THE FINANCIAL SECTOR

The Problems

1. Indian companies depend too much on borrowing from banks to finance their investment. They need to be able to access a corporate bond market as an additional source of credit.

2. Banks are forced to spend some of their capital on government debt through the statutory liquidity ratio (SLR). The government uses this to tap household savings to finance its fiscal deficit. But it means that there is less room available for corporate bonds.

3. The government’s reliance on banks to hold its securities means that individuals and foreign investors find it difficult to access safe and secure sovereign-guaranteed returns.

4. While many Indians now have a bank account, trust in – and understanding of – the formal financial sector still has to be built to encourage households to save financially rather than through, say, buying gold.

Financial Sector Development and Reforms^*

Eswar Prasad

To sustain India’s high growth rate and spread its benefits more evenly, the financial sector has a crucial role to play in mobilizing resources and channelling them to productive uses.

A well-developed financial system should effectively harness domestic savings; facilitate the efficient allocation of domestic and foreign savings to productive investments; allow households and firms to share risk; and support consumption and expenditure smoothing. To meet these goals, the financial sector needs a strong banking system as well as deep equity and bond markets. These in turn should be supported by liquid secondary markets and a robust regulatory and legal infrastructure.

Financial sector development should go hand-in-hand with reducing inequality in access to finance, with the aim of achieving universal coverage of banking and financial services.

The long-term objectives of financial sector reforms include the following:

· Making the banking system more robust and well capitalized, expanding its capacity to extend credit and improving incentives to lend to the most productive sectors.

· Increasing the reach of banking services with the aim of achieving universal coverage.

· Developing a liquid and deep corporate bond market to enable firms to raise debt at a low cost, with a view to gradually increasing the share of corporate bond markets in the financing of firms and providing an alternative to bank financing.

· Enhancing liquidity in the government debt market and making it more attractive to institutional and retail investors.

· Developing missing (or nascent) markets like fixed income derivatives to hedge the credit and interest rate risk of fixed income securities.

· Integrating financial markets, streamlining regulation, eliminating regulatory arbitrage.

· Creating a robust legal framework and effective judicial apparatus that supports the functioning of financial markets.

· Developing sophisticated IT infrastructure for trading exchanges that has the capability to support trading of innovative financial products.

· Making the financial sector more open to international investment to enable India to become a global financial centre in the long term.

Some specific recommendations regarding different parts of the financial system follow below.

Corporate bond markets

· Increase the participation of institutional investors in the corporate bond market by relaxing norms on investment guidelines. There are restrictions on institutional investors such as insurance companies and pension funds that inhibit their demand for corporate bonds. Relaxing these limits can help increase the participation in the Indian corporate bond market of these big-ticket, long-term investors.

· Reduce the Statutory Liquidity Ratio. The SLR determines how much government debt banks are forced to hold. A reduction in the SLR would allow banks to instead increase their holding of corporate bonds. The RBI has initiated the process of reducing the SLR; implementing a clear medium-term path for bringing down the SLR significantly would help banks prepare better, increase depth and liquidity in bond markets and reduce financial system distortions resulting from bank financing of fiscal deficits through their holdings of government debt.

· Develop the credit-default swap (CDS) market for corporate bonds to help investors hedge risk. Investment in corporate bonds is risky. Investors will be more willing to invest in the bond market if they have access to a CDS market in which they can hedge their risk. The RBI should allow netting of exposures to make trading in CDSs less expensive, while retaining regulatory safeguards to prevent excessive gross exposures. Restrictions preventing institutional investors from selling CDSs should be removed, and foreign investors could be allowed to sell CDS contracts.

· Rationalize stamp duty. Rationalization of stamp duty can make bond issuance more attractive – but action on this suggestion, first proposed in the R.H. Patil Committee Report (2005), has been slow. The government should take prompt action on this reform.

· Increase the limit on foreign portfolio investment. The current limit on foreign investment in corporate bonds accounts for less than 10 per cent of the value of outstanding corporate bonds. The RBI should consider increasing this limit. Higher foreign investment will not only bolster the liquidity of the market but will also improve market discipline.

· Creation of a benchmark yield curve. Government securities (G-Secs) set the benchmark yields for the corporate bond markets. In India, G-Secs issued tend to be of longer duration – i.e., they are concentrated in the long end of the yield curve. Hence, there is no reliable benchmark yield for the short end of the yield curve. This makes pricing of corporate bonds difficult. Expanding the G-Sec market to include bonds with short maturities will help develop a benchmark yield curve for corporate bonds, which are clustered in the short-medium tenor (up to five years).

Government bond markets

· Increase diversity in the investor base in the G-Sec market. The share of scheduled commercial banks in the investor base should be gradually brought down by lowering the SLR. The market should also be made more accessible to retail investors.

· Increase issuance of inflation-indexed bonds and floating-rate bonds. These instruments are attractive to investors and provide a measure of inflation expectations, which helps guide monetary policy. In addition, they will encourage fiscal discipline by making inflation costly for the government, thereby serving as a commitment device for maintaining low inflation.

Other financial markets

· Increase retail participation in the equity market. Implement measures to increase the low retail participation in equity markets in India and mobilize the large pool of household savings through these markets, perhaps by educating people about the benefits (and risks) of investing in them. Eliminating regulatory arbitrage and increasing the ease of investment can also increase investor participation in the equity market.

· Initiate steps to reduce market concentration in equity markets. On the supply side, participation of smaller firms should be encouraged to make the market less concentrated. One way is to reduce entry costs for small firms. To bolster demand for shares issued by small firms, tax incentives can be given to investors for investment in small- or mid-cap firms.

· Restore confidence of market participants in the commodities market. This can be done by minimizing ad hoc government interference and strengthening measures to detect market abuse.

· Improve liquidity in the commodities derivatives market. Remove restrictions on the participation of banks, mutual funds, institutional investors and foreign investors in the commodities derivatives market.

· Introduce more hedging instruments for commodities. Trading in commodities is inherently risky, partly because commodity prices are determined internationally and also because they are influenced by both domestic and global factors.

· Increase participation of farmers in trading of agricultural commodities. Farmers’ participation in these markets is limited, since the current procedures and guidelines are excessively complex. Having a demat or a trading account is a prerequisite to participate in the market. In addition to reducing procedural complexities, farmers should be given formal training on how to manage futures trading, perhaps by appointing special agents who can assist them in trading.

· Develop the interest rate futures (IRF) market. A major reason for low liquidity in this market is the limited retail participation in the government bond market, which dampens demand for IRFs to hedge interest rate exposure. To increase participation in the IRF market, participation in the underlying G-Sec market should be made more diverse. Further, IRFs should be introduced on money market instruments that more closely track monetary policy changes.

· Relax rules for foreign investment in exchange-traded IRFs. Requirements that the gross short position in IRFs be less than the gross long position in G-Secs and IRFs may curtail foreign investment. Guidelines for investing in IRFs should be relaxed for foreign portfolio investors to make this market more liquid.

· Increase participation of firms in the currency derivatives market by increasing open position limits. While some degree of speculation may be required for the smooth functioning of the currency derivatives market, there should not be a huge disconnect between currency derivatives and the underlying market (foreign trade). Participation by firms to hedge currency risk can be encouraged by increasing open position limits for clients, which are lower than position limits for proprietary traders and stock brokers.

Financial inclusion

· Complementing financial inclusion reforms with measures to improve financial literacy.

· Shift away from saving in gold. The majority of households invest their savings in gold, diverting a large pool of savings from the formal banking system. Incentives should be given to people to deposit their savings in bank accounts by offering attractive savings options. The government introduced sovereign gold bonds in 2015 but the market for these bonds has been thin. Making them available for sale on-tap (continuously, rather than in intermittent tranches) and reducing the lock-in period could boost demand.

· Making the business correspondents (BCs) more reliable. The BC model introduced by the RBI is a good approach to provide banking services in rural areas. The model needs to be made more reliable to restore trust of local communities in this programme. Agents should go through proper screening and be certified by the associated banks so that data security is not compromised. Grievance settlement centres should be made accessible to people in rural areas where cases of misappropriation of funds by BCs can be reported. A database on BCs would help to evaluate the effectiveness of this programme and assess the changes required.

· Use of technology. In 2015, according to World Bank data, 79 of every 100 persons in India had mobile cellular subscriptions. This implies that mobile banking can be used to a greater extent to provide banking services in the unbanked/underbanked areas, especially in remote areas where Internet connectivity is poor.

Regulation and supervision

· Integration of financial markets. Integration of trading will generate economies of scope and reduce trading costs, as participants will not need to maintain separate margins for separate trades. For instance, commodity exporters prone to price risk and currency risk now have to maintain two separate margins – one at the commodity exchange and the other at the securities exchange, which is inefficient and increases the cost of participating in the market.

· Reforms on resolution of financial firms. India does not have a well-defined resolution mechanism for failing financial firms. The draft bill on the resolution of financial firms should be pursued as a high priority to strengthen the legal landscape in India.

· Effective implementation of the Insolvency and Bankruptcy Code: The Insolvency and Bankruptcy Code (2016) is a welcome step in strengthening the legal infrastructure – but, as highlighted in Raghuram Rajan’s note on banking reforms in this volume, effective implementation is crucial. Also, this cannot serve as a panacea for a broad range of corporate and banking sector deficiencies.

The Solutions

1. The government should expand, through deregulation, the market for corporate bonds. Long-term investors like pension funds and insurance companies should be encouraged to participate; the limits on foreign investors should also be relaxed.

2. Create a clear pathway to reducing the requirements for banks to hold government securities. Open up the government debt market to more foreign investors, as well as to individuals – who should be offered secure, inflation-indexed bonds.

3. Financial literacy needs to be built up, especially among those accessing formal finance for the first time. Mobile-first and rural-focused models for banking need to be developed to encourage people to shift their savings away from gold.

4. Both the regulatory and legal systems need to be strengthened. The Insolvency and Bankruptcy Code needs to be effectively implemented, and equivalent bankruptcy proceedings for financial firms need to be worked out.

^*This note draws extensively on Isha Agarwal and Eswar Prasad, ‘A Vision and Action Plan for Financial Sector Development and Reforms in India’, 2018, Brookings Institution Report.

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