Rajeshwar Rao: Reflections on policy choices in the Indian financial
system
Text of the 12th R K Talwar Memorial Lecture by Mr Rajeshwar Rao, Deputy Governor
of the Reserve Bank of India, at the Reserve Bank of India, Mumbai, 21 October 2022.
* * *
I. Introduction: Indian Financial System- Looking back and looking
ahead in the 75th year of Indian Independence
Distinguished members of banking fraternity, ladies, and gentlemen
It is a privilege to deliver the twelfth memorial lecture honouring the great legacy of late
Shri R.K. Talwar. I feel thankful and humbled for this opportunity as an occasion to
remember personality like Shri R.K. Talwar given his contribution to the banking
industry.
India recently celebrated 75 years of its independence and during this period, our
country has witnessed a transition to a promising and prominent force in the new global
order. However, the journey is far from complete, and a lot remains to be accomplished
to realise our true potential. Such occasions as these give us an opportunity to reflect
on the path traversed, the continuing and emerging challenges and the way ahead.
Shri R. K. Talwar took the helm at India's largest bank at a very pivotal point in our
banking history- the period of nationalisation. He reoriented the commercial banking to
serve the underprivileged, which aligned seamlessly with the objectives of
nationalisation. His emphasis on innovative banking, rehabilitation of sick units,
convenient and accessible financing to small scale industries and credit impetus for
rural development are testaments to his vision which later became the cornerstone of
responsible banking, paving way for inclusive development in our country.
Since independence, our country has taken giant strides in growth and development in
all sectors. The GDP of India rose from a meagre Rs. 5 lakh crore (1950-51) to about
147 lakh crore (2020-21) at constant prices of 2011-12, growing about 27 times with a
CAGR of about 4.8 per cent. But in the shadow of this growth story lies a duality which
attracts the attention of every policymaker and concerned citizens. Even as the GDP
has grown 27-fold in last seven decades, the per capita income has grown merely
seven-fold from about Rs.14,000 (1950-51) to about Rs. 1 lakh (2020-21) at constant
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prices of 2011-12, with a CAGR of about 2.9 per cent . This duality highlights the
importance and requirement of inclusive growth of our country - a goal we all should
aspire for and contribute towards in our respective professional capacities.
The evolution of the financial system, too, has been dotted with several twists and
turns, reflecting the policy choices made in a given socio-economic and political
context. As is generally said, policy making is not amenable to corner solutions. The
outcomes more often than not lie somewhere in the hazy middle, reflecting the
contextual trade-offs. In my remarks today, I intend to dwell on some of these tradeoffs,
the idea being not to judge them for their existence, or to contemplate about their
counterfactuals but just to bring forth the specific structural paths our financial system
has journeyed over the course of last seven decades whilst bolstering the ever-evolving
Indian growth story.
I will therefore briefly touch upon some of such structural and regulatory dualities of
Indian financial system which are integral to addressing some of the key questions that
I highlight, while venturing with a few thoughts of my own on the way ahead.
II. Bank-led vs market-led financial intermediation in India
Is it possible to envision a transition from a bank-dominated financial system to a
non-bank intermediation channel?
There is extensive empirical evidence and literature which substantiates the claim that
economic development of a country is closely associated with the development of
financial system, which creates an efficient system of pooling the savings and
channelising them to productive capacities of the country.
While bank credit has historically been a dominant source of financing in India, the
same has been supplemented over the period by non-bank channels, which have
grown significantly in last one decade or so. India now has more than 10 crore demat
accounts and there has been a spurt in the entities accessing primary market to raise
funds. Relatively newer entrants to this game, Mutual Funds, have clocked assets
under management (AUM) of around Rs. 40 lakh crores. The corporate bond market
has also grown significantly, though structurally it remains confined to better rated
corporates with the expected penetration down the credit curve remaining an enduring
challenge. There has been a steady increase in the corporate bond issuances and the
outstanding amount has crossed Rs. 40 lakh crore as of March 2022. As we all know,
corporate bond market acts as a risk diffuser within the financial system, redistributing
the risk among a larger set of investors.
While the gradual shift in the flow of credit from banks to market-based mechanisms
has been evident, the road has been longer in our case as we can still see the centrality
of banks in the economic system. Ironically, banks have also been supporting several
market segments of non-bank intermediation channel - as providers of secondary
market liquidity, for credit enhancement and as market makers. This makes the job of
Reserve Bank, as a regulator, even more critical because of the interconnectedness of
all economic agents with the banking system.
The government, SEBI and the Reserve Bank have taken several steps to develop
corporate bond market. SEBI has put in place a market microstructure for corporate
bonds in the form of DvP settlement, electronic bidding platform and reporting of trades
to increase transparency in pricing. Reserve Bank has also endeavoured to develop
complementary markets such as repo and CDS to supplement the efforts of SEBI. We
firmly believe that with growing need for credit, the sources would also need
diversification. This would enable a competitive pricing of credit risk among the market
participants and give more bargaining power to the companies looking to fund their
growth and expansion and thus, would be beneficial to the real sector.
However, let me emphasize here that over the years, there is, one key aspect in which
the role of banks has become more and not less important, - inclusiveness of
intermediation - both geographic as well demographic. The banking sector has, over
the years, borne much of the burden in this regard, absorbing a lot of costs in the
process. Any assessment of the performance of the banking system vis-à-vis other
channels must not lose sight of this critical aspect!
III. Ownership - Public vs Private
Does there exist a middle ground in the debate?
Indian banking system has a very distinguishing characteristic pre-and-post
liberalisation. Before liberalisation, Indian economy was largely a mixed economy with
government playing a dominant economic role for planned development. This economic
structure was well aligned with the contemporaneous banking structure where public
sector banks owned roughly 90 per cent of total banking assets in India, especially after
two major episodes of nationalisation of banks (1969 and 1980).
The genesis of financial sector reforms in India could be attributed to the
recommendations of the Committee on the Financial System- chaired by Shri M
Narasimham in 1991 (popularly known as Narasimham Committee-1). Based on the
recommendations of the committee, the dual regulation of banks was proposed to be
removed, interest rates were largely deregulated, Statutory Liquidity Ratio (SLR) and
Cash Reserve Ratio (CRR) were reduced to increase the productive capacity of bank
capital, and more importantly, the banking sector started to get re-organised with entry
of private sector and foreign banks. The idea of introducing new banks was to improve
the competitiveness of the banking system for better allocative efficiency.
Since commencement of their business, the new age private sector banks have been
contributing increasingly to the credit needs of the economy. In about last 25 years,
their share in total credit has increased from about 3 per cent in 1996-97 to 36 per cent
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in 2021-21 . While private banks have had their share of problems, their presence has
made the financial system more resilient and has provided impetus to the efforts of
financial deepening in form of an accelerated growth in bank-credit to GDP ratio from
about 26.7 per cent in 1995 to about 52 per cent in 20214.
As regards the public sector banks, their role has been extensively debated over the
years. The idea of banking consolidation was first pitched in the Narsimham
Committee1 through establishment of a three-tier banking structure: i) three large banks with
international presence, ii) eight-to-ten national banks, and iii) large number of regional
and local banks. It is argued that large, consolidated banks may potentially have better
risk diversification due to economies of scale and capacity to finance large projects. The
latter rationale of consolidation becomes more pertinent as Indian firms, and their
concomitant credit requirements grow.
Government of India has been facilitating consolidation of public sector banks in India
over last few years. As a result, the number of public sector banks has reduced from 27
(as of Mar 2017) to 12 (as of Jun 2022). The number of private sector banks has
remained constant at 21 during the same period. The consolidation of public sector
banks does not seem to have had any negative impact on their outreach or inclusive
banking efforts as the total number of bank branches has largely remained same (with
minor reductions due to rationalisation) pre-and-post merger. Besides, the financial
inclusion efforts have already transcended to a business correspondent led model
leveraging on technology.
At a broader level, for enabling a reasonable level playing field, there would have to be
a gradual convergence in terms of the operating space and flexibility available to each
class of entity. In terms of regulatory and prudential norms governing the Public and
Private Sector banking operations, there is already a significant amount of
convergence. Therefore, from prudential perspective, the debate is infructuous.
However, the same level of convergence would have to be extended to managerial and
operational flexibility of PSBs based on certain governance standards. Going forward,
this will generate the requisite space for both PSBs as well as private banks to grow
their business and thrive.
IV. Business models - Diversified vs Specialised
Does the promise of niche, specialised banking still hold?
With widespread digital revolution and massive penetration of internet in Indian
households, the need for aligning banking practices of 21st century with new
aspirations of India was felt. Based on this evolving scenario, a committee under the
chairmanship of Dr Nachiket Mor, the then member of central board of RBI, was
constituted to study the scope of comprehensive financial services to small businesses
and low-income households. The committee submitted its report in 2013 and discussed
idea of 'differentiated banking' in India on the basis of horizontal and vertical
differentiation involving formation of separate stylised banks on the basis of regional
/sectoral scope and activities (deposit, transaction, or credit). The concept of 'payment
bank' was first discussed in that report which started the formal discourse on
differentiated banking.
Subsequently, the union finance minister announced in 2014-15 budget speech that
RBI will create a framework for licensing Small Finance Banks (SFBs) and other
differentiated banks. In accordance with the announcement, Reserve Bank issued
guidelines for setting up SFBs and Payments Banks (PBs) in November 2014. The
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specified objectives of setting up of SFBs, as envisaged in the licensing guidelines , is
to further financial inclusion by provision of savings vehicles, and increase supply of
credit to small business units; small and marginal farmers; micro and small industries;
and other unorganised sector entities, through high technology-low-cost operations. On
similar lines, PBs were set-up with the objective to further financial inclusion by
providing small savings accounts and payments/remittance services to migrant labour
workforce, low-income households, small businesses, other unorganised sector entities
and other users6.
Since their inception, SFBs have started playing a progressive role in mobilising
savings from and providing credit to their niche customer segments, furthering the
cause of financial inclusion. The growth of aggregate deposits and credit of SFBs have
been significant since March 2018. In the quarter ended Mar 2022, the deposits grew
by 37.3 per cent on y-o-y basis while growth in credit portfolio was 25.6 per cent, as
against growth rate of deposits and credit of SCBs at 10.2 per cent and 10.8 per cent
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respectively . Although, it may seem unfair to compare the concerned numbers of
public and private sector banks to SFBs because of scale-effects, even in terms of
outreach through bank branches, SFBs represent about 4 per cent of bank branch
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network in India currently, expanding from less than 1% in 2017 .
Payments Banks are truly first-generation new age differentiated banks designed on
activity based functional differentiation. The impact of these banks on digital payment
economy and doorstep banking cannot be assessed just by their points of presence but
also from the data of facilitated digital transactions. Just to give you all a perspective on
this, the payments banks facilitated a total of about 11.4 crore mobile banking
transactions amounting Rs.17,465 crore in value in the month of June 2020, which has
increased to 47.3 crore transactions with aggregate value of about Rs.46,338 crore in
just two years (August 2022), growing by 4.1 times in terms of volume and 2.7 times in
terms of value. It is also important to highlight that as of August 2022, there were 2.5
crore active users of payments banks using their mobile banking facilities, representing
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about 2.7 per cent of all active internet users in India .
The primary objective of a differentiated banking structure, as alluded earlier, was to
expand the reach of financial services and institutions with financial inclusion being the
overarching objective. Therefore, the underlying premise of differentiated banking
institutions is based on differentiated reach. As we all are experiencing now, almost all
banks have or are adopting technology to improve and expand delivery of financial
services and products. The Reserve Bank has been taking progressive measures to
improve availability of digital infrastructure for banking services and this process
recently got a significant boost by the launch of 75 Digital Banking Units (DBUs) by
Hon'ble Prime Minister.
These DBUs will be set up in 75 districts to commemorate 75 years of independence
under the Azadi Ka Amrit Mahotsav for a targeted Digital Banking drive. The DBUs
would facilitate the customers in embarking the digital journey through digital modes
/channels in a paperless, efficient, safe and secured environment, enhance financial
inclusion and make available the full array of financial service products to the public in a
seamless and efficient manner and enhance their banking experience. These DBUs
would also help in creating awareness on various aspects on digital banking, lessening
the hesitation among customers towards availing digital financial services and thereby
catalyse faster adoption of digitization.
Establishment of DBUs is a noteworthy step to augment digital infrastructure for
banking services in the country and facilitate a seamless banking experience. Given the
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scope to scale up the financialisation of the Indian economy , and accelerate the pace
of financial inclusion, there exists enough space for differentiated financial institutions to
operate and grow. At the same time, it needs to be ensured that business models have
to be sufficiently robust to provide the required financial resilience; and good
governance and technological standards are adhered to while striving to fulfil their
desired objectives.
V. Innovation vs. Customer Protection
Technology-enabled innovation in financial services has been one of the greatest
disrupters to the traditional way of banking. Alternate models of lending are rapidly
changing the market dynamics and affecting the role of traditional intermediaries. While
banks have access to low-cost deposits, tech firms' advantage is that with technology's
aid, they can utilise a range of data/ alternate inputs for evaluating creditworthiness or
who to lend to. From a regulatory standpoint, while there are strong arguments for
making sure that the traditional vehicles of lending continue, there is a view that
regulators are reluctant to encourage fintech led innovations and this approach is
perceived to unfairly skew the balance in favour of banks. To my mind this would not be
the right inference; technological changes need to be imbibed in digestible doses to
forestall destabilising of the financial system. No doubt, growth of tech led innovation
need to be fostered, but preserving financial system stability is an overriding objective
for the Regulators and achieving the right mix of ensuring stability while fostering
innovation remains the goal. Therefore, regulators expect that the nature of partnership
between traditional banks and the new fintech players to evolve into a symbiotic one,
and not necessarily an adversarial one.
This could create a win-win outcome for all the stakeholders, but one challenge that
may arise is that of proxy disintermediation, with the attendant risks of financial
activities taking place outside the regulatory perimeter. The recent guideline on digital
lending is an attempt to have an enabling framework, balancing competing
considerations.
Most of the innovations in the delivery of financial services have an inherent aspect of
conduct - the choice between exploitative vs responsible conduct. It is important to
establish a common denominator of what is 'responsible'. This dimension has a lot
more subjectivity while seeking to address the issue.
Ethical and responsible banking, being sensitive to the needs of people we are serving,
being inclusive in our approach to vulnerable sections of the society, taking prudent
financial decisions - these all are the choices which are always available to each one of
us engaged in the financial sector. Banking fraternity being the trust bearer of the
society owes it to people and the country, to be sensitive, inclusive, responsible, and
prudent.
Our financial institutions have navigated and will continue to navigate through these
choices. Adopting unfair means, oblivious to the consequences may push top line in the
short run but will potentially harm organisation in the long run. After all, financial
institutions are not in this business for few years but for a long haul. Hence, purely from
a business point of view, it makes a lot of sense to act in the interest of all stakeholders.
All aspects- affordability, accessibility, and especially the appropriateness should,
therefore, be adhered whenever we design a financial product or deliver it. Breaching
any of the above cannot be a choice at all.
VI. Concluding remarks
I have tried to briefly highlight the critical dualities of Indian financial system. As
mentioned earlier, I do not intend to judge any of these categories. The only intention to
bring forth these dualities is to emphasize the largely organic evolution of Indian
financial system in response to our growing economy and highlight that the regulatory
frameworks of RBI have facilitated meeting the ever-changing needs of the country. At
every juncture of growth in financial system, at every kink, there are innumerable policy
choices for a regulator. The decisions we make today have the potential to shape the
present and future of our economy and our nation. But sometimes, we can wonder on
what could have been the counterfactual and answering such a counterfactual is
difficult. But it can be most certainly stated that the depth, size, and resilience of Indian
financial system owes much to such decisions in past taken at various crossroads. One
may well argue that these policy choices were not necessarily pro-active but sometimes
reactive as well. True! Central Bankers do not have liberty to innovate freely, we have
to put our mandate and financial stability first. There have been times when we are
appreciated for our prudent policies and times when we are criticised for being
conservative. But let me assure you, whatever we do, we strive to do in broader public
interest. Every policy stance of ours is customised to the need of our growing economy
and preserving financial stability, and that remains our guiding principle.
In a conventional set-up, the banking regulation has some pre-specified toolkits which
are time tested and globally adopted. Every financial crisis offers some insights to the
regulators, and the toolkit is accordingly modified in response to the lessons learnt. But,
with a dynamically evolving financial system, regulators do not have liberty to rely
excessively on existing means because many of the potential challenges emanating
from the emerging financial order are not foreseeable. Worldwide, regulators are
striving to remain ahead of the curve, because they simply cannot afford to be reactive
in this environment. The changes we feel to be insignificant can now grow manifold in a
very short span of time posing threat to the stability of financial system. Therefore, we
have to be cognisant of all the financial changes happening around and respond
appropriately to such changes. As the regulatory perimeter gradually extends to
uncharted domains - climate finance, regulation of digital lending, etc. some of these
issues will become even more relevant.
To guide us in this transition, we have tried to fix some broad principles that make the
policy stances adaptive enough to cope up with any present and future challenges,
while creating enabling environment for innovations with positive externalities. At a
broad level, three guiding principles that would be helpful in framing financial regulation
going ahead are - principle-based, proportionate and activity-based regulations. In an
uncertain business environment, it is very difficult to predict and then prescribe all
possible scenarios of a financial transaction. Therefore, such complex superstructure
warrants that regulator should move away from rule-based prescriptive regime to
principle-based regime and the principles of regulation should always have the financial
stability and interests of consumers at its core.
The second principle for present and future regulation should be a differentiated
regulatory system based on size, complexity and contribution to systemic risk. Further,
as the interconnectedness, scope of activities and harmonisation of financial
intermediation increases, entity-based regulatory architecture may create arbitrage
between different entities undertaking similar activity. Therefore, going forward, activity
should form a common regulatory thought for future regulations.
Let me end by citing a few lines from the well-known poem by Robert Frost, which not
only resonates with what I just said but also touches upon the theme of this lecture- the
reflection on policy choices:
"Two roads diverged in a yellow wood, And sorry I could not travel both-
I took the one less travelled by,
And that has made all the difference."
Thank you once again IIBF for organising this lecture and giving me an opportunity to
share my thoughts. And thank you to all the distinguished guests for your patient
listening.
Thank you all!
The inputs provided by Shri Vaibhav Chaturvedi, Shri Pradeep Kumar and Shri Saurabh
Pratap Singh are gratefully acknowledged.
2
Ministry of Statistics and Programme Implementation, GoI, accessed at https://mospi.
gov.in/web/mospi/download-tables-data/-/reports/view/templateOne/28401?q=TBDCAT
3
Handbook of Statistics on Indian Economy, RBI, Sep 2022
4
Bank for International Settlements
5
Guidelines for licensing small finance banks, RBI https://www.rbi.org.in/Scripts
/BS_PressReleaseDisplay.aspx?prid=32614
6
Guidelines for licensing of payment banks, RBI https://www.rbi.org.in/Scripts
/BS_PressReleaseDisplay.aspx?prid=32615
7
Commercial Banks at a glance, DBIE, RBI
8
Bank-wise Number of Functioning Offices of Commercial Banks as at end of the
Quarter, DBIE, RBI
9
Bank wise volumes in ECS/NEFT/RTGS/Mobile transactions, Data releases, RBI
10
Financialization of an economy may be defined as increasing depth and size of
financial market. In this context, I refer it to the volume of financial assets in an
economy as a proportion of its GDP.