Report of the Committee on Financial Sector Reforms

A Hundred Small Steps ii A HUNDRED SMALL STEPS A Hundred Small Steps Report of the Committee on Financial Sector Reforms

Government of India Planning Commission New Delhi iv A HUNDRED SMALL STEPS

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ISBN: 978-81-7829-950-1 (PB) The SAGE Team: Rekha Natarajan, Meena Chakravorty, Rajib Chatterjee and Umesh Kashyap Photo Credit: Mckay Savage Contents

Members’ List and Terms of Reference vii Acknowledgements ix List of Abbreviations xi

1. Introduction, Executive Summary, and List of Main Proposals 1

2. The Macroeconomic Framework and Financial Sector Development 22

3. Broadening Access to Finance 49

4. Levelling the Playing Field 77

5. Creating More Efﬁ cient and Liquid Markets 103

6. A Growth-Friendly Regulatory Framework 124

7. Creating a Robust Infrastructure for Credit 151

8. Special Topics 181 vi A HUNDRED SMALL STEPS List of Abbreviations vii

No. A-43011/17/2007-Adm.-I GOVERNMENT OF INDIA PLANNING COMMISSION

Yojana Bhawan, Sansad Marg New Delhi, 17th August 2007

ORDER

Subject: Constitution of a High Level Committee on Financial Sector Reforms

With a view to outlining a comprehensive agenda for the evolution of the ﬁ nancial sector indicating especially the priorities and sequencing decisions which the Govt. must keep in mind, it has been decided to set up a High Level Committee on Financial Sector Reforms with the following composition:

(i) Shri Raghuram G. Rajan, Professor, Graduate School of Business, University of Chicago—Chairman. (ii) Suman Bery, Director General, NCAER. (iii) Uday Kotak, CEO, Kotak Mahindra Bank. (iv) Rajiv Lall, CEO, IDFC. (v) Vijay Mahajan, Chairman, Basix. (vi) Zia Mody, Senior Partner, AZB Partners. (vii) O.P. Bhatt, Chairman, State Bank of India. (viii) K.V. Kamath, MD & CEO, ICICI Bank. (ix) Chitra Ramakrishna, Deputy MD, NSE. (x) R. Ravimohan, MD & CEO, CRISIL. (xi) J.R. Varma, Professor, Indian Institute of Management, Ahmedabad. (xii) R. Sridharan, Adviser (FR), Planning Commission—Convenor.

02. The Terms of Reference of the Committee will be as follows:

(i) To identify the emerging challenges in meeting the fi nancing needs of the Indian economy in the coming decade and to identify real sector reforms that would allow those needs to be more easily met by the fi nancial sector. (ii) To examine the performance of various segments of the fi nancial sector and identify changes that will allow it to meet the needs of the real sector. (iii) To identify changes in the regulatory and the supervisory infrastructure that can better allow the fi nancial sector to play its role, while ensuring that risks are contained; and (iv) To identify changes in other areas of the economy—including in the conduct of monetary and fi scal policy, and the operation of the legal system and the educational system—that could help the fi nancial sector function more effectively.

03. The High Level Committee may invite such person(s) as it deems appropriate to participate in any of its meetings as special invitee(s). viii A HUNDRED SMALL STEPS Acknowledgements

When the Deputy Chairman of the Planning their very able assistants, Persis Bharucha Commission, Shri Montek Singh Ahluwalia, and Nita Colaco. I particularly thank ICICI asked me to put together a Committee to for making available the services of Dr. Sona write a report on the next generation of ﬁ - Varma and Mr. Vinay D’Costa. Dr. Varma was nancial sector reforms, I was intrigued but a great help throughout, and directed the also puzzled. Why another report when so Committee’s work on financial inclusion. many reports had been commissioned in the Vinay embodies for me the spirit of young recent past? He convinced me that there was India. He has been tireless throughout this merit in taking an overall view, highlighting Committee’s tenure, working at all hours the links between various needed reforms, of the day and night, going well beyond the and offering a generally consistent underlying call of any reasonable concept of duty, to approach. The purpose of the report would make this report come together. Thank you be to catalyze debate as well as action, some Vinay! immediate and some over time as political I also am very grateful to Mr. Om Bhatt of will emerged. the State Bank of India, who hosted a number With this in mind, I set about putting of the Committee’s meetings and events. He together a Committee of some of the finest also was instrumental in helping us reach financial and legal minds in the country. My a number of constituencies that we would first pleasant surprise was that no one I asked otherwise not have been able to access. Ms. said no, despite their undoubtedly hectic Brinda Jagirdar from SBI was of tremendous schedules, and the fact that many of them help, both at Committee meetings and in were already on other Committees. Since reaching out to various parts of SBI. then, I have been treated to a truly awesome The Planning Commission has also been display of true public–private partnership as invaluable to the working of the Commit- people from the public sector, government, tee. Shri Ahluwalia, of course, has been regulators, the private sector, academia, pol- very supportive throughout. The convenor, iticians, unions, NGOs, and the press have Mr. Sridharan, and his assistant, Mr. A.K. given freely of their valuable time to make Chakrabarti, have been extremely helpful. this report possible. All constituencies had Mr. Sridharan’s knowledge of how govern- input into this process. We have also benefited ment works have been especially important from a large number of comments since a in clarifying my views, and the views of the preliminary draft of the report was placed in Committee. the public domain for commentary. All the members of the Committee took I start my acknowledgements by thanking on the additional burden of attending its Mr. K.V. Kamath of ICICI Bank for kindly Saturday meetings cheerfully. Committee hosting many of the Committee’s meetings, discussions, while sometimes heated (and and creating a secretariat to take care of the never short), were always focused on at- logistical arrangements. It is clear that with- tempting to understand what in our opin- out the efficiency of the ICICI staff helping ion would be right for the nation. Many us, this report would certainly not have been Committee members have written pieces completed on time. Dr. Nachiket Mor and of the report, and have drawn others from Ms. Chanda Kochhar were free with their their organizations to help in the work. time, as well as their resources, including This has been truly a collective effort, and I x A HUNDRED SMALL STEPS

would like to express my sincere gratitude to from a variety of public, private, domestic, Mr. Suman Bery, Mr. Uday Kotak, Mr. Rajiv and foreign organizations, as well as some Lall, Mr. Vijay Mahajan, Ms. Zia Mody, Ms. self-employed individuals. In each case, Chitra Ramakrishna, Mr. Ravimohan, and the individual shared their expertise with Prof. Jayanth Varma, in addition to the three the Committee in their personal capacity. members who have been acknowledged Among those that we would like to thank earlier. especially are: Anup Banerji, Priya Basu, The Committee is especially grateful Gautam Bhardwaj, Sanjay Bhargava, Tarun to our ‘virtual’ members, Prof. Rajesh Bhatia, Saugata Bhattacharya, Christopher Chakrabarti, Prof. Eswar Prasad, Mr. Joydeep Butel, Nick Collier, M. Damodaran, Amaresh Sengupta, Dr. Ajay Shah, and Mr. Bahram Dubey, Ajay Dwivedi, Tilman Ehrbeck, Vakil, as well as Prof. Sankar De, Prof. Joshua Felman, Neeraj Gambhir, Jim Hanson, Ashok Jhunjhunwala, Mr. Nirmal Mohanty, Dharmakriti Joshi, Sachin Khandelwal, Mr. Ramesh Ramanathan, and Mr. Vidhu S. Khasnobis, Kalpana Kochhar, Charles Shekhar. Each of them wrote, or helped in Kramer, K.P. Krishnan, Roopa Kudva, P.J. the writing of, significant portions of the Nayak, M. Mahapatra, Varsha Marathe, Mihir report, and greatly enhanced the intel- Nanavati, Sanjay Nayar, Robert Palacios, lectual quality and practical content of the Aurobind Patel, V. Ramkumar, C.S. Rao, Committee’s discussions. It also thanks Ms. Renuka Sane, Naveen Tahilyani, Vijay Tata, Naga Annamalai, Mr. Anindya Bannerjee, Yashwant Thorat, Arun Thukral, Essaji Mr. Abhinav Chandrachud, Mr. Ashwin Vahanvati, S. Venkataraman. Ramanathan, Mr. Pramod Rao, and Mr. A number of reviewers (because some of Mahesh Uttamchandani, who while not them asked not to be named, we have decided explicitly part of the Committee, helped to keep the entire list anonymous) read a first guide important aspects of the Committee’s draft of this report and offered very useful work. Ritu Anand, Sugandha Garg, Leena comments. They have our gratitude. Kinger Hans, Leena Pillai, Swati Ramanathan, After a preliminary draft was placed in Subrata Sarkar, and Priyanka Vasishtha were the public domain for comment, we received also very useful contributors to the work a large number of comments, both directly, of the Committee. IIMS Dataworks and and in the press. While we have not accepted FINO helped us with data and in assessing all suggestions, each one has been weighed for practices. its consistency with our overall framework We held nine formal Committee meetings and alterations, where justified, have been and 11 informal ones. In addition, members made to the report. of the Committee met with a number of relevant players in the financial sector arena. We Raghuram G. Rajan obtained tremendous help from employees 12 September 2008 List of Abbreviations

AAIFR Appellate Authority for Industrial and Financial Reconstruction ABS Asset-backed Securities ACC Appointments Committee of the Cabinet AD Authorized Dealer ADB Asian Development Bank ADR American Depository Receipts AMC Asset Management Company AML Anti-Money Laundering AP Andhra Pradesh ARC Asset Reconstruction Company ATM Automated Teller Machines BANSEFI, Mexico Banco de Ahorro Nacional y Servicios Financieros, Mexico BC Business Correspondents BCD Bond-Currency-Derivatives BF Business Facilitators BIFR Board for Industrial and Financial Reconstruction BIS Bank for International Settlements BoE Bill of Exchange BOT Bank of Thailand BPL Below Poverty Line BRIC Brazil, Russia, India, China BSE Bombay Stock Exchange BSNL Bharat Sanchar Nigam Limited CAGR Compounded Annual Growth Rate CAL Capital Account Liberalization CBLO Collateralized Borrowing and Lending Obligations CBRC China Banking Regulatory Commission CCIL Clearing Corporation of India Limited CD Ratio Credit-Deposit Ratio CDFI Community Development Financial Institutions CDO Collateralised Debt Obligations CDR Corporate Debt Restructuring CDS Credit Default Swaps CDSL Central Depository Services India Limited CFT Combating the Financing of Terrorism CGAP Consultative Group to Assist the Poorest CIBIL Credit Information Bureau (India) Limited CICA Credit Information Companies (Regulation) Act CMIE Centre for Monitoring Indian Economy COSPI CMIE Overall Share Price Index CPC Code of Civil Procedure CPI Consumer Price Index CRA Community Reinvestment Act xii A HUNDRED SMALL STEPS

CRA ID Central Record Keeping Agency identifi cation CRISIL Credit Rating and Information Services of India CRR Cash Reserve Ratio CVC Central Vigilance Commission DA Direct Assignments DCCBs District Central Cooperative Banks DICGC Deposit Insurance and Credit Guarantee Corporation DIP Debtor-in-Possession DRT Debt Recovery Tribunal ECB External Commercial Borrowings EPFO ID Employees Provident Fund Organisation identifi cation EPIC Elector’s Photo Identity Card FDI Foreign Direct Investment FI Financial Institution FII Foreign Institutional Investor FINO Financial Information Network and Operations FIPB Foreign Investment Promotion Board FIRA, Mexico Fideicomisos Instituidos en Relación con la Agricultura FMC Forward Markets Commission FRBM Fiscal Responsibility and Budget Management FSA Financial Services Authority FSC Financial Supervisory Commission, Korea FSDC Financial Sector Development Council FSM Act Financial Services and Markets Act, 2000, UK FSOA Financial Sector Oversight Agency GDP Gross Domestic Product GDR Global Depository Receipts GIC General Insurance Corporation of India HLCC High Level Co-ordination Committee on Capital Markets HPEC High Powered Expert Committee IBA Indian Bankers Association IBPC Inter-bank Participation Certifi cates ICA Inter-Creditor Agreements ICAI Institute for Chartered Accountants of India ICR Insolvency and Creditor Rights ICRA Information and Credit Rating Agency ID Identifi cation IDBI Industrial Development Bank of India IDRBT Institute for Development and Research in Banking Technology IFCI Industrial Finance Corporation of India IIMS Invest India Market Solutions IISS Invest India Incomes and Savings Survey IMF International Monetary Fund IOSCO International Organization of Securities Commissions IPDI Innovative Perpetual Debt Instruments IRDA Insurance Regulatory and Development Authority ISO International Organization for Standardization IT Information Technology List of Abbreviations xiii

KYC Know Your Customer LAB Local Area Bank LIBOR London Inter-Bank Offered Rate LIC Life Insurance Corporation of India LLP Limited Liability Partnership LSO Loan Sell-Off M&A Mergers and Acquisitions MBA Master of Business Administration MCA Ministry of Corporate Affairs MFI Microfi nance Institution MGBBY Mahatma Gandhi Bunkar Bhima Yojana MNIC ID Multi Purpose National Identity Card MOF Ministry of Finance MOFE Ministry of Finance and Economy, Korea MPFI Mobile Payment Forum of India MTNL Mahanagar Telecom Nigam Limited NABARD National Bank for Agriculture and Rural Development NAFIN Nacional Financiera, Mexico NAIS National Agricultural Insurance Scheme NBFC Non-Banking Financial Company NCAER National Council for Applied Economic Research NCDEX National Commodity & Derivatives Exchange Limited NCLT National Company Law Tribunal NDS Negotiated Dealing System NEFIS Nationwide Electronic Financial Inclusion System NGO Non-Governmental Organization NHB National Housing Bank NPA Non-Performing Assets NPF National Pension Fund, Korea NPL Non-Performing Loans NPS New Pension System NREGS National Rural Employment Guarantee Scheme NRI Non-Resident Indian NSCC National Securities Clearing Corporation NSDL National Securities Depository Limited NSE National Stock Exchange NSEL NCDEX Spot Exchange Ltd NYMEX New York Mercantile Exchange OFO Offi ce of the Financial Ombudsman OTC Over the Counter PAN Permanent Account Number PCAOB Public Company Accounting Oversight Board PCARDBs Primary Cooperative Agriculture and Rural Development Bank PIN Personal Identifi cation Number PLR Prime Lending Rate POS Point of Sale PSB Public Sector Bank PSLC Priority Sector Lending Certifi cates PSU Public Sector Undertaking xiv A HUNDRED SMALL STEPS

PTC Pass-Through Certiﬁ cates QFII Qualiﬁ ed Foreign Institutional Investor RBI Reserve Bank of India REER Real Effective Exchange Rate RMBS Residential Mortgage Backed Securities RNBFC Residuary Non-Banking Finance Company ROE Return on Equity RRBs Regional Rural Banks RSBY Rashtriya Swasthya Bima Yojana RTGS Real Time Gross Settlement SAFE State Administration of Foreign Exchange, China SAT Securities Appellate Tribunal SBI State Bank of India SC(R)A Securities Contract Regulation Act SCARDBs State Cooperative Agriculture and Rural Development Bank SCBs Scheduled Commercial Banks SEBI Securities and Exchange Board of India SEC Securities and Exchange Commission SENSEX Sensitive Index SEWA Self Employed Women’s Association SGL Subsidiary General Ledger SGSY Sampoorna Gramin Rozgar Yojana SHG Self-Help Group SIB Securities and Investment Board, UK SICA Sick Industrial Companies Act SIDBI Small Industries Development Bank of India SIP Systematic Investment Plan SLR Statutory Liquidity Ratio SME Small to Medium Enterprises SMS Short Message Service SNX SAFAL National Exchange SPV Special Purpose Vehicles SR Security Receipts SRFAESI Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act SRO Self-Regulatory Organisation SSI Small Scale Industries STCBs State Cooperative Bank TRAI Telecom Regulatory Authority of India UCBs Urban Cooperative Banks ULIP Unit Linked Insurance Plan UNCITRAL United Nations Commission on International Trade Law UP Uttar Pradesh US 64 Unit Scheme 64 of Unit Trust of India UTI Unit Trust of India VAT Value-added Tax VSNL Videsh Sanchar Nigam Limited WPI Wholesale Price Index WTO World Trade Organization Introduction, Executive Summary, and List of Main Proposals

The Committee on Financial Sector Reforms There are thus at least three reasons for (henceforth ‘the Committee’) was tasked with financial sector reform: to include more proposing the next generation of reforms for Indians in the growth process; to foster the Indian ﬁ nancial sector. The immediate growth itself; to improve financial stability, question, of course, is whether we need a new flexibility, and resilience and thus protect chapter generation of reforms at all. There are two the economy against the kind of turbulence ways of answering this. that has affected emerging markets in the First, so much is yet to be done. On the past, and is affecting industrial countries 1 retail side, financial services are still not reach- today. ing the majority of Indians. The single most Why do we need a new report? After all frequently used source of loans for the median there have been numerous well-written re- Indian household is still the moneylender. ports over the past few years, many of whose On the wholesale side, the financial sector is recommendations remain unimplemented. not able to meet the scale or sophistication of One reason why this report is different is that the needs of large corporate India, as well as of other reports have been tasked with looking public infrastructure, and does not penetrate at specific segments of the financial sector deeply enough to meet the needs of small and (the corporate bond market, infrastruc- medium-sized enterprises in much of the ture financing, the inclusion agenda, the country. Large parts of our financial system cooperative sector, etc.). By the very nature of are still hampered by political intervention their terms of reference, though, the analysis and bureaucratic constraints, limiting their and proposed reforms have had to be partial. potential contribution. And with external This Committee has had both the benefit forces such as commodity prices and external of studying those earlier reports and the demand volatility buffeting us, it is not clear luxury of painting on a broader canvas, that we have the macroeconomic frameworks, the is, the entire financial sector. The Committee risk management structures, or the micro- has attempted to see links that others have not economic flexibility to cope. because of their narrower mandate. Hope- Second, there is so much to be gained fully, its proposals then take these linkages from doing it. The financial sector has built into account and attempt to create mutually capabilities such that, with appropriate pol- reinforcing influences in the financial sector. icy changes, it can grow tremendously, both Indeed, while the report is divided into sep- domestically and internationally. It can gen- arate self-contained chapters, the underlying erate millions of well-paying jobs, and more theme behind all our proposals is the need to important, have an enormous multiplier enhance inclusion, growth, and stability by effect on inclusion and economic growth. allowing players more freedom, even while Given the right environment, financial sec- strengthening the financial and regulatory tor reforms can add between a percentage infrastructure. point and two to the economic growth rate. An example may be useful. Reports on why Financial sector reform is both a moral and India does not have a sizeable corporate bond an economic imperative! market point out that many natural investors, 2 A HUNDRED SMALL STEPS

such as banks and insurance companies, while working harder to contain risks. The have restrictions placed on them, forcing shift in paradigm, if implemented, could them to invest large amounts in government usher in a revolution in the financial sector securities. Foreigners are strictly limited in almost as dramatic as the revolution that hit how much government debt they can buy. A the real economy in the early 1990s, whose straightforward recommendation seems to fruits we are now reaping. be to remove these restrictions. But why do There has been an enormous amount of regulators impose them in the first place? attention paid to issues like capital account In part, it is because regulators know the convertibility, bank privatization, and prior- government deficit needs funding, in part ity sector norms. While important, there they are overly conservative because their are many other areas where reforms are less reward structure penalizes any failures on controversial, but perhaps as important. An their watch far more than it penalizes lost example of the kind of reforms we would growth, and in part corporate bonds are support is the trading of warehouse receipts. indeed risky given weak creditor protection. With the promulgation expected soon of the So a solution needs to address issues rang- Warehousing (Development and Regulation) ing from how the government deficit will be Act, 2008, warehouse receipts will become financed, to regulator incentive structures, a negotiable instrument. They will become a to fixing the credit infrastructure. Similarly, new, reliable form of collateral in the agri- if we wonder why foreign participation is so cultural sector, where till now there was restricted, we have to address issues ranging no other security except land, which has its from how open the capital account should be own infirmities. Warehouse receipts can be to whether the monetary framework should in physical or electronic form and must be target the exchange rate at all. The point issued by registered warehouses, which will is that both analysis and recommendations be accredited by the Warehousing Develop- have to ensure consistency across a number ment and Regulatory Authority. of policy areas, which this report attempts The advent of the warehouse receipt sys- to achieve. tem will result in a lower cost of financing An equally important reason for a new and an increase in liquidity for agriculture, report is that we need a new paradigm in and is a break from the focus of the last few the financial sector. Such a paradigm should decades on targeted lending as a way to ener- recognize that efficiency, innovation, and gize agricultural credit. In addition, the Act value for money are as important for the poor encourages scientific warehousing of goods, as it is for our new Indian multinationals, and improved supply chains, enhances rewards these will come from deregulation, new entry, for grading and quality and encourages better and competition. The role of the government price risk management. This is an example is not to take on the tasks that should leg- of how forward looking regulation can help itimately be delegated to the private sector, build the credit infrastructure (in this case, but to create an enabling environment by for agriculture) and enhance the availability building sound financial infrastructure. In of finance. other words, the kind of liberalization, as In anticipation of the legislation being well as the more effective regulation, that passed (the Bill was introduced in 2005), and has had such beneficial results in sectors assisted by some well-targeted government like telecom, should now be extended to the schemes to build rural godowns, a large num- financial sector, where the rewards could be ber of technologically advanced warehouses so much more substantial. In this dynamic are already in various stages of construction. environment, we will need skilled regulators In addition, the traditionally unreliable ware- who encourage growth and innovation even house keepers are being upstaged by newer Introduction, Executive Summary, and List of Main Proposals 3 actors such as collateral management agen- debt, and corporate debt markets, despite cies, assayers for checking the quality/grades being close to the epicenter of the crisis, have of commodities stored, and authorized ware- remained far more resilient than markets in house agents, who under the new Act will far away countries. become legally liable for any shortfall in It is important to recognize that vul- quantity and any variation in quality, from nerabilities may be building up in India. what is stated in the warehouse receipt issued Underdeveloped markets and strict regu- by them. Assuming that at any time, about lations on participation are no guarantee that 15–20 per cent of the annual agricultural risks are contained, in fact they may create produce is stored in warehouses, the Act has additional sources of risk, a forewarning the potential to inject over US$ 30 billion of of which may come from recent reports of agricultural credit. substantial losses incurred by corporations This is the kind of reform the country can on currency bets. For instance, a significant easily achieve. Instead of focusing primarily quantity of lending is undertaken by non- on a few large, and usually politically con- bank financial companies (NBFCs), some of troversial steps, we also need to take a which are growing at extremely rapid rates, hundred small steps in the same direction free of burdens that hamper other sectors and that will collectively take us very far. As an- relatively free of regulatory oversight. These other example, credit to small and medium entities have a very light regulatory burden enterprises could be boosted enormously because they do not take deposits. Yet their if the trade receivable claims they have on funding could, in some cases, be short-term large firms could be converted to electronic money from mutual funds or from deposit format, accepted by the large firms, and sold taking institutions like banks, even though as commercial paper. Mexico has a central their assets are long term. This structure agency facilitating this process, there is no is risky because of the mismatch between reason why we could not create an environ- the duration of assets and the duration of ment where some institution like the National funding. The banking system, which is part Securities Depository Ltd could do this. All of this structure through its loans, is thus not this is not to say that we should not tackle insulated from risk because of its direct loan the controversial large issues, and the report exposure to NBFCs. does offer comprehensive proposals on them, The typical regulatory response is to but it is to say progress can be made even tighten bank exposure norms. But if the otherwise. NBFCs are to maintain lending and sustain This is, however, a difficult time to pro- economic growth, they have to find fund- pose financial sector reforms in India. The ing somewhere. NBFCs would be far more near meltdown of the US financial sector stable if they funded themselves with long- seems to be proof to some that markets and term debt from the corporate debt market. competition do not work. This is clearly the Moreover, the market and passive investors wrong lesson to take from the debacle. The would absorb any risk associated with the right lesson is that markets and institutions NBFCs’ lending, instead of that risk being do succumb occasionally to excesses, which passed on to financial institutions like banks. is why regulators have to be vigilant, constantly A corporate bond market could thus serve as finding the right balance between attenuat- a useful buffer between financial institutions, ing risk-taking and inhibiting growth. In the and be an important source of stability in United States, they clearly failed this time. But the current environment. But as indicated this is not to say they cannot find the right earlier, this will require a number of ancillary balance elsewhere. At the same time, well- reforms, some of which taken by them- functioning competitive markets can reduce selves may seem to increase the potential for vulnerabilities—the US equity, government instability (such as opening the corporate 4 A HUNDRED SMALL STEPS

bond market further to foreign investors). the chapter with a discussion of possible This is yet another reason why a holistic pic- sequencing. ture is necessary. The chapters that follow offer a much Put differently, the Asian financial crisis more detailed and nuanced analysis, as well is etched in the minds of Indian commen- as more specific, and ancillary, proposals. tators. Yet the primary lesson of the Asian Anyone who wants to take issue with specific financial crisis is not that foreign capital or proposals should read the background financial markets are destabilizing, but that chapter for that proposal before coming to a poor governance, poor risk management, definite conclusion. asset liability mismatches, inadequate disclosure, excessive related party transactions, and murky bankruptcy laws, make an eco- THE MACROECONOMIC nomic system prone to crisis. Financial sec- FRAMEWORK tor reform can reduce these vulnerabilities substantially. As much as the Committee’s Chapter 2 is on the macroeconomic frame- report focuses on the need to deregulate work. The Committee believes that while certain areas of the financial sector, we also monetary management has been very cre- focus on creating necessary institutions, and ditable thus far, the framework will need closing important gaps in regulation. Clearly, to adjust more to a world of rapid capital there is little urgency for reforms because fl ows. While infl ows have been the problem India is not in a crisis. This is where political in recent years, outfl ows could well be a prob- leadership is of essence. Reforming in a crisis lem in the future. The Committee believes is similar to driving with a gun to your head— that given how open India has become, it you pay more attention, but there is much will be impossible to control capital fl ows in greater risk of accidents. Better to do it in either direction for anything more than the normal times! very short term, and even that will create This Committee believes that it is critic- substantial uncertainty and volatility in ally important to introduce new ideas (or markets. reintroduce old ones) into the debate. India Moreover, given capital flows, the real mulls over many issues far longer than some exchange rate, which is the key factor deter- would like, but eventually takes the right step. mining India’s competitiveness, is influ- With apologies to Keynes, practical pieces of enced by factors such as productivity growth legislation, that seem to be exempt of any and demand supply imbalances that are intellectual influence, are usually drawn from not changed by central bank intervention some long-forgotten report. Despite the cur- against the dollar. So given that the real ap- rent political climate, this is indeed the rea- preciation has to take place, the country has son we have no doubt that this report will the Hobson’s choice of taking it as inflation not be a wasted effort. or as a nominal exchange rate appreciation. In what follows, we list the Committee’s The central bank can keep the market major proposals, as well as a brief rationale guessing about which option it will choose, for them. As far as possible, in this report the sometimes intervening in currency markets Committee has tried to focus on a few key to keep the exchange rate fixed and accept- areas, and even there, on broad principles and ing more inflation, and at other times letting directions, without entering too much into the exchange rate appreciate while focusing details of implementation—the Committee’s on controlling inflation. This freedom of broad mandate necessitates such an ap- action however confuses markets, even while proach. We do propose some intermediate, the real exchange rate goes where funda- or bridging, steps wherever possible. We do mentals say it must. This is not a theoretical not go into nuances in this chapter. We end assessment, it is consistent with the experience Introduction, Executive Summary, and List of Main Proposals 5 of a number of countries including ours. are ineffective beyond the short run. In an But the confusion does have adverse effects. economy as open to trade as India is today, To the extent that the public is not sure about capital will always find a way to come in on the central bank’s commitment to control- the back of trade, for example as under- ling inflation, it will expect higher inflation, invoicing and over-invoicing, or as trade and charge a high interest rate premium for credit. Moreover, even though India looks inflation risk, both of which will increase attractive right now, it may not in the fu- long-term interest rates, hurting growth. ture. We should not stamp on foreign capital We therefore believe the Reserve Bank now for we may need to retain its con- of India (RBI) can best serve the cause of fidence in the future. Similarly, sterilized growth by focusing on controlling inflation, currency intervention by the central bank and intervening in currency markets only to can re-export inflows, but it is rarely effective limit excessive volatility. This focus can also beyond the short term, and creates a number best serve the cause of inclusion because of other costs for the economy. the poorer sections are least hedged against While the Committee recognizes there are inflation. There are other benefits in choos- no easy solutions here, and a wide divergence ing this option. By reducing the accumulation of beliefs amongst respectable economists, of foreign reserves beyond what is necessary the Committee believes we should use the for precautionary purposes, the burden on current period when foreign investors are the budget will be limited. And an exchange rediscovering India to strengthen India’s rate that reflects fundamentals tends not markets so that foreign investors feel com- to move sharply, and serves the cause of fortable entering, and use them to help im- stability. Lastly exporters weaned away from prove the experience for domestic investors expecting an undervalued exchange rate too. For instance, given India’s infrastructure will focus on increasing productivity, thereby needs, it has too few long-term domestic contributing to growth. investors. Similarly, India relies too much on Proposal 1: The RBI should formally force-feeding government debt to its financial have a single objective, to stay close to a low institutions. By allowing foreign investors in inflation number, or within a range, in the greater numbers into the corporate rupee- medium term, and move steadily to a single denominated bond market, we can build instrument, the short-term interest rate (repo liquidity in that market through investors and reverse repo) to achieve it. who are willing to take risks domestic in- The RBI should be as willing to cut rates vestors are not. In turn, that liquidity will when inflation is expected to fall below the attract domestic investors and create a vir- objective, so that the policy revives growth, as tuous cycle. By allowing foreign investors it is to raise rates when inflation is expected to into the government bond market, we fund exceed the objective because growth exceeds our government debt more easily, freeing the economy’s potential. It is in this way that the balance sheets of domestic financial the RBI can best support the objectives of institutions to finance other entities and growth and stability. expand access. The Committee is well aware of the prob- Proposal 2: Steadily open up investment lems posed by substantial capital inflows. in the rupee corporate and government bond The real exchange rate is likely to appreciate markets to foreign investors after a clear when foreign capital flows in, and this can monetary policy framework is in place. hurt the country’s competitiveness. But what Of course, there is a worry about whether is the alternative? Is shutting off inflows, that we will encourage more foreign inflows by is, imposing capital controls, likely to work opening debt markets further, exacerbating in helping India retain competitiveness? We our real exchange rate appreciation. It may think not, simply because capital controls well be that some of those who now can 6 A HUNDRED SMALL STEPS

only get India exposure through equity credibility of monetary policy can be sev- might switch to debt. But given our concern erely compromised by high budget deficits. about appreciation, we should liberalize the The principal elements of the framework bond markets opportunistically, expanding laid out in this chapter—strengthening fiscal, foreign investor limits more when other financial and monetary institutions—would forms of capital inflows are at low ebb. Of thus reinforce each other. course, it would not be prudent to wait till Finally, one cannot overemphasize the foreign investors shun India to liberalize, for need for real sector reforms. Finance ultim- there would be no interest precisely when ately provides the lubrication that allows the the country needs them. Instead, we should engine of the economy to run smoothly. But accept the possible costs of appreciation as it is not the engine itself—that needs real a legitimate down payment on the more sector reforms such as building out infra- robust markets and financing we will enjoy structure, reforming the labour laws, im- in the future. proving the social safety net, etc. The effects We should also relieve pressure from in- of the proposals made by this Committee will flows by becoming more liberal on outflows, be magnified if they can piggy-back on real especially in forms that can be controlled sector reforms. if foreign currency becomes scarce. For instance, we should encourage greater outward investment by provident funds and BROADENING ACCESS insurance companies when inflows are high. TO FINANCE Such diversification will make these funds more stable (give them less exposure to high In Chapter 3, the Committee turns to the volatility Indian markets). The relevant con- most important issue of fi nancial inclusion. stituencies need to be persuaded that by re- The Committee proposes a paradigm shift stricting their investment options to domestic in the way we see inclusion. Instead of seeing government securities, they are greatly limit- the issue primarily as expanding credit, which ing future returns and possibly increasing puts the cart before the horse, we urge a risk. At the very least, a first step would be refocus to seeing it as expanding access to to diversify across foreign government secur- fi nancial services, such as payments services, ities, so that we offset foreign inflows into our savings products, insurance products, and government debt markets with outflows into infl ation-protected pensions. If, for example, foreign government debt markets, without the enormous transfers to the poor through these flows being driven by the RBI. various government programmes can be The Government of India must also rec- channelled into savings accounts that the ognize that fiscal discipline is an essential poor open, not only will leakage be reduced, adjunct to the process of financial reforms. but the poor will be able to build savings A high level of public deficit financing soaks histories with their bank which can then open up capital and has serious consequences for the door to credit. Moreover, the fi nancial macroeconomic development and for the experience dealing with the account and the financial system. With a more flexible ex- bank will help households build a greater change rate and a more open capital account, business capacity, a critical need in making fiscal policy also has an important role to better use of credit. This is why the Committee play as a short-term demand management advocates a national goal of ensuring in three tool. Moreover, disciplined fiscal policy— years that 90 per cent of households, if they lower levels of government deficits and a so desire, have access to a deposit account declining ratio of public debt to GDP—is and to the payments system, and that gov- necessary to free up monetary policy to ernment transfers under various schemes focus on its key objective of price stability. be implemented through this system. While Indeed, the effectiveness, independence and the proposed nationwide electronic fi nancial Introduction, Executive Summary, and List of Main Proposals 7 inclusion system (NEFIS) could utilize much knowledge to bear on the products that are of the existing infrastructure, some elem- needed locally, and to have the locus of ents, especially the last mile, will have to be decision making close to the banker who is built out, and should be encouraged on an in touch with the client, so that decisions can expedited basis. be taken immediately. It would also offer an Ultimately, though, it is opportunities in entry point into the banking system, which the real sector, created by broader growth, some entities can use to eventually grow into which will give the poor the ability to use large banks. credit effectively. Instead of forcing credit A large number of commentators be- to household that could thereby become lieve, based on historical evidence, that heavily indebted, the focus should be on small banks will be unviable in India. They making them creditworthy so that when op- question the honesty of small promoters, as portunities arise, they have access. well as the profitability of these banks given In addition, this Committee would sug- high fixed costs. This Committee recognizes gest moving away from a sole focus on rural that small banks have not distinguished areas, where undoubtedly many of our poor themselves in India in the past, often because live, to also include the urban areas where of poor governance structures, excessive gov- more of them are migrating. But perhaps ernment and political support as well as the most important shift in paradigm is interference, and an unwillingness/inability to alter the emphasis somewhat from the of the regulator to undertake prompt cor- large-bank-led, public-sector-dominated, rective action. These are not the banks the mandate-ridden, branch-expansion-focused Committee wants, and the Committee would strategy for inclusion. The poor need effi- call for substantial care in who is licensed, as ciency, innovation, and value for money, well as greater regulatory oversight. which can come from motivated financiers There is, however, no necessary link who have a low cost structure and thus see between size and honesty, as the recent ex- the poor as profitable, but who also have the perience with large banks suggests. Indeed, capacity of making decisions quickly and the larger number of potential applicants for with minimum paperwork. The Committee small banks suggests the regulator can be far proposes two organizational structures to more selective in applying ‘fit and proper’ foster such delivery: criteria. Moreover, technological solutions Proposal 3: Allow more entry to private can bring down the costs of small banks well-governed deposit-taking small finance substantially, even while increasing their banks offsetting their higher risk from being transparency. Finally, the failure of even a geographically focused by requiring higher few small banks will not have systemic con- capital adequacy norms, a strict prohibition sequences, unlike the failure of a single on related party transactions, and lower allow- large bank. In sum, the Committee believes able concentration norms (loans as a share there has been sufficient change in the en- of capital that can be made to one party). vironment to warrant experimentation with Make significant efforts to create the super- licensing small banks. visory capacity to deliver the greater monitor- The second organizational structure the ing these banks will need initially, and put Committee proposes makes it easier for large in place a tough prompt corrective action financial institutions to ‘bridge the last mile’. regime that ensures these banks do not be- Large institutions have the ability to offer come public charges. commodity products like savings accounts The small finance bank proposed above at low cost, provided the cost of delivery and emulates the Local Area Bank initiative by the customer acquisition is reduced. They should RBI that was prematurely terminated, though be able to use existing networks like cell- the details of the Committee’s proposal dif- phone kiosks or kirana shops as business fers somewhat. The intent is to bring local correspondents to deliver products. The RBI’s 8 A HUNDRED SMALL STEPS

proposals on business correspondents, with for expanding access, others may be able to some relaxations, are an important step in offer the service more efficiently. this direction. The Committee proposes the following Proposal 4: Liberalize the banking cor- scheme to allow a more efficient imple- respondent regulation so that a wide range mentation of the priority sector lending of local agents can serve to extend financial mandate (with similar schemes extending services. Use technology both to reduce costs to possible financial service mandates also— and to limit fraud and misrepresentation. see later). Any registered lender (including Cooperative banks, both urban and rural, microfinance institutions, cooperative banks, are the face of banking that most Indians banking correspondents, etc.) who has made encounter. Unfortunately, primarily because loans to eligible categories would get ‘Prior- of excessive political interference, poor gov- ity Sector Lending Certificates’ (PSLC) for ernance and a willingness of governments the amount of these loans. A market would to recapitalize and refinance even poor per- then be opened up for these certificates, formers, this sector has underperformed where deficient banks can buy certificates seriously. This Committee supports the to compensate for their shortfall in lending. thrust of the Vaidhyanathan Committee Importantly, the loans would still be on the recommendations on governance reforms books of the original lender, and the defi- and recommends they not be diluted in cient bank would only be buying a right to implementation. Indeed, it would suggest undershoot its priority sector-lending re- rethinking the entire cooperative bank struc- quirement by the amount of the certificate. If ture, and moving more to the model practiced the loans default, for example, no loss would elsewhere in the world, where members have be borne by the certificate buyer. The merit their funds at stake and exercise control, of this scheme is that it would allow the most debtors do not have disproportionate power, efficient lender to provide access to the poor, and government refinance gives way to re- while finding a way for banks to fulfil their financing by the market. The Committee norms at lower cost. Essentially the PSLC will would suggest implementation of a strong be a market-driven interest subsidy to those prompt corrective action regime so that un- who make priority sector loans. viable cooperatives are closed, and would Proposal 5: Offer priority sector loan recommend that well-run cooperatives with certificates (PSLC) to all entities that lend to a good track record explore conversion to a eligible categories in the priority sector. Allow small bank license, with members becoming banks that undershoot their priority sector shareholders. obligations to buy the PSLC and submit it to- The Committee believes that priority wards fulfilment of their target. sector mandates have a role in promoting One big factor impeding the flow of cre- inclusion, but they should be revised down dit from formal institutions to the poor is to focus solely on the sectors that truly need that interest rate ceilings (either imposed access (including the urban poor). The process by the centre or the state) make priority sec- by which the mandates are implemented tor lending unprofitable, and ensure that should be reformed to emphasize efficiency the banker attempts to recover his money and ease of compliance, and once the new through hidden charges in the loans that are process is in place, the mandate should be made, or that he does not lend so the poor strictly enforced. The focus should be on are driven to the moneylender. The Com- actually increasing access to services for the mittee believes a better way to proceed is poor regardless of the channel or institution to liberalize interest rates while increasing that does this—large banks may or may not safeguards that prevent exploitation. be the best way to reach the poor, and while Proposal 6: Liberalize the interest rate the mandate may initially force them to pay that institutions can charge, ensuring credit Introduction, Executive Summary, and List of Main Proposals 9 reaches the poor, but require (i) full trans- gets the maximum out of its productive re- parency on the actual effective annualized sources. This is also equitable for only thus interest cost of a loan to the borrower, (ii) will the interests of the consuming masses be periodic public disclosure of maximum and emphasized, instead of the more usual trend average interest rates charged by the lender of privileged producers being protected. to the priority sector, (iii) only loans that stay The Committee makes a number of re- within a margin of local estimated costs of commendations on ways to level the playing lending to the poor be eligible for PSLCs. field, with a focus on the banking sector. In Liberalizing interest rates would allow particular, it believes it is time to unwind the formal sector to lend to the poor and the grand bargain underlying the treatment keep them from the moneylender, though of banks in India whereby banks get access liberalization would require the political to low-cost deposits in return for fulfilling will to accept the widespread evidence that certain social obligations such as lending to low interest rate ceilings simply do not help the priority sector, as well as meeting pru- the poor. Formal institutions will have repu- dential norms such as statutory liquidity tational reasons to not charge exorbitant rates, ratios (that also have a quasi-fiscal objective even after liberalization. The Committee of funding the government). The reason, believes that through a combination of trans- quite simply, is that the bargain will become parency, incentives, and eventually com- increasingly unbalanced as competition petition, liberalized interest rates to the poor erodes bank privileges. This is why the Com- can be kept within reasonable limits, and mittee suggests that the government pay liberalization would enhance, and improve more directly for the social obligations it the sources of, credit to the poor. wants banks to undertake (for example, by The Committee believes that we also have reducing priority sector obligations and, to improve methods of risk mitigation for over time, paying directly for PSLCs), while the poor. Finally, technology may be the way it steadily allows more competition in bank- of reducing costs so that services can be ing activities. provided cheaply, and the Committee exam- Perhaps the greatest source of uneven ines potential actions the government can privileges in the banking system stems from take to facilitate roll-out. ownership. The public sector banks, accounting for 70 per cent of the system, enjoy benefits but also suffer constraints, with the LEVELLING THE PLAYING latter increasingly dominating. There is little FIELD evidence that the ownership of banks makes any difference to whether they undertake There are a number of ways the playing fi eld social obligations, once these are mandated is not level in India. Some institutional forms, or paid for. So on net, what matters is how an such as banks, are favoured in certain ways ownership structure will affect the efficiency relative to others, while disfavoured in other with which financial services are delivered. ways. The public sector is constrained in some And it is here that government ownership ways but enjoys some privileges in other is likely to have serious adverse effects going ways. The domestic private sector enjoys some forward. Much of the public sector is falling privileges relative to foreign players, but not behind in its ability to attract skilled people, everywhere. In an effi cient fi nancial system, especially at senior levels, in its ability to take the playing fi eld is level so that different insti- advantage of new technologies, in its ability tutions compete to provide a function, no to motivate employees at lower levels, and institution dominates others because of the in its ability to innovate. Since all these cap- privileges it enjoys, competition results in re- abilities are needed in the emerging areas of sources being allocated effi ciently, and society opportunity, public sector banks risk falling 10 A HUNDRED SMALL STEPS

seriously behind, and because risk manage- least in the foreseeable future. That leaves a ment is one of the needed new areas, also risk sale through a public offering. But such a sale becoming destabilizing. would require confidence in the corporate The majority of this Committee does governance of these enterprises so that a high not see a compelling reason for continuing price can be realized. government ownership. There are other This Committee therefore believes that activities where government attention and the second aspect of the pragmatic approach, resources are more important. However, the especially for large and better performing Committee does recognize that public public sector banks, should be to focus on re- opinion in the country is divided on the issue forming the governance structure, while per- of privatization. A parallel approach is to haps also acquiring strategic partners, with undertake reforms that would remove con- the eventual disposition determined based straints on the public sector banks, even while on experience with privatization, the public retaining government ownership. Inter- mood, and the political environment. mediate steps such as reducing the govern- Proposal 8: Create stronger boards for ment’s ownership below 50 per cent while large public sector banks, with more power retaining its control (as suggested by the to outside shareholders (including possibly Narasimham Committee) are also possible. a private sector strategic investor), devolving Unfortunately, ideology has overtaken the power to appoint and compensate top reasoned debate in this issue. The pragmatic executives to the board. approach, which should appeal to practical Proposal 9: After starting the process of people of all hues, is to experiment, as China strengthening boards, delink the banks from does so successfully, and to use the resulting additional government oversight, including experience to guide policy. One aspect of the by the Central Vigilance Commission and pragmatic approach would be to sell a few Parliament, with the justification that with small underperforming public sector banks, government-controlled boards governing possibly through a strategic sale (with some the banks, a second layer of oversight is protections in place for employees), so as to not needed. Further ways to justify reduced gain experience with the selling process, and government oversight is to create bank hold- to see whether the outcomes are good enough ing companies where the government only to pursue the process more widely. has a direct stake in the holding company. Proposal 7: Sell small underperforming Another is to bring the direct government public sector banks, possibly to another bank stake below 50 per cent, perhaps through or to a strategic investor, to gain experience divestment to other public sector entities or with the process and gauge outcomes. provident funds, so that the government For the largest PSBs, the options are (broadly defined) has control, but the gov- more limited. The selling of large PSBs to ernment (narrowly defined) cannot be con- large private sector banks would raise issues sidered the owner. of concentration. The selling of banks to Turning from the public sector to the industrial houses has been problematic banking sector as a whole, the Committee be- across the world from the perspective of fi- lieves that fewer constraints should be nancial stability because of the propensity imposed on banks, and more growth, com- of the houses to milk banks for ‘self-loans’. petition, and entry should be encouraged. Without a substantial improvement in the One method to foster bank growth is to allow ability of the Indian system to curb related- bank mergers. party transactions, and to close down failing To the extent that takeovers of Indian banks banks, this could be a recipe for financial (or domestically incorporated subsidiaries disaster. While large international banks of foreign banks) do not raise issues of ex- could swallow our largest banks, it is unlikely cessive concentration or stability, they should that this would be politically acceptable, at be permitted. It may be sensible to start by Introduction, Executive Summary, and List of Main Proposals 11 being more liberal towards the takeover of urban areas, but it can be explicitly achieved small banks with a view to allowing bidders, today by instituting a service norm—for every targets, regulators, and market participants x savings accounts that are opened in high gain experience in how to manage takeovers. income neighbourhoods, y low-frill accounts Domestically incorporated foreign banks have to be opened in low income neigh- should be treated on par with private and bourhoods. The service provision obligation public sector Indian banks in this regard could become traded (much as the priority from April 2009, as announced by the RBI sector norms earlier), with small banks or in its roadmap. cooperatives acquiring certificates for the Proposal 10: Be more liberal in allowing excess number of accounts they provide and takeovers and mergers, including by domes- selling them to deficient banks. The gov- tically incorporated subsidiaries of foreign ernment may provide added incentives by banks. buying certificates, and should take over this The commitment to allow foreign banks obligation from banks over time. subsidiaries to participate in takeovers will Turning finally to the need for structures substantially increase the pressure on domes- that allow a variety of financial functions tic banks. This can be salutary, but domestic under one roof, the Committee endorses banks need to prepare themselves to meet the much of the RBI proposal for holding challenge. A second way to foster growth and companies. competition, but also to strengthen banks, is Proposal 12: Allow holding company to de-license the process of branching im- structures, with a parent holding company mediately. The RBI can retain the right to owning regulated subsidiaries. The hold- impose restrictions on the growth of certain ing company should be supervised by the banks for prudential reasons, but this should Financial Sector Oversight Agency (see later), be the exception rather than the norm. with each regulated subsidiary supervised Proposal 11: Free banks to set up branches by the appropriate regulator. The holding and ATMs anywhere. company should be well diversified if it owns Domestic banks have not had the freedom a bank. to set up branches anywhere thus far, and Universal banking should thus be pos- will not have anticipated such liberalization sible in India through holding company (which was not an element of the RBI structures. Some legislative and tax change roadmap). Given that foreign banks have is required to make these structures viable, deeper pockets, experience, and skills re- and these are outlined in the report. lative to domestic banks in rolling out a branching strategy in the newly liberalized environment, the Committee believes it neces- CREATING MORE EFFICIENT sary to allow a period of say two years from AND LIQUID MARKETS the announcement of the policy till the liberal licensing policy applies to domestically Financial markets and institutions need to incorporated subsidiaries of foreign banks. evolve considerably in order to keep up with Till such time, the existing policy of branch the requirements of Indian ﬁ rms and Indian licensing will apply to domestically incor- investors in coming years. The corporate porated subsidiaries of foreign banks. They bond market is moribund and will have to will, however, be able to acquire branches be revived and a number of missing markets through takeovers of existing Indian banks. will have to be created, including exchange One objective of branch licensing is to traded interest rate and foreign exchange force banks into under-banked areas in ex- derivatives contracts. But even in markets change for permission to enter lucrative urban that exist, apart from the equity market for areas. This is again an obligation that will have large capitalization stock, the ability to trade to be revisited as competition increases in consistently at low cost (that is, liquidity) 12 A HUNDRED SMALL STEPS

and the tendency of market prices to refl ect Proposal 16: Create the concept of one fundamentals (that is, market effi ciency) are consolidated membership of an exchange typically low for most markets. This needs to for qualified investors (instead of the current change for markets to play a bigger role in need to obtain memberships for each prod- inclusion, growth and stability. uct traded). Consolidated membership In the equity markets, the environment should confer the right to trade all the ex- needs to be made more conducive to private change’s products on a unified trading screen equity, venture capital, and hedge funds. with consolidated margining. Mutual funds and pension funds (when they Proposal 17: Encourage the setting up of emerge) should play a more active role in ‘professional’ markets and exchanges with governance. In other markets, participation a higher order size, that are restricted to needs to increase substantially to enhance sophisticated investors (based on net worth liquidity, and foreign players could play a key and financial knowledge), where more role, as could domestic financial institutions sophisticated products can be traded. such as insurance companies and provident Proposal 18: Create a more innovation- funds. Access to markets for the poor need to friendly environment, speeding up the process be increased, as does access to international by which products are approved by focusing financial services for Indian firms and primarily on concerns of systemic risk, fraud, investors. The production of international contract enforcement, transparency and in- financial services by Indian financial firms appropriate sales practices. The threshold needs to be enhanced. for allowing products on professional ex- Turning to specific suggestions, the Com- changes (see Proposal 16) or Over the Counter mittee believes that there are substantial markets should be lower, so that experi- efficiencies to be had by consolidating the mentation can take place. regulation of trading under one roof—this Proposal 19: Allow greater participation will allow scope economies to be realized, im- of foreign investors in domestic markets as in prove liquidity, and increase competition. Proposal 2. Increase participation of domes- Moreover, all markets are interconnected, so tic investors by reducing the extent to which fragmenting regulation weakens our ability regulators restrict an institutional investor’s to regulate. choice of investments. Move gradually in- Therefore, stead to a ‘prudent man’ principle where the Proposal 13: Bring all regulation of trad- institutional investor is allowed to exercise ing under the Securities and Exchange Board judgement based on what a prudent man of India (SEBI). might deem to be appropriate investments. In areas where multiple regulators share Emphasize providing access to suitable equity- concerns about a market (for example, RBI linked products to the broader population has a legitimate interest in the government as part of the inclusion agenda. bond market), regulators will have to cooperate even after the supervision of trading moves to SEBI. The rest of the Committee’s CREATING A GROWTH- main market-related proposals are self- FRIENDLY REGULATORY explanatory. ENVIRONMENT Proposal 14: Encourage the introduction of markets that are currently missing such as Sixteen years of reforms have created a fairly exchange traded interest rate and exchange sound regulatory framework. Though the rate derivatives. task is by no means complete, the ground- Proposal 15: Stop creating investor un- work that has been laid will allow us to move certainty by banning markets. If market rapidly towards the regulatory architecture manipulation is the worry, take direct action that is appropriate for a country of India’s against those suspected of manipulation. size and aspirations. While building on past Introduction, Executive Summary, and List of Main Proposals 13 successes, it is also important to remember financial markets in industrial countries. there are defi ciencies in the current regulatory While it is too early to draw strong lessons, a system. number of issues seem apparent: A number of problems exemplify the substantial road that still has to be travelled in 1. It is not suffi cient for regulators to only look at the part of the system under their achieving an adequate financial regulatory immediate purview. Because markets are and supervisory structure in India. First, the integrated, any unregulated participant pace of innovation is very slow. Products can infect markets and thus contaminate that are proposed to be introduced in India regulated sectors also. For instance, there (though well established elsewhere in the is some evidence that unregulated mortgage brokers originated worse loans than world) take several years to get regulatory regulated ones, contaminating the sec- approval. uritization process. While the immediate Second, excessive regulatory micro- conclusion is not to regulate everyone management leads to a counter-productive to the same degree, it does suggest regulators have to be alert to entities that could interaction between the regulator and the have systemic consequences, including regulated. The regulated respond to the needs on markets. and opportunities in the marketplace while 2. Capital regulation is no substitute for attempting to comply only with the letter ensuring the incentives of fi nancial institution management are adequate—that of the law. The regulator then attempts to the spirit of the regulation is being stamp out violations of the spirit through obeyed rather than just the rule. For ex- new rules and the regulated find new ways ample, the off-balance sheet entities of to get around them. the major banks, including the structured Third, some areas of the financial sector investment vehicles (SIVs), met the rules of being off-balance sheet (and hence did have multiple regulators, while others that not require a charge on capital), but in could pose systemic risks have none. Both practice turned out to be effectively on- situations, of unclear responsibility, and of balance sheet. Indeed, there is increasing no responsibility, are dangerous. debate about whether the Basel II capital norms are adequate, both in good times Fourth, regulators tend to focus on their in preventing excessive risk taking, and in narrow area to the exclusion of other sectors, bad times when strict capital norms can leading to balkanization even between areas hold back bank lending and result in a of the financial sector that naturally belong downward spiral. 3. In a market-based system, banks are not together. Financial institutions are not able the only source of illiquidity risk. Any to realize economies of scope in these areas, entity that has mismatched assets and leading to inefficiency and slower growth. liabilities (mismatched in terms of dur- Moreover, by ignoring the links between ation or liquidity) is subject to the risk of becoming illiquid. To the extent that areas, regulators miss sources of systemic risk. entity is of systemic importance—either Macro-prudential risk assessments will too big, too interlinked, or too many become increasingly important as the econ- investors to fail—it will have a call on pub- omy modernizes and becomes integrated lic funds. To the extent that regulators with the world economy. are likely to provide either liquidity or solvency support (and the line between Finally, regulatory incentive structures these is very thin), they owe it to the pub- lead to excessive caution, which can be aug- lic to monitor these entities and ensure mented by the paucity of skills among the the charge on the taxpayer is limited. regulator’s operational staff relative those of Moreover, systems will have to be evolved to assess and maintain the overall liquid- the regulated. Such caution could actually ity position of the fi nancial system, over exacerbate risks. and above its capital adequacy. Of course, any discussion of regulation has 4. Deep markets with varied participants can to take cognizance of the recent turmoil in absorb overall risk better. While indeed 14 A HUNDRED SMALL STEPS

the risk that has infected world markets clever about managing the risks, focusing started in the US sub-prime sector, efforts better at warding off the really big in part because of excessive fi nancial ones, and making participants cooperate exuberance, despite its proximity and ex- more in the process rather than making them posure the United States fi nancial system has weathered the losses thus far adversaries. Furthermore, financial sector surprisingly well. Indeed, US equity mar- development can help the risk management kets have held up better than the Indian process, both by reducing risks, and by stock markets! Part of the reason has to shifting them to where they can be borne be its openness and variety. US banks better, a theme through much of this report. could recapitalize quickly by tapping The Committee’s proposals therefore seek into sovereign wealth funds elsewhere. Even while banks are hamstrung by over- to create: loaded balance sheets, hedge funds and private equity players are entering the 1. A better risk management process for markets for illiquid assets. regulators and the regulated, addressing 5. Consumer protection is important. Not both the environment in which they oper- every household is fully cognizant of the ate, as well as the way they tackle risks, transactions they enter into. While the line while allowing the innovation needed to between excessive paternalism and ap- spur growth. propriate individual responsibility is 2. A more streamlined regulatory architec- always hard to draw, in a developing coun- ture that reduces regulatory costs, overlaps, silos, and gaps. try like ours, it may well veer to a little 3. Better coordination between regulators more paternalism in interactions between so that systemic risks are recognized early fi nancial fi rms and less-sophisticated and tackled in a coordinated way. households. It is important to improve 4. A coordinated process to protect con- consumer literacy, the transparency of sumer interests as well as raise literacy products that are sold, and in some cases, levels. limit sales of certain products in certain 5. Better frameworks for reducing the level jurisdictions, especially if they have pru- of fi nancial risk—for example, through dential consequences. prompt corrective action. 6. There is no perfect regulatory system. The problems with Northern Rock in the United Kingdom are being attributed to the fact that the United Kingdom Changes to legislation had moved to a single supervisor, the Financial Services Authority (FSA), The primary source of the micro-management with the monetary authority having no starts with the legislation governing regu- supervisory powers. At the same time, lation. For instance, the requirement that the Bear Stearns debacle in the United banks obtain regulatory approval for a range States is being attributed to the absence of a single supervisor. What is essential is of routine business matters, including opening effective cooperation between all the con- branches, remuneration to board members cerned authorities, which transcends the and even payment of fees to investment specifi cs of organizational architecture. bankers managing equity capital offerings, is enshrined in the Banking Regulation Act. In sum then, the Committee believes The Committee supports the recommen- that there is no room for complacency. The dation of the High Powered Expert Committee imperatives of the need to grow the econ- on Making Mumbai an International Finan- omy and improve inclusion will necessarily cial Centre that legislation governing fi nancial create more risk. The regulators cannot sector regulation has to be fundamentally re- stand in the way, they have to monitor and written, focusing on broad principles rather manage the greater risk, and the public has to than specifi c rules. be more tolerant of regulators in that more Proposal 20: Rewrite financial sector losses are part and parcel of the greater risk. regulation, with only clear objectives and At the same time, we have to become more regulatory principles outlined. Introduction, Executive Summary, and List of Main Proposals 15

However, such legislation would have regulator every five years. Every year, each to be drafted carefully, as Indian courts are regulator should report to a standing com- not likely to look upon excessive delegation mittee (possibly the Standing Committee on favourably (the Supreme Court of India has Finance), explaining in its annual report the held that the ‘essential legislative function’ progress it has made on meeting the remit. cannot be delegated and a statutory delegate The interactions should be made public. cannot be given an unguided or un-canalized In addition, to ensure there are more dir- power). What should be left to the regulator ect checks on the regulator in a system that is is the ancillary function of providing the less rule-bound, the Committee recommends details. Proposal 22. Proposal 22: Regulatory actions should be subject to appeal to the Financial Sector Changes to the process of Appellate Tribunal, which will be set up along evaluation and compensation the lines of, and subsume, the Securities Appellate Tribunal. It should also be recognized that excessive To enhance the quality of regulatory micro-management or rule-based regulation staff, the Committee suggests that regulators is not merely refl ective of the statute books continue their ongoing attempts to give of the nation, but is also refl ective of the ap- recruits higher remuneration as well as re- proach adopted by the regulator. A regulator sponsibilities, but also that every effort that adopts a ‘rule-based’ approach will seek should be made to allow mobility to and to prosecute every minor breach of a rule, ir- from the private sector. Each individual respective of its import in the larger scheme organization will, however, have to take of things. It may well be that the regulator’s reasonable precautions against conflicts of fear that an acquittal may result in a pos- interest arising out of prior or subsequent sible vigilance commission inquiry leads to employment. this emphasis. By contrast, when adopting a ‘principle-based’ approach, a regulator may ignore a minor violation of positive law, so Changes to the regulatory long as the spirit of the laws is retained. architecture This is why the Committee believes that regulators should be given a clearer sense The Committee felt it premature to move of their mandate and the specific outcomes fully towards a single regulator at the moment, they will be evaluated on, with any evaluation given other pressing regulatory changes focused on whether those outcomes were that are needed. However, regulatory struc- achieved, and if not, whether the actions tures can be streamlined to avoid regu- the regulator took had a high expectation latory inconsistencies, gaps, overlap, and of achieving the outcomes at the time they arbitrage. Steps in this direction should were taken. In other words, regulators at include a reduction in the number of regu- the highest level should not run the risk of lators, defi ning their jurisdiction wherever having to face roving enquiries that second possible in terms of functions rather than guess specific decisions with the benefit of the forms of the players, and ensuring a level hindsight. Regular interaction with parlia- playing fi eld by making all players perform- ment, where they explain how they are ad- ing a function report to the same regulator hering to their mandate, should give them regardless of their size or ownership. In safe harbour against such enquiries. addition, the Committee felt it is prudent to Proposal 21: Parliament, through the start the process of unifying regulation and Finance Ministry, and based on expert opin- supervision at certain levels, and recom- ion as well as the principles enshrined in mends a strengthening and consolidation legislation, should set a specific remit for each of regulatory structures to deal with large 16 A HUNDRED SMALL STEPS

complex, systemically important, fi nancial between various aspects of the financial conglomerates on the one hand, and with system necessitate constant communication the consumer on the other. between regulators at the highest levels. One aspect of regulatory architecture has Regulators also need to have an overall view already been presented—to bring all regu- of the financial sector to initiate prompt and lation of trading under SEBI. The Committee coordinated corrective action, and to remove also suggests a proposal (23). inconsistencies in approach. Even though Proposal 23: Supervision of all deposit our Committee recommends separate pru- taking institutions must come under the RBI. dential regulators, it strongly recommends Situations where responsibility is shared, such strengthening the ties between them and as with the State Registrar of Cooperative improving coordination. Societies, should gradually cease. The RBI Proposal 25: A Financial Sector Over- will have to increase supervisory capacity to sight Agency (FSOA) should be set up by take on this task. The Committee recogn- statute. The FSOA’s focus will be both izes this involves constitutional issues but macro-prudential as well as supervisory; the nevertheless recommends a thorough over- FSOA will develop periodic assessments of haul of the system of shared responsibility. macroeconomic risks, risk concentrations, Drawing a lesson from the current crisis in as well as risk exposures in the economy; it industrial countries, the Committee recom- will monitor the functioning of large, sys- mends that joint responsibility for monetary temically important, financial conglomerates; policy and banking supervision continue to anticipating potential risks, it will initiate be with the RBI, and that the RBI play an balanced supervisory action by the concerned important role in the joint supervision of regulators to address those risks; it will ad- conglomerates and systemically important dress and defuse inter-regulatory conflicts. NBFCs (see the proposal for the Financial The FSOA should be comprised of chiefs Sector Oversight Agency below). of the regulatory bodies (with a chair, typic- In India, annual accounts are filed with the ally the senior-most regulator, appointed Registrar of Companies under the Depart- from amongst them by the government), and ment of Company Affairs in the Government should also include the Finance Secretary of India. However there is no system of re- as a permanent invitee. The FSOA should viewing accounting reports even on a selective have a permanent secretariat comprised of or sample basis. The Committee believes that staff including those on deputation from the such a process of review is absolutely es- various regulators. There should be a pre- sential so that the public can have more con- scribed minimum frequency of meetings fidence in company reports. This process of the FSOA. All issues of regulatory co- can be outsourced initially. Furthermore, ordination, and supervision of systemically it should be monitored carefully so that it important financial conglomerates and does not become a source of harassment but financial institutions will be taken up by indeed adds genuinely to public confidence the FSOA. in accounts. The discussions of the FSOA with the Proposal 24: The Ministry of Corporate management of systemically important Affairs (MCA) should review accounts of un- institutions will be ‘principles-based’, and listed companies, while SEBI should review this will initiate the process of gradually accounts of listed companies. implementing more ‘principles-based’ regu- As financial conglomerates or holding lation throughout the system. It will be companies begin to dominate the system, important that the FSOA add value by sub- a consolidated system of supervision be- stituting for some existing processes instead comes more important. Moreover, spillovers of adding another layer, while bringing Introduction, Executive Summary, and List of Main Proposals 17 collective regulatory views to bear. It is exception, especially when there is more not our intent that the FSOA be a ‘super- rapid entry into the system. regulator’ displacing existing regulators. Proposal 28: The Committee recommends Instead it provides needed coordination and strengthening the capacity of the Deposit In- fills gaps that current structures have proved surance and Credit Guarantee Corporation inadequate for. (DICGC) to both monitor risk and resolve a In addition, there is merit in setting up a failing bank, instilling a more explicit system Working Group on Financial Sector Reforms of prompt corrective action (see Proposal 3), with the Finance Minister as the Chairman. and making deposit insurance premia more The main focus of this working group would risk-based. be to monitor progress on financial sector The combination of the proposed changes reforms (such as the proposals of the Patil, to legislation, regulatory incentive structures, Parekh, Mistry, and this Committee), and to and regulatory architecture, should help initiate needed action. The working group’s create a far more enabling regulatory frame- membership would include the regulators, work, which will provide for greater stability, as well as ministries on as-needed basis. The higher growth and innovation, and more working group would be supported by a inclusion. secretariat inside the Finance Ministry. Proposal 26: The Committee recommends setting up a Working Group on Financial CREATING A ROBUST Sector Reforms with the Finance Minister as INFRASTRUCTURE the Chairman. The main focus of this work- FOR CREDIT ing group would be to shepherd financial sector reforms. In order for credit to fl ow freely, lenders The Committee also notes the consumer should have sufficient knowledge about faces an integrated portfolio of services. It is borrowers, be able to take the borrower’s increasingly important for the consumer to assets as collateral, be able to enforce penal- have a ‘one stop’ source of redress for com- ties in case the borrower defaults (such as plaints, a financial ombudsman. Also, an shutting the borrower’s access to credit, at integrated ombudsman is needed to enhance least for a while, or seizing the borrower’s financial literacy and financial counseling, pledged assets), and be able to renegotiate issues that span regulators. The ombudsman their claims in an orderly fashion in case the can also monitor the selling of different borrower is simply not able to pay. A strong products, the degree of transparency about credit infrastructure allows widespread cre- their pricing, and their suitability for targeted dit information sharing, low-cost pledging customers. Finally, given that household debt and enforcement of collateral interests, and loads are increasing, the ombudsman can an effi cient bankruptcy system, which re- provide a neutral forum (and possibly act as negotiates un-payable fi nancial claims while an arbitrator) for out-of-court negotiated preserving the assets in their best use. settlement of debt. Even though a strong credit infrastruc- Proposal 27: Set up an Office of the ture seems to enhance creditor rights only, Financial Ombudsman (OFO), incorporat- research shows it also significantly enhances ing all such offices in existing regulators, to the capacity of individuals to borrow, since serve as an interface between the household creditors are now confident they will be re- and industry. paid. Conversely, weakening the infrastruc- Finally, the Committee noted that a large ture, which seems politically appealing, number of undercapitalized deposit taking while seemingly letting borrowers off the entities continued to survive in the sys- hook, also hurts their future access to credit. tem. Regulatory forbearance should be the Despite progress on a number of fronts, 18 A HUNDRED SMALL STEPS

India still has weak credit infrastructure, a Proposal 31: Ongoing efforts to improve major factor in limiting financial inclusion. land registration and titling—including full Some of the Committee’s key proposals are cadastral mapping of land, reconciling vari- stated below. ous registries, forcing compulsory registration Proposal 29: Expedite the process of of all land transactions, computerizing land creating a unique national ID number with records, and providing easy remote access biometric identification. to land records—should be expedited, with Any system of tracking individual infor- the Centre playing a role in facilitating pilots mation requires a unique identifier, and our and sharing experience of best practices. The credit information system is hampered by Committee also suggests the possibility of the lack of one. Furthermore, in a country special law courts to clear the backlog of land where so many of our people are excluded disputes be examined. from the formal financial system, credit Widespread prohibition of land leasing information alone may not help inclusion is not consistent with efficient resource much because so many have never had cre- allocation. It raises the cost to rural-urban dit. More sources of information, such as migration as villagers are unable to lease their payments of rent or of utilities/cell-phone land, and often have to leave a family mem- bills, need to be tapped to build individual ber (typically the wife) behind to work the records of payment, which can then open land. Lifting these restrictions can help the doors to credit and expand access. landless (or more efficient large land owners) Proposal 30: The Committee recommends get land from those who migrate, and allow movement from a system where information those who currently lease land informally to is shared primarily amongst institutional formalize their transactions and thus obtain credit providers on the basis of reciprocity to institutional credit and other benefits. To a system of subscription, where information the extent that liberalization of land leasing is collected from more sources and a sub- enhances owners’ security and may allow scriber gets access to data subject to verifi- adoption of long-term contracts, it is also cation of ‘need to know and authorization to likely to increase investment incentives for use’ of the subscriber by the credit bureau. all parties. This will also require rethinking the incen- Proposal 32: Restrictions on tenancy tives of providers to share information, and should be re-examined so that tenancy can a judicious mix of payments as well as man- be formalized in contracts, which can then datory requirements for information shar- serve as the basis for borrowing. ing will have to be developed. Given clear title to an asset, let us now Turning to collateral, it can be pledged turn to the process of registering a creditor’s if the potential borrower has clear title to interest in the asset. In order for creditors assets. Land is probably the single most to establish they have a secured claim to an valuable physical asset in the country today. asset, and in order that prospective lenders Unfortunately, the murky state of property or purchasers be made aware of prior claims, rights to land make it less effective as col- a well organized system to register and lateral than it could be. The current state of publicize security interests is essential. The land rights has many other adverse effects, current system of registration in India is including preventing agricultural land from fragmented and neither fully computerized migrating to its best use, slowing land ac- nor easily accessible. The Committee offers quisition for industrial and infrastructure some suggestions in the report on how this projects, clogging courts with disputed cases, can be remedied. and elevating the level of political conflict. Once registered, secured debt claims are While making land rights clear and trans- valuable only if they are enforced. Two im- parent is expensive, it is probably one of the portant recent initiatives towards this pur- most pressing needs of the country today. pose are the Securitisation and Reconstruction Introduction, Executive Summary, and List of Main Proposals 19 of Financial Assets and Enforcement of secured creditors to drive a well-functioning Security Interest Act, 2002 (SRFAESI), and firm into the ground by seizing assets. A good asset reconstruction companies (ARCs). bankruptcy code is especially needed for The SRFAESI Act helps secured creditors large complex infrastructure projects, which by promoting the setting up of asset recon- typically have many claimholders. struction companies to take over the Non- Proposal 35: The Committee outlines a Performing Assets (NPAs) accumulated with number of desirable attributes of a bankruptcy the banks and public financial institutions. code in the Indian context, many of which are Furthermore, it provides special powers to aligned with the recommendations of the lenders and asset reconstruction companies Irani Committee. It suggests an expedited to enable them to take over the assets of bor- move to legislate the needed amendments to rowers without first resorting to courts. There company law. is no reason though that only a special group In the final chapter, the Committee of- should enjoy the powers of SRFAESI. fers views on three important topics, the Proposal 33: The powers of SRFAESI financing of infrastructure, the financing of that are currently conferred only on banks, old age pensions, and the generation of in- public financial institutions, and housing formation in the economy. finance companies should be extended to all institutional lenders. ARCs have additional powers such as PRIORITIES AND step-in rights and the ability to change man- SEQUENCING agement, and the right to sell or lease the business. Given these additional powers, it Low hanging fruit is important that a number of ARCs flourish so that no single ARC has excessive power. Many of the proposals of this Committee are There is really no sensible case to keep for- not controversial, do not conﬂ ict with any eign direct investment out of ARCs. The political party’s views, and require little legis- kind of risk capital as well as the kind of lative effort. They should be implemented expertise foreign investors bring is useful in on an expedited basis. These proposals in- the economy, and can help provide a valuable clude almost all the proposals on ﬁ nancial buffer. From an economic perspective, cap- inclusion, on improving markets, and on ital that comes into the country when the improving the credit infrastructure. banking sector is distressed and a flood of In particular, it ought to be a national assets are sold to ARCs, is particularly valu- priority to roll out a unique national ID num- able, and foreign investors, not domestic ber tied to biometric identification, to offer financial institutions, are most likely to be access to a linked ‘no-frills’ savings account flush with capital at those times. for every household that wants one, and to Proposal 34: Encourage the entry of more channel all government transfer payments well-capitalized ARCs, including ones with to poor households through such accounts. foreign backing. The credit information sharing system should Finally, while secured creditors have been be reformed to allow more information, such empowered, unsecured creditors still have as rental and utility payments, to be used in as- little protection. If India is to have a flourish- sessing credit histories. Credit information ing corporate debt market, corporate public should also be made available to a wider group debt, which is largely unsecured, needs to have of users, with appropriate safeguards. value when a company becomes distressed. With financial services reaching a wider This means a well functioning bankruptcy fraction of the population, the Office of the code, that neither protects the debtor at the Financial Ombudsman (OFO) should be set expense of everyone else including employees, up so as to expand customer literacy, pre- as our current system does, nor one that allows vent exploitation, arbitrate grievances, and 20 A HUNDRED SMALL STEPS

facilitate debt settlements. Technological the licensing of Local Area Banks). We need innovations to reduce transactions costs a more pragmatic approach here amongst (such as mobile payments) and new insti- policymakers, and need to begin experiment- tutional and contractual structures (such ing more widely. Successful experiments as warehouse receipts and trade credit ac- should be rolled out quickly on a nationwide ceptances) should be encouraged. scale. Amongst the other policies where ex- Many of the market reforms we have sug- periments or evidence could prove useful are gested in Chapter 5 are also not technically the Priority Sector Loan Certificate scheme, difficult or politically controversial. They and the proposal to liberalize interest rates. typically require steady liberalization and Improving land titling and registration institution building, and will likely occur if is a reform, the need for which is not con- the regulatory authorities exercise leader- troversial but for which the right approach is ship, and are given support. a matter of substantial debate. Experiments have been under way in different states, and it is now important to distill lessons, develop Technically simple but a national consensus on a possible approach difﬁ culties exist (or approaches), and find a way to allocate the expenses. Administrative, rather than A variety of reforms are technically quite political, leadership is required here. simple (they do not require new thinking, new Many of the reforms relating to banking— institutions, or substantial new legislation) freeing bank branching, allowing public sec- but either do not command widespread con- tor bank boards more freedom and improv- sensus among technocrats, or are opposed by ing bank governance—are blocked because of regulators or interest groups. a natural belief (or desire) amongst some in Among the reforms that do not command (or for) command and control. The need here widespread consensus include those on is for a reformist government that is willing monetary policy and on liberalizing the few to limit its powers (and the powers of future remaining capital controls opportunistically. governments) in the national interest. This report has encouraged more debate on Finally, the costs of dealing with economic these issues, and it is our hope that tech- fluctuations will be reduced if we have a nocrats will realize the merit of our pro- rapid and transparent process of dealing posals. Unfortunately, this is an area where with the financial distress of households, experimentation is not possible, and policy firms, and financial institutions. While the will have to be reformed in the face of sub- OFO could help create a structure for house- stantial uncertainty. All the policy choices holds, much of the elements of a viable involve some benefits and some costs. A corporate bankruptcy code are in place and pragmatic assessment needs to be made should be enacted rapidly, and the systems about the path that is best suited for India’s in place for dealing with the distress of large trajectory as a fast growing and rapidly inter- financial institutions should be stress-tested, nationalizing economy. Ultimately, though, it and deficiencies remedied. It will be much is our belief that if we do not undertake the harder putting codes and systems in place in needed reforms willingly, circumstances will the midst of financial turmoil, when vested force our hand. interests will come to the fore, so it is best to Some reforms, such as allowing more undertake these reforms now. At the same small banks, are controversial amongst tech- time, one should not minimize the strength nocrats, burnt by the past experience with of the interests already in existence, who small cooperative banks. But unlike with favour a distress resolution system based macroeconomic policy, experiments can, on government preferences and patronage, and have, been conducted (see, for example, rather than on an arm’s length process. Introduction, Executive Summary, and List of Main Proposals 21

Technically and politically diffi cult age, and unfortunately, this is the part that our poor typically face. There is an op- The toughest reforms are clearly those that portunity here. In the process of gaining the are technically diffi cult (in that there is no productivity and innovativeness to serve agreement on the details on how it would the masses, the financial sector will get the be carried out) and politically controversial unique edge and scale to be competitive (in that support will have to be built for the internationally—indeed, the road to making substantial amount of legislation involved, Mumbai an international financial centre and to overcome vested interests). These runs through every village and slum in include substantially reducing government India. control in the fi nancial sector and regulatory But as we argue in this report, there is reform (such as rewriting archaic legislation no easy path for the government. The old to make it more principles based and stream- system of attempting to mandate outcomes lining the regulatory architecture). While from the centre does not work any more, they are extremely important for the health even if it might have when our private sector of the fi nancial sector, they will take time. institutions were less well developed and The Committee would suggest that a fi rst step the Indian economy was more closed. The be to build more acceptance of the technical proper role of the government today is to details through a mix of debate and experi- improve the financial sector’s infrastructure mentation (where possible). and its regulation even while removing the Overall, the Committee would urge re- plethora of constraints and distortions that ducing bottlenecks where possible, in par- have built up over the years. It also requires ticular on legislation. It would urge a high the government to withdraw from financing quality technical effort on drafting new laws and direct control of institutions so that the and putting them through a process of public financial sector can get on with the job. The scrutiny, as well as utilizing various govern- populism and the direct intervention, that ment and non-governmental organizations unfortunately seems to be making a come- in educating legislators on their import. It back, should be relegated firmly to the past. would urge greater speed of action in Stand- This report places inclusion, growth, ing Committees, and a prioritization of bills and stability as the three objectives of any to make best use of scarce parliamentary reform process, and fortunately, these ob- time. jectives are not in contradiction. With the right reforms, the financial sector can be an enormous source of job creation both dir- CONCLUSION ectly, and indirectly through the enterprise and consumption it can support with fi- India’s fi nancial sector is at a turning point. nancing. Without reforms, however, the There are many successes—the rapidity and financial sector could become an increasing reliability of settlement at the NSE or the source of risk, as the mismatches between mobile phone banking being implemented the capacity and needs of the real economy around the country indicate that much of and the capabilities of the financial sector our system is at the Internet age and beyond. widen. Not only would the lost opportun- There is justifi able reason to take pride in ities be large, but, the consequences for the this. economy could be devastating. The country’s Yet much needs to be done. Some parts of leaders have a choice to make, and this Com- our system have not yet reached the electronic mittee hopes they will make the right one. The Macroeconomic Framework and Financial Sector Development

CONTEXT evolved in response to changing economic, institutional and political imperatives.2 The India’s economy has posted a stellar economic economy’s recent strong performance pro- performance in recent years, with high growth, vides a good background for intensifying chapter moderate infl ation and the absence of major this process and undertaking the substantive turbulence. This suggests that the overall macro policy reforms that are needed to re- macroeconomic policy framework has de- spond to the rapid evolution in the domestic 2 livered good outcomes despite concerns about economy and in the global financial system. its durability and effectiveness. Indeed, this The recent painful surge in inflation does success has fostered an ambitious average raise some more basic questions about growth target of 9 per cent per annum for the whether the present monetary policy frame- fi ve-year period from 2007 until 2012. This work is the right one for effectively stabilizing rapid sustained growth is expected to be sup- inflation expectations over a 2–3 year horizon ported by a rising investment rate and greater in the face of sharp short-run shocks to prices. integration with the world economy.1 Moreover, the policy framework has to be But past success does not necessarily mean adapted to cope with the practical realities on that the existing framework is well suited the ground. For instance, the capital account for achieving this ambitious growth target. has already become quite open, both in terms The economy now faces major challenges in of fewer formal restrictions on these flows maintaining high growth and moderate and in terms of the sheer volume of flows. It inflation. Volatile capital inflows, while is neither feasible nor desirable to turn back providing capital for investment, are caus- the clock on capital account opening by re- ing complications for domestic macro pol- introducing controls or tightening the ones icies. There are still major infrastructural that still exist. The same is true of the rising bottlenecks that could prevent the economy sophistication and complexity of financial from attaining its full potential. Moreover, markets, which cannot and should not be the political sustainability of this growth unwound. Rather, the Committee’s view is that process depends on its being inclusive and the right approach is to manage the pace and remaining non-inflationary. sequencing of further reforms in a way that Given the changes in the structure of the takes advantage of favourable circumstances economy and its increasing outward orien- and helps manage the inevitable risks during tation in terms of both trade and financial the transition process. flows, India has reached a stage in its eco- How do macroeconomic policies fit in to nomic development where the macro policy the game plan for financial sector reforms? framework has to be significantly adapted There are deep, two-way links between macro- to changing circumstances, both domestic economic management and financial sector and external. The apparent success of the development. Disciplined and predictable framework so far, however, suggests that the monetary, fiscal and debt management required changes are evolutionary rather policies constitute the crucial foundation for than revolutionary. India’s monetary policy further progress in financial sector reforms framework, for instance, has continuously and the effective functioning of financial The Macroeconomic Framework and Financial Sector Development 23 markets. At the same time, a well-functioning (or 1 per cent of GDP) in 2006–07. Capital financial system is essential for macroeco- infl ows continued at a rapid pace during the nomic stability, and can be particularly help- fi nancial year 2007–08, but have eased off in ful in reducing the secondary effects of various recent months, partly as a result of increasing shocks that inevitably hit any economy. A well- turmoil in international fi nancial markets. functioning financial system is also relevant While the increase in net fl ows in recent for the implementation of macro policy. In its years is itself impressive, the challenges of absence, monetary policy, for instance, has to monetary and exchange rate management are use considerably less effective instruments to arguably equally related to the increased scale stabilize economic activity and inflation. of both gross infl ows and outfl ows. This chapter begins by reviewing the The challenges these large flows pose to current institutional and policy framework macroeconomic policy have been commented for macroeconomic management. The on extensively by academics (both within chapter then discusses some short-run chal- India and outside), by official bodies (in- lenges posed by the recent volatility of cap- cluding the government and the RBI), and ital inflows for monetary policy and for by distinguished expert Committees, most macro management. It explores how macro- notably in the Report of the Committee on economic policy choices can influence the Fuller Capital Account Convertibility and the medium-term evolution of the financial HPEC Report on Making Mumbai an Inter- sector and how that, in turn, can affect macro- national Financial Centre. Despite this large economic outcomes. It also describes a set body of detailed and well-informed work, it of desirable outcomes in key dimensions of is useful, for several reasons, to revisit these macro policies, and discusses strategies to issues. make progress towards those outcomes. Spe- First, belief in the Indian growth story has cific policy recommendations are listed in been strong, and so the scale of capital flows the final section of the chapter. to be managed has been larger than previously anticipated. Such flows represent only a minor adjustment in global portfolios in CHALLENGES FROM favour of India. This implies that if confidence CAPITAL FLOWS in India remains strong, the absolute scale of these flows may well pick up again.3 Indeed, Cross border capital fl ows pose profound the depth of India’s equity markets, improve- challenges for macroeconomic management. ments in corporate governance, and the In the past, the concern of the authorities was internationalization of many Indian firms in to limit capital fl ight, and India maintained terms of trade in goods and services and in tight capital controls in support of this goal. financial flows means that cross-border flows In recent years, the problem has been the are likely to increase in any event. It would reverse: foreign investors have been fl ock- therefore be prudent to adapt the financial ing in droves to India’s doorstep, eager to be system to larger inflows than in the past. At a part of India’s growth story. In common the same time, it would also be wise to be with other parts of fast-growing Asia, India prepared for a larger outflow of funds if has experienced unusually large capital either domestic or global circumstances were movements over the past four years. Over to deteriorate. The fact that India continues to this period, capital infl ows have more than run a current account deficit, albeit a modest quadrupled, although from a relatively one, makes it vulnerable to a sudden stop of low base. In 2006–07, net capital infl ows inflows, although the level of foreign currency amounted to 45 billion US dollars, a fi gure reserves does provide a cushion if this were to equivalent to nearly 5 per cent of India’s happen. The economy’s managers therefore GDP. These infl ows far exceed the current need to develop a policy framework that account defi cit, which was 10 billion dollars would help deal with both eventualities. 24 A HUNDRED SMALL STEPS

Second, the exigencies of dealing with this and outflows). Nevertheless, with India likely large volume of flows have slowed financial to continue posting higher productivity sector reforms in the Indian economy. They growth than some of its major trading part- have also led to an increase in the fiscal bur- ners, the underlying pressures for exchange den through the cost of sterilization. There rate appreciation may well return in the is therefore a need to think through the in- near future. The discussion in the next two stitutions and markets needed to facilitate a sections focuses on the scenario associated more effective response to what is likely to with an appreciating exchange rate, which be a recurrent phenomenon. was the relevant scenario until very recently, Third, the debate surrounding the au- although many of the arguments about ex- thorities’ response to the ‘capital flows change rate management are general and problem’ has indicated some uncertainty symmetric. and occasional misunderstanding of what the monetary authorities can and cannot control. Frequent (and often misleading) Capital infl ows and the real references to the rather different macro pol- exchange rate icy choices exercised by China have also permeated the debate. Hence, this chapter A completely open capital account creates engages in a discussion of the Chinese situ- familiar and well-known issues for monetary ation to see what lessons should (and should management, usually referred to as the ‘im- not) be drawn that are relevant for the Indian possible trinity’.4 This refers to the diffi culty context. that an open capital account presents to a There are no ‘correct’ or ‘ideal’ solutions for monetary authority in reconciling exchange managing the integration of a large domes- rate stability with interest rate autonomy. As tic financial system into the global economy. the experience of the oil-exporting countries While the gains are considerable, the penal- (or of China) shows, imbalances between the ties for mistakes can be both large and harsh. supply and demand for foreign exchange What is clear is there is a premium on con- can arise from trade fl ows just as much as sistency, clarity, credibility and continuity of from the capital account, and generate pres- policies. It is also clear that a whole range of sures for the nominal exchange rate to ap- institutional (and even political) factors go preciate. Thus, exchange rate appreciation, to shape each nation’s response. These in- and measures to counter it (such as central clude the nature of the financial system, the bank purchases of foreign exchange), are independence of the central bank (and its re- not phenomena that arise exclusively from lationship with the Ministry of Finance), an open capital account. What progressive the quality of market regulation and even opening of the capital account does is to the functioning of the labour market. Thus, enhance the scale (and potential volatility) developments in the capital market and the of foreign exchange fl ows, and to link these possible policy responses must be seen in a fl ows to domestic monetary conditions, par- much broader context. ticularly efforts to set domestic interest rates Much of the discussion within India about and/growth of domestic credit. exchange rate policy in the last 3–4 years has In common with most large emerging been about the desirability of limiting ex- markets, India has a long tradition of man- change rate appreciation in the face of large aging its nominal exchange rate to maintain capital inflows. More recently, the fickleness ‘external competitiveness’, with generally of foreign capital has been in evidence, with positive results for growth in exports of goods inflows easing off and the rupee depreciating and services. Stability and predictability of relative to the US dollar. This episode points the exchange rate of the rupee, nominally to the need for a more flexible framework to against a basket of currencies but primarily cope with volatile capital flows (both inflows against the US dollar, has been an established The Macroeconomic Framework and Financial Sector Development 25 feature of the policy landscape for many its main trading partners, and between the years. The link to the dollar over the years traded goods sector in a country (e.g., manu- can also be seen as representing an informal facturing, IT services) and the non-traded ‘nominal anchor’ for the Indian monetary goods sector (haircuts). This is because system, necessary in the absence of either more productive manufacturing workers in fiscal restraint or a formal inflation target. a country will earn more, and push up the While in the present decade there has been price of housing or haircuts, thus causing a boom in exports of business services, the the real exchange rate to appreciate. In the magnitude of the ensuing surpluses did not short to medium term, the exchange rate can present major problems for either exchange also be influenced by conditions of domestic rate or monetary management. Thus, in the aggregate demand and supply, and, of course, mind of the Indian public and Indian policy- the net capital inflows into a country. makers, pressure on the nominal exchange In India, a confluence of forces has in rate to appreciate, and the perceived resulting recent years put enormous pressure on the threat to competitiveness, have come to be real effective exchange rate to appreciate. associated with the surge in capital inflows Relative productivity growth of the traded described above. The management problems goods sector has been higher than in most have been complicated and aggravated by industrial countries that constitute final mar- the decline of the dollar against other major kets for India’s exports, as well as relative currencies, and the tight link to the dollar of to the domestic non-traded goods sector.6 the currencies of major Asian competitors for Aggregate demand has been higher than India in third markets, particularly China. supply, in part due to the large government Capital inflows have indeed created dif- budget deficit (centre and states together). ficult challenges for monetary policy. In par- And foreign investors have been pouring ticular, they have generated pressures for money into India. nominal exchange rate appreciation of the Even if it were granted that the real ex- rupee against the dollar. In order to counter- change rate is appreciating too quickly, it does act this pressure, the central bank has inter- not necessarily follow that the most efficient vened by buying foreign exchange. But too response is to attempt to restrain the nominal much intervention could lead to excess exchange rate through sterilized intervention. domestic liquidity, and consequent infla- Indeed, as noted below, if the real appreciation tionary pressures. Balancing these two is an equilibrium phenomenon, attempting considerations—external competitiveness to resist it through sterilized intervention can versus domestic inflation—has become an lead to an outcome of higher inflation, higher increasingly complex problem. However, debt and a more repressed financial system framing the issue in this manner, which than the alternative of allowing the nominal has become the norm in the public debate, exchange rate to take on some of the burden may in fact be misleading and has gen- of adjustment. erated unrealistic expectations about what policy, and monetary policy in particular, can and should try to achieve. Let us exam- Countering real appreciation ine both dimensions of the debate about pressures the external value of the rupee. What matters for external competitiveness How can the economy possibly counter these is of course the real effective exchange rate pressures for real appreciation? The answer (REER) rather than the nominal dollar-rupee to this question follows directly from the exchange rate per se.5 And the factors that causes listed above. Three strategies could be drive the REER go beyond just capital flows. employed to prevent real appreciation. One The primary factor tends to be differentials in is a non-starter for obvious reasons—to slow productivity growth between a country and productivity growth. The second, tackling 26 A HUNDRED SMALL STEPS

the fiscal deficit more aggressively or re- abroad. We need to make it much easier for straining private consumption will help the individual to invest in foreign assets. rectify the demand-supply imbalance. And But perhaps the greatest opportunity lies in the third, limiting net infl ows could help slow Indian institutions like pension funds and appreciation pressures. provident funds, as well as insurance com- Let us examine the last two more care- panies. They could benefit tremendously fully. There is evidence that increased fiscal from foreign diversification, and should be discipline may help offset some of the ex- encouraged to place a fraction of their assets pansionary effects of capital inflows by re- in well-diversified foreign equity and bond ducing aggregate demand.7 At a minimum, portfolios. it is important to avoid fiscal deficits that Notwithstanding any such steps, given add to demand when the economy is already India’s stage of growth and productivity booming, in part due to surges in inflows.8 performance, as well as its robust domestic Turning to net inflows, one way to limit demand, it is likely that there will continue them is through capital controls. Capital to be strong underlying pressures for ap- controls always appear attractive in theory, preciation, and they will be difficult to resist but there is little evidence that they work over for anything more than a short period. In sustained periods of time in an economy as the short run also, appreciation pressures open as India’s—we will have more to say will be exacerbated by the need for industrial on this shortly. Indeed, trying to manage countries like the United States to increase inflows using controls could simply spark exports to reduce their current account de- more speculative inflows in search of quick ficits and boost growth, which implies their returns associated with eventual currency currencies will have to depreciate. appreciation. The same is true of the circum- Real exchange appreciation is not all bad. stance when controls on outflows are used It makes foreign goods cheaper and thereby as a tool to try and limit exchange rate de- raises the standard of living of the average preciation. Over time, as de facto financial citizen—indeed, a significant portion of the openness of the economy increases with rise in Russia’s per capita GDP over the last greater integration into international capital few years has been through real exchange rate markets, controls on capital flows may end appreciation. It reduces the real value of the up becoming not just ineffectual but counter- foreign currency debt of companies that have productive. raised money in international markets. When inflows surge again, as they in- The implications for employment growth evitably will at some stage, perhaps more in the tradables sector are also not as clear-cut useful than preventing foreign capital from as might seem to be at first glance. For firms coming in is to encourage domestic capital that specialize in processing of imports and to flow out. One method is to encourage re-exports of finished products, the fall in Indian corporations to take over foreign import costs would offset much of the de- firms. It is dangerous, however, to force the cline in export revenues (if these firms can- pace of this process since takeovers have a not change their prices in foreign markets). checkered history, with losses for the acquirer For a growing country, the lower cost of more likely on average than gains. A second investment stemming from cheaper capital is to encourage domestic individuals to goods imports can also help. Similarly, if real invest abroad. Indian investors have the exchange rate appreciation is a consequence opportunity to maintain assets abroad, but of productivity growth, then the loss in ex- have not taken advantage of it to diversify ternal competitiveness through the price their savings thus far, perhaps because of channel may be offset by the increase in the strength of the performance of the productivity. Indeed, a steadily appreciating Indian market, and perhaps because of their real exchange rate puts pressure on the export unfamiliarity with the channels of investing sector to improve productivity even while The Macroeconomic Framework and Financial Sector Development 27 allowing the country to become richer in policy play a role by attempting to peg the real terms. nominal exchange rate? It is also not a good idea to hold down the The answer typically is no. History has real exchange rate to make the country’s export shown that strong pressures for real ap- sector artificially competitive. An under- preciation cannot be bottled up for long by valued exchange rate is a subsidy to the pegging the nominal exchange rate. If the export sector and the rest of the world that nominal exchange rate is prevented from comes from taxing the rest of the domestic rising, the real exchange rate will rise through economy, something a poor country can ill greater inflation, and the economy will both afford. Moreover, it can lead to inefficient have high inflation and be uncompetitive. patterns of investment that are not based Put differently, a strategy for boosting com- on comparative advantage, that reduce the petitiveness by holding down the nominal country’s overall productivity growth, and exchange rate can be successful only if there is that can create serious problems when the no underlying pressure for the real exchange real exchange rate returns to equilibrium. For rate to rise. an economy that has a low stock of physical Also, the channel through which real ex- capital and where the investment to GDP change appreciation takes place has import- ratio is nearly 35 per cent, the cost of such ant effects—especially in terms of income distortions is likely to be very large in terms of distribution. A nominal exchange rate ap- long-term growth and economic welfare. preciation can help hold down inflation and To summarize, it is hard to counteract reduce the prices of imported (or tradable) pressures for a rising real exchange rate, goods, including food and oil. By contrast, an especially if the pressures are driven by long- increase in domestic inflation has far greater term fundamentals. It is also probably not adverse consequences for the poor since the necessary to counteract such appreciation, prices of tradable goods such as food and for it is a natural consequence of growing energy tend to rise fast and these constitute richer. At the same time, our intent is not a substantial fraction of the consumption to minimize the danger of a real exchange baskets of the poor. rate appreciating excessively, beyond what is Some argue that inflation is not a na- warranted by fundamentals. An overvalued tural consequence of the central bank pur- exchange rate can be very detrimental to chasing foreign exchange to keep the rupee export competitiveness and can affect job from rising. It can issue market stabilization growth in exporting and export-competing bonds to soak up the liquidity from capital industries. It is an important factor in inflows and prevent inflation from taking slowing the growth of countries. We should off. However, this ‘sterilization’ strategy has guard against it happening, but it is not its limitations. The interest rate that has to representative of India’s situation today. be paid on these sterilization instruments increases as the market absorbs more and more of these instruments, and ultimately Should nominal exchange rate adds to the budget deficit. Sterilized inter- appreciation be resisted? vention also frustrates the two natural forces for slowing inflows that would normally The question is what to do if there is a function, namely nominal exchange rate ap- renewed tendency for excessive real appre- preciation and a decline in domestic interest ciation, fuelled by strong capital infl ows? rates. Instead, it acts as a stimulus to further Appreciation of the real effective exchange flows by widening the differential between rate has two components—an increase in foreign and local interest rates while creating domestic infl ation relative to infl ation in trad- expectations of additional returns once the ing partner countries and an appreciation of postponed nominal appreciation finally the nominal exchange rate. Can monetary occurs. 28 A HUNDRED SMALL STEPS

Sterilization also hampers financial re- boosting their efficiency. These adjustments forms if the government relies on public sector are much more likely to take place in an en- banks to hold large stocks of sterilization vironment where manufacturers anticipate bonds. In India, market stabilization bonds exchange rate appreciation and prepare for it. constitute the primary sterilization tool. A If manufacturers believe that the central bank substantial expansion of this stock, which (or fiscal authorities) will protect them from would be required to avoid nominal exchange appreciation or that the government will offer rate appreciation if strong capital inflows sops to deal with the effects of appreciation, were to resume, would have fiscal costs as they will have no incentive to prepare for it well as broader costs by affecting financial in advance. When the inevitable—exchange reforms. rate appreciation—then happens, they will be A more basic question is whether steril- caught off guard and not be able to respond ized intervention is effective, at least in the effectively. short run, in limiting the nominal exchange Of course, not all exporters can adapt rate appreciation that could otherwise result easily, especially the small- and medium- from a surge in capital inflows. There is no sized ones. The medium-term answer is to evidence that other East Asian economies help them do so, by providing them more that have been experiencing large and per- flexible labour laws, better finance, and man- sistent capital inflows have been able to sig- agerial support services. In the short run, nificantly influence the level or changes in however, there should be a two-pronged ap- the exchange rate, especially beyond very proach. Employees of ailing firms could be short horizons.9 But there is some evidence supported directly by whatever safety nets that sterilized intervention modestly reduces the government deems appropriate (though exchange rate volatility, which suggests that in a poor country like India, it is not clear the role of intervention should be limited, that the support can be substantial), while if at all, to marginal smoothing out of trend viable firms can be helped to adapt. Though changes in the exchange rate. the consequences are not pleasant, the eco- In summary, this Committee believes nomic pain would be worse, though possibly that it is neither possible, nor advisable to more widely spread, if the macroeconomic manage the external value of the rupee framework was held hostage by a small seg- through persistent nominal exchange rate ment of the export sector. intervention. Clearly, steps to curb domestic Let us summarize our analysis. The Com- demand or expand supply can help slow mittee does not suggest a real exchange the rise of the rupee, as can steps to encour- rate appreciation is always a good thing. age domestic savings to be invested abroad. But to the extent it is an equilibrium phe- These should be implemented. But perhaps nomenon (and the rebalancing of world the best antidote to pressures for the exchange investment portfolios towards India can be rate to rise is to increase the flexibility of the part of the fundamentals driving the equi- economy to adapt to it and for firms to hedge librium), currency intervention can, at best, the risk (see next section). This is cold com- smooth short-term movement. Indeed, if the fort for those who believe the government appreciation pressure is strong, intervention can always do something, and is anathema may just bottle up the volatility, only to to those who believe India can still adhere to unleash it when intervention stops. The the old ways it followed when the economy Committee does not believe that tried and was closed and India unattractive, but it may tested methods of exchange intervention can be the right answer today. help preserve India’s competitiveness in Sometimes, adaptation is best achieved today’s more open economy. While the impli- when firms realize they have no alternative. cations for competitiveness and inflation For instance, exporting firms will have an are obviously very different in an environ- incentive to achieve productivity gains by ment with a depreciating exchange rate, the The Macroeconomic Framework and Financial Sector Development 29

Lessons from China10

Many analysts have argued that China is a counter- cheap for fi rms, has been the ceiling on deposit These constraints on using interest rates to example to the proposition that productivity rates. This has led to negative real rates of return meet domestic objectives have also meant that growth will unavoidably lead to real exchange for Chinese households, which save nearly one- banking reforms, which the government has rate appreciation. They note that China has quarter of their disposable income and put most declared to be a major priority, have been held kept the real exchange rate undervalued for a of it into bank deposits. Over the last year, the back. After all, it is diffi cult to get the banks to prolonged period by tightly managing the nominal negative real interest rates have led to some function as effi cient fi nancial intermediaries if they exchange rate relative to the US dollar and has money fl owing out of bank deposits and into the do not have price signals (policy interest rate done so without major infl ationary consequences. stock market, creating a huge bubble that is likely changes) to respond to but simply continue to take With CPI infl ation now surging past 6 per cent to end very messily. their marching orders from the government. and reserve money growth in excess of 30 per Another complication is that the leakiness of Finally, commentators in India have not ad- cent, the latter proposition is less tenable now. capital controls has increased over time, thereby equately recognized the unnaturally low level of Moreover, the mix of policies that has main- constraining the independence of monetary Chinese consumption (unnatural for a country of tained this configuration includes extensive policy, which has become increasingly beholden to its per capita GDP) which has helped keep demand- fi nancial repression along with a relatively closed the exchange rate objective. Indeed, the massive supply imbalances in check and thus prevented capital account. Financial repression has kept the accumulation of foreign exchange reserves since some of the pressures on the real exchange rate costs of sterilized intervention low by inducing the beginning of this decade is an indication of the that are seen in India. If India is to emulate China in state-owned banks to absorb large quantities of amount of capital that has managed to fi nd its way exchange rate management, as some suggest, one sterilization bonds at low interest rates. into China despite the efforts of the authorities should ask whether India is also ready for policies This set of policies has led to substantially un- to control infl ows (capital infl ows through offi cial such as the constraints on fi nancial development, balanced growth, driven largely by investment. and unoffi cial channels account for about two- reductions in social expenditures on health and Not only has fi nancial repression kept the price fi fths of the reserve accumulation since 2000). education, and the one-child policy that are prime of capital cheap in the form of low interest rates, In an economy with real GDP growth of over factors driving high savings and low consumption. but energy and land have also been subsidized to 10 per cent and rising infl ation, negative real inter- There are many useful lessons to be learnt from encourage more investment. As a consequence, est rates clearly do not constitute an appropriate the Chinese growth experience—the emphasis on more than half of nominal GDP growth in recent monetary policy stance. But the increasingly fi scal discipline, the reduction in trade barriers as years (almost two-thirds of growth in some open capital account has constrained the central part of the WTO accession commitments, the years) has been accounted for by investment bank’s ability to aggressively raise policy interest focus on building physical infrastructure etc. It is growth, with consumption growth accounting rates to control credit expansion and invest- equally important that India’s policymakers see for a signifi cantly smaller fraction. This has had ment growth. If it tried to do so, even more cap- the risks and welfare costs that China’s growth serious environmental consequences and greatly ital would flow into the economy to take model has generated, and not just the positive limited employment growth. It has also reduced advantage of the higher interest rates, especially outcomes to date. Besides, India is simply too the welfare consequences of growth; moreover, since interest rates in the US have been falling far along in the process of financial sector excessive investment has created huge risks for due to recent actions by the Federal Reserve. This development and capital account liberalization, the future. would fl ood the economy with more money relative to China, to return to a regime of fi nancial A different facet of fi nancial repression, which and complicate domestic macroeconomic man- repression and/or capital controls, or to severely has been necessary to keep the price of capital agement even more. constrain consumption.

basic points about the futility of orienting a series of spurts of exchange rate volatility macroeconomic policy towards exchange as the RBI tries to hold the line on the nom- rate management over long horizons are inal exchange rate until a particular level essentially the same. becomes diffi cult to sustain, either because infl ationary pressures mount or sterilization operations become costly and harder to man- IMPLICATIONS FOR age. Moreover, the recent surge in infl ation MANAGEMENT OF has highlighted the diffi culties the current MONETARY POLICY monetary policy framework faces in serving as a credible anchor for stabilizing infl ation Options for the monetary expectations over the medium term in re- policy framework sponse to sharp short-run price shocks. Such demands on monetary policy in India are Despite the challenges laid out in the pre- going to grow over time and it is import- vious section, monetary policy has in the past ant that the framework be upgraded to managed to strike a balance between man- make monetary policy more effective and aging infl ation and stabilizing the nominal independent. exchange rate. This balance has become in- What are the options? One is to try and creasingly diffi cult to maintain, resulting in manage the exchange rate more aggressively. 30 A HUNDRED SMALL STEPS

Indeed, the Committee on Fuller Capital as low and stable inflation). An exchange Account Convertibility had recommended rate objective would limit policy options for that the real exchange rate should be main- domestic macroeconomic management and tained within a band. Many observers in is not compatible with an increasingly open fact argue that this should be a central ob- capital account. jective of monetary policy so that loss of competitiveness through real exchange rate appreciation can be avoided. As the discus- Is a low infl ation objective sion in the previous section makes clear, too limiting? this Committee feels that this is not a viable option—even if desirable, it is simply not The Committee’s recommendation of a possible to use monetary tools (other than single objective for monetary policy may through demand management) to control at fi rst glance seem divorced from the real- the real exchange rate. ity of the public pressures that a central Another option would be to continue with bank faces. After all, it seems reasonable the mixed approach, hitherto used with a for a central bank to be concerned not just reasonable degree of effectiveness by the RBI. about infl ation, but also about overall macro- This approach is based on a medium-term economic stability, high employment and objective for inflation but involves active output growth, and fi nancial sector devel- management of the exchange rate at certain opment. Especially in a developing economy times. It has a certain degree of appeal since like India, surely the central bank needs to it gives policymakers some flexibility in their worry as much about growth as it does responses to pressures on the exchange rate about infl ation. The Committee fully agrees or on inflation at different times. with this proposition—but the issue is how This approach also has its drawbacks. best monetary policy can contribute to non- The mix of inflation and exchange rate infl ationary and stable growth. objectives generates uncertainty of its own The argument against the emphasis on and, in contrast to a framework with a single an inflation objective is based on a deep well-defined objective, does not serve as a fallacy that there is a systematic trade-off firm and predictable anchor for inflation between growth and inflation. There is a expectations. Thus, it can in fact be counter- great deal of evidence, both from indivi- productive by generating unpredictability dual country experiences and cross-country of policies and, consequently, unpredictabil- studies, and not just in industrial countries, ity in market participants’ responses to policy that a central bank that is focused on price actions.11 It could therefore constrain rather stability can be most effective at delivering than increase the room for aggressive policy good monetary and macro outcomes.13 Low responses to shocks. By contrast, a more and stable inflation has large macroeconomic predictable and transparent policy frame- benefits—it would stabilize GDP growth, work can in fact generate more room for help households and firms make long-term policymakers to respond to large shocks be- plans with confidence, increase investment, cause the market would better understand and thereby allow monetary policy to make the objectives of monetary policy. Besides, as its best possible contribution to long-term the preceding discussion suggests, exchange employment and output growth. It would rate management (other than to reduce day- also have financial market benefits—for in- to-day volatility) is unlikely to be effective stance, by enabling the development of a and will be increasingly costly. 12 long-maturity bond market, which would What is the way forward? This Com- assist in infrastructure financing and public mittee feels that monetary policy should debt management. be reoriented towards focusing on a single Another fallacy is that the process of objective, and there are good reasons why this switching to an objective of price stability objective should be price stability (defined entails a loss in output growth. This is true The Macroeconomic Framework and Financial Sector Development 31 in countries where an inflation target has rather than being hamstrung by an exchange been used as a device to bring down inflation rate objective, is crucial. Indeed, this is dem- from a high level and to build credibility for a onstrably the way that central banks with central bank that has lacked inflation-fighting inflation objectives have responded to growth credentials. One of the earliest inflation slowdowns. targeters—New Zealand—suffered this prob- Focusing on low and stable inflation lem. Inflation targeting was introduced in does not mean that short-term fluctuations early 1988 in an attempt to bring inflation in output and employment growth will be down from around 15 per cent in the mid- ignored in monetary policy formulation. This 1980s. Inflation was brought down to 2 per objective provides a framework for thinking cent by 1991, although with an adverse im- about how other macro developments affect pact on growth and employment during inflation and, therefore, how monetary pol- that period.14 Output losses were also ex- icy should react to those developments. This perienced at the time of introduction of in- means that a slowdown in growth would, flation targeting in some Latin American through its implications for inflation, cause economies. But in every one of these cases, the central bank to loosen monetary policy in inflation targeting was seen as a solution order to prevent inflation from falling below to high inflation and lack of central bank the objective. Thus, an inflation objective is credibility. However, there is no reason why, quite consistent with using monetary policy if inflation is low and the central bank has a as a tool to stabilize the business cycle. reasonable degree of credibility, switching to Moreover, an inflation objective can in- a focus on price stability rather than multi- crease the independence and effectiveness ple objectives should have output costs. of monetary policy by setting more realistic A third fallacy is that making low and expectations about what monetary policy can stable inflation the objective of monetary and cannot achieve. When households, firms policy creates an anti-growth bias, wherein and financial market participants clearly inflationary pressures would be dealt with understand the central bank’s intentions swiftly and decisively, but disinflationary about its medium-term objective, then the growth slowdowns would not be resisted as central bank in fact has more flexibility in aggressively. In fact, there is no reason why responding to shocks in the short run without there should be an asymmetric approach to losing control of inflationary (or deflationary) inflation versus disinflation. If the inflation expectations. Finally, transparency about the objective is specified as a range, the norm is to monetary policy process allows financial treat the floor of the target range as seriously market participants to plan for the already as the ceiling. high volatility they need to deal with without Put differently, if growth falters, it is also it being augmented by policy volatility. likely to bring inflation down below the In short, a predictable and transparent floor of the inflation objective, allowing the monetary policy that has a clearly-defined central bank to ease. Indeed, if the public’s primary objective may be the best contri- expectations of future inflation are firmly bution that monetary policy can make to fixed, as would be the case if the central macroeconomic and financial stability and, bank has a transparent policy objective, a therefore, to long-term growth. By contrast, cut in short-term interest rates will not be trying to do too much with one instrument accompanied by a rise in inflationary expec- is a recipe for ineffectiveness, especially in tations and, thus, long-term interest rates. difficult times. Stabilizing the domestic busi- The central bank then can bring all interest ness cycle, which would be a corollary of an rates down by cutting the short-term interest inflation objective, would be a better use of rate, and can thus stimulate growth. In this monetary policy than attempts to manage case again, the ability of the central bank to the exchange rate. Moreover, the notion that move aggressively with its policy instrument monetary policy can itself raise long-term to maintain price stability (and thus growth), growth through activist policies has been 32 A HUNDRED SMALL STEPS

shown to be demonstrably false—in fact, the details are unimportant or easy to grap- faith in that belief led to stagflationary ple with, but they can best be examined in episodes (economic stagnation coupled detail separately once the principles are es- with high inflation) in the US in the 1970s tablished. For instance, in India there are and 1980s. intense debates even about the right index of Let us now turn to the importance of infl ation (WPI or CPI) that the RBI should monetary policy for financial markets. Trans- focus on. These are important practical parency and predictability of monetary pol- issues. But to let debates about such details icy are essential ingredients for achieving shift the focus away from the broader ques- liquid financial markets, reducing fragility of tions about the right framework that are this financial firms and stabilizing capital flows. Committee’s mandate would be to allow the A stable macroeconomic environment not tail to wag the dog. only helps make cross-border capital flows The RBI already has a medium-term more stable by giving domestic and foreign inflation objective, and its actions and state- investors more confidence in a country’s fund- ments are consistent with that being a key amentals, but it also helps in dealing with the objective of monetary policy. But making that vagaries of those flows. the primary objective of the RBI and indi- In the absence of a clearly-defined monet- cating this clearly to markets, both through ary framework, the effectiveness of the mon- communications and actions, may provide etary transmission mechanism may also be important additional benefits in terms of reduced. Since long-term interest rates are anchoring inflation expectations and the more important than short-term rates for ag- macroeconomic stability that would follow gregate demand management, there is a from that. Indeed, what is needed is not so temptation to manage different points of the much a drastic change in operational ap- yield curve for government debt (the return proach but rather a change in strategic focus. on debt instruments at different maturities) Some changes in the operational approach rather than just setting the short-term policy would also be useful to make the transmission rate, as is typical in most mature economies. of monetary policy more effective. The use This has three deleterious effects. It ham- of multiple tools other than the interest rate pers the development of the government in attempting to meet multiple objectives bond market. It stymies the development of can generate distortions in the financial and a corporate bond market since a market- corporate sectors. Varying the CRR affects determined yield curve is needed to serve as only banks while their competitors like non- a benchmark for pricing corporate bonds. banking finance companies (NBFCs) and It also limits the information and market money market funds are left unhindered. feedback from the yield curve about inflation Lack of predictability of regulations and expectations and the market’s assessment of ceilings on external commercial borrowings monetary policy actions. (ECB) makes it hard for corporations to plan borrowing, and even service old loans that need to be refinanced, creating Changes needed to the current added uncertainty and risk, which adds to framework their costs. These costs need to be factored into the broader assessment of monetary What modifi cations to the present monetary management. The Committee recognizes policy framework are needed to enhance its that it may not be practical to do away with effectiveness? In answering this important multiple monetary policy tools immediately. question, it is necessary for the Committee Given the adverse implications of the use of to establish some general principles, rather tools such as the CRR for financial sector than delve deeply into specifi c aspects of the reforms, there should be a definite and monetary framework. This is not to say that short time line for modifying the strategy The Macroeconomic Framework and Financial Sector Development 33 for monetary policy implementation, in in turn, can work better if monetary policy tandem with other reforms to the framework. is based on a stable domestic anchor. Thus, Moreover, developments in the economy, a move towards an inflation objective and including the declining importance of agri- financial sector reforms need to be pushed culture and the rising importance of interest- forward in tandem and can, together, deliver sensitive sectors such as consumer durables good macroeconomic outcomes in terms of and housing, should make it easier to use both growth and stability. interest rates as the tool for managing ag- Some have argued that available indicators gregate demand. of inflation are subject to huge measure- There are undoubtedly difficult constraints ment error and are therefore unreliable. on the effective operation of monetary pol- There is no doubt that ongoing attempts to icy in India. These include a variety of real improve the quality and timeliness of data rigidities, such as a labour market that is not are a high priority for effective macro man- fully flexible on account of restrictive regu- agement. Pending improvements in the qual- lations, a higher education system that is ity of inflation data more, rather than less, not meeting demand, a moribund system of transparency on the part of the RBI in laying corporate restructuring, and an economy out its inflation objectives, and how it views that is still based to a considerable extent on the incoming data is called for. primary industries, including agriculture. The RBI is already transparent in the These structural factors put an even greater sense that it puts out regular monetary policy burden on monetary policy to deliver macro- reports and its senior officials frequently economic stability based on a clear objective. make speeches about their macroeconomic Waiting for rigidities in the economy to assessments and policy intentions. But a disappear fully before improving the mon- clearly-specified monetary policy framework etary framework could in fact be counter- would greatly enhance the benefits of such productive. The interaction of these rigidities open communications. In short, improving with a monetary policy framework that does both the clarity of objectives and the clarity not firmly and credibly anchor inflation ex- of communications about these objectives pectations could exacerbate the adverse ef- would help to make monetary policy more fects of shocks to the economy. Similarly, effective.15 while large budget deficits undoubtedly Some observers argue that there is a constrain the room for monetary policy strong political consensus in favour of low actions as well as its effectiveness, the right inflation in India, and therefore it is not implication is that a well-focused and pre- necessary to enshrine it in an objective. The dictable monetary policy is all the more im- Committee agrees that inflation is politic- portant for macroeconomic stability. ally very sensitive, but would argue this is all A related argument has been made that, the more reason to make it the overriding given the weaknesses in the monetary trans- focus of the RBI. The problem is political mission mechanism, focusing on an infla- attention focuses on inflation only when it tion objective would be a strategy doomed is high—when, given the lags in monetary to failure. The corollary is that the nominal policy transmission, it is already too late to exchange rate could serve as a more stable do anything about it. The time to focus pol- nominal anchor. As already discussed earlier icy on curbing inflation is when inflation in this chapter, there are good reasons why is anticipated to rise. But if at that time the an exchange rate target is neither desirable central bank is being held to other objec- nor feasible without adding distortions to tives, it will not act in time. The consequence the economy. Many of the financial sector then is that politicians lose faith in the reforms discussed in this chapter will make ability of the RBI to exercise control, and the monetary policy transmission mechan- attempt to implement short-sighted, distor- ism work much better. But these reforms, tionary actions to control inflation. This is to 34 A HUNDRED SMALL STEPS

the detriment of overall macroeconomic accommodation on their respective roles, management. this should not be left to the personalities Instead, the Committee believes the gov- heading these organizations. Clearly, trad- ernment should invoke the political con- ition plays a large role in determining, and sensus against inflation in giving the RBI strengthening, the accommodation, and we its mandate, in setting the medium-term would urge that this tradition be reinforced inflation objective, and in providing sup- over time through clarifying statements by port in the form of more disciplined fiscal all concerned. policies that keep budget deficits in check. Finally, the Committee wishes to emphasize that it is key that the RBI should have oper- CAPITAL ACCOUNT ational independence—i.e., the freedom to LIBERALIZATION take monetary policy actions to attain its medium-term objective. The government Capital account liberalization (CAL) can play should not, through its control of certain a useful role in fi nancial reforms. Opening up interest-setting entities, work at cross- to foreign banks and other fi nancial fi rms and purposes. While typically the RBI and the to foreign direct investment in the fi nancial Finance Ministry have reached a reasonable sector has many potential benefi ts. These benefi ts include the introduction of fi nancial How Transparent is the RBI? innovations and sophisticated financial instruments by foreign fi nancial fi rms, added In an extensive cross-country study, Dincer written) emanating from the RBI since then and Eichengreen (2007) construct a composite are evidence of a concerted effort to increase depth in domestic fi nancial markets due to measure of central bank transparency that transparency. Indeed, a recent IMF (2007) foreign infl ows, and more effi ciency in the incorporates indices of transparency on fi ve study notes that the RBI’s communications domestic banking sector through increased dimensions—political (openness about policy strategy has improved in a number of areas. objectives); economic (economic information, There are still residual concerns about the competition. The HPEC Committee on including data and models, used in monetary RBI’s transparency, however, especially when Making Mumbai an International Financial policy formulation); procedural (clarity about compared to international best practices in Centre lays out the reasons why an open cap- operational rules and procedures); policy some dimensions. The Dincer-Eichengreen (prompt disclosures of policy decisions and index provides a useful benchmark for ital account is necessary for Mumbai to explanations thereof); and operational (con- evaluating the current level of transparency compete with other aspiring international cerns the implementation and evaluation of and how it can be enhanced to improve comfi nancial centres and also to minimize in- policy actions). Their index is based on 15 ele- munications with the markets and the overall centives to import fi nancial intermediation ments and the scale goes from zero to 15 effectiveness of monetary policy. (Saudi Arabia gets a score of zero and, at the What are the specific dimensions in services from abroad. other end, New Zealand, Sweden and the which monetary policy transparency could The academic literature indicates, how- UK get scores of 12 or higher). They report be improved? One is related to operational ever, that precipitous opening of the capital that their composite measure of central bank procedures and the other relates to the com- transparency is positively associated with munications strategy. The use of multiple tools account before the domestic financial sector lower output and infl ation volatility, and re- have generated market uncertainty about the has reached a certain level of maturity and the duced infl ation persistence. RBI’s intentions. The RBI should refrain from appropriate regulatory expertise is in place How does the RBI stack up? India gets a using the CRR or SLR as a standard tool of rather measly score of 2. More importantly, monetary policy. More regular policy meetings could spell trouble. How can the process of India’s score remains unchanged from 1998 to on a pre-announced schedule would also be CAL in India be fine-tuned to balance these 2005. The average for Asian central banks goes helpful in giving markets more direction at benefits and risks? from 3.0 to 5.1 over this period (from 4.6 to predictable intervals. In the case of India, this debate may al- 6.6 for selected East Asian countries including As for communications, a key step would be Japan). The Dincer-Eichengreen index involves to make the main policy documents and state- ready be irrelevant to a large extent. The a judgemental (but careful) assessment of the ments put out by the RBI (especially the Quar- official channels for bringing capital into various elements that go into the construction terly Review) much shorter and more focused. or taking capital out of the country have of the index, so it should not be taken too In addition, the RBI could provide more in- literally. But it does point to some concerns formation to the public about its fore-casting been opened up quite significantly over the about monetary policy transparency in India. and simulation models, which could in fact be last decade. Recent steps taken by the RBI In response to such concerns, a number of useful for the central bank in getting feedback to liberalize outflows of capital are welcome improvements were introduced in 2004–05 from the academic and market communities and the volumes of material (both spoken and that could help improve the models. as they will give domestic investors more opportunities for international portfolio The Macroeconomic Framework and Financial Sector Development 35

diversification and increase competition for The State of the Academic Debate on Capital Account Liberalization the domestic pool of funds. Moreover, as There has been a long, contentious and still- experienced a deterioration in risk sharing noted earlier, channels for unofficial capital unresolved debate about the costs and bene- during the period 1985–2004. Interestingly, flows have expanded in tandem with rising fi ts of capital account liberalization (CAL). FDI and portfolio equity fl ows facilitate more Kose et al. (2006) survey the vast literature effi cient risk sharing by emerging markets, trade flows and the rising sophistication of on CAL and conclude that it is diffi cult to fi nd while debt fl ows work against it. Thus, the investors. per-suasive evidence that fi nancial integration predominance of debt in total inflows of This inevitable de facto opening of the boosts growth, once other factors that af- emerging markets during the 1980s and 1990s capital account, which is a common phe- fect growth—financial development, good drives these results. macroeconomic policies, quality of corporate So why should a developing/emerging mar- nomenon in virtually every emerging market governance—are controlled for. Prasad, ket country expose itself to the risks of CAL (including China) as financial globalization Rajan and Subramanian (2007) report an even if the benefi ts are ephemeral? Kose et al. argue continues apace, makes capital controls an more surprising fi nding—developing/emerging that the real benefi ts of fi nancial integration market economies that are less reliant on are not related to fi nancing, but the ‘collateral increasingly ineffective tool in managing cap- foreign capital have on average grown faster benefi ts’ that come with openness to foreign ital flows and exchange rate volatility. The over the last three decades. This is consistent capital. These collateral benefi ts, which should notion of waiting for all of the preconditions with work by other authors that a higher increase total factor productivity growth, share of domestic fi nancing in total investment include fi nancial development, effi ciency gains to be put in place before allowing further is positively related to growth outcomes through increased competition, incentives for CAL is also a distraction as it ignores the (Aizenman, Pinto and Radziwill, 2007). better corporate governance, discipline on practical realities on the ground and could Why does CAL not have strong positive macro policies, etc. Mishkin (2006), for instance, give policymakers false comfort that they effects on growth? PRS note some channels provides a detailed account of how fi nancial through which CAL could hurt growth. integration can boost domestic financial can control capital flows in order to give Surges in infl ows could lead to exchange rate development. The evidence for such collateral themselves more room to manage domes- overvaluation that hurt the external com- benefi ts of fi nancial openness is mounting but is tic policies. petitiveness of the manufacturing sector. not yet conclusive. Indeed, Eichengreen (2007) Authors such as Bhalla (2007) and Rodrik and Rodrik and Subramanian (2008) express How should policymakers approach fur- (2008) go even further in suggesting that a scepticism about the size and even about the ther CAL? The alternatives are clear. One is policy of undervaluing the currency could be very existence of these benefi ts. to manage the process of further capital ac- good for growth. Rodrik (2007) argues that What about the risks? The composition of the constraint on growth may not be related gross private infl ows into emerging markets has count opening in a manner that maximizes its to domestic savings but to investment. That been shifting over time, to the point where direct and indirect benefits. The second is to is, domestic fi nancial systems may simply not FDI and portfolio equity fl ows now exceed try and resist de facto openness using capital be up to intermediating fi nance from savings debt fl ows. FDI and portfolio equity fl ows are controls. Evidence from other countries that into productive investment. Indeed, Prasad, likely to bring with them more of the indirect Rajan and Subramanian fi nd that countries benefi ts of fi nancial integration and also enable have imposed capital controls shows that they with weak financial sectors are the ones more effi cient risk sharing. Moreover, even tend not to be effective beyond short horizons, where foreign capital has its most harmful infl ows in the form of debt are now increasingly if at all, and can create multiple distortions in effects on growth. Moreover, Henry (2007) denominated in domestic currencies, which is argues that CAL should, even in theory, have far less risky for recipient countries. an economy. For instance, limiting external only temporary effects on output growth. Given these developments, Prasad and Rajan borrowing tends to disproportionately hurt Of course, these ‘temporary’ effects could (2008) conclude that it makes more sense smaller firms that may find it difficult to raise last for many years. Gourinchas and Jeanne for emerging markets to actively manage the 16 (2006) contend that the welfare gains from process of CAL rather than attempt to resist capital from abroad through other means. additional financing provided by foreign fi nancial integration. With expanding trade Moreover, capital tends to find ways around capital are likely to be small since, ultimately, fl ows, the rising sophistication of international controls, which inevitably results in a cat- even a relatively poor economy can eventually investors, and the sheer volume of fi nancial and-mouse game as country authorities and attain the optimal level of capital through fl ows, capital controls are growing increasingly domestic savings. impotent since they can easily be evaded. investors try to stay a step ahead of each other. The other presumed benefi t of fi nancial Hence, trying to use capital controls as a policy This game is detrimental to the efficiency and integration is that it should allow for more tool to fend off fi nancial integration is likely to the stability of the financial system. effi cient sharing of risk among countries. The prove futile, deprive the economy of many of basic logic is that open capital accounts allow the indirect benefi ts of fi nancial integration, Ostensibly temporary and targeted con- individuals to acquire fi nancial assets in other and impose costs on the economy through trols are tempting but are typically not very countries, enabling them to achieve better various distortions created by capital controls effective; they even have the potential to diversification of their portfolios. In this and the measures taken by individuals and manner, they can make national consumption corporates to evade them. A well-articulated backfire by creating uncertainty in market much less volatile than national income. programme of CAL can provide a context for participants’ minds about the authorities’ Industrial countries have in fact achieved a broader set of macroeconomic reforms. But policy intentions and possible future actions. substantial risk sharing through international hurtling towards CAL without undertaking When the Thai government imposed a fi nancial markets. Unfortunately, Kose, Prasad other necessary reforms in tandem is also and Terrones (2007) fi nd that emerging markets not a good idea. modest unremunerated reserve requirement 36 A HUNDRED SMALL STEPS

on portfolio inflows in December 2007, market liquidity and pricing, and introduce domestic stock markets fell precipitously more market discipline on government bor- and the government was forced to retract rowing. It would provide more funding for the measure. The rollback of CAL is rarely government-aided infrastructure projects. a viable option, either economically or It could also more directly assist financial politically. sector reforms by offsetting some of the loss There is another cost of ad hoc capital of debt financing that would occur if the controls such as the actions on limiting ex- statutory liquidity ratio was no longer used as ternal commercial borrowings. It creates un- a regular instrument for government deficit certainties about the overall macroeconomic financing. As discussed further in Chapter 4, policy environment, making it harder for banks should be required to own government corporations to plan, which can serve as a securities only as a prudential measure, and deterrent for domestic investment. not to fund the government deficit. In short, the option of trying to use capital There is a legitimate concern that opening controls to restrict inflows and/or outflows these channels could induce more inflows. may leave policymakers in the worst of all But, given that foreign investors who want worlds—the complications of domestic to bring money in can easily find ways to macroeconomic management related to de do so, it is more likely that this will lead to a facto capital account openness, distortionary shift in the markets that inflows go to. That costs of capital controls, and few of the in- is, some foreign investors may see govern- direct benefits of financial globalization. ment or corporate bonds as providing a less Before going further, it makes sense to risky instrument than equity holdings to see where India stands in the comparative participate in the India growth story. This picture on openness. The picture on how may even help take some of the froth off equ- open India’s capital account is relative to ity markets as debt markets get built up. other major East Asian economies is mixed There is also little justification for main- (see Appendix 2.1). In terms of Foreign taining restrictions on foreign direct invest- Institutional Investors’ (FIIs) investment ment. These flows tend to bring with them in equity, India is largely in line with other the greatest indirect benefits of financial countries, both in terms of caps on individual integration, including spillovers of techno- investors and in terms of an aggregate cap. logical and managerial expertise. Concerns The restrictions on FII participation in the about national security and about the lack corporate and government debt markets, of transparency of certain investors such as and domestic financial institutions invest- sovereign wealth funds are legitimate. But ing in securities in overseas markets, are these concerns should not be used as a cloak generally more restrictive in India than in to block FDI in sectors where the real concern other countries. India also has more re- may be those of incumbents who are wary strictions on FDI than most other countries of increased competition due to foreign including China. India has liberalized to a investment. considerable extent outflows by corporates One could also debate the necessity for for mergers and acquisitions overseas, and restrictions on external commercial borrow- has also liberalized outflows by individuals. ings. On the one hand, there is an element of The right approach to further capital ac- risk in a regime where the exchange rate is count opening at this stage may be to see how not freely floating in allowing corporations best it can serve as an adjunct to other reforms, to take on exchange rate mismatches between especially those related to the financial sector. earnings and obligations. Foreign lenders are One concrete measure would be to eliminate also not subject to the same impediments restrictions on foreign institutional investors’ that domestic banks are subject to, which participation in corporate and government may partly explain the lower cost of foreign bond markets. This could help improve funds and their higher attractiveness. At the The Macroeconomic Framework and Financial Sector Development 37 same time, lower cost foreign funds can help prohibitions against foreign institutional in- bear some of the funding risk our banks vestors, against non-resident Indians, against are unwilling to undertake, as well as create products other than futures, against under- needed competitive pressure on our banks. lying trades other than on the rupee–US Moreover, leaving the equity channel open dollar rate, and against positions greater than for foreign equity/mutual fund inflows while US$5 million). closing the debt channel simply creates all We also need to make it easier for our kinds of arbitrage as entities bring in equity individuals and institutions to invest abroad. capital and on-lend it to domestic firms. For individuals, the primary task may be to Ultimately the domestic firms get debt, but simplify procedures, and liberalize the kinds with an added costly layer of intermediation. of assets and managers that can be invested It is debatable whether the risks are any in. For our institutions like pension funds, lower. we have to convince various constituencies This Committee would advocate a steady that a portfolio diversified across the world liberalization of constraints on external com- is safer than a portfolio concentrated only in mercial borrowing (with a time path laid India, and has better risk properties (for one, out in terms of permissible quantities), with it retains value when the Indian economy hard-to-monitor stipulations about end-use suffers a downturn). Regulatory authorities being done away with. It would advocate then have to allow institutional portfolios more freedom for small firms to use this to become broadly and internationally channel, especially in export-oriented sec- diversified. tors. Since small firms are by necessity riskier, At the end of this chapter, we summarize they are more likely to find interest rate these and a list of other concrete steps towards ceilings (or ceilings on spreads) on foreign further CAL that could be implemented in borrowings a constraint. Over time, interest relatively short order and that would serve rate spreads should also be liberalized. as a useful complement to a broader set of As the capital account becomes more open, macro and financial sector reforms. The other elements of financial regulation need recommendations on CAL are in fact simi- attention. For instance, a priority is to foster lar to those of the Committee on Fuller the development of currency derivatives mar- Capital Account Convertibility although kets. Currency derivatives are important for this Committee recognizes that changes firms and households to deal with exchange in international capital markets as well as rate volatility, which may increase temporar- changes in India’s macroeconomic environ- ily as monetary policy focuses on stabilizing ment have led to much greater de facto prices. Manufacturers in traded goods indus- financial openness. Hence, the timetable laid tries, in particular, need to be able to hedge out in that earlier report and its emphasis against short-run fluctuations in exchange on certain preconditions being met before rates in order to maintain their competi- removing certain capital controls may now tiveness and margins. Access to these hedging be less relevant. Another key difference is that instruments would alleviate some of the this Committee would like to emphasize the pressures on monetary policy to manage inconsistency between CAL and tight man- the exchange rate. It is encouraging that cur- agement of the exchange rate. rency futures trading in India was sanctioned and began in August 2008. The Committee notes that foreign investors can play a useful FISCAL POLICY role in developing products to be traded on these markets and adding depth to these Fiscal policy is a key component of the reform markets. In this context, the Committee process. It ties together all of the elements of would encourage the RBI to rapidly elimin- macroeconomic policy discussed so far. ate the remaining restrictions (which include With a more ﬂ exible exchange rate and a 38 A HUNDRED SMALL STEPS

more open capital account, fi scal policy has as fiscal obligations of the government. a crucial role to play as a short-term de- Indeed, by some counts there has been little mand management tool. Fiscal discipline is improvement in the central government essential to manage pressures generated by deficit when these obligations are added capital infl ows and also to reduce fi nancial back. Third, the burgeoning impact of the repression. Well-managed fiscal policy is recent waiver of farm loans and the full cost also necessary to free up monetary policy to of implementing the 6th Pay Commission focus on its key objective of price stability. In- report could derail any recent progress that deed, the effectiveness, independence, and has been made on reducing the deficit. These credibility of monetary policy can be severely factors have been compounded by the surge compromised by high budget defi cits. in oil prices that has resulted in a massive A high fiscal deficit also creates pressures increase in fuel subsidies. to hide it by burying it in public sector firms These issues are of serious concern to the (for example, the enormous oil subsidy) or Committee since any halting or reversal of in disguised and less efficient forms (when progress on reducing the public sector bor- a government guarantees returns in an in- rowing requirement would hamper financial frastructure project, it is essentially bearing reforms and the effectiveness of monetary all the risk associated with borrowing even policy. The Committee would like to em- if the project is ostensibly private sector phasize that it will be difficult to make sig- financed). Indeed, rather than disguising nificant headway on financial sector and more of the deficit, the government should monetary policy reforms if India’s fiscal achieve more of its public objectives by house is not in order. explicitly paying for them rather than by im- In particular, the burden of high levels posing an implicit tax. For instance, it should of public deficit financing has serious con- attempt to achieve priority sector objectives sequences for macroeconomic develop- and universal service objectives through ment and for the financial system. Issuance of explicit and targeted fiscal transfers rather public debt crowds out financing for private than routing these objectives implicitly investment. If banks are seen as a continued through the banking system and hindering source of cheap debt financing through the its efficiency. statutory liquidity ratio, it can also have Although India has a history of chronic- long-term economic costs by holding back ef- ally large fiscal deficits, the situation had ficient financial intermediation. A roadmap been improving until recently. The Fiscal for eliminating such elements of financial Responsibility and Budget Management repression thus needs to go hand in hand Act of 2003 was beginning to show results, with the restoration of fiscal health. with a declining central government deficit This is also a good time to carefully think and prospects for further reductions in the about changing the structure of public debt deficit over the medium term. However, management, particularly in a way that min- there are a number of concerns about the imizes financial repression and generates medium-term outlook for the fiscal position. a vibrant government bond market. The First, it remains to be seen to what extent the Ministry of Finance has announced that decline in the central government deficit is an independent Debt Management Office merely cyclical and mainly a result of strong (DMO) will be set up. This provides an op- economic growth in recent years, or the re- portunity to think about and incorporate sult of a structural and longer-term trend best practices in this field. The structure decline in deficits. Second, there are a number of public debt management should also of disguised or off-budget obligations of be designed while keeping in mind the the government that could swell the deficit broader implications for financial market and public debt if properly recognized development. The Macroeconomic Framework and Financial Sector Development 39

CONNECTIONS AND reform process. For instance, given latent de- TIMING mand among foreign institutional investors for government debt, this may be a good time One of the key themes of this chapter is that to consider liberalization on this front. This there are inextricable linkages among various would add depth to this market and improve macroeconomic reforms and reforms to the incentives for fiscal discipline. A resumption ﬁ nancial sector. Fortunately, a combination of large inflows would also make it possible to of favourable circumstances makes this a opportunistically liberalize capital outflows, propitious time to move forward aggressively but this should be done as part of a broader on multiple fronts. CAL programme rather than just as a short- On monetary policy, the heightened term attempt to manage exchange rate focus on inflation management makes this pressures. To make liberalization of outflows an opportune time for a transition to a new serve its purposes, however, it will be neces- framework that shifts from multiple ob- sary to reduce regulatory restrictions on jectives to a sharper focus on the objective of vehicles that allow households to efficiently price stability (low and stable inflation). As diversify their portfolios internationally. discussed earlier in the report, no big discon- The principal elements of this framework— tinuity in the RBI’s operational procedures strengthening fiscal, financial, and monetary is required. What is essential, however, is a institutions—would reinforce each other. In change in strategic focus and some modifi- sum, a programme of reform on all three cations to operational procedures. Indeed, fronts, while seemingly more ambitious, may focusing on an inflation objective, moving in fact be easier than a programme of reform away from exchange rate management and in just any one dimension. clarifying the roles of different tools in the monetary policy toolkit could have the beneficial effects of reducing incentives for specu- POLICY lative capital inflows and improving the RECOMMENDATIONS effectiveness of the transmission mechanism. The fiscal deficit had been shrinking, in Based on the analysis in the chapter, the Com- part because of improvements in fiscal man- mittee proposes the steps below as a means agement, and in part because the surging to upgrade the policy framework to meet the economy had resulted in a cyclical reduction challenges that lie ahead. The Committee em- in the deficit. Some of this progress has been phasizes that these recommended reforms reversed recently, but there is still room for should be seen as a package. Implementing optimism that progress towards the FRBM them partially would make the individual targets will be restored. But this will require reforms far less effective; indeed, the Com- some political will and tough choices will mittee cautions that implementing the recom- have to be made. An improving fiscal position mendations selectively could in some cases would provide an opportunity to reduce the be counterproductive. For instance, liberal- pre-emption associated with financing of the izing external commercial borrowings by cor- deficit and to rethink the structure of public porates without allowing for greater exchange debt management. Reducing the financing rate ﬂ exibility would increase incentives for needs of the government would create more borrowing via foreign currency-denominated space for monetary policy and reduce the risks debt, which could be risky. of CAL. It would also create more room for The Committee views proper sequencing private debt issuance. As noted above, how- of the recommended reforms as important ever, it may be premature to declare victory but, rather than lay out a specific and rigid on the fiscal front. timeline, prefers to take a more practical ap- Well-managed CAL can serve as a useful proach of indicating which reforms could component of the overall financial sector be undertaken in the short run (the next 40 A HUNDRED SMALL STEPS

1–2 years) and which ones should be seen about its assessments of macroeconomic as longer-term objectives (over a 3–5 year developments, the balance of risks in the horizon). economy, and projections for output growth and infl ation. 6. The RBI’s Monetary Policy Committee should take a more active role in guid- Monetary policy ing monetary policy actions. This Com- mittee should meet more regularly; its 1. Move towards establishing RBI’s primary recommendations and policy judgements objective as the maintenance of low and should be made public with minimal stable infl ation. Implicit in this objective delays. will be to maintain growth consistent with 7. The RBI should develop a model for fore- the economy’s potential and to ensure casting infl ation and make the details of fi nancial sector stability. The objective the model public. The model will re- could be translated quantitatively into a quire refi nement as techniques and data number, a number that can be brought improve; feedback from analysts and down over time, or a range that will be academics will facilitate this process. It achieved over a medium-term horizon will have to be made clear (and the public (say, two years). This will have to be done and market participants will quickly with the full support of the government, learn) that the model is intended to which would simultaneously commit to guide monetary policy decisions but not maintain fi scal discipline (i.e., stick to in a slavish manner or in a manner that the FRBM defi cit reduction path) and precludes a healthy dose of judgement. not hold the central bank accountable for either the level or volatility of the nom- Timing: Steps 1, 2 and 4 could be im- inal exchange rate. plemented in the short term. Legislation The infl ation objective would initi- (step 3) could take longer to formulate and ally have to be set on the basis of a pass, but it is important that the other steps widely-recognized indicator such as the WPI or CPI, notwithstanding the con- be implemented and tied to a clear public ceptual and practical problems with understanding between the government and targeting these measures of infl ation. the RBI. Steps 5–7 should be implemented Measurement issues will need to be soon, especially since they are refinements tackled as a priority and, over the initial (although fairly substantive ones) to current medium-term horizon, the RBI will have practices. to be transparent about what its headline objective implies for infl ation based on other price indexes. 2. The government would make the RBI Capital account accountable for the medium-term infl ation objective, with the terms of this 1. Remove restrictions on outfl ows by accountability initially being laid out in corporates and individuals. There are al- an exchange of letters between the Gov- ready few restrictions on these outfl ows, ernment of India and the RBI. but formal removal of controls, easing 3. The RBI should be given full operational of procedures and elimination of the independence to achieve the infl ation need for permissions, as well as a strong objective. It would be useful to enshrine push to encourage outward fl ows would this operational independence and the send a strong signal that the government infl ation objective in legislation, but also is committing to increased fi nancial inte- strengthen it through clarifying public gration and the policies that are needed statements on the respective roles of the to support it. Easing of restrictions on RBI and the government. vehicles such as mutual funds and domes- 4. The RBI would progressively reduce its tic fund managers (see Chapter 5), that intervention in the foreign exchange individuals could use for international market. portfolio diversifi cation, would be an im- 5. The RBI should make its operational portant ancillary reform. framework clear, and supplement this with 2. The registration requirements on for- more frequent and concise statements eign investors should be simplifi ed. One The Macroeconomic Framework and Financial Sector Development 41

transparent approach would be to end public debt management. Step 7 could be the foreign institutional investor (FII) implemented over 2–3 years. This lag is to framework for investment in equities and, allow for adequate regulatory capacity to be instead, allow foreign investors (including NRIs) to have direct depository accounts. built up, and to allow for public debt man- The distinctions between FIIs, NRIs and agement to be improved and for foreign other investors could also be eliminated, investors to be allowed to participate in dom- with the intent being to eliminate any estic debt markets so that there are no major privileges or costs they may experience implications for financing of the public debt. with respect to domestic investors. As noted earlier, step 8 should be tied in with 3. Remove the ceilings on foreign portfolio investment in all companies, with a other reforms and not undertaken in isolation narrow exception for national security from reforms to the monetary policy frame- considerations—treat foreign investors work described under Monetary Policy above. just like local shareholders. 4. Remove restrictions on capital infl ows based on end-uses of funds. These do not serve much purpose anyway, since they Fiscal policy are diffi cult to monitor. 5. Remove restrictions on inward FDI, with 1. Continue to reduce levels of consolidated a narrow exception for national security government defi cit and public debt considerations. (ratios to GDP); resume progress to- 6. Liberalize, then eliminate, restrictions on wards targets specifi ed under the Fiscal foreign investors’ participation in rupee- Responsibility and Budget Management denominated debt, including corporate Bill. Amend the FRBM Act so as to bring and government debt. the off-balance-sheet borrowing by the 7. Remove regulations that hinder inter- government integrally into calculations national diversifi cation by domestic insti- of the government budget defi cit and tutional investors. Insurance companies, public debt. as well as government pension and pro- 2. Reduce the Statutory Liquidity Ratio to vident funds should especially be en- a level consistent with prudential needs; couraged to diversify their holdings by switch to direct bond fi nancing of new investing abroad. defi cits. Similarly, regulators of pension 8. Reduce restrictions on borrowing by funds and insurance companies should domestic fi rms and banks, whether this set regulations on fund portfolio hold- borrowing occurs offshore or onshore, ings so as to maximize the welfare of bene- in Indian rupees or foreign currencies. fi ciaries, and not so as to mobilize the For instance, the ceiling on corporate ex- purchase of government bonds. ternal commercial borrowing could be 3. Transition away from providing sops for steadily raised for the next few years until exporters in response to currency ap- eliminated. If there is excess demand dur- preciation. While many of the recent ing the transitional phase to removal of sops are in the process of being removed, restrictions, borrowing rights could be it is important to curtail expectations of auctioned.17 Stability concerns raised by similar sops being offered in the future in exchange mismatches between bank as- the event of currency appreciation. sets and liabilities should be addressed by supervisory and prudential measures. Timing: The time horizon for some of these measures could be in the range of 1–2 Timing: The first four steps would essen- years, but it is essential to start laying the tially formalize existing de facto arrange- foundation for some of these changes much ments and remove impediments that serve sooner. no substantive purpose in terms of economic efficiency or macro management. These changes could be implemented relatively Other reforms quickly. Steps 5–6 could be implemented over the short term, in tandem with other reforms 1. Remove the remaining restrictions on including improvements in the structure of the currency futures market in the short 42 A HUNDRED SMALL STEPS

term (prohibitions against foreign insti- The Committee is pleased to note that tutional investors, against non-resident the RBI is working on the first item and the Indians, against products other than fu- Finance Ministry has announced that it is tures, against underlying trades other than the rupee–US dollar rate, and against setting up a public debt management office. positions greater than US$5 million). These measures are long overdue and should Permitting onshore currency derivatives be implemented soon. markets with no restrictions on par- The set of reforms listed here has not ticipation is an important measure that touched upon broader issues, some of includes elements of ﬁ nancial market which were discussed in the main text of regulation as well as capital account liberalization. These markets could be the chapter—easing of labour market regu- developed fairly quickly as the technical lations, increasing investment in physical infrastructure for trading of these deri- infrastructure and education, reducing red vatives could be built up soon on the tape, improving data collection, etc. Action on backbone of the existing securities trad- all of these fronts will ultimately determine ing infrastructure. 2. Improve the structure of public debt India’s growth trajectory. But the specific steps management to increase depth and listed above will make a major contribution transparency of this market. to achieving the desired trajectory and could generate momentum for broader reforms. The Macroeconomic Framework and Financial Sector Development 43

ANNEXURE 2.1: A COMPARISON OF CAPITAL CONTROLS IN SELECTED ASIAN ECONOMIES

INDIA Investment Restrictions FII in: Ratio of 70:30 for Equity and Debt respectively Stock Market 1. Each FII (investing on its own) or sub-account cannot hold more than 10 per cent of the paid-up capital of a company. A sub-account under the foreign corporate/individual category cannot hold more than 5 per cent of the paid-up capital of the company. 2. The maximum permissible investment in the shares of a company, jointly by all FIIs together is 24 per cent of the paid-up capital of that company. 3. This limit of 24 per cent can be raised to 30 per cent, 40 per cent, 49 per cent or up to the FDI limits specifi ed for that particular sector, subject to approval from the shareholders and RBI. Government Debt Effective 31March 2007, the cumulative debt investment limits for the FIIs/sub-accounts in government securities and treasury bills is US$3.2 billion (previously US$2 billion). Corporate Debt The cumulative debt investment limits for the FII/sub-accounts in corporate debt is US$1.5 billion. Investments in IPDI and Upper Tier II instruments raised in Indian rupees, are subject to a separate ceiling of US$500 million. FII/FDI in: Banking The total foreign ownership in a private sector bank cannot exceed 74 per cent of the paid-up capital and shares held by FIIs under the portfolio investment schemes through stock exchanges cannot exceed 49 per cent of the paid-up capital. In case of public sector banks the foreign ownership limit is 20 per cent. Single investor cap is 10 per cent and RBI approval required for acquisition or transfer of shares to the equivalent of 5 per cent or more of its total paid up capital. Insurance Cap of 26 per cent Domestic FI Investing in Foreign Securities: Insurance Cannot invest in securities in offshore markets. Pensions N.A. Mutual Funds/Investment Firms Mutual Funds in India with at least 10 years of operation may invest in overseas securities such as global and Collective Investment Funds depository receipts by Indian companies, equity of overseas companies and foreign debt securities in countries with fully convertible currencies, within an overall limit of US$3 billion. Outward Direct Investment by Indian corporations can invest in joint ventures/subsidiaries or acquire foreign companies overseas up to Domestic Corporations 200 per cent of their net worth through the automatic route. They can invest 200 per cent of their GDR and ADR issues for these investments. ECB credits/borrowings can be used to fund these investments. Share swap transactions require prior approval of the Foreign Investment Promotion Board (FIPB). Any Indian company that has issued ADRs or GDRs may acquire shares of foreign companies engaged in the same area of core activity up to 10 times their annual exports. Resident employees of a foreign company’s offi ce, branch or subsidiary in India in which the foreign company holds not less than 51 per cent equity, either directly or indirectly, may invest under an employee stock option plan without limit, subject to certain conditions. Borrowing Restrictions External Commercial The maximum amount of ECB credit that a corporation can engage in under the automatic route is the Borrowings equivalent of US$500 million in a fi nancial year. All corporations registered under the Companies Act (except banks, fi nancial institutions, housing fi nance companies and non-bank fi nancial companies) may borrow abroad up to the equivalent of US$20 million for loans of a minimum three years’ average maturity and up to US$500 million for loans of more than fi ve years’ average maturity under the automatic route without RBI approval. Borrowing with an average maturity of three to fi ve years is subject to a maximum spread of 200 basis points over the six-month LIBOR of the currency in which the loans are raised or the applicable benchmark(s), and borrowing with more than fi ve years’ average maturity is subject to a maximum spread of 350 basis points. 44 A HUNDRED SMALL STEPS

Borrowing Overseas by Banks/ External Commercial Borrowing is subject to the policy framed by the RBI in consultation with the MOF. FIs Authorized Dealers (ADs) may avail themselves of foreign currency borrowing not exceeding 25 per cent of their unimpaired Tier-I capital or the equivalent of US$10 million, whichever is higher. Banks are allowed to raise capital using two foreign exchange instruments. First, banks may augment their capital funds through the issue of IPDI in foreign currency up to 49 per cent of the eligible amount (i.e., 15 per cent of Tier-I capital) without seeking the prior approval of the RBI, subject to compliance with certain specifi ed conditions. Second, banks may augment their capital funds through the issue of Upper Tier II instruments in foreign currency up to 25 per cent of their unimpaired Tier-I capital without seeking the prior approval of the RBI, subject to compliance with certain specifi ed conditions. Capital funds raised through the issue of these two instruments in foreign currency are in addition to the existing limit for foreign currency borrowing by ADs. Imports and Exports Commercial Credits Trade credits up to one year for non-capital goods and less than three years for capital goods are available up to US$20 million for an import transaction; ADs are permitted to guarantee such trade credits. Trade credits (buyer credits, supplier credits) exceeding US$20 million for fi nancing imports of goods and services for a period less than three years are considered by the RBI, subject to certain conditions. Documentation Requirements Documentary evidence is required for foreign exchange payments for imports exceeding the equivalent for Release of Foreign Exchange of US$100,000. for Imports Export Proceeds—Surrender Effective 30 November 2006, exporters are permitted to retain up to 100 per cent (previously 50 per cent) Requirements of foreign exchange receipts in foreign currency accounts with banks in India. Effective 28 February 2007, ADs may extend the period of realization of export proceeds beyond six months from the date of export, up to a period of six months at a time, irrespective of the invoice value of the export, subject to conditions. CHINA Investment Restrictions FII in: Restrictions on Investment in ‘A’ Shares, but no Restrictions on Investment in ‘B’ Shares Stock Market Qualifi ed Foreign Institutional Investor (QFII) may invest in A shares, subject to the following limitations (in addition to the criteria of investee’s net worth, track record, assets etc): 1. Ownership of any Chinese company listed on the Shanghai or Shenzhen stock exchange by a QFII may not exceed 10 per cent. 2. Total shares owned by QFIIs in a single Chinese company may not exceed 20 per cent. 3. QFIIs are restricted or prohibited from investing in some industries or businesses (e.g., medicine manufacturing, mining, telecommunication, etc.). Government Debt QFIIs may invest in treasury bonds listed on domestic securities exchange. Corporate Debt QFIIs may invest in convertible bonds and corporate bonds listed on domestic securities exchange. FII/FDI in: Banking CBRC approval is required. Aggregate cap of 25 per cent with ceiling of 20 per cent for single foreign investors. Insurance Cap of 50 per cent. Domestic FI Investing in Foreign Securities: Insurance Approved Insurance companies may invest in shares in offshore markets within the permitted limit, but may not exceed 10 per cent of the investment limit permitted by the SAFE. Pensions N.A. Mutual Funds/Investment Firms Effective 15 April 2006, on approval, qualifi ed fund management fi rms and other securities management and Collective Investment Funds companies may, within a certain limit, combine foreign exchange funds owned by domestic institutions and individuals and use the funds overseas for portfolio investments, including for stocks. Outward Direct Investment by Effective 1 July 2006, the limit on the amount of foreign exchange used in Chinese enterprises’ direct Domestic Corporations investments abroad has been abolished, allowing domestic investors to purchase foreign currency to participate in direct investments abroad. The Macroeconomic Framework and Financial Sector Development 45

Borrowing Restrictions External Commercial One-year or longer international commercial borrowing by Chinese institutions must be approved in Borrowings advance. Financial Institutions with an approval to engage in foreign borrowing may conduct short-term foreign borrowing with maturities of one year or less within the balance approved by the SAFE. Specifi c transaction-based approval is not required. All foreign borrowing must be registered with the SAFE. Borrowing Overseas by Banks/ The regulations governing ECB-corporates above apply. Domestic banks that are funded abroad may not FIs convert proceeds from debt contracted abroad into renminbi and are not allowed to purchase foreign exchange to service these debts. Imports and Exports Commercial Credits The regulations governing ECB above apply. Documentation Requirements In order to purchase foreign exchange or make payments from a foreign exchange account, importers for Release of Foreign Exchange must provide the import contract, the exchange control declaration related to the import payment in for Imports foreign exchange, the customs declaration (required for payment-on-delivery settlement), the invoice and the import bill of lading. Collections and LCs do not require customs declaration, and cash-on-delivery payments do not require bills of lading. Export Proceeds—Surrender Domestic institutions may establish current account foreign exchange accounts with proof of a business Requirements licence (or organization registration) and an institution identifi cation number and may retain foreign exchange revenue resulting from 80 per cent of the previous year’s current account foreign exchange revenue minus 50 per cent of current account foreign expenditure. Domestic institutions that in the previous accounting year had no current account foreign exchange revenue may retain an initial limit of foreign exchange revenue of US$500,000 when establishing accounts. THAILAND Investment Restrictions FII in: Stock Market The combined shareholdings of an individual and related family members may not exceed 5 per cent of a bank’s total amount of shares sold and 10 per cent of that of fi nance companies and credit companies. Foreign equity participation is limited to 25 per cent of the total amount of shares sold in locally incorporated banks, fi nance companies, credit fi nance companies and asset management companies. Foreign investors are allowed to hold more than 49 per cent of the total shares sold in local fi nancial institutions for up to 10 years, after which the amount of shares will be grandfathered, and the non- residents will not be allowed to purchase new shares until the percentage of shares held by them is brought down to 49 per cent. Foreign equity participation is limited to 49 per cent for other Thai corporations. Holdings exceeding this limit are subject to the approval of the BOT. Corporate Debt Effective 4 December 2006 investments of more than B 50 million a consolidated entity in short-term debt and related products (not exceeding six months) issued by local fi nancial institutions in the primary market without underlying transactions are not allowed. Effective 15 November 2006, local fi nancial institutions may not issue or sell bills of exchange in baht for any maturity to non-residents. FII/FDI in: Foreign capital may be brought into the country without restriction, but proceeds must be surrendered to authorized fi nancial institutions or deposited in foreign currency accounts with authorized fi nancial institutions in Thailand within seven days of receipt. Banking Same as applied to FIIs above. Foreign investors may be allowed, on a case-by-case basis, to hold up to 100 per cent of shares sold in commercial banks for a period of 10 years, which will be grandfathered. However, after the 10-year period, they will not be allowed to purchase additional shares unless their holding is less than 49 per cent of the total amount of shares sold. Domestic FI Investing in Foreign Securities: Insurance Effective 15 January 2007 insurance companies are allowed to invest in securities issued abroad by Thai juridical persons without limit and in foreign securities issued by non-residents up to US$50 million but not exceeding the limit set by their regulator, without BOT approval. Pensions Same as above for insurance. The ceiling on investment in stocks is 25 per cent of the portfolio, and that on any single stock is 5 per cent of the portfolio. 46 A HUNDRED SMALL STEPS

Mutual Funds/Investment Firms Same as above for Insurance. and Collective Investment Funds Outward Direct Investment by Investments exceeding US$10 million (or the equivalent) a year require BOT approval. Effective 15 January Domestic Corporations 2007, residents may invest up to US$20 million a person a year in their parent companies abroad (owning at least 10 per cent of the resident companies) and US$50 million a person a year in their affi liated companies abroad (owned at least 10 per cent by the resident) without approval from the BOT. Borrowing Restrictions External Commercial A limit of B 50 million applies on the amount that non-residents may lend to domestic fi nancial institutions. Borrowings This limit applies to loans granted by non-residents without underlying transactions, with maturities not exceeding—effective 24 December 2006—six months (previously, three months). The non-resident’s head offi ce, branches, representative offi ces and affi liated companies are counted as one entity. Borrowing Overseas by The limit that non-residents may lend to domestic fi nancial institutions is B 50 million or its equivalent. Banks/FIs Effective 24 December 2006, this limit applies to loans granted by non-residents without underlying transactions with maturities of less than or equal to six months (previously three months). Imports and Exports Documentation requirements No documentation requirements. for release of foreign exchange for imports Export proceeds—Surrender Foreign exchange proceeds must be surrendered to authorized fi nancial institutions within seven days requirements of receipt. Effective 15 January 2007, foreign exchange earners are allowed to deposit foreign exchange proceeds in their foreign currency accounts up to US$50,000 for a natural person and US$2 million for a juridical person even if no future obligation on foreign exchange can be documented. KOREA Investment Restrictions FII in: Stock Market Foreign investors are allowed to freely purchase shares issued by Korean companies. However, purchase of shares of unlisted or non-registered corporations requires notifi cation to a foreign exchange bank. Acquisitions of shares exceeding certain ratios of designated public sector utilities in the process of privatization are limited by the relevant laws. FII/FDI in: Banking Non-residents may acquire 10 per cent of stocks without restrictions; acquisition exceeding 10 per cent requires approval of the FSC. Domestic FI Investing in Foreign Securities: Insurance The sum of the assets of an insurance company denominated in foreign currency must not exceed 30 per cent of its total assets. Pensions There are no restrictions on the compositions of foreign currency assets imposed by the relevant laws. For example, according to the National Pension Fund (NPF) Act, there is no limitation on the composition of the NPF’s foreign currency assets. Instead, this is ruled by internal asset management guidelines. Mutual Funds/Investment Firms According to the Indirect Investment Asset Management Business Act, there are no limitations on the and Collective Investment Funds compositions of investment fi rms and collective investment funds. Outward Direct Investment by Residents are free to invest abroad on notifi cation to the designated foreign exchange bank. However, Domestic Corporations investments in fi nancial institutions or insurance companies require notifi cation to and acceptance by the MOFE. Investment by individuals is also limited to 30 per cent of annual sales revenue. Effective 2 March 2006, the limit on investment by individual was abolished. Borrowing Restrictions External Commercial Financial credits up to the equivalent of US$30 million require notifi cation to foreign exchange banks. Borrowings Other credits exceeding US$30 million require notifi cation to the MOFE. Borrowing Overseas by Foreign exchange banks are required to notify the MOFE of funding with maturities exceeding one year Banks/FIs and amounts exceeding US$50 million. The Macroeconomic Framework and Financial Sector Development 47

Imports and Exports Commercial Credits Commercial credits other than trade credits (including deferred payments, installment payments, exports advances, and export down payments) up to US$30 million require notiﬁ cation to foreign exchange banks. Other credits exceeding US$30 million require notiﬁ cation to the MOFE. Documentation Requirements No documentation requirements. for Release of Foreign Exchange for Imports Export Proceeds—Surrender Effective 2 March 2006, export earnings exceeding US$500,000 (previously US$100,000) must be Requirements repatriated within one and a half years (effective 1 January 2006; previously, six months) of receipt. These funds, however, may be held abroad and used for overseas transactions in accordance with the regulations on foreign exchange transactions.

NOTES exercise (how much the exchange rate would have appreciated if there was no intervention), so one should be cautious in interpreting these results. 1. Acharya (2006) and Virmani (2006) discuss 10. This box is based on material taken from Prasad the roles of different policies in driving India’s (2008). growth. 11. Patnaik and Shah (2007) discuss the related 2. See RBI (2004) and Bery and Singh (2007) for a problem of moral hazard caused by implicit gov- comprehensive documentation of this evolutionary ernment guarantees such as those related to process. In reviewing monetary policy outcomes, reducing exchange rate fluctuations through Virmani (2007) notes that there has been a steady intervention. They provide fi rm-level evidence convergence between Indian and international that a managed exchange rate induces fi rms to (US) infl ation levels, as measured by comparable increase unhedged currency exposures. consumption defl ators, over the last 15 years. Such 12. See Shah (2007) for a more detailed discussion of convergence greatly facilitates fi nancial integration these points. and needs to continue. 13. In a recent contribution, Rose (2007) marshals 3. This point has been made by Virmani (2007). empirical evidence that countries that have 4. See Mohan (2007) and Reddy (2007) for a clear adopted infl ation targeting regimes have lower articulation of some of these issues in India’s exchange rate volatility and fewer sudden stops context. than similar countries that do not target infl ation. 5. In plain language, even if the exchange rate of He also notes that this monetary regime seems the rupee for the dollar remains fi xed, India loses durable—no country has yet been forced to competitiveness if its infl ation rate is higher than abandon an infl ation targeting regime. US inflation. This is because the rupee’s real 14. See Brash (2000). exchange rate—nominal appreciation, augmented 15. Crowe and Meade (2008) discuss different as- by the inflation differential—has appreciated. pects of central bank transparency and provide There are several related concepts of the real some evidence on the benefi ts of increased trans- exchange rate. One concept focuses on the change parency. in the relative price of non-tradables (haircuts) 16. See Forbes (2006, 2007). to tradables (iPods), with an increase in the price 17. This suggestion is taken from Virmani (2007). of non-tradables representing a real appreciation of the rupee. An alternative concept focuses on external competitiveness and typically compares changes in price levels between the home country REFERENCES and its main competitors. We use the term ‘real effective exchange rate’ to refer to the latter concept. Acharya, Shankar, 2006, Essays on Macroeconomic 6. Bosworth and Collins (2008) present calculations Policy and Growth in India, New Delhi: Oxford of total factor productivity growth for China and University Press. India, both at the aggregate level and separately for Aizenman, Joshua, Brian Pinto, and Artur Radziwill, agriculture, manufacturing and services. 2004, ‘Sources for Financing Domestic Capital—Is 7. See the analysis in the IMF’s October 2007 World Foreign Saving a Viable Option for Developing Economic Outlook, and the references therein. Countries?’, NBER Working Paper No. 10624. 8. Kaminsky, Reinhart and Vegh (2004) discuss how Forthcoming in Journal of International Money procyclical fi scal policy has hurt the ability of Latin and Finance. American economies to deal with capital fl ows. Bery, Suman, and Kanhaiya Singh, 2006, ‘Domestic 9. See Chapter III in the IMF’s October 2007 Financial Liberalisation and International Financial World Economic Outlook. Of course, it is diffi cult Integration: An Indian Perspective’, in J. Aziz, to establish a clear counterfactual in such an S. Dunaway, and E. Prasad (eds.), China and 48 A HUNDRED SMALL STEPS

India: Learning from Each Other, Washington, DC: Mishkin, Frederic S., 2006, The Next Great Globalization: International Monetary Fund. How Disadvantaged Nations Can Harness Their Bery, Suman, and Kanhaiya Singh, 2007, ‘A Century Financial Systems to Get Rich, Princeton, NJ: of Monetary Policy Making in India,’ in S. Bery, Princeton University Press. S. Bhalla, and R. Mohan (eds.), Applied Economic Mohan, Rakesh, 2007, ‘Capital Account Liberalisation Research in Independent India: NCAER Golden and Conduct of Monetary Policy: The Indian Jubilee Volume, Sage Publications. Experience,’ RBI Bulletin, July. Bhalla, Surjit S., 2007, Second Among Equals: The Middle Patnaik, Ila, and Ajay Shah, 2007, ‘Does the Currency Class Kingdoms of India and China, Washington, DC: Regime Shape Unhedged Currency Exposure?’, Peterson Institute of International Economics. Manuscript, National Institute for Fiscal Policy Bosworth, Barry, and Susan M. Collins, 2008, ‘Accounting Research, New Delhi, India. for Growth: Comparing China and India,’ Journal of Prasad, Eswar, 2007, ‘Is China’s Growth Miracle Built Economic Perspectives, Vol. 22, pp. 45–66. to Last?’, Manuscript, Cornell University. Forth- Brash, Donald T., 2000, ‘Inﬂ ation Targeting in New coming in China Economic Review. Zealand: 1988–2000,’ Manuscript, Reserve Bank Prasad, Eswar, and Raghuram Rajan, 2008, ‘Practical of New Zealand. Approaches to Capital Account Liberalization,’ Crowe, Christopher, and Ellen E. Meade, 2008, ‘Central Manuscript, Cornell University. Forthcoming in Bank Independence and Transparency: Evolution Journal of Economic Perspectives. and Effectiveness,’ European Journal of Political Prasad, Eswar, Raghuram Rajan, and Arvind Economy, forthcoming. Subramanian, 2007, ‘Foreign Capital and Economic Dincer, Nergiz, and Barry Eichengreen, 2007, ‘Central Growth,’ Brookings Papers on Economic Activity, Bank Transparency: Where, Why, and With What Vol. 1, pp. 153–230. Effects?’, NBER Working Paper No. 13003. Reddy, Yaga V., 2007, ‘Financial Globalisation, Growth Eichengreen, Barry, 2007, ‘The Cautious Case for Cap- and Stability: An Indian Perspective,’ Remarks at ital Flows,’ Manuscript, University of California, the International Symposium of the Banque de Berkeley. France on Globalisation, Inﬂ ation and Monetary Forbes, Kristin. 2005, ‘The Microeconomic Evidence on Policy, held in Paris on 7 March 2008. Capital Controls: No Free Lunch,’ NBER Working Rodrik, Dani, 2007, ‘The Real Exchange Rate and Paper 11372. Economic Growth: Theory and Evidence,’ Manu- Gourinchas, Pierre-Olivier, and Olivier Jeanne, 2006, script, Kennedy School of Government, Harvard ‘The Elusive Gains from International Financial University. Integration,’ Review of Economic Studies, Vol. 73, Rodrik, Dani, and Arvind Subramanian, 2008, ‘Why pp. 715–41. Did Financial Globalization Disappoint?’, Manu- Henry, Peter B., 2007, ‘Capital Account Liberalization: script, Kennedy School of Government, Harvard Theory, Evidence, and Speculation,’ Journal of University. Economic Literature, Vol. 45, pp. 887–935. Rose, Andrew, 2006, ‘A Stable International System IMF, World Economic Outlook, various issues, Emerges: Bretton Woods, Reversed,’ CEPR Dis- Washington, DC: IMF. cussion Paper No. 5854. ———, 2008, ‘India: Selected Issues,’ Country Report Shah, Ajay, 2007, ‘New Issues in India’s Macro Policy,’ No. 08/52. Manuscript, National Institute for Fiscal Policy Kaminsky, Graciela, Carmen M. Reinhart, and Carlos Research, New Delhi, India. A. Vegh, 2004, ‘When it Rains, it Pours: Procyclical Virmani, Arvind, 2006, Propelling India from Socialist Capital Flows and Macroeconomic Policies,’ NBER Stagnation to Global Power, Academic Foundation, Working Paper No. 10780. New Delhi, India. Kose, M. Ayhan, Eswar Prasad, Kenneth Rogoff, and ———, 2007, ‘Macroeconomic Management of the Shang-Jin Wei, 2006, ‘Financial Globalization: A Indian Economy: Capital Flows, Interest Rates Reappraisal,’ NBER Working Paper No. 12484. and Inflation,’ Government of India, Ministry Kose, M. Ayhan, Eswar Prasad, and Marco Terrones, of Finance, Department of Economic Analysis, 2007, ‘How Does Financial Globalization Affect Working Paper No. 2/2007. International Risk Sharing: Patterns and Channels,’ Manuscript, Cornell University. Broadening Access to Finance

Financial sector policies in India have long • Perhaps the most important fi nancial been driven by the objective of increasing services for the poor are vulnerability re- 1 financial inclusion, but the goal of uni- ducing instruments. Thus access to safe and remunerative methods of saving, reversal inclusion is still a distant dream. The mittances, insurance, and pensions needs network of cooperative banks to provide to be expanded signifi cantly. Within in- chapter credit to agriculture, the nationalization of surance, crop insurance for farmers and banks in 1969, the creation of an elaborate health insurance for the poor in general, framework of priority sector lending with are major vulnerability reducers. A signifi cant expansion in coverage is needed, 3 mandated targets were all elements of a even while action is taken on the real side state-led approach to meet the credit needs to reduce the factors creating vulnerabil- of large sections of the Indian population ity (such as broader access to irrigation, who had no access to institutional fi nance. agricultural extension services, and pre- The strategy for expanding the reach of ventive, as well as actual, health care). • Efforts at fi nancial inclusion need to move the financial system relied primarily on away from sectors to segments of people expanding branching, setting up special that are excluded. Past efforts have focused purpose government sponsored institutions largely on agriculture. As the Indian econ- (such as regional rural banks (RRBs) and omy diversifi es and more people move cooperatives) and setting targets for credit to away from farming, there is an urgent need to focus on other segments as well, for broad categories of the excluded. Its success instance the poor in urban areas. More- has been mixed, and has been showing over, sector-specifi c approaches result in diminishing returns. benefi ts that often accrue to non-poor reci- A new approach to financial inclusion is pients, as in the case of subsidized agri- needed that builds on the lessons of the past. culture credit. • Past strategies to expand inclusion are It will require a change in mindset on the reaching seriously diminishing returns. part of policymakers, practitioners, and other { While mandated branching, especially stakeholders in India to figure out effective by public sector banks in rural areas, ways to provide financial services to the poor. has made banks easier to reach for sig- It should lead to a set of financial sector re- nificant portions of the population, forms that explicitly prioritize inclusion. We these branches have not gone out of note some important lessons from India’s their way to attract the poor. Rural branches are seen as a burden rather past experience: than an opportunity by the increasingly profit-oriented public sector. At • Financial inclusion is not only about cre- the same time, it appears that more dit, but involves providing a wide range branching itself cannot be the way to of fi nancial services, including saving reach the poor, since the poor in richly accounts, insurance, and remittance prod- branched urban areas have no more ucts. An exclusive focus on credit can lead access than the poor in rural areas. to undesirable consequences such as over- { Priority sector norms do force a focus indebtedness and ineffi cient allocation of on particular sectors. But because they scarce resources. Moreover, credit provision, are now so broad in coverage, banks without adequate measures to create live- migrate towards the bankable within lihood opportunities and enhance credit the priority sector rather than the ex- absorption among the poor will not yield cluded, with those lucky enough to get desired results. themselves classified as priority sector 50 A HUNDRED SMALL STEPS

enjoying access over and above what the political unwillingness to make they would otherwise normally get. changes has ensured that the poor { Interest rate ceilings for small loans are excluded from the formal sector further reduce commercial banks’ de- and driven further into the hands of sire to service the truly excluded—the moneylenders. higher fixed costs and higher per- • There is a clear need to increase the com- ceived credit risk associated with small mercial viability of reaching the poor. loans imply lenders need higher, not Product innovation, organizational fl ex- lower, interest rates to meet demand.2 ibility, and superior cost effi ciency are When a low interest rate is mandated essential in reaching the excluded (as cell in the face of tremendous unfulfilled phone companies have discovered) and demand for credit, it has three effects. offering them fi nancial services that they First, a market determined interest will want to use. Competition, technology, rate is often charged, but the differ- as well as the use of low cost, local organ- ence between the ceiling and the true izations for outreach will have to play a rate is made up through hidden fees or much greater role in any strategy. The role through bribes (and when bribes are of the government should be to attempt to paid to secure the loan, the incentive increase the returns and reduce the costs to repay is severely diminished). Sec- of servicing the fi nancially excluded, even ond, the very poor, who have the least while expanding the desire and the abil- ability to pay these additional charges, ity of fi nancial fi rms to compete for such are further excluded. Third, a plethora business. By necessity, this will imply a of bureaucratic norms and paper- greater tolerance for innovation and risk, work is imposed on loan officers to which is not inappropriate so long as that counter the possibility of corruption, risk does not become systemic. which further reduces the flexibility • The Committee recognizes, however, that or the attractiveness of the loans. The greater commercial viability cannot be need to remove interest rate ceilings truly achieved for all sections of the poor, and replace them with transparent and therefore some kind of mandated but market-based pricing has been coverage will always be required. The key echoed by past Committees that have is to move the primary strategy towards seriously addressed the issue, but innovation and commercial viability, with more carefully targeted mandates seen as Figure 1: Household Access to Financial Services fi lling the gaps, rather than having broad mandates as the central instrument as is current practice.

DEFINING ACCESS IN A FINANCIALLY INCLUSIVE SYSTEM

Financial inclusion, broadly defi ned, refers to universal access to a wide range of fi nancial services at a reasonable cost. These include not only banking products but also other fi - nancial services such as insurance and equity products (see Figure 1). Households need access to fi nance for several purposes, the most important being for contingency planning and risk mitigation. Households build buffer savings, allocate savings for retirement (for example via pension plans) and purchase insurance and hedging products for insurable Source: IISS, 2007. contingencies. Once these needs are met, Broadening Access to Finance 51 households typically need access to credit— contrast, in the highest income quartile, 92.4 for livelihood creation as well as consump- per cent have savings and 86.0 per cent have tion and emergencies (in the event that they bank accounts. Similarly, 29.8 per cent of the do not have savings/insurance to fund them). lowest income quartile had taken a loan in Finally, wealth creation is another area where the last two years, but only 2.9 per cent had fi nancial services are required. Households loans from banks (about one tenth of all require a range of savings and investment loans), while 16.3 per cent of the highest products for the purpose of wealth creation income quartile had loans and 7.5 per cent depending on their level of fi nancial literacy had loans from banks (about half of all as well as their risk perception. loans). The rich-poor divide has replaced the conventional rural-urban divide in access FINANCIAL INCLUSION to financial services, as measured by the IN INDIA—AN UPDATE distribution of savings accounts. It is true OF THE EVIDENCE3 that headline statistics on access to banks seem to convey that there is a rural-urban Broad assessment divide in access to banking services. The population served per bank branch in rural India’s poor, many of who work as agricul- India is approximately 18,000 while in urban tural and unskilled/semi-skilled wage labour- India is 5,000 (World Bank-NCAER Rural ers, micro-entrepreneurs and low-salaried Financial Access Survey, 2003). But 80 per cent worker, are largely excluded from the formal of those without savings reside in the rural fi nancial system (Figure 2). Over 40 per cent areas. For those in higher income brackets, of India’s working population earn but have access to banks in rural areas is not vastly no savings.4 Even accounting for those with different from access in urban areas. Banks financial savings, too large a proportion are approaching near 100 per cent cover- of the poor lie outside the formal banking age of individuals with incomes above Rs. 2 system. For example, only 34.3 per cent of lakh, irrespective of geographical location. the lowest income quartile has savings, and In urban India, 34 per cent of workers in the only 17.7 per cent have a bank account. By lowest income quartile have savings, and of

Figure 2: Link between Annual Income and Bank Accounts by Occupation Group

Source: IISS, 2007. 52 A HUNDRED SMALL STEPS

whom only 60 per cent have bank savings Specifi c needs of the poor account, while in the highest income quartile, and extent to which met 92 per cent have financial savings and of by formal system whom 96 per cent have bank savings account. A similar trend is evident for rural The use of fi nancial services is not only a India where 83 per cent of rural workers function of economic criteria but is also with annual incomes above the national dependent on socio-cultural parameters average (Rs. 71,000 for the Survey) have and risk perception, an understanding of bank accounts. Even inter-state differences which is critical to increase usage—not just in banking coverage can largely be explained availability—of formal financial services. by large differences in incomes and savings What is particularly of concern is the extent 5 among states. Though we cannot rule out to which the poor use fi nancial services, but the possibility of other sources of causality, sourced from the informal rather than the income seems to be a big factor explaining formal fi nancial system. access to financial services. Public ownership of financial services also 1. Savings does not contribute significantly towards Seventy-six per cent of respondents with expanding access. The clientele of private or savings reported keeping their money in foreign banks located in rural areas is not very bank savings accounts. Other popular savings instruments include life insurance different from the clientele of public sector and postal savings (Figure 3). In the lowest banks (see Chapter 4). Similarly, the poor’s income quartile, the most preferred savings access in the public sector dominated rural instruments were bank savings accounts areas is not significantly higher than in urban though only 50 per cent of those with areas (though costs of access may indeed be savings had bank accounts. Life insurance higher in rural areas). Finally, branching as a and informal savings schemes like self- help groups and microfi nance institutions strategy to improve inclusion itself seems to were the other preferred instruments. have reached diminishing returns. The poor Over 20 per cent of respondents in the have no more access in the richly branched lowest income quartile held savings in chit urban areas than in the rural areas. Inclu- funds and self-help groups/microfi nance, sion has to be more than opening up more though the absolute number of people saving in these informal savings schemes branches. is still small—approximately 10 per cent of those with cash incomes or 33 million. Over 50 per cent of the clients saving with Figure 3: Incidence of Savings in Different Financial Instruments SHGs/microfi nance institutions were agricultural wage labourers and self-employed farmers, while 30 per cent of chit fund members belonged to this category (Figure 4). Few people save for retirement, with less than 10 per cent of the paid workforce saving explicitly for retirement through employer-sponsored schemes, or volun- tarily through public provident fund, life insurance and mutual fund products.6 In the lowest income quartile, 3.7 per cent of respondents in the category saved for old age security. Higher income categories are more likely to diversify into other fi nancial instruments. The RBI Annual Report, 2006–07, states that the share of household fi nancial savings in shares and debentures increased from 1.1 per cent in 2004–05 Source: IISS, 2007. to 6.3 per cent in 2006–07.7 The Survey Broadening Access to Finance 53

Figure 4: Use of Informal Savings Schemes by Occupation Category

Source: IISS, 2007.

reveals that increased investor interest as more low income households invest in in equities and mutual funds ﬁ gured mutual funds and equities. prominently among respondents citing 2. Insurance wealth creation and investment as their The participation of low-income groups main motivation for savings.8,9 Although in life insurance, the second most pre- 30.0 per cent of equity investors and 32.0 ferred savings instrument after bank per cent of mutual fund investors report savings deposits, is still very limited. Life an annual income of below Rs. 2.5 lakh, insurance is the preferred choice to deal they comprise less than 1 per cent of with insurable contingencies, particu- the population in this income category. larly premature death. One-third of all In the income category above Rs. 2.5 paid workers have some life insurance lakh, over 29 per cent have invested in protection. However, only 14 per cent of mutual funds and 20 per cent in equities. The one common quality among these Figure 5: Returns on Various Savings Instruments for an Investment of Rs. 10,000 in 1997 investors appears to be education—over three-fourths of investors are graduates. Less than 4 per cent of the investors are women. Bank savings are overwhelmingly the most popular savings medium even among those who appear to have choices in deployment of their savings. However, real returns on bank savings have paled in comparison with returns on equity especially in recent years (Figure 5). The poor have largely missed out on the boom in the equity markets for a number of reasons, including a high priority on security and liquidity, and perhaps a limited understanding of the economic effects of inﬂ ation on savings. Worse, the tax on bank deposits has increased the gap in returns between bank savings and equity.10 This emphasis on bank deposits is Source: ICICI Bank research. Note: COSPI is an equities index developed by the Centre for Monitoring Indian Economy which beginning to change slowly at the margin is based on all listed Indian companies. 54 A HUNDRED SMALL STEPS

people in the lowest income quartile and made in the past two years. For the lowest 26 per cent in the second quartile have income quartile population, the incidence life insurance as against 69 per cent in of emergency loans was highest at almost the highest income quartile. While the 50 per cent, with the top three loan elaborate sales and distribution model sources being moneylenders, friends and has contributed to the popularity of life relatives and SHGs. Nearly 90 per cent of insurance, this has come at considerable Survey respondents in this quartile relied cost by way of high commissions and a on informal sources for credit. In the large per cent of lapsed policies.11 Policy highest income quartile, the incidence of lapses are low only in the highest income emergency loans was around 35 per cent, quartile, while in all other segments at mostly for fi nancial emergencies. The least 20 per cent respondents have had Survey results on incidence of fi nancial a policy lapse. The penetration of non- and medical emergency loans among the life insurance products is negligible. For various income quartiles revealed that example, only 1 per cent of the popu- medical emergencies were particularly high lation appears to have medical insurance. for the lowest income quartile. Loans for 3. Credit medical emergencies decline substantially The poor borrow predominantly from in- as income levels increase. Loans taken formal sources, especially moneylenders for emergency purposes created an un- and relatives/friends. In the lowest income sustainable amount of debt for the lowest quartile, over 70 per cent of loans taken income segment with outstanding debts were from these sources. Only 10 per cent out of emergency loans resulting in debt of respondents took a loan from a bank on average exceeding a full year’s earnings. in the last two years. Correspondingly, in The high dependence on informal the highest income quartile, banks were sources in turn implies that bulk of the the most preferred followed by relatives/ borrowing by the very poor is at very high friends (Figure 6). A large proportion interest rates. Almost half the loans taken of borrowers, irrespective of income, by the lowest income quartile carry annual sourced their loans from friends and re- interest rates above 36 per cent (Figure 7). latives (though the fact that nearly half While the majority of small loans by these loans are made at interest rates banks are at low interest rates, only a small above 36 per cent per annum suggest they fraction of the loans the poor get are from may include informal commercial sources banks. It appears that the low interest rate such as shop keepers that are well-known ceiling may be a factor leading to the higher- to the poor). Even among the urban poor, credit-risk poor being denied credit by the a large per cent of their housing fi nance formal sector. needs are met by informal sources. Given the extremely high demand for Medical and fi nancial emergencies were credit, interest rate ceilings could simply the main reason for household borrowing increase the extent to which costs are accounting for 42 per cent of all loans recovered through fees and other mechanisms. A 2003 World Bank survey revealed Figure 6: Sources of Loan by Income Group that despite lower nominal interest rates, Percentage of persons in income quartile who have taken rural borrowers paid substantial unoffi cial loan from sources in last two years borrowing costs in the form of bribes and Lowest Second Third Highest the time taken to process a loan.12 While income income income income the per cent of bribes as a share of the loan Loan sources quartile quartile quartile quartile were highest in government sponsored Relatives/friends 39.2 34.4 33.2 32.0 schemes (around 42 per cent of the loan) Moneylenders 39.8 33.2 25.8 14.8 and lowest for banks (10 per cent of the Banks 9.6 20.7 33.3 45.8 loan), the time taken to process loans was the longest for commercial banks in rural Self-help groups 9.7 8.4 3.3 3.4 areas. Households generally received sig- Cooperative societies 5.4 4.9 6.5 7.4 nifi cantly less than the total amount of Chit funds/NBFC 1.6 1.9 1.5 1.2 loan they applied for, and the data suggest Microfi nance Institutions 1.1 1.4 1.2 0.9 that speed of loan approval was positively correlated with the amount of bribe paid. Others 1.0 0.9 0.8 1.4 The Survey covered just two Indian states Source: IISS, 2007. (Uttar Pradesh and Andhra Pradesh), Broadening Access to Finance 55

however, anecdotal information supports Figure 7: Annualized Interest Rates Paid by Income Groups the fi ndings of this survey and strengthens Percentage of persons in the income quartiles the belief that the cost of access to credit paying interest at the rate often goes well beyond nominal interest Income quartile <=12% pa 12%–24% pa 24%–36% pa >36% pa rates charged on the loan. Other sources support our conclusion Lowest income quartile 16.0 16.9 18.7 48.4 that large segments of India’s poor house- Second income quartile 22.8 18.8 18.7 39.7 holds continue to be shut out of main- Third income quartile 29.1 26.1 18.7 26.2 stream fi nance. More worrying, according Highest income quartile 40.4 24.5 11.7 23.4 to some measures, access is actually declining. The All India Debt and Invest- Total 22.6 19.4 17.7 40.4 ment Survey, conducted every 10 years, Source: IISS, 2007. documents how Indian cultivators’ Note: Figures are indicative and do not take into account the fact that some sources provide only short-term loans. reliance on formal debt sources increased substantially from 18 per cent in 1961/62 to the poor is still the moneylender, in part to 63 per cent in 1981/82, but this pro- because he is fl exible, does not need docu- gress was reversed in the next two decades as the share of cultivators’ debt from mentation, is prompt, and can respond to his moneylenders increased from 18 to 30 per client’s emergency needs very well. cent between 1991 and 2002. The National Commission for Enterprises in the Un- organized Sector points out that micro- Credit enterprises with investments below Rs. 0.5 million constitute over 90 per cent of small enterprises in the country and contribute Special purpose government sponsored 30 per cent to industrial production but local institutions such as rural cooperatives receive just 2 per cent of net bank credit. did increase access to credit, but they are experiencing serious financial problems, in part because they did not have the right ASSESSING THE STRATEGY governance and incentive structures. As indi- FOR INCLUSION cated by the Vaidyanathan Committee, cooperatives unfortunately became agencies The broad strategy for expanding the reach solely for credit dispensation.13 Upper tiers of the fi nancial system had mixed results. were created to provide refi nance for the The strategy relied primarily on expanding lower. This resulted in a structure driven by branching into rural areas, setting up special borrowers at all levels, with each layer adding purpose government sponsored institutions costs. Indeed, the whole concept of top-down (such as regional rural banks and coopera- fi nancing inherent in the Indian cooperative tives) and setting targets for credit to broad sector is in sharp contrast to the cooperative categories of the excluded. Rural branches movement in other countries, where member have not been profi table, and there is little savings are channelled through careful mem- interest among private and public sector ber control into local loans. This bottom-up banks in opening new branches there. It is flow of financing, coupled with member fair to question whether the stationing of monitoring, ensures that loans are carefully highly-paid urban-recruited staff in short- made and repayment rates are high. Loan as- term postings in rural areas is conducive to sessment and monitoring in the cooperative the development of local knowledge and low movement in India has been much more lax, cost effi cient delivery of fi nancial services, in part because of the easy availability of re- especially credit. Even if the staff make local fi nance from outside, and because of limited contacts and understand local needs, the control exercised by those whose funds are controls that central offi ces have to exercise being employed. over them allow them little leeway for taking Cooperatives also suffer from a number of initiative. Indeed, the predominant lender other disadvantages. Their inability to lend 56 A HUNDRED SMALL STEPS

well has increased the interest cost of deposit The dilution in priority sector norms over financing. They have high transaction costs time was a reaction to the lack of profitable owing to over-staffing and salaries unrelated lending opportunities when norms were to the magnitude of business. Actual repay- more tightly specified. The fundamental di- ments are influenced by ad-hoc government lemma is obvious. Profit-seeking banks will decisions to suspend, delay or even waive look for all lending opportunities that are recovery. All these impediments have ensured profitable. Priority sector norms will expand they have played a smaller role than they access only if they make banks do what they could have.14 would otherwise not do, which almost by Priority sector lending requirements definition is unprofitable. There is therefore played a useful role in facilitating the provi- a delicate balance in setting priority sector sion of bank credit to underserved sectors norms and eligible categories. High priority and sectors identified as national priorities.15 requirements and narrow eligible categories It is probably fair to say that banks’ loan port- targeted at those who truly do not have ac- folios in agriculture, microfinance, small- cess could lead to greater access to credit, but scale industry and other sectors (that were could reduce bank profitability considerably. neglected with respect to credit provision) Essentially, banks would be making transfers would have seen a more modest growth in the to the needy, a role better played by the absence of priority sector lending norms. If government. an objective of priority sector lending, however, was to direct credit to those segments that are truly underserved, the outcomes Insurance are not encouraging. All banks, public and private, have consistently missed their targets Government efforts at providing risk mitiga- for credit provision under the direct agri- tion have also been less than adequate, and culture segment (though public sector banks have unfortunately hindered the develop- have done relatively better), which is largely ment of private efforts. Recognizing the need intended for farmers.16 Similarly, they have for risk mitigation, the government set up a missed priority sector lending targets for the mandatory National Agricultural Insurance ‘weak and vulnerable’ category. Scheme (NAIS) for farmers, which requires Dilution in priority sector norms also that farmers borrowing for 16 specifi c crops contributed to a reduced focus on under- purchase crop insurance through the NAIS. served segments. The bulk of increase in However, the payout from this scheme for credit to agriculture was accounted for by the past six years has been in excess of the increase in indirect finance to agriculture, premia received. This is a direct consequence which includes activities that can be consid- of the caps imposed on the premium rates of ered commercially viable. Another example is oilseeds and food crops—less than 1.5 per the loans to housing. Housing loans were in- cent and 3.5 per cent or the actuarial assessed troduced into the priority sector framework rates for food crops and oilseeds respectively. in the 1990s to spur the development of this Though the broad structure of the NAIS is market. The ceiling on housing loans eligible sound, a key problem is the signifi cant de- for priority sector treatment was initially set lays in claims settlement (9–12 months on at Rs. 5 lakh; this limit was rapidly increased average). These delays could be signifi cantly to Rs. 20 lakh by 2006. To qualify for a hous- reduced by strengthening the yield data col- ing loan of Rs. 20 lakh, an individual needs lection process, combining early trigger an annual income of at least Rs. 4 lakh per indices into NAIS to make part payments year. Surely this is not the category of bor- during the crop cycle with fi nal settlements rowers that need to be targeted via mandated made on the area yield measured, and most lending! importantly by moving towards an actuarial Broadening Access to Finance 57 regime where the Agriculture Insurance employees, microfi nance provides fi nancial Company of India (AICI) could receive services (largely credit) using processes that upfront government support and would work, and in close proximity to the client. bear residual insurance risks.17 For now, the These qualities facilitated the proliferation highly subsidized nature of this insurance of microfi nance from a virtually non-existent has distorted farmers’ views on what the activity in 1990 to a small, but increasingly true price of insurance should be, and dis- important, source of finance for India’s couraged private initiatives to provide crop poor.18 insurance. Subsidized livestock insurance Two models of microfinance are practiced schemes have had a similar effect. Insurance in India: (i) the Self-Help Group (SHG)- against agricultural price fluctuation has Bank linkage model where commercial been hampered, as small farmers are unable banks lend directly to SHGs formed explicitly to exercise hedging options that are available for this purpose and (ii) the Microfinance to larger farmers. Institution (MFI) model where MFIs borrow In summary, the past strategy for inclu- funds from banks to on-lend to microfinance sion had mixed results. While the public clients, many of whom form joint liability sector did create a rural network, that net- groups for this purpose. The first model is work did not bring enough of the poor into the predominant channel for microfinance the formal system, and the rural network in India and is a good example of a mean- weighs on public sector bank profitability ingful liaison between commercial banks (see Chapter 4). The cooperative system is and informal SHGs. As of end-March 2007, in serious financial difficulty. Narrowly de- 29 lakh SHGs had been formed and total fined priority sector norms can force banks to loans outstanding to these groups was about lend, but again by impairing profitability. The Rs. 11,000 crore.19 Credit provided by MFIs focus on increasing credit in the absence of to microfinance clients was about Rs. 3,500 appropriate products for risk mitigation led crore in end-March 2007, 80 per cent of to over-indebtedness among the poor. As the which was provided by less than 20 large financial sector becomes more competitive, MFIs which are registered as NBFCs/Section and as banking privileges get eroded, it will 25 companies. The bulk of microfinance become more difficult and unwise to com- activity was concentrated in South India, promise bank profitability by mandating though this is beginning to change.20 that banks take on the burden of financing There is evidence that an increase in micro- inclusion. Instead, the approach has to be to finance lending is associated with a lower make inclusion more profitable. incidence of borrowing from moneylenders, especially for low income segments. The IISS 2007 survey reveals that in the lowest income Microfi nance category, respondents who are members of SHGs appear to borrow less from money- Microfi nance is the fastest growing ‘non- lenders and friends and family than those institutional’ channel for financial inclu- who are not members of SHGs. It also ap- sion in India. A key factor that infl uenced pears, however, that the demand for credit of the success of microfi nance was its ability SHG members is appreciably high, and this to fill the void left by mainstream banks group still needs to source a large share of its that found the poor largely uncreditworthy, credit from elsewhere (Figure 8). and were unable (or unwilling) to design Microfinance also appears to help its products that could meet the needs of this clients in their efforts to reduce poverty, segment in a commercially viable manner. though more careful randomized evalua- Using group-based lending and local tions are needed to fully assess its impact. 58 A HUNDRED SMALL STEPS

Figure 8: Credit Sources for Loans Taken in Past Two Years by Income Groups of trained management talent to facilitate sustainable scaling up. Income group Members of SHGs (Rs. lakh) <=0.3 0.3–0.6 0.6–0.9 >0.9 Relatives/friends 24.8 27.0 32.9 25.3 A NEW STRATEGY FOR Banks 7.8 15.0 19.9 36.8 Self-help groups 40.5 36.7 32.6 19.2 INCLUSION Money lender 33.3 21.3 18.4 14.9 Any comprehensive and sustainable response Others 5.0 6.8 5.8 13.8 to addressing issues of fi nancial inclusion Non-members of SHGs must necessarily factor in the role of the Relatives/friends 41.4 35.2 34.7 30.6 market. This is because effi ciency, innovation Banks 11.3 22.8 38.7 51.0 and cost-effectiveness are key to serving the Cooperative society 6.1 5.3 5.6 7.4 fi nancial needs of the poor. The fi nancial Money lender 40.1 34.5 21.8 13.6 sector does not ignore the poor because of Others 7.6 7.4 4.5 4.2 biases, but because the transaction costs in Source: IISS, 2007. serving them are high. Initiatives that reduce Note: Figures relate only to SHG members who have regular cash incomes. Numbers denote these costs will allow service providers to begin percentage of respondents in each category that had borrowed from a particular thinking of fi nancial services for the poor as source. Cells add up to more than 100 due to borrowing from multiple sources by respondents. a business opportunity and not as an act of charity. Policy initiatives need to make fi nancial services for the poor as attractive as those A recent report by the Grameen Foundation for the rich, and increase competition to serve took stock of the evidence on the impact them. To reduce transaction costs, public 21 of microfinance on poverty alleviation. It policy must facilitate the use of technology highlighted several studies that indicated and the creation of low cost organizational microfinance plays a significant role in structures to reach the poor. poverty reduction. For example, one study A new strategy for increasing access to by Khandkar suggested that microfinance financial services will require the creation of was responsible for 40 per cent of the entire a vibrant ecosystem that supports financial 22 poverty reduction in Bangladesh. Another inclusion. This calls for changes on several study of SEWA Bank, Gujarat, found that fronts. Six areas are identified and are de- SEWA Bank clients had higher levels of scribed in detail below: income than others in the area who were also self-employed, but did not participate in SEWA Bank’s programmes.23 The Report An organizational structure that also found evidence that microfinance had facilitates inclusion a wider positive impact on socio-cultural issues, such as women’s empowerment, nutri- The starting point for a vibrant ecosystem tion and contraceptive use. for fi nancial inclusion is to ensure that the Despite its success, the future growth of organizational architecture supports and microfinance is constrained by a number creates institutions that can reach the poor. of factors. An important issue is the abil- The Committee recommends a two-pronged ity of MFIs to raise financing. Given the approach—fi rst, to facilitate the creation of large estimated demand for microcredit, small fi nance banks, and second, to strengthen MFIs need multiple sources of financing, the linkages between large and small fi nan- apart from the traditional loan financing cial institutions. Both measures should be from banks.24 Other constraints include pursued with equal vigour. an unclear regulatory environment and There is a growing consensus around the the lack of well-developed management in- world that small business/farmer credit is best formation systems and an adequate supply delivered by local small private or voluntary Broadening Access to Finance 59

Institutions, especially if standardized credit to facilitate the retailing of large banks’ finan- information is limited. Experiences in US, cial products to small clients. Europe, the Philippines, and other countries The Indian financial landscape is dotted in the creation of small and local financial with a number of small, local financial institutions are a case in point. These institu- institutions. As mentioned in ‘Assessing tions should be ‘local’ because someone who the strategy for inclusion’, many of these, is part of the locality has much better infor- especially those in the public sector, ran into mation on who is creditworthy than someone difficulties, and are now in various stages of who is either posted temporarily from a city, transformation. Various categories of small or someone who takes the bus everyday from banks were created, but with less than sat- the nearest town. They are also better able to isfactory success in banking the poor. The understand local farmer and business needs. RRBs and the Urban Cooperative Banks ‘Small’ because the centre of decision mak- (UCBs) are testament to this. A key problem ing is close to the loan officer—he can get faced by these institutions was that the qual- approval directly from the manager without ity of lending was compromised due to the documentation, delays, and loss of in- various reasons. In the case of RRBs, the wage formation that would be incurred if he had structure for RRB staff was equalized with to get approval from head office. ‘Private’ or their higher wage national commercial bank ‘voluntary’ because the manager has the right counterparts, resulting in a cost structure that incentives in handling flexible, low documen- was unprofitable. High profile crises in two tation, loans if he has a significant stake in the UCBs in 2001–02 led to a decline in public 25 enterprise and its future. And finally, local, confidence in UCBs.26 These institutions small, private or voluntary institutions have were largely denied the key factors that are the low cost structure and low staffing costs crucial to small banks’ success, namely the (because their local hires will be paid at local flexibility and independence to adopt low wage rates instead of at city rates) that allow cost, innovative processes and structures to small loans to be profitable. In fact, success- make small-scale banking viable. ful micro-lenders, the moneylender and the A large number of commentators believe, microfinance institutions have precisely these based on historical evidence, that small banks characteristics. will be unviable in India. They question the Many of the government initiatives in this probity of small promoters, as well as the pro- regard suffer from one or more deficiencies fitability of these banks given high fixed costs. with respect to local private or voluntary This Committee recognizes that small banks institutions. Large banks do not have the have not distinguished themselves in India in decentralized loan making authority, the the past, often because of poor governance local knowledge, the incentives (in the case structures, excessive government and polit- of public sector banks), or the low cost struc- ical interference, and an unwillingness/in- tures to make local loans. More automated ability of the regulator to undertake prompt credit information with wide coverage corrective action. These are not the banks the would help (see Chapter 7). This is not to say that large banks have no role in financial Committee wants, and the Committee would inclusion—they do have an important direct call for substantial care in who is licensed, as role in offering ‘commoditized’ products such well as greater regulatory oversight. There is, as checking accounts, where scale economies however, no necessary link between size and can be brought to bear, and an indirect role probity. Indeed, the larger number of po- through local partners in offering custom- tential applicants for small banks suggests ized products. Hence the recommendation the regulator can be far more selective in of a two-track approach that involves the applying ‘fit and proper’ criteria. Moreover, creation and promotion of small finance technological solutions can bring down the banks as well as the strengthening of linkages costs of small banks substantially, even while between large banks and small local entities increasing their transparency. 60 A HUNDRED SMALL STEPS

This Committee believes that notwith- The Committee recommends, therefore standing the checkered history of small banks that the regulator allow more small finance in India, a strong emphasis on good quality banks to be established, with the ability to lending, low cost structures, effective govern- provide both asset and liability products to ance and management, and tight prudential their clients. One rationale for these banks norms, could make small banks very useful would be to increase financial inclusion by to provide financial services to the poor. reaching out to poorer households and local The Local Area Bank (LAB) scheme, that small and medium enterprises. But these bears some resemblance to our proposal, was banks should not be constrained to only these prematurely discontinued, and certainly has clients. As we argue in Chapter 4, these banks not resulted in the catastrophic failure that could also be an important entry point into some associate with small banks.27 Indeed, the banking system from which some banks Box 1 documents the case of small banks could grow into large banks. We suggest the that have achieved success by leveraging following features: these strengths. 1. Having obtained the permission to start up based on an initial business plan, small banks should have some leeway to decide Box 1: A Case for Small Banks where they will grow and what they will focus on, much as we advocate for large Experience in Indonesia and the Philippines were better able to target fi nancially excluded banks (see Chapter 4), conditional on showed that the establishment of small banks who tend to have geographic concentrations. meeting regulatory requirements and obli- has been a critical factor for increasing the pro- New innovations in fi nancial inclusion strat- gations. Given, for example, that the poor vision of fi nancial services to the poor (ADB, egies have often come from credit unions, 2004). For example, several rural banks in the community banks and non-profit banking will increasingly be concentrated in towns Philippines that cater to small savers and bor- institutions (House of Commons, 2006). and cities, and given they are underserved rowers were offered incentives in the form A number of dynamic local fi nancial in- there, we do not see any reason to limit of low minimum capital requirements, lower stitutions with a good track record of reaching small bank locations to only rural areas. reserve requirement ratio and exemption from the poor currently exist in India. Many of these 2. However, given that we are recommend- various taxes for the initial fi ve years of oper- are MFIs, with a client base that largely consists ing unlimited branching for banks else- ations. These incentives enabled these banks to of the poor. These institutions are small, yet where, it would be appropriate to restrict offer higher interest rates on their deposits and well performing, and are undertaking a fair the initial license to a certain maximum lower interest rates on loans and also build-up amount of innovation in increasing fi nancial number of branches and asset size, with their capital. By 2004, these banks had a share services to the poor. They are constrained in these restrictions removed after a review of over 40 per cent of the total microfi nance that they cannot offer a full range of fi nancial market in the country. In Indonesia, a study of products to their clients, especially deposits of performance. the banking sector post the East Asian Crisis which would also allow them to lower their 3. These banks would provide a compre- showed that 77 largely private small banks that cost of funds (and commensurately their hensive suite of fi nancial services (credit, were an important source of small business lending rates). This results in a situation where savings, insurance, remittances, and lending were profi table and had a return on MFIs cannot reach critical mass, in terms of investments). To facilitate appropriate di- assets that was higher than that for the banking asset size or profi tability, to be able to fi nance versifi cation and smaller loan ticket sizes, system as a whole. investments in core banking solutions, HR etc. their exposure limits would be set at a In the US, there is evidence of a strong These MFIs are too small to apply for an SCB lower fraction of capital than for SCBs, negative correlation between the ability to banking license, which would require a capital allowing them to increase ticket sizes as lend to smaller entities and bank size (see base of Rs. 300 crore. As of March 2007, the they grow.28 They would also be expected Berger et al. [2005]). A large number of small, total equity base of all the 54 Indian MFIs put community-focused, banks co-exist with together was a shade below the Rs. 300 crore to provide mainstream-banking prod- large money centre banks, primarily be-cause capital requirements. Even among the top 15 ucts, thus precluding, for example, the they provide relationship loans within the MFIs, it would take anywhere between 5 years need for a large treasury operation or community. The US data shows that small to 15 years to grow their asset and equity base other activities that require very sophis- businesses with local banking relationships to meet the minimum criteria to be a bank. ticated human capital or management.29 received loans at lower rates and fewer col- Given the current interest in microfi nance, 4. Interest rates on loans would be deregu- lateral requirements, had less dependence on raising equity capital is a possibility for ex- lated, as is the case for Local Area Banks trade credit, enjoyed greater credit availability, pansion, but this would require promoters to (LABs). Initial total required capital and protection against the interest rate cycle signifi cantly dilute their stake in the MFI, with should be kept at a low level, consistent than other small businesses (see Petersen and attendant loss of incentives and governance. with the initial intent behind LABs. How- Rajan [1994]). Some of these well-performing MFIs would In the UK, the Treasury Committee of the benefi t from transforming into small fi nance ever, the focus should be on a number House of Commons noted that localized forms banks. of performance measures, such as (i) the capital adequacy ratio, which could be Broadening Access to Finance 61

more conservative for small banks given Still others that have established a good that they typically operate in smaller geog- track record of banking and wish to raise raphies and lend to riskier businesses; their own deposits could choose to become (ii) the ownership structure (for private banks) ensuring appropriate incentives; small finance banks with a capital base which (iii) governance norms, fi t and proper would, in effect be well below the current criteria; (iv) the adoption of a core bank- Rs. 300 crore for SCBs. These institutions’ ing solution, which could be developed financial health would be monitored using in-house for larger entities or purchased risk ratios, governance and management from a specialized provider for smaller standards that attest to their financial sound- entities; (v) the track record of the promoters and (vi) strict prohibitions on self- ness. As these banks grow and achieve scale, lending to promoters and directors. they could be permitted to become full- 5. These banks would require greater moni- fledged SCBs. The regulator would need to toring and would likely increase the further think through the ownership issues supervisory burden on the regulator, espe- related to the transition between small banks cially in the beginning. In the initial years after the inception of a small bank, the and SCBs. While at inception a small bank banking supervisor should conduct more could be majority owned by a single pro- off-site and on-site inspections (perhaps moter, as it scales up and approaches the quarterly as with the LAB proposal), size of an SCB (i.e., gets closer to a capital bringing them down as confi dence is es- base of Rs. 300 crore) it would be governed tablished in the bank’s procedures. Off- by ownership norms currently applicable site supervision could be via standardized uniform back-offi ce processes and to SCBs, and it is expected that promoters computerization through a common would dilute their shareholding to that platform. Strict prompt corrective ac- applicable to SCBs. tion norms should be applied after the We see four important merits in the pro- initial teething years (see Chapter 6) so posal for small finance banks. First, a full range that unviable banks, and there will be unviable banks, are not continued. The of institutional options will become available Committee understands that regulatory to a spectrum of players who are important capacity will have to be increased (cer- for an inclusive finance marketplace. Second, tainly, for example, the number of bank a point of entry will be established into the supervisors). But regulatory capacity banking system, increasing competition, should adapt to the needs of the banking especially for small customers. Third, this system rather than vice versa. 6. The government should encourage flexibility would be enabled in a manner that the creation of low cost technological preserves the stability of the overall financial platforms that can be offered widely to system, an important consideration for the small banks. Small banks may also be regulator. Fourth, the clarity that emerges encouraged to pool back-offi ce func- from the small finance bank structure will tions, and even a centralized skill base, along the lines of models that exist in remove the regulatory uncertainty that other countries.30 many MFIs currently operate under and release management time to focus on the With the creation of a small bank categ- clients of these organizations, and also in- ory, current institutions that operate at a crease risk appetite and innovation in these local level—MFIs, community-based lend- institutions. ing organizations, etc.—would have the choice A clear articulation of the regulatory and of deciding their institutional structures. organizational options to service poor clients Those that would like to remain purely credit- will help do away with many lingering issues based institutions can choose to remain as plaguing institutions operating in the ‘inclu- NBFCs—as most MFIs today are—or Section sive finance’ space. For example, small finance 25 companies. Others could choose to pro- banks would be required, by virtue of their vide savings facilities as limited business ‘bank’ status, to disclose the effective interest correspondents of large banks (see below). rate charged including loan processing fees, 62 A HUNDRED SMALL STEPS

bad debt provisions and other ancillary in order to make this business viable, it is charges. The focus on transparency, reporting important that business correspondents be standards and codes of conduct should also allowed to levy reasonable user charges to be carried through to the rest of the financial recover the cost of services. Competition, as institutions—NBFCs, MFIs, etc. well as mechanisms for consumer protection, The second channel to create an inclu- rather than regulation, should be the means sive financial architecture is to create strong through which the regulator ensures business linkages between large institutions and correspondent charges are not excessive. local entities to bring the existing large Given the reality that moneylenders will banks closer to the poor. This is certainly always perform the much-needed function of the trend to reach the poor, as evidenced by providing residual credit to the poor, rather the increasing use of credit-scoring and than prohibit them or levy unenforceable technology by large banks to reach remote interest caps, it may be prudent to explore areas. To facilitate this, in India, the business ways in which moneylenders and banks may correspondent legislation is particularly work together. The Committee endorses the laudable given its good potential for com- model legislation recommended by the RBI bining the scale economies and diversifi- Technical Group to Review Legislations on cation that large banks bring with the local Money Lending, 2007 as a good step towards knowledge and low cost outreach provided providing a single regulatory framework for by business correspondents.31 However, re- money lending.33 cently announced regulations, such as one Finally, the Committee recommends that stipulating the presence of a bank branch the regulator actively explore the channels by within 15 km of its business correspondent which non-traditional entities with exten- in rural areas, vitiates the objective of low sive low cost networks (e.g., post offices), cost outreach. regular contact with the underserved (e.g., A central difficulty in using business cor- kirana shops, cell phone companies) or with respondents is the extent of responsibility some leverage over potential borrowers (e.g., the bank should bear for the processes and buyers of produce, sellers of inputs such as actions of the correspondent. While it seems fertilizers) could be used to provide finan- clear that the bank should be responsible for cial services in a viable manner.34 While the actions undertaken by the agent on its behalf, business correspondent model will be one requiring the same standards and processes way these entities can link up to the formal at the agent as the bank would negate the financial system, the larger question, however, potential benefits of a correspondent model. will be whether some non-traditional entities The true test is whether the standards and can directly and independently provide re- processes are adequate for the business the gulated financial services. For instance, correspondent is required to do. So long as should cell phone companies be able to offer the bank exercises due diligence and is re- account-to-account transfers without going sponsible for outcomes, a fair amount of through bank deposit accounts? The answer flexibility should be allowed in the relation- to these questions should be based on what ship. The Committee recommends that the is the most efficient way to provide services BC definition be broadened and endorses the while imposing tolerable levels of systemic recommendations of the Rangarajan Com- risk. Some of the new non-traditional players mitttee on Financial Inclusion with regard may be large and well capitalized (e.g., cell to the BC model. It supports the proposal to phone companies), and may therefore add less allow microfinance NBFCs to act as limited risk to the system than the existing reliance BCs for banks for savings and remittances on some financial entities. However, the more products and recommends that microfinance such players are allowed to take part in pay- NBFCs also be allowed to provide credit as ments, the more extraneous obligations on BCs of banks if they choose to do so.32 Finally, the banking system will have to be brought Broadening Access to Finance 63

down so that banks can compete on a level high for them to obtain insurance at afford- playing field (see Chapter 4). able rates. Thus the levels of risk may have More generally though, given the im- to be fi rst brought down through physical portance of expanding inclusion, a greater methods—soil and water conservation for tolerance for risk is warranted, and more reducing drought risk in case of crop insur- entities should carefully be allowed into ance; herd vaccination in case of livestock regulated activities. Box 2 highlights some insurance; and preventative health care, safe guiding principles that could help regulators drinking water and sanitation, in case of health identify the key features of a regulatory and insurance. A key policy implication there- supervisory framework that could underpin fore is to increase investments that lead to branchless banking. intrinsic risk reduction so that insurance can be offered at premia that minimize the need for subsidies. Once this is done, it will be A focus on risk mitigation useful to use public funds to build awareness about insurance as a critical fi nancial service, Perhaps the greatest challenge to fi nancial since greater demand for insurance can bring inclusion is to design effi cient risk manage- down costs due to scale economies. ment products for the poor. The poor are A number of specific policy initiatives can typically exposed to a level of risk that is too help develop microinsurance products that

Box 2: Regulating Branchless Banking: Key Considerations

Branchless banking has emerged as an important from savings bank accounts from these banks • Third, implementation of branchless banking medium to increase fi nancial inclusion in a cost- by sending a text message. Recently, Pakistan should be closely monitored in order to effective manner. The two models currently used released draft guidelines for branchless banking provide policymakers/regulators relevant, include the bank-based model where customers and has endorsed the bank-led model either via recent and reliable data about the progress transact with an agent of a prudentially licensed the bank-agency arrangement or creating joint of various initiatives. and supervised fi nancial institution, and the non- ventures with telecom/non-banks. • Fourth, the regulator should clarify the legal bank based model where deposits are taken by The experience so far with both models is power of non-bank retail outlets and clearly and cash is exchanged with a retail agent not limited and it is diffi cult to draw clear lessons specify restrictions (if any) on the range of affi liated to a bank, such as mobile operator or about which model may be superior. The risk permissible agents and types of relationship. an issuer of store value cards. The virtual account issues related to the non-bank model are far • Fifth, and perhaps most important, regu- is stored on the server of this non-bank entity. from trivial, though not insurmountable, as the lators should strive to achieve complete Branchless banking has been especially useful in Philippines and Kenyan examples show. Going interoperability between banks, telecom providing remittance and payments services. forward, a number of guiding principles are companies, and other branchless banking The Philippines and Kenya have achieved some useful for policymakers to consider as countries entities in the medium term. This is crucial degree of success with the non-bank model. In adopt the model most viable for them. These are to ensure value added from branchless bank- the Philippines, both major telecom operators, highlighted below: ing to the consumer. A good analogy is the Globe and Smart, offer mobile fi nancial services text message market, which ballooned only to over 4 million users. In Kenya, Safaricom’s • First, it is imperative to enact regulation that after users could send text messages to per- M-PESA service also focuses on getting domestic takes care of issues related to compliance with sons even if the recipient subscribed to a dif- and international remittances to remote parts of anti-money laundering and combating the ferent telecom provider. This would involve Kenya using a POS device that captures client fi nancing of terrorism (AML/CFT) guidelines. a number of steps, including uniform KYC details in a smart card. Brazil and South Africa This is well understood globally, and explains requirements, the ability of RTGS to handle have chosen bank-based models to mitigate why some countries have chosen bank-linked branchless banking transactions, and other risks associated with the non-bank model. In models for branchless banking. Compliance issues that are just beginning to be understood Brazil, Caixa Economica is a bank that uses a issues should not rule out the viability of non- as branchless banking gathers steam. range of retail outlets (grocery stores, lottery bank models; however it is diffi cult today to shops, etc.) as business correspondents to provide point to a non-bank model that seems to achieve The success of branchless banking will depend banking services, the most popular being payment full compliance with AML/CFT issues. greatly on the ability of different regulators and services. The two models can also be used in • Second, regulators should set clear guidelines agencies responsible for banking, telecom, and combination. For example, Philippines’ Globe for technology use, security of customer data anti-money laundering to ensure an outcome Telecoms has teamed up with member banks of and standards for messaging (in the case of that is truly value added to the consumer and can the Rural Bankers’ Association of the Philippines mobiles). This should be complemented by a radically transform the way fi nancial transactions to offer its clients the ability to effect loans robust mechanism for consumer protection are conducted. payments, deposits, withdrawals and transfers that is well communicated to consumers.

Sources: CGAP, Regulating Transformational Branchless Banking: Mobile Phones and other Technology to Increase Access to Finance. 64 A HUNDRED SMALL STEPS

are critical for the poor. Among the most insurance company.36 These ‘mutuals’ would important are actions that would increase require adequate reinsurance cover against awareness about the benefits of insurance and large covariant risks and ‘long-tail’ claims to communicate the provision of government ensure that they remain solvent in the event insurance more transparently to the insured of large covariant adverse events such as an population. A number of central and state gov- epidemic or a few expensive claims. ernment insurance programmes are cur- Customer service issues in terms of claim rently offered through insurance companies, processing delays and deductions need to however, awareness about these schemes is be monitored tightly and penalties enforced minimal as indicated by the fact that claims on erring companies. The Office of the ratios on them are far below actuarial ex- Financial Services Ombudsman needs to be pectations.35 This leads to short run profits for set up quickly (see Chapter 6), with close ties insurance companies but no benefits to the to the IRDA. poor. User fees are also critical to ensure Finally, a number of policy actions are ownership of insurance by the insured. A num- required to deal with the insurance needs of ber of public insurance programmes have agriculture. The link between crop credit and required no premia contribution on part of crop insurance, though mandatory, should the insured. A ‘symbolic’ premium would go be made more effective and benefit more a long way to increase awareness about the farmers. The National Agricultural Insur- insurance plan as well as increase usage. The ance Scheme should be reengineered to government should also conduct negative ensure timely claim settlement by improving auctions, where an insurance company ask- the crop cutting experiments or using remote ing for the least amount of subsidy for a spe- sensing data. Weather index insurance prod- cified level of coverage of a target group, ucts could enhance NAIS, for example, should be given the mandate to do so and through advance, part indemnity payments collect the premia. during the crop cycle based on weather A second set of issues relates to deregu- indices, with final settlement based on the lation of premia. IRDA microinsurance area yield assessment. This could represent guidelines should eliminate caps on premia a cost-effective combination of the best fea- and commissions, and allow for-profit tures of both area-yield and weather-based entities to be microinsurance agents. The insurance and could be introduced as part argument here is analogous to the interest of the proposed modifications to NAIS. rate deregulation argument. To cover a Further, weather indexed products could large number of the poor, pricing must be continue to have a separate existence as left free so that over a period of time many standalone products, thereby, giving farmers players will enter and reduce costs through choice in selecting risk mitigation measures. competition. The counterpart of free pricing However, weather index insurance is mainly has to be greater transparency about all-in effective for select hazards like deficient and costs, as well as public disclosure of premia. excess rainfall, and not for all perils and hence Similarly, in addition to NGOs and SHGs, needs to be used judiciously. Lastly, where NBFCs and banks as well as non-traditional weather insurance is offered as a standalone outlets should be allowed to distribute product, government’s role in fostering a microinsurance. level playing field for all providers of weather Health insurance for the poor, and par- insurance would be critical in stimulating ticularly for women, needs to be designed competition, innovation and providing with a high priority. For this, the IRDA should benefits to farmers through better prod- facilitate the creation of health insurance uct features and services. An increase in mutuals, friendly local entities that function post-harvest credit, which would in turn be as the interface between the client and the greatly facilitated if warehouse receipts could Broadening Access to Finance 65 be issued, can reduce price risks for small exclusive, objectives. One is to channel farmers. This requires building a network resources to areas that were deemed na- of credible ware-house agents, including as- tional priorities, and the other is to foster inclusion. The value of a developed fi - sayers and the quick implementation of the nancial sector is precisely to allocate re- Warehousing Regulation and Development sources to areas that are most valuable Authority Bill. for the economy. By designating national Though India has three major and several priorities, the government or central bank smaller modern commodity futures ex- vitiates this process by imposing political changes with billions of dollars of transactions or personal judgements on what should be strictly a market driven, economic pro- on a daily basis, small farmers are not able to cess. Why, for instance, are loans of up to benefit from these. This is because the key Rs. 20 lakhs to students for undergraduate functions—quantity aggregation and price studies abroad deemed priority sector? assessment (based on quality)—are currently The reality is that priority sector norms played by ahratiyas (traditional commodity were set historically, at a time when the fi - brokers), who often collude to make lower nancial sector and the economy, were very different. Many Committees proposed a payments to small farmers. To ensure that reduction in the level of directed lending ahratiyas do not exploit farmers, apart from through the priority sector for a number wide dissemination of price information, of reasons, but this suggestion was not which is happening already, farmers need the implemented.37 There appear to be very ability to sell to a processor right from the strong political constraints on revising village (as is currently happening with ITC these norms downwards. As a result, regulators have taken the next best option of e-Choupals) if they find the price attractive. broadening the categories that qualify for Alternately, farmers bringing their pro- the priority sector. duce to a mandi, but not finding the price This Committee understands the im- attractive, should be able to sell to another perative behind such actions, but strongly distant mandi. This is being enabled by recommends the political will be found to the new generation of ‘spot’ exchanges like revisit the norms. Failing that, it suggests the categories that truly impact the under- NCDEX Spot Exchange Ltd (NSEL) and served (such as direct agriculture and the SAFAL National Exchange (SNX) but re- weaker sections category) be preserved quires a network of reliable warehousing and strictly enforced even as the process of and assaying agents. It is important to sup- broadening other categories continues. port these legitimate functions and let Keeping in view the growing importance of banks finance them, so as to encourage the rural to urban migration, and the growing emergence of this commodity marketing eco- share of the urban poor, consideration should be given to including them in the system. Once again the implementation of the overall agricultural share. The Committee Warehousing Regulation and Development further recommends certain steps below Authority Bill expeditiously will help. that would increase the fl ow of credit to these underserved segments as well as facilitate the provision of priority credit by Rethink targets, subsidies, and specialized fi nancial institutions that are better placed to provide it. public goods The Committee recommends that all banks—domestic and foreign—should be While a new, more market friendly approach subject to uniform priority sector lending is advocated, the role of public intervention requirements. In the interest of equitable must change to focus more closely on the ex- treatment, and given the magnitude of need to provide credit to underserved seg- cluded. Important policy actions are required ments, it is not clear why a differentiated in the following areas: framework should exist for foreign banks. Foreign banks do not have the branch infra- 1. Priority sector lending framework structure to provide agricultural credit, The priority sector lending framework has but free branching (see Chapter 4) will historically had at least two, not mutually give them the capacity to undertake such 66 A HUNDRED SMALL STEPS

loans if they desire. Moreover, the Priority obligations from the credit risk transfer Sector Lending Certifi cate scheme (see and refi nancing aspects, which are com- below) will help them bear their share of mingled in the IBPC. obligations without a branch network. The RBI has proposed a scheme, which New PSLC Scheme. Here is how the with a few modifi cations could prove very scheme would work. Any registered attractive in facilitating fl ows to the prior- lender (e.g., MFIs, NBFCs, co- ity sector. The inter-bank participation operatives, and eventually, registered certifi cates (IBPC) are a form of securit- moneylenders) who has made loans to ization of loans through which a bank buys eligible categories would get ‘Priority the assets of another bank for a stipulated Sector Lending Certifi cates’ (PSLC) for period that can vary between 90 and 180 the amount of these loans. The criteria days. The RBI allows a bank that is unable for certifi cation (say by NABARD or its to meet the priority target of 40 per cent agents) would simply be whether the to make up the defi cit by buying out loans loan is to an eligible sector, whether the disbursed by other banks for 180 days. interest rate follows the norms below One problem in any securitization is including transparency, and whether that the buyer has to take on the credit risk the loan duration is greater than 180 of the loans, which is high in the case of days. After an initial period of verifi - the underserved priority sector. More- cation, institutions should be allowed over, loans have to be standardized, well to self-certify, with periodic random documented, and serviced, all of which monitoring to ensure adherence to pose diffi culties for loans to the truly criteria. Any bank that exceed priority needy. Perhaps this explains why the sector norms should also receive scheme has yet to take off. The Committee PSLCs based on the amount by which proposes a new scheme that will separate the requirement is exceeded. the objective of transferring priority A market would then be opened up for these certifi cates, along the lines Box 3: The US Community Reinvestment Act and Its Impact on Financial Inclusion of the IBPC, where defi cient banks can buy certifi cates to compensate for The Community Reinvestment Act (CRA) was US. Reports show that CDFIs signifi cantly their shortfall in lending. Importantly, enacted in 1977 with the objective of getting outperform regular banks in serving low the loans would still be on the books mainstream fi nancial institutions in the USA to income and minority communities. of the original lender, and the defi cient increase provision of credit to low and middle- The US experience shows that big banks’ bank would only be buying a right to income communities. While there is much response to CRA type of regulations can be undershoot its priority sector-lending debate about CRA’s effectiveness in achieving signifi cantly enhanced by coupling the need fi nancial inclusion in the USA, an important to meet the mandate with creating dedicated requirement by the amount of the benefi t of the legislation—unanticipated at entities like CDFIs, which can use CRA credits certifi cate. If the loans default, for ex- the time of its enactment—was its success in to serve the under-served market segments. ample, no loss would be borne by the fostering the growth of specialized Community In the Indian context, this experience suggests certifi cate buyer. The certifi cates would Development Financial Institutions (CDFI) that priority sector lending could enhance foster the creation of small fi nancial that were instrumental in expanding fi nancial fi nancial inclusion if the lending requirements institutions that specialize in priority services to low-income communities. CDFIs are coupled with incentives to create spe- sector lending, much like the impact of include banks, loan funds, credit unions— cialized fi nancial institutions that can lend the US Community Reinvestment Act fi nancing entities with the primary mission successfully to underserved segments in India. on Community Development Finan- of serving underserved or economically dis- Specialized institutions can cultivate the local cial Institutions (Box 3). tressed areas. In 1995 CRA reforms allowed knowledge needed to reach informationally banks to comply with the CRA by making opaque markets and can develop uniquely The IBPC scheme could continue, loans to and investments in CDFIs. Since then, tailored underwriting and risk management but would not qualify for priority CDFIs have come to rely signifi cantly on CRA procedures as needed. Specialized know- sector norm—it would be simply a qualifi ed investments and loans from banking ledge coupled with specifi cally tailored and form of securitization and refi nance. institutions as a major source of funding fl exible operations are often necessary to Of course, the seller could also transfer for their activities. A bank may receive two reach under-served market segments. How- its associated PSLC certifi cates if it so benefi ts from investments in CDFIs; fi rst it ever, while the promotion of specialized chooses. receives CRA credit, and second it can apply institutions is highly desirable, established While all PSLCs could be used for financial awards from the CDFI fund. fi nancial institutions should still be encouraged towards meeting overall norms, sep- The customer base of CDFIs is 68 per cent to directly serve these under-served market arate certifi cates could be issued for low income and 58 per cent minority in the segments. enforceable sub categories (e.g., direct Source: ‘The Community Reinvestment Act and Financial Inclusion’, Yale Law School Community agricultural credit), and these may Development Financial Institutions Clinic, 2008. carry a different price. If indeed banks Broadening Access to Finance 67

fi nd priority sector requirements units target volume of purchases) so that profi table, there will be a high price potential lenders have greater certainty for these certifi cates, and it will draw about the rewards from lending. more lenders (including banks that The market would make explicit the want to specialize) into priority-sector subsidy to the priority sector (effect- lending. If the price is low or zero after ively the price of PSLCs), and allow the the market is given time to stabilize, government to gradually take over the it would mean that priority sector re- role of providing these subsidies from quirements, as set, are not onerous. the banks in a minimally distortionary However, this market also offers the and disruptive way. While, a priori, government a way to expand lending— this market may seem complicated to all it needs to do is purchase eligibility manage, there are really no additional certifi cates and increase their price. complications than in managing say Charities and NGOs that want to con- the market for bank reserves, which is tribute to inclusion could also buy in easily accomplished across the world. this market. Also, over time, as bank 2. Interest Rates privileges diminish, the priority sector Finally, it would also be necessary to de- requirements for banks should be regulate interest rates in order to unlock brought down, with the government funds to activities that are commercially playing a larger role in purchasing cer- unviable and therefore denied credit tifi cates. The government could estab- (Box 4). Current priority sector norms— lish a predictable pattern of activity in especially those focused on lending to this market (for instance, by stabilizing the poor (loans below Rs 2 lakhs)—have the price of certifi cates or by specifying interest rate ceilings that make lending

Box 4: Interest Rate Ceilings Hurt the Poor

A study by the Consultative Group to Assist per cent post the imposition of the interest rate has facilitated a signifi cant expansion of micro- the Poorest (CGAP) examined the impact of ceiling. In Kenya, the threat of a new interest credit. In sectors where interest rate ceilings interest rate ceilings on microcredit pene- rate-ceiling bill caused the Cooperative Bank of exist, such as agricultural loans in the priority tration in 30 countries and found that on Kenya to put its plans for a major expansion into sector below Rs. 2 lakh to farmers, and such balance, interest rate ceilings deterred ex- the rural microfi nance market on hold. credit could not be provided via the MFI/SHG pansion of microcredit to higher-cost markets. In India, allowing MFIs and SHGs to charge route, credit provision grew at a slow pace. The study compared market penetration rates market-determined rates from fi nal borrowers between 23 countries with interest rate ceilings and seven countries without ceilings. On average, Microfi nance Market Penetration in Countries with and without Interest Rate Ceilings, the former had a market penetration of 4.6 per 2004 cent, whereas countries without interest rate ceilings enjoyed penetration rates of 20.2 per cent. In countries without ceilings, the study found that competition was an important force in bringing down interest rates. For instance, the microfi nance portfolio yield* decreased from an average of 57 per cent in 1997 to 31 per cent in 2002 in four competitive markets without interest rate caps (Bolivia†, Bosnia, Cambodia and Nicaragua). Operating effi ciency (defi ned as total administrative costs as a percentage of the average loan portfolio) improved during the period from 38 per cent to 24 per cent. The study cited specifi c examples of the impact of Source: CGAP, Occasional Paper No. 9, ‘Interest Rate Ceilings and Microfi nance, The Story So Far’, interest rate ceilings on microcredit expansion. September 2004. In Nicaragua the market for microcredit shrunk Note: Number of microfi nance borrowers shown as percentage of population living on less than after the national Parliament introduced an US$2 per day. Sources: Calculations for 23 countries with interest rate ceilings and seven interest rate ceiling on microfi nance institutions countries without ceilings based on Christen et al., Financial Institutions with a ‘Double Bottom (MFIs) in 2001. The annual growth of portfolio Line’, and World Bank. of these MFIs fell from 30 per cent to less than 2

Notes: * Portfolio yield is deﬁ ned as the ratio of income from lending to average outstanding loan portfolio. Income used to calculate yield includes all cash interest and fee payments, but does not include interest accruals. † Introduced ceiling in January 2004. 68 A HUNDRED SMALL STEPS

unattractive for the banks. In general, statutes should be automatically exempt the true cost of small loans is very high from usury laws. (Figure 9). This is also refl ected in the The Committee recognizes that weaker interest rates currently paid by the poorest sections are liable to exploitation. But borrowers, which is typically in the range driving them away from banks via interest of 36 per cent plus per annum. rate ceilings into the hands of moneylend- The approach thus far has been to de- ers is no solution. Instead, it proposes the regulate interest rates for certain activities following safeguards. A liberalized inter- in order to stimulate credit provision. For est rate regime should be accompanied example, in 2000, RBI deregulated the by a transparent way of communicating interest rates on loans made by commercial to borrowers up front what the all-in cost banks to MFIs, and interest rates on loans of a loan will be (a simple number which made by MFIs to borrowers. Again in 2006, refl ects the effective interest rate they are RBI emphasized that the interest rates being charged when all fees are included), applicable to loans given by banks to MFIs public disclosure of margins on loans to or by MFIs to SHGs/member benefi ciary the priority sector relative to reasonable would be left to their discretion. This leads cost benchmarks,38 and an effective sys- to an anomalous situation where loans tem for tackling consumer grievances (see to the same benefi ciaries if dispensed the fi nancial ombudsman proposed in through alternate channels of fi nancing are Chapter 6). However, the most important priced differently. Indeed, these regulatory check will be that loans with interest rates anomalies suggest yet another reason for that meet a ‘reasonable margin’ test im- avoiding interest rate ceilings—it tilts the posed by the regulator based on prevailing playing fi eld against the formal sector costs will get priority sector lending cer- where such ceilings will be respected in tifi cates, which they can sell for an extra favour of the informal sector, where they margin. are much harder to enforce. 3. Subsidies and public goods A related issue is the implementation The Committee believes that well-targeted of usury laws. While the Committee rec- subsidies provided directly to the poor are ognizes the value of usury laws to protect a more useful option than subsidies to against unscrupulous lenders, the reality fi nancial entities for provision of services. is that these laws are diffi cult to enforce, Notwithstanding this belief, there is still and are often misused. The Committee a case for the provision of subsidies for recommends that all fi nancial institutions services in remote areas or to target under- licensed and registered with the RBI or served segments. A minimum set of ser- enacted under special state government vices could be specifi ed, which would satisfy the needs of a poor family (e.g., offering micro payments and micro savings) or standards set for an entire underserved Figure 9: True Cost of Lending for Banks for Small Ticket Loans area. The standards could be set in such a way as not to preclude innovative ways of offering them, including through technology. The service obligations in areas that are considered fi nancially excluded could then be auctioned off, with (typically) negative bids indicating subsidies the government would have to offer. The subsidies could be set on a per account or a per area serviced basis. The hope is that such subsidies would be short term, with their need eliminated as these areas and segments exhibit signs of commercial viability. An alternative would be to have those who provide fi nancial services in underserved areas obtain certifi cates based on creating accounts or other services in Source: ICICI Bank Staff Estimates (for cost of funds) and Boston Consulting Group (2007), The Next underserved areas, and allow these cer- Billion Consumers: A Road Map for Expanding Financial Inclusion in India (for other costs). tifi cates to be traded, much like the PSLC. Broadening Access to Finance 69

Instead of banks being obligated to open services like electronic transfers, liquidity rural branches, they could incur a service management, clearing house services, obligation based on the number of ac- debit and credit card services, and foreign counts they have of the better off in urban exchange and derivatives transactions to areas (see Chapter 4). They would initially enable fi nancial institutions scale up fi nan- support the market for the certifi cates. cial services to low-income households. Another useful step would be to provide Mexico also offers other examples of existing subsidies and cash transfers to innovative provision of public goods to the poor via bank accounts to encourage facilitate fi nancial inclusion that might their use of the banking infrastructure. be worth replicating in India. One is the Recipients of payments from various anti- securitization of trade credit through poverty schemes (SGSY, NREGS, etc.) as NAFIN, a Mexican development bank that well as microinsurance and old age pension has created an electronic system to facili- schemes could be asked to open no-frills tate this activity (see Chapter 7). A second bank accounts augmented by biometric example is that of FIRA, a Mexican devel- cards (which will help reduce multiple opment fi nancial institution that provides or benami IDs and, hence, corruption). increased fi nance to agriculture sector Payments could be channelled to these using structured fi nance transactions. ‘household development’ accounts via a monthly cash transfer that is electronically swept into the account (rather than the current lump-sum transfer which is a Use technology to reduce large portion of the household’s assets and cost of delivery is often misused). The precise modalities for these products will have to be worked out but channelling them in this way will A recent Boston Consulting Group report help greatly in organizing payments from estimates that the cost of funds today is various existing schemes in a manner that 9 per cent, provision for bad debts is 10 per the poor can get maximum leverage from cent and cost of consumer acquisition and the resources they receive.39 The pattern transaction and operation cost is 13 per cent of their usage of these funds will also help them build savings histories that can be for the poorest customers, leading to banking the basis of formal credit later on. for the poor becoming unprofi table.40 The Public intervention may be needed to key role that technology has to play is to promote simple low-fee savings instru- reduce the last two components drastically. ments that are indexed to the stock mar- Reducing these costs can translate into lower ket and available for purchase in small units by small investors, savings funds, lending costs, which would help improve etc. This would allow small investors to the viability of risky rural businesses and tap into the large gains that equity market allay concerns that the high cost of lending investors have enjoyed the world over in to poorer segments is resulting in over- recent times. It would also allow them a indebtedness. Equally, distances are large in better savings instrument than savings rural areas and transport sparse. Here again, accounts that have given them miserable real returns in the past. Currently, the communications technology could play an lack of PAN numbers among the poor important role by bridging the last miles prevents the wider dissemination of such between the customer and the provider and products. There may be a case to subsidize thus facilitating transactions. the provision of PAN numbers for poor Transaction and operation costs consist of clients who wish to participate in this scheme. front-end costs, network costs and back-end The government could also provide for operation costs. Back-end costs for banks (by arranging or paying for, not neces- vary from Re 1 to 2 per transaction. Indian sarily undertaking the function itself) mobile companies however, have managed common services that could help achieve to reduce backend costs (for what are essen- scale and reduce the costs of fi nancial intermediaries in providing fi nancial ser- tially similar operations to between 1 and 2 vices. For example, in Mexico, BANSEFI paise per transaction. While banks have done (National Savings and Financial Services a good job in computerizing their operations, Bank) provided centralized back-offi ce they need to learn from mobile operators and 70 A HUNDRED SMALL STEPS

optimize back-end technologies and leverage banks, to reduce transaction costs and sub- volume to significantly reduce these costs. stantially increase the deployment and util- The telecom network in India is rapidly ization of POS terminals. An important evolving. The banks need to move towards advantage of all these interfaces is that they leveraging this network and design their are essentially cash-less and minimize fraud networks afresh to expand operations, re- and the costs related to cash handling. duce costs and increase reliability of their Further, technology can be significantly operations. leveraged for acquiring customers. Banking The front-end continues to be the dom- correspondents (BC) with Internet Kiosks inant costs for banks. The use of ATMs has at villages as well as BCs armed with mobile significantly reduced front end costs but they phones with back-end interface (e.g., the are still too high. Banks need to promote kirana shop) has to be used extensively. A lower costs indigenous ATM technologies, unique ID for each citizen would help ac- especially for rural areas. Going beyond celerate this. ATMs, front-end costs can be brought to Finally technology has to be used to re- negligible amounts by replacing cash trans- duce provisions for bad debt. Credit ratings actions with electronic transactions. More for retail customers and a unique citizen than 80 per cent of India’s financial trans- ID are critical in this regard. Capturing all actions are processed in physical cash. Cash the transactions electronically and man- as means of payment has a large cost in terms datory sharing of data with a credit bureau of handling, transaction processing, holding would significantly help in this direction (see and risk of loss. On the other hand, Internet Chapter 7). The absence of this and high banking transactions have zero front-end provision for bad debts, is in fact hurting the cost for the banks; efforts have to be made to poorest most. make this a preferred mode of transactions The role of public policy is to enable the for large corporations. Its extension to SMEs adoption and scale up of appropriate tech- may have much larger impact. Rural Internet nologies while mitigating risks of their misuse. Kiosks can be used by all rural businesses to Public policy can play an important role in carry out such transactions. the establishment of a unique identification Mobile banking is perhaps the most number and the promotion of biometric promising front-end technology for facili- authentication, which would facilitate the de- tating financial inclusion in India, especially velopment of credit bureaus (see Chapter 7). for individual customers. Given the success As mobile banking becomes widely pre- of mobile phones in reaching out to segments valent, it may be worthwhile to map a citizen’s and geographies not yet penetrated by bank- unique ID to his/her phone number. Low ing and the simplicity of their operation, this cost ATMs will also play a major role in fi- may be one of the more preferred interface of nancial inclusion. Further development of choice for most banking clients. The telecom real time inter-bank transactions would be and the banking industry along with RBI has essential for mobile banking to take off. To recently constituted a Mobile Payment Forum make mobile banking profitable, the costs of India (MPFI) to examine technological, of this system need to be very low. While the regulatory and business constraints related RBI in consultation with IDRBT can initiate a to the scaling up of mobile banking in India common payments platform, it would be (Box 4). This Forum’s recommendations useful to encourage private initiatives in this would be the key to provide a roadmap for area in order to foster innovation and drive mobile banking. Additionally, Stored Value down costs. KYC norms should be made com- Cards would be another important vehicle mon for banking, telecom and insurance. for financial inclusion. Government funds could be used to There is a need to create common pay- promote the use of technology among the ments systems with participation by multiple poorest clients and small financial service Broadening Access to Finance 71 providers. The Rs. 500 crore Financial In- M–Banking Solutions for India clusion Technology Fund, proposed by the Mobile telephony has made signifi cant impact in are underway as players—banks, telecom Rangarajan Committee on Financial In- India, with India now adding 100 million mobile companies, other fi nancial players—search for clusion and announced in the 2007 Budget phones a year. The total number of mobile a viable M-banking model for Indian markets. phones is likely to touch 500 million by 2010 Sensibly, the banking industry, telecom speech, could be used to finance the creation or 2011. It is likely that most Indian families operators and technology providers have got of common technology platforms or back would own at least one mobile. together with academia and banking regulators office services for small financial services Mobile phones have a great capability of to form the Mobile Payment Forum of India providers who are serving the poorest clients. becoming devices for fi nancial transactions, (MPFI). The Forum examined the technology, substituting cash and enabling funds transfer business and regulatory issues to enable this It could also be used to promote mobile to become more widespread. Thus payment service in India and its draft report has been payments amongst the poor. can be done from one individual’s mobile to released by the RBI for public comments. The The most important way to figure out the that of another; further the payment is equally early focus is on transactions from one bank possible whether the two individuals are at the account to another (as also from one card appropriate technology would be through same location or at different geographical lo- account to another) through mobile phones, careful experiments. Many experiments are cations. The transfer could be from one’s bank given the need to ensure compliance with KYC required. Many of these experiments would account to another or from one’s virtual account and anti-money laundering guidelines, among (held by a telecom operator or a third party) to other prudential requirements. Other modes fail. But results from these experiments that of another. The transfer would be secure, of transfer will be explored in due course once would help us get the answers. To the extent instantaneous and possible at anytime. experience is gained with the initial model. there is a role for the government apart from Mobile payments, though in their infancy, Right from the beginning, it is envisaged that helping coordinate the setting of standards, have made signifi cant impact in several coun- the service would work in multi-operator tries including the Philippines, Kenya, Japan (telecom) and multi-banking scenario. it would be to fund experimentation in areas and South Africa. The technology is quickly The key is to discover the appropriate price where there is a significant public goods maturing and has great potential to substitute point and consumer confi dence in safety of component (such as payments). cash as well as help reach unbanked population. transactions, only post which the Indian user While today the authentication would be would adopt mobile banking in a large way. An ambitious goal can serve to bring all done by the possession of phones and a PIN Going by the experience of telecom operators, these considerations together. The Com- (just like a card and a PIN for ATM machine), India adopts solutions only when it is very mittee believes that with some effort, 90 per bio-authentication like fi ngerprint would be low priced, easy to use and safe, making it available in the next few years. affordable to larger sections of people. The cent of Indians can have access to the formal The question therefore is what is the best challenge would then be to develop the right financial system, at the minimum through a way for India to adopt this technology in its technology so that the service providers and ‘no-frills’ bank account if they so desire, and drive for fi nancial inclusion? Many initiatives the banks consider this as a viable business. advocates that this goal be achieved in three years.41 These accounts would be especially useful for households with migrant workers incremental communication networks to to receive remittances as well as for low- service about 50 crore un-served citizens income households to receive cash trans-fers would be around Rs. 1,000 crore. The variable from NREGS and other programmes. As costs are relatively small; if smart cards were discussed in previous section under point 3 used, the variable cost per user would be less ‘Subsidies and public goods’, providing such than Rs. 40, while putting biometric capabil- payments through bank accounts minimizes ity on a user’s cell phone would cost less. The the logistical challenges associated with cost per transaction of NEFIS could drop providing cash as well as the incidence of to a few paisas, as millions of outlets accept leakage. e-payments. Of course, for cash-in/cash-out In this regard, the Committee recommends transactions, requiring a human/machine the creation of a nationwide electronic fi- interface, the cost per transaction could be nancial inclusion system (NEFIS) that would as higher. link these bank accounts and allow funds Once NEFIS is in place, it would enable to be transferred into them electronically. transactions as small as Re 1 to be carried Such mechanisms can present a saving to the out with limited transaction costs, as long as government, both in terms of administrative these are cashless (indeed millions of these burden and in terms of cost. The cost per are being done and recorded, as in case of beneficiary of this infrastructure is largely cell phone calls and SMS-es which are a function of volumes. Fixed costs of the charged). If cash was to be out in or taken out, POS/mobile devices, computer servers and transactions as small as Rs. 100 could be 72 A HUNDRED SMALL STEPS

done at a reasonable transaction cost. This interest-free finance on a larger scale, in- would greatly incentivize the poor to make cluding through the banking system. This micro-savings and eventually become full- is in consonance with the objectives of in- participants in the financial system. The clusion and growth through innovation. The government should explore on an expedited Committee believes that it would be possible, basis, together with deposit taking institu- through appropriate measures, to create a tions, business correspondents, and tech- framework for such products without any nology providers, what aspects of the NEFIS adverse systemic risk impact. could ride on the current backbone, what will need new infrastructure and common standards, and whether any incentives need Financial literacy to be provided to the system to undertake this task. The ambitious timeline should be The Committee also believes that a signifi - adhered to. cant investment in fi nancial literacy is required if the poor are to make effective use of various initiatives to foster fi nancial in- Improving infrastructure for clusion. A good understanding of the costs fi nancial inclusion and benefi ts of various fi nancial services, the impact of infl ation on savings, and the The Committee believes that it is important trade-off between risk and return can help to improve the infrastructure for inclusion. households choose the right products for Section on ‘Use technology to reduce cost their needs and weed out dubious schemes of delivery’ discusses the creation of NEFIS, from truly benefi cial ones. The Committee which would be instrumental in facilitating believes that efforts to promote fi nancial the poor’s access to the payments system. literacy should start early. Starting around Chapter 7 deals extensively with the issue of Vth standard, students could be introduced credit infrastructure, including the creation to terms such as income, expenditure, sav- of a national ID, the use of land as collateral, ings, deposits, interest, insurance, etc. In and personal bankruptcy, which are all addition, TV channels could be encouraged measures that would improve the poor’s access to fi nancial services. to run educational programmes on fi nancial Another area that falls broadly in the issues such as household budgeting, savings, ambit of financial infrastructure for inclu- insurance, and pensions. The proposed Of- sion is the provision of interest-free banking. fice of the Financial Ombudsman could Certain faiths prohibit the use of financial aggregate the funds currently set aside by instruments that pay interest. The non- various regulators for this purpose, and availability of interest-free banking products sponsor these shows (for example, SEBI has (where the return to the investor is tied to the Investor Education Fund and IRDA has the bearing of risk, in accordance with the the Insurance Fund). These efforts could also principles of that faith) results in some be sponsored by individual banks, insur- Indians, including those in the economic- ance companies, etc. ally disadvantaged strata of society, not being able to access banking products and services due to reasons of faith. This non- NOTES availability also denies India access to 1. This evidence comes from the results of the 2007 substantial sources of savings from other IIMS Dataworks survey that was used as an input countries in the region. to this chapter. While interest-free banking is provided 2. For example, for priority sector loans below Rs. in a limited manner through NBFCs and co- 2 lakh, the interest rate is capped at the Prime Lending Rate (PLR). Banks do have some fl exibility operatives, the Committee recommends that in determining their PLR, an in addition, a nominal measures be taken to permit the delivery of additional charge is allowed over and above the PLR Broadening Access to Finance 73

for loans above Rs. 25,000. But for loans below as 16 per cent among private providers, due to Rs. 25,000, where much of the poor’s borrowing higher contribution of ULIPs and aggressive lies, no additional charges are permitted other selling policies. Source: ISEC Securities, ‘Indian than the PLR. The interest rate cap is however not Life Insurance’, 7 December 2007, p. 43. applicable on certain categories including loans 12. World Bank-NCAER Rural Finance Access for purchase of consumer durables, to individuals Survey, 2003. against shares/debentures/bonds, and other non- 13. Task Force on Revival of Cooperative Credit priority sector personal loans. Institutions, December 2004, Chairman: Prof. A. 3. The analysis in this section is based largely on a Vaidyanathan. household survey of 100,000 respondents carried 14. The cooperative banking sector is undergoing out by the Invest India Market Solutions (IIMS) extensive reform based on the recommendations in 2006–07 (and referred to as IISS 2007 or ‘the of the Vaidyanathan Committee. The revival Survey’ in this chapter). plan has been accepted by 17 states ‘in-principle’, 4. Approximately three-fourths of the total working while 13 states have signed MOUs with the population, or 321 million people in 2006, earn government. It is imperative that the revival cash incomes (the rest are primarily unpaid family package is implemented in full, without diluting workers). Of those only 193 million or 60 per cent the contingent legal, fi nancial, regulatory, and reported having any fi nancial savings in formal institutional reforms that in turn would entail and informal instruments. significant decisions on the part of the par- 5. For instance Kerala, which has the highest incidence ticipating state governments and cooperative of savings has also the highest proportion of cash credit societies. This would have the effect of clean- earning adults with bank accounts. By contrast, ing the balance sheets and strengthening the Bihar with the lowest incidence of savings also has capital base of rural cooperatives, and allay fears the lowest bank account penetration. that the implementation of the revival package 6. Other surveys have similar fi ndings. For example, may not provide any substantial remedy to the a 2004 Survey commissioned by the Ministry problem of fi nancial exclusion. of Finance titled ‘Pension Reforms for the Un- 15. Though priority sector lending norms initially organised Sector in India’ found that 94 per cent focused on increasing commercial finance to of existing earners were not saving or building sectors deemed as ‘national priority’ since 1980, up assets for retirement. This was despite the fact the scope of the priority sector has largely evolved that 40 per cent of respondents in urban India to give greater prominence to segments of the and 30 per cent in rural India reported that they population that have traditionally been denied did not expect their children to take care of them credit, thus making it a tool to address fi nan- in their old age, the traditional mode of funding cial inclusion. In 1980 the Working Group on retirement in India. In contrast, the Max New York Priority Sector Lending and 20-Point Economic Life—NCAER India Financial Protection Survey Programme (Chairman: Dr. K.S. Krishnaswamy) found that nearly 69 per cent households save for introduced a focus on ‘weaker sections’ within old age fi nancial security. the priority sector by identifying underprivileged 7. RBI Annual Report 2006–07, p. 32. segments that required access to banking services. 8. Of the population citing wealth creation as their The Committee also recommended separate sub- prime motivation for savings, 13.9 per cent and targets for lending to the weaker sections within 15.1 per cent had invested in mutual funds and agriculture and SSI. The fi rst Narasimham Com- equities respectively. mittee (1991) proposed a redefinition of the 9. At an aggregate level, the investor base for mutual priority sector to comprise small and marginal funds and equities is small—mutual fund invest- farmers, the tiny sector of small-scale industry, ors represent only 2.8 per cent of the total popula- small business and transport operators, rural tion with savings, while equity investors represent artisans, and other weaker sections. The C.S. 1.9 per cent. Murthy Committee (2005) further redefi ned the 10. Capital gains from short-term sale of equities priority sector to include those sectors that ‘affect attract taxes, while sale of long-term equities large sections of society, benefi t small borrowers (over one year) are not taxed. However, all interest and involve small loans, and lead to substantial over Rs. 10,000 earned on bank deposits is taxed. employment generation’. Clearly, the poorest households are likely to be 16. The bulk of lending in that category appears to exempt from taxes on deposit interest, but as be in the form of large ticket loans to farmers interest rates rise, more households will pay taxes with larger landholdings. While marginal farmer on deposit interest. households comprise over 66 per cent of all farmer 11. For traditional life insurance products, a policy- households, the share of credit accounts among holder typically loses the entire investment if the this section of farmers barely increased between policy lapses within the fi rst three years. After 1991 and 2005, while the share of credit accounts that, only the surrender value is paid in the case for medium and large farmers increased by 41 of a lapse, which is less than 35 per cent of the per cent over the same period. Similarly, credit total premia paid. IRDA reported that almost access among the tiny enterprises under the small 5 per cent of life insurance policies lapsed be- and medium enterprise category fell post-2000 tween 2000 and 2005. This number was as high (Chavand and Ramkumar, 2007). 74 A HUNDRED SMALL STEPS

17. World Bank, 2007, India: National Agricultural to assets of about 1.2 per cent, which is about the Insurance Scheme: Market Based Solutions for same as other banks. Better Risk Sharing. p. 3. 28. Committee members were hesitant to mandate an 18. Indian microfi nance had a late start, well after explicit loan ceiling, but the idea is that the average Bangladesh, Indonesia, and Latin American ticket size of loans made by small fi nance banks countries. The key policy change that jumpstarted would be much smaller than those of SCBs. microfi nance provision in India was RBI’s 1996 29. Since these banks would be serving a large section decision to allow commercial banks to lend to of farmers, they would provide simpler derivative self-help groups without collateral. products to hedge price risks. They could simply 19. The SHG-Bank Linkage programme has been de- aggregate the demands of farmers and purchase scribed as the largest microfi nance intervention the necessary exchange traded or OTC products, in the world (Christen, 2006). without the need for hedging operations. 20. In 2001, over 70 per cent of SHGs were located 30. Examples include Rabobank in Netherlands and in the four southern states of Andhra Pradesh, BANSEFI in Mexico. Tamil Nadu, Karnataka, and Kerala. This num- 31. In 2005, the RBI allowed banks to use business ber has fallen to 45 per cent in 2007 (Thorat correspondents (BCs) and facilitators (BFs). A et al., 2007). number of entities can serve as BCs—cooperatives, 21. Goldberg (2005). Measuring the Impact of Section 25 companies, non-deposit taking NBFCs, Microfi nance: Taking Stock of What We Know. post offi ces, etc. Grameen Foundation USA Publication Series. 32. The 2008 Budget announced that a number of 22. Khandker (2005). Microfinance and Poverty: additional categories would be eligible to be BCs, Evidence Using Panel Data from Bangladesh. World such as retired bank offi cers, ex-servicemen, etc. Bank Economic Review. 33. The RBI report has proposed a Moneylenders & 23. Chen and Snodgras (2001). Managing Resources, Accredited Loan Providers Bill, 2007. Under this Activities and Risk in Urban India: The Impact of proposed legislation, moneylenders who sign SEWA Bank. up to a model code of conduct detailed in the 24. Apart from loans, MFIs have been able to raise legislation could be offered finance from the equity fi nancing from private equity players. The formal system. securitization of MFIs portfolios also provides 34. Brazil and South Africa are good examples. The an attractive source of fi nance. South African low-frills Mzansi bank account can 25. See Berger et al. (2005). be accessed through various non-bank locations. 26. Thorat (2007). In India, the underdeveloped organized retail 27. The Local Area Bank Scheme, initiated in August sector has been a constraint in scaling up such 1996, was set up with the intent of creating new partnerships. However the postal network of local, private banks with jurisdiction over three India Post, which has the largest number of contiguous districts that would mobilize rural branch offi ces in the country, is a potentially savings and make them available for investments viable channel for expanding fi nancial service in the local areas. Only six were approved initially, delivery. India Post is already a large repository and four are currently in operation. The LAB of household savings and the largest provider of scheme was never given a serious try, and this remittance services. Unfortunately, India Post’s is unfortunate because every proposal for small past role in playing a larger role in financial banks meets the rejoinder ‘the LABs did not services has been checkered. This is largely due work’. This largely inaccurate conclusion stems to weak management and governance issues that from over-interpreting a 2002 RBI internal review must be tackled. Clearly a revamping is underway group, which examined the operations of the four as evidenced by recent announcements of various existing LABs. While admitting that it was too tie-ups between India Post and various fi nancial early to make strong judgements, and despite the institutions. banks being profi table, meeting priority sector 35. An example is the Mahatma Gandhi Bunkar targets, and maintaining high credit-deposit Bhima Yojana (MGBBY), a group insurance ratios, the Review Group recommended that until scheme for handloom weavers. The scheme offers existing LABs achieved a measure of fi nancial insurance cover of Rs. 50,000 for natural death, soundness, no more LAB licenses were to be and Rs. 80,000 for accidental death. In 2005–06, issued. The Review Group also recommended, weavers had made claims of only Rs. 1.67 crore on the basis of a priori reasoning, and the RBI out of the premium amount of Rs.13 crore paid by accepted, that size was important in banking, and the gov-ernment to insurance companies (Source: therefore the capital base of the existing LABs be Press Information Bureau, November 2006 and increased from the initial Rs. 5 crore to Rs. 25 crore Hindu Business Line, 6 September 2006). over seven years, and that LABs should maintain In contrast the NAIS, described in Section III, is a minimum capital adequacy ratio of 15 per cent unable to collect adequate premia to meet the given the higher level of risks they face. The Khan required payout. Committee, which examined issues relating to 36. The government has announced plans for a rural credit and microfi nance (2005) and the subsidized national health insurance scheme Rangarajan Committee on Financial Inclusion for unorganized workers. This scheme shifts (2008) have supported the revival of the LAB government spending to demand-side subsidies scheme. The latest fi gures show LABs have profi ts away from supply-side spending. A McKinsey & Broadening Access to Finance 75

Company report argues that this scheme could Bays, Jonathan et al., 2008, ‘Promoting Financial be enhanced by leveraging the country’s civic ins- Inclusion—Lessons from around the World’, in titutions as ‘social aggregators’ uniquely capable New Vistas in Financial Services, McKinsey & of rapidly bringing large numbers of citizens into Company, pp. 46–56. a health insurance system. Social aggregators can Berger, Allen N., Nathan H. Miller, Mitchell A. Petersen, act as informed consumers on behalf of their Raghuram G. Rajan et al., 2005, ‘Does Function members, while simultaneously improve risk Follow Organizational Form? Evidence from the sharing and reduce the likelihood of fraud and Lending Practices of Large and Small Banks’, Journal moral hazard. of Financial Economics, 76 (May), pp. 237–69. 37. The fi rst Narasimham Committee (1991) pro- Chavan, Pallavi, and R. Ramkumar, 2007, Revival of posed that the scope of directed lending under Agricultural Credit in the 2000s: An Explanation, priority sector be reduced from 40 per cent New Delhi: Jawaharlal Nehru University. to 10 per cent. This was not accepted. The Chen, Martha A., and Snodgrass, Donald, 2001, Man- second Narasimham Committee (1998) noted aging Resources, Activities and Risk in Urban India: the reasons why priority sector obligations could The Impact of SEWA Bank, Washington: AIMS. not be reduced while stressing that priority loans Christen, R.P., 2006, ‘Microfi nance and Sustainability: be appraised on commercial considerations International Experiences and Lessons in India’, without any extraneous infl uences. The High in Towards a Sustainable Microfi nance Outreach in Level Committee on Agricultural Credit through India, New Delhi: NABARD GTZ and STZ. Commercial Banks (R.V. Gupta Committee, 1996) CGAP Focus Note No. 43, 2008, Regulating Trans- noted that the target of 18 per cent for lending to formational Branchless Banking: Mobile Phones agriculture was fi xed when the reserve require- and Other Technology to Increase Access to Finance, ments were 63 per cent. Due to progressive Washington: Consultative Group to Assist the Poor. reduction of the reserve requirements over the Cowley, Amanda, and Tilman Ehrbeck, 2007, Health years, the total lendable resources of banks have Insurance for the Poor: Leveraging India’s Unique increased substantially. The Committee estimated Strengths, part of Sustainable Health Insur- that the base on which the target of 18 per cent ance: Global Perspectives for India, pp. 30–42, was calculated had doubled; thus the banks would McKinsey & Company. have to double their lending to agriculture just Ghate, Prabhu, 2007, Microfi nance in India: A State of to maintain the same share in conditions where the Sector Report, 2007, New Delhi: Microfi nance agricultural production itself was growing at India. 2.1 per cent per annum. It suggested that banks Goldberg, Nathanael, 2005, Measuring the Impact of prepare special agricultural credit plans and set Microfinance: Taking Stock of What We Know, their own lending targets for agriculture based on Grameen Foundation USA Publication Series, Reserve Bank’s expectation of increase in the fl ow Washington: Grameen Foundation USA. of agricultural credit on an annual basis. Gupta, S.C., 2007, Report of the Technical Group 38. RBI could periodically collect and publish infor- to Review Legislations on Money Lending, mation on costs of lending to particular hard to RBI Technical Working Group (http://rbi. reach segments and disseminate such information org.in/scripts/PublicationReportDetails. in its various publications, highlighting cases where aspx?UrlPage=&ID=513). entities have achieved signifi cant cost reduction Helma, Brigit, and Xavier Reille, 2004, ‘Interest Rate in providing such credit. Such information would Ceilings and Microfi nance: the Story so Far’, CGAP exert pressure on banks to fi nd ways to reduce the Occasional Paper No. 9, Washington: Consultative cost of credit provision in the priority sector, and Group to Assist the Poor. could also be used to judge reasonable margins. Invest India Market Solutions Pvt Ltd (IIMS Dataworks), 39. Government of Andhra Pradesh concluded suc- October 2007, Financial Inclusion and Access: Dis- cessful pilot routing social security payments to cussion Paper, prepared exclusively for the Com- widows, handicapped, old and eligible weavers mittee on Financial Sector Reforms, based on the through the use of smart cards and BCs. fi ndings of the Invest India Income and Savings 40. Sinha, J., and A. Subramanium, 2007, The Next Survey 2007, India. Billion Customers: A Road Map for Expanding Khan, H.R., 2005, Final Report of the Internal Group to Financial Inclusion in India. Boston Consulting Examine Issues Relating to Rural Credit and Micro Group. fi nance, RBI Internal Working Group. 41. The Committee recognizes that 90 per cent of Khandker, Shahidur, 2005, Micro-fi nance and Poverty: households are likely to be covered in three years. Evidence Using Panel Data from Bangladesh, The remaining 10 per cent would be diffi cult to World Bank Economic Review, Washington: reach, and the goal should be to cover those in the World Bank. following two years. Kumar, Anjali, Ajai Nair, Adam Parsons, and Eduardo Urdapilleta, 2006, Expanding Bank Outreach through Retail Partnerships, Correspondent Banking in Brazil, World Bank Working Paper No. 85, REFERENCES Washington: World Bank. Mor, Nachiket, and Bindu Ananth, 2006, Inclusive Basu, Priya, 2006, Improving Access to Finance for India’s Financial Systems: Some Design Principles and the Rural Poor, Washington: World Bank. Case Study of ICICI Bank, Centre for Development 76 A HUNDRED SMALL STEPS

Finance Working Paper Series, Chennai: Institute Sengupta, Arjun K., 2007, Report on Conditions of for Financial Management and Research. Work and Promotion of Livelihoods in the Un- Murthy, C.S., 2005, Draft Technical Paper by the Internal organised Sector, National Commission for Enter- Working Group on Priority Sector Lending, RBI prises in the Unorganised Sector, New Delhi: Internal Working Group. Government of India. Narasimham, M., 1998, Report of the Committee on Shukla, Rajesh, 2007, How India Earns, Spends and Banking Sector Reforms, Ministry of Finance, Saves, New Delhi: The Max New York Life—NCAER Government of India. India Financial Protection Survey. Natu, A.J., Aashish Bansal, Amrita Kurian, Gurinder Sinha, Janmejaya, and Arvind Subramanian, 2007, The Pal Singh Khurana, and Tanushree Bhushan, 2008, Next Billion Consumers, A Road Map for Expanding ‘Linking Financial Inclusion with Social Security Financial Inclusion in India, Boston: The Boston Schemes’, Centre for Microfi nance Working Paper Consulting Group. Series No. 22, Chennai: Institute for Financial Man- Thorat, Usha, 2007, ‘Urban Cooperative Banks: Evo- agement and Research. lution of the Banks, Current Issues in Corporate New South Global Pty Limited, 2006, India—Pension Governance and Challenges in their Regulation Reforms for the Unorganised Sector, Final Report, and Supervision’, RBI Monthly Bulletin, January. Technical Assistance Consultant’s Report, Asian Thorat, Yashwant, Howard Jones, and Marylin Williams, Development Bank, for the Ministry of Finance, 2007, Rural Financial Institutions and Agents in Government of India. India: A Historical and Contemporary Comparative Petersen, M.A., and Rajan, R.G., 1994, ‘The Benefi ts of Analysis, presented at the International Conference Firm-Creditor Relationships: Evidence from Small on Rural Finance Research: Moving Results into Business Data’, Journal of Finance, Vol. 49, p. 3. Policies and Practice, Italy, FAO. Radhakrishna, R., 2007, Report of the Expert Group on Torre, Augusto de la, Juan Carlos Gozzi, and Sergio L. Agricultural Indebtedness, Ministry of Finance, Schmukler, 2007, ‘Innovative Experiences in Access Government of India. to Finance: Market Friendly Roles for the Visible Ramachandran, G., 2002, Report of The Review Group Hand?’, World Bank Policy Research Working Paper on The Working of the Local Area Bank Scheme, 4326, Washington: World Bank. Reserve Bank of India. Vaidyanathan, A., 2004, Draft Final Report of the Task Rangarajan, C., January 2008, Report of the Committee Force on Revival of Cooperative Credit Institutions, on Financial Inclusion, Ministry of Finance, Ministry of Finance, Government of India. Government of India (http://www.nabard.org/ Verma, Niraj, and Olivier Mahul, 2007, India—National report_comfi nancial.asp). Agriculture Insurance Scheme: Market-based solu- Reserve Bank of India, July 2007, Master Circular— tions for Better Risk Sharing, Report No. 39353, Lending to Priority Sector, RBI/2007–08/34, RPCD. India Country Management Unit, Washington: No. Plan. BC. 5/04.09.01/2007–08. World Bank. Levelling the Playing Field

In an effi cient fi nancial system, the playing are making it much harder to maintain fi eld is level so that different institutional the balance without standing in the way of forms compete to provide a function, no in- development. Consider payments. With tech- stitutional form dominates others because of nological improvements and the advent of the privileges it enjoys, competition results real time gross settlement systems, more chapter in resources being allocated efficiently, institutions such as money market mutual and society gets the maximum out of its funds can be allowed access to the payment productive resources. This is also equitable system and given the ability to offer cus- 4 for only thus will the interests of the con- tomers checking accounts, much as they suming masses be served, instead of the more are in industrial countries.1 But then banks usual trend of privileged producers being would be right to ask why they should bear protected. However, it will be a challenge to unremunerated obligations, such as priority level the playing fi eld in India because his- sector lending if money market funds are tory has given us a peculiar legacy of fi nan- given a free pass. Should banks be absolved cial institutions and a set of interest groups of priority sector obligations, or should it ranging from employees to regulators and be imposed on money market funds? As politicians, who will support special privil- these questions suggest, the grand bargain eges to their favoured institutions. will become harder and harder to sustain, The tilted playing field is central to under- and require ever increasing intervention by standing some of the features of the Indian the authorities, as competition increases. financial system. In India, the liquidity, Moreover, intervention will come in the way safety, and payment services, offered by bank of efficiency. deposits have made them an investment Rather than regulatory authorities trying vehicle of choice for the public. Banks can to determine what institutions should be provide depositors with the product they privileged, and how costs and benefits should need because of their access to certain pub- be balanced, this Committee believes they lic institutions, including the discounting should let competition decide. This would or repo facilities at the central bank, the require steadily lowering privileges, ob- deposit insurance system, the payment sys- ligations, and regulations that differentiate tem, and credit enforcement rights. Access to one institution performing a function from depositors gives banks a source of low cost another institution performing that same financing. In return for this, made possible in function, so that the most efficient form can part by privileged access to state institutions, prevail. To the extent that differences serve banks are required in India to fulfil certain a social purpose, this suggests more direct social obligations such as lending to the attempts to achieve that social purpose by priority sector, as well as meeting prudential the government. It would also imply greater norms such as statutory liquidity ratios that tolerance for a variety of institutional struc- also have a quasi-fiscal objective of funding tures and linkages so that needed products the government. This is the grand bargain can be created. Institutional structure should underlying the treatment of banks in India. drive regulatory structure rather than vice For the bargain to hold, there must be a versa. rough balancing of the costs and benefits Artificial differences abound in the Indian of being a bank. Yet competitive changes system. For example, money market mutual 78 A HUNDRED SMALL STEPS

funds have a tax advantage over deposit- they will slow growth and increase instability. taking institutions with what are effectively For instance, the skill deficit will make public interest payments to holders being taxed at a sector firms less effective at pricing risk. But lower dividend rate. This gives money mar- they may still be able to win business, given ket funds an undue advantage, best removed their access to low cost financing (resulting by equalizing interest and dividend taxes, or from government backing). This will crowd setting the personal tax rate on mutual fund out the private sector, which will not be able dividends in proportion to the fund’s receipt to compete at such un-remunerative prices. of equity and debt income—in other words The distorted prices will inhibit the financial the mutual fund should pass through tax sector’s effectiveness in allocating resources obligations instead of distorting them. and risks. And the costs will partially have to While we will offer more examples of be borne by the government when the under- institutional privilege that should be done priced risk eventually hits public sector away within the chapter, we cannot be ex- balance sheets. haustive for the Indian financial system has The Committee believes the way for- many. The ultimate aim is to have a level ward is to make institutions ‘ownership playing field where institutional form does neutral’. For the public sector, this means not affect the costs of undertaking an activ- removing the overlay of costs and benefits ity other than for purely economic reasons. imposed by government ownership. One Another important source of differen- way is bank privatization, or reducing the tiation is ownership—whether private, government’s majority stake so that even if government, or foreign. For example, gov- the government has de facto control, the bank ernment ownership automatically confers is not ‘public sector’. The other is through benefits (government guaranteed support, serious governance reform. The Committee favours by regulatory authorities, guaranteed believes that while this debate has become public sector customers) as well as costs (pol- entangled in politics and ideology, pragmatic iticization of decisions, limitations on pay, steps are possible in both directions so that unremunerated activities for the public or experience can guide future moves. It makes support for public sector entities, extra layers recommendations along these lines. of oversight by government organizations Consider next foreign ownership. Many and the resulting inflexibility, difficulties in arguments are put forward for treating for- raising capital). If government ownership eign firms differently. Yet the country has made a structural difference, with govern- had a generally good experience with foreign ment owned institutions performing certain direct investment elsewhere. And given that activities better simply because they were there are strong domestically incorporated government owned—for example, if public firms in almost every segment of the fi- sector employees treated the poor better than nancial sector, ‘infant industry’ arguments did private sector employees—there might for protecting domestic financial firms at still be a case for differentiation. There is, the expense of domestic financial service however, little evidence that government consumers hold little water. ownership creates deep differences in em- What would foreign financial firms ployee actions and behaviour. bring? The past Indian experience may not Indeed, it is increasingly evident that have much bearing for the future, given the when asked to generate profits, public sector substantial changes in the Indian economy. entities do exactly what private sector entities But cross-country studies indicate foreign fi- do, though less well because they have more nancial institutions would bring competition constraints, a poorer skill pool, and poorer that would improve service and prices for incentives. The danger is that unless they are the consumer—indeed a study finds foreign unshackled and their privileges minimized, entry is the single biggest factor in enhancing Levelling the Playing Field 79 domestic competition and efficiency.2 They burden (see Chapter 6). Of course, the more would also bring skills that are needed in the an NBFC approaches the characteristics of Indian economy, and the talent they bring to a bank by issuing short-term deposits, the India, or train in India, would become part greater should be the similarity in treatment. of the domestic labour pool, leading to cross- Indeed, this principle is being followed by the fertilization. Particularly useful might be RBI in its approach towards deposit taking evaluating and channelling credit to small NBFCs. and medium enterprises.3 Finally, they will There are, however, differences that are have access to foreign capital that will be not essential, and deserve to be eliminated. available even if the Indian economy is doing These differences are often highlighted badly, thus providing a valuable source of through competition, as one entity or prod- insurance.4 uct appears to gain a seemingly unfair ad- There are, no doubt, concerns about for- vantage. There are obviously two ways of eign financial firms. There is some academic eliminating burdensome differences. One is evidence that their entry is not particularly to place the burden on everyone. The second helpful when an economy is at a low level of is to eliminate it for everyone. In general, the financial development.5 India’s financial sec- Committee would favour equalization by tor is probably much above that threshold. removing burdens rather than by adding Also, to the extent foreign financial firms are burdens. To the extent that a burden cannot not domestically incorporated, regulatory be removed for sound economic reasons, it authorities may not have full control over would suggest a ‘warranted’ difference that them. This is remedied by requiring domestic might have to remain, rather than a need to incorporation in exchange for full domestic increase burdens for everyone. business privileges. Yet another concern is Second, institutions should be given time reciprocity. Domestic banks would like to to adjust, so that legacy institutions can com- expand abroad and feel that some countries pensate for the loss of rents by developing erect undue hurdles in their way. It is im- new skills and businesses, or by shrinking portant for the Indian authorities to exert gracefully, rather than by taking risks they every pressure on foreign governments to do not understand or cannot manage. A time extend reciprocal privileges to Indian banks. bound, pre-announced, steady withdrawal However, we believe that the expansion of of differentiation is usually better than an foreign banks in the Indian economy is bene- overnight change. ficial to the Indian public and should not be Third, as financial integration proceeds held hostage to the vagaries of foreign gov- apace, a variety of institutional linkages ernments. In the same way as India benefited may emerge to provide the products people by liberalizing trade over and beyond its need. For example, a loan linked with crop foreign commitments, India will benefit by insurance (or alternatively, one where inter- welcoming foreign financial firms. The high est and principal payments are linked to road seems to be the most beneficial one for rainfall) seems to be a felt need of farmers. our country here. Given the desire of investors for safety, an The Committee would offer some cautions equity linked deposit account, with a guar- about any reforms. First, it may be impossible anteed minimum interest rate, liquidity, to level the playing field completely. Some and some (but not full) upside performance differences may be warranted, for example, related to the performance of the stock mar- for prudential reasons. For instance, a bank ket could be popular. Such products would making certain loans has a capital require- require linkages across institutional and ment that a NBFC does not have to meet. regulatory silos, some of which is already This is because the bank has issued demand happening. More needs to be encouraged. deposits, which entail a higher supervisory Holding company structures could help 80 A HUNDRED SMALL STEPS

facilitate such linkages, and we will offer main focus will be the banking sector, but the some recommendations. Regulatory reforms annex offers examples from other sectors. will also be needed and we will offer views in Chapter 6. Fourth, care should be taken that insti- TAKING STOCK tutions do not misuse their freedom of activity and structure to create fragile institutions Key to growth with equity is an efﬁ cient and that impose charges on the system. Certain competitive banking sector providing the activities do tend to create fragility, and full range of products and services to indi- should be monitored particularly closely viduals of all incomes and locations, as well or, in extremis, even prohibited for certain as corporations of all sizes. The system should structures. For example, key to open-ended be stable with banks and bank employees mutual funds being safe is the fact that their appropriately incentivized so that there is assets are liquid and continuously marked little systemic propensity for sloth, excessive to market. An open ended real estate mutual risk taking, fraud, or customer abuse. fund has neither characteristic and can be By some of these counts the banking sys- very fragile—mutual fund ‘runs’ have oc- tem has been very successful. Steady growth curred in some countries like Germany. has come without significant instability, in Similarly, banks, mutual funds, or insurance contrast to the experience of some other companies with guaranteed returns neces- emerging markets. Historically, our banks sitate additional monitoring to ensure that have attracted some of the best talent avail- the institutions are managing their assets to able. Some of our banks are setting world produce the guaranteed returns, else they standards in the use of technology, and the too could suffer runs and become a public recent thrust into housing and retail credit charge. suggest banks are prepared to meet demand The point therefore is to proceed steadily, when it arises. Banks are also in fairly good predictably, but with care to reduce privilege health, as suggested by low NPAs and sizeable and obligations, while expanding permis- profits. sible activities wherever possible. This One cannot be complacent though be- chapter contains some proposals towards cause periods of strong growth are also these goals but it cannot be exhaustive. The periods when banking system problems build-up. While the rest of this section will attempt to understand the deficiencies in Figure 1: Size of Bank Credit the banking system and possible areas of concern, this should not detract from past successes, which are considerable.

1. The role of the Indian banking sector is still small relative to GDP. While the size of the banking sector relative to the economy has more than doubled between 2000 and 2007, with bank loans to GDP ratio rising from 22.7 per cent to 46 per cent, the banking sector in India is still relatively small compared to other emerging markets (see Figure 1). 2. Even the largest Indian banks are relatively small, and account for a small share of the banking sector. India has only one bank (State Bank of India) that features among the top 100 banks in the world in terms Source: Financial Structure Database, World Bank. of assets with a rank of 80. By contrast, Levelling the Playing Field 81

four Chinese banks feature in the top Table 1: Credit Market Structure in India 30 banks. While banks of all sizes can be (Figures in Rs. Lakh Crores) effi cient—with technology allowing even Number of Loans and small banks to fl ourish by making local, banks Total assets advances relationship intensive loans, size can bring 2006 2007 2006 2007 2006 2007 some scale economies and allow banks to make loans to large projects while re- 1 Commercial Banks 217 178 28.76 35.69 15.55 20.29 maining diversifi ed. Scheduled Commercial Banks 84 82 27.86 34.63 15.17 19.81 Indian corporations are also relatively 1.1 Public Sector Banks 28 28 20.15 24.40 11.06 14.40 small, hence the size of the capitalization 1.1.1 Nationalized Banks 19 19 12.34 15.30 6.82 8.95 of the 10 biggest Indian banks to the 10 biggest Indian corporations is not dis- 1.1.2 SBI Group 8 8 6.92 8.06 3.72 4.82 proportional to ratios elsewhere (2.72 in 1.1.3 Other Public Sector Banks 1 1 0.89 1.04 0.53 0.62 India versus 2.45 in the USA in terms of 1.2 Private Sector Banks 27 25 5.72 7.45 3.13 4.15 total assets though a lower 0.23 to 0.44 1.2.1 Old Private Sector Banks 19 17 1.50 1.61 0.83 0.93 respectively in terms of market capital- 1.2.2 New Private Sector Banks 8 8 4.22 5.85 2.30 3.22 ization). But as Indian corporations and projects grow in size and ambition, espe- 1.3 Foreign Banks 29 29 1.99 2.78 0.98 1.26 cially through mergers and acquisitions, 2.1 Regional Rural Banks (RRBs) 133 96 0.90 1.06 0.39 0.47 some Indian banks will have to grow in size and capabilities. 2 Financial Institutions 55 1.45 1.67 1.11 1.32 3. If countries are ranked by the share of the top three banks in total banking assets, 2.1 All India FIs 4 India comes in at number 102 in 2005. Of 2.2 Specialized FIs 7 course, this is assuming that public sector 2.3 State Level Institutions 44 banks should all be treated differently. 2.3.1 State Financial Corporations While public sector banks do compete State Industrial Development 18 with each other, they do have a common 2.3.2 Corporations 26 owner, whose policies thus infl uence the activities of 70 per cent of banking sector assets. 3 NBFCs 13,014 13,369 0.60 0.71 4. India is an outlier in the extent of state 3.1 NBFC—D 428 401 0.38 0.48 0.11 0.11 ownership of the banking sector. Out of 138 3.2 RNBFC and Others 12,586 12,968 0.22 0.23 countries surveyed by Barth, Caprio and Levine (2006), only nine had a predominantly state owned banking sector. 4 Cooperative Institutions 111,777 109,310 4.76 4.99 2.27 2.49 India and China are in this group, along 4.1 Urban Cooperative banks 1,853 1,813 1.51 1.60 0.72 0.79 with Bhutan, Libya, Algeria, Belarus, 4.2 Rural Cooperative Institutions 109,924 107,497 3.25 3.39 1.56 1.70 Turkmenistan, Egypt, and Costa Rica. No high income country has a state dom- 4.2.1 Short Term 109,177 106,781 2.81 2.93 1.50 1.65 inated banking sector, and we should note 4.2.1.1 STCBs 31 31 0.72 0.76 0.44 0.48 that China has recently made moves to 4.2.1.2 DCCBs 367 369 1.33 1.43 0.66 0.74 introduce strategic foreign partners in its 4.2.1.3 PACs 108,779 106,384 0.75 0.73 0.39 0.43 large state owned banks. 4.2.2 Long Term 747 716 0.45 0.46 0.06 0.05 5. In March 2007, there were 82 scheduled commercial banks in India (see Table 1 4.2.2.1 SCARDBs 20 20 0.24 0.25 0.03 0.03 and Figure 2). Together, they accounted 4.2.2.2 PCARDBs 727 696 0.20 0.21 0.03 0.02 for about 80 per cent of the total assets Source: RBI, Trend and Progress in Commercial Banking 2006–07. Number of reporting companies of all formal institutions in the Indian in case of NBFCs is 435 in 2006 and 362 in 2007. The total assets and loans and advances credit market. Among the scheduled comfi gures for the cooperative institutions are for the years ending 2005 and 2006. mercial banks the public sector banks accounted for about 70 per cent of the total assets in March 2007, Indian private banks 22 per cent and foreign banks 8 per cent. private sector commercial banks—banks Interestingly, the share of the foreign banks that have been allowed to enter since the has remained steady at about 8 per cent beginning of reforms in 1991. over the last decade or so even while the India does not have many small private private sector banks have gained. Among banks. The United States has over 7,000 the commercial banks, only eight are ‘new’ banks, over 85 times the number of banks 82 A HUNDRED SMALL STEPS

Figure 2

Panel A: Credit Market Panel B: Scheduled Commercial Banks

Source: RBI, Trend and Progress in Commercial Banking 2005–06 and 2006–07 respectively.

in India, handling total deposits that are to shareholders, registering the highest merely over eight times larger. It should be regional growth rate in assets, deposits, and noted that many of these banks are small ROE as well as one of the highest total community banks, comparable to our co- returns globally according to a recent de- operative banks, of which we have a vast tailed survey of 14 leading public sector, number. But these have a different gov- new private sector and foreign banks con- ernance and funding structure from the ducted by McKinsey for the Indian Bankers typical bank. While there are a number of Association (IBA).6 Banks’ contribution notable exceptions, the experience with to GDP in India is comparable to the cooperatives has been mixed, in part due ratios in developed and developing world. to problems with governance. These issues Signifi cant improvements were made in are addressed in Chapter 3, and the rest of capital allocation between 2003 and 2007 this chapter will focus on scheduled com- reducing the share of industries with re- mercial banks. turns lower than cost of debt from 56 per 6. As a group, Indian banks have done ex- cent to 22 per cent. NPA levels have been cut ceedingly well in providing high returns to about a third during the same period. Among the different bank ownership categories, foreign banks are clearly the Figure 3: Group-wise Bank Profi tability most profi table (see Figure 3). Apart from fee-based activities, these banks enjoy a signifi cantly higher interest spread (Figure 4). Part of their success in maintaining this margin lies in their ability to attract low interest corporate checking account deposits (Figure 5). The profi tability levels of Indian bank groups are largely comparable. 7. With an average spread exceeding 5 per cent, intermediation costs in India remain high compared to other countries in the world as well as in the region. For example, spreads between borrowing and lending rates are 4 per cent in Thailand, 3.4 per cent in China, and only 2.4 per cent in Singapore. The high spreads are more than offset by unprofi table priority sector obligations and statutory requirements, as we will argue later. But this means that the burden of these social and public obligations are borne by the Indian saver, whose low return pays for the grand Source: RBI, Trend and Progress in Commercial Banking 2005–06. bargain described in the introduction. Levelling the Playing Field 83

8. While Indian banks are fairly effi cient in Figure 4: Net Interest Margin as a Percentage of Total Assets their spending on IT, the use of technology to reduce transactions costs of outreach is still at a nascent stage. For example, there are 19 ATMs per million people in India, compared to 51 in China or 193 in Brazil. Clearly, the cost of human-intermediated transactions is still low in India, but it is suffi ciently high that signifi cant portions of our population do not have access to fi nancial services. 9. There are, however, fundamental differences between new private banks and foreign banks on one hand (the ‘attackers’ in the IBA-McKinsey study) and the public sector banks and old private sector banks (the ‘incumbents’) on the other. The largely comparable profi tability levels across leading banks today conceal critical differences in the underlying economics that is likely to shape the future. The fi rst Source: RBI, Trend and Progress in Commercial Banking 2005–06. group enjoys signifi cant relative advantages in terms of organizational capabil- Figure 5: Share of Deposits: 2005–06 ities, sales and distribution channels, credit and risk management practices and use of information technology and operation. Moreover, they target more affl uent segments of the population in urban areas (see Box 1). Not surprisingly, therefore, since 2000 they have more than doubled their share of total assets, raised their share of total profi ts by more than 50 per cent, and account for almost half of the total market capitalization of the industry today enjoying over three times higher market valuation. 10. We have mentioned bank privileges and obligations a number of times. Before con- cluding this section, it is worth asking whether the banking system is benefi ted or hurt on net by obligations, pre-emption, and interest rate caps. While a detailed exercise is beyond the scope of this report, a quick estimate by McKinsey (see Figure 6), Source: RBI, Trend and Progress in Commercial Banking 2005–06. with all the caveats that accompany quick estimates suggests: In sum, while currently in robust health, (a) The banking sector is, on net, hurt to the tune of Rs. 10,000 to 15,000 crores India’s banking sector is relatively small and by the ‘grand bargain’. intermediates less than half the country’s (b) The greatest benefi t from getting rid household savings. The sector enjoys very high of both the obligations and benefi ts spreads, in part through controlled interest would accrue to the public sector banks, whose profi tability would rise rates on savings and checking accounts, but by between 8,000 and 13,000 crores, this last benefit is more than offset by the a sizeable proportion of their current pre-emption of bank assets into government operating profi ts of about 42,000 mandated channels. Banking could become crores. increasingly unprofitable as competition from (c) The likely consequences are much smaller for foreign banks and private other institutions increases. Moreover, the sector banks. system is relatively unsuccessful in reaching 84 A HUNDRED SMALL STEPS

Box 1: Private and Foreign Banks vs. Public Sector Banks: The IBA-McKinsey Study

New private and foreign banks are much private sector banks have set themselves apart businesses and credit and market risk. Here more profi table in wholesale businesses than by superior levels of convenience and customer while many foreign and new private sector banks the public sector and old private banks. The service. However they have also created more are using sophisticated and world standard risk latter group mainly depends upon its valuable customers with negative experiences. Besides management techniques, public sector banks legacy retail franchises enjoying a massive ROE this customer segment is prone to greater have fallen behind often simply conforming to (return on equity) of about 33 per cent on diversifi cation. regulatory and compliance measures. their retail banking portfolios. Retail banking Indian banks have traditionally had better access In terms of use of information technology, profi tability is largely driven by access to retail to superior talent compared to other global in general Indian banks enjoy a competitive banking and the ‘attackers’ today are investing banks leading to better average organization advantage even by global standards. But here too, heavily in building large-scale retail franchises. performance. However, public sector banks new private banks and foreign banks have done Customer experience is the critical value suffer from a crippling lack of specialist skills and better primarily because they could avoid legacy driver in banking anywhere and given that the new-age leaders. While foreign and new private systems and had better governance practices. young and affl uent section of Indian customers banks are currently in a better position on this Most public sector banks have made large are more demanding and discerning and are front, they will also have to deal with severe talent investments in technologies such as core banking less credit-averse, customer experience and shortage soon. solutions, are yet to use them effectively to tailored offerings are increasingly becoming key Treasury is a signifi cant contributor to bank enhance levels of customer service. to bank profi tability. In this area foreign and new earnings in India, managing capital market

Figure 6: Costs vs. Beneﬁ ts of Deregulating Interest Rates, CRR/SLR and Priority Sector Obligations

Source: McKinsey analysis, RBI. ∗Operating proﬁ t as deﬁ ned by the RBI Levelling the Playing Field 85 the very poor. Indeed, the strategy of at- In part, the differences come from better tempting to reach the poor through large use of technology. For example, private national banks branching into rural areas is and foreign banks’ share of ATMs is signifi- reaching diminishing returns. The banking cantly greater than their share of branches system therefore needs to change, both to pre- (see Figure 7). Moreover, they have been pare for a more competitive future, as well as better at reducing costs by centralizing to remedy current deficiencies. Perhaps the processing through the use of technology, greatest area of concern is the public sector even while using employees to get out of banks. That is what we turn to now. branches on to the street to sell products.

Figure 7 PUBLIC SECTOR BANKS: AN OVERVIEW

In simple proﬁ tability terms, the performance of public sector banks in India has, in recent years, been comparable if not better than that of other groups of domestic banks (see Figure 3). The future, however, looks more challenging for the public sector banks than those in the private sector, especially the ‘new’ ones. In the past decade, public sector banks have witnessed a gradual erosion of their share in total assets of the banking sector from over 80 per cent to close to 72 per cent. During the period 2003–07, public sector bank balance sheets have grown at a compounded annual growth rate (CAGR) of 16 per cent, less than half that of private banks at 35 per cent. At these rates of growth, the public sector banks’ share of total banking assets is expected to drop to about 56 per cent in 2012. Of course, given private sector banks started from a lower base, such differentials may not persist forever. Public sector banks have lower productivity—profit per branch for public sector banks at Rs. 0.5 crores, is a fifth of the Rs 2.5 crores figure for private banks. Pro- fit per employee at Rs 2.6 lakhs is only a third of the Rs 7.6 lakhs figure for the private banks. In part, some, but not all, of these differences come from a greater presence of public sector banks in lower profitability rural areas. For example, profit per rural branch for State Bank of India (SBI) is just 0.2 crores while profit per employee is 1.67 lakhs, and SBI has twice as many rural branches as urban branches. Source: Report on Trend and Progress of Banking in India 2006–07, RBI. 86 A HUNDRED SMALL STEPS

Equally portentously, the demographic these activities have taken-off recently, so profile of public sector bank customers is quite the public sector starts from the same low different from that for the private banks. base as the private sector, and should not, in While 60 per cent of foreign and private principle, have a lower growth rate. banks customers are below the age of 40, the Perhaps most telling are the numbers on corresponding share for public sector banks productivity. A McKinsey study in 20017 found is only 32 per cent. Further, the economic that productivity of bank employees in India profiles of the customers differ considerably based on the number of transactions and the as well. Public sector banks today have a number of loan and deposit accounts opened much lower share of the more profitable per hour was a miserable 12 in comparison ‘mass affluent’ segment of the population as to 100 in the United States. The public sector compared to their private competitors. These banks were particularly backward on this differences have implications for the future dimension, scoring 10 while the old private growth potential of public sector banks, sector banks scored 32 and the new private particularly relative to their private sector sector banks scored 55. By comparison, Brazil counterparts. scored 32 and Korea scored 55. Another trend in banking—both global These considerably poorer prospects of as well as in India—that does not portend public sector banks relative to their pri- well for public sector banks is the shift in vate sector counterparts are reflected in revenues from traditional lending to more their significantly lower valuation in the complex areas like bond-currency-derivatives marketplace. At March-end 2007, public products and fee-based wholesale and re- sector banks traded at an average price to tail banking services like M&A advisory, book ratio of 1.11 while for private sector institutional investments, and insurance. banks the ratio was 2.96. The price-earnings These are precisely the areas where public ratios were 6.85 and 25.19 respectively. sector banks are at a relative disadvantage, primarily because of their inability to attract and retain talent or provide employees strong SERVING PUBLIC POLICY incentives, and their inability to make rapid OBJECTIVES investments in the technology necessary for being competitive in these segments. It may be argued that profitability and The public sector market share in the banc- valuation should not be the sole measures to assurance market in March 2007 stood at capture the effectiveness of public sector 32 per cent (compared to its 72 per cent share banks in India since they have to fulfi l im- of assets) while in mutual fund sales it was portant public policy objectives like inclusion about 5 per cent. Between 1997 and 2007, cash and development of priority sectors in the management throughout rose at a CAGR country—objectives that often confl ict with of only 16 per cent for public sector banks the profi t motive. It is therefore important to as opposed to 28 per cent for private sector evaluate the effi ciency and effectiveness with banks. Between 2002 and 2007, the num- which public sector banks have served these ber of credit cards issued and spending in public policy goals. credit cards rose at CAGRs of 24 per cent and 44 per cent respectively as opposed to private sector CAGRs of 57 per cent and 71 per cent. Inclusion In services like debt syndication and wealth management the public sector share has Inclusion has certainly been a public policy been a minuscule 2.7 per cent and 0 per cent objective in the area of banking and it is respectively with foreign and private sector undeniable that public sector banks have banks completely dominating the space. All played a pivotal role in this area. Public sector Levelling the Playing Field 87 banks account for 88 per cent of all com- more growth) is in Figure 8, which shows each mercial bank branches in India and in rural state’s credit-deposit ratio plotted against the areas the proportion rises to 95 per cent. share of public sector banks in total deposits Rural and semi-urban branches expansion in the states in 2000. The correlation of public was driven in the 1970s and 1980s by the sector bank share in deposits and the credit 4:1 rule which required banks to open four deposit ratio in 2001 and 2005 are –0.50 and branches in rural or semi-urban areas to get –0.54 respectively, suggesting that in states a license for opening a single new branch in with lower lending opportunities (lower bars the urban or metro areas. There are, how- in the figure) public sector banks are indeed ever, differences in where they are to be found. the primary provider of banking (the dark Public sector banks expanded in rural areas line indicating the PSB share of deposits is where there were people—the correlation be- higher). Interestingly, the correlation between the number of public sector branches tween percentage changes in credit–deposit in a state today and state rural population ratio during the period and the deposit share is 0.9. By contrast, private sector banks, of public sector banks in 2000 is a statistically perhaps because they have really grown after insignificant 0.16, suggesting no systematic the period of enforced branching, may have relationship between improvement in the been more selective in where they grew. The regional credit disbursement and public corresponding correlation for private sector sector bank presence during this period. branches is only 0.2. Since the reforms began however and the Another demonstration of the private sec- pressure to open new rural branches eased for tor’s location preference for areas with more public sector banks, the nature of branch ex- lending opportunities (and thus probably pansion has also changed drastically. While

Figure 8: Credit–Deposit Ratio

Source: RBI, Trend and Progress in Commercial Banking, several years. 88 A HUNDRED SMALL STEPS

the preference for private sector banks for banks and private sector/foreign banks in the more profitable urban locales is clear, in rural areas is quite narrow (for example, just 2005–06 public sector banks as a group did over 80 per cent of public sector bank clients not open a single new rural branch though earn incomes below 1 lakh per annum, while they added 486 branches to their network (in the comparable figure for private and for- 2006–07, a total of 1,014 branches were added eign banks is over 70 per cent), while private by PSBs of which 69 were rural). A variety of sector/foreign banks attract a much richer explanations for the paucity of rural branch clientele in urban areas. This suggests that in openings are possible. It may be that rural the rural areas they choose to be present in, coverage is complete so few new branches are private sector/foreign banks do serve the local needed. However, it may also be that banks clientele, and do not discriminate against the have realized rural branches are really not the poor, at least not significantly more than the most cost-effective way to achieve outreach. It public sector banks. In urban areas though, may also be that when public sector banks are where the public has more choice (and tasked with being profitable, they gravitate to where banks can be more selective in their similar behaviour to private sector banks. clientele), private sector/foreign banks have This last point of the relative similarity in significantly greater share amongst the more behaviour between public and private sec- affluent. Put differently, in markets where tor when in the same environment and facing the bankable population is small, private/ similar incentives deserves further reinforce- foreign banks go after nearly everyone the ment. Note from Figure 9 that the difference public sector reaches out to. in customer profiles between public sector These observations have profound implications for the rationale of using public Figure 9 sector banks to facilitate branching and thus inclusion in rural areas. First, additional rural branching is not very profitable, and when given a choice, everyone stays away from it— public sector banks and private sector banks alike. Low rural incomes may not warrant the posting of an employee of a large national bank, who enjoys the same wages as an urban employee (and some hardship perks to boot) in the rural area. One alternative may be to recruit from the local area, at local wages, but such pay differentiation is typically not possible in a large bank (or, in RRBs, as history has suggested). A better alternative is the licensing of new small finance banks proposed in Chapter 3. But we also have to rethink modes of delivering financial services, abandoning the emphasis on fixed-location branches that cannot be used intensively, and focusing on electronic or multi-use delivery channels such as shops—the large bank linkages proposed in Chapter 3. Second, when in a rural area, differences in bank ownership do not significantly affect the kind of clientele that is served. Money has no odour, and when there are profits to be Source: IIMS Dataworks. made, the private sector will reach out for it. Levelling the Playing Field 89

The answer to inclusion is not to rely solely Figure 10: Priority Sector Lending on the ‘public spirit’ of public sector banks but to make the poor worth competing for. Third, efficiency and innovation are critical to reaching the underserved profitably. The relatively low productivity of public sector banks is an important impediment in using the public sector banks as the primary instrument to achieve inclusion. Finally, there is large population of poor and unbanked in urban areas as well. The Committee believes the proposals for expanding inclusion in rural India will also address the concerns of the urban poor as well, perhaps a little more effectively given the large urban presence of banks.

Source: RBI, Trend and Progress in Commercial Banking 2005–06. Directed credit

In recent years, private banks have actually agricultural loans, while public sector banks done better than public sector banks (see provide more consumption loans. On net, Figure 10) in terms of fulfi lling the overall there is little difference in overall lending in priority sector quota, though in the sub- times of drought between public sector banks component of agricultural credit, public and private sector banks, though private sector banks have done a slightly better job. sector banks are significantly more likely to When we consider the share of net bank lend in times of plentiful rainfall than public credit to weaker sections (mandated at 10 sector banks.9 per cent of net bank credit), however, pub- Finally, there is variance in the quality of lic sector banks are signifi cantly ahead at directed lending. The share of non-performing 7.7 per cent in 2005–06 as compared to 1.6 per loans in the priority sector lending has been cent for private banks. Taking a more long- higher for nationalized banks than for the pri- term perspective, public sector banks have vate banks with some indication that polit- generated more credit to agriculture and ical interference has reduced credit quality.10 rural areas and government enterprises, less In March 2007, though priority sector credit to the trade, transport and fi nance lending constituted a slightly higher share sector, with little difference in credit to small- of total lending for private sector banks scale industries and industries identified (42.7 per cent) than the public sector banks for support in the post-1980 fi ve-year plans.8 (39.6 per cent), less than 32 per cent of the In terms of impact of the additional agri- former’s NPAs came from priority sector cultural credit from public sector banks, activities, while for public sector banks, agricultural investment and output growth over 59 per cent of their NPAs came from do not reflect any effect of increased agri- priority sector lending. NPAs in agriculture cultural credit either, raising questions about constituted 3.1 per cent of total outstanding appropriate end-use of agricultural credit direct agricultural credit for private banks provided by public sector banks (though as opposed to 4.4 per cent for public sector the absence of supportive public invest- banks. The corresponding figures for small ment could also be a factor). In terms of scale industry were 4.9 per cent and 5.6 loan timing, in times of drought in a district, per cent respectively, and for other prior- private sector banks appear to provide more ity sectors, 1.8 per cent and 5.3 per cent 90 A HUNDRED SMALL STEPS

respectively. Total priority sector NPAs con- leads to the obvious question—is there any stituted 2.4 per cent of total priority sector purpose in continuing the status quo for lending less indirect agricultural advances public sector banks when their ownership for the private sector banks as opposed to and governance structure offers little specific 5.0 per cent for public sector banks. benefit for the nation, and possibly leaves In this regard, it is disheartening that after these important national assets vulnerable a period when governments desisted from an- for the future? We think not, and this is the nouncing waivers, agricultural loan waivers rationale for the proposals that follow. have returned to the policy discourse. As Chapter 3 on inclusion suggests, the poor are not the largest recipients of bank loans even PROPOSALS though they are highly indebted, so bank loan waivers are typically poorly directed— The intent of the proposals that follow are: though it is debatable whether they are more poorly directed than other government trans- 1. To free the public sector banks from factors fers. More problematic, the anticipation that cripple their ability to compete. of a loan waiver, especially if only loans to 2. To improve variety and effi ciency in the defaulters are waived, creates enormous banking sector specifi cally, and in the moral hazard and reduces everyone’s incen- fi nancial sector more generally. 3. To reduce the overlay of obligations and tive to repay. It also increases corruption as benefi ts on the banking sector as a whole. everyone attempts to get classified as a past 4. To allow for a more effective provision defaulter. Politicians who exhort people not of products that cut across fi nancial to repay loans are particularly irresponsible activities. for they ensure that future credit dries up, in part because the lender is weakened, and in part because the lender has little confidence Proposal 1: Reforming the public of getting paid. This Committee strongly sector banks counsels against short-sighted indiscrimin- ate waivers, or loose talk about defaulting. The public sector banks (henceforth PSBs) Finally, some would see the employment have a number of strengths including their the public sector provides as an important historic ability to attract talent (a number function in its own right. While the public of successful private and foreign banks are sector banks employ proportionately more staffed by former public sector employees), people than private sector banks by most their vast branch network, their strong name metrics, this does hamper their efficiency recognition, and their association with safety, and their growth. Furthermore, overstaffing especially in rural areas. While these strengths results in stagnation, which further hampers offer an opportunity, their ability to compete the banks’ ability to retain talent. It is time to is hampered, in part by their governance struc- ask whether the nation would be better served ture. Consider some of their handicaps com- by freeing public sector banks to generate pared to private banks: jobs through efficient growth rather than through forced mandates and constraints • Both the level of pay as well as its sensi- that compromise their ability to compete, tivity to performance are limited, making and will eventually shrink their share. it hard to attract new talented employees, To sum up, it does not seem that public retain superior old ones, or incentivize sector lending to the priority sector has been them to perform better. • Promotion is typically on the basis of sen- markedly higher or of better quality than pri- iority, and it is hard to let go of employees vate sector lending. Again, differences in bank for non-performance. The talented young ownership have limited influence on whether are more attracted towards private banks the public purpose is served, once mandates where they can get signifi cant responsibil- are imposed equally across banks. This then ity quickly. Public sector banks used to be Levelling the Playing Field 91

much larger than private banks, and thus with which state owned banks carry out their be able to promise much greater infl uence functions, and probably imposes constraints. and a broader range of experience even- Unprofitable activities, such as providing fi- tually. As bank sizes become more equal, even that is not possible. Public sector nancial services in remote thinly-populated banks have a legacy of talent from their areas, which need to be carried out for the past, but that talent pool is ageing and is greater benefit of society, can be encouraged not being replenished. through targeted subsidies. What matters • The most important corporate decision, appointment and dismissal of the bank’s for the nation is how efficiently these activ- top management, is not taken by the ities are carried out, not who owns the bank board, but by the central government. This producing the activities. Similarly, other limited delegation of power to the bank activities can be better encouraged through board, despite the board consisting of a a combination of mandates and incentives, majority of government nominees, inhibits the board’s ability to guide bank with the latter being emphasized over time. strategy and limits the responsibility it Again, these should apply uniformly across has to shoulder for bank performance. At banks, independent of ownership. the same time, the government’s power to Some of the other discretionary activ- appoint and transfer management introduces political infl uence over day-to-day ities forced on public sector banks are, of decision making. Governments have dif- course, undesirable activities involving pure fered in the extent they have used infl u- patronage. Even those that are not should ence, but this issue, with important either not be undertaken by government economic consequences, should not be banks (such as supporting prices in various left to the ballot box. • Unlike private companies, the bank’s financial markets) or are more transparently board is not considered an adequate trus- undertaken by the government (such as tee for the interests of its owner. Instead, providing fiscal transfers through debt re- additional layers, for example, the Central lief to drought hit areas). Indeed, because Vigilance Commission, second guess all important bank decisions. This induces the public has a direct sizeable minority delay as every decision has to be docu- shareholding in public sector banks, it is im- mented for a possible future enquiry, risk- portant that the government respect the aversion, and an excessively bureaucratic minority interest (as promoters in the private decision process through all levels. sector are forced to) by allowing these banks • Unions can be a very positive force in employer–employee relations, and indeed to be run efficiently to maximize their value. some public sector banks enjoy model That will also be in the national interest. management–union relations. To the ex- An immediate question then is how tent, however, that public sector bank to distance public sector banks from the unions can use their proximity to political government. One option is privatization. power to have an added infl uence over the management of some public sector banks The majority of this Committee does not (an infl uence that would be weaker in pri- see a compelling reason for government vate sector banks), it creates an imbalance ownership. There are other activities where that can be detrimental to the bank as government attention and resources are more a whole. • Because the government is strapped for important. However, the Committee does resources, and because a number of PSBs recognize that public opinion in the coun- are at the limit of their ability to issue try is divided on the issue of privatization. shares to the private sector without al- An alternative approach is to undertake re- tering majority government ownership, forms that would remove constraints on the capital is increasingly constraining their growth. public sector, even while keeping it under government ownership. In many ways, therefore, government Unfortunately, ideology has overtaken ownership does not increase the efficiency reasoned debate in this issue. The pragmatic 92 A HUNDRED SMALL STEPS

approach, which should appeal to practical The major steps include: people of all hues, is to experiment, as China does so successfully, and to use the resulting 1. Create stronger boards for PSBs. experience to guide policy. One aspect of the (a) Government nominees: Some governments have seen appointments pragmatic approach would be to sell a few to the boards of public sector banks small underperforming public sector banks, as a means of distributing patronage. possibly through a strategic sale, so as to gain Other government appointees have experience with the selling process, and to limited understanding of the busi- see whether the consequences are acceptable ness of banking and are on boards or not.11 This would allow some facts and simply because of their eminence in other areas. Board members must experience to enter the public debate, some- be chosen based on their capacity thing which is sorely lacking. to guide the bank’s business to For the largest PSBs, the options are more maximize value creation for all its limited. The selling of large PSBs to large stakeholders and balance stakeholder private sector banks would raise issues of interests in areas of confl ict. This is concentration. The selling of banks to in- why we suggest the government set up an independent Selection Board dustrial houses has been problematic across of eminently qualifi ed individuals the world from the perspective of financial from varied backgrounds to propose stability because of the propensity of the board members for various PSBs. The houses to milk banks for ‘self-loans’. With- Selection Board’s members should out a substantial improvement in the ability retire at staggered intervals so that no of the Indian system to curb related-party future government can easily change its character. transactions, and to close down failing banks, When an incumbent PSB director’s this could be a recipe for financial disaster. term expires, the Selection Board will While large international banks could swal- propose qualifi ed individuals to re- low our largest banks, it is unlikely that this place them. So long as the individual would be politically acceptable, at least in the meets ‘fi t and proper’ criteria, the government should accept the pro- foreseeable future. That leaves a sale through posal, or offer a written rationale for a public offering. But such a sale would re- why the nomination is rejected. quire confidence in the corporate governance (b) Shareholders nominees: Non- of these enterprises so that a high price can government shareholders should be be realized. allowed to appoint board directors This Committee therefore believes that following the same regulations that apply to private companies—minority the second aspect of the pragmatic approach shareholders in public sector banks should be to focus on reforming the gov- should not be treated any differently. ernance structure and perhaps also acquir- Moreover, it should be possible for ing strategic partners for large and better PSBs to seek out strategic partners performing public sector banks, with the among other fi nancial institutions eventual disposition determined based on (including private and foreign ones), with partners allowed a voting stake experience with privatization, the public of up to 20 per cent. Given that even mood, and the political environment. Gov- Communist China allows this, it is ernance reform, we should emphasize, is time for India to liberalize. needed not simply as a matter of fashion, but In addition, board seats allocated so that PSBs can survive the coming com- to shareholder directors should be petitive onslaught. The reforms we propose more proportional to their voting stake. For instance, out of 14 directors would reduce the constraints imposed by on SBI’s board, only four are elected by government ownership, allowing public shareholders, even though the gov- sector banks to hire more talent, make needed ernment only holds 59.7 per cent of investments, and react more dynamically to the equity in SBI. Five directors are the rapidly developing environment. appointed by the government and the Levelling the Playing Field 93

RBI, three consist of management, and also protect management, when it and two are employee appointees. But is performing its duties, from political since the government appoints man- interference. Greater pay for directors, agement, eight directors are effect- of which a signifi cant portion is stock- ively government appointees. The based, is also warranted in order to at- balance would become more equit- tract capable individuals and to give able if the board appointed manage- them a greater sense (and duty) of re- ment (see below). Pending that, it sponsibility. This is a small price to pay would be sensible to give more seats to safeguard the value of the national to shareholders. assets that the PSBs represent. Of course, given that the share- The Committee recognizes that it holding in PSBs is dispersed, the slate will take time for boards to become of potential directors proposed by fully self-governing, and the Finance management to the minority share- Ministry will have to disassociate itself holders for election is likely to win from decision making steadily. One easily. To prevent the formation of useful change would be for the gov- ‘pet’ Boards, it will be important to ernment, through its directors, to devise a transparent process of con- evaluate management and its per- sultation with shareholders and inde- formance through a broader set of pendent directors in coming up with parameters than just current pro- the proposed slate of directors. This is fi tability, inclusion, and growth. not to say that the process is perfect in Forward looking measures including private sector banks, but reasonable human resources development and processes can be formulated for both. the quality of risk management will The process by which shareholders need greater attention. Management can also propose alternative nominees institutes could help through com- should be simplifi ed, and the process prehensive training programmes to of voting made easier. acquaint new directors with their re- (c) Delegate all decision making to the sponsibilities and to impart skills to bank board: The bank board, which carry them out. Better governance is closer to the real needs of the bank, will, however, have immense payoffs should make all decisions including and will be worth the time and selecting the Chairman and CEO of effort. the bank and all its important of- 2. Delink banks from the government. fi cers, as well as terminating them. Part of the problem PSB managements While the appointment may have to face is that they are directly owned by the go through the Appointments Com- government, and therefore come under mittee of the Cabinet (ACC), such government administrative norms. Bur- appointments should be approved eaucracy and business are fundamentally as a matter of course. In the rare case incompatible, especially in a dynamic the appointment is rejected, the ACC open economy. It is also better that man- should explain the grounds for re- agement decisions be vetted by boards jection and ask for a new nominee. In rather than by criminal investigators. the long run, the ACC should not play While there is growing acceptance of a role in selecting bank management. these truths, more effort should be made The board should also set per- to remove management from the shadow formance bonuses for senior man- of the government. agement and the objective and One possibility is that large PSBs transparent parameters that will trig- create fi nancial holding companies (see ger these bonuses. Larger bonuses later), with the bank and other fi nancial will make the job more attractive, fi rms as subsidiaries, so as to better real- and help attract talent, but the quid ize economies of scope from providing pro quo should be greater effort to multiple fi nancial services. The govern- achieve those bonuses and a greater ance proposals listed above should then risk of losing one’s job (and bonuses) apply to the holding company board also, for underperformance. especially if the bank is a wholly owned With greater authority over top subsidiary. As the PSBs become more in- management, the board can help guide directly owned by the government, and the company in the national interest, as their boards become more vigilant 94 A HUNDRED SMALL STEPS

in safeguarding the value of the bank, has the capabilities of managing the merged and as their management are better paid entity without impairing stability. and better incentivized, the rationale Following these criteria, it should be clear for maintaining oversight of the banks through administrative means such as the that small, regional, and unprofitable banks Central Vigilance Commission become would be a natural candidate for takeover weak. Indeed, when the PSB boards are by well-managed financial institutions that functioning effectively, the government seek complementary assets.12 The screening should legislate to remove the oversight criteria for identifying weak banks may in- of bodies such as the CVC over PSBs. clude parameters like capital adequacy ratio, Holding company structures could also allow the bank to sell more shares to the proportion of NPAs in total credit, return public even while the government re- on assets, return on equity and net interest tains majority control over the holding margin. Responsible boards of target banks company, and thus over the bank. This will recommend offers to shareholders that would enable banks to raise more capital are in the larger interest of their bank. There for growth. A second possibility, which was recom- is little role for the authorities here other mended by the Narasimham Commit- than to welcome such consolidation and tee, is to reduce the government stake to stay out of the way. One question is whether below 50 per cent, so that the bank no the authorities should interfere in direct longer comes under government statutes. approaches to shareholders, bypassing the The government will still have a control- target board (the so-called ‘hostile’ take- ling stake, so this could be politically more palatable than full privatization to over). So long as potential acquirers are some. Moreover, no large sale of shares is deemed fit and proper, there is no reason required for a number of banks. Never- again for them to intervene. theless, such a move will require a change in the statutes, and the political dif- (a) Takeovers of PSBs: A takeover of a PSB by fi culty may be no less than for outright a private or foreign bank will effectively privatization. Yet another option is to be a privatization. Until the political will explore the possibility of divestment of is found to amend the relevant acts, these government shares to other public sector takeovers will be ruled out. Till such time entities (such as provident funds or in- though, takeovers of PSBs by other PSBs surance companies), if that process can or public fi nancial institutions should reduce some of the aforementioned not be discouraged (though there is no constraints on public sector banks, even point in one weak bank taking over an- while retaining ownership within the other). Takeovers of PSBs should be no government broadly defi ned. different from takeovers of private banks, with boards playing a key role. This is yet another reason for strengthening the PSB boards. Proposal 2: Encourage, but do not The key problem, though, is that a force, consolidation number of interest groups in potential target banks have little incentive to be acquired, even if acquisition is in the lar- Given the fragmented nature of the Indian ger interest of the bank. These include banking system and the small size of the all those who will lose position or power typical bank, some consolidation may be in in the enlarged entity, including some order for banks that aim to play on a larger managers, board members, and union stage. Of course, there could still be room offi cers. for small banks that have different aims More incentives may be needed for (see Chapter 3). The main concerns of the banks to seek out matches. One is simply for matches to be brokered in the Finance regulatory authorities should only be whether Ministry. This will defeat the objective the takeover will impair competition in key of decentralizing decision making, and areas and whether acquirer management may not be fair to shareholders. The Levelling the Playing Field 95

Committee recommends against such regulators, and market participants gain ‘marriages made in heaven’. Another is to experience in how to manage takeovers. identify the banks the government wants reformed based on transparent criteria, and set a reasonable time horizon during Proposal 3: Reduce barriers which the board (perhaps led primarily by the non-government shareholders) to competition has leeway to act—whether by merging or seeking out strategic partners. At the 1. Other methods of restructuring. expiry of this time the government could Takeovers are just one way to improve take action, exercising its rights as major- bank structure. But they constrain the ity shareholder. mode of restructuring to whole com- (b) Takeovers by private banks and elig- pany transactions. Other actions should ible fi nancial institutions: Private Indian include: banks and eligible fi nancial institutions (a) Abolish branch and ATM licensing (appropriately structured as holding immediately (other than licensing for companies—see below, and satisfying the foreign incorporated banks in metro fi t and proper criteria) should have full and urban areas based on reciprocity). freedom to take over other private banks While the RBI as supervisor could today provided the above-mentioned con- curb branch expansion for specifi c cerns of regulatory authorities are met. banks that it has prudential concerns They should also be permitted to take about, the norm should be that once over small PSBs that are offered for sale. a bank is licensed, where it puts up A possible route for large public sector branches is its own business decision. banks to acquire more talent, once they As suggested in Chapter 3, the differentiated license for small banks could undertake the governance and compen- include an initial constraint on the sation reforms suggested above, may be overall number of branches and asset to acquire a smaller well-functioning size, but this should be removed on private sector bank. While not minimiz- review. ing the required cultural adjustment, and Domestic banks have not been able while recognizing the risk that talent may to set up branches freely thus far, leave if the acquisition is not handled and will not have anticipated such well, this Committee believes that such liberalization (which was not an elem- possibilities should be considered. ent of the RBI roadmap). Given that Foreign banks that create a separately foreign banks have deeper pockets, incorporated domestic subsidiary in experience, and skills relative to dom- India should have the same rights that estic banks in rolling out a branching private sector Indian banks have from strategy in the newly liberalized en- April 2009, as suggested in the RBI road- vironment, the Committee believes it map (2005). The RBI should allow such necessary to allow a period of say two incorporation freely. Foreign banks that years from the announcement of the seek to operate through Indian branches policy till the liberal licensing policy should be accorded permission based applies to domestically incorporated on reciprocity. The Committee would foreign banks. Till such time, the strongly urge the government to pressure existing policy of branch licensing foreign governments to extend to Indian should apply to foreign banks. They banks the liberal rights that are proposed will, however, be able to acquire here for foreign banks. branches through takeovers of exist- (c) Takeovers of large Indian banks: To the ing Indian banks. extent that takeovers of large Indian (b) Part of the rationale for branch licens- banks (or domestically incorporated sub- ing is the RBI’s attempt to force banks sidiaries of foreign banks) do not raise into under-banked areas in exchange issues of excessive concentration or sta- for permission to enter lucrative bility, they should be permitted. It may urban areas. Regardless of what views be sensible to start by being more liberal are on overall de-licensing, there is towards the takeover of small banks absolutely no reason to not de-license with a view to allowing bidders, targets, under-banked areas immediately for 96 A HUNDRED SMALL STEPS

all banks. Furthermore, banking in can start out de-novo. The only entry underserved areas can be encouraged is likely to be foreign institutions, by instituting a norm—for every x or through conversions of domestic branches that are opened in urban fi nancial institutions to a banking branches, y branches have to be license. But as India grows, it is hard opened in semi-urban or rural to imagine that all the valuable fi - areas. In other words, enforce the nancial ideas will only originate in norm that is now implicit in RBI’s existing institutions. The way to allow licensing decisions, but allow banks entry for smaller and possibly more the freedom to choose how many innovative players is to license small branches to open, where, and when. banks thus facilitating both entry Since branches are likely to become and competition (see Chapter 3 for less important channels for outreach, details). it may be better to focus the norm on The Committee would also urge more objective measures of service the licensing authorities to not focus (which also focuses on including the overly on the level of capital. Large urban poor, an increasingly import- players are not necessarily the most ant category as migration increases). capable, and in the dynamic fi nancial For instance, the norm could be for markets of today, large quantities every x savings accounts that are of capital can be quickly dissipated. opened in high income neighbour- What matters is not the quantity of cap- hoods, y low-frill accounts have to ital but the quality of the promoters, be opened in low income neigh- their management capabilities, their bourhoods. Finally, it may be that the capital adequacy (relative to the size bank is not the best institution to offer of the tasks they undertake) and their fi nancial services over the last mile systems. Provided regulators apply to the poor. In that case, the service stringent entry criteria to banks on provision obligation could become these dimensions, the minimum cap- traded (much as the priority sector ital requirement could be relaxed norms earlier), with small banks or considerably even for scheduled com- cooperatives acquiring certifi cates for mercial banks, and the resultant the excess accounts they provide and entity nevertheless easy to supervise. selling them to defi cient banks. While the process of freeing entry (c) Allow banks to freely exchange or should be undertaken carefully, stabil- buy branches, and close branches as ity concerns can be alleviated by re- alternative mechanisms of delivery of quiring high governance standards, fi nancial services emerge. If a branch higher capital and reserve ratios, closure will signifi cantly impact ser- more transparent and automated risk vices in an area, the authorities could measurement processes linked to a negotiate a transition period. vigilant supervisory regime, and a Eventually all branches that are strict prompt corrective action re- forcibly kept open to fulfi l universal gime. Indeed, the last two steps should service requirements should be paid accompany the process of liberaliz- for through an auction where quali- ing entry. fi ed banks bid for the minimum (e) More generally, the prompt correc- subsidy they need to meet an objective tive action regime (see Chapter 6) level of service. should be strictly enforced, after (d) Entry into banking should be made offering a period of notice, so that more liberal. The purpose of this undercapitalized banks and co- entry is not primarily to increase the operatives are forced to wind down. level of competition, but to bring It will be particularly risky if they are new ideas and variety into the system allowed to continue to operate in a through entry. For scheduled com- time of enhanced competition. Thus mercial banks, the minimum scale freer entry should be accompanied by for entry right now is Rs. 300 crores stricter enforcement. (of capital). This immediately means 2. Levelling the playing fi eld. only large players can enter, and given (a) Banking privileges such as access to the commensurate asset size (Rs. 3,000 the payment system or check writing crores at a 10 to 1 leverage), few banks facilities should slowly be reduced Levelling the Playing Field 97

by allowing more institutions access, together activities of the different subsidiaries but in tandem with reductions in in providing products to customers. banking obligations such as priority The absence of a viable holding company sector lending and other modes of pre-emption such as the Statutory structure means that parent companies that Liquidity Ratio (SLR) and Cash are fully engaged in regulated activities may Reserve Ratio (CRR). While the obli- have to hold subsidiaries in other (possibly gations are in place, though, all differentially regulated) activities. This can entities that are allowed to issue de- create problems, especially in India, where mand deposits should also have to banks are the typical parents, because: undertake these obligations. Once the procedural improvements that are contemplated on priority sector lend- 1. The risks from its investment in lightly ing are implemented, all foreign regulated and volatile businesses can banks should be asked to meet the feed onto the bank’s balance sheet. This same obligations as domestic banks. makes the task of the bank regulator (b) The practice of the government giving more diffi cult. Also to the extent that the preference to public sector entities in bank benefi ts from fl at-priced deposit in- matters such as where to place de- surance, some of the costs are ultimately posits should also cease, as should un- borne by the taxpayer. remunerated obligations such as 2. The need to raise large resources for de- forced support of public issues by ployment in subsidiary companies strains other public sector entities. The pref- the parent company’s ability to fund its erences tend to be at a cost to the own core business. Moreover, under current regulations, a bank’s aggregate in- public exchequer and to the taxpayer, vestment in fi nancial services companies because the government could get (including subsidiaries) is capped at a better deal through a more com- 20 per cent of the concerned bank’s paid- petitive bid. The obligations hurt the up share capital and free reserves. This PSBs, and typically also tend to create clearly limits its ability to grow those ser- other distortions because they are vices (especially the insurance business non-transparent and not paid for. where signifi cant accounting losses accompany a start-up). 3. Regulatory restrictions on the heavily Proposal 4: Moving to holding regulated parent bank’s exposures (to company structures capital markets and to single parties) can limit its overall ability to do business elsewhere. Increasingly, financial firms will provide 4. Tax rules may prevent losses at a sub- services that come under different regulators, sidiary from being offset against parent and products that combine different activ- profi ts, even while they need to be recognized for accounting, disclosure, and ities. While some entities may choose to capital maintenance purposes. Similarly, remain specialized and provide services investments in a subsidiary may have to through joint ventures or collaborations with be carried at book value, even though the other specialized entities, others may choose market value could contribute substanti- to provide a variety of services under one ally to the parent’s net worth and capital. roof. The best way to undertake these activities, while ensuring appropriate regulation, The holding company structure is through a holding company structure. The purpose of a fi nancial holding company Typically, the holding company does not en- is to raise and allocate resources in various gage in any operating activity and its leverage subsidiary companies depending on their is limited (typically to not more than 20 to needs, thereby using capital effi ciently within 25 per cent of the capital). The cash fl ows the group as well as segregating risks across of the holding company come through divi- various fi nancial businesses. The structure dends paid by the subsidiary companies and also allows the parent to coordinate and bring royalties received for use of the brand name. 98 A HUNDRED SMALL STEPS

done away with to ensure the effectiveness of the holding company structure. The re-organizing of current structures into financial holding companies will entail either a transfer of assets or a share swap by the bank/financial institution to the newly created holding company. These de-merging/restructuring transactions will attract payment of stamp duty and will also have capital gains tax implications. A one- It also does not raise short-term public time waiver is required, along the lines of deposits. It should, however, be allowed the benefits accorded stock exchanges at the to raise resources through short-term debt, time of demutualization. subordinated debt and hybrid debt for investment in its subsidiary companies. Both the holding company and the underlying Legislative issues subsidiary companies should be allowed a listing on the stock exchanges. This would The creation of such a structure would re- enable the holding company and the under- quire amendments to certain rules and lying companies to access the capital markets regulations. For instance, Section 12 of the from time to time. In particular, if the holding Banking Regulation Act, 1949 prohibits company owns a bank, the holding company the exercise by any single shareholder of will have to list and be well-diversified. voting rights in excess of 10 per cent, irrespective of the level of shareholding. This would need to be altered in light of Regulation and supervision the holding company structure. The RBI’s desire for diversifi ed ownership of banks The Committee envisages that each hold- can be implemented at the holding company ing company will be supervised by the level, with the holding company listed and Financial Sector Oversight Agency (FSOA, diversifi ed. In addition, the holding com- see Chapter 6). Each subsidiary will be regu- pany could also list the subsidiary bank and lated and supervised by its activity regulator. have only a simple majority holding in it. Of course, the supervisors of the largest sub- Diversifi cation at this second tier will allow sidiaries will play an important role in the the bank a liquid stock, which can be used to supervisory discussions held at the FSOA. raise capital when in times of need.

Taxation related issues Conclusion The holding company should present its accounts on a consolidated basis. Currently, We have made a number of proposals for the Indian system of taxation does not per- reforming the banking sector and to create mit consolidation of accounts at the holding a more even playing fi eld, that can increase company level for tax purposes. The hold- the level of competition, efficiency, and ing company as a standalone entity and the thereby growth and inclusion in the sector. subsidiaries in their individual capacities In the annex that follows, we will offer some are liable to pay taxes on their profi ts. The additional proposals for other segments of double taxation within the group has to be the fi nancial sector. Levelling the Playing Field 99

ANNEXURE 4.1 Of course, products such as insurance will require some regulation, to ensure that the fi rm We do not have the space to go exhaustively in has the ability to deliver its promise. The mutual how the playing fi eld is tilted, sector by sector, and fund company will not be able to offer ULIPs between sectors. Instead, we will offer a taxon- without an insurance license. But this is omy of the kind of impediments that are placed why entry barriers into insurance should be in the way of effi cient allocation of resources. kept relatively low so there are no excess profi ts There is no clear pattern of who is discriminated in that industry. against, with foreign investors or producers being Put differently, any institution should be al- favoured sometimes relative to domestic ones, but lowed to offer any fi nancial product provided also discriminated against on many occasions. prudential and consumer protection issues can Similarly, the public sector can be favoured or be addressed. No product should be ‘reserved’ for disfavoured relative to the private sector. We will a particular type of entity, simply because it has not attempt to diagnose why the fi nancial sector historically focused on it, or because it has a pro- has arrived at these patterns. Instead, we should tective regulator. For instance, mutual funds and focus on reducing them to the essential. insurance companies should be able to compete to offer defi ned contribution pension schemes to fi rms and government organizations. Regulatory silos should be brought down. Regulatory limitations on product offering Differences in taxation A recent controversy should make the point clear. Insurance companies offer products that look Taxation should not create artifi cial differences similar to mutual fund products, but with an between fi nancial institutions. For instance, a cor- insurance component (of varying magnitude). porate investor in the highest tax bracket will pay One such product is an unit linked insurance 34 per cent tax on interest from bank deposits and plans (ULIPs), which has been very successful. an effective 22 per cent tax rate on funds deposited While mutual funds allege that this is because in debt mutual funds. This immediately creates insurance companies have an unfair regulatory ad- a preference for debt mutual funds, which has vantage, insurance companies deny any advantage nothing to do with its inherent capacity to invest whatsoever. assets. Such artifi cial differences should be done The purpose of this example is not to take away with. sides on who is right. Instead, it is to suggest there As another example, foreign institutional in- are two fundamental ways of dealing with this vestors who invest in India through Mauritius problem. One is to keep insurance companies are exempt from taxes on short-term capital gains from providing cheap asset management products while Indian fi rms that manage foreign money by forcing a more signifi cant insurance layer on while resident in India are not. This creates an the products they offer. This hampers competition incentive for Indian fi rms to send asset managers and is not in the best interest of the consumers. to reside abroad so that they enjoy the same tax A better approach would be to diagnose more treatment. While the magnitude of such tax- carefully why ULIPs are popular, and see if there related migration is likely to be small, in the longer are any government/regulator induced differ- run it could come in the way of creating a strong ences that make them so. To the extent that mutual asset management industry in India managing funds have undue burdens, the focus should be foreign money for domestic investment. While it on reducing them rather than on constraining is probably unwise to tax FIIs unduly some way insurance companies. To the extent that success of minimizing the difference in tax treatment may stems from lack of transparency about costs or eventually become necessary to prevent an asset benefi ts, there is a need to increase transparency. manager drain. But to the extent that insurance companies have devised a more attractive product, there is no reason why they should be prevented from selling them. Indeed, it should be possible for mutual Differences in creditor rights funds to tie up with insurance companies so that each provides their specialty (funds man- Some institutions are offered more rights than agement and insurance) more efficiently in a others. For instance, only banks, public fi nancial joint product. institutions, and housing fi nance companies have 100 A HUNDRED SMALL STEPS

the right to seize collateral under SRFAESI or Debt is unfortunate that LIC, being governed by the Recovery Tribunals. It is not clear, for example, LIC Act and not by the IRDA, does not need to why a registered deposit-taking NBFC should not comply with the solvency margin requirements have a similar right—after all, SRFAESI only helps stipulated by the IRDA. There is a strong need to enforce a secured creditor’s rightful claim. This repeal legislation that creates a special status for will assume importance if the economy slows, entities like LIC or SBI. because of the increasing exposure of NBFCs to Finally, regulations or guidelines requiring weaker credits in a search for yield. We discuss public sector entities to favour other public sec- differential creditor rights in more detail in tor entities are no longer warranted and should be Chapter 7. repealed. For example, there is no reason why Another example is asset reconstruction com- Navratnas and mini-ratnas, or the gems among panies (ARCs). Asset reconstruction companies state-run enterprises, should invest up to 30 per have powerful rights (such as replacing firm cent of their surplus funds in public sector mutual management) when they hold suffi cient secured funds only. Similarly, private sector mutual funds debt of a defaulting fi rm. This is useful in securing should also be invited to bid to manage the repayment, and a source of value to the ARC, pension contributions of central government em- which is why there should be many more providers ployees, instead of reserving this for the public of ARC services—it should not be an oligopoly, sector alone. From a national perspective, what let alone a monopoly. While the authorities have matters is how effi ciently the task is carried out, licensed a number of ARCs, high capital require- not whether a public or private fund manages it. ments and strong explicit and implicit restrictions on foreign participation and control make many inoperative, leaving only a very few active. While Different application of regulations the reluctance of the authorities to confer such powerful rights on all and sundry is under- Regulators should not override more generally standable, it is also unwise to create rights that applicable regulations in order to favour particular only a few can be trusted with. In some ways, it entities. For instance, accounting rules are there may be better to have a more competitive indus- for a purpose, to present a true and fair picture try with fewer rights than an oligopoly with power- of a fi rm’s condition. A regulator cannot simply ful rights. Better still would be a competitive decide to waive rules for its regulated entities be- industry with appropriate creditor rights. cause the rules would reveal inconvenient losses or reduce profi ts. When the RBI allows small urban cooperatives Differences in access to the to maintain lower SLR or extends to 180 days from sovereign, the regulator, or the normal 90 days the period of delinquency before assets have to be provisioned for as non- other public sector entities performing, and relaxes these requirements in order to boost the cooperatives’ capital and pro- Public sector entities have the possibility of a fi tability, it is indirectly suggesting that the weaker government bailout, which lowers their cost of norms will not affect their stability. In that case, all funds considerably. Short of privatization, there banks have the right to ask why they too cannot be is little one can do about this. And as we have subjected to weaker norms, so that they can boost argued, there are other government-imposed profi tability. Of course, no one would question the constraints on public sector fi rms that offset these RBI if it tightened regulations beyond the norm advantages. for some risky banks—that is its job. This does not mean, however, that attempts As another example, minority shareholders should not be made to make the playing fi eld in public sector entities should have the same more level both in terms of advantages and in protections against mis-governance by the major- terms of costs. For instance, the LIC Act stipulates ity shareholder as do minority shareholders in a sovereign guarantee for the policies issued by the private sector fi rms. The government should not Life Insurance Corporation of India (LIC). This have the right to erode the value of public sector explicit guarantee should be revoked through fi rms (other than wholly owned ones) through legislation so that the guarantee is left implicit directives to undertake unremunerated activ- for new policies. ities, at the expense of the minority shareholder. In addition, public sector fi rms have a greater As a fi rst step towards this, the rights of minority duty to follow prudential requirements so that shareholders in PSUs should be brought on par they limit the advantage they get from the im- with those of minority shareholders in private plicit government guarantee. In this regard, it fi rms. A necessary step in this direction is for PSU Levelling the Playing Field 101

Banks’ Accounts to be put to vote at the annual pensions—as it stands, they are overly exposed general body meetings by the shareholders. to India risk. Alternate asset classes may also be considered in due course. In liberalizing restrictions, however, it is important not to attempt to direct fl ows to favoured Limitations in investment choice sectors through selective liberalization, but to liberalize more generally. India’s experience with There are many examples where the asset choices directed credit has been abysmal, with flows of an institution are limited through regulation. historically going into sectors with low pro- One reason is prudential—for liquidity or solvency ductivity that happen to be favoured.15 Selective reasons, the regulator requires some investment liberalization will tend to push resources to the in safe assets. A second reason is the capability selected sectors only, distorting prices, inhibiting of the fund manager—when an industry like resource allocation, and increasing risk. For ex- insurance or pension management starts out, it ample, it may be tempting for the authorities to may be prudent to limit investment choices till the allow insurance companies or pension funds to manager (and the regulator) acquires capabilities invest some of their assets in infrastructure. But and confi dence. if these asset managers have no other choices But maintaining such limitations beyond when (other than government securities) they may they are strictly needed can be both ineffi cient and under-price credit to the infrastructure sector, de-stabilizing. For example, given the strength of and fi nance too many unviable infrastructure India’s capital markets, there is really no need to projects, at great risk to their policy holders or use bank statutory liquidity ratio requirements to pensioners. Infrastructure is risky, and while it is fund government debt. Instead, these should be good to allow insurance companies and pension lowered to a level consistent only with prudential funds to build exposure to it, it should be out of requirements. Indeed, too much exposure to choice and not because it is the least bad of their government debt has proved a source of signifi cant limited options. Liberalization of asset portfolio banking system risk in other countries (though choices should be broad based so that credit is Indian bank exposure is certainly not at alarming not directed, however well-meaning the intention, levels today).13 More important, a captive market into the wrong places. for government debt prevents it from being priced Finally, before closing this section, it is useful properly, and from sending the right signals to the to note another example of how well-meaning market and to the government. policies can indeed build-up costs and risk. Cur- Similarly, restrictions on the types of private rently GIC is the sole re-insurer in the Indian securities that insurance companies and pension market, with the general insurers having to com- funds can hold tends again to artifi cially boost pulsorily cede 15 per cent of their business to GIC. demand for government debt, while limiting Foreign re-insurers can only operate in India as their risk diversifi cation. It also reduces the access joint ventures with the 26 per cent FDI cap. So important sectors of the economy have to long- far no foreign re-insurer has shown interest in term funds. For instance, there is no reason why entering the Indian market with a joint venture. these institutions should not hold diversified The net effect is that the prime source of re- portfolios of domestic corporate assets, private insurance within the country is a domestic insurer, equity positions, and securitized retail assets as whose capital is likely to be greatly impaired if the part of their overall asset portfolio. This would country is hit by a calamity. Of course, GIC may give a boost to sectors of the economy like infra- have laid off the risk in international markets structure, technology, and housing that provide through re-insurance. But then it will have added the kind of long-term fi nancial assets that insurers multiple and costly layers of intermediation that and pension funds like, and would end the anom- could have been avoided simply by freeing in- alous situation where foreign pension and insur- surers to reinsure with whomsoever they please. ance funds are extensive users of the Indian equity The point is requirements such as these tend to market but domestic pension funds are not. concentrate risk and increase costs. Moreover, there Equally important, given our enormous sur- are some types of business—such as catastrophic plus foreign reserve position, it is high time we re-insurance—that should be exported simply encouraged our fi nancial institutions to diversify because foreign capital, not domestic capital, is into foreign government and corporate assets most appropriate to insure Indian entities against (see Chapter 2). This can be done at relatively large shocks (much as foreigner funded ARCs are low cost.14 Not only will this reduce the burden appropriate). It is therefore entirely appropriate on the RBI of managing foreign infl ows, it will that the decision to steadily eliminate compulsory provide useful diversifi cation to our insurance and cessation has been taken. 102 A HUNDRED SMALL STEPS

Discriminating against service 11. The rationale for focusing on underperforming PSBs is simply that the need for governance providers based on national origin improvement (and thus the possibility of transformation) is much greater there, and the political If India is to build a strong asset management willingness to sell is likely to be higher. industry, Indian asset managers should be able to 12. We refer to weak banks only because there is provide foreign investment opportunities to dom- greater value to taking them over, and less con- estic investors, as well as domestic investment troversy. Nevertheless, no bank should be immune from takeover, except on grounds of excessive opportunities to foreign investors. It is some- concentration. what paradoxical that our system bars domestic 13. Even in India, US 64 was included in the list of asset managers from providing portfolio manage- approved securities till the scheme ran into dif- ment services for overseas clients, unless they fi culty, forcing the government to bail it out. This create asset management vehicles outside India. highlights the hazards of labelling securities as This creates additional transaction costs and preferred and hence safe investments. makes Indian AMCs even less viable while com- 14. For instance, moderate amounts of foreign equity peting with tax-favoured foreign asset managers or corporate debt exposure can be acquired by for fund management business from foreign buying exchange traded indexed funds or invest- clients. ing in index portfolios, a relatively low cost way of acquiring exposure without signifi cant man- We also create roadblocks in asset managers agement fees. taking money out—in their managing offshore 15. See Wurgler (2000) for evidence. equity under portfolio management schemes, or offering products that invest in domestic as well as offshore equity. All this while residents can move capital out of India and then purchase products REFERENCES offered to them by foreign product providers. At a time when India would like to export capital, Banerjee, Abhijit V., Shawn Cole, and Esther Dufl o, 2005, ‘Bank Competition in India’, Sixth Annual as well as boost the asset management industry Conference on Indian Economic Policy Reform, and the high-paying jobs it creates, these impedi- Stanford Center for International Development. ments may stunt growth. Barth, James, Gerard Caprio, and Ross Levine, 2006, Rethinking Bank Regulation: Till Angels Govern, Cambridge, UK: Cambridge University Press. Beck, Thorsten, Asli Demirguc-Kunt, and Vojislav NOTES Macsimovic, 2004, ‘Bank Competition, Financ- ing Constraints, and Access to Credit’, Journal of 1. There are some restrictions. In the United States, for Money, Credit, and Banking, 36(3): 627–48. example, only checks over US$250 can be processed Claessens, Stijn, and Luc Laeven, 2004, ‘What drives by money market funds. With time and infl ation, Bank Competition? Some International Evi- this is becoming less and less of a constraint. dence,’ Journal of Money, Credit, and Banking, 2. Claessens and Laeven (2004). 36(3): 563–83. 3. See Beck, Demirguc-Kunt and Macsimovic Cole, Shawn, 2007, ‘Fixing Market Failures or Fixing (2004). Elections? Elections, Banks and Agricultural 4. See, for example, Schnabl (2008), who looks at Lending in India’, Working Paper. the case of Peru in the 1998 crisis. Foreign banks Detragiache, Enrica, Thierry Tressel, and Poonam brought in capital when capital dried up for Gupta, 2006, ‘Foreign Banks in Poor Countries: domestic banks, and were a signifi cant factor in Theory and Evidence,’ IMF Working Paper 06/18. fi nancing domestic fi rms during the crisis. Washington: International Monetary Fund 5. This evidence comes from a study of very poor (January). countries—Detragiache et al. The Mexican ex- IIMS Dataworks, 2007, ‘Financial Inclusion and Access’, perience, where a huge part of the domestic Discussion Paper, 25 October. banking sector was sold to foreign banks, which McKinsey & Co., 2007, ‘Indian Banking: Towards Global were cautious in lending, with attendant effects on Best Practices—Insights from Industry Bench- aggregate credit growth, is also a salutary one. marking Surveys’, November. 6. McKinsey (2007). McKinsey Global Institute, 2001, ‘India: The Growth 7. McKinsey Global Institute (2001). Imperative’, September. 8. Banerjee, Cole and Dufl o (2005). Schnabl, Phillip, 2008, Financial Globalization and the 9. Cole (2007). Transmission of Credit Supply Shocks: Evidence from 10. Cole (2007). an Emerging Market, Working Paper, MIT. Creating More Effi cient and Liquid Markets

THE ROLE OF FINANCIAL 5. Allow for better allocation of resources MARKETS IN GROWTH, in the economy, including taking away resources from declining sectors and re- STABILITY, AND INCLUSION investing them in sunrise sectors. This function improves both the effi ciency Financial markets have a very important role with which scarce capital is used, as well chapter to play in a modern economy. Specifi cally, as the overall stability of the economy. 6. Equity and bond markets also serve as 1. Well functioning fi nancial markets allow a buffer, passing losses from risky ven- risks to be borne by investors who are tures directly to households that would 5 best placed to bear them. For instance, otherwise be passed on to more fragile instead of farmers bearing the risk of institutions. crop price fl uctuation or total crop fail- 7. Improve macroeconomic policy setting ure, diversifi ed investors in cities or from as well as transmission. For example, the abroad can bear that risk through com- RBI has a better sense of how infl ation modities futures markets or through crop might evolve by looking at the yields of insurance. long-term bonds, and its own actions in 2. A healthy market also provides clear altering the short-term interest rate could signals about which companies and sec- have much stronger effects across the tors are doing well (the price of equity in spectrum of government and corporate those companies and sectors goes up), bonds if these markets worked well. which commodities are likely to be in short supply (the futures price rises), In what follows, we elaborate on some and whether the RBI is doing a good job of these benefits of markets to the Indian in keeping infl ation under control (the economy. While these may be obvious to infl ation premium in long-term bond some, far too many people in positions prices is low). of authority in India are unconvinced by 3. Financial markets can also bring the users of capital and savers together at low cost, the importance of markets, and hence the eliminating layers of intermediation, and knee-jerk reaction to ban them or intervene thus costs. One virtue of bond market fi - in them whenever they send unpleasant nance over bank fi nance, for example, is messages. that it allows investors to bear the credit risk of the fi rm they are investing in directly, without going indirectly through a bank. For high quality fi rms, this could Why are markets becoming more entail substantial cost savings. important in India today?

Better risk sharing, better information Corporations signals, and lower costs combine to: In the last decade, Indian fi rms have been 4. Reduce the cost of fi nance for fi rms, house- transformed by the forces of competition holds, and the government, allowing them and the economy’s integration with the to fi nance investment and innovation and grow. Since the poorer sectors are world economy. Firms which were stagnant, hurt most by high costs, this effect can be eking out a respectable rate of return by a substantial force for greater inclusion. doing the same thing year after year, were 104 A HUNDRED SMALL STEPS

confronted with global competition. In (3) Control is not concentrated in a few fi- response, Indian firms have improved nancial institutions which could limit com- productive efficiency and increased their petition in the market. focus on research and development. Some This is not to say that financial institu- have turned themselves into multinationals tions have no role to play in equity markets. with overseas investments. As fi rms move Institutions such as venture capital provide towards the technological frontier, there is the financial nurturing and management greater technological risk. support needed to take entrepreneurs from Also, as India becomes richer, it will in- the garage to the market. Mutual funds and creasingly experience business cycles and pension funds play an important role in the the attendant risks. Corporations will have governance of existing firms, while insti- to have sufficient financial cushions to deal tutions such as private equity and hedge with downturns—they will have to live funds help restructure firms that are poorly through inventory build-ups, and sustained managed, and provide the risk capital and periods of low demand and low profitability. management to rescue failing firms. Moreover, as India becomes more open, its corporations have to deal with new risks such as the effect of exchange rate movements on Corporate and government debt their competitiveness. On the debt side also, markets will become more important. The size of some infra- Equity fi nancing structure projects such as power plants are so large that no bank can take a reasonable Even after corporations have obtained the stake without breaching concentration full benefi ts of risk reduction through oper- limits. These projects require substantial ational fl exibility (such as the ability to alter amounts of bond market fi nancing. Some workforces and production locations and institutions such as NBFCs offering long- schedules—far more needs to be done on term fi nance will also need fi nancing them- this front in India) and through hedging selves. By borrowing from bond markets markets, there will be a secular increase in rather than from banks, they can achieve a the uncertainty faced by fi rms in this new better asset liability match, as well as reduce environment. As profi ts become less reli- the risks the banking system is exposed able, and as research and development and to. Corporate bond markets can work as new technologies become a greater part of effective buffers here. Unfortunately, the fi rm activities, as India moves away from corporate bond market is still miniscule the asset-intensive mature industries of old and will need to develop to meet these needs. to the human-capital-intensive industries Effective infrastructure fi nance would also of the future, equity fi nancing will become depend on the existence of deep and liquid more important. derivative markets where the specifi c risks In principle, equity financing could be associated with infrastructure projects can obtained from development finance insti- be managed. tutions or from universal banks. Among the The government will also need a vibrant virtues of obtaining finance directly from government bond market to provide it low- equity markets are: (1) Risk is spread across cost financing, as it relies less on forcing more shoulders so that riskier, higher-return banks through statutory requirements to projects can be financed; (2) The market is hold its debt. A deep government debt not dominated by one bureaucratic view, market across all maturities will provide the so that many varieties of technologies are benchmarks that the private sector needs for financed, with some doomed to fail and pricing corporate debt, and various kinds of others becoming a Google or Infosys; hedging instruments. Creating More Effi cient and Liquid Markets 105

International a strong equity market already in place, but the environment needs to be made more As Indian fi rms turn themselves into multi- conducive to private equity, venture capital, national corporations, and engage more and hedge funds. Mutual funds and pension closely with the world economy, they will funds (when they emerge) should play a more require international financial services, active role in governance. The corporate the production of which is impeded by an bond market is moribund and will have to inward-looking financial system, missing be revived, and a number of missing mar- markets for hedging products, and vestiges kets will have to be created. Indian firms and of the system of capital controls. Indeed, investors need better access to international one of the themes in this chapter is that a financial services, and the production of fuller opening to foreign capital and insti- international financial services by Indian tutions, as well as a more outward orientation financial firms needs to be enhanced. of Indian financial institutions, can help achieve domestic goals such as greater fi - nancing for infrastructure, even while mak- Are markets casinos? ing Indian fi rms more competitive in the world economy. Despite all the legitimate benefi ts of markets described in the previous paragraphs, a number of serious commentators have con- Households and diversifi cation cerns about the development of what they term ‘casino capitalism’. Is the fi nancial world For far too long, the Indian saver has got short engaged in trading securities that have no shrift. Too many Indians do not have savings links to reality? Is the stock market or futures that are protected against infl ation, let alone market simply legalized gambling, which earning decent real returns. Many do not diverts time and attention from the worthy have suffi cient exposure to equity because of task of building the real economy? Are specu- archaic rules on where the institutions they lators setting futures prices for grain way save in, such as provident funds, can invest. before prices are actually realized and thus Even while foreign institutions have gained ‘manipulating’ the grain market? Without annual double digit returns from the rise in convincing answers to these questions, mar- the Indian equity market (and deservedly so kets will have little legitimacy. because they were willing to take the risk), It is true that a number of investors are risk- some Indian institutions, forced by regu- seekers, much like gamblers, and that there is lation to invest primarily in government a certain amount of luck in who makes money securities, have completely missed the rise in and who loses money in any single market equity markets. Indian investors are not even transaction. But unlike gambling, which is as well diversifi ed against risk as they could based purely on luck, the investor in financial be. Of course, the equity market fl uctuates. markets has a view of future outcomes, and While those who have owned equity over it is this that allows prices to be informative time have done well, many are overexposed because the price aggregates collective infor- to the Indian market and its fl uctuations, mation. And informative prices affect real and would well benefi t from a more diver- decisions and thus help the economy, unlike sifi ed global portfolio. Here again regula- pure gambling, which only involves transfers tions and restrictions come in the way of from losers to winners. mitigating risk. The important point that more com- Financial markets and institutions need mentators need to understand is that price to evolve considerably in order to keep up fluctuation in financial markets does not with the requirements of Indian firms and mean more economic instability, and con- Indian investors in coming years. India has trolling prices can create economic instability. 106 A HUNDRED SMALL STEPS

For example, when bad news appears about stability is worsened directly and indirectly. a country, well functioning financial mar- The direct impact takes place through the kets such as equity, currency, government lack of financial markets as shock absorbers. bonds, corporate bonds, etc., all adjust. Thus, The indirect impact takes place through the bad news about fundamentals creates price negative impact upon public and private fluctuation. But the price fluctuation itself decision making that comes from the lack creates equilibrating forces. If the bad news of information. results in reduced prices on the securities Even the short term speculator who is markets and currency depreciation, while interested only in pure profit plays a useful some economic agents might panic and role, for example by taking the other side take money out of the country, many others in hedging contracts. If farmers want to would see reduced prices as buying oppor- hedge the price of grain by effectively selling tunities. These purchases would act as an it in advance through the futures market, equilibrating influence. Flexibility of financial someone has to take the other side. There prices induces stability in the economy.1 By are often a few firms such as grain mills that contrast, if the government prevented price want to lock in their future input prices. movements on the securities markets and But typically there are too few of them. The currency market by propping them up, this speculator plays a useful role by offering a would give the many smart participants who fixed price to the farmer, and betting that he thought the market was overvalued a con- will make some money in the process. Com- venient exit route. The government action mentators who complain some market is full would support capital flight from the country, of speculators do not understand that the leading to a bigger fall when the government speculator is playing a vital role. Both sides ran out of money. Far too many currency are better off—the farmer because he gets crises and banking crises have been created price certainty; the speculator because he by governments; attempting to prevent price makes a little profit on average. What keeps movements through intervention. the speculator from making outsize pro- Flexible financial prices are a shock ab- fits is competition from other speculators. sorber. When times are good, if the exchange This is why we need deep and liquid mar- rate appreciates, this reduces the profit rate of kets with many players—that is precisely corporations producing exports or import- what prevents market manipulation. competing goods and slows investment. Finally, there is still tremendous dis- When times are bad, if the exchange rate trust of certain products such as financial depreciates, this enhances the profit rate of options, or more generally derivatives, which these corporations and spurs investment. seem to involve pure directional bets rather Through this, a flexible exchange rate acts as a than any financing. But there is now uni- stabilising force in the economy. Equivalently, versal agreement about the importance of the high futures grain prices give farmers an infrastructure of transportation and com- incentive to invest, and an ability to lock in munications, and a recognition of the role gains, so that production rises and brings of the private sector in (say) building and down prices. The stability that matters is operating a highway. When a private firm the stability of output and employment, embarks on such a task, it requires financ- and not stability of financial prices and ex- ing from banks, equity, and debt markets. change rates. Indeed, when government tries But sophisticated derivatives markets which to prevent movements of prices on financial enable the promoter to protect against fluc- markets, this yields greater instability of tuations in exchange rates, interest rates, output and employment. macroeconomic risk, natural disasters, etc., A full set of financial markets thus acts as a are as much a technological input into a source of information and enhances stability. road project as are the state-of-the-art con- When these markets are missing, systemic struction equipment which is now being Creating More Effi cient and Liquid Markets 107 deployed in India. Greater sophistication to nurture new fi rms and new projects, com- in financing leads to reduced user charges petitive pressure against incumbents is re- and a larger pace of infrastructure invest- duced. This has far-reaching ramifi cations ment. The sophisticated infrastructure for the meritocratic dynamism, the pace of transportation and communications, of technological change, and the rate of which is desired by all, critically requires GDP growth of the country. This also has sophisticated financial markets. implications for inclusion: when finance In some areas, there are also opportunities does not support and enable entry against for utilizing hedging markets in pursuing incumbents, the profi t rates of incumbents the goals of public policy in India. As an are enhanced, and this leads to entrenched example, the goal of food security can be pockets of wealth and infl uence. achieved at a lower cost if the government From the viewpoint of competition in the held long positions on commodity deriv- economy, external financing is important. atives markets, through which the govern- A profitable incumbent generally has re- ment could access physical grain under tained earnings, and is able to invest and certain scenarios, instead of holding physical grow using this. New entrants lack that inventories of grain at all times. internal cash flow; their entry is critically More generally, financial markets are enabled by the availability of external equity far from casinos when they function well. and debt capital. For relatively safe projects, However, such an outcome cannot be taken external debt financing is appropriate, for granted. The authorities have to create and this requires a well functioning debt sound deep liquid markets by fostering market. When risk levels are high, external transparency, competition, and enforce- financing must come in the form of equity ment against fraud. In the absence of that, financing. This requires a corresponding financial markets can be worse than casinos well functioning equity market. As an ex- in that, unlike a well-run casino, the odds will ample, while borrowing made up 27 per cent be stacked against the average investor. of the liabilities of non-financial firms in Similarly, derivatives offer very useful tools India in 2006–07, the corresponding value for for laying off risk, and can thus increase the software companies was just 8 per cent.2 This level of investment without resorting to less illustrates the unique role of equity financ- efficient devices like government guarantees. ing in fostering high-risk, high-technology, But derivatives are like dynamite—used human-capital-intensive projects. properly in construction, they can move Banks could play a role in nurturing new mountains; used improperly, they cause firms, but are typically far better at financing tremendous damage. The point then is mature well-understood technologies than to create all the conditions that will make green-field projects. India has vibrant equity markets work well, and participants behave markets, and a significant number of sunrise properly, so that the nation can derive the max- industries like software or biotechnology imum benefits from markets. that depend on these markets for financing. In this sense, it has already evolved away from a bank-dominated financial system Financial markets and competition characteristic of emerging markets.

When an entrepreneur has ideas but not capital, the fi nancial sector plays a critical The inclusion agenda role in enabling fi rm entry and growth by infusing debt and equity capital. Competition In India, over the 29 years for which data are in the economy is fostered by a fi nancial available, a passive investment in an equity sector which is able to perform this role ef- index generated average nominal returns of fectively. Conversely, when fi nance is unable 19 per cent per annum.3 Yet, equity portfolios 108 A HUNDRED SMALL STEPS

are held by only a small number of house- into economical order sizes, and then place holds in India.4 Equity investments are not appropriate orders. Financial firms and a luxury, they are an essential element of any NGOs have to improve their own levels of fi- long-term savings plan, for they offer the only nancial sophistication and the efficiency of true protection against infl ation. In a de- their transactions processes to intermediate veloping country like India, they also allow effectively, but when this happens, the poor everyone to participate in the growth story, will be great beneficiaries from hedging not just the rich. While equity is risky, two markets also. In the Chapter on Financial factors help mitigate risk to acceptable levels Inclusion, the Committee has recommended for even the poor. First, equity portfolios have the setting up of a nationwide electronic to be diversifi ed, not just domestically but financial inclusion system (NEFIS). This also internationally. Stock picking is not for would enable payments as ‘micro’ as Rs. 100 the average investor, indexation is. Second, in cash and as ‘nano’ as Re. 1 in electronic equity needs to be invested over the long run. form (as a debit or credit to an account), High returns of diversifi ed equity portfolios to be carried out at reasonable transaction have been observed all over the world over costs. Once transactions costs are lowered, the long run, and we need to make sure all the poor can hope to participate in a wide Indians have access to these returns. variety of financial markets, such as equities The participation of more poor (and and commodity derivatives, beyond just foreign) investors in Indian markets would savings, credit and insurance. also improve the markets’ liquidity and depth, However, cutting transactions costs of making them even less susceptible to un- micro-payments is only one part of the task. warranted fluctuation. Thus the inclusion Given the small size of transactions, such as agenda should also be seen as part of the say a Rs. 200 per month systematic invest- growth agenda. ment plan (SIP) or a sale of five quintals paddy, The poor are not just savers—they can would require aggregation, before willing also be borrowers who need financing. More counterparties are found. This aggregation attention needs to be provided on finding infrastructure requires a new category of ways to link up the capabilities of finan- players in the market. For example, in case of cial markets—in supplying equity and debt the SIP, it could be a self-help group (SHG) capital at a low cost in high volume—with of 10 women, saving Rs. 20 each and pooling the entrepreneurial energies of individuals it monthly to invest in a Rs. 200 pm SIP. This spread all across the country. In Chapter 7, we would require mutual funds to recognize discussed the importance of securitization SHGs as legitimate participants, just as ten in refinancing financial firms lending to years ago, banks began to permit SHGs to the poor. Further progress requires greater open bank accounts. The rule about a PAN competition and innovation amongst fi- number would have to be revisited for an nancial firms, which would induce new SHG. technological and business models through Similarly, to enable a minimum 10 ton which transactions costs are lowered and transaction take to place on a commodity barriers to access overcome. This Committee derivatives exchange, 20 small farmers with cannot predict what models will emerge, but five quintals each will have to be brought it is confident that given the innovative spirit together for a single options contract. This of Indians, new ones will. could be done by a farmers’ cooperative or Finally, we have argued in Chapter 3 that a warehouse keeper. The service charges of the poor need products that lower risk, even the aggregator will add to the transaction more so than the rich. Financial markets costs and to that extent make options less provide such products, but a financial inter- attractive. Thus it is important to develop mediary has to interact with the poor to deter- simple aggregating mechanisms, with mine their needs, aggregate their demands as much standardisation and electronic Creating More Effi cient and Liquid Markets 109 transaction recording as possible so as to In a well functioning fi nancial system, all minimize the need for discretion and cash these prices—exchange rates, interest rates handling. for government bonds and interest rates for Another important constituency that has corporate bonds—are tightly linked through not been reached by financial markets in arbitrage. The key policy goal in this area lies India is the small business sector. Small and in fully linking the markets, and for these medium scale businesses are vital for growth markets to (in turn) be linked to other fi nan- and employment creation. There is a need to cial markets such as the equity market. When find innovative ways for small businesses to India achieves a well functioning BCD Nexus, raise debt and equity, and to hedge their fi- this would have a number of implications. nancial risks. By definition, small businesses It would enable funding the fi scal defi cit at are too small to directly access public equity a lower cost and with reduced distortions. markets, but their capital needs can be met It would produce sound information about through specialized funds that provide funds interest rates at various maturities and credit to small businesses and in turn are subject to qualities, which would shape investment plans market discipline. of fi rms and give them access to debt fi nanc- Markets are driven by information, and ing. In particular, this would strengthen systematic information dissemination can fi nancing for debt-heavy infrastructure pro- help direct capital to credit and equity pools jects. Monetary policy involves changes in the of various sizes and segments. For example, short-term interest rate by the central bank; if there was a monthly or quarterly posting the BCD Nexus would enable the ‘monetary of the analysis of bank NPAs by loan size and policy transmission’ through which changes segments, and it became widely known that in the short-term policy rate reach out and loans below Rs. 10,000 to Dalit women in infl uence the economy through the market Bihar have only a 0.1 per cent NPA while loans process of changes in all other interest rates above Rs. 1,000,000 to MBA students have for government bonds and corporate bonds. 4.3 per cent NPA, it is likely that some market Finally, the currency spot and derivatives mar- participants will overcome their aversion to ket would link up the Indian bond market working with Dalit women of Bihar. Simi- to the world economy and reduce excessive larly, if it became clear that a cluster of small price or interest rate differentials. businesses in a particular industry can gen- In mature market economies, the full set erate above market returns, investors will be of financial markets produce a unique array willing to invest in funds that however, for of information including forecasts of vola- such micro markets to be discovered, the infor- tility of all traded products, estimates of expec- mation infrastructure has to be created as a tations of the market such as beliefs about public good. The CGAP Mixmarket data base inflation in the future and expectations about of 1,000 plus microfinance institutions is an the future course of monetary policy. This in- example of such an effort. While it is difficult formation plays an important role in inform- to anticipate solutions, the approach should ing and improving decision-making processes be to encourage intermediaries who are able in both the public sector and the private sec- to provide capital to those excluded today, but tor. In particular, it is particularly important are in turn subjected to market discipline. for the operations of the central bank. This is one important benefit of fostering a complete set of well functioning markets. Getting the full range of markets and its effect on policy Markets and risk-taking The Bond-Currency-Derivatives (BCD) Nexus is the interlinked set of markets on govern- As we argued earlier, while capable of creating ment bonds, corporate bonds and currencies. enormous good, every fi nancial product is 110 A HUNDRED SMALL STEPS

also capable of creating enormous losses THE NEED TO IMPROVE for the holder. Participants have to develop LIQUIDITY AND MARKET a level of sophistication to use them well. EFFICIENCY Given the limited fi nancial literacy in this country, there is a role for segmenting mar- Let us start with how one would measure kets, so that only ‘sophisticated’ or institu- the performance of markets. The two critical tional participants can participate in certain features of a well functioning fi nancial mar- markets, while retail customers have to ket are market effi ciency and high liquidity. go through an intermediary. Even then, it Both these are ‘outcomes’ measures. sometimes turns out that the ‘sophisticated’ Market efficiency is the extent to which take excessive risks, or do not understand information and forecasts about the future what they are doing and burn themselves. are impounded into financial prices. Liquid- This is normal—corporations make losses ity pertains to the ability to transact with low all the time making real products, and will transactions costs. It has three dimensions: make them in financial products also. The immediacy, depth, and resilience. Immediacy only way they will learn to be more circum- refers to the ability to execute trades of small spect is if they are forced to absorb the full size immediately without moving the price consequences of their actions. Indeed, in adversely (in the jargon, at low impact cost).5 many financial markets, for every side that Depth refers to the impact cost suffered loses, there is another side that gains, so when doing large trades. Resilience refers to unlike with real losses, the economy as a the speed with which prices and liquidity of whole does not lose. the market revert back to normal conditions The real regulatory concerns are three. after a large trade has taken place.6 First, do participants have a reasonable level The two concepts of efficiency and li- of sophistication so that they can under- quidity are linked. In order for markets to be stand the products and their consequences? efficient, market participants who obtain Second, are products sold with adequate information have to be able to trade on that disclosure so that these participants under- basis and impound that information into stand (or can understand if they ask reason- prices. For economic agents to have an incen- able questions) the risks they are taking? tive to expend resources in information pro- Third, are the systemic consequences of price cessing and forecasting, markets must be movements in any direction likely to be liquid, else any profits from the activity will limited? In a developing economy like India’s, be dissipated in the transactions costs alone. the first two concerns are important, but slip- Expensive or infeasible transactions reduce page there can be absorbed provided the third the profits from successful forecasting. This concern is addressed. Indeed, in the process (in turn) inhibits the investments made in of learning, there are bound to be losses for information processing and forecasting. Mar- some parties (such as recent unverified re- ket liquidity is thus a critical precondition for ports of large corporate losses on currency market efficiency. In turn, market efficiency derivatives), but so long as the systemic con- assures uninformed participants that mar- sequences are contained, these should be ket prices are up-to-date and reflect funda- viewed as the costs of market development. mentals, so they can trade safely. This in turn Indeed, such costs are borne by the economy provides volumes that ensure liquidity. in numerous situations when new technol- Table 1 summarizes the state of Indian ogy enters the country for the first time. financial markets on the three aspects of fi- In what follows, we will diagnose how well nancial market liquidity. In the view of the Indian financial markets are performing Committee, resilience is found in the large and the sources of the deficiencies, and offer stocks, their stock futures, and the index fu- proposals to rectify some of the problems. tures. All other markets in India lack resilience. Creating More Effi cient and Liquid Markets 111

Table 1: Liquidity of Indian Financial Markets Market Immediacy Depth Resilience Large cap stocks/futures and index futures Y Y Y Other stocks On the run government bonds Y Y Other government bonds Corporate bonds Commercial paper and other money market instruments Near money options on index and liquid stocks Y Other stock options Currency Y Interest rate swaps Y Y Metals, energies, and select agricultural commodity futures Y Other commodity futures

Depth is found, in addition, with on-the-run the efforts being put in for the outcome. All government bonds and interest rate swaps. the effort is a means to an end. That end is Immediacy is found in a few more mar- market liquidity and market efficiency. In- kets. A well functioning market is one which puts such as technology or trading systems has all three elements. India has only one mar- are neither necessary nor sufficient. Some ket where this has been achieved, for roughly technologically primitive markets—such the top 200 stocks, their derivatives and index as the floor trading which once dominated derivatives. the exchanges of Chicago—had achieved When a financial market does not exist, tremendous liquidity and market efficiency. or is inadequately liquid to meet the require- Conversely, Indian finance is replete with ments at hand, or suffers from deviations advanced trading technology and trading from fair price, this constitutes market in- platforms, but the end-goal of liquidity and completeness. Economic agents are unable market efficiency remains elusive on most to enter into transactions that they require elements of the financial markets. There is for conducting their optimal plans. Market more to achieving liquidity and efficiency incompleteness has many pernicious impli- than setting up trading platforms using in- cations for resource allocation and ultimately formation technology, and ticking off some GDP growth. boxes in IOSCO checklists. Many official documents have emphasized Table 1 highlights some genuine accom- the efforts made by government in trying to plishments in achieving liquid financial create a policy environment that would fos- markets in India. At the same time, it high- ter liquidity and efficiency. As with all aspects lights the journey ahead. Achieving a sound of government, a greater focus needs to be set of financial markets is synonymous with placed on outcomes. Input measures—such achieving a ‘Y’ in all the cells above. This re- as the policy efforts that have been put in— quires diagnosing the reasons for the empty are unimportant in the final analysis. What cells, and identifying policy paths through matters is the outcome: whether a liquid and which those difficulties can be addressed. efficient market was achieved or not. A particularly important point, that At first blush, a lot of activity is visible in would be apparent if we also saw the table almost all parts of Indian financial markets. A for 2003, is the lack of progress. In the period great deal of hardware and software has been 2003–08, three elements have come through: acquired; an alphabet soup of new acronyms the onset of immediacy with near money is in the air; many IOSCO checklists are filled options on index and liquid stocks, the onset out. However, it is important to not confuse of immediacy and depth on the interest rate 112 A HUNDRED SMALL STEPS

swap market, and the onset of immediacy policy environment that comes in the way on some commodity futures products. In is the banning of products and markets. As other words, in a table with 36 elements, the an example, products such as currency fu- progress over the latest five years has con- tures and commodity options are banned. sisted of going from 7 cells to 10 cells. This A market that is banned can obviously not is disappointing progress, given India’s rapid attain liquidity or efﬁ ciency. Equally prob- growth and India’s urgent requirement of so- lematic, a missing market can hamper the efﬁ - phisticated financial markets. Policymakers ciency of other markets also. For instance, the should view it as unacceptable. absence of interest rate futures can hurt the This calls for fresh effort in diagnosing Treasury market. problems and making a break with the policy The recent practice of closing down com- frameworks which have failed to deliver modity markets when the price reaches high results. The goal of financial sector policy levels is unfortunate to say the least. Even must be to obtain a ‘Y’ in all 36 cells within if these markets are being manipulated at five years. This requires getting 26 new ‘Y’ present, an allegation there is little concrete values into the table over the next five years, proof of thus far, the way to make them func- as compared with the 3 that were obtained tion better is to improve their liquidity and in the last five years. broaden participation so that manipulation Some developing countries have suffered becomes difficult (the exchange could also from the inability to obtain liquidity and take steps to restrict the trading of those it con- efficiency in any element of the financial mar- siders to be manipulating markets if it has kets. India is in a better position in having evidence). Creating uncertainty about whether achieved some elements of success. A careful the markets will remain open is probably the understanding of the sources of success and most effective way to kill liquidity. The dam- failure is thus possible in the Indian set- age done by these short-sighted policy moves ting. In addition, the areas of success have need to be reversed by distancing market thrown up an institutional capability which regulation from the government (one more will be useful. reason why all market regulation should come under SEBI—see later), and making DIAGNOSING THE it much harder for the government to close SOURCES OF DIFFICULTY markets.

Why are so many markets illiquid and in- Restricted participation efﬁ cient? Some of the main reasons are:

1. Banning of products and markets. In many cases, while an outright ban is not 2. Rules that impede participation of fi rms in place, there are restrictions on partici- and individuals in certain markets for pation. There are various shades of grey in reasons other than sophistication. restrictions. These include outright bans 3. Inadequacies of fi nancial fi rms arising out of their ownership, size, and other reasons. (e.g., domestic individuals cannot partici- 4. A silo model of regulation and the struc- pate in currency markets) or regulatory ture, incentives, and staffi ng, of regulatory restrictions on some kinds of activities (for institutions that results in barriers to in- example, banks are prohibited from adopt- novation and competition. ing long positions on interest rate futures) 5. Frictions caused by taxes. or quantitative restrictions (for example, all FIIs put together are required to keep their Banned products and markets aggregate ownership of corporate bonds below US$ 1.5 billion). Why are numerous fi nancial markets illiquid There are a variety of rationales for re- and ineffi cient? The simplest element of the striction, including the belief that some Creating More Effi cient and Liquid Markets 113 participants (and regulators) are new and Table 3 looks at the elements of Indian therefore should proceed cautiously at the financial markets from this perspective. The outset, and the desire to limit capital inflows equity market—the only element of Indian and outflows so as to make exchange rate finance which has achieved immediacy, management easier. An often unvoiced, but depth and resilience—has few restrictions important, rationale is the need to finance on participation in both spot and derivatives the government, and thus the need to pre- markets (it does restrict foreign individual empt funds collected by various institu- investors, and some institutional investors tions through restrictions on investments such as hedge funds). As a consequence, the other than in government securities. Table 2 equity market, especially for large stocks, has from the BIS is enlightening: Among the developed a distribution capability which countries in the table, India has one of the reaches millions of market participants largest government shares in the public around the world. All kinds of economic debt market—a staggering 91 per cent. Even agents come together into a unified market China, which has a reputation for weak fi- to make the price. Competitive conditions nancial markets, has much larger public are upheld; for the most part, no one player debt issuance by financial and non-financial is large enough to distort the price. The corporations than India. The need for the gov- diverse views and needs of the diverse array ernment to finance itself, coupled with in- of participants impart resilience, depth, and vestment restrictions on the main domestic market efficiency. Competition between NSE institutions collecting long-term public and BSE has helped improve technology and savings and a ban on foreign participation, reduce costs. The most important feature of results in a domestic bond market that is the equity market has been free entry and dominated by government securities. exit for financial firms that become members

Table 2: Domestic Debt Securities—Amount Outstanding as on September 2007 (in US$ Billions) World US UK Japan India China Indonesia Malaysia Singapore A) Domestic Debt 55,389 23,899 1,354 8,706 435 1,528 89 155 90 Securities B) Government 26,200 6,480 901 7,034 396 1,042 80 66 64 C) Govt securities as a % 47% 27% 67% 81% 91% 68% 90% 43% 71% of total Domestic Debt securities (B/A) D) Financial Institutions 23,053 14,499 429 969 29 400 4 31 19 E) Corporate Issuers 6,135 2,918 23 703 8 86 5 57 6 Source: BIS Quarterly Review, March 2008.

Table 3: What Kinds of Participants are Permitted into what Kinds of Markets? Domestic Domestic Domestic Foreign Foreign Market institutions retail corporate institutions retail Equities & Equity Derivatives Y Y Y Y N Government Bonds Y – Y – N Interest Rate Swaps Y – Y – N Other Interest Rate Derivatives – – – – - Corporate Bonds Y Y Y – N Credit Derivatives N N N N N Currencies & Currency Derivatives Y – Y Y N Commodity Futures N Y Y N N Commodity Options N N N N N Note: ‘Y’ = Yes. ‘N’ = No. ‘–’ = Limited/Negligible. 114 A HUNDRED SMALL STEPS

of NSE and BSE, and the free entry and exit that competitive conditions are upheld so that for the economic agents who trade on these no player has market power and distorts price markets through exchange members. discovery. While these conditions may not The Committee feels that such an open pertain initially, and may therefore require environment is of critical importance for extra regulatory vigilance, the only way they achieving liquidity and efficiency in all the will emerge is if an open environment is other elements of Indian financial markets. created. This approach needs to be applied The trading rules of a market, such as plac- across all financial markets in India. ing collateral associated with a position, or position limits, must be neutral to the nature of the market participant. There should not Inadequacy of fi nancial institutions be one rule for a bank and another rule for an FII. In principle, most financial firms If the fi rst diffi culty lies in rules that impede would have adequate levels of sophistica- participation of certain kinds of fi nancial tion, so rules should not prevent access to fi rms in certain markets, the next diffi culty any market, especially if the firm can demon- lies in the inadequacies of the fi nancial fi rms strate competence to the regulator (see the themselves. discussion on professional markets below). Table 4 summarizes the state of play Further, end-users of markets should have with financial firms. As shown in the table, a full range of choices of the financial firms in numerous areas, financial firms have in- through which they access the market. In a firmities in India or are non-existent. healthy financial market, all players come The institutional structure of market together in a transparent market to make a participants is shaped by the forces of com- price, while a regulatory framework ensures petition and regulation. When firms face

Table 4: Capabilities of Financial Firms Institution Current status Securities Brokers/Dealers There are enough large, well capitalized, professionally managed brokers/dealers to support a vibrant market. However many poorly capitalized entities continue to exist. Mutual Funds There are enough large, professionally managed mutual funds. However, their success in channelizing retail savings into the debt/equity markets have been limited. They have been more successful in providing a tax sheltered investment vehicle for corporate cash surpluses. Hedge Funds Non-existent. Other activist investors Non-existent. Private equity players are the most hands-on investors today, but they rarely confront corporate management with a view to improving governance. Pension Funds Practically non-existent. Investment restrictions prevent provident funds from playing an important role in the fi nancial markets. Rating Agencies The big international rating agencies have affi liates in India. However, the current debate over global rating practices offers an opportunity for Indian rating affi liates to leapfrog over global counterparts and adopt state- of-the-art technological and organizational practices. Investment Banks Compared with global peers, Indian investment banks are poorly capitalized. Exchanges, clearing corporations, and Some of the exchanges are close to being world class as is the clearing, settlement, and depository infrastructure. depositories New entry by professional exchanges catering to institutional/sophisticated customers could help, as could greater competition between elements of the infrastructure. Insurance Companies Much of the investable funds are with the state-owned behemoths. Private sector players are growing fast. Together, they could contribute to the development of a corporate bond market if investment restrictions were moderated. Banks State owned banks dominate the banking system. They have a tremendous branch network, as well as a strong image of trustworthiness among poorer sections, which could be used to provide more access for households to the markets. Some of the PSBs suffer from an inability to attract adequate human capital for skilled tasks and an inability to incentivize performance, which limits their ability to develop strong risk management. In turn, this hampers their ability to create new and appropriate products for households, or to invest effectively in the riskier part of the spectrum of assets. Creating More Effi cient and Liquid Markets 115 competition for market share, they are forced certain activities. It is relatively easy to re- to find new ways of serving their customers. It solve this problem. However, the second is this pressure that, over time, creates highly problem is deeper and requires more long- competitive companies that are able to bring term efforts, that of improving the capabil- down costs through technological innov- ities of financial firms. The way to do this is to ation and better management of resources. increase competitive pressures in the market The inadequacies of Indian financial insti- ecosystem by removing constraints in the way tutions can be traced at least partly to the of entry of new players. forces that restrict competition. We do not have room for a full analysis of all factors that inhibit competition and Infi rmities in regulation innovation. However, two points are worth making. First, state ownership of financial Two factors that have deleterious consequ- institutions is a major factor that inhibits ences for both markets and actors are: competition. This is compounded by the need for regulators to take into account the in- 1. India uses a ‘silo model’ where the fi nan- centive structures and special circumstances cial markets are broken up across three that come from being government owned. agencies: SEBI, RBI, and FMC. There are A second factor is restrictions on owner- hard constraints that separate fi rms and players in one silo from operating in other ship and shareholding. This applies especi- silos. These constraints reduce compe- ally to institutions like banks and exchanges, tition, hamper economies of scale and clearing corporations, and depositories. scope, and impede the fl ow of successful Limits on how much shares an individual institutional arrangements and ideas shareholder can hold (5 per cent in exchanges, from one part of the fi nancial markets to others. 10 per cent cap on voting rights in banks), 2. Steep barriers to innovation are in place. and limits on ownership by foreigners makes New ideas are banned unless explicitly it difficult for new institutions to be started, permitted. A great deal of what would and for shareholders to exercise influence be considered ordinary activities in the on management. This reduces competi- world of global fi nance is incompatible tive pressures on incumbents, and slows with existing laws and subordinate legislation. In a well functioning market econ- down the pace of development of market omy, fi rms are constantly on the lookout institutions. for new ideas in designing products and Most such restrictions have been intro- processes so as to reduce cost and better duced with the good intention that such in- serve customers. A fi rm that comes up with stitutions should remain in the hands of that an innovation obtains a temporary ad- is ‘fit and proper’ persons. These restrictions vantage and enhanced profi tability for the time period that is taken by competitors are a recognition of the perception that the to catch up. In Indian fi nance, the glacial regulatory system is too weak to prevent mis- pace of change has given out signals to use of management authority, and the only fi nancial fi rms that the rate of return on way to prevent institutions from falling innovation is tiny. Approvals take years, into ‘wrong hands’ is to have rules on con- so there is no question of obtaining a centration of ownership. However, it is im- temporary elevation of profi tability by innovation. portant to recognize the costs imposed by these rules. In short, the deficiencies in Indian finan- Frictions caused by taxes cial markets stem from missing markets and missing actors. The way to address the first is We have earlier discussed the importance of in opening markets, equalizing market rules having all types of markets, cash and deriv- for all kinds of participants, and in removing atives, exchange traded and OTC, exist side rules that ban specific players only from by side, in order to allow customers to achieve 116 A HUNDRED SMALL STEPS

their portfolio objectives at the minimum The first element consists of addressing possible cost. One factor that makes this out- the problems of missing markets and mis- come diffi cult to achieve is the different tax sing actors within the existing legal and treatment that is applied to different types of institutional framework. This is low-hanging investments and transactions. Taxation plays fruit that the government can implement an important role in determining returns relatively easily. generated by trading. The existence of a But the next two elements are essential transaction tax reduces the incentive for day to obtaining genuine progress. Capital ac- traders and speculators to provide valuable count liberalization is important from the liquidity to the market. This difference may viewpoint of bringing in new kinds of players not be felt when the markets are doing well, and new kinds of competition. Elsewhere in and when the returns from trading are sig- this report, we have commented on the fact nifi cantly higher than the friction imposed that capital account restrictions do not work by transaction costs. However, liquidity tends in practice. But they do drive liquidity away to disappear when it is most desirable, that from organized financial markets. By plac- is, when markets go down. Investment being restrictions on investment by foreigners haviour is also affected by taxes. One of the in domestic securities, we force them away side effects of having a low tax on Mutual from the market and into other channels, Funds is that a signifi cant portion of debt thereby depriving the Indian financial mar- fund investments are made only to make kets from the opportunity to benefit from the use of the tax advantage. The same applies participation of foreign firms. to small savings scheme, which attract a sig- Given the infirmities of financial firms in nifi cant amount of savings. India, even if all problems of regulation were solved, there is likely to be a gap in liquidity and market efficiency. Foreign financial PROPOSALS firms would play a valuable role in filling this gap. In addition, the entry of foreign finan- To achieve the true economic benefi ts of cial firms into all markets would increase markets, we need: competitive pressure on Indian financial firms and markets. Indian households and 1. The availability of complete markets Indian financial firms would be better where agents are able to trade and hedge served under convertibility, because they all the risks that they need to manage, and would have greater choice on the financial the existence of adequate liquidity (depth, resilience, and immediacy) in all these firms and financial markets that they markets. choose to utilize. This competitive pressure 2. A regulatory structure that protects cus- would induce significant improvements on tomers from fraud, but without imposing the part of Indian market institutions and undue costs and without creating barriers Indian financial firms. The role of con- to entry, innovation, and competition. vertibility in increasing competitive pressure and fostering greater technological The reforms that would achieve the dynamism in finance is the same as the role above objectives comprise of three broad played by trade reforms in the case of non- elements: financial firms. 1. Reforms within existing legal and insti- A key defect of financial markets lies in tutional framework; the separation between RBI, SEBI, and FMC. 2. Capital account liberalization; The Committee deliberated on this issue 3. Merger of regulatory and supervisory at length and emerged with two main con- functions for all organized fi nancial trading into SEBI and strengthening the legal clusions: (a) there is a lot to be gained by foundations of market regulation. unification of these functions; and (b) the 4. Implement Debt Management Offi ce. right agency into which these functions Creating More Effi cient and Liquid Markets 117

The Corporate Bond Market

The state of India’s corporate bond market has which the larger players ‘retail’ the bonds they often works out cheaper than issuing a bond. been the subject of much discussion and analysis have picked up to smaller pension funds and Add to this the issuance and compliance costs, but little progress over the last 10 years. This is in cooperative banks. Most trading is between and issuers do not fi nd signifi cant reasons to run contrast to the strong growth witnessed in fi nancial institutions. a regular issuance programme. the equity markets as well as the government secur-ities market. Starting in the late 1990s, RBI 5 Years Rates carried out a series of reforms in the government Yields US India China Singapore Korea Japan securities market. This included the following main elements: Gsec 4.92 7.62 1.89 2.52 5.23 1.52 1. creation of market makers in the form of AAA Bond 5.60 10.00 4.42 2.58 5.59 2.01 specialized Primary Dealers of government Spread 0.68 2.38 2.53 0.06 0.36 0.49 securities, who were allowed to borrow in Source: 2007 CRISIL. the inter-bank market to fund their government securities portfolios; The reasons for the near-absence of a corporate Also, until the recent credit crisis, larger 2. reforms intended to remove frictions in bond market can be divided into constraints that corporate issuers had access to much cheaper trading, such as removal of stamp duties limit the demand for the bonds, and constraints funds in the offshore debt capital markets. Even and withholding taxes; that limit the issuance of the bonds. after hedging their currency risks, the total cost 3. better trading, clearing and settlement On the demand side, pension funds, who could of borrowing offshore is much lower than the infrastructure in the form of an online be large buyers of corporate debt, are constrained cost of borrowing in the domestic market. This primary auction mechanism, a trade re- by their prudential norms and conservative is refl ected in the strong growth of External porting system (NDS), an electronic order investment policies. Mutual Funds, and to a lesser Commercial Borrowings (ECB) in recent years. matching system (NDS–OM), the Clearing extent insurance companies, are buyers of higher While excessively easy credit conditions abroad Corporation of India, and innovations like yield debt, but do not create enough demand for must be part of the story, higher tolerance for risk Collateralized Borrowing and Lending the market to grow. on the part of foreign participants whose presence Obligations (CBLO). Banks tend to prefer loans to bonds, because is limited in domestic corporate bond markets These reforms occurred in the context of a loans can be carried on the books without being must also be part of the explanation. secular decline in infl ation and interest rates in the marked to market, thus reducing the possibility The state of affairs in the corporate bond market years following the 1997 Asian crisis, allowing of unexpected demands on bank capital. The is symptomatic of these deeper problems, and the traders in government debt to make signifi cant internal organization of the bank also inhibits attitude of regulators towards fi nancial markets. trading profi ts, and encouraging the development demand—corporate bond portfolios are managed Risk aversion of state-owned fi nancial institu- of an active secondary market. Banks, insurance by the treasury, while loans are managed by credit tions, confl icts in policy objectives, unwillingness companies, and pension funds were large captive departments, creating barriers between the two to let fi nancial institutions manage their risks, buyers of government debt, and the government’s forms of lending. all conspire together to keep the market in a debt manager, RBI made use of this opportunity to Foreign investors, who do not suffer from the stillborn state. reduce cost of borrowing, increase duration, and same sources of risk aversion as Indian institutions, Among the recommendations that would help consolidate government debt into fewer but larger are allowed only to a very limited extent into the revive the corporate bond market are: (i) allow issues. Though signifi cant challenges still remain, market (a total of US$ 3 billion). Given the very domestic fi nancial institutions greater leeway to the government securities market is generally limited liquidity, they are not always eager to even invest in corporate bonds; (ii) steadily raise the considered a success story. take up the available quota. limit on foreign investment in corporate bonds; In stark contrast, the corporate bond market Finally, the absence of a reliable system of resol- (iii) amend the bankruptcy code (Chapter 7) remains practically non-existent. Most of the ving fi nancial distress (see Chapter 7) must be a part so that the rights of unsecured creditors are large issuers are quasi-government, including of the explanation for why investors are reluctant protected; (iv) reduce the transactions costs in banks, public sector oil companies, or government to buy unsecured bonds (in contrast to lending issuing and trading corporate bonds, including sponsored fi nancial institutions. Of the rest, a few secured debt), especially those of high risk fi rms. repeated onerous disclosures (move instead to a known names dominate. There is very little high Issuers do not have much reason to issue cor- shelf-registration scheme), as well as high stamp yield issuance, and spreads between sovereign porate bonds either. The high interest rates de- duties; (v) reduce the artifi cial preference of debt, AAA debt and high yield debt are high in manded by buyers, because bonds are illiquid and banks for loans by subjecting loans and bonds to comparison to other markets. Very few papers because bond holders are poorly protected in similar mark-to-market requirements, especially trade on a regular basis. Trading in most papers bankruptcy, means that bank debt is available at for aspects such as interest rate exposure that dries up after the fi rst few days of issuance, during much more attractive terms. A syndicated loan are easily measured. should be unified is SEBI. These changes will Reforms within existing legal and have their full impact on innovation only institutional framework if we also rethink the legal foundations of financial market trading in India and move We have to identify all situations where new towards a more ‘principles-based’ approach. products, new kinds of fi nancial fi rms and These issues are more fully discussed in new activities of fi nancial fi rms are feasible Chapter 6. under the existing legal and institutional 118 A HUNDRED SMALL STEPS

framework. Permissions need to be given is restricted only to professional investors to enable such new activities to commence doing large transactions. The criteria will immediately. In addition, many other areas have to be determined on the basis of the needs of the market being approved. of incremental progress are feasible imme- Once this is done, the burden of regula- diately. The 12 key areas for work, in the view tion can ease considerably. Professional of the Committee, are: exchanges can thus be lightly regulated. They can be a hotbed of technological 1. Improvements in market design: Many and product innovation.8 Finally, there improvements in the market design are is the OTC market, which would involve feasible within the existing legal and bilateral transactions between economic institutional framework. These include: agents. The presence of all three ele- (i) True auctions for primary market sale ments of the overall market would induce of securities, (ii) Reduction of the delay greater competitive pressure for all three between the date of auction of a security elements. and the date of trading, (iii) Unifi cation 4. Domestic hedge funds: Domestic hedge of disclosure requirements for fi rms funds should be recognized and registered having multiple listed securities, (iv) Im- as a valuable addition to the landscape of proved risk management at clearing cor- fi nancial fi rms. They would require a large porations so as to do full cross-margining minimum investment (e.g., Rs. 10 mil- and portfolio margining, (v) The use of lion) by any one customer; such custom- call auctions for the opening price and ers have the wherewithal to judge the closing price on exchanges, and (vi) Re- merits of the fund management activity moval of regulatory restrictions against by themselves. The role for SEBI would algorithmic trading. then be to ensure that hedge funds satisfy 2. Rapid and simplifi ed product approval: the trading and regulatory rules of the SEBI needs to establish a new approval markets that they operate in, exactly as process for new products as well as new is required of all other market partici- methods of price discovery, clearing, and pants. The presence of hedge funds would settlement. This approval process needs induce greater competitive pressure for to be rapid, supportive of innovation, other regulated fund management chan- and keep the government out of issues nels such as mutual funds. of product design. The role of the regu- 5. Staffi ng of regulatory institutions: The lator should be restricted to questions staffi ng and management of regulatory of systemic risk, fraud, contract enforce- institutions needs to be considerably ment, transparency and inappropriate strengthened. Specifi cally, regulators sales practices. The task of designing should: (i) Acquire greater knowledge products, markets and processes legitim- of modern fi nancial products and mar- ately resides with the private sector. The kets; (ii) Offer greater clarity on what uniquely Indian newspaper headline constitutes malpractice; (iii) Possess high ‘SEBI introduces long-dated options’ quality investigation capabilities leading needs to be replaced by ‘Firm X intro- up to high quality drafting of legal orders. duces long-dated options’, since a product The regulator could also encourage a launch is the task of a fi nancial fi rm and similar upgradation of skills and know- not a government agency.7 ledge among market participants, in- 3. Professional markets with light regu- cluding senior management. lation: There is much merit in thinking 6. Uniform accounting treatment: Regu- of a three-tier world of fi nancial mar- lations that give banks a bias to lend kets, comprising ‘public exchanges’, ‘pro- through loans as opposed to investing fessional exchanges’, and the OTC market. in corporate bonds need to be modifi ed Public exchanges would be exchanges to have a level playing fi eld. Similarly, such as NSE and BSE, where the full bur- regulations that give banks and insurance den of regulation is applied because the companies a bias to use OTC derivatives general public participates in the market. instead of exchange-traded derivatives Access to professional exchanges can be need to be modifi ed to have a level restricted on the basis of suitable criteria. playing fi eld. For instance, a minimum transaction size 7. Securities transaction tax: The inci- of Rs. 10 million can be prescribed for dence of the securities transactions tax professional exchanges so that the market falls upon trading strategies that require Creating More Effi cient and Liquid Markets 119

more trading. While the quest of fi nan- space for such institutional investors to cial sector policy is to have low trans- play a more effective role in other fi nan- actions costs, this tax directly increases cial markets. Prudential norms should be transactions costs. To the extent that based on the basis of fi duciary respon- Indian fi nancial markets face global sibility to meet the investment objectives competition (e.g., Infosys ADRs trading of the fund being managed. The regulator in the US) or aspire to achieving global should be silent on what investments are customers (e.g., currency futures trading allowed, and instead focus on how the in Mumbai), the securities transaction tax fi duciary responsibility is being applied. puts India at a competitive disadvantage. Regulators have the right to question There is a need to phase out this tax, or when things go wrong, not on the basis reduce it to token levels. of outcomes, but on the basis of whether 8. Remove segmentation within ex- those investments were consistent with changes: NSE and BSE suffer from in- ones a prudent investor would have creased costs and operational overheads bought. owing to ‘segmentation’. As an example, Effectively, such a principle would the equity spot market is one ‘segment’ move the test of reasonable investment and the equity derivatives market is an- strategy from whether the investments other ‘segment’. Financial fi rms have to performed or not, to whether it was obtain separate memberships in each reasonable to think they would per- segment and suffer from a duplication of form. Such a move need not occur over- compliance costs. This separation reduces night. Investment restrictions could be the ability of a clearing corporation to progressively lightened, while ‘safe har- know the full position of a fi nancial fi rm bours’ that meet the fi duciary principles or its customer, and do correct portfolio could be developed so that risk-averse risk calculations. This segmentation con- investment managers would be sure stitutes yet another silo system, within what investments would defi nitely meet exchanges. There are no benefi ts from regulatory approval. such segmentation, and there are many 11. Currency derivatives: Exchange-traded negative implications. The Committee currency derivatives including futures, feels there is much merit in ending this options and swaps, on all currencies, silo system within exchanges, so as to should be permitted. While capital con- have only one concept of a member of trols inhibit settlement in foreign cur- an exchange, who then obtains a trading rency, rupee cash-settled derivatives are screen and is able to trade in all products. feasible immediately. These can trade To the extent that some participants are alongside equity derivatives on NSE not deemed sophisticated enough for cer- and BSE. In doing this, it is important tain activities (unlikely for an exchange to avoid special rules which inhibit par- member), their access rights can be re- ticipation of banks, NRIs, FIIs, and to stricted, but this should be by exception avoid forced segmentation of the market rather than as a default. where large positions on the exchange- 9. Restrictions on participation: The archi- traded market are prohibited in order to tecture of trading with SEBI-regulated avoid competitive pressure against the exchanges is conducive to free entry for OTC market. fi nancial fi rms and free entry for par- 12. Interest rate derivatives: Exchange- ticipants. As an example, currency and traded interest rate derivatives using interest rate derivatives could become both cash settlement and physical settle- immediately accessible to all fi nancial ment should be permitted. These can fi rms and all market participants (e.g., trade alongside equity derivatives on FIIs) by bringing them into the existing NSE and BSE. Exchanges should have the policy framework of SEBI-regulated ex- freedom to structure products accord- changes. In addition, the same strategy can ing to market needs. The issue of removal be used with corporate bonds and credit of ‘segments’ of exchanges becomes par- derivatives for the same effect. ticularly important with interest rate 10. Fiduciary responsibility based on derivatives. The BCD Nexus requires investment objectives: Institutional in- full integration between interest rate vestors in India are often forced to buy derivatives and currency derivatives on government bonds. This ‘fi nancial re- one hand, and between interest rate de- pression’ needs to be eased, thus making rivatives and corporate bonds and credit 120 A HUNDRED SMALL STEPS

derivatives on the other hand. If efforts from higher returns (such as on equities) are made on setting up a ‘silo’ structure that they have been prohibited from acces- that limits arbitrage, then the fully inte- sing thus far. grated BCD Nexus cannot come about. Quantitative restrictions on domestic institutional investors currently limit their global diversification. As an example, all mu- Use capital account liberalization tual funds (taken together) are permitted to to deepen markets invest no more than US$ 5 billion overseas. These quantitative restrictions need to be In this subsection, we address specifi c areas removed. Mutual fund schemes need to be of capital account liberalization that would designed to give customers the best risk/ directly impact on liquidity and market effi - reward trade-off, which inevitably involves ciency of Indian fi nancial markets. Larger global diversification. As an example, an issues of capital account liberalization, their Indian institutional investor should have consequences for Indian fi nance as a whole, the full flexibility to buy an Infosys ADR in and the inter-linkages for macroeconomic the US or to buy shares of Infosys in India, or policy, are addressed in the chapter on macro- IBM in the United States. Similarly, an Indian economics. institutional investor should have the full Capital account restrictions interfere with flexibility to buy government bonds issued markets in two broad ways. When foreign by governments all over the world, or to buy players are not allowed to participate in the government bonds in India. These changes, local markets, the expertise, risk bearing which are analogous to removing barriers capacity, and capital they could bring to the to imports, will improve the risk/reward market is lost. The volumes they contribute characteristics obtained by their Indian cus- are also lost. Both factors reduce liquidity tomers, expose institutional investors and and efficiency. Indeed, this liquidity can be their customers to international practices critical for kick starting a market. For in- and ideas, and increase competition faced by stance, Indian investors have little experi- Indian financial markets. It will also set the ence with long-term corporate bonds, while stage for Indian institutional investors to sell foreign investors have this. The broader financial products overseas. The removal of participation for foreign investors in that barriers to imports is an essential preamble market could allow more attractive debt to exporting. structures to emerge, greater liquidity, and While each individual in India is able eventually, more domestic participation to take US$ 200,000 out of the country per also. year, in practice, this is operationally cum- Quantitative restrictions presently inhibit bersome owing to restrictions that inhibit FII participation in rupee-denominated domestic and foreign financial firms from government bonds, corporate bonds, debt- selling international financial products. oriented mutual funds, and securities issued These restrictions need to be eliminated. A by asset reconstruction companies. These customer of an Indian securities firm should restrictions need to be eliminated, to place be able to access unified screens where he is FII activities on these products and their able to trade all financial products, all over derivatives on parity with FII transactions the world. Conversely, an Indian individual on equities and equity derivatives. For in- should be able to become a customer of an stance, as investment restrictions on do- international securities firm and obtain this mestic funds are reduced, freeing them from same trading screen, with access to all global investing in government securities, foreign financial products (subject to this limit of a investors can take up the slack. This will net outflow of US$ 200,000 per person per allow domestic institutions like insurance year). Foreign exchanges should be able to companies and provident funds to benefit recruit members in India and place trading Creating More Effi cient and Liquid Markets 121 screens and Internet-based trading software and the structural bias of the regulator can in India, as long as the limit of US$ 200,000 potentially result in rules that favour one type per person per year of net outflow is adhered of participant over another. to. This would increase exposure for Indian In view of the above reasons, the Com- customers and financial firms with global mittee believes that the merger of all market practices and ideas, and increase competi- regulation into SEBI will reduce transaction tive pressure on Indian financial firms and costs and improve liquidity in financial markets. Foreign mutual funds should be markets. At present, regulation of different able to raise money directly in India, and markets is covered under a large body of Indian mutual funds should be able to legislation. The Committee proposes the raise money overseas for investment in India, enactment of legislation that would bring obtaining the same tax treatment as FIIs, all market regulations under a single roof, without setting up a parallel apparatus or and ease the transition from a rule based ap- having to become FIIs. proach to a principles-based approach to As Chapter 2 suggests, these relaxations regulation. These issues are more carefully could also help India macroeconomically at explored in Chapter 6. the current juncture, by allowing outflows While considering SEBI as a single mar- that keep the exchange rate from appreci- ket regulator, it is important to recognize ating, and reduce the fiscal burden of reserve that SEBI presently lacks the skill and accumulation. These outflows will also sophistication to regulate new markets. It is create more room for foreign participation beyond the scope of this chapter to present in Indian financial markets. a detailed plan for institutional reform and strengthening of regulatory institutions including SEBI. However, we need to recog- Modifi cations to legal framework nize the need for such reform, and start the and fi nancial regulatory architecture process and recognize it as a prerequisite for moving all market regulation to SEBI. As discussed in Chapter 6 of this report, fragmentation of market supervision between multiple regulatory authorities in- Implement debt management offi ce creases transaction costs, creates frictions, and reduces liquidity in all markets. Market At present, the ‘investment banking’ function supervision is a specialized function, and it for the government is performed by the RBI. In is not easy to get professionals who can detect the past decade, a series of expert committees insider trading, manipulation, and other have commented on the undesirability of abuses. Having multiple regulators makes burdening RBI with the task of selling bonds it more difficult to staff these functions. for the government. This involves a confl ict of Another argument for consolidation of interest, since the government would benefi t regulators arises from the blurring of boun- from lower interest rates, which the RBI has daries between different types of products. A some control over. Investors in the bond futures contract on a commodity Exchange market may also perceive the sale of bonds by Traded Fund can become a proxy for com- RBI to be informed by a sense of how interest modity futures product. Financial engineer- rates will evolve in the future. Finally, the RBI ing could create products that do not fall into is the regulator of banks. Banking supervision any category and therefore escape regula- could be distorted by the desire to sell bonds tion. A fi nal reason for consolidation of mar- at an attractive price. ket supervision under a single regulator is Internationally, there has been a strong that there could be confl icts between mar- movement towards establishing independent ket regulation and prudential supervision, debt management offices (DMOs) which 122 A HUNDRED SMALL STEPS

sell bonds for the government. This is now markets, rules impeding participation, considered best practice. Moreover, as rules inadequacies of financial firms because of that force financial firms to buy government constraints imposed on them, a silo model bonds are relaxed, greater demands will of regulation, and frictions caused by taxes. be placed on the DMO, hence the need to Each of these factors have to be analyzed in move in an expedited fashion. The February detail, and ways found to fix them. In this 2007 Budget Speech had announced the report, we have not gone into the minute creation of a DMO, and this now needs to details of recommendations. Instead, we be implemented. have pointed out the large number of needed reforms that can easily be effected without requiring any significant changes CONCLUSION in the legal and institutional framework. Of course, market reforms will have a sig- We started this chapter by focusing on the nificantly greater effects when we are also— role that markets for stocks, interest rates, prepared to take a fresh look at our macro- currency, credit risk, and commodities play in economic and regulatory policies. These driving economic growth. We discussed the issues are considered elsewhere in this need to take actions that improve the ability report. of markets to achieve better risk sharing and information signalling, to lower the cost of fi nance to households and companies, and NOTES to improve returns from savings. We then examined the current state of markets, the 1. One well-known example which illustrates the issues institutions that participate in these mar- at stake is the administered prices of petroleum products. The real economy would fare better in kets, and the quality of the regulatory frame- continually adjusting to small changes of prices work in which they operate. We discussed the which would result from a market process. The perception that markets behave like casinos, strategy adopted in India—of having constant prices for a period of time followed by a sudden large the distinction between price fl uctuations adjustment—actually induces greater instability and economic instability, and the dangers in the economy. of government intervention in price for- 2. The universe of large non-fi nancial fi rms had total liabilities of Rs. 29 trillion in 2006–07. Of this, Rs. 8.1 mation. All these arguments were used to trillion was borrowings. In the same year, large make the case for creating deep and well software companies had total liabilities of Rs. 944 functioning markets in all fi nancial asset billion. Of this, just Rs. 75 billion was borrowings. classes and derivatives. 3. This calculation uses the BSE Sensex from 1979 till 1990. Over this period, data for dividends is not We also discussed the importance of available, thus understating the returns to an equity lowering the cost of access to markets as a index. From 1990 onwards, the CMIE Cospi index key objective of financial market reforms. is used, which includes dividends. 4. There are roughly 10 million depository accounts Many of the long standing obstacles can in the country. Assuming one account per family be removed through the use of innovative and assuming fi ve individuals per family, direct technology. If the regulatory system is ownership of equities does not exceed 50 million supportive of this effort, we will be able people. 5. Suppose a fi nancial market offers bid/offer quotes to handle very small ticket transactions, of Rs. 99 and Rs. 101. In other words, a small buy allowing people with very small savings, transaction can be done at Rs. 101 and a small sell credit and insurance needs to participate transaction can be done at Rs. 99. The ‘ideal price’ or the ‘benchmark price’ is defi ned as half-way be- in the market. tween the bid and the offer. In this case, it is Rs. 100. The second part of our analysis ex- Impact cost is defi ned as the extent to which a trade amined the sources of our difficulties, and price diverged from the benchmark price. As an example, suppose a large buy order gets executed at traced these to a few key important ele- Rs. 102. In this case, the impact cost is said to be 2 per ments, including banning of products and cent, for this execution price was 2 per cent worse Creating More Effi cient and Liquid Markets 123

than the benchmark price. In the electronic limit 7. In one recent example of these lines not being drawn order book market, it is possible to have full trans- properly, a recent RBI report on interest rate futures parency of the order book, and market participants speciﬁ es the time at which trading should start and can compute impact cost before an order is placed. In stop each day. other methods of organizing markets, impact cost is 8. Such a distinction was introduced by the Commodity generally known after the event but not before. Futures Modernisation Act of 2000 in the US, and 6. Susan Thomas. 2006. ‘Resilience of liquidity in made possible a proliferation of Internet-based Indian securities markets,’ Economic and Political trading platforms, particularly in the area of debt Weekly, XLI(32): 3452–3454. and currencies. A Growth-Friendly Regulatory Framework

CURRENT REGULATORY z Gold Exchange Traded Funds were pro- FRAMEWORK posed in 2002 and launched in 2007. z Interest rate futures were proposed in 2003 (and there was also an abortive launch of Sixteen years of reforms have created a fairly an unviable variant) but have yet to be chapter sound regulatory framework. There has been permitted in a viable form. a convergence towards global best practices in areas like prudential regulation of the banking Second, attempts to exercise unduly strict 6 system, securities regulation, and insurance control over the market and over financial regulation. Substantial deregulation of inter- institutions result in excessive regulatory est rates, the shift from merit-based regulation micro-management, which leads to a counter- to disclosure-based regulation of securities productive interaction between the regulator offerings, and the move towards de-tariffi ng and the regulated. The regulated respond to of insurance products are signifi cant steps the needs and opportunities in the market towards the creation of a modern regulatory place while attempting to comply only with framework for the fi nancial sector. Though the letter of the law. The regulator then the task is by no means complete, the ground- attempts to stamp out violations of the spirit work that has been laid will allow us to move through new rules and the regulated find new rapidly towards the regulatory architecture ways to get around them. that is appropriate for a country of India’s The Committee believes that low toler- size and aspirations. While building on past ance for innovation and excessive micro- successes, it is also important to remember management themselves stem from there are defi ciencies in the current regu- deeper rooted problems in the regulatory latory system. structure:

z Regulators often have unclear, sometimes Low tolerance for innovation and mutually inconsistent, and infeasible ob- excessive micro-management jectives as in the case of the RBI’s mandate regarding exchange rates, infl ation, and A number of problems exemplify the sub- growth. Objectives have not kept pace with changes in the economy. stantial road that still has to be travelled in z Regulators also suffer from confl icts of achieving an adequate fi nancial regulatory interest, some explicit (such as the one be- and supervisory structure. First, the pace of tween monetary policy and management innovation is very slow. Products that are of the public debt, which is being resolved sought to be introduced in India (though by separation of function) and some im- well established elsewhere in the world) plicit, such as a widely perceived desire to protect certain kinds of institutions and take several years to see the light of day. The certain forms of ownership. following examples illustrate the long delay z Regulated entities sense pervasive risk from serious proposal by a potential innova- aversion on the part of the regulators, re- tor to actual successful launch: fl ected in ‘zero tolerance by the regulator for deviation from letter of law’, and po- z Index futures were proposed in early/mid- tential regulatory prohibition even if the 1990s and launched in 2000. activity is currently permitted by the letter A Growth-Friendly Regulatory Framework 125

of the law. This could be partly due to the Some examples of regulatory overlap limited capacity, experience, and skills of include: regulatory staff. But it is also partly due to the atmosphere of distrust associated with z Overlap between SEBI and MCA in the vigilance processes in the government, and regulation of issuer companies. the open ended nature of parliamentary z Overlap between SEBI and RBI in the investigation into alleged or real regulatory regulation of foreign institutional invest- lapses. ors as well as in exchange traded currency z Regulators confront immense hetero- and interest rate products. geneity in the entities they regulate, as well z Overlap between RBI and state govern- as in the investors and customers whom ments in the regulation of cooperative they protect. This heterogeneity is in terms banks. of experience, capital, capabilities, as well as honesty. Regulators respond to this het- Some examples of regulatory gaps erogeneity by targeting their regulations include: at the lowest common denominator. z Frank communication between the regu- z Absence of any mechanism for regula- lator and the regulated could improve the tory review of corporate accounting state- regulatory environment, but all too fre- ments for compliance with disclosure quently it is inadequate. The regulated requirements. have little incentive to be frank for fear it z The growing number of credit co- might elicit more micromanagement. operative societies and MFIs involved in z Given difﬁ cult objectives, regulatory risk deposit taking or gathering, with little aversion, heterogenous regulated entities, oversight. as well as a legacy of command and con- z Absence of supervision of cross-market trol and substantial discretionary powers, activities. regulators appear to protect themselves z Inadequate regulation of ﬁ nancial plan- through a resistance to innovation, aver- ners and advisors. sion to risk, as well as through micro- management, even if the costs are obvious.1 Sometimes the structure can also lead to regulatory arbitrage as similar financial The combination is a recipe for some- services may be offered by institutions that times excessive, and excessively conservative, come under different regulators and are regulation, inhibiting innovation and growth. therefore subject to different regulatory In some cases, the regulated have recourse to requirements. For example, investment an appellate body (like the Securities Appel- linked insurance products include fund man- late Tribunal in the case of SEBI) and therefore agement services similar to that offered by regulatory excess can be publicly corrected. mutual funds, but under completely different In other cases, regulatory overreach is neither regulatory requirements regarding capital, identified nor corrected. With no mechanism expenses and disclosure. Competition is for attenuating overreach, the constant fear not bad if it eventually results in the right of regulatory interventions distorts activity institution undertaking the activity. It be- in the financial sector. comes a problem when one institution has an advantage only because the other is excessively constrained by its regulator. With Regulatory gaps and overlaps excess regulation in India, this is a real danger. As may be seen from Figure 1 in a report by The overlapping regulatory structure the World Bank, the current system involves also becomes a barrier to innovation as any half a dozen apex regulatory agencies, apart new product might need approval from from several ministries in the government more than one regulator. In some cases, it that retain direct regulatory powers. This is not even clear which regulator has pri- structure leads to major regulatory overlaps mary jurisdiction over the product. While and regulatory gaps. competition between regulators creates 126 A HUNDRED SMALL STEPS Current Regulatory Architecture Regulatory Current

Figure 1: Figure A Growth-Friendly Regulatory Framework 127 space for innovation, as discussed above, too early to draw strong lessons, a number competition with uncertain jurisdiction of issues seem apparent: does not. 1. It is not suffi cient for regulators to only look at the part of the system under their immediate purview. Because markets are Balkanization and capture integrated, any unregulated participant can infect markets and thus contamin- Where jurisdiction is clear, regulators require ate regulated sectors also. For instance, activity to be carried out in separate subsi- there is some evidence that unregulated diaries of a fi nancial conglomerate, each of mortgage brokers originated worse loans than regulated ones, contaminating the which is separately regulated. This increases securitization process. While the imme- costs, reduces scope economies and makes it diate conclusion is not to regulate every- diffi cult to offer customers a one stop solu- one to the same degree, it does suggest tion to their fi nancial needs. regulators have to be alert to entities Another problem with the current regu- that could have systemic consequences, including on markets. latory structure is that it is much more 2. Capital regulation is no substitute for vulnerable to regulatory capture because ensuring the incentives of fi nancial in- each regulator regulates only a narrow set of stitution management are adequate— intermediaries. A narrow regulator is more that the spirit of the regulation is being easily persuaded to adopt regulations that obeyed rather than just the rule. For example, the off-balance sheet entities of shield its regulated entities from competi- the major banks, including the structured tion. A unified regulator is less vulnerable to investment vehicles (SIVs), met the rules this kind of capture because it faces counter- of being off-balance sheet (and hence did vailing pressure from different segments of not require a charge on capital), but in the regulated. practice turned out to be effectively on- Multiplicity of regulators creates severe balance sheet. Indeed, there is increasing debate about whether the Basel II capital problems in inter-agency coordination. norms are adequate, both in good times Experience around the world suggests that in preventing excessive risk taking, and this problem is very difficult to solve even in bad times when strict capital norms with strong structural mechanisms for co- can hold back bank lending and result in ordination. In India, these coordination a downward spiral. 3. In a market-based system, banks are not mechanisms are also quite weak. Coordin- the only source of illiquidity risk. Any ation problems are aggravated by the vari- entity that has mismatched assets and ation in skills and experience across regulators liabilities (mismatched in terms of dura- (sometimes related to novelty of area being tion or liquidity) is subject to the risk regulated). of becoming illiquid. To the extent that that entity is of systemic importance— While the Committee will not propose either too big, too interlinked, or too India moves towards an integrated regula- many investors to fail—it will have a tor and supervisor, it will suggest some new call on public funds. To the extent that structures than can help improve coordin- regulators are likely to provide either ation as well as eliminate regulatory gaps. liquidity or solvency support (and the line between these is very thin), they owe it to the public to monitor these entities and ensure the charge on the taxpayer is Lessons from the ongoing fi nancial limited. Moreover, systems will have to be market turmoil evolved to assess and maintain the overall liquidity position of the fi nancial system, over and above its capital adequacy. Any discussion of regulation has to take 4. Deep markets with varied participants cognizance of the recent turmoil in fi nancial can absorb overall risk better. While markets in industrial countries. While it is indeed the risk that has infected world 128 A HUNDRED SMALL STEPS

markets started in the US sub-prime sec- are part and parcel of the greater risk. At the tor, in part because of excessive fi nancial same time, we have to become more clever exuberance, despite its proximity and about managing the risks, focusing efforts exposure the United States fi nancial system has weathered the losses thus far better at warding off the really big ones, and surprisingly well. Indeed, US equity making participants cooperate more in the markets have held up better than the process rather than making them adversaries. Indian stock markets! Part of the reason Furthermore, fi nancial sector development has to be its openness and variety. US can help the risk management process, both banks could raise capital quickly by tapping into sovereign wealth funds else- by reducing risks, and by shifting them to where. Even while banks are hamstrung where they can be borne better, a theme by overloaded balance sheets, hedge through much of this report. This chapter funds and private equity players are therefore focuses on: entering the markets for illiquid assets and establishing a bottom. 1. A better risk management process for 5. Consumer protection is important. Not regulators and the regulated, addressing every household is fully cognizant of the both the environment in which they op- transactions they enter into. While the erate, as well as the way they tackle risks, line between excessive paternalism and while allowing the innovation needed to appropriate individual responsibility is spur growth. always hard to draw, in a developing coun- 2. A more streamlined regulatory archi- try like ours, it may well veer to a little tecture that reduces regulatory costs, more paternalism in interactions between overlaps, silos, and gaps. fi nancial fi rms and less-sophisticated 3. Better coordination between regulators households. It is important to improve so that systemic risks are recognized early consumer literacy, the transparency of and tackled in a coordinated way. products that are sold, and in some cases, 4. A coordinated process to protect con- limit sales of certain products in certain sumer interests as well as raise literacy jurisdictions, especially if they have levels. prudential consequences. 5. Strengthening procedures that reduce 6. There is no perfect regulatory system. the level of fi nancial risk—for example, The problems with Northern Rock in the through prompt corrective action. United Kingdom are being attributed to the fact that the United Kingdom had moved to a single supervisor, the Financial Services Authority (FSA), with TOWARDS THE SPIRIT the monetary authority having no super- RATHER THAN THE LETTER visory powers. At the same time, the Bear Stearns debacle in the United States is being attributed to the absence of a single A strength of the vibrant Indian fi nancial supervisor. What is essential is effective market and its institutions is their ability to cooperation between all the concerned develop decentralized innovative solutions authorities, which transcends the spe- to India’s vast problems. One-size-fi ts-all cifi cs of organizational architecture. risk-averse micro-management by a regulator will deny the financial sector these In summary very strengths. An analogy may be useful here. Think of the fi nancial sector as water In sum then, the Committee believes that fl owing downhill, that has to be channelled there is no room for complacency. The im- to irrigate the economy. It is best to allow peratives of the need to grow the economy water to fi nd its natural course, rather than and improve inclusion will necessarily create impose a centralized solution that fails to more risk. The regulators cannot stand in make best use of the topology. And when the way, they have to monitor and manage the the regulator believes there is a better greater risk, and the public has to be more path, it is best for him to nudge the water tolerant of regulators in that more losses slightly with gentle banks, using the water’s A Growth-Friendly Regulatory Framework 129 natural propensities. Setting up roadblocks to permit far more entry and growth in or dams will only ensure fl ooding and de- the system. As the relationship between the struction, as the water fi nds disruptive ways regulator and the regulated becomes more around the block. cooperative, efficiency and stability in the system will improve. Principles vs. rules Concerns with a principles-based These concerns would suggest a move from system an exclusively ‘rule-based’ regulatory system to one with a greater share of ‘principles- Can a ‘principles-based’ system work in based’ regulation. In the ‘principles-based’ India? Does it assume more capacity, trust, system, entities would not be evaluated on and probity among regulators and regulated their adherence to the letter of regulation. than available in India? Is it a pipe-dream? Instead, they would have far more latitude It should be understood that a ‘principles- in making their business decisions, but would based’ system is no magic solution. Indeed, it be held responsible by the regulator for the can have more rules written in than a rules- quality of their ‘output’, i.e. their fulfi lment based system (see Box 1 on FSA). What is im- of certain pre-specifi ed principles of sound portant is a change in mindset on the part and ethical business. of the regulator and the regulated. The prin- A regulatory system with greater emphasis ciples based system offers a framework under on principles would avoid the centralized which that change in mindset can take place, micro-management of the day-to-day but it is no substitute. operations of enterprises, increasing their It should also be recognized that ‘rule- efficiency and endowing them with greater based’ regulation is not merely reflective of nimbleness and agility to deal with a dy- the statute books of the nation, but is also namic business landscape. It would help reflective of the approach adopted by the promote greater innovation in financial firms regulator. A regulator that adopts a ‘rule- operating in India, an increasingly necessary based’ approach pursues every minor breach feature for survival and success in the new of a rule, irrespective of its import in the world economy. larger scheme of things. This ‘rule-based’ More focus on principles would also make mindset is further fuelled by the disinclina- better use of regulatory capacity. By shifting tion of the Indian regulator to admit that the the onus of providing positive outcomes to accused may sometimes actually be innocent the regulated, an emphasis on principles in principle. For example, SEBI very rarely, if can generate a range of best practices from at all, acquits a concern which has been the regulated that would far outweigh the issued a show cause notice, regardless of the innovative capacity of the regulator. Indeed, severity of the violation. It may well be that its greatest benefits will come when the the regulator’s fear that an acquittal may regulator learns from the regulated instead result in a possible vigilance commission of imposing its own, more limited, views. inquiry leads to this emphasis on the ‘rule- Moreover, the time spent in ‘box-checking’ based’ approach. supervision and compliance, which eats up By contrast, when adopting a ‘principle- substantial capacity, can be devoted instead based’ approach, a regulator may ignore a to understanding deviations that truly mat- minor violation of positive law, so long as the ter. Self regulation and confession by the spirit of the laws is retained.2 It may there- regulated, a natural consequence of the shift fore be better to term the ‘principles-based’ in responsibility for regulatory outcomes to approach as an approach based on getting the regulated, would reduce the strains on the regulated to adhere to the spirit of the regulatory capacity, and allow regulators regulation while a ‘rules-based’ approach is 130 A HUNDRED SMALL STEPS

intent on the regulated obeying the letter of can draw on the necessary skills to have a the regulation. Given the extensive outside fruitful dialogue. We would thus advocate use of the terms ‘principles’ and ‘rules’, we will institutional change from the top, moving however continue to use them. steadily down over time. ‘Principles-based’ regulation is thus more More generally, while a long-run switch than changing the statutes, the details of im- to a more ’principles-based’ regulatory ap- plementation matter. And there are indeed proach is certainly the right prescription concerns with any implementation. Overly for a dynamic and increasingly market broad principles may not provide enough oriented economy like India, in view of these guidance to either the regulator or the regu- concerns, the transition must happen in a lated in terms of acceptable behaviour. The gradual and well-planned manner. Even as regulators’ freedom to interpret broad rules an end-objective, a more ‘principles-based’ may endow them with excessive powers and regulatory regime does not mean the com- may lead to a fear psychosis among market plete absence of rules. No system in the world participants. Ad-hoc application or disputed is exclusively ‘principles-based.’ interpretation of principles may also lead to litigation, which, particularly given India’s slow judicial process, may prove to be a major The transition hindrance to efficiency. A more ‘principles- based’ system necessitates a certain level of Rule-based regulation starts from the stat- trust between the regulators and the players utes governing regulators and the ﬁ nancial and this can probably develop only with sector (such as the Reserve Bank of India time as the regulated entities’ perception of Act and the Banking Regulation Act) and the regulators’ fairness and even-handedness the regulations specifying the regulator’s emerges, and as regulators develop a comfort powers and obligations under these stat- level with the capabilities and probity of the utes. For instance, the requirement that banks regulated. Till such time, rules, or at least indicative quantitative norms, may provide safe obtain regulatory approval for a range of harbours to which either party can resort to routine business matters, including opening when in need. branches, remuneration to board members Principles will also require adequate cap- and even payment of fees to investment acity on both sides. A low-level supervisor, bankers managing equity capital offerings, accustomed to ticking boxes, is unlikely to is enshrined in the Banking Regulation Act. suddenly have the ability to comprehend The obligations imposed on regulators under the overall risk management strategy of the statute further leads them to frame regula- regulated firm, or the confidence to sign off tions that are formulaic and result in micro- on it. Similar issues will apply to the regu- management of regulated entities. lated. Skills and capacity have to be built The starting point for any transition there- on both sides, and when coupled with ex- fore has to be with the legislation governing perience and precedents, will result in the the regulators. This has to be re-written with emergence of confidence. clear objectives and regulatory principles This discussion suggests it would not be outlined. However, this would have to be sensible to roll out such a system across drafted carefully, as Indian courts are not the board. Indeed the entities that would likely to look upon excessive delegation most benefit from, and have the skills to favourably. The Supreme Court of India has manage, a principles based system, are large held that the ‘essential legislative function’ complex financial firms. And senior regu- cannot be delegated and a statutory dele- lators who would deal with these firms have gate cannot be given an unguided or un- the authority to set precedents, have the canalized power. It would be necessary for experience to see the bigger picture, and the draftsman to therefore formulate the A Growth-Friendly Regulatory Framework 131

Box 1: The Financial Services Authority in the United Kingdom

The Financial Services Authority (‘FSA’), the main The FSA’s general functions are: (a) making rules, ‘Principle-Based Regulation’: The FSA Handbook statutory regulator for the UK, was set up on (b) preparing and issuing codes, (c) giving gen- lists the following as Principles For Businesses: 20 May 1997. The Securities and Investment Board eral guidance, (d) determining the general policy 1. Integrity: A fi rm must conduct its business (‘SIB’) formally changed its name to the ‘Financial and principles by reference to which it performs with integrity. Services Authority’ in October 1997. By virtue of particular functions, (e) issuing statements/giving 2. Skill, care and diligence: A fi rm must conduct the Bank of England Act, 1998, the responsibility of directions. its business with skill, care and diligence. banking supervision was transferred to the FSA, There are provisions in the FSM Act which 3. Management and control: A fi rm must take and through the Financial Services and Markets regulate insurance, business transfer schemes, reasonable care to organize and control Act, 2000 (‘FSM Act’) the FSA took over the re- banking, the listing of securities, and ‘market its affairs responsibly and effectively, with sponsibilities of several other regulatory and abuse’. The FSA may take disciplinary action adequate risk management systems. self-regulating organizations. The FSA is fi nanced against errant entities either by publishing a state- 4. Financial prudence: A fi rm must maintain by the fi nancial services industry and regulates ment against the entity, or by imposing a penalty adequate fi nancial resources. 29,000 fi rms ranging from global investment banks against the entity, or both. 5. Market conduct: A firm must observe to very small businesses, and around 165,000 ‘Principle-based regulation’ means placing proper standards of market conduct. individuals. greater reliance on principles and outcome fo- 6. Customers’ interests: A fi rm must pay due The FSA formally gained its powers under the cused, high-level rules as a means to drive the regard to the interests of its customers and FSM Act on 1 December 2001. Additionally, the regulatory aims that the FSA wants to achieve, treat them fairly. FSM Act also gave the FSA new responsibilities, as opposed to prescriptive rules. Under the risk- 7. Communications with clients: A fi rm must e.g. taking action to prevent ‘market abuse’. based approach adopted by the FSA, the FSA does pay due regard to the information needs of Since the FSM Act, Parliament has extended the not pursue every rule breach. Minor problems its clients, and communicate information to responsibilities of the FSA to include mortgage are usually resolved through the day-to-day re- them in a way which is clear, fair and not misleading. lending and insurance broking. The members lationships that the FSA has with regulated fi rms, 8. Confl icts of interest: A fi rm must manage of the FSA board are appointed by the Treasury. without the need for any formal regulatory action confl icts of interest fairly, both between The Board sets the overall policy of the FSA, but to be taken. The FSA accordingly selects cases itself and its customers and between a day-to-day decisions and management of the staff to investigate according to their seriousness and customer and another client. are the responsibility of the executive. how they fi t in with the FSA’s priorities. This 9. Customers relationships of trust: A fi rm approach is underpinned by the principle that it The regulatory objectives of the FSA are de- must take reasonable care to ensure the is neither possible nor desirable to write a rule to scribed as follows by the FSM Act: (a) market suitability of its advice and discretionary cover every specifi c situation or need for decision confi dence; (b) public awareness; (c) the pro- decisions for any customer who is entitled that a regulated fi rm might encounter. tection of consumers; and (d) the reduction of to rely upon its judgment. fi nancial crime. Over the last few years, the FSA has increas- 10. Clients’ assets: A firm must arrange In discharging these functions, the FSA must ingly taken a principle-based approach. The FSA adequate protection for clients’ assets have regard to certain principles, e.g. the principle still relies heavily on a large number of detailed when it is responsible for them. that a burden or restriction which is imposed rules, and often specifi c process requirements. 11. Relations with regulators: A fi rm must on a person, or on the carrying on of any activ- The FSA accepts that as an inevitable result of deal with its regulators in an open and co- ity, should be proportionate to the benefits, amalgamating the rulebooks of all its predecessor operative way, and must disclose to the considered in general terms, which are expected regulators, the FSA rulebook is a large document FSA appropriately anything relating to to result from the imposition of that burden or (which is popularly said to cover several book- the fi rm of which the FSA would reason- restriction. shelves!). ably expect notice. legislation as a binding rule of conduct. What It is important to note that ‘principle-based’ should be left to the regulator is the ancillary regulation even in India would not be an function of providing the details. At the entirely new phenomenon. SEBI, for ex- same time, it would have to be borne in mind ample, has devised several codes of conduct that regulatory law is penal in nature, and (for instance, in insider trading law) which vague penal law has been found by Indian operate on principles rather than in an ex- courts to be void. Keeping this in mind, a cessively rule-based manner. ‘principle-based’ approach could be achieved We take as given our recommendation by outlining principles which the regulator is (see section ‘Consolidation of all market to be governed by, in the statute itself. In the regulation and supervision under SEBI’) Indian context, these cannot be as broad as that all organized financial trading, spanning those of the FSA (see Box 1) but would prob- currencies, fixed income, equities, com- ably have to contain further specificity. modity futures, exotics (such as weather In what follows, we attempt to sketch and decision markets), and spanning all what ‘principles-based’ securities legislation trading venues and forms of trading should might look like for a specific regulator, SEBI. come under a single regulator, the SEBI. 132 A HUNDRED SMALL STEPS

In order to widen the ambit and functions mechanisms should not be written into of SEBI, the SEBI Act should be amended the legislation. by the insertion of chapters which confer The transition to a more ‘principles-based’ upon it the powers of other regulators to the regulatory system is a multi-dimensional extent that such other regulators regulate and complex process. It is possible to be trading. Each of the amendment acts would so overwhelmed by the task that one never concurrently repeal the statute governing the starts. The status quo should be seen as an regulator sought to be integrated, or divest unacceptable drag on India’s growth, which the regulator of some of these powers, and is why we must not delay. The next few sec- would either itself contain provisions for tions will outline a number of other changes, integration of personnel etc., of such other which undertaken carefully, will take us to regulators or leave such matters to a statutory our goal. These include changing the in- delegate. centive structure and talent pool in the SEBI’s mandate should be devised at the regulator so that the regulatory mindset can level of principles, starting at the broadest change, as well as changes in the oversight level with overall objectives such as stability. process over the regulator so that regulatory At one level, this means that in devising the powers do not go unchecked. It also includes statutes, to the extent possible details about changes in the structure of the regulatory products/securities, players, institutions, mar- architecture so that silos are broken down ket platforms and market mechanisms must and gaps are reduced. be left out of the legislation, to be filled in dynamically by the regulator. More specifically: IMPROVING THE QUALITY OF THE REGULATOR z Repeal the Securities Contracts (Regu- lation) Act, 1956; the RBI (Amendment) A move towards principles will require Act, 2006; and the Forward Contracts (Regulation) Act, 1952; capable, motivated, regulators, who have z Through a permissive, enabling frame- the vision to focus on important essentials work, all organized fi nancial trading must rather than on bureaucratic box-checking. be brought within the ambit of SEBI. For Clearly, there are such regulators to be found this purpose, Section 412 of the United in our system, but how do we ensure they Kingdom’s Financial Services Modern- are the norm? ization Act is instructive, as it permits a statutory delegate to specify contracts that are exempt from wagering restrictions (and thus come under the ambit Incentives of securities trading and regulation). For our purposes, this may be better achieved The quality of regulatory output is infl u- through a negative, rather than a positive, enced by the overall environment in which list; the regulator operates, the consequent in- z The regulator must recognize that centives they face, and the performance traditional trading venues can be trans- standards they are held to. In fact, the performed, with trading taking place in ceived inadequacies in the quality of regu- venues ranging from existing public exchanges such as the NSE and BSE (requir- latory output may have more to do with ing full investor protection norms) to incentives and environment than with innovative Internet-based trading plat- fundamental defi ciencies in the quality of forms for Qualifi ed Institutional Buyers talent that regulators attract (though this is (the professional exchanges discussed in not always inconsequential). Chapter 5) and the Over The Counter Regulators at the highest level constantly markets, where required investor protection may be different. In order to run the risk of having to face roving enquiries facilitate innovation in trading plat- that second guess specific decisions with the forms in the future, details about trading benefit of hindsight. As long as this risk is A Growth-Friendly Regulatory Framework 133 not eliminated, the response of regulators z The parliamentary Committee would be to the need for innovation and proactive guided by the remit in its discussions with behaviour will not change. The starting the regulator. z The annual report, the statement of the point for protecting regulators from open regulator to the Committee, and a trans- ended demands is a clear written directive cript of the Committee discussions with from the government, acting in pursuance of the regulator should be made widely ac- the legislative mandate, specifying with the cessible to the public. maximum possible clarity the principles the regulator will be held accountable for. Existing law has provisions that enable gov- Appellate tribunal ernment authorities to do so. The fact that Checks on regulatory excess are necessary these provisions have not been used so far for any regulator but they are even more is sometimes held out as an example of the important for ‘principles-based’ regulators maturity of the actors involved. More likely, because of the greater discretionary powers this is probably a reflection of inadequacy. that they enjoy. We now specify how such a directive could This Committee recommends that there be developed. should be an appellate tribunal for all major regulators including the RBI. This should Accountability be a single tribunal which might through its own rules and processes create benches specializing in different aspects of financial An independent regulator can be held regulation. The Securities Appellate Tribunal accountable only through a process of inde- (SAT) that hears appeals from SEBI has served pendent evaluation, given pre-specified a very useful purpose and the proposed Fi- objectives or principles. This Committee nancial Sector Appellate Tribunal should recommends that all financial regulators have similar scope, powers and processes and should be subject to a periodic external evaluation. In a parliamentary system of should subsume SAT. government, the ultimate locus of accountability is the parliament. Therefore, Staffi ng all fi nancial regulators should be accountable to a standing Committee of parlia- Of all the staffi ng decisions relating to the ment (possibly, the Standing Committee on regulators, the most important is the choice of Finance). the head of the body. As at present, the re-

z Once in fi ve years, a body of reputed out- spective statutes provide that the heads side experts (including possibly regulators of these bodies are to be appointed by the elsewhere) would be constituted to pro- government. The credibility of the selection pose guidelines for the evaluation of the process could be greatly enhanced by sti- regulator for the next fi ve years, given the legislative mandate. pulating that selection Committees, with z Based on the report of experts, the gov- credible expert participation (including from ernment, in consultation with the Parlia- the private sector), should prepare a short list mentary Committee and the regulator, from which the fi nal selection can be made would fi nalize the specifi c principles by the government. (the ‘remit’) the regulator would be held accountable for, including any parameters The selection Committee should also for annual evaluation. recommend the remuneration package that z The regulator would submit an annual should be provided; the statutory protection report to parliament (this does happen cur- against variation of the conditions during the rently for many regulators). This report would include the progress on pre-agreed term of office should continue. Government evaluation parameters and would be dis- should offer this recommended package as a cussed in the parliamentary Committee. matter of course. 134 A HUNDRED SMALL STEPS

With a competent and respected indi- the talent required, at least no more than in vidual of proven integrity at the head of a other professions in India. regulator, substantial freedom would have to be provided to this person to choose the best possible individuals for key positions, STREAMLINING offering them terms that are in line with THE REGULATORY the market. The recent proposals by the ARCHITECTURE 6th Pay Commission for hiking compensation for top regulators are a step in the right Should India move towards a single direction. The pay of the head regulator, while substantial, should not, however, be- regulator and prudential supervisor? come a ceiling for pay among regulators. It should be possible to carve out key positions As the boundaries between fi nancial activ- in respect of which the terms and conditions ities blur, it makes sense for the boundaries of employment are left to be decided by the between regulators to blur, and eventually, head of the organization, or a Committee for supervision of fi nancial services to be of senior officials. A staffing and remuner- consolidated. Eventual consolidation will ation sub-Committee of the regulator’s board reduce overlaps, costs, eliminate gaps in should provide the necessary guidance in supervision, and improve regulatory and this regard. This would enable the induc- supervisory coordination. It will allow the tion of talented young employees, and also unifi ed supervisor to take an overall view provide for lateral entry at all levels. Every of risks, including risk concentration and effort should be made to allow mobility to risk transfer, across different kinds of insti- and from the private sector, though each tutions. The unifi ed supervisor will be bet- individual organization would have to take ter able to handle large complex fi nancial reasonable precautions against conflicts of institutions. And an integrated regulator will interest arising out of prior or subsequent probably offer ‘one-stop-shopping’, which employment. will speed up innovation, as well as ensure With a restructuring of the staffing process consistency in regulation and supervision in the manner described above, processes across institutions. relating to performance measurement, ac- An integrated regulator is not an unmiti- countability, training, and human capital gated blessing. An integrated regulator may enhancement can be redesigned. have conflicts between objectives. More- To summarize, low compensation is often over, there may be a need for a difference seen as the main impediment in improving in emphasis in different situations—in the the quality of regulators. While compensation case of insurance and banking on pruden- is an important factor in attracting the right tial supervision, while in the case of markets talent, it is not the only, or even critical, factor. on business conduct and integrity. Such Key positions in the regulators would be differences may not sit well within an attractive for very talented individuals, given integrated regulator. Furthermore, since a the great satisfaction that would undoubt- unified regulator is likely to be formed by edly accrue from shaping public policy and the merging of existing agencies, it may result taking decisions of tremendous import, as in a mammoth bureaucracy that, while on also the value placed by the market on such paper a single entity, is likely to experience experience. It is thus important to structure the same divisions that characterize the responsibility and mobility appropriately. existing set of regulators. The older and Experience also indicates that, to the limited more established regulators may dominate extent to which regulators have been able to and overrule fledgling ones within the inte- break out of rigid staff and pay structures, grated whole, to the detriment of the over- there has been no real difficulty in attracting all system. This, coupled with regulatory A Growth-Friendly Regulatory Framework 135 monopoly, could potentially negate the of the players, and ensuring a level playing possible sensitivity of a unified regulator to field by making all players performing a the needs and changing realities of the mar- function report to the same regulator regard- ket and its participants. Finally, there may less of their size or ownership. In addition, be a public perception that the integrated the Committee feels it is prudent to start the regulator will bear equal responsibility for all process of unifying regulation and super- supervised institutions, extending the safety vision at certain levels, and will recom- net enjoyed by depository institutions more mend a strengthening and consolidation widely, with ensuing moral hazard. of regulatory structures to deal with large As the chart below shows, countries are fairly complex, systemically important, financial evenly distributed across regulatory archi- conglomerates on the one hand, and with tectures. On balance, the Committee feels it the consumer on the other. is premature to move fully towards a single regulator at the moment, given other pressing regulatory changes are needed. However, Consolidation of all market regulatory structures can be streamlined regulation and supervision to avoid regulatory inconsistencies, gaps, under SEBI overlap, and arbitrage. Steps in this direction should include a reduction in the number At present, in India, the regulation of organ- of regulators, defining their jurisdiction in ized financial trading is spread between terms of functions rather than the forms three agencies: RBI (government bonds and

A Snapshot of International Regulatory Architectures

Source: How Countries Supervise their Banks, Insurers, and Securities Markets, 2004, London, Freshﬁ elds. Note: * Indicates that banking supervision is conducted by the central bank. 136 A HUNDRED SMALL STEPS

currencies), SEBI (equities and corporate This would include equities, corporate debt, bonds) and FMC (commodities, futures). government bonds, currencies, commodities, This unusual framework is the product of his- and other kinds of products. This would in- torical legacy and is suboptimal. It induces clude both spot contracts and derivatives, three kinds of problems: exchange-traded and OTC products. SEBI is ideally suited for filling these roles 1. It induces a loss of economies of scope for several reasons. First, the equity market and economies of scale for the government, exchanges, fi nancial fi rms, and (both spot and derivatives) is India’s most customers. There are strong commonali- sophisticated and most liquid market; hence, ties between all kinds of trading—an SEBI’s knowledge is rooted in the strongest electronic order-matching system for market. Second, the legal foundations of currencies or index futures or gold fu- SEBI are relatively recent, and it is less subject tures or interest rate swaps is largely the same. Government, exchanges and to legacy issues. Finally, the vigorous pace fi nancial fi rms would be able to harness at which the SEBI Act and SC(R)A have been economies of scale and economies of amended in the last decade—in response to scope by undertaking, or dealing, with the requirements of the equity market— all organized fi nancial trading under a have helped position SEBI to take on new single roof. 2. It fragments liquidity, and encourages challenges. regulatory gaming. Arbitrage tightly Note that in some markets, such as the binds all fi nancial securities related to a government debt market or the currency given underlying asset. For example, futures market, some coordination will be exchange-traded Nifty futures are required between SEBI and other regula- strongly linked to OTC derivatives based tors that have an interest in the market. on Nifty. It is best that all channels for trade be open, so that traders seek the For example, the RBI may have an ongoing best one, and that the regulatory regime legitimate interest in determining who par- not impose differential costs. However, ticipates in these markets—it might continue at present, OTC trading is either banned to determine who the Primary Dealers would (e.g., equity) or dealt within a frag- be in the government securities market. mented way (OTC trading on interest rate derivatives is supervised by RBI while Similarly, it may have an ability to influence exchange-traded interest rate derivatives participation (by altering bank SLR re- are supervised by SEBI). Fragmentation quirements for example). While the logic of creates all sorts of gaming opportunities SEBI regulation of trading is clear (and this for participants, as well as turf issues will help the RBI by reducing the conflicts among regulators in favouring one or other venue for the fi rms they regulate, of interest created when it both trades in, that leads to a loss of liquidity, price ef- as well as regulates trading in, markets), it fi ciency, and even stability. is imperative that the regulators work out 3. Loss of competitive pressure. At present, respective responsibilities so that the func- Indian markets are carved into three silos, tioning of the markets is not impeded.3 each regulated (and protected) by a separate regulator. An exchange or a clearing Simultaneously with the merger of regu- corporation or a depository working in lation and supervision of organized finan- one silo is prohibited from competing cial trading at SEBI, a clear effort needs to be with entities in other silos. India’s inter- undertaken to limit the role to regulation and ests would be served far better if all these supervision, while distancing other services entities were in a unifi ed industry with vigorous competition and innovation. from the regulator. This is similar to the clarification of the role of the regulator in The Committee was persuaded by the (say) telecom, where TRAI is the regulator, importance of these three considerations to and erstwhile government service functions recommend unification of all regulatory and have been corporatized in MTNL, VSNL supervisory functions connected with or- and BSNL. Applying this principle, the bond ganized financial trading into a single agency. market depository within RBI (SGL) will A Growth-Friendly Regulatory Framework 137 need to be corporatized. It would then The RBI has historically been reluctant to compete with NSDL and CDSL as a third take on the full responsibility for supervising depository. Similarly, the bond exchange cooperative banks and state governments (NDS) will need to be corporatized. It would have also been reluctant to give responsibility then compete with other exchanges in up. This is a potentially dangerous situation the country. The CCIL and its exchange where no one really bears full responsibility subsidiary would be brought under SEBI for problems that might emerge. The recent regulation as an exchange. trend towards memoranda of understand- Once unification is achieved; full coming (MOU) between state governments and petition should prevail between the pool of the RBI to revitalize urban cooperatives exchanges, clearing corporations and depo- while strengthening the powers of the RBI, is sitories. Low entry barriers should ensure that welcome. But given increasing competition new players can enter in each of these areas, and the wider powers that are proposed for including innovative professional exchanges banks, cooperative banks, whose managerial/ which target sophisticated or institutional administrative matters are currently partly customers, and foreign exchanges. The goal under the State Registrar of Cooperative should be to achieve securities infrastruc- Societies, should be treated like commercial ture which has world class economies of banks and brought completely under the scale, world class efficiency and low prices, banking supervisor over time. This will and a world class pace of innovation. simply be a logical extension of the path The Committee further recommends currently being travelled with the MOUs. that the unification of trading under one This would require a considerable in- regulator be further accompanied by steps crease in central regulatory capacity, as well to break down unnecessary barriers that pre- as political enterprise, but the alternative is vent trading across exchanges or products. to allow dangerous regulatory gaps to build. As this Committee repeatedly stresses, in- All kinds of financial products should be adequacy of regulatory capacity cannot be represented in unified exchange screens, acceptable as a long-term constraint on the and a firm with multiple exchange member- financial system. ships should be able to trade them seamlessly. There is no point having a consolidated Finally, the SEBI has been dealing with ex- supervisor if that supervisor is weak. In add- changes as self regulatory organizations ition to consolidating supervision, the system (SROs). The exchanges therefore assist of prompt corrective action and resolution SEBI in regulatory matters that pertain to of weak banks should be strengthened their activities. There is, however, a need and made more explicit, possibly under a for a regulatory structure to assist SEBI in revamped consolidated deposit insurer. It supervising cross-exchange activity, which should be recognized that the continued will increasingly become more important. existence of weak banks without resolution Greater integration of market regulation spreads weakness to the rest of the system, under SEBI will create the conditions to set is a potential source of instability, and in- up such a structure. creases the regulator’s reluctance to permit new entry. Consolidation of all deposit-taking entities under one banking supervisor Consolidation of monetary policy and banking supervision All banks and any other deposit taking entities should come under one supervisor The Committee considered carefully the as suggested by the Narasimham Committee question of whether responsibility for Report on Banking Sector Reforms. monetary policy and banking regulation 138 A HUNDRED SMALL STEPS

and supervision should be separated, or the banking system. A monetary authority consolidated under one roof. The argu- with deep knowledge of the banking sys- ments in favour of separation are strong. tem will be best placed to undertake such Any regulator tends to have sympathies for intervention. There are also significant scope the entity it regulates, and not just because economies in the information needed for the it has responsibility for the well-being of conduct of monetary policy and for assessing those entities. Monetary policy could be bank health. conducted with the intent of restoring the The international experience offers little health of banks (as was arguably the case with guidance as to what might be best. The Bank Bank of Japan and Federal Reserve policy in of England does not supervise domestic the 1990s) to the detriment of infl ation and banks, and neither does the Bank of Japan, but growth objectives for the larger economy the Federal Reserve does supervise large bank (in which bank health is just one, albeit holding companies. The European Central important, component). Similarly, in an Bank does not supervise banks directly, but economy with fl edgling markets, the incentive the heads of member central banks, which for the monetary authorities to intervene in have regulatory and supervisory functions, markets so as to preserve the value of secur- sit on its monetary policy committee. ities bought by banks can retard the growth As with any issues to do with organiza- of those markets and impair fair and trans- tional structure, outcomes depend heavily parent pricing, as well as information on practice. Separation of powers can work discovery. well if the monetary authority and the regu- In a financial sector dominated by banks, latory & supervisory authority have clear conflicts of interest may also go in the other responsibilities and strong channels of direction. In order to achieve its monetary communication. Consolidation can work well policy objectives, the central bank may use if the monetary authority is transparent tools other than the short term interest rate, about its objectives and is sparing in its use such as the Cash Reserve Ratio. Regard- of instruments other than the interest rate less of the debatable efficacy of such tools to achieve them. in achieving monetary policy goals, the In the final analysis, the Committee problem is they have an asymmetric effect on believes the move towards separation may institutions, affecting banks while leaving be premature today, especially keeping in others like finance companies untouched. mind there are strong arguments to be made This is to be avoided for it tilts the playing on both sides of the debate, as listed above. field, giving undue advantage to some, creat- The rationale is as follows. First, the record of ing competitive uncertainty, and inefficient cooperation between regulators is mixed at allocation of resources. The use of prudential best. Before separating functions, it would be and supervisory tools to meet monetary sensible to make sure that we have a better policy objectives also reduces their effec- understanding of what it will take to ensure tiveness in enhancing stability, and their seamless cooperation—it would be a recipe signalling value. for systemic catastrophe if the monetary These concerns have to be set against authority does not communicate with the the benefits of consolidation. The ability banking supervisor. Second, we believe that of the monetary authority to have intimate important changes are warranted both in the knowledge of the condition of banks can monetary policy setting function (as outlined help it conduct monetary policy better, espe- in Chapter 2) and in banking regulation and cially in times of distress when banks may supervision. These changes are more press- be less effective conduits for transmission. ing. Of course, one could argue that it is best And there may be occasions when the larger to make all changes at once. The majority interests of the economy are served by using of the Committee believes that the area of liquidity infusion and interest policy to help banking supervision is probably one where A Growth-Friendly Regulatory Framework 139 changes should be measured rather than and NHB. For example NABARD supervises revolutionary, for the downside risks of tur- Regional Rural Banks, as well as the state moil here could be extremely detrimental to cooperative bank network (a shared re- the economy. sponsibility with the state Registrar of Co- Ultimately, as barriers between financial operative Societies). In addition, though, activities fall, India should move towards it plays a role in refi nancing some of these one consolidated prudential regulator and organizations. Dual roles of this kind typic- supervisor. Given this entity will be con- ally create confl icts of interest that impair cerned with more institutions than only effective regulation. The Committee would banks, it should be distinct from the monetary advocate focusing these bodies over time on authority, but should cooperate closely with the purely regulatory function (and con- it. Thus separation of monetary policy and solidating these regulatory activities where supervisory authority should likely emerge possible with the single regulator for the in the medium term. function), and separating the refi nancing and other commercial functions into a different Bring all fi nancial intermediaries body. Over time, markets should take up the governed by special statutes under commercial functions. general statutes An improved system of audit for Several of the key fi nancial services inter- listed and unlisted companies mediaries including SBI and its Associate Banks, Public Sector Banks, LIC, GIC, etc., In India, annual accounts filed with the are governed by their own statutes such as the Registrar of Companies under the Depart- SBI Act, the SBI (Subsidiary Banks) Act, the ment of Company Affairs in the Government two Bank Nationalization Acts, the LIC Act of India. However there is no system of and the GIC Act. These special statutes should reviewing accounting reports even on a be repealed, and statutory corporations selective or sample basis. By contrast, in the should be corporatized or formed under the USA, the Securities and Exchange Com- general statutes governing form of business mission (SEC) has a division comprising enterprise (such as the Companies Act, 1956 hundreds of lawyers and accountants to or the proposed LLP law under consideration) review such annual reports and if necessary, and placed on a level playing fi eld with all seek clarifi cations from the companies in other fi nancial services intermediaries (that question. are formed or organized under such gen- The Committee believes that such a pro- eral statutes governing form of business cess of review is absolutely essential. To enterprise). The precedent exists for IFCI, ensure that this does not add to red-tape, such UTI and IDBI, which previously operated review should not lead to any certification under special statutes. or clearance for the companies concerned. The reviews may be selective to begin with Consolidate regulation of pensions (perhaps starting with large listed companies) and the companies should be allowed While pension regulation is still in its for- to clarify questions. However if and when mative stages, the aim should be to have a evidence of financial fraud is revealed, it consolidated regulator for the industry. should lead to penal actions against the offending companies. Given the additional Streamline tier 2 regulators regulatory capacity and personnel necessary to implement this, it may be desirable ini- India has a number of regulators who are tially to have the review partially or fully out- at a second tier, such as NABARD, SIDBI, sourced to accounting or legal firms. 140 A HUNDRED SMALL STEPS

The Committee believes the responsibil- CONSOLIDATING ity for this oversight for unlisted companies REGULATION should be with the Ministry of Corporate Affairs (MCA) because the statutory powers in As fi nancial conglomerates begin to domin- respect of accounting statements under the ate the system, a consolidated system of Companies Act vests with the MCA. For listed supervision becomes more important. More- companies, the Committee recommends over, spillovers between various aspects of vesting the review with the SEBI, which in the financial system necessitate constant any case reviews disclosure by companies communication between regulators at the when they issue securities. highest levels. Even though our Committee In line with the Committee’s general recommends separate prudential regulators, view that information technology can and it strongly recommends strengthening the should be leveraged to solve several problems ties between them and improving coordin- in the financial sector, the Committee also ation, especially given the potential systemic recommends consideration of adoption of consequences of regulatory gaps and un- a standards-based way of communicating regulated entities on the fi nancial system. business and financial information to fa- The Committee also notes the consumer cilitate the regulatory review process. XBRL faces an integrated portfolio of services. It is (Extensible Business Reporting Language) increasingly important for the consumer to that has been adopted in several countries have a ‘one stop’ source of redress for com- is one such platform. Use of such a format plaints. An integrated ombudsman for con- in the annual online filings of companies to sumer issues may also be important for MCA is likely to facilitate the review process dealing with aspects like financial literacy and considerably. financial counselling that span regulators. Oversight of audit firms is another area that needs significant improvement in India. Currently the auditors are largely governed Current situation by the Institute for Chartered Accountant of India (ICAI). An independent and credible The High Level Coordination Committee body to oversee the audit industry—like on Capital Markets (HLCC) was constituted the non-profit Public Company Account- by the Ministry of Finance to resolve any ing Oversight Board (PCAOB) introduced important regulatory and policy issues re- in the United States by the Sarbanes Oxley quiring consideration at a high level. The Act—would go a long way in enforcing high remit of this Committee has changed over auditing standards and creating credibility time. At present, the HLCC is expected to in the corporate financial reports. Such a body consider only divergence in policy issues could be set up by the authority regulating among different regulatory authorities. It the accuracy of company accounts, and its does not have statutory backing, nor does it members appointed by the SEBI Board in have a dedicated secretariat. Separately, the consultation with MCA. The Accounting Ministry of Finance has constituted three Oversight Board should have a variety of separate technical Committees. Each Com- functions, including moving towards inter- mittee is headed by a senior level functionary national audit standards, verifying standards in RBI, SEBI and IRDA and has representa- of transparency and governance of audits at tives from other regulators or agencies. These public firms, and sustaining the capabilities technical Committees monitor developments of auditors at high levels. Care should be in the markets and suggest action on early taken that appropriate powers move from warning signals. ICAI to PCAOB so that there is no overlap The Reserve Bank of India has now set up in functions. a system for conglomerate supervision as part A Growth-Friendly Regulatory Framework 141 of the activities of the Board for Financial apex regulatory authority, without disturbing Supervision. Data and information are now the existing jurisdiction, is necessary. In this being regularly collected from the designated view, the apex authority would have, by law, entities for the 12 financial conglomerates jurisdiction to assign regulatory gaps to one of under its purview. These data are analyzed the agencies, arbitrate on regulatory overlaps, and semi-annual discussions are held with and ensure regulatory coordination (what the CEOs of the designated entities in asso- is known as the Reddy formula). ciation with other regulators. The consensus of our Committee is that There is also some operational coordin- there is a need for a Financial Sector Oversight ation amongst different regulators. For Agency (FSOA) that is set up by statute. The instance, SEBI’s guidelines relating to the FSOA’s focus will be both macro-prudential government securities market have been as well as supervisory; the FSOA will develop issued after consultation with the RBI. periodic assessments of macroeconomic Despite these structures, the general feel- risks, risk concentrations, as well as risk ex- ing among regulators the Committee spoke posures in the economy; it will monitor the with was that coordination and commu- functioning of large, systemically important, nication was not as effective as it could be. financial conglomerates as well as large sys- For instance, meetings of the HLCC were temically important financial institutions often thought to be formulaic, with little of that would otherwise be unregulated;4 antici- substance really being discussed. We believe pating potential risks, it will initiate balanced this to be a worrisome state of affairs, which supervisory action to support the action by needs to be remedied. the concerned regulator to address those risks; it will address and defuse inter-regulatory conflicts. The FSOA will take over the work Improving coordination and now done by the HLCC as well as the tech- supervising conglomerates nical Committees. The FSOA should be comprised of chiefs There are essentially three broad sets of of the regulatory bodies (with a chair, typic- activities that need to be carried out in an ally the senior-most regulator, appointed integrated manner: from amongst them by the government), and should also include the Finance Secretary 1. Coordination amongst regulators so as to as a permanent invitee. The FSOA should remove gaps and overlaps, and to remove have a permanent secretariat comprised of inconsistencies in approach; staff including those on deputation from the 2. Integrated regulation and supervision various regulators. There should be a pre- of systemically important fi nancial con- scribed minimum frequency of meetings glomerates and organizations; 3. Overall monitoring of the entire fi nancial of the FSOA. All issues of regulatory co- sector and initiation of prompt and coordination, and supervision of systemically ordinated corrective action. important financial conglomerates and organizations will be taken up by the FSOA. The need to establish the coordination The FSOA should not lead to fractured mechanism on a firmer footing has been felt responsibility, nor should it add, as far as even earlier. The Advisory Group on Securities possible, an additional layer of regulation. Market Regulation, 2001 (Chairman Shri The FSOA will have a periodic ‘principles- Deepak Parekh) felt that there would be based’ discussion with the managements of merit in formalizing the HLCC by giving it these systemically important financial or- a legal status. It also felt that the HLCC needs ganizations on the basis of material put to meet more frequently and its functioning together by the lead regulator for that entity, made more transparent. Another view is that together with staff from other regulators. This an umbrella regulatory legislation creating an will be the primary high-level discussions 142 A HUNDRED SMALL STEPS

between the management of the institutions between equity linked insurance products and the regulators, and should be attended and mutual funds, each regulated by a differ- by all regulators at a high level. However, while ent entity. Regulatory differences may create attempting to avoid repetitive discussions different levels of product transparency to the that cover the same ground already covered detriment of the customer. Similarly, many by the FSOA, each regulator will continue products contribute to their overall debt level, to have full responsibility for the portion some that might come from banks, others of the conglomerate that falls under their that might come from their broker. Whether purview. it be in improving consumer awareness of The FSOA will also undertake periodic over-indebtedness, taking up grievances system wide stress tests of the financial sys- about excessive zeal in debt-collection, or en- tem to assess the levels of liquidity, capital, couraging amicable negotiation between an and the build-up of risk concentration. over-indebted individual and his creditors, Care must be taken to ensure that the FSOA no single regulator has the overall picture. does not impose undue additional regula- This Committee believes there is a need for an tory burdens on financial conglomerates and Offi ce of the Financial Ombudsman (OFO) does not put entities within such a conglom- to take over the disparate efforts at consumer erate at an undue competitive disadvantage literacy, protection, counselling, and arbitra- vis-à-vis standalone competitors. The iden- tion, by replacing existing such efforts at the tification of financial conglomerates must regulators. also be strengthened and clarified, and all sig- The Committee envisages a number of nificant groups, whether or not they include functions for this office: deposit-taking entities, must be considered for supervision by this mechanism. 1. Take responsibility for improving fi nan- In addition, there is merit in setting up a cial literacy in the country using funds that Working Group on Financial Sector Reforms are accumulating unused at the various regulators for this purpose. The OFO with the Finance Minister as the Chairman. can conduct integrated educational and The main focus of this working group would advertising campaigns that no single be to monitor progress on financial sector regulator can. reforms (such as the proposals of the Patil, 2. Monitor selling of different products, the Parekh, Mistry, and this committee), and to degree of transparency about their pric- initiate needed action. The working group’s ing, risks, and other attributes, and their suitability for targeted customers. membership would include the regulators, 3. Serve as the primary ‘catchment’ for con- as well as ministries on as-needed basis. The sumer grievances that are not addressed working group would be supported by a through communication between con- secretariat inside the Finance Ministry. sumer and fi rm, and serve as liaison be- Finally, steps could be taken to improve tween consumers and fi rm, and between the channels of communication between fi rm and regulator, on repeated grievances. 4. Arbitrate compromises between over- regulators. Cross board membership would indebted borrowers and creditors, head- be an important step (and not just between ing off more costly confl ict. SEBI and RBI). Moreover, the necessary laws 5. License investment advisors and the should be amended so that information can variety of other fi nancial service counsel- be shared between all regulators without lors who interact with retail customers. violating secrecy rules. The OFO should take over all the activities by current regulators that overlap with An integrated ombudsman 1–5. The Committee was mindful of the need to not create a costly new bureau- Consumers typically face a range of prod- cracy that would simply increase layers of ucts, not a single product. They have to choose regulation. At the same time, it recognized A Growth-Friendly Regulatory Framework 143 that without a reasonable and responsive of new fi rms and the exit or failure of weak structure to govern interactions between fi rms. Under this ‘Schumpeterian creative firms and customers, there was an increasing destruction’, exit by weak fi rms frees up re- risk of outcomes that was in neither group’s sources that are better utilized by strong interest. It therefore suggests an organiza- fi rms, thus leading to the maximal growth of tion that has much of the characteristics the country. Some failures of fi nancial fi rms, of a self-regulatory organization, with only while not actually to be welcomed, should a small permanent staff, and the rest on be deemed as a necessary accompaniment to temporary deputation from existing regu- competitive dynamic conditions, and indeed lators and industry. The OFO should estab- a salutary refl ection of those conditions. lish strong links to NGOs and pillars of the So it is necessary to ask whether the failure community (for example, retired accountants, of financial firms pose more public policy lawyers, judges, and bankers) for the broader concerns than the failure of industrial firms, educational, counselling, and arbitration which would then necessitate greater efforts activities it will need to undertake. It should at prevention and resolution. Indeed, in some work as a complement to consumer courts, cases, failure raises no special concern. As an resolving a number of situations directly and example, when a fund manager is the agent at low cost. And it should make maximum of a customer, and the losses of the portfolio use of technology to expand its reach. are transparently and continually borne by It is beyond the remit of this Committee the customer, negative portfolio returns are to suggest the precise design of the OFO. not a problem. Even if there is an extreme That will depend on the ingenuity of the event and the fund manager goes out of person(s) charged with setting it up. But business, this need not significantly affect it does emphasize the need for some such the customer, for his assets can then be organization, especially as financial services transferred to another fund manager (or returned to the customer) by the resolution expand their coverage and reach the weaker agency. sections of the population. Four broad concerns do arise, however, with financial firms. First, the fear of failure PREVENTING CRISIS AND of a financial firm could lead to a run that actually causes the firm to fail. This has DEALING WITH FAILURE historically been the rationale for deposit insurance. Second, the failure of one finan- One of the most important aspects of the cial firm could disrupt liquidity conditions stability of a fi nancial system is the mechanism in the market, which then causes other finan- for preventing fi nancial failure and the means cial firms to fail—a rationale for liquidity through which the failure of fi nancial fi rms regulation. Third, financial firms could be is resolved. Clearly, both macroeconomic the repository of knowledge about small and policy as well as prudential supervision will medium borrowers, and their failure could play a role, and we discuss those aspects else- disrupt credit, a critical input, to a vulner- where. In this section, we discuss the pre- able section of the local economy. Finally, vailing framework for corrective action and in a developing country like India, ‘buyer resolution, and proposals for reform. beware’, which places the entire responsibility for judging the soundness of a financial firm upon a household, may not be When does failure of fi nancial fi rms an entirely feasible economic or political have public policy implications? strategy. There will be a demand for a few products to be identified as safe (e.g., demand A healthy competitive dynamic economy is deposits), with the government implicitly one in which there is a steady fl ow of entry guaranteeing their return.5 144 A HUNDRED SMALL STEPS

In general, this Committee believes that orders and trades; order matching by price- every effort should be made to narrow what time priority ensures that buying is done is guaranteed by the government to the bare from the lowest-cost order and avoids the po- minimum. This is another reason to reduce tential of malfeasance where a dealer buys the public sector presence in the financial from an accomplice at a higher price. From sector, for that presence implies an implicit the perspective of failure, however, the crit- guarantee the government can ill afford, ical edge of exchange-traded derivatives and places private players at a disadvantage. lies in the risk management services of the It is also a reason for regulators to pay par- clearing corporation. The clearing corpor- ticular attention to entities that are not just ation becomes the legal counterparty for large but also service many customers, for the net settlement obligations of all clearing those entities may have too many customers members. Thus, if one clearing member to fail. Finally, it is important for regulators to fails, nobody else is affected because their ex- create awareness that the fact an entity is regu- posures are against the clearing corporation lated does not imply its safety and continued and not the failed firm. existence is guaranteed. The clearing corporation, in turn, is a spe- Despite all attempts to ring fence the costs cialized risk management institution with a of failure and preventing it from spilling professional focus on measuring and con- over into the public domain, the regulator/ trolling the credit risk of clearing members, government will have to intervene in some in part through margin requirements. India cases. The role of prudential supervision is has two successful clearing corporations— thus to minimize the probability of such NSCC and CCIL. occurrences, as well as the public costs when While both OTC derivatives and exchange- they occur, without unduly hampering traded derivatives undoubtedly have a growth. It is important to achieve the right role to play in a sophisticated financial sys- balance between prudential caution and tem, there is merit in encouraging the mi- growth, for the surest (and clearly wrong) gration of trading in standardized products way to minimize failure is to ban all activities to the exchange so as to mitigate risk. There that imply any risk. A regulator who targets is certainly no case for biasing public policy zero risk of failure may not be hitting the against exchange-traded, and in favour of, right balance. OTC. Complex derivatives, because they are not standardized, must be transacted on the Minimizing risk: Exchange OTC market. Internationally, these have trad- traded vs. OTC itionally involved bilateral exposures. These can induce a ‘domino effect’ when one fi- The fi rst step in preventing fi nancial sys- nancial firm fails. However, for these trans- tem risk spillovers is to adopt preventative actions also, it is possible to engage the methods. We do not have the space in this risk management services of a clearing report to address the many ways of risk miti- corporation. Here, a clearing corporation gation and prevention, but illustrate with would earn a fee by becoming the legal some examples from counter-party risk. counterparty to both sides of a complex For simple derivatives—such as currency OTC derivative. It would impose margin forwards—the exchange is a superior method requirements, and collect a daily mark-to- for organizing the market as compared with market margin, from both counterparties. the Over The Counter (OTC) market. Elec- India was a pioneer in embarking on such tronic trading on the exchange reduces the thinking, with the Clearing Corporation of cost of search for counterparties; trading on India (CCIL) playing such roles on the OTC an exchange involves transparency of both derivatives market, such as the currency A Growth-Friendly Regulatory Framework 145 forward market. This method of risk miti- related party transactions are limited is to gation needs to be strengthened and extended ensure widespread ownership, or owner- considerably. As an example, in the United ship by an entity that is unlikely to suffer States, the NYMEX clearing house has serious confl icts of interest. Indeed, this has encoded hundreds of structures of OTC deriv- been one of the underlying rationales for ative contracts, and levies margins taking the RBI’s guidelines for ownership of banks. into account the entire portfolio of exchange- This Committee endorses those guidelines, traded and OTC-derivatives positions of its while suggesting that an exception can be clearing members. This is beneficial for the made in the case of a strategic stake held by members, who benefit from the reduced mar- a diversely owned fi nancial company (where gins on the aggregate portfolio (in contrast to the voting share could go up to 20 per cent, the higher margin necessary if the member with the permission of the RBI), and in the had to post margins on each individual case of a stake held by a diversely held parent position). This is also beneficial for NYMEX, holding company. which is able to have a sustained engage- The Committee also believes it is pre- ment with the OTC market, understanding mature to allow industrial houses to own the product structures that are successful on banks. This prohibition on the ‘banking and that market, which could then be launched commerce’ combine still exists in the United on the exchange. Clever risk mitigation can States today, and is certainly necessary in thus be a source of substantial profits, as well India till private governance and regulatory as stability. capacity improve. In sum then, India is likely to witness the There are, however, fewer restrictions explosive growth of derivatives positions, on ownership in other segments of the fi- given the growing importance of risk man- nancial sector. Regulators should be more agement, the growing size of exposures by alert in those segments to possible conflicts financial and non-financial firms, and the of interest, and to related party transactions. growing sophistication of financial firms. For instance, it might be possible for a mutual In order to control the associated systemic fund to own a significant stake in com- risks, a two-pronged strategy needs to con- panies owned by its promoter. While a blanket templated. First, standardized products ban on such ownership might be excessive, should be encouraged to migrate to exchanges. strict limits on ownership should be enforced Second, clearing corporations such as NSCC at all times, as should guidelines on excessive and CCIL must be encouraged to offer risk trading or trading before key announcements. management services for the OTC market. More generally, promoters should not just If these two strategies are applied fully, sys- be enjoined to follow a strict code of conduct temic risk will then be limited to the small but also have clear rules of disclosure for class of OTC derivatives positions which are related party transactions (along the lines of not understood by the clearing corporations. Caesar’s wife should be above suspicion). Finally, note that a market regulator can work to mitigating these risks only if they see the whole picture across all markets, another Minimizing risk: Management and reason for integrating market regulation director education under one roof.

The financial sector has developed en- Minimizing risk: Related party ormously over the last few decades. Most transactions senior managers, directors, and regulators, however, received their education when very The bane of any ﬁ nancial system is related few of the products that exist today were avail- party transactions. One way to ensure that able. Moreover, India was a closed economy 146 A HUNDRED SMALL STEPS

then, and many of the issues related to an at the end of the programme. As senior of- open economy that need to be understood ficials get re-educated, it will set an example by senior players simply were not on the for more junior officials to keep abreast of horizon then. developments, and be an important factor in Some senior managers have kept abreast improving the governance of risk taking of developments through their own curiosity, in the system. reading, and experience. They are also not afraid to ask questions of their subordinates when they do not know. Others are not so Increasing buffers: Capital and bold, and they continue to fall further be- liquidity hind. This is not only a concern in India, it is a concern worldwide, and is often a factor in Another way to reduce spillovers is to ensure why boards and management do not question that buffers are maintained by the ﬁ nan- rogue operations in their institutions. cial ﬁ rm. Two important buffers are capital It is not easy for senior managers or of- and liquidity. While we do not have the space ficials to admit to a lack of knowledge, and to to examine each in detail, a few points are sign up to basic courses in finance and open- worth noting. economy macroeconomics. Moreover, even if Start first with capital. Capital is meant the institution is far-thinking and organizes to accomplish a number of things. First, it education programmes for senior managers/ is a buffer against losses, giving time for the directors, there is little immediate reward firm to raise more capital, for regulators to for the sceptical to pay attention. Yet these take stock, and for counterparties to react. are precisely the people who can place the Second, it is an entry ticket to participate in firm at the greatest risk through their lack financial activities—if a firm loses money of awareness. but is not recapitalized by its shareholders, There is merit for regulators in con- it has to curtail activities. As such, it is a re- sidering whether a basic certification should quirement from regulators for the market be required for all directors of financial insti- to vote its confidence in the financial firm. tutions above a certain size (including both Third, it constrains risk taking by requir- technical knowledge as well as material ing that the available capital be enough to about director responsibilities), and all meet the requirements of the risk that is being senior managers and regulators. The value undertaken. The second and third objective of a blanket mandate will be that there leads to the fourth—a capital requirement will be no stigma attached to signing up serves to incentivize firm management to (though participants could have the option manage risk for they know they will be forced of taking a test and opting out of some, or to shrink, or even close down, if they take too all, of the coursework). The regulator could much risk and incur losses that the market is cooperate with academia, industry groups unwilling to recapitalize. and institutions, and regulators elsewhere One reason this issue is important in India in tailoring the course material to the needs is because a substantial portion of the fi- of the particular sector (and the level) of the nancial sector is state-owned. It is useful to official. There could also be scale economies ask whether any of the objectives capital is in running the programme for the entire intended to achieve other than the first— industry, as well as little stigma for specific serve as a buffer—really have any import in firms when they send participants to the state-owned firms. To the extent that state programme. Finally, to avoid this becoming owned firms are not allowed to go out of busi- merely another industry conference in a nice ness, and to the extent they are automatically location, it is important that there be a test recapitalized, the role of a capital requirement of the knowledge acquired and a certificate is much diminished. A Growth-Friendly Regulatory Framework 147

State-owned firms have other reasons Resolution of distress in banks to not take on excessive risk. However, it is important to recognize that, other things At present, in India, the ‘Deposit Insurance equal, state-owned financial firms cannot and Credit Guarantee Corporation’ (DICGC) be given the same incentives through cap- supplies deposit insurance. A generous limit ital regulation as private financial firms of Rs. 100,000 per person (summed across because the former have an unlimited claim all kinds of accounts) is protected. In practice, on the public exchequer. As we push state- over 98 per cent of the deposits of most banks owned institutions to do exactly what are protected since they fall below this limit. private institutions do, they could become In other words, there is a very extensive safety an increasing source of risk, that can only be net protecting unsophisticated consumers limited if the government is willing to insist who utilize the services of a bank. DICGC does that all new capital come from public issues, not distinguish between the soundness of or it lets go of its majority stake. different banks and charges a ﬂ at insurance A second concern about the use of pru- premium of 0.05 per cent for all banks. While dential capital requirements in India is the DICGC is technically a separate corporation, increasing tendency to use risk weights to in practice, it is a department of RBI. reward or penalize activities that are viewed There are three difficulties with the pre- as national priorities (such as infrastructure sent situation: or small loans). This is an aberration that should cease. If the authorities want to en- 1. As measures of the failure probability of courage activities, they should subsidize Indian banks suggest (see Box 2), the insur- them more directly (see Chapter 3) instead ance premium of 0.05 per cent is an under- estimate compared with the market price of tampering with prudential norms. of a credit derivative against the failure of The recent turbulence in financial mar- most Indian banks. By comparison, the kets has renewed the focus on mandatory premium in Indonesia is risk based and liquidity holdings by banks. While the varies from 0.1 to 0.6 per cent, in Korea appropriate quantum and mode of main- from 0.1 to 0.3 per cent, in Malaysia 0.5 per cent, in Phillippines 0.2 per cent, taining such buffers will be debated in the and in Hong Kong risk based, 0.05 per years to come, the time has come to limit cent to 0.14 per cent. The extensive safety requirements of statutory holdings of high net at a low price constitutes a subsidy for quality securities or cash reserves to only banks. It is particularly inappropriate in prudential purposes, and not for the pur- India, where (as the graph in the box suggests) there is a substantial variation in the poses of funding government debt or for failure probability across banks. A uni- attempting to conduct monetary policy. form insurance premium tends to reduce Regardless of their efficacy for these other incentives for weak banks to maintain purposes, their use tends to distort the play- soundness. By contrast, higher insurance ing field—being a burden only on banks— premia for higher risk generates better discipline. and tends to diminish the signal sent when 2. DICGC lacks the ﬁ nancial capital re- prudential measures ought to be taken. quired to cope with the failure of one or While it is not in this Committee’s remit more large bank in a business cycle down- to specify the technical factors that should turn. It lacks the operational capability determine appropriate regulatory levels, to close down a bank swiftly, cleanly and preemptively. the norms in other countries suggest a lower The key principles that should guide level than the current ones in India. Indeed, the resolution mechanism for banks are the RBI seems to implicitly have recognized as follows: this by cutting SLR norms for small urban z A bank must be given the chance to cooperatives in order to improve their pro- recapitalize while it is still solvent, or fitability. closed otherwise. If the DICGC waits 148 A HUNDRED SMALL STEPS

too long, the net worth of a weak bank resolving a ‘crisis’. This practice needs can become deeply negative, with sub- to be questioned, if nothing else, on stantial cost to the public exchequer. the grounds of corporate governance: If the DICGC steps in early to resolve such a merger is not necessarily in the a bank that cannot raise capital from interests of the public shareholders the market, the cost of resolution is of PSU banks. More importantly, this much lower. practice offers an easy but detrimental z Distance the DICGC from RBI. There alternative to genuinely confronting are considerable benefi ts in separat- the problems of resolution. The re- ing the resolution mechanism from cent auction of United Western Bank either the central bank or the banking is a commendable step in the right regulator. Distancing the DICGC from direction. the central bank helps reduce the feel- z Strengthen the information coming ing on the part of the DICGC that it into DICGC. Various information has access to unlimited resources. Dis- sources, especially from public secur- tancing the DICGC from the banking ities markets, can be valuable to regulator helps induce independence deposit insurers, both in assessing of thought on the part of the DICGC, risks and in pricing insurance. The which must make pre-emptive deci- DICGC needs to draw on more of sions about the closure of a bank with- these sources, as well as develop a bet- out worrying whether this will signal ter understanding of what to draw its past failure. from them (see Box 3). z Build DICGC’s capability for swift and z Strengthen disclosure about bank assets clean intervention so that impaired and liabilities so as to assist the infor- banks can be resolved without delay. mation processing of the securities mar- The DICGC should be able to enter an kets. For public markets to work well in impaired bank, assess its needs and assessing risk, information disclosure the various resolution options, and re- by banks (and other fi nancial fi rms) store access to insured depositors within needs to be improved. Banks need to the span of days. For deposit insurance report a P&L and balance sheet based to be effective, such speedy resolution on the marked-to-market value of all is imperative, else deposit insurance assets and positions, even if certain will be ineffective in preventing bank assets are permitted to be held-till- runs. The Committee has not been maturity by the regulator. Informa- able to determine whether any such tion about the currency and maturity capability exists. composition of assets and liabilities z Consider automatic triggers for cor- needs to be disclosed every month, in rective action and for bank resolution. a summary fashion that allows infor- Given the tremendous amount of pol- mation about exposures to be under- itical pressure that is brought to bear stood by the market. More work needs for regulators to forbear on weak in- to be done by the regulator in devis- stitutions, automatic and objective ing such summary measures, so that triggers for bank resolution are worth they reveal enough without imposing considering and possibly enacting. an undue burden of disclosure. When There is reluctance on the part of distressed assets are liquidated or regulatory authorities in making ex- sold, comprehensive data on recovery plicit the prompt corrective action re- rates needs to be revealed to the pub- gime. This allows too much fl exibility lic market. All these initiatives can to the authorities to exercise forbear- easily be undertaken by SEBI as part ance, which defeats the purpose of of rules that all listed fi rms have to such a regime. The authorities ought satisfy. to make such a regime transparent. z Hold the limit of Rs. 100,000 per z In India, a weak private bank has, in person until per capita GDP exceeds the past, been merged into a PSU Rs. 100,000. India’s safety net is un- bank. The negative net worth of the usually generous: in many coun- defunct bank is hidden in the larger tries, the limit does not exceed per balance sheet of the PSU bank. The capita GDP, and in most countries, managers of PSU banks are unable to over 98 per cent of deposits are not refuse when called upon to ‘help’ in covered. A Growth-Friendly Regulatory Framework 149

Box 2: How Risky are Indian Banks?

In recent years, there has been a heightened focus on measures of default risk that are derived from stock prices. The process of speculative price discovery on the stock market harnesses a diverse array of information—including information from within the company when insiders or their friends trade on the market—and reduces it into a publicly visible stock price. Using the analytical framework originating in Merton (1974), and extended by KMV Corporation, this strategy has come to prominence as one of the most effective ways for measuring credit risk. As an example, in the case of ﬁ rms like Enron or IFCI, the stock price moved towards near-zero levels, thus signalling distress, well before traditional credit measures reported this. This approach can be usefully applied to listed Indian banks in order to judge their failure probability. Some results on this subject, drawn from the IMF Article IV consultation report of February 2008 are illuminating. They are, in turn derived from Moody’s KMV CreditEdge Plus. The chart on the right shows the time-series of the failure probability on a one-year horizon of the average bank in the system. It shows that India (deep black line) has had a high failure probability when compared with many Asian countries. The second chart, on the right, shows the cross- sectional dispersion amongst banks of this one- year failure probability. While the 25th percentile had always had low values of below 0.2 per cent, the 75th percentile has often taken values above 0.5 per cent, though it has come down in recent years. In other words, roughly a quarter of Indian banks have had a failure probability in excess of 0.5 per cent over the coming one year at all times over the 2002–07 period. With appropriate caveats on relying too much on one methodology, these substantial values for the failure probabilities of banks suggest that more thinking is required on reducing the probability of failure, and designing institutional mechanisms for coping with it.

Box 3: Source of Public Information about Bank Risk

As deposit insurance becomes more risk based, A credit derivative can be defi ned as follows: A defaults and its need to resolve a bank before a variety of information sources can be used to security which pays Re1 in the event that the bank’s failure becomes imminent). supplement standard ratings in assessing premia. subordinate bonds default over the next year. For When a bank has a signifi cant failure probability, One good information source about distress is the the top 20 banks, trading in these instruments as judged by a combination of the three meas- public equity market. When a bank is in distress, could be initiated on NSE and BSE, and could be ures proposed above, as well as the subjective the share price drops sharply. Good quality credit an input into determining the premia that are judgements of bank supervisors, many strictures risk measures can be constructed from this share charged by the DICGC. can come into play before the DICGC decides price and its volatility. RBI has made considerable Note that such securities have been proposed to close down the bank. The most important progress in forcing large banks to be listed. This elsewhere, but the lack of liquidity in the market stricture that should be employed is to require strategy needs to be pursued vigorously, with for these securities has been a barrier. While more equity capital, but limitations on business a requirement that at least 33 per cent of the DICGC could become an active participant in this activity can also be imposed. Finally, a caveat: shares of each bank be held by non-promoters. market (thus insuring itself against bank default, One should note that these securities are likely Bank bond spreads, where the corporate bond and its consequent liability), that participation to be informative about the risk of private sector market to be liquid, could also provide valuable would have to be carefully managed so that banks, but less so about the risk of public sec- information about bank risk. DICGC does not become confl icted (between tor banks. Furthermore, a propensity for the In addition, when the market develops, bank focusing on its portfolio of holdings of credit authorities to bail out banks will render the risk credit derivatives could be directly useful in pricing. derivatives that increase in value when a bank measures far less informative. 150 A HUNDRED SMALL STEPS

NOTES poor and the uneducated, the cost of regulation needs to be very carefully weighed against the benefi ts. 1. Chit funds have had much success in providing 2. At a more basic level, every law is ennobled by a fi nancial services to the poor, and in many ways reason, and when the reason behind the law ceases, are comparable to the microfi nance industry in so does the law itself: cesante ratione legis cessat their record of reaching households underserved ipsa lex. by mainstream banks (see Chapter 3). The Chit 3. This is yet another reason to limit the use of changing Fund Act, however, imposes substantial reporting SLR requirements as a tool of monetary policy. requirements sometimes running into lakhs of 4. For example, large non-deposit taking NBFCs may documents that are required to be submitted annu- borrow from both banks and mutual funds, and are ally. These levy enormous costs on the Chit Fund. properly an inter-regulator concern, hence under the Moreover, fi nancial regulations, such as the need to purview of FSOA. post a security deposit for 100 per cent of the chit 5. In principle, there will be a constant pressure to value, a ceiling of 40 per cent on the discount rate expand this list to include products such as defi ned in chit auctions, and a fi xed commission payable to benefi ts pensions and life insurance. Of course, any the ‘foreman’ of the chit irrespective of general cost such guaranteed products from the government escalation have contributed to make the chit fund reduces market discipline on providers, penalizes business essentially unviable. While chit funds need the healthy amongst them, and creates incentives to be regulated because of their access to the very for taking undue risk. Creating a Robust Infrastructure for Credit

OVERVIEW costs of implementation, as also the substantial benefits from information sharing. For in- Debt claims are an important instrument stance, if most of the economy does not have of financing in an emerging market. Yet access to credit from the formal financial India’s private credit to GDP ratio is low re- sector, restricting the sharing of credit infor- chapter lative to comparable countries, its corporate mation to only financial institutions ensures bond market virtually non-existent, and that much of the economy, including the retail credit growing rapidly but from a very neediest sectors, do not benefit. 7 low base. Part of the explanation for the Most borrowing takes place against low level of credit may lie in India’s credit collateral/security. It is important to ensure infrastructure, which is underdeveloped. that real assets can be pledged easily, in- Strong credit infrastructure is also useful formation about pledged assets is easily when it comes to dealing with distress and accessible to potential lenders through col- reallocating resources to their best use. This lateral registries, and the security interest is will become increasingly important as India easily enforced so it does provide security shifts out of mature low-skilled industries to the lender in case of default. Collateral into high-skilled frontier technologies in the registries that are universally accessible are process of catching up. All this suggests a another important aspect of credit infra- need for a very close look at the credit infrastructure development. structure to remedy what is deﬁ cient. Perhaps the biggest source of collateral The flow of debt requires a number of value in India in the years to come will be facilitating mechanisms. Information about land. This is also the form of collateral a borrower’s credit history, if widely shared, most easily available to rural India. Yet and if it includes both positive information land mapping is uneven, land title is not and negative information, could greatly help final, land registries typically do not have expand both access to credit and incentives to complete records, records conflict with those repay it.1 For instance, a steady record of pay- maintained by the revenue department, and ing electricity bills or rent could alert potential both are also typically hard to access. Exp- lenders to a person’s creditworthiness, and anding the use of land as collateral is one of give them incentives to lend. The fear that a the more important of the needed reforms, default would be publicized and would lead especially for the poor. to a cut-off of further credit or of services In order for debt financing to be available, can be the ‘reputational’ collateral that gives creditor rights have to be protected. While borrowers incentives to pay and lenders to it is easy to feel sympathy for the distressed moderate interest rates. debtor, too easy violation of creditor rights, For credit information to be aggregated or political agitation preventing creditors and shared, a primary requirement is a unique from enforcing interests, will make it harder national identifier for each individual. Rules for potential borrowers to get access to ensuring information accuracy, security, ad- credit. At the same time, debt will occasion- equate privacy, and prevention of abuse are ally be impossible to pay. Both the borrower necessary, but they should take into account (whether individual or firm), the society, 152 A HUNDRED SMALL STEPS

and even lenders can be better off if the India (data in the paragraphs that follow are debtor can restructure unpayable debts from the World Bank’s Doing Business 2008 using a low-cost, speedy framework that af- report), while they cover 40 per cent of the fords appropriate amounts of relief without population in China and between 46 and vitiating the whole culture of repayment. The 64 per cent of the population in Brazil. key word here is balance. Too harsh and rigid Second, the system is slow and costly. For a system of debt enforcement will be both example, the time taken to register property politically infeasible (in the sense that, even if among the BRICs is by far the highest in India enacted, politicians will intervene constantly at 62 days, and the costliest at 7.7 per cent of and will have public support in doing so) the property value. It is the lowest among and reduce borrowing as potential borrowers BRICs for China, where it is 29 days and weigh the substantial costs of distress. Too lax 3.6 per cent of property value. It is disquieting a system of enforcement will weaken lenders that transactions taxes and fees such as stamp and reduce lending. duties and registration fees are very high in Society therefore needs an effective sys- India and extremely variable across states. tem of debt enforcement and protection of Such transaction taxes are a bad form of creditor interests, a speedy and low-cost sys- taxation because they inhibit transactions. tem of renegotiating debt outside the legal Third, because of the delays (sometimes system, and a transparent, fair, and speedy endless), the system prevents the reallocation bankruptcy process that can determine the of assets to their best use, and greatly wastes best future use of the debtor’s assets, while also asset values of impaired debtors, to the detri- determining and satisfying all legitimate ment of the economy. Closing a business claims on the debtor following a pre-agreed also takes a long time in India—on average system of priority. Also, if some of the other 10 years in India compared to 1.7 years in improvements in credit infrastructure are China. Among the BRICs, India recovers implemented, such as the sharing of credit in- the least value at the end of the bankruptcy formation, a better system of personal process—12 per cent of debts—while China bankruptcy can be evolved. recovers 36 per cent of debts. It would take us too far afield if we were These infirmities do impair the flow of to detail all the infirmities in the current credit. Credit to GDP averages 8 per cent for credit infrastructure. The most typical in- the 10 countries ranked at the bottom in the firmities are the following: first, the system World Bank’s 2008 Doing Business report on is fragmented in jurisdiction, operations, measures of credit registries and collateral and coverage. An example of fragmented laws, while it averages 130 per cent for the 10 jurisdiction is that there are multiple avenues countries ranked at the top. Indeed, as some for bankruptcy resolution such as the Com- of the comparisons above show, even though panies Act, the BIFR/SICA, and the Debt China is reputed to have an inferior financial Recovery Tribunals. An example of frag- system than India’s, it scores much higher on mented operations is that collateral is measures of credit infrastructure, especially registered both at state registries (e.g., im- after recent reforms. movable property) and the register of charges Finally, it is easy to be complacent in these under the Company Act (for example, charges times when reforms like the SRFAESI Act against equipment), and there is little com- are ‘working’ in that debtors are paying up. munication between them, and between While not downplaying the extent of reforms the various state registries. This multiplies that have taken place, one should recognize the task for a potential lender who wants to that it is relatively easy to restructure and re- verify encumbrances on a borrower’s assets. negotiate debt during a boom, when debtors One stark measure of the fragmentation find it particularly attractive to repay and in coverage is the fact that credit registries recapture the use of their assets, especially cover only 11 per cent of the population in land. Matters may be quite different during Creating a Robust Infrastructure for Credit 153 an economic downturn. Now is the time to all above 18 years and provides identifi cation make serious reforms, for an adequate credit based on profession and vital statistics like infrastructure will enhance the stability of the height, age along with personal information, corporate sector, the household sector, as well photograph and fi ngerprints at the backend. as the banking system. While it would seem The fi ngerprints are used for removing dupli- that all parties have to gain from such re- cations in the system. The Nigerian card is forms, unfortunately, there seems to be little required for commercial transactions, as urgency at present. This must change. an identity proof, for availing health care and other state provided benefi ts, educational ad- missions and for procuring other important CREATING A NATIONAL ID2 documents like passport, driving license, etc. In the Sultanate of Oman, the first to Every country needs some basic and robust issue smart cards in the Middle East, the identifi cation mechanism for its citizens for card comprises of high-end security features various purposes. It will have two critical and applications like biometrics and digital components—enumeration (assigning some signatures and capability to load new ap- unique number) and personalization (en- plications to the card post issuance. The card abling positive identifi cation of individual by caters to multiple applications like driving his/her biometrics such as photo, etc.) For license, passport and work permit. In Sri example, individual may have a number as- Lanka, the national ID is used widely by signed but not a photo document (as is the various public programs. The card itself is case with the US Social Security Number); a simple laminated paper card; however, ef- or, on the other hand, individual may have forts are underway to modernize it by a photo document issued but no unique developing a database, introducing modifi- lifetime number associated with it (as would cations into the number structure, and be the case with some national passport setting up a sound data collection process systems that would have a document number including the thumb imprint capture. but not an individual number provided). Perhaps the best in the region national An identification system should ideally be identification system is hosted by the Gov- unique, universal, and widely recognized. It ernment of Pakistan: it uses the medium of should be provided through a mechanism that a smart card, storing photo and fingerprint is universally supported by various agencies. information; it is broadly and universally A unique ID establishes a person’s identity in used; it operates with a support of a very a decisive manner and is a critical element of robust back-end electronic database and any functional credit infrastructure for finan- relies on the network of specially designated cial inclusion. Countries lacking such system local offices. will be bound to have less efficient retail banking and credit systems. ID programmes in India

ID schemes elsewhere India is still at an early stage of developing a universal national identifi cation system. This A number of identifi cation mechanisms and allows the country to take advantage of the national ID programmes exist across the world existing international experiences and state in various forms. The fi rst ever smart card of the art technology. It is also important based ID scheme was launched by Malaysia, that various government bodies work to- with multiple applications on the chip, gether and fully coordinate their efforts to and incorporating biometrics in the form provide varied services to the same popu- of fi ngerprints of the holder. The Nigerian lation. At present there seem to be few ex- identity card is a plain plastic card issued to amples of such cooperation. 154 A HUNDRED SMALL STEPS

A number of current government proof customers and generation of a unique grammes in India require the identification identification number. of a person or household. As a result, multiple identification mechanisms are in use, without any link between them, varying Instituting a national ID number widely in terms of quality of the document in India issued or the process supporting it. The PAN card (Permanent Account Number) is used In order to set the groundwork for a uni- by the income tax department to identify versal national identifi cation system, the gov- income tax payers. The Elector’s Photo ernment needs to work out a strategy that Identity Card (EPIC) is used by the Election would include: (i) a common set of criteria Commission and issued to people of 18 years for identifi cation of individuals; (ii) mechan- and above. Yet another set of identity cards isms for coordination among various govern- are used to provide various government cash ment agencies at the central and state level transfers and benefits. The BPL card is an to ensure universal enrollment and sound identification based on income criteria and administration; (iii) nomination of a steering used for the receipt of various benefits under committee that would be in charge of design government schemes. The Ration card used and implementation of the policy and an by the public distribution system is issued to a executive committee that would ensure uni- family unit as per the socio-economic criteria formity and correctness of the system. to enable low-income households purchase If a universal, centrally sponsored national subsidized food and kerosene. Beneficiaries ID system is a distant reality given the initial of the Rashtriya Swasthya Bima Yojana conditions, perhaps a workable second best (RSBY, health insurance for BPL families) solution could be identified. For example, are issued smart cards, which not only offers an arrangement where multiple agencies a unique number, but also contains security are engaged in issuing identification docu- keys, fingerprints and details of the family ments to the groups they serve in a highly members, and a group photograph of all the coordinated fashion could go far along in enrolled members. the process to provide an ID that is widely In the banking and financial sector, it has accepted and recognized. been difficult so far to use any of the above To facilitate operation of such a decentral- described government issued identity cards ized system, some minimum elements for the purpose of providing financial ser- would have to be defined. These include the vices. Recently there have been a number of following: (i) a common universal design pilots where private players have been as- of the numbering system that is used by sisting banks and microfinance institutions all participating agencies and helps agen- to issue smart card based identity cards to cies recognize and process each others customers (see also Chapter 3). These ini- cards; (ii) a multi-purpose centralized data- tiatives have been used not only to open bank base that ensures efficient monitoring of accounts and provide microcredit, but also to this decentralized ID system—updates on provide cash transfers via NREGS, pensions, issued/cancelled IDs would be periodically etc. These cards are largely capable of relat- uploaded into this system, and the system ing a single identification number or account could help detect duplicates; (iii) minimum number to multiple relationships with the operational standards that all participating bank. Much of these efforts are sporadic and agencies would need to adhere to, to ensure localized or specific to the bank and card a transparent and efficient system; agencies service provider. In the absence of specific would also need to submit to periodic audits; guidelines, the card service provider largely (iv) a common card which could bear the determines the mechanism for identification logo of the issuing agency but would be Creating a Robust Infrastructure for Credit 155 identical in look and features and would Box 1: Features of Key Identification Systems Currently Available in India and have minimum information required for Opportunities for Scaling Up identification (name, address, date of birth, Identifi cation system Observations photo, fingerprint, etc.); and (v) if possible, PAN Card Pros: Covers sizable group of middle/high income population; no this new system should integrate with other limitations on other categories to join; centralized computerized system; effi cient outsourcing of the enrollment process. core systems of individual identification Cons: Low incomes at present are not covered; perception of such as birth, death, and marriage registers. implicit tax liability; lack of biometric data on the card. Allowing different agencies to issue the EPIC Card Pros: Potentially close to universal coverage among the age eligible ID in a coordinated fashion could deal with citizens. Cons: Weak institutional set up and poor card design. the problem that the burden of verification is EPFO ID Pros: Covers sizable population of the formal workers; has an different for some purposes than for others— extensive network of offi ces for enrollment; introduced new and for instance, verification for the purposes effi cient numbering system. of establishing citizenship or voting can be Cons: So far experiences seem to have been limited to needs of the different from the verification needed to issue pension programme; may not cater to the larger set of unorganized workers or non-workers. a tax payer ID. Individuals would choose to CRA ID Pros: Will gradually expand to cover all government workers and get their ID from the organization that most potentially members of other population groups participating in addresses their specific needs, minimizing the new pension scheme; interlinked with the PAN numbering personal costs, and ensuring that coverage system. Cons: New untested system; phase-in will take a considerable time; is enhanced. highly centralized operation but no local infrastructure except Also, rather than establishing a new ID, it possibly for some outsourced services. might be more useful to examine the exist- MNIC Card Pros: A step up from EPIC card in terms of numbering system ing schemes running in the country and design and media of information (smart card). adapt and scale up one of them to be more Cons: Lack of institutional continuity; deteriorating quality of existing dataset. widely acceptable. Under any scenario, one RSBY Card Pros: Will cover most of the low income population; potentially of the agencies would need to take the lead a robust centralized computerized system; smart card based in designing the card structure and the enu- identifi cation with photo and fi ngerprint. meration system and in coordinating the Cons: Early stages of implementation, lack of experience; no dedicated offi ces for maintenance/enrollment; lack of identifi cation process by which all agencies would come of individual. together to collaborate on this effort. Box 1 Income based IDs Pros: Covers most low income population; has highly decentralized provides a quick overview of the existing and represented service network. enumeration/identification mechanisms Cons: Lack of computerization and inconsistent records; weak from the perspective of their potential for institution and administration; lack of dedicated personnel at the local level; lack of systemic updates (critical revisions introduced scaling up and/or adopting them as a on 5 year cycles); focus on family rather than individual. core standard for a universal identification scheme. Another possibility is a partnership in of the new scheme as can be seen in the PAN this area between the government and non- issuance and is also envisaged in RSBY case. government organizations, e.g., to facilitate Once established, the unique ID would be enrolment and verification. Though such the basis for storing information in credit models are commonly used in many areas of registries. Borrowing and savings behaviour governance, a more robust structure would could be tracked via this ID, with the shared need to be formulated to ensure proper col- information resulting in credit scores that laboration, monitoring, and accountability. could both reduce the cost of offering credit If well defined guidelines and a strong ac- over time, as well as offer borrowers incen- countability can be guaranteed, a public– tives to pay. The objective should be to private partnership could provide for a achieve near universal information sharing most efficient model, reaching out to certain (at least on negative information) by bringing population groups in a most efficient way, banks, cooperatives, MFIs, and NBFCs into ensuring fast implementation and roll out the sharing network. 156 A HUNDRED SMALL STEPS

GATHERING AND SHARING companies and credit card companies use OF CREDIT INFORMATION CIBIL’s services. Data sharing has been based on the principle of reciprocity, which meant that only members who had submitted Credit information bureaus help bridge the all their credit data could access credit in- information gulf between borrowers and formation reports from CIBIL. However the lenders, by helping lenders identify good Credit Information Companies (Regulation) borrowers through their past credit history. Act 2005 (CICA 2005) has allowed for a set of The practical consequence of this is better ‘Specifi ed Users’ like cellular companies, in- risk management, which enables banks and surance company, credit rating agencies, etc. other fi nancial institutions to increase their who can have access to reports. Currently volume of lending and extend credit to 146 credit grantors, including 77 banks with segments of the population that may have over 90 per cent of total credit outstanding to previously been excluded, such as small individuals have accepted membership and and medium sized fi rms (SMEs). Credit re- have committed to give data. porting helps lenders by reducing default CIBIL has two bureaus, one for consumer rates and helps borrowers by allowing them credit and the other for commercial credit. to develop payment histories or ‘reputation The objective of CIBIL’s Consumer Credit collateral’ that they can use in securing more Bureau is to minimize defaults and maximize competitive loan rates. Once loans have been credit penetration and portfolio quality, provided, sharing data on payment behaviour by providing comprehensive credit infor- through credit bureaus can help to limit prob- mation pertaining to individual borrowers. It lems of willful default (where borrowers do contains over 100 million records. CIBIL has not make a good faith effort to repay). This is more than 4 years of credit history on bor- because a borrower’s cost of paying late or de- rowers and has been able to introduce a num- faulting on a loan to one institution is greatly ber of value added products such as generic increased by the effect this has on his credit bureau scores for individuals. history and thus his future cost and access to The Commercial Credit Bureau aims to credit across the fi nancial system. minimize instances of concurrent and serial A study based on more than 100 devel- defaults by providing credit information oped and developing countries shows that the pertaining to non-individual borrowers existence of credit registries is associated with such as public limited companies, private a higher private credit to GDP ratio, after limited companies, partnership firms’ pro- controlling for other country-level measures prietorships, etc. The bureau contains 1.5 m of development (Miller, 2003; Djankov, records. McLiesh and Shleifer, 2005). A study on credit Once it was established, CIBIL has grown reporting firms in over 40 countries shows rapidly in a short span of time. Strict and greater information sharing increases lend- regular vigilance and monitoring of the ing as a per cent of GNP and lowers default borrowers is essential to ensure quality and rates (Japelli and Pagano, Forthcoming.) reliability of the information, which, in turn, requires participation by a large part if not all credit-granting institutions in the country The situation in India in the information sharing exercise. CIBIL has taken significant steps in this direction. The Credit Information Bureau (India) Nevertheless, there are some concerns about Limited (CIBIL) is the primary credit infor- credit information sharing in India. These mation bureau. It was incorporated in 2000. have to do with what is collected and shared, Banks, fi nancial institutions, non-banking data security and integrity, and the degree of financial companies, housing finance competition in the industry. Creating a Robust Infrastructure for Credit 157

What is collected and shared specified users, as well as non-credit contributors needs to be expanded as India CIBIL typically collects and shares credit gains experience with credit information. For information. While CIBIL does a good job instance, in the United States, landlords can in covering the most important institutional access credit information. We need to move sources of credit by volume, there are a large to a system where any person having a written number of small credit institutions such as authorization of the borrower or entity on cooperatives and microﬁ nance institutions whom information is being sought, ought that make a large number of loans in small to be able to have access to the credit records volumes. To play a more effective role in in- in question, with only the truly necessary clusion, CIBIL will eventually have to cover safeguards. Among potential users should these institutions, and should be given per- include a prospective employer, landlord, or mission to do so. It could even contemplate creditor, whether bank or non-bank. extending coverage to registered money- A number of specified users have data, lenders who follow an accepted code of and could well share it under the principle conduct, a necessary step when so much of of reciprocity. But for some, the gains from credit to poorer sections still comes from using data are low, while the value of their moneylenders. data is high. For other users (such as po- For corporate borrowers, information on tential employers), there is little data they credit rating, as well as assessment of ac- can contribute. As more such users come counting and auditing standards and cor- into the system, the notion of reciprocity porate governance may be useful, though (I get to use data if I share data) becomes these items, being third party evaluations more strained. India should move from a should be purely advisory inputs in decisions. system of reciprocity to one of subscription, Perhaps most important of all in sheer where a subscriber gets access to data sub- volume would be performance on inter- ject to verification of ‘need to know and firm credits, of the kind collected and dis- authorization to use’ of the subscriber by the seminated by Dun and Bradstreet in the credit bureau. At the same time, efforts should United States, which CIBIL is in the process be made to persuade non-users to share data of collecting. (including through an appropriate mix Creditworthiness can be gauged from of mandated sharing and payments). more than just past credit-related behaviour. Finally, how long a history should be Many individuals make steady payments shared? International best practice is to es- outside the formal credit sector that could be tablish time limits on the length of the used to gauge creditworthiness. Expanding credit history available to a potential lender. coverage for individuals from just loan pay- Economic research shows that recent credit ments to other common payments, includ- payment record is of most relevance for pre- ing rent, utilities, and cell phone bills, would dicting future default. Moreover, the fact that draw in a lot more information, and cover a after a certain period of time information, lot of potential borrowers who are now out- especially regarding defaults, will not be side the formal credit system, resulting in distributed to lenders creates additional in- better credit assessments and inclusion. centives for the borrower to improve credit One constraint on coverage and sharing repayment behavior and to ‘clean up’ the information is the principle of reciprocity— record. For example, records are available only those institutions that provide infor- only for 5 years in Australia, Brazil, Germany, mation to CIBIL can access reports. CIC Act Ireland, Peru, and Spain, and for 7 years in the 2005 provides for specified users, notified US, and Mexico. In the case of bankruptcy, by the RBI, who can get access. The list of records are kept for 10 years generally. It is 158 A HUNDRED SMALL STEPS

essential, though, that all information in countries, the law requires consent of an the file is kept for this set period. Deleting individual to authorize issuance of a credit records, or parts of records, significantly report by a credit registry. While requests lowers the predictive power of the data in the from regulated financial institutions may registry and weakens the incentive the bureau not require authorization, as the set of speci- creates for repayment. fied users is expanded it may be necessary to require authorization when the request is from an unregulated or non-financial entity. Data security and integrity Identity theft is becoming increasingly common in developed countries. Con- The key to making credit bureaus and comitant with expanding the set of users will registries effective, reliable and proﬁ table lies be the need to verify that the authorization in widespread data sharing. This can only from the object of the credit report is valid. happen when data providers and users are While there are no easy solutions, the sooner assured that their ‘trade secrets’ are safe and the system moves to unique national identi- when regulations ensure that the individual fication numbers accompanied by biometric borrower is not exploited or discriminated validation, the more it will be able to contain against using the information available from the problem of identity theft. credit bureaus. The regulations necessary The object of the credit report, whether to ease the operation and success of credit an individual or a firm, is in the best pos- bureaus, therefore, include those concerning ition to know who has a valid reason for bank secrecy; data protection laws; laws on accessing their report. They know where consumer protection; fair credit granting they have requested credit or employment and consumer credit regulations; and pro- and whether other firms or individuals have visions regarding privacy and personal or a valid reason to request the information. corporate secret in existing laws.3 Therefore, one of the best ways to limit un- In most countries there is a tendency to authorized use of credit information is to rely on industry self-regulation for ensuring develop systems, which record all queries for data safety. Credit bureaus as well as their an individual’s report. Consumers can review members have strong incentives to establish this information if they think their data proper mechanisms for data processing and has been used in an inappropriate manner. data protection. In general, development of This simple reporting tool can greatly help mechanisms for data processing is driven to detect misuse of the data by lenders and by competition within the industry and de- others who may request this information, as velopments in technology, while data security well as by staff of the credit reporting firm. standards are set high to avoid the significant Currently potential borrowers in India costs a loss of data or an unauthorized access can find out why they have been refused may cause. However, an independent audit credit only from the lender and not from of data security for credit information firms the registry, which goes against international should be mandated in India by the RBI to best practice that allows the subject to view ensure compliance with best practices. his/her own impaired record free or at a low Some other aspects of protecting consumer cost. Notice of refusal of credit also serves as information deserve consideration. The key a good educational tool informing consumer aspect in ensuring privacy and authorized of the importance of building good credit access to the data is to define a set of legitimate history and improving payment discipline. purposes for access. This set of purposes One impediment currently in the way of usually include not only consideration for direct access is that the credit information granting credit or a lease, but also monitoring bureau may have no way of verifying that the of existing credit, collecting on a credit, etc. individual who is trying to rectify his record and even for employment purposes. In some is who he is. As national IDs and biometric Creating a Robust Infrastructure for Credit 159

identification becomes more widespread, Quality of Credit Information in India the credit bureau and the individual should At the moment, there is no independent due’. In addition, the PAN number does not be encouraged to deal more directly. verification of the data submitted by the serve as a unique identifi cation number as Procedures should be in place to facilitate bank to the bureau. CIBIL does not carry not all customers register for a PAN number. out verifi cation of information using third Also, the PAN number is only given to the tax challenges to erroneous data. Consumers party sources including courts, government payer. While banks try to use date of birth should be able to review their reports and registration department, company registry and other information as a way to identify a identify reporting errors via the Internet and etc. An important reason is that these person, it is still a poor substitute for a unique by phone. It is particularly important that sources have not centralized information, identification number. This will become a or made them accessible in electronic form serious issue as the consumer credit bureau consumers have access to reports when an at remote locations. This is likely to be re- expands. National identification numbers adverse action has been taken. Clear pro- medied over time as more information is are needed for data validation and matching cedures should be established in regulations captured in electronic form. The data is as accurately, but also to contain identity theft. good as the integrity of a bank’s data. Also In the absence of its availability in India now, specifying the steps in the dispute resolution the information submitted by lenders does the CIB industry is severally handicapped. process and the time that credit reporting not use similar criteria. For instance, some use Thus there is paramount need to shift quickly firms have to verify and respond to complaints. RBI loan classifi cation requirements (standard, to biometric identifi cation and validation, and substandard, etc.) and others use ‘days past a rapid roll out of a national ID. These regulations should seek to facilitate consumer access without hampering the functioning of the system or allowing its Information Collected by Credit Bureaus in the US abuse. The CICA 2005 provides a number of guidelines for dispute resolution, and these 1. Identification and employment US$150,000 worth of credit or life should be implemented. information—Name, birth date, ID insurance has no time limit. number, employer, and spouse’s name. z Default information concerning US The credit bureau may also provide in- Government insured or guaranteed stu- formation about employment history, dent loans can be reported for seven Fostering competition in home ownership, income, and previous years after certain guarantor actions. address, if a creditor requests this type of z Information about a lawsuit or an un- the industry information. paid judgment against a person can 2. Payment history—Accounts with be reported for seven years or until different creditors are listed, showing the statute of limitations runs out, Competition in the area of credit information how much credit has been extended and whichever is longer. provision is the key for expanding cover- whether it has been paid on time. Related age, and improving the use of credit infor- events, such as referral of an overdue 5. Accurate Negative Information— When negative information in the report is mation. However, a few roadblocks need to account to a collection agency, may also be noted. accurate, only the passage of time can assure be removed to pave the way for easier entry 3. Inquiries—CBs must maintain a record of its removal. Accurate negative information of, and greater competition among, credit all creditors who have asked for a person’s can generally stay in a report for 7 years. There are certain exceptions: information companies in India. The Com- credit history within the past year, and a record of those persons or businesses mittee notes that liberalizing access to credit z Information about criminal convictions requesting credit history for employment may be reported without any time information through a change in the in- purposes for the past two years. limitation. 4. Public record information—Events formation collection and sharing model is z Bankruptcy information may be re- that are a matter of public record, such as ported for 10 years. an important condition for the success of bankruptcies, foreclosures, or tax liens, z Credit information reported in re- competition. Licensing too many bureaus may appear in a report. sponse to an application for a job with without expanding access will simply frag- a salary of more than US$75,000 has ment the market for credit information and z Bankruptcy information may be no time limit. reported for 10 years. affect the growth of this industry. z Credit information reported because z Credit information reported in re- of an application for more than Moreover, dispersed ownership may sponse to an application for a job with US$150,000 worth of credit or life have been necessary when the owners were a salary of more than US$75,000 has insurance has no time limit. no time limit. credit-granting institutions, so that a single z Information about criminal convictions Information about a lawsuit or an unpaid owner could not monopolize information. has no time limit. judgment against a person can be reported for As new players who are essentially in the z Credit information reported be- seven years or until the statute of limitations cause of an application for more than runs out, whichever is longer. information-sharing business enter, this is less of a concern. Furthermore, with CIBIL already in existence, it is unlikely that new entrants would monopolize information. It would be sensible to allow experienced 160 A HUNDRED SMALL STEPS

foreign players to take significant stakes in Land as collateral4 new entrants so that they can transfer technology. Of course, a liberalization of owner- Land is probably the single most valuable ship norms should also be extended to physical asset in the country today. Un- CIBIL so that it too can attract experienced fortunately, the murky state of property rights strategic partners if it so desires. Finally, the to land make it less effective as collateral than Committee emphasizes that the multiplier it could be. The current state of land rights effect from the credit information industry has many other adverse effects, including can be substantial, especially for inclusion, preventing agricultural land from migrating and hence urgent steps are needed to expand to its best use, slowing land acquisition it so that it can support growth. for industrial and infrastructure projects, clogging courts with disputed cases, and elevating the level of political confl ict. While COLLATERAL, SECURITY making land rights clear and transparent is INTERESTS, AND expensive, it is probably one of the most pres- REGISTRIES sing needs of the country today. Land can be used more effectively as a Overview source of collateral, first, through clear property rights in the form of clean title to land, and, second, through improving the menu Let us now turn to the process of obtaining of land tenure options so that tenants with security or collateral for debt. Security is es- secure tenure can borrow against evidence sentially a claim on a borrower’s asset if a debt of their tenure. is not repaid. Security interests typically have The process of establishing clear title to to be registered with a public registry so that land is not easy. India has two principal sys- everyone knows the asset is pledged. tems of land records: a deeds registration The law should allow for the following system and a land revenue system of record features: of rights (RoR). Multiple agencies and multiple systems exist in most states. Typically, 1. Security interests in all types of assets, movable and immovable, tangible and a Survey, Settlements and Land Records intangible, including inventory, receiv- Department prepares and maintains survey ables, and proceeds; future or after- and mapping records and property cards acquired property, and on a global basis; where they exist. The Revenue Department and based on both possessory and non- prepares and maintains the record of rights possessory (where the creditor does not and a Department of Registration and hold on to the asset) interests; 2. Security interests related to any or all of Stamps maintains the deeds registry with a debtor’s obligations to a creditor, pre- records on land transactions. These systems sent or future, and between all types of are neither comprehensive nor consistent persons; with one another. In the past, maintaining 3. Methods of notice that will suffi ciently accurate land records has been the prime publicize the existence of security interests to creditors, purchasers, and the public gen- responsibility of fiscal authorities, given the erally at the lowest possible cost, as also importance of land records in facilitating permit swift, inexpensive, and reliable revenue collection. As a result, the use of searches using multiple fi elds (owner of land records in confirming property rights asset, type of asset, location, amount of has been neglected. This has to be remedied encumbrance, etc.); now. 4. Clear rules of priority governing competing claims or interests in the same The deeds registry simply gives public assets, with the highest priority typically notice of a transaction. However, registration given to security interests. of a deed does not imply any inference about Creating a Robust Infrastructure for Credit 161 the legal validity of the transaction or that the namely the deeds and RoR systems, to pro- parties were legally entitled to carry out vide land owners with a certificate that con- that transaction. Indeed, the registration tributes relevant and current information office in India will, in principle, register any pertaining to a plot, for example ownership transaction, and in practice officers invest status, transaction history, current and past more time in verifying the identity of parties mortgages and liens, and a map that allows to the transaction than the physical location identification of neighbours and general and attributes of the land.5 This means that boundaries. The decision on whether to make someone who has registered a past purchase the transition towards a full title registration cannot use the deed as proof he owns the system will depend on a number of factors, land—in fact, there is always the possibility including political will to make the necessary that some prior seller did not have owner- legal and institutional changes, consensus ship, so all subsequent transfers are invalid. on the desirability of incurring the costs en- Clearly, the uncertainty this creates over tailed, and agreement on the establishment ownership is substantial. By contrast, under of a guarantee fund which is required for a registration of titles, the register itself serves title registration system. as the primary evidence of ownership. The immediate steps that need to be One possible long-term goal could be to undertaken include: establish a single computerized title registration system that includes conclusive • Full computerization and integration information about rights over land and the of land records. Efforts towards computerizing land records were initiated spatial extent of these rights. This will en- in 1988 through central assistance, but sure security of title to landowners and pro- progress remains highly variable (see box vide plot information to the government and below). Government measures to encourage private users. This system is often referred to computerization could include (i) clari- as the Torrens system of registration and has fying the policy and establishing clear criteria and accountability mechanisms been implemented in various parts of the for allocation of central funds on this; world (in various forms), including Australia, (ii) identifying and publicizing best prac- New Zealand and parts of the US and Europe. tices on technical and legal issues and In India, a title registration system broadly promoting exchange and communication along the lines of Torrens is being piloted in among technical staff across states; and (iii) prioritizing full functional integration a number of states. To establish such a sys- between records and registry. tem it is important to have clear titles, make • Full cadastral mapping of land. An im- registration compulsory, facilitate complete portant problem is that existing cadastral computerization of records, and ensure con- survey records are largely limited only sistency between the various government to agricultural land. The inhabited portions of villages, as well as towns and databases. Given the current state of affairs cities, have largely remained unsurveyed. of land records and land administration, Identifi cation of urban property is, there- meaningful implementation of title regis- fore, only by means of description of tration is clearly a long-term objective. boundaries. This has to be remedied. Regardless of whether single title regis- Even for agricultural land, surveys are dated. Even though resurveys are under tration is the ultimate goal—and much can way, the process of cadastral survey in be achieved without going all the way—it is India has not yet taken full advantage of of critical importance to improve the deeds modern low cost technology available system. A number of states—Karnataka, in surveying and mapping. Though the state government departments under- Maharashtra, Andhra Pradesh and Gujarat— take most of the cadastral surveys in have taken this approach. The next step India, the private sector is now becoming would be to functionally integrate the differ- involved in these surveys. A relatively low ent databases used in land administration, cost method to implement basic cadastral 162 A HUNDRED SMALL STEPS

mapping is to combine satellite imagery • Compulsory registration of all with existing village maps and other read- transactions. A large number of land ily available spatial products. A central transactions, especially in case of suc- body to establish a regulatory framework cession, do not need to be registered, and enforce technical benchmarks and partly because it is deemed unreasonable standards could speed up the roll-out of to charge stamp duty on these. Requiring proven models for cadastral mapping and that any change in the revenue records avoid costly trial and error on the more as a result of succession triggers a cor- complex issues of generating spatial data. responding change in the land registry, • Settlement of land disputes. Land dis- without any payment in stamp duty, will putes need to be settled to establish validity go some way in ensuring registries are of titles for land. These would require complete. special land courts (or administrative • Remote and easy access to registration tribunals) that will deal exclusively with procedures and to land records. The use land disputes. A possible policy initiative of Internet kiosks to access land records in this regard is to set up some fast track has proved very useful in increasing trans- land courts for the settlement of land dis- actions in states where it has been tried. putes in rural and urban areas. This was • Standardization of forms and computer- done in Mexico, where 42 land courts and ization of land offi ce. Petty corruption, one appeals court were created, which loss of records, delay in transactions and dealt with nearly half a million confl icts in threat of fi re or fl ood to records are some fi ve years. In addition, a special institution common problems that can be dealt with to provide legal assistance to small land- easily through standardization and com- holders and represent them in court deal- puterization. ings was set up; this helped the poor access • Elimination of restrictions on land 6 this dispute resolution system. An out of markets. Widespread prohibition of land court settlement procedure with binding leasing is not consistent with effi cient effect could be pursued in parallel. resource allocation. It raises the cost to • Reduction of stamp duty. India has rural–urban migration as villagers are un- among the highest rates of stamp duty in able to lease their land, and often have the world. With Stamp Duty on the con- to leave a family member (typically the veyance of immovable property ranging wife) behind to work the land. Lifting from 15 per cent in Bihar to 6 per cent these restrictions can help the landless in Gujarat and 5 per cent in Maharashtra (or more effi cient large land owners) get and Andhra Pradesh, and an additional land from those who migrate, and allow registration fee ranging from 0.5 per cent those who currently lease land informally in Andhra Pradesh to 2 per cent in Bihar, to formalize their transactions and thus India is clearly an outlier among countries, obtain institutional credit and other where the Stamp Duty rates range from benefi ts. To the extent that liberalization 1 per cent to 4 per cent. It is necessary to of land leasing enhances owners’ security reduce the rate to promote land trans- and may allow adoption of long-term actions in a transparent manner and ensure contracts, it is also likely to increase in- the sustainability of any improvements vestment incentives for all parties. made in land administration. Some Indian states, namely Andhra Pradesh, Jharkhand, and Maharashtra have signifi cantly re- A prerequisite to formalizing tenancy duced stamp duties. Reduction of stamp agreements would be to put in place a system duty has been included as a condition for of guaranteed titles that capture details on accessing funds from the Government of proprietorship, property extents, rights and India under the Jawaharlal Nehru National Urban Renewal Mission. All States who encumbrances. Compulsory registration of have signed up to access funds from this lease-holds and on the owner’s title would mission have had to provide a roadmap then provide tenants protection. Registra- for reducing stamp duties to no more than tion fees should be minimal and procedures 5 per cent in a defi nite timeframe. This is simple in order for both tenants and land- a welcome step. Revenue neutrality could be maintained by combining a reduction lords to formalize their contracts. The formal of stamp duty with an increase in the land tenancy agreement would provide tenants tax. the legal collateral to access credit based on Creating a Robust Infrastructure for Credit 163

tenancy. Of course, for such a leasing market Status of Computerization of Land Record in India to take off, owners should be confident that Computerization of land records was launched lagging states to overcome resistance and long-term tenancy would not lead to their as a centrally sponsored scheme in 1988–89. bridge the gap with the progressive states. losing ownership. With a vibrant market Though progress under this scheme has not The integration of textual and spatial data, been consistent across states, many large linkage of registration with mutation and a for land, and clear title, there would be little states have digitized basic land records data comprehensive and standard database of land political justification for such a step. and have started the process of recording records across the country will be essential It is also important to drop restrictions on sales (mutations) and distribution of record for effi cient administration and policy making. of rights (RoRs) using computers. As of 2007, As of today, these are stand-alone in nature, the sale or transfer of interests of agricultural states that had completed data entry of RoRs as there is no comprehensive framework to land to non-agriculturists which has little included Andhra Pradesh, Goa, Gujarat, collate and integrate the data into a seamless economic justification. If farmers were al- Karnataka, Tamil Nadu, Chhattisgarh, Madhya system of land information management that Pradesh, Maharashtra, Rajasthan, Sikkim, Uttar could run on a geographic information system lowed to freely transact their land, they could Pradesh, Uttarakhand and West Bengal. The (GIS) platform and provide land data. retain more of the windfall profits from states of Karnataka, Tamil Nadu, Gujarat, In fi scal year 2007–08, the central govern- such transactions, without resorting to less Madhya Pradesh, Maharashtra, Uttar Pradesh, ment announced a major reform initiative Uttarakhand and West Bengal have stopped under the National Land Resource Management profitable subterfuge. While the Committee manual issue of RoRs. Programme (NLRMP). This initiative includes understands there are important historical Since land is a state subject, every state computerization, updating and maintenance rationales for such prohibitions, the whole has independently pursued initiatives towards of land records and validation of titles, as issue needs to be reconsidered as urban and computerization of land databases. For well as plans to provide a comprehensive instance, the RoR has been computerized tool for development planning. Under this non-farm employment increases, cities and under the Bhoomi project in Karnataka, programme, the following three layers of data: towns expand, and the need to sell land and Mahabhulekh in Maharashtra, LRMIS in Andhra (i) spatial data from satellite imagery/aerial exit agriculture increases. Pradesh, Tamil Nilam in Tamil Nadu, and photography; (ii) topographic maps and other SWAN in Gujarat. Similarly, computerization data from Survey of India and Forest Survey In sum, three steps would help facilitate of the land registration (mutation) has been of India; and (iii) land records data—both access to credit from financial institutions implemented through the KAVERI project in RoR and maps, will be integrated into a GIS based on tenancy of property: (i) Eliminate Karnataka, SARITA in Maharashtra, CARD in platform. The primary focus of this effort is Andhra Pradesh, C-STAR in Tamil Nadu, and to provide citizens with RoRs with maps to prohibitions on tenancy; (ii) Create a climate RajCREST in Rajasthan. Progress has remained scale and other land-based certifi cates such as of judicial balance between landlord and skewed, as despite efforts since 1988, most income certifi cates (particularly in rural areas), tenant rights; (iii) Institute formal contracts states have not progressed much beyond just domicile certifi cates, information for eligibil- data entry or piloting on a limited scale. In ity for development programmes, land between landlords and tenants that are clear, this regard, it will be important to disseminate passbooks, etc. This would also act as a easy, affordable, and reliable, that protect more widely the best practices of successful comprehensive tool for land-based develop- the tenant’s tenancy while not impairing the states and design incentives that encourage ment planning. landlord’s right to reclaim or dispose off the Source: Ministry of Rural Development (http://rural.nic.in); World Bank report, India Land Policies property after the period of contract, and for Growth and Poverty Reducation, 2007. with appropriate notice.

Creating and registering security • Debtors, because it allows them to interests: Operation obtain access to credit at a lower cost and more expeditiously than in systems where information about the We have examined concerns with the single encumbrances on the assets of the largest form of collateral, land. Let us turn debtor is not readily available; now to the process of registering a security • Creditors, because it allows them to interest in this and other property. extend credit with relative certainty as to their rights: 1. Beneﬁ ts of registering security interest { Registration enables prospective In order for creditors to establish they have secured creditors to ascertain a secured claim to an asset, and in order whether the relevant assets have that prospective lenders or purchasers be already been collateralized in made aware of prior claims, a well organ- favour of a prior creditor. In the ized system to register and publicize sec- absence of registration, secured urity interests is essential. Registration of creditors must rely on debtor as- security interest is beneﬁ cial to all parties surances or undertake extensive concerned: factual inquiries. 164 A HUNDRED SMALL STEPS

{ Registration is needed to deal registering the security interest when the adequately with the consequences asset falls under asset specifi c registration of an unauthorized disposition requirements (see table below) that are al- of the encumbered assets by the ready prevalent in India. It should integrate debtor. all registry databases (many of the state • Third parties, because it puts them on databases are not computerized, let alone notice as to potential encumbrances on linked to a common searchable facility), the assets of the debtor. Registration and be user friendly so as to facilitate establishes a clear date stamp, which effi cient registration and searching. This together with the principle of fi rst- will require some central coordination. in-time priority, provides an objective There should be a movement towards mechanism for establishing priority a conclusive proof of the transactions as (and avoids litigation associated with found in modern registries so that cre- falsifi ed dates on securities). ditors and others can rely upon their title 2. Preconditions for realizing the benefi ts search with certainty. The law should proof registration as outlined above vide for reasonable rules on the allocation Security interests are usually recorded in of liability for loss or damage caused by an documents. In case of non-possessory error in the administration or operation security interest (where the creditor does of the registration and search system. not hold on to the asset), documents are 3. Current regime for creation and regis- the only place where the creditors’ rights tration of security interest in India and interest are recorded. This makes re- In India, there is a well established system gistration critically important. Moreover, for registration of security interests widespread registration increases the use created by companies incorporated under of registration as creditors attempt to the Companies Act, 1956, but there is no protect their interests. registration process mandated for certain Given the importance of expanding cov- types of security interests created by indi- erage, it is disconcerting that, as with sev- viduals, partnership fi rms, cooperative so- eral transactions discussed in this report, cieties, trusts, etc. Additionally, for certain exorbitant stamp duties under state laws categories of movable assets, there are asset deter borrowers and creditors alike from specifi c registration systems in operation, obtaining security, or registering it. Given and registration is required in respect of the benefi ts discussed above, stamp duty charges created on such assets irrespective (and registration fees) should be reduced of who holds the asset. The following table to such a level that it does not deter trans- offers a brief snapshot of the existing actions, with the state benefi ting from the structure, which underscores the lack of a increased economic activity it engenders Single comprehensive framework for regis- (as well as the moderate taxation of larger tration of security interest covering all transaction volumes).7 The stamp duty types of borrowers and all types of assets. rates and registration fees should also be Other assets including intangibles such uniform across all the states in India. as copyrights, trademarks, or units of The registration system should be set mutual funds, or government securities up to permit the indexing and retrieval of lack formalized systems of recognition and information using some reliable identi- registration of security interests. Security fi er of the grantor such as his name or tax interests in these are usually obtained payer ID. The need for unique national along with mortgage or hypothecation of identifi ers is again obvious. The registra- other assets, or require outright transfer/ tion system should permit the creditor/ assignment by way of security. or the borrower to register the security 4. Way forward to achieve a comprehensive interest within a reasonable timeframe. registration regime Reasonable public access to the registry The Committee sees three main options should be assured by setting fees for regis- to register security interests in a compre- tration and search at a cost-recovery level hensive way. and making available remote modes, and (a) Using the existing network of points, of access. The system should also Registrar of Companies and the Mini- provide for registration of notices of secur- stry of Corporate Affair’s MCA 21 e- itization (or transfer of receivables/credit governance initiative. facilities which are secured). The system The benefi ts of starting with the infra- should dispense with the requirement of structure the Ministry of Corporate Affairs Creating a Robust Infrastructure for Credit 165

Applicability to persons Types of security interest covered for the Security interest Applicable law/Enactment (All or speciﬁ c) purpose of registration excluded The Companies Act, 1956 Companies (governed by A charge on: Pledge the Companies Act, 1956) • Debentures; • Uncalled share capital of the company; • Immovable property; • Book debts; • Movable property; • Floating charge on any property; • Calls made but on paid; • Ships; • Goodwill; • Intellectual property right. The Registration Act, 1908 All persons Deeds pertaining to: • Equitable mortgage8 • immovable property viz. mortgage deeds; and • All movable properties • debenture trust deeds. (registration optional)9 The Merchant Shipping Act, 1958 All persons Mortgage over ships — Motor Vehicles Act, 1988 All persons Hypothecation10 of Motor Vehicles — The Patents Act, 1970 All persons Mortgage of the Patents — The Depositories Act, 1996; All persons Pledge of securities — (NSDL/CDSL Business rules and bye laws)

already has in place are clear, especially implementing this will require starting because MCA21, its e-governance initia- a registration system afresh. tive already stipulates electronic fi ling of This Committee believes that there is documents and has remote access through some merit in creating competing regis- the Internet in place. tration systems, especially in the private It will be important, though, that the sector, but we should also guard against system of registration of charges should be fragmentation of the databases. The data- opened to individuals, partnership fi rms, base maintained by each competing cooperative societies, trusts, etc., and registry should be accessible to anyone should extend to all assets through an ex- accessing other registries (on payment of tension of the mandate in the Companies the requisite inter-registry fee), and the Act, 1956. search process should make the bound- (b) Using the nascent credit information aries between registries seamless to the companies (or alternatively, the de- searcher (much as is envisaged for credit pository infrastructure—which serves information bureaus). With this proviso, the capital markets). the Committee would advocate exploring Credit Information Companies (CICs) all three options with the focus on making formed under the Credit Information registries compete on registration fees, Companies (Regulation) Act, 2005, are search fees, and ease of access. licensed and regulated entities with the infrastructure capabilities of undertaking the registration of security interests. INSOLVENCY AND Another alternative are the electronic CREDITOR RIGHTS: depositories—the National Securities Depository Ltd and Central Depository PRINCIPLES AND Services Ltd. The use of CICs or de- TAKING STOCK positories will require legislative action (amending the CIC Act or amending the Principles Depositories Act). (c) Using the yet-to-be-notifi ed SRFAESI A well functioning system of credit should Act provisions dealing with the registry of security interests. provide mechanisms for dealing with cor- The SRFAESI Act envisages an en- porate distress. It should broadly have four tity to register security interest. Clearly, key elements: 166 A HUNDRED SMALL STEPS

1. An effective legal framework for creditor information on the distressed enterprise; rights. A well-functioning system of credit encourage lending to, investment in or should be supported by mechanisms that recapitalization of viable distressed enter- provide effi cient, transparent, fair and prises; support a broad range of restruc- reliable methods for recovering debt, turing activities, such as debt write- including the seizure and sale of im- offs, rescheduling, restructurings and movable, movable and intangible assets. debt-equity conversions; and provide This is particularly true in India where favourable or neutral tax treatment for the bulk of business fi nancing is debt restructurings; and fi nancing, especially at the SME level. 4. Effective institutional and regulatory cap- 2. An effective legal framework for corpor- acity for implementing the law. Any legal ate insolvency. Where an enterprise is framework is only as good as the integrity not viable, the main thrust of the law and capacity of both the institutions and should be swift and effi cient liquidation the personnel needed to carry it out. of the assets of the business to maximize recoveries for the benefi t of creditors. Let us now consider the existing system for Piece-meal liquidation often generates dealing with corporate insolvency in India. less value than the preservation and sale of the business itself to new owners, and whenever feasible, this will be the preferred form of liquidation. Sometimes, Bankruptcy/restructuring though, the economic value of the enter- framework in India: An overview prise is fundamentally sound, even in its existing form, and preserving the enterprise as a going concern will generate Legal framework the most value for all concerned. The enterprise then needs to go through a A rough sketch of the legal framework for process of rehabilitation, where claims restructuring would look as below. are renegotiated, new fi nance obtained for investment, and certain organizational, managerial, and ownership changes made to preserve the confi dence of claimants. Revival and rehabilitation provisions under the The process of rehabilitation should be Companies Act, 1956 and the Companies quick, easy to access, and cheap when (Second Amendment) Act11 deemed necessary, protect all those involved, permit the negotiation of a commercial plan, enable a majority of creditors The legal, court-driven framework in India in favour of a plan or other course of is characterized by three processes: (i) the action to bind all other creditors (subject Companies Act, 1956 (‘Companies Act’); to appropriate protections) and provide (ii) the Sick Industrial Companies (Spe- for supervision to ensure that the process cial Provisions) Act, 1985 (‘SICA’); and is not subject to abuse. 3. An effective legal framework for informal (iii) the Recovery of Debts Due to Banks workouts. The formal legal process and Financial Institutions Act, 1993 (‘DRT’). necessitates additional costs and delays At the outset, it is instructive to note that that, whenever possible, should be the Companies (Second Amendment) Act, avoided. Out of court informal corpor- 2002 (‘Second Amendment Act’) created a ate workouts are therefore preferable new quasi judicial mechanism, namely, the wherever possible. Informal workouts are negotiated in the ‘shadow of the law’, with National Company Law Tribunal (‘NCLT’) the legal insolvency framework providing which would encompass the power and both a threat point if informal bargain- jurisdiction of the Company Law Board, ing breaks down, and a way of giving the Board for Industrial and Financial legal status to agreements that are reached Reconstruction, the Appellate Authority for informally. Accordingly, the enabling environment must include clear laws and Industrial and Financial Reconstruction and procedures that require disclosure of, or of the High Court relating to company law access to, timely and accurate fi nancial matters. Creating a Robust Infrastructure for Credit 167

The NCLT has not, however, been put into operation as yet. As the SICA has not yet been repealed, sick Companies however continue to be governed by the Board for Industrial and Financial Reconstruction (‘BIFR’) and the Appellate Authority for Industrial and Financial Reconstruction (‘AAIFR’) which are defunct. The legal structure is therefore, to put it charitably, in a state of transition, and this state of affairs needs to be remedied quickly. Fortunately, the economy has been doing well, but this state of affairs will not last forever. The Board of Directors of the industrial company classified as a ‘sick industrial Every winding up, whether it be by the company’12 under the Companies Act shall Court or a voluntary winding up, is under- make a reference to NCLT within 60 days taken by appointment of a Liquidator, from the date of adoption of final accounts, who takes under his charge all of the and submit a scheme for its revival. On Company’s assets and manages the affairs conducting an enquiry into the working of of the Company in a manner which would the sick company, NCLT may pass any of the prove to be the most beneficial to the following orders: interests of the creditors, shareholders, and the Company itself. • That the company be given reasonable time to make its net worth higher than the accumulated loss or pay its debt; Recovery under the recovery of debts due to • If the above is not possible, NCLT may banks and fi nancial institutions act, 1993 direct an operating agency to submit a (the ‘DRT Act’) scheme of rehabilitation within 90 days, which may entail fi nancial reconstruction; change in or take over of management; The DRT Act provides for the speedy ad- amalgamation with any other company; judication of matters relating to recovery sale or lease of assets or rationalization of of debts that are due to notifi ed banks and management and personnel. The scheme fi nancial institutions. Every case pending be- may also provide for fi nancial assistance fore the Civil Courts, where the debt amount by way of loans, advances or guarantees or relief or concessions or sacrifi ces from the has exceeded Rs. 1 million, gets automatically Central Government; transferred to the Debt Recovery Tribunal • If NCLT comes to the decision that the (‘DRT’ or ‘Tribunal’) established under the company cannot be revived, it may record DRT Act. Once the Tribunal passes a fi nal its opinion to recommend winding up order, the recovery process is automatic and of the company and initiate winding up proceedings. a separate application is not required to enforce the orders of the Tribunal. An appeal Winding up under the Companies Act, against an order of the Tribunal must 1956 (the ‘Companies Act’): be made to the Debt Recovery Appellate Under the Companies Act, 1956, there are Tribunal within 30 days from date of receipt two modes of winding up of a company: of the DRT order. The DRT suffers from a number of • Winding up by the Court 13 weaknesses including the following: • Voluntary winding up which may be: { Members voluntary winding up • The DRTs were hampered for a long time, { Creditors voluntary winding up due to an insuffi cient number of tribunals • Conduct of winding up proceedings. and Presiding Offi cers—an urgent need 168 A HUNDRED SMALL STEPS

to train Presiding Offi cers and cut down Other creditors than banks and financial delays remains. Only 22 DRTs with 5 Ap- institutions must typically resort to the or- pellate Tribunals located in fi ve centres dinary civil courts under the Code of Civil have been established so far. Procedure (‘CPC’) or pursue a foreclosure • Though DRTs follow summary procedures for deciding cases, the recom- action under the Transfer of Property Act mended statutory timeframe of 6 months to recover debts. Both proceedings are for deciding cases is rarely complied with. cumbersome and time-consuming. The The proceedings before the DRTs often 2002 amendments to the CPC simplified take more than 2 years and, fail to produce procedures, but cases still take 5 to 7 years to signifi cant recoveries for unsecured creditors. If the matter goes into appeal to the get resolved. Decrees granted to unsecured DRAT, further time is taken and 3 years creditors have little enforcement value. elapse before any recovery takes place. • Recovery Offi cers by and large, lack suffi cient judicial experience and are not Corporate Debt Restructuring (CDR) framework adequately trained for their appointment. There is no transparency in the appointment of auctioneers by Recovery The CDR Mechanism is a voluntary non- Offi cers. statutory system based on Debtor-Creditor • Different DRTs follow different pro- Agreements (DCA) and Inter-Creditor cedures, leading to inconsistency and lack Agreements (ICA) and all banks/fi nancial of clarity in approach of DRTs in matters institutions in the CDR System are required involving the serving of summons on debtors, fi ling of original documents and to enter into the legally binding ICA. evidence, permitting cross-examination of The CDR system in the country has a creditors, procedure on day-to-day con- three-tier system: duct of proceedings etc. • A Working Group to examine the func- • CDR Standing Forum and its Core Group tioning of DRTs was set up, but no further • CDR Empowered Group steps have been taken so far. • CDR Cell

‘Out of Court’ Framework The CDR Standing Forum is the representative general body of all financial institutions and banks participating in CDR system, which is required to meet at least once every six months and has the task of reviewing and monitoring the progress of the corporate debt restructuring system. Individual cases of corporate debt restructuring are decided by the CDR Empowered Group. The CDR Empowered Group is mandated to look into each case of debt restructuring, examine the viability and rehabilitation potential of the Company and approve the restructuring package within a specified timeframe of 90 days, or at best within 180 days of reference to the Empowered Group. The CDR Cell scrutinizes the proposals received from borrowers/creditors and puts up the matter before the CDR Empowered Group within 30 days to decide whether rehabilitation is prima facie feasible. If found feasible, the CDR Cell then proceeds to Creating a Robust Infrastructure for Credit 169 prepare a detailed Rehabilitation Plan with more ventures are contemplated, such as in- the help of creditors and, if necessary, experts frastructure projects, that could result in engaged from outside. If not found prima complex bankruptcies and tie up enormous facie feasible, the creditors may start action resources, the need to clarify the frame- for recovery of their dues. work becomes even more imperative. The Second Amendment, when implemented, will improve bankruptcy resolution, while Securitization and reconstruction of fi nancial SRFAESI has improved creditor rights out- assets and enforcement of security interest side bankruptcy, but as discussed below, act, 2002 (‘SRFAESI Act’) there is scope for improvement. We deal in sequence with reforms to the process of SRFAESI Act addresses the interests of enforcement and out-of-court negotiation secured creditors’. Its purpose is to promote (section VI), and to the bankruptcy system the setting up of asset reconstruction com- itself (section VII). panies to take over the Non Performing Assets (NPAs) accumulated with the banks and public fi nancial institutions. The Act DEBT RECOVERY AND provides special powers to lenders and asset REORGANIZATION reconstruction companies to enable them OUTSIDE BANKRUPTCY to take over the assets of borrowers without fi rst resorting to courts. In the event of default by a borrower, the CDR Act empowers the lender to issue demand notice to the defaulting borrower and guar- The RBI’s Corporate Debt Restructuring antor, calling upon them to discharge their (CDR) rules have facilitated many informal dues in full within 60 days from the date of and out of court workouts of troubled the notice. If the borrower fails to comply companies. Nevertheless, there is signifi cant with the notice, the Bank may take recourse room for improvement. An unintended con- to one or more of the following measures: sequence of the success of the CDR rules has (i) Take possession of the security; (ii) Sale been a proliferation of debt re-scheduling or, or lease or assign the right over the security; at best, ‘balance-sheet restructuring’ as op- (iii) Manage the security; (iv) Ask any debtor posed to more comprehensive operational of the borrower to pay any sum due to the restructuring. In the absence of an effective borrower. formal framework for reorganization (dis- In case of financing by more than one cussed below), this can have the effect of secured lender the rights under the Act can masking NPLs and creating latent, systemic be exercised only if supported by secured problems. It is important to balance the CDR creditors representing not less than three- mechanism (which is largely creditor-driven) fourth in value of the amount outstanding. with a debtor-led formal process. Such action is binding on all secured creditors. The framework for bankruptcy resolu- SRFAESI tion, as we have seen, is fragmented, complex, and fraught with delay. Some of the Although potentially more efficient and delays are because key resources such as time-sensitive than ordinary courts, the trained judges are in short supply. Better DRTs remain unable to complete the debt re- legal management, more training, and more covery process within a reasonable amount outsourcing of less central tasks could help of time (the typical case takes approximately reduce delays. But the framework itself 3 years). SRFAESI presented a realistic and needs consolidation and clarification. As attractive alternative to DRTs and, indeed, 170 A HUNDRED SMALL STEPS

after its implementation, the number of provisions on enforcement. Of course, due new DRT cases fi led was reduced by almost regard will have to be had to potential abuses 40 per cent.14 Today, even after the SRFAESI of the extraordinary enforcement powers in amendments that placed certain limitations the act, but there is no evidence to suggest on creditor enforcement rights, SRFAESI that these would be worsened by expanding remains generally popular amongst its core SRFAESI’s users. constituency, commercial banks. Never- theless, there remain a number of key roadblocks within the system that should Asset reconstruction companies be addressed. (ARCs) in India Although the experience with SRFAESI has not been uniformly positive,15 there is a Asset Reconstruction Companies world-wide strong sentiment in the business community can be classifi ed into: (i) Government owned/ that ‘it works’. By facilitating out of court supported ARC; (ii) Bank owned ARC— enforcement, SRFAESI promotes the type workout units and bad bank models; (iii) Pri- of certainty that allows lenders to more vate sector ARCs. India follows the ‘Private accurately price risk and creates a legal en- sector ARC’ structure, where ARCs may be set vironment conducive to lending. The tools up by lenders, specialized investors in non- available under SRFAESI should now be performing loans (NPLs) or corporations. expanded to other lenders besides banks, There is a restriction that no shareholder in public financial institutions, and housing an ARC may have a controlling interest with finance companies. At a minimum, asset- the intent of preventing a lender from using based lenders (such as equipment financiers) an ARC as a ‘warehouse’ for its NPLs. Indian should have access to SRFAESI-type pro- law allows the sellers of bad assets to double visions. Because SRFAESI encompasses up as investors. So, when an ARC buys bad non-corporate borrowers, expanding the assets from banks, it issues Security Receipts definition of who can be a lender under (SRs) to such banks and instead of being SRFAESI would have the added effect of a lender to bad assets, the banks become creating a single statutory regime for secured investors in such assets. Bad assets bought lending, applicable to virtually all business from different banks are pooled and SRs are forms. This not only contributes to both issued against such a pool (see Figure 1). transparency and simplicity, but also allows Banks are repaid as and when ARCs recover for greater competition amongst lenders as on the assets, and if the recovery is above the all lenders, will have access to the same legal purchase price, the difference is shared by the investor and the ARC involved. This is, however, for such deals where SRs are issued. Figure 1: Security Receipts—Transaction Structure ARCs can buy bad loans paying cash also. In such cases, banks do not get a share of the extra money made through recovery. ARCs bring some specific attributes to debt recovery. First, they can aggregate debt claims from a number of lenders, and from different classes of creditors, thus obtaining the legal and intrinsic leverage from being a large lender, as well as reducing conflicts between creditors. Second, they can acquire the specialized skill sets necessary for debt resolution. The SRFAESI Act has also provided wide-ranging powers to ARCs for resolution of NPLs. ARCs have access to Creating a Robust Infrastructure for Credit 171 all possible powers available to banks/FIs foreign direct investment out of Asset Re- for resolution as also access to additional construction Companies. The kind of risk powers such as step-in rights and the ability capital as well as the kind of expertise foreign to change management, and sell or lease the investors bring is useful in the economy, and business [Section 9(a) & 9(b) of the Act]. can help provide a valuable buffer. From an The primary impediments to the more economic perspective, capital that comes effective functioning of ARCs in India can be into the country when the banking sector is classified under three broad headings: distressed, and a fl ood of assets are sold to ARCs is particularly valuable, and foreign 1. Limited supply of impaired assets coming investors, not domestic financial institu- on the market. tions, are most likely to be fl ush with capital 2. Limited set of buyers and capital entering at those times. The danger of ARCs buying the business. 3. High transactions costs. from their parent fi nancial institutions can be eliminated through specifi c regulations against self-dealing, and is anyway small Limited supply of impaired assets for foreign institutions who do not have local operations. If there is a fear that ARC The book value of the NPLs that banks/FIs powers are too draconian to entrust certain hold on their books is higher than the ‘mar- players with (such as provisions of Section 9), ket value’ ARCs are willing to pay. The need it should be dealt with by amending the law to recognize an additional loss when assets rather than keeping out players with reason- are transferred comes in the way of transfer. able probity. This has real consequences since NPLs It should be noted that in a number of typically lose value over time as the impaired countries in Asia, there is active encour- borrower’s assets deteriorate. The solution agement of foreign participation. In Taiwan is to require that NPLs be marked down on there are no restrictions on foreign owner- the books to market values that prevail in ship of ARCs. Indeed, a tax incentive is the ARC market. In turn this requires that provided to encourage foreign entry. That prices ARCs pay be realistic assessments of incentive is given by way of a reduction in the value (and that banks have enough capital rate of withholding tax from 35 per cent to to absorb losses). 20 per cent on dividends distributed to for- Such prices can be realistic only if the eign shareholders in ARCs. Likewise, both market is deep, with many sophisticated the People’s Republic of China and Korea have players on both sides. One step to expand the encouraged international participation in number of sellers is to amend SRFAESI to the market for NPLs promoted by the ARCs include a variety of other non-bank lenders in those countries. In the case of Korea’s under the definition of secured creditor ARC, KAMCO, it has used international under SRFAESI, and to allow these non- bidding to dispose of NPLs. Some of those banks (such as NBFCs) to sell their assets auctions have been conducted with put- to ARCs. back options enabling the successful bidder to resell NPLs to KAMCO as an additional incentive for investors to participate. Limited set of buyers and limited access of Finally, as with other forms of investment, ARCs to capital it would help if mutual funds, insurance companies, and FIIs were allowed to invest On the other side of the transaction, the num- in the senior claims and SRs issued by ARCs. ber of buyers can be expanded by licensing Banks prefer cash for the assets they transfer more ARCs. The institutional capacity to run to ARCs, and requiring them to hold SRs ARCs can be found amongst foreign players. instead on their balance sheet is a poor use There is really no sensible case to keep of bank capital. But ARCs will not have the 172 A HUNDRED SMALL STEPS

cash to pay for the assets they buy unless they raises a series of competing policy decisions can access a wider pool of investors. that will be informed by, among other things, the experiences India has had with BIFR and SICA and their perceptions as failures, as well Transactions costs as the dramatic structural changes within India which demand flexible reorganization As with every other fi nancial transaction, methods on par with those in more developed the transfer of assets to ARCs is held back economies. The next section deals with the in some States on account of high incidence key elements that will need to make up an of stamp duty on such transactions. Several Indian reorganization mechanism. This list states have lowered or capped stamp duty is by no means exhaustive, but identifies the on such transactions and this has helped critical elements that cannot be overlooked. facilitate transfers to ARCs. The SRFAESI has made an attempt to deal with this issue of high stamp duty in Section 5, which provides Key elements of an Indian formal for the acquisition of fi nancial assets by an rehabilitation scheme ARC by way of an issue of debentures to the originators. However, this section does Eligibility not contain clear provision for the vesting of the title to such assets in the acquiring The restructuring law needs to clearly defi ne ARC and further, it is not clear whether who it applies to. The challenge in India is to such an acquisition would attract the stamp avoid both over- and under-inclusiveness. duty payable in respect of an assignment/ Certain types of entities in India, such as conveyance of financial assets. SRFAESI banks, insurance companies and major need to be amended to provide for a clear utilities, serve important economic and so- vesting of title in the ARC on an acquisition cial functions. The ramifi cations of these en- of fi nancial assets by way of an issue of bonds tities becoming insolvent go far beyond the or debentures under Section 5(1)(a). predominantly commercial considerations associated with ordinary businesses and, accordingly, it is perhaps best to exclude DEBT RECOVERY AND these entities from the restructuring law. At REORGANIZATION IN the other end of the spectrum, while it should BANKRUPTCY be noted that the protections afforded and discipline imposed by a sound insolvency law Introduction to formal should be as widely available as possible, in rehabilitation the Indian context it may be inappropriate to allow small businesses the right to a By far, the most diffi cult and most pressing complex restructuring mechanism that could issue facing India’s ICR system is the need cause undue delay. This goes back to the im- for a functioning and realistic reorganization portant issue of ensuring a balance between scheme, capable of being either debtor or liquidation and rehabilitation and, also, to creditor led. SICA and the related BIFR are the balance between using the law to facilitate considered failures. The Second Amendment debt collection (and access to credit) or to proposed certain turnaround provisions for serve broader socio-economic purposes such the Companies Act, but is generally viewed as stability. as not having gone far enough and, without There is international precedent for a the operation of the NCLT, has not had much bi-furcated approach, which may be appro- effect in India. priate in the Indian context (subject to There are myriad issues to consider when any specific constitutional concerns). Such designing a rehabilitation scheme. Each issue systems are typically split along the lines of Creating a Robust Infrastructure for Credit 173 highly objective criteria (e.g., the total amount assets. The moratorium is at the heart of of debt owed to arms length creditors) that the restructuring because it is the formal are not, themselves, likely to be contested. For mechanism by which the debtor is given the entities that exceed the threshold, the full breathing room to reorganize. At the same process should be available and, for those that time, the SICA moratorium was widely do not, a more truncated process (without, abused and led to the need for, amongst for example, complex tools such as post- other things, SRFAESI. Closely linked to this commencement financing and with shorter issue is the general question of time limits, timelines) would be utilized. which also poses some diffi culty for India. Moreover, for all entities, there should be Leaving the courts with unlimited discretion clear, bright-line rules for transferring a in determining timeframes opens the process proceeding out of restructuring and into to abuse, relies heavily on the judiciary’s liquidation. This transfer could occur at a constant involvement in the case and creates number of ‘trigger’ points, including deter- too much uncertainty for creditors. Very tight mination by the court or insolvency office timelines may, on the other hand, leave too holder (in India, preferably the latter) that little fl exibility. the restructuring process is unlikely to be When a debtor has failed the liquidity successful or not in the best interests of the test and approached the courts with an ap- stakeholders. It could also occur immediately plication for restructuring or rehabilitation, upon the failure of the restructuring plan he should simultaneously be able to file for and, in some cases, after a fixed length of time an automatic stay on creditors proceeding from the commencement of proceedings. to seize assets. The automatic stay should This helps to balance the concepts of certainty begin upon filing and last until the first hear- and flexibility, and also addresses the often- ing by the courts. Given the delays that are expressed concern that the restructuring law otherwise likely in the Indian context, the should not undo SRFAESI’s successes. first hearing of petition should be required by law to be heard within a short period (say 15 days) from the date of filing. Commencement of proceedings The automatic stay should stand vacated by law on the date of first hearing, where- As noted in the Dr. J.J. Irani Committee upon, if the debtor wants to have the stay Expert Committee on Company Law Report, granted/continued for a further period (which the most appropriate commencement test again the law should prescribe), the court in India is the ‘liquidity’ test. This requires should consider this only after affording an that the debtor has generally ceased making opportunity to the creditors to be heard, and payments and will not have suffi cient cash provided a majority of creditors by value sup- fl ow to service its obligations as they fall port the continuation of the stay. due in the ordinary course of business. It is The law should specify clear and very generally accepted that this test can be ap- narrow circumstances under which a judge plied on a fairly objective basis and helps can grant a further stay overriding the wishes put a company under the insolvency law’s of the majority of creditors in value. Among protection before it is too late. the necessary conditions for granting a further stay over the objection of a secured creditor (in respect of that creditor’s assets) Moratorium and timeframes is if the court believes that the asset is vital for the restructuring and, importantly, that One of the most contentious issues in de- the secured creditor will not be materially signing the restructuring scheme will be prejudiced by the stay. A secured creditor or the nature, applicability and duration of the insolvency representative should have a any moratorium on seizure of the debtor’s mechanism to seek extraction of a specific 174 A HUNDRED SMALL STEPS

asset from the estate on explicit grounds the security of the court’s direct involvement during the life of the restructuring. Typically, on specifi c issues. these grounds relate to whether the asset is By contrast, the ‘administration ap- dramatically being reduced in value without proach’ (where the insolvency administrator some form of protection being provided to takes possession and control of the com- the secured creditor, or where the asset is pany, subject to court oversight) has seemed deemed by the insolvency representative to to result in somewhat less contentious not be necessary for the purposes of the re- proceedings and, in any event, less court in- organization. Whether the exceptions in this volvement. While the court’s involvement is paragraph lead to substantial debtor abuse, not, in and of itself, negative, it has tended or whether they offer some necessary respite to make DIP systems considerably more ex- from excessive creditor power is something pensive and, where DIP has been applied in only actual experience will tell. The legis- countries where the courts have difficulty in lation should be altered with experience. quickly advancing cases, it has caused con- Extension of the stay should be in fixed siderable delay. The Committee therefore intervals (for example, 60 days) with a max- recommends that whether the debtor be al- imum number of stays (say 3) during the lowed to continue to manage be put to vote in lifetime of the restructuring. the initial hearing, and it be allowed only with There should be reasonable timelines the approval of the majority of the creditors. for the regular distribution of cash flow Else the ‘administration approach’ should statements to the court and creditors, filing be followed and a cadre of well-trained proof the restructuring plan, voting on the plan fessional bankruptcy administrators should and implementation of the plan. In the case be developed to implement it. of the latter three, the consequence of failing to meet the timelines should be a transfer of the case out of restructuring and into Post-commencement fi nancing liquidation. In the vast majority of cases in which a company enters a restructuring, the company Control of the debtor does not have suffi cient liquidity to operate during the time it takes to restructure. The There is no universally agreed upon ap- continued operation of the business during proach to the issue of control of the debtor this period has been shown to be vital to the company during reorganization. Many sys- business’ health. Employees and suppliers tems prefer the debtor-in-possession (DIP) must continue to provide services and be approach, with existing management run- compensated and the company must con- ning the company, while others prefer the tinue to trade so that its customer base is appointment of the insolvency administrator not eroded. Many countries, therefore, have to control the company. There are some adopted provisions by which a debtor in advantages to the DIP approach in that the reorganization can obtain additional fi- existing management of the company are nancing. In some countries, this is a purely usually best equipped to continue the com- academic question in the sense that no pany’s operation during restructuring in a realistic market for fi nancing troubled com- cost effective manner (i.e., without the reten- panies exists. In India, however, it is reason- tion of outside professionals). On balance, able to hypothesize that a market for this type however, DIP systems tend to be considerably of fi nancing could develop. more court-intensive in that, while the debtor Post-commencement financing itself remains in possession, creditors and the incomes in many forms. At the most basic level, solvency administrator often feel the need for many companies need trade credit to order Creating a Robust Infrastructure for Credit 175 inventory. The most common approach to of commercial bargaining. In the long run, this issue, particularly when possession and this will simply have a negative effect on the control of the company is in the hands of an availability and cost of credit and, again, will insolvency administrator, is to permit the cause the reorganization scheme to be viewed administrator to take on such credit in its as just another tool by which debtors can personal capacity, with such costs forming avoid paying their obligations. As a result, a priority charge over all of the assets of the there are some key principles to be observed: estate. In practical terms, this is not usually creditors should be grouped according to a problem because, if the initial tests for classes that are determined based on having restructuring have all been met, the con- a set of shared interests and rights; approval tinuity of trade is a foregone conclusion of the plan should be dependent upon a and the purchase of inventory will bring formula that requires both some form of new assets into the estate for the benefit of majority approval within classes and of the the creditors. classes as a whole; creditors of a similar class More contentious is the ongoing pay- should receive the same treatment under ment of operating expenses when the com- the plan; creditors whose rights are being pany is operating on a negative cash flow compromised in any way should have the basis. Although two broad approaches are ability to vote on the plan; if any class of prevalent here (one where the court can creditors dissents but is being bound by order a ‘super-priority charge’ ahead of all the plan, the proponents of the plan should secured creditors on all assets for the pur- be required to demonstrate that such class pose of obtaining additional capital and one is receiving no less than they would under where the debtor can only grant security liquidation. over unencumbered assets unless secured creditor consent is obtained) in practice, there is little difference. Even in jurisdictions Priority where courts are empowered to override secured creditor objections, they rarely do The statutory priority of different claim- except in the most extreme of circumstances. holders to bankruptcy proceeds is typically Nevertheless, it would seem that, given the a compromise between political and eco- novelty of this concept globally, a more nomic compulsions. While the need to pro- conservative approach is warranted. Such tect employee claims such as overdue pay an approach would necessarily require the is important, there should be a limit (say debtor to work towards a consensual solu- six months) to which pay is protected, after tion with its largest secured creditor so that, which employees should also join the ranks in most cases, that creditor would be the of unsecured creditors. The government, one providing the additional financing in which has substantial powers to recover restructuring. arrears to it prior to bankruptcy, should not stand ahead of secured creditors. But perhaps most important, the statutory priorities of a Approval of the reorganization plan fi rm should be well disclosed so that creditors can act well in time, before they get crowded The desired result of any restructuring is the out by other claims. creation and approval of a plan that allows the debtor to emerge from restructuring in a viable state. Determining how this plan will Personnel issues be arrived at is therefore critical. In India, it is important that reorganization plans Virtually all modern insolvency law frame- not be used as a tool to subvert the essence works rely upon a highly competent 176 A HUNDRED SMALL STEPS

adjudicative body. Although truncating for the last, which should be the charge of an judicial processes may be an effective way of external board set up by the NCLT. speeding up simple contract and secured credit enforcement, reorganizations will require an effective judicial or quasi-judicial Cross-border insolvency authority. India possesses a large body of highly qualifi ed, experienced judges and a Although briefl y touched on in the Irani relatively strong judicial branch of govern- Report, cross-border insolvency is rapidly ment. This is a strength that needs to be drawn becoming a ‘hot-button’ issue in domestic upon in the design of an Indian restructur- insolvency reform in emerging market coun- ing system. In particular, the creation of a true tries. As one of the largest recipients of for- specialized court, with appropriate training eign direct investment in the world, India has and resources (the NCLT), is a realistic option an urgent need for a mechanism of dealing for India. Such a court would facilitate the with foreign judgements, cooperation implementation of more sophisticated re- and assistance amongst courts in different structuring tools that rely on an effective countries and the transnational nature of judiciary to constantly balance the interests corporate entities. of creditors and debtors. India’s ICR framework does not recognize In addition to facilitating the training the jurisdiction of foreign courts in respect of the judiciary in the finer points of fi- of the branches of foreign banks operating in nance, business, and bankruptcy practice— India. As such, if a foreign company is placed something that can be undertaken by joint into liquidation outside India, its Indian programmes between some combination business will be treated as a separate matter of the National Judicial Academy, business and will not automatically be bound by the schools, law schools and expert judges/ same proceeding unless Indian stakeholders lawyers in India—there is also a need for a commence a separate proceeding. This re- whole host of supporting staff such as the sults in confusion, multiplicity of proceedings bankruptcy administrator or the official and unnecessary costs. liquidator. It would be efficient to outsource The UNCITRAL Model Law on Cross- these tasks to professionals such as business Border Insolvency provides a roadmap, lawyers, consultants, or accountants on a case adaptable to India’s needs, for the treatment by case basis, making the chosen individuals of foreign entities and foreign proceedings. ‘officers of the court’ in the same way that legal practitioners are (and holding them to the same ethical and professional standards). Review Alternative compensation structures such as a fixed percentage of the overall realizations, No bankruptcy system, especially given or a fixed percentage of the realizations for India’s complexities, will be born perfect. creditors, or a fixed amount plus a sliding Whatever the bankruptcy legislation that scale of percentages, could be considered to emerges from parliament, a process of re- give these professionals the right incentives. view should be undertaken every few years Reappointment to future cases should be on to examine its success in practice. Easy- the basis of a sound track record. to-collect metrics such as the duration of More generally, specific guidelines will bankruptcy, the extent of creditor recovery, have to be created for the licensing, training, the number of successfully rehabilitated remuneration, supervision, and discipline/ companies, the administrative costs of suspension of these individuals. Ideally, a self bankruptcy, etc. should be collected, and regulating body of bankruptcy professionals features of the bankruptcy code continuously should undertake many of these tasks except examined to understand their practical Creating a Robust Infrastructure for Credit 177 impact. This will be especially important We indeed need an urgent review of per- because new factors will emerge that will sonal insolvency laws, as well as a framework require change in the laws. within which debts can be renegotiated if For instance, it is possible using credit excessively onerous, without making it too default swaps (CDS) for a debt holder to easy for debtors to escape obligations (which completely hedge the risk of default of the will hurt the debtors themselves as they debt he owns, and even stand to gain from will be unable to borrow). Such a framework default, despite owning debt. Such a debt should recognize that many debt claims may holder has perverse incentives, and may be from informal sources, that the most frustrate the restructuring process based indebted may be very poor, that they may need on a hidden interest derived out of his CDS counseling and financial advise as much as position. This is an issue that is relatively debt rescheduling, and that they may have minor in India today, but will undoubtedly little resources to navigate the legal system. become more important in the future. How A first step towards credit counseling bankruptcy code will have to be amended to and mediation could be the Office of the take such issues into account is a task best Financial Ombudsman that is proposed in undertaken by a future review. Chapter 6. That office can be a first stop in bringing creditors together and attempting a mediated settlement with the debtor. PERSONAL BANKRUPTCY Such an out-of-court settlement may be the most efficient way to consensually renego- The wave of farmer suicides has highlighted tiate excessively onerous debts, with the the importance of personal indebtedness. shadow of the courts (such as the Lok Adalat) While suicides are a complex phenomenon, providing the backstop. At the same time, and cannot be attributed solely to indebted- as the provisions for tracking credit his- ness, it does raise the question of whether tories become better, it may be possible to there are sufficient mechanisms to write reduce the current penalties for bankruptcy down or even forgive the value of individual substantially, imposing financial penalties debts when they get too high. (limited and costly future access to finance) Current provisions for personal bank- on the bankrupt rather than moral or ruptcy essentially place severe penalties on criminal penalties. an individual who is declared insolvent, with various statutes treating insolvency as a disqualification on par with insanity or SECURITIZATION moral turpitude. It may be worthwhile to debate whether a reform of personal in- Background solvency provisions should be considered, that provides workout opportunities to indi- Securitization as a means of raising fi nance viduals while protecting creditor interests. or transferring credit risk has existed in India Because Indians have become more willing since the early 1990s. Initially, it consisted to take on debt, and not just in the agricul- primarily of quasi-securitizations16 or Direct tural sector, many more will experience Assignments (DA). Portfolios or individual difficulties. As the business cycle becomes a loans simply moved from the balance sheet of feature of the Indian landscape, many small the originator to the investor (such as a bank), businessmen without the protection of without any type of tradable security being limited liability will be overwhelmed by their created. Over time, the market has moved debts, and many middle class households to more formal securitization involving spe- will find themselves unable to their monthly cial purpose vehicles (SPV). The individual installments. loan(s) are assigned to an SPV (normally a 178 A HUNDRED SMALL STEPS

trust) which issues tradable securities in the cross-border securitization because there form of pass-through certiﬁ cates (PTC) to is little regulatory clarity on treatment investors. of participation by foreign institutional The Indian market saw a significant in- investors (FIIs). crease in securitization activity in the period 2000–06, partly because of increases in retail consumer loans such as car loans, com- Need for securitization mercial vehicle loans, unsecured personal of trade credit loans and residential mortgages. Despite the flexibility provided by direct assignment As yet, corporate accounts receivables (trade transactions, SPV transactions continue to credit) are not securitized. The existing RBI grow since one of the most significant in- guidelines do not make it clear whether re- vestors, mutual funds, can only invest in volving assets such as trade credit or working tradable assets. capital loans etc. can be securitized. Turning to assets being securitized, auto However, trade credit is a critically im- loans were the mainstay of the securitization portant source of finance for Indian firms market in the 1990s. Since 2000, residential across the board. For all firms together, mortgage backed securities (RMBS) have also the share of trade credit in total corporate contributed to market growth, though RMBS financing has grown steadily from 7.25 per activity has slowed significantly during the cent to almost 16 per cent during 2001–05. last two years. Corporate loans, commercial In 2005, it was the biggest funding source. mortgage receivables, project receivables, Further, the proportion was much higher (26 toll revenues, etc. have also been securit- per cent) for SME’s. ized. According to ICRA estimates, issuance SMEs could reduce their investment in volume in the Indian structured finance mar- working capital, and thus their need for ket grew at a CAGR of 34 per cent between finance, significantly if the receivables due to FY 2003–07 and by 44 per cent in FY 2007. them from large firms could be securitized. Asset-backed securities (ABS) claimed the In principle, such receivables, if accepted, are biggest share in the market, accounting for essentially commercial paper with the high 63 per cent in FY 2007, followed by CDO/LSO credit ratings of the large firms. Further, if (32 per cent). RMBS, hindered by limited the SME can securitize and sell its receivable investor interest, amounted to less than claim, its resulting smaller and better 5 per cent of the total in FY 2007. The total capitalized balance sheet would improve its size of the new issues was INR 370 billion. credit worthiness. Given that the underlying asset classes Though the securitization process is being securitized are largely retail and short similar to factoring, it could be more cost- or medium term corporate loans, the issuers effective than bank funding, factoring, and are typically private sector banks, foreign letters of credit. A negotiable Bill of Exchange banks, and non-bank finance companies (BoE) issued by a buyer against goods re- (NBFC). The key motivations for originators ceived provides a form of securitization of are raising finance, generating a lower cost trade credit. The supplier can have the BoE of funds (especially because securitization discounted with any financial intermediary proceeds are not subject to capital require- in a private transaction. The supplier and ments or reserve requirements), and man- the intermediary can also endorse the bill in agement of asset liability mismatches. Key favour of any other party. Currently, mostly investors are mutual funds in SPV trans- banks deal in BoEs, and usually the accept- actions and banks in DA transactions. The ance and discounting are kept under the transactions are purely domestic with no credit limit set up for the buyer. However, the Creating a Robust Infrastructure for Credit 179

Sources of Funds for Non-fi nancial Indian Corporations All fi rms SMEs Manufacturing Services Average Average Average Average Year 2005 2001–05 2005 2001–05 2005 2001–05 2005 2001–05 (%) (%) (%) (%) (%) (%) (%) (%) Internal Sources 67 61 44 24 74 67 44 46 Equity 13 12 13 29 9 7 13 6 Debt –3 0 1 0 –6 0 5 19 Banks & FIs 1 8 15 12 0 4 11 9 Group Cos/Promoters 1 2 4 2 1 2 2 0 Trade Credit 16 11 11 26 15 14 19 8 Others 5 7 12 8 6 7 10 12 Number of Observations 4,766 24,658 752 3,760 3,242 17,426 1,524 7,232 Source: CMIE, Prowess. nature of the transactions and the physical • Additionally, since most of these instru- format of BoEs rules out a sizable secondary ments are not rated, a formal rating pro- market in them. gramme along the lines of commercial paper could be instituted to enhance The Mexican development bank, NAFIN, secondary market tradability. created an electronic system where any small firm could present receivables on a number of large firms to it. NAFIN had set up Potential for freeing up balance arrangements with these large firms before- hand to have these receivables presented sheets of small banks and and accepted electronically. The accepted cooperatives receivables, now full-fledged claims on the large firms, were then auctioned off in the Another important area where securitization market, and the proceeds paid out to the can help is in refi nancing small banks and small firms. Nothing prevents a private sec- cooperatives. This is an area where public tor entity in India from setting up this ex- entities like NABARD have typically played change, but the government could provide a large role in the past. If, however, the mar- significant encouragement, as well as any ket for securitization became more effective, needed legislative support. Therefore, the standardized loans made by small banks or Committee proposes measures that will cooperatives could be packaged and sold. Of dematerialize trade credit receivables and course, a number of safeguards would have enable them to trade in a similar way to com- to be in place so that the kind of aberrations mercial paper. we now see in industrial country markets do Specifically, we propose that: not emerge. For instance, originating banks would have to retain a signifi cant portion of • An organization like NSDL should pro- the ‘fi rst loss’ so that they have an incentive vide dematerialization capability. • An intermediary along the lines of NAFIN to originate higher quality credits, and so that could tie up with large buyers and an they keep close tabs on the borrower. authorized list of their suppliers to have With reasonable safeguards, the securit- automatic bill presentment and ac- ization market could be an important way of ceptance facilities. Such bills could then refinancing small and medium lenders such be auctioned, and the existing exchanges and reporting mechanisms (NSE/BSE/ as cooperatives in rural and semi-urban areas, CCIL) should be used to trade and settle as is already the case in urban areas. One these instruments. set of potential investors would be other 180 A HUNDRED SMALL STEPS

banks. If the only buyers were banks through valorem basis, then at 0.01 per cent subject to direct assignment, this would be equivalent a statutorily prescribed cap, say of Rs. 100,000. The registration fee itself can be a fi xed nominal to extending the Inter Bank Participatory amount. Certificate (see Chapter 4) scheme to a wider 8. Equitable mortgage or mortgage by deposit of category of institutions. The set of investors title deeds is most prevalent in home mortgages— the reforms to the stamp duty and registration with a formal securitization process in law could facilitate a move to mortgage deeds place could, however, be even broader and being obtained and diminish the utility of equit- eventually include mutual funds, insurance able mortgages. companies, and pension funds. 9. Optional registration also lacks the pre-requisite of mandatory registration—it does not amount to public notice, which other registrations, as listed, ensure. 10. The Act also deals with fi nance in nature of lease NOTES and hire-purchase, and consequent recognition of separation of ownership (with the fi nancier) and 1. Positive information typically refers to a past re- user (the person availing of fi nance). cord of successful repayment of loans, rent, utilities 11. The Companies (Second Amendment) Act, 2002 bills, etc., but could also include information about incorporates the regime governing sick industrial the borrower’s financial assets such as deposit companies from SICA, 1985 into the Companies accounts. Negative information typically refers to Act, 1956, in the form of part IV A – the provisions defaults on commitments. of which are yet to be notifi ed. 2. This section was adapted from a note titled ‘Inven- 12. ‘Sick Industrial Company’ means an industrial tory of the Personal Identifi cation Mechanisms in company which has the accumulated losses in any India’, prepared by Financial Information Network fi nancial year equal to 50 per cent or more of its and Operations Ltd (FINO) for the Committee. average net worth during four years immediately 3. ISO 27001 is the most widely recognized infor- preceding such fi nancial year; or failed to repay mation security standard in the world. This inter- its debts within any three consecutive quarters on national standard has been prepared to provide a demand made in writing for its repayment by a model for establishing, implementing, operating, creditor or creditors of such company [Section 2 monitoring, reviewing, maintaining and improv- (46AA)]. ing an Information Security Management System. 13. Substituted by ‘National Company Law Tribunal’ CIBIL is ISO 27001 certifi ed. by the Companies (Second Amendment) Act, 2002, 4. This section has benefi ted substantially from the w.e.f. a date yet to be notifi ed. World Bank report, India Land Policies for Growth 14. Reserve Bank of India Report on Trend and Pro- and Poverty Reduction, 2007, and the interested gress of Banking in India, 2004–05. reader is referred to that report for details. 15. Amongst other complaints, borrowers suggest 5. India Land Policies for Growth and Poverty that SRFAESI’s tools remain too draconian, even Reduction, 2007, p. 31. after reform, and lenders assert that the limited 6. This was also tried in Andhra Pradesh with some appeal rights available under SRFAESI are still success. open to abuse. 7. The reduction of the stamp duty can be to nominal 16. High Level Committee on Corporate Bonds (2005) amounts, say of Rs. 100, or if calculated on an ad has used this term. Special Topics

INFRASTRUCTURE cent of GDP in 2006/07 to 9.2 per cent FINANCING of GDP in 2011/12, the last year of the Eleventh Plan and be sustained at that level from then on. No discussion on fi nancial sector reforms 2. The share of private sector will rise from in India can be complete without reference 20 per cent of total infrastructure invest- chapter to how they will help infrastructure fi nance. ment in 2006/07 to about 30 per cent in First, it is well recognized that signifi cant 2011/12. 3. The budgetary support in total infrastruc- improvement in infrastructure is required ture investment, would gradually decline 8 not only to sustain the growth momentum (from 43 per cent of total infrastructure but also to distribute the benefi ts of higher investment in 2006/07 to 31 per cent in growth to a larger population. Financial sector 2011/12), implying that user charges will reforms therefore cannot be oblivious to the play an increasingly bigger role in fi nancing infrastructure. requirements of such a critical segment of 4. Budgetary support would be directed the economy. Second, infrastructure creates ‘largely towards rural infrastructure and certain special demands on the fi nancing the North East, leaving little room for system. Infrastructure projects are capital funding other infrastructure projects’. intensive with long gestation periods; their revenues accrue over a long period of time; If the current savings trend growth con- they involve higher sunk costs; and their tinues into the medium term, much of this output is non-tradable. These characteristics need can be financed domestically, pro- translate into certain demands on the fi nan- vided other sources of investment demand cial system (in terms of scale, tenor, and risk) do not increase rapidly also. But, adequacy of that are very different from those of other domestic financial savings is not enough; they goods and services. have to be intermediated into infrastructure Given the criticality of infrastructure and on a scale that would achieve the investment its peculiar demands on the financing sys- target. This is where the problem is expected tem, it is important to know the quantum to arise, as some of the deficiencies of the of India’s infrastructure financing needs and current financial system may not allow the how are they going to be met. A consultation intermediation to be scaled up to the required 2 paper by the Planning Commission has en- level. visaged an investment in infrastructure of For the most part, until quite recently, Rs. 20.3 trillion (at 2006/07 prices) or US$ India’s spending on infrastructure invest- 494 billion during the Eleventh Plan (April ment was low enough (about 3–5 per cent of 2007 to March 2012), substantially above the GDP) to be financed largely from budgetary realized investment in the Tenth Plan (Rs. 8.8 allocations and the internal resources of trillion at 2006/07 prices) in order to sustain infrastructure-focused government enter- a real GDP growth rate of 9 per cent.1 Of this, prises. Under these conditions, infrastructure about 20 per cent would be spent exclusively financing placed little demands on the finan- on rural infrastructure. Some of the salient cial system. It is only now that infrastructure points made by the paper are: spending has picked up enough momentum that the financial system must cope with 1. Gross capital formation in infrastructure new and enlarged demands, for which it is is envisaged to grow rapidly from 5.6 per arguably under-prepared. 182 A HUNDRED SMALL STEPS

At the institutional level, constraints market at the longer end of the maturity have emerged for all three major classes of spectrum cannot be overemphasized. By domestic financing institutions: commercial tapping the growing pool of long-term banks, NBFCs and insurance companies. With funds available with the insurance and pen- rapid increase in exposure in recent years, sion funds, as also foreign investors, the commercial banks are now the predominant corporate bond market can significantly financiers of infrastructure.3 They may not, benefit infrastructure investment, by (i) bet- however, be able to sustain the growth rates ter distributing the risk of financing such recorded in the past, primarily due to the fact investments more widely across the financial that long duration infrastructure projects system, and (ii) facilitating a better match create significant maturity mismatches for between the maturity profile of infrastruc- banks, given the essentially short-term nature ture assets and the liabilities needed to fund of bank financing. Also sectoral caps4 and them. This can only lend stability to the fi- limits on single and group borrower exposure nancial system. (emerging because of the enormity of project Second, the scale of banks’ balance sheets size relative to bank capital size) will place needs to expand to keep pace with the scale further constraints on financing. While it of infrastructure financing requirements. might be tempting to relax prudential norms This is an important underpinning for the in the cause of infrastructure, this would Committee’s call for a more liberal approach simply be wrong—infrastructure finance to consolidation in the banking system. Con- can be risky, and it would be short-sighted solidation would mean more efficient use of to sacrifice the health of the banking system infrastructure risk appraisal skills (which are on the altar of infrastructure finance. Instead, limited and whose distribution is skewed), banks need to raise capital. Particularly and at the same time, greater opportunities constrained here are the public sector banks, to use unutilized exposure limits.6 since more capital means either a dilution of Third, the banks need access to more in- the government stake or further investment struments to manage the interest rate risk by the government. for infrastructure lending induced ALM Specialized NBFCs have begun to play an mismatches. The Committee’s recommen- important role in infrastructure development; dation of a more enabling regulatory envir- but their future growth may be constrained onment towards instruments such as credit by banks’ growth potential, since banks are default swaps and interest rate futures is key the primary source of funding for NBFCs to helping this process along. and there are limits on bank exposure to Fourth, steps to nurture the evolution of NBFCs.5 Though insurance companies are a variety of institutional forms, including well suited to finance infrastructure because hedge funds and private equity, would help of their long-term liabilities, they have been the financial system cater better to the com- constrained due to their own risk aversion plexity of the financing requirements for the and preference for government, or govern- infrastructure sector which needs not only ment backed paper, restrictive investment long-term debt financing, but also significant guidelines and the lack of liquidity in the equity capital. market for longer term corporate bonds. In Finally, initiatives that help investors better addition, a number of insurance companies manage the credit risk associated with infra- will have to develop their own capacity to structure financing deserve special attention. evaluate infrastructure projects. Infrastructure lending is typically cash flow Infrastructure requirements are too large based, not asset backed. The Committee’s for the risk of associated financing to be suggestion for strengthening the rights of concentrated directly or indirectly in the unsecured lenders would help reduce losses banks. In this context, the need for a well in the event of default for infrastructure loans, functioning, deep and liquid corporate bond make it easier to securitize such assets or Special Topics 183 borrow in the bond markets against them. pension, and with employees of firms with Not only will this reduce the direct costs of over 20 employees through EPFO. Many infrastructure finance, the added liquidity problems were encountered in this path. for infrastructure-backed loans could help The fiscal liability on account of civil ser- Asset Liability Management for financial vants alone—who make up a tiny fraction of intermediaries engaged in infrastructure the workforce—exceeds 65 per cent of GDP. finance. Hence, this strategy is not scalable to the general population. Attempts at funding have been made: the Employee Pension Scheme OLD AGE PENSIONS (EPS) which is run by EPFO is a defined benefit programme which requires payments The problem by participants and has some assets. However, defined benefit systems tend to suffer from With the elongation of longevity, individuals inherent political problems. There is an have to plan for living for decades after they incentive to make generous payments, to have ceased working for a living. Changing cut corners on the required contributions, social mores have reduced the extent to which and to make improper asset management children satisfactorily solve this problem. decisions thus leading to poor asset returns. Hence, households critically require a way to As a consequence, the unfunded liability of obtain consumption in old age. This is where EPS has steadily built up over the years, as formal pension provisions come in. has happened with defined benefit pensions Back of the envelope calculations show all over the world. that the amounts of pension wealth required In countries where there are large de- by a household, to support consumption fined benefit pension systems, where promises for two or more decades, vastly exceed the have been made about future pension pay- sums of money involved in issues such as ments to a large fraction of the population, spells of unemployment or ill-health. Hence, this yields a difficult combination of fiscal the most important reason why ordinary stress and political intractability. Fiscal sta- households require the financial system is bility requires cutting back benefits, while preparing for old age. In a well functioning populism pushes in the opposite direction. financial system, pension-related savings is In Europe and Latin America, where there a large part of the savings of household, and is the longest experience with defined bene- pension funds are amongst the largest pool fit pensions, these difficulties have exerted of investible assets. considerable pressure on both politics and economics.

The problems of defi ned benefi ts pensions Defi ned contributions, individual accounts One strategy that can be adopted to address the problem of consumption in old age is to In response to these experiences, there has socialize the problem; to require the State been a worldwide shift towards ‘individual to make payments to all old people. The account, defi ned contribution’ pension sys- numbers involved in this are substantial. tems, which avoid the political and gover- A modest pension of Rs. 1,000 per month, nance problems of defi ned benefi t systems. paid to 20 crore people, works out to a cost Under an individual account defi ned con- of Rs. 240,000 crore per year. tribution pension system, individuals hold This approach, with payments made by a pass book, much like a bank account. The the State or underwritten by it, was used with individual makes payments into the pen- civil servants for the traditional civil servants sion account every month, but is prohibited 184 A HUNDRED SMALL STEPS

from withdrawing money from this until he on government bonds might work out to reaches old age. This money is invested by roughly 5 per cent, and the nominal return pension fund managers. The value of pen- on the equity index might work out to 13 per sion wealth is strictly based on the net asset cent on average. This equity premium of value of the investments made by the pension eight percentage points makes a massive fund managers. At all points in time, the difference to pension wealth, given the long individual can see how much pension wealth time horizons involved. There will, of course, has been created, and can adapt his savings be substantial swings in the stock market rate in order to achieve desired consumption index from year to year. But the returns to in old age. an equity index will outperform investing in Prefunding pensions—as opposed to government bonds, over a 25 year horizon, making promises about payments by the State with high probability. deep in the future—is particularly feasible in The swings in the stock market index from India given where India is in the demographic year to year can be significantly alleviated transition. A vast army of young people will by spreading pension assets all across the come into the labour force between 2008 world. A portfolio spread across indexes from and 2025. The dependency ratio will only all over the world has a volatility which is start worsening from 2025 onwards. This roughly half of a portfolio invested only in suggests that policy decisions on pension an Indian index. There is, thus, a powerful reforms by 2010 have an opportunity to case for equity investment, into stock market make a substantial dent on the problem, by indexes from all across the world, in pension catching young people early in their careers, fund management in India. and helping them build up pension wealth in time. In countries such as China, where the dependency ratio will start rising from Simple-minded pension 2010, such an opportunity for prefunding reforms do not work does not exist. The space for policy in India is, thus, luckily greater. The application of these ideas might suggest a simple-minded strategy of establishing a regulatory framework through which citizens Investment management obtain their own pension products in a for DC pensions decentralized way from fi nancial fi rms. This approach has run into diffi culties in many From the investment management per- countries, and is particularly inappropriate spective, the two central insights on how in India. these assets should be managed are: If private financial firms offer defined (i) Equity investment and (ii) International benefit (DB) pension products, then there diversifi cation. is a difficult regulatory problem attached to Economic reasoning, and the empirical it. For a young person, a DB pension makes evidence from all countries, suggests that promises about payments 40 to 65 years over long time-periods, equity investment into the future. Over 40 to 65 year hori- yields the highest returns. For a person zons, in a healthy and competitive financial who is saving money from age 20 to age 65, system, most financial firms normally which will yield consumption from age 65 exit the business through acquisition or to age 85, the time horizons are long indeed. bankruptcy. DB pensions sold by financial Looking forward, assuming a full array of firms thus require a considerable apparatus macroeconomic policy reforms are under- of State regulation, and inevitably involve taken, India might experience stable in- messy problems for the State when the firm flation of 2 per cent, the nominal return experiences bankruptcy. This underlines the Special Topics 185 importance of defined contribution pensions The new pension system (NPS) where there are no such problems. The central difficulty with ‘simple minded In the late 1990s, the Ministry of Social Justice pension reforms’ lies in the high fees and ex- and Empowerment set up ‘Project OASIS’, penses charged by financial firms. In some which led to the New Pension System. The countries, as much as a third of the lifetime key ideas of the NPS are the centralization contributions end up as payments to financial of recordkeeping, standardization of fund firms. Financial firms have an incentive to management products and competitive spend a lot of money on marketing and dis- procurement of fund managers. tribution, which helps them gain market On the core tasks of transactions and re- share, and this money is paid by the pension cordkeeping, there are economies of scale. accounts of their customers. Individuals Instead of each fund manager maintaining worldwide have tended to be remarkably un- a client database, it is cheaper to have a single informed about the size of payments being centralized database. This is termed the ‘Cen- made to their fund managers. Fund managers tral Recordkeeping Agency’ (CRA) in the have an incentive to devise a large number NPS. Contribution flows from all individuals of non-comparable products, so as to evade go up to the CRA, where netting takes place, accountability through comparison of re- and pension fund managers only get a single turns, and to confuse customers with high- big transaction every day. This reduces costs pressure sales campaigns which encourage of transacting and administration. The customers to buy each of these products. CRA also plays a useful function in enabling These problems—of financial firms competition: through a single computerized spending a lot of money on marketing and instruction, a customer can switch from one distribution—are alive and well with Indian fund manager to another. This is much easier, mutual funds and particularly insurance and cheaper, than the switching process seen companies. They illustrate the pitfalls of with mutual funds or insurance companies simple-minded pension reforms. today. Another source of costs is the inevitable An extensive literature in financial eco- transactions costs and administrative costs. nomics suggests that the dominant deter- Transactions inevitably involve costs, and minant of investment performance is the these costs generally have a fixed rupee asset allocation, and not security selection. value. When the transaction size is small, the The NPS envisages exactly three kinds of rupee value of the transactions cost looms asset allocations. Scheme ‘A’ would have large. In India, where a large number of mostly government bonds, and a small share small-value customers would engage in a in corporate bonds and corporate equities. large number of small-value transactions, It would look similar to the existing EPFO- this is an onerous challenge. Similarly, each style asset allocation. Scheme ‘B’ would have pension fund manager would inevitably a greater emphasis on corporate bonds and suffer administrative and record-keeping equities. Scheme ‘C’ would have a further costs. These costs would be large, in percent- emphasis on corporate bonds and equities. age terms, when there are small value ac- All fund managers selected into the NPS count balances. would produce exactly three products. Put together, the implementation of in- Equity investment within all three schemes dividual accounts in India through simple- is expected to be implemented using index minded pension reforms suffers from fund investment, thus yielding reduced cost daunting problems where a large fraction and regulatory complexity. of the contributions would be used up for From the viewpoint of the consumer, transactions, recordkeeping, administra- this simplification would simplify decision- tion, distribution, and marketing costs. making. Fund managers would be forced to 186 A HUNDRED SMALL STEPS

compete on performance and not on ad- Reaching into the unorganized vertising, given the head-on comparability sector of performance. There is a lower role for high-pressure marketing when there are The NPS solves the problem of the pension only three products. liability of civil servants. However, civil Fund managers are recruited into the NPS servants are a small part of India’s labour through auction. Bidders are required to market. The real signifi cance of the NPS lies pre-commit a consolidated number for the in the fact that in the process of building grand total of fees and expenses that they the NPS for civil servants, some valuable would charge. A small number of lowest institution building is taking place, and eco- bidders would be the fund managers of NPS. nomies of scale are being achieved. The most So far, very low bids of 3 to 5 basis points important benefi ts of the NPS will come per year have been obtained in these auc- when it is scaled up to reach into the vast tions. These prices compare favourably with unorganized sector. Here, it will play a role in the lowest prices seen worldwide in pension addressing the inclusion agenda, of bringing fund management. sophisticated fi nance to help improve the Through these innovations, the NPS ap- lives of millions of households. pears to be headed to becoming one of the In the unorganized sector, the NPS would, lowest-cost individual account pension sys- for the first time, offer an efficient mechanism tems in the world. In an interesting and par- for transferring consumption into old age. allel set of developments, ideas much like the However, there are onerous difficulties of NPS were put into the ‘Thrift Savings Plan’ distribution, of reaching out to households (TSP) in the United States which was set up all over India. The international experience in recent years for civil servants. suggests that voluntary participation in in- The NPS has been adopted by the centre dividual account pension systems is low. If and almost all state governments for new the NPS uses the sales practices of mutual recruits after 1 January 2004. Three fund funds and insurance companies, then it managers have been recruited through an would lose its core attributes of low cost. If auction, and a private firm (NSDL) has been the NPS does not use these sales practices, it contracted for construction of the Central might obtain few customers. Recordkeeping Agency. The NPS is expected A few elements of a strategy for bringing to come to life in late 2008. the NPS into the vast unorganized sector can In 2008 and 2009, the primary task is that be outlined: of making the NPS work, and of bringing in all employees recruited by central and Outreach will be critically enabled by har- state governments after the cut-off date. By nessing occupational groupings. As an 2010, the NPS should be fully operational. example, UTI has established a pilot in- At that point, it should be possible for the volving dairy farmers in Bihar. When the State to reduce its pension liability by giving farmer sells milk to his cooperative, 10 per cent of the price for milk is deducted and employees recruited before 1 January 2004 sent upstream into a pension account. Or- an option to shift into the NPS. Employees ganizations such as Sewa Bank have been who choose to do this would be paid a certain active in carrying the idea of a pension ac- amount into their NPS account on the first count to their audience. They can be a day, reflecting the pension wealth that they valuable intermediary through which ac- would have built up in the NPS if they had counts are opened and contributions collected. These approaches would avoid the been part of it all along from their date of low cost of selling to individuals and inter- recruitment. This will further increase the acting with them. size of the NPS, and reduce the pension At a conceptual level, when a micro- liability of the State, albeit at the cost of a fi nance fi rm such as Sewa Bank interacts one-time payment. with a household, it would require a series Special Topics 187 of fi nancial products through which var- The NPS has a great asset in terms of ious problems of risk management and having millions of civil servants who are consumption smoothing of the house- part of it, who will experience it and talk hold are addressed. NPS constitutes the about it to their friends and colleagues. upstream infrastructure through which Civil servants are spread all over the coun- one element of this—pension planning— try and are respected in their community. can be delivered by Sewa Bank to house- Over the long haul, patient communica- holds at a low cost. tion with users of the NPS, and with the The government runs many welfare unorganized sector at large, will yield programmes, and generally faces daunt- results in terms of expansion. ing problems of achieving effective delivery of these programmes. The administrative strength of the NPS gives an alternative through which money can be SUGGESTIONS FOR delivered at a very high effi ciency. This can IMPROVING INDIAN best be done through co-contribution by the government. DATA COLLECTION Roughly speaking, if a person in the unorganized sector brings in a contribution Introduction of Rs. 500 a month, the government could come through with a co-contribution of Rs. 50. If a person brings in lower or In a vast, diverse, largely rural country, the higher contributions, he would not be eli- challenge of gathering information that gible for this co-contribution. There is both relevant and accurate is daunting. would be leakages to the extent that some These challenges have become even more rich people would harness this benefi t. However, it constitutes a transfer of only complex with faster economic growth, the Rs. 600 per person per year and constitutes shift to greater deregulation of the economy a small leakage. Such a co-contribution (particularly in infrastructure and manu- strategy has been used with much success facturing) and with increased international in countries such as Mexico in increas- openness in trade, fi nance, investment, and ing participation in the formal pension system on the part of individuals in the human movement. unorganized sector. This expenditure can This is not to suggest that the Indian be seen as replacing the direct poverty- data system has not been responsive to the alleviation expenditures that the State changing needs of the economy. Over the last might have to otherwise undertake if the decade, the Indian data system has undergone same individuals are destitute in old age. The expansion of NPS into the un- significant changes in terms of institutional organized sector through such methods structure, improved methodology, reduced would inevitably take time. Policymakers time lags, and expanded coverage. have to have fortitude in patiently apply- In this regard, two recent landmark events ing these strategies to obtain results over have been the report of the National Statisti- time. There are no quick results to be had, cal Commission chaired by Dr. C. Rangarajan and the short-cuts through which (say) 1 crore accounts can rapidly come about (2001, see Box 1) and India’s subscription to in the unorganized sector generally do the Statistical Data Dissemination Stand- violence to the essence of the NPS. ards of the IMF on 27 December 1996. Each Over the years, a combination of low of these initiatives has led to a large work costs, equity investment and international programme to improve the statistical base diversifi cation will yield superior results for households, and this message will go of the Indian economy; and these efforts out by word of mouth. The tremendous continue. price advantage—where charges such as These initiatives have been complemented 3 to 5 basis points in the NPS are 20 to by continuing domestic efforts to modernize 50 times smaller than those seen with standards in corporate accounting (through mutual funds and insurance companies— will gradually infl uence the views of SEBI and the Institute of Chartered Account- households. ants of India (ICAI)) and in government 188 A HUNDRED SMALL STEPS

Box 1: Organizational Reforms Proposed by National Statistical Commission ‘inclusive growth’ is an established overall (Chair: Dr. C. Rangarajan) goal of economic policy. These needs are sub- The Report of the National Statistical Com- proposed a methodological unit in NSSO to stantially met by the various surveys of the mission (2001) made a number of suggestions conduct studies in order to improve survey National Sample Survey Organisation, which for improving the administration of the methodology. now also undertakes the All-India Debt and statistical system in India. The Committee emphasized the need The Commission recommended the setting to enhance the professional capabilities of Investment Survey previously conducted by up of permanent apex statutory body ‘National staff that produces national statistics and the Reserve Bank of India. Commission on Statistics’ which would be an recommended a number of steps towards However, as noted below, the huge share of independent statistical authority. The NCS was achieving it. expected to be responsible for policy making, One of the critical requirements of a good informal employment in total employment, coordination and maintaining quality standards statistical data is strong legal backing for and the growing share of the services sector in statistical data. NCS was set up by an act of collection of data. Lack of this is now seriously in total output mean that infrequent surveys, Parliament in 2006. impacting collection of key statistics like in- The Commission also made recommenda- dustrial production and wholesale price index. no matter how careful, leave large gaps in tions on organizational aspects of the Central The Committee had recommended changes our understanding of the mechanisms by CSO and NSSO as well as methodological to the Collection of Statistics Act, 1953 to which policy actions translate into household issues related to statistical data generation give it effective while taking into account the welfare. These gaps can only partially be filled to make them more effective. They had informant’s right to privacy. by the efforts of data-gathering organizations Source: Report of National Statistical Commission. outside government, commendable though these efforts are. accounting (through the Government Ac- A related and much commented upon counting Standards Advisory Board, which issue, is the widening gap between parameters is supported by the Office of the Controller (such as personal final consumption) esti- and Auditor General). Both the World Bank mated from household surveys, and their and the International Monetary Fund remain equivalent in the national accounts stat- deeply engaged with India’s data collection istics (NAS). institutions. Fourth, for planning development of new Given the span of issues covered in the products, the business sector has a need for present report, one can distinguish the fol- timely, geographically differentiated data on lowing purposes and constituencies which a range of topics. While some of this can be would benefit from improved data. gathered by private enteritis, information First, there is a continuing need for a is better treated as a public good, where the range of timely and credible leading and con- raw material is best financed by government, current indicators of the cyclical position of with subsequent analysis being performed by the economy. These are essential both for private firms. sound policymaking and to help the financial markets to take a view of the likely future path of the economy, and price this view into Business cycle indicators financial instruments. A second broad group of indicators has For effective decision making by investors, to do with risk management and the vul- managers and policymakers information nerability of the economy. These are the on business cycles (their leading, lagging indicators typically needed for multilateral and coincident indicators) is essential. The (and financial market) surveillance. As such main leading indicators presently avail- they are covered by the IMF’s SDDS, and a able come from the fi nancial sector. Even review of the current status of these indi- here information on some key indicators, cators is provided in the IMF’s 2007 Article IV such as the actual rate of interest paid by Consultation Staff Report.7 the borrowers is missing; what are avail- A third broad group of indicators has to able are the prime lending rate (largely ig- do with the economic and distributional nored by commercial banks in actual loan impact of government policy, of particu- pricing) and a range of interest rates on lar importance in an environment where treasury instruments. Despite the enormous Special Topics 189 importance of informal fi nance to the bulk headline infl ation—WPI—misses out on of India’s economic agents, data that formerly over 50 per cent of the economy. The need was reported on cost of credit in informal for a representative, comprehensive, and timely measure of infl ation from the point fi nancial markets has been discontinued. of view of monetary policy targeting as A major lacuna in the leading indicators well as fi nancial market participants is for the economy is the lack of seasonally- very critical. Efforts have been on to con- adjusted time series. While this can be done struct a Producer Price Index (PPI) and a mechanically by many econometric pack- comprehensive CPI for urban and rural areas for quite some time. These efforts ages, it is useful to have uniformly produced, need to be intensifi ed as existing measures official data for analysts. of infl ation are losing their relevance. The Availability of data on consumption, in- suggestions made by the National Stat- vestment, employment, capacity utilization, istical Commission are documented in inventories and housing starts help to identify Box 2. cyclical movements in the economy. Some issues in this regard are pointed out below. Economic activity, employment, • Private Final Consumption Expenditure and asset behaviour data from the national accounts is now available at quarterly frequency with The unorganized sector forms an important a three-month lag (Source: CSO). A part of the Indian economy, and bears the monthly series (e.g., retail sales) with a brunt of cyclical adjustment in the economy. shorter time lag would be desirable. • Inventory/stock data is available at broad Despite this importance, information on sectoral and manufacturer level but not at this sector’s output is only available through the retail level. Also the sales data on most the fi ve-yearly Economic Census and the variables is available at the manufacturer Enterprise Surveys conducted by the NSSO. level and not at retail level. Data on retail The National Account Statistics do bring orders for consumer durables or orders for out estimates of value added for both the new construction or for new machinery are not available on a monthly basis/quarterly unregistered and registered parts of the basis. Defi ciency of such data hinders the manufacturing sector but not for the other identifi cation/prediction of turning points sectors of the economy.8 in industry. Data gaps are equally serious in the ser- • In case of construction, which has been vices sector, which is now the largest and an important driver of growth in recent years, there is no systematic information on housing-starts or housing prices. The Box 2: Recommendations of the National Statistical Commission for Improving Price information on housing loans provides Statistics only a partial coverage of the construction activity. Collating information on housing Currently the Wholesale Price Index is the The Consumer Price Index (CPI) is used measure of headline infl ation in India. The for a variety of purposes including the stocks, housing starts and housing prices latest data covers 435 commodities with increments in wages. There are four different should be given top priority. Regular col- 1993–94 as the base. The Commission had CPI measures in India; CPI-Industrial workers, lection of a few series on rural housing recommended frequent revision of base year CPI-Urban Non-manual Employees, CPI- would also be helpful given the enormous to capture the changes in the structure of the Agricultural labourers, CPI-Rural Labourers. importance of this sector for rural activity, economy, particularly the industrial structure. Coverage of each measure is limited to specifi c employment, and the demand for such im- Since services sector which accounts for over part of the population and none of them can portant industrial products as steel and 50 per cent of GDP is not covered by WPI, serve as an all-India measure of infl ation. The cement. NSC had recommended a separate indicator commission had recommended development • The lack of a comprehensive and reliable for the services sector. No progress has been of all-India consumer price index for rural and indicator of infl ation is widely recognized. made on these suggestions. urban areas in 2001. It is yet to be released. The Committee had stressed the need In the absence of legislation for collection of The existing measures of infl ation (WPI, to bring about uniformity in WPI compiled price data, the Commission had recommended CPI and GDP defl ator) differ with respect by various state governments and Union that possibility of bringing it under the umbrella to coverage, time-lag, associated markets Territories in terms of base year, num-ber of of Collection of Statistics Act, 1953 should and purpose of use, but none of them can items, weighting diagram, data sources etc. be explored. be considered as a representative measure of infl ation in India. The key measure of Source: Report of National Statistical Commission. 190 A HUNDRED SMALL STEPS

fastest-growing part of the economy. In CSO would need to be improved for timely many cases, output is indirectly estimated compilation and release of these statistics. (such as in the estimates of value-added from At present, the following important data trading activity). Even the value added from gaps exist at the level of most states, parti- transportation is based on indirect estimates cularly the poorer ones: as direct information is available only for the registered sector. There are difficulties • No state-level data on savings and investment are available. in collection of data through the Follow-up • Only partial data on export and import Enterprise Surveys of Economic Census for are available (inter-state). the household and unregistered sector which • There are no offi cial input/output tables. constitutes all unincorporated enterprises • Time series estimates of GDP and Value including proprietorship and partnerships of output at two or three-digit level for run by individuals. The services sector manufacturing (organized and unorganized) are not available. includes a large segment of business and • Sectoral Disaggregated GSDPs are missing. professional services. Moreover, newer ser- • Government Final Consumption Expen- vices are coming into existence very rapidly diture data are only available at the ag- which further complicates collection of data gregate level. on this sector (see Box 3). Reliable estimates of value-added at the As noted below, the introduction of sub-national level (state and district) con- state-level Value-added Taxes (VAT), the sistent with national estimates of GDP pub- expansion of the coverage of the Service lished by the CSO would fill a major data Tax and the move to an integrated Goods gap. The need for sub-national GDP data is and Services Tax (GST) generates data that also being increasingly felt by businesses to might be used to fill out these gaps. facilitate their decision making, and would be of particular interest to modern, service- oriented small and medium enterprises who Public fi nance data might wish to concentrate their activities only to a small geographic area. Coordination Emerging markets have been prone to a range between state statistical departments and the of so-called ‘capital account crises’, largely stemming from perceived inconsistencies and mismatches of various agents in the Box 3: Data on Employment, Productivity, and Skills economy. In India, according to the IMF In a country like India where the share of po- does provide some information on these source cited earlier, the external trade and pulation in the working age group is already aspects, frequency of updates remains a serious fi nance accounts are reasonably transparent, very high and is projected to rise in future, issue. A data set on an annual basis is defi nitely careful monitoring of both the employment needed/desirable. although some issues remain in regard to situation and availability of skilled manpower Today we are faced with a situation where remaining maturity of external debt and is indispensable. This information is critical for a large part of population is virtually un- trade credit. designing policies, which will match skills and employable due to the lack of requisite skill opportunities to generate sustained increases sets, in other areas there is a severe shortage Weak public finances and a high gross in productivity and growth. of skilled manpower. For instance, the sur- public debt stock even though largely deno- The NSSO’s Employment–Unemployment plus labour from agriculture is potentially minated in rupees, are known sources of Surveys are the standard source of structural unemployable in the manufacturing sector and vulnerability, and this vulnerability may change in the employment picture. These are a large part of the services sector due to lack only undertaken at intervals of fi ve years. of skills. Without doubt the availability of a well increase with further liberalization Non-availability of employment data at shorter large workforce is inconsistent with emerging of the capital account. In such a situation, frequency is an important gap in the existing formal and sophisticated work environment. transparent disclosure can be an important data set for effective policy/business decision At the same time the fi nancial sector is facing making. Related to the employment is the manpower shortage, which is pushing up mitigating factor, while also assisting in the information regarding education level/skill wages. Availability of information on supply and deepening of the market for public debt. set of the workforce/prospective workforce. quality of labour can facilitate a timely policy Some of the issues related to inadequate While the Population Census and the/NSSO response to such a situation. disclosure are highlighted below. Absence Special Topics 191 of such information also constrains fiscal Data useful for fi nancial product analysis at both national and sub-national design and innovation levels: A critical organizing framework for any fi - • Finances are maintained on a cash-fl ow, nancial system is the fl ow of funds matrix instead of accrual, basis. This militates against any objective assessment of oper- for the economy. The fl ow of funds data ating effi ciency of the governments, i.e., captures the movement of fi nancial fl ows the parameters like collection effi ciency, from the sectors that serve as sources of debtors, etc. cannot be ascertained. capital through intermediaries like banks, • There is an inadequate segregation of mutual funds to the sectors that use capital transactions relating to revenue and cap- to acquire assets. This is an essential tool ital expenditure. The problem is compounded by the fact that there is limited to understand the relationship between fi - accountability of end-use of funds re- nancial sector and the real economy. The ceived towards a specifi c purpose. fl ow of funds accounts open up possibilities • Project-level budgeting is absent, result- of examining the wealth effect and savings ing in inadequate project monitoring and behaviour. In US, the Federal Reserve Board control over cost-over runs, if any. produces the fl ow of funds data. The fl ow • For many entities fi nancial accounts are not audited for years together; as a result, of funds data was being reported for India the correct position of opening and clos- till 1995–96. Its publication needs to be ing balances are not available. In many in- revived. stances, even the fi nancial accounts are Although income data are collected by not prepared on a regular basis. the NSSO for households earning wage and Overall, lack of adequate transparency in • salary income, the standard indicator of fi nancial disclosure refl ects and reinforces low accountability in utilization of public household well-being collected by the NSSO funds. is household consumption expenditure. • No disclosures are done with respect to As already mentioned, there are large and public assets, their economic use, market increasing gaps between growth in per value etc. The level of detail on both on- capita household consumption as measured balance-sheet and off-balance sheet lia- in the survey data and growth in per capita bilities could be signifi cantly enhanced. • The estimates of debt at different levels private final consumption in the national of governments are also available with accounts. varying time lags. The debt of the public While difficulty in collecting income sector enterprises is not provided along data is understandable, consumption data with the government debt. The off- alone cannot help much where income data balance sheet borrowing is also only now beginning to be disclosed at the central becomes crucial for decision making. For government level. Corporate debt data are example, decision-making with regard to not available at more frequent intervals. insurance/health policy or products can be • Public accounts standards need to be re- more effective only if income data is avail- viewed and standardized to ensure that able. Regular time series data, preferably the data at the central government, state annual would be an important addition to government and the local government and governmental bodies are consistent the existing data set. Some surveys could also and follow fair accounting standards. The be specially designed to capture high income degree of divergence seen in treatment categories. of accounting heads even between revenue and capital classifi cation leads to disharmony and undependable data on Other data issues public fi nance currently. (As already noted, a work programme to generate relevant standards in this area is currently under- The split of the population as between urban way under the auspices of GASAB.) and rural is reported only at the time of the 192 A HUNDRED SMALL STEPS

decennial census. It would be helpful if these Tax (VAT). It is important to integrate the data could be periodically updated based on information collected through VAT filing with purposive surveys. other data bases in the economy. For example With suitable privacy safeguards, there is the VAT data base should be integrated with need to put in place a system to capture the customs, excise, income tax, credit data from identity and key statistics of each citizen. banks, etc., to improve its usefulness. This A robust information infrastructure based will facilitate efficient decision making and on unique personal identifiers is critical to help in plugging revenue leakages. many areas of economic and financial activ- Given rapid development of the financial ity such as directed citizen programmes (like system, and simultaneous divergence in ser- food subsidy or unemployment benefit) vice levels and penetration levels of various and security perfection and repossession. financial sectors, it is essential to formally Priorities include a system to capture the track the provision of financial services to identity of nationals (like the social secur- the entire population. The segments of po- ity number in the US), and a system to pulation not serviced by basic financial ser- digitize land records (as done by the NSDL vices such as banking, insurance, pension for equities). and investment need to be tracked both in With increased globalization, it is also the urban and the rural sectors. This would essential that data on Indian securities and be critical in shaping policy and direction currencies that are held actually or nominally of financial sectors’ evolution towards more overseas be tracked through effective licens- inclusive growth. ing of Indian leg of the transactions. Another important issue relates to the reliability of data. With the liberalization of NOTES

the economy, the inducement to industry 1. See ‘Projections of Investment in Infrastructure to furnish regular and timely data to the during the Eleventh Plan’, Planning Commission, government has reduced with adverse im- Government of India, October 2007. plications for quality and timeliness of data, 2. According to our estimates, which use optimistic assumptions about India’s savings performance, particularly industrial production data. More the share of ﬁ nancial savings to be channeled into teeth should be provided to the official data infrastructure would have to rise from 23 per cent collection agencies to get the required data. in 2006/07 to 33 per cent in 2011/12. 3. Between March 2001 and March 2007, commer- Harmonization of the data classification cial banks’ infrastructure credit outstanding has across activities, e.g., harmonization of Na- grown at a CAGR of 53 per cent, partly due to a tional Industrial Classification (NIC) codes small starting base. 4. Many banks are close to cap on power projects, for with trade data classification, would greatly example. enhance the combined utility and value of 5. NBFCs can and do have access to mutual funds and the data system. insurance companies, but such access is typically limited. A number of new initiatives/reforms 6. Several banks in India have little or no exposure to in the last few years are generating a lot infrastructure. of useful information. The framework for 7. IMF Country Report No. 08/51, February 2008. Annex. V. www.imf.org. centralization and integration of databases 8. For a more extended discussion of Indian output should be strengthened to ensure that new and employment data, and their implications for sources of information are captured in the estimates of economic growth and productivity, database regularly and are also integrated please see, Barry Bosworth, Susan M. Collins and Arvind Virmani, ‘Sources of Growth in the Indian with other databases. One prominent ex- Economy’, in India Policy Forum 2006/07. Sage, ample is the introduction of the Value-added New Delhi, 2007.