nvestment management

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removed. (October 2011)
Investment management is the professional asset management of various securities (shares,
bonds and other securities) and other assets (e.g., real estate) in order to meet specified investment
goals for the benefit of the investors. Investors may be institutions (insurance companies, pension
funds, corporations, charities, educational establishments etc.) or private investors (both directly via
investment contracts and more commonly via collective investment schemes e.g. mutual
funds or exchange-traded funds).
The term asset management is often used to refer to the investment management of collective
investments, while the more generic fund management may refer to all forms of institutional
investment as well as investment management for private investors. Investment managers who
specialize in advisory or discretionary management on behalf of (normally wealthy) private investors
may often refer to their services as money management or portfolio management often within the
context of so-called "private banking".
The provision of investment management services includes elements of financial statement analysis,
asset selection, stock selection, plan implementation and ongoing monitoring of investments.
Coming under the remit of financial services many of the world's largest companies are at least in
part investment managers and employ millions of staff.
Fund manager (or investment advisor in the United States) refers to both a firm that provides
investment management services and an individual who directs fund management decisions.
According to a Boston Consulting Group study, the assets managed professionally for fees reached
[1]
an all-time high of US$62.4 trillion in 2012, after remaining flat-lined since 2007. Furthermore,
these industry assets under management were expected to reach US$70.2 trillion at the end of 2013
as per a Cerulli Associates estimate.
The global investment management industry is highly concentrated in nature, in a universe of about
70,000 funds roughly 99.7% of the US fund flows in 2012 went into just 185 funds. Additionally, a
majority of fund managers report that more than 50% of their inflows go to just three funds.

Contents
[hide]

1 Industry scope
o

1.1 Key problems of running such businesses

1.2 Representing the owners of shares

2 Size of the global fund management industry

3 Philosophy, process and people

4 Investment managers and portfolio structures

o

4.1 Asset allocation

4.2 Long-term returns

4.3 Diversification

5 Investment styles

6 Performance measurement
o

6.1 Risk-adjusted performance measurement

7 Education or certification

8 See also

9 References

10 Further reading

11 External links
Industry scope[edit]
The business of investment has several facets, the employment of professional fund managers,
research (of individual assets and asset classes), dealing, settlement, marketing, internal auditing,
and the preparation of reports for clients. The largest financial fund managers are firms that exhibit
all the complexity their size demands. Apart from the people who bring in the money (marketers) and
the people who direct investment (the fund managers), there are compliance staff (to ensure accord
with legislative and regulatory constraints), internal auditors of various kinds (to examine internal
systems and controls), financial controllers (to account for the institutions' own money and costs),

computer experts, and "back office" employees (to track and record transactions and fund valuations
for up to thousands of clients per institution).

Key problems of running such businesses[edit]

Key problems include:

revenue is directly linked to market valuations, so a major fall in asset prices can cause a
precipitous decline in revenues relative to costs;

above-average fund performance is difficult to sustain, and clients may not be patient during
times of poor performance;

successful fund managers are expensive and may be headhunted by competitors;

above-average fund performance appears to be dependent on the unique skills of the fund
manager; however, clients are loath to stake their investments on the ability of a few individualsthey would rather see firm-wide success, attributable to a single philosophy and internal
discipline;

analysts who generate above-average returns often become sufficiently wealthy that they
avoid corporate employment in favor of managing their personal portfolios.

Representing the owners of shares[edit]

Institutions often control huge shareholdings. In most cases they are acting as fiduciary agents
rather than principals (direct owners). The owners of shares theoretically have great power to alter
the companies via the voting rights the shares carry and the consequent ability to pressure
managements, and if necessary out-vote them at annual and other meetings.
In practice, the ultimate owners of shares often do not exercise the power they collectively hold
(because the owners are many, each with small holdings); financial institutions (as agents)
[by whom?]
sometimes do. There is a general belief
that shareholders in this case, the institutions
acting as agentscould and should exercise more active influence over the companies in which
they hold shares (e.g., to hold managers to account, to ensure Boards effective functioning). Such
action would add apressure group to those (the regulators and the Board) overseeing management.
However there is the problem of how the institution should exercise this power. One way is for the
institution to decide, the other is for the institution to poll its beneficiaries. Assuming that the
institution polls, should it then: (i) Vote the entire holding as directed by the majority of votes cast? (ii)
Split the vote (where this is allowed) according to the proportions of the vote? (iii) Or respect the
abstainers and only vote the respondents' holdings?
The price signals generated by large active managers holding or not holding the stock may
contribute to management change. For example, this is the case when a large active manager sells
his position in a company, leading to (possibly) a decline in the stock price, but more importantly a
loss of confidence by the markets in the management of the company, thus precipitating changes in
the management team.
Some institutions have been more vocal and active in pursuing such matters; for instance, some
firms believe that there are investment advantages to accumulating substantial minority
shareholdings (i.e. 10% or more) and putting pressure on management to implement significant
changes in the business. In some cases, institutions with minority holdings work together to force
management change. Perhaps more frequent is the sustained pressure that large institutions bring
to bear on management teams through persuasive discourse and PR. On the other hand, some of

the largest investment managerssuch as BlackRock and Vanguardadvocate simply owning

every company, reducing the incentive to influence management teams. A reason for this last
strategy is that the investment manager prefers a closer, more open and honest relationship with a
company's management team than would exist if they exercised control; allowing them to make a
better investment decision.
The national context in which shareholder representation considerations are set is variable and
important. The USA is a litigious society and shareholders use the law as a lever to pressure
management teams. In Japan it is traditional for shareholders to be low in the 'pecking order,' which
often allows management and labor to ignore the rights of the ultimate owners. Whereas US firms
generally cater to shareholders, Japanese businesses generally exhibit a stakeholder mentality, in
which they seek consensus amongst all interested parties (against a background of
strong unions and labour legislation.

Size of the global fund management industry[edit]

Conventional assets under management of the global fund management industry increased by 10%
in 2010, to $79.3 trillion. Pension assets accounted for $29.9 trillion of the total, with $24.7 trillion
invested in mutual funds and $24.6 trillion in insurance funds. Together with alternative assets
(sovereign wealth funds, hedge funds, private equity funds and exchange traded funds) and funds of
wealthy individuals, assets of the global fund management industry totalled around $117 trillion.
Growth in 2010 followed a 14% increase in the previous year and was due both to the recovery in
equity markets during the year and an inflow of new funds.
The US remained by far the biggest source of funds, accounting for around a half of
conventional assets under management or some $36 trillion. The UK was the second largest centre
[2]
in the world and by far the largest in Europe with around 8% of the global total.

Philosophy, process and people[edit]

The 3-P's (Philosophy, Process and People) are often used to describe the reasons why the
manager is able to produce above average results.

Philosophy refers to the overarching beliefs of the investment organization. For example: (i)
Does the manager buy growth or value shares, or a combination of the two (and why)? (ii) Do
they believe in market timing (and on what evidence)? (iii) Do they rely on external research or
do they employ a team of researchers? It is helpful if any and all of such fundamental beliefs are
supported by proof-statements.

Process refers to the way in which the overall philosophy is implemented. For example: (i)
Which universe of assets is explored before particular assets are chosen as suitable
investments? (ii) How does the manager decide what to buy and when? (iii) How does the
manager decide what to sell and when? (iv) Who takes the decisions and are they taken by
committee? (v) What controls are in place to ensure that a rogue fund (one very different from
others and from what is intended) cannot arise?

People refers to the staff, especially the fund managers. The questions are, Who are they?
How are they selected? How old are they? Who reports to whom? How deep is the team (and
do all the members understand the philosophy and process they are supposed to be using)?
And most important of all, How long has the team been working together? This last question is
vital because whatever performance record was presented at the outset of the relationship with
the client may or may not relate to (have been produced by) a team that is still in place. If the

team has changed greatly (high staff turnover or changes to the team), then arguably the
performance record is completely unrelated to the existing team (of fund managers).

Investment managers and portfolio structures[edit]

At the heart of the investment management industry are the managers who invest and divest client
investments.
A certified company investment advisor should conduct an assessment of each client's individual
needs and risk profile. The advisor then recommends appropriate investments.

Asset allocation[edit]
The different asset class definitions are widely debated, but four common divisions
are stocks, bonds, real estate and commodities. The exercise of allocating funds among these
assets (and among individual securities within each asset class) is what investment management
firms are paid for. Asset classes exhibit different market dynamics, and different interaction effects;
thus, the allocation of money among asset classes will have a significant effect on the performance
of the fund. Some research suggests that allocation among asset classes has more predictive power
than the choice of individual holdings in determining portfolio return. Arguably, the skill of a
successful investment manager resides in constructing the asset allocation, and separately the
individual holdings, so as to outperform certain benchmarks (e.g., the peer group of competing
funds, bond and stock indices).

Long-term returns[edit]
It is important to look at the evidence on the long-term returns to different assets, and to holding
period returns (the returns that accrue on average over different lengths of investment). For
example, over very long holding periods (e.g. 10+ years) in most countries, equities have generated
higher returns than bonds, and bonds have generated higher returns than cash. According to
financial theory, this is because equities are riskier (more volatile) than bonds which are themselves
more risky than cash.

Diversification[edit]
Against the background of the asset allocation, fund managers consider the degree
of diversification that makes sense for a given client (given its risk preferences) and construct a list
of planned holdings accordingly. The list will indicate what percentage of the fund should be invested
in each particular stock or bond. The theory of portfolio diversification was originated by Markowitz
(and many others). Effective diversification requires management of the correlation between the
asset returns and the liability returns, issues internal to the portfolio (individual holdings volatility),
and cross-correlations between the returns.

Investment styles[edit]
There are a range of different styles of fund management that the institution can implement. For
example, growth, value, growth at a reasonable price (GARP), market neutral, small capitalisation,
indexed, etc. Each of these approaches has its distinctive features, adherents and, in any particular
financial environment, distinctive risk characteristics. For example, there is evidence
that growth styles (buying rapidly growing earnings) are especially effective when the companies
able to generate such growth are scarce; conversely, when such growth is plentiful, then there is
evidence that value styles tend to outperform the indices particularly successfully.

Performance measurement[edit]

Fund performance is often thought to be the acid test of fund management, and in the institutional
context, accurate measurement is a necessity. For that purpose, institutions measure the
performance of each fund (and usually for internal purposes components of each fund) under their
management, and performance is also measured by external firms that specialize in performance
measurement. The leading performance measurement firms (e.g. Frank Russell in the US or BISAM [1] in Europe) compile aggregate industry data, e.g., showing how funds in general performed
against given indices and peer groups over various time periods.
In a typical case (let us say an equity fund), then the calculation would be made (as far as the client
is concerned) every quarter and would show a percentage change compared with the prior quarter
(e.g., +4.6% total return in US dollars). This figure would be compared with other similar funds
managed within the institution (for purposes of monitoring internal controls), with performance data
for peer group funds, and with relevant indices (where available) or tailor-made performance
benchmarks where appropriate. The specialist performance measurement firms calculate quartile
and decile data and close attention would be paid to the (percentile) ranking of any fund.
Generally speaking, it is probably appropriate for an investment firm to persuade its clients to assess
performance over longer periods (e.g., 3 to 5 years) to smooth out very short-term fluctuations in
performance and the influence of the business cycle. This can be difficult however and, industry
wide, there is a serious preoccupation with short-term numbers and the effect on the relationship
with clients (and resultant business risks for the institutions).
An enduring problem is whether to measure before-tax or after-tax performance. After-tax
measurement represents the benefit to the investor, but investors' tax positions may vary. Before-tax
measurement can be misleading, especially in regimens that tax realised capital gains (and not
unrealised). It is thus possible that successful active managers (measured before tax) may produce
miserable after-tax results. One possible solution is to report the after-tax position of some standard
taxpayer.

Risk-adjusted performance measurement[edit]

Performance measurement should not be reduced to the evaluation of fund returns alone, but must
also integrate other fund elements that would be of interest to investors, such as the measure of risk
taken. Several other aspects are also part of performance measurement: evaluating if managers
have succeeded in reaching their objective, i.e. if their return was sufficiently high to reward the risks
taken; how they compare to their peers; and finally whether the portfolio management results were
due to luck or the managers skill. The need to answer all these questions has led to the
development of more sophisticated performance measures, many of which originate in modern
portfolio theory. Modern portfolio theory established the quantitative link that exists between portfolio
risk and return. The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) highlighted
the notion of rewarding risk and produced the first performance indicators, be they risk-adjusted
ratios (Sharpe ratio, information ratio) or differential returns compared to benchmarks (alphas). The
Sharpe ratio is the simplest and best known performance measure. It measures the return of a
portfolio in excess of the risk-free rate, compared to the total risk of the portfolio. This measure is
said to be absolute, as it does not refer to any benchmark, avoiding drawbacks related to a poor
choice of benchmark. Meanwhile, it does not allow the separation of the performance of the market
in which the portfolio is invested from that of the manager. The information ratio is a more general
form of the Sharpe ratio in which the risk-free asset is replaced by a benchmark portfolio. This
measure is relative, as it evaluates portfolio performance in reference to a benchmark, making the
result strongly dependent on this benchmark choice.
Portfolio alpha is obtained by measuring the difference between the return of the portfolio and that of
a benchmark portfolio. This measure appears to be the only reliable performance measure to
evaluate active management. In fact, we have to distinguish between normal returns, provided by
the fair reward for portfolio exposure to different risks, and obtained through passive management,
from abnormal performance (or outperformance) due to the managers skill (or luck), whether

through market timing, stock picking, or good fortune. The first component is related to allocation and
style investment choices, which may not be under the sole control of the manager, and depends on
the economic context, while the second component is an evaluation of the success of the managers
decisions. Only the latter, measured by alpha, allows the evaluation of the managers true
performance (but then, only if you assume that any outperformance is due to skill and not luck).
Portfolio return may be evaluated using factor models. The first model, proposed by Jensen (1968),
relies on the CAPM and explains portfolio returns with the market index as the only factor. It quickly
becomes clear, however, that one factor is not enough to explain the returns very well and that other
factors have to be considered. Multi-factor models were developed as an alternative to the CAPM,
allowing a better description of portfolio risks and a more accurate evaluation of a portfolio's
performance. For example, Fama and French (1993) have highlighted two important factors that
characterize a company's risk in addition to market risk. These factors are the book-to-market ratio
and the company's size as measured by its market capitalization. Fama and French therefore
proposed three-factor model to describe portfolio normal returns (FamaFrench three-factor model).
Carhart (1997) proposed to add momentum as a fourth factor to allow the short-term persistence of
returns to be taken into account. Also of interest for performance measurement is Sharpes
(1992) style analysis model, in which factors are style indices. This model allows a custom
benchmark for each portfolio to be developed, using the linear combination of style indices that best
replicate portfolio style allocation, and leads to an accurate evaluation of portfolio alpha.

Education or certification[edit]
Increasingly, international business schools are incorporating the subject into their course outlines
and some have formulated the title of 'Investment Management' or 'Asset Management' conferred as
specialist bachelor's degrees (e.g. Cass Business School, London). Due to global cross-recognition
agreements with the 2 major accrediting agencies AACSB and ACBSP which accredit over 560 of
the best business school programs, the Certification of MFP Master Financial Planner Professional
from theAmerican Academy of Financial Management is available to AACSB and ACBSP business
school graduates with finance or financial services-related concentrations. For people with
aspirations to become an investment manager, further education may be needed beyond a
bachelors in business, finance, or economics. Designations, such as the Chartered Investment
Manager (CIM) in Canada, are required for practitioners in the investment management industry. A
graduate degree or an investment qualification such as the Chartered Financial Analyst designation
[3]
(CFA) may help in having a career in investment management.
There is no evidence that any particular qualification enhances the most desirable characteristic of
an investment manager, that is the ability to select investments that result in an above average (risk
[citation needed]
weighted) long-term performance
. The industry has a tradition of seeking out,
employing and generously rewarding such people without reference to any formal qualifications

Racing ahead
Tata Capital commenced business
operations in 2007 and has today
evolved into a full-service non-banking

financial company catering to the diverse financial

requirements of retail and institutional customers. In
spite of the economic turbulence of 2008-09, the
company closed fiscal 2011 with an asset book of
Rs164 billion and Rs1.03 billion profits before tax.
Managing director and CEO Praveen Kadle talks
about the goals, strategies and challenges before this
Tata company
Tata Capital's financial performance in 2010-11 has
been steady and robust. What were the critical
factors that affected Tata Capital's growth and
performance?
At the start of 2010, we drew up a five-year plan called
RACE 2015, a strategy leading up to 2015 with set
goals: Revenues of Rs60 billion; Assets size of Rs500
billion; Contributing net profit of Rs10 billion; and a
sharp focus on business excellence and highly
Engaged stakeholders.
Once we all agreed to pledge our commitment to RACE
2015, we did an extensive communication campaign to
create adequate awareness and comprehension on
what RACE 2015 means and how each employee can
and should contribute in this exciting journey. Today

when I interact with employees, I get the conviction that

this ground work has really put us in good stead.
We have successfully institutionalised key business
enablers like a differentiated brand strategy, good
people practices, strong IT backbone, wide range of
products and services, robust customer relationship
management platform and adequate branch network.
All this has led us to improve our total asset book by
more than Rs45 billion, starting the year with close to
Rs110 billion and closing it at a little under Rs157
billion. We also significantly improved the quality of our
book, reducing both gross and net non-performing
assets. Our revenues improved by about 20 per cent.
Tata Capital has concentrated on investing in Tata
companies and some Tata associates. Investing in
Tata companies would also mean conflict-ofinterest issues for Tata Capital. How do you resolve
these?
We have introduced a private equity fund called the
Tata Opportunities Fund. The fund will predominantly

invest in unlisted Tata companies that need capital

support. We will provide supplementary capital support
through this private equity route to Tata operating
companies.
Traditionally Tata companies do not invite investments
from private equity players in their unlisted ventures
(except perhaps Tata Sky and Tata Teleservices) and
hence many such investors lost the opportunity to
participate in the value growth of Tata companies in
their early stages. Under the fund, we invite the large
players, ie pension funds, sovereign funds, large
banks, large institutional investors, etc rather than
individual private equity players, to invest in these
unlisted Tata companies through our Tata Opportunities
Fund. It's a win-win proposition for both the Tata
companies and the investors.
Will there be a conflict of interest? No. The decisionmaking will be controlled by the investment committee
that is under majority control by the investors, not Tata
Capital representatives. We will have a very minority
role as far as the investment decision goes. I think we

can keep enough independence and at the same time

provide a great opportunity to investors to invest in and
harvest value in the invested company.
Japanese investors seem to constitute a
substantial chunk of Tata Capital's customers. Why
and how did you look to Japanese investors?
When we started our private equity business, we were
looking for new non-traditional investors. By this time,
the global financial crisis had hit the markets and the
traditional investors in private equity, the North
American and European investors, were wary of private
equity funds, particularly the new ones. We turned to
the uncharted Asian markets, particularly Japan, which
had enough depth and liquidity. It was a leap of faith,
both in our strategy and the Japanese investors
commitment to make it work. We teamed up with
Mizuho, our strategic partner in Japan, to enter the
Japanese market. The focus of the alliance has been
largely in the area of private equity business but it also
supports other areas such as investment banking and
securities broking.

Overall, at the start of 2010, we had aimed to raise

about $1 billion by December 2011, and by March 2011
we have already raised $800 million.
What challenges does Tata Capital face in the days
ahead?
In the immediate future, we are expecting a slowdown
in the industry. High inflation has resulted in the
Reserve Bank of India raising interest rates steadily in
the last 18 months. Experts believe that industrial
production may get adversely affected as a
consequence, and this phenomenon may have a
bearing on our growth targets. The slowdown could
also impact the quality of our assets, and we will have
to be extra careful in monitoring and controlling the
quality of the book.
In the longer term, as a relatively new entrant in the
arena, we face the challenge of catching up with those
that came before us mainly in terms of creating our own
identity. While we have the Tata DNA, we have to go
beyond that to establish the Tata Capital identity, create
our own distinctive corporate culture and a strong

brand value among our customers and other

stakeholders. Being an NBFC, we are also constrained
by certain regulatory requirements like the capital
adequacy norms. When we started in September 2007,
the required capital adequacy was only 10 per cent;
today, it is 15 per cent. Alongside, there is the factor of
the debt to equity ratio. Also, an NBFC does not have
the cost advantage that a bank typically has.
Youve talked about the challenges; what about
your strengths?
Our principal strengths lie in the strong Tata brand and
its DNA, with its inherent stamp of credibility and
transparency, and the advantage of having holistic,
seamless support for all financial services requirements
under one reliable roof.
We also have the advantage of the Tata ecosystem. All
business partners, customers and vendors of Tata
companies provide a big universe of opportunities,
especially in the corporate customer segment, an
advantage that no other NBFC has. The Tata
companies per se account for less than 20 per cent of

our business and the Tata ecosystem another 30 to 40

per cent.
Another advantage is that, as an NBFC, we can
provide acquisition financing and promoter funding,
which banks cannot offer. There are no restrictions on
the number of branches that NBFCs can set up, and
NBFCs, being customer-focused, have a faster
turnaround in servicing customers than banks.
We have also created an intrinsic advantage in our
business model unlike most NBFCs which focus on
retail or B2C business; we have an equal emphasis on
corporate clients. Tata Capital was the first NBFC to
have this B2B focus. This gave us an added advantage
in terms of the pace of growth as the B2C business has
a longer gestation. In this segment, we should breakeven or even make a small profit this year. This would
be quite an achievement, given the tough environment.
How does the company see itself evolving its
international footprint over the next five years?
Weve established our first footprint in Singapore,

creating a subsidiary, Tata Capital Pte, to facilitate our

private equity and investment banking businesses in
particular. Weve also set up another subsidiary, Tata
Capital Plc, in London.
Going forward, we aim to create another international
subsidiary company focusing on wealth management
and private banking services. We also have plans for
international private equity, investment banking and
fund management businesses, maybe even private
banking and institutional broking businesses. And we
have our sights firmly set on expansion in Japan, West
Asia and even North America.
The money tree
Tata Capital offers a complete basket of financial
services for its corporate and retail clients, including
commercial finance, infrastructure finance, investment
banking, private equity, securities, wealth
management, consumer loans, credit cards, travelrelated services and foreign exchange. The private
equity funds include:

 Growth Fund: Sector-agnostic; looks at

opportunities across sectors. Specifically seeks
transactions in consumer-led sectors
(urbanisation), discrete manufacturing, specialised
services and infrastructure-linked growth
opportunities.
Healthcare Fund: Looks at all aspects of
healthcare, from drug development to healthcare
delivery (diagnostic labs, pathology clinics,
hospitals, etc).
Innovation Fund: For proven innovation ideas
where the focus is on commercialisation of the
idea and subsequently commercialisation of the
business (through IPOs etc).
Special Situations Fund: Targets distressed
companies, mainly in the manufacturing space,
and attempts to turn them around and exit.
Tata Opportunities Fund: Provides long-term
investors the ability to participate in Indian private
equity investment opportunities both from within
the Tata companies, as well as from outside the
Tata group.

This interview is a part of the

RBI tightens
norms for NBFCs
Raises capital requirement, proposes stricter NPA
guidelines; norms to be introduced in a phased manner by
April 2018; aim to bring norms on a par with those for banks
BS Reporter | Mumbai November 11, 2014 Last Updated at 00:46
IST

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In a bid to bring non-banking financial company (NBFC)

norms in line with those of banks, the Reserve Bank of
India (RBI) on Monday unleashed tighter rules for
NBFCs. According to the new guidelines, NBFCs will
require higher minimum capital, have less time to
declare bad loans, and a board-approved fit and proper
criteria for director appointments.
The new norms, which will be implemented in a phased
manner, are made applicable for NBFCs that manage
funds worth Rs 500 crore and for those that accept
public deposits. The central bank will also start granting
freshNBFC licences.
"A lighter regulatory framework has been placed on
NBFCs other than for those with large asset sizes and
deposit accepting. For NBFCs with large asset sizes,
and for all deposit-accepting NBFCs, regulations have
been harmonised across NBFCs, and to some extent,
with banks," said RBI, adding that the intent was to
create a level-playing field that does not unduly favour

any institution. (QUICK COMPARISON OF NBFC

NORMS)
To harmonise the deposit acceptance regulations
across all deposit-taking NBFCs (NBFCs-D) and move
to a regime of only credit-rated NBFCs-D accessing
public deposits, existing unrated asset finance
companies(AFCs) have been asked to get themselves
rated by March 31, 2016. "Those AFCs that do not get
an investment grade rating by March 31, 2016, will not
be allowed to renew existing or accept fresh deposits
thereafter," RBInoted.
According to current regulations, an asset is classified
as non-performing when it remains overdue for six
months or more for loans and overdue for 12 months or
more in case of lease rental and hire-purchase
instalments, compared with 90 days for banks.
The new norms proposed to reduce the period in a
phased manner so that the norms are at par with banks

by March 31, 2018.

In the past, NBFCs had opposed this on two grounds.
One, their borrowers generally come from the
unorganised and informal sections of the economy.
There are often some difficulties in repayment of due to
issues such as fuel cost increase, insurance and so
forth but this doesn't essentially translate into default.
Also, NBFCs don't get any tax benefit on their
provisioning, while banks do.
Vibha Batra, senior vice-president and co-head
(financial sector rating) at ICRA, said the revised norms
are balanced but there would be short-term pain. "The
economy is picking up and the regulator has a long
transition period to meet stringent asset quality norms,"
she said.
Similarly, provisioning for standard assets, which is
0.25 per cent for NBFCs now, is proposed to be
increased to 0.40 per cent by March 2018, in line with

banks.
On capital, however, larger and deposit-taking NBFCs
will have to increase their minimum tier-1 capital
adequacy ratio to 10 per cent by March 2017, from 7.5
per cent now. The overall capital adequacy ratio (asset
size of Rs 100 crore), has been retained at 15 per cent.
The regulator has also tightened the corporate
governance and disclosure norms for NBFCs. Besides
that, RBI said NBFCs that are part of a corporate group
or are floated by a common set of promoters, will not
be viewed on a standalone basis.
On directors' appointment, RBI said: "NBFCs shall
ensure there is a policy put in place for ascertaining the
fit and proper criteria at the time of appointment of
directors and on a continuing basis."
The minimum net worth for NBFCs, which were granted
licences before 1999, was retained at Rs 25 lakh. Now,

all NBFCs are to attain a minimum net-owned funds of

Rs 2 crore by March 2017.
RBI has also asked for application of enhanced
prudential regulations to NBFCs, wherever public funds
are accepted and conduct of business regulations will
be made applicable wherever customer interface is
involved.

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NBFCs expected more from

Mor panel

M. RAMESH
COMMENT PRINT T+

inShare


Nachiket Mor, Chairman, RBI-appointed financial inclusion
committee

CHENNAI, JAN. 13:

The recommendations of the Nachiket Mor Committee,
released by the RBI on January 7, fall short of
expectations of leading non-banking finance
companies.
NBFCs are a motley lot, though. Included under the
same rubric are large, bulk lenders such as Power
Finance Corporation, subsidiaries of foreign banks,
companies such as Sundaram Finance and Shriram
Transport Finance that finance purchase of assets used
for business (like trucks), those who lend money
against pledged gold, and a large number of cubby-hole
localised, informal lending companies that give you
money, if they know you.

 Common brush
The refrain of NBFCs is that the regulations are too
broad-based, not distinguishing their varied
characteristics.
Ever since the failure of CRB Capital Markets in 2000,
NBFCs seem to think the RBI sees them as companies
that raise funds from the public and vanish. The irony is
that the amount of public deposits with them is a
mere Rs. 7,000 crore compared with some Rs. 40-lakh
crore held by banks as deposits.
However, the committees report, titled Comprehensive
Financial Services for Small Business and Low-Income
Households, observes that NBFCs have a great deal of
continuing value to add. This held out the hope that
some path-breaking recommendations would ensue.
Key demands unmet
Many NBFCs that Business Line spoke to said that
while the recommendations had some positive features
such as allowing them to raise funds from abroad as
external commercial borrowings and permitting them
to seize the assets of defaulters under the Sarfaesi Act,
just as banks do some of their biggest and longstanding demands have not been addressed.
They, for instance, have been seeking permission to
raise more money from the market for the same
amount of own capital. Banks need Rs. 9 of their own
for every Rs. 100 they lend; NBFCs need Rs. 15.
That is, if a bank has Rs. 9 of its own money, it can
borrow Rs. 91 from the market to be able to
lend Rs. 100. An NBFC, on the other hand, can borrow

only Rs. 85. The Mor Committee wants to retain status

quo.
The committee has also rejected the call to bring risk
weights of the loans given by NBFCs on a par with
those by banks. A lower risk weight means lesser
amount of own funds relative to the quantum of the
loan.
Had these two demands been met, NBFCs would have
had more funds to lend. NBFCs are surprised that given
the mandate of the committee, which is to step up
access to formal credit to all, these demands were not
met.
Financial inclusion
Today, most Indians have no means of getting a loan
from an institution, which is far cheaper than their only
source currently, the local moneylender.
The committee itself notes: Close to 90 per cent of
small businesses have no links with formal financial
institutions and 60 per cent of the rural and urban
population do not even have a functional bank
account.
NBFCs, being the closest to the poor borrowers, claim
they are best suited for achieving more financial
inclusion. Those who know financial inclusion the
best are being excluded, laments T. T. Srinivasa
Raghavan, Managing Director, Sundaram Finance Ltd.
Bad loans
Also, the Mor Committee wants to tighten the screws on
NBFCs when it comes to bad loans. For banks, if a
borrower has not paid interest for 90 days, the money

lent to him becomes a non-performing asset and has to

be provided for, which means lower profits.
NBFCs could, however, wait until 180 days before
having to declare the loan as an NPA. The committee
now wants to bring NBFCs on a par with banks, though
it says both types of institutions should follow riskbased approaches, rather than a generic that is,
number of days.
Banks, however, can claim tax benefits for the
provision for NPA, while NBFCs cannot. The
committee is silent on this, presumably because tax
issues come under the Finance Ministry.
BANKING SECTOR LIBERALIZATION IN INDIA Christian Roland* European Business
School, Oestrich-Winkel, Germany Paper prepared for "Ninth Capital Markets
Conference" at the Indian Institute of Capital Markets ABSTRACT India has over the
last decades experienced different degrees of repressive policies in the banking
sector. This paper focuses on the changing intensity of three policies that are
commonly associated with financial repression, namely interest rate controls,
statutory pre-emptions and directed credit as well as the effects these policies had.
The main findings are that the degree of financial repression has steadily increased
between 1960 and 1980, then declined somewhat before rising to a new peak at the
end of the 1980s. Since the start of the overall economic reforms in 1991, the level
of financial repression has steadily declined. Despite the high degree of financial
repression, no statistically significant negative effects on savings, capital formation
and financial development could be established, which is contrary to the predictions
of the financial liberalization hypothesis. * E-Mail: christian.roland@web.de 1
INTRODUCTION The year 1991 marked a decisive changing point in India's
economic policy since Independence in 1947. Following the 1991 balance of
payments crisis, structural reforms were initiated that fundamentally changed the
prevailing economic policy in which the state was supposed to take the
"commanding heights" of the economy. After decades of far reaching government
involvement in the business world, known as the "mixed economy" approach, the
private sector started to play a more prominent role (Acharya, 2002, pp. 2-4;
Budhwar, 2001, p. 552; Singh, 2003, p. 1f.). The enacted reforms not only affected
the real sector of the economy, but the banking sector as well. Characteristics of
banking in India before 1991 were a significant degree of state ownership and
farreaching regulations concerning among others the allocation of credit and the
setting of interest rates. The blueprint for banking sector reforms was the 1991

report of the Narasimham Committee. Reform steps taken since then include a
deregulation of interest rates, an easing of directed credit rules under the priority
sector lending arrangements, a reduction of statutory pre-emptions, and a lowering
of entry barriers for both domestic and foreign players (Bhide, Prasad and Ghosh,
2001, p. 7; Hanson, 2001, pp. 5- 7). The regulations in India are commonly
characterized as "financial repression". The financial liberalization literature
assumes that the removal of repressionist policies will allow the banking sector to
better perform its functions of mobilizing savings and allocating capital what
ultimately results in higher growth rates (Levine, 1997, p. 691). If India wants to
achieve its ambitious growth targets of 7-8% per year as lined out in the Common
Minimum Programme of the current government, a successful management of the
systemic changes in the banking sector is a necessary precondition. While the
transition process in the banking sector has certainly not yet come to an end,
sufficient time has passed for an interim review. The objective of this paper
therefore is to evaluate the progress made in liberalizing the banking sector so far
and to test if the reforms have allowed the banking sector to better perform its
functions. The paper proceeds as follows: section 2 gives a brief overview over the
role of the banking sector in an economy and possible coordination mechanisms. A
discussion of different repressive policies and their effect on the functioning of the
banking sector follows in section 3. Section 4 gives a short historical overview over
developments in the Indian banking sector and over the reforms since 1991. An
evaluation of the status of the reforms and their effects follows in section 5. Section
6 concludes. 2 ROLE AND MANAGEMENT OF THE BANKING SECTOR A banking sector
performs three primary functions in an economy: the operation of the payment
system, the mobilization of savings and the allocation of savings to investment
projects. By allocating capital to the highest value use while limiting the risks and
costs involved, the banking sector can exert a positive influence on the overall
economy, and is thus of broad macroeconomic importance (Bonin and Wachtel,
1999, p. 113; Jaffe and Levonian, 2001, p. 163; Rajan and Zingales, 1998, p. 559;
Wachtel, 2001, p. 339). Since the general importance of a banking sector for an
economy is widely accepted, the questions arise under which coordination
mechanism state or market it best performs its functions, and, if necessary, how
to manage the transition to this coordination mechanism (Kaminsky and Schmukler,
2002, p. 30). Currently, there are opposing views concerning the most preferable
coordination mechanism. According to the development and political view of state
involvement in banking, a government is through either direct ownership of banks
or restrictions on the operations of banks better suited than market forces alone to
ensure that the banking sector performs its functions. The argument is essentially
that the government can ensure a better economic outcome by for example
channeling savings to strategic projects that would otherwise not receive funding or
by creating a branch infrastructure in rural areas that would not be build by profitmaximizing private banks. The active involvement of government thus ensures a
better functioning of the banking sector, which in turn has a growth enhancing
effect (Arun and Turner, 2002c, p. 93; Denizer, Desai and Gueorguiev, 1998, p. 2;

Gerschenkron, 1962, pp. 19-22; La Porta, Lopez de Silanes and Schleifer, 2002, p.
266f.). 1 The proponents of financial liberalization take an opposite stance. In their
view, repressive policies such as artificially low real interest rates, directed credit
programs and excessive statutory pre-emptions that are imposed on banks have
negative effects on both the volume and the productivity of investments. Removing
these repressionist policies and giving more importance to market forces will, in the
view of the proponents of financial liberalization, increase financial development
and eventually lead to higher economic growth (Demetriades and Luintel, 1997, p.
311; Denizer, Desai and Gueorguiev, 1998, p. 3; King and Levine, 1993, p. 730;
McKinnon, 1991, p. 12). A majority of empirical studies support the conclusion of the
financial liberalization hypothesis. The policy recommendations arising from these
studies are evident: abolishment of repressionist policies and privatization of stateowned banks (Fry, 1997, p. 768; King and Levine, 1993, p. 734f.; Wachtel, 2001, pp.
357-359). The next section explores various measures of financial repression and
discusses their effects on the banking sector. 3 MEASURES OF FINANCIAL
REPRESSION Financial repression refers to policies, laws, formal regulations and
informal controls that through the distortion of financial prices inhibit the proper
functioning of the banking sector.1 While there is certainly a wide array of ways in
which a government can interfere in the banking sector, three common policies are
statutory pre-emptions, regulated interest rates, and directed credit programs
(Demetriades and Luintel, 1997, p. 314; Denizer, Desai and Gueorguiev, 1998, p. 3
and 10f; Wachtel, 2001, p. 336). Statutory pre-emptions can take the form of
reserve or liquidity requirements. Reserve requirements oblige banks to deposit a
certain percentage of deposits at the central bank. While this is a common practice
in many countries, it becomes a repressive policy if the amount of funds pre-empted
is above the level required to ensure an orderly functioning of the monetary policy.
Liquidity requirements are relatively similar in nature and oblige banks to keep a
certain percentage of deposits in government securities or other approved
securities. Thus, statutory pre-emptions create both an under-supply of credit by
taking liquidity out of the market and an artificial demand for government securities
(Demetriades and Luintel, 1997, p. 311; Denizer, Desai and Gueorguiev, 1998, p. 3;
Joshi and Little, 1997, p. 112). Interest rate regulation can take several forms.
Demetriades and Luintel describe a total of six interest rate controls. These controls
are a fixed deposit rate, a ceiling on the deposit rate, a floor on the deposit rate, a
fixed lending rate, a ceiling on the lending rate and a floor on the lending rate
(Demetriades and Luintel, 1997, p. 314). Depending on how the interest-rate
controls are set, they can either constitute an incentive or disincentive for
investments and savings. The controls on the lending side are especially important
since they can affect the riskiness of the loan portfolio. Fixed lending rates or floors
on the lending rate tend to crowd out "low-risk, low-return" projects that become
unprofitable with higher interest rates. Under a directed credit program, banks have
to allocate a certain portion of bank credit to priority sectors. In the case of India,
40% of the total credit has to go to priority sectors such as agriculture, small-scale
industries, small transport operators or the export sector. The quantitative priority

sector lending targets are often combined with interest rate controls that lead to a
segmentation of financial markets and constitute a barrier to financial development.
Furthermore, loans to priority sectors can have a destabilizing effect on the banking
system, since they are often less profitable and more likely to be nonperforming
(Denizer, Desai and Gueorguiev, 1998, p. 11; Ganesan, 2003, p. 14 and 21; Shirai,
2002b, p. 18). The results of statutory pre-emptions and regulated interest rates are
a forced low return on assets and high portions of reserve money. This effectively
leads to disincentives to save because of low real interest rates while at the same
time creating demand for credit due to relatively low lending rates. In this
environment, a directed lending program serves as an allocation mechanism for
scarce credit (Denizer, Desai and Gueorguiev, 1998, p. 3; Giovanni and de Melo,
1993, p. 954). Repressive policies can have negative effects on the development of
the banking sector and the economy as a whole. Among them are a higher degree
of less efficient self financing due to a shortage of loans, a cross-subsidization
through interest rates that provides disincentives for certain groups to fulfill their 2
banking needs through the organized banking sector, and a lower productivity of
investments caused by restrictions on investments. Finally, the resulting
underdevelopment of the banking sector associated with financial repression may
result in lower economic growth (McKinnon, 1991, p. 11f.). The policy
recommendation for countries using repressive policies is to liberalize the banking
sector through the removal of repressive policies. Various measures have been
proposed to achieve this goal. First, real interest rates for deposits and loans should
be market-determined. This includes the abolition of interest rate ceilings and floors.
Second, reduction of reserve requirements to the extent that is necessary to ensure
the stability of the financial system. Third, discontinuation of the mandated
allocation of credit to certain sectors (Fry, 1997, p. 756; McKinnon, 1991, p. 12;
Wachtel, 2001, p. 337). While liberalization should entail further elements such as
institution building or privatization of stateowned banks, the removal of
repressionist policies is certainly an important step towards more marketoriented
banking. India is a case in point for a country where the government used the
described policies to gain control over the banking sector and integrate it in its
overall development strategy. The following section gives an overview over the
development of the banking sector in India. 4 DEVELOPMENT OF THE INDIAN
BANKING SECTOR 4.1 Development from Independence until 1991 At the time of
Independence in 1947, the banking system in India was fairly well developed with
over 600 commercial banks operating in the country. However, soon after
Independence, the view that the banks from the colonial heritage were biased in
favor of working-capital loans for trade and large firms and against extending credit
to small-scale enterprises, agriculture and commoners, gained prominence. To
ensure better coverage of the banking needs of larger parts of the economy and the
rural constituencies, the Government of India (GOI) created the State Bank of India
(SBI) in 1955 (Cygnus, 2004, p. 5; Joshi and Little, 1997, p. 110f.; Kumbhakar and
Sarkar, 2003, p. 406f.; Reddy, 2002b, p. 337). Despite the progress in the 1950s and
1960s, it was felt that the creation of the SBI was not far reaching enough since the

banking needs of small scale industries and the agricultural sector were still not
covered sufficiently. This was partly due to the still existing close ties commercial
and industry houses maintained with the established commercial banks, which gave
them an advantage in obtaining credit (Reddy, 2002b, p. 338). Additionally, there
was a perception that banks should play a more prominent role in India's
development strategy by mobilizing resources for sectors that were seen as crucial
for economic expansion. As a consequence, in 1967 the policy of social control over
banks was announced. Its aim was to cause changes in the management and
distribution of credit by commercial banks (ICRA, 2004, p. 5; Reddy, 2002b, p. 338;
Shirai, 2002b, p. 8). Following the Nationalization Act of 1969, the 14 largest public
banks were nationalized which raised the Public Sector Banks' (PSB) share of
deposits from 31% to 86%. The two main objectives of the nationalizations were
rapid branch expansion and the channeling of credit in line with the priorities of the
five-year plans. To achieve these goals, the newly nationalized banks received
quantitative targets for the expansion of their branch network and for the
percentage of credit they had to extend to certain sectors and groups in the
economy, the so-called priority sectors, which initially stood at 33.3% (Arun and
Turner, 2002a, p. 184; Bhide, Prasad and Ghosh, 2001, p. 4; Ganesan, 2003, p. 14;
Hanson, 2001, p. 2; Joshi and Little, 1997, p. 111; Kumbhakar and Sarkar, 2003, p.
407; Reddy, 2002b, p. 338). Six more banks were nationalized in 1980, which raised
the public sector's share of deposits to 92%. The second wave of nationalizations
occurred because control over the banking system became increasingly more
important as a means to ensure priority sector lending, reach the poor through a
widening branch network and to fund rising public deficits. In addition to the
nationalization of banks, the priority sector lending targets were raised to 40%
(Arun and Turner, 2002a, p. 184; Hanson, 2001, p. 2f.; Ganesan, 2003, p. 14;
Kumbhakar and Sarkar, 2003, p. 407). However, the policies that were supposed to
promote a more equal distribution of funds, also led to inefficiencies in the Indian
banking system. To alleviate the negative effects, a first wave of liberalization 3
started in the second half of the 1980s. The main policy changes were the
introduction of Treasury Bills, the creation of money markets, and a partial
deregulation of interest rates (Bhide, Prasad and Ghosh, 2001, p. 5; Shirai, 2002b, p.
9). 2 Besides the establishment of priority sector credits and the nationalization of
banks, the government took further control over banks' funds by raising the
statutory liquidity ratio (SLR) and the cash reserve ratio (CRR). From a level of 2%
for the CRR and 25% for the SLR in 1960, both witnessed a steep increase until
1991 to 15% and 38.5% respectively (Joshi and Little, 1997, p. 112). 3 In summary,
India's banking system was at least until an integral part of the government's
spending policies. Through the directed credit rules and the statutory pre-emptions
it was a captive source of funds for the fiscal deficit and key industries. Through the
CRR and the SLR more than 50% of savings had either to be deposited with the RBI
or used to buy government securities. Of the remaining savings, 40% had to be
directed to priority sectors that were defined by the government. Besides these
restrictions on the use of funds, the government had also control over the price of

the funds, i.e. the interest rates on savings and loans (Mukherji, 2002, p. 39). This
was about to change at the beginning of the 1990s when a balance-of-payments
crisis was a trigger for far-reaching reforms. 4.2 Developments after 1991 Like the
overall economy, the Indian banking sector had severe structural problems by the
end of the 1980s. Joshi and Little characterize the banking sector by 1991 as "[]
unprofitable, inefficient, and financially unsound" (Joshi and Little, 1997, p. 111). By
international standards, Indian banks were even despite a rapid growth of deposits
extremely unprofitable. In the second half of the 1980s, the average return on
assets was about 0.15%. The return on equity was considerably higher at 9.5%, but
merely reflected the low capitalization of banks. While in India capital and reserves
stood at about 1.5% of assets, other Asian countries reached about 4-6%. These
figures do not take the differences in income recognition and loss provisioning
standards into account, which would further deteriorate the relative performance of
Indian banks (Joshi and Little, 1997, p. 111). The 1991 report of the Narasimham
Committee served as the basis for the initial banking sector reforms. In the following
years, reforms covered the areas of interest rate deregulation, directed credit rules,
statutory pre-emptions and entry deregulation for both domestic and foreign banks.
The objective of banking sector reforms was in line with the overall goals of the
1991 economic reforms of opening the economy, giving a greater role to markets in
setting prices and allocating resources, and increasing the role of the private sector
(Arun and Turner, 2002a, p. 183; Bhide, Prasad and Ghosh, 2001, p. 7;
GuhaKhasnobis and Bhaduri, 2000, p. 335f.; Hanson, 2001, pp. 5-7; Shirai, 2002a, p.
54). A brief overview of the most important reforms follows. Statutory pre-emptions
The degree of financial repression in the Indian banking sector was significantly
reduced with the lowering of the CRR and SLR, which were regarded as one of the
main causes of the low profitability and high interest rate spreads in the banking
system (Shirai, 2002b, p. 12). During the 1960s and 1970s the CRR was around 5%,
but until 1991 it increased to its maximum legal limit of 15%. From its peak in 1991,
it has declined gradually to a low of 4.5% in June 2003. In October 2004 it was
slightly increased to 5% to counter inflationary pressures, but the RBI remains
committed to decrease the CRR to its statutory minimum of 3%. The SLR has seen a
similar development. The peak rate of the SLR stood at 38.5% in February 1992, just
short of the upper legal limit of 40%. Since then, it has been gradually lowered to
the statutory minimum of 25% in October 1997 (Ghose, 2000, p. 199; Reserve Bank
of India, 2004a, p. 10). The reduction of the CRR and SLR resulted in increased
flexibility for banks in determining both the volume and terms of lending (Kamesam,
2002, p. 379; Reddy, 2002a, p. 364). 4 Priority sector lending Besides the high level
of statutory pre-emptions, the priority sector advances were identified as one of the
major reasons for the below average profitability of Indian banks. The Narasimham
Committee therefore recommended a reduction from 40% to 10%. However, this
recommendation has not been implemented and the targets of 40% of net bank
credit for domestic banks and 32% for foreign banks have remained the same.
While the nominal targets have remained unchanged, the effective burden of
priority sector advances has been reduced by expanding the definition of priority

sector lending to include for example information technology companies (Ganesan,

2003, p. 15; Hanson, 2001, p. 8; Reserve Bank of India, 2004a, p. 16). 4 Interest
rate liberalization Prior to the reforms, interest rates were a tool of crosssubsidization between different sectors of the economy. To achieve this objective,
the interest rate structure had grown increasingly complex with both lending and
deposit rates set by the RBI. The deregulation of interest rates was a major
component of the banking sector reforms that aimed at promoting financial savings
and growth of the organized financial system (Arun and Turner, 2002b, p. 437;
Singh, 2005, p. 18; Varma, 2002, p. 10). The lending rate for loans in excess of
Rs200,000 that account for over 90% of total advances was abolished in October
1994. Banks were at the same time required to announce a prime lending rate (PLR)
which according to RBI guidelines had to take the cost of funds and transaction
costs into account. For the remaining advances up to Rs200,000 interest rates can
be set freely as long as they do not exceed the PLR (Arun and Turner, 2002b, p. 437;
Reserve Bank of India, 2004a, p. 15; Shirai, 2002b, p. 13). On the deposit side, there
has been a complete liberalization for the rates of all term deposits, which account
for 70% of total deposits. The deposit rate liberalization started in 1992 by first
setting an overall maximum rate for term deposits. From October 1995, interest
rates for term deposits with a maturity of two years were liberalized. The minimum
maturity was subsequently lowered from two years to 15 days in 1998. The term
deposit rates were fully liberalized in 1997. As of 2004, the RBI is only setting the
savings and the non-resident Indian deposit rate. For all other deposits above 15
days, banks are free to set their own interest rates (Reserve Bank of India, 2004a, p.
11; Shirai, 2002b, p. 13f). Entry barriers Before the start of the 1991 reforms, there
was little effective competition in the Indian banking system for at least two
reasons. First, the detailed prescriptions of the RBI concerning for example the
setting of interest rates left the banks with limited degrees of freedom to
differentiate themselves in the marketplace. Second, India had strict entry
restrictions for new banks, which effectively shielded the incumbents from
competition (Deolalkar, 1999, p. 60; Joshi and Little, 1997, p. 148). Through the
lowering of entry barriers, competition has significantly increased since the
beginning of the 1990s. Seven new private banks entered the market between 1994
and 2000. In addition, over 20 foreign banks started operations in India since 1994.
By March 2004, the new private sector banks and the foreign banks had a combined
share of almost 20% of total assets (Arun and Turner, 2002b, p. 439; Hanson, 2001,
p. 6; Reserve Bank of India, 2004a, p. 236-238; Shirai, 2002b, p. 20). Deregulating
entry requirements and setting up new bank operations has benefited the Indian
banking system from improved technology, specialized skills, better risk
management practices and greater portfolio diversification (Reserve Bank of India,
2004a, p. 167). Prudential norms The report of the Narasimham Committee was the
basis for the strengthening of prudential norms and the supervisory framework.
Starting with the guidelines on income recognition, asset classification, provisioning
and capital adequacy the RBI issued in 1992/93, there have been continuous efforts
to enhance the transparency and accountability of the banking sector. The

improvements of the prudential and supervisory framework were accompanied by a

paradigm shift from micro-regulation of the banking sector to a strategy of macromanagement (Reserve Bank of India, 2004a, p. 24f; Shirai, 2002b, p. 21). 5 The
Basle Accord capital standards were adopted in April 1992. The 8% capital
adequacy ratio had to be met by foreign banks operating in India by the end of
March 1993, Indian banks with a foreign presence had to reach the 8% by the end of
March 1994 while purely domestically operating banks had until the end of March
1996 to implement the requirement (Joshi and Little, 1997, p. 117; Shirai, 2002b, p.
21f). Significant changes where also made concerning non-performing assets (NPA)
since banks can no longer treat the putative 'income' from them as income.
Additionally, the rules guiding their recognition were tightened. Even though these
changes mark a significant improvement, the accounting norms for recognizing
NPAs are less stringent than in developed countries where a loan is considered
nonperforming after one quarter of outstanding interest payments compared to two
quarters in India (Joshi and Little, 1997, p. 117; Madgavkar, Puri and Sengupta,
2001, p. 114). 5 Public Sector Banks At the end of the 1980s, operational and
allocative inefficiencies caused by the distorted market mechanism led to a
deterioration of Public Sector Banks' profitability. Enhancing the profitability of PSBs
became necessary to ensure the stability of the financial system. The restructuring
measures for PSBs were threefold and included recapitalization, debt recovery and
partial privatization (Kamesam, 2002, p. 377; Reddy, 2002a, p. 358). Despite the
suggestion of the Narasimham Committee to rationalize PSBs, the Government of
India decided against liquidation, which would have involved significant losses
accruing to either the government or depositors. It opted instead to maintain and
improve operations to allow banks to create a good starting basis before a possible
privatization (Shirai, 2002b, p. 26). Due to directed lending practices and poor risk
management skills, India's banks had accrued a significant level of NPAs. Prior to
any privatization, the balance sheets of PSBs had to be cleaned up through capital
injections. In the fiscal years 1991/92 and 1992/93 alone, the GOI provided almost
Rs40 billion to clean up the balance sheets of PSBs. Between 1993 and 1999
another Rs120 billion were injected in the nationalized banks. In total, the
recapitalization amounted to 2% of GDP (Deolalkar, 1999, p. 66f.; Reddy, 2002a, p.
359; Reserve Bank of India, 2001, p. 26).6 In 1993, the SBI Act of 1955 was
amended to promote partial private shareholding. The SBI became the first PSB to
raise equity in the capital markets. After the 1994 amendment of the Banking
Regulation Act, PSBs were allowed to offer up to 49% of their equity to the public.
This lead to the further partial privatization of eleven PSBs. Despite those partial
privatizations, the government is committed to keep their public character by
maintaining strong administrative control such as the ability to appoint key
personnel and influence corporate strategy (Ahluwalia, 2002, p. 82; Arun and
Turner, 2002b, p. 436-442; Bowers, Gibb and Wong, 2003, p. 92; CASI, 2004, p. 33;
Economist Intelligence Unit, 2003, p. 9; Reddy, 2002a, p. 358f.; Shirai, 2002a, p. 5456; Shirai, 2002b, p. 26). After an overview of the developments in the Indian
banking sector over the last years, the next section tries to measure the changing

degree of financial repression in the banking system and to explore the effects
these changes had.