Indian Financial Sector Reform

Submitted by:- Surangama Banerjee Gaurav Gupta

Coverage:-

Introduction

Major Contours of Reforms

Banking Sector Reforms

Monetory Policy Reforms

Financial Market Reforms

Assessment

Conclusions

In early 1990’s

• Financial Repression - Extensive Regulations- Administered Interest Rates- Directed Credit Programmes- Weak Banking Structure- Lack of Proper Accounting & Risk Management Systems- Lack of Transparency in Operations

In early 1990’s

- Pre-emption of resources from the banking system by the govt. 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- Poorly developed debt and money market.- Outdated technological and institutional structures that made

the capital markets and the rest of the financial system highly inefficient.

Resulting into…

- Govt. regulated the price at which firms could issue equity, the rate of interest which they could offer on their bond, and the debt equity ratio that was permissible in different industries.

- Working capital was financed almost entirely by banks at interest rates laid down by the central bank

- Working capital finance was related more to the credit need of the borrower than to creditworthiness.

At larger level…

• The balance of payment crisis that threatened the international credibility of the country and pushed it to the brink of default.

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

• Hindered efficient allocation of resources.

Major Contours of Reforms• Removal of existing financial repression.• Creation of an efficient, Productive and profitable financial sector.• Enabling the process of price discovery by the market determination

of interest rates that improves allocative efficiency of resources.• Providing operational and functional autonomy to institutions• Preparing the financial system for increasing international

competition.• Opening the external sector in a calibrated manner.• Promoting financial stability in the wake of domestic and external

shocks.

• First Generation (Early 1990):- Ist Phase: — Creating an efficient, productive and profitable financial sector to function with operational flexibility and functional autonomy.

• Second Generation (Mid 1990 ...) ‘IInd phase

— Strengthening the financial system and introducing structural improvements

Major Sectors of Reforms

• Banking Sector • Monetary policy• Financial Market• Forex Market

Banking Sector Reform

• Competition Enhancing Measures• Measures Enhancing Role of Market Forces• Prudential Measures• Institutional and Legal Measures• Supervisory Measures• Technology related Measures

Banking Sector Reform : Competition Enhancing Measures • Operational autonomy to Public Sector banks in 2005 under which  PSBs

are now allowed to acquire any company, NBFC or even their private sector competitors. They also have the autonomy to enter any business which offers a greater potential for growth.

• Reduction in public ownership of public sector banks

- Can raise capital from equity market up to 49% of paid

up Capital • Transparent Norms related to entry, mergers /amalgamation and _

governance issues for Indian private sector, foreign and joint-venture banks, NBFC's and insurance companies .

• The Industrial Development Bank of India, 1964 amended to allow IDBI to raise upto 49% of its paid up capital from public and to induct private participation in its board of directors.

Banking Sector Reform : 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.• Enhanced transparency and disclosure norms to facilitate

market discipline. • Introduction of pure inter-bank call money market and

developing markets for securitized assets. • Auction-based repos-reverse repos for short-term liquidity

management and Improved payments and settlement mechanism.

Banking Sector Reform :Prudential Measures

• Introduction and phased implementation of international best practices and norms related to:- CRAR, Income recognition, Provisioning and Exposure.

• Strengthen Risk management - 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 — 'Know Your Customer’ norms — 'Anti Money Laundering' guidelines — Graded provisioning for NPA's — Capital charge for market risk • Guidelines for ownership and governance, securitization and debt

restructuring mechanisms norms, etc.

Banking Sector Reform :Institutional and Legal Measures

• Setting up of Lok-Adalats (people's courts), debt recovery tribunals, asset reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc.

• Promulgation of Securitization and Reconstruction of Financial Assets Enforcement of Securities Interest (SARFAESI) Act, 2002 and its sequent amendment to ensure creditor rights

• Setting up of Credit Information Bureau of India Limited (CIBIL) in August,2000 for Information sharing on defaulters as also other borrowers

• 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.

Banking Sector Reform : Supervisory Measures-

• Board for Financial Supervision as the apex supervisory authority for based supervision

• Introduction of CAMELS supervisory rating system (capital adequacy, asset quality, management, earning, liquidity and system and control).

• Consolidated supervision of financial conglomerates. • Recasting of the role of statutory auditors with increased

internal control through strengthening of internal audit.• Strengthening corporate governance.• Fit and proper tests for directors along-with enhanced due

diligence on important shareholders.

Banking Sector Reform : Technology Related Measures-

• INFINET as the communication backbone for the financial sector

• Negotiated Dealing System (NDS) for screen-based trading in Government securities.

• Real Time Gross Settlement (RTGS) System “True test of the success of the banking reforms

would be the extent of NPA's.”

Monetory Policy Reforms

• Objectives• Instruments• Development Measures• Institutional Measures

• Twin objectives of "Maintaining price stability" and "Ensuring lability of adequate credit to productive sectors.• Use of broad money (M2) as an intermediate target has been de-emphasized and a multiple indicator approach has been adopted.• Development of multiple instruments to transmit liquidity and interest rate signals in the short-term in a flexible and bi-directional manner. • Increase of the inter-linkage between various segments of the financial market including money, government security and forex markets.

Monetory Policy Reforms:

Objectives

Monetory Policy Reforms: Instruments : Shifts from: Indirect to Direct

• Open Market Operation(OMO) to deal with overall market liquidity situation especially those emanating from capital flows.

• Introduction of Market Stabilization Scheme (MSS) as an additional instrument to deal with enduring capital inflows without affecting short-term liquidity management role of LAF.

• Introduction of Liquidity Adjustment Flow(LAF) which operates through repo and reverse repo auctions Liquidity Adjustment Flow(LAF).

— To nudge overnight interest rates within a specified corridor. — TO de-emphasize targeting of bank reserves and focus increasingly on interest rates. — reducing the cash reserve ratio (CRR) without loss of monetary control.

LAF + MSS + OMO => Flexibility• Transition from Direct instruments of monetary control (such as

administered interest rate, reserve requirement, selective capital control)

to indirect instruments like OMO, purchase and repurchase of govt.

securities.

Monetory Policy Reforms: Developmental Measures

• Discontinuation of automatic monetization through an agreement between the Government and the Reserve Bank.

• Amendment of Securities Contracts Regulation Act (SCRA), to

create the regulatory framework. • Introduction of automated screen-based trading in govt. securities

through Negotiated Dealing System(NDS).• Setting up of risk-free payments and system in government

securities through Clearing Corporation of India Limited(CCIL). • Phased introduction of Real Time Gross Settlement (RTGS) System • Deepening of inter-bank Repo market Deepening of government

securities market by making the interest rates on such securities market related

Monetory Policy Reforms: Institutional Measures

• Setting up of Technical Advisory Committee on Monetary with outside experts to review macroeconomic and monetory developments and advise the Reserve Bank on the instance of monetary policy

• Creation of a separate Financial Market Department with in the RBI. • Development of appropriate trading, payments and settlement

systems along with technological infrastructure. • Success of Monitory management such as interest rates, is contingent

upon the extent and speed with which changes in the central bank's Policy rate are transmitted to the spectrum of market interest rates and exchange rate in the economy and onward to the real sector.

Capital Market Reforms :

• -Abolition of capital issues control and the introduction of free pricing of equity issues (CCI)

• Securities and Exchange Board of India (SEBI) was set up as the apex regulator of the Indian capital markets.

• Primary market regulations: — Entry norms for capital issues were tightened — Disclosure requirements were improved — Regulations were framed and code of conduct laid down for — merchant bankers — Underwriters, mutual funds, bankers to the issue and other intermediaries • Corporate governance regulations: — Regulations were framed for insider trading — Regulatory framework for take overs was revamped

Capital Market Reforms:-

• Secondary market regulations: — Capital adequacy and prudential regulations were introduced for brokers, and other intermediaries — Dematerialization of scrips was initiated with the creation of a legislative framework and the setting up of the first depository — settlement period was reduced to one week — Carry forward trading was banned — Tentative moves were made towards a rolling settlement system.

Reforms in Government SecuritiesMarket:-

• Institutional Measures • Increase in Instruments in the Government

Securities Market • Enabling Measures

Government Securities Market:-Institutional Measures• Administrated interest rates on government securities were

replaced auction system for price discovery • Banks have been permitted to undertake primary dealer

business while primary dealers are being allowed to diversify their business.

• 'Central Government would cease to raise resources on behalf of State Governments. State Governments' capability in raising resources will be market determined and based on their own financial health

• Effective April 1, 2006, RBI has withdrawn from participating in primary market auctions of Government paper

— fully market based system in the G-sec market.

Government Securities Market:-Increase in Instruments

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

— 91-day Treasury bill was introduced for benchmarking — Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued — Exchange traded interest rate futures were introduced — OTC interest rate derivatives like IRS/ FRAs were introduced • Repo status has been granted to State Government securities in order to improve secondary market.

Government Securities Market:- Enabling Measures

• Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to certain limits with non-banks allowed participate in repo market.

• Introduction of trading in government securities on stock exchanges for promoting retailing and Non-banks participation.

Reforms in Foreign Exchange Market:-

• Exchange Rate Regime• Finance Mobilization• Institutional Framework• Increase in Instrument in foreign Exchange

Market• Liberalization Measures

Reforms in Foreign Exchange Market:- Exchange Rate Regime

• 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.

• Adoption of convertibility of rupee for current account transactions with acceptance of Article VIII of the Articles of Agreement of the IMF

• De facto full capital account convertibility for non residents

• Calibrated liberalization of transactions undertaken for capital account purposes in the case of residents

Reforms in Foreign Exchange Market:- Finance Mobilization

• companies were allowed to raise equity in international

markets subject to various restrictions. • Indian companies were allowed to borrow in international

markets subject to a minimum maturity, a ceiling on the maximum interest e, and annual caps on aggregate external commercial borrowings all entities put together.

• Indian mutual funds were allowed to invest a small portion of their — assets abroad.

• Indian companies were given access to long dated forward contracts and to cross currency options.

Reforms in Foreign Exchange Market:- Institutional Framework

• Replacement of the earlier Foreign Exchange Regulation Act (FERA), y 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.

Reforms in Foreign Exchange Market:- Increase in Instruments

• Development of rupee-foreign currency swap market.

• Introduction of additional hedging instruments, such as, foreign currency-rupee options

• Permission to use innovative products like cross-currency options, interest rate swaps (IRS) and currency swaps, caps/collars and forward rate agreements (FRAs) in the international forex market.

Reforms in Foreign Exchange Market:- Liberalization Measures

• Authorized dealers permitted to initiate trading positions, borrow and 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 specifications.

• Use of derivative products for asset-liability management and to overnight open position limits and gap limits in the foreign exchange market, subject to ratification by RBI.

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

2013Aug. 16 Jul. 18 Jul. 25 Aug. 1 Aug. 8 Aug. 15

1 2 3 4 5 6Ratios

Cash Reserve Ratio 4.00 4.00 4.00 4.00 4.00 4.00Statutory Liquidity Ratio 23.00 22.50 22.50 22.50 22.50 22.00Cash-Deposit Ratio .. .. 4.83 .. 4.64 ..Credit-Deposit Ratio .. .. 76.54 .. 76.06 ..Incremental Credit-Deposit Ratio .. .. 42.25 .. 38.21 ..Investment-Deposit Ratio .. .. 29.09 .. 29.39 ..Incremental Investment-Deposit Ratio .. .. 39.42 .. 44.19 ..

RatesPolicy Repo Rate 7.25 8.00 8.00 8.00 8.00 8.00Reverse Repo Rate 6.25 7.00 7.00 7.00 7.00 7.00Marginal Standing Facility (MSF) Rate 10.25 9.00 9.00 9.00 9.00 9.00Bank Rate 10.25 9.00 9.00 9.00 9.00 9.00Base Rate 9.70/10.25 10.00/10.25 10.00/10.25 10.00/10.25 10.00/10.25 10.00/10.25Term Deposit Rate >1 Year 8.00/9.00 8.00/9.05 8.00/9.05 8.00/9.05 8.00/9.05 8.00/9.05Savings Deposit Rate 4.00 4.00 4.00 4.00 4.00 4.00Call Money Rate (Weighted Average) 10.18 8.05 8.67 8.05 7.97 8.2591-Day Treasury Bill (Primary) Yield 11.43 8.60 8.60 8.65 8.65 8.65182-Day Treasury Bill (Primary) Yield 11.00 8.64 .. 8.71 .. 8.71364-Day Treasury Bill (Primary) Yield .. .. 8.70 .. 8.74 ..10-Year Government Securities Yield 8.78 8.77 8.40 8.52 8.65 8.53

RBI Reference Rate and Forward Premia

INR-US$ Spot Rate ( ̀Per Foreign Currency) 61.82 60.33 60.14 60.85 61.56 61.06

INR-Euro Spot Rate ( ̀Per Foreign Currency) 82.45 81.58 81.02 81.46 82.41 81.56Forward Premia of US$ 1-month 10.29 8.75 8.18 8.87 8.77 9.14

3-month 9.90 8.55 8.71 8.55 8.58 8.526-month 9.46 8.55 8.68 8.51 8.51 8.48

(Per cent)

Item/Week Ended2014

5. Ratios and Rates

Conclusion:-

• Financial system in India, through a measured, gradual, cautious, and steady process, has undergone substantial transformation

• Reasonably sophisticated, diverse and resilient system through well-sequenced and coordinated policy measures aimed at making the Indian financial sector more competitive, efficient, and stable

• Effective monetary management has enabled price stability while ensuring availability of credit to support investment demand and growth in the economy.

• The multi-pronged approach towards managing capital account in conjunction with prudential and cautious approach to financial liberalisation has ensured financial stability in contrast to the experience of many developing and emerging economies

• Monetary policy and financial sector reforms in India had to be fine tuned to meet the challenges emanating from all global and domestic shocks.

• Viewed in this light, the success in maintaining price and financial stability is all the more creditworthy.

• The overall objective of maintaining price stability in the context of economic growth and financial stability will remain

Thank You