1. A Project Report on
“RefoRms in indian financial system”
TOWARDS FULFILLMENT OF THE PROJECT REQUIREMENTS OF
POST GRADUATE DIPLOMA OF MANAGEMENT STUDIES
SUBMITTED BY:
RAHUL JAIN
ROLL NO: 38
PGDM-EBIZ-1
BATCH-2011-13
UNDER THE GUIDANCE OF
Dr. ANIL RAO PAILA
DEAN, WELINGKAR INSTITUTE OF MANAGEMENT
And
Dr. MADHAVI LOKHANDE
Core Faculty, WELINGKAR INSTITUTE OF MANAGEMENT
WELINGKAR INSTITUTE OF MANAGEMENT DEVELOPMENT AND RESEARCH,
ELECTRONIC CITY, BANGALORE

2. STUDENT DECLARATION
I, Mr. Rahul Jain, studying in the First Year of Master of
Management Studies at Welingkar Institute of Management Studies,
Electronic City, Bangalore, hereby declare that I have completed the
project titled “Reforms in INDIAN FINANCIAL SYSTEM” as a part of
the course requirements for PGDM Programme.
I further declare that the information presented in this project is true
and original to the best of my knowledge.
Date:
Place: (Signature of the student)

3. CERTIFICATE FROM THE INTERNAL GUIDE
I, Prof. Anil Rao Paila hereby certify that Mr. Rahul Jain, a student
for the Master of Management Studies course at Welingkar Institute
of Management Studies, Electronic City, Bangalore, has competed a
project on “Reforms in INDIAN FINANCIAL SYSTEM” under my
guidance during this year.
His work and output has been found to be satisfactory.
Date:
Place: (Signature of the Guide)

4. Acknowledgement
This project was done in partial fulfilment of the requirements for
the Post Graduate Diploma of Management Studies. I would like to
thank and extend my warm regards to Mr. Vikas Jain, Vice President
(Factoring), HSBC Bank for his support and Dr. Anil Rao Paila, Dean,
Welingkar Institute of Management, Bangalore and also Dr. Madhavi
Lokhande, Core Faculty, Welingkar Institute of Management,
Bangalore for their guidance and support throughout the project. I
take this opportunity to thank all the people without whose help,
guidance and inputs it would not have been possible to make the
project report a success. Finally, I would like to thank all those who
were directly or indirectly related to my project.
The timely guidance of my mentors not only helped in making the
effort fruitful, but also transformed the whole process of learning
into an enjoyable and memorable experience. This project proved as
an excellent opportunity for me to apply the concepts learnt in the
course of my program at the institute. The three things which go on
to make a successful endeavour are dedication, hard work and
correct guidance.
I express heartfelt gratitude to Welingkar Institute Management for
giving me this opportunity which helped me in gaining knowledge
about Indian Financial Systems.
- Rahul Jain

5. EXECUTIVE SUMMARY
Financial sector reforms are at the centre stage of the economic liberalization that
was initiated in India in mid 1991. This is partly because the economic reform
process itself took place amidst two serious crisis involving the financial sector the
balance of payments crisis that threatened the international credibility of the
country and pushed it to the brink of default; and the grave threat of insolvency
confronting the banking system which had for years concealed its problems with
the help of defective accounting policies.
Moreover, many of the deeper rooted problems of the Indian economy in the early
nineties were also strongly related to the financial sector:
Large scale pre-emption of resources from the banking system by the
government to finance its fiscal deficit;
Excessive structural and micro regulation that inhibited financial innovation
and increased transaction costs;
Relatively inadequate level of prudential regulation in the financial sector;
Poorly developed debt and money markets; and
Outdated (often primitive) technological and institutional structures that
made the capital markets and the rest of the financial system highly
inefficient.
Over the last six years, much has been achieved in addressing many of these
problems, but a lot remains to be done.

6. Table of content
1) Acknowledgement
2) Objective
3) Executive summary
4) Introduction
5) Current Structure of Financial System
6) What changed in Recent Decades?
7) Need and Importance of Financial Sector
8) Banking and Credit Policy
9) Financial Innovations
10) Conclusion

7. 1. Introduction
Strengthening financial systems has been one of the central issues facing emerging
markets and developing economies. This is because sound financial systems serve
as an important channel for achieving economic growth through the mobilization of
financial savings, putting them to productive use and transforming various risks.
Many countries adopted a series of financial sector liberalization measures in the
late 1980s and early 1990s that included interest rate liberalization, entry
deregulations, reduction of reserve requirements and removal of credit allocation.
In many cases, the timing of financial sector liberalization coincided with that of
capital account liberalization. Domestic banks were given access to cheap loans
from abroad and allocated those resources to domestic production sectors
A financial system is a network of financial institutions, financial markets, financial
instruments and financial services to facilitate the transfer of funds. The system
consists of savers, intermediaries, instruments and the ultimate user of funds. The
level of economic growth largely depends upon and is facilitated by the state of
financial system prevailing in the economy. Efficient financial system and
sustainable economic growth are corollary. The financial system mobilises the
savings and channelizes them into the productive activity and thus influences the
pace of economic development. Economic growth is hampered for want of effective
financial system. Broadly speaking, financial system deals with three inter-related
and interdependent variables, i.e., money, credit and finance.

8. 2. Current Structure of the Financial System
2.1 Finance and the Economy
In recent years, the Indian economy has grown sharply and has enjoyed high rates
of savings and investment. This has inevitably involved a substantial role for
finance as the intermediary between households and firms (Shah, Thomas, and
Gorham, 2008). Table 1 compares components of GDP at current prices for 2008-
2009 against the picture as seen one decade ago. The nominal rupee-dollar
exchange rate exhibited a depreciation of roughly 9% over this period. Hence, the
bulk of the change across this decade can be interpreted as a change expressed in
nominal dollars.
Over this decade, India went from being a medium sized developing country (with
an aggregate GDP of $379 billion in 1998-99) to being a member of the G-20 (with
an aggregate GDP of $1.13 trillion in 2008-09), with a rough tripling of aggregate
GDP. Alongside this, the savings rate went up dramatically from 24.13% to 34.65%.
This combination gave a 4.64 times rise in gross domestic savings: the financial
system which used to handle a flow of $91 billion of savings in 1998-99 was
handling $390 billion of savings in 2008-09.

9. In addition, the private corporate sector, which is the focus of the formal financial
system, came to play a bigger role in investment. Gross capital formation by the
private corporate sector grew from 7.67% of GDP to 13.53% of GDP over this
decade. There was a rise of 5.71 times: private corporate investment went from $29
billion in 1998-99 to $153 billion in 2008-09.
Through this combination of high GDP growth, rise in household savings, and a
bigger role for private corporate investment, the financial system has come to play a
more prominent role in the economy, and has achieved a significant size by world
standards.
Through these changes, the materiality of financial reform has risen. With $390
billion of household savings being produced a year, and $153 billion of private
corporate investment taking place a year, modest improvements in the capability of
the financial system would help accelerate growth.
Table 2 shifts focus to the financing structure of large companies. For each of the
two years (1998-99 and 2008-09), the aggregate balance sheet of all large non-
financial firms in the CMIE database is computed and shown. The overall balance
sheet grew much faster than GDP, with a rise of 4.52 times over the decade.
A pronounced deleveraging is visible. Equity, which used to be 33.94% of the
balance sheet in 1998-99, made up for 39.22% of the balance sheet in 2008-09.

10. Alongside this, the corporate debt market faded into insignificance: it grew by only
1.58 times, and went from 5.69% of the balance sheet in 1998-99 to 2.06% of the
balance sheet in 2008-09.
The evidence in Table 2 pertains only to large companies. In addition, banks do
lend to smaller, unlisted companies. In order to assess the role of banks versus the
equity market, Figure 1 juxtaposes the market capitalisation of the CMIE Cospi
index against the aggregate non-food credit of all banks. This shows that in the
comprehensive picture, bank credit is small in the Indian economy, when
compared with the market value of equities (Thomas, 2006a). This broad
relationship has held up even though there has been an unprecedented boom in
bank credit in the period under examination.
2.2 Financial Repression
In most areas, the interaction between the Indian State and the economy is ruled
by sound procurement principles. As an example, purchases of steel or cement by
the government are done through auctions, where these commodities are
purchased from the lowest voluntary bidder. However, in the area of government

11. borrowing, the Indian State does not borrow from voluntary lenders. The bulk of
government bond issuance is forcibly placed with financial norms. These include
banks, insurance companies and pension funds. As an example, banks are forced
to hold atleast 24% of their assets in government bonds. The pension system
operated by the Employee Provident Fund Organisation (EPFO) is almost entirely
invested in domestic government bonds. Of the Rs.7.43 trillion invested by life
insurance companies on 31 March 2009, 42.5% was in central government bonds
and another 14.4% was in state government bonds.
Indian financial policy thus ensures that the government gets roughly all EPFO
assets, roughly half of the assets of life insurance companies and roughly a quarter
of the assets of banks. Data for 2007-08 shows that of the total stock of Rs.11.47
trillion of government bonds, only Rs.1.7 trillion or 15 per cent were held
voluntarily.
2.3 Protectionism
In most aspects of the merchandise trade, the Indian State has shifted away from
protectionism. The Indian buyer of steel or benzene or mobile phones is able to
choose between local and global producers without either quantitative restrictions
or tariffs imposed by the State. Once the Goods and Services Tax (GST) is properly
implemented, imported goods will face a GST-on-imports, and apart from that,
customs tariffs would go to near-zero levels. With financial products and services,
in most areas, the local buyer is inhibited from purchase of products or services
from offshore providers. This is done either through outright prohibition or
quantitative restrictions (typically through capital controls), or constraints upon
establishment of distribution channels for foreign producers (typically through
financial regulation).

12. One example of such protectionism lies in the treatment of banks, where all foreign
banks (put together) are permitted to open no more than 18 branches in India. This
disables the extent to which foreign banks are able to build branches in India and
offer competition to Indian banks. For another example, the Indian buyer of futures
on the NSE-50 index has a choice of three venues where orders can be placed:
India's NSE, the Singapore Exchange (SGX) and the Chicago Mercantile Exchange
(CME). However, the prevailing capital controls are structured in a way which
prevents an Indian resident from paying initial margin on overseas futures
exchanges. Through this, offshore competition against the NSE-traded Nifty futures
and options is undermined.
2.4 Public ownership
The third defining feature of Indian finance lies in the extent of public ownership.
Roughly 80% of banking, 95% of insurance and 100% of pensions is held in public
sector financial norms. With insurance, it is possible to establish a private
insurance company with no more than 26% of foreign ownership. With banking
and pensions, entry is infeasible either for private or for foreign financial norms.
The combination of public ownership and protectionism hampers competitive
dynamism in large parts of Indian finance. At the same time, competitive
dynamism is found in certain areas. The barriers are the weakest with securities
norms that seek to become members of exchanges such as NSE and BSE, and with
mutual funds. In these two areas, India is de facto open to private or foreign norms
that seek to establish business. Unsurprisingly, these are also areas where creative
destruction is visible, with both entry and exit taking place every year.

13. 2.5 Central Planning
The fourth defining feature of Indian finances lies in the extent to which the
government controls minute details of financial products and processes. The
structure of legislation and regulation is one where everything is prohibited unless
explicitly permitted. Hence, every time a firm wishes to make a modification to a
small detail about a product or a process, it has to go to a government agency in
order to request permission.
As a recent example, until recently, SEBI specified that securities trading must
start at 9:55 AM and stop at 3:30 PM. In an element of liberalisation, SEBI has
announced that exchanges can start and stop at any time of day, as long as the
start of trading is after 9 AM and the end of day is before 5 PM. In most OECD
countries, governments do not get involved in specifying the time at which trading
starts and ends. On a related note, on the equity derivatives market, options
trading on the index involve cash-settled European-style options and options
trading on individual securities involve cash-settled American-style options. None
of these parameters can be changed without explicit approval from SEBI. In most
OECD countries, decisions about whether options should be cash-settled or
physically-settled, and decisions about whether options should be European-
style or American-style, are not the purview of government.
2.6 Regulatory and Legal Arrangements
The fifth and final defining feature of Indian finance is the financial regulatory
architecture. Table 3 shows the role and function of major government agencies in
Indian finance. In addition to these external agencies, finance policy work is
undertaken by the Department of Economic Affairs (DEA), Department of Financial

14. Services (DFS), Department of Consumer Affairs (DCA) and the Department of
Company Affairs (DCA). There are also other government bodies which perform
quasi-regulatory functions, including NABARD, NHB and DICGC.
This assignment of functions into agencies is embedded in the texts of laws before
1956, and thus reflects a vision of economic policy, and a state of development of
the financial system, rooted in mid-20th century India.
An associated set of issues concerns the legal process. From the 1990s onwards,
regulators in India have been placed in a legal setting where there is a clear
separation between a regulator performing regulation while a private industry
performs service provision, where the regulator is charged with creation of
subordinated legislation through a transparent and consultative process, where the
investigative and enforcement process is performed in a quasi-judicial fashion with
full transparency of reasoned orders, and there is a fast-track specialised court
which hears appeals. None of these principles were part of the ethos of governance
in India in 1956. As a consequence, a large part of the financial regulatory
landscape lacks these features.
3. What changed in recent decades ?
Much has been written about the changes in Indian finance in recent decades.
Following are the eight areas where major changes took place in Indian financial
policy in the last 20 years.
3.1 The revolution of equity market
The equity and fixed income scandal of 1992, and the desire of policy makers to
encourage foreign investors in the Indian equity market, in the early 1990s, helped
in reopening long-standing policy questions about the equity market. From 1993 to

15. 2001, the Ministry of Finance and SEBI led a strong reforms effort aiming at a
fundamental transformation of the equity market. The changes on the equity
market from December 1993 to June 2001 were quite dramatic:
A new governance model was invented for critical financial infrastructure
such as exchanges, depositories and clearing corporations. This involved a
three-way separation between shareholders, the management team and
member financial norms. These three groups were held distinct in order to
avoid conflicts of interest. The shareholders were configured to have an
interest in liquid markets, and not maximise dividends.
Floor trading was replaced by electronic order books.
Counterparty credit risk was eliminated through netting by novation at the
clearing corporation. This has supported a competitive environment where
entry barriers have been set to very low levels and a steady stream of norm
goes out of business every year.
Exchange membership for foreign securities norms was enabled, thus
making it possible for foreign investors to transact through their familiar
securities norms.
Physical share certificates were eliminated through dematerialised
settlement at multiple competing depositories.
Exchange-traded derivatives trading commenced on individual stocks and
indexes. The NSE-50 (Nifty) index became the underlying for one of the
world's biggest index derivatives contracts, with onshore trading at NSE,
offshore trading at SGX in Singapore and CME in Chicago, and an entirely
offshore OTC market.
A diverse order flow was accessed from all across India and abroad, through
hundreds of thousands of trading screens. This gave heterogeneous views,
and a large mass of investable capital.

16. Asymmetric information was diminished through improvements in
accounting standards and disclosure.
The eligibility rules for FIIs were enlarged through time, so that thousands of
FIIs were operating on the market, bringing both foreign capital and
heterogeneous views.
Through these events, the Indian equity market has come to have a dominant role
in Indian finance. The financing of norms has shifted away from debt towards
equity. Nifty-related products (ETFs, futures, options, OTC derivatives) make up the
biggest single traded product. NSE and BSE are at rank 3 and 5 in the world's top
exchanges by the number of transactions, and this is the only global ranking in
finance where India is found.
In the larger setting of Indian finance, the equity market is the first place in India
where modern finance and financial regulation have taken root. This is a major
change when compared with the India of old, where none of the financial markets
worked well. Looking forward, the institutional capabilities and experience of these
reforms will help in transforming other components of the financial system. As an
example, in 2008, the institutional capabilities of the equity market were used with
great success in establishing a currency futures market.
3.2 Entry of Private Banks
India's starting condition, in the early 1990s, was one with an almost entirely
government-owned banking system, where entry by foreign or private banks was
blocked. In this environment, an important experiment in easing entry barriers

17. took place from 1994 to 2004, where a total of 12 `new private banks' were
permitted to come into being.
In terms of barriers to entry, this remains an environment with onerous barriers to
entry, given that only 12 new private banks were permitted, and that over 80% of
assets remain in the public hands. In addition, strong entry barriers have gone
back up, for after 24 May 2004, no new private banks have come about.
At the same time, this limited opening has had significant consequences. While
some of these new private banks fared badly, others have done well. They have
experienced sharp growth in assets. They dominate certain newer market
segments, such as cards and POS terminals. They have exerted a certain limited
competitive pressure upon public sector banks. As an example, public sector banks
now accept computers and ATMs on a scale that was not seen in 1993, and it is
likely that competitive pressure from private banks has helped.
In summary, the limited economic reform, of bringing in 12 new private banks from
1994 to 2004, was one of the important milestones of change in Indian finance,
even though it was highly limited in scope and onerous entry barriers remain in
place.
3.3 The RBI Amendment Act of 2006
In 2006, an amendment to the RBI Act was passed, which established RBI as a
regulator of the bond market and the currency market. This was a step in the
wrong direction, given India's direction for reform on the regulation and supervision
of securities markets. In all OECD countries but one, only one government agency
(the securities regulator or the unified financial regulator) deals with all aspects of
organised financial trading. In India itself, shortly after 2006, expert committee
reports were produced advocating the merger of all regulation of organised financial

18. trading into a single regulator. The RBI Amendment Act of 2006 stands out as a
step in the wrong direction; the policy agenda now involves reversing this.

21. 3.4 Fiscal transfers to public sector financial firms
In recent decades, the exchequer has brought money into public sector financial
firms under three scenarios:
Explicit obligations of the exchequer: Some public sector financial firms
encountered bankruptcy, and were always rescued using public money. This
covers experiences such as Indian Bank, IFCI, etc.
Implicit obligations of the exchequer: One scenario { the difficulties of UTI in
2001 { concerned implicit promises which were made by UTI, where
upholding those promises required money from the Ministry of Finance.
Failure of banks to generate equity capital through retained earnings: In a
well run bank, the growth of equity capital through earnings retention
should enable growth of the balance sheet. In India, on many occasions,
public sector banks which failed to produce retained earnings and thus
adequate equity capital were given additional equity capital by the
government so as to obtain balance sheet expansion.
The Indian experience has been a healthy one, when compared with that of some
other countries such as Indonesia, in that these payments have been relatively
small. At the same time, a three-pronged modification of strategy is appropriate:
1. Problems should be solved before they are crystallised. Just as the UTI problem
should have been detected and blocked ahead of time, today there are looming
problems which will yield difficulties in the exchequer in the future. One example of
these is the Employee Pension Scheme (EPS).
2. The discomfort associated with accessing public resources needs to be increased.
Firms like IDBI and IFCI experienced rescues which were too comfortable from the

22. viewpoint of the (civil servant) managers. This generates poor incentives for other
managers of public sector financial firms.
3. Finally, government needs to deny additional resources to banks which have
failed to build up adequate capital, for these are precisely the banks which are not
efficient.
3.5 Critical financial infrastructure of the bond market
In the equity market, the strategy for critical financial infrastructure (exchanges,
learning corporations and depositories) was based on three principles. First, there
was a three-way separation between shareholders, the management team and the
member financial firms. Second, there was a competitive framework. Third, the
regulator (SEBI) did not own critical financial infrastructure.
None of these three principles was used on the bond market. The critical bond
market infrastructure involved a depository (the SGL) owned and operated by RBI
and an exchange (NDS) owned and operated by RBI.
This was a problematic arrangement because RBI had conflicts of interest by virtue
of being an owner and service provider, and at the same time being the regulator
(after the enactment of the RBI Amendment Act of 2006). There was a loss of
competitive dynamism when RBI's policy decisions leaned in favour of blocking
competition against NDS and SGL. The implementation capability in SGL and NDS
was limited, by virtue of being run by civil servants.
Entry barriers into membership of this critical financial infrastructure were enacted
by RBI. A small club of financial firms (banks and primary dealers) was allowed to
connect into this infrastructure. This policy framework gave dismal failure in
achieving bond market liquidity. On paper, India has an impressive bond market
with trading screens, clearing corporation, etc. But the essence of a market is

23. liquidity, speculative views, and resilience of liquidity. None of these are found on
the Indian bond market.
3.6 Institution building of IRDA and PFRDA
Indian financial policy showed an impressive ability to throw up new institutions
which rapidly made a difference in the form of SEBI (founded in 1988), NSE
(founded in 1992) and NSDL (founded in 1995). In other areas, institution building
ran into greater problems.
IRDA was established with the intent of becoming a regulator of the insurance
business. In an unusual decision, IRDA was placed in Hyderabad, which led to an
increased distance from the knowledge and staff quality of Bombay. While IRDA
was relatively cutoff from the main Indian discourse on financial policy and
regulation which takes place in Bombay and Delhi, insurance companies had a
strong incentive to engage with IRDA. With focused lobbying by insurance
companies acting upon relatively weak staff quality, and the lack of the context of
the financial discourse of Bombay, IRDA came to increasingly share the world view
of insurance companies.
Through this, IRDA came to increasingly support questionable sales practices and
tax subsidies for fund management by insurance companies. The establishment of
IRDA, thus, must be chalked up as a failure of institution building.
In similar fashion, PFRDA was intended to start out as a regulator and project
manager for the New Pension System (NPS), and perhaps to grow into a full edged
regulator of Indian pensions in the future. PFRDA faced a difficulty akin to SEBI's
early years in that its legislation has been delayed.
At the same time, SEBI started chalking up important achievements in the 1988-
1992 period. In addition, PFRDA has a strong contractual role in the NPS, which

24. gives it regulatory powers through enforcement of contracts. Yet, in its first seven
years, PFRDA has failed to emerge as a strong organisation.
The Indian discussion on the role and function of government agencies in financial
regulation needs to be accompanied by a treatment of the difficulties of high quality
agencies. While Indian policy makers have one important success in SEBI, which
has emerged as a relatively high quality agency, Indian policy makers need to
diagnose and the sources of problems at the other four agencies in finance (RBI,
FMC, IRDA and PFRDA). The difficulties of IRDA and PFRDA serve as a reminder
that even when an agency starts with a clean slate, without institutional baggage
from a pre-reforms India, without conflicts of interest and archiac legal
foundations, there is still a substantial risk of failure in institution building.
3.7 Payments system
A critical element of the plumbing which underlies the financial system is the
payments system. Significant changes have taken place in this field, with the
establishment of the Real time Gross Settlement (RTGS) system. However, the
requirements for the Indian payments system involve five dimensions:
1. Support for very high volumes by world standards, given the large number of
economic agents in India
2. 24 x 7 operation, given the need to function in Indian time, and to eliminate
Herstatt risk in cross-border transactions around the globe
3. Private management, so as to achieve efficiency and technological dynamism
4. A competitive framework, with multiple competing providers
5. A governance framework which induces a focus on efficiencies for the economy
rather than maximisation of dividends.
At present, these features are largely absent in the Indian payments system.

25. Existing systems support low transaction intensities, limited hours of operation,
have an excessive role for government and lack competition. While critical financial
infrastructure in payments has fared better than the critical financial
infrastructure in the bond market, the outcomes are substantially below the
requirements of the economy.
The governance problems in the payments system are akin to those seen with other
critical financial infrastructure. Hence, there is an applicability of many of the key
ideas seen in ownership and governance of critical financial infrastructure such as
exchanges, depositories and clearing corporations.
4. Need and importance of financial sector:
The New Economic Policy (NEP) of structural adjustments and stabilization
programme was given a big thrust in India in June 1991. The financial system
reforms have received special attention as a part of this policy because of the
perceived interdependent relationship between the real and financial sectors of the
modern economy.
The need for financial reforms had arisen because the financial institution and
markets were in a bad shape. The banking sector suffered from lack of
competition, low capital base, low productivity, and high intermediation costs. The
role of technology was minimal, and the quality of service did not receive adequate
attention. Proper risk management system was not followed, and prudential norms
were weak. All these resulted in poor assets quality. Development financial
institutions operated in an over – protected environment with most of the funding
coming from assured sources. There was little competition in insurance and
mutual funds industries. Financial markets were characterized by control over

26. pricing of financial assets, barriers to entry, and high transactions costs. The
banks were running either at a loss or on very low profits, and, consequently were
unable to provide adequately for loan defaults, and build their capital.
There had been organizational inadequacies, the weakening of management and
control functions, the growth of restrictive practices, the erosion of work culture,
and flaws in credit management. The strain on the performance of the banks had
emanated partly from the imposition of high Cash Reserve Ratio (CRR), Statutory
Liquidity Ratio (SLR) and directed credit programmes for the priority sectors – all at
below market or concessional or subsidized interest rates. This, apart from
affecting bank profitability adversely, had resulted in the low or repressed or
depressed interest rates on deposits and in higher interest rates on loans to the
larger borrowers from business and industry.
Further, the functioning of the financial system, and the credit delivery as well as
recovery process had become politicized, which damaged the quality of lending and
the culture of repaying loans. The widespread write-offs of the loans had seriously
jeopardized the viability of banks. As the closure of sick industrial units was
discouraged by the government, banks had to continue to finance non-viable sick
units, which further compromised their own viability. The legal system was not of
much help in recovering loans. There was a lack of transparency in preparing
statements of accounts by banks.
In other words, the reforms had become imperative on account of the facts that
despite its impressive quantitative growth and achievements, the financial health,
integrity, autonomy, flexibility, and vibrancy in the financial sector had deteriorated
over the past many years. The allocation of resources had become severely
distorted, the portfolio quality had deteriorated, and productivity, efficiency and
profitability had been eroded in the system. Customer service was poor, work

27. technology remained outdated, and transaction costs were high. The capital base
of the system remained low, the accounting and disclosure practices were faulty,
and the administrative expenses had greatly soared. The system suffered also from
a lack of delegation of authority, inadequate internal controls and poor
housekeeping.
5. Banking and credit policy:
At the beginning of the reform process, the banking system probably had a negative
net worth when all financial assets and liabilities were restated at fair market
values (Varma 1992). This unhappy state of affairs had been brought about partly
by imprudent lending and partly by adverse interest rate movements. At the peak
of this crisis, the balance sheets of the banks, however, painted a very different
rosy picture. Accounting policies not only allowed the banks to avoid making
provisions for bad loans, but also permitted them to recognize as income the
overdue interest on these loans. The severity of the problem was thus hidden from
the general public.
The threat of insolvency that loomed large in the early 1990s was, by and large,
corrected by the government extending financial support of over Rs 100 billion to
the public sector banks. The banks have also used a large part of their operating
profits in recent years to make provisions for non performing assets (NPAs). Capital
adequacy has been further shored up by revaluation of real estate and by raising
money from the capital markets in the form of equity and subordinated debt. With
the possible exception of two or three weak banks, the public sector banks have
now put the threat of insolvency behind them. The major reforms relating to the
banking system were:

28. · Capital base of the banks were strengthened by recapitalization, public equity
issues and subordinated debt.
· Prudential norms were introduced and progressively tightened for income
recognition, classification of assets, provisioning of bad debts, marking to market of
investments.
· Pre-emption of bank resources by the government was reduced sharply.
· New private sector banks were licensed and branch licensing restrictions were
relaxed.
At the same time, several operational reforms were introduced in the realm of credit
policy:
· Detailed regulations relating to Maximum Permissible Bank Finance were
abolished
· Consortium regulations were relaxed substantially
· Credit delivery was shifted away from cash credit to loan method
The government support to the banking system of Rs 100 billion amounts to only
about 1.5% of GDP. By comparison, governments in developed countries like the
United States have expended 3-4% of GDP to pull their banking systems out of
crisis (International Monetary Fund, 1993) and governments in developing
countries like Chile and Philippines have expended far more (Sunderarajan and
Balino, 1991).
However, it would be incorrect to jump to the conclusion that the banking system
has been nursed back to health painlessly and at low cost. The working results of
the banks for 1995-96 which showed a marked deterioration in the profitability of
the banking system was a stark reminder that banks still have to make large
provisions to clean up their balance sheets completely. Though bank profitability
improved substantially in 1996-97, it will be several more years before the
unhealthy legacy of the past (when directed credit forced banks to lend to

29. uncreditworthy borrowers) is wiped out completely by tighter provisioning. It is
pertinent to note that independent estimates of the percentage of bank loans which
could be problematic are far higher than the reported figures on non performing
assets worked out on the basis of the central bank‘s accounting standards. For
example, a recent report estimates potential (worst case) problem loans in the
Indian banking sector at 35-60% of total bank credit (Standard and Poor, 1997).
The higher end of this range probably reflects excessive pessimism, but the lower
end of the range is perhaps a realistic assessment of the potential problem loans in
the Indian banking system.
The even more daunting question is whether the banks' lending practices have
improved sufficiently to ensure that fresh lending (in the deregulated era) does not
generate excessive nonperforming assets (NPAs). That should be the true test of the
success of the banking reforms. There are really two questions here. First, whether
the banks now possess sufficient managerial autonomy to resist the kind of
political pressure that led to excessive NPAs in the past through lending to
borrowers known to be poor credit risks. Second, whether the banks' ability to
appraise credit risk and take prompt corrective action in the case of problem
accounts has improved sufficiently. It is difficult to give an affirmative answer to
either of these questions (Varma 1996b). Turning to financial institutions,
economic reforms deprived them of their access to cheap funding via the statutory
pre-emptions from the banking system. They have been forced to raise resources at
market rates of interest. Concomitantly, the subsidized rates at which they used to
lend to industry have given to market driven rates that reflect the institutions‘ cost
of funds as well as an appropriate credit spread. In the process, institutions have
been exposed to competition from the banks who are able to mobilize deposits at
lower cost because of their large retail branch network. Responding to these
changes, financial institutions have attempted to restructure their businesses and

30. move towards the universal banking model prevalent in continental Europe. It is
too early to judge the success of these attempts.
6. Financial Innovations:
From the early 1970s there has been an explosive growth in financial innovations.
Here is a partial list of important novelties:
• Eurodollar accounts
• Forward rate agreements
• Zero coupon bonds
• Commodity bonds
• Negotiable certificates of Deposits
• Puttable and callable bonds
• NOW accounts
• Indexed linked gilts
• Variable life insurance
• Interest rate swaps
• Money market mutual funds
• Currency swaps
• Index funds
• Shelf registration process
• Options
• Electronic funds transfer system
• Financial futures
• Screen based trading
• Options on futures
• Leveraged buyouts
• Options on indexes

31. This appendix explores various aspects of financial innovations. It is divided into
four sections:
• What and why of financial innovations
• Type of financial innovations
• Financial innovations in India
• Excesses
1. WHAT AND WHY OF FINANCIAL INNOVATIONS
Miller, Silber, and Van Horne characterise and analyse financial innovations
somewhat differently. Miller describes financial innovations as unanticipated
improvements in the array of financial products and instruments that are
stimulated by unexpected tax or regulatory impulses.
• The Eurobond market emerged in response to a 30 percent withholding tax
imposed by the US Government on interest payments on bonds sold in the US to
overseas investors.
• Zero coupon bonds were offered to exploit a mistake of the Internal Revenue
Service in the US which permitted deduction of the same amount each year for tax
purposes.( Put differently, the Internal Revenue Service employed simple interest,
not compound interest.)
• Financial futures came into being when the Bretton Woods system of fixed
exchange rates was abandoned in the early 1970s.
• Paper currency, in a sense the most fundamental financial instrument, was
invented when the British Government prohibited the minting of coins by the
colonial North America.
• The Eurodollar market developed in response to Regulation Q in the US that
imposed a ceiling on the interest rate payable on time deposits with commercial
banks

32. • Financial swaps emerged initially in response to a restriction imposed by the
British Government on dollar financing by British firms and sterling financing by
non-British firms.
Since taxes and regulation have triggered a number of major financial innovations,
Miller likens them to the grains of sand that irritate the oyster to produce the
pearls of financial innovation.
Silber2 looks at financial innovations differently from Miller. He considers
innovative financial instruments and processes as devices used by companies to
reduce the financial constraints faced by them. Firms, he argues, maximise utility
under certain constraints, some dictated by governmental regulation, some defined
by the market place, and some self-imposed.
Financial innovations seek to reduce the cost of complying with these constraints.
Here are two examples.
• A lot of effort has gone into the designing of capital notes, which are essentially
debt instruments but are treated as ‗capital‘ for the purposes of bank regulation.
• Highly volatile interest rates enhanced the cost of following a policy of investing in
fixed dividend rate preferred stock. This stimulated the development of various
forms of adjustable rate preferred stock.
Silber‘s constraint-induced model of innovation explains well a large proportion of
commercial bank products. Yet it offers only a partial view of financial innovation
as its focus is almost wholly on the issuers of securities, not the investors in
securities.
Van Horne3 views a new financial instrument or process as innovative, if it makes
the financial markets more efficient and/or complete. A financial innovation makes
the market more efficient if it reduces transaction costs or lowers differential taxes
or diminishes ‗deadweight‘ losses. A financial innovation makes the market more
complete if its after-tax market is one where every contingency in the world is

33. matched by a distinct marketable security. The sheer number of securities required
to span every possible contingency suggests that the market is bound to be
incomplete in some way or the other. In such a market, there are unfulfilled
investor needs. Hence, there is scope for designing securities to satisfy investor
desires with respect to maturity, interest rate, protection, cash flow characteristics,
put feature, or some other attribute.
According to Van Horne the following factors prompt financial innovation: volatile
inflation and interest rates, regulatory changes, tax changes, technological
advances, the level of economic activity, and academic work on market efficiency
and inefficiency.
Collectively, the Miller, Silber, and Van Horne papers suggest that the following
factors drive financial innovations:
1 M.H.Miller, ―Financial Innovation: The Last Twenty Years and the Next‖, Journal
of Financial and Quantitative Analysis, December 1986.
2 W.L. Silber, ―The Process of Financial Innovation‖, American Economic Review,
May 1983.
3 J.C. Van Horne, ―Of Financial Innovations and Excesses‖, Journal of Finance,
July 1985.
• Tax asymmetry
• Regulatory or legislative changes
• Volatility of financial prices
• Transaction costs
• Agency costs
• Opportunities to reduce some form of risk or reallocate risk
• Opportunities to increase an asset‘s liquidity
• Academic work
• Accounting benefit

34. • Technological advances
• Level of economic activity
2. TYPES OF FINANCIAL INNOVATIONS
Financial innovations may be divided into the following categories:
Category Example
A. Consumer-type instruments
• Variable life insurance policy
• Money market mutual fund
B. Securities
• Zero coupon bond
• Indexed — linked gilts
C. Derivative securities
• Options
• Futures
D. Process
• Shelf registration process
• Screen — based trading
E. Creative solutions to a financial
• Project financing problem
• Leveraged buyout
Since categories A, B and C represent financial products, we may broadly define a
financial innovation as a new product or a new process or a creative solution to a
financial problem.
3. FINANCIAL INNOVATIONS IN INDIA
Till the mid — 1980s, the Indian financial system did not see much innovation. In
the last two decades, financial innovation in India has picked up and it is expected

35. to grow in the years to come, as a more liberalised environment affords greater
scope for financial innovation.
The important financial innovations that have taken place in India are listed below
along with the principal factor which motivated it or fuelled its growth.
Innovation Principal Motivating Factor
• Debt-oriented schemes of mutual funds
• Tax benefit
• Partially convertible debentures and fully convertible debentures
• Pricing and interest rate regulation obtaining under the Capital Issues
Control Act
• Deep discount / Zero coupon bonds
• Tax benefit
• Puttable and callable bonds
• Perceived volatility of interest rates
• Stock index futures
• Volatility of equity prices
• Badla transactions
• Restriction on forward trading
• Ready forwards
• Restrictions under the portfolio management scheme
• Havala transactions
• RBI restrictions
• Interest rate caps/floors/collars
• Volatility of interest rates
• Interest rate swaps
• Volatility of interest rates
• Currency swaps

36. • Volatility of foreign exchange rates
• Forward rate agreements
• Volatility of interest rates
• Automated teller machines
• Technology
• Screen-based trading
• Technology
• Floating rate bonds
• Volatility of interest rates
• Electronic funds transfer
• Technology
• Money market mutual funds
• Volatility of interest rates
• Specialised mutual funds
• Investor preferences
• Exchange-traded options
• Volatility of stock prices
• Project finance
• Risk sharing
7. Conclusion
One of the most important areas of economic reform lies in the financial system.
On one hand, finance is the `brain' of the economy, and the skills of the financial
system shape the efficiency of translation of gross capital formation into GDP
growth. In addition, a sophisticated financial system gives resilience to shocks,
particularly in an increasingly internationalised India. As an example, the extent to
which monetary policy can stabilise the economy critically relies on a competitive

37. banking system and a well functioning Bond-Currency-Derivatives Nexus: until
financial policy puts these in order, monetary policy will remain relatively
ineffectual.
In some respects, Indian finance has made major progress. Policy makers over the
last 20 years made important progress with revolutionary reforms of the equity
market (including sophisticated thinking on institution building for SEBI, NSE and
NSDL), the limited entry of private banks, and the limited liberalisation of the
capital account. But these three areas of greater success have not been adequate in
obtaining a financial system that is commensurate with India's needs, for
intermediating $390 billion of savings and investment a year for an increasingly
complex and internationalised economy.
Key elements of the ancien regime that remain intact are financial repression,
Protectionism, public sector ownership of financial norms, central planning, an
archaic financial regulatory architecture and weaknesses of the rule of law. The
reforms program now needs to frontally confront these elements. Some of the ideas
emphasised in this paper have been accepted by policy makers and are under
various stages of implementation. These five areas are:
Establishment of the National Treasury Management Agency (NTMA)
Establishment of the New Pension System (NPS) and the Pension Fund
Regulatory and Development Authority (PFRDA)
Establishment of the Financial Stability and Development Council (FSDC)
Drafting rules for ownership and governance of critical financial
infrastructure (presently underway with SEBI's Bimal Jalan committee)
Drafting effort for financial law at the Financial Sector Law Reforms
Commission (FSLRC).
In these areas, the challenge is one of implementation. Thirteen issues remain the
agenda for policy for the future:

38. Roadmap for removal of financial repression.
Unification of regulation of organised financial trading.
Separation of banking regulation and supervision from RBI.
Establishment of a meaningful deposit insurance corporation.
Establishment of the Financial Services Appellate Tribunal (FSAT).
Modifying FEMA to emphasise the rule of law, which would also remove the
gap between de facto and de jure openness.
Modifying capital controls so as to scale down protectionism.
A fresh effort at building IRDA.
A fresh effort at building a payments system.
A reduced willingness to inject equity capital into public sector financial
norms.
Removal of entry barriers against banks and banking.
Removal of transaction taxes, i.e. the stamp duty and the securities
transaction tax.
Shift towards residence-based taxation of global financial income.