4. Reform Strategies in the Indian Financial Sector

Wanda Tseng, and David Cowen
Published Date:
May 2007
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4.1 Introduction

Financial sector reforms in India in the 1990s have undeniably advanced the objectives of significantly opening the constituent segments to competition and liberalized operations. India now has a world-class equity markets infrastructure; measures are steadily being implemented to build up liquid debt markets; and banks are moving toward, even if they remain some way off, international prudential norms.

Despite this progress, one may be forgiven for a lingering perception that, if one were to start scratching the surface, things do not seem to have changed decisively. There remains a disjunction in the reported systems and structures that have ostensibly been established for safe and efficient intermediation and the perception of its soft underbelly by various stakeholders. While the discerning reader is informed almost daily of some problem or the other, official statistics indicate that most efficiency parameters are non-threatening and even improving. Yet, even in academic and policy conclaves, there emerges a sense of widespread dissatisfaction (not to mention unease) regarding the possibility of systemic risk posed by the financial sector. While there are not many overt signs of failures, by way of defaults and payments crises, there are increasing signs of structural strains in the system. The banking system remains saddled with large amounts of bad loans. The recent years have seen a succession of distress in and failures of various intermediaries, necessitating the provision of “comfort and support” from the government. Institutions remain characterized by both political and regulatory forbearance.

Is there a fundamental problem in the financial sector in India, warranting the sense of unease? By fundamental, we mean a threat to the stability of the system. Or is this more a problem of lingering inefficiency in intermediating resources, negatively impacting investment and growth? Are the discrepancies now evident simply the outcome of more stringent information disclosure requirements? Or has there been a tangible disconnect between the “ratio-centric” reforms specified by regulators and the intrinsic operating practices of many intermediaries and the environment in which they function? Are norms sufficient in mitigating financial sector fragility in the absence of effective enforcement?

This chapter seeks to investigate the validity of the unease about a systemic fragility of the financial sector. It attempts to inter alia explore the apparent divergence between “facts” and perception. The conflict, between the objectives of establishing an efficient intermediation process for channeling funds to finance private investment and the need of the government to use the intermediaries for it owns to ameliorate its increasing fiscal stress, may explain to some extent the divergence between the reported statistics and the perceived distress in the sector.

The lessons of the turbulence of the Asian markets have been assimilated in various degrees by policymakers and regulators the world over. Overt and blatant abuse of depositor flows is now largely a thing of the past. The next lesson on financial sector risks was provided in the United States a couple of years later. Despite having one of the most transparent and efficient systems, the speed and complexity of financial transactions demonstrated the pressures that can potentially be exerted on regulatory mechanisms. One of the important revelations that emerged is the increasing interlinkages between the real and financial segments of the economy. Increasing efforts to involve the private sector in economic activity in India has lent urgency to devising new regulatory and enforcement structures and practices.

There is now a large literature on the reform actions in the banking, para-banking, securities and insurance segments in India2 for a comprehensive overview. There is, however, yet little unified enunciation of the rationale and strategies underlying these changes; these are mostly available through scattered articles and speeches. An observer of the Indian financial markets may be hard-pressed to decipher a cogent message that is sought to be delivered by policymakers and regulators and will be correct in his or her conclusion that the strategy has centered on loosely interconnected strands of a “Basle regulatory framework.” The main contention of the chapter is that while reforms have reduced the fragility of the sector, it has not addressed the broader environment in which the financial sector, operates. In an attempt to construct a coherent framework to assess the efficacy of reforms in the Indian financial sector, we both develop an institutional scaffolding to embed the disparate reform strategies as well as explore select weaknesses that continue to exert a debilitating influence. Ahluwalia (2002) offers a succinct review of the political economy considerations underlying the reforms, and some of the issues raised in that paper merit deeper exploration.

The prevalent official view is that India now has quite well-developed and sophisticated institutions for both financial intermediation and regulation. This is at best only partially correct. Institutions are not merely organizations and bodies of people. They are primarily the contracts and rules that govern transactions, as well as the mechanisms through which these contracts are enforced. Contracts are critically important given the speed and complexity of modern financial transactions and the huge information inadequacies and asymmetries that are consequently generated. And it is the incentive structures underlying these contracts that are quite distorted.

One of the major distortions is that involvement of the government—not just ownership of various intermediaries—in most segments of the sector remains high. Some of the associated costs are well known: the unwarranted and onerous oversight by a multitude of government audit and law enforcement agencies, high levels of deposit preemption through mandated reserves, directed lending requirements, political meddling, and so on. The systemic implications of this feature have been extensively explored, both analytically and through an empirical assessment in Patel and Bhattacharya (2003) and Bhattacharya and Patel (2002), respectively. They argue that these distortions are more severe in India than official statistics indicate, in large part because government involvement in intermediation is much more widespread than mere ownership. The system, even after a decade of reforms, retains many discrepancies that allow banks to both sidestep regulatory norms and simultaneously avoid taking “prudent risks.” Intermediaries continue to exist with significant corpuses of funds that invest large amounts in “socially significant” activities and yet whose functions remain relatively opaque. The chapter argues that the sense of unease may, in part, emanate from the lack of information relating to the operations of not just these intermediaries but also pertaining to other activities and practices in the sector. Other operational and policy distortions remain entrenched: asymmetries in prudential norms for lending to the private sector and investing in government securities allow safe havens for bank deposits. This phenomenon is furthermore aggravated by a seemingly limitless supply of (perceived) risk-free government securities that finance the government’s fiscal deficit, ambiguities in asset classification and income recognition of legacy “development” projects plagued by time and cost overruns, inadequacies in systems for intermediating financial savings in semi-urban and rural areas, and so on.

A singular aspect of financial sector reforms in India has been that while change has come to the “look and feel” of organizations associated with intermediation, it has primarily revolved around the introduction of stricter sector regulatory standards. Caprio (1996) argues that regulation-oriented reforms cannot deliver the desired outcome unless banks are restructured simultaneously; this includes introduction of measures that empower banks to work the new incentives into a viable and efficient business model and encourage prudent risk-taking. These mechanisms are also meant to inter alia mitigate the “legacy costs” that continue to burden intermediaries even after restructuring. Some of these costs, in the Indian context, apart from the consequences of public ownership, are well known: weak foreclosure systems and legal recourse for recovering bad debts, ineffective exit procedures for both banks and corporations, and so on. In addition, during difficult times, fiscal stress is sought to be relieved through regulatory forbearance; there are demands for (and occasionally actual instances of) lax enforcement (or dilution) of income recognition and asset classification norms. A multiplicity of “economic” regulators, most of them not wholly independent, deters enforcement of directives.3

We focus primarily on the strategy, as opposed to the actions, of reform that have been undertaken. Given the systemic distortions already enunciated, the absence of a cogent strategy that addresses the kinds of issues raised by Caprio (1996) is likely to render the actions of reform largely ineffective. Of particular concern are the institutions, processes, and intermediaries that have the potential of severely disrupting the sector. We feel that a very serious lacuna in the oversight framework is the inadequate attention that has been devoted to the role of market discipline for banks and some of the other large government-sponsored systemically important financial institutions like the Life Insurance Corporation of India (LIC) and Employees’ Provident Fund Organisation (EPFO). At best, it has been seen as a supplement to supervisory discipline; at worst, the actual functioning of the system has actively militated against attempts at market discipline. Practices such as cross-holdings by institutions of common and preference shares, a flat-rated and non-risk based deposit insurance system, directed lending, investments of behemoth public sector intermediaries and retention of interest rate floors for select financial instruments are instances of these hindrances.

The crux of the arguments in this chapter is that the regulatory processes and ratios that have been gradually introduced as cornerstones of safety and efficiency in the financial sector are only a subset of the comprehensive institutional changes that are needed for “effective” reform and market discipline. We argue that there still persist deeper intrinsic shortcomings that have a high probability of negating the desired reform outcomes and that the strategy to enhance the soundness and efficiency of the sector has to be a two-step strategy, with a set of prudential and regulatory norms to infuse short-term stability and the development of market-discipline to impart long-term efficiency. Adapting a framework that had earlier been developed for a different context by Rodrik (2002), we attempt to situate the required reforms into the following categories: (i) market stabilization, (ii) market regulation, (iii) market creation, and (iv) market legitimization, with each reinforcing and complementing the processes already in place. While the reform measures have touched on aspects of each, they have been in no sense looked upon as a whole; the resulting contradictions may have weakened the effectiveness of the individual measures. As a result, intermediaries have still not graduated from being predominantly resource conduits to risk-management entities offering the cheapest possible capital to firms.

As in any paper that deals with sector-wide issues, the scope of the subject is extensive. Paucity of space does not permit us to provide a detailed description of the sector nor of all the changes that are still ongoing in different segments. The focus of this chapter is predominantly the banking sector rather than capital markets. The reasons are twofold: (i) the likelihood of problems emerging in the future appears greater among the set of deposit-taking institutions, especially given their deeper links to the public sector;4 and (ii) the impact of inefficiencies in the banking sector is likely to be greater on future economic growth.5 India also has many institutions—for instance, contractual savings institutions like insurance and pensions—that straddle both the banking sector (as deposit-taking institutions) and capital markets (where they deploy these deposits). While the chapter does not deal in detail with these aspects (which are likely to become increasingly important in the future), it does explore the potential systemic implications of the lending practices of the largest public sector intermediaries in nonbank segments.

The structure of the chapter is as follows. Section 4.2 recounts the reform actions and changing characteristics of the financial sector in India. Section 4.3 attempts to deconstruct the reform strategy underpinning these actions and analyzes the institutional, policy and regulatory context in which these reform actions were undertaken, including our perception of the main unfulfilled tasks for taking these reforms to their logical conclusion. In doing this, it attempts to take a view on the extent to which changes in the broader environment in which intermediaries function have been compatible with the official stance of reform. Section 4.4 then explores those structural characteristics of intermediation that need to be addressed if reforms in the financial sector are to achieve their stated objectives. These aspects, among others, include the overhang of the past (primarily the legacy of nonperforming assets), and the weaknesses relating to some large public sector financial intermediaries that have the potential of creating problems for the sector. Section 4.5 concludes.

4.2 Reform in the financial sector

After a decade of reforms and deregulation, the financial sector—including markets, institutions, and products—has changed, sometimes beyond recognition. The banking sector has undergone several watershed structural reforms, the capital markets are deeper and more liquid, and equity markets are currently booming. In September 2003, Standard and Poor’s (S&P) revised upwards their outlook on the Indian banking sector from negative to stable and Fitch Ratings assessed that economic reforms have considerably “strengthened” financial sector fundamentals.

4.2.1 Genesis and drivers of reform

At the onset of reforms, the heavy hand of government had been omnipresent in the financial sector, and there was very limited market-based decision making. Bank deposit and lending rates were mostly controlled. Statutory preemptions and directed lending requirements left banks little discretionary funds for commercial lending. Term lending and intermediation of contractual savings (effectively insurance) were almost completely dominated by public sector intermediaries (with the probable exception of housing finance). There were no debt markets as such; the government’s debt issues were structured in a primarily “administrative” manner by the Reserve Bank of India (RBI). A proper yield curve was nonexistent in the face of RBI interventions across the term structure of interest rates. Monetization of government deficit was automatic. The Controller of Capital Issues used to determine the pricing and magnitude of primary issues and broker-owned stock exchanges reportedly manipulated share prices.

The genesis of financial sector reform in India was the aftermath of the fiscal and external crises of the early 1990s, when many segments of economic activity were gradually freed. It was realized early on that deregulated activity required liberalized financial systems to raise resources efficiently. As domestic reforms progressed, increasing integration with global markets then became another catalyst for further reforms. Foreign entry into the banking, mutual funds and later, the insurance segments has been progressively allowed. At the same time, a series of financial crises over the years, triggered by disparate events in various countries, have alerted policy makers and regulators to the potential fragility of intermediaries in a deregulated environment and resulted in ongoing modifications and improvements in processes and disclosure requirements (see Table 4.1 for the changing profile of various segments of the sector).

Table 4.1India: comparative profile of financial intermediaries and markets(in billions of rupees, unless otherwise specified)
Gross domestic savings1,3013,9325,500
(in percent of GDP)24.322.324.0
Bank deposits outstanding2,0787,14013,043
(in percent of GDP)38.240.550.1
Small savings deposits, public provident funds, etc.1,0713,3333,810
(in percent of GDP)
Mutual funds (assets under management)2538581,093
(in percent of GDP)
Public/regulated nonbank finance companies’ deposits174a204178
(in percent of GDP)
Total borrowings by development finance institutions (outstanding)b2,108901
(in percent of GDP)12.03.5
Annual stock market turnover (BSE and NSE)c360d15,2419,321
(in percent of GDP)5.679.035.8
Stock market capitalization (BSE and NSE)c845d18,73211,093
(in percent of GDP)15.897.142.6
Annual turnover of stock market turnover (in percent)b24276
Turnover of government securities (excluding repos) through subsidiary general ledger
(monthly average)b3102,287
(in percent of GDP)1.89.0
Volume of corporate debt traded at NSE (excluding commercial paper)b958

Denotes figures at end-March 1993.

Not comparable to later periods.

Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).

Pertains to the BSE only.

Sources: Reserve Bank of India, Handbook of Statistics on the Indian Economy and Report on Trend and Progress of Banking in India (various years); and National Stock Exchange, Indian Securities Market: A Review (2003).

Denotes figures at end-March 1993.

Not comparable to later periods.

Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).

Pertains to the BSE only.

Sources: Reserve Bank of India, Handbook of Statistics on the Indian Economy and Report on Trend and Progress of Banking in India (various years); and National Stock Exchange, Indian Securities Market: A Review (2003).

4.2.2 The banking sector

Significant financial deepening has taken place over the last three decades (Table 4.2). The ratio of broad money (M3) to gross domestic product (GDP) has increased from 24 percent in 1970/71 to 63 percent in 2000/01, and the number of bank branches have increased eightfold. Commercial banks, especially public sector banks (PSBs), have an inordinately large presence in rural and semi-urban areas, which accounts for much of their expansion in recent decades. While only 34 percent of their deposits are sourced from and 23 percent of their advances are disbursed in these areas, 70 percent of their branches are located there.6 The RBI licensing conditions for new private sector banks stipulate that, after a moratorium period of three years, one out of four new branches has to be in rural areas, thereby adding significantly to operating costs in an intensely competitive environment. This branching requirement occurs despite the prevalence of a large network of post offices that might ideally channel small savings, as well as specialized regional rural banks, cooperatives and other intermediaries working through National Bank for Agriculture and Rural Development.

Table 4.2India: decadal indicators of financial deepening
Broad money (M3) to GDP (in percent)24394763
Bank branches (per 1,000 persons)
Sources: Reserve Bank of India and authors’ estimates.
Sources: Reserve Bank of India and authors’ estimates.

Banks continue to dominate financial intermediation7 with bank deposits now accounting for half of financial savings. Much of this segment is publicly owned and accounts for an overwhelming share of financial transactions. After a hiatus of over twenty years, private banks were allowed to be established in 1993, but their share in intermediation, albeit increasing, continues to be low. Moreover, Figure 4.1 shows that there has been little change in the degree of concentration in the banking sector over the period 1993–2002, as measured by the m-bank concentration indicator.8 While interest rates for the banking sector have been largely freed, except for savings deposits with maturities of 15 days or less, there still remains considerable stickiness arising from the fixed (although lowered) interest rates on small savings instruments and provident funds.

Figure 4.1India: concentration of banking sector

(share of total banking sector assets controlled by each group, in percent)

Sources: Shirai (2001) and authors’ estimates.

Banks are likely to need capital in the future, despite almost all of them having met the prescribed capital adequacy norms as of end-March 2003.9 If the risk-weighted assets of scheduled commercial banks (SCBs) are to grow in line with the projected growth of the economy over 2003/04-2008/09, additional capital requirement of these banks may exceed Rs 500 billion, assuming a 10 percent capital adequacy requirement.10 Although the current response to the public issue offerings of several banks may appear to rebut this concern, a combination of weaknesses in equity markets in a downturn and large loan portfolios accumulated in prior growth periods could constrain banks from accessing capital markets.11 Even the stronger banks may soon be constrained by the prescribed floor of the RBI and government shareholding. Although the government has been toying with the idea of statutorily reducing its mandated 51 percent shareholding in PSBs down to 33 percent, there has not been much progress.12 Besides fresh equity issues through the capital market, this requirement in the past has, in large measure, been met by continual infusion of capital by the government, often through indirect methods, even when there was little danger of systemic risk (see Table 4.3 for the cost of bank bailouts in the past). Banks have reportedly requested the RBI to raise the ceiling of 10 percent of their investment portfolio that is currently allowed with a view to increasing their Tier II capital.

Table 4.3India: cost of bank rescues(in billion of rupees)
Capital infusion57.052.98.515.
Cumulative infusion97.0a149.9158.4173.5200.5204.5222.5

Includes Rs 40 billion injected prior to 1993.

Sources: Ministry of Finance, Economic Survey (various years); Reserve Bank of India, Annual Report, Monetary Policy Statement, Report on Trend and Progress of Banking in India, Report on Currency and Finance (various years), and Monthly Bulletin (various issues); Industrial Development Bank of India (IDBI), IDBI Report on Development Banking (various years); and National Stock Exchange, Indian Securities Markets: A Review (2002).

Includes Rs 40 billion injected prior to 1993.

Sources: Ministry of Finance, Economic Survey (various years); Reserve Bank of India, Annual Report, Monetary Policy Statement, Report on Trend and Progress of Banking in India, Report on Currency and Finance (various years), and Monthly Bulletin (various issues); Industrial Development Bank of India (IDBI), IDBI Report on Development Banking (various years); and National Stock Exchange, Indian Securities Markets: A Review (2002).

Total gross nonperforming assets (NPAs) of banks were estimated to be 9.5 percent of outstanding advances at end-March 2003.13 This problem might be more serious than it seems, since the accounting requirements are still less stringent than the Basle norms of income recognition and asset classification; and, there are other ambiguities—in definitions of project completion classification, financial closure, lending procedures, and so on—elaborated later. A minor digression might be worthwhile here. One of the factors that is widely deemed to have been a large contributory factor for NPAs is the policy of directed and priority sector lending. In light of the numbers on the sector-wise origins of NPAs, as of end-March 2002 (Table 4.4), the notion of directed lending being the primary culprit may need to be nuanced (even if just a little). While the share of priority sector NPAs in the total is about 40 percent, it should be noted that total loans outstanding to the priority sector (as a percentage of total loans) at end-March 2001 was about 34 percent.14 At the same time, it is noteworthy that banks have to adhere to the statutory directed credit share of 40 percent of incremental deposits (if necessary, through mechanisms such as Rural Infrastructure Development Fund). In comparison to these percentages, therefore, the share of priority sector NPAs is disproportionate.

Table 4.4India: segment-wise distribution of gross nonperforming assets(as of March 31, 2002)
In billions of rupeesIn percent of total NPAs
Public sector units111.6
Large- and medium-scale industries and other nonpriority sectors39457.9
Total nonpriority sectors40559.5
Small-scale industries12117.8
Other priority sectors7310.7
Total priority sectors27640.5
Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 2001–02.
Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 2001–02.

4.2.3 Other intermediaries

The share of non-banking finance companies (NBFCs) as intermediaries rose in the period following the opening of capital markets. However, a combination of an economic slowdown and loss of investor confidence (following a series of scandals), together with increasingly stringent regulatory norms, has resulted in a marked and persistent decline in their business. Although the assets under the management of mutual funds (MFs) in India (including the Unit Trust of India (UTI)) accounted for just about a twelfth of total bank deposits in 2002/03, they are becoming increasingly significant. Following the string of troubles at UTI, investors made significant redemptions; the share of UTI’s assets in total MFs fell from 84 percent in 1996/97 to under 38 percent in 2002/03. Resources mobilized by funds other than the UTI have increased over the last couple of years, partially due to tax incentives on dividends paid out by MFs.

Contractual savings institutions will play a critical role in developing capital markets, by inter alia helping to narrow the spread between long- and short-term interest rates thereby reducing the cost of capital for both equity and debt finance. The scope in this regard is considerable. Indian insurance premium payments account for a small fraction of total financial savings and lag far behind their Western (and even Chinese, on per capita terms) equivalents.15 A number of companies have already entered the life and general insurance segments, introducing much needed competition in these fields.

4.2.4 Capital markets

The economic and financial turmoil in Asia in the late 1990s provided evidence of the relative failure of the banking sector in imparting market signals on the then current situation and future expectations. Other crises in the past, notably in Mexico, also indicate that when a financial system predominantly relies on its banks, the scope for systemic risk and vulnerability increases. The most likely reason is their proximate role in risk and liquidity management, information revelation, and corporate governance. Well-functioning money and capital markets can help to prevent localized liquidity shocks from leading to a failure of solvent banks. In addition, they facilitate government debt management and monetary policy transmission, and provide a channel for privatization. Capital markets will also have an increasingly important role in India in enabling financial institutions (FIs) and NBFCs to access funds in an environment where public deposits may not be readily forthcoming.

Fixed income markets

The functioning of debt markets in India since the inception of reforms has been undisputedly transformed. The government dominates the debt market, comprising about three-fourths of outstanding debt in 2001/02,16 but only a small part of its total outstanding stock is traded—a mere 0.7 percent daily,17 compared to 15.5 percent in the United States.18 At present, PSBs, which are the biggest holders of these securities, have little incentive to enhance returns through active trading. However, a market has gradually emerged as banks become increasingly more profit oriented and the RBI risk-management requirements become more stringent. Another reason has been the gradual reduction in counter-party risk prevalent in the over-the-counter market through the establishment of the Clearing Corporation of India. Trading volumes in government securities, which had exceeded trading volumes in the equity segment during 2001/02 for the first time, increased (as a proportion of equity turnover) from 24 percent in 1998/99 to 276 percent in 2002/03.19

Financial institutions have also been large issuers of debt. Their issues have increased in size and complexity, especially after other cheaper government-based avenues of funds were curtailed. New financial instruments have been introduced, encompassing a whole spectrum of liquidity, risks, and returns. At one end, “money-like” instruments such as “liquid” mutual funds, bonds with call and put options and others traded on stock exchanges now compete with traditional assets like bank deposits. At the other, deep discount bonds and zero coupon bonds complement traditional contractual savings instruments. These developments have led to the emergence of a relatively more meaningful (although still distorted) yield curve.

Equity markets

Equity markets grew at a rapid rate during the 1990s. The market capitalization to GDP ratio, which was only around 6 percent in 1983, spurted to over 97 percent in 1998/99, before settling down to a more modest 43 percent in 2002/03.20 Even this is markedly higher than the levels prevailing prior to economic reforms. Indian bourses have simultaneously made significant progress in the three critical areas of trading, depositories, and settlements; giving them a world-class trading infrastructure. Trading has by now become automated—the “pit” is extinct. The settlement cycle has been shortened to T + 2 since April 2003 from T + 5 a year earlier.


As India moves toward implementing the Basle II framework, risk-management techniques and products will become increasingly important. With the amendment of the Securities Contracts (Regulation) Act (SCRA) in early 2000, trading in derivatives of securities commenced in June 2000, beginning with index futures contracts based on the National Stock Exchange of India S&P–CNX–Nifty Index and Bombay Stock Exchange BSE-30 (Sensex) Index. This was followed by approval for trading in options based on these two indices and options on individual securities. As for institutional hedging, following the amended SCRA, deals with notional principals of forward rate agreements and interest rate swaps have increased dramatically since they were progressively introduced from 2000/01, but the capital markets are a long way off from exchange traded derivatives, especially in fixed income products. Table 4.5 provides indicative magnitudes of derivatives volumes in India.

Table 4.5India: volume of activity in cash and derivatives markets in 2002/03
Market TypeCash



(in percent of

cash turnover)
Foreign exchange (in billions of US dollars)a276662239
Interest rates (in trillions of rupees)b28.01.55.4
Equity (in trillions of rupees)c9.34.447.2

Gross turnover in the interbank spot and forward markets in 2001/02.

Estimated annual turnover of Government of India securities, corporate bonds, and swaps in 2002/03.

Gross turnover on the Bombay Stock Exchange and National Stock Exchange in 2002/03.

Sources: ICICI Bank, presentation on “Indian Derivatives Markets: Future Prospects” to the Federation of Indian Chambers of Commerce and Industry’s Convention on Capital Markets (August 2003).

Gross turnover in the interbank spot and forward markets in 2001/02.

Estimated annual turnover of Government of India securities, corporate bonds, and swaps in 2002/03.

Gross turnover on the Bombay Stock Exchange and National Stock Exchange in 2002/03.

Sources: ICICI Bank, presentation on “Indian Derivatives Markets: Future Prospects” to the Federation of Indian Chambers of Commerce and Industry’s Convention on Capital Markets (August 2003).

The shortcomings of benchmark zero coupon yield curves in India are hindering proper pricing of derivatives. One reason is that financial market developments have affected trading horizons of securities,21 especially for longer tenor instruments, thereby flattening the yield curve.22 However, some derivatives markets are gradually developing.23 In November 2002, foreign institutional investors were granted permission to hedge their entire investments in Indian equity markets, up from the 15 percent ceiling allowed earlier.

4.3 Deconstructing the reform strategy

4.3.1 The framework of reforms

Increased efficiency, systemic stability and financial deepening with greater access have been the three objectives for the decade-long reforms in the financial sector. Sector liberalization, a prudential framework and increased competition, it is claimed, has admirably advanced these objectives. This officially declared stance of financial sector reform, however, does seem to be somewhat at variance with ground realities. Although many intermediaries and markets are rapidly moving toward world standards (in terms of prudential norms and systems) with increasingly sophisticated processes (including risk-management tools and extensive use of information technology (IT)), they have also concomitantly taken on a very different risk profile. In this new operating environment, there remain features of the financial sector that are incompatible with the processes and systems critical for both efficient functioning and commercial viability. This is especially true in banking, where, despite progress in terms of prudential norms, risk management, and lower NPAs, systemic weaknesses still remain obdurately entrenched.

First, it is fairly incontrovertible that the financial system still, in effect, remains predominantly configured to serve the government in its objectives of conducting, redirecting, and allocating resources for itself (ostensibly for investment and development). The concern is the extent of the adverse impact on the sector’s role in intermediating resources efficiently for private investment. Second, the belief of depositors and investors that the system is insulated from systemic risk and crises because government involvement engenders a sense of confidence in the system, making deposit runs somehow unlikely, even when the system becomes insolvent. In effect, has the government “signed a social contract” with depositors that substitutes “support and comfort” to intermediaries in lieu of market discipline in attempting to mitigate systemic risk?

The reality of financial sector reform in India, as evidenced by the actual conduct of monetary and fiscal policy during the corresponding period, is complex. Financial market efficiency and stability requires more than a patchwork of rules, regulations, ratios, and directives. For instance, recent studies24 suggest that countries with legal systems that strengthen creditor rights, contract enforcement, and accounting practices have better functioning financial intermediaries than countries that do not. We argue that a broader combination of actions, circumstances, and institutions have combined to seriously distort the incentives that are critical for the market discipline, which is now globally acknowledged to be a more effective oversight mechanism for intermediaries.25

With a view to organizing these distortions into a coherent whole, we adapt a framework explored in Rodrik (2002)—formulated in the context of general economic development—to the analysis of the financial sector reform strategy in India. This framework is institution-specific and is meant to buttress the economic analysis of trade-offs of market discipline and government intervention. While banking and financial reforms in India have comprised a set of actions that can be broadly grouped into enabling, strengthening, and institutional, we focus on the third plank—the framework in which financial sector reforms in India have been conducted—the crux of the argument being that weaknesses in this area are crucial for understanding the sector’s travails. We group the current shortcomings and required actions related to reforms in the financial sector into the classification used by Rodrik (2002), namely (i) market stabilization; (ii) market regulation; (iii) market creation; and (iv) market legitimization. These four elements are unbundled and re-aggregated into three broad categories (see Table 4.6), which are more familiar and amenable to our analysis in terms of the information available. These categories are the profligate fiscal environment, regulatory forbearance, and public ownership of institutions. While reform measures have touched on aspects of each category, when considered as a whole; contradictions emerge that have weakened the effectiveness of the individual measures. We now explore these categories in more detail.

Table 4.6India: institutional processes in the reform strategy of the financial sector
Role of institutionsObjectiveMapping to the Indian (financial) contextAddressing


Market stabilizationStable monetary and fiscal managementProfligate fiscal environmentLower preemption of resources by government Greater efficacy of central bank functions
Market regulationMitigating the impact of scale economies and informational incompletenessRegulatory forbearance Public ownership of institutionsAppropriate prudential regulation Imposition of market discipline Transparency and information disclosure
Market creationEnabling property rights and contract enforcementPublic ownership of institutionsEnforcement of creditor rights Effective dispute resolution mechanisms
Market legitimizationProviding social protection, conflict management, and market accessProfligate fiscal environment Regulatory forbearance Public ownership of institutionsMixing social and commercial objectives (e.g. rural branch requirements for banks) Appropriate deposit insurance Capital market senforcement Effective redress of investor grievances
Sources: Rodrik (2002) and authors’ adaptation.
Sources: Rodrik (2002) and authors’ adaptation.

4.3.2 The fiscal environment

There are two sets of consequences to the increasing preemption of financial savings by the government. First is the well-known argument of crowding out private investment, either directly or through manipulating interest rates. Second, and more insidiously, is a dilution of the credit creating role of intermediaries—“lazy banking”26—resulting from the distortion of risk and return signals that encourage banks to divert their liabilities into the relatively more attractive government securities.

Pre-emption of financial resources

The borrowings of the public sector—center and states and other government-owned entities—have increased steadily. The discrepancy between the saving and investment of the public sector is growing larger, and in 2001/02 the public sector utilized a fourth of domestic savings, while actually dissaving 2.5 percent of GDP. The overall public sector fiscal deficit has risen from 8.3 percent of GDP in 1995/96 to currently around 11–12 percent of GDP.27 The government is also increasingly relying on banks to finance its resource requirements—banks’ holdings of central and state government securities increased from 27 percent of their deposits in 1998/99 to about 42 percent in 2002/03, as Table 4.7 indicates.

Table 4.7India: portfolio allocation of lendable resources of scheduled commercial banks(in percent of total deposits)

with RBI

Investments in



Annual averages.

Sources: Reserve Bank of India, Report on Currency and Finance 1998–99 and Report on Trend and Progress of Banking in India 2001–02.

Annual averages.

Sources: Reserve Bank of India, Report on Currency and Finance 1998–99 and Report on Trend and Progress of Banking in India 2001–02.

Not only is the government appropriating an increasing share of financial savings for itself, it is increasingly influencing the process of intermediation in its favor. While restrictions on applicable interest rates (especially on the lending side) have been freed considerably, statutory preemptions (statutory liquidity ratio (SLR) and even cash reserve ratio) remain at high levels by international standards, thereby distorting banks’ lending decisions. The share of priority sector loans of PSBs in their bank credit also has consistently remained above those of private and foreign banks and, since 1995/96, has also been above the statutory floor. Furthermore, banks have repeatedly been used by the government as quasi-fiscal instruments, including de facto sovereign borrowings for shoring up foreign exchange reserves. It is well known, moreover, that the State Bank of India (SBI) is often used by the central bank as an indirect conduit for managing exchange rates. Finally, apart from direct appropriation, the government is also facilitating lending activity through credit enhancements and guarantees. Despite awareness of the inherent dangers, government guarantees have actually increased, from 9.8 percent of GDP in 1996/97 to over 12 percent in 2000/01.

Credit creation role of banks

An ironic outcome of the new realities is that the government has managed to expand the proposed transformation of weak banks into “narrow” banks (that had been mooted earlier) to the entire banking sector! It has effectively “narrowed” the entire sector into a repository of “safe” government securities. As a result, banks in India seem to have curtailed their credit creation role. SCBs have surpassed, quite endogenously, the statutory SLR preemptions of 38.5 percent of their net demand and time liabilities (NDTLs) observed during the pre-reform days. Outstanding government and other approved securities held by the SCBs were over 45 percent of NDTLs at end-September 2003, much higher than the mandated SLR of 25 percent (Figure 4.2).28

Figure 4.2India: banks’ investment in government securitiesa

(ratio of government securities to total deposits at end-quarter, in percent)

a For SCBs, on a fiscal year basis (April–March).

Sources:Reserve Bank of India, Handbook of Statistics on the Indian Economy (2002 and 2003) and Weekly Statistical Supplement (various issues).

In deciding on a trade-off between increasing credit flows and investing in government securities, the economic, regulatory, and fiscal environment is stacked against the former. Commercial lending is currently inhibited inter alia by ongoing structural changes in corporate financing patterns and multiple oversight processes for PSBs. Banks also face distortions arising from interest rate restrictions. These come mainly in the form of (i) continuing floors on short-term deposits; and (ii) various prime lending rate (PLR)-related guidelines on loans to small- and medium-scale enterprises and priority sectors, with these factors keeping banks’ commercial lending rates artificially high. As a result, banks’ treasury operations continue to be an important source of improved profitability.29 On the one hand, there is arrayed against PSB disbursing officers the entire administrative oversight machinery, including India’s Parliament, Central Bureau of Investigation, Central Vigilance Committee, Comptroller and Auditor General, Enforcement Directorate, and so on. On the other, declining interest rates have made holding government securities more profitable. An unintended consequence of the increasingly tighter prudential norms that banks are being forced to adhere to has been a further shift in the deployment of deposits to government securities and other investments that carry comparatively lower risk weights.30

4.3.3 Regulatory forbearance

The increasing complexity of financial transactions points not just to the close links between the banking and securities segments (especially in increasingly sophisticated markets), but also to the extreme difficulty of exercising regulatory oversight of such transactions. As argued earlier, although a ratio-centric prudential and risk-management framework has been progressively implemented and several structures related to financial sector development (especially capital market) are in place, shortcomings in enhancing sector efficiency lie in the broader framework within which the sector functions. And while control has become increasingly sophisticated, with most intermediaries and at least some processes geared toward risk management, this change is hampered by structural weaknesses and contradictions, as the periodic eruptions of crises demonstrate.31

The RBI has gradually implemented the Basle framework for banks, even if it does not, as of now, require intermediaries to fully adhere to these norms. It is in the process of exploring the Basle II framework and is moving toward risk-based supervision of banks. But the government ownership of large segments of intermediaries will inevitably vitiate the market discipline on which the efficacy of this supervision is predicated. For instance, public ownership results almost inevitably in either a fiscal infusion to recapitalize banks and term-lending development intermediaries, or, in a tight fiscal situation which provides little elbow room for the government to clean up the banking system, a substitution of regulatory forbearance for its inability to fill the recapitalization gap. When intermediaries have not been able to access capital markets for their capitalization, they have resorted to “double gearing,” by cross-purchasing each other’s papers, often at the behest of the government. If even this measure is not feasible (or is deemed undesirable), weakening of Basle norms is the sole respite for banks. The whole process is likely to result in a vicious cycle: fiscal compulsions lead to the use of intermediaries (banks and FIs) as quasi-fiscal instruments by the government, the consequent asset additions increase the capital requirements of these entities, and the poor quality of these assets hampers intermediaries from raising capital through the markets, thereby necessitating a loosening of regulatory restrictions, which, in turn, provides government more elbow room to further exploit the resources of these intermediaries.

The changing process of supervision

The thrust of regulatory oversight is changing from an across-the-board imposition of prudential norms to a more sophisticated and “customized” approach. The RBI initiated a Prompt Corrective Action (PCA) scheme in December 2002 on a trial basis to direct preemptive adjustments at troubled banks in response to early signs of financial vulnerability. A risk-based supervision approach is also in the works, as a prelude to the full implementation of the Basle II structure around 2006.

The PCA scheme is intended to apply prudential regulations in a more flexible and structured manner, depending on the degree of prospective trouble of the bank, in contrast to the uniform approach of the Basle framework. It envisages a response from the regulator based on three trigger points relating to the (i) capital to risk-weighted assets ratio (CRAR), (ii) net NPAs to net advances ratio, and (iii) return on assets. In principle, the rationale of the scheme is sound, relying as it does on a linkage between the deterioration in a bank’s financial performance and the consequent stipulations associated with the bank rather than a one-size-fits-all application of prudential norms. The PCA scheme can thus be considered a bridge to the market-based orientation of supervision put forward in Table 4.8, which outlines the threshold levels of the trigger points as well as the mandatory and discretionary actions that need (or should) be initiated by the respective intermediary.

Table 4.8Reserve Bank of India: prompt corrective action framework
TriggerTrigger pointMandatory actionsDiscretionary actions by the RBI
1.1Capital to risk-weighted assets ratio (CRAR)Between 6 and 9 percentSubmission and implementation of capital restoration, restrictions on the expansion of risk-weighted assets, prior approval of the RBI for new branches and lines of business, pay-off of costly deposits and certificates of deposits (CDs), reduced or suspended dividendsOrdered recapitalization, reduced stake in subsidiaries, shedding of risky business, caps on deposit interest rates, restrictions on borrowings from the interbank market, revision of credit/investment strategies and controls
1.2Between 3 and 6 percentOther than those in 1.1, ordered recapitalization, reduced overseas presence and/or stake in subsidiaries, caps on deposit interest rates, revision of credit/investment strategies and controls, employment of consultants for business restructuring, establishment of new management board, reduced advances, capital expenditures, and overheadChange in the promoters and/or owners, wage freeze and/or voluntary retirement scheme (VRS), merger or liquidation
1.3Less than 3 percentOther than those in 1.2, wage freeze and/or VRS, merger or liquidation, appointment of observers to monitor the performance of the bank
2.1Gross nonperforming assets (NPAs)Between 10 and 15 percentSpecial drive to reduce NPA stock and contain fresh NPAs, review of loan policy, upgrade of credit appraisal skills and systems and loan review mechanisms for large loans, effective follow-up of suits filed, establishment of proper credit risk-management policies, reduced loan concentration, restrictions on loan portfolio growthPrior approval of the RBI for new branches and lines of business, reduced overseas presence, reduced or suspended dividends, employment of consultants for revamping credit administration, reduced stake in subsidiaries
2.2Over 15 percentOther than those in 1.2, reduced overseas presence, reduced or suspended dividends, employment of consultants for revamping credit administration, reduced stake in subsidiaries, discussion with bank’s board on a corrective plan of action
3.1Return on assets (ROA)Below0.25 percentPay-off of costly deposits and CDs, reduced or suspended dividends, reduced administrative expenses, special drive to reduce NPA stock and contain fresh NPAs, prior approval of the RBI for new branches and lines of business, restrictions on borrowings from the interbank market, reduced capital expenditures within board-approved limitsCap on deposit interest rates, wage freeze and/or VRS
Source: Reserve Bank of India, Discussion Paper on Prompt Corrective Action (2000).
Source: Reserve Bank of India, Discussion Paper on Prompt Corrective Action (2000).

The operation of this scheme, however, leaves much to be desired. In the first place, the PCA regime does not require the concerned bank and the regulator to make public the precise shortfalls under which the PCA regime is triggered, which is against the spirit of greater accountability and transparency that is central to the Basle framework. Fears of a public disclosure of the PCA regime causing a run on the concerned bank are likely to have been exaggerated.

Exposure ceilings are part of prudential norms imposed by the financial sector regulators worldwide. However, for rapidly growing emerging countries with large investment requirements, these norms can often become a constraint on growth. Infrastructure projects are a prominent example. Given the dilapidated state of the sectors consequent upon the low investments that have characterized these sectors in India and the urgent need for upgrading these assets, infrastructure projects may perforce have to look to foreign markets to access funds that are denied by regulatory norms in the domestic markets (Table 4.9),32 despite abundant funding sources in India. To worsen matters, there are often restrictions on the ability of projects to access both equity and debt funds abroad as well.

Table 4.9Reserve Bank of India norms on exposure limits for banks and financial institutions
Industry/SectorSingle CompanyGroup
15 percent of gross exposure15 percent of the capital fundsa40 percent of the capital funds
20 percent of the capital funds for infrastructure projects50 percent of the capital funds for infrastructure projects

Capital funds comprise share capital, Tier 1 and 2 capital, and reserves and surplus.

Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 2002–03.

Capital funds comprise share capital, Tier 1 and 2 capital, and reserves and surplus.

Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 2002–03.

The institutional framework of supervision

There remain two lacunae in the regulatory structure, however, that hamper efficacious supervision of the financial sector. The first set of weaknesses relates to the oversight structure imposed by regulations. This includes the whole gamut of processes, starting from appointments, accountability, jurisdictions, and enforcement powers. The second set of weaknesses involves the operating practices used by regulators, namely requirements for information disclosure.33 Poor enforcement against past malfeasance remains a prime source of the mistrust of retail investors in most primary issues. A failure to address deep-seated issues—like disclosures, monitoring, and enforcement—and instead tinker with arbitrary incentives for investors (like dividend taxes and small savings returns) has led to policy responses that have been alternatively overzealous and halting.34

On the first set of weaknesses, the burden imposed by the oversight structure relates to the multiplicity (and often overlapping jurisdictions) of regulators, especially given the increasingly integrated nature of financial and commercial transactions. While the number and jurisdiction of regulators continues to remain a subject of academic argument and political dispute, a real danger remains of sector regulators transforming themselves into sectoral “fund managers” for their individual domains in the financial markets. An illustrative instance is the Report of the Joint Committee on Stock Market Scam, probing the 2001 stock market swindle, which indicts the RBI for its “weak and ineffective supervisory role” and notes that the central bank and the Registrar of Cooperative Societies were often issuing cross-directives. Simultaneously, the report faulted the Securities and Exchange Board of India (SEBI) and the Ministry of Finance’s (MoF) Department of Company Affairs (DCA) (then a part of the Ministry of Law, Justice, and Company Affairs) for incessant delays in initiating action based on the SEBI’s Preliminary Investigation Report, as a result of interminable squabbling about which regulatory or government entity was statutorily responsible for initiating action against companies “named” for market manipulation.

The feasibility or even desirability of establishing an integrated financial markets regulator on the lines of the Financial Services Authority (FSA) of the United Kingdom is also a matter of debate. From the limited information available on the functioning of the umbrella High Level Coordination Committee on Financial and Capital Markets (HLCC), this body—established in the early stages of financial reform, chaired by the RBI Governor and comprising representatives of the SEBI and MoF—might not be entirely effective in light of its composition. The HLCC, for instance, has little control over the actions of state registrars, which are often lax in implementing RBI directives. Another important set of shortcomings relates to composition of and appointments to the regulatory bodies. The perception is that appointments to the boards of independent regulatory bodies are often dilatory and discretionary.35 For instance, despite the enabling provision for increasing the number of SEBI board members from six to nine in the SEBI Amendment Act of 2002, the Board currently has just two whole-time members, down from three in 2002/03 (surely a dearth of work cannot explain the vacancies).

On the second set of weaknesses, information disclosure norms are still inadequate given the degree of market discipline needed to supplement current financial sector regulation. The nontransparent nature of disclosure requirements of banks and FIs make a quantitative assessment of the extent of the problems difficult. Even in these information enabled times, the number of organizations that post their annual reports on websites is minimal. Regulatory decisions are often made without a discussion and consultation process, on the lines of the better utility regulators. Even the investigation reports of the regulator are confidential. Case files of securities markets enforcement have only started being available recently as training devices for financial sector regulators.

The multiple and often contradictory roles of the RBI—as a financial sector regulator, major owner of intermediaries, monetary policy authority and investment banker to the government—have arguably vitiated the central bank from fully implementing them. As lead arranger for the government’s borrowing program, the RBI has to manage the issue of government paper with a view to ensure subscription at the lowest interest cost. In its role as monetary policymaker, it has to manage system liquidity, in part by using direct and indirect instruments to affect the term structure of interest rates. Interest rate formation is a monetary policy prerogative and internal debt management must be undertaken within this rate structure. Insidiously, the actions of the RBI—in discharging its roles as the government’s investment banker (through influencing primary market yields on government treasury instruments, by taking on new issue devolvement and other measures designed to reduce the cost of borrowing) and debt manager (through the management of the average maturity of debt)—are interfering with the establishment of a proper yield curve. The interventions across the term structure of interest rates impinges on the RBI’s ability in conducting its core function—monetary policy—which hinges on a credible market-determined benchmark yield curve as the transmission channel to interest rates.

4.3.4 Ownership of intermediaries and other rigidities

India is one of a number of countries with intermediaries used by the government to allocate and direct financial resources to both the public and the private sector. Government ownership of banks in India is, barring China, the highest among large economies (Figure 4.3).36 There is another large segment of intermediaries that has not attracted requisite attention, specifically the FIs, which were responsible for 70 percent of total loans sanctioned in 2000/01.37 The lending portfolios and processes of some of these entities are more opaque than banks and, given their significant exposure to government and other public sector entities, is cause for greater concern. The portfolios of some FIs are also heavily concentrated in a few sectors, which make them more vulnerable to economic downturns.

Figure 4.3Cross-country comparison of government ownership of banks

(share of total banking sector assets controlled by each ownership group, in percent)

Source: Boston Consulting Group, presentation to the Confederation of Indian Industry Banking Summit (2003).

The involvement of the public sector, in particular the government, in intermediation is much wider than mere ownership numbers indicate; its ambit stretches across the mobilization of resources, direction of credit, appointment of management, regulation of intermediaries, provision of “comfort and support” to depositors and investors, and so on. In the process, the incentive structures that underlie the functioning of financial intermediaries are blunted and distorted to the extent that they override the safety systems that have nominally been put in place. There are two ways in which this dominance skews incentives and magnifies distortions. First, public ownership of intermediaries vitiates the profit maximizing incentive for requiring optimal co-financing from borrowers; intermediaries know that hard budget constraints no longer hold. Public equity issues in the primary capital markets have been falling since the middle of the post-reform period, implying decreasing levels of co-financing—at least in a transparent and, therefore, a more desirable form. On the other hand, private placements of both debt and equity instruments have increased during this period. However, the bulk of these placements have predominantly been in fixed-income instruments, often subscribed by publicly owned intermediaries, where the due diligence may be less than exemplary. Second, the high degree of government involvement in the financial sector reinforces the belief of depositors and investors that the system is insulated from systemic risk and crises. This involvement engenders a sense of confidence in investors in the system, making deposit runs somehow unlikely, even when the system becomes insolvent.

While selective regulatory forbearance might be justified to mitigate financial panics, the government’s blanket guarantee makes such forbearance difficult to calibrate and has the effect of sharply increasing system-wide moral hazard. A virtual certainty of sustained bailouts by the government has replaced a policy of ”constructive ambiguity” with one of ”destructive unambiguity.”38 Depositors, borrowers and lenders all know that the government is the guarantor. Since, for all intents and purposes, all deposits are covered by an umbrella of implicit government guarantees, there is little incentive for “due diligence” by depositors. As a result, any semblance of market discipline for lenders in deploying funds is further eroded, as witnessed most recently in the case of cooperative banks. The regularity of “sector restructuring packages” (for steel and textiles and proposed most recently for telecommunications), also diminishes incentives for borrowers for mitigating the credit risk associated with their projects.

The large fiscally funded recapitalizations of banks in the early and mid-1990s may be rationalized as having been designed to prevent a system-wide collapse at a time when the sector had been buffeted by the onset of reforms and had not yet developed risk mitigation systems. Moreover, the overall reforms were designed to enhance domestic and external competition, which adversely affected the banks’ past loans and balance sheets. The nascent state of capital markets at that time also was a hindrance to accessing equity capital without a large risk premium. The impact of this support, though, has been considerably reduced, if not eliminated, by the series of ongoing bailouts, with seemingly little by way of binding reciprocating requirements imposed on intermediaries to prevent repeats of these episodes. It needs to be recognized that the only sustainable method of ensuring capital adequacy in the long run is through improved earnings, not further government recapitalization or even private capital mobilization.

Deposit insurance

The Deposit Insurance and Credit Guarantee Corporation (DICGC) came into existence in 1978 as a statutory body through an amalgamation of the erstwhile separate Deposit Insurance Corporation and Credit Guarantee Corporation. It has a relatively liberal structure for insuring deposits compared to international norms.39 Depositors in India do not have to bear coinsurance on the insured deposit amount and the ceiling insured amount (Rs 100,000) is five times the per capita GDP. Banks are required to bear the insurance premium of Rs 0.05 per Rs 100 per annum (insurance protection is available to depositors free of cost). As of 2001/02, about 74 percent of the total deposits of commercial banks were insured.40 The DICGC extended its guarantee support to credit granted to small-scale industries from 1981 and to priority sector advances from 1989. However, from 1995, housing loans have been excluded from the purview of guarantee cover. Some of the major recommendations of the 1999 Working Group constituted by the RBI to examine the issue of deposit insurance are withdrawing the function of credit guarantee on loans from the DICGC and instituting a risk-based pricing of the deposit insurance premium instead of the present flat-rate system. A new law, superseding the existing one, is supposedly to be passed in order to implement the recommendations.

Institutional rigidities

Apart from the government’s preemption of resources, lingering institutional bottlenecks and practices in the public and private sectors are both creating and reinforcing conditions for vitiated commercial discipline. This subsection consolidates indicative and anecdotal evidence of financial fragility, which may necessitate some reevaluation of inferences drawn from published (and audited) results of the sector. The practices outlined are difficult to quantify and can only be delineated as “stylized facts.” First, there has been an absence of effective bankruptcy and foreclosure procedures, which has forced intermediaries to roll over existing substandard debt, usually debt-equity swaps,41 thereby continually building up the fragility of their asset portfolio and further diluting debt-equity norms. This has had the inevitable consequence of encouraging intermediaries—both lending and investing institutions—to approach the government for bailouts with disquieting regularity. Let alone large players, very few banks are “too small to fail,” with even the humblest of cooperative banks granted support. Thankfully, the Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act of 2002 offers some scope for relief. Second, the holding company (pyramid) structure of many Indian corporations implies a separation of ownership from control, which creates strong incentives for diversion of funds among group companies (tunneling).

The resulting inefficiencies not only distort lending and deposit rates, but also create a major incentive for smaller and more efficient intermediaries (for example, foreign banks) to behave like “Stackelberg” followers and extract rents, in the sense that they continue to retain high lending rates (despite comparatively low operating costs), as well as to carve out large loan shares in lucrative business segments, thereby maintaining higher operating margins than the PSBs.42 An important implication of the structural weaknesses and the distortions engendered is the proper pricing of associated premia. As a consequence, the net interest spreads of the system as a whole may be above the “optimal” levels. The outcome is that, while this has helped to keep the inefficient public sector intermediaries’ heads “above the water,” the efficient ones have simply been able to “ride the wave,” as it were.

4.4 A good beginning, but… aspects of financial intermediation

Section 4.3 elaborated on elements of the institutional framework that we feel have been key obstacles to promoting the market discipline needed for enhancing the efficiency of financial intermediation. This section illustrates the lacunae in the framework by examining select processes and strategies that have been instituted to improve the overall efficiency of the system.

4.4.1 Dealing with nonperforming assets

The level of NPAs is one that has attracted the most alarmist statements about India’s financial system. Before examining methods proposed to deal with the stock of NPAs, we assess the ramifications of the existing stock of NPAs, especially in relation to bank capitalization. Special emphasis is accorded to the PSBs, given their dominance in the banking sector. As on end-March 2002, gross NPAs of SCBs and FIs (excluding investment institutions) amounted to Rs 710 billion and Rs 118 billion, respectively, or totaling about 3.3 percent of GDP.43 NPAs of NBFCs were another Rs 33 billion.

Focusing on the PSBs, which are widely considered to be the most vulnerable group, the stock of gross and net NPAs amounted to Rs 565 billion and Rs 280 billion, respectively, the difference being provisioning of Rs 286 billion (Table 4.10). As against this, total capital of the PSBs was Rs 575 billion. The cumulative provisions against loan losses of PSBs amounted to 42.5 percent of their gross NPAs at end-March 2002, which is lower than international standards, (foreign banks in India were, on average, estimated to have a provisioning rate of 75 percent).44 This level of provisioning represented 70 percent of loss and doubtful assets as of end-March 2002. When SCBs are considered as a whole, net profits increased to Rs 142 billion in 2002/03 (1 percent of total assets), but admittedly due to higher noninterest income. This amount, at least conceptually, is two-thirds of the substandard assets of SCBs. Even if the true level of NPAs is double of that as officially reported, as is widely claimed by industry analysts, the situation is unlikely to result in a systemic crisis. In fact, the stress on the banking sector that is claimed to originate in their bad loans may be exaggerated. Unlike their counterparts elsewhere in Asia, bad loans of banks in India tend to be concentrated in heavy industries, infrastructure projects, or “priority” sectors rather than in real estate or the stock market. Total advances of SCBs to the so-called sensitive sectors, that is, capital markets, real estate and commodities, was Rs 232 billion at end-March 2002—a mere 3.6 percent of the total loans and advances portfolio.

Table 4.10India: loan classification of scheduled commercial banksa(as of March 31, 2002; in billions of rupees)
Standard assetsSubstandard assetsDoubtful assetsLoss assetsTotal


assets (NPAs)
Total advances
Public sector banks4,529158337715655,094
Old private banks3921827449441
New private banks7002939068768
Foreign banks478910928506
Total SCBs6,099214412847106,809

Banks are required to provision for NPAs at 100 percent for loss assets; at 100 percent of the unsecured portion plus 20–50 percent of the secured portion for doubtful assets, depending on the period the loan has been in this category; and at 10 percent on the outstanding balance for substandard assets.

Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 2001–02.

Banks are required to provision for NPAs at 100 percent for loss assets; at 100 percent of the unsecured portion plus 20–50 percent of the secured portion for doubtful assets, depending on the period the loan has been in this category; and at 10 percent on the outstanding balance for substandard assets.

Source: Reserve Bank of India, Report on Trend and Progress of Banking in India 2001–02.

While the data suggests that NPAs of financial intermediaries in India are not likely to precipitate a crisis, it should be noted that several independent agencies have reexamined the official figures and take a more measured view. CRISIL estimated that the gross NPAs of SCBs were Rs 1,300 billion at end-March 2002—more than 80 percent higher than the officially reported data. Similarly, Fitch Ratings has estimated that the net NPAs of SCBs at end-March 2002 would have gone up from 51.5 percent of net advances to 11.5 percent of net advances, if a 90-day norm (as adopted in April 2004) had been in place instead of the 180-day norm now being used. However, the validity of these estimates is difficult to ascertain. The estimates of NPAs by both CRISIL and Fitch were obtained using sample techniques and extrapolating results to the entire system, which makes their validity difficult to ascertain. Nonetheless, they raise some concerns about the seriousness of the NPA problem.

The RBI issued revised guidelines on asset classification in 2002, according to which a loan is classified as an NPA at an SCB if interest or principal payments are overdue by 180 days or if interest is overdue for 180 days or principal for 365 days at an FI. Even within the confines of these relatively liberal norms, there remain glaring loopholes in the treatment of stressed assets. For instance, the Dabhol Power Company’s power project, to which Indian lenders have an exposure of Rs 62 billion, is still not classified as an NPA, despite interest and principal repayments remaining overdue for more than 180 days. This arises from the definition of “financial closure of projects under implementation” adopted by the RBI. The RBI, to its credit, has expressed concern regarding large project loans that continue to be classified as standard despite loan service delays, merely by dint of the project continuing to be “under implementation.” An independent group constituted in 2002 to look into such projects (and establish deemed completion dates) has estimated that intermediaries have already disbursed about Rs 360 billion to 26 such projects with a total cost of Rs 560 billion and with a debt component of about Rs 390 billion. The concept of disbursement only after “financial closure” of projects had not been followed in the past based on the erstwhile “development” approach of banks and FIs to lending.

Debt recovery tribunals

Procedures for recovery of bad assets have, in the past, been cumbersome at best and ineffective at worst. Banks used to file suits for recovery of bad loans in debt recovery tribunals (DRTs) only as a last resort.45Adhivarahan (2003) cites a report prepared by the RBI’s Banking Supervision Department based on data from 33 banks (27 public sector and 6 private sector), which finds that 15 of these banks did file suits after exhausting other means of recovery. The amounts involved in suit filed cases accounted for 26.2, 33.9, and 46.4 percent of these banks’ NPAs, in 1996, 1997, and 1998, respectively. However, recoveries were generally meager at 7.3, 4.7, and 4.3 percent, respectively. The report goes on to note that in view of such meager recovery, “the banks before filing suit weigh the likely recovery prospects out of the suit and the opportunity cost of any amounts that could be recovered immediately.”

In light of the inadequacies of the DRT arbitration, the government of India and the RBI have instituted various settlement mechanisms like the Settlement Advisory Committee, Lok Adalats (Peoples’ Courts), and nondiscretionary and nondiscriminatory one-time settlement (OTS) schemes for NPAs up to Rs 50 million.46 An interinstitutional corporate debt restructuring (CDR) mechanism also has been established to provide a transparent mechanism for restructuring debts of “viable entities” facing payment problems due to internal and external factors. At least regarding infrastructure projects, our experience with the CDR mechanism does not inspire confidence.

Asset reconstruction and securitization

Given the various shortcomings of the various approaches used to tackle loan defaults, a landmark development in the reform of the financial sector in India was the enactment of the SARFAESI Act effective June 2002.47 The Act, meant to facilitate foreclosures and enforcement of securities in cases of default and to enable banks and FIs to realize their dues, marked a major change in the balance of power between lenders and borrowers. It empowers secured creditors, without intervention of a court or tribunal, to enforce any “security interests” created. The Act has also created an enabling framework for asset reconstruction companies (ARCs) and securitization in general (see Box 4.1).

Although the SARFAESI Act is a significant step in dealing with the stock of existing NPAs of the banking sector (and, more importantly, instilling discipline among borrowers), some loopholes still remain. It inter alia addresses only one aspect of credit risk, that is, the power of a lender to takeover collateral. However, the Act ignores the broader aspect of creditors’ rights and introduces yet another disincentive to extending credit by skewing banks toward secured loans. This represents an inefficient form of credit expansion in an economy where the share of services is large and growing. Likewise, our rough estimate suggests that one-third of outstanding NPAs are beyond the purview of the Act, given exemptions on all loans to the agricultural sectors and on interest due of less than Rs 0.1 million. Expectedly, there has also been confusion over the definition of “default” under the Act, as well as the modus operandi of issuing notices, taking possession, and disposing of such securities.48

Box 4.1Salient features of the SARFAESI Act 2002

A securitization or asset reconstruction company (ARC) with own funds of not less than Rs 20 million may be established, in compliance with RBI prudential norms. This company may acquire assets of any bank or financial institution (FI) by issuing debentures or bonds. Notices of acquisition of financial assets may be sent by banks or FIs to a defaulter (an obligor), who will then make payments to the ARC. In the case of nonperforming assets, a secured creditor is entitled to serve a notice to the borrower to discharge his liabilities within 60 days. In case of failure to do this, the creditor is entitled to take possession of the secured assets. A shareholder of an ARC holding at least 75 percent of a defaulter’s securities may call for a meeting of all other shareholders in the ARC, with the resolution of this meeting binding. Appeals by aggrieved borrowers to Debt Recovery Tribunals (DRTs) are allowed only after the borrower deposits 75 percent of the disputed amount and, in cases of adverse decisions, then appeals to a Debt Recovery Appellate Tribunal (DART). The same rules apply to interest earned from these assets. No civil court has jurisdiction to entertain a suit for a case that has been filed before a DRT or DART.

Sources: Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest Act 2002; Ministry of Finance, Economic Survey 2002–03; and Reserve Bank of India, Annual Report 2002-03.

A criticism of SARFAESI Act has been that flawed lending practices of intermediaries have in the past contributed in undermining commercial viability of the project for which the loan was disbursed. For instance, a corporation claimed that delays in disbursement of working capital and substitution by high cost bridge loans had increased the project cost and rendered it unviable. To level the playing field somewhat for future lending (keeping in mind principles of “natural justice”), the RBI issued Guidelines for Lenders Liability and a Fair Practices Code for Lenders in May 2003, addressing issues of transparency in loan application, conduct of proper due diligence, disbursement and sanction timelines and processes, recovery procedures, and so on.

Owing to Supreme Court concerns of “serious defects” in the SARFAESI Act, it stayed the Act in August 2003 following holding up questions about the constitutional validity of the Act but with some caveats for a petition filing. The Court cited the Act as being inordinately biased towards creditors, especially the requirement to deposit 75 percent of the disputed amount before approaching a debt tribunal. A tentative judgment was issued by the Supreme Court in March 2004, which held up the constitutional validity of the Act, but with some caveats for proceeding on further asset foreclosures and sales. This judgment has effectively paved the way for full-fledged operation of the Asset Reconstruction Company of India Limited (ARCIL)—India’s first ARC.49

4.4.2 Reforming nonbank intermediaries

As mentioned in Section 4.3, although the focus of prudential regulations has been the banking segment, the proximate source of serious problems in India’s financial sector has often been other intermediaries. Although a series of piece-meal fixes have lugubriously corrected some of the maladies of FIs, there remain a few other intermediaries whose asset portfolios have the potential of imparting systemic instability in the financial sector. We briefly examine the asset portfolios of two such intermediaries, the LIC and the EPFO (see Box 4.2). A point to note is the opacity of their asset portfolios, a shortcoming which is especially serious in the case of the latter.

Box 4.2Investment patterns of large financial institutions

This box provides an overview of the investment patterns of several large nonbank financial intermediaries. Assets of these institutions can be characterized, in part, as “socially oriented investments.”

Life Insurance Corporation (LIC)

The investments of the LIC are intended to “channelize the savings mobilized for the welfare of people at large” and are defined as investments that “help to improve the quality of life of the people at large through improvements of basic amenities like potable water, drainage, housing, electrification and transport.” Assets under this head include investments in central and state government securities (as well as those guaranteed by governments) and loans to various socially oriented schemes. It is noteworthy that the LIC’s asset portfolio is large (equivalent to 8 1/3 percent of India’s GDP in 2000/01).

Although the LIC does not publish a complete breakdown of its investments into equity and debt, a partial breakdown in the table below shows that incremental investments in equities (line II.f) and debt (line II.g) increased by 31 percent and 34 percent, respectively, in 2000/01.

Employees’ Provident Fund (EPF) and Employee Pension Scheme (EPS)

The EPF is subject to investment norms prescribed by the government of India in 1998, and also tends to channel funds into asset holdings similar to the LIC. A breakdown of the EPF’s investment as well as those of the EPS is shown in the figure below.

Life Insurance Corporation of India: Utilization of Funds(as of March 31, 2001)
Amounts outstanding

(in billions of rupees

at book value)
In percent

of total

In percent

of subtotal

I. Loans
a. State electricity boards/power corporations70.775.64.323.5
b. State government housing (including the Delhi Development Authority and Police Housing Corporation)27.331.41.89.8
c. National Housing Bank10.
d. Housing finance societies (including the Life Insurance Corporation) (LIC)63.774.94.323.3
e. Municipalities/Zila Parishads/water supply and sewerage boards20.
f. State road transport corporations3.
g. Private sector power generation companies1.
h. Joint stock companies (including public sector undertakings) and cooperative societies28.326.61.58.3
Total loan portfolio289.3321.618.4100.0
II. Investments in securities
a. Government of India securities705.3851.448.660.8
b. State government securities119.2143.78.210.3
c. Other government securities (including Kisan Vikas Patras)35.635.02.02.5
d. Roadways, ports, railways0.
e. Private sector power generation13.714.60.81.0
f. Shares (including holdings in LIC Mutual Fund)114.8149.98.610.7
g. Debentures and bondsa150.8202.711.614.5
Total investments1,140.31,401.180.1100.0
III. Special deposits with the Government of India20.418.61.1
IV. Other items (unidentified)

Including those issued by the Industrial Reconstruction Bank of India, Rural Electrification Corporation, Small Industries Development Bank of India, state finance corporations, state level development banks, and port trusts.

Source: Life Insurance Corporation of India Annual Report 2001–02.

Including those issued by the Industrial Reconstruction Bank of India, Rural Electrification Corporation, Small Industries Development Bank of India, state finance corporations, state level development banks, and port trusts.

Source: Life Insurance Corporation of India Annual Report 2001–02.
Investment norms prescribed for the Employees’ Provident Fund Organisation’s Employees’ Provident Fund(in percent)
Investment categoryInvestment shares
1.Central government securities25
2a.Government securities created and issued by the state government15
2b.Any other negotiable securities whose principal and interest is fully and unconditionally guaranteed by the central or a state government
3a.Bonds and securities of “public financial institutions,” public sector companies (including public sector banks), and Infrastructure Development Finance Company40
3b.Certificates of deposit (CDs) issued by a public sector bank
4.Any of the three categories above, to be decided by the Board of Trustees20
Source: Employees’ Provident Fund Organisation (EPFO), Annual Report 2001–02.
Source: Employees’ Provident Fund Organisation (EPFO), Annual Report 2001–02.

Investments of the Employees’ Provident Fund and Employees’ Provident Scheme corpuses in various instruments, end-March 2002ab

a Outer ring is Employees’ Provident Fund; inner ring is Employees’ Provident Scheme.

b Figures (in percent) represent share of total investments.

c Including government guaranteed securities.

Source: EPFO, Annual Report 2001/02.

The LIC had a total business of Rs 7300 billion (in terms of sums assured) as of March 2001, and a corpus in its Life Fund of Rs 1860 billion. The book value of the LIC’s “socially oriented investments”—mainly comprising government securities holdings and social sector investments—amounted to Rs 1253 billion at end-March 2001 or 72 percent of the LIC’s total portfolio value of Rs 1750 billion (equivalent to 8.4 percent of GDP in 2000/01).50 A staggering 84 percent of its total portfolio comprises exposure to the public sector.

Compared to the LIC, the EPFO’s accounts are considerably more opaque. Cumulative contributions to the three schemes of the EPFO, that is the Employees’ Provident Fund (EPF), Employees’ Pension Scheme (EPS) and Employees’ Deposit Linked Insurance, amounted to Rs 1271 billion as of end-March 2002. Total cumulative investments of these three schemes were Rs 1390 billion (5.6 percent of GDP), with the EPF being the largest scheme. The EPFO does not come under the purview of an independent regulator, with oversight resting on three sources: the Income Tax Act (1961), EPF Act (1952) and Indian Trusts Act (1882). When the RBI relinquished its role as portfolio manager of the EPF funds in 1995, the SBI was appointed to the role. It is estimated that the average real annual compound rate of return over the period 1986–2000 was 2.7 percent (Asher (2003)). A rough estimate in Patel (1997a) indicates that the EPS was actuarially insolvent. The EPFO’s reluctance to make public its actuarial calculations does little to assuage this concern.

4.4.3 Domestic financial fragility and external sector strength

The relatively minor impact in India of the turbulence that swept the East Asian economies in the late 1990s is widely ascribed to the closed capital account. With the increasing international financial integration in India, a closed capital account is becoming increasingly more difficult to maintain. The road map for full capital account convertibility (CAC) that was laid out in RBI (1997) specified elaborate preconditions on indicators of vulnerability. The report singled out health of the financial system as the most important precondition to moving to CAC. Since the report’s release, the benchmarks that have not been met for CAC invariably relate to longstanding problems with strong undercurrents in political economy, specifically the persistence of large fiscal deficits (which have worsened since 1997) and state of India’s financial system.

The main deficiency in India’s external sector indicators currently pertains to its low international credit rating, which has hovered around the speculative grade for most of the last decade and is generally attributed to unhealthy fiscal indicators. A significant improvement in the country’s fiscal health is unlikely even in the medium term, and indeed could be compounded by the government’s seemingly carte blanche policy toward financial intermediary bailouts, the uncertainty regarding the magnitude of unfunded pension commitments of the central and state governments and concerns over the quantum of credit guarantees and enhancements provided by central and state governments that may have to be honored. It could be argued51 that India will maintain large foreign exchange reserves as a signal to compensate for internal weaknesses (both fiscal and financial) and global uncertainties through the strength in its external accounts, much like the perception in the case of China.

4.5 Conclusion

We have attempted to discern and define the strategies that have underpinned financial sector reforms in India during the 1990s, and then to identify the institutional features that have, in some significant measure, mitigated the effectiveness of these reforms. Despite a significant strengthening of financial intermediaries and transactions systems in both the banking sector and the capital markets, especially the latter, there remain significant weaknesses. While India has advanced considerably along the route mapped by international organizations like the Bank for International Settlements and International Organization for Securities Commissions in developing financial markets, these measures, although useful for reducing systemic risks, may prove inadequate in the face of structural distortions, flawed practices, and insipid enforcement. Most of the recommendations of the Narasimhan Committee II that have been accepted and introduced, although significant, are in the nature of ratios, rates, and accounting norms. The same progress has not been attained with regard to structural and systemic aspects of the reform agenda. Financial sector reforms have to be more widely encompassing than supervision by central bank regulators; an integral part is the wider environment in which intermediaries function, and their operational freedom and ability to take commercial decisions. In the absence of market discipline and given the level of government intervention, the reform actions are likely to have only a limited impact on the efficiency of the intermediation process and prudential norms result in little effective change.

Some restrictions on the banking sector (that are part of the prudential requirements) may also be inconsistent with the ability of intermediaries to raise needed resources in the near future. For instance, in order to prevent connected lending (one of the original motives for bank nationalization), private banks in India cannot have corporate owners who own more than 10 percent of the bank’s equity capital. Precluding this route could constrain the ability of some new private sector banks to expand networks and offer more services. Attempts to mix commercial and social objectives (for instance, rural bank branch requirements) also serve to increase the costs of intermediation.

India is unlikely to suffer a full-blown systemic crisis, witnessed in different contexts in various countries. Its financial sector inefficiencies are likely to simply simmer, with occasional payments crises, like the one at the dominant mutual fund over the last five years. However, the cumulative inefficiencies and grim fiscal outlook, with the concomitant regulatory forbearance that public involvement inevitably entails, are certain to retard India’s transition to a high growth trajectory. The persistent unease with the state of the system, it can be speculated, arises from the recognition that the perceived safety of intermediaries is due more to the “social contract” between the government and depositors (that is, the Indian public) than a real robustness in the health of the sector.

The system of intermediation will not improve appreciably in the absence of any serious steps toward changing incentives, which remain blunted by public sector involvement (of which ownership is an important aspect). To sharpen these incentives, outright privatization may not be sufficient, but it is necessary. It is the first step to a true relinquishing of management control, which remains far beyond the scope envisaged in the Banking Companies (Acquisition and Transfer of Undertakings) Bill tabled in Parliament, designed to reduce the government holding in nationalized banks to 33 percent, but allowing it to retain the “public sector character” of these banks by maintaining effective control over their boards and restricting the voting right of nongovernment nominees. Attempts to shed the commercial risks of investors, borrowers, and depositors (through implicit bailouts and other means of accommodating fragility) will almost certainly lead to economic risks during slowdowns, creating a new kind of instability.

Given the increasing integration of financial markets, there is also a need to shift reform focus from individual intermediaries to a system level. An important component in this shift is enhancing intermediaries’ ability to de-risk their asset portfolios. Undoubtedly, the SARFAESI Act of 2002 is a crucial step forward in addressing bad loans, but, on its own, is limited in scope and has been beset by various legal challenges. Establishing asset reconstruction companies, even under private management, will serve only to tackle the overhang of existing bad assets—they per se do little to correct the distortions in incentives that are intrinsic to large parts of the system.

The banking sector is caught in a cleft stick. On the one hand, a predatory fiscal regime has injected a large corpus of government securities into the market that offer an attractive risk-adjusted return for banks, given the increasingly stringent risk-management regulatory framework in place. On the other, government ownership of many of these institutions increases aversion for “good” commercial risk by imposing an idiosyncratic combination of blunted incentives for credit creation and disincentives from the intrusive oversight by numerous government (investigative) agencies. It is ironic that the government has (unintentionally) managed to expand the proposed transformation of weak banks into “narrow” banks, a move that had been mooted earlier, to the entire banking sector! Through an entirely endogenous evolution, we seem to have moved back to the pre-reform days, at least in this respect.


Hindustan Lever Limited (Unilever India) and Infrastructure Development Finance Company Limited (IDFC), respectively. The opinions presented in the paper are those of the authors and not necessarily of the institutions to which they are affiliated.

For instance, cooperative banks have been lax in implementing RBI notifications on lending to brokers.

Apart from commercial banks, the largest of these other deposit-taking institutions are also government owned (including the EPFO), with many cooperative banking institutions having been singled out for their close links to the local political establishments.

For instance, it is periodically reported in the media that accounting and regulatory loopholes in banks are used as conduits for various irregularities in equity and debt transactions.

RBI, Statistical Tables Relating to Banks in India, 2001–02.

See Reddy (2002) and Patel (2000) for a detailed exposition.

The market share of assets of the “m” largest banks.

The capital to risk-weighted assets ratio (CRAR) for scheduled commercial banks is currently 9 percent.

This figure is calculated assuming a nominal GDP growth rate of 11 percent per annum over 2003/04–2007/08 and then using simple extrapolations based on outstanding bank deposits and credit-deposit ratios as at end-March 2003.

See Patel (1997b) for a conceptual underpinning.

The Banking Companies (Acquisition and Transfer of Undertakings) Bill and the Financial Institutions Laws (Amendment) Bill were tabled in Parliament in 2000, but have not yet been enacted.

RBI Annual Report 2002–03. The ratio of net NPAs to advances is 4.5 percent. Estimates by various ratings and other agencies put this number much higher.

RBI, Statistical Tables Relating to Banks in India, 2001–02.

In 2000, India ranked 78th in terms of insurance density (that is, premia per capita, equivalent to about US$10, as compared to US$15 in China) and 52nd in terms of insurance penetration (that is, premia as a percent of GDP, which was 2.3 percent). As a share of gross domestic savings, insurance premiums in India in 1999 were 9 percent compared to 52 percent in the United Kingdom and 35 percent in the United States and Europe (Insurance Regulatory Development Authority, Annual Report 2001–02).

Total outstanding marketable debt at the end of 2001/02 was approximately Rs 8500 billion (41 percent of GDP), of which central government securities was Rs 5363 billion; state government, Rs 1040 billion; and (informed estimates) of public sector undertakings and private corporate bonds, Rs 2000 billion (Tahir (2002)).

Calculated from figures in the RBI’s Monthly Bulletin (October 2003) and Handbook of Statistics on the Indian Economy 2002–03.

“Treasury Debt Management” presentation by Timothy Bitsberger, United States Treasury Department, 2003.

RBI, Annual Report 2002–03 and Monthly Bulletin (October 2003).

See various RBI Annual Reports.

For instance, defeasance periods (that is, holding period for assets) of debt instruments have declined to about 30 days at present from an average of 90–100 days two years earlier.

Given the RBI’s apparent decision to increase the average maturity of government debt, with a consequent increased issuance of longer dated securities, increased trading interest in these securities and subsequently increased illiquidity premiums for shorter dated papers has flattened the yield curve.

For example, exchange traded derivatives for stock indexes and individual stocks at the NSE.

Demirguc-Kunt and Levine (1999), Jagtiani et al. (1999), and Karacadag and Shrivastava (2000). In market-oriented systems, the banking sector as a whole as well as individual banks are penalized, as choice clients desert them for stronger competitors. The cost of capital increases as credit ratings and share prices fall, and trading gets tougher as counterparties cut back on long established credit lines.

An expression used by a Deputy Governor of the RBI.

See Buiter and Patel (1997) for a formal assessment of the sustainability of India’s fiscal stance.

RBI, Weekly Statistical Supplement (October 11, 2003). It is also noteworthy that 52 percent of the outstanding stock of government securities is held by just two public sector institutions: the SBI and the LIC.

Trading profits (in securities) of PSBs in 2001–02 jumped more than 2.5 times that of the previous year and accounted for 28 percent of operating profits (RBI, Report on Trend and Progress of Banking in India, 2001–02).

Banks were advised in April 2002 to build up an investment fluctuation reserve (IFR) to a minimum 5 percent of their investments in the categories “held for trading” and “available for sale” within five years. At end-June 2003, the total IFR of SCBs amounted to only about Rs 100 billion (that is 1.7 percent of investments under the relevant categories). While 12 banks had yet to make any provisions for an IFR, 20 had built their IFR up to 1 percent and 65 had an IFR exceeding 1 percent (RBI, Mid-Term Credit and Monetary Policy Statement, 2003).

“Individual cases of financial fraud in themselves may not constitute a scam. But persistent and pervasive misappropriation of public funds falling under the purview of statutory regulators and involving issues of governance become a scam” (Government of India, Report of the Joint Committee on Stock Market Scam (2002)).

Few countries have regulatory limits on exposures to certain sectors (see RBI, Report on Trend and Progress of Banking in India 2001–02 (Box 2.1)). Of the ones that do, the restrictions pertain to “sensitive” sectors like property and share-related loans.

Compare this to the confirmation hearings for the Securities and Exchange chairman in the United States Congress or the recommended procedures of the Nolan Committee for public appointment in the United Kingdom, including those for the FSA chairman.

La Porta et al. (2001) and Hawkins and Mihaljek (2001) outline the characteristics of financial systems that are dominated by government-owned intermediaries.

FIs’ share of total loans outstanding at end-March 2003 was about 20 percent, compared to about 50 percent at end-March 2001. The decline is partially due to the reclassification of the merged ICICI Bank as a commercial bank.

DICGC Annual Report 2001–02.

Forms of the reportedly widespread practice of “ever-greening” assets.

This amounts to US$18 billion, compared to China’s nonperforming loans, officially reported at US$307 billion, after having transferred US$170 billion to the four asset management companies.

RBI, Report on Trend and Progress of Banking in India, 2001–02 (p. 25).

Recovery cases over Rs 1 million can be filed by banks and FIs in the DRTs. Between March 1994 and March 2002, 56,988 cases involving a sum of Rs 1087 billion were filed before the 29 DRTs and 5 Debt Recovery Appellate Tribunals. Of these, 23,393 cases, involving an amount of Rs 186 billion, had been disposed of, with banks recovering Rs 47 billion, or a recovery rate of about 26 percent (Adhivarahan (2003)).

The RBI issued a fresh OTS scheme in January 2003 for compromise settlement of NPAs up to Rs 100 million but not covering cases of willful default or malfeasance.

The Act was formally passed by parliament in November 2002, after having been promulgated as an ordinance in June 2002.

RBI guidelines issued in April 2003 define a willful defaulter as one who has not used bank funds for the purpose for which they were taken and who has not repaid bank loans despite having adequate liquidity.

The ARCIL was formally established under Section 3 of the SARFAESI Act as a securitization and reconstruction company with effect from August 29, 2003. It had an initial equity of Rs 100 million, with the ICICI Bank, Industrial Development Bank of India (IDBI), and SBI each having a 24.5 percent stake in ARCIL (with the remaining held by Housing Development Finance Corporation, IDBI Bank, and UTI Bank). Another Asset Care Enterprises (ARC), is being promoted by the Industrial Finance Corporation of India (with a 33 percent stake), Punjab National Bank (26 percent), the Tourism Finance Corporation of India (10 percent), and the rest by the LIC.

Social sector investments include loans to State Electricity Boards, housing, municipalities, water and sewerage boards, State Road Transport Corporations, roadways, and railways. However, these account for only about a fifth of the socially oriented investments portfolio, with the balance accounted for by government and government guaranteed securities.


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