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 Efficiency of the price discovery
other liquid instruments rates process
Correlation between the reverse repo Enhanced effectiveness of monetary
rate and money market rates policy transmission
Correlation between long-term Significance of term structure of
government bond yield and short-term interest rates in financial markets
Treasury Bills rate
Correlation between interest rates in High horizontal integration
money markets and three month forward
premia
Integration of the foreign exchange Closer co-ordination of monetary and
market with the money market 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
