The financial system reforms were accompanied by economic reforms of 1991. To support economic growth, the country requires financial system that supports and stimulates the growth. India’s financial system is diversified consisting of commercial banks, insurance companies, non-banking financial companies, cooperatives, pensions funds, mutual funds and other smaller financial entities.
India adopted state-controlled development strategy after attaining independence. The allocation of resources was made by government. In this type of controlled environment, the role of financial system was limited.
The government failed to achieve higher economic growth. The government was neither able to generate resources for investment or creating public services nor able to arouse public interest in savings.
Till 1990s, the Indian financial system was closed, restrictive, highly regulated and segmented. The resource allocation was not efficient. The financial system was characterized by administered interest rates, complex regulation and restrictions on securities market, high statutory reserve requirements, strong entry barriers for new entrants. This led to low level of competition, efficiency and productivity
There was need for market led strategy of development to improve allocative and operational efficiency of financial system. The major economic reforms in India were initiated in 1991.
The major aim of the reforms in the early phase of reforms was to create an efficient, productive and profitable financial service industry operating within the environment of operating flexibility and functional autonomy. The focus of the next phase of financial sector reforms was the strengthening of the financial system and introduction of structural improvements.
Objectives of Financial System Reforms
The major objectives of financial system reforms were:
- To remove structural rigidities and inefficiencies
- To efficiently channelize and allocate resources
- To improve efficiency, stability and integrate the various components of financial system.
- Provide operational and functional autonomy to institutions
- Prepare the financial system for increasing international competition
- Easing of capital controls to give Indian firms access to foreign capital
Financial System Reforms
The financial system reforms can be broadly classified into three categories:
- Banking Sector Reforms
- Capital Market Reforms
- Foreign Exchange Market Reforms
Watch this article as video
Banking Sector Reforms
The domestic savings were utilized to achieve capital accumulation. The savings were accumulated by levying high taxes, profits through state-controlled enterprises and suppressing consumption. Public sector banks were utilized to accumulate savings and financing the industrial activity.
The interest rate on saving deposits were quite low and controlled. There was no incentive for public to inculcate the habit of savings. There was high level of statutory and cash reserve requirements needed to be met by banks, therefore large portion of funds available with banks were pre-empted by government.
Banks used to lend funds to priority sector at subsidised interest rates as per directions of government. To offset the subsidised rates, the depositors were paid low interest rates and non-priority sector borrowers were charged exorbitant high interest rates. Thus, banks were mere deposit taking agencies.
The banks were nationalised in 1969 and 1980. The objective was to was to extend the reach of organised banking services to rural areas and to the neglected sections/sectors of society. By 1990s, the Indian banking system became predominantly government owned. However, the operational efficiency was unsatisfactory. Banks were characterised by low profitability with high and growing non-performing assets.
Various reforms were undertaken to improve banking sector in India. But comprehensive reforms were initiated after recommendations of Narasimham committee-I, 1991 and Narasimham committee-II, 1998.
The important reforms taken up in banking sector were:
- Liberalisation of interest rates. Banks can charge differential interest rates based on perceived risk
- Reduction in statutory reserve requirements (CRR and SLR)
- Board for Financial Supervision was set up under RBI exclusively for supervision purpose
- Entry of new private banks. Increase in FDI in banking sector from 49% to 74%
- Introduction of prudential norms of income recognition, provisioning and capital adequacy to improve financial health of banks
- Technology upgradation and introduction of Core banking solutions (CBS), ATMs, internet banking, phone banking, mobile banking etc.
- Recovery of debt through measures like Debt recovery tribunals, Lok Adalats and enactment of SARFAESI Act
- Adequate capitalization of banks
- Human resource development
- Reduction in number of public sector banks by ways of mergers and amalgamations
Capital Market Reform
Capital market refers to the market for long-term funds for investment purposes. The capital market comprises of two segments – the primary and the secondary markets. The companies, corporates and government bodies raise funds from capital market for their long-term productive use. The instruments like bonds, equity shares are traded in this market.
Till 1990s, the primary capital market was controlled by government. There was no price discovery mechanism.
The Indian capital market was opened up for foreign institutional investors (FIIs) in 1992. The Indian corporate sector has been allowed to tap international capital markets through American Depository Receipts (ADRs), Global Depository Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowings (ECBs).
The important reforms taken up in capital market were:
- The Capital Issues (Control) Act of 1947 was repealed. It led to Removal of barriers to entry. The companies are free to enter the capital market any time to raise any amount
- Free pricing and rationalisation of price discovery through book building process and auctions
- Dematerialisation of shares has been introduced
- Computerised Screen Based Trading System to reduce down time, cost, risk of error and fraud
- SEBI was established to protect the interest of investors in primary and secondary stock markets in the country
- Establishment of Investor Education and Protection Fund (IEPF) for promotion of awareness amongst investors and protection of their interests
- Foreign institutional investors (FII) permitted to invest in capital market
- New instruments of trading were introduced
- Improvement of clearing and settlement system
- Improvements in efficiency of financial institutions and markets
Foreign Exchange Market Reforms
Traditionally Indian forex exchange market had been heavily controlled to foster import substitution policy. Therefore, both the current and capital accounts were closed. There was complex licensing system operated by Reserve Bank of India to operate foreign exchange.
The foreign exchange market reforms were initiated with introduction of market-based exchange rate regime in 1993. Subsequently, the current account convertibility was adopted. Banks have been given large autonomy to undertake foreign exchange operations. A large number of products have been introduced and entry of newer players has been allowed in the market. Authorised Dealers of foreign exchange have been allowed to carry on a large range of activities.
The prominent reforms were:
- The rupee was devalued against foreign currencies. This led to increase in export and consequent increase in foreign exchange reserves.
- Foreign Exchange Management Act, 1999 was enacted by replacing the Foreign Exchange Regulation Act (FERA), 1973
We hope you liked this article. Here are some useful articles for you to read next:
Download article as PDF