K C Chakrabarty: Indian economy - imperatives for second generation
reforms
Address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at the
inaugural session of the State level seminar, organized by the Department of Economics of
the Vivekananda Education Society's College of Arts, Science and Commerce, Mumbai,
14 September 2012.
* * *
The assistance provided by Smt. Rekha Misra and Shri S.M. Lokare in preparation of this address is gratefully
acknowledged.
Dr. Suresh Kotak, Chairman, Kotak and Co. Ltd.; Dr. J. Phadnis, Principal of the VES
College of Arts, Science and Commerce; Shri B.L. Boolani, Trustee In-charge; Dr. Suniti
Nagpurkar, Head of the Economics Department and Convener of the Seminar, Mrs. Dipta
Dasgupta, my old friend from the Banaras Hindu University; faculty members and students
participating in the Seminar, Ladies and Gentlemen. It is, indeed, a matter of great pleasure
and privilege for me that I have been called upon to address today's Seminar, which indeed
is topical, given the changing contours of the financial regulatory architecture amidst
uncertain global financial market environment. The global banking and financial system is
currently undergoing structural transformation with standard setting institutions and national
authorities framing new regulatory paradigms to address the weaknesses of the global
financial system that surfaced during the crisis. Against this backdrop, I am delighted that the
Vivekananda Education Society is conducting this State level Seminar on this subject.
The Vivekananda Education Society, which started its educational activities in 1962, today
imparts education to more than 18000 students ranging from primary school to advanced
learning in diverse areas such as management, law, engineering, science, etc. With a
mission of "Pursuit of Excellence in Higher Education", the society has sought to impart
quality education and help in character building in students. I am told that the society and this
college in particular, were set up to cater to the needs of the socially and economically
weaker sections of the population, in line with the recognition that education provides
opportunities for improvement in quality of life of these deprived sections. I congratulate the
Society for completion of 50 glorious years and commend its achievements over this period. I
hope that it continues its good work in the times to come.
I must admit that interacting with a gathering of teachers and students provides us with an
opportunity to get a different perspective on issues from what we normally get while
interacting with fellow finance professionals. Besides, interacting with teachers provides a
platform to convey our ideas, through you, to a much larger audience consisting of young
minds who will define the path that the country and the financial sector will take in the years
to come. It is, hence, a great pleasure for me to be here today.
Swami Vivekananda - a great reformer himself
On the eve of the Golden Jubilee celebrations of the Vivekananda Education Society, it is apt
to recall Swami Vivekananda, from whom the College derives its name and inspiration.
Swami Vivekananda was a great thinker and reformer of India who envisioned a new
educational model for the society. His valuable thoughts on education are relevant and viable
even today. According to him, "education is the manifestation of the perfection already in
man". He said "mere book-learning won't do. We want that education by which character is
formed, strength of mind is increased, the intellect is expanded, and by which one can stand
on one's own feet". He taught that it is only through education that the upliftment of masses
is possible. However, Swami Vivekananda's scheme of education, through which he wanted
to build a strong nation that will lead the world towards peace and harmony, is still a far cry. It
is high time that we give serious thought to his philosophy of education and remember his
call to every-body - "Arise, awake, and stop not till the goal is reached." I hope the society
pursues this vision of Swami Vivekananda.
Swamiji's most unique contribution to the creation of new India was to open the minds of
Indians to their duty to the downtrodden masses. He was the first religious leader in India to
understand and openly declare that the real cause of India's deep rooted problems was the
neglect of the masses. Long before the ideas of Karl Marx were known in India, Swamiji
spoke about the role of the labouring classes in the production of the country's wealth.
Having said this, let me come back to the realm of financial sector reforms in India. As many
of you are aware, the Indian financial sector has seen wide ranging reforms during the last
two decades. However, these reforms were broader and focused at the macro level with
internal reforms at the institutional level yet to take place. Thus, the need of the hour is to go
for second generation reforms. Nonetheless, the reforms in the financial sector alone will not
bring perpetual prosperity. It is the real sector which needs reforms. The financial sector has
to grow and keep pace with the developments in the real sector.
Why financial sector regulation?
On an intuitive basis, the business of finance and banking is different from other businesses.
This is on account of the fact that while other businesses operate with their own funds, banks
are highly leveraged institutions that operate with public money and hence, require to be
closely regulated and supervised. Besides, unlike other businesses where, due to absence of
entry barriers, free market competition can be expected to ensure efficiency and fair
treatment of customers, in the banking business, high entry barriers imply that banking
operations cannot be carried out without a license. This restricts the free play of competitive
forces and hence, makes it all the more imperative to have a sound regulatory framework,
particularly for protection of customers. In the business of banking and finance, there is an
inherent inequity between the provider of the service and the consumer and this, again,
presents the need for a framework of rules and procedures, which we call as regulation.
The health of the financial sector is a matter of public policy concern in view of its critical
contribution to economic performance. Financial regulation and supervision assumes
importance in ensuring that the financial system operates along sound lines. The primary
justification for financial regulation by authorities is to prevent systemic risk, avoid financial
crises, protect depositors' interest and reduce asymmetry of information between depositors
and banks. As the costs of financial crises are perceived to be very high, the authorities
realised that they should be avoided at all costs. As a result, banks came to be regulated
everywhere. Besides, financial regulation attempts to enhance the efficiency of the financial
system and to achieve a broad range of social objectives. Going by the experience in several
countries, effective regulation is in the interests of all concerned, though it cannot be based
on a "one-size-fits-all" approach. However, it is important to bear in mind that while financial
institutions do benefit from an appropriate regulatory regime, there is not much evidence that
the existence of a regulatory jurisdiction makes institutions stronger and less prone to
shocks. There is neither a unique theoretical model, nor just one practical approach to the
regulation and supervision of a financial system. The existence of different types of
regulatory models of the financial system makes the ideal choice a difficult exercise.
The regulation and supervision of the financial system in India is carried out by different
regulatory authorities. The Reserve Bank regulates and supervises the major part of the
financial system. In the past five decades, the Indian banking system has traversed through
a difficult path endeavoring to balance several competing and conflicting demands on it from
large, medium, small and tiny borrowers in both the organised and unorganised sectors. The
banking system's activities were initially tightly regulated and their freedom was restricted. It
also confronted several domestic stresses and external shocks. However, the regulations
have changed over time to ensure that the banking system steps out of the restrictive
operational environment and functions in an atmosphere that provides the freedom to
innovate.
In recent years, innovations in instruments and processes, advances in technology and the
increasing volumes of capital intermediated by the financial system have necessitated a
proactive strengthening of the regulatory and supervisory framework. Emergence of several
players with diversified and significant presence in the financial sector makes it imperative for
supervision and regulation to be spread across various segments of the financial system. In
recent years, there has been a shift in emphasis from microregulation to
macromanagement, supported by a tightening of prudential norms and improvements in the
functioning of the financial system.
Since the global crisis, there has been a decisive shift in trend towards assigning increased
responsibility to the central banks for both "systemic oversight" and "macro-prudential
regulation". This greater responsibility is driven by the capability of the central banks among
regulators and public institutions to perform the intended task. Central banks have robust
frameworks for macroeconomic analysis, and in India, the Reserve Bank has the
responsibility for micro-prudential supervision of banks and non-banking financial companies.
As a result, while macroeconomic analysis has helped in strengthening the microprudential
supervision, supervisory information aggregated for the financial system as a whole has also
helped in conducting more appropriate macroeconomic policies.
The Reserve Bank has been deeply involved in the development of markets, and it monitors
and analyses the impact of market trends on the economy and financial institutions. Another
important reason why central banks have to be the systemic risk regulator is because of their
mandate of Lender of Last Resort (LOLR). Going forward, given the complex nature of the
challenge, significant strengthening of the capacity for systemic risk assessment and
macroprudential regulation would be critical for the Reserve Bank.
Macroeconomic and financial sector reforms
In response to the macroeconomic crisis, a programme of stabilisation and structural
adjustment was initiated in July 1991, with wide ranging reform measures encompassing the
areas of trade, exchange rate management, industry, public finance and the financial sector.
Fiscal correction, exchange rate adjustment, monetary targets and inflation controls
constituted the immediate measures for macroeconomic stability. These measures were
supported by structural reforms in the form of industrial deregulation, liberalisation of foreign
direct investment, trade liberalisation, overhauling of public enterprises and financial sector
reforms. Apart from aiming at restoring the economic stability on both domestic and external
fronts, the economic reform programme strived towards achieving a higher growth trajectory
through increased levels of investment and improvements in productivity, efficiency and
competitiveness. Structural reforms aimed at reorientation of the economy from a centrally
directed command and control economy to a market oriented one to foster greater efficiency
and growth. This was done by introducing greater competition in the economy through
progressive internal deregulation accompanied by external competition promoted by foreign
direct investment and trade liberalisation.
The reform measures had sectoral dimensions as well. Beginning with the industrial policy of
1991, reforms in the industrial sector were undertaken with a view to remove distortions in
the resource allocation and improve competitiveness of Indian industry. The reform
measures included removal of industrial licensing, reduction in the number of industries
reserved for the public sector, abolition of restrictions on investment and expansion under the
Monopolies and Restrictive Trade Practices (MRTP)Act, 1969, automatic approval of foreign
investment, elimination of quantitative import restrictions on intermediate and capital goods
and steady reduction in protective customs tariffs. These measures created a favourable
environment for industry to upgrade its technology and build-up capacity in order to cater to
growing domestic and external demand. A series of policy initiatives were undertaken in
agricultural sector as well. These included, inter alia, replacement of quantitative controls by
tariffs, partial decontrol of fertilizer prices, removal of bottlenecks in agricultural marketing,
relaxation of restrictions of the Essential Commodities Act, 1955, replacement of the
Revamped Public Distribution System (RPDS) with Targeted Public Distribution System
(TPDS), and establishment of Rural Infrastructure Development Fund (RIDF). Moreover,
price reforms improved terms of trade for agriculture. Also, exchange rate and international
trade reforms improved the incentive structure facing agriculture.
Several initiatives were undertaken for the development and reform of financial markets,
particularly since the 1990s. The reforms in various segments of financial markets such as
money, the government securities and the foreign exchange markets were introduced in a
calibrated, sequenced and careful manner, in step with those in other markets in the real
economy. The sequencing has also been informed by the need to develop market
infrastructure, technology and capabilities of market participants and financial institutions in a
consistent manner. In India, the initiation of the structural reforms in the early 1990s
encompassed a process of phased and coordinated deregulation and liberalisation of
financial markets. Financial markets in India, in the period before the early 1990s, were
marked by administered interest rates, quantitative ceilings, statutory pre-emptions, captive
market for government securities, excessive reliance on central bank financing, pegged
exchange rate, and current and capital account restrictions. As a result of various reforms,
the financial markets have transited to a regime characterised by market-determined interest
and exchange rates, price-based instruments of monetary policy, current account
convertibility, phased capital account liberalisation and an auction-based system in the
government securities market. Enhancing efficiency, while at the same time avoiding
instability in the system, has been the challenge for the regulators in India. This approach to
development and regulation of financial markets has imparted it greater resilience. India's
reform programme has had a definite positive and significant impact on the economy as
compared with the past.
Who are the stakeholders?
In the whole process of reforms, the key stakeholders are the customers themselves. The
regulators have a critical role in ensuring fair treatment to customers and it cannot be left to
the market forces alone. The key to a prompt, effective and courteous customer service
emanates from having the right attitude. A radical transformation of attitude right from Top
Management to ground level employees is the first step towards improving customer service.
Communication is at the root of effective customer care in a service industry, especially like
banking, where the documents, terms and conditions, practices and precedents are all
heavily loaded against the customer. In many fields and in different countries, regulators
determine the price. But, the financial sector regulator in India does not do so. Therefore,
whatever charges are levied, it is expected that they are reasonable and that the pricing is
fair, transparent and non-discriminatory. Globally, regulators are expected to usher in much
stricter regulations in the area of fair treatment to customers. Banks need to price their
products and services fairly and competitively and ensure higher transparency in their
products and pricing. Lack of transparency in designing and pricing of products and services
and selling them to inappropriate customers could expose banks to litigation and reputational
risks, besides making them liable for supervisory action. There should be no unreasonable
post sale barriers if the customers wish to change product or bank. Customer education is
also critical in providing appropriate and need based products and services and the Indian
Banks' Association may have a critical role to play in this regard. The banking business
would, thus, have to turn customer centric in all its true dimensions.
Financial sector reforms - what next?
The Indian approach to financial sector reforms, so far, has been driven by the predominant
objective of enhancing the role of finance in promoting growth and economic development,
while preserving financial stability, which is equally critical for sustained economic progress.
While balancing the goals of efficiency and stability in introducing reforms, the Reserve Bank
has moved towards deregulation of interest rates, promoted development of markets, and
strengthened the legal infrastructure to facilitate better enforcement of financial contracts.
Going forward, three areas will continue to be important in policy debates, i.e., development
of long-term corporate bond markets, derivative markets to facilitate better price discovery
and risk transfers, and more competition by allowing greater foreign participation.
The regulatory and supervisory framework of the financial system across the world is
undergoing a paradigm shift following the problems experienced during the global financial
crisis. In this regard, multilateral and standard setting bodies like the G-20, IMF, BIS and FSB
have been in the forefront to design an advanced regulatory framework to prevent the
recurrence of such crisis. Addressing the regulatory gaps based on the lessons from the
global financial crisis in advanced economies will be a major challenge for regulators all
around the world. Much of the challenges in the domain of financial stability regulation would
arise from complexities surrounding the assessment of systemic risk, interconnectedness,
common exposures, risk concentrations in complex innovative products and use of models to
manage and price risks which, at times, mask information.
While India's financial sector remained resilient in the face of global shocks, there are a
number of areas where the reforms would be needed to promote stability and generate
growth impulses for the real economy. In the wake of turbulent global financial environment,
banks and financial entities have to grapple with growing complexities and risks associated
with their businesses. Against this backdrop, the policy initiatives such as adoption of tighter
capital and liquidity standards, improved risk management practices and sound
compensation practices are required to place the Indian banking system on a strong footing
and enhance the banking sector's ability to absorb shocks arising from any financial and
economic stress and encourage prudent risk taking.
Moreover, in India, while broader institutional reforms have taken place at the macro level,
the internal reforms among banks and financial institutions are yet to take place. Thus, there
is a need to go for second generation reforms, particularly focusing on bringing down the
cost of banking services, strengthening the credit delivery mechanism, improving customer
service, reforming the human resources management systems and enhancing the financial
outreach to hitherto unbanked areas.
Second generation reforms
Let me talk about some of the elements of these second generation reforms.
(i) Adopting improved risk management practices
One fundamental principal of finance that I would like to emphasize is the direct relationship
between risk and return. Any investment that offers greater returns, invariably involves more
risk. Similarly, if you avoid taking risk, then the returns could even be negative. Banks, for
instance, are in the business of taking risks and hence, cannot be expected to shun risk in its
entirety. Four basic requirements that banks and professionals in the field need to develop is
to:
•
Understand Risk
•
Define Risk
• Measure Risk
•
Manage Risk
My advice to all students entering the finance field would be that never take a risk where you
cannot meet the above four requirements.
Globally, there is an increasing move towards more advanced approaches to risk
management. Banks in India have made progress in moving towards the advanced risk
management approaches. Banks, however, need to traverse a long distance in this regard.
As capital always comes at a cost, banks need to have in place a fair and differentiated risk
pricing of products and services. This involves costing, quantitative assessment of revenue
streams from each product and service and an efficient Transfer Pricing Mechanism, which
would determine capital allocation. Each business unit in the enterprise would have to aim at
being a profit centre within the overall risk-return framework. In essence, it would mean
accountability for profit, tempered by the discipline of risk-return within a deeply embedded
culture of good governance. Our past experience has been of poor savers subsidising the
rich borrowers. Also, there are incidences of rampant mis-pricing of risks. From a business
perspective, pricing of assets should be non-discriminatory and in line with risk rating of the
customer. A lower rated customer should not get a better price than a higher rated customer.
Once these basic issues are addressed, other issues such as migration to advanced
approaches, etc. would gain importance.
While all Indian banks have adopted the standardised approaches under the Basel II
framework in 2009, the pace of migration to the advanced approaches has, naturally, been
very slow. Though the Reserve Bank has set an indicative time schedule for implementation
of the Advanced Approaches, banks' response has been less than encouraging so far.
Migration to the Advanced Approaches is important for larger banks as it involves adoption of
more sophisticated risk management systems. Moreover, there are reputational issues also
in large banks continuing with standardised approaches. Apart from these fundamental
issues, much of this sluggishness could be attributed to issues relating to development of
human resource skills, technology upgradation, branch interconnectivity, availability and
management of historical data, robustness of risk management systems, etc. within the
banks. Even within the Reserve Bank, the supervisors would have to make rapid strides to
be able to appreciate the nuances associated with the quantitative techniques and models.
The objective of the Basle III reform package is to improve the banking sector's ability to
absorb shocks arising from financial and economic stress, whatever the source, thus
reducing the risk of spillover from the financial sector to the real economy. An assessment of
Indian banks' capital requirements under Basel III has revealed that, notwithstanding some
issues with a few individual banks, the system as a whole, is very well capitalised and the
transition to the revised capital norms of overall capital adequacy, Tier I component or equity
component would be smooth. The implementation period of Basel III capital requirements,
including capital conservation buffer and regulatory deductions, will begin from January 1,
2013 and will be fully implemented by March 31, 2018, before the timeline (January 1, 2019)
indicated in Basel III rules.
(ii) Reforming human resources management
There is an imperative need to improve the productivity and efficiency of human resources.
An organisation can only be as good as its people. They are the force behind innovation,
business process re-engineering and making the difference between success and failure. A
committed and highly motivated work force can make the difference in winning and retaining
customers as banking is a people oriented business. Banks have to be knowledge
organisations, able to attract and retain talent. HR policies should look at right size, right fit
and career growth with market related compensation. Increasingly, there is going to be
intense competition for the right kind of talent as they are likely to be in short supply. The
demand for efficient manpower will not only stem from domestic institutions but also from
foreign institutions/ countries; and not just from the banking industry but from other
financial/non-financial sectors. The challenge before Indian banks is, therefore, to revitalise
themselves by hiring the right talent, investing in training and bringing about a vibrant
transformation in their DNA.
(iii) Technology to be more customer focused
Most banks are already on Core Banking Systems (CBS) which covers banking operations
pertaining to deposits, withdrawals, credit delivery, back-office operations, etc. Banks need to
look beyond Core Banking to harness the benefits of technology. CBS could provide inputs
for developing customised products based on customer database. It would help in planning
product delivery and service at selected/ multiple delivery points, better Customer
Relationship Management and building lasting customer relationships which will translate
into higher revenues. Technology needs to be more customer focused than employee or
vendor focused. In case of glitches, the rectification must be swift to instill faith and
confidence in the system. It is only the more agile and innovative players who will stay ahead
in the game. Along with IT solutions arise allied issues such as IT security, governance and
audits. Gaps in IT security could make banks vulnerable to data piracy, fraud and operational
risk leading to reputation risk and erosion of customer confidence.
(iv) Focusing on MIS and information literacy
MIS is an inseparable part of bank's decision making process. The integrity and timeliness of
data is critical in formulating the bank's capital planning, business strategies, reviewing
achievements vis-a-vis targets, formulating course correction exercises where required,
feeding data into stress tests and importantly, taking action on the outcomes. This brings us
to technology support for decision making. Banks have made huge investments in
technology, which should be translated into better MIS through decision support systems and
yield returns on investment by providing economical, affordable and customised customer
centric banking solutions. The use of technology should not be seen as an end in itself but as
a means to an end.
(v) Business strategy and vision
The role of banks' Boards would become increasingly crucial in the next decade in view of
the looming competition. The Board would need to have a clear vision for the bank, a
strategy to achieve its objectives, both medium and long-term, and a well laid out long-term
plan. Banks would need to look beyond their existing customer base and large corporates
and reach out to rope in the vast number of small, retail and SME clients which are presently
deprived of bank credit. Alongside extending the reach of their banking services, there would
be a need to improve the products offered to customers and the quality of services. They
need to have proper business model and delivery model.
(vi) Reaching to the unbanked / under-banked areas
In India, growth with equity has been the central objective right from the inception of the
planning process. The objective of financial inclusion is to provide financial services at
affordable cost to those who are excluded from the formal financial system. This is vital for
sustaining long term equitable development, since a large proportion of the
households/areas do not have access to basic banking facilities, notwithstanding the
existence of vast institutional framework in the country. An important challenge is to
channelise more savings to the financial system, particularly in rural areas and from the
urban informal sector. This would need further penetration of the banking system. The
Reserve Bank's emphasis on financial inclusion is important in attaining this objective over
time. There is also enormous potential for extending finance in semi-urban and rural areas
for productive activities, which may require strengthening the banking correspondent
relationship, simultaneously enhancing the risk assessment and risk management capacities
in order to maintain credit quality and sustain the credit growth in these sectors. Besides
benefiting the unbanked masses, this will also ensure viability and scalability of banks'
financial inclusion initiatives.
(vii) Bringing down the cost of banking services
Further reduction in the cost of banking services may require greater competition among
product lines, improved delivery mechanisms and increasing use of information technology.
The costs of banking transactions need to be dramatically reduced as has happened in many
other fields such as telecom, after the advent of technology. However, it is observed that, in
banking, the transaction costs continue to be high, particularly in agriculture sector, which
include costs incurred in appraisal of borrowers, processing, documentation and
disbursement charges, loan monitoring/supervision and collection. It is essential to bring
down such transaction costs to make available credit at affordable price to the farmers.
Balancing the real and financial sector reforms
Financial sector reforms alone will not bring continued prosperity. In the recent years, we
see, growing evidence on growth deceleration in the Indian economy. For sustaining the high
growth path, improving the investment climate and enhancing the absorptive capacity by
bringing in the real sector reforms would be critical. The fact that a well-developed financial
sector is necessary to act as the intermediary between entrepreneurs/ investors and savers
can hardly be overstated. An efficient financial sector reduces the cost and risk of producing
and trading goods and services and, thus, makes an important contribution to raising
standards of living. The recent crisis, however, showed that the financial sector had
apparently taken a quasi-autonomous existence without close connection with the financing
requirements of the real economy. The financial industry, indeed, grew oversized in the
preceding years, reflected in rapid credit creation, asset price bubbles and high levels of
indebtedness, particularly in advanced financial systems. The disproportionate growth in the
global financial sector was largely due to the aggressive search for yield, engendered by the
easy liquidity in the global system that triggered a wave of financial innovation. Complex
financial products were created by structuring and hedging, originating and distributing, all
under the belief that real value could be created by sheer financial engineering. There were
hardly any signs of growing capital formation due to the growing and increasingly complex
financial sector.
The financial sector grew more rapidly than other goods and services. In a way, that made
growth of finance an end in itself and not a means to meet human needs such as food, fuel,
health and education. Given that the busting of the oversized financial sector has a
devastating impact on the real sector, it becomes important to (i) examine the optimal size of
the financial sector relative to growth and development needs and (ii) make financial sector
innovations more meaningful to cater to the needs of the real sector.
For sustaining the high growth path, it is imperative that we bring in reforms in the
agriculture, industry, infrastructure and services sectors. I would like touch upon some of the
elements of these reforms.
Improving agricultural governance and productivity
In order to step up agriculture growth, a judicious use of technology is required along with
institutional reforms, including those relating to land, incentives for supply response and
better input use. Given the dependence of a vast majority of workforce on agriculture,
enhancing the agricultural output, driven by higher yield and diversification of crops, assumes
importance. Higher investment, backed by sustained research and extension activities, could
be critical for augmenting yield. The policy focus, so far, has been on using higher MSP to
generate supply response and public investment