India's Financial System | A History

Illustrate the history of Indian Financial sector, and highlight what were the major changes that took place in liberalization policies of 1991-92 in India’s Financial Sector.

An efficient, articulate and developed financial system is indispensable for the rapid economic growth of any country/economy. The process of economic development is invariably accompanied by a corresponding and parallel growth of financial organizations. However, their institutional structure, operating policies, regulatory/legal framework differ widely, and are largely influenced by the prevailing politico-economic environment. Planned economic development in India had greatly influenced the course of financial development. The liberalization/deregulation/globalization of the Indian economy since the early nineties has had important implications for the future course of development of the financial system/sector. The present essay sketches the main stands in the evolution of the Indian financial system against the background of the development of planning and economic liberalization. The focus of description of the emerging trend is organizational /structure / institutional and not quantitative data. The evolution of the Indian financial system falls, from the viewpoint of exposition, into three distinct phases. Accordingly, the essay is divided into three parts corresponding to the three phases. The principal features of the organization of the Indian financial system before 1951 are outlined in Phase 1. The main elements of the system during the second phase are presented in Phase 2. Phase 3 is devoted to delineating the emerging scenario in the post 1990 period.

The role of financial system in economic development has been a much discussed topic among economists. Is it possible to influence the level of national income, employment, standard of living, and social welfare through variations in the supply of fiancé? In what way financial development itself is affected by economic development? There is no unanimity of views on such questions. A recent literature survey concluded that the existing theory on this subject has not given any generally accepted model to describe the relationship between finance and economic development. In the environment-friendly, appropriate-technology-based, decentralized Alternative Development Model, finance is not a factor of crucial or critical importance. But even in a conventional model of modern industrialism, the perceptions in the regard vary a great deal. One view holds the finance is not important at all. The opposite view regards it to be very important.

Following section provides a brief history of India’s shift from financial repression to financial liberalization. Seven interrelated challenges that India faces in its second wave of financial sector reforms:

1. reducing the fiscal deficit, to reduce the risk of macroeconomic instability and to increase the availability of finance to the private sector;
2. improving the legal, regulatory and supervisory frameworks, in order to improve banks’ credit and risk management;
3. improving systems for dealing with weak banks;
4. developing capital markets further,
5. developing pensions and insurance to increase finance for long term investments, including infrastructure;
6. improving financial services to improve the welfare of customers and meet the challenge of globalization of financial services; and
7. managing links to external capital markets;
8. and possible approaches to meeting these challenges.

Phase-I: PRE-1951

The organization of the Indian financial system before 1951 had a close resemblance with the theoretical model of a financial organization in a traditional economy. A traditional economy, according to R. L. Bennett, “is one in which the per capital output is low and constant.” The principal features of the pre-1951 financial system were aptly described by L.C. Gupta as: “The principal features of the pre-independence industrial financing organizations are the closed-circle character of industrial entrepreneurship; a semi organized and narrow industrial securities market, devoid of issuing institutions and the virtual absence of participation by intermediary financial institutions in the long term financing of the industry. As a result, the industry had very restricted access to outside savings. It simply means that the financial system was not responsive to opportunities for industrial investment. Such a financial system was clearly incapable of sustaining a high rate of industrial growth, particularly growth of new and innovating enterprises.

Phase II: 1951 to MID-EIGHTIES

In sharp contrast to the position around 1951, when the organization of the financial system left much to be desired, the ability of the system to supply finance and credit to varied enterprises in diverse forms was greatly strengthened during the second phase. Th organization of the Indian financial system during the post-1951 period evolved in response to the imperatives of planned economic development. In pursuance of the broad economic and social aims of the state to secure economic growth with social justice as enshrined in the Indian Constitution, under the Directive principles of State Policy, the scheme of planned economic development was initiated in 1951. The introduction of planning had important implications for the financial system. With the adoption of mixed economy as the pattern of industrial development, in which a complimentary role was conceived for the public and private sector, there was a need for an alignment of the financial mechanism with the priorities laid down by the Government’s economic policy. In other words, planning signified the distribution of resources by the financial system to be in conformity with the priorities of the five-year plans. The requirement to allocate funds in keeping with the corresponding pattern implied Governmental control over distribution of credit and finance. The main elements of the financial organization in planned economic development could be categorized into four broad groups:

1. Public /Government ownership of financial institutions.
2. Fortification of the institutional structure.
3. Protection to investors and
4. Participation of financial institutions in corporate management.

Phase III: Post Nineties

The organization of the Indian financial system, since the mid-eighties in general, and the launching of the new economic policy in 1991 in particular, has been characterized by profound transformation.

Needs for economic reforms or new economic policy was felt mainly because of the following reasons:

Increasing in fiscal deficit was main reason to bring new economic policy. It was 5.4% of gross domestic product in 1981-82 and rose up to 8.4 % of GDP in 1990-91.

Disequilibrium in balance of payment is occurred when total imports exceed the total exports. In 1980-81 it was adverse with the Rs. 2,214 Crores and rose up to 17,367 Crores in 1990-91.

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Petrol priceswere at high at the time of Iran war in 1990-91 and during that time India did not get any remittances from gulf countries and which lead to adverse balance of payment. It was called Gulf Crisis.

Diminishing foreign reserves were not sufficient even to pay two weeks’ imports in 1990-91. Reserves were Rs 8151 crores in 1986-87, declined up to 6252 crores in 1989-90.

Increasing pressure of inflation due to rise in prices. Cost of production is high due to high rate of inflation which affects the domestic and foreign demand.

Lack of sufficient gain form public sector in recent years due to poor performance of some of the public sector enterprises and suffered loss.

On view of above reasons it was inevitable for the government to adopt new economic policy.

The fundamental philosophy of the development process in India shifted to free market economics and the consequent liberalization /deregulation /globalization of the economy. Major economic policy changes such as macro economic stabilization, delicensing of industries, trade liberalization, currency reforms, reduction in subsidies, financial sector/capital market/banking reforms privatization/disinvestments in public sector units, tax reforms, and company law reforms in terms of simplifications and debureaucratisation were gradually implemented, and they have had far-reaching impact on the structure of the corporate industrial sector in India. In such an emerging economic scenario, the role of the Government in economic management did obviously shrink and with greater momentum in the process of economic liberalization/globalization, the relative importance of the Government in this sphere will decline further. As a logical corollary, the role of the Government in the distribution of finance and credit is marked by a considerable decline and the organization of the Indian financial system, dominated until the mid-eighties by state control is witnessing capital market-oriented developments/ reforms. The capital market is emerging as the main agency for the allocation of resources and all segments of the Indian economy like the public sector, private sector, and state governments are competing to raise resources in the capital market. The essence of these developments is the fact that the Indian financial system is poised for integration with the savings pool in the domestic economy and abroad. The notable developments in the organization of the Indian financial system during this phase are briefly outlined below with reference to (i) privatization of financial institutions (ii) reorganization of institutional structure and (iii) investor protection. The phase III organization of the Indian financial system is portrayed in the figure 1:-

Post -1991 phase organization of the Indian Financial System

Source: Khan, MY “Indian Financial System” p 2.17

Main Features of economic reforms

Privatization

Globalization

Liberalization

In the context of economic reforms, Privatizationmeans allowing the private sector to setup more and more of such industries as were previously reserved for public sector. Under it existing enterprises of the public sector are either wholly or partially sold to private sector.

Privatization was brought due to less output of public sector. It was just due to lack of decision making of managers in public sector enterprises who always took decisions over a long time. Consequently productivity of the public sector was to go down. In view of these reasons privatization was brought into existence so that there would be more competition, quality of production and customer may be benefited.

Following measures were adopted in respect of privatization under economic reforms:

Sale of Public sector securities

Disinvestment in public sector

Number of industries exclusively reserved for public sector was reduced from 17 to 4

Investment in private sector was at maximum

Globalizationmeans integrating the economy of a country with the economies of other countries under condition of freer flow of trade and capital and movement of persons across borders.

In the globalization policy it was assumed that Indian economy should have linked with the rest of world so that there may be mutual cooperation of Indian economy with the rest of the world. Following measures were adopted under the globalization of Indian economy are as under:

Foreign investment limit raised i.e. 40 percent to 51percent.

Devaluationwas taken place in 1991 to the extent of 20 percent on an average to promote export, import substitution and foreign capital.

Partially convertibility of Rupee means to buy or sell foreign currency like, dollar or pound sterling for foreign transactions at a price determined by the market,

Tariffs are being reduced on export and import gradually.

Long duration policy (five year plan) was introduced for trade.

Liberalization of the economy means to free it form direct or physical controls imposed by the government.

Before 1991 government had imposed many controls like restrictions on big house investment, licensing policy, foreign exchange controls etc. but these controls spread over the economy only corruption, long time process, political interference, and inefficiency. The rate of growth was fallen down and reserves of foreign exchange were just sufficient to cater the needs of two weeks’ import only. There was political instability, inflation, gulf crisis, rising deficit in balance of payments etc. To bring the economic stability and put the economy into the path of consistent growth it was must to remove the curb rising pricing, correct adverse balance of payments etc.

Following measures adopted under the liberalization in Indian economy are as under:

End up of the rigid licensing system as a result of adopting the liberal policy since 1991, new industrial policy was announced in which all industries were kept license free except 6 industries i.e. 1) liquor 2) cigarette 3) defense equipments 4) industrial explosives 5) dangerous chemicals 6) drugs.

Free from MRTP(Monopolies and restrictive trade practice) Provision. Thecompanies which have assets more than 100 crores need not to get prior approval of the government.

Abolish the limit of production expansion and investment limit for the small industries.

No barrier to import the technology and no need totakepermissionfor doing high technology contract.

Financial Sector reforms and Liberalization

A vibrant efficient and competitive financial system is necessary to support the structural reforms in the real economy. As pointed out by the tenth five year plan, “An important outcome of financial sector reforms is that it contributes to greater flexibility in the factor and product markets with the real sector becoming increasingly market driven and engulfed by a competitive environment there is need for a matching and dynamic response from the financial sector.” This is possible only if the productivity and efficiency of the financial system improves. Keeping this in view, the government set up a committee on the financial system in 1991 and on banking sector reforms in 1998. (Narasimham Committee).

It is in the context of foregoing features of Indian Banking in the post- nationalization period that the Narasimham Committee I (Committee on Financial Sector, 1991) suggested a comprehensive framework for the reorganization/reform of the system.

With the implementation of several recommendations of Narasimham Committee I, there had been far-reaching changes in the practices, policies and structure of banking system. They are briefly summarized below:

1. Inflationary pressures generated by large budgetary deficits were combated by raising the level of the statutory liquidity ratio (SLR) and the cash reserve ratio (CRR) in 1980.

The committee favored reduction in CRR. The RBI should have the flexibility to use it as an instrument of monetary policy. The rate on SLR should get linked with markets rates and rate of interest on CRR should be broadly related to banks’ average cost of funds.

SLR brought down 25 percent in 1997 and CRR brought down 4.5 percent in 2003 to remove adverse effect on profitability of banks.

2. Deregulate Interest rates. The committee favored deregulation of interest rates. The recommendations regarding interest rates were:

1. Deregulate interest rates to reflect emerging market conditions.
2. Link deregulation with reduction in fiscal deficits. Premature deregulation could be dangerous.
3. Ceilings on bank deposit rates be increased with progressive reduction of SLR
4. Concessional interest rates be phased out.
5. Structure of interest rates should bear a broad relationship with bank rate.
6. It will be desirable to provide for prime rate, which will be minimum lending rate by banks and institutions.

The interest rates for deposits and loans almost completely deregulated in April 1998. All advances from RBI are now linked to the bank rate. Lending rates of banks have been linked with prime lending rate (PLR) from 1997.

3. Capital Adequacy Norms. The committee recommended bank of international standards (BIS) norms in a phased manner. The capital adequacy ratio of 4% may be achieved by March 1993 by banks and financial institutions and BIS norms of 8% by March 1996. Profitable banks may raise funds from the capital market immediately.

All banks have attained the norm (except UCO & Indian Bank)

4. Income recognition. The committee recommended :

1. In banks and financial institutions which are following accrual system of accounting, no income should be recognized in respect of non-performing assets (NPA’s).
2. An asset would be considered NPA, if interest on such assets is past due for a period exceeding 180 days on balance sheet date(past due means outstanding for 30 days beyond due date).

New norms be attained over a period of three years.

Provisions regarding income recognition have been implemented in a phased manner and are being further strengthened.

5. Structure of banking system. Regarding structure of the banking system it should evolve towards a pattern of

1. 3 or 4 large banks (including SBI) which could be international in character.
2. 8 to 10 national banks with branches throughout the country engaged in universal banking.
3. Local banks with operations in specified region
4. Rural banks (including RRB’s) confined to rural areas concentrating on agriculture finance.

Setting up of new private sector banks and entry of foreign banks has been allowed. Number of private banks has come up.

6. Branching licensing :

1. Branch licensing should be abolished. Opening and closing of branches (other than rural ) be left to the judgment individual bank
2. A government should be more liberal with opening of branches of foreign banks. They should be treated at par with domestic banks
3. The internal organization be left to the bank. In case of national bank a three tier structure of head office, zonal office and branches is favored. Local banks may be to tears and SBI may have four tears.

Branch licensing has been liberalized. Domestic banks satisfying capital adequacy requirements are free to start branches.

7. Computerization. Committee favored Rangrajan Ccommittee on computerization. Computers are indispensable tools of customer service.

An agreement for the computerization was signed with trade unions. Bank computerization is taking place at a fast pace.

8. Control. The committee favored less regulated and administered system. Duality of control over banks between RBI and Banking Division of Ministry of Finance be ended. Only RBI should control. The supervisory function of banks and financial institution be given to a quasi autonomous body working under RBI.

Board for Financial Supervision (BFS) has been set up. BFS supervises financial institutions, NBFC’s in addition to banks.

9. Development Financial Institutions (DFT’s):

1. They should be granted operational flexibility, measure of competition and adequate internal autonomy.
2. A system of syndication or participation in lending should be evolved.
3. While commercial banks should be encouraged to provide term finance, DFI’s should be encouraged to finance core working capital.
4. Cross equity holdings amongst DFI’s should be done away with
5. Regulated framework be developed for new institutions like merchant banks, mutual funds, leasing companies, ventured capital companies etc. a new agency under RBI should be setup for this purpose.
6. Prudential guidelines relating to capital adequacy, debt equity ratio, income recognition, provisioning, sound financial and accounting policies, disclosures and valuation of assets should be laid down.

Others:

1. Phasing out of Directed credit. The directed credit should be phased out. The priority sector should be redefined to include marginal framers, tiny sector of industry, small business and transport operators, village and cottage industries, rural artisans and other weaker sections. The credit target of this sector should be fixed at 10 %. The segments which will be taken out of priority sector should be covered through a preferential refinance scheme.

Number of directed credit categories and interest rate subsidy element has been reduced. Weaker sections under priority sectors have been redefined. Return on loans to SSI units has been increased.

2. Adoption of Uniform Accounting Practices. The banks and financial institutions should adopt uniform accounting practices. This is particularly required with regard to income recognition and provisioning against doubtful debts. Valuation of investments should be done on the lines suggested by Ghosh Committee on financial accounts.

Prudential accounting norms regarding income recognition, asset classification and provisioning have been implemented.

Valuation norms of investment in Government securities are being brought at par with international practices. In 1992, banks were directed to divide their investments into ‘permanent’ and ‘current’ categories and to keep not less than 30% of their investment in current category in 1992-93.

3. Provisioning. The committee recommended that:

1. The assets should be classified in to four categories- standard, sub-standard, doubtful and loss assets.
2. Provision of 10 percent in case of substandard assets and 100 percent of security shortfall in case of doubtful debts. In case of secure debts in doubtful category a further provision of 20 to 50 percent should be created. Loss assets should be either fully written off or hundred percent provision should be created.

Asset classification and provisioning have been implemented.

4. Transparency. The balance sheets of banks and financial institutions should be made transparent. Full disclosure be made as per international accounting standards committee norms. This may be done after implementing income recognition and provisioning norms.

Implementation of computerization of banks will support to transparency.

5. Asset Reconstruction fund (ARF). The need is that –

1. An ARF with special power be set up, which should take off bad and doubtful debts from balance sheets at a discount.
2. Special tribunals as recommended by Tiwari Committee be setup to speed up process of recovery.

Special debts recovery tribunals have been setup.

Banking ombudsman scheme was introduced for speedy settlement of customer disputes.

Conclusion:-

Crisis, increase in fiscal deficit, adverse balance of payments, fall in foreign reserves, rise in price, etc. create difficult problems for the financial sector in an economy which impose heavy social costs. The economy has been strengthened and currently is close to International Standards since the recommendations of Narasimham Committee- I have been adopted.