Are winds of change blowing through the hallowed portals of India’s central bank, which turned 75 this year? Last month it took quite a few baby steps towards financial sector liberalization. It expanded the scope of currency futures by allowing stock exchanges to offer future contracts in pairs of euro-rupee, Japanese yen-rupee and pound sterling-rupee in addition to dollar-rupee; introduced plain vanilla credit default swaps, or CDS, for corporate bonds; and permitted banks to set up as many branches as they wish to in smaller cities and towns without its approval.
Winds of change: The Reserve Bank of India is slow in opening up the financial sector, but the government, too, needs to walk the talk. Mint
Ahead of these measures, in August, the Reserve Bank of India (RBI) introduced interest rate futures and, in September, put up the draft guidelines on repurchase, or repo of, corporate bonds with a commitment to issue the final guidelines by end-November. And now, within a week of Prime Minister Manmohan Singh announcing at the India Economic Summit of the World Economic Forum that his government will carry out large-scale financial sector reforms to push economic growth, RBI has proposed that banks should be allowed to offer plain vanilla cross-currency options to resident Indians. When it finalizes the draft guidelines, importers and exporters will also be allowed to write and sell put options both in foreign currency-rupee and cross-currencies and earn a premium on them.
The credit for shaking the central bank out of a self-congratulatory mode for protecting the Indian financial system from the brunt of the sub-prime crisis and the global meltdown in the wake of the collapse of US investment bank Lehman Brothers Holdings Inc. goes to finance minister Pranab Mukherjee. In July, in his post-budget meeting with the central board of RBI, Mukherjee focused on the need for financial sector reforms. He spoke about better coordination among regulators, bringing all financial market regulations under the capital market watchdog, and setting up a separate public debt office, relieving RBI of its role as the investment banker for the government. He also called for new regulation for supervision of non-banking finance companies and inclusion of financial stability in the Act that governs the Indian central bank.
In the past few years, at least three expert panels have looked at what needs to be changed in the Indian financial sector and who should do it. Let me attempt a status report.
Also Read Tamal Bandyopadhyay’s earlier columns
Regulatory pre-emptions: Indian banks’ investment in government bonds and cash reserve ratio (CRR), or the portion of deposits kept with RBI, is very high compared with other economies. They should come down.
They continue to be very high, 30% of banks’ deposits, even though the regulatory minimum limits on such preemptions have been removed.
Directed lending: Currently, 40% of bank loans (35% for foreign banks) are to be given to agriculture and small business units and a substantial portion of them at concessional rates, but it has not helped financial inclusion. Ideally, banks should move from a mandated directed lending target to a market-based approach. Suggestions include allowing banks to set their own targets, making mandated loan obligations tradable and offering direct subsidies instead of forcing banks to give loans at low rates.
An internal RBI panel has suggested replacement of mandated loan rates by direct subsidy. The central bank is also in the process of setting up a working group to examine the issues involved in the introduction of priority sector loan certificates and trading them on exchanges.
Consolidation: Expert panels have been in favour of consolidation in the Indian banking system and leveraging the scale. One panel even suggests selling small underperforming public sector banks to other banks or strategic investors and allowing acquisitions by domestically incorporated subsidiaries of foreign banks.
Nothing has happened so far even as the “too big to fail concept” is being challenged globally. Also, no foreign bank has opted for the local subsidiary route as yet.
Abolition of branch licensing: Banks should be free to set up branches and ATMs anywhere, except for foreign banks in urban India. Also, sale, closure and exchange of bank branches should be allowed.
Substantial progress has been made on this front. Banks are free to set up ATMs and the domestic players are free to open branches in smaller towns with a population of 50,000 or less, provided at least one-third of such branches are in under-banked pockets. Opening of branches in tier 1 and tier 2 centres continues to require RBI permission.
Ownership and management of public sector banks: Direct government ownership in these banks should be reduced from 51% and they should be board-managed companies. Large public sector banks should have stronger boards with possibly a private sector strategic investor; they should have the power to appoint and compensate top executives and take all business decisions without any intervention by the government.
Nothing has happened so far. Public sector banks continue to run like a wing of the finance ministry.
Rural banking: Small, well-governed, private deposit taking institutions should be allowed to focus on specific geographies on the lines of local area banks. Unviable cooperative banks should be closed and well-run cooperatives with a good track record should be allowed to convert themselves into small banks, with their members becoming shareholders.
RBI is planning to revive the rural cooperative credit structure by mergers and capital infusion in regional rural banks and changing the regulatory and supervisory framework for urban cooperative banks.
Banking correspondents: A wide range of local agents should be employed to extend financial services. While technology can cut costs to improve the viability of the model, they should be allowed to levy user charges to recover costs of services.
RBI has allowed banks to appoint grocery stores, medical and fair price shop owners, individual public call operators, petrol pump owners, agents of small savings schemes, retired teachers and members of well-run self-help groups as banking correspondents. Banks can now impose reasonable service charges on customers.
Insurance: The Insurance Laws (Amendment) Bill, 2008, which was introduced by the government in the Rajya Sabha in December 2008, provides for enhancement of share holdings by a foreign company, either by itself or through its subsidiary firms or its nominee in Indian insurance companies from 26% to 49%.
The Bill is pending parliamentary approval.
Tax rationalization to boost long-term savings: A separate tax exemption limit is recommended for long-term life insurance and pension/annuity products. A similar provision may be considered for investment in dedicated close-ended infrastructure mutual funds and long-term bank deposits. Tax arbitrage between debt mutual funds and bank deposits needs to be minimized/eliminated.
The direct tax code proposes the removal of most exemptions to reduce tax arbitrage between various investment schemes.
Pension reforms: Private sector entities should be permitted to manage pension funds of Central government employees. Besides, all categories of pension and provident funds should be permitted to diversify their investment portfolios.
Private sector entities have been invited to manage pension funds of Central government employees. Changes have been proposed by the finance ministry in provident fund guidelines for more flexibility in investments, especially in corporate and PSU (public sector units) bonds, but they are yet to be approved by the ministry of labour.
Debt market: The bond market in India remains limited in terms of nature of instruments, their maturity, investor participation and liquidity.
Disclosure requirements have been simplified for listed companies and the cap on investment by foreign institutional investors, or FIIs, has been lifted from $6 billion to $15 billion. The final guidelines for repo in corporate bonds will be released later this month. Plain vanilla over-the-counter CDS for corporate bonds for resident Indians are being introduced.
Derivative markets: Currency and interest rate derivative market is a key missing link in Indian markets. Besides, banks are not permitted to deal in equity derivatives and commodity derivatives.
Exchange-traded interest rate futures were introduced in August and their scope has been increased by permitting currency futures contracts in three other currency pairs beside dollar-rupee.
Regulations: The expert panels are divided on the critical issue of single regulator versus multiple regulators. The finance ministry seems to believe that all market regulations and supervision should be consolidated under the Securities and Exchange Board of India, or Sebi. The capital market regulator should oversee trading of currency futures, interest rate futures, government and corporate bonds.
RBI has strong reservations on this proposal.
There are quite a few other suggestions. For instance, financial houses should be allowed to set up holding companies for various intermediaries that come under different regulators. A financial holding company can raise and allocate resources in various subsidiary companies, depending on their needs, thereby using capital efficiently within the group as well as segregating risks across various financial businesses. Such holding companies should be supervised by a financial sector oversight agency while its subsidiaries will continued to be regulated and supervised by respective regulators.
Indeed RBI is slow in opening up the financial sector and withdrawing from certain areas where Sebi should step in, but the government, too, needs to walk the talk. In three most critical areas of reforms—ownership of public sector banks, insurance firms and banking consolidation—the onus is on the government to change the rules of the game. The buck does not stop with RBI.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint in Mumbai.
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