Chapter 4

An Overview of the Indian Financial System

in the Post-1950 Period

1
 To discuss the Indian financial system in the post
independence period with its major features of
development.

2
Financial System & Economic Reform
 Indian Financial System (Post 1950 period) has two
aspects in terms of size, efficiency, complexity, growth,
diversity and sophistication

 Pre-Reform Periods (1950-1990)

 Post-reform Periods ( 1991- till now)

 Significant Change in terms of mixed economic

structure and growth priorities of emerging economy
3
 Sustained Economic growth
 Globalisation of the Indian financial system
 Introduction of international best practices in prudential
regulation and
 Improving market efficiency
 Appropriate institutional framework
 Functioning foreign exchange market
 Independent monetary policy environment
 Increasing transparency, integration of national markets
 regulatory effectiveness, enhancing competitive
 conditions, reducing information asymmetries
4
 Financial Market Integration
 Financial Stability
 Financial Inclusion
 Development of Financial Market Infrastructure
 Growth in Domestic Savings & Investment
 Regulatory Infrastructure
 Consolidation of Business Entities
 Efficient Financial Market Market Structure
 Corporate Bond Market
 Foreign Exchange Market
 Money Market
 Derivative market
5
 Primary & Secondary Market
 Major Points of Attention:

 Sometimes its has taken place in spurts, cycles,

temporary booms and unusual ways without
considering long-term implications
 It has taken place at the initiative of the Govt. or
as a result of superimposition of authorities
 It has been boosted by tax or fiscal concessions

6
 contd.

 Strong element of imitation or transplantation of

foreign ideas and institutions
 It has an element of internal contradiction
 Politicisation of Reform Priorities
 Confusion for Regulations Vs. Market discipline
 Casino Finance through overemphasis of Equity
Culture

7
 Financial Ratio
(total issue of Primary & Secondary claims in relation to
national income)
 Financial Inter-relation Ratio
(Financial assets to Physical assets)
 New Issue Ratio
(Ratio of Primary issues to the physical capital
formation)
 Intermediation Ratio
(Ratio of Secondary issue to Primary Issue)
 Gross Domestic Savings
 Total Capital formation in the Economy
 Flow of Funds Account (FOFA)
 Select Indicators of Financial Development (Rs crore )

Item 1951-52 1980-81 1995-96 1996-97 1997-98 199899 1999-00 2000-01

1. Secondary Issues -71 15098 179116 185638 240884 277498 273759 294765

2. Primary Issues all 140 19824 255192 222351 362009 367061 307956 484461
sectors other than
financial intermediaries
2.1 Domestic Sectors 193502 342359 350075 293354 434573
-------- -------- ---------
2.2 Rest of the World 28849 19650 16986 14602 49888
-------- --------- ----------
3. Total Issues (1+2) 69 34921 434308 407989 602893 644559 581715 779226
4. Net Domestic Capital 9141 13263 105743 198627 238099 241280 320651 303677
Formation at current
Prices

5. National Income at 9141 105743 941861 1115449 1434826 1434826 1585502 1696387
Factor Cost at Current
Prices
6. Financial Ratio (3/5) 0.007 0.3303 0.493 0.37 0.49 0.45 0.37 0.46
7. Financial Inter- 0.08 0.69 1.18 2.05 2.53 2.67 1.81 2.57
relations Ratio (3/4)
8. New Issue Ratio (2/4) 0.17 0.85 1.328 1.12 1.52 1.52 0.96 1.60
9. Intermediation Ratio 0.76 0.702 0.83 0.67 0.76 0.89 0.61
(1/2) --------
9
Pattern of Sources of Funds for Indian Public
Limited Companies (Percentage to Total)

1985-86 to 1990-91 to 1995-96 to 2000-01 to 2005-06

1989-90 1994-95 1999-2000 2004-05
Internal Sources 31.9 29.9 37.1 60.7 43.6
External Sources 68.1 70.1 62.9 39.3 56.4
a)Equity Capital 7.2 18.8 13.0 9.9 17.0
b) Borrowings 37.9 32.7 35.9 11.5 24.4
i) Debentures 11.0 7.1 5.6 -1.3 -2.7
ii) From Banks 13.6 8.2 12.3 18.4 23.8
iii) From FIs 8.7 10.3 9.0 -1.8 -2.4
c) Trade Dues and other 22.8 18.4 13.7 17.3 14.7
Current Liabilities
Total 100.0 100.0 100.0 100.0 100.0
A) Share of Capital 18.2 26.0 18.6 8.6 14.3
market Related
Instruments
B) Share of Financial 22.2 18.3 21.3 16.6 21.4
Intermediaries
C) Debt-Equity Ratio 88.4 85.5 65.2 61.6 43.0
10
 Depth of Financial Markets in India –
Average Daily Turnover (Rs crore )
Year Money Government Foreign Equity Market Equity
Market Securities Exchange (Cash Derivative
Market Market Segment) s at NSE
1991-92 6,579 391 - 469 -
2000-01 42,657 2,802 21,198 9,308 11
2001-02 65,500 6,252 23,173 3,310 410
2002-03 76,752 7,067 24,207 3,711 1,752
2003-04 28,660 8,445 30,714 6,309 8,388
2004-05 38,528 4,826 39,952 6,556 10,107
2005-06 60,034 3,643 56,391 9,504 19,220
2006-07 88,803 4,863 83,984 11,760 29,803

 Overall capital adequacy of scheduled commercial banks the improved from 11.4
per cent in 2001 to 12.3 per cent in 2007
 The foreign exchange market remained fairly stable during the 1990s,
especially late 1998 onwards.
 RoA of Indian scheduled commercial banks recorded 0.9 % at end-March
2007; globally, the range varied from 0.2 % to 4.3 % in 2006
11
 A greater integration of various segments of the financial
market:

 Reduces arbitrage opportunities & induce market

discipline
 Achieves higher level of efficiency in market operation of
intermediaries
 Increasing efficacy of monetary policy in the economy
 Long-term Financial Stability
 Financial deepening. in the money market segment
 To transmit important policy signals
 To emerge as an international or a regional financial centre
 Correlations among Major Financial Markets
RRE Call TB 91 TB Yield CDs CPs FR 1 FR 3 FR 6 EXCH LBS
PO 364 10 ES
RREPO 1.00
Call 0.35 1.00
April 1993 TB 91 0.44 0.61 1.00
to TB 364 0.32 0.40 0.90 1.00
March 2000 Yield 10 0.04 0.46 0.57 0.49 1.00
CDs 0.30 0.32 0.45 0.41 0.38 1.00
CPs 0.39 0.54 0.81 0.75 0.57 0.71 1.00
FR 1 0.27 0.80 0.45 0.33 0.46 0.47 0.63 1.00
FR 3 0.28 0.68 0.47 0.32 0.56 0.58 0.65 0.97 1.00
FR 6 0.30 0.61 0.48 0.36 0.60 0.62 0.68 0.91 0.98 1.00
EXCH 0.03 -0.04 -0.23 -0.38 -0.06 -0.19 -0.31 -0.25 0.12 0.13 1.00
LBSES -0.37 -0.10 -0.24 -0.34 -0.05 -0.40 -0.28 -0.32 -0.28 -0.30 0.35 1.00

RREPO 1.00
Call 0.86 1.00
TB 91 0.86 0.95 1.00
TB 364 0.84 0.92 0.99 1.00
April 2000
Yield 10 0.78 0.88 0.96 0.98 1.00
to
CDs 0.78 0.90 0.94 0.93 0.93 1.00
Dec. 2006
CPs 0.81 0.90 0.96 0.94 0.92 0.95 1.00
FR 1 0.58 0.62 0.57 0.52 0.50 0.60 0.67 1.00
FR 3 0.60 0.61 0.60 0.54 0.52 0.63 0.71 0.98 1.00
FR 6 0.61 0.62 0.61 0.55 0.54 0.66 0.74 0.95 0.99 1.00
EXCH 0.29 0.20 0.14 0.08 0.04 0.24 0.28 0.60 0.66 0.70 1.00
LBSES -0.26 -0.23 -0.20 -0.15 -0.11 -0.27 -0.31 -0.57 -0.64 -0.68 -0.69 1.00
Gross Domestic Savings and Capital Formation
as a Percentage of GDP
Year Public Sector Private Household Total Total Capital
Saving Corporate Savings Savings Formation
Sector Saving
1950-51 1.8 1.0 7.7 10.4 9.3
1960-61 2.6 1.7 8.4 12.7 13.3
1970-71 2.9 1.5 11.3 15.7 14.8
1980-81 3.4 1.7 16.1 21..2 19.3
1990-91 1.0 2.8 20.5 24.3 23.2
1995-96 1.9 4.1 19.5 25.6 24.6
1999-2000 -1.00 4.4 20.8 24.1 25.2
2000-01 -1.66 4.28 21.03 23.65 24.25
2001-02 -2.04 3.73 21.78 23.47 22.85
2002-03 -0.57 4.22 22.74 26.4 25.24
2003-04 1.15 4.79 23.76 29.66 28.02
2004-05 2.38 7.14 21.58 31.12 31.54
2005-06 1.99 8.08 22.34 32.42 33.76
14
 contd.
Stronger correlation among interest rates in the more recent
period 2000-06 than the earlier period 1993- 2000

Financial Integration Resultants of Integration

 High correlation between risk free and
other liquid instruments rates
 Correlation between the reverse repo
rate and money market rates
 Correlation between long-term
government bond yield and short-term
Treasury Bills rate
 Correlation between interest rates in
money markets and three month forward
premia
 Integration of the foreign exchange
market with the money market
 Efficiency of the price discovery
process
 Enhanced effectiveness of monetary
policy transmission
 Significance of term structure of
interest rates in financial markets
 High horizontal integration
 Closer co-ordination of monetary and
external sector management.
15
 Prerequisite for the smooth and efficient functioning of
the market economy
 Instability: Monetary, Economic and Financial
 Financial Stability, Instability & Volatility?
 Financial stability does not require that all parts of the
financial system operate in most efficient manner all
the time
 Strong complementarities between financial stability
and macroeconomic stability

16
 contd.
 The importance of financial stability:

1. An imbalance of growth between the financial

sector and the real economy
2. A change in the mode of financial operations due to
financial deepening
3. Emergence of a globally integrated financial system
4. An evolution of sophisticated financial instruments
and attendant risks
5. Use of Stress testing- To quantify risk arising from
interest rate risk, credit risk and exchange rate risk

6. Helps to resolve imbalances in Financial Market,

institutions and infrastructure through self-
corrective mechanism before they precipitate a
crisis
 contd.

 Indicators of Financial Stability

 The return on total assets (RoA) of banks

 Quality of assets of banks
 The ratio of nonperforming loans (NPLs) to total
advances
 Bank capital is used as an indicator of bank
soundness
 Capital to asset ratio
 Developments in international financial markets
 Domestic liquidity conditions
 Money market conditions
 The foreign exchange market
 Financing Pattern of corporate sector
 The volatility in the stock markets
 Government cash balances/tax inflows
 contd.

Financial Sector Reforms and Financial Stability

 Assessment of financial stability conditions in India,

RBI Committee on Financial Sector Assessment
(CFSA) to look in to

 Financial stability assessment and stress testing

 Legal, infrastructural and market development issues
 Assessment of the status and progress in
implementation of international financial standards
and codes
1. Risks from Rising Oil Prices and Increasing
Inflationary Pressures
2. Rising International Interest Rates and Global
Turnaround in the Credit Cycle
3. Risks from Global Financial Imbalances
4. Risks of Asset Price Adjustments

20
 Major Initiatives are:

 Fiscal Responsibility and Budget Management Act

(FRBM)
 The Fixed Income Money Markets and Derivatives
Association (FIMMDA) of India
 Foreign Investment Promotion Board (FIPB) and Foreign
Investment Promotion Council(FIPC)
 Pension Regulatory and Development Authority
 SEBI(Ombudsman)Regulation, 2003

21
 contd.

 Securitisation and Reconstruction of Financial Assets and

Enforcement of Securities Interest (SARFAESI), Act
 Introduction of CAMELS supervisory rating system
 Replacement of the earlier FERA by the market friendly
Foreign Exchange Management Act, 1999.
 Board for Financial Supervision (BFS)
 Insurance Regulation and Development Act (IRDA),1999
 Negotiated Dealing System (NDS) and Real Time Gross
Settlement (RTGS) System
 Setting up of Clearing Corporation of India Ltd. (CCIL)
 Setting up of INFINET as the communication backbone
for the financial sector
22
 Credit and market risks have increased and financial
markets have become more volatile in the recent period

 Excessive leveraging

 The increased degree of financial market integration

across various segments of the market

 financial system is not only expanding but also

becoming increasingly complex.

23
 contd.

 The issue of valuation of complex products in the

context of a market where liquidity is insufficient to
provide reliable market prices

 To establish frameworks that encourage investors to

maintain high credit standards and strengthen risk
management systems
 There is a need to generate more objective
information on the market value of collaterals

 Recognisation of limits to marking to market certain

kinds of assets whose values are not available on a
high frequency basis.
24
 contd.

 Various market segments have become highly

integrated

 While securitisation and financial innovations have,

made markets more efficient, their role in the current
situation may have to be better understood.

 particularly from the financial stability point of view

25