Financial Sector Reforms: The Road Ahead

An examination of the brief history of financial sector reforms in India clearly indicates that the process suffered from lack of consensus, which led to continuous skirmishes between the regulated and the regulator; lack of future orientation, whereby adequate attention was not paid to the needs of the emerging scenario; control orientation, with inadequate emphasis on development of the financial markets; framing of regulations which were not supported by effective systems for prudential supervision; inadequate understanding of the functioning of the markets because of lack of empirical analysis, and absence of efforts to educate and train market participants.

These shortcomings severely undermined the reforms and not surprisingly, therefore, the financial sector continues to show signs of repression in the form of varying costs and access to funds unrelated to financial parameters; discontinuous relationship between risks and returns; distorted interest rates because of market segmentation, which do not adjust to fundamental economic parameters; and narrow and shallow markets unable to cater to wider investor needs. These distortions substantially reduce the allocational efficiency of the market, a luxury which a capital-scarce economy like India can ill-afford. There is, therefore, urgent need to carry out financial sector reforms, with the primary objective of improving the markets allocational and informational efficiency. This article discusses the steps, grouped under six broad categories, needed to set the reforms process on the right path.

 

Corporate governance: The ITC episode is symptomatic of the poor standards of corporate governance in India. The governments response of directing the nominees of FIs on the boards to be more vigilant, is far short of what needs to be done. A far more effective measure would be to enhance the quality of accounting information by adopting international accounting standards. Given the increased familiarity of the corporate sector with these standards because of forays into international capital markets for raising resources, it would not be difficult for them to change over. The disclosure norms for the primary market and the mutual funds industry too should be brought on par with international norms. These would boost investor confidence and lead to easier integration of the Indian financial markets with global ones.

Information and communication technologies : The experience of screen-based trading has y demonstrated the improvement possible in the markets operational efficiency. The gains need to be consolidated by expediting the next obvious steps of dematerialisation of securities and establishment of EFTS (electronic funds transfer system) in the banking sector, to eliminate the risks associated with transfer of shares and payment for transactions. While the process of dematerialisation of securities has begun with the establishment of the NSDL (National Securities Depository Limited), no progress has been made on establishing EFTS. Information technology should also be used to strengthen surveillance against insider trading.

Professionalisation: There is a need to improve the sophistication of security research and analysis. While the quality of analysis has improved with the entry of foreign institutions, it is still well below the required standards. There is also a great need to educate lay investors, who are taken in by unscrupulous issuers in the primary market. Sebi should initiate comprehensive education and training programmes for market participants and sponsor empirical research on relevant issues. For this, the government should provide the necessary funds to it.

Deepening of markets: There are pros and cons of a deepening market. While a deeper and more liquid market is likely to emerge if all orders converge on one market, existence of several markets improves the quality of service because of competition. However, it appears difficult to justify the existence of 22 SEs in the country on the basis of benefits from competition. There is a need to reduce their number. In the long run, only four at, say Mumbai, Delhi, Calcutta and Chennai should be allowed to operate. One of the two stock exchanges at Mumbai (the BSE or the NSE) should be converted either into a market for derivatives or debt.

Widening of markets: Thou-gh the last decade witnessed a surge of innovative instruments, particularly in the debt markets the world over, the Indian market is still stuck with traditional instruments. There is an urgent need to introduce newer instruments with wider risk-return characteristics. There is also need to establish options and futures markets to allow investors to hedge their investments against risks arising from fluctuations. These measures will also help boost the savings rate in the economy.

Integration: The best way to integrate markets is by providing access to all markets, individuals and institutions, to ensure the emergence of active arbitrageurs. This would require framing of sound prudential regulations and establishment of effective supervision systems. The norms on capital adequacy and margins must be such as to minimise chances of defaults, while encouraging higher volume of transactions. Finally, there is a need to appreciate that the Darwinian theory of evolution applies equally well to the inorganic world of finance. Interpreted in this new context, the principles of variation and natural selection imply that innovation and survival of the fittest in fair competition is necessary for evolving a strong and vibrant financial sector. This implies that the government must not intervene in the reforms process to prop up the weak and allow them to perish, even if they happen to be state-owned institutions. That is the only way to ensure that the financial sector remains innovative, dynamic

and continues to be relevant.

( Samir K Barua is a professor at IIM, Ahmedabad)