Evolution of Indian Financial System: A Critical Review EXECUTIVE SUMMARY The Economic Development of a country depends, inter alia, on the financial system. The larger the proportion of the financial assets (money and monetary assets) to real assets (physical goods and services), the greater the scope for economic growth in the long run. For growth to take place, investment is necessary which flows from the financial system. Besides, as a scarce factor of production in the Less Development Countries (LDCs), finance has a crucial role to play in these economies.

The growth objective of the financial system is to achieve the structure and rate of growth of various financial assets and liabilities in consonance with the optimal characteristics of real capital stock. The more efficient composition of real wealth is obtained through the promotion of such financial assets which provide incentives to savers and the public to hold a growing part of their wealth in financial form. Increasing rate of savings correlates well with the increase in the proportion of saving held in the form of financial assets relative to tangible assets.

There is a direct correlation between growth of the economy and the growth of the financial assets. Investment in the real sector depends on the functioning of the financial sector, as the latter collects and channels saving into investment which is necessary for growth. It would be pertinent to note here that economic growth is function of the level of investment, capital-output ratio in each activity of productive process, the level of investment, determines the increase in output of goods and services and incomes in the economy.

The Indian financial system is undergoing a sea change in response to the changes that have been taking place in the social, political and economic environment and in the process laying a sound edifice for a vibrant economy. MAJOR IMPACT EVENTS SINCE INDEPEDENCE The Indian financial sector comprises a large network of commercial banks, financial institutions, stock exchanges and a wide range of financial instruments. It has undergone a significant structural transformation since the initiation of financial liberalization in 1990s.

Before financial liberalization, since mid 1960’s till the early 1990’, the Indian financial system was considered as an instrument of public finance (Agarwal, 2003). The evolution of Indian financial sector in the post independent period can be divided in to three distinct periods. During the first period (1947-68), the Reserve Bank of India (RBI)consolidated its role as the agency in charge of supervision and banking control (Sen & Vaidya, 1997).

Till1960’s the neo-Keynesian perspective dominated, argued interest rates should be kept low in order to promote capital accumulation (Sen & Vaidya, 1997). During this period Indian financial sector was characterized by nationalization of banks, directed credit and administered interest rates (Lawrence & Longjam, 2003). The second period (1969 - mid 1980’s), known as the period of financial repression. The financial repression started with the nationalization of 14 commercial banks3 in 1969.

As a result interest rate controls, directed credit programmes, etc. increased in magnitude during this period (Sen & Vaidya,1997). The third period, mid 1980’s onwards, is characterized by consolidation, diversification and liberalization. However a more comprehensive liberalization programme was initiated by the government of India during early 1990’s. The impetus to financial sector reforms came with the submission of three influential reports by the Chakravarty Committee in 1985, the Vaghul in 1987 and the Narasimham Committee in 1991.

But the recommendations of the Narasimham Committee provided the blueprint of there forms, especially with regard to banks and other financial institutions. In 1991, the government of India initiated a comprehensive financial sector liberalization programme. The liberalization programme includes de-controlled interest rates, reduced reserve ratios and slowly reduced government control of banking operations while establishing a market regulatory framework (Lawrence & Longjam, 2003).

The major objectives of the financial liberalization were to improve the overall performance of the Indian financial sector, to make the financial institutions more competent and more efficient. However, Indian financial system continues to be a bank based financial system and the banking sector plays an important role as a resource mobiliser. It remains the principal source of resources for many households small and medium enterprises and also caters the large industries. And also provides many other financial services.

Underlining the importance of the banking sector, several banking sector specific reforms as apart of financial reforms were introduced to improve the performance of the Indian banking sector and to make the Indian banks more competent and efficient. Against this backdrop, the present paper intends to determine the efficiency of the banks operating in India. FINANCIAL INSTRUMENTS The term ‘derivatives, refers to a broad class of financial instruments which mainly include options and futures. These instruments derive their value from the price and other related variables of the underlying asset.

They do not have worth of their own and derive their value from the claim they give to their owners to own some other financial assets or security Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as: a) “a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security; b) “a contract which derives its value from the prices, or index of prices, of underlying securities”. As defined above, the value of a derivative instrument depends upon the underlying asset.

The underlying asset may assume many forms: i. Commodities including grain, coffee beans, orange juice; ii. Precious metals like gold and silver; iii. Foreign exchange rates or currencies; iv. Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc. v. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index vi. Short term securities such as T-bills; and vii. Over- the Counter (OTC)2 money market products such as loans or deposits. Derivatives markets have been in existence In India in some form or other for a long time.

In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities.

The last decade, beginning the year 2000, saw lifting of ban on futures trading in many commodities. Around the same period, national electronic commodity exchanges were also set up. The trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges (NSE and BSE). Initially, SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and Sensex.

Subsequently, index-based trading was permitted in options as well as individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001.

The index futures and options contract on NSE are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue. The regulatory framework in India is based on the L. C. Gupta Committee Report, and the J. R. Varma Committee Report. The L. C. Gupta Committee Report provides a perspective on division of regulatory responsibility between the exchange and the SEBI. It recommends that SEBI’s role should be restricted to approving rules, bye laws and regulations of a derivatives exchange as also to approving the proposed derivatives contracts before commencement of their trading.

Derivatives trading commenced in Indian market in 2000 with the introduction of Index futures at BSE, and subsequently, on National Stock Exchange (NSE). Since then, derivatives market in India has witnessed tremendous growth in terms of trading value and number of traded contracts. The BSE created history on June 9, 2000 when it launched trading in Sensex based futures contract for the first time. It was followed by trading in index options on June 1, 2001; in stock options and single stock futures (31 stocks) on July 9, 2001 and November 9, 2002, respectively.

Currently, the number of stocks under single futures and options is 1096. BSE achieved another milestone on September 13, 2004 when it launched Weekly Options, a unique product unparalleled worldwide in the derivatives markets. Equity derivatives market in India has registered an "explosive growth" and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets.

The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130,90,477. 75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038 Cr. If we compare the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories.

Among all the products traded on NSE in F& O segment, single stock futures also known as equity futures, are most popular in terms of volumes and number of contract traded, followed by index futures with turnover shares of 52 percent and 31 percent, respectively. In case of BSE, index futures outperform stock futures. Innovation of derivatives have redefined and revolutionized the landscape of financial industry across the world and derivatives have earned a well deserved and extremely significant place among all the financial products. Derivatives are risk management tool that help in effective management of risk by various stakeholders.

Derivatives provide an opportunity to transfer risk, from the one who wish to avoid it; to one, who wish to accept it. India’s experience with the launch of equity derivatives market has been extremely encouraging and successful. THE FINANCIAL MARKETS The history of Indian capital markets dates back 200 years toward the end of the 18th century when India was under the rule of the East India Company. The development of the capital market in India concentrated around Mumbai where no less than 200 to 250 securities brokers were active during the second half of the 19th century.

The financial market in India today is more developed than many other sectors because it was organized long before with the securities exchanges of Mumbai, Ahmedabad and Kolkata were established as early as the 19th century. By the early 1960s the total number of securities exchanges in India rose to eight, including Mumbai, Ahmedabad and Kolkata apart from Madras, Kanpur, Delhi, Bangalore and Pune. Today there are 21 regional securities exchanges in India in addition to the centralized NSE (National Stock Exchange) and OTCEI (Over the Counter Exchange of India).

However the stock markets in India remained stagnant due to stringent controls on the market economy that allowed only a handful of monopolies to dominate their respective sectors. The corporate sector wasn't allowed into many industry segments, which were dominated by the state controlled public sector resulting in stagnation of the economy right up to the early 1990s. Thereafter when the Indian economy began liberalizing and the controls began to be dismantled or eased out, the securities markets witnessed a flurry of IPOs that were launched.

This resulted in many new companies across different industry segments to come up with newer products and services. A remarkable feature of the growth of the Indian economy in recent years has been the role played by its securities markets in assisting and fuelling that growth with money rose within the economy. This was in marked contrast to the initial phase of growth in many of the fast growing economies of East Asia that witnessed huge doses of FDI (Foreign Direct Investment) spurring growth in their initial days of market decontrol.

During this phase in India much of the organized sector has been affected by high growth as the financial markets played an all-inclusive role in sustaining financial resource mobilization. Many PSUs (Public Sector Undertakings) that decided to offload part of their equity were also helped by the well-organized securities market in India. The launch of the NSE (National Stock Exchange) and the OTCEI (Over the Counter Exchange of India) during the mid 1990s by the government of India was meant to usher in an easier and more transparent form of trading in securities.

The NSE was conceived as the market for trading in the securities of companies from the large-scale sector and the OTCEI for those from the small-scale sector. While the NSE has not just done well to grow and evolve into the virtual backbone of capital markets in India the OTCEI struggled and is yet to show any sign of growth and development. The integration of IT into the capital market infrastructure has been particularly smooth in India due to the country’s world class IT industry.

This has pushed up the operational efficiency of the Indian stock market to global standards and as a result the country has been able to capitalize on its high growth and attract foreign capital like never before. The regulating authority for capital markets in India is the SEBI (Securities and Exchange Board of India). SEBI came into prominence in the 1990s after the capital markets experienced some turbulence. It had to take drastic measures to plug many loopholes that were exploited by certain market forces to advance their vested interests.

After this initial phase of struggle SEBI has grown in strength as the regulator of India’s capital markets and as one of the country’s most important institutions. FINANCIAL INTERMEDIARIES The term ‘financial intermediaries’ is a very wide term and covers a wide range of institutions like mutual savings societies, commercial banks, insurance and investment companies, etc. to specialized financial institutions such as development banks, etc. In the present study entitled “Role of Financial Intermediaries in Industrial Development of India Since 1970”, the term financial intermediaries has been used in a very restrictive sense viz. pecialized financial institutions meeting the term-requirements of the industrial sector. To accelerate the process of industrialization, immediately after independence, Government of India took appropriate steps to create a network of financial institutions to fill the gaps in the supply of long-term finance to industry. IFCI was the first institution which was set-up in 1948 followed by SFCs established by different States/Union Territories under the SFCs Act. 1951. The NIDC (1954), ICICI (1955), NSIC (1955), and RCI (1958) were established. IDBI was established in 1964 as the apex institution in the field of industrial finance.

UTI was also established in the same year. LIC came into existence in 1956 and GIC in 1972. SIDCs/SIICs strengthened institutional set-up at regional level. IRCI was set-up in 1971 which was later renamed as IRBI. Reserve Bank has played an important role in creation of all these institutions. Thus, structure of financial institutions in India has become so greatly diversified and strengthened that it has the ability to supply finance to a variety of enterprises in diverse forms. securities markets since the inception of the financial liberalization process of the early nineties.

They continue to remain dominant, however, in mobilizing India’s financial savings. Although the design of equity markets in India is sophisticated, their use as vehicles for primary resource mobilisation has diminished considerably in recent years, primarily through a loss of investor confidence following a series of scandals. Debt markets are relatively undeveloped, although there is large debt outstanding, primarily of government securities, a large part of which is held by banks, especially public sector banks (PSBs). Mutual funds are an increasingly important vehicle for financial intermediation in India.

The growth in the corpus of assets under their management had outpaced that of bank deposits in the early and mid-nineties, although they have fallen behind since 199798. The total assets under management of mutual funds, as of September 30, 2001, were Rs 918 bn (4. 2 percent of GDP). Even in this competitive segment with relatively low entry barriers, the importance of public sector mutual funds, especially Unit Trust of India (UTI), as a share of total assets under management continues, seven years after the entry of private funds. Although UTI’s share of the total corpus has declined to 53. percent at this date (from its share of over 80 percent in 1995-96), it remains by far the largest fund. The major intermediaries in the Indian financial sector are commercial banks, the All India Financial Institutions (AIFIs, henceforth FIs) - encompassing term-lending institutions, investment institutions (IIs), specialized financial institutions and the state level development banks – and Non-Bank Financial Companies (NBFCs). Following the nationalization of the banks (in 1969 and 1980), the banking sector primarily met the government’s dual objectives of financing priority sectors and minimizing the cost of government borrowing.

These objectives were met, for the most part, through administrative measures, which impeded the free and efficient allocation of financial resources, creating a number of distortions. By 1990, there was serious concern about the financial condition of public sector banks, many of which had become unprofitable, under-capitalized and burdened with unsustainable levels of non-performing assets on their books. Against this background, and as part of the structural adjustment program initiated in 1991, a number of reform initiatives were taken on the basis of the recommendations of the Committee on Financial System (CFS), 1991.

The reform measures have had a positive impact on the financial system. Competition in the system has increased, but the overwhelming presence of government owned institutions in all segments has meant that they still continue to be Stackelberg leader. The introduction of new prudential norms uncovered a large stock of non-performing loans and gave a clearer indication of the weak financial position of the public sector commercial banks.

Nonetheless, banks responded positively to the new initiatives: most of the banks now meet the capital adequacy ratio; non-performing loans have declined (as a percent of advances), although at some banks they remain at uncomfortably high levels; and there has been some improvement in profitability. This improvement, however, has been meager and the financial performance of PSBs leaves a lot to be desired. Unlike India’s equity markets, substantive reforms have mostly bypassed the lending side of its financial sector.

Although there have been changes in the norms of capital adequacy, income recognition and asset classification during the past decade of liberalisation, adequate – let alone complete – transparency has not been achieved. Compounding this lack of reform (or probably being its predominant cause), much of this segment is publicly owned (or has a significant government shareholding) and accounts for an overwhelming share of financial transactions. The public ownership of these institutions creates an environment where market discipline is perceptibly weak.

FIs (including IIs) have been used to support vague (and sometimes extra-legal) objectives –providing artificial support to stock markets, underwriting the government’s disinvestment targets, contributing assistance to states based on the political clout of the representatives, and occasionally, overt lapses in due diligence. It is worth noting that most of the recommendations of the CFS that have been accepted and introduced, although significant, are in the nature of ratios, rates and accounting. The same degree of progress has not been attained with regard to structural and systemic aspects of the reform agenda.

The importance of FIs in financial intermediation can be gauged from their 70 percent share in total loans sanctioned in 2000-0122. The Life Insurance Corporation of India (LIC), as of March 2001, the latest date for which figures are available, had a total business of Rs 7,300 bn, in terms of sums assured. The corpus of its Life Fund was Rs1,860 bn. THE REGULATORY ENVIORNMENT Red tape and regulations still rank among the leading deterrents for business and foreign investment in India leading to its latest ranking of 116 out of 155 in the World Bank’s Ease of Doing Business indicator in 2006 (World Bank, 2006).

India features consistently in the second half of the sample for all aspects of business regulation (and is out of the top 100 for most aspects) except for investor protection. To start a business in India entrepreneurs have close to twice the number of procedures to follow as in OECD countries, about three and a half times the time delay and close to nine times the cost (as a proportion of per capita income). Delays and costs of dealing with licenses in India is roughly in corresponding proportions with their respective OECD values.

Very recently (second half of August 2007) , the Government of India has decided to improve this situation and has announced a drastic reduction in the number of 15 approvals and permits necessary to start new business. Whether and when this translates to actual practice is yet to be seen. It is almost twice as hard to hire people in India as in OECD countries and almost three 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 decades before liberalization began in 1991, Indian states that followed more pro-worker policies experienced 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 quality information 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 with her performance in contract enforcement where the number of procedures and time delays are about double that in OECD countries and the costs of contract enforcement over 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 public enforcement of the regulations controlling securities markets, India scores 0. 2 in the index of disclosure requirements third highest after the United States and Singapore. As for 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 the supervisory authority, the Securities and Exchanges Board of India (SEBI), India scores 0. 67, higher than the overall sample mean as well as the English-origin average of 0. 52 and 0. 62 respectively and ranks 14th in the sample.

In comparing the regulatory powers and performance of SEBI with those of the SEC (Securities and Exchanges Commission) in the USA, Bose (2005) concludes that while the scope of Indian securities laws are quite pervasive, there are significant problems in enforcing compliance, particularly in the areas like price manipulation and insider trading. Between 1999 and 2004, Bose finds that SEBI took action in 481 cases as opposed 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 their 16r espective jurisdictions, SEBI’s figure comes out to be an unimpressive 0. 09 while that of the SEC is 0. 52. Also the ratio for action taken to investigations made is quite low for SEBI (e. g. 1 out of 24 cases of issue related manipulation in 1996-97, 7 out of 27 in the 5 year period 1999-2004). As for appeals before higher authorities – the Securities Appellate Tribunal (SAT) or the Finance Ministry – in 30 to 50% of cases, the decision goes against SEBI.

Though SEBI has had some success prosecuting intermediaries, it has failed to convince the SAT in its proceedings against corporate insiders and major market players. 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 of Security Interest (SARFAESI) Act in 2002 were aimed at remedying the slowness of the judicial process.

The SARFAESI Act paves the way for the establishment of Asset Reconstruction Companies (ARCs) that can take the Non-Performing Assets (NPAs) off the balance sheets of banks and recover them. Operations of these ARCs would be restricted to asset reconstruction and securitization only. It also allows banks and financial institutions to directly seize assets of a defaulting borrower who defaults fails to respond within 60 days of a notice. Borrowers can appeal to DRTs only after the assets are 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’s right to approach the DRT, the DRAT (Debt Recovery Appellate Tribunal) and, in some cases, 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 to evaluate its effects on reducing defaults but public sector banks have had some success recovering their loans by seizing and selling assets since the Act came into existence.

The recovery rates of bad debts have registered a sharp rise in 2005-06, but it is difficult to separate the contribution of the booming economy to this from that of the improvement in corporate governance. Another positive development in the area of disclosure has been the adoption of 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” by 17 Indian companies mandatory.

Related parties include holding and subsidiary companies, key management personnel and their direct relatives, “parties with control exist” which includes joint ventures and fellow subsidiaries; and other parties like promoters and employee trusts. Transactions include purchase/sale of goods and assets, borrowing, lending and leasing, hiring and agency arrangements, guarantee agreements, transfer of research and development and management contracts. This step has gone a long way in bringing transparency to the dealings of Indian companies, particularly the group affiliates.

The area of the Ease of Doing Business index where India fares worst is undoubtedly that of closing a business. India has the dubious distinction of being among the countries where it takes the longest time to go through bankruptcy in the world (10 years on an average). Consequently recovery rates are very low too – below 13% as opposed to about 74% in OECD countries. Kang and Nayar (2004) point out that there is no single comprehensive and integrated policy on corporate bankruptcy in India in the lines of Chapter 11 or Chapter 7 US bankruptcy code.

Overlapping jurisdictions of the High Courts, the Company Law Board, the Board for Industrial and Financial Reconstruction (BIFR) and the Debt Recovery Tribunals (DRTs) contribute to the costs and delays of bankruptcy. The Companies (Second Amendment) Act, 2002 seeks to address these problems by establishing a National Company Law Tribunal and stipulating a time-bound rehabilitation or liquidation process to within less than two years as well as bringing about other positive changes in the bankruptcy code. WAY FORWARD

The contours of the financial markets are expanding with the advent of new technology, innovations in products and fast changing customer expectations. The Indian financial services sector comprises a good blend of domestic and foreign participants. Opening up of the financial markets has resulted in competition and greater efficiency; however, foreign participation could also bring in the baggage of increased risk and exposure as recent events have shown. Stability is therefore a critical need for financial markets for which safeguarding mechanisms need to be established, to prevent systemic risks and absorb shocks.

The equity market in India is extremely vibrant, but equity based funding solely, cannot lead the economy to growth. The debt market remains under-developed, with a huge potential for increased activity. A strong bond market is required to drive long term financing of infrastructure, housing and private sector development. The role of capital markets is vital for enhancing growth in wealth distribution and increasing availability of funds for infrastructure development. One of the underlying challenges that the banking and financial services sector is dealing with is the issue of increasing the out-reach ; enhancing financial inclusion.

The huge scale of the drive towards inclusive growth is intimidating, as various stakeholders like banks, insurance companies and asset management companies struggle to move a step closer to the untapped areas and newer target consumers. The challenge lies in devising a cost-effective delivery model to reach out to the low income group of society, penetrating the remote areas. A debate on new banking licenses, banks developing and formulating strategies for inclusive banking and an increasing thrust on infrastructure financing, have been some of the initiatives which have been taken to give an added impetus to financial inclusion.

The road ahead for deepening the financial markets needs to be paved by the formulation of a strong linkage between the development of the economy and the capacity of the financial system. The global financial environment is moving towards an integrated financial system, and will serve in good stead to standardize compliance norms and procedures. A greater measure of transparency is also required to be built into regulatory procedures, to bring in a new dimension to financial markets, and take it to the next level.