Financial Deepening in India

According to C Rangarajan, financial reform measures in India have been sequenced to create an enabling environment for banks to overcome external constraints and operate with greater flexibility

01 July, 2010 Opinion, Finance
Print Friendly, PDF & Email
C Rangarajan, Chairman, Economic Advisory Council to the Prime Minister

The role of an integrated financial infrastructure in stimulating and sustaining economic growth is well recognised now. It is also widely accepted that financial intermediation is essential for both extensive and intensive growth. Efficient intermediation of funds from savers to users enables the productive application of available resources. The greater the efficiency of the financial system in such resource generation and allocation, the higher is its likely contribution to economic growth. Such efficiency creates a virtuous cycle of higher real rates of return and increasing savings, resulting in higher resource generation. Thus, development of the financial system is essential for sustaining higher economic growth.

The key to an efficient financial system is a network of financial institutions that help channelise the savings of the people even as they meet the needs of the borrowers. This is especially so because savers, in general, are cautious and conservative, while investors are more daring and dynamic. Savers normally prefer financial assets that are more liquid and less risky than those which can be obtained through providing credit directly to the ultimate borrowers. This is where the financial institutions enter the picture. These institutions are called financial intermediaries because they mediate between the ultimate borrowers, who are the investors, and the ultimate lenders, who are the savers.

The process of financial intermediation results in three things: one, it provides savers with different varieties of financial assets to meet their diverse preferences, enabling them to increase their savings. Two, the borrower also benefits, enabling him to avoid a direct approach to the ultimate lenders, which in any case would be difficult given the scale of required finance. Third, it raises the productivity of aggregate investment by improving its allocation. Thus, financial institutions raise the totals of savings and investment above the level that would have occurred had there been no institutional borrowing and lending. And, in addition, by bringing about a better allocation of investment, the productivity of capital improves.

Productivity of capital is also closely linked with the speed and ease with which transactions can be settled. Thus, while the role of financial institutions in the savings and investment process emphasises the store of the value characteristic of financial assets, the innovations in the field of transmission of funds emphasise the medium of the exchange characteristic of such assets. And it is innovations in the latter that have a far-reaching impact on the working of financial institutions. This then raises the question: How does one evaluate the development of the Indian financial system as it is today?

The role of the financial system in capital accumulation in particular and the economy in general is best gauged by certain financial deepening ratios. Each sector of an economy borrows from other sectors by issuing claims on itself, or it lends to other sectors by accepting their claims.

Volumes of these financial flows form the basis of several indicators of financial deepening of an economy, and this includes the relationship between financial development and overall economic growth.

The finance ratio, defined as the ratio of total financial issues in a year to national income, is a clear indicator of how financial deepening has been taking place over the years. For example, in India, the finance ratio, which was just around 32 per cent during 1990-91 and around 45 per cent in the early 2000s, rose steadily to reach as much as 77 per cent in 2007-08. Similarly, the relationship between financial development and the growth of physical investment is captured by the financial interrelation ratio, defined as the ratio of increase in the stock of financial claims to net capital formation. In India, the financial interrelation ratio has averaged around 2.10 to 2.40 since 1990-91.

The reforms process in India has been a gradual one. Nevertheless, the transition to a regime of prudential norms and free interest rates has had its own traumatic effect. It must be said to the credit of our financial system that the system was able to absorb these changes, emerging stronger in the process.

While the progress made by the Indian financial system in taking banking and other financial facilities to a large cross-section of people is well recognised, the question that arises is how efficient has the system been. Efficiency has several dimensions. Since the major role of the financial system is the transfer of funds from the surplus sector to the deficit sector, one way of judging efficiency is to determine how well this intermediation function is being performed. This can be measured by the spread between the cost of raising funds and the rate at which these funds are lent. An efficient financial system must try to minimise this spread. As the Economic Survey for 2009-10 reveals, during 2007-08, the interest income of all scheduled commercial banks stood at 7.13 per cent while interest expenditure stood at 4.81 per cent. Such a low spread might indicate that the system is efficient.

However, it has to be examined whether the net spread of 2.32 per cent is adequate to cover provisions and contingencies after taking into account establishment and other costs.

The Indian financial system and, more particularly the banking system, have evolved in an environment of administered interest rates and stipulations on asset allocation. The reforms process has been a gradual one, with the country’s central bank raising the bar every year in terms of liberalisation of the sector. Nevertheless, the transition to a regime of prudential norms and free interest rates has had its own traumatic effect. It must be said to the credit of our financial system that the system was able to absorb these changes, emerging stronger in the process.

C Rangarajan

Reform measures in India have been sequenced to create an enabling environment for banks to overcome external constraints and operate with greater flexibility. Such measures related to dismantling of administered structure of interest rates, reduction of several pre-emptions in the form of reserve requirements and credit allocation to certain sectors. Interest rate deregulation was in stages and allowed build up of sufficient resilience in the system. This is an important component of the reform process which has imparted greater efficiency in resource allocation. Parallel strengthening of prudential regulation, improved market behaviour, gradual financial opening and, above all, the underlying improvements in macroeconomic management helped the liberalisation process to run smooth. Another major objective of banking sector reforms has been to enhance efficiency and productivity through increased competition. Establishment of new banks was allowed in the private sector and foreign banks were also permitted more liberal expansion. This apart, several steps were taken to boost the regulatory and supervisory framework and bringing these in line with global standards.

The question that arises here is how useful has been the financial liberalisation process in India towards improving the functioning of institutions and markets? Prudential regulation and supervision has improved; the combination of regulation, supervision and safety nets has limited the impact of unforeseen shocks on the financial system. In addition, the role of market forces in enabling price discovery has enhanced. The dismantling of the erstwhile administered interest rate structure has permitted financial intermediaries to pursue lending and deposit taking based on commercial considerations and their asset-liability profiles. The financial liberalisation process has also enabled to reduce the overhang of non-performing loans.

In this context, one must also look at the widening of the scope of activities of the organised financial system, which is what we now describe as ‘financial inclusion’ apart from the role of financial innovations in widening and deepening the financial system.

Despite the faster rate of growth of manufacturing and service sectors in the country, the bulk of the population still depends on agriculture and allied activities. In this background, one cannot over-emphasise the need for expanding credit to agricultural and allied activities. While banks have achieved a higher growth in this area in recent years, the momentum has to be carried further. And this is particularly necessary when it comes to the provision of credit to small and marginal farmers. They constitute the bulk of the farmers and account for a significant proportion of the total output. Today, the proportion of institutional credit going to submarginal and marginal farmers is far lower than for other classes of farmers.

Thus, a critical issue is how to meet the credit requirements of marginal and sub-marginal farmers. What changes do we need to introduce so that credit flow to this class of farmer households can be accelerated? Should banks think in terms of supporting other institutions which are in a better position to lend to marginal and sub-marginal farmers? Can the banking system through its present mode of distribution of credit meet this challenge? As a solution, banks are today looking at the business facilitator and correspondent models. And if we are to ensure greater financial deepening, a re-look at the organisational structure of our rural branches is also called for. Banks need to think deeply on how to meet the challenge of meeting the credit needs of the marginalised. Financial inclusion is no longer an option; it has become a compulsion.

As far as banks are concerned, financial inclusion has two dimensions. One is in terms of providing deposits and payment facilities to the disadvantaged and under-privileged. The second relates to the provision of credit facilities to such people. In some ways, it is easier to tackle the former than the latter. Technology has opened up opportunities for providing improved facilities in terms of depositing and withdrawing cash. The business correspondent model combined with the new technology should be able to take these banking facilities to the interior parts of the country and to people who have remained un-banked. But the provision of credit facilities to such people is a much harder task. Once credit is granted, the business correspondents can take over but the grant of credit itself requires some fundamental changes in the way the rural branches function. In taking credit to persons with small means, banks will have to play a proactive role in organising self-help groups. This experiment so far has proved to be useful. Thus, the two key instruments for widening the ambit of the organised financial system and making the banking system more inclusive will be the business correspondents and SHGs.

Banking development has taken big strides in the last two decades. The basic motivation for inducting new financial products is to improve customer satisfaction. A question that is being asked increasingly is whether the financial sector today is inherently more volatile and vulnerable than before. Close interdependence among markets and market participants have increased the potential for adverse events to spread quickly. Some question whether the new financial products serve any socially useful purpose. It has been argued that much of the recent innovation in the financial system has sought to increase the short-term profitability of the financial sector rather than to increase the ability of financial markets to better perform their essential functions of managing risks and allocating capital.

The two key instruments for widening the ambit of the organised financial system and making the banking system more inclusive will be the business correspondents and facilitators and the self-help groups.

It will be inappropriate to classify all or even most of the financial innovations as socially purposeless. Many of the financial products satisfy a felt need. We are living in a world of uncertainty. Customers need to protect themselves from the volatility in exchange rates and interest rates. Appropriate hedging mechanisms are therefore needed. It is wrong to argue that the economic growth seen by the industrially advanced countries in the recent period has not been helped by improvements in the financial markets. But excesses in any field have their own dangers. There is no argument that the regulatory regime needs to be restructured to make the banking system more sound. In developing economies like India, the structure of the economy is undergoing rapid change. The financial system must be able to meet the diversified needs of a growing economy. In this context, we must actually encourage financial innovations. For example, there is a need to encourage the emergence of a vibrant corporate debt market. An efficient debt market will help not only large industries but also small and medium enterprises. We also need institutions which will serve as market makers offering two-way quotes. This will provide the required liquidity and make the market attractive to investors.

Also, there is need to explore innovative ways of financing infrastructure. Banks at present have certain limitations. They have to take care of the mismatch in liability and asset management. Of course, a vibrant debt market will also help investors’ need for long term funding. ‘Take out financing’ has been suggested as one way by which the tenure of loan can be increased. Thus, the scope for financial innovation continues to remain wide in India. We need to draw appropriate lessons from the current international financial crisis. Too little regulation may encourage financial instability but too much of it can impede financial innovations which are badly needed.

Regulatory oversight of innovations is necessary. But the regulatory perspective on innovation must not become too restrictive. In short, policy makers must strike an appropriate balance between the need for financial innovations to sustain growth and the need for regulation to ensure stability.

Recommended Articles

cover

MODI YEARS OF INCLUSIVE GROWTH
NO STATE LEFT BEHIND (2014-2023)

India is supposed to become a developed economy by 2047 with a GDP size of $30 Tn. While there is largely a consensus on the feasibility of this, it is...

0 Comments
Inline Feedbacks
View all comments
0
Would love your thoughts, please comment.x
()
x