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State of financial sector regulation and competition in India

A B Rastogi
1

NMIMS University
Mumbai 400 056


1. Introduction
Financial sector regulation witnessed lessening of onerous regulation or
deregulation in the name of enhancing competition among financial sector firms
and service providers in the last three decades. The underlying principles of
deregulation have been to achieve market efficiency and reducing regulatory
cost. This principle is derived from the overarching belief that market efficiency
leads to protection of consumers and depositors and solvency of financial
institutions.
The 2008 credit crisis unfolded the downside of excessive deregulation and
shortcoming of light handed approach to regulation. The deregulation allowed
development of financial institutions to become too big to fail. This perception of
financial institutions that they will not be allowed to fail as it was done in the past
in the US and the UK
2
, allowed them to take excessive risk because profits of
these institutions remained private whereas losses were borne by public directly
or indirectly. The size of some of these institutions allowed them to influence
political economy of regulators and stimulated irresponsible behavior on their
part in developed economies. With the help of hindsight one can say that the
2008 crisis was the result of lack of regulation in different markets and institutions
(credit, housing, rating agencies etc.), improper implementation of existing
regulation, regulatory overlap, failure of models in calculating different risks
(particularly liquidity risk) and interdependence of markets.
Indian economy came out of the credit crisis comparatively unharmed. Both,
financial institutions and real economy measured in terms of jobs and economic
growth reached pre-crisis level in roughly eighteen months time. This paper
attempts to throw some light on the state of financial sector regulation in India,
how it survived the 2008 credit crisis and what needs to be done to meet the
challenge of financing infrastructure competitively.

2. An overview of Financial Sector Regulations and Competitiveness
Scenario
Soon after the 2008 credit crisis broke out, the President of the UN General
Assembly established a UN commission on the global crisis under the

1
This article was written for the India Competition and Regulation Report, 2011, to be published by CUTS
International, New Delhi which holds copyright of the paper.
2
The Savings and Lending companies were bailed out in 1987, Long-Term Capital Management was bailed
out in September 1998 by the Federal Reserve in the US and Northern Rock was nationalized in February
2008 in the UK.
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Chairmanship of Professor Joseph Stieglitz to study its impact on the developing
countries (Reddy, 2011). The commission did not have teeth to implement its
suggestions but its findings rationalized the importance of financial sector for a
developing country and the role of public policy in a developing country to
develop its financial sector. Needless to say that the commission was to take
heads-on the Washington consensus of the role of financial sector in the world
economy in general and the role of capital account convertibility in particular.
The UN commission recognized two paramount reasons to implement good
regulations in the financial sector. First, the regulations to protect consumers
and investors who are considered unsophisticated and whose savings are in the
custody of the financial system. Second, failure of financial firms leads to
severely limit trust and confidence among economic agents. The authorities
should take cognizance of empirical evidence that there will be attempts to avoid
regulations; but this should not be the basis for diluting appropriate and effective
regulations. Moreover, regulations should be made to ensure that all bank like
entities whether they are called a bank or not should be regulated such that
peoples trust in such institutions remains intact. Even intermediaries which
serve financial sectors such as credit rating agencies should also be regulated.
Under the paradigm of market based economy, the central banks and financial
regulators believed that the financial markets would ensure a smooth correction
of mis-pricing of risks by themselves. After the 2008 crisis, such trust placed by
the central banks in financial markets seems to have been misplaced.
It is widely believed there was a regulatory capture by the financial institutions
3
.
The post-crisis inquiries suggest that the market participants had grown so big in
size, wealth, income and influence than the non-financial sector that they
exercised a strong influence on opinion making including through the media.
A recent documentary movie, written and directed by Charles Ferguson, titled
Inside Job has severely damaged the reputation of financial economists,
regulators, teachers of business schools and financial institutions in general. The
film argues that the global economic crisis arose from a few hundred individual
acts of uncontaminated self-interest which led to deregulation. These individuals
earned enormous amount of money at the expense of general public at large and
put to risk their jobs, savings, houses and pensions. The film depicts that there
was a thin line between legality and outright fraud.
The Financial Crisis Inquiry Commission (FCIC) of the US was established in 2009
to ask and answer this central question: how did it come to pass that in 2008 our
nation was forced to choose between two stark and painful alternativeseither
risk the total collapse of our financial system and economy or inject trillions of
taxpayer dollars into the financial system and an array of companies, as millions
of Americans still lost their jobs, their savings, and their homes?. The
Commission found that it was the collapse of the housing bubble fueled by low
interest rates, easy credit, scant regulation and toxic mortgages which sparked

3
The regulatory capture implies persuading or gently forcing the regulator by the regulated to do what is
favourable to the regulated, essentially based on an information asymmetry because the regulated tend to
have more and better information on relevant aspects than regulators.
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the crisis in 2008. The crisis could be avoided if the Federal Reserve had
stopped the flow of toxic mortgages by setting prudent mortgage-lending
standard. The failures in financial regulation and supervision proved devastating
to the stability of the financial markets. The supervision failed because
government allowed financial firms to choose their regulator and they chose the
weakest one. Further, there was a failure of corporate governance and systemic
failure of risk management. The firms took excessive risk with too little capital
and with too much dependence on short-term funding. Moreover, the leverage
was often hidden in OTC derivatives position, in off-balance sheet entities and
through window dressing of financial reports (FCIC, 2011). The Commission
found that there was a systemic breakdown in accountability and ethics and OTC
derivatives contributed significantly to the crisis. The commission also found the
credit rating agencies to be equally responsible as they gave their seal of
approval blindly without understanding mortgage related derivatives of
derivatives. The Commission concluded that they found dramatic breakdown of
corporate governance, profound lapses in regulatory oversight, and near fatal
flaws in our financial system.
The FCIC findings are not very different from the documentary film Inside Job.
The subprime crisis has an important bearing on the design of regulatory system
not only in the US but all over the world because pursuit of self-interest in the
absence of moral integrity is harming fortune of innocent millions4. In the US the
multiplicity of regulatory authorities are blamed for the crisis as they complicated
the issues of jurisdiction. In the UK, where there was the single regulator the
Financial Services Authority could not anticipate the extent of latent risk. Leave
aside quantification, even the identification of risks associated with the
widespread diffusion of derivative products seemed beyond the capabilities of the
regulatory authorities. Moreover, risk management models which could capture
macroeconomic risks emanating from interest rates or exchange rate were
unable to endogenise systemic risk or liquidity risk.
The FCIC found that just prior to the crisis, there was an explosion in risky
subprime lending and securitization, an unsustainable rise in housing prices,
widespread reports of egregious lending practices, a dramatic increase in
household mortgage debt and an exponential growth in unregulated derivatives,
among many other red flags. The commission also identified widespread failures
in financial regulation, corporate governance and risk management, lack of
transparency, and a systematic breakdown in accountability and ethics as key
causes of the crisis
There are protagonists who still believe that free market, if left by itself, is able to
take corrective steps on its own. According to Alan Greenspan, former Chairman

4
Adam Smith referred to the advantages of an economic system based on self-interest of
individuals. I presume that he had in mind individuals who had a moral fiber akin to that
described in his Theory of Moral Sentiments. The Theory discusses concepts like propriety, the
foundation of judgments concerning our sentiments and conduct, the sense of duty, character of
virtue and systems of moral philosophy.

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of the Federal Reserve, things went well over the long period of deregulation and
light-touch oversight, and he argues that the global financial system is now so
unredeemably opaque that policymakers and legislators cannot hope to
address its complexity (Frank, 2011). However, both his predecessor and
successor as chairman of the Federal Reserve called for substantial changes
and helped to shape the new rules.
A sharply critical report from the Internationally Monetary Funds (IMF)
independent evaluation office pointed out that the IMF was very late to spot
the severe interconnected problems in the worlds advanced economies. As late
as the summer of 2008, the IMFs management was confident that the US has
avoided a hard landing and the worst news are [sic] behind us (Beattie, 2011).
The FCIC findings, the IMFs independent evaluation office and FSA in the UK
are agreeing to have higher risk weighted capital, control over capital flows,
financials sector being subservient to real economy and reduction in OTC
derivative products.
It is believed that the new Basel III capital standards and the ability of regulators
to insist on even greater capital will ensure more prudent and productive lending.
Financial institutions in the developed world have raised alarms and loss of
competitiveness due to new capital adequacy norms as credit supply must rise
by more than $100,000bn in the next 10 years double of its current levels to
meet demand for new funding worldwide. S&P has estimated that public and
private sector borrowers worldwide will need to raise or refinance about
$70,000bn of bonds between now and the end of 2015. (Sharma, 2011)
The Basel III rules prescribing higher standards for assessing risks and stricter
capital requirements come in the wake of the credit crisis that pushed the world
into recession. Written by the Bank of International Settlements, the rules are due
for implementation from 2013. The Basel liquidity proposals, according to the
financial institutions, could undermine banks ability to provide services such as
backup credit lines as well as funding for international trade and retail borrowers
(ET, 2011a). Therefore, the head of the Financial Services Authority has called
for a radical rethink of consumer protection in the UK, including the possible
imposition of fee caps and bans on some retail financial products (Masters,
2011).
The FSA is not the only regulator trying to tighten rules. The US has established
a consumer bureau to oversee mortgages and credit cards, while the Securities
and Exchange Commission recommended that brokers be required to act in the
best interest of their customers. In the UK, regulators have begun shifting to
more intrusive supervision of financial products. The FSA now asks more
questions when companies record large gross margins on the sale of a particular
product, and is also increasing scrutiny of bundled products and sales of related-
party investment products by financial advisers.


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3. Indian Scenario : A Comparative Perspective vis--vis the Global
Best Practices
The main regulators of the financial sector in India are the Reserve Bank of India
(RBI), the Securities Exchange Board of India (SEBI), the Forward Market
Commission (FMC), the Insurance Regulation and Development Authority
(IRDA), the Pension Fund Regulation and Development Authority (PFRDA) and
the Ministry of Finance (MoF). They regulate money, securities, commodities,
insurance markets and pension funds in India. All of them have been established
by an act of parliament and report to the Ministry of Finance except the FMC.
The MoF is the policy making body of the financial sector in India and the
Department of Consumer Affairs is for the commodities market. In principle, all
regulators are to maintain a free and fair market, maintain price stability and
protect the small investor.
The Reserve Bank of India, the central bank, does not have a formal mandate to
maintain financial stability in the country but the bank has interpreted its mandate
on monetary stability to include both price and financial stability. The way
forward for financial sector regulation in India is three fold: to maintain
macroeconomic stability, the growth of domestic financial system and to manage
integration of domestic financial system with that of the international financial
system.
It is difficult to pin-point what has led Indian regulators to be conservative and
cautious in financial regulation. However, the Asian financial crisis of 1997 left
an indelible impression on their minds. The Asian financial crisis was linked to
foreign capital and foreign exchange markets destabilizing the domestic markets.
The Raghuram Rajan report, however, comments that it is not the foreign capital
but the poor governance, poor risk management, asset liability mismatches,
inadequate disclosure, excessive related party transactions and murky
bankruptcy laws that make an economic system prone to crisis (GoI, 2009).
Before we go over to the question of learning from the 2008 credit crisis, it would
be appropriate to highlight the salient features of the Indian financial sector. A
large population of India lives close to the poverty line and their well being is
extremely sensitive to inflation. Price stability forms overarching goal of financial
sector regulation. Incidentally, the price stability is also conducive to investment.
Hence, the underlying belief that policy makers carry with them is that the health
of the financial sector is contingent upon prospects in the real sector. This
perspective has resulted in a cautious gradualist approach to financial
liberalization and deregulation in the past three decades.
Indian banks continue to remain well capitalized. In March 2009, common equity
accounted for 7% of risk capital against the norm of 3-4% for most of
international banks. Tier 1 capital reserves were 13.75% against 9.4% for large
multinational banks. Thus leverage ratio was only 17. Indian banks, accused of
over-capitalization earlier, were well equipped to deal with the initial losses as
some borrowers started to default when the 2008 credit crisis hit the market.
More than 2/3
rd
of banks are state owned and though rupee is fully convertible on
the current account, it is partially convertible on the capital account. Thus, a
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major channel of transmission of financial instability does not exist. The
convertibility restrictions keep the debt markets, especially the sovereign debt
market insulated from global financial markets. This provides strength to the
monetary policy to operate with relative independence and limits contagion
effects and moderates the adverse effects of the global crisis.
The smaller size of Indian banks coupled with non-convertibility of rupee on
capital account did not permit banks to enter into complex derivative transactions
in international markets. Their size and local presence forced them to operate in
domestic market rather than develop international expertise to operate in
international operations. The central banks perspective of the financial sector,
on the other hand, ensures that a pre-emptive counter-cyclical monetary policy is
followed to mitigate the effects of the business cycle by raising risk weights and
tightening the provisions against loans to sectors with rapid credit growth be it
housing sector, mutual funds or capital markets. The pre-emptive steps remove
incentives to the under pricing of risk. Additionally, monetary policy is used in
tandem for macro-prudential measures.
According to the Raghuram Rajan report, the last two decades of reforms have
created a robust regulatory framework but it is insufficient for a growing Indian
economy now and India must recognize that there are some deficiencies in the
current regulatory system which needs to be put right now.
The Indian economy reached its pre-crisis level in less than eighteen months
time and economic growth rate in 2009-10 and 2010-11 was 7.4% and 7.5%.
Therefore, there is little doubt that India emerged stronger, more resilient and self
confident after the crisis
5
(see Appendix 3). It is difficult to say what would have
happened if the crisis had occurred after India had allowed full capital account
convertibility. At least now, the macro-balances that were judiciously maintained
and doggedness with which the financial sector was not allowed to outgrow the
real sector, have earned appreciation globally.
According to Y.V. Reddy, the former Governor of the Reserve Bank of India,
India has been less affected by the crisis than most other countries
6
. Of the
several reasons responsible for this, the most important have been the
avoidance of macroeconomic imbalances; more active countercyclical policies in
the monetary and financial sectors; and a moderate integration with the global
economy. The policy response was also prompt and effective. A well-thought-
out use of a range of policy instruments already put in place during the boom
years helped to effectively manage the crisis (Reddy, 2011). Dr Reddy has
gone on to argue that the impact of the 2008 credit crisis was less than the
shrinkage in GDP growth rate observed in 2008 and 2009 because in 2007 the
economy was showing signs of overheating and some cyclical correction was to
be expected in 2008. If that cyclical correction is taken into account, the

5
See growth rates of BRIC countries in Appendix 3 which support Dr Y.V.Reddys claim in spite of euro-
crisis.
6
The comparison shows that growth rate of all the BRIC countries were hit by the crisis in 2009 but India
suffered much less. Rebound in all the economies occurred in 2010 but were not able to maintain growth
momentum in 2011 except that in India
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slowdown in economy which can be attributed to the 2008 credit crisis will be
even less than the contraction recorded in the GDP figures of 2008 and 2009.

SEBI
The objectives of the Securities Exchange Board of India are to develop the
securities market and to promote investors interest. To fulfill its objectives it
makes rules and regulations for the securities market.
In the past two decades of its existence, SEBI has achieved a securities market,
which is modern in infrastructure and follows international best practices. The
markets are efficient, safe, investor friendly and globally competitive. SEBI has
been in the forefront of protecting interest of minority share holders. Small
investors have benefited from improved market transparency, quarterly
disclosure standards, monitoring of corporate governance and enhancement of
the market safety through an efficient margin system and stepping up of
surveillance. SEBI is quite active in solving investor grievances issues promptly.

Role of Competition Commission of India
As markets are becoming competitive in different sectors, the underlying belief is
that with easy conditions of entry and exit, and open access to networks, the
markets would provide sufficient constraints on the behavior of service providers.
Demand would be responsive to supply cost. Information transparency
empowers consumers to make inter-company comparisons or measure
performance over time and thus, put pressure on companies to improve
performance. Adequate standards exist for Quality of Supply and Service along
with reliable systems for monitoring and enforcing them. Therefore, regulators
need not be involved in detailed price controls or choice of technology. In certain
sectors, the impact of competition on prices of services is palpable and in others
the gradual change hides away the underlying competitive forces. In a
competition led scenario where competition emerges as a reliable and effective
means of regulation, protection of consumer interest, and driving user charges
towards marginal costs, the Competition Commission of India could play a bigger
role than sector specific regulatory authorities.
The Competition Commission of India having economy wide mandate
encourages competition in real sector as well as the financial sector. Within the
real sector it is the market penetration (measured by the Herfindahl-Hirschman
Index, a commonly accepted measure of market concentration). In the
infrastructure sector, where due to network effect local monopoly exists, the CCI
could also provide an oversight in the monitoring of contracts. The manner in
which contracts are implemented can result in competition issues that can
include abuse of dominant position or anti competitive agreements on the basis
of the rights vested under the concession agreement. The CCI can, in such
situations, examine the manner in which the contract is being implemented.
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The issues related to financial sector have started coming up recently. SEBI has
detailed guidelines on the mergers and acquisitions of listed companies to
protect interest of minority shareholders. These norms are going to be tested
against the merger control provisions of the Competition Act, 2002, when they
become effective from June 1, 2011.
From the draft regulations, it appears that the procedure for acquisition of shares
or voting rights of listed companies in the country will undergo a substantial
change from June 2011. The new regulation will impact all combinations that
meet the prescribed threshold for India or worldwide assets or turnover of the
target company and the India or worldwide assets or turnover of the parties to the
acquisition or the group to which the target would belong after the acquisition.
There seems to be a divergence when it comes to the operative provisions. The
Competition Act states that any person who proposes to enter into a combination
shall give notice to the commission in the relevant form within 30 days of
execution of any agreement or other document for acquisition.
Given that the SEBI Takeover Regulations are also due to undergo a substantial
change, it is still early days to predict how acquisition of listed companies will be
regulated because jurisdiction of CCI and SEBI are overlapping. (Shroff and
Khan, 2011)

Indian perspective on financial sector reforms
In the last decade the GoI has tried with mixed results to carry out reforms in the
financial sector in the country. A committee of bankers, investment bankers and
stock exchanges submitted their report in 2007 known as the High Powered
Expert Committee on Making Mumbai an International Financial Centre (also
known as the Percy Committee) (MoF, 2007). The Percy Committee was in
favour of liberalizing the financial sector as much as the leading financial centres
of the world such as London and New York. It was in favour of adopting light
handed regulatory regime.
Another committee on financial sector reforms was constituted under the
Chairmanship of Raghuram Rajan to identify the emerging challenges in meeting
the financing needs of the Indian economy in the coming decade and to identify
real sector reforms that would allow those needs to be more easily met by the
financial sector in August 2007. The Committee had wider representation than
the Percy Committee and compared to the Percy Committee had wider mandate.
The Committee submitted its report in September 2008, i.e. soon after the credit
crisis of 2008 had almost brought down the financial system of the world to its
knees. The Committee made 35 recommendations (Appendix -1). The
proposals are a mixture of micro and macro level reforms for the banking,
securities and non-banking financial sector. According to the Raghuram Rajan
Committee the guiding principle of the financial sector reforms in India should be
to include more Indians in the growth process; to foster growth itself and to
protect the Indian economy from financial market bubble which afflicted
developed world in 2008 (GOI, 2009). Another guiding principle for the
Committee was to recognize that efficiency, innovation and value for money are
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as important for the poor as they are for emerging Indian multinationals, and
these will come from deregulation, new entry and competition in the sector.
Since 2008, the recommendations made by the Raghuram Rajan Committee
have been the guiding reforms in the financial sector in India.
The regulatory philosophy followed by the central bank in the past in India was
that innovations in the financial sector should serve the needs of the real sector.
This philosophy in the financial sector avoided a significant build-up of asset
price bubble before the financial crisis caused by the global liquidity in 2008. The
high macro-prudential measures helped in maintaining the health of the
banking system when credit crisis came in 2008.
Another feature of our financial system which makes us less globalized and
sophisticated also leads us to being less susceptible to contagion effects.
Besides this the central bank took measures to counteract the ripple effects after
the crisis occurred
7
.

After the crisis, inquiries carried out by the US Congress, the IMFs independent
evaluation office and the UN Commission have not only endorsed this philosophy
but have strongly recommended the Basle III capital adequacy norms and re-
regulate the sector to serve the needs of the real sector. This implies that SME
would get credit at a reasonable rate of interest while maintaining price stability.
The issue of credit needs of tiny sector, until recently met by unorganized sector,
is being brought into the purview of the central bank in line with the
recommendation of the Raghuram Rajan Committee (Recommendations 6 and
29: Appendix 1).
The Raghuram Rajan committee which went into the details of financial sector
reforms started its work with the premise that Indian financial sector needs to
reach out to small enterprises, those people who are outside the ambit of the
banking sector. The government is following the blue print provided by the
Committee. The Committee has recommended a gradual approach to financial
sector reform rather than a big bang approach. Financial sector regulations
wedded to meet the needs of the real economy carried out gradually will help
financial inclusion. Not only that, governments poverty alleviation schemes such
as MGNREGA will have payment component delivered through the banking
sector. Other centrally sponsored schemes such as pension and insurance are
also going to be delivered through the banking network and that would ensure
financial inclusion.
The GoI established a Financial Stability Development Council to engage in
macro prudential supervision of the economy, including the functioning of large
financial conglomerates and address inter-regulatory coordination issues.
However, doubts have been raised that the constituent regulators such as RBI
will lose some of their regulatory powers and the possibility of dilution of their
accountability (Patil, 2010).

7
I am thankful to an unknown reviewer for expanding the philosophy very succinctly.
10/21

Establishing one regulator for the financial sector has been opposed by the
existing regulators of financial markets and the Raghuram Rajan committee also
has suggested that India is not ready for a single super regulator in India.
Collating central banking regulation with the capital markets regulation is a non-
starter. Regulators and regulated have to reconcile to such multiple domain
suzerainty and learn to consult, cooperate and coexist in a harmonious manner
such that no unsolvable inconsistencies creep in. The whole process put
enormous burden of compliance on the regulated entities. In India, there exists
strong representation of regulatory membership on boards and other decision
making bodies; hence, practical conventions should be developed regarding
which of the regulators in particular circumstances work as the first among
equals and defer to their wisdom and domain. Government of the day, then,
should leave the regulators to carry on with their job (Balasubramanian et. al.,
2010). The time-tested method of diffusion of authority and a well-functioning
system of checks and balances overseen by an independent judiciary is probably
the best bet to ensure regulatory maturity, independence, and constraint.
The FCIC in the US found enough evidence that firms have strong short-term
incentives to avoid and even evade regulation which threaten to limit their profits.
Hence, the success of regulation depends on compliance rather than having just
the rule book.
One of the recommendations of the Raghuram Rajan committee is to rewrite
financial sector regulation (Recommendation 20 : Appendix 1). The government
has appointed a retired Supreme Court judge B.N Srikrishna as the Chairman of
the Financial Sector Legislative Reform Commission. According to him the case
for a super-regulator becomes strong as the boundary lines for most financial
products getting blurred. The commission is going to appoint sub-committees
and identify key areas for research and come out with concept paper. The full
commission will debate on the issues. The concept paper is going to be written
after due consultation with industry associations and stock exchanges (ET,
2011b).
One of the driving forces in the financial sector reform in India is to provide
financial resources for construction of infrastructure sector in India. It is widely
believed that physical infrastructure supports economic growth. For the reasons
of prudent fiscal policy, GoI is not keen to fund infrastructure sector using tax
payers money and encourages private sector to raise funds from domestic and
international markets to fund infrastructure. The responsibility to provide
infrastructure sector services such as roads, ports, railways, airports, electricity
and water would always remain with the government, and the private sector can
only be responsible for construction, operation and maintenance of these
services.

4. Infrastructure Financing Regulations in India
Until 1990, the provider of capital and services for infrastructure in India was
government. With prospects of weak commercialization, low levels of public
investment, rationing, shortage, and poor quality becoming evident, economic
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reforms were initiated in these sectors to encourage private sector participation
(PSP). The aim of PSPs was to attract private capital and management skills in
infrastructure provisioning and service delivery. Due to monopolistic nature of
infrastructure services, there were concerns that transfer of rights to provide
infrastructure services from public to private sector may result in either under-
provisioning of services to some segments of society by the private sector or
private sector may charge higher prices well above the cost of providing such
services. At the same time, PSP would not materialize without enabling legal,
policy and regulatory frameworks that address risks of administrative
expropriation ex-post i.e. after the private sector investment has come through. If
the private sector perceives expropriation risk to be too high, they will either
demand a very high risk premium or they would not invest at all.
The infrastructure projects generally are highly leveraged. In the next few years,
capital markets will need to make an even bigger contribution to supporting
growth, building infrastructure, and creating jobs worldwide. Nurturing their
development as transparent, well-governed and liquid sources of funding must
be a policy priority. Therefore, deregulation of debt market has become
important. However, that would also mean that the central bank would have
lesser control on one of the policy levers as explained in section 3. Given the
financial needs of the infrastructure sector, government is bringing forth reforms
in the financial sector to meet its capital needs.

a. Key concerns of private financing for infrastructure
India faces significant challenges if the $1 trillion infrastructure investment
requirement over the 12th five year plan (FYP)
8
period is to be met. Success in
attracting private funding for infrastructure will depend on Indias ability to
develop a financial sector which can provide a diversified set of instruments for
investors and issuers to address key risk factors to increasing infrastructure
exposure by project sponsors and financial institutions. Over the last year, while
the central bank, the Reserve Bank of India (RBI), introduced regulatory changes
allowing banks to increase their infrastructure exposures, increasing private
investment will require addressing fiscal barriers and procedural inefficiencies
that have contributed to project delays and discouraged private investors. In this
context, while the public sector will remain the key investor in infrastructure, the
public-private partnership (PPP) modality is expected to reduce funding pressure
on the government.
The mid-term appraisal of the 11th FYP (ending FY2012) indicates that the
private sector investment in infrastructure is likely to meet the $150 billion target
by 2012, encouraging the government to target 50% of the planned $1 trillion
infrastructure investment from the private sector during the 12th FYP. Preliminary
estimates suggest that if $500 billion is to come from private sector and
assuming a 7030 debt equity ratio, India would need around $150 billion of
equity and $350 billion of debt over a period of five years or around $70 billion of

8
Ending FY2017.
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debt a year. In light of the large debt requirements, India does not have a
sufficiently active debt market where the predominant providers are banks.
Banks are not designed to provide long-term loans required by infrastructure
projects, as they have short-term deposits and can develop asset liability
management (ALM) mismatches as a consequence of providing long-term
financing. In developed markets, long-term debt is provided by corporate bonds
and thus, the development of the corporate debt market is a key element in
financial sector reforms in India.

While government policies support the PPP modality to meet the infrastructure
deficit, PPPs also represent a claim on public resources. PPP transactions are
often complex, needing clear specifications of the services to be provided and an
understanding of the way risks are allocated between the public and private
sector. Their long-term nature implies that the government has to develop and
manage a relationship with the private providers to overcome unexpected events
that can disrupt even well-designed contracts. Thus, financiers need to manage
long-term risk, given potential for delays in commissioning projects and risks due
to market factors post commercial operation date (COD) (WB, 2006).

b. Can regulatory changes/policies alleviate these problems
Regulatory limits. As Scheduled Commercial Banks (SCB) play an important
role in infrastructure financing, regulatory limits on bank investments in corporate
bonds have been relaxed to 20% of total non-statutory liquidity ratio (SLR)
investments. As per revised norms, credit exposure to single borrower has been
raised to 20% of bank capital, provided the additional exposure is to
infrastructure, and group exposure has also been raised to 50% provided the
incremental exposure is for infrastructure.
9
As a consequence of revised norms,
bank exposure to infrastructure has grown by over 3.7 times between March
2005 and 2009.

With regard to SCB exposures to non-banking finance companies (NBFCs), the
lending and investment, including off balance sheet, exposures of a SCB to a
single NBFC/NBFC Asset Financing Company (AFC) may not exceed 10%
and/or 15% respectively, of the SCBs audited capital funds. However, SCBs
may assume exposures on a single NBFC/NBFC-AFC up to 15% and/or 20%
respectively, of their capital funds, if the incremental exposure is on account of
funds on-lent by the NBFC/NBFC-AFC to infrastructure. Further, exposures of a
bank to infrastructure finance companies (IFCs) should not exceed 15% of its
capital funds as per its last audited balance sheet, with a provision to increase it
to 20% if the same is on account of funds on-lent by the IFCs to infrastructure.
10


To ensure that equity appreciation of sponsors in infrastructure special purpose
vehicles (SPVs) can finance other infrastructure projects, the government has

9
The definition of infrastructure lending and the list of items included under infrastructure sector are as per
the RBIs definition of infrastructure (Annexure 2).
10
Reserve Bank of Indias Master Circular on Exposure Norms issued on July 1, 2010 (RBI/2010-11/68,
DBOD No.Dir.BC.14/13.03.00/2010-11).
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substituted the word substantial in place of wholly in section 10(23G) of the
Income Tax Act 1961. This change will provide operational flexibility to
companies that have more than one infrastructure SPV and will allow sponsors to
consolidate their infrastructure SPVs under a single holding company which can
have the critical threshold to carry out a successful public offering. Such a
mechanism will give sponsors and financial intermediaries an exit option from
equity participation which could be recycled for new projects. Given the
overwhelming long-term debt requirements of the infrastructure sector the
following remedial measures are required to develop the debt markets in India.

c. Remedial/ reform measures required to accelerate PPP in
infrastructure
Foreign participation in corporate debt. In January 2009, the government
raised the foreign investment limit in corporate debt to $15 billion from $6 billion.
As of date, foreign exposure in local corporate bonds remains below the $15
billion limit and this limit has been increased to $40 billion now. Higher (FII)
participation will add depth to the market. Secondly, with the essential building
blocks in terms of enabling infrastructure in place, FIIs participation could deepen
longer-tenor (infrastructure) corporate debt market.

Increasing active trading by large domestic participants. Banks should be
persuaded to trade in corporate bonds. This will lead to opening up more
avenues for banks, especially public sector banks, to actively trade in corporate
bonds, which will increase turnover in the secondary market and add to the
liquidity and depth in the market.

Regulatory Reforms
The RBI has taken steps to help the development of the government securities
and corporate bond markets. The gradual extinguishing of illiquid, infrequently
traded bonds, and re-issue of liquid bonds has helped in improving liquidity in
government securities and issue of long-dated bonds has helped in lengthening
the reference yield curve. Compulsory announcement of government market
deals has provided transparency. However, products such as interest rate futures
have not taken off as long-term investors such as insurance and pension funds
are not allowed to operate in this market.

Regulatory reforms which will help in providing liquidity in the debt markets are:

(i) Regulations require pension and insurance funds to hold all
government securities until maturity. This regulation restricts trading
and hampers liquidity and depth to the secondary debt market.
(ii) IRDA requires insurance companies to invest in debt paper with a
minimum credit rating of AA, which automatically excludes
investment by insurance companies in debt paper of most private
infrastructure sponsors. Credit enhancement products can help in
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regulatory concerns as well as attracting long-term funds to
infrastructure sector.
(iii) While exposure limits of banks to Non-Banking Finance Companies
(NBFCs) and Infrastructure Finance Companies (IFCs) have been
relaxed, a large part of it will be taken up by the existing working
capital requirements. Going forward, pension and insurance funds
may be permitted to deposit part of their long-term funds with banks
for infrastructure financing.
(iv) To encourage investment in infrastructure assets and to de-risk
financial sector balance sheet, investment in SEBI- registered debt
funds may be treated on par with direct exposures like direct bonds
and debentures, and not subject to limits.
(v) RBI may gradually relax limits placed on FIIs in long-term corporate
bonds and securitized products allowing debt funds to invest in units
of debt/fixed income mutual funds and in SEBI registered private debt
funds.


5. Conclusion
An important lesson for India from the subprime crisis is that the national
regulatory structure has a much stronger impact in mitigating the effects of the
crisis than a banks governance structure. A small part of Indian banking sector
which took the hit from the subprime crisis illustrates that the banks governance
structure of these banks was no different from their counterparts in the developed
world.
Some of the analysts in India and abroad have commented on Indias daft
handling of the credit crisis pointing out to Indias comparative underdeveloped
nature of the financial sector and in particular, conservative stand taken by the
central bank. The Former RBI Governor Y.V. Reddy refutes this misplaced
belief. According to him, India was active in policy interventions in both,
monetary and financial sectors. The RBI adopted an active countercyclical policy
unlike other central banks, which failed to intervene (Reddy, 2011). Hence,
these policies need to be pursued as appropriate to evolving circumstances.
Notwithstanding the success of the past policy interventions, India cannot afford
to maintain status quo in the financial sector as the Indian financial system has
many inadequacies, spanning from an inappropriate credit culture to financial
exclusion and poor service. He is confident that India can weather a similar
credit crisis but the financial sector needs to develop further to meet the
demands of the real sector. These needs can be met only when there are
synchronized reforms in both, real and financial sectors.
Keeping government debt market strictly controlled is something which the
successive governments and RBI governors have espoused but no policy
document has ever mentioned it publically. Reddy (2011) enumerates this latent
policy maxim in the following way The proven resilience of the Indian economy
and the anticipated bright prospects for growth may whet the appetite for Indian
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government securities in international financial markets. This will increase the
pressure on government by global financial markets for greater access to the
public debt of India. If India gives in to such pressures, it would undermine an
important policy source of stability in Indian debt markets. The lessons of
Greece should not be ignored in haste.
It is critical, however, to note that infrastructure investment requires significant
dedication of time, organizational resources, and management focus. To meet
capital needs of the infrastructure sector, government is willing to open debt
markets in India. The RBI has taken several steps to make the debt market
liquid and increase the FII participation in it. The RBIs steps are gradual and
with deferred time frame keeping up with its philosophy that financial sector
should serve the growing needs of the real sector.
Merger control provisions of the Competition Act, 2002, are now set to be
effective from June 1, 2011. The merger control provisions of the Act give the
CCI the power to review qualifying transactions before they close, to see whether
they might cause an appreciable adverse effect on competition. (Shroff and
Khan, 2011)
The state of financial sector regulation in India is evolving at a gradual pace and
there is no evidence of regulatory capture. We are hopeful that financial sector
reforms carried out in tandem with the real sector would be beneficial to millions
of people who, at present, fall outside the periphery of Indian financial system.
16/21

References
Balasubramanian N. and D.M. Satwalekar (editors) ( 2010) Corporate
Governance : An Emerging Scenario, National Stock
Exchange of India Ltd., Mumbai (NSE)
Beattie Alan (2011) Watchdog says IMF missed crisis risks, Financial Times,
London, February 9, 2011
ET (2011a) Bankers Inc Flags Risk of Regulatory Overkill, Economic Times,
March 5, 2011
ET (2011b) FSLRC to Decide on RBIs Bank Licensing Powers, Economic
Times, March 31, 2011
FCIC (2011) The Financial Crisis Inquiry Report, The Financial Crisis Inquiry
Commission, The United States, Washington
FSA (2011) - Product Intervention, Discussion Paper DP11/1, Financial Services
Authority, London, UK
Frank Barney (2011) Greenspan is wrong : we can reform finance, Financial
Times, London, April 3, 2011
GOI (2009) - A Hundred Small Steps, Report of the Committee on Financial
Sector Reforms, Planning Commission, New Delhi, India
(Also known as the Raghuram Rajan Committee Report)
Masters Brooke (2011) FSA chief seeks new consumer safeguards, Financial
Times, London, January 24, 2011
MoF (2007) - Report of the High Powered Expert Committee on Making Mumbai
an International Financial Centre, Ministry of Finance,
Government of India, New Delhi (Also known as Percy
Mistry Committee Report)
Patil R. H. (2010) Financial Sector Reforms : Realities and Myths, Economic
and Political Weekly (8 May 2010), 45(19).
Reddy Y.V.(2011) Global Crisis Recession and Uneven Recovery, Orient
Blackswan Pvt. Ltd., New Delhi, India
Sharma Deven (2011) Reforms need to nurture capital markets, Financial
Times, London, January 26, 2011
Shroff P. and Khan P. (2011) Case of Regulatory Overreach, Economic Times,
March 31, 2011
WB (2006) - India: Addressing Supply Side Constraints to Infrastructure
Financing. The World Bank, Washington, D.C
17/21

Annexure 1
Proposals made by the Committee on Financial Sector Reforms (The
Raghuram Rajan Committee Report)
1. The RBI should formally have a single objective, to stay close to a low
inflation number, or within a range, in the medium term, and move steadily
to a single instrument, the short-term interest rate (repo and reverse repo)
to achieve it.
2. Steadily open up investment in the rupee corporate and government bond
markets to foreign investors after a clear monetary policy framework is in
place.
3. Allow more entry to private well-governed deposit-taking small finance
banks
4. Liberalize the banking correspondent regulation so that a wide range of
local agents can serve to extend financial services. Use technology both
to reduce costs and to limit fraud and misrepresentation.
5. Offer priority sector loan certificates (PSLC) to all entities that lend to
eligible categories in the priority sector. Allow banks that undershoot their
priority sector obligations to buy the PSLC and submit it towards fulfillment
of their target.
6. Liberalize the interest rate that institutions can charge, ensuring credit
reaches the poor.
7. Sell small underperforming public sector banks, possibly to another bank
or to a strategic investor, to gain experience with the process and gauge
outcomes.
8. Create stronger boards for large public sector banks, with more power to
outside shareholders (including possibly a private sector strategic
investor), devolving the power to appoint and compensate top executives
to the board.
9. After starting the process of strengthening boards, delink the banks from
additional government oversight, including by the Central Vigilance
Commission and Parliament.
10. Be more liberal in allowing takeovers and mergers, by including
domestically incorporated subsidiaries of foreign banks.
11. Free banks to set up branches and ATMs anywhere.
12. Allow holding company structures, with a parent holding company owning
regulated subsidiaries.
13. Bring all regulation of trading under the Securities and Exchange Board of
India (SEBI).
14. Encourage the introduction of markets that are currently missing such as
exchange traded interest rate and exchange rate derivatives.
15. Stop creating investor uncertainty by banning markets. If market
manipulation is the worry, take direct action against those suspected of
manipulation.
16. Create the concept of one consolidated membership of an exchange for
qualified investors (instead of the current need to obtain memberships for
each product traded).
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17. Encourage the setting up of professional markets and exchanges with a
higher order size, that are restricted to sophisticated investors (based on
net worth and financial knowledge), where more sophisticated products
can be traded.
18. Create a more innovation friendly environment, speeding up the process
by which products are approved by focusing primarily on concerns of
systemic risk, fraud, contract enforcement, transparency and inappropriate
sales practices.
19. Allow greater participation of foreign investors in domestic markets as in
Proposal 2
20. Rewrite financial sector regulation, with only clear objectives and
regulatory principles outlined.
21. Parliament, through the Finance Ministry, and based on expert opinion as
well as the principles enshrined in legislation, should set a specific remit
for each regulator every five years. Every year, each regulator should
report to a standing committee.
22. Regulatory actions should be subject to appeal to the Financial Sector
Appellate Tribunal, which will be set up along the lines of, and subsume,
the Securities Appellate Tribunal.
23. Supervision of all deposit taking institutions must come under the RBI.
Situations where responsibility is shared, such as with the State Registrar
of Cooperative Societies, should gradually cease.
24. The Ministry of Corporate Affairs (MCA) should review accounts of
unlisted companies, while SEBI should review accounts of listed
companies.
25. A Financial Sector Oversight Agency (FSOA) should be set up by statute.
The FSOAs focus will be both macro-prudential as well as supervisory.
26. The Committee recommends setting up a Working Group on Financial
Sector Reforms with the Finance Minister as the Chairman. The main
focus of this working group would be to marshal financial reforms.
27. Set up an Office of the Financial Ombudsman (OFO), incorporating all
such offices in existing regulators, to serve as an interface between the
household and industry.
28. The Committee recommends strengthening the capacity of the Deposit
Insurance and Credit Guarantee Corporation (DICGC) to both monitor risk
and resolve a failing bank, instilling a more explicit system of prompt
corrective action, and making deposit insurance premia more risk-based.
29. Expedite the process of creating a unique national ID number with
biometric identification.
30. The Committee recommends movement from a system where information
is shared primarily amongst institutional credit providers on the basis of
reciprocity to a system of subscription.
31. Ongoing efforts to improve land registration and titlingincluding full
cadastral mapping of land, reconciling various registries, forcing
compulsory registration of all land transactions, computerizing land
records, and providing easy remote access to land recordsshould be
expedited.
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32. Restrictions on tenancy should be re-examined so that tenancy can be
formalized in contracts, which can then serve as the basis for borrowing.
33. The power of SRFAESI that are currently conferred only on banks, public
financial institutions, and housing finance companies should be extended
to all institutional lenders.
34. Encourage the entry of more well-capitalized ARCs, including ones with
foreign backing.
35. The Committee outlines a number of desirable attributes of a bankruptcy
code in the Indian context, many of which are aligned with the
recommendations of the Irani Committee. It suggests an expedited move
to legislate the needed amendments to company law.

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ANNEXURE 2 - THE RBIS DEFINITION OF INFRASTRUCTURE LENDING
Any credit facility in whatever form extended by lenders (i.e. banks, FIs or
NBFCs) to an infrastructure facility as specified below falls within the definition of
"infrastructure lending". In other words, a credit facility provided to a borrower
company engaged in:
developing or
operating and maintaining, or
developing, operating and maintaining any infrastructure facility that is
a project in any of the following sectors, or any infrastructure facility of
a similar nature :
i. a road, including toll road, a bridge or a rail system;
ii. a highway project including other activities being an integral part of
the highway project;
iii. a port, airport, inland waterway or inland port;
iv. a water supply project, irrigation project, water treatment system,
sanitation and sewerage system or solid waste management
system;
v. telecommunication services whether basic or cellular, including radio
paging, domestic satellite service (i.e., a satellite owned and
operated by an Indian company for providing telecommunication
service), Telecom Towers network of trunking, broadband network
and internet services;
vi. an industrial park or special economic zone ;
vii. generation or generation and distribution of power including power
projects based on all the renewable energy sources such as wind,
biomass, small hydro, solar, etc.
viii. transmission or distribution of power by laying a network of new
transmission or distribution lines.
ix. construction relating to projects involving agro-processing and
supply of inputs to agriculture;
x. construction for preservation and storage of processed agro-
products, perishable goods such as fruits, vegetables and flowers
including testing facilities for quality;
xi. construction of educational institutions and hospitals.
xii. laying down and / or maintenance of pipelines for gas, crude oil,
petroleum, minerals including city gas distribution networks.
xiii. any other infrastructure facility of similar nature.
Source : RBI
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ANNEXURE 3 GROWTH RATES OF BRAZIL, INDIA, CHINA AND SOUTH
KOREA
Brazil India China South Korea
2008 5.1 9.0 13.0 2.2
2009 -0.2 6.7 8.7 0.2
2010 7.5 7.4 10.3 6.1
2011 (est.) 3.0 7.5 9.0 3.5
Note: For India 2009, 2010 and 2011 implies FY 2008-9, 2009-10 and 2010-11 respectively.