adjustment facility (LAF) for the facilitation of forex and money market transactions that result in price discovery sans excessive volatility. The LAF coupled with OMOs and the Market Stabilisation Scheme (MSS) has provided the Reserve Bank greater flexibility to manage market liquidity in consonance with its policy stance. The introduction of LAF had several advantages (Mohan, 2006b). control to indirect and, in the process, certain dead weight loss for the system was saved. determining both the quantum of adjustment as well as the rates by responding to the needs of the system on a daily basis. basis to meet day-to-day liquidity mismatches. rate changes.

-term money market rates. Financial sector reforms: The financial sector has been witnessing restructuring and reformation exercise ever since the economic liberalization started in India. This restructuring especially in banking sector, enhanced the banking transactions investments further as well as brought about the financial stability. Being one of the fastest developing economies, India is gradually integrating itself into the world market mainly due to the reform process initiated by the government in 1991-92. The objectives of the financial liberalization can be divided into two broad categories. First deregulation of financial m,