What next for India's financial sector?

For the financial sector to serve the real sector, yesterday's beliefs offer no road map for tomorrow's policy options, says Yaga Venugopal Reddy.

Some say India has been saved from the financial crisis only because the policy was conservative and did not act to improve the efficiency of the system.

Hence, their prescription is to act now on efficiency. This view is not right because India was active in policy interventions in both monetary and financial sectors. RBI adopted an active countercyclical policy, while many others failed to intervene.

There is another problem with acting rapidly or comprehensively on reform -- there is no agreement on a right model for financial sector reforms.

It is, therefore, desirable to look carefully and pragmatically at specific and urgent issues that need attention and not proceed with what I would call yesterday's beliefs on what is good for tomorrow.

There are several inadequacies in our financial system, ranging from credit-culture to financial exclusion and poor service.

Serious infirmities that could cause a crisis may not exist in our system, but the financial sector is yet to fully serve the needs of the real sector. The needs of the real sector can be met only when there are synchronised reforms in both real and financial sectors.

This point may be illustrated with housing finance. Housing should be a priority for India, in view of demographics, growth trend and urbanisation. Hence housing finance ought to be encouraged. 

But for housing finance to be viable and efficient, there should be reasonably good housing markets, preferably liquid markets.

The nature of formal and informal construction activity as well as financing models; high transaction costs in terms of registration fee etc; difficult tenancy laws; non-standardised layouts etc; inadequate processes of price discovery; unrealistic loan to rental value ratios etc, make the housing markets in general very complex and illiquid at this juncture.

Thus, developments and reform in housing products and housing finance products should be reviewed together while focusing on increasing of housing finance and innovating related products.

Some feel that our financial system needs improvement and there are several reform proposals around that should be implemented, drawing appropriate lessons from the global financial crisis.

We should recognise that the lessons that we are in the process of learning are of a fundamental nature and not merely incremental. The intellectual basis of some of the reforms under consideration in India prior to the crisis are being questioned now.

Let me illustrate with attitude to Tobin Tax. This was considered by many to be retrograde and not practical till recently both in India and globally.

Now, eminent persons in finance such as former US Fed Chief Paul Volcker and current chief of UK FAS Lord Turner suggest consideration of such a tax even for domestic financial transactions. Brazil has actually announced a few measures. G-20 has recognised the need for capital controls, if temporary.

What does this mean for India? This idea could be examined for the forex market and also suitably modifying the securities transaction tax system and extending them to transactions in participatory notes, though they are traded abroad.

Similarly, issues of tax arbitrage and residents are being revisited globally, and need to be revisited by India also.

Finally, as a result of the crisis, there are some fundamental factors that have been identified as being critical to the efficiency and stability of the financial sector. I subscribe to the view that it is essential to assess our financial system with reference to these critical factors or questions that have been flagged in global debates. These questions are:

1. Is macroeconomic management reasonably balanced? The answer is obviously yes -- by and large. We have no excessive current account surplus or deficit; no excessive dependence on exports or external demand; no excessive reliance on investment or consumption expenditure; and, no excessive leverage in most households or corporate houses or financial intermediaries.

We are, however, vulnerable to shocks on four fronts: fuel, food, fiscal and finance -- external. In regard to fiscal, the quality of management and subordination of monetary policy continue to be issues. On the external sector, the quality of capital flows will continue to be an area of concern.

2. Is monetary policy sound and well-equipped? The answer is yes, by and large. 

3. Are there suitable mechanisms for regulatory coordination in the financial sector? The answer is broadly yes, but with some scope for improvement.

4. Are there incentive systems that are inappropriate for stability of the financial system and the interests of depositors or investors? Perhaps a systematic study may be needed on this before we make any conclusions.

5. Is there evidence of conflicts of interests in the financial sector? This is another area in which study is needed to make an assessment.

6. Is there evidence of excessive financialisation? Excessive financialisation may be occurring due to the proclivities of financial markets and institutions to multiplicity of transactions since they obtain incomes through margins on trading. Generally speaking, when multiplicity in financial transactions take place with no visible signs of redistributing risk or more efficiently reallocating resources, it amounts to excessive financialisation.

7. Is there any evidence of irresponsible lending, like the subprime in the US? There is no direct evidence of any large-scale lending in India that could be characterised as irresponsible lending. But, a study should be made of commercial banks' lending and support to micro-finance institutions, which are profit-seeking (MFI-PS).

8. Are there any concerns relating to the integrity of financial markets?

9. Is the banking system sound, resilient, efficient and performing the functions expected of the system?

India, like many developing economies, has a bank-dominated financial system. There is a broad agreement about the strength and resilience of banks in India, while there are debates on the level of efficiency in the context of externally imposed policy constraints and governance standards.

However, we have to assess whether there is hollowness in the provision of banking services in our country. I am not referring to the issue of financial inclusion or efficiency of customer service, though both are important and need attention. I refer to the main functions of a bank, namely, taking deposits and providing credit.

Over a quarter of the asset base of banks is already earmarked for government securities. Banks are encouraged to participate in bond markets, establish private equity or venture capital subsidiaries and step up lending to infrastructure as well as housing.

They are also allowed in equity. Banks also invest in mutual funds. As a result, there is a reduction in advances towards working capital and other funding, especially to agriculture, small business and small and medium industry.

But these are the sectors that need the funding of banks most and their access to the new forms of funding through capital markets is limited. Banks are expected to have special retail skills to make such advances.

The main justification for issuing a banking licence is primarily to conduct traditional retail banking activities that are vital to facilitate economic growth. A study on this emerging hollowness in traditional lending pattern is essential.

Extracts from S Guhan Memorial Lecture, Chennai, October 22, 2009.