Financial sector reforms

Financial sector reforms – X

THE REPORT suggests making institutions "ownership neutral." For the public sector, this means removing the overlay of costs and benefits imposed by government ownership. One way is bank privatisation, or reducing the government's majority stake so that even if the government has de facto control, the bank is not "public sector." The other is through serious governance reform. The report believes that while this debate has become entangled in politics and ideology, pragmatic steps are possible in both directions so that experience can guide future moves.

The report makes certain valid observations in regard to foreign ownership. Many arguments are put forward for treating foreign firms differently. Yet the country has had a generally good experience with foreign direct investment elsewhere. And given that there are strong domestically incorporated firms in almost every segment of the financial sector, "infant industry" arguments for protecting domestic financial firms at the expense of domestic financial service consumers hold little water.

As for foreign financial firms the past Indian experience may not have much bearing for the future, given the substantial changes in the Indian economy. But cross-country studies indicate foreign financial institutions would bring competition that would improve service and prices for the consumer – indeed a study finds foreign entry is the single biggest factor in enhancing domestic competition and efficiency. They would also bring skills that are needed in the Indian economy and the talent they bring to India or train in India would become part of the domestic labor pool, leading to cross-fertilisation. Particularly useful might be evaluating and channelling credit to small and medium enterprises. Finally, they will have access to foreign capital that will be available even if the Indian economy is doing badly, thus providing a valuable source of insurance.

There are, no doubt, concerns about foreign financial firms. There is some academic evidence that their entry is not particularly helpful when an economy is at a low level of financial development. India's financial sector is probably much above that threshold. Also, to the extent foreign financial firms are not domestically incorporated, regulatory authorities may not have full control over them. This is remedied by requiring domestic incorporation in exchange for full domestic business privileges. Yet another concern is reciprocity. Domestic banks would like to expand abroad and feel that some countries erect undue hurdles in their way. It is important for the Indian authorities to exert every pressure on foreign governments to extend reciprocal privileges to Indian banks. However, the report believes that the expansion of foreign banks in the Indian economy is beneficial to the Indian public and should not be held hostage to the vagaries of foreign governments. In the same way as India benefited by liberalising trade over and beyond its foreign commitments, India will benefit by welcoming foreign financial firms. The high road seems to be the most beneficial one for our country here.

The report offers some cautions about any reforms. First, it may be impossible to level the playing field completely. Some differences may be warranted, for example, for prudential reasons. For instance, a bank making certain loans has a capital requirement that an NBFC does not have to meet. This is because the bank has issued demand deposits, which entail a higher supervisory burden. Of course, the more an NBFC approaches the characteristics of a bank by issuing short term deposits, the greater should be the similarity in treatment. Indeed, this principle is being followed by the RBI in its approach towards deposit taking NBFCs. There are, however, differences that are not essential, and deserve to be eliminated. These differences are often highlighted through competition, as one entity or product appears to gain a seemingly unfair advantage. There are obviously two ways of eliminating burdensome differences. One is to place the burden on everyone. The second is to eliminate it for everyone. In general, the report favours equalisation by removing burdens rather than by adding burdens. To the extent that a burden cannot be removed for sound economic reasons, it would suggest a "warranted" difference that might have to remain, rather than a need to increase burdens for everyone.

Second, institutions should be given time to adjust, so that legacy institutions can compensate for the loss of rents by developing new skills and businesses or by shrinking gracefully, rather than by taking risks they do not understand or cannot manage. A time-bound, pre-announced, steady withdrawal of differentiation is usually better than an overnight change.

Third, as financial integration proceeds apace, a variety of institutional linkages may emerge to provide the products people need. For example, a loan linked with crop insurance (or alternatively, one where interest and principal payments are linked to rainfall) seems to be a felt need of farmers. Given the desire of investors for safety, an equity linked deposit account, with a guaranteed minimum interest rate, liquidity, and some (but not full) upside performance related to the performance of the stock market could be popular. Such products would require linkages across institutional and regulatory silos, some of which is already happening. More needs to be encouraged. Holding company structures could help facilitate such linkages.

Fourth, care should be taken that institutions do not misuse their freedom of activity and structure to create fragile institutions that impose charges on the system. Certain activities do tend to create fragility and should be monitored particularly closely or in extremis, even prohibited for certain structures. For example, the key to open-ended mutual funds being safe is the fact that their assets are liquid and continuously marked to market. An open-ended real estate mutual fund has neither characteristic and can be very fragile – mutual fund "runs" have occurred in some countries like Germany. Similarly, banks, mutual funds, or insurance companies with guaranteed returns necessitate additional monitoring to ensure that the institutions are managing their assets to produce the guaranteed returns; else they too could suffer runs and become a public charge. The point therefore is to proceed steadily, predictably, but with care to reduce privilege and obligations, while expanding permissible activities wherever possible.

Written by S Shivakumar (Merinews)