Khan Panel Pens Reforms Agenda

The Khan Committee report, the full text of which was released yesterday, has argued that progressive liberalisation of the domestic financial regime coupled with the eventual transition to capital account convertibility as also the commitments to the WTO on freer movements in financial services makes it necessary to strengthen the financial system so as to derive the benefits of these developments.

Harmonisation of the roles and operations of banks and financial institutions has, in this context, become an important issue, says the report of the working group for harmonising the role and operations of DFIs and banks, headed by S H Khan, chairman and managing director, IDBI.

The seven-member committee was appointed in December, 1997, to review the role, structure and operations of DFIs and commercial banks in the emerging operating environment and suggest changes in them.

In a broad approach to the issues under considerations, the committee has deliberated upon wide ranging issues like environmental changes, regulatory framework, legal framework, supervisory practices, funding-related aspects, organisational reforms, risk management, information technology and HRD aspects.

The major recommendations of the committee are to move towards universal banking, permit banks and DFIs to enter into gainful mergers, and that the RBI/GOI should provide an appropriate level of financial support to enable them to fulfill these obligations. It has further suggested the establishment of a super regulator to ensure uniformity in regulatory treatment, speedy legal reforms, and the development of a risk-based supervisory framework.

The committee has gone in length to explain the rationale behind these recommendations. In view of information asymmetries present in the financial system, particularly in developing countries, the functions of financial intermediaries, with their diversified portfolio and the high degree of familiarity with borrowers' operations and financial conditions, become even more relevant, says the report.

Since banks and financial institutions can exploit economies of scale in information provision, it is optimal for investors to delegate the responsibility of screening the prospective borrowers to the intermediaries. And since banks and DFIs have a diversified portfolio, they are better equipped for risk taking activities than their investors. The differences in risk aversion levels make it beneficial for institutions and investors to enter into an implicit risk-sharing contracts, says the Khan committee.

With the introduction of financial sector reforms, DFIs' access to assured sources of long term and low cost funds have been completely phased out. The liberalisation process also led to a change in the ownership pattern. DFIs were also brought under the RBI to an increasing degree.

The committee finds that such restrictions go against the spirit of financial sector liberalisation. It has also recommended that the overall ceiling on DFIs' funds mobilisation by way of term money bonds, certificates of deposits , term deposits and inter-corporate deposits should be removed. Further, the committee has suggested that CRR should not be applicable to DFIs under the present structure where they are not permitted to access cash and cash-like instruments.

DFIs have made concrete efforts to diversify their range of activities and enter into new areas. Both IDBI and ICICI set up banking and broking subsidiaries.

IDBI also set up, in association with others, NSDL with the objective of maintaining records of securities' ownership in electronic form. ICICI has set up ICICI Credit Corporation to create a retail network.

Moreover, the changes also led to a shortening in the maturity profile of DFI's sources of funds. Consequently, the twin dictates of a reasonable asset-liability matching and growing competition from banks in term-financing have led the DFIs to enter working capital and short term financing of industrial units leading to further blurring of distinction between banks and DFIs, and hence the need for universal banking.

Over the last three decades, state level institutions, mainly the state finance corporations and the state industrial development corporations, have contributed substantially to investment activity in the industrial sector at the state level, especially to medium and small scale sectors. However, the financial conditions of these state level organisations are far from satisfactory. At the end of March, 1997, 10 SFCs and 11 SIDCs posted profit after tax while 5 SFCs and 7 SIDCs ended up with losses. Their recovery performance, too, is unsatisfactory. While traditionally they have been concentrating on long term loans, they are also focusing, of late, on providing working capital limits. The reforms in the financial sector have necessitated market orientation in the operations of the state level institutions, points out the Khan committee report.