The Indian financial system of the pre-reform period, before 1991, essentially catered to the needs of planned development in a mixed-economy framework, where the Government sector had a predominant role in economic activity. Interest rates on Government securities were artificially pegged at low levels, which were unrelated to the market conditions. The system of administered interest rates was characterized by detailed prescriptions on the lending and the deposit side, leading to multiplicity and complexity of interest rates.
Consequently, by the end of the eighties, directed and concessional availability of bank credit to certain sectors adversely affected the viability and profitability of banks. Thus, the transactions of the Government, the Reserve Bank and the commercial banks were governed by fiscal priorities rather than sound principles of financial management and commercial viability. It was then recognized that this approach, which, conceptually, sought to enhance efficiency through a co-ordinate approach, actually led to loss of transparency, accountability and incentive to seek efficiency.
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 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 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.
For a long time, an alarming increase of sickness in the Indian financial system had required urgent remedial measures or reforms which were introduced in 1991.
Main and sub-objectives of financial reforms introduced in 1991:
- To develop a market-oriented, competitive, world-integrated, diversified, autonomous, transparent financial system.
- To increase the allocative efficiency of available savings and to promote accelerated growth of the real sector.
- To increase or bring about the effectiveness, accountability, profitability, viability, vibrancy, balanced growth, operational economy and flexibility, professionalism and depoliticisation in the financial sector.
- To increase the rate of return on real investment.
- To promote competition by creating level-playing fields and facilitating free entry and exit for institutions and market players.
- To ensure that the rationalization of interest rates structure occurs, that interest rates are flexible, market-determined or market-related, and that the system offers to its users a reasonable level of positive real interest rates. In other words, the goal has been to dismantle the administered system of interest rates.
- To reduce the levels of resource pre-emptions and to improve the effectiveness of directed credit programmes.
- To build a financial infrastructure relating to supervision, audit, technology, and legal matters.
- To modernize the instruments of monetary control so as to make them more suitable for the conduct of monetary policy in a market economy i.e. to increase the reliance on indirect or market-incentives based instruments rather than direct or physical instruments of monetary control.
The key words describing reforms have been liberalization, deregulation, marketisation, privatization, and globalization, all of which convey reforms objectives in a clear manner. The basic premise underlying the reforms has been that the state ownership and regulation have harmed the financial system, particularly the banks and the investors, and that such regulation is no longer relevant and adequate. To use the well-known academic terminology, the objective of financial reforms has been to correct and eliminate financial repression; and to transform a financially repressed system into a free system.
Financial sector reforms are said to be grounded in the belief that the competitive efficiency in the real sectors of the economy cannot be realized to its full extent unless the allocative efficiency of the private sector was improved. The main thrust of financial sector reforms was on the creation of efficient and stable financial institutions and markets, the removal if structural bottlenecks, introduction of new players and instruments, introduction of free pricing of financial assets, relaxation of quantitative restrictions, improvement in trading, clearing and settlement practices, promotion of institutional infrastructure, refinement of market micro-structure, creation of liquidity, depth, and the efficient price discovery process, and ensuring technological up gradation.