School of Management Studies, Nagaland University 1 MFM 108 Securities & Portfolio Analysis

Liberalisation of the Indian Financial System

By Rokov N. Zhasa (NU Reg. No. 111291 of 2011-2012) Content 1.1 Introduction 1.2 Financial Sector Reforms 1.2.1 Narasimham Committee 1.3 Capital Market Reforms 1.4 Reforms in Development Banking Sector 1.5 Conclusion Reference

1.1 Introduction The main aim of the liberalisation was to dismantle the excessive regulatory framework that curtailed the freedom of enterprise. Over the years, the country had developed a system of licencepermit raj. The aim of the new economic policy was to save the entrepreneurs from unnecessary harassment of seeking permission from Babudom (the bureaucracy of the country) to start an undertaking. Similarly, the big business houses were unable to start new enterprises because the Monopolies and Restrictive Trade Practices (MRTP) Act had prescribed a ceiling on asset ownership to the extent of Rs.100 crores. In case a business house had assets of more than Rs.100 crores, its application after scrutiny by the MRTP Commission was rejected. It was believed that on account of the rise in prices this limit had become outdated and needed a review. The second objection by the private sector lobby was that it prevented big industrial houses from investing in heavy industry and infrastructure, which required lump sum investment. In order that the big business could be enthused to enter the core sectorsheavy industry, infrastructure, petrochemicals, electronics etc., with big projects, the irrelevance of MRTP limit was recognized and hence scrapped. The major purpose of liberalisation was to free the large private corporate sector from bureaucratic controls. It, therefore, started dismantling the regime of industrial licensing and controls. In pursuance of this policy, the industrial policy of 1991 abolished industrial licensing for all projects except for a short set of 18 industries. This long list also got truncated to six by 1999.

School of Management Studies, Nagaland University 2 MFM 108 Securities & Portfolio Analysis

1.2 Financial Sector Reforms The experience of successful developing countries indicates that rapid growth requires a sustained effort at mobilizing savings and resources and deploying them in ways, which encourage efficient production. Financial sector reform thus constitutes an important component of the programme of stablisation and structural reform. 1.2.1 Narasimham Committee At the outset the Government had recognised that financial sector reform was an integral part of the new economic policy. A high level committee headed by Mr. M.N. Narasimham was appointed to consider all relevant aspects of the structure, organisation, functions and procedures of the financial system. Following the committees report in November 1991, the Government embarked on a farreaching processes of reform covering both the banking system and the capital market. The need for a thorough going reform of the financial system was further underscored by the now famous securities scam (or irregularities of the banks) news of which broke out in April 1992. The Narasimham Committee recognised the fact that the quantitative success of the public sector banks in India was achieved at the expenses of deterioration in qualitative factors such as profitability, efficiency and the most important the quality of the loan portfolio which now needed to take the centre stage. The elements of the recovery programme reiterated by the committee are as follows: Reduce presumption of lending capacity through staged reductions in SLR and CRR, while moving the yield on government debt to marketrelated levels. Stress availability rather than subsidy in provision of credit to the priority sector, and restrict cross-subsidy only to the smaller borrowers. The goal should be to establish incentives that induce adequate flows of credit to priority uses, especially agriculture, without compromising on prudential and commercial consideration. Move to objective, internationally recognised accounting standards, with suitable transitional provisions to give banks time to adjust. These accounting norms will clarify and strengthen the incentives for bank managements to exercise greater care in credit assessment and recover. Make additional capital available from the government and the capital markets to strengthen banks financial position and provide a basis for future growth. Provision of capital by the government will be conditional on monitorable improvements in the management and recovery performance of each bank. Access to the markets will impose the additional discipline of prospectus registration or assessment by credit rating agencies and accountability to non-governmental shareholders.

School of Management Studies, Nagaland University 3 MFM 108 Securities & Portfolio Analysis

Improve prospects for recovery by setting up special recovery tribunals in major metropolitan areas. Set up a credit information database for exchange of information on the credit history of large borrowers subject to confidentiality. Upgrade the caliber of appointees to board level posts, stressing longevity and security of tenure. Enhance managerial accountability and stress performancerelated promotion. Encourage technological modernization in banks through computerization and greater labour flexibility. Encourage greater competition for public sector banks through the controlled entry of modern, professional private sector banks including foreign banks. Create a new board for financial supervision to devote exclusive attention to issues of compliance and supervision and review the Banking Regulation Act. Ensure viable mechanisms for supply of credit to the rural sector, small-scale industry and weaker sections.

Targets set The steadfast pursuit of this agenda promised to transform Indian banking and the public sector banks in particular (By June 1996 the following targets had to be attained). a) b) c) d) e) f) g) all public sector banks achieving 8 percent capital to riskassets ratio half the public sector banks (weighted by deposits) should be quoted on the stock market with appropriate representation of shareholders on bank boards. significant entry of new private sector banks SLR and CRR appreciably reduced interest rates deregulated at least 500 branches of public sector banks would be fully computerized.

1.3 Capital Market Reforms The Securities Exchange Board of India (SEBI) has been issuing guidelines from time to time for establishing a fair and transparent capital market. Some of the major measures announced by SEBI are briefly enumerated below: In October 1993, regulations for underwriters of capital issues and capital adequacy norms for the stock brokers in the stock exchanges were announced. As per modified guidelines, bonus issues can be made out of free reserves built out of the genuine profits or share premium collected and the interest of holders of fully or partly convertible debentures will have to be taken into account while issuing bonus shares. The stock exchanges have been directed to broad base their governing boards and change the composition of their arbitration, default and disciplinary committees.

School of Management Studies, Nagaland University 4 MFM 108 Securities & Portfolio Analysis

SEBI notified regulations for bankers to issues in July 1994. The regulations make registration of bankers to issues with SEBI compulsory. It stipulates the general obligations and responsibilities of the bankers to issues and contains a code of conduct. Under the regulations, inspection of bankers to an issue will be done by the Reserve Bank on request from SEBI. RBI has liberalized the investment norms evolved for NRIs by allowing companies to accept capital contributions and issue shares or debentures to NRIs or overseas corporate bodies without prior permission. The government has allowed foreign institutional investors (FIIs) such as pension funds, mutual funds, investment trusts, asset or portfolio management companies etc. to invest in the Indian Capital market provided they register with SEBI. SEBI has made it compulsory for credit rating of debentures and bonds of more than 18 months maturity. The maximum debt-equity ratio of banks is 2:1 and the minimum debt service coverage ratio required is 1:2. Reductions in Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) According to the Narasimham Committee, one of the problems facing our banking system was that the levels of SLR and CRR had been progressively increased over the past several years. In the case of SLR this happened because of the desire to mobilize even larger resources through so-called market borrowing (at below-market rates) in support of the central and state budgets. In the case of the CRR this happened because of the need to counter the expansionary impact on money supply of large budget deficits. Together the SLR and CRR stipulations preempted a large part of bank resources into low income earning assets thus reducing bank profitability and pressurising banks to charge high interest on their commercial advances. The high SLR and CRR were in effect a tax on financial savings in the banking system and served to encourage flows in the market where this tax did not apply. The Government therefore decided to (and has) reduced SLR in stages over a three year period from 38.5 per cent to 25 per cent and that of CRR over a forty-year period to a level of 10 per cent.

1.4 Reforms in Development Banking Sector The Narasimham Committee recognized that the development financial institutions operation in India was marked by the total absence of competition in the matter of provision of loans and medium-term finances. The system had evolved into a segmentation of business between DFIs and the banks, the latter concentrating on working capital finance and the former on investment finance. Borrowers as a consequence had no choice in selecting an institution to finance their projects. The committee suggested delinking of these institutions from the state governments for better efficiency. The operations of the DFIs in respect of loan sanctions should be the sole responsibility of the institutions

School of Management Studies, Nagaland University 5 MFM 108 Securities & Portfolio Analysis

themselves based on a professional appraisal of projects. The Government also embarked on a process of disinvestments in some of the bigger institutions like IDBI etc. 1.5 Conclusion With a looming finaincial crisis facing the nation, the Government of India appointed the high-level committee headed by Mr. M.N. Narasimhan. The committee considered all relevant aspects of the structuring, organisation, functioning and procedures of the Indian financial system. The Committee placed its report before Parliament in December, 1991. The committee many far reaching recommendations with regard to carrying out reforms covering the length and breadth of the Indian Financial system. The reform measures that followed have been credited for the creation of the framework that has enabled India become one of the fastest growing economies of the world. Reference: 1. MS 03 Economic and Social Environment, Block 5 Economic Reforms Since 1991, Unit 19 ECONOMIC REFORMS : LIBERALISATION, GLOBALISATION AND PRIVATISATION, pp 33-48 (IGNOU) 2. MS 03 Economic and Social Environment, Block 5 Economic Reforms Since 1991, Unit 20 FINANCIAL SECTOR REFORMS, pp 49-72 (IGNOU)