9th Five Year Plan (Vol-1)
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Macro-Economic dimensions and Policy framework
Growth and Investment Targets || Domestic Resources for the Plan || Sustainable Current Account Deficit and External Resources || Structure of Growth and the ICOR || Fiscal Balance, Inflation and the Monetary Stance || Issues in Aggregate Demand Management || Sectoral and Investment Pattern || Strategy for agricultural Development || Infrastructure and Basic Industries || The External Sector and International Dimensions || Issues in Finance Intermediation

Issues in Financial Intermediation

2.199 The Ninth Plan, is based on the assumption that all available savings or investible resources in an economy are utilised in creating productive capacity through investment. This may not necessarily always be the case. The extent of transformation of desired savings into investment is largely determined by the process of financial intermediation and the ability of the financial sector to not only mobilise resources but also to channelise them in a manner desired by the investors. This function becomes increasingly more important and demanding as an economy grows in complexity. In addition, the efficiency of the financial intermediation process can also affect the desired level of savings in the economy by altering the expected returns to savings.

2.200 The financial sector in India has developed quite substantially in both size and sophistication during the past three decades. The nationalisation of the commercial banks in 1969 led to a rapid growth and spread of banking services all over the country. The sharp increase in financial savings by households, during the 1970s can be largely traced to the spread of banking in the economy. A further fillip was given by the emergence of the non-bank financial companies (NBFCs) in hire purchase and leasing finance and the boom in the stock markets in the early 1990s arising out of the liberalisation of the financial sector. Despite these favourable developments, it is becoming increasingly apparent that the financial sector in India needs to develop further and faster if the growth rate of the economy of 6.5 per cent per annum and more is to be attained during the Ninth Plan and sustained thereafter.

2.201 Recognition of the critical nature of the financial sector prompted the Government to set up a Committee on the Financial System (Narasimham Committee) in 1991 to examine all aspects relating to the structure, organisation, functions and procedures of the financial system. The deliberations of the Committee were guided by the demands that would be placed on the financial system by the economic reforms taking place in the real sectors of the economy and by the need to introduce greater competition through autonomy and private sector participation in the financial sector. Despite the fact that the bulk of the banks were and are likely to remain in the public sector, and therefore with virtually zero risk of failure, the health and financial credibility of the banking sector was an issue of paramount importance to the Committee.

2.202 Most of the measures suggested by the Narasimham Committee have been accepted by the Government and implemented to a substantial extent. The recommendations regarding reduction in the statutory liquidity ratio (SLR) and the cash reserve ratio (CRR) have more or less been effected with the SLR having been reduced to the recommended level of 25 per cent and the CRR to 10 per cent. In so far as the prudential norms are concerned, banks have moved towards greater transparency through adoption of recommended income recognition and asset classification norms. The balance-sheets of banks have also been made more transparent and provide greater disclosures to reflect the new accounting procedures. Most banks have also achieved a capital adequacy ratio (CAR) of 8 per cent in relation to their risk-weighted assets in conformity with the standards set by the Bank for International Settlements (BIS). To a large part this has been achieved by considerable injection of recapitalisation funds by the Government, particularly to the weaker public sector banks. The stronger nationalised banks have been permitted to access the capital market for raising equity funds in order to maintain the desired level of CAR at higher levels of operation. This has also initiated the process of private participation in the public sector banks. In addition, entry of private banks is being permitted with stringent entry conditions and strict adherence to prudential norms. At present ten new private banks have become operational. In line with the recommendations, a Board for Financial Supervision (BFS), assisted by a Department of Supervision in the RBI, which is authorised to exercise the powers of on-site inspection and off-site supervision of banks, financial institutions and non-bank financial companies has been functional for the banking sector since November 1994, which has also started supervising the operation of other financial institutions. However, the duality of control over banks by both the RBI and the Ministry of Finance continues to obtain.

2.203 Despite these significant steps at financial sector reform, certain areas of concern remain. The main area of concern relates to the ability of the financial sector in its present structure to make available investible resources to the potential investors in the forms and tenors that will required by them in the coming years. In a very stylized sense, the requirement of investment funds for productive investment can be divided into three broad categories - equity, long-term debt, and medium- and short-term debt. The proportion in which different forms of funds are required depends on the nature of the activity and the sector in which the investment is proposed to be made and on the perceptions regarding the future developments in the financial sector. Although there is some flexibility in these proportions, by and large not too much variation in either the debt:equity ratio or the term structure of debt appropriate for the particular industry is either possible or desirable from the point of view of both the lenders and the borrower. Thus the desired sectoral and institutional investment pattern in the country gives rise to a particular structure in which investible funds would need to be made available. If the financial sector is unable to provide the funds in the three broad categories in more or less the same proportion as required by the demand, the possibility is that there could simultaneously exist excess demand and excess supply in different segments of the financial market. In such a situation, the segment facing the highest level of excess demand would prove to be the binding constraint to investment activity and effectively determine the actual level of investment in the economy. It is therefore entirely possible that the level of aggregate investment could fall short of the aggregate supply of investible resources not because of a lack of investment demand, but because of a mismatch between the structures of the demand for and the supply of investment funds arising from an inadequately developed financial sector.

2.204 In an efficient and integrated financial market, much of these problems is resolved through movement of funds between various types of financial institutions and instruments, and also by portfolio reallocation by the savers, in response to differential movements in the returns to the alternative financial instruments. Frequently, new instruments are also developed to meet specific investment needs. Even in such relatively efficient markets, aberrations can arise due to the fact that the rates of return in financial markets, unlike prices in goods markets, have to be qualified by risk factors, and are therefore susceptible to problems arising out of asymmetric information and speculative behaviour. Issues of "adverse selection" and "moral hazard", characteristic of imperfect information and incomplete markets, are present even in the most developed and sophisticated financial systems. The Indian financial sector, however, has yet to attain this degree of integration and maturity, and can be characterised as a fragmented market. By and large, there is very little movement of funds between the various segments of the Indian financial sector in response to the discrepancies in the demand and supply positions. To make matters worse, most segments of the Indian financial sector are specialised in providing only a limited component of the investment portfolio and are either restricted from or technically incapable of addressing the demand for other components. As a result, both the quantum and pattern of investment in the economy are determined primarily by the portfolio decisions of the savers, and it would be entirely fortuitous if the savings portfolio more or less matches the desired structure of investment.

2.205 Earlier, the potential mis-match between the patterns of demand for investible funds and the supply was not of much consequence since there was a situation of pervasive excess demand in all segments of the market, arising primarily out of the high level of preemption of financial savings by the government and a substantial proportion of directed lending. With the considerable expansion and liberalisation of the financial markets in recent years, both through higher rates of savings and external capital flows and through reduction in the preemptive and directive role of the government, the problems arising out of the non-integration of the financial sector are likely to become increasingly more acute. Unless efforts are made to identify the emerging structure of investment demand, particularly from the private sector, and to reorient the functioning of the financial sector accordingly, not only may there be a problem in attracting investment in those areas which are of national importance, but also the possibility exists of inadequate utilisation of investible resources leading to a slower rate of growth than would be potentially justified by exante savings. In addition, an excess supply of funds in one segment of the financial sector carries the danger that such funds may be used for speculative purposes in foreign exchange, real estate or commodities, which create their own problems in economic management.

2.206 As has been repeatedly emphasised, private participation in economic infrastructure sectors and basic industries will need to be increased significantly in the coming years. These activities tend to be characterised by heavy investments, long gestation lags and long pay-back periods, which require the commitment of long term funds, both as equity and long term debt. In the past, since these sectors were predominantly catered to by public investment, the need to develop appropriate financing mechanisms was not felt. As a result, the Indian financial sector is heavily biased towards short and medium term debt, whether it be the commercial banking sector or the development finance institutions (DFIs). Unless the availability of equity and long term debt to the private sector is increased substantially in the coming years, the likelihood of adequate private investment in these sectors appears to be remote.

2.207 The most fundamental basis for all investment activity is equity, and its likely availability needs to be considered with some care. Although India has a fairly well developed secondary market in shares, the primary issues market has historically been fairly small and sluggish, except for a short period of intense activity during the early and mid 1990’s. One of the reasons for the slow growth in the primary market has been the tendency for the major corporates to rely more on internal accruals for providing equity funds than to dilute share holdings through public issues. There is no reason to believe that this pattern will change in the near future. Even foreign companies in India tend to hold their shares quite closely and therefore do not contribute in any meaningful manner to the development of the equity market. Rapid growth in the infrastructural sectors will therefore require that relatively new firms enter the market by raising sizeable equity from the public, unless the existing corporate sector becomes considerably more aggressive in its expansion plans. In the alternative, excessive reliance may have to be placed on attracting foreign equity inflows to bridge this shortage.

2.208 Unfortunately, the recent experiences in the share market, particularly in primary issues, has led to a withdrawal of the small investors from participation in these markets. While the negative developments like the stock market scam may have only short run effects, there are basic deficiencies which may have a longer run effect unless corrected. With the deregulation of the share market through the closure of the Controller of Capital Issues (CCI) and the establishment of the Securities and Exchanges Board of India (SEBI), and greater freedom being given to promoters for determining the premium on equity issues, there has been a tendency for pricing shares on an excessively optimistic basis. This was permitted by a booming secondary market and a basic lack of information, knowledge and analytical skills among the small investors. Theoretically, share premia should be determined on the basis of the expected future stream of returns and the likely capital gains that arise from secondary trading. These are dependent not merely on the performance of the company and the overall level of activity and liquidity in the secondary market respectively, but primarily by the extent to which the specific share is traded, whereby the underlying fundamentals get reflected in the market price of the share. In the absence of adequate secondary trading, the quoted share price is of little significance since it is determined by marginal transactions, often only by insiders, and genuine investors may find it virtually impossible to buy or sell the share in the market at rational prices. The use of a general share price index is therefore not a proper basis for determining the likely premium that a specific new issue should command. This is particularly true when the most readily available share price indices are composed of the most heavily traded shares and are not necessarily reflective of the state of the segment to which the new issue belongs. Uncritical acceptance of such a basis for pricing of new issues by relatively ill-informed investors can lead to the phenomenon of pervasive over-pricing. The result of having excessively high share premia on the basis of the movement of general share price indices has been a considerable loss of confidence among the small investors, who have lost fairly substantially in the recent past on account of insufficient secondary market transactions in most scrips and the consequent lack of liquidity in the over-priced shares. Frequently such shares have also traded well below their issue prices, which has not been reflected in the indices, and thereby permitted the aberration to continue for extended periods.

2.209 There is no case for reintroducing the office of the Controller of Capital Issues. However, institutional improvements in the market are needed to ensure that excessive over-pricing of primary issues does not occur on a regular basis. The SEBI has clearly and correctly indicated that it would not perform the function of determining the issue price of shares and that this should be determined by more market based arrangements. The principal tasks to be performed by SEBI are to ensure investor protection through transparency in the capital markets and full disclosure by the promoters and to prevent market manipulation. While transparency and disclosure are undoubtedly essential, they only provide the information base which, combined with strong analytical skills, enable a proper determination of the issue price. The appropriate institutions for this purpose would be the merchant bankers and the issue managers, who are not only responsible for advising the clients but also for ensuring that the issue is picked up by the market or that the underwriting functions are carried out smoothly. Unfortunately the track record on this account is not particularly good. In order to bring greater discipline into the primary issues market it is suggested that the conditions for recognition of lead merchant bankers and their supervision be made more stringent. This role would have to be carried out by SEBI and appropriate institutional arrangements would have to made for expeditious and rigorous implementation of enhanced penal provisions. The other source of discipline in issue pricing could be the major financial institutions which would act as the intermediary for the small investors. In the Indian case, however, neither the banking system nor the development financial institutions are involved in any significant manner in the primary issues market. A number of mutual funds were set up in the earlier 1990’s in order to play this intermediary role. These too could not effectively perform the disciplining function and most of them withdrew from the primary market and started focussing excessively on the secondary market and in debt instruments. With the decline in the stock market, most of the mutual funds have suffered serious erosion in their net asset values (NAVs). The involvement of mutual funds in the primary issues market, however, is essential for the healthy growth of industry and revival of investor confidence. Earlier efforts at encouraging mutual funds were centered around tax concessions. While these are useful, they are not a substitute for demonstrated expertise in investment appraisal and asset management; and tax incentives should be granted, if at all, only primarily to encourage greater focus on primary markets.

2.210 In order to revive confidence in the equity market a number of steps need to be taken. First, the tendency to list new issues on the major stock markets needs to be checked. Shares should be quoted on the major stock exchanges only after they have established adequate track records in terms of trading behaviour. The existing classification system of grading shares adopted by most major bourses may not be adequate for this purpose, unless distinct indices are developed and publicised for each category, and every new issue is placed in a specific category by the concerned exchange and ratified by SEBI. Another methodology would be to have a distinct exchange for new issues with well-defined graduation criteria for listing in the major exchanges. The Over the Counter Exchange of India (OTCEI) was established essentially for this purpose, but has remained more or less non-functional due to the lack of adequate market-making efforts. This institution needs to be revived and energised, and all new issues should be listed first with the OTCEI and should be allowed to graduate to the major exchanges only on the establishment of a minimum track record. This would have the advantage of bringing a certain amount of discipline in the matter of setting issue prices. In order to energise the primary market and the operation of the OTCEI it is suggested that market-making efforts be broadened by encouraging further participation of the major financial institutions, including banks. Furthermore, in order to increase the level of liquidity, foreign portfolio investments should be permitted freely in these two segments over and above the limits placed on their activity in other markets and instruments. In addition, the restrictions on forward trading activities such as "badla" and other derivatives should be less stringent in the OTCEI than in the major exchanges. Another method to bring rationality into issue pricing would be to introduce "Issue Houses", which would have to take responsibility for providing equity funds even before the shares are sold to the public.

2.211 In so far as long term debt is concerned, at present the Government monopolises practically all sources of long term funds, such as insurance, pension and provident funds. Earlier there was a certain logic to this in the sense that since the Government was practically the only investor in capital intensive long gestation projects, its needs for such funds was of overriding importance. With the desired shift in investment responsibilities, it has become necessary for the Government to vacate some of this space for the private sector. In addition, there is need to create conditions whereby savers are attracted towards investing in long term debt instruments, which are practically non-existent today.

2.212 The insurance sector has been an important source of low cost long term funds all over the world. This is permitted by the fact that most insurance companies operate in only two major areas - risk cover and annuities - which do not require payment of interest or repayment of the principal respectively. In the Indian context, however, the insurance companies, particularly in life insurance, also tend to act as investment funds in the sense that they not only provide risk cover but are also committed to repayment of the principal with interest, although with long maturities. One of the reasons that this has happened is that the average premium charged by the insurance companies in India tend to be relatively high due to obsolete and rigid actuarial practices and inefficient operations. There is a pressing need to reorient the insurance sector in India in a manner that it fulfills its principal mandate of providing risk cover. It is unlikely that this sector would attain the requisite degree of efficiency and professionalism unless it is exposed to a certain degree of competition. A comprehensive package consisting of restructuring of the existing institutions and introduction of domestic private sector participation will need to be implemented. A blue-print for such a restructuring already exists, and the necessary legislation to bring about some of these changes has been introduced in Parliament.

2.213 The other principal source of long term funds internationally has been the various forms of contractual savings such as pension and provident funds. In India, although the quantum of resources available in such funds is quite considerable, they have not played their legitimate role in providing finances for growth and development in an adequate manner. The attitude towards such funds in India has been excessively focussed on safety and security rather than on returns. As things stand today, the responsibility of the management of such funds is either that of the Government or of the employer. This, coupled with the regulatory framework, has led to a situation where such funds have been deployed only in Government securities or in "trustee bonds", which are generally also public debt instruments. As a result, the returns to the employees, who are the legitimate owners of these funds, is determined primarily by the interest on Government debt. In a situation where efforts are sought to be made in lowering the interest on public debt, such restrictions would reduce the returns to these funds. However, efforts at widening the portfolio of these funds are unlikely to be successful unless the pattern of management and responsibility is changed significantly. In the present situation, where either the Government or the employers, in the form of trustees, are responsible for the deployment of these funds, risk averse behaviour is only to expected, and merely enabling a more diversified portfolio may not be of much significance. It is suggested therefore that in the case of organised labour, which are the groups presently covered under such schemes, the responsibility for management of provident and pension funds should be vested in associations of employees and workers, such as the recognised trade unions or any other institutional arrangement that may be deemed appropriate. Since a direct nexus would thereby be drawn between the management of these funds and the beneficiaries, the likelihood of taking greater risks for higher returns would be increased. Typically such arrangements also involve professional asset management companies which provide the expertise for obtaining the best returns for their clients. Such arrangements also need to be encouraged. The Government’s efforts in this direction should be redirected to providing the prudential guidelines and supervisory functions, on one hand, and to widen the coverage of contractual savings by bringing unorganised labour also within the ambit of such schemes, on the other.

2.214 As far as the creation of a debt market is concerned, particularly for long term debt, much more concerted efforts need to be made. At present, in the absence of such a market, practically all debt instruments are held to maturity, and this illiquidity reduces the attractiveness of debt instruments, particularly those of longer maturity. The National Stock Exchange (NSE) was originally set up as a market for debt, but has over time become essentially a market in equity and has thereby not fulfilled its principal charter. The main reasons for this appear to be the fact that public debt instruments, which set the benchmark or the reference rate, are issued in denominations which are much too large for the average investor, and that there has been an inadequacy of market-making activities. The present structure of stamp duties too have had a dampening effect on generating sufficient debt market activity. The efforts at creating a debt market need to be revived with full vigour. As a starting point, the National Stock Exchange should be encouraged to increase its involvement in debt instruments, for which the Government would have to issue public securities of appropriately low denominations. This would no doubt increase both the cost and the uncertainty faced by the Government in terms of its debt raising efforts, but it would be a small price to pay in order to generate a healthy debt market in the country in which not only financial institutions but also other companies and even individuals can participate. More importantly, once the interest rate on public debt instruments becomes the reference rate, it would considerably enhance the effectiveness of monetary policies in the country, and the dependence on the CRR as an instrument of monetary control can be reduced.

2.215 Until the secondary debt market becomes sufficiently active so as to be able to absorb debt instruments of various maturities, there is a case for the Central government to move its debt portfolio towards the shorter end of the maturity spectrum which would increase the liquidity in the debt market. This would be consistent with the recommendation for the Centre to vacate more space in SLR placements in favour of States and PSEs. A major source of illiquidity in the debt market is the cost of funds to the primary dealers which are too high to make investment in government securities remunerative. This problem would need to be tackled if treasury bills are to be used as the main instrument for creating and energising the secondary debt market. Since there is an integral relationship between the emergence of the treasury bill rate as a credible instrument of monetary policy and the reduction in the CRR, it is suggested that the banks should be permitted to utilise a part of the CRR funds for investment in the secondary T-bill market once the institutional arrangements have been established instead of depositing these with the RBI. Over time these funds can be gradually released for more diversified investment, thereby achieving the target CRR level in a phased manner. The Government can also utilise the debt of PSEs held by it both to activate the debt market and to provide investible funds for public investment. In order to do so, the Government would have to securitise its loans to PSEs, which could then be floated in the market. The advantage of such instruments is that they not only would be relatively risk-free, since they are implicitly guaranteed by the Government, but would also carry interest rates which would be sufficiently high so as to make trading feasible for the market-makers.

2.216 The second area of concern relates to the relatively high rates of interest that prevail in the country. Interest rates are no doubt related to the rate of inflation in a trend sense, but this relationship is primarily with respect to the rates received by the savers. With a decrease in inflationary expectations in the economy, the nominal deposit rates should be amenable to reduction without materially affecting the expected real returns to savers. There are two dimensions to this. First, the actual rate of inflation would need to be brought down to its target level and maintained at that level for a sufficient period of time for inflationary expectations to be adjusted downwards. Second, the Government would have to clearly signal its anti-inflationary stance in a credible manner. The conduct of monetary policy is one method of doing so, but it may not be generally discernible to the average saver. On the other hand, the rates of interest offered by the Government on its borrowings also offer an indication of the Government’s inflation expectations, and should be consistent with the target inflation rate. A starting point could be the interest rates offered on the various small-saver schemes operated by the Government. Since these schemes are in direct competition with the deposit raising activities of banks and other financial institutions, a general reduction in deposit rates cannot be achieved without a lowering of the interest rates applicable to these schemes. The interest rates paid by the borrowers, however, though based on the deposit rates, are also determined by the level of efficiency of the financial system. The spread between the deposit and lending rates in India are much too high by international standards and reflect both the constraints faced by and the relatively low level of efficiency in the financial intermediation system. Long-run competitiveness of the economy cannot be ensured unless these spreads are brought down to at or near international levels. Although in recent years there has been considerable liberalisaion of the banking sector along with a tightening of prudential norms and practices, which have led to an improvement in the health of the banking sector, there are some areas of concern which need to be examined.

2.217 The Narasimham Committee had recommended deregulation of the administered interest rate structure on attainment of a reasonable degree of macro-economic balance through a reduction in the fiscal deficit in order to control increases in the nominal interest rates. However, there has been considerable deregulation of interest rates such that almost all lending rates and deposit rates over one year maturity are now determined by individual banks on the basis of their asset-liability mix. Deposit rates for one year maturity have been linked to the "bank rate", which is the rate charged by the RBI on its general refinance facility. The Narasimham Committee had envisaged the bank rate to be an anchor to be used by RBI to signal changes in the direction of the level of interest rates. However, the bank rate in its present form can acquire significance only in a situation of tight liquidity during which recourse to refinancing would be taken by banks. Even in such cases, the over-all limit on general refinance appears to be too low for the bank rate to act as a meaningful reference rate. Consideration needs to be given to making the bank rate an effective instrument of control of interest rates during periods of liquidity stringency by enhancing the refinance limit substantially. This would have implications regarding the pace of reduction in the CRR and the conduct of open market operations by the RBI since there would be an additional source of bank liquidity which would need to be taken into account while determining the desirable rate of growth of credit.

2.218 One aspect of the banking industry which has received a great deal of attention lately has been the high level of nonperforming assets (NPAs). It is undoubtedly true that high NPAs raise the cost of bank operations and thereby the spread, and efforts need to be made to bring these down. However, a balance has to be drawn between the reduction in NPAs, on one hand, and ensuring adequate supply of credit to the economy, on the other. Excessive pressure on banks to reduce NPAs is likely to lead to a high degree of selectivity in the credit disbursal process. As a result, it may well be possible that the total level of credit issued by the banking system may fall short of the levels dictated by the growth in deposits. While this would no doubt reduce the level of NPAs, it would also have the effect of raising the average cost of credit actually disbursed. As a result the spreads would be affected by two contradictory influences and, in the short run, it is likely that the latter effect would dominate so that either the spreads would actually rise or the health of the banking sector would be adversely affected. An increase in spreads through an increase in the lending rates would be self-defeating for the banking sector in view of the fact that the prime borrowers also have access to international sources of funds and are likely to switch if domestic interest rates are raised in any significant manner, thereby raising the average level of risk exposure in the lending portfolios of banks. The likelihood therefore is that there would be downward pressure on the deposit rates which would, on one hand, tend to divert savings from the commercial banking sector to other more risky instruments and institutions and, on the other hand, may actually reduce the desired savings of individuals who do not have access to alternative forms of financial savings.

2.219 The approach to addressing this problem would need to be on two tracks. First, the rate of reduction of NPAs will have to be fairly gradual keeping in mind the normal lending risks associated with the Indian economy and the speed at which debt recovery and settlement processes operate in the country. Second, the factors other than NPAs which affect the level of spread required for the viability of banks would need to be considered in the context of national priorities and policy objectives. In so far as the first is concerned, the risk profile of investors tend to change only slowly over time and this has to be consciously taken into account before mandating minimum NPA levels for the banks. The main action to be taken in this regard is on strengthening and professionalising the internal control and review procedures of banks and other financial institutions with a view to ensuring autonomy with accountability. The efforts made towards establishing Debt Recovery Tribunals have achieved some effect in speeding up debt recovery proceedings. However, the process of judicial review and implementation of debt recovery decisions need to be given further impetus, and the role of the States is critical in this regard.

2.220 There are a number of considerations which enter into determining the effects of policy on banking spreads. First, the level of the cash reserve ratio (CRR) that is to be maintained by the Indian banks are considerably higher than the international levels which are specified for prudential reasons. Although in recent years there has been significant reduction in the CRR from 15 per cent to 10 per cent and also the interest paid on CRR deposits with the RBI has been raised from 3.5 to 4.5 per cent, there is a view that the CRR should be reduced even further, preferably to 3 per cent. While such a target for the CRR is eventually desirable for the health of the banking sector and a reduction in the spreads, it needs to be seen in the context of the immediate policy imperatives. A decrease in the CRR enables the banking system to generate a higher level of credit from the same deposit base, which implies an increase in the money multiplier. Thus, in view of a given inflation target a decrease in the CRR would require a corresponding decrease in the rate of growth of base money, which would reduce significantly the extent of seignorage available to the Government. In view the relatively high level of fiscal deficits that are likely to obtain during the Ninth Plan period, it does not appear desirable to reduce the potential seignorage excessively. Sharper decreases in the CRR can be brought about once the fiscal deficit of the Government has been brought to about 3.5 per cent of GDP and the revenue account comes into surplus. Secondly, with the greater importance of monetary policy in macro economic management, the CRR will continue to be an important instrument until such time as the interest rate on treasury bills and the bank rate become credible instruments of monetary control. This is unlikely to happen until an active market in treasury bills is created and the treasury bill rate becomes a commonly accepted reference rate for the structure of interest rates in the country.

2.221 The second point of policy intervention by the Government in the operation of the banking system has been the statutory liquidity ratio (SLR) through which banks are compelled to hold Government and public sector securities. The negative effects of the SLR have been mitigated to a considerable extent in recent years both by a reduction in the SLR from 38.5 per cent of the total net demand and time liabilities (NDTL) of banks to 25 per cent, and by having market determined rates of interest on public debt instead of rates prescribed by Government. However, in the absence of an active debt market in Government securities, the SLR is characterised both by a certain degree of illiquidity with the banks and an interest rate on public debt which is not determined in a truly competitive market. These factors will become increasingly more important during periods of relatively tight liquidity. On the whole, however, the SLR is desirable both as a prudential measure and in view of the need to generate debt resources for the Government. The latter rationale will be obviated once a proper debt market comes into existence and the creditworthiness of the public sector, particularly States and PSEs, improves adequately. In order to reorient the SLR system to the needs of the Ninth Plan, it is desirable that the SLR concept also be extended to non-bank financial institutions so that the holdings of public debt are diversified. This would also contribute towards achieving a more uniform regulatory framework for the financial system as a whole. In addition, it would be desirable for the Centre to gradually vacate the space for long term debt and make these available to the States and public sector enterprises which have the most pressing needs for long term funds.

2.222 The third area which needs examination is the directed lending for priority sectors. There is a point of view which holds that priority sector lendings have been made to the detriment of the health of the banking sector in India, and that it should be abolished at the soonest possible. Even the Narasimham Committee had recommended that priority sector lending should be reduced to 10 per cent of total bank credit instead of the present 40 per cent, which should be restricted to a very limited category of borrowers, and the entire directed credit system should be reviewed after three years with a view to phasing it out altogether. However, the role that priority sector lending has played in making credit available to sectors which are of national importance in terms of their effects on employment and poverty alleviation, such as agriculture and small scale industries, and which have strong externalities cannot be gainsaid. The Indian economy is still not in a position in which the sectors which have access to organised sector credit will be able to take care of these objectives. Moreover, priority sector lending needs to be seen in the context of the implicit credit rationing system that needs to be followed in a relatively capital scarce economy. Since pure price rationing in the sense of using the interest rate as a single allocation device is neither feasible nor desirable in the presence of incomplete information and adverse selection possibilities, and since a comprehensive portfolio balancing approach is administratively difficult in a widely dispersed banking network, there is a high probability that smaller borrowers would be systematically discriminated against in terms of credit allocation. This would be contrary to the interests of both the nation and even the banking sector itself. Priority sector lending therefore would have to continue, but with certain changes in order to diffuse the risk which is carried presently only by the banking system. First, priority sector lending also should be extended to the non-bank financial institutions in such a manner that the total volume of credit remains more or less the same and thereby reduces the burden on the banks. Second, the institutional mechanism for making available credit to the priority sectors needs to be revised. Since most new and foreign banks and practically all non-bank financial institutions do not have the capacity to either appraise or effectively supervise lendings in the priority sectors, specialised institutions may have to be developed not only on a sectoral basis but perhaps also on a regional basis. In this context institutions such as NABARD, SIDBI, local area banks (LABs), regional rural banks (RRBs) and cooperative financial institutions need to be strengthened and professionalised, and the linkages between themselves and with the commercial banking sector established on a firmer and more formal footing. It should be ensured that with greater autonomy and private participation in public sector banks, the institutional structure of branch networks, which are critical for effective implementation of priority sector lending, is not diluted. In the case of banks without such wide-spread infrastructure and non-bank financial institutions, the funds may have to be routed through the specialised institutions. In such cases care would have to be taken that the rate of interest paid by the specialised institutions is no higher than the risk weighted interest received by the public sector banks on their direct loans to the priority sectors. Finally, the recent tendency for inclusion of various activities under priority sector needs to be curbed since it tends to diffuse the focus from those sectors which have high externalities and which need to be supported in a distinct and focussed manner. Therefore, not all infrastructure should be categorised as priority sector, but only those which have high social returns and long pay-back periods.

2.223 An important area of priority sector lending involves credit to the social sectors and activities which may not be "bankable" in the usual sense of the term, but which have very high social returns. Micro-credit is well established as an area of focus not only in India but in a number of other countries as well and a number of experiments have been successfully tried. It has been found that the loan servicing experience with microcredit can be as good or even better than credit to formal sectors if it is implemented through appropriate mechanisms such as group-lending. These efforts should be pursued much more vigorously.

2.224 In addition to the above policy influences on the performance of the banking sector, the vulnerability of financial institutions, particularly banks, has increased on account of the much larger range of activities that they need to undertake and for which they may not be adequately prepared. Especially in the nationalised banking sector, each bank is presently undertaking the full range of banking and other services for which they may not be fully competent. Some of the areas where such short comings are becoming increasingly apparent are project appraisal skills, particularly for non-industrial activities, treasury and portfolio management skills, merchant banking skills and skills in operating in the foreign exchange and derivatives markets. There is need to upgrade the level of such skills in all segments of the financial sector, and most particularly in the nationalised banks. While formal training in these areas is necessary, it is not sufficient. In order to develop most of these skills there has to be a considerable amount of learning by doing experience, which can be acquired only gradually. In the private financial sector some of these problems have been addressed by hiring professionals with the requisite skills and qualifications. In the nationalised sector however, there are policy and other barriers to taking recourse to such solutions. This would put the nationalised banks at a disadvantage and, given the dominance of this sector in the Indian economy, harm the interest of their customers.

2.225 The dangers arising from an undifferentiated nationalised banking sector have been recognised by the Narasimham Committee, which has suggested that there should be multi-tier banking system in which a very limited number of banks should be international in character offering the full range of services, a somewhat larger set of national banks, local banks confined to specific regions, and rural banks for agricultural financing. It is not clear, however, the manner in which this structure would contribute to the strength and viability of the banking sector. With the growing role of fee-based activities in bank profitability, a structure which restricts specific segments to only traditional banking functions may in the longer run lead to greater incidence of non-viability as the spreads come under pressure from the stronger banks. While it is certainly true that skill requirements are considerably more demanding in feebased activities, which would restrict the number of banks that can operate effectively in them, it may not be prudent to restrict the operational domain of the rest. One possible solution is to merge some of the banks in order to get a more viable set of larger and stronger entities. This would have to be done carefully with a thorough assessment of the complementarities and synergies that can be obtained. Mere consolidation of banks on financial considerations would not serve the purpose. Another possible solution would be to recognise the complementarity that exists between the branch network and deposit-taking function of commercial banks and the skill availability with the development finance institutions (DFIs). It is suggested therefore that the lower tiers of the banking sector be organised around the four major DFIs either on a geographical basis or on the basis of areas of operation. This would not only strengthen the capabilities of the banks, but would also contribute to the greater integration of the financial sector, which has been recognised as a fundamental weakness of the Indian system.

2.226 One characteristic feature of the organised financial sector in India which is a cause of considerable concern is the lack of free flow of information within the financial system regarding the creditworthiness of borrowers and solvency of institutions. The high level of existing NPAs can in some measure be traced to this lacuna. Unless information sharing and early warning systems are instituted, the dangers to the financial system will get multiplied as the level of complexity of financial transactions in the economy increases. The institutionalisation of such an information system should be of the highest priority and may require legislative action to make it credible.

2.227 Finally, the liberalisation of the Indian economy particularly with respect to foreign investment and external flow of funds is exposing the Indian financial sector to issues that have not been of great significance earlier. In particular, the Indian markets have extremely slow operational and reaction speeds in comparison the international market. Unless the speed of transaction in the Indian system is increased significantly it would expose the Indian financial institutions to vulnerabilities arising out of arbitrage and speculative behaviour. The introduction of modern banking and money management systems has to be of the highest priority before further liberalisation of international financial flows can be contemplated. There is as yet both inadequate appreciation of this need and considerable resistance to introduction of automation. This mind set will need to be changed if the Indian financial sector is to fully perform the functions that are required from it. The move towards capital account convertibility has to be predicated on the Indian financial system attaining international levels of expertise and speeds of operation if the dangers from speculative and arbitraging activities are to be mitigated.

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