Financial sector Reforms 1991
An efficient banking system and a well-functioning capital market are essential to harness family savings and redirect them into productive uses. High rates of saving and productive investment are critical for economic progress. Prior to 1991, although the banking system and capital market saw tremendous expansion in number of activities, they suffered from several flaws in terms of efficiency and quality.
The committee (1991) on financial sector changes, led by Narasimham, conducted a detailed analysis of the banking system’s shortcomings. The committee concluded that the financial sector was both over- and under-regulated. Prior to 1991, various regulated interest rates occurred. Furthermore, the government preempted a considerable amount of bank money by imposing a high Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). As a consequence, banks’ ability to lend to the private sector for investment decreased.
The government’s preemption of bank funds undermined the banking system’s financial health, forcing banks to charge high interest rates on loans to the private sector in order to fulfill their credit requirements for investment reasons. Furthermore, the banks’ lack of openness in accounting procedure and failure to apply international principles resulted in balance sheets that did not represent their underlying financial status.
Harshad Mehta’s 1992 scarcity fraud brought this to light dramatically. In this circumstance, the quality of the banks’ investment portfolio deteriorated, and a culture of “non-recovery” evolved in public sector banks, resulting in a significant issue with non-performing assets (NPAs) and poor bank profitability. Financial sector reforms attempt to address all of the financial system’s problems.
These changes aimed to make the Indian financial sector more viable, operationally efficient, responsive, and allocatively efficient. Financial reforms have been implemented in all three components of the financial system: banking, the capital market, and the government securities market.
Reduction of Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR)
A significant financial reform has been the decrease of the Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) to increase bank loan availability to industry, commerce, and agriculture. The statutory liquidity ratio (SLR), which was as high as 39% of bank deposits, has been scaled down to 25%.
It should be mentioned that under the statutory liquidity ratio, banks must retain a minimum level of liquid assets, such as government securities and gold reserves, equal to 25% of their total liabilities. In 2008, the RBI cut the statutory liquidity ratio to 24%.
Similarly, the cash reserve ratio (CRR) was cut gradually from 15% to 4.5% in June 2003. It should be emphasized that the decrease in CRR was made possible by reducing the government’s monetized budget deficit and eliminating the automated mechanism of financing the government’s budget deficit via the practice of issuing ad hoc treasury bills to the Central Government.
On the other hand, a lowering in the Statutory Liquidity Ratio (SLR) was made feasible by the government’s attempts to minimize the budget deficit and hence its borrowing obligations. Furthermore, the payment of market-related interest rates on government securities has made it feasible to reduce the SLR.
Since government securities are risk-free and currently bear market-related interest rates, banks may feel compelled to invest their excess money in these securities, particularly when demand for loan from industry and commerce is insufficient.
The drop in CRR and SLR has increased the availability of lendable resources in industry, commerce, and agriculture. Reductions in CRR and SLR also enabled the Reserve Bank of India to employ open market operations and adjustments in bank rates as monetary policy instruments to accomplish the goals of economic growth, price stability, and exchange rate stability.
Thus, Dr. C. Rangarajan, the former Governor of the Reserve Bank of India, states, “As we move away from automatic monetisation of deficits, monetary policy will come into play.” The management of money and credit will be established by the Central Monetary Authority’s overall view of the acceptable amount of money and credit growth based on how the actual forces in the economy are changing.”
End of Administered Interest Rate Regime:
The Reserve Bank/Government administered interest rates, which was a fundamental flaw of the Indian financial system. In the case of commercial banks, the Reserve Bank of India controlled both deposit and lending rates. Prior to 1993, the interest rate on government securities may be kept low by maintaining a high Statutory Liquidity Ratio.
Under SLR regulation, commercial banks and other financial institutions were forced by law to invest a significant part of their liabilities in government securities. The administered interest-rate system was designed to allow certain priority industries to receive money at concessional interest rates. Thus, the managed interest rate structure incorporated cross-subsidization: concessional rates paid to primary sectors were offset by higher rates imposed to other non-concessional borrowers.
The administered rate structure has been gradually phased out. The RBI no longer mandates interest rates on fixed or term deposits made by its banks to depositors. Banks are also no longer required to impose any limitations on depositors’ early withdrawals. Individual banks are able to set their own criteria for premature withdrawal. Currently, the recommended rate for Savings Bank Accounts is 3.5%.
Individuals utilize Savings Bank Accounts as current accounts, even with the option of using a checkbook. Because banks incur enormous costs in managing these accounts, interest rates on them are certain to be low. Furthermore, lower interest rate limitations are set for foreign currency denominated deposits from non-resident Indians (NRIs). A lower mandated ceiling is essential for regulating external capital flows, particularly short-term capital flows, until the capital account is liberalised.
Lending rates of interest for many categories that were formerly restricted have progressively been deregulated. However, the RBI insists on openness in this area. Each bank is obligated to disclose its prime lending rates (PLRs) and the maximum spread it charges. The maximum spread represents the difference between the loan rate and the bank’s cost of funds.
Interest on loans up to Rs. 2,00,000 is controlled at a concessional rate. Currently, the interest rate on these smaller loans should not surpass prime lending rates. Furthermore, loan interest rates for exports are set and connected to the term of availment. Changes in mandated interest rates for exports are sometimes utilized to affect the repatriation of export revenues.
Thus, save for regulated lending rates for exports and small loans up to Rs. 2, 00,000, lending rates are no longer under supervision. Banks may now set lending rates based on their risk-reward view of borrowers and the objectives for which bank loans are sought.
Prudential Norms: High capital adequacy ratio
To guarantee that the financial system works on a solid and competitive foundation, prudential regulations, particularly the capital-adequacy ratio, have been steadily established to meet international standards. The capital adequacy standard refers to the ratio of banks’ paid-up capital and reserves to their deposits. Indian banks’ capital base has been far lower than international requirements, and it has actually fallen over time.
As part of financial sector reforms, India implemented an 8% capital adequacy rule based on a risk-weighted asset ratio scheme. Indian banks with branches overseas were obliged to meet this capital-adequacy standard by March 31, 1994. Foreign banks operating in India required to meet this standard by March 31, 1993.
Other Indian banks had to meet the 8% capital adequacy criteria by March 31, 1996. The RBI recommended banks to examine their current level of capital funds in comparison to the mandated capital adequacy requirement and to take efforts to grow their capital base gradually in order to meet the prescribed norm by the specified date.
It should be mentioned that Global Trust Bank (GTB), a private sector bank whose activities were suspended by the RBI on July 24, 2004, had a capital adequacy ratio much lower than the mandated sensible capital adequacy ratio requirement. In this context, the relationship between capital adequacy and provisioning is worth mentioning. Banks may meet the capital adequacy criterion by ensuring that enough capital provisions are made.
To meet this capital adequacy standard, the government stepped in to give capital money to several nationalized banks. Some stronger public-sector banks raised funding from the capital market by selling stock. The law was created to allow public-sector banks to raise money from the capital markets in order to strengthen their capital basis. Banks may also utilize a portion of their yearly profits to increase their capital base (by investing retained earnings).
Competitive Financial System:
After the nationalization of 14 big banks in 1969, no new private-sector banks were permitted. While the necessity and function of public sector banks in the Indian financial system was emphasized, it was also acknowledged that there was an urgent need to introduce more competition in the Indian money market, which might lead to increased financial system efficiency.
As a result, private sector banks such HDFC, Corporation Bank, ICICI Bank, UTI Bank, IDBI Bank, and others have been established. The establishment of these institutions has made a significant contribution to mortgage financing, auto loans, and retail credit via the credit card system. They have enabled the widespread usage of what is often referred to as plastic money, namely ITM cards, debit cards, and credit cards.
In addition to the establishment of private sector Indian banks, competition has also sought to be promoted by permitting liberal entry of branches of foreign banks. As a result, CITI Bank, Standard Chartered Bank, Bank of America, American Express, and HSBC Bank have opened more branches in India, particularly in metropolitan cities.
Foreign direct investment in banks has just been liberalised, which is a crucial step. The budget for 2003-04 increased the ceiling on foreign direct investment in banking businesses from 49% to 74% of the banks’ paid-up capital. This did not apply to international banks’ entirely owned subsidiaries.
A foreign bank may operate in India via any of three avenues, namely:
(1) As branches of foreign banks.
(2) A fully owned subsidiary of a foreign bank,
(3) A subsidiary having aggregate foreign investment of up to 74% of its paid-up capital.
The steps outlined above are intended to make it easier for international banks to establish subsidiaries. Aside from encouraging competition among banks, they have enhanced transparency and disclosure rules to meet international norms. Banks must disclose to the RBI and SEBI the maturity trend of their assets and liabilities, changes in the provision account, and information on non-performing assets (NPAs).
The RBI’s yearly publication ‘Trends and Progress of Banking in India’ includes specific information on individual banks’ financial positions, such as losses, assets, liabilities, NPAs, and so on, allowing the public to analyze the banks’ performance.
Non-performing assets (NPAs) and the Income Recognition Norm:
Commercial banks have faced significant challenges due to non-performing assets. Non-performing assets refer to poor loans, which are difficult to recover. A significant number of non-performing assets also reduces the profitability of a bank. In this context, the RBI’s revenue recognition standard is worth emphasizing. According to this, revenue from a bank’s assets is not recognized if it is not received within two quarters of the latest date.
In order to enhance the performance of commercial banks, recovery management has been significantly increased in recent years. Bank restructuring, bad debt collection via Lok Adalats and Civil Courts, the establishment of collection Tribunals, and compromise agreements are all examples of measures adopted to minimize non-performing assets. The enactment of the ‘Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest’ (SARFAESI) Act significantly aided bad debt recovery. This Act established Debt Recovery Tribunals to help banks collect delinquent loans.
As a consequence of the foregoing steps, gross NPAs fell from Rs. 70,861 crores in 2001-02 to Rs. 68,715 crores in 2002-03. However, significant quantities of non-performing assets have yet to be recovered. Furthermore, as a consequence of the RBI’s implementation of risk-based supervision, the ratio of gross nonperforming assets to gross advances of scheduled commercial banks fell from 12.7% in 1999-2000 to 8.8% in 2002-03.
Elimination of Direct Credit Controls
Another key financial change is the removal of direct or selective credit regulations. Credit limitations have been implemented selectively. Under selective credit restrictions, the RBI employed a system of margin modifications to limit the issuance of bank credit to traders against stockpiles of critical commodities and to stock brokers against shares. As a consequence, banks and borrowers now have more credit flexibility.
However, it is worth noting that banks are mandated to follow the RBI’s lending rules for priority sectors like as small-scale enterprises and agriculture. The amounts allowed for priority sector financing have been raised to deregulated interest rates.
This is consistent with the idea that the primary issue is more the availability of credit than the cost of credit. In June 2004, the UPA government stated that agricultural loan will be accessible at 2% below banks’ PLR. Additionally, credit for agriculture will be increased in three years time.
Promoting Microfinance to Improve Financial Inclusion:
To encourage financial inclusion, the government launched a microfinance plan. The RBI provides guidelines to banks for mainstreaming micro-credit providers and increasing their outreach, including the requirement that micro-credit extended by banks to individual borrowers directly or through any intermediary be considered part of their priority-sector lending. However, no specific model was established for microfinance, and banks were given the discretion to create their own model(s) or use any conduit/intermediary to issue microcredit.
Though there are several strategies for pursuing microfinance, the Self-Help Group (SHG)-Bank Linkage Programme has emerged as the country’s largest microfinance program. It is being carried out by commercial banks, regional rural banks (RRBs), and cooperative banks.
Setting up the Rural Infrastructure Development Fund (RIDF):
The Government of India established the RIDF in 1995 with contributions from commercial banks to cover the shortfall in priority sector lending by banks, with the goal of providing low-cost fund support to states and state-owned corporations for the timely completion of ongoing projects relating to medium and minor irrigation, soil conservation, watershed management, and other forms of rural infrastructure.
The Fund has persisted, with its corpus disclosed each year in the Budget. Over time, the RIDF’s scope has expanded in each tranche, and 31 initiatives across several industries are now being funded.
Pension reforms:
Since October 2003, the Central Government has implemented a new pension scheme (NPS) for its workers. Later, numerous states adopted the system for their personnel. The New Pension Scheme is a contributing retirement plan.
To be eligible for a pension after retirement, all Central Government workers hired after January 1, 2004 must join the system and contribute to it. Later, numerous states adopted the system for their personnel. Private people may now participate in the plan, which is managed by eight investment managers.
The pension authority was given the name Pension Fund Regulatory and Development Authority (PFRDA). Since October 2003, this pension authority has operated under executive control until September 2013. In September 2013, the Indian Parliament approved the Pension Fund Regulatory Development Authority Bill, eight years after it was presented in March 2005. This bill proposes to give PFRDA the authority to regulate the pension program (NPS).
PFRDA has a corpus of Rs 34,965 crore. NPS has been with us for nine years, and managing such a significant sum of Rs. 35,000 crore was not suitable for a non-statutory body. It should be governed by a statutory body. The only change made by this new law is that the non-statutory power becomes statutory.
Parliament enacted legislation establishing the Pension Fund Regulatory and Development Authority, which is a significant financial reform that will allow foreign investment in the industry. Currently, the new pension program has over 5.3 million participants and a capital of roughly Rs. 35,000 crore.
The Finance Minister has said that foreign investment in the pension sector would be 26%, which is tied to that in the insurance industry. The government has previously authorized 49% of foreign investment in the insurance business.
The NPS will also allow withdrawals for certain restricted reasons, which was not previously possible. The change would significantly increase the coverage of official pension and social security schemes in India, where just approximately 12% of the active workforce has one.
The liberalization of the pension industry, even at 26%, would entice international investors to invest their money, since India has a large population that need social security coverage. We don’t have many pension goods right now, but as more companies enter the market, more products will emerge, helping to channel pension money into the economy. The Bill would provide the PFRDA more authority to regulate the NPS and other pension systems that are not covered by any Act.