In August last year, the Planning Commission asked me to chair the Committee on Financial Sector Reforms. The members, comprising some of the finest minds in finance, law, academia and government in India were tasked with proposing the next generation of reforms for the Indian financial sector. Our draft report will be available on the web for public comment on Monday, April 7.
The Committee believes that financial sector reform is urgently needed today to improve inclusion, stability and growth. In formulating proposals to achieve these objectives, the committee has taken a comprehensive approach. An example may be useful to show why this matters. Reports on why India does not have a sizeable corporate bond market point out that many natural investors, such as banks and insurance companies, have restrictions placed on them, forcing them to invest large amounts in government securities.
Foreigners are strictly limited in how much government debt they can buy. A straightforward recommendation seems to be to remove these restrictions. But why do regulators impose them in the first place?
In part, it is because regulators know the government deficit needs funding, in part they are overly conservative because their reward structure penalises any failures on their watch far more than it penalises lost growth, and in part corporate bonds are indeed risky given weak creditor protection. So a solution needs to address issues ranging from how the government deficit will be financed, to regulator incentive structures, to fixing the credit infrastructure.
Similarly, if we wonder why foreign participation is so restricted, we have to address issues ranging from how open the capital account should be to whether the monetary framework should target the exchange rate at all. The point is that both analysis and recommendations have to ensure consistency across a number of policy areas, which this report attempts to achieve.
Also, while previous reports have focused on 'big' issues like capital account convertibility, bank privatisation and priority sector norms, our report goes further, into other areas where reforms are less controversial, but perhaps as important.
Consider the trading of warehouse receipts. With the promulgation of the Warehousing Act, 2008, warehouse receipts will become negotiable instruments, a new, reliable form of collateral in the agricultural sector, where till now there was no other security except land, which has its own infirmities.
Warehouse receipts can be in physical or electronic form and must be issued by registered warehouses. The advent of the warehouse receipt system will result in a lower cost of financing, and greater availability of financing, for agriculture. It will be a break from the focus of the last few decades on targeted lending as the primary way to energise agricultural credit. Assuming about 15-20 per cent of the annual agricultural produce is stored in warehouses, the Act has the potential to expand agricultural credit by over Rs 120,000 crore (Rs 1,200 billion).
The country needs more of such reforms. Instead of just the few big, and usually politically controversial steps, we also need to take a hundred small steps that will collectively take us very far.
As another example, credit to small and medium enterprises could be boosted enormously if the trade-receivable claims they have on large firms could be converted to electronic format, accepted by the large firms, and sold as commercial paper.
Mexico has a central agency facilitating this process, there is no reason why we could not create an environment where some institution like the National Securities Depository Ltd could do this. The controversial big issues need to be tackled on a priority basis, but progress can be made even otherwise.
This is, however, a difficult time to propose financial sector reforms in India. The near meltdown of the US financial sector seems to be proof that markets and competition do not work. This is clearly the wrong lesson to take from the debacle - else the logical conclusion would be to adopt the economic system of North Korea.
The right lesson is that markets and institutions do succumb occasionally to excesses, which is why regulators have to be vigilant. In the US, they clearly failed this time. At the same time, well-functioning competitive markets can reduce vulnerabilities - the US equity, government debt and corporate debt markets, despite being close to the epicentre of the crisis, have remained far more resilient than markets in faraway countries.
The point is that underdeveloped markets and strict regulations on participation are no guarantee that risks are contained. In fact, they may create additional sources of risk, a forewarning of which may come from recent reports of substantial losses incurred by corporations on currency bets.
As another example, a significant quantity of lending is undertaken by non-bank financial companies, some of which are growing at extremely rapid rates, free of burdens that hamper other sectors and relatively free of regulatory oversight. These entities have a very light regulatory burden because they do not take deposits.
Yet their funding could, in some cases, be short-term money from mutual funds or from deposit-taking institutions like banks, even though their assets are long-term. The mismatch between the duration of assets and the duration of funding is risky, and the risk spills over into the banking system because of its direct loan exposure to NBFCs.
The typical regulatory response is to tighten bank exposure norms. But if the NBFCs are to maintain lending and sustain economic growth, they have to find funding somewhere. NBFCs would be far more stable if they funded themselves with long-term debt from the corporate debt market.
Moreover, the market and passive investors would absorb any risk associated with the NBFCs' lending, instead of that risk being passed on to financial institutions like banks. A corporate bond market could thus be an important source of stability.
But as indicated earlier, this will require a number of ancillary reforms, some of which taken by themselves may seem to increase the potential for instability (such as opening the corporate bond market further to foreign investors).
In sum, we need both small and big reforms. There is no escaping the fact that political leadership is of essence to achieve them in the relatively benign environment today. Reforming in a crisis is similar to driving with a gun to your head - you pay more attention, but there is much greater risk of accidents. Better to do it in normal times!
This Committee believes that it is critically important to introduce new ideas (or reintroduce old ones) into the debate. India mulls over many issues far longer than some would like, but eventually takes the right step.
With apologies to Keynes, practical pieces of legislation, which seem to be exempt of any intellectual influence, are usually drawn from some long-forgotten report. Despite the current political climate, this is indeed the reason we have no doubt that this report will not be a wasted effort.
The author is a professor at the University of Chicago's Graduate School of Business
