10-10-2012, 04:05 PM
FINANCIAL REFORMS IN BANKING SECTOR AND THEIR CRITICAL
EVALUATION
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INTRODUCTION
From the study on financial reforms it reveals that the initiation of reforms in the
early 1990s, the Indian economy has achieved high growth in an environment of
macroeconomic and financial stability. The period has been marked by broad
based economic reform that has touched every segment of the economy. These
reforms were designed essentially to promote greater efficiency in the
economy through promotion of greater. As a result of the growing openness,
India was not insulated from exogenous shocks since the second half of the
1990s. These shocks, global as well as domestic, included a series of financial
crises in Asia, Brazil and Russia, 9/11 terrorist attacks in the US, border
tensions, sanctions imposed in the aftermath of nuclear tests, political
uncertainties, changes in the Government, and the current oil shock.
Nonetheless, stability could be maintained in financial markets. Indeed, inflation
has been contained since the mid-1990s to an average of around five per cent,
distinctly lower than that of around eight per cent per annum over the previous
four decades. Simultaneously, the health of the financial sector has recorded
very significant improvement.
FINANCIAL SECTOR AND MONETARY POLICY: OBJECTIVES AND
REFORMS
Till the early 1990s the Indian financial sector could be described as a classic
example of “financial repression”. Monetary policy was subservient to the fiscal.
The financial system was characterised by extensive regulations such as
administered interest rates, directed credit programmes, weak banking
structure, lack of proper accounting and risk management systems and
lack of transparency in operations of major financial market participants (Mohan,
2004b). Such a system hindered efficient allocation of resources. Financial sector
reforms initiated in the early 1990s has attempted to overcome these
weaknesses in order to enhance efficiency of resource allocation in the economy.
Simultaneously, the Reserve Bank took a keen interest in the development of
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financial markets, especially the money, government securities and forex
markets in view of their critical role in the transmission mechanism of monetary
policy. As for other central banks, the money market is the focal point for
intervention by the Reserve Bank to equilibrate short-term liquidity flows on
account of its linkages with the foreign exchange market. Similarly, the
Government securities market is important for the entire debt market as it
serves as a benchmark for pricing other debt market instruments, thereby aiding
the monetary transmission process across the yield curve. The Reserve Bank
had, in fact, been making efforts since 1986 to develop institutions and
infrastructure for these markets to facilitate price discovery. These efforts by the
Reserve Bank to develop efficient, stable and healthy financial markets
accelerated after 1991.
INDIAN BANKING SECTOR AND FINANACIAL REFORMS
The main objective of banking sector reforms was to promote a diversified,
efficient and competitive financial system with the ultimate goal of improving
the allocative efficiency of resources through operational flexibility, improved
financial viability and institutional strengthening. The reforms have focussed on
removing financial repression through reductions in statutory pre- emptions, while
stepping up prudential regulations at the same time. Furthermore, interest rates
on both deposits and lending of banks have been progressively deregulated (Box
I).
As the Indian banking system had become predominantly government owned by
the early 1990s, banking sector reforms essentially took a two pronged
approach. First, the level of competition was gradually increased within the
banking system while simultaneously introducing international best practices in
prudential regulation and supervision tailored to Indian requirements. In particular,
special emphasis was placed on building up the risk management
capabilities of Indian banks while measures were initiated to ensure
flexibility, operational autonomy and competition in the banking sector.
Second, active steps were taken to improve the institutional arrangements
including the legal framework and technological system. The supervisory
system was revamped in view of the crucial role of supervision in the
creation of an efficient banking system.
MONETARY POLICY FRAMEWORK
The basic emphasis of monetary policy since the initiation of reforms has
been to reduce market segmentation in the financial sector through
increased interlinkages between various segments of the financial market
including money, government security and forex market. The key policy
development that has enabled a more independent monetary policy
environment as well as the development of Government security market
was the discontinuation of automatic monetization of the government's
fiscal deficit since April 1997 through an agreement between the Government
and the Reserve Bank of India in September 1994.
Financial Markets
The success of a framework that relies on indirect instruments of monetary
management such as interest rates, is contingent upon the extent and
speed with which changes in the central bank's policy rate are transmitted
to the spectrum of market interest rates and exchange rate in the economy
and onward to the real sector. Given the critical role, played by financial
markets in this transmission mechanism, the Reserve Bank has taken a
number of initiatives to develop a pure inter-bank money market. A
noteworthy and desirable development has been the substantial migration
of money market activity from the uncollateralized call money
segment to the collateralized market repo and collateralized borrowing
and lending obligations (CBLO) markets. The shift of activity from
uncollateralized to collateralized segments of the market has largely
resulted from measures relating to limiting the call market transactions
to banks and primary dealers only. This policy-induced shift is in the interest
of financial stability and is yielding results.