Overview of Indian Financial System
Indian Financial System and Capital Market
The Indian financial system comprises a set of financial institutions,
financial markets and financial infrastructure. The financial institutions mainly
consist of commercial and co-operative banks, regional rural banks (RRBs), all-
India financial institutions (AIFIs) and non-banking financial companies
(NBFCs). The banking sector which forms the bedrock of the Indian financial
system, falls under the regulatory ambit of the Reserve Bank of India under the
provisions of the Banking Regulation Act, 1949 and the Reserve Bank of India
Act, 1934. The Reserve Bank also regulates select AIFIs. Consequent upon
amendments to the Reserve Bank of India (Amendment) Act in 1997, a
comprehensive regulatory framework in respect of NBFCs was put in place in
January 1997.
The financial market in India comprises the money market, the
Government securities market, the foreign exchange market and the capital
market. A holistic approach has been adopted in India towards designing and
development of a modern, robust, efficient, secure and integrated payment and
settlement system. The Reserve Bank set up the Institute for Development and
Research in Banking Technology (IDRBT) in 1996, which is an autonomous
centre for technology capacity building for banks and providing core IT services.
(The structure of Indian financial system is presented in Slide 2).
Financial Institutions
Scheduled commercial banks (SCBs) occupy a predominant position in the
financial system accounting for around three fourths of the total assets in the
financial system. While the public sector banks (PSBs), consisting of eight banks
in the State Bank group and 19 nationalised banks, constitute almost threefourths
of the total assets of SCBs, the private sector banks, 30 in number,
2
constitute less than one-fifth of the total assets. The 33 foreign banks operating in
India account for about 6-7 per cent of the assets of SCBs. The 196 RRBs play a
critical role in extending credit to the poorer sections of the rural society. The
ownership of RRBs jointly vests with the Central Government, the State
Governments and the sponsor banks. The co-operative banking system, with two
broad segments of urban and rural co-operatives, forms an integral part of the
Indian financial system. While the urban co-operative banking system has a
single tier comprising the Primary Co-operative Banks (commonly known as
ʹurban co-operative banks – UCBs), the rural co-operative credit system is
divided into long-term and short-term co-operative credit institutions which
have a multi-tier structure.
The term-lending institutions are mostly Government-owned and have
been the traditional providers of long-term project loans. Non-Banking Financial
Companies (NBFCs) encompass an extremely heterogeneous group of
intermediaries and provide a gamut of financial services. Primary Dealers (PDs)
in the Government securities market constitutes a systemically important
segment of the NBFCs. At present, there are a total of 17 PDs playing active role
in the Government securities market. A majority of them are promoted by banks.
Apart from this, India has a well-established and vibrant insurance sector within
the financial system. The Insurance Regulatory and Development Agency
(IRDA) has been established to regulate and supervise the insurance sector.
(The structure of Indian financial institutions is presented in Slide 3).
Pre-reforms Phase
Indian Financial System and Capital Market
Until the early 1990s, the role of the financial system in India was
primarily restricted to the function of channelling resources from the surplus to
deficit sectors. Whereas the financial system performed this role reasonably well,
its operations came to be marked by some serious deficiencies over the years.
The banking sector suffered from lack of competition, low capital base, low
productivity and high intermediation cost. After the nationalisation of large
banks in 1969 and 1980, the Government-owned banks dominated the banking
3
sector. The role of technology was minimal and the quality of service was not
given adequate importance. Banks also did not follow proper risk management
systems and the prudential standards were weak. All these resulted in poor asset
quality and low profitability. Among non-banking financial intermediaries,
development finance institutions (DFIs) operated in an over-protected
environment with most of the funding coming from assured sources at
concessional terms. In the insurance sector, there was little competition. The
mutual fund industry also suffered from lack of competition and was dominated
for long by one institution, viz., the Unit Trust of India. Non-banking financial
companies (NBFCs) grew rapidly, but there was no regulation of their asset side.
Financial markets were characterised by control over pricing of financial assets,
barriers to entry, high transaction costs and restrictions on movement of
funds/participants between the market segments. This apart from inhibiting the
development of the markets also affected their efficiency.
Financial Sector Reforms in India
It was in this backdrop that wide-ranging financial sector reforms in India
were introduced as an integral part of the economic reforms initiated in the early
1990s with a view to improving the macroeconomic performance of the
economy. The reforms in the financial sector focussed on creating efficient and
stable financial institutions and markets. The approach to financial sector
reforms in India was one of gradual and non-disruptive progress through a
consultative process. The Reserve Bank has been consistently working towards
setting an enabling regulatory framework with prompt and effective supervision,
development of technological and institutional infrastructure, as well as
changing the interface with the market participants through a consultative
process. Persistent efforts have been made towards adoption of international
benchmarks as appropriate to Indian conditions. While certain changes in the
legal infrastructure are yet to be effected, the developments so far have brought
the Indian financial system closer to global standards.
(The major achievements of the financial sector reforms are presented in Slide 4).
4
The reform of the interest regime constitutes an integral part of the
financial sector reform. With the onset of financial sector reforms, the interest
rate regime has been largely deregulated with a view towards better price
discovery and efficient resource allocation. Initially, steps were taken to develop
the domestic money market and freeing of the money market rates. The interest
rates offered on Government securities were progressively raised so that the
Government borrowing could be carried out at market-related rates. In respect of
banks, a major effort was undertaken to simplify the administered structure of
interest rates. Banks now have sufficient flexibility to decide their deposit and
lending rate structures and manage their assets and liabilities accordingly. At
present, apart from savings account and NRE deposit on the deposit side and
export credit and small loans on the lending side, all other interest rates are
deregulated.
Indian banking system operated for a long time with high reserve
requirements both in the form of Cash Reserve Ratio (CRR) and Statutory
Liquidity Ratio (SLR). This was a consequence of the high fiscal deficit and a
high degree of monetisation of fiscal deficit. The efforts in the recent period have
been to lower both the CRR and SLR. The statutory minimum of 25 per cent for
SLR has already been reached, and while the Reserve Bank continues to pursue
its medium-term objective of reducing the CRR to the statutory minimum level
of 3.0 per cent, the CRR of SCBs is currently placed at 5.0 per cent of NDTL.
(Interest rate deregulation is presented in Slide 5)
As part of the reforms programme, due attention has been given to diversification
of ownership leading to greater market accountability and improved efficiency. Initially,
there was infusion of capital by the Government in public sector banks, which was
followed by expanding the capital base with equity participation by the private investors.
This was followed by a reduction in the Government shareholding in public sector banks
to 51 per cent. Consequently, the share of the public sector banks in the aggregate assets
of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in
2004. With a view to enhancing efficiency and productivity through competition,
guidelines were laid down for establishment of new banks in the private sector and the
Indian Financial System and Capital Market
foreign banks have been allowed more liberal entry. Since 1993, twelve new private
sector banks have been set up. As a major step towards enhancing competition in the
banking sector, foreign direct investment in the private sector banks is now allowed up to
74 per cent, subject to conformity with the guidelines issued from time to time.
(Banking Sector: Competition and Efficiency is presented in Slide 6).
As a part of the financial sector reforms, the regulatory framework and
supervisory practices have almost converged with the best practices elsewhere in the
world. The minimum capital to risk assets ratio (CRAR) has been kept at nine per cent
which is one percentage point above the international norm; and additionally, banks are
required to maintain a separate Investment Fluctuation Reserve (IFR) out of profits,
towards interest rate risk. Impressive institutional and legal reforms have been
undertaken in relation to the banking sector. There have been a number of measures for
enhancing the transparency and disclosures standards. The regulatory framework in
India, in addition to prescribing prudential guidelines and encouraging market discipline,
is increasingly focusing on ensuring good governance through "fit and proper" owners,
directors and senior managers of the banks. Transfer of shareholding of five per cent and
above requires acknowledgement from the Reserve Bank and such significant
shareholders are put through a 'fit and proper' test. Banks have also been asked to ensure
that the nominated and elected directors are screened by a nomination committee to
satisfy `fit and proper' criteria. Directors are also required to sign a covenant indicating
their roles and responsibilities. The Reserve Bank has recently issued detailed guidelines
on ownership and governance in private sector banks emphasizing diversified ownership.
In 1994, a Board for Financial Supervision (BFS) was constituted comprising
select members of the Reserve Bank Board with a variety of professional expertise to
exercise 'undivided attention to supervision' and ensure an integrated approach to
supervision of commercial banks, development finance institutions, non-banking finance
companies, urban cooperatives banks and primary dealers. Certain amendments are being
considered by the Parliament to enhance Reserve Bank’s regulatory and supervisory
powers.
(Issues in regulation and supervision are presented in Slide 6).
Indian Financial System and Capital Market
Over the last few years, the several policy initiatives undertaken in the
form of recapitalisation of the weak RRBs, deregulation of deposits and lending
rates and relaxation to lend to non-target groups, have improved their
operational efficiency, governance and regulation and brought them almost at
par with the rural branches of commercial banks.
The co-operative banks besides suffering from the problem of multiple
supervisory authorities, also face the challenge of reconciling the democratic
character with financial discipline and modernising systems and procedures. The
Task Force on Cooperatives constituted by the Government (December 2004) has
made several suggestions for the revival of the sector to be implemented in
consultation with the State Governments. The Reserve Bank has adopted a
cautious approach regarding granting licenses for new banks and branches of
urban cooperative banks (UCBs), while focussing on consolidation within the
sector through mergers and amalgamations. In addition, initiatives have been
undertaken to gradually tighten the prudential norms for regulation and
supervision of UCBs. As a prelude to revamping the sector, a vision document
for UCBs has been released by the Reserve Bank, highlighting the importance of
a differentiated regulatory regime for the sector.
The ongoing restructuring of AIFIs is evident in the recent conversion of
Industrial Credit and Investment Corporation of India (ICICI) and Industrial
Development Bank of India (IDBI) into banks. The Board of Directors of
Industrial Finance Corporation of India (IFCI) Ltd. have approved, in principle,
the merger with a bank. In view of the deteriorating financial position of
Industrial Investment Bank of India (IIBI) Ltd., the Government has undertaken a
programme of restructuring its liabilities. Apart from Infrastructure
Development Finance Company Ltd. (IDFC), there are three refinancing
institutions viz., National Bank of Agriculture and Rural Development
(NABARD), Small Industries Development Bank of India (SIDBI) and National
Indian Financial System and Capital Market
Housing Bank (NHB), and EXIM Bank. At the State level, the State Financial
Corporations registered under the State Financial Corporations Act, 1951 and the
State Industrial Development Corporations (SIDCs) - purvey credit to
industries/sectors in different States. On balance, the development financial
institution (DFI) model has become increasingly unsustainable and AIFIs are fast
adopting the business model of a bank for long-term commercial viability.
Non-Banking Financial Companies (NBFCs) encompass an extremely
heterogeneous group of intermediaries. The main area of concern has been the
substantial growth in deposits of the Residuary Non-Banking Companies
(RNBCs), with just two companies accounting for more than 80 per cent of the
total deposits held by NBFCs. The Indian banking sector is gradually heading
towards consolidation of core competencies of different financial intermediaries,
which would engender greater economic efficiency in the form of lower
transaction cost, and greater product sophistication.
Financial System: Current Status
There has been a notable reduction in the ratio of non-performing assets
(NPAs) to advances in response to various initiatives, such as, improved risk
management practices and greater recovery efforts driven, inter alia, by the
recently enacted Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act, 2002. The financial
performance of most of the PSBs has improved in recent times as reflected in
their comfortable capital adequacy ratios and declining NPL ratios. The CRAR in
respect of all categories of banks has improved. New private sector banks have
displayed impressive performance particularly in terms of efficiency and
customer service (Table 1).
Indian Financial System and Capital Market
Table 1: Select Financial Sector Indicators: 2002-03 vis-a-vis 2003-04
Financial Indicator 2002-03 2003-04
Entity
1 2 3 4
1. a) Growth in Major Aggregates (Per cent)
Aggregate Deposits 13.4 * 17.5
Scheduled
Commercial
Banks Non-food Credit 18.6 * 18.4
Investment in Government Securities 27.3 25.1
b) Financial Indicators (as percentage of total assets)
Operating Profits 2.4 2.7
Net Profits 1.0 1.1
Spread 2.8 2.9
c) Non-Performing Assets (as percentage of advances)
Gross NPAs 8.8 7.2
Net NPAs 4.4 2.9
d) CRAR 12.7 12.9
2. a) Growth in Major Aggregates (Per cent)
Deposits 9.1 8.6
Credit 4.5 4.0
b) Financial Indicators (as percentage of total assets)@
Operating Profits 1.4 2.1
Net Profits -1.1 0.9
Spread 2.1 2.7
c) Non-Performing Assets (as percentage of advances)
Gross NPA 21.0 28.9
Scheduled
Urban
Co-operative
Banks
d) CRAR N.A. N.A.
3. All-India a) Growth in Major Aggregates (per cent)1
Financial Sanctions -31.3 65.2
Institutions Disbursements -30.5 25.9
b) Financial Indicators (as percentage of total assets) 2
Operating Profits 1.4 1.3
Net Profits 0.9 0.9
Spread 0.7 0.2
c) Non-Performing Assets (as percentage of advances) 2
Net NPA 10.6 N.A.
Indian Financial System and Capital Market
d) CRAR
i) IDBI 18.7 18.3
ii) IFCI 0.95 -17.0
iii) SIDBI 44.0 51.6
iv) NABARD 39.1 39.4
v) IDFC 51.3 36.9
4. a) Growth in Major Aggregates (per cent)
Public Deposits 6.8 —
Non-banking
Financial
Companies b) Financial Indicators (as percentage of total assets)
Net Profits 0.9 —
c) Non-Performing Assets (as percentage of advances)3
Net NPA 2.9 N.A.
CRAR 93.7#
*Adjusted for merger. @ Relates to scheduled urban co-operative banks.
# percentage of NBFCs above 30 per cent CRAR.
1. Comprise IDBI, IFCI, IIBI, IDFC, SIDBI, IVCF, ICICI Venture, TFCI, LIC, UTI, and GIC.
2. Comprise following nine FIs, viz., IDBI, IFCI, IIBI, IDFC, Exim Bank, TFCI, SIDBI, NABARD and NHB.
3. For reporting companies with variations in coverage.
Financial Markets
A major objective of reforms in the financial sector was to develop various
segments of the financial market as also eliminate segmentation across various markets
in order to smoothen the process of transmission of impulses across markets, easing the
liquidity management process and making resource allocation process more efficient
across the economy. The strategy adopted for meeting these objectives involved removal
of restrictions on pricing of assets, building the institutional structure and technological
infrastructure, introduction of new instruments, and fine-tuning of the market
microstructure. The 1990s saw the significant development of various segments of the
financial market. At the short end of the spectrum, the money market saw the emergence
of a number of new instruments such as CP and CDs and derivative products including
FRAs and IRS. Repo operations, which were introduced in the early 1990s and later
refined into a Liquidity Adjustment Facility, allow the Reserve Bank to modulate
liquidity and transmit interest rate signals to the market on a daily basis. The process of
financial market development was buttressed by the evolution of an active government
securities market after the Government borrowing programme was put through the
auction process in 1992-93. The development of a market for Government paper enabled
the Reserve Bank to modulate the monetisation of the fiscal deficit. The foreign
exchange market deepened with the opening up of the economy and the institution of a
market-based exchange rate regime in the early 1990s. Although there were occasional
Indian Financial System and Capital Market
episodes of volatility in the foreign exchange market, these were swiftly controlled by
appropriate policy measures. The capital market also underwent some metamorphic
changes during the 1990s. The development of the financial markets was well supported
by deregulation of balance sheet restrictions in respect of financial institutions, allowing
them to operate across markets. This resulted in increased integration among the various
segments of the financial markets.
Overview of Indian Capital Market
The Indian capital market is more than a century old. Its history goes back
to 1875, when 22 brokers formed the Bombay Stock Exchange (BSE). Over the
period, the Indian securities market has evolved continuously to become one of
the most dynamic, modern, and efficient securities markets in Asia. Today,
Indian market confirms to best international practices and standards both in
terms of structure and in terms of operating efficiency.
Indian securities markets are mainly governed by a) The Company’s Act
1956, b) the Securities Contracts (Regulation) Act 1956 (SCRA Act), and c) the
Securities and Exchange Board of India (SEBI) Act, 1992. A brief background of
these above regulations are given below
a) The Companies Act 1956 deals with issue, allotment and transfer of
securities and various aspects relating to company management. It
provides norms for disclosures in the public issues, regulations for
underwriting, and the issues pertaining to use of premium and discount
on various issues.
b) SCRA provides regulations for direct and indirect control of stock
exchanges with an aim to prevent undesirable transactions in securities. It
provides regulatory jurisdiction to Central Government over stock
exchanges, contracts in securities and listing of securities on stock
exchanges.
Indian Financial System and Capital Market
c) The SEBI Act empowers SEBI to protect the interest of investors in the
securities market, to promote the development of securities market and to
regulate the security market.
The Indian securities market consists of primary (new issues) as well as
secondary (stock) market in both equity and debt. The primary market provides
the channel for sale of new securities, while the secondary market deals in
trading of securities previously issued. The issuers of securities issue (create and
sell) new securities in the primary market to raise funds for investment. They do
so either through public issues or private placement. There are two major types
of issuers who issue securities. The corporate entities issue mainly debt and
equity instruments (shares, debentures, etc.), while the governments (central and
state governments) issue debt securities (dated securities, treasury bills). The
secondary market enables participants who hold securities to adjust their
holdings in response to changes in their assessment of risk and return. A variant
of secondary market is the forward market, where securities are traded for future
delivery and payment in the form of futures and options. The futures and
options can be on individual stocks or basket of stocks like index. Two
exchanges, namely National Stock Exchange (NSE) and the Stock Exchange,
Mumbai (BSE) provide trading of derivatives in single stock futures, index
futures, single stock options and index options. Derivatives trading commenced
in India in June 2000 (Slide 7).
Major Reforms in the Indian Capital Market
The major reforms in the Indian capital market since the 1990s are
presented below:
As a first step to reform the capital market, the Securities and Exchange
Board of India (SEBI), which was earlier set up in April 1988 as a nonstatutory
body under an administrative arrangement, was given statutory
powers in January 1992 through an enactment of the SEBI Act, 1992 for
regulating the securities markets. Twin objectives mandated in the SEBI
Indian Financial System and Capital Market
Act are investor protection and orderly development of the capital
market.
The most significant development in the primary capital market has been
the introduction of free pricing. The issuers of securities are now allowed
to raise the capital from the market without requiring any consent from
any authority either for making the issue or for pricing it. However, the
issue of capital has been brought under SEBI’s purview in that issuers are
required to meet the SEBI guidelines for Disclosure and Investor
Protection, which, in general, cover the eligibility norms for making issues
of capital (both public and rights) at par and at a premium by various
types of companies, reservation in issues, etc.
The abolition of capital issues control and the freeing of the pricing of
issues led to unprecedented upsurge of activity in the primary capital
market as the corporates mobilised huge resources. It, inter alia, exposed
certain inadequacies of the regulations. Therefore, without seeking to
control the freedom of the issuers to enter the market and freely price
their issues, the SEBI further strengthened the norms for public issues in
April 1996. Alongside, SEBI raised the standards of disclosure in public
issues to enhance their transparency for improving the levels of investor
protection. Issuers of capital are now required to disclose information on
various aspects, such as, track record of profitability, risk factors, etc.
Issuers now also have the option of raising resources through fixed price
floatations or the book building process.
Trading infrastructure in the stock exchanges has been modernised by
replacing the open outcry system with on-line screen based electronic
trading, unlike several of the developed countries where the two systems
still continue to exist on the same exchange. In all, 23 stock exchanges in
India have approximately 8,000 trading terminals spread all over the
country. This improved the liquidity of the Indian capital market and a
better price discovery.
Indian Financial System and Capital Market
The trading and settlement cycles were initially shortened from 14 days to
7 days. Subsequently, to further enhance the efficiency of the secondary
market, rolling settlement was introduced on a T+5 basis. With effect from
April 1, 2002, the settlement cycle was further shortened to T+3 for all
listed securities. The settlement cycle is now T+2.
All stock exchanges in the country have established clearing houses.
Consequently, all transactions are settled through the clearing house only
and not directly between members, as was practiced earlier.
Several measures have been undertaken/strengthened to ensure the safety
and integrity of the market. These are: margining system, intra-day
trading limit, exposure limit and setting up of trade/settlement guarantee
fund.
Securities, which were earlier held in physical form, have been
demateralised and their transfer is done through electronic book entry,
which has eliminated some of the disadvantages of securities held in
physical form. There are two depositories operating in the country.
In India, all listed companies are now required to furnish to the stock
exchanges and also publish unaudited financial results on a quarterly
basis. To enhance the level of continuous disclosure by the listed
companies, the SEBI decided to amend the Listing Agreement to
incorporate the Segment Reporting, Accounting for Taxes on Income,
Consolidated Financial Results, Consolidated Financial Statements,
Related Party Disclosures and Compliance with Accounting Standards.
The Indian capital market is also increasingly integrating with the
international capital markets. One of the significant steps towards
integrating Indian capital market with the international capital markets
was the permission given to Foreign Institutional Investors (FIIs) such as,
mutual funds, pension funds and country funds to operate in the Indian
markets. Indian firms have also been allowed to operate in the Indian
markets. Indian firms have also been allowed to raise capital from
Indian Financial System and Capital Market
international capital markets through issues of Global Depository Receipts
(GDRs), American Depository Receipts (ADRs), Euro Convertible Bonds
(ECBs), etc.
Boards of various stock exchanges, which in the past included mainly
brokers, have been broad-based in order to make them more widely
representative so that they represent different interests and not just the
interests of their members. Reconstituted Governing Boards have now
broker and non-broker representation in the ratio of 50-50 apart from the
Executive Director who has a seat on the Board and is required to be a
non-broker professional. To remove the influence of brokers in the
functioning of stock exchanges, the SEBI decided that no broker member
of the stock exchange shall be an office bearer of an exchange or hold the
position of President, Vice President, Treasurer, etc. Efforts are afoot to
demutualise and corporatise the stock exchanges.
Apart from stock exchanges, various intermediaries, such as mutual
funds, stock brokers and sub-brokers merchant bankers, portfolio
managers, registrars to an issue and share transfer agents, underwriters,
debenture trustees, bankers to an issue, custodian of securities, venture
capital funds and issuers have been brought under the SEBI’s regulatory
purview.
There are now regulations in place governing substantial acquisition of
shares and takeovers of companies. The Regulations are aimed at making
the takeover process more transparent and to protect the interests of
minority shareholders.
Trading in derivative products, such as stock index future, stock index
options and futures and options in individual stocks have also been
introduced.
(The major reforms in Indian capital market are presented in Slide 8-11)
Indian Financial System and Capital Market
Foreign Institutional Investment in India
The liberalisation and consequent reform measures have drawn the
attention of foreign investors leading to a rise in portfolio investment in the
Indian capital market. Over the recent years, India has emerged as a major
recipient of portfolio investment among the emerging market economies. Apart
from such large inflows, reflecting the confidence of cross-border investors on
the prospects of Indian securities market, except for one year, India received
positive portfolio inflows in each year. The stability of portfolio flows towards
India is in contrast with large volatility of portfolio flows in most emerging
market economies.
The Indian capital market was opened up for foreign institutional
investors (FIIs) in 1992. The FIIs started investing in Indian markets in January
1993. The Indian corporate sector has been allowed to tap international capital
markets through American Depository Receipts (ADRs), Global Depository
Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External
Commercial Borrowings (ECBs). Similarly, non-resident Indians (NRIs) have
been allowed to invest in Indian companies. FIIs have been permitted in all types
of securities including Government securities and they enjoy full capital
convertibility. Mutual funds have been allowed to open offshore funds to invest
in equities abroad.
FII investment in India started in 1993, as FIIs were allowed to invest in
the Indian debt and equity market in line with the recommendations of the High
Level Committee on Balance of Payments. These investment inflows have since
then been positive, with the exception of 1998-99, when capital flows to emerging
market economies were affected by contagion from the East Asian crisis. These
investments account for over 10 per cent of the total market capitalisation of the
Indian stock market.
Limits on Foreign Institutional Investors
Each FII (investing on its own) or sub-account cannot hold more than 10
per cent of the paid-up capital of a company. A sub-account under the
Indian Financial System and Capital Market
foreign corporate/individual category cannot hold more than 5 per cent of
the paid up capital of the company.
The maximum permissible investment in the shares of a company, jointly
by all FIIs together is 24 per cent of the paid-up capital of that company.
The limit is 20 per cent of the paid-up capital in the case of public sector
banks. The ceiling of 24 per cent for FII investment can be raised up to
sectoral cap/statutory ceiling, subject to the approval of the board and the
general body of the company passing a special resolution to that effect.
A cap of US $1.75 billion is applicable to FII investment in dated
Government securities and treasury bills under 100 per cent and the 70:30
route. Within this ceiling of US $1.75 billion, a sub-ceiling of US $200
million is applicable for the 70:30 route. (FIIs are required to allocate their
investment between equity and debt instruments in the ratio of 70:30.
However, it is also possible for an FII to declare itself a 100 per cent debt
FII in which case it can make its entire investment in debt instruments.)
A cumulative sub-ceiling of US $500 million outstanding has been fixed
on FII investments in corporate debt and this is over and above the subceiling
of US $1.75 billion for Government debt.
(The limits on FII investments and trends in FII investments in India are presented in
Slide 12-13)
Growth of Indian Capital Market
The Indian equity market has developed tremendously since the 1990s.
The market has grown exponentially in terms of resource mobilisation, number
of listed stocks, market capitalisation, trading volumes, turnover and investors’
base. Along with this growth, the profiles of the investors, issuers and
intermediaries have changed significantly. The market has witnessed a
fundamental institutional change resulting in drastic reduction in transaction
costs and significant improvement in efficiency, transparency and safety. In the
1990s, reform measures initiated by the SEBI such as, market determined
allocation of resources, rolling settlement, sophisticated risk management and
Indian Financial System and Capital Market
derivatives trading have greatly improved the framework and efficiency of
trading and settlement. Almost all equity settlements take place at two
depositories. As a result, the Indian capital market has become qualitatively
comparable to many developed markets.
There are 23 stock exchanges in the country with 9413 listed companies as
at end-December 2004. The market capitalization of BSE has grown over the
period and is estimated at Rs.16,860 billion as at end-December 2004. (Slide 14).
(The comparative picture of Indian capital market with select country groups is
presented in Slide 15)
Latest Trends in Indian Stock Markets
Indian stock markets are currently trading at all-time high levels. The BSE
Sensex (a BSE index comprising 30 large-cap companies with Base: 1978-79=100)
closed at all-time high level of 7859.53 on August 17, 2005. On a point-to-point
basis, the BSE Sensex has gained 21.05 per cent during the current financial year
so far (up to August 17, 2005). The rally has been supported by strong investment
by the FIIs, satisfactory progress of monsoon, firm trends in the international
markets and satisfactory financial results by the corporates for Q1 2005-06.
The market capitalization of BSE increased by 24.3 per cent to Rs.21,112
billion (60.7 per cent of GDP) as on August 17, 2005 over the level of March 31,
2005. The market capitalization as a percentage of GDP has increased from 43.5
per cent as at end-March 2004 to 54.6 per cent as at end-March 2005 due mainly
to increase in the stock prices as well as listing of new securities.
Despite unprecedented price levels, the price-earning ratio for Indian
equities has remained attractive due to strong growth in corporate earnings. The
P/E ratio of BSE Sensex, however, is marginally higher than that in the other
emerging market economies, even though the ratio is much lower than that
witnessed in earlier stock market rallies in India.
The gains in the stock markets in the financial year so far have been
widespread among blue-chips as well as small and mid-cap stocks.
Indian Financial System and Capital Market
The Indian stock markets have outperformed the other markets. On pointto-
point basis, the BSE Sensex witnessed an increase of 21.05 per cent during
current financial year so far (up to August 17, 2005) over end-March 2005, as
compared with Hong Kong (14.3 per cent), Japan (5.2 per cent), UK (8.1 per cent),
US (Dow Jones – 0.4 per cent), South Korea (15.3 per cent), Taiwan (3.9 per cent),
Indonesia (3.1 per cent), and Malaysia (6.3 per cent).
(The latest trends in Indian stock markets are presented in Slide 16)
Payment and Settlement System
In recent years, the endeavour of the Reserve Bank has been to improve
the efficiency of the financial system by ensuring safe, secure and effective
payment and settlement system. In the process, the Reserve Bank apart from
performing the regulatory and oversight functions has also played an important
role in promoting its functionality and modernisation on an on-going basis. The
consolidation of the existing payment systems revolves around strengthening
computerised cheque clearing, expanding the reach of Electronic Clearing
Services (ECS) and Electronic Funds Transfer (EFT). The critical elements of the
developmental strategy are opening of new clearing houses, interconnection of
clearing houses through the Indian Financial Network (INFINET); development
of Real Time Gross Settlement (RTGS) System, Centralised Funds Management
System (CFMS), Negotiated Dealing System (NDS) and the Structured Financial
Messaging System (SFMS). Similarly, integration of the various payment
products with the systems of individual banks has been another thrust area. A
Board for Regulation and Supervision of Payment and Settlement Systems
(BPSS) has also been recently constituted to prescribe policies relating to the
regulation and supervision of all types of payment and settlement systems, set
standards for existing and future systems, authorise the payment and settlement
systems and determine criteria for membership to these systems.
(Issues in payment and settlement system are presented in Slide 17)
Indian Financial System and Capital Market
The Indian Financial Sector: Some Issues
The Indian financial system has undergone structural transformation over
the past decade. The financial sector has acquired strength, efficiency and
stability by the combined effect of competition, regulatory measures, and policy
environment. While competition, consolidation and convergence have been
recognised as the key drivers of the banking sector in the coming years,
consolidation of the domestic banking system in both public and private sectors
is being combined with gradual enhancement of the presence of foreign banks in
a calibrated manner. There has been improvement in banks’ capital position and
asset quality as reflected in the overall increase in their capital adequacy ratio
and declining NPLs, respectively. Significant improvement in various
parameters of efficiency, especially intermediation costs, suggest that
competition in the banking industry has intensified. The efficiency of various
segments of the financial system also increased.
The major challenges facing the banking sector are the judicious
deployment of funds and the management of revenues and costs. Concurrently,
the issues of corporate governance and appropriate disclosures for enhancing
market discipline have received increased attention for ensuring transparency
and greater accountability. Financial sector supervision is increasingly becoming
risk based with the emphasis on quality of risk management and adequacy of
risk containment. Consolidation, competition and risk management are no doubt
critical to the future of Indian banking, but governance and financial inclusion
have also emerged as the key issues for the Indian financial system.
(Issues facing the banking sector are presented in Slide 18).
The capital market in India has become efficient and modern over the
years. It has also become much safer. However, some of the issues would need
to be addressed. Corporate governance needs to be strengthened. Retail
investors continue to remain away from the market. The private corporate debt
market continues to lag behind the equity segment.
Indian Financial System and Capital Market
The Indian financial system comprises a set of financial institutions,
financial markets and financial infrastructure. The financial institutions mainly
consist of commercial and co-operative banks, regional rural banks (RRBs), all-
India financial institutions (AIFIs) and non-banking financial companies
(NBFCs). The banking sector which forms the bedrock of the Indian financial
system, falls under the regulatory ambit of the Reserve Bank of India under the
provisions of the Banking Regulation Act, 1949 and the Reserve Bank of India
Act, 1934. The Reserve Bank also regulates select AIFIs. Consequent upon
amendments to the Reserve Bank of India (Amendment) Act in 1997, a
comprehensive regulatory framework in respect of NBFCs was put in place in
January 1997.
The financial market in India comprises the money market, the
Government securities market, the foreign exchange market and the capital
market. A holistic approach has been adopted in India towards designing and
development of a modern, robust, efficient, secure and integrated payment and
settlement system. The Reserve Bank set up the Institute for Development and
Research in Banking Technology (IDRBT) in 1996, which is an autonomous
centre for technology capacity building for banks and providing core IT services.
(The structure of Indian financial system is presented in Slide 2).
Financial Institutions
Scheduled commercial banks (SCBs) occupy a predominant position in the
financial system accounting for around three fourths of the total assets in the
financial system. While the public sector banks (PSBs), consisting of eight banks
in the State Bank group and 19 nationalised banks, constitute almost threefourths
of the total assets of SCBs, the private sector banks, 30 in number,
2
constitute less than one-fifth of the total assets. The 33 foreign banks operating in
India account for about 6-7 per cent of the assets of SCBs. The 196 RRBs play a
critical role in extending credit to the poorer sections of the rural society. The
ownership of RRBs jointly vests with the Central Government, the State
Governments and the sponsor banks. The co-operative banking system, with two
broad segments of urban and rural co-operatives, forms an integral part of the
Indian financial system. While the urban co-operative banking system has a
single tier comprising the Primary Co-operative Banks (commonly known as
ʹurban co-operative banks – UCBs), the rural co-operative credit system is
divided into long-term and short-term co-operative credit institutions which
have a multi-tier structure.
The term-lending institutions are mostly Government-owned and have
been the traditional providers of long-term project loans. Non-Banking Financial
Companies (NBFCs) encompass an extremely heterogeneous group of
intermediaries and provide a gamut of financial services. Primary Dealers (PDs)
in the Government securities market constitutes a systemically important
segment of the NBFCs. At present, there are a total of 17 PDs playing active role
in the Government securities market. A majority of them are promoted by banks.
Apart from this, India has a well-established and vibrant insurance sector within
the financial system. The Insurance Regulatory and Development Agency
(IRDA) has been established to regulate and supervise the insurance sector.
(The structure of Indian financial institutions is presented in Slide 3).
Pre-reforms Phase
Indian Financial System and Capital Market
Until the early 1990s, the role of the financial system in India was
primarily restricted to the function of channelling resources from the surplus to
deficit sectors. Whereas the financial system performed this role reasonably well,
its operations came to be marked by some serious deficiencies over the years.
The banking sector suffered from lack of competition, low capital base, low
productivity and high intermediation cost. After the nationalisation of large
banks in 1969 and 1980, the Government-owned banks dominated the banking
3
sector. The role of technology was minimal and the quality of service was not
given adequate importance. Banks also did not follow proper risk management
systems and the prudential standards were weak. All these resulted in poor asset
quality and low profitability. Among non-banking financial intermediaries,
development finance institutions (DFIs) operated in an over-protected
environment with most of the funding coming from assured sources at
concessional terms. In the insurance sector, there was little competition. The
mutual fund industry also suffered from lack of competition and was dominated
for long by one institution, viz., the Unit Trust of India. Non-banking financial
companies (NBFCs) grew rapidly, but there was no regulation of their asset side.
Financial markets were characterised by control over pricing of financial assets,
barriers to entry, high transaction costs and restrictions on movement of
funds/participants between the market segments. This apart from inhibiting the
development of the markets also affected their efficiency.
Financial Sector Reforms in India
It was in this backdrop that wide-ranging financial sector reforms in India
were introduced as an integral part of the economic reforms initiated in the early
1990s with a view to improving the macroeconomic performance of the
economy. The reforms in the financial sector focussed on creating efficient and
stable financial institutions and markets. The approach to financial sector
reforms in India was one of gradual and non-disruptive progress through a
consultative process. The Reserve Bank has been consistently working towards
setting an enabling regulatory framework with prompt and effective supervision,
development of technological and institutional infrastructure, as well as
changing the interface with the market participants through a consultative
process. Persistent efforts have been made towards adoption of international
benchmarks as appropriate to Indian conditions. While certain changes in the
legal infrastructure are yet to be effected, the developments so far have brought
the Indian financial system closer to global standards.
(The major achievements of the financial sector reforms are presented in Slide 4).
4
The reform of the interest regime constitutes an integral part of the
financial sector reform. With the onset of financial sector reforms, the interest
rate regime has been largely deregulated with a view towards better price
discovery and efficient resource allocation. Initially, steps were taken to develop
the domestic money market and freeing of the money market rates. The interest
rates offered on Government securities were progressively raised so that the
Government borrowing could be carried out at market-related rates. In respect of
banks, a major effort was undertaken to simplify the administered structure of
interest rates. Banks now have sufficient flexibility to decide their deposit and
lending rate structures and manage their assets and liabilities accordingly. At
present, apart from savings account and NRE deposit on the deposit side and
export credit and small loans on the lending side, all other interest rates are
deregulated.
Indian banking system operated for a long time with high reserve
requirements both in the form of Cash Reserve Ratio (CRR) and Statutory
Liquidity Ratio (SLR). This was a consequence of the high fiscal deficit and a
high degree of monetisation of fiscal deficit. The efforts in the recent period have
been to lower both the CRR and SLR. The statutory minimum of 25 per cent for
SLR has already been reached, and while the Reserve Bank continues to pursue
its medium-term objective of reducing the CRR to the statutory minimum level
of 3.0 per cent, the CRR of SCBs is currently placed at 5.0 per cent of NDTL.
(Interest rate deregulation is presented in Slide 5)
As part of the reforms programme, due attention has been given to diversification
of ownership leading to greater market accountability and improved efficiency. Initially,
there was infusion of capital by the Government in public sector banks, which was
followed by expanding the capital base with equity participation by the private investors.
This was followed by a reduction in the Government shareholding in public sector banks
to 51 per cent. Consequently, the share of the public sector banks in the aggregate assets
of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in
2004. With a view to enhancing efficiency and productivity through competition,
guidelines were laid down for establishment of new banks in the private sector and the
Indian Financial System and Capital Market
foreign banks have been allowed more liberal entry. Since 1993, twelve new private
sector banks have been set up. As a major step towards enhancing competition in the
banking sector, foreign direct investment in the private sector banks is now allowed up to
74 per cent, subject to conformity with the guidelines issued from time to time.
(Banking Sector: Competition and Efficiency is presented in Slide 6).
As a part of the financial sector reforms, the regulatory framework and
supervisory practices have almost converged with the best practices elsewhere in the
world. The minimum capital to risk assets ratio (CRAR) has been kept at nine per cent
which is one percentage point above the international norm; and additionally, banks are
required to maintain a separate Investment Fluctuation Reserve (IFR) out of profits,
towards interest rate risk. Impressive institutional and legal reforms have been
undertaken in relation to the banking sector. There have been a number of measures for
enhancing the transparency and disclosures standards. The regulatory framework in
India, in addition to prescribing prudential guidelines and encouraging market discipline,
is increasingly focusing on ensuring good governance through "fit and proper" owners,
directors and senior managers of the banks. Transfer of shareholding of five per cent and
above requires acknowledgement from the Reserve Bank and such significant
shareholders are put through a 'fit and proper' test. Banks have also been asked to ensure
that the nominated and elected directors are screened by a nomination committee to
satisfy `fit and proper' criteria. Directors are also required to sign a covenant indicating
their roles and responsibilities. The Reserve Bank has recently issued detailed guidelines
on ownership and governance in private sector banks emphasizing diversified ownership.
In 1994, a Board for Financial Supervision (BFS) was constituted comprising
select members of the Reserve Bank Board with a variety of professional expertise to
exercise 'undivided attention to supervision' and ensure an integrated approach to
supervision of commercial banks, development finance institutions, non-banking finance
companies, urban cooperatives banks and primary dealers. Certain amendments are being
considered by the Parliament to enhance Reserve Bank’s regulatory and supervisory
powers.
(Issues in regulation and supervision are presented in Slide 6).
Indian Financial System and Capital Market
Over the last few years, the several policy initiatives undertaken in the
form of recapitalisation of the weak RRBs, deregulation of deposits and lending
rates and relaxation to lend to non-target groups, have improved their
operational efficiency, governance and regulation and brought them almost at
par with the rural branches of commercial banks.
The co-operative banks besides suffering from the problem of multiple
supervisory authorities, also face the challenge of reconciling the democratic
character with financial discipline and modernising systems and procedures. The
Task Force on Cooperatives constituted by the Government (December 2004) has
made several suggestions for the revival of the sector to be implemented in
consultation with the State Governments. The Reserve Bank has adopted a
cautious approach regarding granting licenses for new banks and branches of
urban cooperative banks (UCBs), while focussing on consolidation within the
sector through mergers and amalgamations. In addition, initiatives have been
undertaken to gradually tighten the prudential norms for regulation and
supervision of UCBs. As a prelude to revamping the sector, a vision document
for UCBs has been released by the Reserve Bank, highlighting the importance of
a differentiated regulatory regime for the sector.
The ongoing restructuring of AIFIs is evident in the recent conversion of
Industrial Credit and Investment Corporation of India (ICICI) and Industrial
Development Bank of India (IDBI) into banks. The Board of Directors of
Industrial Finance Corporation of India (IFCI) Ltd. have approved, in principle,
the merger with a bank. In view of the deteriorating financial position of
Industrial Investment Bank of India (IIBI) Ltd., the Government has undertaken a
programme of restructuring its liabilities. Apart from Infrastructure
Development Finance Company Ltd. (IDFC), there are three refinancing
institutions viz., National Bank of Agriculture and Rural Development
(NABARD), Small Industries Development Bank of India (SIDBI) and National
Indian Financial System and Capital Market
Housing Bank (NHB), and EXIM Bank. At the State level, the State Financial
Corporations registered under the State Financial Corporations Act, 1951 and the
State Industrial Development Corporations (SIDCs) - purvey credit to
industries/sectors in different States. On balance, the development financial
institution (DFI) model has become increasingly unsustainable and AIFIs are fast
adopting the business model of a bank for long-term commercial viability.
Non-Banking Financial Companies (NBFCs) encompass an extremely
heterogeneous group of intermediaries. The main area of concern has been the
substantial growth in deposits of the Residuary Non-Banking Companies
(RNBCs), with just two companies accounting for more than 80 per cent of the
total deposits held by NBFCs. The Indian banking sector is gradually heading
towards consolidation of core competencies of different financial intermediaries,
which would engender greater economic efficiency in the form of lower
transaction cost, and greater product sophistication.
Financial System: Current Status
There has been a notable reduction in the ratio of non-performing assets
(NPAs) to advances in response to various initiatives, such as, improved risk
management practices and greater recovery efforts driven, inter alia, by the
recently enacted Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act, 2002. The financial
performance of most of the PSBs has improved in recent times as reflected in
their comfortable capital adequacy ratios and declining NPL ratios. The CRAR in
respect of all categories of banks has improved. New private sector banks have
displayed impressive performance particularly in terms of efficiency and
customer service (Table 1).
Indian Financial System and Capital Market
Table 1: Select Financial Sector Indicators: 2002-03 vis-a-vis 2003-04
Financial Indicator 2002-03 2003-04
Entity
1 2 3 4
1. a) Growth in Major Aggregates (Per cent)
Aggregate Deposits 13.4 * 17.5
Scheduled
Commercial
Banks Non-food Credit 18.6 * 18.4
Investment in Government Securities 27.3 25.1
b) Financial Indicators (as percentage of total assets)
Operating Profits 2.4 2.7
Net Profits 1.0 1.1
Spread 2.8 2.9
c) Non-Performing Assets (as percentage of advances)
Gross NPAs 8.8 7.2
Net NPAs 4.4 2.9
d) CRAR 12.7 12.9
2. a) Growth in Major Aggregates (Per cent)
Deposits 9.1 8.6
Credit 4.5 4.0
b) Financial Indicators (as percentage of total assets)@
Operating Profits 1.4 2.1
Net Profits -1.1 0.9
Spread 2.1 2.7
c) Non-Performing Assets (as percentage of advances)
Gross NPA 21.0 28.9
Scheduled
Urban
Co-operative
Banks
d) CRAR N.A. N.A.
3. All-India a) Growth in Major Aggregates (per cent)1
Financial Sanctions -31.3 65.2
Institutions Disbursements -30.5 25.9
b) Financial Indicators (as percentage of total assets) 2
Operating Profits 1.4 1.3
Net Profits 0.9 0.9
Spread 0.7 0.2
c) Non-Performing Assets (as percentage of advances) 2
Net NPA 10.6 N.A.
Indian Financial System and Capital Market
d) CRAR
i) IDBI 18.7 18.3
ii) IFCI 0.95 -17.0
iii) SIDBI 44.0 51.6
iv) NABARD 39.1 39.4
v) IDFC 51.3 36.9
4. a) Growth in Major Aggregates (per cent)
Public Deposits 6.8 —
Non-banking
Financial
Companies b) Financial Indicators (as percentage of total assets)
Net Profits 0.9 —
c) Non-Performing Assets (as percentage of advances)3
Net NPA 2.9 N.A.
CRAR 93.7#
*Adjusted for merger. @ Relates to scheduled urban co-operative banks.
# percentage of NBFCs above 30 per cent CRAR.
1. Comprise IDBI, IFCI, IIBI, IDFC, SIDBI, IVCF, ICICI Venture, TFCI, LIC, UTI, and GIC.
2. Comprise following nine FIs, viz., IDBI, IFCI, IIBI, IDFC, Exim Bank, TFCI, SIDBI, NABARD and NHB.
3. For reporting companies with variations in coverage.
Financial Markets
A major objective of reforms in the financial sector was to develop various
segments of the financial market as also eliminate segmentation across various markets
in order to smoothen the process of transmission of impulses across markets, easing the
liquidity management process and making resource allocation process more efficient
across the economy. The strategy adopted for meeting these objectives involved removal
of restrictions on pricing of assets, building the institutional structure and technological
infrastructure, introduction of new instruments, and fine-tuning of the market
microstructure. The 1990s saw the significant development of various segments of the
financial market. At the short end of the spectrum, the money market saw the emergence
of a number of new instruments such as CP and CDs and derivative products including
FRAs and IRS. Repo operations, which were introduced in the early 1990s and later
refined into a Liquidity Adjustment Facility, allow the Reserve Bank to modulate
liquidity and transmit interest rate signals to the market on a daily basis. The process of
financial market development was buttressed by the evolution of an active government
securities market after the Government borrowing programme was put through the
auction process in 1992-93. The development of a market for Government paper enabled
the Reserve Bank to modulate the monetisation of the fiscal deficit. The foreign
exchange market deepened with the opening up of the economy and the institution of a
market-based exchange rate regime in the early 1990s. Although there were occasional
Indian Financial System and Capital Market
episodes of volatility in the foreign exchange market, these were swiftly controlled by
appropriate policy measures. The capital market also underwent some metamorphic
changes during the 1990s. The development of the financial markets was well supported
by deregulation of balance sheet restrictions in respect of financial institutions, allowing
them to operate across markets. This resulted in increased integration among the various
segments of the financial markets.
Overview of Indian Capital Market
The Indian capital market is more than a century old. Its history goes back
to 1875, when 22 brokers formed the Bombay Stock Exchange (BSE). Over the
period, the Indian securities market has evolved continuously to become one of
the most dynamic, modern, and efficient securities markets in Asia. Today,
Indian market confirms to best international practices and standards both in
terms of structure and in terms of operating efficiency.
Indian securities markets are mainly governed by a) The Company’s Act
1956, b) the Securities Contracts (Regulation) Act 1956 (SCRA Act), and c) the
Securities and Exchange Board of India (SEBI) Act, 1992. A brief background of
these above regulations are given below
a) The Companies Act 1956 deals with issue, allotment and transfer of
securities and various aspects relating to company management. It
provides norms for disclosures in the public issues, regulations for
underwriting, and the issues pertaining to use of premium and discount
on various issues.
b) SCRA provides regulations for direct and indirect control of stock
exchanges with an aim to prevent undesirable transactions in securities. It
provides regulatory jurisdiction to Central Government over stock
exchanges, contracts in securities and listing of securities on stock
exchanges.
Indian Financial System and Capital Market
c) The SEBI Act empowers SEBI to protect the interest of investors in the
securities market, to promote the development of securities market and to
regulate the security market.
The Indian securities market consists of primary (new issues) as well as
secondary (stock) market in both equity and debt. The primary market provides
the channel for sale of new securities, while the secondary market deals in
trading of securities previously issued. The issuers of securities issue (create and
sell) new securities in the primary market to raise funds for investment. They do
so either through public issues or private placement. There are two major types
of issuers who issue securities. The corporate entities issue mainly debt and
equity instruments (shares, debentures, etc.), while the governments (central and
state governments) issue debt securities (dated securities, treasury bills). The
secondary market enables participants who hold securities to adjust their
holdings in response to changes in their assessment of risk and return. A variant
of secondary market is the forward market, where securities are traded for future
delivery and payment in the form of futures and options. The futures and
options can be on individual stocks or basket of stocks like index. Two
exchanges, namely National Stock Exchange (NSE) and the Stock Exchange,
Mumbai (BSE) provide trading of derivatives in single stock futures, index
futures, single stock options and index options. Derivatives trading commenced
in India in June 2000 (Slide 7).
Major Reforms in the Indian Capital Market
The major reforms in the Indian capital market since the 1990s are
presented below:
As a first step to reform the capital market, the Securities and Exchange
Board of India (SEBI), which was earlier set up in April 1988 as a nonstatutory
body under an administrative arrangement, was given statutory
powers in January 1992 through an enactment of the SEBI Act, 1992 for
regulating the securities markets. Twin objectives mandated in the SEBI
Indian Financial System and Capital Market
Act are investor protection and orderly development of the capital
market.
The most significant development in the primary capital market has been
the introduction of free pricing. The issuers of securities are now allowed
to raise the capital from the market without requiring any consent from
any authority either for making the issue or for pricing it. However, the
issue of capital has been brought under SEBI’s purview in that issuers are
required to meet the SEBI guidelines for Disclosure and Investor
Protection, which, in general, cover the eligibility norms for making issues
of capital (both public and rights) at par and at a premium by various
types of companies, reservation in issues, etc.
The abolition of capital issues control and the freeing of the pricing of
issues led to unprecedented upsurge of activity in the primary capital
market as the corporates mobilised huge resources. It, inter alia, exposed
certain inadequacies of the regulations. Therefore, without seeking to
control the freedom of the issuers to enter the market and freely price
their issues, the SEBI further strengthened the norms for public issues in
April 1996. Alongside, SEBI raised the standards of disclosure in public
issues to enhance their transparency for improving the levels of investor
protection. Issuers of capital are now required to disclose information on
various aspects, such as, track record of profitability, risk factors, etc.
Issuers now also have the option of raising resources through fixed price
floatations or the book building process.
Trading infrastructure in the stock exchanges has been modernised by
replacing the open outcry system with on-line screen based electronic
trading, unlike several of the developed countries where the two systems
still continue to exist on the same exchange. In all, 23 stock exchanges in
India have approximately 8,000 trading terminals spread all over the
country. This improved the liquidity of the Indian capital market and a
better price discovery.
Indian Financial System and Capital Market
The trading and settlement cycles were initially shortened from 14 days to
7 days. Subsequently, to further enhance the efficiency of the secondary
market, rolling settlement was introduced on a T+5 basis. With effect from
April 1, 2002, the settlement cycle was further shortened to T+3 for all
listed securities. The settlement cycle is now T+2.
All stock exchanges in the country have established clearing houses.
Consequently, all transactions are settled through the clearing house only
and not directly between members, as was practiced earlier.
Several measures have been undertaken/strengthened to ensure the safety
and integrity of the market. These are: margining system, intra-day
trading limit, exposure limit and setting up of trade/settlement guarantee
fund.
Securities, which were earlier held in physical form, have been
demateralised and their transfer is done through electronic book entry,
which has eliminated some of the disadvantages of securities held in
physical form. There are two depositories operating in the country.
In India, all listed companies are now required to furnish to the stock
exchanges and also publish unaudited financial results on a quarterly
basis. To enhance the level of continuous disclosure by the listed
companies, the SEBI decided to amend the Listing Agreement to
incorporate the Segment Reporting, Accounting for Taxes on Income,
Consolidated Financial Results, Consolidated Financial Statements,
Related Party Disclosures and Compliance with Accounting Standards.
The Indian capital market is also increasingly integrating with the
international capital markets. One of the significant steps towards
integrating Indian capital market with the international capital markets
was the permission given to Foreign Institutional Investors (FIIs) such as,
mutual funds, pension funds and country funds to operate in the Indian
markets. Indian firms have also been allowed to operate in the Indian
markets. Indian firms have also been allowed to raise capital from
Indian Financial System and Capital Market
international capital markets through issues of Global Depository Receipts
(GDRs), American Depository Receipts (ADRs), Euro Convertible Bonds
(ECBs), etc.
Boards of various stock exchanges, which in the past included mainly
brokers, have been broad-based in order to make them more widely
representative so that they represent different interests and not just the
interests of their members. Reconstituted Governing Boards have now
broker and non-broker representation in the ratio of 50-50 apart from the
Executive Director who has a seat on the Board and is required to be a
non-broker professional. To remove the influence of brokers in the
functioning of stock exchanges, the SEBI decided that no broker member
of the stock exchange shall be an office bearer of an exchange or hold the
position of President, Vice President, Treasurer, etc. Efforts are afoot to
demutualise and corporatise the stock exchanges.
Apart from stock exchanges, various intermediaries, such as mutual
funds, stock brokers and sub-brokers merchant bankers, portfolio
managers, registrars to an issue and share transfer agents, underwriters,
debenture trustees, bankers to an issue, custodian of securities, venture
capital funds and issuers have been brought under the SEBI’s regulatory
purview.
There are now regulations in place governing substantial acquisition of
shares and takeovers of companies. The Regulations are aimed at making
the takeover process more transparent and to protect the interests of
minority shareholders.
Trading in derivative products, such as stock index future, stock index
options and futures and options in individual stocks have also been
introduced.
(The major reforms in Indian capital market are presented in Slide 8-11)
Indian Financial System and Capital Market
Foreign Institutional Investment in India
The liberalisation and consequent reform measures have drawn the
attention of foreign investors leading to a rise in portfolio investment in the
Indian capital market. Over the recent years, India has emerged as a major
recipient of portfolio investment among the emerging market economies. Apart
from such large inflows, reflecting the confidence of cross-border investors on
the prospects of Indian securities market, except for one year, India received
positive portfolio inflows in each year. The stability of portfolio flows towards
India is in contrast with large volatility of portfolio flows in most emerging
market economies.
The Indian capital market was opened up for foreign institutional
investors (FIIs) in 1992. The FIIs started investing in Indian markets in January
1993. The Indian corporate sector has been allowed to tap international capital
markets through American Depository Receipts (ADRs), Global Depository
Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External
Commercial Borrowings (ECBs). Similarly, non-resident Indians (NRIs) have
been allowed to invest in Indian companies. FIIs have been permitted in all types
of securities including Government securities and they enjoy full capital
convertibility. Mutual funds have been allowed to open offshore funds to invest
in equities abroad.
FII investment in India started in 1993, as FIIs were allowed to invest in
the Indian debt and equity market in line with the recommendations of the High
Level Committee on Balance of Payments. These investment inflows have since
then been positive, with the exception of 1998-99, when capital flows to emerging
market economies were affected by contagion from the East Asian crisis. These
investments account for over 10 per cent of the total market capitalisation of the
Indian stock market.
Limits on Foreign Institutional Investors
Each FII (investing on its own) or sub-account cannot hold more than 10
per cent of the paid-up capital of a company. A sub-account under the
Indian Financial System and Capital Market
foreign corporate/individual category cannot hold more than 5 per cent of
the paid up capital of the company.
The maximum permissible investment in the shares of a company, jointly
by all FIIs together is 24 per cent of the paid-up capital of that company.
The limit is 20 per cent of the paid-up capital in the case of public sector
banks. The ceiling of 24 per cent for FII investment can be raised up to
sectoral cap/statutory ceiling, subject to the approval of the board and the
general body of the company passing a special resolution to that effect.
A cap of US $1.75 billion is applicable to FII investment in dated
Government securities and treasury bills under 100 per cent and the 70:30
route. Within this ceiling of US $1.75 billion, a sub-ceiling of US $200
million is applicable for the 70:30 route. (FIIs are required to allocate their
investment between equity and debt instruments in the ratio of 70:30.
However, it is also possible for an FII to declare itself a 100 per cent debt
FII in which case it can make its entire investment in debt instruments.)
A cumulative sub-ceiling of US $500 million outstanding has been fixed
on FII investments in corporate debt and this is over and above the subceiling
of US $1.75 billion for Government debt.
(The limits on FII investments and trends in FII investments in India are presented in
Slide 12-13)
Growth of Indian Capital Market
The Indian equity market has developed tremendously since the 1990s.
The market has grown exponentially in terms of resource mobilisation, number
of listed stocks, market capitalisation, trading volumes, turnover and investors’
base. Along with this growth, the profiles of the investors, issuers and
intermediaries have changed significantly. The market has witnessed a
fundamental institutional change resulting in drastic reduction in transaction
costs and significant improvement in efficiency, transparency and safety. In the
1990s, reform measures initiated by the SEBI such as, market determined
allocation of resources, rolling settlement, sophisticated risk management and
Indian Financial System and Capital Market
derivatives trading have greatly improved the framework and efficiency of
trading and settlement. Almost all equity settlements take place at two
depositories. As a result, the Indian capital market has become qualitatively
comparable to many developed markets.
There are 23 stock exchanges in the country with 9413 listed companies as
at end-December 2004. The market capitalization of BSE has grown over the
period and is estimated at Rs.16,860 billion as at end-December 2004. (Slide 14).
(The comparative picture of Indian capital market with select country groups is
presented in Slide 15)
Latest Trends in Indian Stock Markets
Indian stock markets are currently trading at all-time high levels. The BSE
Sensex (a BSE index comprising 30 large-cap companies with Base: 1978-79=100)
closed at all-time high level of 7859.53 on August 17, 2005. On a point-to-point
basis, the BSE Sensex has gained 21.05 per cent during the current financial year
so far (up to August 17, 2005). The rally has been supported by strong investment
by the FIIs, satisfactory progress of monsoon, firm trends in the international
markets and satisfactory financial results by the corporates for Q1 2005-06.
The market capitalization of BSE increased by 24.3 per cent to Rs.21,112
billion (60.7 per cent of GDP) as on August 17, 2005 over the level of March 31,
2005. The market capitalization as a percentage of GDP has increased from 43.5
per cent as at end-March 2004 to 54.6 per cent as at end-March 2005 due mainly
to increase in the stock prices as well as listing of new securities.
Despite unprecedented price levels, the price-earning ratio for Indian
equities has remained attractive due to strong growth in corporate earnings. The
P/E ratio of BSE Sensex, however, is marginally higher than that in the other
emerging market economies, even though the ratio is much lower than that
witnessed in earlier stock market rallies in India.
The gains in the stock markets in the financial year so far have been
widespread among blue-chips as well as small and mid-cap stocks.
Indian Financial System and Capital Market
The Indian stock markets have outperformed the other markets. On pointto-
point basis, the BSE Sensex witnessed an increase of 21.05 per cent during
current financial year so far (up to August 17, 2005) over end-March 2005, as
compared with Hong Kong (14.3 per cent), Japan (5.2 per cent), UK (8.1 per cent),
US (Dow Jones – 0.4 per cent), South Korea (15.3 per cent), Taiwan (3.9 per cent),
Indonesia (3.1 per cent), and Malaysia (6.3 per cent).
(The latest trends in Indian stock markets are presented in Slide 16)
Payment and Settlement System
In recent years, the endeavour of the Reserve Bank has been to improve
the efficiency of the financial system by ensuring safe, secure and effective
payment and settlement system. In the process, the Reserve Bank apart from
performing the regulatory and oversight functions has also played an important
role in promoting its functionality and modernisation on an on-going basis. The
consolidation of the existing payment systems revolves around strengthening
computerised cheque clearing, expanding the reach of Electronic Clearing
Services (ECS) and Electronic Funds Transfer (EFT). The critical elements of the
developmental strategy are opening of new clearing houses, interconnection of
clearing houses through the Indian Financial Network (INFINET); development
of Real Time Gross Settlement (RTGS) System, Centralised Funds Management
System (CFMS), Negotiated Dealing System (NDS) and the Structured Financial
Messaging System (SFMS). Similarly, integration of the various payment
products with the systems of individual banks has been another thrust area. A
Board for Regulation and Supervision of Payment and Settlement Systems
(BPSS) has also been recently constituted to prescribe policies relating to the
regulation and supervision of all types of payment and settlement systems, set
standards for existing and future systems, authorise the payment and settlement
systems and determine criteria for membership to these systems.
(Issues in payment and settlement system are presented in Slide 17)
Indian Financial System and Capital Market
The Indian Financial Sector: Some Issues
The Indian financial system has undergone structural transformation over
the past decade. The financial sector has acquired strength, efficiency and
stability by the combined effect of competition, regulatory measures, and policy
environment. While competition, consolidation and convergence have been
recognised as the key drivers of the banking sector in the coming years,
consolidation of the domestic banking system in both public and private sectors
is being combined with gradual enhancement of the presence of foreign banks in
a calibrated manner. There has been improvement in banks’ capital position and
asset quality as reflected in the overall increase in their capital adequacy ratio
and declining NPLs, respectively. Significant improvement in various
parameters of efficiency, especially intermediation costs, suggest that
competition in the banking industry has intensified. The efficiency of various
segments of the financial system also increased.
The major challenges facing the banking sector are the judicious
deployment of funds and the management of revenues and costs. Concurrently,
the issues of corporate governance and appropriate disclosures for enhancing
market discipline have received increased attention for ensuring transparency
and greater accountability. Financial sector supervision is increasingly becoming
risk based with the emphasis on quality of risk management and adequacy of
risk containment. Consolidation, competition and risk management are no doubt
critical to the future of Indian banking, but governance and financial inclusion
have also emerged as the key issues for the Indian financial system.
(Issues facing the banking sector are presented in Slide 18).
The capital market in India has become efficient and modern over the
years. It has also become much safer. However, some of the issues would need
to be addressed. Corporate governance needs to be strengthened. Retail
investors continue to remain away from the market. The private corporate debt
market continues to lag behind the equity segment.
Indian Financial System and Capital Market
