THE STUDY ON INDIAN FINANCIAL SYSTEM

POST LIBERALIZATION

A PROJECT REPORT

in partial fulfillment o f the requirement

for the award of the degree

Of

MBA( FINANCE)
 Objective

1.To study the Indian financial system post liberalization in terms of its
characteristics , factors affecting the market and trends visible in the market and
future prospects.

2.Portrayal of an unbiased view of the industry for potential issue.

3. Recommendation to enter the market .

4. Strategies to enable a new entrant to capitalize the opportunity prevailing in the

market , establish itself and gain a market share .
 Executive Summary

Finance is the major element witch activates the overall growth of the economy.
Finance is the life blood of the economy activity. A well system directly
contributes knit financial 4w to the growth of the economy .An efficient financial
system calls for the effective performance of financial institution , financial
instrument and financial markets.
Over the decades, India’s banking sector has grown steadily in size (in terms
oftotal deposits) at an average annual growth rate of 18%. There are about 100
commercialbanks in operation with 30 of them state owned, 30 private sector
banks and the rest 40foreign banks. Still dominated by state-owned banks (they
account for over 80% ofdeposits and assets), the years since liberalization have
seen the emergence of newprivate sector banks as well as the entry of several new
foreign banks. This has resultedin a much lower concentration ratio in India than in
other emerging economies(Demirgüç-Kunt and Levine 2001). Competition has
clearly increased with theHerfindahl index (a measure of concentration) for
advances and assets dropping by over28% and about 20% respectively between
1991-1992 and 2000-2001 (Koeva 2003).
Within a decade of its formation, a private bank, the ICICI Bank has become the
secondlargest in India.Compared to most Asian countries the Indian banking
system has done better inmanaging its NPL problem. The“healthy”status of the
Indian banking system is in partdue to its high standards in selecting borrowers (in
fact, many firms complained about thestringent standards and lack of sufficient
funding), though there is some concern about“ever-greening” of loans to avoid
being categorized as NPLs. In terms of profitability,Indian banks have also
performed well compared to the banking sector in other Asianeconomies, as the
returns to bank assets The financial sector prior to the 1990s was thus characterised
by
segmented and underdeveloped financial markets coupled with paucity of
instruments and there existed a complex structure of interest rates arising from
economic and social concerns of providing directed and concessional credit
tocertain sectors, ensuing “cross subsidisation” among borrowers. Formaintaining
spreads of banking sector, regulation of both deposit and lendingrates resulted not
only in distorting the interest rate mechanism, but alsoadversely affected the
viability and profitability of banks and equity.
 Table of Contents

1. Overview……………………………………………………………9
2. LiberalizingIndia’s Financial Sector………………………………21
3. The Institutional Environment in India – An Assessment…………51
4. Capital Markets…………………………………………………….65
5. Recent FII Flows to India…………………………………………..74
6. Banking Sector……………………………………………………..78
7. Corporate Governance……………………………………………..86
8. Microfinance in India…………………………………………….100
9. Issues for Research ……………………………………………….112
10.Bibliography ……………………………………………………..115
 India's Financial System
Overview
One of the major economic developments of this decade has been the recent
takeoffof India, with growth rates averaging in excess of 8% for the last four years,
a stockmarket that has risen over three-fold in as many years with a rising inflow
of foreigninvestment. In 2006, total equity issuance reached $19.2bn in India, up
22 per cent.
Merger and acquisition volume was a record $27.8bn, up 38 per cent, driven by a
371 percent increase in outbound acquisitions exceeding for the first time inbound
deal volumesDebt issuance reached an all-time high of $13.7bn, up 28 per cent
from a year earlier.
Indian companies were also among the world's most active issuers of depositary
receiptsin the first half of 2006, accounting for one in three new issues globally,
according to theBank of New York.
The questions and challenges that India faces in the first decade of the new
Millenniums are therefore fundamentally different from those that it has wrestled
with fordecades after independence. Liberalization and globalization have breathed
new life intothe foreign exchange markets while simultaneously besetting them
with new challenges.
Commodity trading, particularly trade in commodity futures, have practically
startedfrom scratch to attain scale and attention. The banking industry has moved
from an era ofrigid controls and government interference to a more market-
governed system. Newprivate banks have made their presence felt in a very strong
way and several foreign
Banks have entered the country. Over the years, microfinance has emerged as
animportant element of the Indian financial system increasing its outreach and
providingmuch-needed financial services to millions of poor Indian households.
1.1 The Indian Economy -- A Brief History
The second most populated country in the world (1.11 billion), India currently
hasthe fourth largest economy in PPP terms, and is closing in at the heels of the
third largesteconomy, Japan. At independence from the British in 1947, India
inheritedone of the world’s poorest economies (the manufacturing sector accounted
for only onetenth of the national product), but also one with arguably the best
formal financial
markets in the developing world, with four functioning stock exchanges (the oldest
redating the Tokyo Stock Exchange) and clearly defined rules governing listing,
tradingand settlements; a well-developed equity culture if only among the urban
rich; a bankingsystem with clear lending norms and recovery procedures; and
better corporate laws thanmost other erstwhile colonies. The 1956 Indian
Companies Act, as well as othercorporate laws and laws protecting the investors’
rights, were built on this foundation.
After independence, a decades-long turn towards socialism put in place a
regimeand culture of licensing, protection and widespread red-tape breeding
corruption. In1990-91 India faced a severe balance of payments crisis ushering in
an era of reformscomprising deregulation, liberalization of the external sector and
partial privatization ofsome of the state sector enterprises. For about three decades
after independence, Indiagrew at an average rate of 3.5% (infamously labeled “the
Hindu rate of growth”) and thenaccelerated to an average of about 5.6% since the
1980’s. The growth surge actuallystarted in the mid-1970s except for a disastrous
single year, 1979-80. As we have seen inTable 1.1, the annual GDP growth rate
(based on inflation adjusted, constant prices) of5.9% during 1990-2005 is the
second highest among the world’s largest economiesbehind only China’s 10.1%.In
2004, 52% of India’s GDP was generated in the services sector,
whilemanufacturing (agriculture) produced 26% (22%) of GDP. In terms of
employment,however, agriculture still accounts for about two-thirds of the half a
billion labor force,indicating both poor productivity and widespread
underemployment. Over 90% of thelabor force works in the “unorganized
sector.”1
1.2 Indian Economy and Financial Markets since liberalization
The Domestic Economy
There is hardly a facet of economic life in India that has not been radically
alteredsince the launch of economic reforms in the early 90’s. The twin forces of
globalization and the deregulation have breathed a new life to private business and
the long-protectedindustries in India are now faced with both the challenge of
foreign competition as wellas the opportunities of world markets. The growth rate
has continued the higher trajectory
started in 1980 and the GDP has nearly doubled in constant prices .The end of the
“LicenserRag” has removed major obstacles from the path of newinvestment and
capacity creation.. The unmistakable ascent in theratio following liberalization
points to the unshackled private sector’s march towardsattaining the “commanding
heights” of the economy. In terms of price stability, theaverage rate of inflation
since liberalization has stayed close to the preceding half decadeexcept in the last
few years when inflation has declined to significantly lower levels .Perhaps the
biggest structural change in India’s macro-economy, apart from therise in the
growth rate, is the steep decline in the interest rates. Interest rates have fallen to
almost half in the period following the reforms, bringingdown the corporate cost of
capital significantly and increasing the competitiveness ofIndian companies in the
global marketplace.
The External Sector and the Outside World
Along with deregulation, globalization has played a key role in transforming
theIndian economy in the past dozen years. A quick measure of the rise in India’s
integrationwith the world economy is a standard gauge of“openness” – the
importance of foreigntrade in the national income. the unmistakable rise in the
share ofimports and exports in India’s GDP since 1990-91. In just over a decade
sinceliberalization, the share of foreign trade in India’s GDP had increased by over
50%.
While imports increased steadily and continued to exceed exports, the rise in the
latterhas been almost proportional as well. The “export pessimism” that marked
India’sforeign trade policy truly appears to be a thing of the past.
While trade deficits have continued after liberalization, foreign investment in
India, bothportfolio flows as well as FDI, (and more recently in the form of
external commercialborrowing (ECBs) by Indian firms) have been substantial.
Bothkinds of flows have shown remarkable growth rates with comparable average
levels over The years. However the portfolio flows have been much more volatile
as compared to FDIflows. This raises the familiar concerns over “hot money”
flows into the country withportfolio flows.As for FDI, perhaps much of the
potential still lays untapped. A recent study byMorgan Stanley holds “bureaucracy,
poor infrastructure, rigid labor laws and anunfavorable tax structure” in India as
responsible for this poor relative performance2.
Nevertheless this difference should be viewed more as indicative of future
growthopportunities in FDI inflows provided India properly carries out its second
generationreforms and should not obscure India’s significant achievement in
attracting foreigninvestment in the years since liberalization.
As a result of substantial capital inflows, the foreign exchange reserves situationfor
India has improved beyond the wildest imagination of any pre-
liberalizationpolicymaker. Today the Reserve Bank has a foreign exchange reserve
exceeding twohundred billion US dollars, a situation unthinkable at the beginning
of liberalization whenIndia barely had reserves to cover a few weeks of imports..
The Indian rupee has largely stabilized against major world currencies, over
theperiod. The economic reforms era began with a sharp devaluation of the rupee.
As liberalization lifted controls on the rupee in the trade account, there were
considerableconcerns about its value. However, propped up largely by inflows of
foreign investmentthe floating rupee stabilized in the late 90’s and has appreciated
somewhat against the USdollar in recent months. In fact, it is fair to say that the
rupee is currently considerablyundervalued against the dollar as its value is
managed by the RBI. A lot has changed in the world beyond India’s borders during
these years. Japan,the second largest economy in the world, has experienced a deep
and long recession overmuch of the period. The Asian Crisis, one of the most
widespread of all financial andcurrency crises ever, devastated South-East Asia
and Korea in 1997. Continental Europehas entered into a monetary union creating
the Euro that now rivals the US dollar inimportance as a world currency. Several
economies like Russia, Argentina and Turkeyhave witnessed financial crises. The
internet bubble took stock markets in the US andseveral other countries to dizzying
heights before crashing back down. More recently, USsub-prime market woes have
sparked global sell-offs.
India has appeared largely unscathed from the Asian crisis. Most observersattribute
this insulation to the capital controls that continue in India. Nevertheless,
Indianfinancial markets have progressively become more attuned to international
market forces.
The reaction of Indian markets to the recent sub-prime meltdown bears testimony
to thelevel of financial integration between India and the rest of the world.
1.3 The Financial Sector
Despite the history of India’s stock exchanges (4 at independence to 23 today)and
the large number of listed firms (over 10,000), the size and role in terms of
allocatingresources of the markets are dominated by those of the banking sector,
similar to manyother emerging economies. The equity markets were not important
as a source of fundingfor the non-state sector until as recently as the early 1980s.
The ratio of India’s marketcapitalization to GDP rose from about 3.5% in the early
1980’s to over 59 % in 2005,which ranks 40th among 106 countries while the size
of the (private) corporatebond market is small. On the other hand, from The
efficiency of the banking sector, measured bythe concentration and overhead costs,
is above the world average.
In a series of seminal papers beginning in the late 1990s, La Portal, Lopez
deSilages, Shellfire and Vishnu (LLSV) have empirically demonstrated the effects
that theinvestor protection embedded in the legal system of a country has on the
developmentand nature of financial systems in the country. Broadly speaking, they
posit thatcommon-law countries provide better investor protection than civil law
countries leadingto “better” financial and systemic outcomes for the former
including a greater fraction ofexternal finance, better developed financial markets
and more dispersed shareholding inthese countries as compared to the civil law
countries. Consequently, the LLSV averagesof financial system indicators across
different legal system groups serve as a benchmarkagainst which an individual
country’s financial system can be compared.
Interms of the size (bank private credit over GDP), India’s banking sector is much
smallerthan the (value-weighted) average of LLSV sample countries, even though
its efficiency(overhead cost as fraction of total banking assets) compares favorably
to most countries.The size of India’s stock market, measured by the total market
capitalization as fractionof GDP, is actually slightly larger than that of the banking
sector, although this figure isstill below the LLSV average. However, in terms of
the “floating supply” of the market,or the tradable fraction of the total market
capitalization, India’s stock market is only halfof its banking sector.3
“Structure activity” and “Structure size” measure whether a financial system
isdominated by the market or banks. India’s activity (size) figure is below (above)
eventhe average of English origin countries, suggesting that India has a market-
dominatedsystem; but this is mainly due to the small amount of bank private credit
(relative toGDP) rather than the size of the stock market. In terms of relative
efficiency (“Structureefficiency”) of the market vs. banks, India’s banks are much
more efficient than themarket (due to the low overhead cost), and this dominance
of banks over market isstronger in India than for the average level of LLSV
countries. Finally, in terms of thedevelopment of the financial system, including
both banks and markets, we find thatIndia’s overall financial market size (“Finance
activity” and “Finance size”) is muchsmaller than the LLSV-sample average level.
Overall, based on the above evidence, wecan conclude that both India’s stock
market and banking sector are small relative to the size of its economy, and the
financial system is dominated by an efficient (low overhead cost) but significantly
under-utilized (in terms of lending to non-state sectors) bankingsector.However,
the situation has changed considerably in recent years: Since the middleof 2003
through to the third quarter of 2007, Indian stock prices have appreciated rapidly.In
fact, as shown in Figure 1, the rise of the Indian equity market in this period
allowed investors to earn a higher return (“buy and hold return”) from investing in
the BombayStock Exchange, or BSE’s SENSEX Index than from investing in the
S&P 500 Index and other indices in the U.K., and Japan during the period. Only
China did better. Manycredit the continuing reforms and more or less steady
growth as well as increasing foreign direct and portfolio investment in the country
for this explosion in share values. the two major Indian exchanges, the Bombay
Stock Exchange(BSE), and the much more recent, National Stock Exchange,
(NSE)) vis-à-vis other largest stockmarket in the world in terms of market
capitalization, while NSE ranked eighteenth. the trading in the BSE is one of the
most concentrated among thelargest exchanges in the world, with the top 5% of
companies (in terms of marketvelocity of
BSE (35.4% for the year) is much lower than that of exchanges with
similarconcentration ratios.5 Figure 1.9 shows that Indian markets outperformed
most majorglobal markets handsomely during 1992-2006 period.
In 2004-05, non-government Indian companies raised $2.7 billion from the
Market through the issuance of common stocks, and $378 million by selling
Bonds/debentures (no preferred shares). Despite the size of new issues, India’s
financialmarkets, relative to the size of its economy and population, are much
smaller than thosein many other countries. a comparison of external markets
(stock andbonds) in India and different country groups (by legal origin) using
measures from LLSV 1997a). Thedegree of protection of investors based on the
data used in the horizontal axismeasures overall investor protection (protection
provided by the law, rule of law, and
government corruption) in each country, while the vertical axis measures the
(relative)size and efficiency of that country’s external markets.6 Most countries
with the Englishcommon-law origin (French civil-law origin) lie in the top-right
region (bottom-leftwithrelatively strong legal protection (in particular, protection
provided by law) but relativelysmall financial markets.
The Financial Sector
Along with the rest of the economy and perhaps even more than the rest,
financialmarkets in India have witnessed a fundamental transformation in the years
sinceliberalization. The going has not been smooth all along but the overall effects
have beenlargely positive.
Over the decades, India’s banking sector has grown steadily in size (in terms
oftotal deposits) at an average annual growth rate of 18%. There are about 100
commercialthe rest 40foreign banks. Still dominated by state-owned banks (they
account for over 80% ofdeposits and assets), the years since liberalization have
seen the emergence of newprivate sector banks as well as the entry of several new
foreign banks. This has resultedin a much lower concentration ratio in India than in
other emerging economies. Competition has clearly increased with theindex (a
measure of concentration) for advances and assets dropping by over28% and about
20% respectively between 1991-1992 and 2000-2001.
Within a decade of its formation, a private bank, the ICICI Bank has become the
second largest in India. As compared to most Asian countries the Indian banking
system has done better in managing its NPL problem. The “healthy” status of the
Indian banking system is in partdue to its high standards in selecting borrowers (in
fact, many firms complained about thestringent standards and lack of sufficient
funding), though there is some concern about“ever-greening” of loans to avoid
being categorized as NPLs. In terms of profitability.
Indian banks have also performed well compared to the banking sector in other
Asianeconomies, as the returns to bank assets and equity in Table 1.6
convey.Private banks are today increasingly displacing nationalized banks from
theirpositions of pre-eminence. Though the nationalized State Bank of India (SBI)
remains thelargest bank in the country by far, new private banks like ICICI Bank,
UTI Bank(recently renamed Axis Bank) and HDFC Bank have emerged as
important players in theretail banking sector. Though spawned by government-
backed financial institutions ineach case, they are profit-driven professional
enterprises.
The proportion of non-performing assets (NPAs) in the loan portfolios of the
banks are one of the best indicators of the health of the banking sector, which, in
turn, iscentral to the economic health of the nation. Clearly theforeign banks have
the healthiest portfolios and the nationalized banks the worst, but thedownward
trend across the board is indeed a positive feature. Also, while there is stillroom for
improvement, the overall ratios are far from alarming particularly when
While the banking sector has undergone several changes, equity markets
haveexperienced tumultuous times as well. There is no doubt that the post-reforms
era haswitnessed considerably higher average stock market returns in general as
compared tobefore. Since the beginning of the reforms, “equity culture” has spread
across the countryto an extent more than ever before. Although GDP itself has
risenfaster than before, the long-term growth in equity markets has been
significantly higher.
 Liberalising India’s Financial Sector
Constraints, Challenges And Prospects
Following the unprecedented macroeconomic and balance of payments
crisis in 1991, a comprehensive program of macroeconomic stabilisation and
structural adjustment was undertaken in India. Early on in this reform
process,financial sector reform was initiated in 1992-93. My speech today reviews
thechallenges and constraints in liberalisingIndia's financial sector and makes
anassessment of its future prospects.
The speech is organised as follows: First, I shall present a brief historical
background and rationale for financial sector reform. This is followed by a
discussion of main features of the reform and its critical aspects. Against that
backdrop, Section an evaluation of the performance of India's financial sectorwill
be made. This will be followed by an analysis of the performance ofIndia's
financial sector in the global context. Finally, I shall try to identify thechallenges
that lay ahead for India's financial sector.

I. PRE-REFORM FINANCIAL SYSTEM IN

INDIA AND RATIONALE FOR REFORMS
The Indian financial sector today is significantly different from what itused to be in
the 1970s and 1980s. The Indian financial system of the prereformperiod
essentially catered to the needs of planned economicdevelopment in a mixed-
economy framework where the Government sectorhad a predominant role in
economic activity. Fiscal activism was resorted tokick start economic growth was
evidenced in took the forms of large
developmental expenditures by the public sector, much of it to finance
longgestationprojects requiring long-term finance(Reddy, 2000). This
necessitatedlarge borrowings by the Government. In order to facilitate the large
borrowingrequirements of the Government, interest rates on Government securities
wereartificially pegged at low levels, quite unrelated to market conditions.
Theaccommodative fiscal stance had to be supported by issuances of ad
hoctreasury bills (issued on tap at 4.6 per cent) leading to high levels of
monetisation of fiscal deficit during the major part of the 1980s. With a viewto
check the monetary effects of such large-scale monetisation, the cash reserveratio
(CRR) was increased frequently to control liquidity.The financial sector prior to
the 1990s was thus characterised bysegmented and underdeveloped financial
markets coupled with paucity ofinstruments and there existed a complex structure
of interest rates arising fromeconomic and social concerns of providing directed
and concessional credit tocertain sectors, ensuing “cross subsidisation” among
borrowers. Formaintaining spreads of banking sector, regulation of both deposit
and lendingrates resulted not only in distorting the interest rate mechanism, but
alsoadversely affected the viability and profitability of banks. The lack
ofrecognition of the importance of transparency, accountability and
prudentialnorms in the operations of the banking system led also to a rising burden
ofnon-performing assets. As Reddy (2000) has observed, there was a de factojoint
family balance sheet of Government, RBI and commercial banks, withtransactions
between the three segments being governed by plan prioritiesrather than sound
principles of financing.
The policies pursued did have many benefits, though such benefits came
at a higher cost. The phase was characterised by significant branch expansionto
mobilise savings and there was a visible increase in the flow of bank credit
toimportant sectors like agriculture, small-scale industries, and exports.
However,these achievements co-existed with emergence of macro-economic
imbalancessuch as the persistent fiscal deficits and inefficient functioning of the
financialsector. Excessive concentration of financial resources was contained to
asignificant extent. Importantly, there was no major episode of failure offinancial
intermediaries during this period.
The state of the financial sector in India thus, resembled the classic case
of “financial repression” a la propounded by MacKinnon and Shaw .The sector
was characterised, inter alia, by administered interest rates,large pre-emption of
resources by the State and extensive micro-regulationsdirecting the major portion
of the flow of funds to and from the financialsector. The regulatory regime prior to
the 1990s led to (i) inefficiencies in thefinancial system, (ii) underdeveloped
financial markets serving as a captive market for resource requirement by the State,
iii) very little product choice inall segments of the financial market, iv) low level of
liquidity in the securitiesmarket. New equity issues were governed by extensive
regulations. Therewas pre-emption of resources in government debt market to
fulfill highstatutory reserve requirements and limited depth in the foreign
exchangemarket as most such transactions were governed by inflexible and low
limitsbesides approval requirements. These, in turn, resulted in low levels
ofcompetition, efficiency and productivity in the financial sector.
Accordingly, the main objectives of the financial sector reform process
in India initiated in the early 1990s have been to:
First, getting rid of the complexities created by excessive regulation and
financial repression with a view to create an atmosphere conducive to the
emergence of an efficient, productive and profitable financial sector industry;

Second, enabling the growth of financial markets that would enable price
discovery, in particular, determination of interest rates by the market dynamicsthat
then helps in efficient allocation of resources;

Third, to provide operational and functional autonomy to institutions to

facilitate the growth of a healthy and robust financial system;

Fourth, opening up the external sector in a calibrated fashion so that the

domestic sector could withstand the challenges from international financial
system (Reddy, 1998).

Fifth, the financial sector reforms were guided by the desire to prepare
the financial entities to effectively deal with the impulses arising from the
developments in the global economy by promoting measures of financial
stability, which emerged as an important objective of monetary policy along
with price stability and economic growth; andAs financial markets grew in size,
especially since the late 1990s, thedominant fear of market failure receded, the
process of financial sector reformssaw a decisive shift towards market-oriented
strategies, enabling pricediscovery through deepening of the financial system with
multiple and diversefinancial entities of different risk profiles.

II. SALIENT FEATURES OF THE REFORM

The first phase of current reform of financial sector was initiated in

1992, based on the recommendations of Committee on Financial System (CFSor
Narasimham Committee).The initiation of financial reforms in the countryduring
the early 1990s was to a large extent conditioned by the analysis
andrecommendations of various Committees/Working Groups set-up to
addressspecific issues. The process has been marked by ‘gradualism’ with
measuresbeing undertaken after extensive consultations with experts and
marketparticipants. From the beginning of financial reforms, India has resolved to
thatthe international best practices.
The salient features of the financial sector reforms in India so far include
the following: First, financial sector reforms (FSR) were undertaken as part
ofoverall economic reform. Second, while the reform process itself commencedin
India well after many developing countries undertook reform, FSR wereundertaken
early in the reform cycle. Third, these were orderly as designedtaking into account
the prevailing circumstances. Fourth, the reforms havebrought about some
efficiency, as for example evidenced by recent reduction ininterest spreads or
increasing trend in household savings, especially financialsavings. Fifth, the
financial system and in particular the banking systemdisplays continued stability
relative to other countries. While during the initialstages of the FSR, India was
often criticised as being far too gradual, the financial crisis in the recent years
which have afflicted a number of developingcountries, not to talk about some
developed countries, have shown the merits ofIndia’s gradual reforms. Finally, the
progress that has been made in asubstantial yet non-disruptive manner, has given
confidence to launch what hasbeen described as second generation or second phase
of reforms - especially inthe banking sector.
The Reserve Bank's approach to reform in financial sector could be
summarised as pancha-sutra or five principles ( Reddy, 1998).

First, cautious and proper sequencing of various measures – giving

adequate time to the various agents to undertake the necessary norms; e.g.,
thegradual introduction of prudential norms.

Second, mutually reinforcing measures, that as a package would be

enabling reform but non-disruptive of the confidence in the system, e.g.,
combining reduction in refinance with reduction in the cash reserve ratio
(CRR) which obviously improved bank profitability

Third, complementarity between reforms in banking sector and changes

in fiscal, external and monetary policies, especially in terms of co-ordination
with Government; e.g., recapitalisation of Government owned banks coupled
with prudential regulation; abolition of ad hoc Treasury bills and its
replacement with a system of Ways and Means Advances, coupled with
reforms in debt markets.

Fourth, developing financial infrastructure in terms of supervisory body,

audit standards, technology and legal framework; e.g., establishment of Boardfor
Financial Supervision, setting up of the Institute for Development andResearch in
Banking Technology, legal amendment to the RBI Act on Non-Banking Financial
Companies (NBFCs).

Fifth, taking initiatives to nurture, develop and integrate money, debt

and forex markets, in a way that all major banks have an opportunity to
develop skills, participate and benefit; e.g., gradual reduction in the
minimumperiod for maturity of term deposits and permitting banks to determine
thepenalty structure in respect of premature withdrawal, syndication in respect
ofloans, flexibility to invest in money and debt market instruments, greaterfreedom
to banks to borrow from and invest abroad.
III. CRITICAL ASPECTS OF FINANCIAL
SECTOR LIBERALISATION IN INDIA

Financial sector liberalisation in India has been calibrated on cautious

and appropriate sequencing of reform measures and was marked by a
gradualopening up of the economy. This gradualist strategy seemed to have served
thecountry well, in terms of aiding growth, avoiding crises, enhancing
efficiencyand imparting resilience to the system. From the vantage point of 2005,
one ofthe successes of the Indian financial sector reform has been the maintenance
offinancial stability and avoidance of any major financial crisis since early 1990s-
a period that has been turbulent for the financial sector in most emergingmarket
countries.
The process of financial liberalisation has resulted in innovations in
instruments and processes, technological sophistication and increased capital
flows. In order to fulfil the broad objectives of the financial liberalisation in
India, a multi-pronged approach was adopted. This included removing the
constraints facing the financial system through the creation of an enabling
policy environment; improving the functioning of the financial institutions,
andthrough the pursuit of financial stability as an essential ingredient of
macroeconomic stability ( Reddy, 2004; Mohan, 2004b).
As the Indian financial sector stands at a crucial juncture today, it may
be instructive to look back at some of the important steps taken in the last
fewyears. Unshackling the financial system from excessive controls constituted
animportant element of financial liberalisation in India. This was necessary
toenable the financial sector to perform efficiently and attain its true potential.
Tothis end, major reform measures undertaken may be summed up as follows :

First, there was an increasing realisation that pre-emption of banks’

resources to finance Government’s budgetary needs through administered
interest rates was a binding constraint to efficient functioning of the banking
sector, structurally the dominant segment of the Indian financial system.
Removal of these constraints meant a planned reduction in statutory
preemptionand a gradual deregulation of interest rate prescriptions. In the early
1990s, as much as 63.5 per cent of bank's resources were pre-empted by the useof
cash reserve ratio (CRR) and statutory liquidity ratio (SLR). Since the
introduction of financial sector reforms, the SLR has been reduced to astatutory
minimum of 25 per cent while CRR has been reduced to 5 per cent.
The medium-term objective of reducing CRR has to take account of money
supply considerations and also the objectives of exchange rate stabilisation. .
Also, the Statutory Liquidity Ratio (SLR) has been gradually brought down
from an average effective rate of 37.4 in 1992 to the statutory minimum of
per cent at present.

Second, the complex structure of administered interest rates has been

almost totally dismantled. Prescriptions of rates on all term deposits,
includingconditions of premature withdrawal, and offering uniform rate
irrespective ofsize of deposits have been dispensed with. There is a differentiated
interest rateceiling prescribed for foreign currency denominated deposits from non-
residentIndians, and such ceiling will have to continue as part of managing
externaldebt flows, especially short-term flows till fuller liberalisation of
capitalaccount. Lending rates for different categories, which were earlier
prescribed,have been gradually abolished but transparency is insisted upon.

Third, since the onset of the reforms process, monetary management in

terms of framework and instruments has undergone significant changes,
reflecting broadly the transition of the economy from a regulated to liberalizedand
deregulated regime. Reflecting the development of financial markets andthe
opening up of the economy, the use of broad money as an intermediatetarget has
been de-emphasised, although the growth in broad money (M3)continues to be
used as an important indicator of monetary policy. Thecomposition of reserve
money has also changed with net foreign exchangeassets currently accounting for
nearly one-half. A multiple indicator approachwas adopted in 1998-99, wherein
interest rates or rates of return in differentmarkets (money, capital and Government
securities markets) along with suchdata as on currency, credit extended by banks
and financial institutions, fiscalposition, trade, capital flows, inflation rate,
exchange rate, refinancing and transactions in foreign exchange available on high
frequency basis arejuxtaposed with output data for drawing policy perspectives.
Such a shift wasgradual and a logical outcome of measures taken over the reform
period sincethe early 1990s (Reddy, 2001).

Fourth, there has been a sea change in the functioning of financial

markets in India since the onset of financial liberalization. The responsibility ofthe
Reserve Bank in undertaking reform in the financial markets has been
driven mainly by the need to improve the effectiveness of the transmission
channel of monetary policy. The development of financial markets have
therefore, encompassed regulatory and legal changes, building up of
institutional infrastructure, constant fine-tuning in market microstructure and
massive upgradation of technological infrastructure. Since the onset of reforms,a
major focus of architectural policy efforts has been on the principalcomponents of
the organised financial market spectrum: the money market,which is central to
monetary policy, the credit market, which is essential forflow of resources to the
productive sectors of the economy, the capital market,or the market for long-term
capital funds, the Government securities marketwhich is significant from the point
of view of developing a risk-free credibleyield curve and the foreign exchange
market, which is integral to externalsector management. Along with the steps taken
to improve the functioning ofthese markets, there has been a concomitant
strengthening of the regulatoryframework.
Furthermore, the Reserve Bank has achieved considerable success in
attaining monetary stability through maintaining low and stable inflation. Sincethe
second half of the 1990s, inflation has been brought down to an average offive per
cent per annum compared to an average of around 8-9 per cent perannum in the
preceding two and a half decades. The reduction in inflation sincethe early 1990s
has also enabled inflation expectations to stabilise. Low andstable inflation
expectations increase confidence in the domestic financialsystem and, thereby
contribute in an important way to the stability of thedomestic financial system
(Reddy, 2002).

Fifth, as observed by Governor Reddy, contextually, financial stability

in India means (a) ensuring uninterrupted settlements of financial transactions(both
internal and external), (b) maintenance of a level of confidence in thefinancial
system amongst all the participants and stakeholders and (c) absenceof excess
volatility that unduly and adversely affects real economic activity(Reddy, 2004).
The overall approach of the Reserve Bank to maintainfinancial stability is three-
pronged: maintenance of overall macroeconomicbalance; improvement in the
macro-prudential functioning of institutions andmarkets; and strengthening micro-
prudential institutional soundness throughregulation and supervision.

IV. PERFORMANCE OF THE FINANCIAL SECTOR

Adducing to the success of banking sector reforms, the various

parameters of performance of banking sector has shown continuous
improvement. The sources of income has witnessed increasing share of
noninterestincome amidst declining interest rate, increasing diversification
ofbanks’ portfolio and greater deepening of financial market. The share of
noninterestincome comprises fees, trading income, and gains from exchange
operations in banks’ total income has increased steadily from 9-10 per cent inearly
1990s to about 22 per cent in 2003-04. On the expenditure side, there hasbeen a
containment of overall expenditure accompanied mainly by decline ininterest
expenditure. The provisions and contingencies, particularly, on accountof non-
performing loans have shown higher growth due to tighter prudentialnorms in
order to improve asset quality.
The profitability of banks has shown significant improvement,especially, during
the last five years. During the last two years in particular,despite lower interest
rates, the banks have recorded a momentum of high
growth in profits of the range of 30-47 per cent attributing to improvement inasset
quality, better loan recovery, rising non-interest income, and containmentof
expenditure. From cross-country perspective, India’s banking sector nowbelongs to
the most profitable category. The profitability [measured by return on assts (ROA)]
of India’s banking sector at 1 per cent is comparable to someof the advanced
countries including U.K. and the U.S.A. The return on equity(ROE) indicator of
banks provides information as to how banks conductbusiness in the interest of
shareholders has also shown improvement. Thereturn on equity (ROE) of the
banking system, which was in the range of about10-16 per cent during the period
1998-99 to 2001-02, increased to about 19-20per cent in 2003-04. The spread has
shown a sustained movement in the rangeof 2.8-2.9 per cent during 2002-03 and
2003-04.Banks have made substantial progress in cleaning off NPAs from
theirbalance sheet adducing to various institutional measures pertaining to one-
timesettlement, debt recovery, asset reconstruction and securitisation,
lokadalats,and corporate debt restructuring. Despite the switchover to 90-day
delinquencynorm with effect from March 2004, the gross and the net NPAs of
SCBsdeclined in absolute terms for the second year in succession and stood at
only2.9 per cent as at end-March 2004 and further declined to 2.5 per cent as
atend-September 2004. The Reserve Bank’s thrust on adequate level ofprovisions
is reflected in the fact that the cumulative level of provisioning forthe scheduled
commercial banks works out to 70.6 per cent of gross NPAs as atend-March 2004.
This achievement is notable in comparison with theinternationally prescribed
benchmark of 50 per cent provisioning against
NPAs.The banking sector has shown sustained improvement in regard to
solvency and soundness as revealed from the capital adequacy requirement.
The capital to risk weighted assets ratio (CRAR) SCBs stood at 13 per cent
in2003-04, above the regulatory minimum of 9 per cent. In 2003-04, all but
twocommercial banks complied with the regulatory minimum CRAR of 9 per
cent.The two banks, which did not comply with the regulatory minimum,
accountedfor a negligible 0.5 per cent of total assets of scheduled commercial
banks in2003-04.Various other segments of the financial sector have also
witnessedimprovement during the recent years. The scheduled co-operative banks
registered a net profit during 2003-04 as against losses in the previous year.The
state co-operative banks registered profit during recent years while thefinancial
health of central co-operative banks deteriorated. A large number ofprimary
agricultural credit societies, however, faced severe problems due tosignificant
erosion of own funds, deposits and low recovery rates. Variouspolicies have been
adopted to improve the financial health of the PrimaryAgricultural Credit Societies
(PACs) including extension of funds byNABARD to develop the infrastructure of
the PACs.Among All India Financial Institutions (AIFI), barring two
institutionsfacing financial and organizational restructuring all other institutions
registeredpositive operating and net profits. The business model of the AIFIs came
understrain since the withdrawal of the concessional sources of funds and
impositionof restrictions on raising short-term funds of maturity less than one
yearresulting in AIFIs raising high cost debt from the market. The Non-
BankFinancial Companies (NBFCs) sector has registered improved profit in the
current years along with a strengthening of the soundness indicators.

V. INDIAN FINANCIAL SECTOR IN THE GLOBAL CONTEXT

Reflecting the growing credit needs and increasing levels of

monetisation in the economy, the ratio of money and quasi money to GDP in
India increased continuously from 35.0 per cent in 1981-85 to 57.9 per cent
in2001-03 . From a cross-country perspective India’s rank in terms of the ratio
ofmoney and quasi money to GDP remained broadly unchanged at around
55thwithin a sample of around 180 countries. However, at the current level, theratio
remained substantially lower than the global average and also those forChina,
Korea and major industrialised countries.
Over the last two decades, the growth in money supply in Indiaremained
remarkably stable at around 17 per cent. Money supply growth rate in
the country contrasts with the experience of the Latin American and East
european emerging market economies (EMEs). The stability in money
supplygrowth played an important role in the price stability of the country.
It has been generally observed that due to structural constraints
including relatively lower levels of development of financial intermediaries
andmarkets, there exists substantial excess demand for credit in the
developingcountries. In line with this, over the last two decades, the net domestic
credit toGDP ratio in India remained substantially lower than those in the
industrialized countries. The ratio also remained lower than that in China and
Korea.However, at the aggregate level, in terms of net domestic credit to GDP
ratio,India ranked 63rd among 175 countries, which indicate that the level of
excesscredit demand in the country is relatively modest. Moreover, over time,
therehas been substantial improvement in the credit-GDP ratio in the country from
44.5 per cent in 1981-85 to 56.8 per cent in 2001-03. This reflects deepening ofthe
Indian financial sector.With the introduction of the financial sector reforms in
India, there hasbeen substantial reduction in the role of administered policies in
deciding thedistribution of credit across sectors. Moreover, the level of pre-
emption ofcredit by the government sector has also been reduced substantially.
Reflectingthis, flow of credit to the private sector as a proportion of GDP
increasedconsiderably from 24.1 per cent in 1991-95 to 31.2 per cent in 2001-03.In
the post-liberalisation period, the ratio of domestic credit provided bythe banks to
GDP increased from 49 per cent in 1991-95 to 57 per cent in 2001-03.
Consequently, during this period, India’s relative ranking in the worldimproved
from 91st to 80th. However, as in the case of net domestic credit,credit from
banking sector as a proportion of GDP in India remains much lessthan the global
average and the levels in China and most East Asian EMEsAccording to the Indian
Banks’ Association Report on Banking IndustryVision 2010, the presence of
global players in the Indian financial system islikely to increase and
simultaneously some of the Indian banks would becomeglobal players in the
coming years. As the process of mergers and acquisitiongathers momentum in the
Indian banking sector, some of the Indian banks mayemerge as world-class banks
with operations at the global scale. Presently,there are twenty Indian banks
including a private sector banks which appearamong the “Top 1000 World Banks”
as listed by the London based magazine“The Banker”. Among the top 100 global
banks, India has only one bank, i.e.,
State Bank of India (SBI) which ranks 82nd, whereas China has 4 banks in thetop
100. In terms of size, Indian banks including SBI are far behind the topbanks in the
world. However, the financial strength of the Indian banks isamong the highest in
Asia.
Other segments of financial market, particularly, Indian stock market is
comparable to the international stock markets in terms of turnover ration.
Presently, India has third largest investor base in the world. Indian Stock
market trading and settlement system are of world class. India has one of the
world's lowest transaction costs based on screen-based transactions,
paperlesstrading and a T+2 settlements cycle. At the end of 2003, Standard and
Poor’s(S&P) ranked India 17th in terms of market capitalization (19th in 2002),
16th in terms of total value traded in stock exchanges (17th in 2002) and 6th
interms of turnover ratio which is a measure of liquidity (7th in 2002). India hasthe
number two ranking in terms of listed securities on the exchanges secondonly to
the USA. Despite having a large number of listed companies on itsstock
exchanges, India accounted for a meagre 0.96 per cent in total worldturnover as
compared to that of the US at 52.4 per cent of worldwide turnoverin 2003. In terms
of market capitalization, Indian companies accounted for 0.87per cent of the
worldwide market capitalization while US accounted for 44.7per cent in 2003.
These data, though quite impressive, do not reflect the fullIndian market, as S&P
(even other international publications) does not coverthe whole market. For
example, India has more than 9000 listed companies atthe end of March 2004,
while S&P considers only 5,644 companies. If wholemarket were taken into
consideration, India’s position vis-à-vis other countrieswould be much better.

VI. CHALLENGES AHEAD

(A) CHALLENGES IN THE BANKING SECTOR
What strategies can be adopted by Indian financial sector to become and
remain globally competitive? While there is no single mantra to become
globally competitive, one can identify issues that merit attention:
In the context of the banking sector, there is the issue of consolidation,
which is the current buzzword in the banking industry worldwide. The largestbank
in China with an asset base of over US $400 billion. In contrast, the totalassets of
the largest two banks in India, one in public sector and another aprivate entity, are
US $127 billion and US $29 billion. These figures are quiteilluminating and the
onus is on Indian banks to take cognisance of this fact.The Government has raised
the cap on FDI in private banks. The RBI has, onits part, suggested certain changes
in the Banking Regulation (Amendment) Bill,2003 that seek to address some of the
legal impediments arising in theconsolidation process.

The second issue of import is that of management of costs. Cost

containment is a key to sustainability of bank profits as well as their long-
termviability. In 2003, operating costs of banks, expressed as per cent of
totalaverage asset, was lower than 2 per cent in major European economies
likeSweden, Austria, Germany and France. In contrast, in 2003, operating costs
ofcommercial banks in India were 2.24 per cent of total assets. The
downwardstickiness continued in 2004 as operating costs have remained well
above 2 percent, as percentage of total assets.
Another related challenge is in reducing the cost of funds of the banking
sector.1 In tandem with the soft interest regime over the last few years, cost
offunds of the banking sector has been declining. The cost of funds of publicsector
banks, which was 6.9 per cent in 1995-96 has since declined to 5.0 percent in
2003-04. Other bank groups have also experienced concomitantdeclines. With the
rise in oil prices and its cascading effects on inflation alongwith the raising of
policy rates by several central banks, sooner or later, thisreversal of the existing
comfortable liquidity conditions is likely to haveramifications on domestic
financial markets, and with that, on the cost of fundsof banks as well.
Diversification into fee-based activities coupled with prudentasset liability
management hold the key to future profitability.
The issue of credit delivery systems has come into focus of late. The
persistence of divergence between the informal and formal sector interest ratesin
effect has meant that, with deregulation, the formal credit mechanisms havenot
been able to pierce the informal system. The differences in ‘apparent cost’and
‘total real cost’ might be an important factor behind this divergence.2Reducing the
‘total real cost’ in the formal sector is likely to be an importantconsideration to
bring about a degree of convergence between the price ofcredit between the formal
and informal sectors. In recognition of this fact, thelast several Annual Policy
Statements of the Governor have placed explicit emphasis on streamlining credit
delivery through a gamut of measures,including, among others, widening the scope
of infrastructure lending,revamping the rural credit delivery system by envisaged
restructuring of therural banking segment, widening the scope of priority sector
lending, and thelike.
The fourth issue is the management of sticky assets. This is a key to the
stability and continued viability of the banking sector. Although the ratio of
nonperforming loans to total assets are higher in comparison to international
standards, the Indian banks have done a remarkable job in containment of
nonperformingloans (NPL) in recent times. Non-performing loans to total loans
ofbanks were 1.2 per cent in the US, 1.4 per cent in Canada and in the range of 2-5
per cent in major European economies. In contrast, the same for Indian bankswas
8.8 per cent. Gross NPL ratio for Indian scheduled commercial banksdeclined to
7.3 per cent in 2004 bearing testimony to the serious efforts by ourbanking system
to converge towards global benchmarks.
The fifth issue concerns the management of risks. Banking in modern
economies is all about risk management. The successful negotiation and
implementation of Basel II is likely to lead to an even closer focus on risk
measurement and risk management at the institutional level. Thankfully, BaselII
has, through their various publications, provided useful guidelines onmanaging the
various facets of risk. Institution of sound risk management
practices would be an important plank for staying ahead of the growing
competition. Over the past few years, the Reserve Bank has initiated several
steps to promote adequate risk management systems across market
participants.Among the measures that were instituted to insulate the financial
institutionsfrom the vagaries of the market were gradual increase in the cushion of
capital,frequent revaluation of the portfolio based on market fluctuations,
increasingtransparency and a framework for asset liability management (ALM) to
combatthe risks facing the Indian financial Sector. The Reserve Bank has taken a
leadin providing guidance to banks by bringing out guidance notes on how
toidentify, monitor, measure and control the various facets of risks. However, in
the ultimate analysis, the onus is on the banks themselves to adopt an
integratedrisk management approach, based on coherent risk models suited to their
riskappetite, business philosophy and expansion strategies. Such improved risk
management systems are not only crucial stepping stones towards Basel II
but also are expected to enable banks to shed their risk averse attitude and
contributing more finance to hitherto unbaked segments of agriculture, industryand
services. It is important that banks look at the expansion of the creditportfolio in a
healthy way, particularly in the background of higher industrialgrowth, new plans
of corporate expansion and higher levels of infrastructurefinancing.Improved risk
management practices by financial intuitions is the key tosuccess in a competitive
environment where new instruments such asderivatives are introduced in a gradual
and progressive manner. Financialinnovation provides opportunities and rewards to
those with enterprise andvision. But at the same time, it exposes them to increased
risks. Unless marketparticipants institute sound risk management systems, holding
trading positionstantamount expose them to severe risks. Indeed, risk taking and
riskmanagement must go hand in hand. The financial market needs players who
arenot afraid to take contrarian positions, who search for unoccupied habitats
toprovide diversity, provided they have adequate risk management systems
inplace. For market participants, there is little room for complacency and
thereappears to be no choice but to be pro-active in instituting appropriate
riskmanagement models. My view is that early adoption in this regard makessound
business sense and may prove immensely beneficial in a competitivefinancial
sector.

(B) DEVELOPMENTAL CHALLENGES

The return to high growth in 2003-04 has brought with it renewed
business optimism and a wider appreciation regarding India’s potential for
growth. The industrial climate during 2004-05 reflects a revival of
investmentdemand and building up of capacity. Both the capital goods and
intermediategoods sectors have recorded robust growth signifying the quickening
ofinvestment activity. This has been supported by improved corporateprofitability,
expansion in non-food credit and continuing optimism regardingproduction and
export growth. Resurgence of investment demand and buoyantexternal demand are
likely to be the main drivers of India’s growth processduring 2004-05.A key issue
in most fast growing economies is how to ensure adequateavailability of finance to
support investment and growth. Most countries relyon a combination of banking
sector, other financial institutions and capitalmarket for channelising funds to the
corporate sector. Each country, however,has its unique set of dilemmas in their
financial sectors. India is no different in
this respect. There are several key issues, which are of particular relevance toIndia
for the country to meet the challenges of globalization:
(C) INTER-LINKAGES AMONG FINANCIAL MARKETS
The first step towards globalisation is integration of various segments of
the domestic financial markets. The dream of all central banks is to see the
various segments of financial markets working in a smooth and
wellcoordinatedmanner. Well-developed financial markets help central banks
toeffectively conduct monetary policy with the use of market-based instruments.
These markets also generate appropriate reference rates for pricing other
financial assets. A necessary prerequisite for the smooth operation of the financial
markets is the integration of domestic markets so that impulses can
flow smoothly across different market segments and resource allocation
process becomes more efficient. The inter-linkages between money market,
Government securities market and foreign exchange market are now fairly
wellestablished. However, as in financial markets in other developing
economies,the capital markets in India are not yet fully integrated with the other
segmentsof the markets. While the extent of integration between capital market
andother segments of financial markets is much deeper in the developedeconomies,
a consensus is yet to emerge on the role that equity prices shouldplay in monetary
policy formulation. This is more so because typically equityprices are more
sensitive to “news” than to the underlying “fundamentals”. InIndia, there have
been some episodes of volatility spillovers between marketsin times of uncertainty.
In view of the progressive integration of varioussegments of financial markets, the
Reserve Bank keeps a close watch onactivity in the equity market to guard against
any possible spillover ofdisturbances to the money, the Government securities and
the foreign exchangemarkets. In such situations, concerted policy response from
the regulators cancontain to a great extent the risks of transmission of volatility.
This is the firstcrucial step towards being globally competitive.
(D) CHALLENGES TO REGULATION AND SUPERVISION
As the Indian financial system undergo structural changes relating to
ownership, competition and integration with global financial markets, the
necessity of an ongoing restructuring of the regulatory framework and
improved monitoring of the embedded risks in the financial system has been
recognized. The hallmark of Indian regulatory response has been its
inclusiveapproach through a consultative framework, increased emphasis on
selfregulation and strengthening of market participants through measures of
capitaladequacy, corporate governance and effective internal control
mechanisms.Increasingly, on-site supervision is being complemented by Risk
basedSupervision(RBS). Presently, the RBS has been used in 23 Banks on a
pilotbasis, but one can certainly visualize the extensive use of RBS by regulators
inIndia in the near future. In view of the complex nature of operation of
financialconglomerates, the Reserve Bank is putting in place appropriate
supervisorystrategies. Regulatory initiatives also include consolidation of
domesticbanking sector; restructuring of Development Finance Institutions;
andappropriate timing for the significant entry of foreign banks so as to be
coterminuswith the transition to greater capital account convertibility while
beingconsistent with our continuing obligation under the WTO commitments. In
respect of foreign banks, regulatory initiatives are directed at: choice of the mode
of presence, acceptable transition path, according national treatment,addressing
supervisory concerns, linkages between foreign banks and theirpresence in other
(non-banking) financial services.

(E) IMPROVING PAYMENT AND SETTLEMENT SYSTEMS

Several efforts at reducing Settlement Risks have been undertaken in
recent years. The payment system in India has been considerably strengthenedin
2003-04 with the introduction of Real time Gross Settlement System(RTGS), the
Special Electronics Funds Transfer System and the Online TaxAccounting System.
Liquidity in the Government securities market has beenenhanced by the
introduction of Delivery versus Payment (DvP III) mode fromApril, 2004.
Automated value-free transfer of securities between marketparticipants and the
Clearing Corporation of India Ltd. (CCIL) was facilitatedto further develop the
collateralized borrowing and lending obligation (CBLO)segment.

(F) GOVERNANCE ISSUES

Finally, Governance issues in banks as also in capital markets have
come to occupy centre-stage in recent times. The quality of corporate
governance becomes critical as competition intensifies, ownership is
diversified and banks strive to retain their client base. The Reserve Bank has,on its
part, made significant efforts to improve governance practices in banks,drawing
upon international best practices. Thus, the recommendations of theConsultative
Group under the Chairmanship of Dr. A.S. Ganguly wereforwarded to banks for
implementation. It is heartening to note that corporategovernance presently finds
explicit mention in the annual reports of severalbanks. Having said that, it is
important to recognize that there is nothing like‘optimal’ level of corporate
governance. As banking business becomes moreand more complex, banks should
continuously strive to improve shareholdervalue through better governance
practices.

Corporate Debt Market

The development of a deep and liquid corporate bond market is
necessary for funding projects with long gestation lags and also for lending
support to the process of asset securitisation. Typically, the corporate bond
markets remain underdeveloped in most emerging economies. Despite long
tradition, the corporate debt market in India is still in a nascent stage of
development. The primary corporate debt market is largely of the private
placement type and is concentrated among a few institutions both in terms of
issuance and subscription. On the other hand, the secondary market for
corporate debt is virtually absent in India. The stage for the development of
avibrant corporate debt market with a large issuer profile and investor base isnow
set with the successful development of the Government securities and
money markets. With the development of an active primary and secondary
market in Government securities, a sovereign yield curve has emerged even
forsufficiently longer-term securities. An efficient clearing and settlement
systemand credit rating system also exist. Some steps are still required to
improvestandards of public disclosure, implement bankruptcy laws and
enhancesupporting infrastructure. There is also need to broaden the
institutionalinvestor base, standardise products and reduce transaction costs.
Long-term Financing /Infrastructure FinancingPerhaps the biggest challenge in
Indian financial sector at this juncture isto find resources for funding investments
in long gestation projects includinginfrastructure. As in most other emerging
market economies, corporate sectorin India is often credit constrained. The
shortage is particularly marked withrespect to longer-term finance with the
constraint being particularly severe forthe small and medium-size firms.
Traditionally, the development financialinstitutions (DFIs) were the major source
of long-term finance in India. During
the 1990s, the operative environment for the DFIs underwent a drastic
change,which substantially altered their business profile. The balance sheets of
DFIsbecame smaller with a continuous decline in their lending activities over the
last few years. The DFIs found it difficult to raise funds at market rates andlend
them in a profitable manner. The DFIs, therefore, were forced to followthe path of
transformation. In regard to infrastructure financing, a multi-agencyapproach for
meeting the needs of the economy is crucial.
Pension ReformWhile sound institutional arrangements for tapping funds need to
bedeveloped, there is also a need to ensure adequate supply of these funds.
Thedevelopment of the pension and insurance sector is an important area
wherereforms need to be implemented with vigor. Intensification of reforms in
theareas of insurance and pension are essential not only from the angle of
socialsecurity, but also for raising resources for long-term financing especially
forinfrastructure projects. The integral part of the process of evolution of
thefinancial sector is the tapping of new savings to meet the surge in
investmentdemand. Contractual savings that can be placed with the
pensionfunds/insurance companies are the most natural source of funds that can
bedeployed productively in medium and long-term investments. At present, alarge
part of contractual savings is invested in the Government securities.Backed by the
rich experiences of other countries, there is a need for wideningthe investment
avenues for pension funds and insurance companies afterputting in place adequate
prudential measures including a robust riskmanagement framework. By doing this,
it would be possible to exploit theemerging opportunities in both industrial and
infrastructure financing.

Venture Capital
For financing start-up firms, the role of venture capital can hardly be
over-emphasised. The venture capital financing is especially important as theycan
focus on sunrise industries and also provide guidance to the start-up firmsin the
initial stages of their development. They play a very useful role insolving the
problem of pre-IPO financing. The venture financing has not pickedup that
satisfactorily in India possibly because of stringent regulations. Severalissues
relating to lock-in of shares, exit options, freedom to invest in varioustypes of
instruments, modes of investment and some tax-related issues need tobe addressed
to encourage flow of venture capital funds in India.In sum, the Indian financial
sector has taken several steps in the rightdirection, but much more needs to be done
to ascend to commanding heights. Acautious approach towards increasing
efficiency within the framework of overall financial stability can
significantlycontribute towards India becoming aleading financial force in the
world.

The Institutional Environment in India

An Assessment

3.1 Law, Institutions and Business Environment

The most striking fact about India’s legal system is the difference between
investors protection provided by the law as opposed to protection in practice.
compares India’s scores relative to different legal-origin country groups examined
in themarkets alongseveral dimensions of law and institutions. As discussed above,
with the Englishcommon-law system, India has strong protection of investors on
paper. For example, theCompany’s Act of 1956, to 2/4 in DMS (2005), based on
the Sick Industrial CompaniesAct of 1985) and shareholder rights (5/6) are the
highest of any country in the world.Corruption is a major systemic problem in
many developing countries and is ofDevelopment Report2005) have found that
corruption was the number one constraint for firms in South Asiaand that the two
most corrupt public institutions identified by the respondents in India (asBased
onTransparency International’s Corruption Perception Index, India has a score of
2.9 out of10 in 2005 (a higher score means less corruption), which ranked 88 out of
140 countrieshas notNext, we have two measures for the quality of accounting
systems. Thedisclosure requirements index (from 0 to 1, higher score means more
disclosure; LLS2006) measures the extent to which listed firms have to disclose
their ownershipstructure, business operations and corporate governance
mechanisms to legal authoritiesand the public. India’s score of 0.92 is higher than
the averages of all LLSV subgroupsfirms mustdisclose a large amount of
information. However, this does not imply the quality of (higher scoremeans
moreearnings management; Leuz, Nanda, and Wysocki 2003), India’s score
is13much higher than the average of English origin countries, and is only lower
than theGerman origin countries, suggesting that investors have a difficult time in
evaluatingIndian companies based on publicly available reports. It seems that
while Indiancompanies produce copious amounts of data, form triumphs over
substance in disclosureand with an accounting system that allows considerable
flexibility, there is enough roomfor companies to hide or disguise the truth.The
efficiency and effectiveness of the legal system is of primary importance
forcontract enforcement, and we have two measures. First, according to the legal
formalism(DLLS 2003) index, India has a higher formalism index than the average
of Englishorigin countries, and is only lower than that of the French origin
countries. The legalityindex, a composite measure of the effectiveness of a
country’s legal institutions, is basedon the weighted average of five categories of
the quality of legal institutions andgovernment in the country (see Berkowitz,
Pistor, and Richard 2003). Consistent withother measures, India’s score is lower
than the averages of all the subgroups of LLSVcountries, suggesting that India’s
legal institutions are less effective than those of manynew legal rulesand
regulations than other countries.Finally, as for the business environment in India, a
recent World Bank surveyfound that, among the top ten obstacles to Indian
businesses, the three which the firmssurveyed considered to be a “major” or “very
severe” obstacle and exceeding the worldaverage are corruption (the most
important problem), availability of electricity, and laborregulations. Threat of
nationalization or direct government intervention in business is new economy in
India issignificant. It is estimated to be about 23% of GDP.7 Creditor and investor
rights wereagainst willfuldefaulters. Large corporate houses often got away with
default, or got poor projects
financed through the state-owned banking sector, often by using connections
withinfluential politicians and bureaucrats.7 This figure is 22.4% according to
Schneider and Enste (2000), and 23.1% by Schneider (2002) (WorldBank).
Popular perception, however, would put it significantly larger, particularly given
that the averagefigure of OECD countries themselves is about 12%.14Since the
beginning of liberalization in 1991, two major improvements have takenplace in
the area of creditor rights protection – the establishment of the quasi-legal
DebtRecovery Tribunals that have reduced delinquency and consequently lending
rates(Visaria (2005)); and the passing of the Securitization and Reconstruction of
FinancialAssets and Enforcement of Security Interest Act in 2002 and the
subsequent Enforcement
These lawshave paved the way for the establishment of Asset Reconstruction
Companies and allowbanks and financial institutions to act decisively against
defaulting borrowers. In recentyears, recovery has shown significant improvement,
presumably because, at least in part,of a well-performing economy (figure 2.1).To
summarize, despite strong protection provided by the law, legal protection
isconsiderably weakened in practice due to an inefficient judicial system,
characterized byoverburdened courts, slow judicial process, and widespread
corruption within the legalsystem and government. While the need for judicial and
legal reforms has long been
recognized, little legislative action has actually taken place so far
(Debroy(2000)).Currently, the government is trying to emulate the success of
China by following theSpecial Economic Zone approach rather than overhauling
the entire legal system.

3.2 Financial/Business Laws and Regulations in India

Red tape and regulations still rank among the leading deterrents for business
andforeign investment in India leading to its latest ranking of 116 out of 155 in the
WorldBank’s Ease of Doing Business indicator in 2006 (World Bank, 2006). India
featuresconsistently in the second half of the sample for all aspects of business
regulation (and isout of the top 100 for most aspects) except for investor
protection.
To start a business in India entrepreneurs have close to twice the number
ofprocedures to follow as in OECD countries, about three and a half times the time
delay and costs ofdealing with licenses in India is roughly in corresponding
proportions with their respectiveOECD values. Very recently (second half of
August 2007) , the Government of India hasdecided to improve this situation and
has announced a drastic reduction in the number of15approvals and permits
necessary to start new business. Whether and when this translates toactual practice
is yet to be seen.It is almost twice as hard to hire people in India as in OECD
countries and almostthree times as hard and costly to fire them. With have
considerable variation in their labor
laws across states, Besley and Burgess (2004) show that during the three and half
decadesbefore liberalization began in 1991, Indian states that followed more pro-
worker policiesexperienced lower output, investment, employment and
productivity in the registered or“formal” sector and higher urban poverty with an
increase in informal sector output.In the area of credit availability, India lags
behind not because of creditors’ rights(which is close to OECD standards) but
because of the paucity of credit qualityinformation through the use of public
registry or coverage of private bureaus. However,
India’s excellent investor protection provisions in the law should be viewed
together withher performance in contract enforcement where the number of
procedures and timedelays are about double that in OECD countries and the costs
of contract enforcementover four times that in OECD countries.
As for securities markets regulation, using the framework of La Porta et al
(2006)that focuses on disclosure and liability requirements as well as the quality of
publicenforcement of the regulations controlling securities markets, India scores
0.92 in theindex of disclosure requirements third highest after the United States
and Singapore. Asfor liability standard, India’s score is the fifth highest, 0.66 while
the sample mean is
0.47. In terms of the quality of public enforcement, i.e. the nature and powers of
thesupervisory authority, the Securities and Exchanges Board of India (SEBI),
India scores0.67, higher than the overall sample mean as well as the English-origin
average of 0.52and 0.62 respectively and ranks 14th in the sample.
In comparing the regulatory powers and performance of SEBI with those of
theSEC (Securities and Exchanges Commission) in the USA, Bose (2005)
concludes thatwhile the scope of Indian securities laws are quite pervasive, there
are significantmanipulation andinsider trading. Between 1999 and 2004, Bose finds
that SEBI took action in 481 cases asopposed to 2,789 cases for the SEC even
though the latter regulates a significantly more
mature market. As a ratio of actions taken to the number of companies under
theirrespective jurisdictions, SEBI’s figure comes out to be an unimpressive 0.09
while that ofthe SEC is 0.52. Also the ratio for action taken to investigations made
is quite low . As for appeals before higher authorities – the SecuritiesAppellate
Tribunal (SAT) or the Finance Ministry – in 30 to 50% of cases, the decisiongoes
against SEBI. Though SEBI has had some success prosecuting intermediaries, it
hasfailed to convince the SAT in its proceedings against corporate insiders and
major marketplayers. Thus the quality of public enforcement of securities laws
appears to be a problem
in India.
The institution of Debt Recovery Tribunals (DRTs) in the early 90’s and the
passing of the Securitisation and Reconstruction of Financial Assets and
Enforcement ofSecurity Interest (SARFAESI) Act in 2002 were aimed at
remedying the slowness of thejudicial process. The SARFAESI Act paves the way
for the establishment of AssetReconstruction Companies (ARCs) that can take the
Non-Performing Assets (NPAs) offthe balance sheets of banks and recover them.
Operations of these ARCs would berestricted to asset reconstruction and
securitization only. It also allows banks and
financial institutions to directly seize assets of a defaulting borrower who defaults
fails torespond within 60 days of a notice. Borrowers can appeal to DRTs only
after the assetsare seized and the Act allows the sale of seized assets. The
SARFAESI Act itself,however, does not provide a final solution to the recovery
problems. With the borrower’sright to approach the DRT, the DRAT (Debt
Recovery Appellate Tribunal) and, in somecases, even a High Court, a case can
easily be dragged for three to four years during
which time the sale of the seized asset cannot take place. It is perhaps too soon
toevaluate its effects on reducing defaults but public sector banks have had some
successrecovering their loans by seizing and selling assets since the Act came into
existence. Therecovery rates of bad debts have registered a sharp rise in 2005-06,
but it is difficult toseparate the contribution of the booming economy to this from
that of the improvement in
corporate governance .

Accounting Standards (AS) 18 by the Institute of Chartered Accountants in India

(ICAI)in 2001 which, among other things, makes reporting of “related party
transactions” byIndian companies mandatory. Related parties include holding and
subsidiary companies,key management personnel and their direct relatives, “parties
with control exist” whichincludes joint ventures and fellow subsidiaries; and other
parties like promoters andemployee trusts. Transactions include purchase/sale of
goods and assets, borrowing,
lending and leasing, hiring and agency arrangements, guarantee agreements,
transfer ofresearch and development and management contracts. This step has gone
a long way inbringing transparency to the dealings of Indian companies,
particularly the groupaffiliates.

The area of the Ease of Doing Business index where India fares worst is
undoubtedly that of closing a business. Consequently recovery rates are very low
too – below 13% asopposed to about 74% in OECD countries. Kang and Nayar
(2004) point out that there isno single comprehensive and integrated policy on
corporate bankruptcy in India in thelines of Chapter 11 or Chapter 7 US
bankruptcy code. Overlapping jurisdictions of the
High Courts, the Company Law Board, the Board for Industrial and
FinancialReconstruction (BIFR) and the Debt Recovery Tribunals (DRTs)
contribute to the costsand delays of bankruptcy. The Companies (Second
Amendment) Act, 2002 seeks toaddress these problems by establishing a National
Company Law Tribunal and stipulatinga time-bound rehabilitation or liquidation
process to within less than two years as well as
bringing about other positive changes in the bankruptcy code.

3.3 Stock Exchanges in India

India currently has two major stock exchanges: the National Stock Exchange
(NSE) established in 1994 and the Bombay Stock Exchange (BSE), the oldest
stockexchange in Asia, established in 1875. Up to 1992, BSE was a monopoly,
marked withinefficiencies, high costs of intermediation, and manipulative
practices, so that externalmarket users often found themselves disadvantaged. The
economics reforms created fournew institutions: the Securities and Exchanges
Board of India (SEBI), the National Stock
Exchange (NSE), the National Securities Clearing Corporation (NSCC), and the
NationalSecurities Depository (NSDL). The National Stock Exchange (NSE), a
limited liabilitycompany owned by public sector financial institutions, now
accounts for about two-thirdsof the stock exchange trading in India, and virtually
all of its derivatives trading.

The National Securities Clearing Corporation (NSCC) is the legal counter-party

tonet obligations of each brokerage firm, and thereby eliminates counter-party risk
andpossibility of payments crises. It follows a rigorous ‘risk containment’
frameworkinvolving collateral and intra–day monitoring. The NSCC, duly assisted
by the NationalSecurities Depository (NSDL), has an excellent record of reliable
settlement schedulessince its inception in the mid-nineties.
The Securities and Exchanges Board of India (SEBI) has introduced a
rigorousregulatory regime to ensure fairness, transparency and good practice. For
example, forgreater transparency, SEBI has mandated mandatory disclosure for all
transactions wheretotal quantity of shares is more than 0.5% of the equity of the
company. Brokers discloseto the stock exchange, immediately after trade
execution, the name of the client inaddition to trade details; and the Stock
exchange disseminates the information to thegeneral public on the same day.
The new environment of transparency, fairness and efficient regulation led BSE,in
1996, to also become a transparent electronic limit order book market with an
efficienttrading system similar to the NSE. Equity and equity derivatives trading in
India has skyrocketedto record levels over the course of the last ten years.
In 2005, about 5000 companies were listed and traded on NSE and/or BSE.
Whilethe dollar value of trading on the Indian stock exchanges is much lower than
the dollarvalue of trading in Europe or in the US, it is important to note that the
number of equitytrades on BSE/NSE is ten times greater than that of Euronext or
London, and of the sameorder of magnitude as that of NASDAQ/NYSE. Similarly,
the number of derivativestrades on NSE is several times greater than that of
Euronext/ London, and of an order of
magnitude comparable to US derivatives exchanges. The number of trades is
animportant indicator of the extent of investor interest and investor participation in
equities
and equity trading, and emphasizes the crucial importance of corporate
governancepractices in India

3.4 Enforcing Corporate Governance Laws

Enforcement of corporate laws remains the soft underbelly of the legal and
corporate governance system in India. The World Bank’s Reports on the
Observance ofStandards and Codes (ROSC) in its 2004 report on India (World
Bank (2004)) found thatwhile India observed or largely observed most of the
principles, it could do better in areaslike the contribution of nominee directors from
financial institutions to monitoring and
supervising management; the enforcement of certain laws and regulations like
thosepertaining to stock listing in major exchanges and insider trading as well as in
dealingwith violations of the Companies Act – the backbone of the corporate
governance systemin India. Some of the problems arise because of unsettled
questions about jurisdictionissues and powers of the SEBI.

3.5 Indian Courts – an assessment

Djankov et al (2003) (DLLS) in their analysis of “formalism” in the judicial
process around the world, gave India a score of 3.34 on its formalism index, higher
thanthe English-origin average of 2.76 but slightly lower than the average for all
countries. Among the 42 English-origin countries in their sample, India has the
11th highestlevel of formalism. India has the 16th longest process of evicting a
tenant among English common law origin countries (average 199 days). For
collection on abounced check, however, India has the 16th shortest duration (106
days) among Englishcommon law origin countries (average 176 days). In both
cases India’s total duration of
the process is significantly shorter than the overall mean duration of all the 109
countriesconsidered (254 for eviction of tenant and 234 for collecting on bounced
check). Thus, inspite of its formalism, Indian courts do not seem to perform that
poorly (relativelyspeaking) on these two types of cases considered.
The DLLS assurance notwithstanding, case arrears and decade-long legal
battlesare commonplace in India. In spite of having around 10,000 courts (not
countingtribunals and special courts), India has a serious shortfall of judicial
service. While theUSA has 107 judges per million citizens, Canada over 75,
Britain over 50 and Australiaover 41, for India the figure is slightly over 10
(Debroy (1999)). In April 2003, forinstance, the Supreme Court of India had close
to 25,000 cases pending before it (Parekh2001). Hazra and Micevska (2004) report
that there are about 20 million cases pending in
lower courts and another 3.2 million cases in high courts. A termination dispute
contestedall the way can take up to 20 years for disposal. Writ petitions in high
courts can takebetween 8 and 20 years for disposal. About 63% of pending civil
cases are over a yearold and 31% are over 3 years old. Automatic appeals,
extensive litigation by thegovernment, underdeveloped alternative mechanisms of
dispute resolution likearbitration, the shortfall of judges all contribute to this
unenviable state of affairs inIndian courts. Since the same courts try both civil and
criminal matters and the latter gets
priority, economic disputes suffer even greater delays.
3.6 The Small and Medium Enterprises (SME) sector in India
Allen et al (2006) conduct surveys to study the extent to which the formal
legalenvironment directly supports and regulates businesses, particularly small and
mediumenterprises which form an increasingly important part of the Indian
industry. This seemsto indicate that the small firms sector operate in a system
virtually governed throughinformal mechanisms based on trust, reciprocity and
reputation with little recourse to thelegal system and deals with widespread
corruption.
Over 80% of the firms surveyed needed a license to start a business, and for
abouthalf of them obtaining it was a difficult process. Government officials were
most oftenthe problem solved usually through payment of bribes or friends of
government officialsto negotiate. Clearly, networks and connections are of crucial
importance in negotiatingthe government bureaucracy.As for conducting day-to-
day business, legal concerns are far less important tothem than the unwritten codes
of the informal networks in which firms operate. In casesof default and breach of
contract, the primary concern is loss of reputation, followedclosely by loss of
property, with the fear of legal consequences being the least importantconcern.
About half of the firms surveyed did not have a regular legal adviser and less
thanhalf of those that did had lawyers in that capacity. For mediation in a business
dispute orto enforce a contract, the first choice was “mutual friends or business
partners”. Only20% of the respondents mentioned going to courts as the first
option indicating that thelegal system, while not as effective as the informal
mechanisms, is not altogether absent.
The informal system, however, is not perfect in resolving disputes and has itscosts.
About half of the respondents experienced a breach of contract or non-
paymentwith a supplier or major customer in the past three years. Over a third of
themrenegotiated while over 40% did nothing but continued the business
relationships withthe offending parties.
In general, the business environment of the SME sector is marked by strong
informal mechanisms like family ties, reputation and trust. Legal remedies
thoughpresent, are far less important than the rules of the informal networks.
 Capital Markets

Indian capital markets have been one of the best performing markets in the worldin
the last few years. Fuelled by strong economic growth and a large inflow of
foreigninstitutional investors (FIIs) as well as the development of the domestic
mutual fundsindustry, the Indian stock market indices have delivered truly
explosive growth duringthe last 5 years rising over 3 times during the period.
However, it would be a mistake tothink that growth has happened only in
valuation. During this period Indian capitalmarkets have exhibited explosive
growth in almost every respect.
While the two major Indian exchanges, the Bombay Stock Exchange (BSE) andthe
National Stock Exchange (NSE) ranked 16th and 17th respectively among
exchangesaround the world in terms of market capitalization. The former has close
to 5,000 stockslisted, of which about half actually trade. In terms of concentration
(i.e. the share of top5% of stocks in total trading) they are not out of line with other
major exchanges, thoughin terms of turnover velocity, BSE is the lowest among
the top 20 exchanges. The
relatively newly formed NSE has overtaken the more traditional BSE (which is
older thanthe Tokyo Stock Exchange) and now has over 30% higher turnover in
terms of value andalmost 2.5 times BSE’s turnover in terms of number of trades
depicts the evolution of liquidity in Indian capital markets in recent years. The
regionalstock exchanges in India, numbering 20, have recently been relatively
speaking devoid ofaction. In March 2006, the BSE market capitalization accounted
for about 86% of IndianGDP while that of the NSE accounted for about 80%. In
terms of risk and return, while
the Indian markets have been more volatile than those in industrialized nations,
thereturns have been largely commensurate . In the new century, a huge derivative
market hasbeen created from scratch, foreign institutional investors have almost
doubled in number,growth, and thenumber of portfolio managers has risen over
three-fold. The entire industry has thereforegone through a major transformation
during the period.
During 2005-06, Indian corporations mobilized over Rs. 1237 trillion ($
30.93trillion) from the markets (which accounted for close to 4% of the GDP at
factor cost incurrent prices) of which close to 78% was debt, all of which was
privately placed Of equity issues amounting to over Rs. 273 trillion ($ 6.825
trillion), about40% were IPOs and the remainder seasoned offerings. Close to 25%
of these latter wererights offerings. Qualitatively, these proportions have remained
more or less stable overthe years.
The liberalization and subsequent growth of the Mutual Funds industry, for
decades monopolized by the state-owned Unit Trust of India (UTI), since the turn
of thecentury has been one of major stories of Indian capital markets .From theturn
of the century, assets under management have more than tripled, in pace with
andfuelling the rise of the markets.
The biggest development in the Indian capital markets in recent years is
undoubtedly the introduction of derivatives – futures and options – both on indexes
aswell as individual stocks with turnovers growing 50 to 70 times in the past 5
years andthe derivatives segments quickly becoming a crucial part of the Indian
capital markets.The rapid growth in Indian capital markets, and the spread of
“equity culture” hasdoubtlessly strained its infrastructure and regulatory resources.
Nevertheless the securities market watchdog, the Securities and Exchanges Board
of India (SEBI) hasmaintained a rate of around 95% in redressing investor
grievances reported to it , though investigations undertaken and convictions
obtained have, on a proportionalbasis, trailed those of the Securities Exchange
Commission (SEC) of the USA .
4.1 Institutional Features
The transactions in secondary markets like NSE and BSE go through clearing
atclearing corporations (National Securities Clearing Corporation Limited
(NSCCL) forNSE trades, for instance) where determination of funds and securities
obligations of thetrading members and settlement of the latter take place. All the
securities are being tradedand settled under T+2 rolling settlement.
“Dematerialized”, trading of securities, i.e.paper-less trading using electronic
accounts, now accounts for virtually all equity
transactions. This was introduced to reduce the menace of fake and stolen
securities andto enhance the settlement efficiency, with the first depository
(National SecurityDepository Limited established for NSE in 1996. This ushered
the era of paperlesstrading and settlement. Table 3.9 shows the progress of
dematerialization at NSDL anddelivery pattern of various stock exchanges in
India.As a measure of investor protection, exchanges in India (both the NSE and
BSE)administer price bands and also maintain strict surveillance over market
activities inilliquid and volatile stocks. Besides, NSCCL has put in place an on-line
monitoring andthere isbeing inspectedevery year to verify their level of compliance
with various rules.
4.2 Debt Market
The debt market in India has remained predominantly a wholesale market.
During2005-2006, the government and corporate sector collectively has mobilized
Rs 2.6 trillionfrom the primary debt market. Of which, 69.6% were raised by
government and themarket,government securities dominate. The secondary market
for corporate bonds is practical.At the end of March 2006, the total market
capitalizationof securities available for trading at the WDM segment stood at over
Rs 15 trillion . Of this government securities and state loans together accounted for
83% of
total market capitalization. Government of India, public sector units and
corporations together comprise asdominant issuer of debt markets in India. Local
governments, mutual funds andinternational financial institution issue debt
instruments as well but very infrequently.The Central Government mobilizes funds
mainly through issue of dated securities and Tbills.
Bonds are also issued by government sponsored institutions like the
developmentfinancial institutions (DFIs) like IFCI and IDBI, banks and public
sector units. Some, butnot all, of the PSU bonds are tax-exempt. The corporate
bond market comprise ofcommercial papers and bonds. In recent years, there has
been an increase in issuance ofcorporate bonds with embedded put and call
options. The major part of debt is privatelyplaced with tenors of 1-12 years.
Government securities include Fixed Coupon Bonds, Floating Rate Bonds,
ZeroCoupon Bonds, and T-Bills. The secondary market trades are negotiated
betweenparticipants with SGL (Subsidiary General Ledger) accounts with RBI.
The NegotiatedDelivery System (NDS) of RBI provides electronic platform for
negotiating trades.Trades are also executed on electronic platform of the Wholesale
Debt Market (WDM) segment of NSE. The averagetrade size in this market has
hovered aroundRs. 70 million and whileturnover has risen significantly, the rise
has not been uniform.
Central and State governments together have borrowed Rs 1.8 trillion and repaid
over Rs 680 billion ($ 17 billion) during 2005-06. Out of thisover Rs 1.3 trillion
was raised by central government through datedsecurities. On a net basis, the
government has borrowed over Rs 953 billion through dated securities and only
slightly over Rs 28 billion
Through 364-day T-Bills. The net borrowings of State governments in 2005-06
amountedto slightly over Rs 154 billion ($ 3.85 billion).
The yield on primary issues of dated government securities during 2005-06
variedbetween 6.69 % and 7.98 % against the range of 4.49% to 8.24 % during
2004-05. Theweighted average yield on government dated securities increased to
7.34% from 6.11% in2004-05.At about 2% of the GDP, the corporate bond market
in India is small, marginal,and heterogeneous in comparison with corporate bond
market in developed countries.
While a corporate debt market in India has existed in India since 1950s, the bulk of
thedebt has been raised through private placements. In 2004-05, close to Rs 593
billion was raised by the corporate sector through debt instruments, of
whichprivate placements accounted for around 93 %. In 2005-06, the entire
amount of over Rs794 billion ($ 19.85 billion) was raised by 99 issuers through
362 privately placed issues,with no public issues at all. Figure 3.3 shows the
growth of private placement debt in
India. Financial Institutions and banks dominate in private placements, issuing 75
% ofthe total private placement of debt (Refer Figure 3.4). Around 68.12 % of the
resourcesmobilized by private placement were distributed to Financial and
Banking sector and9.64 % to Power sector, while distribution to
Telecommunications and Water resourcestogether was less than 1 %. During 2005-
06, the maturity profile of issues in privateplacements ranged between 12 months
to 240 months.To promote the corporate debt market, especially secondary market
regulatorshave taken several steps. Corporate Debt instruments are traded both on
BSE and oncapital market and the WDM segments of the NSE. SEBI has already
mandated that allbonds traded on the BSE and NSE be executed on the basis of
price/order matching. So,the difference between trading of government securities
and corporate debt marketsecurities is that the latter are traded on the electronic
limit order book like equities. Since
June 2002, the CDSL and NSDL have admitted debt instruments such as
debentures,bonds, CPs CDs, etc. Also, banks, financial institutions and primary
dealers have beenasked to hold bonds and debentures, privately placed or other
wise, in electronic form. Ason March 2006, over Rs 3.3 trillion ($ 82.5 billion)
worth of bonds/debentures wereavailable in paperless (electronic) form consisting
of 652 issuers with 17,508debentures/bonds and 379 issuers with 7,357 issues of
commercial paper.
In terms of market participants, apart from investors and brokers, there were
Primary Dealers8 at the end of March 2006. During 2005-06, banks (Indian and
Foreign)accounted for 42% of the WDM turnover, while primary dealers
accounted for 21% ofthe total turnover (Refer Figure 3.5). In recent years mutual
funds have emerged as animportant investor class in the debt market. They also
raise funds through the debtmarket. Most mutual funds have specialized debt funds
such as gilt funds and liquidfunds. Foreign Institutional Investors (FIIs) are also
permitted to invest in treasury and
corporate bonds, but up to a limit. Provident and pension funds are large investors
in debtmarket, predominantly in treasury and PSU bonds. They are, however, not
very activetraders owing largely to regulatory restrictions.

4.3 Derivatives Market

The derivatives segment in India is not very old. In the year 2000, NSE started
itsoperation in derivatives contracts and introduced futures contracts on the Nifty
index.8 Intermediaries in government securities.
The total exchange traded derivatives volume witnessed an increase (88.14%) to
over Rs48 trillion ($ 1.2 trillion) during 2005-06 as against Rs 25.6 trillion
duringthe preceding year. In terms of products, Stock and Index Futures contracts
togetheraccount for 89 % of the total turnover in derivatives. Over the
period,however, the basket of instruments has widened with futures and option
contracts onindices viz. CNX IT Index, and Bank index as well as options and
futures on 122 singlestocks. The popularity of single-stock futures distinguishes
the Indian derivatives market.In 2005, the NSE of India ranked first (1st) in the
single stock future category with68,911,754 contracts.In India, though trades in
derivatives contracts have been permitted in both theBSE and NSE, the latter has
completely dominated the segment with over 99.9% of theturnover At any point of
time, for equity derivatives, contracts with one month, twomonth and three months
to expiry are available for trading. These contracts expire on thelast Thursday of
the respective expiry months. Interest rate Futures rate contracts are alsoavailable
on Notional 10 year bonds (6% coupon), Notional 10 year zero coupon bondsand
Notional 91 day T-Bills. These contracts are available for a period of one
yearmaturity with three months continuous contracts and fixed quarterly contracts
for theentire year.
Index futures/options naturally have to settle in cash. Previously futures andoptions
on individual stocks could be settled through deliveries but currently they
havemandatory cash settlement as well. In the case of futures, contracts usually
have twotypes of settlements, MTM settlement which happen on a continuous
basis at the end ofeach day and final settlement, which is on the last trading day of
the futures contract. Incontrast, options contracts have three types of settlements,
daily premium settlement; interim exercise settlement in the case of option
contracts on securities; and finalsettlement.
As a part of its comprehensive risk containment mechanism for futures and
Options, the NSCCL (National Securities Clearing Corporation Limited) has
quitestringent capital adequacy requirements for membership in terms of. The
initial marginrequirement on contracts that are specified and which need to be met
on a daily basis. Italso follows the Ver. based margin requirement computed
through the SPAN(Standardized Portfolio Analysis of Risk) model of the Chicago
Mercantile Exchange

Recent FII flows to India

In 2005-06 portfolio investments in India accounted for about 61.7% of total
foreign investment in the country and at about 1.29% of GDP well exceeded the
currentaccount deficit (0.95% of GDP). Foreign Institutional Investors’ (FIIs’)
investmentsaccounted for about 97.5% of this. Ever since the opening of the Indian
equity markets toforeigners, FII investments have steadily grown from about Rs.
2,600 crores ($ 650million) in 1993 to over Rs.48,000 crores ($ 12 billion) in 2005.
At the end of June 2006,
the cumulative FII flows to India accounted for a little over 9% of the Bombay
StockExchange market capitalization.While it is generally held that portfolio flows
benefit the economies of recipientcountries, policy-makers worldwide have been
more than a little uneasy about suchinvestments. Often referred to as “hot money”,
they are known to stampede out at theslightest hint of trouble in the host country
leaving an economic wreck in their wake, likeMexico in 1994. They have been
blamed for exacerbating small economic problems in acountry by making large
and concerted withdrawals at the first sign of economicweakness. They have also
been held responsible for spreading financial crises – causing‘contagion’ in
international financial markets.International capital flows and capital controls have
emerged as important policyissues in the Indian context as well. The danger of
abrupt reversals and their destabilizing
consequences on equity and foreign exchange markets are always a concern.
Nevertheless, in recent years, the government has been making strong efforts to
increaseFII flows in India. Others (Rakshit (2006)) have argued that, far from
being healthy forthe economy, FII inflows have actually imposed certain burdens
on the Indian economy.Understanding the determinants and effects of FII flows
and devising appropriateregulation therefore constitute an important part of
economic policy making in India.
5.1 A few stylized facts about FII flows to India
Over the last few years, research has brought to light a few important features ofFII
flows to India. The key question has been the relationship between FII flows
andreturns in the Indian markets. Clearly FII equity investments and thestock
market performance in India have been very closely interlinked. Also both
variables experience a sharp break around April of 2003 after which they ramp
upsteeply. The association is unmistakable – the correlation of monthly net FII
equityinflows and monthly Sensex returns is 0.49 since April 2003 and 0.30 in the
overall . However, research seems to suggest they are more of an effect than
acause of stock market performance. Analyzing daily flow data during 1999,
Chakrabarti concludes that in the post-Asian crisis period, stock market
performance has beenthe sole driver of FII flows, though monthly data in the pre-
Asian crisis period maysuggest some reverse causality. This return-chasing
behavior has been confirmed usingdaily data during 1999-2002 in Mukherjee et al
(2002), which also finds that the sales ofIndian securities by FIIs are affected by
returns but not purchases. On the other hand,Gordon and Gupta (2003) analyze
monthly data over the period 1993-2000 to concludethat FII flows are negatively
related to lagged stock market returns, suggesting negativefeedback trading. There
are, however, issues about the appropriateness of using monthlydata in this
analysis (Rakshit (2006)). In any case, given that there is a structural break inthe
data around April 2003, careful analysis of more recent data would be instructive
inunderstanding the nature of the relationship and causality, if any, between these
twovariables.The largest single-month pull-out of FII funds happened in May 2006
when theFIIs withdrew over Rs. 8247 crores ($1.7 billion ) followed by the first
three weeks ofAugust 2007 Rs. 5994 crores ($ 1.47 billion ). These were also the
months marked withmajor declines in the Sensex in the post reforms era.As for
other features, Chakrabarti (2001) finds no evidence of any
informationaldisadvantage for foreign investors vis-à-vis their domestic
counterparts. The Asian crisismarked a regime shift
of the Indian market with the American S&P 500 index seemed to inverselyaffect
FII flows to India, but the effect disappeared in the post-crisis period.
India’scountry risk rating did not seem to affect FII flows. Mukherjee et al (2002)
havequestioned the diversification motive behind FII flows to India and report
autocorrelationor inertia in FII flows. Gordon and Gupta (2003) report that FII
flows are sensitive to theLondon Inter-bank Offer Rate (LIBOR) as well as India’s
macroeconomic fundamentals.Coondoo and Mukherjee (2004) argue that both the
stock market as well as FII flows in
India have high and related volatility. Finally, in their analysis of the effects
ofregulatory measures on FII flows, Bose and Coondoofind that liberalizing
policychanges have had an expansionary effect on FII flows while restrictive
measures aimed atgiving regulators greater control over FII flows do not
necessarily dampen them.

Banking Sector

With deposits of over half a trillion US dollars, the Indian banking sector
accountsfor close to three-quarters of the country’s financial assets. Over the
decades, this sectorhas grown steadily in size, measured in terms of total deposits,
at a fairly uniform averageannual growth rate of about 18%. In the years since
liberalization, several significantchanges have occurred in the structure and
character of the banking sector – the mostvisible being perhaps the emergence of
new private sector banks as well as the entry ofseveral new foreign banks. The
spirit of competition and the emphasis onprofitability arealso driving the public
sector banks towards greater profit-orientation in a departure fromthe socialistic
approach followed for decades. In general it seems that the emergence ofthe new
private banks and the increased participation of foreign banks have
increasedprofessionalism in the banking sector. Competition has clearly increased
with theHerfindahl index (a measure of concentration) for advances and assets
dropping by over28% and about 20% respectively between 1991-1992 and 2000-
20019. Over the period,SBI, the largest Indian bank, witnessed a decline in asset
market share from 28% to 24%while its loan market share dropped from 27% to
22%. The deposit share, on the otherhand, stayed pretty much the same at 23%.
The asset, loan and deposit shares of the top10 banks all fell from close to 70% to
below 60%. Nevertheless, the public sector banks
still enjoy a pre-eminent position in Indian banking today, accounting for over 80%
ofdeposits and credit . There is, however, a noticeable trend ofprivate banks
gradually eroding the market share of the public sector.Performance and efficiency
of commercial banks are key elements of theefficiency and efficacy of a country’s
financial sector. It is not surprising then, thatconsiderable attention has been
focused on the performance of commercial banks in Indiain recent years.
According to the general perception as well as on several metrics, the“new” private
sector banks and the foreign banks have led the way in terms of efficiency.Public
sector banks, still not entirely free from the old bureaucratic mode of
functioningand constrained by certain “developmental” lending objectives, are
often thought to belagging behind in the race to efficiency. Bank privatization and
further liberalization of9 Koeva (2003). The Herfindahl index is a measure of
industry concentration and is computed as the sum ofthe squared market shares of
the firms in an industry. Ranging between 0and 10,000, a lower Herfindahlindex
represents less concentration and greater competition.the banking sector including
allowing bank mergers are frequently discussed as remediesfor the situation.
6.1 Performance of commercial banks in recent years – a brief background
The performance of commercial banks in India has been under policy and
academic spotlight for a while now with the public sector bank performance
receiving thegreatest attention. The relatively poor performance of several public
sector banks (PSBs)has led to calls for a complete overhaul of these banks and
privatization as a solution.Performance evaluation of banks, particularly in an
economy that is dominated bypublic sector banks that are not driven purely by
profit motive, however, is not a simpletask. Profitability is definitely a key measure
of performance, but its use as the solemeasure is disputed by many and several
alternative measures of efficiency have beenused in the literature. Here we take a
look at a few of these measures to evaluate theperformance of banks in the post-
reforms era.
A caveat is in order here. A key issue in judging bank efficiency is the link
between management objectives and the selected measure of efficiency. As in
anybusiness, banks too seek to maximize shareholder value as well as pursue
strategicobjectives. Banks at different levels of market share frequently set
differing objectives, soany measure other than Return on Assets is fraught with
comparability problems. Inaddition, more than in many other businesses, risk
management plays a crucial role inbanking and it is, indeed, a difficult task to
figure out the riskiness of a bank’s operations
without going through a detailed analysis of its investments and loan portfolio. A
crosssectionalcomparison of relative bank performance, as presented here,
abstracts in a largemeasure from these considerations, which are doubtless
limitations of such analysis.Panel A of Figure 5.3 shows the Return on Asset
(Profit/Asset) It is evident that foreign banks are, by far, the most profitable bank
category inIndia. The non-SBI public sector banks have consistently been the
worst performers. Thereappears to have been a mild improvement in the efficiency
of the banking sector in generalduring the decade10 much of which has been
driven by improvements in performance of the10 A conclusion also supported by
Koeva (2003)private and foreign banks. Within the private sector banks, the “new”
private sector banks,those that came up in the post-reforms era, seem to have
driven the efficiency gains.It is however, imperative to consider risk in evaluating
a bank’s performance. Theriskiness of banking is not wholly reflected in the
variation of its earnings. This is obtained by dividing theaverage ROA of a bank
group in a year by the (cross-sectional) standard deviation ofROAs of banks in that
group during that year. On this criterion, the SBI group is an orderof magnitude
better than others, simply because of its very low intra-group variability inearnings.
However, banks in the SBI group is also different from other banks in their
lowerdecision-making independence from one another. Among the three other
groups, theredoes not seem to be any systematic pattern. If we measure risk with
time-series rather thancross-sectional standard deviation, however, then the
coefficients of variation . The significant stability of foreign banks on this score
isoteworthy. The “most risky” status of SBI when time-series variation in ROA
isonsidered while being the “least risky” by far using cross-sectional variation as a
measure
of risk, suggests that the SBI group may be distributing temporal shocks among
theonstituent banks to maintain intra-group parity and so should really be viewed
as a singlather than a group.
Another measure of efficiency of the banking sector is the productivity of
itspersonnel. This is not a “total factor productivity” kind of measure, but rather
just aeasure of how well the human resources are exploited by the banks. Clearly
this figurewould depend crucially with the expenditure on non-human inputs that
complement theefforts of the employees. A measure of labor productivity in the
banking sector is theratio of “turnover” or the total business generated as the sum
of total deposits andadvances to the total number of employees. There has been
improvement across allcategories over the time period. However, the foreign
banks’ turnover per employee isabout five times that of the nationalized banks11.
Equally impressive has been the relativesurge of the private banks on this metric,
from below par when compared to the publicsector banks at the beginning of the
decade to over twice as efficient as the nationalizedbanks in later years. Much of
the relative poor performance of the public sector banksstem from the fact that they
are required to have branches in rural areas all over thecountry that are largely cost
centers. However public sector banks are overstaffed evenwhen their metro and
urban area branches are considered12. However, when we look atthe banks’
turnover as a multiple of their employee cost (Figure 5.6), rather than numberof
employees, the difference is less marked. More importantly the Indian private
banksappear to have trounced the foreign banks on this score in the latter half of
the decade.Clearly the “new” private sector banks have been more successful in
keeping theiremployee costs down while raising turnover. Both the foreign and
private banks hire
fewer but more expensive employees than their public sector counterparts.
Foreign banks tend to use information technology more intensively and
practiceniche banking. As for private banks, their climb of the efficiency ladder
has been drivenalmost exclusively by the new private banks – ICICI Bank, UTI
Bank (recently renamedAxis Bank), HDFC Bank etc. – that have followed the
foreign bank-type staffingpractices and business model with lower clerical and
subordinate staff strength. All thesefeatures have important policy implications for
the debate concerning restructuring and
11 D’Souza (2002). 12 D’Souza (2002 privatizing of public sector banks. There is
also the view13, however, that ownership perse does not affect the operational
efficiency of banks – it is the discipline of stock
markets that make the traded private companies more efficient than public sector
banks. While the regulatory mechanism is frequently blamed for the
lacklusterperformance of public sector banks, till 1996, deregulation had not
resulted in aproductivity surge in public sector banks, though private banks
improved performance .
Perhaps the best measure of a country’s financial health and robustness is theextent
of non-performing assets (NPAs) in its banking system. Broadly speaking, a
nonperformingadvance is defined in India as one with interest or principal
repaymentinstallment unpaid for a period of at least two quarters. NPAs form a
substantial drag forindividual banks as well as the banking system of a country.
They represent the poorquality of the assets of the bank and have to be provisioned
for using capital. Obviouslythey have a huge negative impact on a bank’s
profitability and can lead to complete
erosion of its asset base.As noted before public sector banks have traditionally had
higherlevels of NPAs than private sector banks and foreign banks. In recent years,
however,they appear to have managed their NPAs well, steadily reducing them to
levelscomparable to those of private banks. On the other hand, the new private
sector bankshave witnessed an increase in the share of NPAs in their portfolios.A
closer look at the cross-sectional distribution of NPAs among the different banks .
however, suggest that as a group, public sector banks have a tighterdistribution
than other categories, particularly foreign banks which show considerablylarger
skewness in the ratio of net NPAs to net advances.There is, however, skepticism in
some quarters about the definition andmeasurement of NPAs in Indian banks.
Banks often indulge in creative accounting andloan rollovers – “ever-greening” –
to keep the NPA figures artificially low16. The share ofa priori one would expect
the threat of takeovers, rather than trading of shares per se to improveefficiency,
recent evidence suggests that Indian public sector companies listing only anon-
controlling part of the equity have experienced profitability and productivity
enhancements.Banks also face considerableinterest rate risk in that a small rise in
lending rates could cause a considerable increase inthe share of NPAs – a 2% rise
in lending rates could cause a 4 percentage point increasein the share of NPAs.17
As the international NPA recognition standards as well as capitaladequacy ratios
rules are replaced with the new, more complex supervisory system ofBasel II, the
banking sector in India needs to pay even greater attention to properlyidentifying
and controlling NPAs.
Chakrabarti & Chawla (2006) find that on a “value” or profitability basis,
theforeign banks, as a group, have been considerably more efficient than all other
bankgroups, followed by the Indian private banks. From a “quantity” perspective
or on thebasis of volume of deposits and credit created with given input levels,
however, Indianprivate banks have been the best performers while the foreign
banks are the worstperformers. This suggests that the foreign banks have been
“cherry-picking” – focusingon more lucrative segments of banking.

Corporate Governance

Corporate governance issues in India, as in any other country, are

multidimensional.For instance, the intricacies and opacity of conglomerates have
been blamedfor economic crises like the Asian crisis. A glance at India’s 500
largest (by market-cap)companies, that together account for over 90% of the
market capitalization of thecountry’s leading Bombay Stock Exchange, reveals that
about 60% of these companies
(65% in terms of market capitalization), are part of conglomerates, or what are
called“business groups” . Clearly family-run business groups still play a
crucialrole in the Indian corporate sector. Even in 2002, the average shareholding
of promotersin all Indian companies was as high as 48.1% .
Recent studies have documented the presence of “tunneling” of funds among
businessgroups in India19. The actual ownership in these companies are far from
transparent withwidespread pyramiding, cross-holding and the use of non-public
trusts and privatecompanies for owning shares in group companies.
7.1 Corporate Governance in India – a historical background
The history of the development of Indian corporate laws has been marked by
interesting contrasts. At independence, India inherited one of the world’s
pooresteconomies but one which had a factory sector accounting for a tenth of the
nationalproduct; four functioning stock markets (predating the Tokyo Stock
Exchange) withclearly defined rules governing listing, trading and settlements; a
well-developed equityculture if only among the urban rich; and a banking system
replete with well-developedlending norms and recovery procedures.20 In terms of
corporate laws and financialsystem, therefore, India emerged far better endowed
than most other colonies. The 1956Companies Act as well as other laws governing
the functioning of joint-stock companiesand protecting the investors’ rights built
on this foundation.The beginning of corporate developments in India were marked
by the managingagency system that contributed to the birth of dispersed equity
ownership but also gaverise to the practice of management enjoying control rights
disproportionately greater thantheir stock ownership. The turn towards socialism in
the decades after independencemarked by the 1951 Industries (Development and
Regulation) Act as well as the 1956Industrial Policy Resolution put in place a
regime and culture of licensing, protection andwidespread red-tape that bred
corruption and stilted the growth of the corporate sector.The situation grew from
bad to worse in the following decades and corruption, nepotismand inefficiency
became the hallmarks of the Indian corporate sector. Exorbitant tax
ratesencouraged creative accounting practices and complicated emolument
structures to beatthe
In the absence of a developed stock market, the three all-India developmentfinance
institutions (DFIs)– the Industrial Finance Corporation of India, the
IndustrialDevelopment Bank of India and the Industrial Credit and Investment
Corporation of India– together with the state financial corporations became the
main providers of long-termcredit to companies. Along with the government
owned mutual fund, the Unit Trust of
India, they also held large blocks of shares in the companies they lent to and
invariablyhad representations in their boards, though they have traditionally played
very passiveroles in the boardroom.Though financial disclosure norms in India
have traditionally been superior tomost Asian countries, noncompliance with
disclosure norms and even the failure ofauditor’s reports to conform to the law
attract nominal fines with hardly any punitiveaction. The Institute of Chartered
Accountants in India has not been known to take actionagainst erring auditors.
While the Companies Act provides clear instructions for maintaining andupdating
share registers, in reality minority shareholders have often suffered
fromirregularities in share transfers and registrations. Sometimes non-voting
preferentialshares have been used by promoters to channel funds and deprive
minority shareholdersof their dues. Minority shareholders’ rights have sometimes
also been compromised bymanagement’s private deals in the relatively scarce
event of corporate takeovers. Boards
of directors have been largely ineffective in India in their monitoring role, and
theirindependence is more often than not highly questionable.
For most of the post-Independence era the Indian equity markets were not liquidor
sophisticated enough to exert effective control over the companies.
Listingrequirements of exchanges enforced some transparency, but non-
compliance was neitherrare nor acted upon. All in all therefore, minority
shareholders and creditors in Indiaremained effectively unprotected despite the
laws on the books.
7.2 Recent Developments in Corporate Governance in India
Concerns about corporate governance in India were, however, largely triggered
bya spate of crises in the early 1990’s – the Harshad Mehta stock market scam of
1992followed by incidents of companies allotting preferential shares to their
promoters atdeeply discounted prices as well as those of companies simply
disappearing withinvestors’ money. These concerns about corporate governance
stemming from the corporatescandals as well as opening up to the forces of
competition and globalization gave rise toseveral investigations into the ways to fix
the corporate governance situation in India.One of the first among such endeavors
was the CII Code for Desirable CorporateGovernance developed by a committee
chaired by Rahul Bajaj. The committee wasformed in 1996 and submitted its code
in April 1998. Later SEBI constituted twocommittees to look into the issue of
corporate governance – the first chaired by KumarMangalam Birla that submitted
its report in early 2000 and the second by NarayanaMurthy three years later. These
last two committees have been instrumental in bringingabout far reaching changes
in corporate governance requirements in India through theformulation of the
Clause 49 of Listing Agreements.Concurrent with these initiatives by SEBI, the
Department of Company Affairs,
Ministry of Finance of the Government of India has also been contemplating
improvements in the corporate governance area. These efforts include the
establishmentof a study group to operationalize the Birla committee
recommendations in 2000, theNaresh Chandra Committee on Corporate Audit and
Governance in 2002 and the ExpertCommittee on Corporate Law (the J.J. Irani
Committee) in late 2004. All of these effortswere aimed at reforming the existing
Companies Act, 1956 that still formed the backbone
of corporate law in India.
7.3 Clause 49 of the Listing Agreements
SEBI implemented the recommendations of the Birla Committee through the
enactment of Clause 49 of the Listing Agreements. This Clause 49 may well be
viewed asa milestone in the evolution of corporate governance practices in India.
They wereapplied to companies in the BSE 200 and S&P C&X Nifty indices, and
all newly listedcompanies, on March 31, 2001; to companies with a paid up capital
of Rs. 10 crore ($ 2.5
million) or with a net worth of Rs. 25 crore ($ 6.25) at any time in the past five
years, asof March 31, 2002; to other listed companies with a paid up capital of over
Rs. 3 crore($ 750,000) on March 31, 2003. The Narayana Murthy committee
worked on furtherrefining the rules and Clause 49 was amended in 2004. The key
features of this amended Clause are discussed below.The major mandatory areas of
Clause 49 regulations are the following: (i)Composition of the Board of Directors;
(ii) the composition and functioning of the AuditCommittee; (iii) the governance
and disclosures regarding subsidiary companies; (iv)Disclosures by the company;
(vi) CEO/CFO certification of financial results; (vi) Reporton Corporate
Governance as part of the Annual Report; and (vii) certification of
Compliance of a company with the provisions of Clause 49.
The composition and proper functioning of the Board of Directors emerge as
thekey area of focus for Clause 49. It stipulates that non-executive members
shouldcomprise at least half of a board of directors. It defines an “independent”
director andrequires that independent directors comprise at least half of a board of
directors if thechairperson is an executive director and at least a third if the
chairperson is a nonexecutivedirector. It also lays down rules regarding
compensation of board members;sets caps on committee memberships and
chairmanships; lays down the minimumnumber and frequency of board meetings
and mandates certain disclosures for boardmembers.Clause 49 pays special
attention to the composition and functioning of the AuditCommittee, requiring at
least three members on it, with an independent chair and withtwo-thirds made up
of independent directors and having at least one “financially literate”person on it. It
lays down the role and powers of the audit committee and stipulates the
minimum number and frequency of and the quorum at the committee
meetings.With regard to “material” non-listed subsidiary companies (i.e.
turnover/net worthexceeding 20% of holding company’s turnover/net worth),
Clause 49 stipulates the at
least one independent director of the holding company to serve on the board of
thesubsidiary. The audit committee of the holding company should review the
subsidiary’sfinancial statements particularly investment plans. The minutes of the
subsidiary’s boardmeetings should be presented at the board meeting of the
holding company and the boardmembers of the latter should be made aware of all
“significant” (likely to exceed in value10% of total
revenues/expenses/assets/liabilities of the subsidiary) transactions enteredinto by
the subsidiary.The areas where Clause 49 stipulates specific corporate disclosures
are: (i) relatedparty transactions; (ii) accounting treatment; (iii) risk management
procedures; (iv) proceeds from various kinds of share issues; (v) remuneration of
directors; (vi) aManagement Discussion and Analysis section in the Annual report
discussing different
heads of general business conditions and outlook; (vii) background and
committeememberships of new directors as well as presentations to analysts. In
addition a boardcommittee with a non-executive chair should address
shareholder/investor grievances.Finally the process of share transfer, a long-
standing problem in India, should beexpedited by delegating authority to an officer
or committee or to the registrar and sharetransfer agents.The CEO and CFO or
their equivalents need to sign off on the company’sfinancial statements and
disclosures and accept responsibility for establishing andmaintaining effective
internal control systems.The company is required to provide a separate section of
corporate governance inits annual report with a detailed compliance report on also
submit a quarterly compliance report to the stock exchange where it is listed.
Finally,it needs to get its compliance with the mandatory specifications of Clause
49 certified byeither the auditors or practicing company secretaries.
In addition to these mandatory requirements, Clause 49 also mentions
nonmandatoryrequirements concerning the facilities for a non-executive chairman,
theremuneration committee, half-yearly reporting of financial performance to
shareholders,a move towards unqualified financial statements, training and
performance evaluation ofboard members and perhaps most notably a clear
“whistle blower” policy.
By and large, the provisions of Clause 49 closely mirror those of the Sarbanes-
Oxley measures in the USA. In some areas, like certification compliance, the
Indianrequirements are even stricter. There are, however, areas of uniqueness too.
Thedistinction drawn between boards headed by executive and non-executive
chairmen andthe lower required share of independent directors is special to India
(and somewhatintriguing too, given the prevalence of family-run business groups).
7.4 Recent findings about corporate governance in India
Of late, a burgeoning volume of empirical research has begun to document
several interesting features of corporate governance in India. We summarize some
of themajor findings in this section. Corporate Boards in large companies in India
in 2003 were slightly smaller thanthose in the US in 1991 with 9.46 members on
average as compared to 11.45 (Sarkar and
Sarkar 2005a). While the percentage of inside directors was roughly comparable
(25.38%compared to 26% in the US), Indian boards had relatively fewer
independent directors,(just over 54% as compared to 60% in the US) and relatively
more affiliated outsidedirectors (over 20% as compared to 14% in the USA). While
41% of Indian companieshad a promoter in the board, in over 30% of cases a
Promoter served as an ExecutiveDirector. There is evidence (Ghosh, S., 2006) that
larger boards lead to poorerperformance (market-based as well as in accounting
terms) in India as in the USA.The median director in large companies in India held
4.28 directorships in 2003(Sarkar and Sarkar, 2005a). The number is considerably
(and statistically significantly)higher for directors in group-affiliated companies
respectively. As for independent directors however, the median number of
positions heldis 4.59 with no major differences between group and standalone
companies. Interestingly,
independent directors with multiple directorships are associated with higher firm
value inIndia while busier inside directors are correlated negatively with firm
performance.Busier independent directors are also more conscientious in terms of
attending boardmeetings than their counterparts with fewer positions. As for inside
directors, it seemsthat the pressure of serving on multiple boards (due largely to the
prevalence of familyowned business groups) does take a toll on the directors’
performance.However, busy independent directors also appear to be correlated
with a greaterdegree of earnings management as measured by discretionary
accruals (Sarkar et al,
2006). Multiple positions and non-attendance of board meetings by independent
directorsseem to be associated with higher discretionary accruals in firms. After
controlling forthese characteristics of independent directors, board independence,
i.e. proportion ofindependent directors, does not seem to affect the degree of
earnings management.However CEO-duality (i.e. where the top executive also
chairs the board) and thepresence of controlling shareholders as inside directors are
related, perhapsunsurprisingly, to greater earnings management.Shareholding
patterns in India reveal a marked level of concentration in the handsof the
promoters – individuals/family who started the company. In 2002-03, for instance,
promoters held 47.74% of the shares in a sample of close to 2500 listed
manufacturingcompanies (Sarkar and Sarkar, 2005) –50.78% for group companies
and 45.94% forstandalone firms. In comparison, the Indian public’s share
amounted to 34.60%, 28% and38.51% respectively. As for the impact of
concentrated shareholding on firmperformance, Sarkar and Sarkar, 2000 find that
in the mid-90’s (1995-96) holdings above25% by directors and their relatives was
associated with higher valuation of companieswhile there was no clear effect
below that threshold. More recently, based on 2001 datathat distinguishes between
“controlling” insiders and non-controlling groups, Salerka,2006 report a U-shaped
relationship between insider ownership – insider defined aspromoters and “persons
acting in concert (PACs) with promoters” – and firm value withthe point of
inflection lying at a much higher level – between 45% and 63%.
Institutional investors comprising the government sponsored mutual funds
andinsurance companies, banks and “development financial institutions” (DFIs)
that are alsolong-term creditors, and foreign institutional investors, hold over 22%
shares of theaverage large company in India, of which the share of mutual funds,
banks and FIs,insurance companies, and FIIs are about 5%, 1.5%, 3% and 11%
respectively. Analyzingcross-section data of the mid-90’s, Sarkar and Sarkar 2000
find that company valueactually declines with a rise in the holding of mutual funds
and insurance companies inhe range 0-25% holding after which there is no clear
effect. On the other hand, for DFIs’holdings, there is no clear effect on valuation
below 25% but a significant positive effectater the 25% mark, suggesting better
monitoring when stakes are higher. Whether theseeffects have stayed the same
after the changes witnessed in the decade that followed thisperiod remains to be
checked.Executive compensation in India is another area of corporate governance
that hasreceived some attention among researchers. Since 1993-94 executive
compensation hasbeen freed from the strict regulation by the Companies Act.
Executive compensation inIndia often has two components – salary and
performance-based commission – apartfrom retirement and other benefits and
perquisites. Based on an analysis of unbalancedpanel data of roughly 300 firms in
each year, Fagernäs (2007) reports that the averagetotal compensation (salary plus
commission) of CEOs has risen almost three-foldbetween 1998 and 2004 (from Rs.
2.1 million (approx. $48,500) to Rs. 6.4 million in real terms. During this period,
the proportion of profit-basedcommission has risen steadily from 13.4% to 25.6%
and the proportion of CEOs withcommission as part of the pay package has risen
from 0.34 to 0.51. So clearly, CEO payhas become more performance based during
that period. There is some evidence that thisincreasing performance-pay linkage is
associated with the introduction of the corporategovernance code or Clause 49.
Meanwhile the commissions as a fraction of profits havealso almost doubled from
0.55% to 1.06%. also finds that CEOs related to the founding family or
directorsare paid more than other CEOs. In a firm fixed effects model, she finds
being related tothe founding family can raise CEO pay by as much as 30% while
being related to adirector can cause an increase of about 10%. There is some
evidence that the presence ofdirectors from lending institutions lowers pay while
the share of non-executive directorson the board connects pay more closely to
performance.
Ghosh (2006) finds that during 1997-2002, the average (of a sample of 462
manufacturing firms) board compensation in India has been around Rs. 5.3
million(approx. $120,000) with wide variation across firm size – average Rs. 7.6
million or$ 171,000 for large firms and Rs. 2.5 million ($56,000) for small firms.
The boardcompensation also appears to be higher (average Rs. 6.9 million
($155,500)) if the CEOis related to the founding family. Both board and CEO
compensation depended on currentperformance and the former depended on past-
year performance as well. Also diversifiedcompanies paid their boards more.Given
that close to two-thirds of the top 500 Indian companies are groupaffiliated,issues
relating to corporate governance in business groups are naturally very
important in the Indian context. “Tunneling”, or “the transfer of assets and profits
out offirms for the benefit of those who control them”22 is a major concern in
business groupswith pyramidal ownership structure and inter-firm cash flows.
Bertrand et al (2002)estimate that an industry shock leads to a 30% lower earnings
increase for business groupfirms compared to stand-alone firms in the same
industry. They find that firms lowerdown in the pyramidal structure are less
affected by industry-specific shocks than thosenearer the top, suggesting that
positive shocks in the former are siphoned off to the latterhelping the controlling
shareholders but hurting the minority shareholders. However,Khanna and Yafeh
(2007) question how this logic would make them less sensitive tonegative shocks.
There is also some evidence (e.g., Khanna and Palepu 2000) that firmsassociated
with business groups have superior performance than stand-alone firms.More
recently Kali and Sarkar (2007) argue that diversified business groups help
increase the opacity of within-group funds flow driving a wider wedge between
controland cash flow rights and a greater degree of diversification aids tunneling.
Using data forIndian firms in 385 business groups in 2002-03 and 384 groups in
2003-04 they find thatfirms with greater ownership opacity and lower wedge
between cash flow rights andcontrol than those in a group’s core activity are likely
to be located away from the coreactivity. This incentive for tunneling explains,
according to them, the persistence ofsometimes value destroying groups in India
and occasional heavy investment by Indiangroups in businesses with low
contribution to group profitability.
Indianaccounting standards provide considerable flexibility to firms in their
financial reportingand differ from the International Accounting Standards (IAS) in
several ways that oftenmakes interpreting Indian financial statements a challenging
task . These deviations, however, need to be viewed in the right perspective. India
still fallsshort of the median number of deviations from IAS in the 49 country
sample of Bae et al,2007.The nature of corporate governance can arguably affect
the capital structure of acompany. In the presence of well functioning financial
institutions, debt can be adisciplining mechanism in the hands of shareholders or
an expropriating mechanism inthe hands of controlling insider. Studying the
relationship between leverage and Tobin’ Q in 1996, 2000 and 2003, Sarkar and
Sarkar (2005b) conclude that the disciplinaryeffect has been more marked in recent
years with greater market orientation ofinstitutions. They also find limited
evidence of the use of debt as an expropriatingmechanism in group companies.The
market for corporate control has been relatively limited in India till the mid-1990’s
when the average number of mergers per year leapt from 30 between 1973-74
and1987-88 and 63 between 1987-88 and 1994-95 to171 between 1994-95 and
2002-03(Agarwal and Bhattacharya, 2006). Merger activity appears to occur in
waves and is splitroughly evenly between inter-industry and intra-industry
mergers. The share of groupaffiliatedmergers has increased significantly in the post
1994-95 period.

Microfinance in India

The microfinance sector is clearly one of the fastest growing segments of the
Indian financial sector, and also one where such growth is sustainable for a very
longperiod of time. In spite of a large banking sector, about 40% of the Indian
populationdoes not have bank accounts. Given that over 75% of the Indian
population still livesbelow $2 a day, and a vast majority in rural areas,
microfinance – the provision of thriftsavings, credit and other financial products
and services at a very scale to the poor toenable them to raise their income and
improve living standards – is key to financialinclusion in India. Traditionally,
micro-credit in India has been the domain of villagemoney-lenders, generally at
exploitative interest rates that impoverished borrowers.While special emphasis on
rural and small loans have existed in India at leastsince the 1960s and India’s apex
specialized rural credit agency, the National Bank forAgricultural and Rural
Development (NABARD) was established in 1982, microfinance
in India has witnessed a dramatic increase in recent years with the involvement a
largenumber of private players in addition to the government. Providers of
microfinance inIndia today include specialized country-level institutions like
NABARD, the SmallIndustrial Development Bank of India (SIDBI) and that
RashtriyaMahilaKosh (RMK); commercial banks – both private and state-owned;
regional rural banks; cooperative
banks as well as non-banking financial companies (NBFCs). While non-profits
(NGOs)have often played a key role in the formation of microfinance institutions
(MFIs), thecontribution of governmental thrust in scaling microfinance (largely
through the self-helpgroup model) has, at the end of the day, reached a far higher
number of people. Of late,with the realization of the profit opportunities in the
sectors and the spectacular growth inthe past half decade, microfinance in India is
beginning to attract for-profit funding fromcommercial banks as well as from
venture capital firms, both domestic and foreign.Though microfinance in India, as
in most other places, is generally lauded as thesuccess of private enterprise, the
role of the government in scaling and mainstreamingmicrofinance cannot be
overlooked in India, particularly in the SHG Bank LinkageProgram. In 2000, two-
thirds of SHGs in India were promoted by NGOs. Now around
half of them are promoted by government, less then third are promoted by NGOs
and restby banks. SEWA, one of the pioneers of microfinance in India took 35
years to reachmembership of 0.8 million women, but in contrast the government of
the Southern stateof Andhra Pradesh took 15 years to mobilize 8 million women23.
The SwarnajayantiGram Swarojgar Yojana (SGSY), perhaps the biggest
government program promotingSHGs anywhere in the world was launched in
1997, and generated over 0.34 millionSHG loan applications in 2006-07 alone.
8.1 Outreach and recent growth
The Self-Help Group (SHG) model of group-lending and linking of such
groups(almost always of women) to banks has been the predominant model of
microfinance inIndia connecting about 14 million poor households to banks in
March 2006 and providingindirect banking access to an equal number. Loans from
micro-financial institutions(MFIs) have reached about 7.3 million households
among which about 45% are poor.Together these two models appear to have
touched about a quarter of the Indian poor.
The SHG Bank Linkage Program (SBLP) – dominant microfinance model in
India – had, in March 2006, an average loan size of Rs 2,684 ($67.1) for fresh
loans andRs 4,497 ($112.42) for repeat loans per group member with average
group size of 14members. In the five years from 2001 to 2006 outreach and loan
volume in this modelhad witnessed close to nine-fold increases. While the quantity
of bank loan disbursed shotup from Rs 481 crores ($ 120.25 million) to Rs 4, 499
crores ($ 1.12 billion), outreach
expanded from 0.26 million to 2.2 million SHGs, making it the largest such
program inthe world. During the period, average loan size almost doubled from Rs
19,379 ($ 484.5)per SHG to Rs 37, 574 ($ 939.4) per SHG in 2006, the average
size of repeat loans grewalmost three-fold from Rs 22,215 ($ 555.4 ) in 2001 to Rs
62,960 ($ 1,574) in 2006.The alternative model of microfinance institutions (MFIs)
has produced thesuccess stories and poster organizations of Indian microfinance.
MFIs are of diverse legalforms and it is difficult to estimate their exact number.
Sa-dhan, an association of MFIs
in India has 162 members with outstanding loan portfolio of Rs 1600 crores ($
400million) in March 2006. While the number of MFIs in India is probably well in
excess of800, top 20 MFIs in India account for about 95% of their aggregate loan
portfolio.
Microfinance in India also exhibits tremendous regional disparities. It is fair tosay
that microfinance in India is largely a “southern” affair. In 2005 about 83% of
thehouseholds reached by microfinance were in the Southern states. Eastern India
came nextwith 13% of the households while the West accounted for less than 1%.
While consciousefforts are afoot to rectify this regional bias, it is likely to take a
while before the regionaldistribution of microfinance approaches uniformity.In
terms of the products and services, apart from micro loans, the microfinancesector
in India focuses on micro-savings and financial literacy among the poor –
developing the habit and discipline of saving – and, more recently have begun, in
arelatively small way, to introduce micro-insurance. Individual and group level
insuranceis now being offered, in limited areas of both life and non-life types. A
study on microinsurance products by ILO in 2003-04, identified 83 insurance
products provided byinsurance companies; half of them were life products. Out of
those 24 were addressed toindividuals and rest to the groups. Life Insurance
Corporation (LIC) of India, (a publicsector insurance company) provides both
individual and group insurance. Various privatesector insurance companies also
provide these kinds of insurance products. In 2002, theIndian microfinance
institution BASIX and AVIVA jointly designed a group insuranceproduct to
provide life insurance to all BASIX credit customers. Other than life risk,
ruralhousehold faces health risk, risk to agricultural activity, risk to live-stock, risk
to assetsused in non farm activities. Crop insurance and Life stock insurance are
two commonnon-life insurance products offered by General Insurance Corporation
(GIC) of India
(public sector insurance company). But the delivery of the above products has
beenrestricted to beneficiaries of various government sponsored schemes and there
has beenlittle active participation by insurers to deliver these products on a larger
scale. Thesituation has improved somewhat after the opening of the insurance
sector to privatesector companies. For instance, in 2003, BASIX and ICICI
Lombard introduced a rainfallinsurance product, which was rolled over to six
states by the year 2005. Finally,transferring money, particularly for migrant
workers, is another area where micro-financeinstitutions are making an entry.
8.2 The performance of the larger MFIs in India
. The weighted average ROA for these MFIs is 2.1% with
considerable variability. The range is from a low of 0.74% to a high of over 9%.
TheROEs are extremely variable as well, ranging from slightly over 8% to over
173%, with aweighted average of 25.6%. The asset-weighted average loan balance
is slightly over$ 108 with profit margins ranging from below 4% to above 60%.
Clearly even amongthese largest players, the level of variability makes it difficult
to generalize performance.However, it also shows that done properly, a
microfinance institution can be a profitableenterprise.It is possible that higher
profitability may come at the price of lower outreach andthat MFIs experience a
“mission drift”. While data on the poverty level of clients is notuniformly
available, all of these MFIs, with the exception of BASIX have over 98% oftheir
lending to women borrowers. Given the negative correlation between the average
loan size and the ROA and ROE figures, it may not be such a major concern.
A study by Sa-dhan in 2005 (using a sample of 74 MFIs) reflects that these
MFIsperformed well in terms of sustainability, asset quality, and efficiency.
Evidence foundthat, large MFIs were the efficient users of funds, extending 81 %
of their total assets asloans, while this figure is 75 % for medium and small MFIs.
A report by MIX Markets (MIX (2006)) highlighted the inverse relation ship
between growth and size with young MFIs growing faster than the mature MFIs.
Thereport shows that medium MFIs are sustainable and have positive returns on
assets andequity. It also shows that the small MFIs are more efficient, with lower
unit cost ratioscomparing to medium sized MFIs
The MIX report on MFIs in South Asia24, points out that MFIs in India are
uniquein leveraging the borrowed funds. The average capital asset ratio in India is
11%, whichis half of the average of South Asia. Indian MFIs share the feature of
providing loansfrom voluntary deposits with Bangladesh. Around 8.4% of total
loans funded fromvoluntary deposits, hence provide another financial service
‘Saving’ along with credit.
24 Performance and Transparency : A Survey of Microfinance in South Asia
Like Bangladesh, staff costs in the Indian microfinance sector are also one of the
lowestin the world.
In terms of interest charged, Indian MFIs are among the highest in the South
Asiaregion, which, however, has one of the lowest averages in the world. Thus
byinternational standards, interest rates in microfinance in India, are pretty
low.Nevertheless, because of cases of multiple farmer suicides in the Indian state
of AndhraPradesh, reportedly owing to extreme indebtedness, MFIs have come
under governmentpressure to reduce interest rates.

8.3 Financing of MFIs in India

Commercial Banks
The growth of MFIs in the recent past has attracted most of the private
sectorbanks. In the 1990’s most of the MFIs lending comes from FWWB and
SIDBI. Earlierbanks used to lend at the level of priority sector lending obligations,
but now they havefound lending to MFIs being profitable, with almost perfect
repayment rates. For the lastthree years, commercial bank lending almost doubled
in every year. outstanding figures of responding banks at the end of 2006.Banks
provide both term loans and cash credit. The rate of interest charged rangefrom 8.5
to 11% for tenor ranging from 3 months to 5 years. For MFIs lacking trackrecord,
personal guarantees are also taken for security. As Table 7.4 shows, ICICI
bank(the largest private bank and second largest bank in India) has the largest
outstandingcredit accounting for over 80% of the total commercial bank lending to
MFIs. About 60%of this lending is based on the “partnership model” where MFIs
function as socialintermediary providing loan origination, monitoring and
collection services, for a fee. Butthe MFI partner is expected to share the risk of
default up to some specified level.Another way of lending adopted by ICICI is that
of portfolio buy-out. Under deals with
certain MFIs, the bank has bought out their portfolio, for amounts on which MFIs
arecharged 9 %. Apart from lending, ICICI bank has taken the initiative of using
technology,like low cost ATMs, mobile phone banking, internet services and
others that helpautomate cash transactions in the field.
In January 2006, the Reserve Bank of India (RBI) specified guidelines forinclusion
of certain agencies along with MFIs as intermediaries. The intermediaries
weresupposed to work on the basis of two models: the Business Facilitator Model
(BFM) andthe Business Correspondent Model (BCM). Under the BFM, NGOs,
Cooperatives, PostOffices, Insurance agents and community based organizations
work as intermediaries.
These intermediaries would perform the “last mile” services – activities
like,identification of borrowers, creating awareness about savings, processing and
submissionof loan applications and follow up for recoveries. While under the BCM
model,intermediaries include NGOs and MFIs registered under the Trusts Act, not-
for-profitcompanies (“Section 25 companies” in India) and Post Offices. In
addition to BFMactivities, the intermediaries perform the following additional
activities: Disbursal ofsmall value credit, recovery of principal, collection of
interest, Sale of micro insuranceand mutual fund products. The banks may pay
reasonable commissions or fees to theintermediaries for these services.
Shortage of MFIs with requisite capacity and regulatory anomalies, among
otherthings, constrain lending to MFIs by commercial banks. The probation on
banks fromcharging more than PLR (of 11-13 %) on loans less than Rs 2 lakh ($
5,000) and chargesand commissions (over the PLR ) on loans less than Rs 25,000
($ 625) increases the cost of funds for banks and made the BC model
unworkable.Venture Capital Funds
More recently, venture capital funds (VCFs) – both Indian and off-shore –
areentering the microfinance sector in India. Table 7.5 shows the top ten VCFs
investing inIndia on the basis of their total MFI investment worldwide. These
VCFs have helpedreduce the problems faced by start-ups and emerging MFIs.
According to an estimate byM-CRIL (2006), the current equity deficit of sample
MFIs is Rs 23 crores ($ 5.75million) and their total equity fund requirement is
expected to be Rs 1,100 crores ($ 275
million) by 2010.VCF entry into the microfinance sector in India is a recent
phenomenon. Till
Bellwether registered in India in 2005, SIDBI Foundation for Micro Credit
(SFMC) wasthe sole (and far from effective) major provider of equity capital to the
sector. In the2005-2006 budget, the size of NABARD’s MFDEF (Microfinance
Development &Equity Fund) was doubled from Rs 100 crores ($ 25 million) to Rs
200 crores ($ 50million).The instruments preferred by VCFs have included both
loans and equity and can
broadly be classified (using Bellwether’s segmentation) as the following – Tier I:
Equityinvestment in start-ups and big established MFIs; Tier II: Convertible debt
provided tohigh potential NGOs-MFIs; Tier III: Debt to NGOs. The involvement
of the famousventure capitalist Vinod Khosla has also generated considerable
exposure to the sector.

8.4 The regulatory environment

It is fair to say that microfinance in India has evolved so far largely in (and
arguably because of) an absence of sector-specific regulations. While each
player,according to its institutional status, was regulated by its respective apex
body (frequentlythe central bank, the Reserve Bank of India) very little regulation
specifically targeted atmicrofinance was in effect. That is likely to change soon
with the introduction of amicrofinance bill, currently in the Indian Parliament.The
objective of the Microfinance Regulation Bill is to register and regulate thetrusts
and registered societies promoting and helping SHGs. The bill has two
broadobjectives: (a) to promote and regulate the micro finance sector and (b) to
permit MicroFinancial Organizations (MFOs) to collect deposits from ‘eligible
clients’25. The billdefines an MFO as any organization that provides micro finance
services and includes
25 Defined as as any member of an SHG or any group formed to provide micro
finance services to certaincategories of people. The categories include (a) any
farmer owning a maximum of two hectares ofagricultural land; (b) agricultural
cultivators such as oral lessees and share croppers; (c) landless andmigrant
labourers; (d) artisans and micro entrepreneurs; and (e) women
societies, trusts, and co-operative societies. The definition excludes SHG and
groups ofSHGs. The financial assistance to ‘eligible client’ by these MFOs cannot
exceed (a) Rs50,000 ($ 1,250) in aggregate per individual for small and tiny
enterprise, agriculture, andallied activities or (b) Rs 1.5 lakh ($ 3,750) in aggregate
per individual for housingpurposes.The bill seeks to bring the entire microfinance
sector under the surveillance ofThe National Bank for Agricultural and Rural
Development (NABARD). It will be
NABARD’s role to promote and ensure the orderly growth of micro financial
services byformulating policies for transparency, facilitating the development of
rating norms and byspecifying accounting norms and auditing norms. To offer
thrift (savings) services toeligible clients, an MFO will need to obtain a certificate
of registration from NABARD.Every MFO has to create a reserve fund by
transferring a minimum of 15% of its net
profit or surplus realized out of thrift services and micro finance services.
NABARD maydirect that this fund be invested in specified securities.
Also, NABARD shall constitute a Micro Finance Development and Equity Fundto
be utilized for the development of the micro finance sector26.The Fund would
bemanaged by the Board of Directors of NABARD and would be used to provide
anyfinancial assistance to an MFO, invest in equity of an MFO, and meet any other
expensesfor the promotion of the micro finance sector.The proposed bill seeks to
regulate the trusts and cooperative societies promotingand helping SHGs, not
SHGs themselves. However, SHGs are also cooperativesorganized to provide
certain services to its members more economically. These SHGscan not register
themselves as cooperatives because according to state government and
RBI, there can be only one cooperative credit society in a village. Since these
SHGs arenot legal entities, so they can not put money in bank in the name of SHG,
but in the nameone or two members creating room for fraud. The unsettled issues
about the bill includes:(a) whether MFOs are the appropriate vehicle to address
credit needs of the poor; (b)whether NABARD is the appropriate body to regulate
the sector, given that it itself is a26 The Fund would include (a) all grants received
from the government and other sources; (b) any incomereceived from investments
made in equity of an MFO; and (c) the balance outstanding in the Fundmaintained
by NABARD before the commencement of the Act.

Emerging Issues for Research

The fundamental transformations in the Indian economy and financial marketshave
important implications for academic as well as industry research in finance in
India.Indian markets can now no longer be studied in isolation without properly
factoring theglobal market forces to which they have become far more vulnerable
than before.International investors – both portfolio and FDI – will continue to play
animportant in the Indian markets and the perception of Indian industry and
economyabroad will be forceful in deciding several key issues in India. The days
of isolation aregone indeed and the price of a global presence is the susceptibility
to foreign shocks. As
India moves towards planned full capital account convertibility in 2009, the
managementand integration of foreign players in the financial system remain an
important area tostudy.Market institutions and bourse-specific practices in terms of
accounting and bookkeepingand settlement issues go a long way in determining the
microstructure of stockmarkets. Order execution procedures and costs are central
to market efficiency. Astechnology and institutional infrastructure continue to
develop in India, the future islikely to bring about greater financial innovations and
efficiency.
Derivatives are here to stay. Equity options and futures can only increase in
importance in the coming years. Commodity futures are beginning to play a role in
riskmanagement among producers and buyers alike. In the future perhaps, more
exotic onesincluding tradable weather derivatives will make their appearance as
well. A properunderstanding of these instruments and the opportunities and threats
they carry isessential to research in Indian financial markets. There is evidence of
considerable mispricingof equity options in India27. Theoretical and empirical
exploration of these issues
is essential for a better understanding of the functioning of these markets.
Corporate governance and company practices as well as the functioning of
thefinancial services industry including equity analysis create the structure of the
financialsector at large. These issues as well as those related to the service
provider-clientrelationships need to be better studied as well.
The banking sector in India is in a flux. New technology and the growing
importance of private and foreign banks are reshaping the retail banking industry
into adynamic terrain marked with severe competition. The growth in stock prices
and markettransactions is setting the stage for a significant increase in M&A
activity and greaterdemand for quality investment banking services. As banks’
revenue pools move towardsless traditional fee-based activities where today’s
dominant players – public sector banks– are at a relative disadvantage given their
restrictive human resource practices, the shapeand composition of banking is likely
to witness far-reaching changes in India.Finally, despite the good economic
performance in recent years India remains adeveloping country with about a
quarter of its massive population in acute poverty. Withall its sheen and dazzling
capital market performance, the financial system still excludesabout 40% of the
population, mostly the rural poor. Poverty alleviation and developmenthave
traditionally been thought of as government prerogatives to be funded out of
taxpayers’ money. However, as privatization progresses and the importance of the
publicsector wanes, private endeavor and commercial involvement in these efforts
arebecoming increasingly important. The progress of microfinance, often viewed
as aprofitable method of poverty alleviation and development, therefore, is of
considerableimportance to India.
 BIBLIOGRAPHY

1. Berlin M and Mester j 2004 , “ Indian financial system post

liberalization”,review of financial economics vol.13,pp.179-198

2.calem mp s and measterL J (1995), “ the failure of competition in the

financial markets ”American economic review ,vol . 81 .no .1 pp . 50 – 81

JOURNALS

Indian journal of april 2009

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