Next Generation

Financial Reforms
for India
Eswar S. Prasad and Raghuram G. Rajan

I A new report
ndia has grown by leaps and bounds growth trajectory. The financial system’s
in recent years and is emerging as a ability to channel domestic savings and for-
major world economic power. After eign capital into productive investment and advocates
lumbering along at a pace of about 4–5
percent GDP growth a year in the 1980s and
to provide financial services—such as pay-
ments, savings, insurance, and pensions—to
a shake-up
the 1990s, the economy has surged in this a vast majority of households will influence in India’s
decade, posting an average annual growth
of 8.5 percent since 2005 (see Chart 1). The
economic as well as social stability.­
While India’s financial institutions and
financial
challenge now is to maintain this growth regulatory structures have been developing system to
momentum and provide benefits as well as gradually, the time has come to make a more underpin
economic opportunities to a broad swath of concerted push toward the next generation
the population.­ of financial reforms. A growing and increas- growth
India’s financial system—comprising its ingly complex market-oriented economy, and
banks, equity markets, bond markets, and its greater integration with global trade and
myriad other financial institutions—is a finance, will require deeper, more efficient,
crucial determinant of the country’s future and well-regulated financial markets.­
A shopping mall in eastern India.

Finance & Development September 2008   23

 These considerations prompted the Indian government to sive agenda for the evolution of the financial sector.” Indeed,
institute a high-level committee—composed of a select group the report argues that there are deep linkages among different
of financial sector practitioners, businesspeople, academ- reforms, including broader reforms to monetary and fiscal
ics, and policymakers—to map out a blueprint for financial policies, and recognizing these linkages is essential to achieve
reforms. After more than six months of intensive work, the real progress.­
committee recently delivered its draft report to the govern- The report has three main conclusions. First, India’s finan-
ment (available at http://planningcommission.nic.in/reports/ cial system is not providing adequate services to the major-
genrep/report_fr.htm). In this article, we summarize the key ity of domestic retail customers, small and medium-sized
findings of the report and examine its recommendations.­ enterprises, or large corporations. Government ownership
of 70 percent of the banking system and hindrances to the
Three main conclusions development of corporate debt and derivatives markets have
Numerous other government committees over the years have stunted financial development. This will inevitably become a
Author: Prasad, 7/8/08
looked into specific aspects of India’s financialProof reforms, but barrier to high growth.­
this is the first committee mandated to “outline a comprehen- Second, the financial sector—if properly regulated but
unleashed from government strictures that have stifled the
development of certain markets and kept others from becom-
Chart 1
ing competitive and efficient—has the potential to generate
Nice combination millions of much-needed jobs and, more important, have an
Until recently, India has seen strong growth coupled with enormous multiplier effect on economic growth.­
moderate inflation during the current decade, although now Third, in these uncertain times, financial stability is more
prices are climbing rapidly again. important than ever to keep growth from being derailed by
(percent) shocks hitting the system, especially from abroad. Although
12 the Indian economy dodged the Asian crisis and the recent
GDP growth CPI subprime crisis, a lot remains to be done to secure the stabil-
10
ity and durability of the financial system.­
8
Where things stand
6
The report finds that the Indian financial system has made
4 significant strides in recent years. India’s stock exchanges, in
2
particular, have developed well and become a vital source
of funding for enterprises and an alternative savings instru-
0 Author: Celasun, 6/4/08 ment for households. Stock market capitalization has risen
1985–89 1990–94 1995–99 Proof 2000–04 2005–08
significantly—aided by financial inflows from abroad—and
Sources: CEIC; IMF, International Financial Statistics; and authors’ calculations. the technical infrastructure of equity trading is state of the
art (see Chart 2).­
The Indian government has taken a number of steps to
Chart 2 improve the banking system. Banking reforms, which started
Equity boom nearly two decades ago, have increased the efficiency of the
The rapid expansion of India’s stock markets has helped fuel banking system, and the ratio of nonperforming loans to
corporate growth, but debt markets remain small. deposits is about 1 percent—a remarkably low level. Many of
(percent) the public sector banks have become quite profitable and well
300
capitalized, and they coexist with a vibrant private banking
Stock market capitalization as percent of GDP system.­
250 Government debt as percent of GDP However, in terms of overall financial depth—the size of
200
the financial system relative to the economy—India does not
compare favorably with other countries or even most other
150 emerging markets at a similar stage of development. Despite
100
the apparent strength of the banking system, the ratio of pri-
vate sector credit to GDP is still low by international standards
50 (see Chart 3). Some of the restrictions on the banking sys-
0
tem, and the incentives for banks to hold government bonds
rather than make loans, have stifled lending. Consequently,
19 –96

19 98
99 9 9

20 –04

8
20 00
20 01

20 06
19 95

20 2

20 03

20 05

20 0 7
19 97

–0
–0
–
19 98–

–
–

–
–
95

97

03

07
00

05
94

01

02

04

06
96

–2

the average ratio of loans to deposits in the Indian banking

19

system is much lower than in most other countries.­

Sources: CEIC; and authors’ calculations.
Note: Only publicly traded government debt is included in this chart (breakdown not available The government bond market appears large—public debt
before 2003–04). Corporate debt barely shows up on this scale, so we do not include it here.
India reports its macroeconomic data on a financial year rather than calendar year basis.
amounts to about 70 percent of GDP—but much of the stock
of government bonds is held by banks, a requirement pre-

24   Finance & Development September 2008

scribed by the “statutory liquidity ratio,” and is not traded. The forms. In turn, a well-functioning financial system is essential
corporate bond market remains woefully underdeveloped, with for the effective transmission of macroeconomic policies.­
the total capitalization amounting to less than 10 percent of Whatever their faults might be, India’s macroeconomic
GDP. Regulatory restrictions have also kept certain derivatives policies have delivered high growth and, until recently, stable
markets, especially for currency derivatives, from developing.­ inflation. Why fix what ain’t broke? Because, in the memo-
The absence of these markets is being felt sorely as India’s rable words of Bob Dylan, the times they are a-changin’.­
capital account has become more open over time, potentially Cross-border capital flows—both inward and outward—
leading to greater short-term currency volatility. India is seen have ramped up and are likely to remain large and volatile,
as an attractive destination for foreign capital, which has creating huge complications for monetary policy as these
meant large inflows in recent years through various channels, flows affect the domestic money supply, the exchange rate,
especially portfolio equity investment by foreign investors and so on. Reimposing capital controls is not a good option;
(see Chart 4). The financial system faces ever-greater chal- even existing controls are losing their potency as agile inves-
lenges in intermediating the rising amounts of foreign as well tors invariably find ways to evade them. The only viable alter-
as domestic capital in an efficient way to the most productive native is to have predictable and consistent policies that at
investments. At the same time, it will be important not to let least do not create volatility themselves and that give policy-
the capacity and expertise to regulate financial markets fall makers the flexibility to respond rapidly to shocks.­
too far behind innovations in these markets.­ What are the options for monetary policy, especially now
Clearly, there are big challenges to achieving further finan- that the demands on it are growing as the economy becomes
cial reforms. Let us start with the big picture.­ more open and exposed to a wider array of domestic and
external shocks? The Reserve Bank of India (RBI), India’s
Fine-tuning macroeconomic policies central bank, has done a good job of managing the multiple
Why do macroeconomic policies matter for financial re- mandates foisted upon it—keeping inflation under reason-
Author: Celasun, 6/4/08
forms? The links between macroeconomic Proof
management and able control, managing some of the pressures on the exchange
financial development are deep and run in both directions. rate, and coping with capital inflows—all against the back-
Disciplined and predictable monetary, fiscal, and debt man- ground of strong growth. But there is a risk that this high-
agement policies create a foundation for financial sector re- wire act has reached its limits. The recent volatility in the
rupee has revived calls for the RBI to more actively manage
the exchange rate, which is becoming increasingly difficult as
Chart 3 the capital account becomes more open. Sustained interven-
Under potential tion in the foreign exchange market can also create unrealis-
Bank financing has been rising in India . . . tic expectations about the RBI’s ability to manage multiple
(private sector credit to GDP, percent) objectives with one instrument.­
60
Focusing on a single objective—low and stable inflation—
Author: Celasun, 6/4/08
50
is ultimately the best way that monetary Proof
policy can promote
macroeconomic and financial stability. This does not mean
40
30
20
10 Chart 4
0 Pouring in
19 –96

19 98
99 99

20 –04

8
20 00
20 01

20 06
19 95

20 02

20 03

20 05

20 7
19 97

–0
–0
–
19 98–

India is attracting large amounts of portfolio investment from

–
–

–
–
95

97

03

07
00

05
94

01

02

04

06
96

–2
19

abroad.
(billion dollars)
. . . but financial depth remains low by international standards.
(private sector credit to GDP, percent, 2006) 100
Foreign direct investment
250 80 Portfolio
200 Loans
60
Other
150
40
100
20
50

0 0
India
Brazil

Poland
Canada
Japan
United Kingdom
South Africa
China
Malaysia

Thailand

Russia
Pakistan
Indonesia
Peru
Argentina
Spain

Korea
Jordan

Morocco

Colombia
Israel
France

Hungary

Czech Republic

Turkey

Philippines

Mexico
United States

Germany

Chile

Egypt
Italy

–20
19 –98
19 –93

20 000
20 –01

20 –06
19 –95

20 –02
20 –03

20 –05

8
19 –97
19 –92

19 –96

99 99

04 4
94 4

20 –07
–0
20 –0
19 –9

19 8–
97
92

00

05
01
02

07
96
91

95

03
–2
93

06
9
19

Source: World Bank, World Development Indicators. Sources: CEIC; and authors’ calculations.

Finance & Development September 2008   25

sacrificing or ignoring growth. Indeed, well-anchored infla- bution are from informal lenders at an interest rate of more
tionary expectations may well be the best tonic that mon- than 36 percent a year, well above the mandated lending rate
etary policy can provide for growth. Contrary to what some for banks, which is less than half that rate.­
commentators seem to believe, there is no long-run trade- According to the report, the solution is not more inter-
off between growth and inflation, vention but more competition
and for monetary policy to try between formal and informal
and engineer a short-run trade-
off can be dangerous. In short,
“The U.S. subprime problem financial institutions and fewer
strictures on the former. For
the inflation objective would in has highlighted the need for instance, freeing up interest rates
fact make monetary policy more and then setting up incentives for
effective and strengthen the RBI’s good regulation even in the banks to make loans to priority
hands rather than pinning them sectors such as agriculture (rather
down.­ most sophisticated financial than just mandating this by fiat)
India’s fiscal policy also needs a
makeover. There has been encour- markets. Effective regulation could lead to more credit flowing
to these sectors and in a more effi-
aging progress in reducing the
budget deficit, but this may just
is still more important in cient way. Allowing more banks,
especially smaller, well-capitalized
be a cyclical improvement as a
result of a strong economy. Recent
a nascent but fast-growing and well-governed private banks,
to operate and deliver retail ser-
events, such as the government’s financial system.” vices could also improve access to
waiver of certain farm loans and finance—making it more flexible
the growing oil subsidies, raise and more attuned to local needs.­
serious concerns that fiscal rectitude may fall prey to the elec-
tion cycle. Large deficits raise the specter of future inflation, A level playing field
and they could also suck up funds that would otherwise be Given the size of the Indian banking system and its predomi-
available for private investment.­ nant role in the financial system, banking reforms are a cor-
The size of government budget deficits matters for finan- nerstone of the overall reform program. The Indian banking
cial reforms also because the deficit is partially financed by system has been characterized by an implicit “grand bargain,”
getting banks to buy government bonds. Durable reductions whereby banks get access to low-cost deposits in return for
in the fiscal deficit and public sector borrowing requirement fulfilling certain social obligations, such as lending to prior-
are therefore crucial to reduce the constraints on monetary ity sectors and funding the government by buying govern-
policy (as prospects of large deficits make it harder to manage ment bonds. This is becoming an unviable framework as the
inflationary expectations) and allow financial sector reforms, privileges of banks, including state-owned banks, erode and
especially banking reforms, to proceed.­ constraints on them such as priority sector lending, which are
often motivated by political rather than economic consider-
Promoting financial inclusion ations, increase.­
A robust financial system is not much good if most people Maintaining public ownership of a large portion of the
don’t have access to it. Financial inclusion—which means pro- banking system is not conducive to efficiency. A one-shot
viding not just credit but also other financial services such as privatization is not realistic or even desirable, but there is a
savings and insurance products—is a key priority, especially lot that can be done even now to facilitate the transition to
in rural India. Nearly three-quarters of farm households have a more efficient banking system. One step would be to cre-
no access to formal sources of credit and lack instruments to ate stronger and more independent boards, perhaps with
insure against adverse events such as low crop yields due to a private investor owning a large strategic stake, that could
bad weather. But this problem is not limited to rural areas. manage the large state-owned banks better and with less gov-
The lack of access to formal banking services affects more ernment interference. Another would be to allow bank merg-
than one-third of poor households, leaving them vulnerable ers, especially to enable smaller and less efficient banks to be
to informal intermediaries such as moneylenders, and makes taken over. Other steps, such as freeing up banks to set up
the distribution of public transfers less efficient. And the lack branches and ATMs with less onerous licensing restrictions,
of financing and insurance stifles entrepreneurial activities.­ could foster more growth, entry, and competition in the
Mandated requirements of a certain quantum of lending to banking system.­
government-favored “priority” sectors and interest rate ceil-
ings for small loans, especially to the agricultural sector, may Keeping regulation in step with innovation
be well intentioned but have ended up restricting rather than The U.S. subprime problem has highlighted the need for
improving broad access to institutional finance. Banks have good regulation even in the most sophisticated financial
no incentive to expand lending if the price of small loans is markets. Effective regulation is still more important in a
fixed by fiat. Partly as a consequence, nearly half of the loans nascent but fast-growing financial system. The government
taken by those in the bottom quarter of the income distri- has an essential role: making the rules of the game clear and

26   Finance & Development September 2008

flexible enough to cope with financial innovation without For instance, it would make sense to level the playing field
stifling it.­ between banks and nonbank financial corporations by eas-
For instance, fostering markets for foreign exchange deriv- ing the requirement that banks finance priority sectors
atives would help domestic firms with exposure to interna- and the government. But making these changes while the
tional trade protect themselves government continues to have
from currency fluctuations. But it huge financing needs, and with-
does create some risks that foreign
investors will use those markets for
“Although a move to a single out having a more uniform and
nimble regulatory regime, could
mounting speculative runs on the
currency and that domestic firms
regulator may be premature be risky.­
The connections stretch
will get burned if they buy those in India’s context, a lot can beyond just financial reforms
derivatives without fully under- to broader macroeconomic
standing them. The solution is be done even within the reforms, which could reinforce
not to choke off these markets but individual financial sector
to make them more transparent, present framework to improve measures. For instance, allow-
subject participants to uniform ing foreign investors to partici-
disclosure standards, and prevent coordination and to clearly pate more freely in corporate
fraudulent behavior. Can all risks
be eliminated? Certainly not, but
delineate responsibilities and government debt markets
could increase liquidity in those
there are definitely ways to shift
the balance between benefits and
among existing regulatory markets, provide financing for
infrastructure investment, and
risks in favor of the former.­ agencies.” reduce public debt financing
As in many other countries, through banks. It could also
a number of financial services provide an additional risk-bear-
firms in India now operate in different financial markets ing buffer in the economy.­
(for example, insurance, banking, and mutual funds), and India’s rich and complex political process being what it is,
these markets are becoming more closely linked. These focusing solely on the big picture could bog down progress.
trends imply that regulation of each market in isolation is Hence, the report also lists a number of specific steps that
no longer the right approach. The situation right now is could get the process of reforms going and build up some
that there are multiple regulators in some areas and none in momentum as people see the benefits. Many of these are less
others. Many regulators for specific areas tend to focus very controversial but will still require some resolve on the part
narrowly, leaving financial firms unsupervised.­ of policymakers to implement. For instance, converting trade
Although a move to a single regulator may be premature receivable claims to electronic format and creating a struc-
in India’s context, a lot can be done even within the present ture to allow them to be sold as commercial paper could
framework to improve coordination and to clearly delineate greatly boost the credit available to small and medium-sized
responsibilities among existing regulatory agencies. Also, enterprises.­
instead of focusing excessively on enforcing a plethora of We believe that if other policies are in sync, implementa-
sometimes archaic rules, it certainly makes sense for regula- tion of this report’s blueprint for financial sector reforms
tors to focus on the bigger risk picture, especially in their could add significantly to India’s economic growth and
interaction with large, systemically important, financial also make a major contribution to the sustainability of this
conglomerates. Such principles-based regulation will be growth, in both the economic and the political dimensions.
more conducive to rapidly evolving financial markets and is The absence of reforms, on the other hand, would repre-
also more adaptable.­ sent not only a lost opportunity but also a huge source of
The potential risks of a financial meltdown have made risk for the economy.­ n
central bankers and regulators very cautious, perhaps rightly
so. But excessive caution is not a virtue in itself. It can pre- Raghuram G. Rajan, a Professor of Finance at the University
vent markets from becoming larger and capable of absorb- of Chicago’s Graduate School of Business, was the Chairman of
ing shocks, and stifle innovation such as the development of the Committee on Financial Sector Reforms. Eswar S. Prasad,
new markets and financial instruments. It could even gener- a Senior Professor of Trade Policy at Cornell University and a
ate more financial stress (and have perverse effects when such Senior Fellow at the Brookings Institution, was a member of
stress does hit the system) if regulators focus on a rigid set of the committee’s research team.
rules rather than taking a broader view of financial market Other members of the team who contributed to the report
exposures of institutions under their purview.­ include Rajesh Chakrabarti (Indian School of Business),
Vinay D’Costa (ICICI Bank), Ajay Shah (NIPFP, New Delhi),
Connections and small steps Professor Jayanth Varma (IIM Ahmedabad), and Sona Varma
With so many difficult challenges, where does one start? (ICICI Bank). The full listing of the members of the committee
Many of the required reforms are in fact deeply intertwined. and all contributors appears in the preface to the report.

Finance & Development September 2008   27