'Too much regulation can impede financial innovation'

The best way to promote excellence in any field is to honour people of excellence in that field. In any economy, the financial sector plays a critical role in the mobilization and allocation of savings.

Published: 26th August 2012 10:20 AM  |   Last Updated: 26th August 2012 01:37 PM   |  A+A-


The best way to promote excellence in any field is to honour people of excellence in that field. In any economy, the financial sector plays a critical role in the mobilization and allocation of savings. Financial instruments, institutions and markets act as a conduit for the transfer of resources and this process leads to higher savings and investments. The Indian financial system comprises of an impressive network of banks and financial institutions and a wide range of financial instruments. There is no doubt that there has been a considerable deepening of the financial system, particularly in the last two decades. The extension of financial services, more particularly banking to a large cross section of the people stands out as a significant achievement.

 The year 1991 is a landmark. The country faced an acute economic crisis triggered in part by a severe balance of payments problem. The crisis was converted into an opportunity to bring about some fundamental changes in India’s economic policy.

The reforms in the financial sector were an integral part of the liberalization process. By dismantling the administered interest rate structure, by introducing prudential norms, by recapitalizing the public sector banks, by introducing a greater element of competition and by the introduction of an organized and more rigorous regulatory and supervisory system, we have created a banking system that is more sound and safe. As a result of these reforms, the Indian banking system has emerged stronger. And this is particularly evident by the ability of the system to withstand the impact of the international financial crisis.

However, as we move ahead, there are several challenges ahead and I want to mention three of them. First, is the issue of capital inadequacy. The Indian banking system remains well capitalized. The capital adequacy ratio for all scheduled commercial banks is now estimated at 14.7%, which is well above the estimated 9%. This high ratio means that the implementation of even Basel 3 norms will not pose much difficulty at least initially. However, it needs to be noted that the capital requirements consequent upon the introduction of the Basel 3 norms as well as the growth in the demand for credit consistent with the growth rate in the economy of 8 to 9% will require fairly large amount of capital to be injected. While the private sector will have to meet these requirements by accessing the capital market, the public sector banks will require additional budgetary support. Under the present dispensation, nearly 50% of the additional capital requirement in the case of the public sector banks will have to come from the government. While several innovative suggestions have been made to raise this capital, one estimate puts the cumulative additional capital required to be provided by the government at `1.5 lakh to `1. 75 lakh for the period upto March 31, 2018. It is quite evident that the capital infusion by the government will remain large and has to be a continuous process. Otherwise the market share of public sector banks will come down.

 The second challenge relates to entry of the new banks. If the Indian banking system has to remain competitive, there should be periodic entry of new banks. A closed system can only be oligopolistic. The threat of entry should not therefore be eliminated and the central bank should lay down entry norms and also decide who satisfies the criterion of fit and proper. It must be noted that new banks take about two decades to achieve a sizeable level. Our decision on how many banks to be licensed must be based on what the economy needs not today but over the next several decades. The third challenge is on financial inclusion. Financial inclusion has social, sectoral and regional dimensions. Financial inclusion has largely been used in the context of reaching out to the bottom dociles of population in terms of provisional deposits and credit. Thus, it has an equitable growth element in it. However, as the economy grows we must take into account all the three dimensions of inclusiveness and a strong and viable banking system must take care of all the segments of the economy.

One other aspect that I would like to refer to is the relationship between innovation and regulation. The development of the financial system is crucial. However, in the wake of the recent international financial crisis some questions have been raised about whether the unfettered development of the financial markets and products is good for the economy.Financial crisis has forced us to re-evaluate the size, role and rate of growth of the financial sector.

Banking sector has taken big strides in the last two decades. A question that has been raised and has been asked increasingly is that financial sector today is inherently more volatile and vulnerable than before. The very factors that have contributed to the growth of the financial sector may well have contributed to increasing its fragility. It would be inappropriate in my view to classify all of or even most of financial innovations introduced in the last few decades as socially unproductive. We are living in a world of uncertainty. Appropriate hedging mechanisms are therefore needed. It is the function of an efficiently operating financial system to provide these instruments.

But excesses in any field have their own dangers. There is no argument that any regulatory regime needs to be restructured. This is true particularly of the developed countries. Excessive risk taking and leveraging by banks need to be discouraged.

In developing economies like India, the structure of economy is undergoing a rapid change. The financial system must be able to meet the diversifying needs of a growing economy. In this context we must actually encourage financial innovations. In the Indian context, I would cite two instances. Firstly, there is a need to encourage the emergence of a vibrant corporate debt market. Efficient debt market will not only help larger industries but also small and medium enterprises. I feel we also need institutions which will serve as market makers offering two way course. This will provide liquidity to the markets and make it attractive to the investors. Secondly, there is a need to explore innovative ways of financing infrastructure. Too little regulation may encourage financial instability but too much of it can impede financial innovations which are badly needed. Regulatory oversight of innovation is necessary but the regulatory perspective on innovation must not become too restrictive. In short, the policy makers must strike an appropriate balance between the need for financial innovation to sustain growth and the need for regulation to ensure stability. Financial innovations and regulations must go hand in hand in order to ensure growth with stability.

To conclude, the coming decade will be critical. Only if India grows between 8% to 9%, it is possible that the per capita GDP will increase from the current levels of $1,600 to $8,000-$10,000 by 2025. Only then will India transit from being a low-income country into a middle-income country.


-Sunday Standard

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