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Financial sector reforms | Meeting growing requirements

Financial sector reforms | Meeting growing requirements
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First Published: Thu, Sep 22 2011. 01 29 AM IST

Narendra Jadhav, Member, Planning Commission
Narendra Jadhav, Member, Planning Commission
Updated: Thu, Sep 22 2011. 01 29 AM IST
Narendra Jadhav, Member, Planning Commission
Global economic prospects today are hardly encouraging. Thanks to the G-20 process that emphasized global cooperation and coordinated policy responses, a prolonged downturn that was feared in the wake of the 2008 global financial crisis was successfully averted. After contracting in 2009, the advanced economies did resume positive growth in 2010, but it remains anaemic. Moreover, given the fiscal unsustainability and concerns over sovereign debt, the shadow of the euro zone crisis is looming large, and indeed has been lengthening. This has inevitably been creating uncertainties for emerging market economies (EMEs) in respect of the size and volatility of capital flows as well as their prospects for exports. Furthermore, the rise in oil prices and prices of commodities, including food, have led to greater adversities for EMEs like India. On the other hand, EMEs have been growing quite robustly, with India being one of the top performers in bouncing back from the shock of the global financial crisis. Nevertheless, of late, EMEs are also beset with serious difficulties. In India, sluggishness of growth is clearly evident with lowest monthly growth in industrial production (in July) in 21 months and inflation running over 9% for the eighth successive month.
While the short-run view of India and the global economy is thus clouded with grave uncertainties, arguably, this is precisely the time when a longer term view on financial sector reforms in India is called for, in the broader context of unfolding global financial sector developments.
In India, financial sector reform is seen as a process rather than an event. In fact, the Indian strategy for financial sector reforms has traditionally been based on a gradualist (“no big bang”), cautious and calibrated approach. This has served India very well through the two major crises in the recent past: the Asian crisis (1997-98) and the global financial crisis (2008). In fact, not too long ago, India was called a “reluctant liberalizer”. Not any more. After the global financial crisis, with India coming out relatively unscathed and growing faster than advanced economies, the cautious stand has been vindicated.
Over the last two-three years, virtually the entire debate on financial sector reforms—whether in advanced or emerging economies—has been placed in the context of the global financial crisis and the role that the financial sector played in it. Going forward, accordingly, financial sector reforms in India in future would need to be focused on promoting a less leveraged, less risky and, thus, a more resilient financial system that supports strong and sustainable economic growth. India’s future strategy for financial sector reforms would have to grapple with four balancing acts corresponding to four basic principles:
Balancing act I: Balancing between the drivers of financial sector growth and the requirements of the overall growth and development agenda. India’s financial system needs to meet the expanding and increasingly complex requirements of a rapidly growing economy in a cost-effective manner. This corresponds to the principle of efficiency.
Balancing act II: Balancing between the benefits and costs of greater financialization of economic activities. With the perils of excessive financialization being clearly evident from the global financial crisis, it is now recognized the world over that there must be a concrete link between the growth and development of the economy and the capacity and capability of the financial system. In particular, institutional mechanisms are needed to both pre-empt as well as deal with systemic risks. This corresponds to the principle of financial stability.
Balancing act III: Balancing between the benefits and risks of greater global integrations. A critical requirement of a globally integrating financial system is standardization and harmonization of reporting norms, aimed at bringing about global comparability. Such a convergence mechanism can help national regulators identify the vulnerabilities of their systems and enable them to take necessary steps so as to prevent the precipitation of a crisis. This corresponds to the principle of transparency (in terms of conformity with evolving global standards).
Balancing act IV: Balancing between the advantage of scale and the compulsions of diversity. In countries like India, provision of financial access to millions of people in widely differing local environments (in terms of levels of income, means of livelihood and infrastructure conditions) is imperatively needed. This corresponds to the principle of “inclusion”.
In operational terms, given the underlying objective, the Indian strategy for financial sector reforms, as encapsulated in the four balancing acts and corresponding principles stated above can be discussed in terms of two main challenges—financial sector development (i.e., development orientation) and financial sector stability (i.e., stability orientation)—both in the context of the evolving global economy and the collaborative framework emerging from the G-20 process that is currently under way.
I. Imperative of financial sector growth and development
Following the unprecedented macroeconomic crisis of 1991 and the initiation of comprehensive macroeconomic, structural and financial sector reforms in its wake, India’s economic growth accelerated sharply from the long-term average annual growth rate of 3.5% until the mid-1980s to over 9% during the three-year period before the global crisis in 2008 (i.e., during 2005-08). According to International Monetary Fund estimates (IMF), India’s gross domestic product (GDP) rose from $0.5 trillion in 2000 to $1.9 trillion in 2011. It is often not recognized that financial sector growth and development has contributed to this remarkable performance in no small measure. Illustratively, bank credit to GDP ratio improved from 29% at end March 2000 to 55% by end-March 2010.
Notwithstanding recent sluggishness, the Indian economy is expected to continue its robust economic growth. As is being widely recognized, the Indian economy has the potential to become the third-largest GDP in the world in the next two decades. More specifically, according to the Planning Commission estimates, India’s GDP is likely to grow from $1.9 trillion in 2011 to $5.8 trillion in 2020 and further to $10 trillion by 2025. This order of acceleration of overall economic growth calls for strong growth and development of India’s financial sector.
This, in turn, requires several policy initiatives:
• Creation of a vibrant and liquid bond market along with reforms of the government securities (G-Sec) market so as to establish a G-Sec yield curve for all maturities against which corporate bonds can be priced.
• Development of derivative markets so as to facilitate better price discovery as well as risk transfers.
• Establishment of infrastructure debt funds, given the proposed sharp increase in investment in infrastructure. (Illustratively, during the 12th Plan period, the total investment in infrastructure is likely to increase to $1 trillion, 50% of which is expected to come from the private sector.
• Achievement of economies of scale in the public sector banking system through both capital infusion and consolidation. Greater competition also needs to be injected through the issue of fresh banking licences to the private sector along with foreign participation.
• Commitment to financial inclusion and literacy through development of tailor-made, innovative retail financial products (covering thrift, credit and insurance) as well as development of innovative mechanisms for promoting financial literacy.
II. Imperatives of financial stability
Of late, virtually the entire debate on financial sector reforms—whether in advanced economies or EMEs—has been placed in the context of the global financial crisis. Indeed the ongoing G-20 process has greatly contributed to the emergence of a collective view on balancing the role of the financial sector in the development process, while emphasizing the need for global coordination on regulation.
Since India has been recognized by IMF as one of the 25 jurisdictions as having systemically important financial sectors, future financial sector reforms should be dovetailed into the broader context of developments in international regulatory and supervisory framework, adapting them gradually with country-specific factors, wherever deemed necessary.
In this regard, several issues merit attention:
• Prudential regulation
National implementation of the Basel III capital requirements in respect of common equity will begin on 1 January, 2013, and is expected to be completed by 2015. Thereafter, the calibration of the capital conservation buffers will commence, reaching the final level at the end of 2018. Indian banking system is not likely to be unduly stressed on account of the Basel III proposals since the system is already maintaining a high level of capital to risk assets ratio, but there is no room for complacency.
Some elements of countercyclical policies vide provisioning norms and differential risk weights are already being implemented in India (e.g., for the real estate sector, capital markets, and personal loans) so as to control build up of risks. These would have to be strengthened.
Systemically important financial institutions (SIFIs)
The Seoul summit (November 2010) of the G-20 endorsed the policy framework, work processes and timeliness proposed by the Financial Stability Board (FSB) with a view to reducing the moral hazard risks posed by SIFIs.
In India, financial conglomerates, as SIFIs are popularly called, are subject to robust supervision, but their regulation will need to be improved upon, drawing from international policy developments. The constitution of the Financial Stability Development Council (FSDC) in December 2010 for addressing inter-regulatory coordination issues among the Reserve Bank of India (RBI), Securities and Exchange Board of India and Insurance Regulatory and Development Authority is a welcome move in this direction, which would have to be strengthened over time.
Monitoring macro-prudential risks
A macro-prudential approach is generally defined as a policy that focuses on the financial system as a whole, treating aggregate risk as endogenous with regard to the collective behaviour of institutions. The objective of macro-prudential policy is to unburden the monetary policy from the objective of financial stability.
Putting in place a framework of macro-prudential regulation has been a key plank of the global regulatory reform agenda spearheaded by FSB, IMF, and the Basel Committee on Banking Supervision (BCBS).
In particular, FSB, IMF and the Bank for International Settlements have been jointly working on developing framework for macro-prudential policy.
In India, the use of a macro-prudential tool kit has achieved a fair degree of success in countering the potential adverse impact on banks’ balance sheets, emanating from asset-price fluctuations and high credit growth in some sectors. Several gaps, however, remain in developing an appropriate analytical framework, especially in respect of improving its reliability and forward-looking capacity in assessing systemic risks. This would have to be attended to as financial sector reforms unfold.
Convergence with international financial reporting standards
In the G-20 forum, the importance of achieving a single set of high-quality improved global accounting standards has been emphasized. In fact, in the Seoul summit, G-20 leaders urged the International Accounting Standards Board and the Financial Accounting Standards Board to complete their convergence project by end 2011. In India, the road map for convergence of Indian Accounting Standards with International Financial Reporting Standards has been laid down and is expected to be achieved in three phases.
Expanding and refining the regulatory perimeter
At the G-20 Seoul summit, in view of the completion of the new capital standards for banks (Basel III), leaders recognised the potential for regulatory tightening to increase the incentives for business to migrate to the “shadow banking system” and the need to close regulatory gaps. They requested that FSB, in collaboration with other international standard setting bodies, develop recommendations to strengthen the regulation and oversight of the “shadow banking system” by mid–2011.
In the Indian context, the shadow banking system, as it prevails in much of the developed world, is largely irrelevant. Non-banking financial companies (NBFCs) are regulated by the Reserve Bank. They are also required to comply with relevant provisions of the Companies Act, 1956, (being companies) and Sebi regulations. RBI’s regulatory perimeter extends to financial entities accepting public deposits and those non-deposit taking financial entities involved in asset financing, providing loans and investments. The regulatory and supervisory architecture is, however, geared towards systemically important non-deposit taking entities. Certain categories of entities carrying out non-banking financial institution (NBFI) activities are exempted from RBI regulation by virtue of being regulated by another regulator.
For example, mutual funds, insurance companies, stock broking companies, merchant banking companies and venture capital funds are regulated by the respective sector regulators. This regulatory framework raises two sets of issues which could engender possible regulatory gaps: First, a need to plug gaps and tighten controls for the entities regulated by RBI and second, the functional activities being unregulated due to the present system of entity regulation. These issues would have to be addressed.
Of late, a gamut of issues related to the regulation of microfinance institutions (MFIs) in the country have emerged. RBI set up the Malegam committee to study the issues and concerns in the MFI sector, which include, inter alia, charging high interest rates, coercive recovery practices and malpractices in lending such as multiple lending, ever-greening of loans and lending beyond the debt sustainability of households. The committee submitted its report in January.
Prompt action on this front would also have to be an integral part of the future financial sector reforms in India.
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First Published: Thu, Sep 22 2011. 01 29 AM IST